CFA Level I Derivatives

Derivative Markets and Instruments

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Reproduced and republished with permission from CFA Institute. All rights reserved.
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Contents and Introduction

1. Introduction

2. Derivatives: Definitions and Uses

3. The Structure of Derivatives Market
4. Types of Derivatives
5. The Purposes and Benefits of Derivatives
6. Criticism and Misuses of Derivatives
7. Elementary Principles of Derivative Pricing

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2. Derivatives: Definitions and Uses

Derivative: a financial instrument which derives its value from an
underlying (asset)
Underlying

Legal contract
Long and short
Risk management is the process by which an organization or individual defines
the level of risk it wishes to take, measures the level of risk it is taking, and
adjusts the latter to equal the former.
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Example 1

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3. The Structure of Derivative Markets

Exchange-Traded Derivatives Markets

Over-the-Counter Derivatives Markets

Informal network of market
Clearing and settlement process
participants
All contract terms standardized, except
Dealer market
for price
Less liquid
More liquid
Less transparent
More transparent
Customized
Credit guarantee
Margin or performance bonds

Market makers make money through the bid-ask spread

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Example 2

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Example 2 (Cont)

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4. Types of Derivatives
Forward Commitments
Contingent Claims
Hybrids

Derivatives Underlyings

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4.1 Forward Commitments

Forward commitments are contracts entered into at one point in time that require both parties to
engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The
parties establish the identity and quantity of the underlying, the manner in which the contract will be
executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This
fixed price is called the forward price.

Types of forward commitments:

Forward Contracts
Futures
Swaps

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Forward Contracts
A forward contract is an over-the-counter derivative contract in which two parties agree that one party,
the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed
price they agree on when the contract is signed.

Payoff for long and short

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Futures Contracts
A futures contract is a standardized derivative contract created and traded on a futures exchange in
which two parties agree that one party, the buyer, will purchase an underlying asset from the other
party, the seller, at a later date and at a price agreed on by the two parties when the contract is
initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures
exchange through its clearinghouse.

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Swaps
A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of
cash flows whereby one party pays a variable series that will be determined by an underlying asset or
rate and the other party pays either a variable series determined by a different underlying asset or rate
or a fixed series.

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Example 3

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4.2 Contingent Claims

Holder of a contingent claim has the right, but not an obligation, to make a final payment contingent on
the performance of the underlying.

Types of contingent claims:

Options
Credit default swaps
Asset-backed securities

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Options
An option is a derivative contract in which one party, the buyer, pays a sum of money 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.

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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.

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.

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Example 4

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Asset-Back Securities
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled
and claims are issued on the portfolio in the form of tranches, which have different priorities of claims
on the payments made by the debt securities such that prepayments or credit losses are allocated to
the most-junior tranches first and the most-senior tranches last.

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4.3 Hybrids
Hybrid instruments combine derivatives, fixed-income securities, currencies, equities,
and commodities

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Example 5

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4.4 Derivatives Underlyings

Equities

Fixed-Income Instruments
Interest Rates
Currencies
Commodities
Credit
Other

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5. The Purposes and Benefits of Derivatives

Risk Allocation, Transfer, and Management
Information Discovery
Price discovery
Implied volatility

Operational Advantages
Market Efficiency

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6. Criticism and Misuses of Derivatives

Speculation and Gambling

Destabilization and Systemic Risk

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Example 6

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7. Elementary Principles of Derivative Pricing

Hedge portfolio: combination of derivative and underlying such that risk is eliminated.
Hedge portfolio should earn the risk free rate. A derivatives value is the price of the
derivative that forces the hedge portfolio to earn the risk-free rate.

Storage

Arbitrage

Arbitrage is the condition that two equivalent assets or

derivatives or combinations of assets and derivatives sell for
different prices, leading to an opportunity to buy at the low
price and sell at the high price, thereby earning a risk-free
profit without committing any capital.

The combined actions of arbitrageurs bring about a

convergence of prices. Hence, arbitrage leads to the law of
one price: Transactions that produce equivalent results must
sell for equivalent prices.

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Example 7

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Example 7 (Cont)

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Summary
What is a derivative

Exchange-traded and over-the-counter derivatives

Forward commitments: forward contracts, futures, swap
Contingent claims: options (calls and puts), and credit derivatives
Purposes of derivatives
Controversies associated with derivative markets
Arbitrage and law of one price

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Conclusion
Read the summary
Review learning objectives
Examples
Practice problems
Practice questions from other sources

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