CFAderivatives Full (CFA102

1
READING 45: Derivative Markets and Instruments

Learning outcomes
45.a. Define a derivative and distinguish between exchange-traded and

over-the-counter derivatives
45.b. Contrast forward commitments with contingent claims
45.c. Define forward contracts, futures contracts, options (calls and

puts), swaps, and credit derivatives and compare their basic
characteristics
45.d. Describe purposes of, and controversies related to, derivative

markets
45.e. Explain arbitrage and the role it plays in determining prices and
promoting market efficiency.
This LOS list does not follow the Curriculum’s

2

[LOS 45.a] Define a derivative and distinguish between
exchange-traded and over-the-counter derivatives
1. Definition of derivatives
A derivative is a financial contract or instrument that derives its value from

the value of something else (known as the underlying).
The underlying on which a derivative is based can be:

• An asset (e.g., stocks and bonds)
• An index (e.g., S&P 500)
• Something else (e.g., interest rates).
Mutual funds, exchange-traded funds also derive their values from the
values of the underlying securities they hold, why don’t we call them
derivatives?
Answer: We should note one big difference between exchange-traded
funds, mutual funds and derivatives is that:
Mutual funds and exchange-traded Derivatives transform the

funds simply pass through the performance of the underlying asset.
returns of their underlying securities. (Return of derivatives can be
(With the exception of expense, different from return of underlying
the returns of their underlying assets)
securities = returns of the funds)
2. Distinguish between Exchange-traded and OTC market
2.1. Exchange-traded market
Exchange-traded derivatives (e.g., futures contracts) are traded on

specialized derivatives exchanges or other exchanges. The contracts are
standardized and backed by a clearinghouse.
Characteristics:
• Standardization facilitates the creation of a more liquid market for

derivatives. However, it comes at the cost of flexibility.
• Market makers and speculators play an important role in these markets.
o Market makers stand ready to buy at one (low) price and sell at
another (high) price in order to lock in small short-term profits
(known as scalping).
o Speculators are willing to take educated risks to earn profits.
3
2.1. Exchange-traded market
Exchange-traded derivatives (e.g., futures contracts) are traded on

specialized derivatives exchanges or other exchanges. The contracts are
standardized and backed by a clearinghouse.
Characteristics (cont):
• The exchange is responsible for clearing and settlement through its

clearinghouse. The clearinghouse is able to provide a credit guarantee to
market participants.
(More on this in Reading 46 on derivative pricing).
• Exchange markets also have transparency (i.e., information regarding all
transactions is disclosed to regulatory bodies). This regulation does bring
ertain benefits, but also means a loss of privacy.
4
2.2. Over-the-Counter (OTC) Derivatives Markets
OTC derivatives (e.g., forward contracts) do not trade in a centralized

market; instead, they trade in an informal market. OTC derivatives are
customized instruments.
Characteristics:
• Dealers (typically banks) play an important role in OTC markets, as they

buy and sell these customized derivatives to market participants, and
then look to hedge (or lay off) their risks.
• Note that there is a tendency to think that the OTC market is less liquid
than the exchange market. This is not necessarily true. It is worth
repeating that liquidity is primarily driven by trading interest, which can
be weak in both types of markets.
• OTC derivative markets are less regulated than exchange-traded
derivative markets (even though regulation of OTC derivative markets has
increased since the financial crisis of 2007).
• OTC markets offer more privacy and flexibility than exchange markets.
5
Derivatives are created and traded in two different types of markets:
Categories Exchanged-traded market Over-the-counter market
Trading market Centralized market No central location
Contract Standardized Customized
Market makers and

Main participants Dealers
speculators
Transparency Comparatively high Low
Stocks Listed stocks Unlisted stocks
Trading hours Exchange hours Any time
Regulation Stricter Less strict
Counterparty risk No (minimized) Yes
Well established
Used by Small companies6
companies
[LOS 45.b] Contrast forward commitments and contingent
claims
There are two general classes of derivatives:
Forward commitment Contingent claim
A forward commitment is a legally A contingent claim is a claim that

binding obligation to engage in a depends on the outcome or
certain transaction in the future. payoff on a particular event.
Or we can say:
A forward commitment provides A contingent claim provides the

the obligation but not the right to right but not the obligation to
buy or sell the underlying at a pre- buy or sell the underlying at a pre-
determined price. determined price.
7
[LOS 45.b] Contrast forward commitments and contingent
claims
There are different types of derivatives:
Future contracts
Exchange-traded
(section 2)
Forward Forward contracts

commitment (section 1)
OTC
Swaps
Types of derivatives
(Section 3)
Options
Exchange-traded
(Section 4)
Credit derivatives
(Section 5)
Contingent claim
Asset-backed securities
OTC
(Section 6)
Options *
* Options are often traded on exchanges, but some options can also be 8
traded on OTC
[LOS 45.c] Define forward contracts, future contracts, options
(calls and puts), swaps, and credit derivatives and compare
their basic characteristics
1. Forward contracts
1.1. Definition
In a forward contract, two parties agree that one party (buyer) will purchase
an underlying asset from the other party (seller) at a future date and fixed
price they agree on when the contract is signed.
In an option, it’s important to define:

• Forward price F0 T : refers to the price of forward contract that is
initiated at t = 0 and expires at t = T.
• Spot price ST: refers to the price of underlying at expiration of the forward
contract (t = T).
t=0 t=T
t
Contract initiation: Contract expiration:

Forward price F0 T is agreed Underlying transaction
upon at this point of time, but is executed at F0 9T at
no money is transferred. this point of time.
1.2. Settlement
Settlement by physical delivery
Underlying asset worth at spot price ST

Seller Buyer
(Short) (Long)
Forward price F0 T
Settlement by cash
Forward contracts that settle by an exchange of cash are called non-deliverable

forwards (NDFs), cash-settled forwards, or contracts for differences. In these
contract, only cash representing the net amount of the forward at expiration [ST -
F0 T ] is exchanged.
Cash worth ST - F0 T
Seller Buyer
(Short) (Long)
The long would not take possession of the underlying asset, but if he wanted the
10
asset, he could purchase it in the market for its current price of ST .
1.3. Payoffs
Illustration:
Let’s assume that the buyer enters into the forward contract with the seller
for a price of F0 T , with delivery of one unit of the underlying asset to
occur at time T.
Now, let us roll forward to time T, when the price of the underlying is ST.
• From the long position perspective
ST > F0 T S T < F0 T
The long is obligated to pay F0 T , The long is obligated to pay F0 T ,

for which he receives an asset for which he receives an asset
worth more (ST). worth less (ST).
→ Gain on this contract, the pay → Lose on this contract, the pay off
off is ST - F0 T > 0 is ST - F0 T > 0
11
1.3. Payoffs
Illustration:
Let’s assume that the buyer enters into the forward contract with the seller
for a price of F0 T , with delivery of one unit of the underlying asset to
occur at time T.
Now, let us roll forward to time T, when the price of the underlying is ST.
• From the short position perspective
ST > F0 T S T < F0 T
The short is required to deliver the The short is required to deliver the
asset worth ST and receive a asset only worth ST and receive a
smaller amount of money, F0 T . greater amount of money, F0 T .
→ Lose on this contract, the pay off → Gain on this contract, the pay
is F0 T - ST or -[ST - F0 T ] < 0 off is F0 T - ST or -[ST - F0 T ] > 0
12
1.3. Payoffs
Long position Short position

Payoff Payoff
0 0
F0 T F0 T
ST ST
Payoff from buying Payoff from selling
• The payoff of the long position increases as the price of the underlying at
expiration increases.
• On the other hand, the payoff of the short position decreases as the price of the
underlying at expiration increases.
• The more the long positions gains, the more the short position loses, and vice
versa. For a forward contract, at one time, there is always a party winning and the
other losing. 13
1.3. Payoffs
Payoffs at expiration to the counterparties:

S T > F0 T ST < F0 T
ST - F0 T ST - F0 T
Long position
(Positive payoff) (Negative payoff)
- [ST - F0 T ] - [ST - F0 T ]
Short position
(Negative payoff) (Positive payoff)
14
1.3. Payoffs
Example 1:
A buyer enters a forward contract to buy gold four months from now.
• Initial price of gold F0 T = $1,312.90 per ounce.
• The spot price of gold is S0 = $1,207.40 per ounce.
• Four months in the future, the price of underlying gold is ST = $1,275.90
per ounce.
Calculate the payoff from the contract.
15
1.3. Payoffs
Answer:
• Payoff from buying: Buyer is obligated to pay $1,312.90, for which he
receives $1,275.90.
The buyer’s gain from the forward contract is:
ST - F0 T = $1,275.90 - $1,312.90 = -$37.00 (negative payoff).
Because the value of gold when the contract matures is less than the
forward price, ST < F0 T , the buyer has incurred a loss.
• Payoff from selling: Seller is required to deliver the gold worth $1,275.90
and recieve the amount of $1,312.90 of the contract.
The seller’s gain from the forward contract is +$37.00 (positive payoff).
• The gain on owning the underlying is:
ST - S0 = $1,275.90 - $1,207.40 = $68.40
16
2. Futures contracts
2.1. Definition
In a futures contract, two parties agree that one party (buyer) will purchase
an underlying asset from the other party (seller) at a future date and fixed
price they agree on when the contract is signed. Additionally, there is a daily
settling of gains and losses and a credit guarantee by the futures exchange
through its clearinghouse.

• Futures price f0 T : refers to the price of futures contract that is initiated
at t = 0 and expires at t = T.
• At any given time, the number of outstanding contracts is called the open
interest.
• The open interest figure changes daily as some parties open up new
positions, while other parties offset their old positions.
17
2.2. Clearinghouse
• Every futures exchange has a clearinghouse, which guarantees that

participants on the exchange will meet their obligations. The
clearinghouse accomplishes this by taking the opposite side of every
trade on the exchange
• Clearinghouse also engages in a periodic settlement called mark to
market that eliminate counterparty defaults because it prevents the
accumulation of losses in investors’ accounts and ensures that the party
that earns a profit from a futures transaction will not have to worry
about collecting the money.
18
2.3. Mark-to-market
t=0
….
Contract initiation t1 t2 t3 tT
Daily settlement
f1 (T) f2 (T) f3 (T) …. fT (T)
prices
Cashflows to
account of the f1 (T) - f0 T f2 (T) - f1 (T) f3 (T) - f2 (T) …. fT (T) - ft−1 T
long
At the end of each day, the clearinghouse engages in a practice called mark
to market (also known as the daily settlement), which determines an
average of the final futures trades of the day and designates that price as
the settlement price.
19
2.3. Mark-to-market
Example 2: Mark-to-market process:

Samantha takes a long position in a futures contract worth $100. Based on
settlement prices, the value of contract for the next three days is $98, $99,
and $105.
Determine the balance in her margin account at the end of each trading day.
20
2.3. Mark-to-market
Answer:
• Futures price f0 T = $100.
Mark-to-market process:
t0 t1 t2 t3
Daily settlement prices $98 $99 $105
Cashflows to account $98-$100 = -$2 $99-$98 = -$1 $105 - $99 = +$6
loss $2 loss $1 gain $6
Net gain over the three days equals $3
21
2.4. Futures margins
Initial margin Maintenance margin
The initial margin is the amount The maintenance margin is the

that must be deposited by both minimum balance that must be
party (the long and the short) into maintained in an investor’s
their account to be able to trade. account to avoid a margin call (a
This required margin is typically call for more funds to be deposited
less than 10% of futures price. in the account).
Note:
In contrast to the securities market, if the margin balance in a futures market
transaction falls below the maintenance margin, the investor must deposit
enough funds to bring the balance up to the initial margin requirement.
22
Example 3:
Let’s assume that we are dealing with a futures contract with one share of
RIL, which is trading at Rs.300/share, as the underlying.
Initial margin
• If the initial margin requirement is 10%, an investor wanting to take a long

position in futures contract would have to deposit Rs.30 (Rs.300 x 10%)
into her futures account.
• It is important to note that no loan is taken to fund the remainder of the
contract’s value.
23
Maintenance margin
• If the maintenance margin is 5%, the investor is required a minimum
balance of Rs.15 (Rs.300 x 5%) in her margin account. In case the balance
falls below this level, she will receive a margin call to increase the balance
in her account back to the initial margin level.
• If futures contract closes at Rs.284, a loss of Rs.16 will be posted to the
long’s account.
→ Her margin balance will fall from Rs.30 to Rs.14 (Rs.30 – Rs.16) <
maintenance margin level of Rs.15. → Margin call
Investor will have 2 options
She will deposit Rs.16 to restore She could close out her position,
the initial margin (Rs.30) if she but she would still be responsible
wants to keep her position “open.” for any further losses incurred if
prices move further before the
closing transaction is executed.
24
2.5. Price limits
Price limits provision is set by the exchange to restrict the change in the
settlement price of a contract from one day to the next.
No trading is allowed at prices beyond these limits.
Limit up Limit down
If the futures price hits its upper If the price falls to its lower limit,
ceiling, the contract is said to be the contract is said to be limit
limit up. down.
If traders cannot transact because of a limit move, either up or down, the

price is said to be locked limit.
25
2.5. Price limits
Example 4:
Let’s assume that we are dealing with a futures contract with one share of
RIL, which is trading at Rs.300/share, as the underlying.
If the previous settlement price were Rs.284 and an Rs.30 price limit were in
place.
• Limit up would be Rs.314
• Limit down would be Rs.254
→ There would be no trading at prices below Rs.254 or prices above Rs.314.
26
2.6. Cashflows on Forward and Futures contracts
To understand the differences in cashflows between two contracts, we

discuss an example.
Example 5: Cashflows on Forward and Futures contracts
Investor A and Investor B want to take long positions on ABC Stock through
derivative contracts. They both want to purchase the stock for $50 in two
days. Investor A decides to take a long position on a forward contract on
ABC, while Investor B chooses to go long on a futures contract. Both the
contracts expire in two days and have forward/ futures prices of $50.
Describe the cash flows on each investor’s position given that the
settlement price at the end of Day 1 is $49, and at the end of Day 2 (at
contract expiration) is $52.
27
Investor A’s position on the forward contract
• There are no mark-to-market adjustments on forward contracts. The

