READING: DERIVATIVE MARKETS AND INSTRUMENTS

READING: BASICS OF DERIVATIVE PRICING AND VALUATION

Disclaimer: Certain materials contained within this text are the copyright property of
CFA Institute. The following is the source for these materials: “CFA® Program
Curriculum Level I Volume 5”
READING: DERIVATIVE MARKETS AND INSTRUMENTS
READING: BASICS OF DERIVATIVE PRICING AND VALUATION

 A derivative is a security that derives its value from the value or return of another asset or security. The
underlying assets can be equity, commodity and forex.

 Derivatives transform the performance of the underlying asset before paying out in the derivatives transaction.

 On the other hand, mutual funds and ETFs simply pass on the returns on their underlying securities.

 Considering the lower capital requirement, they are highly liquid in nature and have lower transaction cost.

 Derivatives are traded in two types of markets: exchanges and over-the-counter.

 Forwards, Futures
 Swaps
 Options
 Credit Derivatives
2
 Forwards
 A forward contract is an agreement between a buyer and a seller obligating the seller to deliver a specified asset
of specified quality and quantity to the buyer on a specified date at a specified place and the buyer, in turn, is
obligated to pay to the seller a pre-negotiated price in exchange of the delivery. For example:
 Consider a Punjab farmer who grows wheat and has to sell it at a profit. The simplest and the traditional way for
him is to harvest the crop in March or April and sell in the spot market then.
 However, in this way the farmer is exposing himself to risk of a downward movement in the price of wheat which
may occur by the time the crop is ready for sale.
 In order to avoid this risk, one way could be that the farmer may sell his crop at an agreed-upon rate now with a
promise to deliver the asset, i.e., crop at a pre-determined date in future. This will at least ensure to the farmer the
input cost and a reasonable profit.
 Thus, the farmer would sell wheat forward to secure himself against a possible loss in future. It is true that by this
way he is also foreclosing upon him the possibility of a bumper profit in the event of wheat prices going up steeply.
But then, more important is that the farmer has played safe and insured himself against any eventuality of closing
down his source of livelihood altogether. The transaction which the farmer has entered into is called a forward
transaction and the contract which covers such a transaction is called a forward contract.

3
Futures
 A futures contract is a forward contract that is standardized and exchange-traded.
 The agreement is completed at a specified expiration date by physical delivery or cash settlement
or offset prior to the expiration date.
 In order to initiate a trade in futures contracts, the buyer and seller must put up "good faith money"
in a margin account. Regulators, commodity exchanges and brokers doing business on commodity
exchanges determine margin levels.
 Each future exchange has a clearing house. The clearing house guarantees traders in the future
market will honor their obligations and thus, reduces counterparty risk (i.e. the risk that the
counterparty to a trade will not fulfil their obligations at settlement) from futures contract. This is
possible with the help of daily settlement and requirement of margins deposit.
 In case of futures, at the end of each day, the clearing house engages in a practice called mark to
market, also known as the daily settlement. The clearinghouse determines an average of the final
futures trades of the day (In India, the settlement price shall be calculated on the basis of last half an
hour weighted average price) and designates that price as the settlement price. All contracts are
then said to be marked to the settlement price.

4
 Futures (contd.)
 For example, if the long purchases the contract during the day at a futures price of £120 and the settlement price
at the end of the day is £122, the long’s account would be marked for a gain of £2. In other words, the long has
made a profit of £2 and that amount is credited to his account, with the money coming from the account of the
short, who has lost £2. Naturally, if the futures price decreases, the long loses money and is charged with that
loss, and the money is transferred to the account of the short.
 In the futures markets, margin is money that must be deposited by both the long and the short as a performance
guarantee prior to entering into a futures contract. This provides protection for the clearinghouse. Each day, the
margin balance in a futures account is adjusted for any gains and losses in the value of the futures position based
on the new settlement price, a process called the mark to market or marking to market. Initial margin is the
amount that must be deposited in a futures account before a trade may be made.
 Maintenance margin is the minimum amount of margin that must be maintained in a futures account. If the margin
balance in the account falls below the maintenance margin through daily settlement of gains and losses (from
changes in the futures price), additional funds must be deposited to bring the margin balance back up to the initial
margin amount.

