CFA Derivatives

From quick facts to deep dives, we have everything you need to know about derivatives and the CFA exam.

• There are four types of derivatives.
• European and American options can be exercised differently.
• Exchange-traded derivatives carry less risk than OTC derivatives.
• Forward contracts are for OTC derivatives, while futures are exchange-traded derivatives

Grasping the key concepts early on will help with Derivatives on Levels I, II, and III. To do so, you should use study tools that can help you not just learn but understand this complex topic.

By understanding the concepts early, you build a foundation for success through all levels of the CFA exam.

Derivative markets include exchange-traded and over-the-counter (OTC) derivatives. There are also American or European options. It is important to understand both.

Understanding Exchange-Traded VS OTC Derivatives

Exchange-traded derivatives are standardized and less flexible than OTC derivatives. Examples of exchange-traded derivatives would be futures and options. Whereas, OTC derivatives would be forwards and swaps. These hold greater risk and are private and less regulated.

Options (Calls and Puts) Explained

European options can only be exercised at the time of expiration. Whereas, American options can be exercised during the life of the option.

Due to the ability to exercise these options at any time, American option pricing may vary from European options. This is a result of the potential interim cashflows of the underlying assets. This may be dividends or interest.

American put options may also differ from the European option pricing due to the early exercise abilities of American options.

Intrinsic value of European options:

European call = Max [0, ST – X]

European put = Max [0, X – ST]

Call option buyer and seller profit at expiration:

Call option buyer profit = Max [0, ST – X] – c0, where c0 = option premium.

Call option seller profit = c0 – Max [0, ST – X]

Put option buyer and seller payoff at expiration:

Put option buyer profit = Max [0, X – ST] – p0, where p0 = option premium.

Put option seller profit = p0 – Max [0, X – ST]

Derivative Markets and Instruments Practice Question

If the buyer of a call option has a strike price greater than the underlying stock price, the option is:

1. Valued greater
2. Out of the money
3. Overpriced

Answer B.

There is plenty to learn when it comes to derivative pricing and valuation. Take a deeper dive into these topics to gather a better understanding of each to prepare for the CFA exam.

Forward Contracts VS Futures Explained

A forward contract is an OTC derivative contract. In such, two parties agree to exchange a specific quantity of an asset for a fixed price at a future date.

The formula is represented as: F0 = S0 (1+r)T – FVT(benefit) + FVT(cost).

Futures are similar to forward contracts, but they are used on exchange-traded.

Due to the intermediate cashflows available with futures, they may be valued higher or lower than forward contracts. The value is based on its correlation with interest rates.

Forward Rate Agreements (FRA) Explained

Forward contracts that have an interest rate as an underlying are called Forward Rate Agreements (FRAs). FRAs allow individuals to lock in today’s interest rate for a loan to be used in the future. The purpose of this is to reduce interest rate risk.

Interest Rate Swaps Explained

Interest rate swaps can be viewed as a series of FRAs. If the interest rate increases after initiation, the swap would be valuable for the fixed-rate payer. Alternatively, if the interest rate decreases, the swap would benefit the floating-rate payer.

Moneyness of an Option Explained

There are three types of option moneyness: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). Below are the call and put options for each.

Moneyness Option	Call Option	Put Option
ITM	St > X	St < X
ATM	St = X	St = X
OTM	St < X	St > X

Factors Impacting the Value of an Option Explained

Many factors impact the value of an option. Below are some examples of them, as well as their impacts.

Increase in:	Call Option Value	Put Option Value
Value of underlying	Increases	Decreases
Cost of Carry	Increases	Decreases
Risk-Free Rate	Increases	Decreases
Time to Expiration	Increases	Increases (with the exception of deep in-the-money European puts)
Volatility of Underlying	Increases	Increases
Benefits of Underlying	Decreases	Increases
Exercise Price	Decreases	Increases

Put-Call Parity for European Options Explained

A put-call parity is the simultaneous holding of a short European put and long European call. Both of which must be of the same class.