(only) settlement payment occurs at the expiration of the contract.
• The forward contract gives Investor A the ability to purchase the stock for
$50 (forward price) even though it is priced at $52 in the market.
Therefore, the investor gains on the contract.
t0 t1 t2
Pay off = ST − F0 T = $52-$50 = 2
At expired date, investor A will have 2 options
She would receive a $2 profit in She would receive the stock in

cash if the contract were cash- return for a payment of $50 if it
settled. called for physical delivery. 28
Investor B’s position on the futures contract
The futures position would require a mark-to-market adjustment daily.
t0 t1 t2
Daily settlement prices $49 $52
Cashflows to account $49-$48 = -$1 $52 - $49 = +$3
loss $1 gain $3
Net gain over the two days equals $2
(same as Investor A’s)
29
3. Swaps
3.1. Definition
In a swap, 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 (1) a variable series determined by a
different underlying asset or rate or (2) a fixed series.
• At each settlement date, the two payments are netted so that only one
(net) payment is made. The party with the greater liability makes a
payment to the other party.
(How the payments are made will be further illustrated in the next slide)
• The length of the swap is termed the tenor of the swap and the contract
ends on the termination date.
The most common swap is the fixed-for-floating interest rate swap (plain-
vanilla swap), which involves the exchange of fixed interest payments
for floating-rate payments.
The illustration presented in the next slide examines a scenario in which the
30
vanilla interest rate swap is frequently used.
3. Swaps
3.2. Illustration of plain-vanilla interest rate swap
Suppose company A wants to borrow some money from a bank. The bank
only offers floating-rate loans, but the company would much rather make
fixed-interest payments. In such a situation, the company can add a swap to
effectively convert its floating-rate loan to a fixed-rate loan, as shown in the
graph below:
Floating swap payments 2
Company A borrowing
Swap dealer
at floating rate Fixed swap payments
1
3 Floating interest payments
Bank lender
The company will take the pay-fixed/receive-floating side of a plain-vanilla

interest rate swap.
31
See details next slide.
3. Swaps
The process of using an interest rate swap to convert a floating-rate loan to a

fixed-rate loan
It will make fixed interest payments based on the

1
notional principal of the swap. The company
will just make
2 It will receive floating interest payments from the fixed-rate
swap counterparty. payments (as it
originally
desired).
3 It will pass on those floating-rate receipts to the
bank to fulfill its obligations on the original loan.
• Company A is the party that wants to receive floating-rate payments and agrees to
make fixed rate payments → Company A is called the pay-fixed side of the swap or
the fixed-rate payer/ floating-rate receiver.
• Swap dealer is the party that wants to receive fixed payments and make floating-
rate payments → Swap dealer is called the pay-floating side of the swap or the
32
floating-rate payer/fixed-rate receiver.
3. Swaps
The exchange of payment
• There is no exchange of notional principal at initiation or expiration of the

swap. The notional principal is simply used to determine the interest
payment on each leg of the swap.
• Interest payments are not exchanged in full at each settlement date.
Interest payments are netted, and the party that owes more in interest at
a particular settlement date makes a payment equal to the difference to
the other.
• The floating rate is usually quoted in terms of LIBOR plus a spread.
Net fixed rate payment = Fixed rate payment – Floating rate

payment = [Swap fixed rate - (LIBORt−1 + spread)]x (No. of days/360)
x Notional principal
See example 6
33
3. Swaps
Example 6: The exchange of payment on a plain-vanilla interest rate swap
AFC Bank enters into a $5,000,000 quarterly-pay, plain-vanilla interest rate

swap as the fixed-rate payer at a swap rate of 5% based on a 360-day year.
The floating-rate payer agrees to make payments at 90-day LIBOR plus a
0.50% spread (also known as margin).
Ninety-day LIBOR currently stands at 3%.
LIBOR-90 rates are 3.50% - 90 days from today, calculate the amounts that
AFC pays or receives 90 days from now.
34
3. Swaps
Example 6: The exchange of payment on a plain-vanilla interest rate swap
Answer:
When working with LIBOR-based instruments, remember that the LIBOR
rate at a particular reset date determines the interest payment due on the
next reset date.
→ The floating interest rate payment on Day 90 of the swap will be based on
LIBOR-90 at swap inception (Day 0). Similarly, the interest payment on Day
180 will be based on LIBOR-90 on Day 90 of the swap, and so on.
→ The payment on Day 90 depends on LIBOR-90 at Day 0, 3.00%.
Net fixed rate payment90 = Swap fixed rate - (LIBOR0 + Margin) x (No. of
days/360) x (NP)
→ Net fixed rate payment90 = [0.05 - (0.03 + 0.005)] (90/360) x $5,000,000 =
$18,750 > 0
→ AFC Bank pays $18,750 on day 90. 35
[LOS 45.c] Define forward contracts, futures contracts, options
4. Options
4.1. Definition
An option is a derivative contract in which one party, the buyer, pays a sum
of money (premium) 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.

• Expiration date (T): the date at which the option expires
• Exercise price (strike price) (X): the fixed price at which the underlying
asset can be purchased or sold
• Premium: the amount the option buyer has to pay the seller, for the
option
• There are 2 types of options:
Call option (call) Put option (put)
Offers the right to purchase the Offers the right to sell the
underlying asset at a specific price underlying asset at a specific price
36
for a specified time period. for a specified time period.
(calls and puts), swaps, and credit derivatives (…)
4. Options
4.1. Definition (cont)
• There are 4 possible option positions:

o Long call: the buyer of a call o Long put: the buyer of a put
option—has the right to buy an option—has the right to sell the
underlying asset. underlying asset.
o Short call: the writer (seller) of a o Short put: the writer (seller) of a
call option—has the obligation to put option—has the obligation to
sell the underlying asset. buy the underlying asset.
Call option
Right to buy an asset
Call buyer Call writer
(long call) (short call)
$ premium
• By taking the long call position, the investor pays the option’s premium and
get the right to buy.
• By taking the short call position, the writer gets the option’s premium and is
obliged to sell the asset to the call buyer in the future, if the buyer exercise
37
the call.
4. Options
4.1. Definition
Put option
Right to sell an asset @

Put buyer Put writer
(long put) (short put)
$ premium
• By taking the long put position, the investor pays the option’s premium and
get the right to sell.
• By taking the short put position, the writer gets the option’s premium and is
obliged to buy the asset from the put buyer in the future, if the buyer
exercise the put.
It is important to note that:

• Options give their buyers the right (not the obligation) to buy or sell the
underlying from or to the seller (writer) of the option.
• The seller (writer) of the option has the obligation (not the right) to exercise
the choice of the buyer.
• We will learn how to determine the option’s premium, or the option’s price,
in Reading 46: Basics of derivative pricing and valuation 38
4. Options
4.2. Settlement
Time of settlement
An option is also designated as exercisable early (before expiration) or only
at expiration.
European options can be exercised American options may be

only on the contract’s expiration exercised at any time up to and
date. including the contract’s expiration
date.
Method of settlement
As with forwards and futures, an option can be exercised by physical
delivery or cash settlement, as written in the contract.
39
4. Options
4.3. Profit and losses
4.3.1. For call option
Illustration: A call option with an exercise price of X, expires at T. The call premium is
c0 . ST is the price of the underlying at the expiration date.
▪ At the time of expiration, from the call buyer’s perspective
ST < X ST > X
• The call buyer will choose to buy the The call buyer will exercise the option to
asset on the market at ST , instead of buy the asset at X, instead of buying the
exercising the option to buy the asset on the market at ST .
asset at X.
• The buyer just let the call expires.
Payoff to the call buyer: cT = 0 Payoff to the call buyer: cT = ST - X

Profit (loss) to the call buyer: π = - c0 Profit (loss) to the call buyer:
π = ST - X- c0
Payoff to the call buyer: cT = Max(0, ST – X) 40

Profit (loss) to the call buyer: π = Max(0, ST – X) - c0
4. Options
Illustration: A call option with an exercise price of X, expires at T. The call

premium is c0. ST is the price of the underlying at the expiration date.

From the discussion in the previous slide, the call buyer’s payoff and profit can be
described via the following diagram:
Payoff and profit cT = ST - X

π = ST - X- c0
payoff
0
-c0 profit
X
41ST
Not exercise Exercise the option

4. Options


Discussion:
1. In the money, at the money, out of the money
• When ST < X, the call option is said to be out of the money, the call buyer will
not exercise it.
• When ST = X, the call option is said to be at the money, exercising the call or
not all brings about the same payoff.
• When ST > X, the call option is said to be in the money, the call buyer will
exercise it.
2. Extra notes on payoff and profit for call buyer
• The loss of the call buyer is limited at the call premium, c0 , because call buyer
have the right to choose what benefits them the most.
• The gain of the call buyer increases as the price of the underlying increases and
becomes unlimited as the price of the underlying at the expiration increases
42
to
+∞
4. Options
Illustration: A call option with an exercise price of X, expires at T. The call premium is
c0 . ST is the price of the underlying at the expiration date.
▪ At the time of expiration, from the call writer’s perspective
ST < X ST > X
The call buyer will choose to buy the The call buyer will exercise the option to
asset on the market at ST , and just let buy the asset at X
the call expires. → The call writer has to sell the asset at
→ The call writer just get the premium a lower price (X) than its current market
and does not need to do anything price (ST )
Payoff to the call writer: −cT = 0 Payoff to the call writer: −cT = X - ST
Profit (loss) to the call writer: π = c0 Profit (loss) to the call writer:
π = X - ST + c0
Payoff to the call writer: −cT = - Max(0, ST – X);

Profit (loss) to the call writer: π = - Max(0, ST – X) + c0 43
4. Options

From the discussion in the previous slide, the call writer’s payoff and profit can be
Payoff and profit
profit
c0
payoff
0
π = X - ST + c0
−cT = X - ST
X
ST
44
Not exercise Exercise the option
4. Options

Discussion:
From the call writer’s perspective, it’s important to note that:
• The profit of the call writer is limited at the call premium, c0, it happens when
the call buyer do not exercise the price.
• The loss of the call writer increases as price of the underlying increases and
becomes unlimited as the price of the underlying at the expiration increases to
+∞
45
4. Options
▪ Consolidating the pay-off diagram of call buyer and call writer
payoff profit
Call buyer c0 Call buyer

0 0
Call writer − c0
Call writer
X X
ST ST
We see that:
The pay off and the profit of the call buyer and call writer is opposite to each
other, which means the more call buyer gains, the more call writer loses.
→ That’s why we say option is a zero sum game. 46
4. Options
Example 7: Payoff and profit of a call option

Consider a call option selling for $7 in which the exercise price is $100 and the
price of the underlying is $98. Determine the value at expiration (payoff) and the
profit for the call buyer and the call seller if the price of the underlying at
expiration is $102.
Answer:
• For the call buyer
Approach 1: Not using the formula
ST > X ($102 > $100)
→ The call buyer will choose to exercise the call to buy the asset at $100, instead
of buying it on the market at $102.
→ The value at expiration for the call buyer, therefore is: $102 - $100 = $2
→ The call buyer’s profit (loss) = $102 - $100 - $7 = - $5
Approach 2: Using the formula
The value at expiration to the call buyer: cT = Max(0, ST – X)
= Max (0,102 – 100) = $2
Profit (loss) to the call buyer: π = Max(0, ST – X)- c0 = Max (0,102 – 100) - $7 = -$5
47
4. Options
Example 7: Pay off and profit of a call option

Consider a call option selling for $7 in which the exercise price is $100 and the
price of the underlying is $98. Determine the value at expiration (payoff) and the
profit for the call buyer and the call seller if the price of the underlying at
expiration is $102.
Answer:
• For the call writer
The call buyer will choose to exercise the call to buy the asset at $100
→ The call writer has to sell the asset at $100, instead of selling it on the market
at $102
→ The value at expiration for the call writer, therefore is: $100 - $102 = -$2
The call writer’s profit (loss) = $100 - $102 + $7 = $5
Value at expiration to the call writer: −cT = - Max(0, ST – X) = - Max(0, 102-100)
= -$2
Profit (loss) to the call writer: π = - Max(0, ST – X) + c0 = - Max(0, 102-100) = -2 +
48
7 = $5
4. Options
4.3.2. For put option
Illustration: A put option with an exercise price of X, expires at T. The put premium is
p0 . ST is the price of the underlying at the expiration date.
▪ At the time of expiration, from the put buyer’s perspective
ST < X ST > X
The put buyer will exercise the option to • The put buyer will choose to sell the
sell the asset at X, instead of selling the asset on the market at ST , instead of
asset on the market at ST . exercising the option to sell the asset
at X.
• The buyer just let the put expires.
Payoff to the put buyer: pT = X - ST Payoff to the put buyer: pT = 0

Profit (loss) to the put buyer: Profit (loss) to the put buyer: π = - p0
π = X - ST - p0
Payoff to the put buyer: pT = Max(0, X - ST ); 49

Profit (loss) to the put buyer: π = Max(0, X - ST ) - p0
4. Options
Illustration: A put option with an exercise price of X, expires at T. The put

premium is p0 . ST is the price of the underlying at the expiration date.

