In this lecture we will go over the CFA level one reading on derivative markets and

instruments. This is an introductory reading we will talk about the definition of derivatives

the structure off to deliver 2 halves markets. And then we will talk about different types of
derivatives. This section is quite long but most of what you will see in this section will be
covered in much more detail in subsequent readings so what I will do is cover the material
at a level which would be sufficient for you to answer the questions in the examples in this
reading and the questions at the end of this reading on my advice would be to to come back
to this material or come back to the questions after you have done the other readings which
are part of the derivatives course. In section 5 we will talk about the purposes and benefits
of derivatives then we will go over the criticism and misuses of derivatives and finally we
will cover the elementary principles of derivative pricing. Here is the basic definition. Are
delivered to is a financial instrument. Which derives its value from an underlying asset and
I have asked her to input in to seize because sometimes the underlying might not be an
asset the underlying might be an interest rate. The curriculum goes into a lot of detail
related to this definition but I feel that. At this stage as long as you know this basic
definition you are in good shape. But it is important to understand a few important
points. The do you ever give is a legal contract it does piece of paper an agreement all up
contract which is being used on something if that something else is called the
underlying. And this image is good to keep in mind so the derivative is the contract or the
agreement which is based on an underlying asset. We will call the underlying asset for No
because doctors easier to think about a really simple contract is one where 2 parties. Let's
see party and party be agree. Dr after 6 months. Barty it will send a given stock let's say a
stock X. why is it to be. This is a contract the seal of the transaction is not happening now
the 2 parties are agreeing to conduct this transaction after 6 months the underlying in this
example is the stock X. Y. Z. the 2 parties involved D. and B. and note that at this stage all
they're doing is signing a contract coming to an agreement this contract is a delivered to the
value of this contract with the performance of this contract will depend on the underlying
and to make the small concrete. Let's say that this agreement is docked it will sell the stock
to be for $50. Doctor will also be returning in the contract no what is the value of this
contract over time and specifically what is the value of this contract after 6 months clearly
the value depends on how this underlying stock performs if the underlying stock does
extremely well and goes up in value to say $75 then clearly this contract is valuable for
party beat which is buying the underlying asset for 50. So notice that the value of the
contract with the performance of the contract is based on the performance of the underlying
asset. The terminology that is used for these 2 parties is long and short the loan is the party
doctor is going to buy it though underlying aspect and the short is the party which is going
to sell the underlying asset. There are many types of derivatives degree would be talking
about later in this lecture as well as in subsequent readings. Another important dorm to
learn here is it risk management. The reason we need to learn this is because one of the
primary use of derivatives is to manage risk. Risk management is the process by which an
organization or individual defines the level of risk it was just too deep. Measures the level
of risk it just speaking and it just the doctor to equal the former this is a slightly
complicated definition but what you're just saying is fairly simple organization speak on
different kinds of risks and when organizations recognize that risk and take actions to
control or manage that risk then the process that they go through is called risk management
and the link here is that do you ever do this. Can be used to manage risk if you think about
the example that I just gave you we have a given stocks such as exercise it which will
perform in a certain way. A delivered to. Which is based on exercise it could be used to
manage the risk associated with this stock and as you understand deliver jobs over the next
few lectures you will get a sense for how various types of derivative instruments can be
used to manage risk. Now let's go over some questions in the curriculum and these
questions are presented in example one in the curriculum which of the following is the best
example of delivered to. A global equity mutual fund a non callable government bond a
contract to purchase apple computer act fixed price the correct on so here to see. Because
this is contract parties are signing a contract. To execute a transaction actor fixed price
probably at some point in the future. Let's see if you can answer this question now. Which
of the following is not a characteristic offer delivered to. And underlying this is a
characteristic we just talked about it so that's not the right on so Lou degree of
leverage. That's what the question mark here for now 2 parties a buyer and seller we've
already talked about this this is a characteristic I'm. Therefore not the right on so the correct
on so then is low degree of leverage this is not a characteristic off of derivative. Try this
now. Again the question is asking for which statement is not true. They are created in the
spot market D. are used in the practice of risk management we just talked about the fact that
this is a major use of derivatives so doctors a true statement and therefore not the light on
so deep dig their values from the value of something else this is also a true statement and
therefore not the correct answer the correct answer is D. derivatives are not created in the
spot market. Section 3 the structure of directive markets broadly speaking we have to got to
good use exchange traded derivative markets and over the counter derivatives
markets. Futures contracts. Are treated on exchanges and we will see this material in a lot
of detail when we do the reading on futures contracts but at a high level here is what you
need to recognize. With exchange traded markets we have an exchange in the middle. A
classic example of an exchange would be the CME although Chicago mercantile exchange
and futures contracts treed on this exchange. What the exchange does is it defines
standardized contracts where everything is standardized except the price as an example the
exchange might define standardized contract for boot hill it would be defined that this is the
quality of border diss the quantity here is where the goal will be delivered and so on the
only thing not defined would be the price the price is determined in the market by the
buyers and the sellers will be considered long and the short parties. Then. The long and
short parties interact with each other through the exchange. We will have a long party
which we deal with the exchange and a short party which will also deal with the exchange
the exchange is responsible for what discord the clearing and settlement process. The
