CFA L1 - Derivatives

Derivatives
Study Session 15
Reading 45: Derivative Markets and Instruments,
by Don M. Chance, PhD, CFA
Reading 46: Basics of Derivative Pricing and

Valuation, by Don M. Chance, CFA
CFA Level 1 Year 2022 Exam Weight

Topics Weight
Quant Methods 8-12%
Economics 8-12%
FRA 13-17%
Corp Fin / Issuers 8-12%
Equity 10-12%
Fixed Income 10-12%
Derivatives 5-8%
Alt. Investments 5-8%
Portfolio Mgmt. 5-8%
Ethics 15-20%
Chartered Financial Analyst Preparatory Course 1

By Josh Tee CH, CFA, FRM, CA(M)
Agenda
Derivatives Market & Instruments
Basic of Forwards Contract Pricing & Valuation
Basic of Forward Rate Agreement Pricing & Valuation
Basic of Futures Contact Pricing & Valuation
Basic of SWAP Pricing & Valuation
Basic of Option Pricing & Valuation

Derivatives
Definition: Financial instruments that derive their value from the value of another asset (underlying)
Function: Managing financial risk, creating synthetic exposure to asset classes, enhance market efficiency
Exchange Traded Over the Counter

Agreement between a counterparty and an
Agreement between two counterparties
exchange (i.e. CBOE)
Standardized & regulated Customized & unregulated
Backed by clearing house, minimal default risk Expose to default risk of counterparty
Example: Futures contracts Example: Forwards contracts
Firm commitment Contingent claim

Parties in a derivatives trade are OBLIGATED to Buyer has a RIGHT but not an obligation to
complete the transaction as per derivatives complete the transaction.
contracts. Seller has an obligation to complete the
transaction, if the buyer choose to exercise his
right.
Example: Futures, forwards, swaps Example: Options

Major Type of Derivatives
Forwards Futures Swaps Options
• Agreement between • Agreement between a • Series of forward • A right to the buyer or

two parties to buy and party and an exchange contracts. an obligation to the
sell an asset to buy and sell an asset seller of option to
(underlying) at specific (underlying) at specific • Agreement between buy/sell an asset
terms (price, quantity, terms (price, quantity, two parties to (underlying) at specific
quality) on a specific quality) on a specific exchange a series of terms (price, quantity,
date in the future. date in the future. cash flows for a time quality) during a time
period. period.
• OTC, customized, • Exchange-traded,
expose to counterparty standardized, minimal • OTC, customized, • Can be OTC or
risk, no payment is default risk, subject to expose to counterparty exchange-traded,
needed to initiate the margin call (daily mark- risk, no payment is require payment to
contract to-market) needed to initiate the seller (option
contract premium) at the
initiation
Both can be settled either via cash or physically deliver
Zero value at the initiation of contract

Credit Default Swap
• CDS = insurance contract
• Reference obligation = fixed income security on which the swap is written
• Reference entity = issuer of reference obligation
• Credit event = events specified in the contract which upon occurs, the reference obligation is deemed as
default
• Periodic premium for CDS = CDS spread (A function of probability of default, loss given default,
hazard/failure rate)
Note: Certain standardized CDS has a fixed periodic premium/coupon which is higher/lower than the CDS
spread. In this case, one party have to pay another an upfront payment which equivalent to the differences
between CDS coupon and spread times notional amount.
Chartered Financial Analyst Preparatory Course

Credit Spread Option

Purposes & Controversies of Derivatives
Purposes
Provide price information Risk management Reduce transaction cost

Contract with the shortest time to Eliminate price uncertainties, alter Allowed a more cost efficient risk
maturity often serve as proxy price or reduce the risk exposure through management.
of the underlying hedging.
Criticisms
Too risky Linked to gambling
Due to its complexity, especially to those with limited Because of the high leverage payoff and naïve
knowledge. speculation.
Participants
Hedgers- with existing or anticipatory underlying position.
Speculators- seeking trading gains from their predictions or view. Usually

without underlying position.
Arbitrageurs- seeking riskless profit.