The formula is represented as:

c0 + X/(1+r)T = p0 + s0

Put-Call-Forward Parity for European Options Explained

The relationship between a put option, a call option, a forward contract, and the exercise price is called put-call-forward parity.

The formula is represented as:

c0 + X/(1+r)T = p0 + F0(T)/(1+r)T

Basics of Derivative Pricing and Valuation Practice Question

Company A and Company B have a forward contract. Company A also has futures with Company C. Over the period of the forward contract, the futures had a positive correlation with interest rates. Which prices would be higher?

1. Futures
2. Forward contract
3. They would be the same

Answer A.

Level II focuses highly on the concepts. Be sure you understand futures, forwards, and margins and are able to calculate swaps.

To prepare, you are encouraged to utilize support and study materials.

View UWorld’s CFA Exam Study Materials

To prepare yourself for the CFA exam, you must practice, practice, practice. Spending plenty of time practicing will increase your understanding of the concepts. This will increase your chances of success.

Forward commitments include forwards, futures, and swaps.Here are some of the many uses for forwards, futures, and swaps:

• Using equity index futures and swaps to minimize equity risk.
• Using interest rate swaps to reduce interest rate risk.
• Using interest rate swaps to convert floating-rate debt securities to fixed-rate debt securities or vice versa.

Pricing and Valuation of Forward Commitments Practice Question

Using the carry arbitrage model, the forward contract price (F0), assuming annual compounding (r) is:

1. F0 = FV(S0) = S0(1 + r)T
2. F0 = FV(S0) = S0(r)T
3. F0 = FV[S0 + CC0 – CB0]

Answer A.

A contingent claim provides its owner a right to a payoff. This payoff is not required but is an option. It is determined by an underlying asset, rate, or other derivative.

Valuation of Contingent Claims Practice Question

_________ is a static risk measure defined as the change in a given portfolio for a given small change in the risk-free interest rate, holding everything else constant.

1. Theta
2. Vega
3. Rho

Answer C.

Level III of the CFA exam will bring everything together. This means all concepts may be tested in any section.If you need further assistance beyond study guides, UWorld offers professional online mentoring.

Learn more about UWorld’s CFA Program 2022 Review Course Options and choose the course that’s right for you.

In this portion of the CFA exam, there will be an essay and item set questions. The sample questions below are a condensed version of what you may expect.

Marx Inc. took out an R25,000,000, four-year, floating-rate bank loan requiring semi-annual payments of interest based on SELIC (Banco Central do Brazil’s overnight lending rate) plus a spread of 4.5% and repayment of principal at maturity. Marx Inc. representatives believe interest rates will rise in the near future and worry the organization will be unable to absorb the higher loan costs associated with an increase in rates.

Derivatives Constructed Response (Essay) Question Example

Using the following information, would you advise a swap? Explain.

Maturity of Swap	4 years
Payment Structure	Semi annual
Fixed rate on swap	10.8%
Duration of 4-year, 10.8% coupon bond	2.91 years

Derivatives Item Set Question Example

Marx Inc. representatives believe the swap will act as a hedge for the loan, reducing the company’s net cash flow risk and net market value risk.

The characterization of the interest rate swap as a hedge for the bank loan is most likely:

1. Correct
2. Incorrect, because the swap increases the cash flow risk
3. Incorrect, because the swap increases the market value risk

Answer C.

The biggest tip we can give is to truly comprehend the concepts.

Grasp the Concepts Rather Than Just Memorizing Formulas

Memorizing the formulas will not promise you success. By understanding the rationale behind each concept, the formula will come. Not by memorization, but by logic.

Practice Qualitative Questions but Don’t Forget Quantitative Ones

The Level I exam will focus primarily on the qualitative side of questions. However, it is important to still understand the qualitative pieces. Not only for Level I but Levels II and III as well.

Partner With an Experienced Study Program

UWorld’s experienced instructors help students progress from Level I through Level III with ease. Our study materials are structured to help you make the most of Derivatives study sessions.