leading refers to the process by which the exchange verifies the execution of the transaction
and records the participants identities. Settlement refers to the process whereby the
exchange transfers money from one participant to the other. That is all I see at this stage
related to this point and as I mentioned before we will see this material in more detail when
we do futures. All contract terms are standardized acceptable price we've already talked
about this because the contracts are standardized that makes them more liquid relative to
the over the counter market also. These transactions are more transparent the price for
example is published though contracts are standardized so these transactions and these
markets are more transparent relative to go over the counter markets. The exchange also
helps ensure the data is normal credit risk. And as we see in the reading on futures
contracts. Any party that wants to engage in transactions over here needs to post a margin
all what is also called a performance bond which helps ensure that there is no. D. fort the
other attributes of exchanges is that generally there is a delay mark to market or defeat
settlement any party that is winning because the price of the underlying changes that party
is compensated at the end of the day and the party that might be losing will have to. Make a
payment at the end of the day. And this again this material that we would see in more detail
later at this stage you need to recognize that credit risk is effectively eliminated when we
do. Transactions through an exchange. The other type of market is the over the counter
market this is an informal network of market participants this is also called a dealer market
because we have a network of dealers so these market participants all the dealers who
network with each other and buy and sell even with each other or they might also interact
with what scored end users these might be corporations that need to hedge their risks. The
derivatives in this market tend to be less liquid compared to deliver to switch up traded on
an exchange. These are private transactions between different entities so. Destroys actions
are less transparent compared to exchange traded markets and. The contracts all the
agreements are customized sure 2 parties E. and B. can agree on any terms that they want
that's why you see that these transactions up customized we will see this material in more
detail when we do forward contracts later in the directives segment of the curriculum. The
final point I'll make on the slide is that market makers make money or make a profit
through for discord the bid ask spread. What a market maker does is interact with different
parties so if a given party it wants to take a long position then the market maker will take
the opposite position or short position and then the market maker will find another party
let's say party B. with home this market maker will Dick. Long position in other words. A
good party the market maker is is going to take a short position so the market maker saying
that he will sail and over here with party beat the market maker is saying that he is taking a
long position which means that he will. Bye and the store cancel each other out so no
matter what happens to the underlying whether the price goes up or down the market maker
is covered so how does the market maker make money doctor would be through what's
called the bid ask spread. The amount at which the dealer or the market maker would buy
it's called the bid price and this is going to be lower than the awestruck stop loss price is
how much the market maker will sell for the difference between these 2 numbers is called
the bid ask spread and generally this is where the market maker makes a profit. Let's go
over exam for 2 from the curriculum now. And I want you to try this before you look at the
solution. Which of the following characteristics is not associated with exchange traded
derivatives. Margin or performance bonds are required remember these are generally
required with exchange traded derivatives. So these are required. The exchange guarantees
all payments in the event of default again. Given that there is no credit risk doctors because
the exchange is guaranteeing payments so this is a characteristic. All terms except the price
are customized to the parties individual needs. No customization is associated with over the
counter markets north with exchange traded markets so this is not a characteristic of
exchange traded market sense C. is the correct on so. Which of the following characteristics
is associated with over the counter derivatives cheating because in a central location. There
are more regulated than the exchange listed derivatives they are less transparent than the
exchange listed derivatives hopefully record from the previous light duct exchange listed
derivatives are less transparent so this is the correct answer but to this question you can see
another a couple of important points I didn't see this explicitly but you might imagine that
in exchange would have a central location so the Chicago mercantile exchange obviously is
based in Chicago. Over the counter markets have dealers that could be all over the country
all in the global market they could be all over the world. There are more regulated than
exchange listed derivatives a journey exchange listed derivatives tend to be more regulated
and over the counter markets are less regulated. Market makers the profit in both exchange
and over the counter. Delivered diverse markets by charging a commission on each
street. A combination of commissions and markups buying guide one price selling at a
higher price and hedging any risk and this is what we talked about market makers make
money based on the bid ask spread and doctors what is described over here so C. is the
correct answer. Which of the following statements most accurately describes exchange
traded derivatives relative to over the counter derivatives exchange traded derivatives are
more likely to have greed took should interest remember we said exchange traded
derivatives effectively have little credit risk so this going to be right standardized contract
terms stuck looks right. Greet the risk management uses. This is not necessarily true both
exchange traded derivatives and over the counter derivatives have risk management uses
so. The most accurate. Statement is B.. Section 4 types of derivatives here we will talk
about the 2 major types of derivatives which are forward commitments and contingent
claims we will see a little bit about hybrids which is combination of derivatives with other
instruments and then we will talk about derivatives underlings. Let's start with forward
commitments and we will look at the definition first forward commitments are contracts
entered into at 1.in time Dedrick why a book parties to engage in a transaction how to lead
to a point in time and doctors the expiration on terms agreed upon at the start. The parties
establish the identity earned the quantity of the underlying the manner in which the contract
will be executed all set to when it expires and the fixed price at which the underlying will
be exchanged this fixed price it's called the forward price. The definition as long but the
idea is fairly straightforward let's say you have 2 parties D. and B.. At times 0 parties E.