From the discussion in the previous slide, the put buyer’s payoff and profit can be
Payoff and profit
pT = X - ST
π = X - ST - p0
payoff
0
profit
- p0
X
50ST
Exercise the option Not exercise

4. Options

premium is p0 . ST is the price of the underlying at the expiration date.
Discussion:
1. In the money, at the money, out of the money
• When ST < X, the put option is said to be in the money, the put buyer will
exercise it.
• When ST = X, the put option is said to be at the money, exercising the put or
not all brings about the same payoff.
• When ST > X, the put option is said to be out of the money, the put buyer will
not exercise it.
2. Extra note on payoff and profit for put buyer
• The loss of the put buyer is limited at the put premium, p0 , because put buyer
have the right to choose what benefits them the most.
• The gain of the put buyer increases as the price of the underlying at the
expiration decreases and becomes maximum as the price of the underlying 51
decreases to 0.
4. Options
Illustration: A put option with an exercise price of X, expires at T. The put premium is
p0 . ST is the price of the underlying at the expiration date.
▪ At the time of expiration, from the put writer’s perspective
ST < X ST > X
The put buyer will exercise the option The put buyer will choose to sell the
to sell the asset at X asset on the market at ST , and just let
→ The put writer has to buy the asset at the put expires.
a higher price (X) than its current → The put writer just get the premium
market price (ST ) and does not need to do anything
Payoff to the put writer: - pT = ST - X Payoff to the put writer: - pT = 0

Profit (loss) to the put writer: Profit (loss) to the put writer: π = p0
π = ST - X + p0
Payoff to the put writer: - pT = - Max(0, X– ST ) 52

Profit (loss) to the put writer: π = - Max(0, X– ST ) + p0
4. Options

From the discussion in the previous slide, the put writer’s payoff and profit can be
Payoff and profit
payoff
- pT = ST - X profit
π = ST - X + p0
0
- p0
X
53ST
Exercise the option Not exercise

4. Options

Discussion:
From the put writer’s perspective, it’s important to note that:
• The profit of the put writer is limited at the put premium, p0 , it happens when
the put buyer do not exercise the price.
• The loss of the put buyer increases as price of the underlying decreases and
becomes maximum as the price of the underlying at the expiration decreases to
0.
54
4. Options
▪ Consolidating the pay-off diagram of put buyer and put writer
payoff profit
Put buyer
Put buyer
c0
0 0
− c0
Put writer
Put writer
X X
ST ST
We see that:
The pay off and the profit of the put buyer and put writer is opposite to each
other, which means the more put buyer gains, the more put writer loses.
→ That’s why we say option is a zero sum game. 55
4. Options

Consider a put option selling for $4 in which the exercise price is $60 and the
price of the underlying is $62.
Determine the value at expiration (payoff) and the profit for the put buyer and
the put seller if the price of the underlying at expiration is $68.
Answer:
• For the put buyer
ST > X ($68 > $60)
→ The put buyer will choose to sell the asset on the market at $68, not exercise
the put and just let it expires.
→ The value at expiration for the put buyer, therefore is zero.
→ The put buyer’s profit (loss) = $0 - $4 = - $4
Value at expiration to the put buyer: cT = Max(0, X - ST) = Max(0, 60-68) = $0
Profit (loss) to the put buyer: π = Max(0, X - ST) - p0 = Max(0, 60-68) – 4
= -$4 56
4. Options

Consider a put option selling for $4 in which the exercise price is $60 and the
price of the underlying is $62.
Determine the value at expiration (payoff) and the profit for the put buyer and
the put seller if the price of the underlying at expiration is $68.
Answer:
• For the put writer
The put buyer will not exercise the put and just let it expires.
→ The put writer just get the put premium and don’t have to do anything.
→ The value at expiration for the put writer is 0.
The put writer’s profit (loss) = 0 + $4 = $4
Value at expiration to the put writer: - pT = - Max(0, X– ST ) = - Max(0, 60-68) =
$0
Profit (loss) to the put writer: π = - Max(0, X– ST ) + p0 = - Max(0, 60-68) + 4 = $4
57
5. Credit derivatives
A credit derivative is a class of derivative contracts between two parties, a

credit protection buyer and a credit protection seller, in which the latter
provides protection to the former against a specific credit loss.
There are 4 types of credit derivatives:

• Credit default swap
• Total return swaps
• Credit spread options
• Credit-linked notes
5.1. Credit default swap
A credit default swap is a derivative contract between two parties, a credit

protection buyer and a credit protection seller, in which the buyer makes a
series of cash payments to the seller and receives a promise of
compensation for credit losses resulting from the default of a third party.
58
periodic payments 2
Lender (CDS
CDS seller
buyer)
compensation for credit losses
3
interest and
principal
payments
Borrower 1
1 The borrower here is a third party that the CDS buyer buys the
protection over its default (in the case it fails to make payments to the
CDS buyers).
2 The protection buyer makes a series of periodic payments (think of them
as periodic insurance premium payments) to the protection seller during
the term of the CDS.
3 If a credit event occurs, the protection seller is obligated to compensate
the protection buyer for credit losses by means of a specified settlement
59
procedure.
Example 9: Illustration of how a CDS works

Assume that we purchase $10 million worth of five-year bonds issued by
ABC Company at par. In order to insulate our portfolio from ABC’s credit
risk, we enter a CDS on ABC Company as the protection buyer. This CDS has
a notional amount of $10 million, a five-year term, and a CDS premium of
60 bps (payable quarterly).
periodic payments 2
Lender (CDS
CDS seller
buyer)
compensation for credit losses
3
interest and
principal
payments
1
ABC Company
60
Example 9: Illustration of how a CDS works
1 We are buying the protection over the default of ABS company.
2 Until a credit event occurs during the tenor of the swap, we will pay the
swap counterparty a quarterly premium worth 0.006/4 x $10,000,000 =
$15,000.
3 In the case of a credit event, we would stop making premium

payments and the CDS would be settled immediately.
• In a physical settlement, we (as the protection buyer) would:
o Receive the notional amount ($10,000,000) from the swap
counterparty (protection seller).
o Deliver the ABC Company bonds that we hold (reference
obligation) to the protection seller.
• In a cash settlement we would: Receive a cash payment from the
protection seller equal to the difference between the par value
of the bonds and the post-default market value of the reference
obligation. 61
5.2. Total return swaps
The protection buyer pays the protection seller the total return on the
underlying bond (interest, principal, and changes in market value), while
the protection seller pays the protection buyer either a fixed or floating
interest rate.
total return on the underlying bond

(interest, principal, and changes in market value)
Protection Protection
buyer seller
Fixed or floating rate
• If there is a default, the protection seller will continue to make

payments, while receiving a very low or negative return
• This means the protection buyer is being protected from the credit
default risk of the bond.
62
5.3. Credit spread options
Credit spread options are call options based on a bond’s yield spread
relative to a benchmark.
The credit protection buyer selects the strike spread it desires and pays the
option premium to the credit protection seller.
If there is a decline in the bond’s credit quality (which means the default
risk increases)
Yield spread increases
Call holder receives a positive payoff from her position
This means that the call holder is getting a compensation for the credit
default risk.
63
5.4. Credit-linked notes
The credit protection buyer finance the underlying bond (that is subject to
default risk) with a credit-linked note. As a result, periodically it use the
payments from the underlying bond to make payments to the credit-linked note
payments Investor (Credit payments

Underlying bond Credit-linked note
protection buyer)
If the bond or defaults and fails to make sufficient payment to the investor, the
principal payoff on the credit-linked note is reduced accordingly.
Refer to Reading 39, LOS 39.e, session 2.3 for details about credit-linked note
The investor is protected against default risk of the underlying bond
The buyer of the credit-linked note effectively insures the credit risk of the
underlying reference security.
6. Asset-backed securities
64
Refer to Reading 42: Introduction to Asset-Backed Securities for details.
[LOS 45.d] Describe purposes of, and controversies related to,
derivative markets
1. Purposes and Benefits of Derivatives
1.1. Risk Allocation, Transfer, and Management
• Derivatives allow investors to hedge away risks without trading the

underlying itself.
• They improve risk allocation within markets, as parties who do not want
exposure to a particular risk can transfer it to those who do.
1.2. Information Discovery
• Certain forms of derivative contracts (e.g., futures) provide an indication

of the direction of the underlying.
For example, the S&P futures price is a good indicator of where the stock
market will actually open when trading commences.
• Since derivative transactions involve less capital, information can
sometimes be reflected in derivatives prices more quickly than in spot
prices.
• Certain derivatives (e.g., options) can be used to implement strategies
that cannot be implemented with the underlying alone. Further, option
market prices can be used to infer implied volatility, which can be used
to measure the risk of the underlying. 65
derivative markets
1. Purposes and Benefits of Derivatives
1.3. Operational Advantages
• Derivatives entail lower transaction costs (relative to the value of the

underlying) than comparable spot market transactions.
• Derivative markets are typically more liquid than the underlying spot
markets.
• Derivatives offer an easy way to take a short position on the underlying. With
derivatives, it is as easy to take a short position on the underlying as it is to go
long. With some underlying assets (e.g., commodities) it is typically much
more difficult to go short.
• Derivatives allow users to engage in highly leveraged transactions, as a
relatively small amount of money must be invested to take a position on a
derivative compared to taking a position directly in the underlying.
1.4. Market Efficiency
• When asset prices deviate from the fundamental values, derivative markets
offer a less costly method of taking advantage of the mispricing, as less
capital is required, transaction costs are lower, and short selling is easier.
• The ability to hedge various risks through derivatives increases the willingness
of market participants to trade and improves liquidity in the market. 66
derivative markets
2. Criticisms and Misuses of Derivatives
2.1. Destabilization and systematic risk
Benefits of derivatives (low cost, low capital requirements, and ease of

going short)
Excessive amount of speculative trading
If they end up on the wrong side of a trade, speculators can incur huge
losses.
These losses trigger defaults on their creditors, creditors’ creditors, and so

on, spreading instability throughout financial markets and the economy.
However, we should note that, not only derivatives, but any other ways of
taking leverage is just as risky.
67
derivative markets
2. Criticisms and Misuses of Derivatives
2.2. Speculation and gambling
For hedging to work, there must be someone willing to take on the risk.
This role is performed by speculators (e.g., professional traders and hedge

funds)
Speculators are often compared negatively to gamblers.
However, we should note that, gamblers bring no benefit to the society,

while derivatives trading bring many benefits to the financial markets and
thus society.
2.3. Complexity
• The mechanics behind derivative contracts can be complex and difficult

to understand.
• Lack of understanding on the part of users can result in significant losses.
68
[LOS 45.e] Explain arbitrage and the role it plays in
determining prices and promoting market efficiency.
• Arbitrage opportunities exist whenever similar assets or combinations of

assets are selling for different prices. In other words, these opportunities
abound when assets are mispriced.
• Arbitrageurs exploit these opportunities and trade on mispricings until
they are eliminated and asset prices converge to their “correct” levels
(where no arbitrage opportunities exist).
Arbitrage plays an important role in the study of derivatives. It is an

important feature of efficient markets because it helps:
• Determine prices.
• Improve market efficiency.
1. Determination of prices
This role is based on the law of one price, which states that:
“Two securities that will generate identical cash flows in the future,
regardless of future events, should have the same price today.”
69
1. Determination of prices
“Two securities that will generate identical cash flows in the future,
regardless of future events, should have the same price today.”
Justification: Assume that A and B have the identical future payoffs and A is
priced lower than B.
A’s price < B’s price
Buy A Sell B
Investor
Arbitrage profit
 A’s price and  B’s price
A’s price = B’s price
The combined actions of arbitrageurs bring about a convergence