Concept of Arbitrage
It is a process of generating riskless profit by taking at least two positions
Arbitrage opportunities arise when assets are mispriced
Law of One Price: Two assets or combination of assets with similar characteristics (risk and return) should be traded at a
same price. If the relationship does not hold, there is arbitrage opportunity.
Eg 1: If asset A and asset B have the identical characteristic but the price of asset A is lower than asset B. Long asset
A and short asset B, thereby earning a riskless profit without investing any money or being exposed to any risk.
Eg 2: Risk free rate of 3% and there is a portfolio (consist of two assets) which will yield a certain return of 4%.
Borrow at risk free rate to invest in the portfolio, thereby earning a riskless profit without investing any money or
being exposed to any risk.
Arbitrageurs will continue this process until the prices in the both markets become the same (making market more
efficient).
The pricing of derivatives should ensure arbitrage free Left hand side of the equation is a fully
hedged position (long physical asset and
short forward contract).
The future payoff is certain (assuming no

credit risk), hence, we can discount the
future payoff of this position at risk-free rate
Derivatives pricing are risk-neutral (i.e. no risk (right hand side of the equation)
premium is added in the pricing of the risky asset)
Both side must be equal

Replication
With derivatives, a risk-free asset can be crated by taking a long position of a risky asset and
simultaneously short its underlying derivatives (i.e. fully hedged)
The payoff of risk free

asset, risky asset and
derivative can be
duplicate

Agenda

Forward Contract
P&G enters into a forwards contract to purchase 1 metric ton of palm oil from PPB Bhd at an agreed upon price
of MYR2,869 at the end of 6 month.
• Long position: P&G
• Short position: PPB Bhd
Scenario 1: Assumed that the palm oil is trade at MYR3,000 per metric ton at the end of 6 month. The forwards
contract can be settled via two ways:
Physical delivery (deliverable) Cash settlement
• PPB deliver 1 metric ton of palm oil that now • No physical delivery. PPB will pay the difference
worth MYR3,000 to P&G for MYR2,869. between palm oil current market price and
agreed price to P&G. (3,000 – 2,869 = 131).
• P&G has a positive payoff of MYR131 and PPB
has a negative payoff of similar amount. • MYR131 is the value of forwards contract to
P&G and negative MYR131 to PPB at the end of
6 month.
1 metric ton of palm oil

P&G MYR2,869 PPB P&G MYR131 PPB

Forward Contract (con’t)
Scenario 2: What if the palm oil is trade at MYR2,600 per metric ton at the end of 6 month?
Physical delivery Cash settlement
• PPB deliver 1 metric ton of palm oil that now • No physical delivery. P&G will pay the
worth MYR2,600 to P&G for MYR2,869. difference between palm oil current market
• P&G has a negative payoff and PPB has a price and agreed price to PPB. (2,600 – 2,869 =
positive payoff. 269).
• MYR269 is the value of forwards contract to
PPB and negative MYR269 to P&G at the end of
6 month.
1 metric ton of palm oil

P&G MYR 2,869 PPB P&G MYR269 PPB
Conclusion: It is a zero sum game.
Spot price at contract expiration < agreed forward price = Long pays short (short has positive payoff)
Spot price at contract expiration > agreed forward price = Short pays long (long has positive payoff)

Termination of Prior to Expiration
A party can terminate the forwards contract position prior to expiration by entering into an opposite forwards
contract position with an expiration date equal to time remaining on the original position with either:
1) The same counterparty:

Eg: 2 months after inception, 4-month forward price of 1 metric ton of palm oil is MYR2,800. P&G
would like to unwind its original long forwards position. P&G will take a 4-month short forwards
contract position with PPB for MYR2,800.
P&G has locked in a loss of MYR69, but has effectively exited the original position.
2) Another counterparty:
Eg: 2 months after inception, 4-month forward price of 1 metric ton of palm oil is MYR2,800. P&G
would like to unwind its original long forwards position. P&G will take a 4-month short forwards
contract position with IOI for MYR2,800.
P&G has locked in a loss of MYR69, but has effectively exited the original position.
The differences between the two is credit risk. By entering the opposite
position with another party, P&G exposed itself to the credit risk of IOI

Pricing & Valuation of Forward Contract
Key rationale: Non arbitrage pricing
If the current forward price is higher than the

theoretical forward price, arbitrage profit can be
made via cash and carry arbitrage by
simultaneously:
1. Borrow at risk free rate

2. Buy physical asset with the borrowed fund
1. At Initiation: The forward price must be free from arbitrage→ zero value; 3. Short the forward contract of the asset
2. During the life of the contract;
3. At expiration;