and B. sign a contract which C. is that he will send stock X. Y. Z. and B. will buy it stop X.
why is it at the end of 6 months and this is similar to an example that I gave you earlier. Dr
contract. Is a forward commitment because at times 0 both he and be agreeing to do
something in the future. Notice that they are agreeing on the underlying the underlying is
one stalk off X. Y. Z. it. The need to point here is 6 months the parties establish the identity
and quantity of the underlying identity is this stock quantity in my example is one the
manner in which the contract would be executed or certain when it expires the contract
would also see where the the selling party needs to physically deliver this particular item
over the disagreement here will be in cash and this is something that we see in more detail
later. The fixed price at which the underlying will be exchanged this contract also needs to
specify the fixed price if that fixed price is 50. That means that even sell for 50 B. will buy
for 50 regardless of what ex wise it is worth over here. And again this price is going to go
forward price. There are different types of forward commitments and this is slightly
confusing but one type of full forward commitment discord a forward contract another is
called a futures contract and a toad is up swap. Each one of these house urging. Unto itself
later in the curriculum. A forward contract is one where the 2 parties create a customized
contract SO 2 parties agreed on the underlying the quantity and whatever terms they want
to agree on those terms in this contract and sign the contract so it is customized private
contract between 2 parties but. The major characteristic Kip is died. Both parties agreed to
do something at a later point in time. Futures contracts are similar except the data exchange
treated so they are standardized. And swaps representa CD's off cash flows which are
exchanged and we see this in more detail later. Let us know get into the different kinds of
forward commitments in more detail the first one that I just mentioned is a forward contract
and again don't get confused forward commitments is the high level don't under forward
commitments we have forward contracts futures and swaps here we are talking about
forward contracts a forward contract is an over the counter derivative contract in which 2
parties agree that one party the buyer will purchase an underlying asset from the other party
the seller act leader DEET act a fixed price which they agree on when the contract is signed
and the example that I just give you applies just to help you memorize this concept I
will. Show you doctor picture again at times 0. To all parties D. and B.. Sign a contract
which sees that at the end of month 6 he is going to sell and B. is going to buy an
underlying asset so the underlying asset is one stalk of X. why is it that underlying the
specified over here. The expiration of the contract is specified the forward price or 50 is
specified and how the contract would be settled is also specified doors are the key pieces of
information that are written in this contract will be studio other details also but it is the
court information so this is up. Forward contract again I want to emphasize some points
over here. This is an over the counter derivative contract which means it is between 2
parties that does in essence private and customized. I have talked about this before but I
want to emphasize this terminology long and short lived Siddharth in this contract he will
eventually since he is getting into the contract to sell X. why is it and B. is getting into the
contract to by the parties ducked is getting into the contract to sell the underlying is called
the. A short party and one way to remember this is S. for sale and as fall short Barty beat is
getting into the contract to buy this is the long party and the city rail for member and this is
the party doctors buying has deep pockets along pockets and doctors the party which will
buy it so long bye and short. Is the party that will set. No just dart the forward price is set in
the contract no matter what the price of the underlying might be this forward price is fixed
if the stock price ends up being above 50 so let's see the. This particular stock exercise it
ends up back 60 been home games. The long party games and just remember this the long
orders games if the underlying goes up white because the long is committing to buy for 50
the shortest selling to. 3450 if the underlying goes up then the long is getting something
that is worth 64 only 50. So what is the pay off if we look at different stock prices the stock
ex wives and here is the underlying then. At a price of 50. If the stock price ends up at 50 at
expiration then the long does not gain under short does not lose because the longest paying
54 and ask the doctors worked 50 what if the stock price is 60 then the payoff for the game
to the long is Dan. Why because the long will be 54 the underlying asset X. why is it and
then the long considered that seem acid for 60 in the market because the market price is 60
if the market price is 70 then the game through the long is 20 so notice that the payoff
diagram. Looks like this. What if the stock price ends up about 40. Then the long still has to
buy a 450 in the market the long would send for. 48 so the loss here would be. Okay so the