70
of prices.
2. Improve market efficiency
From the previous justification, we see that arbitrage will continue to bring
the two assets’ prices closer until parity is established.
By bringing price closer to the accurate pricing level, arbitrage helps

enhance the efficiency of markets.
71
72
READING 46: BASICS OF DERIVATIVE PRICING

AND VALUATION
Learning outcomes
Forward and future contract
43.a. Explain how the concepts of arbitrage, replication, and risk

neutrality are used in pricing derivatives
43.b. Explain the difference between value and price of forward and
futures contracts
43.c. Calculate a forward price of an asset with zero, positive, or negative
net cost of carry
43.d. Explain how the value and price of a forward contract are
determined at expiration, during the life of the contract, and at
initiation
43.e. Describe monetary and nonmonetary benefits and costs associated

with holding the underlying asset and explain how they affect the
value and price of a forward contract
43.f. Define a forward rate agreement and describe its uses
43.g. Explain why forward and futures prices differ

73

AND VALUATION
Learning outcomes
Swap contract
43.h. Explain how swap contracts are similar to but different from a series
of forward contracts
43.i. Explain the difference between value and price of swaps
Option contract
43.j. Explain put–call parity for European options
43.k. Explain put–call–forward parity for European options
43.l. Explain the exercise value, time value, and moneyness of an option
43.m. Identify the factors that determine the value of an option and
explain how each factor affects the value of an option
43.n. Explain how the value of an option is determined using a oneperiod
binomial mode
43.o. Explain under which circumstances the values of European and
American options differ
74

AND VALUATION
[LOS 46.a] Explain how the concepts of arbitrage, replication,
and risk neutrality are used in pricing derivatives
1. Pricing the underlying

Because derivatives is a financial instrument that derives its value from the
performance of an underlying asset.
→ it is important to first understand how the underlying is priced.
Fundamental value of Current market price of

Compare
assets assets
Makes decision about whether to trade

based on any profit potential (net of trading
costs) and confidence in his valuation model
S0 is determine as the present value (PV) of expected

E(ST ) future price plus (minus) any benefits (costs) of
S0 = −θ+γ
(1+r+ ʎ)T holding the asset, discounted at a rate appropriate
for the risk assumed.
S0 = The fundamental of asset θ = PV of any costs associated with holding

the asset (1.4)
E(ST ) = Expected future price of the γ = PV of any benefits associated with
asset (1.1) holding the asset (1.4)
r = Risk-free rate (1.2) T = Holding period
ʎ = Risk premium (1.2)
75

AND VALUATION
1.1. The formation of expectations
The investor forecasts the future over a holding period spanning time 0
to time T by using a probability distribution (*) of predicted future prices
of the asset.
→ The center of the the distribution is the expected price of the asset at
time T
→ Represent the investor’s prediction of the spot price at T.
The center of the

distribution at time T using
a probability distribution
S0 E(ST )
0 T
(*) The reason for the probability distribution is because the prediction of
investors is imperfect due to risk.
76

AND VALUATION
1.2. The required rate of return on the underlying asset
We must discount the expected future price to determine the value of the
asset
We need to determine the required rate of return (also referred to as the

expected rate of return) – k - the rate that is used to discount the
expected future price of the asset.
k=r+ʎ
At a minimum, k will include the For risky assets, k also includes a

risk-free rate of interest – r risk premium – ʎ
• r represents the opportunity cost, or so-called time value of money, and

reflects the price of giving up your money today in return for receiving
more money late.
• The value of the ʎ depends on three potential types of risk aversion of
the investors: risk averse, risk neutral, or risk seeking (explained in the
next slide)
77

AND VALUATION
1.2. The required rate of return on the underlying asset
Risk premium (ʎ) under each type of risk aversion of the investor
Risk averse Risk neutral Risk seeking
Risk-averse investors are Risk-neutral investors Risk-seeking investors

unwilling to engage in are willing to engage in prefer risk over certainty
risky investment for risky investments for and will pay more to
which they can earn only which they expect to invest when there is risk
the risk-free rate earn only the risk-free → risk-seeking investors
→ risk-averse investors rate require a negative risk
require a positive risk → they do not expect to premium (lower return
premium (higher return earn a premium for and higher price) on risky
and lower price) on risky bearing risk assets
assets →ʎ=0 →ʎ<0
→ʎ>0
It is very important to understand, however, that risk premiums are not

automatically earned. They are merely expectations. Actual outcomes can differ.
78

AND VALUATION
1.3. The pricing of risky assets
For risky assets that do not generate/ incur any benefits or costs
An investor calculate the current price, S0, by discounting the expected

future price of an asset with no interim cash flows, E(ST ), by r (the risk-
free rate) plus λ (the risk premium) over the period from 0 to T.
Discounting the expected future price to

E(ST) obtain the current price
S0 =
(1+r+ ʎ)T E(ST )
0 T
79

AND VALUATION
1.4. Other benefits and costs of holding an asset

Many assets may generate/incur monetary and nonmonetary
benefits/costs to their owners
Costs (θ) Benefits (γ)
Including: cost of storage,
opportunity cost of the money Including: dividend receipts,
invested, costs incurred in protecting coupon receipts, convenience yield
and insuring some commodities from investments in commodities
against theft or destruction
Cost of carry = γ − θ
E(ST )
S0 = −θ+γ
(1+r+ ʎ)T E(ST )
0 T
80

AND VALUATION
1.5. Summary
• Although the various underlyings differ with respect to the specifics of

pricing, all of them are based on expectations, risk, and the costs and
benefits of holding a specific underlying.
• Understanding how assets are priced in the spot market is critical to
understanding how derivatives are priced.
• To understand derivative pricing, it is necessary to establish a linkage
between the derivative market and the spot market. That linkage
occurs through arbitrage. (2)
81

AND VALUATION
2. Principle of arbitrage
Arbitrage is a type of transaction undertaken when two assets or portfolios produce

identical results but sell for different prices.
Given: Assets A and B produce the same values at time T but at time 0, A is selling
for less than B → arbitrage opportunity for investor.
• SA B
0 < S0 • SA B
T = ST
• Buy A at SA0 • Sell A for SA
T
• Sell B at SB
0 • Buy B for SBT
• Cash flow = SB A
0 - S0 > 0 • Cash flow = SA B
T - ST = 0
0 T
At the start of holding period At the end of holding period
The investors take the opportunity of The prices of two assets producing
arbitrage identical results will converge (2.1)
No money is gained or lost due to

Gain a net inflow of fund
the payoff is offset → no risk
The net effect is that the arbitrageur receives money at the start and never has to
pay out any money later.
82

AND VALUATION
2.1. The (in)frequency of arbitrage opportunities
Whenever arbitrage opportunities arise, traders look to exploit them as quickly as

they can.
Time Asset A Asset B
0 SA
0 - Low price SB
0 - High price
Many traders engage in the Many traders engage in the
same transaction of buying same transaction of selling
the asset A the asset B
Increase demand for the Increase supply for the asset
asset A B
Increase the price of the Decrease the price of the
asset A asset B
T SA
T = SB
T
Law of one price

Note that practically speaking, prices may not converge precisely, or as quickly as
you might think, because the cost of trading (transaction costs) on the mispricing
may exceed the benefit.
83

AND VALUATION
2.2. Arbitrage and derivatives
Since the value of a derivative is directly related to the price of its underlying,
the derivative can be used to hedge a position on the underlying. (example
illustrated below)
Underlying payoff
Long position in underlying
− Derivative payoff
+ short position in derivative
= risk-free returns
0 T
Explanation by the example below:
• At t = 0, you buy a stock at $30 and simultaneously take a short position in
a forward contract to sell that stock at $35 after T months.
• At t = T, you will get $35 from selling the stock without any price risks
→ $5 is called the risk-free return
→ it seems like you long (invest/lending) a risk-free asset in T months.
When the underlying is combined with the derivative to create a perfectly
hedged portfolio, all of the price risk is eliminated and the position should
earn the risk-free rate (*).
84

AND VALUATION
2.2. Arbitrage and derivatives
If the investor can not earn a risk-free rate through this hegded portfolio
→ arbitrageurs begin to trade:
The hedged portfolio generates a The hedged portfolio generates a
return more than the risk-free rate return less than the risk-free rate
Arbitrageurs will borrow at the Arbitrageurs will short the hedged

risk-free rate and go long on the portfolio and invest the proceeds
hedged portfolio at the risk-free rate
Arbitrageurs will execute this transaction in large volumes, continuing to

exploit the pricing discrepancy until market forces push prices back in line
such that both risk-free transactions earn the risk-free rate (no arbitrage).
Out of this process, one and only one price can exist for the derivative.
Otherwise, there will be an arbitrage opportunity.
→ We simply assume that no arbitrage opportunities can exist and infer the
derivative price that guarantees there are no arbitrage opportunities.
(Refer to LOS 46.c – 1.2)
85

AND VALUATION
2.3. Arbitrage and replication
Replication refers to the exercise of creating an asset or a portfolio from

another asset, portfolio, and/or derivative.
Recall from the previous slide explaining about the assumption employed
in pricing a derivative:
Derivative price must guarantee no-arbitrage opportunities:
→ Asset + opposite position in derivative = Perfectly hedged portfolio
= Risk-free asset
+ = Long risk-free asset

Long asset Short derivative
(lending)
Alternatively, we can come up with other replication strategies based on the
replication strategy above:
Short risk-free asset
Long asset + = Long derivative
(borrowing)
Short risk-
free asset + Short derivative = Short asset
(borrowing)
86

AND VALUATION
2.3. Arbitrage and Replication

Why would we replicate an asset or derivative instead of directly investing in
risk-free return?
• If there is no cost advantage, buying a government security to earn the
risk-free rate is easier than buying the asset and selling a derivative to
produce a risk-free position → the replication will seem to be useless
• However, if all assets are correctly priced to prohibit arbitrage, using
replicate strategies will bring some advantages below:
(1) Replication may be more profitable to hedge a portfolio with a derivative

to produce a risk-free rate than to invest in the risk-free asset.
(2) Replication can have lower transaction costs.
For example, a derivative on a stock index combined with the risk-free asset [Long
derivative (Stock index futures) + Long risk-free asset (Lending) = Long asset (Stock
index)] can potentially replicate an index fund at lower transaction costs than
buying all the securities in the index.
Replication is the essence of arbitrage. The ability to replicate something with

something else can be valuable to investors, either through pricing
differentials, however temporary, or lower transaction costs.
87

AND VALUATION
2.4. Risk aversion, risk neutrality, and arbitrage-free pricing

The fact that a derivative can be combined with an asset to produce a
risk-free position can be used to infer its price.
→ When pricing a derivative, we do not need a risk premium in
discounting/ calculating the expected payoff/price as we do in pricing
underlying assets
→ In pricing derivatives, we can assume that investors are risk-neutral,
risk aversion investors is not relevant in pricing a derivative..
Derivative pricing models discount the expected payoff of the derivative

at the risk-free rate → Derivatives pricing is sometimes called risk-
neutral pricing:
Risk-neutral pricing uses the fact that arbitrage opportunities guarantee
that a risk-free portfolio consisting of the underlying and the derivative
must earn the risk-free rate → there is only one derivative price that
meets that condition (Law of one price)
The overall process of pricing derivatives by eliminating arbitrage

opportunities and risk neutrality is called arbitrage-free pricing.
88

AND VALUATION
2.5. Limits to arbitrage
Earlier in the reading, we mentioned significant transaction costs as one

reason for an arbitrage opportunity remaining unexploited.
Other reasons include the following:
• The transaction may require a very large amount of capital, which the
arbitrageur may not have access to.
• The transaction may require additional capital down the line to
maintain the position.
• The transaction may require shorting assets that are difficult to short.
• The transaction may entail significant risk, especially if the relevant
derivative pricing models are based on complex models whose
parameters are subject to modeling risk.
89

AND VALUATION
[LOS 46.b] Explain the difference between value and price of
forward and futures contracts
Let’s consider the comparison between the value and price of a stock in
the equity market and the value and price of a derivative (except for
options) in the derivative market.
A future, forward and swap in the A stock in the equity

derivative market market
Price Refer to the fixed price (forward price) Refer to its current
determined at contract initiation at market price
which the underlying transaction will
occur at contract expiration.
→ Not change over the life of the
contract.(illustrated below)
t
t= 0 t=T
Contract initiation: Contract expiration:

Forward price - F0 T is Underlying transaction is
determined at this point executed at F0 T is this
of time point in time
90

AND VALUATION
Value Refer to amount that a counterparty Refer to its fundamental

would need to pay, or would expect value estimated through
to receive, to get out of its forward some valuation model.
position
→ Change over the life of forward
contract as the price of the
underlying asset changes.
(illustrated below)
t=0 t t=T
Contract At any point of time over the term of Contract

initiation the contract expiration
Spot price of the
underlying asset
changes S0 St ST
Value of the
forward contract V0 T Vt T VT T
changes
91

AND VALUATION

Implica- The value and price are not at all Compare the price and
tions comparable with each other value of a stock to make
→ The difference between the price investment decision
and value of a forward contract → The difference
does not refer to the mispricing of a between the price and
forward value of a stock refers to
the perceived mispricing
92

AND VALUATION
[LOS 46.c] Explain how the value and price of a forward
contract with no benefit/cost of the asset are determined at
initiation, during the life of the contract, and at expiration
1. Pricing and valuation a forward contract at initiation date
At initiation date, we must consider two aspects of a forward contract:

1.1. The value of a forward contract for both long and short position
1.2. How to determine the forward price in the contract (Pricing the forward)
1.1. Valuation of the forward contract at initiation date
When a forward contract is initiated, neither party pays anything to the

other
→ It is a valueless contract, both for long or short position.
→ its value at initiation is zero: V0 T = 0
t
t=0 t=T
Contract At any point of time over the term Contract

Spot price of the initiation of the contract expiration
underlying asset
S0
changes
Value of the
forward contract V0 T = 0
changes
93

AND VALUATION
contract with no benefit/cost of the asset are determined (…)
1.2. Pricing the forward contract at initiation date

• Pricing a forward contract means determining the forward price - F0 T
that is agreed by 2 parties at the initiation date and will not change over
the life of the contract.
• This forward price is a special price that results in the contract having zero
value (V0 T = 0) at initiation date and prohibiting arbitrage. (Refer to LOS
46.a – 2.2)
→ The forward price is also called the “no-arbitrage forward price”
Consider the example below to see how to determine the forward price.
Example 1: Forward price
Consider a l forward contract that has a term in 1 year . Assume the current
price of the underlying asset is $100 and 1-year risk-free interest rate is 8%.
Determine the appropriate forward price of this forward contract?
94

AND VALUATION

Answer:
Consider two cases of forward price:
Forward price F0 T = $110 Forward price F0 T = $106
Action now: Action now:

• Borrow $100 at 8% for 1 year • Short sell the asset at S0 = $100
• Then buy the asset at S0 = $100 • Then invest $100 at 8% for 1 year.
• Enter into a forward contract to sell the • Enter into a forward contract to buy the
asset in 1 year at F0 T = $110. asset in 1 year at F0 T = $106.
Action in 1 year: Action in 1 year:

• Sell the asset and receive F0 T = $110 • Buy the asset at F0 T = $106.
• Then repay loan = $100 × (1 + 8%) • Receive $100 × (1 + 8%) = $108 from
= $108 investment
Profit realized = $110 - $108 = $2 Profit realized = $108 - $106 = $2
Arbitrage opportunity Arbitrage opportunity

95

AND VALUATION

Answer: (continue)
To eliminate the arbitrage opportunity, the forward price must equal to $108 =
$100 × (1 + 8%)
The forward price is the spot price compounded at the risk-free rate over the life of
the contract:
F0 T = S0 × (1 + r)T
where:
• F0 T is the forward price at time T established at the initiation date of contract
• S0 is the current price at time 0
• r is the risk-free rate. (*)
t=0 t t=T
Contract Contract
initiation Compounded at risk-free rate expiration
S0 F0 T
96

AND VALUATION
2. Valuing a forward contract during its life
Because the price of the forward contract F0 T will not change, we only
consider about the value of the contract during its life and at its expiration for
long/short position.
For the long position
Obligation of long position Asset of long position
The long position has the obligation to At expiration, the long position will
pay the forward price, F0 T and take receive the underlying asset ST , which
delivery of the underlying asset at will be worth St at current price.
contract expiration. → The value of this asset at time t
→ The value of this obligation at time t during the term of the contract = St
= F0 T × (1 + r) −(T − t)
The value of a forward contract at any point of time during its life is the spot
price of the underlying asset minus the present value of the forward price
agreed to the contract (illustrated in the next slide):
Vt T = St − F0 T × (1 + r) −(T − t)
97

AND VALUATION
t
t=0 t=T
Contract At any point of time over the term Contract

initiation of the contract expiration
Spot price of the
underlying asset S0 St
changes
−
Present value of
F0 T × (1 + r)−T F0 T × (1 + r) −(T − t)
forward price
=
Value of the
forward contract V0 T = 0 Vt T
changes
For the short position

Similar explanation to long position, but note that the payoffs of long and
short position are opposite to each other.
98

AND VALUATION
Example 2: Calculating the Value of a Forward Contract during its Life

A forward contract to sell an asset worth $250 after 6 months at forward
price equal to $256.17. Suppose that two months into the term of the
forward the spot price of the underlying asset is $262. Given an annual
risk-free rate of 5%, calculate the value of the long and short positions in
the forward contract.
Answer:
• The value of the long position in the forward contract is calculated as:
Vt T = St − F0 T × (1 + r) −(T − t)
→ V2/12 6/12 = 262 − 256.17× (1 + 5%) −(6/12 − 2/12) = $9.96
• The value of the short position is just the opposite of the value of the
long position. Therefore, the value of the short position equals -$9.96.
99

AND VALUATION
3. Valuing a forward contract at expiration
t=0 t t=T

Spot price of the
underlying asset S0 St ST
changes
−
Present value of
F0 T × (1 + r)−T F0 T × (1 + r) −(T − t) F0 T
forward price
=
Value of the
forward contract V0 T = 0 Vt T VT T
changes
For the long position
With similar explanation as value of a forward contract during its life, the
value of a forward contract at expiration is the spot price of the
underlying minus the forward price agreed to in the contract. (detail
illustration in Reading 45)
V T T = S T - F0 T
100

AND VALUATION
3. Valuing a forward contract at expiration
For the short position
The payoff of the short position is opposite of the long position
4. Summary
For long position For short position
Price of the forward contract is fixed at F0 T from initiation date to expiration date:
F0 T = S0 × (1 + r)T
Value of the forward contract:
At initialtion date
0 0
V0 T
During its life Vt T St − F0 T × (1 + r) −(T − t) F0 T × (1 + r) −(T − t) − St
At expiration VT T ST − F 0 T F0 T − ST
101

AND VALUATION
[LOS 46.d] Explain how the value and price of a forward
contract with net cost of carry of the asset are determined.
• In LOS 46.c, we have learned how the price and value of a forward
contract in which the underlying generates/incurs no benefit or cost
are determined. In this LOS, we will consider the effect of net cost of
carry on the price and value of a forward contract.
• As we discussed, the net cost of carry consists of the benefits (γ)
(dividends or interest plus convenience yield), minus the costs (θ),
both of which are in present value form.
The net cost of carry will affect on:

1. The forward price F0 T of the underlying agreed at initiation date of
the contract, the value of the contract at initiation date V0 T still equals
to zero and is not affected by the net cost of carry.
2. The value of the contract during its life Vt T
102

AND VALUATION
Pricing a forward contract with net cost of carry of the
1.
asset at initiation date
The forward price of an asset with benefits and/or costs is the spot price
compounded at the risk-free rate over the life of the contract minus the
future value of those benefits and costs:
F0 T = (S0 − 𝛄 + θ) × (1 + r)T
Or
F0 T = S0 × (1 + r)T − (𝛄 - θ) × (1 + r)T
t=0 t t=T

S0 − 𝛾 + θ F0 T
Explain the formula:
To acquire a position in the asset at time T, an investor could buy the asset
today and hold it until time T. Alternatively, he could enter into a forward
contract, committing him to buying the asset at T at the price F0 T .
→ He would end up at T holding the asset, but the spot transaction would
yield benefits and incur costs while the forward transaction would forgo the
benefits (value downward to reflect the forgone benefits → S0 − 𝛾) but
avoid the costs (value upward to reflect the avoided cost → S0 + 𝜃 ).
103

AND VALUATION
1.
Effect of net cost of carry on the return of a forward contract
• If the benefits exceed the costs (net cost of carry (𝛾 - 𝜃) > 0)

→ the forward transaction would return less than the spot
transaction. The formula adjusts the forward price downward by the
expression −(𝛾 - θ) × (1 + r)T to reflect this net loss over the spot
transaction.
o In other words, acquiring the asset in the forward market would be
cheaper because it forgoes benefits that exceed the costs. That
does not mean the forward strategy is better. It costs less but also
produces less.
• If the costs exceeded the benefits (net cost of carry (𝛾 - 𝜃) < 0)
→ the forward price would be higher because it avoids the costs that
exceed the benefits.
104

AND VALUATION
1.
Example 3: Forward price on an underlying generating/incurring
benefits/costs
Sasha wants to purchase a stock of ABC Company in 150 days. The stock is
currently priced at $40. It is expected to pay a dividend of $0.60 in 30 days,
$0.80 in 120 days, and $0.70 in 210 days. To hedge the interim price risk,
Sasha enters the long position on a forward contract on the stock today.
Given an annual risk-free rate of 5%, calculate the no-arbitrage forward price.
Answer:
We would expect the expiration of the forward contract to coincide with the
point in time that Sasha wants to take delivery of the stock (T = 150/365).
Therefore, we ignore the dividend expected to be paid in 210 days, as it will
be paid after the expiration of the forward contract.
• In order to compute the forward price, we first compute the present value
(as of the contract initiation date) of dividends/benefits (y) expected to be
paid on the stock during the term of the forward contract:
γ = 0.60/1.0530/365 + 0.80/1.05120/365 = 0.5976+ 0.7873 = $1.3849
• And then apply the formula for computing the forward price:
F0 T = (S0 − 𝛾 + θ) × (1 + r)T
→ F0 150/365 = (40 − 1.3849) × (1 + 5%)150/365 = $39.3972
105

AND VALUATION
Valuation of a forward contract with net cost of carry
2.
during its life
If the asset has a cost of carry, we must make only a small adjustment :
Vt T =[St − (𝛄 − θ) × (1 + r)t ] − F0 T × (1 + r) −(T − t)
Recall that benefits and costs from the underlying asset (y and θ) are
expressed in terms of present value as of time t = 0 (contract initiation)
We need to adjust the current spot price of the asset St for their value at
time t, which is why they are compounded at the risk-free rate from 0 to
t.
Explain the formula:

The forward contract forgoes the benefits and avoids the costs of holding
the asset. Consequently, we adjust the value downward to reflect the
forgone benefits and upward to reflect the avoided costs.
106

AND VALUATION
[LOS 46.g] Explain why forward and futures prices differ
The different patterns of cash flows for forwards and futures
Future contract Forward contract

Gain/Loss is realized on daily Gain/Loss is realized at
mark-to-market adjustment expiration date.
The differences in the pricing of forwards versus futures when:

(1) Interest rates vary unpredictable
(2) The future prices and interest rates are correlated
If underlying asset prices are positively correlated with interest rates

→ any gains from the mark-to-market adjustment can be reinvested at
higher interest rates, while any losses from the adjustment can be financed
at lower borrowing rates
→ traders prefer futures over forwards, which results in the futures price
being higher than the forward price.
If underlying asset prices are negatively correlated with interest rates

→ any gains from the mark-to-market adjustment must be reinvested at
lower interest rates, while any losses from the adjustment must be
financed at higher borrowing rates
→ traders prefer forwards over futures, which results in the forward price
being higher than the futures price.
107

AND VALUATION
[LOS 46.f] Define a forward rate agreement and describe its uses
• A forward rate agreement (FRA) is a forward contract where the
underlying is an interest rate (usually LIBOR).
• The point of entering into an FRA is to lock in a certain interest rate
for borrowing or lending at some future date.
This instrument slightly differs from most other forward contract in that
the underlying is not an asset, it is the interest rate.
A long position in Give out a hypothetical A short position in

FRAs loan at FRA rate FRAs
FRA
settlement
Long a t-day FRA
on (T-t)-day LIBOR Underlying (T-t)-day LIBOR
Term of the hypothetical loan

0 t T
FRA FRA Hypothetical
initiation expiration: loan
Hypothetical expiration
loan initiation
108

AND VALUATION
1. The payoffs on FRAs are determined by market interest rates (LIBOR)
at FRA expiration.
If LIBOR at FRA expiration is If LIBOR at FRA expiration is
greater than the FRA rate lower than the FRA rate
→ the long has access to a loan → the short position is able to
at lower-than-market rates, invest her funds at higher-than-
while the short is obligated to market interest rates, while the
give out a loan at lower-than- long is obligated to take a loan at
market interest rates higher-than-market interest
→ the long benefits. rates → the short benefits.
2. Implication of FRAs
The whole point of getting into an FRA is to hedge against interest rate
risk.
• A borrower (who would like to lock in a borrowing rate) would take a
long position on an FRA to hedge against an increase in interest rates.
• A lender (who would like to lock in a rate of return) would take a short
position on an FRA to hedging against a decrease in interest rates.
109