Agenda

Eurodollar Time Deposit
Eurodollar: Time deposits that denominated in USD at bank outside the United State
• Not under the jurisdiction of the Federal Reserve and these deposits are subject to much less
regulation than similar deposits within the U.S.
• Eurodollar deposits accrue interest by adding it on to the principal, using a 360-day year assumption.
The primary Eurodollar rate is called LIBOR.
LIBOR (London Interbank Offer Rate): Interest rate that top-tier bank charge each other to borrow USD
outside the U.S.
• LIBOR is used as reference rate for floating rate USD denominated loan world wide.
EURIBOR (Europe Interbank Offer Rate): Interest rate that top-tier bank charge each other to borrow
Euro outside the Europe.

Forward Rate Agreement
A forwards contract that allow contract parties to borrow (buy) / lend (sell) an amount of money at a certain rate (forward rate)
for a certain period (loan period) at a future date (forward contract expiration date).
30-day FRA on
90-day LIBOR
The cash flow structure of a long FRA

(30-day FRA on 90-day LIBOR) can be
The forward rate (price) of a FRA is a rate that makes the FRA
duplicated via synthetic FRA which
has zero value at the inception – No-arbitrage pricing
involves two transactions:
1. Borrow money for 120 days at
The no-arbitrage forward rate is determined via synthetic FRA
LIBOR
2. Simultaneously lend that borrowed
fund for 30 days at LIBOR
At the end of 30-day, the lent fund will

have repaid and bank will use this fund
for the remaining 90-day.
The effective borrowing rate for the 90-

day fund is depending on the 30-day
LIBOR and 120-day LIBOR when the
money is borrowed and loaned.
The effective borrowing rate should be

the same as the forward rate under a
30-day FRA on 90-day LIBOR
Forward Rate Agreement - Example
In anticipate the need of capital in 30-days time for a period of 180-days, AirAsia Bhd enter into a 30-days FRA for which the
underlying is based on 180-days LIBOR and notional of $10 million with Maybank Bhd. Maybank quotes a forward fate of 5%.
What will be the payoff to AirAsia at the end of 30-days (at expiration), if the 180-days LIBOR is 6% at the end of 30-day?
Solution:
Payoff = (Market rate – Forward rate) x (days to maturity for the loan/360) x Notional
1+ Market rate x (days to maturity for the loan/360)
= (6% - 5%) x (180/360) x $10 million
1+ 6% x (180/360)
= $ 48,544
Days
Discount back the interest saving at
0 30 current market rate, as the payoff will 210
FRA Expired be paid at the end of FRA tenure. Loan matured
Interest saving at the end of

Payoff = (50,000 / 1.03)
the loan period.
= 48,544
(3% - 2.5%) x 10m = 50,000
Terminologies:
1-by-7 FRA or 1 x 7 FRA
Months to FRA Total months until end of the loan

expiration period
Agenda

Forward v.s. Futures
Futures contracts are very similar to forward contracts. Both has zero value at the inception and can be settle via physical delivery
or cash. However, both are different in many aspects.
Characteristic Futures Forward

Market Exchange-traded OTC. Private contracts and do not trade
Contract terms Standardized Customized
Conterparty Clearinghouse Originating counterparty
Regulation Highly regulated Usually not regulated
Default risk Non-existent Exist
Initial margin Yes No
Daily mark-to-market Yes No
The pricing of futures contract should be the same as Divergence of forwards price and futures price:
forwards contract, if the interest rate is constant or
uncorrelated with the underlying of the futures: If interest rates and the price of the contract asset is
positively/negatively correlated → MTM is preferred →
futures price > forwards price. (vice versa).
NC = storage cost – yield on asset – convenient yield

Margin Requirement
Each exchange has a clearinghouse to serve as counterparty for each trader and to ensure the performance of the contracts. To
safeguard the clearinghouse, the exchange requires traders to post initial margin (performance guarantee) and settle their
account on a daily basis (Mark-to-market)
Margin
Initial margin (IM) Maintenance margin (MM) Variation margin (VM)