payoff diagram is this 45 degree line which passes through 5050 being the forward
price. What about the pay off for the short party and I'll do this in a different color. So let's
do the short party in blue the bill for the shore party is going to be exactly the opposite if
the stock price is at 60 in the short party loses the short party makes a loss often because the
short party has to sell for 50 an underlying asset doctors worked. 60. We noticed that the
game to the long is the same as the loss to the shore that's why it did it reduce also called a
0 sum game the game to one party is equal to the loss to the other party. Futures contracts
futures contracts also fall under the broader got degree off forward commitments let's look
at the definition. A futures contract is standardized derivative contract created entry did on
a futures exchange in which 2 parties agree that one party the buyer will purchase. An
underlying asset from the other party the seller act a need to delete and at the price agreed
on by the 2 parties when the contract is initiated and in which there is a genie settling of
gains and losses earned a credit guarantee by the futures exchange through its clearing
house. Again this material will be covered in detail when we do did you get in the futures
contracts but I want to emphasize the similarities and differences between futures and
forwards which is what you might be disturbed on over here as with forwards to parties
agree a dying 0 to conduct a transaction at some point in the future and the 2 parties agreed
on a price that price is called the futures price generally denoted by small if forward prices
are denoted by it capital all uppercase if. But there are differences no just don't die
underlined standardized futures contracts are traded on exchanges so that exchange traded
and as we discussed earlier. The contracts are standardized everything is standardized
except for the price the price depends on the buyers and sellers. There is an underlying
asset so you might have a futures contract with the underlying is gold for example. As with
forward contracts the agreement is to do something at a later date the price agreed as the
futures price. This is another important difference there is or do you need a certain amount
of gains and losses. Let's say that you have 2 parties he and. B. he is the party go to Celtic
so he is the shark party B. is the party doctors buying the underlying of getting into the
contract to buy so be is long if initially the futures prices set out 50. And then the price of
gold goes up. Who wins the answer is that the long part G.. Benefits why because the long
got into the contract to buy at a certain price note the underlying has gone up so clearly the
long benefits rather than we did in the end what happens when futures contracts is that at
the end of each treating D. the account off the long party is going to be credited in other
words the appropriate amount of money will be added to the long parties account and the
party which is losing their short party will have a certain amount deducted from their
account. When we do futures contracts later we will go to G. 2 examples really look at
exactly how much money is added and subtracted at the end of every day and since we will
cover this material in detail later I did not talk about it over here. The curriculum goes over
several details but I think that since you would cover this in the reading on futures there is
no point during that same material over here. If you really want you can do the reading on
futures and then come back and read the section from the curriculum. swaps also fall under
the larger character D. V. O. forward commitments but smoke is an over the counter
derivative contract in which all parties agreed to exchange a CD's of cash flows we're by
one party piece of video of the CD's that would be determined by an underlying asset or
heat and the other party B. is either a VAT bill CD's determined by a different underlying
asset or read or a fixed seats. I give you a very simple example and then you would see this
in more detail in the reading on swaps the simplest kind of swap is called 1000000000
vanilla interest rate swap. Let's say you have 2 parties he earned B.. If these 2 parties agree
that it is going to be a fixed rate of let's say 10 percent. NBC is going to be VAT bill. Right
let's say that the variable rate is guy board which is the Karachi interbank offered rate this is
an example of swap but obviously more information needs to be specified. We need to
specify the notional principal which is the amount on which the actual interest payment will
be calculated if the notional principal is 100000000 this means that Barty beat will be a
fixed rate of 10 percent off 0 party be it will be based on tribal. Obviously in this particular
slot we also need to specify when payments must be made and how long the swap is in
effect for the daughter duration of the slope is called the 10 north this might be 3
years. Both parties might agree that payments are made every up then we would see that the
payment is I knew it both parties could also agreed that the payments will be quarterly Dr
really depends on the 2 parties no just that this is an over the counter a contract which
means that it is customized. But the requirements off D. and B..