AND VALUATION
3. Pricing a FRA
The price of an FRA (forward price) represents the interest rate at which the long
(short) position has the obligation to borrow (lend) funds for a specified period
(term of the underlying hypothetical loan) starting at FRA expiration.
→ the price of an FRA is the FRA rate on the hypothetical loan:
1+R(T) N
FRA rate = −1 × T − t
1+R(t)
where:
R(T) is the unannualized spot rate from time 0 to time T
R(t) is the unannualized spot rate from time 0 to time t
N is the numbers of days in a year
Example 4: Pricing a FRA

Thirty days from today Orix Inc. will need to borrow $1 million for 120 days. In
order to hedge the interest rate risk associated with the anticipated borrowing,
Orix takes the long position on an FRA. Current 30-day LIBOR is 5% and 150-day
LIBOR is 6%. Determine the price (forward rate) of this FRA.
Answer:
We are looking to establish the no-arbitrage forward rate (120-day LIBOR) that
would make an investor indifferent between (1) borrowing for 150 days today at
current 150- day LIBOR and (2) borrowing for 150 days by first borrowing for 30
days at current 30-day LIBOR and then (after 30 days) rolling over into another loan
for 120 days at prevailing 120-day LIBOR
110

AND VALUATION
3. Pricing a FRA
Example 4: Pricing a FRA (continue)
Answer:
150-day LIBOR = 6%
30-day LIBOR = 5% 120-day FRA rate = ?
0 30 days 150 days

FRA FRA Hypothetical
initiation expiration: loan
Hypothetical expiration
loan initiation
1. We need to unannualize the 30-day and 150-day LIBOR rates that are
given:
• Unannualized rate on the 30-day loan = R30
= 0.05 x (30/360) = 0.004167
• Unannualized rate on the 150-day loan = R150
= 0.06 x (150/360) = 0.025
111

AND VALUATION
3. Pricing a FRA
Example 4: Pricing a FRA (continue)
Answer:
2. Based on the unannualized 30-day and 150-day rates, we can calculate

the unannualized interest rate applicable on a 120-day loan that will be
taken 30 days from today (the annualized version of which represents
the price of the FRA) as follows: (1 + R30) × (1 + R120) = 1 + R150
→ Unannualized price of 120-day FRA rate or R120
= [(1 + R150) / (1 + R30)] - 1 = [(1 + 0.025) / (1 + 0.004167)] - 1 = 0.02075
→ Annualized price of FRA rate = 0.02075 x 360/120 = 0.0622 or 6.22%
112

AND VALUATION
4. Synthetic FRA
Rather than enter into an FRA, a bank can create the same payment structure
with two LIBOR loans, a synthetic FRA
Illustration for synthetic FRA (30-day FRA on 90-day LIBOR)

• A bank can borrow money for 120 days (1) and lend that amount for 30
days (2).
• At the end of 30 days, the bank receives funds from the repayment of the
30-day loan it made, and has use of these funds for the next 90 days at an
effective rate determined by the original transactions.
Long 30-day FRA on

90-day LIBOR Underlying 90-day LIBOR
Real FRA
0 30 days 120 days
(1) Long 120-day loan
Synthetic 0 30 days 120 days

FRA
(2) Short 30-day loan synthetic long 30-day FRA on 90-day LIBOR
0 30 days 120 days

113

AND VALUATION
4. Synthetic FRA
Illustration for synthetic FRA

The effective rate of interest on this 90-day loan depends on both 30-day
LIBOR and 120-day LIBOR at the time the money is borrowed and loaned
to the third party.
→ This rate is the contract rate on a 30-day FRA on 90-day LIBOR.
→ The resulting cash flows will be the same with either the real FRA or
the synthetic FRA
114

AND VALUATION
[LOS 46.h] Explain how swap contracts are similar to but
different from a series of forward contracts
Illustration for swap contract
Consider a simple swap contract starting at time 0 and ending at time T. The
contract specifies that the two parties will make a series of n payments at
times that we will designate as 1, 2, …, n, with the last payment occurring at
time T. Each payment is illustrated below:
Fixed rate - FS0 (n,T) (*)
Company A
Company B
(buyer of swap)
Floating rate - Sn
From the point of view of the buyer, on each payment date, company A
makes a payment of FS0 (n,T) and receives a payment based on floating rate
S1 , S2 ,…, Sn .
→ The sequence of cash flows from the swap is (illustrated in the next slide):
t1 : S1 - FS0 (n,T)
t2 : S2 - FS0 (n,T)
…
tn : Sn - FS0 (n,T)
(*): FS0 (n,T) is the fixed payment determined at time 0 for a swap consisting n
payments with the last payment at time T
115

AND VALUATION
Illustration for cash flow from the swap contract consisting n payments
S1 - FS0 (n,T) S2 - FS0 (n,T) Sn - FS0 (n,T)

…
0 t1 t2 tn = T
Illustration for cash flow from a forward contract with expiration at time T
ST - F0 (T)
0 tn = T
A swap is in some sense a series of forward contracts, specifically a set of

contracts expiring at various times in which one party agrees to make a
fixed payment and receive a variable payment.
116

AND VALUATION
Illustration for a swap broken down into a series of implicit forward
contract, with the expiration of each forward contract corresponding to
a swap payment date.
S1 - FS0 (n,T) S2 - FS0 (n,T) Sn - FS0 (n,T)

Swap
contract …
0 t1 t2 tn = T
S1 - F0 (t1 )
0 t1
S2 - F0 (t2 )
Forward …
contract t2
0
Sn - F0 (tn )
0 tn = T
117

AND VALUATION
The difference between a swap contract and the replicated forward

contracts
• For the swap, all fixed payment at each payment date is equal (FS0(n,T))
• For each forward contract:
F0(t1 ) = S0 × (1 + r)t1
F0(t2 ) = S0 × (1 + r)t2
…
F0(tn ) = S0 × (1 + r)tn
( r is the risk-free rate between each payment date)
→ The prices of the implicit forward contracts embedded in a swap will not
be equal: F0(t1 ) ≠ F0(t2 ) ≠ … ≠ F0(tn )
How can we equate a swap to a series of forward contract?

(Explanation in the next slide)
118

AND VALUATION
• Recall that the forward price is the price that produce a zero value of the
contract at the start, a forward transaction that starts with a nonzero
value is called an off-market forward.
• However, there is generally no prohibition on the use of off-market
forward contracts
Two parties can engage in a series of forward contracts at whatever fixed

price they desire.
→ each forward contract will be created at the fixed price FS0(n,T) that
corresponds to the fixed price of a swap of the same maturity with
payments made at the same dates as the series of forward contracts.
Some of the forward contracts would have positive values and some would
have negative values, but their combined values would equal zero.
119

AND VALUATION
[LOS 46.i] Explain the difference between value and price of
swaps
Price Refer to the swap fixed rate determined at contract initiation at
which the present value of the floating-rate payments (based on
the current term structure of interest rates) equals the present
value of fixed-rate payments and not change over the life of the
contract.
→ There is zero value to either party.
Value Refer to amount that a counterparty would compensate for the

other
→ Change over the life of swap contract as the term structure of
interest rates change.
If interest rates increase after If interest rates decrease after

swap initiation swap initiation
→ the present value of floating-
→ the present value of
rate payments (based on the
floatingrate payments will be
new term structure) will exceed
lower than the present value of
the present value of fixed-rate
fixed-rate payments.
payments (based on the swap
→ the floating-rate payer
fixed rate).
benefits.
→ the fixed-rate payer benefits.
12
0
READING 46: Basics of Derivative Pricing and
Valuation
OPTION
There are also two important exercise characteristics of options
European options allow

exercise only at expiration
0 T
Expiration
American options allow exercise at any time date
up to the expiration
We will use the same notation used with forwards

Expiration date
0 T
At time 0 At time T
• Price of underlying asset: S0 • Price of underlying asset: ST
• Value of European call: c0 • Exercise price of option: X
• Value of European put: p0 • Value of European call: cT
• Value of European put: pT
12
1
Valuation
OPTION
Call option Put option
American option
LOS 46.o
Option
The factors that
Binomial valuation
determine the value
of options European option of an option
LOS 46.n (Focus point) LOS 46.l-m
Put-call
Call option parity* Put option
LOS 46.j-k
Lower limits for prices of european options
Note: Because the right to exercise can be a complex feature of an option,

European options are easier to understand, and we will focus on them.
READING 46: Basics of derivative pricing and
valuation
[LOS 45.j] Explain put–call parity for European options
1. Protective put
• Protective put is a strategy in which investor owns an asset (S0 ) and buy a put
(p0 ) to sell it at time T at X.
The put protects the investor from the possibility that price of the asset they hold
will decline in the future (T) – that’s why we call this strategy “protective put”.
t=0 t=T
Buy the asset at S0 Exercise the put to

Buy a put at p0 sell the asset at X
Value of this strategy depends on the outcomes of the value of the asset at T,
illustrated below.
Value of a protective put
Outcomes ST < X ST ≥ X
Asset ST 1 ST 2
Long put X - ST 3 0 4
Total X 5 ST 6 122
valuation
1. Protective put
Value of a protective put
1 2 The value of the asset is ST at time T
3 pT = Max(0, X - ST) 4 pT = Max(0, X - ST)

If ST < X → pT = X - ST If ST > X → pT = 0
5 Total value = Value of the asset + 6 Total value = Value of the asset +
value of the long put position (pT ) value of the long put position (pT )
= X - ST + ST = X = 0 + ST = S T
Value
ST
X
X
ST 123
X
valuation
2. Fiduciary call
• Fiduciary call is a strategy in which investor buys a risk-free bond with a face
value of X and holds a call option (c0 ) to buy an asset at time T at X.
t=0 t=T
X Exercise the call to buy

Buy the bond at
(1+r)T the asset at X
Buy a call at c0
Receive the par value X
Value of this strategy depends on the outcomes of the value of the asset at T,
illustrated below.
Value of a fiduciary call
Bond X 1 X 2
Long call 0 3 ST - X 4
124
Total X 5 ST 6
valuation
2. Fiduciary call
Value of a fiduciary call
1 2 The value of the bond at time T is it par value, X
3 cT = Max(0, ST − X) 4 cT = Max(0, ST - X)
If ST < X → cT = 0 If ST > X → cT = ST - X
5 Total value = Value of the bond + 6 Total value = Value of the bond +
value of the long call position (cT ) value of the long call position (cT )
=X+0=X = X + ST - X = ST
Value
This looks exactly similar to the value
diagram of a protective put.
ST
X
X
ST 125
X
valuation
3. Put – call parity
From what we have discussed in the previous sessions “Value of a fiduciary call”
and “Value of a protective put” , we can conclude that a protective put and a
fiduciary call produce the same result.
The amounts invested at time 0 of fiduciary call and protective put have to be
the same.
X
S0 + p0 = c0 +
(1+r)T
126
valuation
3. Put – call parity
Interpretation:
From put-call-parity, we can interpret portfolios that are synthetic equivalents

of each other.
Fiduciary call = protective put
→ Long call + long bond = long put + long asset
• Long call = long put + long asset + short bond

• Long bond = long put + long asset + short call
• Long put = Long call + long bond + short asset
• Long asset = Long call + long bond + short put
Note:
Remember as we change the sign of the components in the equation, we
change the position to which the securities are attached.
Long A = X → - X = short A
127
valuation
[LOS 45.k] Explain put–call–forward parity for European
options
1. Protective put with forward contract
Recall that from the put-call parity,

Long call + long bond = long put + long asset 1
From session 2, LOS 46.a about replication, we also have

Long risk free asset = long asset + short forward
→ Long asset = long risk free asset + long forward 2
Replace Long asset from 2 to 1 , we have:

Long call + long bond = long put + long risk free asset + long forward
This conclusion leads us to another parity for European options, called

“put–call–forward parity”:
Long call + long bond = long put + long risk free asset + long forward
Fiduciary call = Protective put with forward contract 3
3 It is important to note that, by holding a put, longing a forward contract

and a risk-free bond with a face value equal to forward price, we create
128
a
strategy that is equivalent to a protective put.
valuation
options
1.1. Protective put with forward contract strategy
t=0 t=T
F (T)
Buy the bond at 0 T 1. Receive the par value F0 (T)
(1+r)
Buy a put at p0 2. Use the par value to pay
the forward price and get the
asset
3. Exercise the put to sell the
Note that value of the forward contract at time 0 is zero asset at X
1.2. Value of a put with forward contract
Bond F0 (T) 1 F0 (T) 2
Forward contract ST - F0 (T) 3 ST - F0 (T) 4
Long put X - ST 5 0 6
129
Total X 7 ST 8
valuation
options
1.2. Value of a put with forward contract
1 2 The value of the bond at time T is it par value, F0 (T)
3 4 Value of the forward at time T is equal to ST − F0(T)
5 pT = Max(0, X - ST) 6 pT = Max(0, X - ST)