• Money that must be deposited in the • Amount that must be maintained in • Fund that must be deposited into
futures account before any trading the futures account account to bring it back to IM level.
takes place
• If the account balance fall below • VM = (Current acc.balance – IM
• Determined by the clearinghouse MM, additional fund needed to bring requirement)
the balance back to IM level.
• Extra VM can be withdrawn or used as
IM for additional position
Margin in Securities v.s. Margin in Futures
Characteristic Futures Market Securities Market
Initial margin Collateral/performance guarantee, no interest Loan with interest charge
charge
Current acc.bal < MM Top up to bring it back to IM level Top up to bring it back to MM level only
Price limit: Exchange-imposed limit on how much futures contract price can change from the previous day’s
settlement price (average prices of the trades during the last period of trading, called closing period)
Limit move: Occurs when futures price exceeds the limits (limit up or limit down)
Locked limit: Suspension of trading due to limit moves

Margin Requirement – Calculation (Not in LOS)
Consider a futures contract in which the current futures contract price is $82. The initial margin is $5/ctt and
the maintenance margin requirement is $2/ctt. You long 20 futures contracts. What are the margin
requirements:
Initial margin amount =
Maintenance margin amount =
Mark-to-market: Complete the table below
Day Beg acc Futures Price Gain/(Loss) End acc Margin call
balance price change balance
0 0 82 0 0 100 0
1 100 84 2 40 140 0
2 140 78 -6
3 73 -5
4 79 6 120 220
5 220 82 3 60 280 0
6 280 84 2 40 320 0

Termination of Futures at Expiration (Not in LOS)
1. Physical delivery of underlying (trader to clearinghouse)
• The location for delivery, terms of delivery, and details of what is to be delivered are all
specified in the contract
• It represents less than 1% of all contract terminations
2. Cash settlement
3. Closeout / offsetting: Enter an opposite position with the clearinghouse
4. Exchange for physicals (trader to trader)

• find another trader with opposite position with you and settle up between yourselves by
delivering the underlying without the involvements of clearinghouse (off the floor).
• Negotiate on the terms between traders
• Must inform clearinghouse

Types of Futures Contracts (Not in LOS)
Futures Underlying Price convention
Treasury bill 90-days T-bil with USD1 million face value Percentage discount from face value
*One-tick = 0.01%, representing $25 per $1m

contract
Eurodollar 90-days Eurodollar of USD1 million Percentage discount from face value
*One-tick = 0.01%, representing $25 per $1m

contract
Treasury bond T-bond with at least 15 years maturity with face Percent and fraction of 1% (measured in 1/32)
value of USD 100,000 of face value. 98-3 = 98 + (3/32) = 98.09%
*The short party has the option to deliver any several

bonds that satisfied the delivery terms of the contract
(Delivery option)
Stock index Stock indices (KLCI, S&P 500, NASDAQ, etc.) Index level
*Each index point represents $250 (multiplier)

contract
Currency Currency pair Exchange rate
*Contract size for EUR (EUR125,000) *Quoted at USD/foreign currency

Contract size for MXP (MXP500,000)

Agenda

SWAP Contracts
Contract where two parties agree to exchange a series of cash flows on periodic settlement dates over a certain time period
• Swaps are OTC instruments and terms are customized Types of swap:
• Swaps are not traded in secondary market • Currency swap
• Swaps market is unregulated • Plain vanilla interest rate swap (focus of Level 1)
• Default risk is an important aspect • Equity swap
• Most swap participants are large institutions
• Neither party pays anything to the other at the initiation of contract
BAT pays a fixed interest rate and Swap Dealer pays a

floating interest rate in same currency based on the
notional amount every 6-month
It does not involves initial exchange of notional principal
Termination of Swaps
1. Mutual termination: A cash payment (that is acceptable to the other party) is to be made from one party to
another
2. Offsetting contract: Enter an offsetting swap. Exit a swap through an offsetting swap with other than the original
counterparty will also expose the investor to default risk (just as with forwards)
3. Resale: It is possible to sell the swap to another party, with the permission of the counterparty to the swap
4. Swaption: A swaption is an option to enter into a swap. The option to enter into an offsetting swap provides an
option to terminate an existing swap

Plain Vanilla SWAP Equivalent Position (Series of FRAs)
1 year Swap with quarterly payment
Notional amount = P
Fixed leg rate = F
Floating leg rate = 90-day LIBOR (“S”)
Day
0 90 180 270 360
Payment = P x (S0 – F) Payment = P x (S90 – F) Payment = P x (S180 – F) Payment = P x (S270 – F)
Series of off-market FRAs based on 90-day LIBOR