5
Futures (contd.)
 Example: Mr. A enters into future contract to buy equity share of Company XYZ at a price of
Rs. 1,310. Assuming per lot has 100 shares. Initial margin requirement is 8%, maintenance
margin is 6% and considering the following quotations of XYZ futures in the 5 trading days:
Day Closing price
1 1,340
2 1,360
3 1,300
4 1,280
5 1,305
 You are required to calculate the daily balances in the margin account and payment on margin
calls, if any.

6
Futures (contd.)
 Solution: Initial margin = 1,310*100*8% = 10,480,
The moment margin falls below
 Maintenance margin = 1,310*100*6% = 7,860 maintenance margin, there will
Day Opening price Closing price M2M Margin call Closing balance be margin call, which is a
1 1,310 1,340 3,000 - 13,480 request to deposit additional
funds to bring the balance up to
2 1,340 1,360 2,000 - 15,480 initial margin.
3 1,360 1,300 (6,000) - 9,480
4 1,300 1,280 (2,000) 3,000 10,480
5 1,280 1,305 2,500 - 12,980
Total (500)

7
Difference between forwards and futures
Particulars Forwards Futures
Organized exchange Are traded in an OTC market Are traded on organized exchanges
Nature of contract Customised contracts Standardized contract
Counterparty risk Have counterparty risk No counterparty risk
Government regulations Are usually not regulated Government regulates futures market

 Futures are more valuable than forwards when interest rates and futures prices are positively
correlated and less valuable when they are negatively correlated.
 If interest rates are constant or uncorrelated with futures prices, the prices of futures and forwards
are the same.

8
Pricing and Valuation of Forward and Future Contracts
 No arbitrage conditions.
 Investor assumed to be risk neutral: It means an investor required rate of return is risk free
rate because we can replicate a risk-free asset from a position in the underlying asset that is
hedged with a position in a derivative security.
 F (0,T) = S0 (1+r)T

9
 Pricing and Valuation of Forward and Future Contracts (contd.)
• Example: The spot price is $100, the risk-free rate is 10 percent, and the contract is for one years. The
forward price would be F (0,1) = 100 (1+.1)1 = $110
• Case A: Let us assume forward price to be $130 (An arbitrageur will act in the following manner):
• Borrow $100 @ 10%
• Buy underlying share at $100
• Short forward at $130 (right and obligation to sell the asset after one year at $130)
• Will return $110 to the lender and earns a risk-free profit of $20 (cash and carry arbitrageur).

• Case B: Let us assume forward price to be $108 (An arbitrageur will act in the following manner):
• Short sell asset at $100
• Invest $100 @ 10%
• Long forward at $108 (right and obligation to buy the asset after one year at $108)
• Cover the short position and earns a risk-free profit of $2 (reverse cash and carry arbitrageur)

10
Pricing and Valuation of Forward and Future Contracts (contd.)
 No arbitrage forward price is $110.
 Valuations of forwards
RFR 10%
0 6m 1yr

S0 = 100 S6m = 120

F0 (T) = 110

V0 (T) = 0 V6m (T) = 120 - = 15.12

( . ) .

11
Pricing and Valuation of Forward and Future Contracts (contd.)
• When the forward is priced at its no-arbitrage price the value of the forward at initiation: V0 (T) =
( )
S0 - =0
( )

• During its life, at time t < T, the value of the forward contract is the spot price of the asset minus
( )
the present value of the forward price, Vt (T) = St - ( )

• At expiration at time T, the discounting term is (1 + Rf)0 = 1 and the payoff to a long forward is ST
– F0(T), the difference between the spot price of the asset at expiration and the price of the
forward contract.
Particulars t=0 t<T t=T
( ) ( )
Valuation of forwards S0 - = 0 St - ST – F0(T)
( ) ( )

12
 Pricing and Valuation of Forward and Future Contracts (contd.)
• Monetary and nonmonetary benefits and costs associated with holding the underlying asset

Cost Benefits
Storage cost Dividend payment
Insurance cost Interest payment
Opportunity cost of the funds Convenience yield
• The net cost of holding an asset, considering both the costs and benefits of holding the asset, is referred to as the cost
of carry.