If ST < X → pT = X - ST If ST > X → pT = 0
Total value = Value of the bond + Total value = Value of the bond +
7 8
value of forward contract + value value of forward contract + value
of the long put position (pT ) of the long put position (pT )
= F0 (T) + ST − F0 (T) + X - ST = X = F0 (T) + ST − F0 (T) + 0 = ST
Value
This looks exactly similar to the value
ST
X diagram of a protective put and a
X fiduciary call.
130
X ST
valuation
options
2. Put-call-forward parity
From what we have discussed in the previous sessions “Value of a fiduciary call”
(in LOS 45.j) and “Value of a protective put with forward contract” (previous
slide), we can conclude that a protective put with forward contract and a
fiduciary call produce the same result.
The amounts invested at time 0 of fiduciary call and protective put with forward
contract have to be the same.
F0(T) X
+p =c +
(1+r)T 0 0 (1+r)T
Interpretation:
Fiduciary call = protective put with forward contract

→ Long call + long bond (par value X) = long put + long bond (par value F0 (T)) +
long forward
We can interpret portfolios that are synthetic equivalents of each other, for
example:
Long call = long put + long bond (par value F0 (T)) + long forward + short bond
131
(par value X)
13
2
Valuation
[LOS 42.l] Explain the exercise value, time value, and moneyness of an option
[LOS 42.m] Identify the factors that determine the value of an option and
1. Recall pricing and valuation of options
As detailed in Reading 45, the value of the option at expiration* are:
Call Option: The value of the option at expiration is the greater of either zero or
the underlying price at expiration minus the exercise price.
cT = Max(0,ST −X)
Put Option: the put value at expiration is worth the greater of either zero or the
exercise price minus the price of the underlying at expiration.
pT = Max(0,X − ST )
*the value of the option at expiration is also called exercise value
Conclusion 1:
• The value of a European call at expiration is the exercise value, which is the
greater of zero or the value of the underlying minus the exercise price.
• The value of a European put at expiration is the exercise value, which is the
greater of zero or the exercise price minus the value of the underlying.
13
3
Valuation
2. Some characteristics that will influence the value of the option
Note: We might not be able to quantify their effects just yet, but we can
rationalize why these factors affect the value of an option.
2.1.
Value of the
2.6. Underlying
Payments
2.2.
on the
Exercise
Underlying
Price
and the Cost
of Carry Value of
option
2.5.
2.3.
Volatility of
the
Time to
Underlying Expiration
2.4.
Risk-Free
Rate of
Interest
13
4
Valuation
2.1. The Value of the Underlying
From the value of call option and put option
Value of underlying is a
cT = Max(0,ST −X)
critical element in
pT = Max(0,X − ST ) determining option’s value

A call option can be viewed as a mean of acquiring the underlying
V2 The buyer want to purchare the asset at V1 rather than V2

Value of underlying
If the value of Underlying increases more, the benefit from the call
option will increase in line with the underlying’s value
V1 Call option is worth more if the underlying is worth more

13
5
Valuation
2.1. The Value of the Underlying

A put option can be viewed as a means of selling the underlying
V1 The seller want to sell the asset at V1 rather than V2

Value of underlying
If the value of Underlying decreases more, the benefit from put

option will increase in line with Underlying’s value deterioration
V2 A put option is worth more if the underlying is worth less
Note: The value of a call option cannot exceed the value of the underlying
Conclusion 2:
• The value of a European call option is directly related to the value of the
underlying.
• The value of a European put option is inversely related to the value of the
underlying.
13
6
Valuation
2.2. Exercise price
From the value of call option and put option
The exercise price is a critical

cT = Max(0,ST − X) element in determining the
pT = Max(0,X − ST ) value of an option
Moneyness refers to whether an option is in the money or out of the money
Generate a positive payoff In the money
Generate neither a gain nor loss At the money
Generate a negative payoff Out of the money
(Moneyness in call option and put option in the next slides)

13
7
Valuation
2.2. Exercise price
In the money call options ST > X
At the money call options ST = X
Out of the money call options ST < X
Implication
A lower exercise price X
There are more values of the underlying at In the money

(ST − X)
expiration that are above the exercise price call options
The option value is greater cT 

13
8
Valuation
2.2. Exercise price
In the money put options ST < X
At the money put options ST = X
Out of the money put options ST > X
Implication - The effect is just the opposite
A higher exercise price X
There are more exercise price at expiration In the money

(X − ST )
that are above the value of underlying put options
The option value is greater pT 

13
9
Valuation
2.2. Exercise price
Conclusion 3:
• The value of a European call option is inversely related to the exercise price.
• The value of a European put option is directly related to the exercise price.
14
0
Valuation
2.3. Time to expiration
Effect of the increase in time to expiration
1 Opportunity for the change in price 2 Positive/negative effect on the

present value of investor’s cash
flow at expiration
The combination of these two effects will form an overall effect on the value of
call and put options.
14
1
Valuation
1 Opportunity for the change in price

0 T
0 T
Additional time provides further opportunity for
Greater call price

ST > X ST < X
Positive (In the money)
effect on
call value Impact is not Limited to the
Out of the money
significant premium paid
2 Positive/negative effect on the present value of investor’s cash flow

For call, the holder is waiting to pay out money at expiration. More time lowers
the value of this possible outlay.
→ Time to expiration has positive effect on present value of investor’s cash flow
→ Time to expiration has positive effect on call value.
Valuation
1 Opportunity for the change in price
0 T
0 T
Provides further opportunity for
Greater put price

ST < X ST > X
Positive (in the money)
effect on
put value Impact is not Limited to the
Out of the money
significant premium paid
2 Positive/negative effect on the present value of investor’s cash flow

Put option holders are awaiting to receive the exercise price. The longer they have
to wait, the lower the present value of the payoff.
→ Time to expiration has negative effect on present value of investor’s
142 cash flow
→ Time to expiration has negative effect on put value.

14
3
Valuation
Effect 1 Effect 2 Total effect
Call option Positive Positive Positive
Put option Positive Negative Unknown
Conclusion 4:
• The value of a European call option is directly related to the time to
expiration.
• The value of a European put option can be either directly or inversely
related to the time to expiration.
14
4
Valuation
2.4. Risk-free rate of interest
Recall that from the put-call parity

X
c0 = S0 + p0 -
(1+r)T
X
Risk-free rate (r) increases → decreases → c0 increases
(1+r)T
Recall that from the put-call parity

X
p0 = c 0 - S 0 +
(1+r)T
X
Risk-free rate (r) increases → decreases → p0 decreases
(1+r)T
Conclusion 5:
• The value of a European call is directly related to the risk-free interest rate.
• The value of a European put is inversely related to the risk-free interest rate.
14
5
Valuation
2.5. Volatility of the Underlying
The greater the volatility of the underlying, the more an option is worth
A call option will have a

higher payoff the higher the
Range of ST
underlying is at expiration.
X
At time 0 A call option will have a
Price of underlying asset: S0 zero payoff if it expires with
Value of option: c0 the underlying below the
exercise price.
0 T
The payoff has a better chance of being greater because the
Greater underlying has a greater possibility of large positive returns
volatility on
the underlying The zero payoff is unaffected if we impose greater volatility
14
6
Valuation
The greater the volatility of the underlying, the more an option is worth
A put option will have a

zero payoff if it expires with
Range of ST
the underlying above the

exercise price.
X
At time 0
A put option will have a
Price of underlying asset: S0
higher payoff the lower the
Value of option: p0
underlying is at expiration
0 T
The payoff has a better chance of being greater because the
Greater underlying has a greater possibility of large positive returns
volatility on
the underlying The zero payoff is unaffected if we impose greater volatility
14
7
Valuation
Conclusion 6:
• The value of a European call is directly related to the volatility of the
underlying.
• The value of a European put is directly related to the volatility of the
underlying.
The combined effects of time and volatility give rise to the concept of the time
value of an option.
The time value of an option is the amount by which the option premium (price)
exceeds the exercise value
Market option price = Time value + Exercise value
• Time value results in an option price being greater with volatility and time
but declining as expiration approaches.
• At expiration, no time value remains and the option is worth only its exercise
value
14
8
Valuation
2.6. Payments on underlying and the cost of carry
Payments on the underlying refer to dividends on stocks and interest on bonds

Carrying costs include the actual physical costs of maintaining and storing an asset
2.6.1. Payments on underlying
Payments of dividends and interest reduce the value of the underlying (ST )
cT = Max(0,ST −X) This reduction is a negative factor cT
pT = Max(0,X − ST ) This reduction is a positive factor pT
2.6.1. Cost of carry
Carrying costs raise the effective cost of holding or shorting the asset
Benefit of holding call option Drawback of holding put option
Enables an investor to participate in makes it more expensive to participate in
movements of the underlying without movements in the underlying than by short
incurring these costs selling
14
9
Valuation
2.6. Payments on underlying and the cost of carry
Conclusion 7:
• A European call option is worth less the more benefits that are paid by the
underlying and worth more the more costs that are incurred in holding the
underlying.
• A European put option is worth more the more benefits that are paid by the
underlying and worth less the more costs that are incurred in holding the
underlying.
15
0
Valuation
3. Lower limits for prices of european options
3.1. For call option

we need to look at a call option as similar to the purchase of the underlying with
a portion of the purchase price financed by borrowing.
You are at time 0 At time T

You want to buy an
asset at X($)
0 T
S0 ST
Suppose that:
• The asset’s value at time 0 is S0
• The asset’s value at time T is ST
There are two options for you:

Option 1: The leveraged strategy - Buying asset now and hold it to time T
Option 2: The call strategy - Long call option now and exercise its at time T
15
1
Valuation
Option 1: The leveraged strategy - Buying asset now and hold it to time T
X
Borrow
(1+r)T Repay borrow at X
at interest rate of r
0 T
Using additional fund Underlying is

to buy asset at S0 worth ST
Under the investor’s perspective:
The pay off at time 0 Investors achieve the Outcome at time T

target (buying an asset
X
S0 - at year T with X), but if ST - X
(1+r)T the asset deteriorates at
time T, Investor buy at a This amount may be
higher price than its positive or negative
intrinsic value
15
2
Valuation
Long a call option Buy asset at X
0 T
Underlying is Underlying is
worth ST worth ST

target (buying an asset at
c0 Max (0, ST - X)
year T with X), without
any deterioration in
asset’s value
15
3
Valuation
The outcome at time T

We see that the call
Option 1 Option 2 strategy dominates
Call exercise price the leveraged
strategy
ST - X If ST ≤ X If ST > X
This may be a positive or 0 ST - X

negative impact Any strategy that
Call expires Call expires dominates the other
out of the in the can never have a
money money lower value at any
time
Produces a good result in all
other outcomes
1
Two strategies produce equivalent results in some outcomes X
c0 ≥ S0 -
(Buying asset at price X at time T) (1+r)T
15
4
Valuation
X
From 1 ,If S0 <
(1+r)T
X
c0 ≥ Max[0,S0 - ]
(1+r)T
the lowest value of call is a negative
number Lower limit of the call price is the
greater of the value of zero or the
underlying price minus the present
A call can never be worth less than zero value of the exercise price.
Holder cannot be forced to exercise it
15
5
Valuation
3.2. For put option
Similar to Call option, we consider this case, where you want to.