Notional amount = P Off-market FRAs are those that do not
FRA rate = Swap Rate = F (assume same for all FRAs) have zero value at the initiation of the
• 90-day LIBOR (known at time 0) FRA.
• 3x6 FRA (3f3) Assuming the LIBOR
• 6x9 FRA (3f6) However, sum of the values of these FRAs
rates will equal to the
• 9x12 FRA (3f9) (i.e. some positive some negative), should
forward rates
equal to zero which is same as the swap at
initiation
Day
0 90 180 270 360
Payment = P x (S0 – F) Payment = P x (3f3 – F) Payment = P x (3f6 – F) Payment = P x (3f9 – F)
The payoff may be settled at the end of FRA tenure by

discount the payoff back from end of the underlying
tenure
SWAP Pricing & Valuation (only conceptual no computation)
1. Plain vanilla swap = Issuing fixed-coupon rate and invest the proceeds in an equivalent floating-rate bond
2. Swap rate = A fixed rate that make a swap has zero value at initiation
3. Floating rate bond will have the value equal to its par value at reset date (coupon rate = market rate)
A swap that priced on non-arbitrage

basis will have zero value at inception,
but its value will deviate from zero
throughout the life of the swap based
on the interest rate movement

Currency swaps (Not in LOS)
• Contract parties pay interest payments to each other in a different currency
• It involves initial exchange of notional principal amount
• Example of currency swap:


• One party receives a fixed or floating interest rate with the exchange of an equity portfolio return to
another party
• In equity swap, it is possible for one party not to make any payment
• Example of equity swaps:

Agenda

Option Contracts
It gives option owner (buyer) the right but not the obligation to buy (call) or sell (put) an
underlying asset with a predetermined price (exercise price) at a predetermined date. At the initiation, the buyer is required to
make a payment to option writer (option
• Long call option = right to buy the underlying premium)
• Long put option = right to sell the underlying
Options can be traded through an
The seller of option contracts (writer) is obligated to perform the contracts, if the buyer exchange (i.e. CBOE) or OTC. For exchange
exercises the options traded stock options, the size are 100
• Short call option = obligated to sell the underlying stocks per option contract
• Short put option = obligated to buy the underlying
European option: Can only be exercised at the contract’s expiration

date
American option: Can be exercised at any time up to including the

contract’s expiration date
Due to the early exercise feature, the value of American option

should worth at least as the value of identical European option

Moneyness of Options
Immediate exercise
Positive payoff Zero payoff Negative payoff
In the money (ITM) At the money (ATM) Out the money (OTM)
Moneyness Call option Put option

In the money S>X S<X
At the money S=X S=X
Out the money S<X S >X
Component Description Notation

Type of option Call or Put N/A
Underlying Asset that the option is based on S0 = Underlying asset price at inception
ST = Underlying asset price at option expiration
St = Underlying asset price at time "t" before expiration
Exercise price Predetermined price at which the underlying X

asset is to be sold or bought
Option premium Purchase consideration of the option c for European and C for American call
p for European and P for American put
Maturity Time to maturity from inception T

Option Payoff
Assumed that you bought a 3-month European call option (long) of Padini Holding Bhd for a premium of 20 cents, with an
exercise price of MYR1.5. Currently, Padini is trading at MYR1.2.
What is the payoff of this option if the Padini is trading at MYR1.8 at the end of 3 months?
Solution:
Payoff = 1.8 – 1.5 = MYR 0.3
Payoff Long call
MYR 0.3
0 Share price
MYR 1.5 MYR 1.8
Short call

Option’s Intrinsic Value & Time Value
Time value is the amount by which the option
Option Premium = Intrinsic Value + Time Value premium exceeds its intrinsic value (Speculative
value of the option)
Intrinsic value is the amount by which the option is in the money (How much is the positive payoff of that option)
Intrinsic value of an option can never below zero (Option is a right, not an obligation)
Intrinsic value of a call = max[0, S – X] → Greater of (S – X) or 0

Intrinsic value of a put = max[0, X – S] → Greater of (X – S) or 0
• What is the intrinsic value of call option in previous example at the

expiration date?
• What is the intrinsic value of that call option, if the share price at
the expiration date is MYR1.2?