• If an asset has both storage costs and benefits from holding the asset over the life of the forward
contract, the no-arbitrage forward price (that will produce a value of zero for the forward at initiation):
[S0 + PV0 (cost) – PV0 (benefit)] (1 + R )T = F0(T)
• Both the present values of the costs of holding the asset and the benefits of holding the asset decrease
as time passes and the time to expiration (T – t) decreases, so the value of the forward at any point in
time t < T is

13
Pricing and Valuation of Forward and Future Contracts (contd.)
• At expiration t = T the costs and benefits of holding the asset until expiration are zero, as is T
– t, so that the payoff on a long forward position at time T is, again, simply ST – F0(T), the
difference between the spot price of the asset at expiration and the forward price.
• The difference between the prevailing spot price of an asset and the futures price is known
as the basis, i.e., Basis = Spot price - Futures price
• In a normal market, the spot price is less than the futures price (which includes the full cost-
of• carry) and accordingly the basis would be negative. Such a market, in which the basis is
decided solely by the cost-of-carry is known as a contango market.
• Basis can become positive, i.e., the spot price can exceed the futures price only if there are
factors other than the cost of carry to influence the futures price. In case this happens, then
basis becomes positive and the market under such circumstances is termed as a
backwardation market or inverted market.

14
Additional questions – not in syllabus
Consider a 3-month forward contract on a share that is currently quoted at $5,000, and
suppose that the annual risk-free rate is 6%. Determine the price of the forward contract
under the no-arbitrage principle.
Calculate the no-arbitrage forward price for a 100-day forward on a stock that is
currently priced at $300 and is expected to pay a dividend of $4 in 15 days, $4 in 85 days,
and $5 in 190 days.The annual risk-free rate is 5%.
After 60 days, the value of the stock in the previous example is $360. Calculate the value
of the equity forward contract on the stock to the long position, assuming the risk-free
rate is still 5%.

15
Options
An option contract gives its owner the right, but not the obligation, to either buy or sell
an underlying asset at a given price (the exercise price or strike price).
While an option buyer can choose whether to exercise an option, the seller is obligated
to perform if the buyer exercises the option.
The owner of a call option has the right to purchase the underlying asset at a specific
price for a specified time period.
 The owner of a put option has the right to sell the underlying asset at a specific price for
a specified time period.
The seller of an option is also called the option writer.

16
Options (contd.)
There are four possible options positions:
 Long call: the buyer of a call option—has the right to buy an underlying asset.
 Short call: the writer (seller) of a call option—has the obligation to sell the underlying asset.
 Long put: the buyer of a put option—has the right to sell the underlying asset.
 Short put: the writer (seller) of a put option—has the obligation to buy the underlying asset.

The price of an option is also referred to as the option premium.

17
Options (contd.)
Pay-off scenarios (Pay-off for a call buyer and seller)
 For ex: Mr. X buys a call option at strike price of Rs. 40 in exchange of a premium of Rs. 5. In
case if actual price of the stock at the time of exercise is less than Rs. 40, Mr. X would not
exercise his option his loss would be Rs. 5. Mr. X would exercise his option at any price above
Rs. 40. In such situation his loss would start reducing and at the price of Rs. 45 there will be
break even at the price of Rs. 45.

18
• Ex: S0 = 2000, value of the NASDAQ 100 when the strategy is initiated
• T = 0.0833, the time to expiration (one month = 1/12) EP Call price Put price
1,950 108.43 56.01
• The options available will be the following:
2,000 81.75 79.25
2,050 59.98 107.39
• A call buyer will execute the rights only in case of “In the money call options” i.e. when S
> X, where S is the price of the underlying asset and X is the exercise price of the
option. Let us assume the index value to be as follows at expiry:
S EP Moneyness Value of options at expiry Net gain/loss of call buyer
Break even for call buyer
Max (0, S-X)
1,800 2,000 Out the money 0 (81.75) Net profit = S - X – premium
1,900 2,000 Out the money 0 (81.75) Or, 0 = S - X- premium
2,081.75 2,000 In the money 81.75 0 Or, S = X + premium
2,100 2,000 In the money 100 18.25

Break
even
19
Options (contd.)
Pay-off scenarios (Pay-off for a put buyer and seller)
 For example, Mr. X buys a put option at strike price of Rs. 40 in exchange of a premium of Rs.
5. In case if actual price of the stock at the time of exercise is less than Rs. 40, Mr. X would
exercise his option his gain would be (Exercise Price – Spot price - Premium). Mr. X would
exercise his option at any price below Rs. 40. The break- even price will be Rs. 35 and Mr. X
would not exercise his option for any price above Rs. 40.

