Derivatives Workbook
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About this ebook
Derivatives Workbook offers practical instruction for students and professionals seeking additional guidance on working with derivatives instruments. Created by CFA Institute as a companion to the comprehensive Derivatives text, this book helps you practice using what you've learned through problems that mimic real-world scenarios. Working with different derivatives instruments helps you gauge how well you understand the instruments' characteristics, both shared and unique; this intimate knowledge is essential to effective portfolio management, and this book provides an expertly-designed, low-stakes environment ideal for self-assessment.
Derivatives—financial instruments that derive their value from the value of some underlying asset—have become increasingly important for effective risk management, and fundamental for creating synthetic exposures to asset classes. Whether you're a student aspiring to a career in finance, or a professional seeking a stronger skill set, this workbook is an invaluable tool for simulating the use of derivatives in everyday practice.
- Work more effectively with different types of derivative instruments
- Master the valuation of forward, future, options, and swap contracts
- Utilize options for risk management and portfolio optimization
- Explore the practical aspects of working within the derivatives markets
As in other security markets, arbitrage and market efficiency play a critical role in derivative pricing. The experts at CFA Institute recognize the need for realistic, practical derivatives training that translates well into real-world practice; this workbook fills the gap with a wealth of practice problems that have value to both aspiring and practicing investment professionals. Derivatives Workbook provides authoritative training and comprehensive practical instruction on derivative instruments, their markets, and valuation.
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Derivatives Workbook - Wendy L. Pirie
CFA Institute is the premier association for investment professionals around the world, with over 142,000 members in 159 countries. Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst¯ Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice. Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.
DERIVATIVES
WORKBOOK
Wendy L. Pirie, CFA
Wiley LogoCover image: © AvDe/Shutterstock
Cover design: Wiley
Copyright © 2017 by CFA Institute. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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ISBN 9781119381839 (Paperback)
ISBN 9781119381907 (ePDF)
ISBN 9781119381785 (ePub)
CONTENTS
PART I LEARNING OBJECTIVES, SUMMARY OVERVIEW, AND PROBLEMS
CHAPTER 1 DERIVATIVE MARKETS AND INSTRUMENTS
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 2 BASICS OF DERIVATIVE PRICING AND VALUATION
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 3 PRICING AND VALUATION OF FORWARD COMMITMENTS
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 4 VALUATION OF CONTINGENT CLAIMS
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 5 DERIVATIVES STRATEGIES
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 6 RISK MANAGEMENT
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 7 RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES STRATEGIES
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 8 RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
CHAPTER 9 RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES
LEARNING OUTCOMES
SUMMARY OVERVIEW
PROBLEMS
PART II SOLUTIONS
CHAPTER 1 DERIVATIVE MARKETS AND INSTRUMENTS
SOLUTIONS
CHAPTER 2 BASICS OF DERIVATIVE PRICING AND VALUATION
SOLUTIONS
CHAPTER 3 PRICING AND VALUATION OF FORWARD COMMITMENTS
SOLUTIONS
CHAPTER 4 VALUATION OF CONTINGENT CLAIMS
SOLUTIONS
CHAPTER 5 DERIVATIVES STRATEGIES
SOLUTIONS
CHAPTER 6 RISK MANAGEMENT
SOLUTIONS
CHAPTER 7 RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES STRATEGIES
SOLUTIONS
CHAPTER 8 RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES
SOLUTIONS
CHAPTER 9 RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES
SOLUTIONS
EULA
PART I
LEARNING OBJECTIVES, SUMMARY OVERVIEW, AND PROBLEMS
CHAPTER 1
DERIVATIVE MARKETS AND INSTRUMENTS
LEARNING OUTCOMES
After completing this chapter, you will be able to do the following:
define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
contrast forward commitments with contingent claims;
define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
describe purposes of, and controversies related to, derivative markets;
explain arbitrage and the role it plays in determining prices and promoting market efficiency.
SUMMARY OVERVIEW
This first reading on derivatives introduces you to the basic characteristics of derivatives, including the following points:
A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
The underlying asset, called the underlying, trades in the cash or spot markets and its price is called the cash or spot price.
Derivatives consist of two general classes: forward commitments and contingent claims.
Derivatives can be created as standardized instruments on derivatives exchanges or as customized instruments in the over-the-counter market.