Option’s value limit (Not in LOS)
Lower bound = Minimum value of an option at time t:
• No intrinsic value can be below zero → lower bound for both European and American option = zero
Upper bound = Maximum value of an option at time t

• No one will pay more than the asset’s current price for a right to buy that asset in the future → upper
bound for both European and American call option = St
• Maximum value of a put option occurs when the underlying asset price goes to zero → upper bound
for American put = X; European put = Present value of X
Option Min value at time t Max value at time t
American call C >= 0 C <= S
European call c >= 0 c <= S
American put P >= 0 P <= X
European put p >= 0 p <= X/(1+Rf)^(T-t)

Lower bound (Recap)
The intrinsic value of an option at time t is the greater of zero and its payoff: Max[0, Payoff]
If the payoff is positive → lower bound (min value) of an option will be its payoff instead of zero (the range of
option value has tighten)
Option Payoff at time t Min value at time t Max value at time t

American call S-X C <= Max[0, S – Xe -r x (T-t)] C <= S
**
European call S – Xe -r x (T-t) c <= Max[0, S - Xe -r x (T-t))] c <= S
American put X-S P <= Max[0, X - S] P <= X
European put Xe -r x (T-t) – S p <= Max[0, Xe -r x (T-t) – S ] p <= Xe -r x (T-t)
** American option should worth at least as much as an equivalent European option, due to its
early exercise option.
There is no advantage to exercise early a call option, as the Early exercise on a deep in the money put
payoff from immediate exercise will be lower than exercise at option may be viable as its payoff from an
maturity immediate exercise will be higher than
exercise at maturity
Early exercise will only make sense if the underlying asset pays *If there is large dividends, early exercise is
cash flow (i.e. dividend) during the option life which may not optimal so long as
reduce the value of the stock

Finding lower bound (Not in LOS)
Consider call and put option expiring in 42 days, in which the current underlying price is at $72 and the risk free
rate is at 4.5%. Find the lower bound for:
• European call and put at exercise price of $70 and $75

At $70:
At $75:
• American call and put at exercise price of $70 and $75

At $70:
At $75:

Effect of Variables on Option Price
Variables Call Option Put Option
Underlying asset price Increase i n the underl yi ng pri ce makes the val ue of an Increase i n the underl yi ng pri ce makes the val ue of an
opti on to buy such asset hi gher opti on to sel l such asset l ower/worthl ess
Excersice price Hi gher exerci se pri ce resul ts i n l ower payoff from an opti on Hi gher exerci se pri ce resul ts i n hi gher payoff from an
to buy an asset opti on to sel l an asset
Volatility of the Hi gher vol ati l i ty resul ts i n hi gher chances for the pri ce Hi gher vol ati l i ty resul ts i n hi gher chances for the pri ce
underlying asset price move i n favor of cal l opti on hol der move i n favor of put opti on hol der
Time to maturity Longer ti me to maturi ty resul ts i n hi gher ti me val ue for a American Put: Longer ti me to maturi ty resul ts i n hi gher
cal l opti on (both Ameri can and European) ti me val ue for an Ameri can put
European Put: Longer ti me to maturi ty resul ts i n higher

time value but lower present value of the payoff for an
European put (especi al l y when i t i s deep i n the money)
Benefits from underlying Hi gher di vi dend payout pri or to the opti on exerci se peri od Hi gher di vi dend payout pri or to the opti on exerci se peri od
(i.e. dividend) reduces the underl yi ng share's val ue, whi ch hurts the cal l reduces the underl yi ng share's val ue, whi ch i ncreases the
opti on i ntri nsi c val ue, hence l ower premi um put opti on i ntri nsi c val ue, hence hi gher premi um
Costs to hold the Hi gher hol di ng costs benefi t the cal l opti on hol der as he Hi gher hol di ng costs i ncreases the underl yi ng asset's
underlying (i.e. storage can have a l ong exposure on the underl yi ng wi thout payi ng future val ue (i .e.commodi ti es), whi ch decreases the
cost) the hol di ng costs, hence the cal l opti on i s more val uabl e i ntri nsi c val ue (X - S) of a put opti on, hence l ess val uabl e
and l ower pri ce
Risk free rate To avoi d wri ti ng a naked cal l , the cal l opti on wri ter wi l l To ensure there i s suffi ci ent fund to meet the obl i gati on
borrow fund to buy the underl yi ng to cover hi s downsi de ari si ng from wri ti ng a put opti on, the wri ter wi l l set asi de
from wri ti ng a cal l opti on. Hence, the wri ter wi l l ask for an amount of money whi ch enti tl e ri sk free return. Hence,
hi gher premi um i f the borrowi ng cost (ri sk free rate) i s hi gh the wri ter wi l l ask for hi gher premi um i f the ri sk free rate i s
l ow
Note: Assume constant underlying price

