Course Content
DERIVATIVE MARKETS AND INSTRUMENTS
This chapter is covered under study session 19, reading 48 of the study material as provided by the CFA Institute. After reading this chapter, the candidate should be able to: a. define a derivative and distinguish between exchange-traded and over-the-counter derivatives; b. contrast forward commitments with contingent claims; c. define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics; d. determine the value at expiration and profit from a long or a short position in a call or put option; e. describe purposes of, and controversies related to, derivative markets; and f. explain arbitrage and the role it plays in determining prices and promoting market efficiency.
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Introduction
LOS A: Derivatives
LOS B and C: Commitments Vs. Contingent Claims
LOS D: Value at Expiration and Profit for Call and Put Options
LOS E: Purposes/ Controversies Related to Derivatives Market
LOS F: Arbitrage
BASICS OF DERIVATIVE PRICING AND VALUATION
This chapter is covered under study session 16, reading 49 of the study material as provided by the CFA institute. After reading this chapter, the candidate should be able to: a. explain how the concepts of arbitrage, replication, and risk neutrality are used in pricing derivatives; b. distinguish between value and price of forward and futures contracts; c. explain how the value and price of a forward contract are determined at expiration, during the life of the contract, and at initiation; d. describe monetary and nonmonetary benefits and costs associated with holding the underlying asset and explain how they affect the value and price of a forward contract; e. define a forward rate agreement and describe its uses; f. explain why forward and futures prices differ; g. explain how swap contracts are similar to but different from a series of forward contracts; h. distinguish between the value and price of swaps; i. explain how the value of a European option is determined at expiration; j. explain the exercise value, time value, and moneyness of an option; k. identify the factors that determine the value of an option and explain how each factor affects the value of an option; l. explain put–call parity for European options; m. explain put–call–forward parity for European options; n. explain how the value of an option is determined using a one-period binomial model; o. explain under which circumstances the values of European and American options differ.
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Introduction
LOS A: Pricing of Derivatives
LOS B, C, D, and E: Difference Between Value and Price of Forward & Future Contract
LOS F: Forward Rate Agreement
LOS G: Reasons for Differences in the Forward and Future Prices
LOS H and I: Swaps
LOS J: Option Value
LOS K: Effect on Valuation
LOS L: Put-Call Parity
LOS M: Put-Call-Forward Parity
LOS N: Binomial Model
LOS O: European Vs. American Option
Derivatives
About Lesson

a.  The major factor that affects the value of an option is the price of the underlying asset.
If S0 is the price of the underlying asset at the time 0, and ST, the price at the time T:

     i.  The value of a call is directly related to ST, and

    ii.  The value of a put is inversely related to ST

One thing that needs to be noted is that the spot price at any time, serves as an upper boundary for the call price, i.e. the call price can never exceed the spot price at that time.
Therefore,

C0 ≤ So

&

CT ≤ ST

b.  Another factor that affects the value of an option is its exercise price.
So, as an option moves towards getting more and more in-the-money from being out of money, its value keeps on increasing.
If X is the exercise price of an option:

     i.  Call option values are inversely related to X, and

    ii.  Put option values are directly related to X.

Also, the exercise price puts the upper limit on the price of a put option. Thus, the upper limits for the options are:

Option

Upper Limits

Call

ST

Put

  X/(1+r)t or Xe-rt

c.  Another factor that affects the value of an option is the risk-free rate, r. Thus:

     i.  Call option prices are directly related to the risk-free rate, and

    ii.  Put option prices are inversely related to the risk-free rate.

This brings us to the concept of put-call parity. According to this concept, the relationship between a put and a call option has the same exercise price, expiration date, and underlying stock.

d.  Time is also another that affects the value of an option.

     i.  The value of a call option is directly related to the time.

    ii.  The value of a put option is also generally related to the time but the longer the time, the lesser is the present value of the pay-off.

e.  The volatility in the prices of the underlying also increases both call and put prices

NOTE:

1.       Exercise price and the spot prices determine the intrinsic value of an option, and

2.       Time and volatility impact the time value of an option.
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