20
• Ex: S0 = 2000, value of the NASDAQ 100 when the strategy is initiated
• T = 0.0833, the time to expiration (one month = 1/12) EP Call price Put price
1,950 108.43 56.01
• The options available will be the following:
2,000 81.75 79.25
2,050 59.98 107.39
• A put buyer will execute the rights only in case of “In the money put options” i.e. when X
> S, where S is the price of the underlying asset and X is the exercise price of the option.
Let us assume the index value to be as follows at expiry:
S EP Moneyness Value of options at expiry Net gain/loss of call buyer
Break even for put buyer
Max (0, X-S)
1,800 2,000 In the money 200 120.75 Net profit = X - S - premium
1,900 2,000 In the money 100 20.75 Or, 0 = X - S - premium
1,920.75 2,000 In the money 79.25 0 Or, S = X - premium
2,100 2,000 Out the money 0 (79.25)

Break
even
21
Options (contd.)
 Option premium = intrinsic value + time value
 We define the intrinsic value (or exercise value) of an option the maximum of zero and the
amount that the option is in the money. That is, the intrinsic value is the amount an option is
in the money, if it is in the money, or zero if the option is at or out of the money.
 Prior to expiration, an option has time value in addition to any intrinsic value. The time value
of an option is the amount by which the option premium (price) exceeds the intrinsic value.
 When an option reaches expiration, there is no time remaining and the time value is zero. This
means the value at expiration is either zero, if the option is at or out of the money, or its
intrinsic value, if it is in the money.

22
Put-call parity for European options
Protective put Fiduciary call
(Stock + Put) (Call + Bond)
 A protective put is a share of stock together with a put option on the stock. The expiration date
payoff for a protective put is (X – S) + S = X when the put is in the money, and S when the put is
out of the money.
 A fiduciary call is a combination of a call with exercise price X and a pure-discount, riskless bond
that pays X at maturity (option expiration). The payoff for a fiduciary call at expiration is X when
the call is out of the money, and X + (S – X) = S when the call is in the money.
• Conditions to be fulfilled:
• The exercise prices on the put and the call and the face value of the riskless bond are all equal to
X.
• The options must be European-style.
• The puts and calls must have the same exercise price and time to expiration for these relations to
hold.

23
Put-call parity for European options Call out the
money and put in
Expiry spot prices S+P B+C the money, payoff
= Exercise price
80 80+20=100 100+0=100
90 90+10=100 100+0=100
100 100+0=100 100+0=100
110 110+0=110 100+10=110
120 120+0=120 100+20=120 Call in the money and
put out the money,
payoff = Spot prices at
expiry

• In either case, the payoff on a protective put is the same as the payoff on a fiduciary call. Our
no-arbitrage condition holds that portfolios with identical payoffs regardless of future
conditions must sell for the same price to prevent arbitrage. We can express the put-call
parity relationship as: S + P = +C
( )

24
Put-call parity for European options
• Example: Suppose that the current stock price is $520 and the risk-free rate is 5%. You
have found a quote for a 3-month put option with an exercise price of $500. The put
price is $15. Estimate the price of the 3-month, $500 call option.

Based on the fact that the present value of an asset’s forward price is equal to its spot
price, we can substitute the present value of the forward price into the put-call parity
relationship at the initiation of a forward contract to establish put-call-forward parity as:
( )
( )
+P=( )
+C

25
Value of an option is determined using a one-period binomial model
Pluto Inc.'s stock is currently trading at $40. Calculate the value of an money call option
on the stock with an exercise price of $40. given that the size of up-move is 1.60. The
risk-free rate equals 6%.

26
Circumstances the values of European and American options differ.
American option has the right to exercise prior to expiration, while European options can
only be exercised at expiration.
The prices of European and American options will be equal unless the right to exercise prior
to expiration has positive value.
At expiration, both types of options are, of course, equivalent and they will have the same
value, the exercise value. Their exercise value at expiration will either be zero if they are at or
out of the money, or the amount that they are in the money.
For a call option on an asset that has no cash flows during the life of the option, there is no
advantage to early exercise. During its life, the market value of a call option will be greater
than its exercise value (by its time value), so early exercise is not valuable.
Because there is no value to early exercise, otherwise identical American and European call
options on assets with no cash flows will have the same value.