You want to sell an
asset at X($)
0 T
S0 ST
Suppose that:
• The asset’s value at time 0 is S0
• The asset’s value at time T is ST
There are two options for you:

Option 1: The short sale and bond strategy
Option 2: The put strategy
15
6
Valuation
3.2. For put option

You want to sell an
asset at X($)
0 T
S0 ST
Purchase asset at ST
You carry out a short sale of S0
to fulfil short obligation
Obtain S0 cash inflow The total outcome is

(X – ST )**
(*) coupon rate r
X
Invest to a risk-free bond* Obtain X at time T
(1+r)T
You expect to purchase asset at X (**) This amount may be
at time T to fulfil short obligation positive or negative
15
7
Valuation
3.2. For put option

You want to sell an
asset at X($)
0 T
S0 ST
The pay off at time 0 Outcome at time T

Investors achieve the
X target (selling an asset at
-S X - ST
(1+r)T 0 year T at X), but if the
asset appreciate at time
T, Investor buy at a higher
price than its intrinsic
value to fulfil their short
obligation
15
8
Valuation
3.2. For put option

You want to sell an
asset at X($)
0 T
S0 ST
Long a put
Sell asset at X
option

target (buying an asset at
p0 Max (0, X - ST )
year T with X), without
any appreciation in
asset’s value
15
9
Valuation
3.2. For put option
The outcome at time T

We see that the put
Option 1 Option 2 strategy dominates
Put exercise price The short sale and
bond strategy
X - ST If ST ≤ X If ST > X
This may be a positive or X - ST 0

negative impact Any strategy that
Put expires Put expires dominates the other
in the out of the can never have a
money money lower value at any
time
Produces a good result in all
other outcomes
2
Two strategies produce equivalent results in some outcomes X
p0 ≥ -S
(Selling asset at price X at time T) (1+r)T 0
16
0
Valuation
3.2. For put option
X
From 2 ,If S0 >
(1+r)T
X
p0 ≥ Max[0, -S ]
(1+r)T 0
The lowest value of put is a negative
number Lower limit of the put price is the
greater of the value of zero or the
present value of the exercise price
A put can never be worth less than zero minus the underlying price.
Holder cannot be forced to exercise it
Conclusion 8:
X
• c0 ≥ Max[0,S0 - ]
(1+r)T
X
• p0 ≥ Max[0, -S ]
(1+r)T 0
16
1
valuation
[LOS 45.n] explain how the value of an option is determined using a one-
period binomial model
1. Binomial valuation of call option
The option price is determined by the underlying
An option pricing model requires the specification of a model of a random

process that describes movements in the underlying
Binomial model
Two possible movements in the underlying - one going up and one going down
Start with the underlying at S0 , and let it go up to S+1 or down to S−
1
We know only what We specify the returns
the possibilities are implied by these moves
S+1 = S0 u (>X) S+1
q Move up:
c+1 = Max(0, S+1 - X) = S+1 - X S0 = u
S0
c0
S−1 = S0 d (<X) S−
1-q Move down: S1 = d
c−1 = Max(0, S−1 - X) = 0* 0
0 1
(*) Although the lower payoff is zero in this example, that will not always be the case
16
2
valuation
By using mathematic, we obtain the formula for option price:
πc+1 + (1 − π)c−1 1+r−d

c0 = with π =
1+r u−d
Implication:
The price of the call option can be viewed as the probability weighted average of
the two possible next-period call values (c+1 and c−1 ) discounted at the one-period
risk-free rate
π is known as risk-
neutral probabilities c+1 c−1
π 1-π
Discount Probability
c0
weighted average
0 1
16
3
valuation
By using mathematic, we obtain the formula for option price:
πc+1 + (1 − π)c−1 1+r−d

c0 = with π =
1+r u−d
1.1. Notes on formula
1.1.1. The volatility of the underlying, which is reflected in the difference

between S+ − + −
1 and S1 and affects c1 and c1 , is an important factor in determining
the value of the option.
1.1.2. The probabilities of the up and down moves, q and 1 – q, do not appear in
the
formula.
1.1.3. The values π and 1–π are similar to probabilities and are often called
synthetic or pseudo probabilities. They produce a weighted average of the next
two possible call values, a type of expected future value.
1.1.4. The formula takes the form of an expected future value, the numerator,
discounted at the risk-free rate.
16
4
valuation
1.1.1. The volatility of the underlying, which is reflected in the difference

between S+ − + −
1 and S1 and affects c1 and c1 , is an important factor in determining
the value of the option.
Volatility of the underlying increases
The difference between S+1 and S−1 increases
S+1 c+1 
A
S0
Widens the range higher
X
between c+1 and c−1 option
value
S−1 c−1 → 0
0 1
16
5
valuation
1.1.2. The probabilities of the up and down moves, q and 1 – q, do not appear in
the formula.
The actual probabilities of the up and down moves do not matter. This result is
because of our ability to construct a hedge and the rule of arbitrage.
1.1.3. The values π and 1–π are similar to probabilities and are often called
synthetic or pseudo probabilities. They produce a weighted average of the next
two possible call values, a type of expected future value.
The irrelevance of the actual probabilities (q and 1 - q) is replaced by the

relevance of a set of synthetic or pseudo probabilities (π and 1 – π).
1.1.4. The formula takes the form of an expected future value, the numerator,
discounted at the risk-free rate.
These risk-neutral probabilities are used to find a synthetic expected value, which
is then discounted at the risk-free rate.
16
6
valuation
Changing the c’s → p’s leads to the binomial put option pricing formula:
πp+1 + (1 − π)p−1 1+r−d

p0 = with π =
1+r u−d
Note:
In reality there are more than two possible next-period prices for the underlying.
As it turns out, we can extend the number of periods and subdivide an option’s
life into an increasing number of smaller time periods.
 In that case, we can obtain a more accurate and realistic model for option
pricing, one that is widely used in practice. (refer to CFA level 2 – Derivatives ).
16
7
valuation

Example: Binomial valuation
Let S0 be £40 and the risk-free rate be 5%. The up and down factors are u = 1.20
and d = 0.75. Thus, the next two possible prices of the asset are
S+1 = £40 × 1.20 = £48
S−1 = £40 × 0.75 = £30
Consider a call and a put that have exercise prices of £38. Then the next two
possible values of the call and put are
• c+1 = Max(0, £48 - £38) = £10
• c−1= Max(0, £30 - £38) = £0
• p+1 = Max(0, £38 - £48) = £0
• p−1 = Max(0, £38 - £30) = £8
Next we compute the risk-neutral probability
1 + r − d 1 + 0.05 − 0.75
π= = = 0.667
u−d 1.20 − 0.75
The values of the call and put are
0.667 × £10 + (1 − 0.667) × £0
c0 = = £6.35
1 + 0.05
0.667 × £0 + (1 − 0.667) × £8
p0 = = £2.54
1 + 0.05
16
8
valuation
[LOS 45.o] Explain under which circumstances the values of European and
1. American option premium
American options’ European options’ The right to exercise at any

characteristics
= characteristics
+ time prior to expiration.
The right to exercise early can not have negative value because it is not
required. (so it can be zero, or positive)
American options cannot sell for less than European options.
American call premium is greater or equal to European call premium: C0 ≥ c0

American put premium is greater or equal to European put premium P0 ≥ p0
(conclusion 1)
valuation
2. Minimum value of the American call and put option
1.1. American call option
The right to exercise

American options’ European options’
characteristics = characteristics + at any time prior to
expiration.
European options’ Value of the right to

American options’ = value at the same + exercise at any time
value expiration prior to expiration.
Value of the right to

American options’ Exercise value
value
= + exercise at any time
prior to expiration.
American call and put options must be worth at least as much as their exercise
169
values. (conclusion 2)
valuation
1.1. American call option
From conclusion 2, we establish minimum prices for American calls:

C0 ≥ Max [0, (S0 - X)]
From conclusion 1, we know that American option price should be greater

than European option price : C0 ≥ c0
Recall that in LOS 46.m, session 2.1,the minimum value of European call
option is determined as:
X
c0 ≥ Max [0, S0 − ]
(1+RF )T
X
→ C0 ≥ Max [0, S0 - ]
(1+RF)T
X X
But S0 - X < S0 - → Max [0, ( S0 - X)] < Max [0, S0 - ]
(1+RF )T (1+RF)T
X
We reestablish the American call minimum as C0 ≥ Max [0, S0 - ]
)T
(1+RF170
valuation
1.2. American put option
From conclusion 2, we establish minimum prices for American puts:

P0 ≥ Max [0, X − S0 ]
From conclusion 1, we know that American option price should be greater

than European option price : P0 ≥ p0
Recall that in LOS 46.m, session 2.2, the minimum value of European put
option is determined as:
X
p0 ≥ Max [0, − S0 ]
(1+RF )T
X
→ P0 ≥ Max [0, − S0]
(1+RF )T
X X
But X - S0 > - S → Max [0, X − S0 ] > Max [0, − S0]
(1+RF )T 0 (1+RF)T
We reestablish the American call minimum as C0 ≥ Max [0, X − S0 ] 171

valuation
Circumstances that the values of European and American

3. options differ
From conclusion 1, we see that

• The only difference between European and American options is that a
holder of an American option has the right to exercise prior to
expiration
• The prices of European and American options will be equal unless the
right to exercise prior to expiration has positive value
Herein this session, we will discuss

• The comparison of European and American options value
• The circumstances under which the value of early exercise is positive,
therefore lead to the difference between the value of European and
American options.
172
valuation

3. options differ
3.1. Values of European and American calls

Consider a deep in-the-money call (the underlying price reaches its
maximum value)
ST = max (expected)
Call holder may not want to The investor thinks the underlying will not
exercise a deep-in -the-money go up any further and thus expects no further
call, and just choose to hold or gains from the option → she is not
sell it to another investor interested in holding the assets.
Early exercise is not valuable for a call option that is deep in the money
Early exercise has no value for call options
American call options is priced equal to an otherwise identical European call

options, unless there is benefit holding the assets (*).
173
(*) This circumstance will be discussed in the next slide.
valuation

3. options differ
3.1. Circumstance that the values of European and American calls differ
(*) The asset pays cash flows during the life of a call option
Consider a call option on a stock that will pay a $3 dividend.

Ex-dividend date Payment date
Stock price Dividend of $3 is

1
decreases by $3 paid out 2
1 On the ex-dividend day, the decrease of the stock price will decrease the
value of the call option. (cT = Max [0, ST - X])
2 If the call holder exercise the call early, he can receive the dividend of $3
Exercising the call option prior to the ex-dividend date is advantageous
Early exercise may be valuable (has positive value) for call options on assets with
cash flows
Price of American call options on assets with cash flows will be greater than174the
price of otherwise identical European call options.
valuation

3. options differ
3.2. Circumstance that the values of European and American puts differ
Consider the (somewhat extreme) case of a put option at $20 on a stock that has
fallen in value to zero
ST = 0
Exercising the put The price of the stock, ST , may increase and
right when ST = 0 is is not zero anymore, so the exercise value of
the advantageous the put may fall (pT = Max [0, X − ST ])
Early exercise may be valuable for a put option that is deep in the money
Early exercise has positive value for put options
American put options can always be priced higher than otherwise identical
European put options.
175

CFAderivatives Full (CFA102

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFAderivatives Full (CFA102

Uploaded by

Copyright:

Available Formats

1

READING 45: Derivative Markets and Instruments

45.a. Define a derivative and distinguish between exchange-traded and

45.b. Contrast forward commitments with contingent claims

45.c. Define forward contracts, futures contracts, options (calls and

45.d. Describe purposes of, and controversies related to, derivative

This LOS list does not follow the Curriculum’s

READING 45: Derivative Markets and Instruments

A derivative is a financial contract or instrument that derives its value from

The underlying on which a derivative is based can be:

Mutual funds and exchange-traded Derivatives transform the

2.1. Exchange-traded market

Exchange-traded derivatives (e.g., futures contracts) are traded on

• Standardization facilitates the creation of a more liquid market for

2.1. Exchange-traded market

Exchange-traded derivatives (e.g., futures contracts) are traded on

• The exchange is responsible for clearing and settlement through its

2.2. Over-the-Counter (OTC) Derivatives Markets

OTC derivatives (e.g., forward contracts) do not trade in a centralized

• Dealers (typically banks) play an important role in OTC markets, as they

Derivatives are created and traded in two different types of markets:

Categories Exchanged-traded market Over-the-counter market

Trading market Centralized market No central location

Contract Standardized Customized

Market makers and

Transparency Comparatively high Low

Stocks Listed stocks Unlisted stocks

Trading hours Exchange hours Any time

Regulation Stricter Less strict

Counterparty risk No (minimized) Yes

Forward commitment Contingent claim

A forward commitment is a legally A contingent claim is a claim that

A forward commitment provides A contingent claim provides the

Forward Forward contracts

In an option, it’s important to define:

Contract initiation: Contract expiration:

Settlement by physical delivery

Underlying asset worth at spot price ST

Forward contracts that settle by an exchange of cash are called non-deliverable

The long is obligated to pay F0 T , The long is obligated to pay F0 T ,

Long position Short position

Payoffs at expiration to the counterparties:

In an option, it’s important to define:

• Every futures exchange has a clearinghouse, which guarantees that

Example 2: Mark-to-market process:

Daily settlement prices $98 $99 $105

Cashflows to account $98-$100 = -$2 $99-$98 = -$1 $105 - $99 = +$6

loss $2 loss $1 gain $6

Net gain over the three days equals $3

2.4. Futures margins

Initial margin Maintenance margin

The initial margin is the amount The maintenance margin is the

2.4. Futures margins

• If the initial margin requirement is 10%, an investor wanting to take a long

2.4. Futures margins

2.5. Price limits

No trading is allowed at prices beyond these limits.

Limit up Limit down

If traders cannot transact because of a limit move, either up or down, the

2.5. Price limits

2.6. Cashflows on Forward and Futures contracts

To understand the differences in cashflows between two contracts, we

2.6. Cashflows on Forward and Futures contracts