Exchange-traded derivatives are standardized, highly regulated, and transparent transactions that are guaranteed against default through the clearinghouse of the derivatives exchange.
Over-the-counter derivatives are customized, flexible, and more private and less regulated than exchange-traded derivatives, but are subject to a greater risk of default.
A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a fixed price they agree upon when the contract is signed.
A futures contract is similar to a forward contract but is a standardized derivative contract created and traded on a futures exchange. In the contract, two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated. In addition, there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either a variable series determined by a different underlying asset or rate or a fixed series.
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
A call is an option that provides the right to buy the underlying.
A put is an option that provides the right to sell the underlying.
Credit derivatives are a class of derivative contracts between two parties, the credit protection buyer and the credit protection seller, in which the latter provides protection to the former against a specific credit loss.
A credit default swap is the most widely used credit derivative. It is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.
Derivatives can be combined with other derivatives or underlying assets to form hybrids.
Derivatives are issued on equities, fixed-income securities, interest rates, currencies, commodities, credit, and a variety of such diverse underlyings as weather, electricity, and disaster claims.
Derivatives facilitate the transfer of risk, enable the creation of strategies and payoffs not otherwise possible with spot assets, provide information about the spot market, offer lower transaction costs, reduce the amount of capital required, are easier than the underlyings to go short, and improve the efficiency of spot markets.
Derivatives are sometimes criticized for being a form of legalized gambling and for leading to destabilizing speculation, although these points can generally be refuted.
Derivatives are typically priced by forming a hedge involving the underlying asset and a derivative such that the combination must pay the risk-free rate and do so for only one derivative price.
Derivatives pricing relies heavily on the principle of storage, meaning the ability to hold or store the underlying asset. Storage can incur costs but can also generate cash, such as dividends and interest.
Arbitrage is the condition that two equivalent assets or derivatives or combinations of assets and derivatives sell for different prices, leading to an opportunity to buy at the low price and sell at the high price, thereby earning a risk-free profit without committing any capital.
The combined actions of arbitrageurs bring about a convergence of prices. Hence, arbitrage leads to the law of one price: Transactions that produce equivalent results must sell for equivalent prices.
PROBLEMS
A derivative is best described as a financial instrument that derives its performance by:
passing through the returns of the underlying.
replicating the performance of the underlying.
transforming the performance of the underlying.
Compared with exchange-traded derivatives, over-the-counter derivatives would most likely be described as:
standardized.
less transparent.
more transparent.
Exchange-traded derivatives are:
largely unregulated.
traded through an informal network.
guaranteed by a clearinghouse against default.
Which of the following derivatives is classified as a contingent claim?
Futures contracts
Interest rate swaps
Credit default swaps
In contrast to contingent claims, forward commitments provide the:
right to buy or sell the underlying asset in the future.
obligation to buy or sell the underlying asset in the future.
promise to provide credit protection in the event of default.
Which of the following derivatives provide payoffs that are non-linearly related to the payoffs of the underlying?
Options
Forwards
Interest rate swaps
An interest rate swap is a derivative contract in which:
two parties agree to exchange a series of cash flows.
the credit seller provides protection to the credit buyer.
the buyer has the right to purchase the underlying from the seller.
Forward commitments subject to default are:
forwards and futures.
futures and interest rate swaps.
interest rate swaps and forwards.
Which of the following derivatives is least likely to have a value of zero at initiation of the contract?
Futures
Options
Forwards
A credit derivative is a derivative contract in which the:
clearinghouse provides a credit guarantee to both the buyer and the seller.
seller provides protection to the buyer against the credit risk of a third party.
the buyer and seller provide a performance bond at initiation of the contract.
Compared with the underlying spot market, derivative markets are more likely to have:
greater liquidity.
higher transaction costs.
higher capital requirements.
Which of the following characteristics is least likely to be a benefit associated with using derivatives?
More effective management of risk
Payoffs similar to those associated with the underlying
Greater opportunities to go short compared with the spot market
Which of the following is most likely to be a destabilizing consequence of speculation using derivatives?
Increased defaults by speculators and creditors
Market price swings resulting from arbitrage activities
The creation of trading strategies that result in asymmetric performance
The law of one price is best described as:
the true fundamental value of an asset.
earning a risk-free profit without committing any capital.
two assets that will produce the same cash flows in the future must sell for equivalent prices.
Arbitrage opportunities exist when:
two identical assets or derivatives sell for different prices.