Put-call parity
It is a relationship that ensures parity and consistency between European calls and puts with similar
characteristics. It describes by payoffs of two portfolio combinations:
1. Fiduciary call = Long call + Long bond with face value equal to exercise price
2. Protective put = Long put + Long underlying asset
Both portfolios should yield the same payoff

at the maturity. Hence, according to rule of
no arbitrage, both portfolios should be the
same price:
c + X/(1+Rf)^T = p + S
If there is cash flow (i.e. dividend) from the

underlying asset, the underlying asset price
(S) should be adjust (reduce) by PV of
dividend

Put-call parity (con’t)
c + X/(1+Rf)^T = p + S From the put-call parity equation, we can find the price of options and compare to
the market price of options. If they are different → Arbitrage opportunity exist.

Put-Call Parity for Option on Forwards
Substitute S0
Put-call Forward
Parity

One-period Binomial Pricing Model
Binomial Pricing Model is based on backward induction
methodology
Input required:
• Beginning underlying asset value
• Size of up and down (U and D) → D = 1/U
• Possibilities of up and down →P(U) and P(D) → P(D) = 1 – P(U)


CFA L1 - Derivatives

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CFA L1 - Derivatives

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Derivatives

Reading 46: Basics of Derivative Pricing and

CFA Level 1 Year 2022 Exam Weight

Chartered Financial Analyst Preparatory Course 1

Basic of Forwards Contract Pricing & Valuation

Basic of Forward Rate Agreement Pricing & Valuation

Basic of Futures Contact Pricing & Valuation

Basic of SWAP Pricing & Valuation

Basic of Option Pricing & Valuation

Chartered Financial Analyst Preparatory Course 2

Exchange Traded Over the Counter

Example: Futures contracts Example: Forwards contracts

Firm commitment Contingent claim

Example: Futures, forwards, swaps Example: Options

Chartered Financial Analyst Preparatory Course 3

Forwards Futures Swaps Options

• Agreement between • Agreement between a • Series of forward • A right to the buyer or

Both can be settled either via cash or physically deliver

Zero value at the initiation of contract

Chartered Financial Analyst Preparatory Course

Chartered Financial Analyst Preparatory Course 6

Provide price information Risk management Reduce transaction cost

Speculators- seeking trading gains from their predictions or view. Usually

Arbitrageurs- seeking riskless profit.

Chartered Financial Analyst Preparatory Course 7

It is a process of generating riskless profit by taking at least two positions

Arbitrage opportunities arise when assets are mispriced

The future payoff is certain (assuming no

Chartered Financial Analyst Preparatory Course 8

The payoff of risk free

Chartered Financial Analyst Preparatory Course 9

Basic of Forwards Contract Pricing & Valuation

Basic of Forward Rate Agreement Pricing & Valuation

Basic of Futures Contact Pricing & Valuation

Basic of SWAP Pricing & Valuation

Basic of Option Pricing & Valuation

Chartered Financial Analyst Preparatory Course 10

Physical delivery (deliverable) Cash settlement

1 metric ton of palm oil

Chartered Financial Analyst Preparatory Course 11

Physical delivery Cash settlement

1 metric ton of palm oil

Conclusion: It is a zero sum game.

Chartered Financial Analyst Preparatory Course 12

1) The same counterparty:

Chartered Financial Analyst Preparatory Course 13

If the current forward price is higher than the

1. Borrow at risk free rate

2. During the life of the contract;

Chartered Financial Analyst Preparatory Course 14

Basic of Forwards Contract Pricing & Valuation

Basic of Forward Rate Agreement Pricing & Valuation

Basic of Futures Contact Pricing & Valuation

Basic of SWAP Pricing & Valuation

Basic of Option Pricing & Valuation

Chartered Financial Analyst Preparatory Course 15

Chartered Financial Analyst Preparatory Course 16

The cash flow structure of a long FRA

At the end of 30-day, the lent fund will

The effective borrowing rate for the 90-

The effective borrowing rate should be

Interest saving at the end of

Contract size for EUR (EUR125,000) Quoted at USD/foreign currency