27
Circumstances the values of European and American options differ.
 If the asset pays cash flows during the life of a call option, early exercise can be valuable because options are
not adjusted for cash flows on the underlying asset. Consider a call option on a stock that will pay a $3
dividend. The stock price is expected to decrease by $3 on the ex-dividend day which will decrease the value of
the call option, so exercising the call option prior to the ex-dividend date may be advantageous because the
stock can be sold at its pre-dividend price or held to receive the dividend. Because early exercise may be
valuable for call options on assets with cash flows, the price of American call options on assets with cash flows
will be greater than the price of otherwise identical European call options.
 For put options, cash flows on the underlying do not make early exercise valuable. Actually, a decrease in the
price of the underlying asset after cash distributions makes put options more valuable. In the case of a put
option that is deep in the money, however, early exercise may be advantageous. Consider the (somewhat
extreme) case of a put option at $20 on a stock that has fallen in value to zero. Exercising the put will result in
an immediate payment of $20, the exercise value of the put. With a European put option, the $20 cannot be
realized until option expiration, so its value now is only the present value of $20. Given the potential positive
value of early exercise for put options, American put options can be priced higher than otherwise identical
European put options.

28
Factors that determine the value of an option:

Increase in Effect on call option Effect on put option

Price of underlying asset Increase Decrease
Exercise price Decrease Increase
Risk-free rate Increase Decrease
Volatility of underlying asset Increase Increase
Time to expiration Increase Increase, except some
European puts
Cost of holding underlying asset Increase Decrease
Benefit of holding underlying asset Decrease Increase

29
Swaps (Interest rate swaps)
 A swap contract 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 a fixed series.
 In the simplest type of swap, a plain vanilla interest rate swap, one party makes fixed rate interest
payments on a notional principal amount specified in the swap in return for floating-rate payments from
the other party. In a plain vanilla interest rate swap, the party who wants floating-rate interest payments
agrees to pay fixed-rate interest and has the pay-fixed side of the swap. The counterparty, who receives
the fixed payments and agrees to pay variable-rate interest, has the pay-floating side of the swap and is
called the floating-rate payer. The payments owed by one party to the other are based on a notional
principal that is stated in the swap contract.
 The price of a swap is the fixed rate of interest specified in the swap contract.
 The value depends on how expected future floating rates change over time. An increase in expected
short-term future rates will produce a positive value for the fixed-rate payer, and a decrease in expected
future rates will produce a negative value for the fixed-rate payer.

30
US LIBOR
 Benchmark rate that represents the interest rate at which banks offer to lend funds to one
another in the international interbank market for short-term loans.
 Currency USD
 Outside US
 Add-on rate
 No compounding
 LIBOR exist for seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months
 Annualized rate
 Being calculated and reported each business day
 30/360 days convention

31
Numerical based on swaps – not in syllabus.
Compute the amount that must be repaid on a $1 million loan for 30 days if 30-day LIBOR is
quoted at 5%.
Annualized LIBOR spot rates today are:
 R90-day = 0.030
 R180-day = 0.035
 R270-day = 0.040
 R360-day = 0.045

You’re analyzing a 1-year swap with quarterly payments and a notional principal amount of
$1,000,000. Calculate:
 The fixed rate in percentage terms.
 The quarterly fixed payments in $.

32
Forward rate agreement (FRA)
Forward contract where underlying asset is a “Loan”.
Long FRA: Right and obligations to borrow, will benefit if interest goes up.
Short FRA: Right and obligations to lend, will benefit if interest goes down.
Calculate the price of a 1 × 4 FRA (i.e., a 90-day loan, 30 days from now). The current 30-
day LIBOR is 4% and 120-day LIBOR is 5%.
Continuing the prior example for a 1 × 4 FRA, assume a notional principal of $1 million.
Suppose that, at contract expiration, the 90-day rate has increased to 6%, which is above
the contract rate of 5.32%. Calculate the value of the FRA at maturity, which is equal to
the cash payment at settlement.

33
Credit Derivatives
A credit derivative is a contract that provides a bondholder (lender) with protection
against a downgrade or a default by the borrower. The most common type of credit
derivative is a credit default swap (CDS), which is essentially an insurance contract
against default.
Another type of credit derivative is a credit spread option, typically a call option that is
based on a bond’s yield spread relative to a benchmark. If the bond’s credit quality
decreases, its yield spread will increase and the bondholder will collect a payoff on the
option.

34