DERIVATIVES

Derivative Markets and Instruments

The 3 basics of derivatives – What are they, who uses them, why are they helpful?
A derivative is a security that derives its value from another security or asset. Think of a
derivative like insurance—its purpose is to transfer risk from one party to another.
There are two sides to any derivative contract.
• The buyer of a derivative is long the position
• The seller of a derivative is short the position
Creating derivatives also helps improve the performance of underlying markets:
• It lets market participants create different investment strategies
• It better matches supply/demand for different levels and types of risk assets
• Derivatives have lower transaction costs than their underlying asset(s)
What are the pros and cons of using derivatives?
• Criticisms of derivatives– Risky & Complex
Center on the fact that they can be too risky, especially for uneducated investors who don’t
understand their complexity. In addition, derivative payoffs can be highly leveraged
outcomes, leading some to view them as “gambling” and subject to abuse by speculators.
• Benefits of derivatives – Better info, lower costs, enhanced risk management

Provides price discovery/information, allow risk to be managed and shifted between parties,
reduce transaction costs (b/c of higher liquidity and lower physical cost relative to the
underlying asset)

What are the pros and cons of using derivatives?

Criticisms of derivatives– Risky & Complex
Center on the fact that they can be too risky, especially for uneducated investors who don’t
understand their complexity. In addition, derivative payoffs can be highly leveraged
outcomes, leading some to view them as “gambling” and subject to abuse by speculators.

Benefits of derivatives – Better info, lower costs, enhanced risk management

Provides price discovery/information, allow risk to be managed and shifted between parties,
reduce transaction costs (b/c of higher liquidity and lower physical cost relative to the
underlying asset)

Compare and contrast OTC and Exchange-traded derivative markets

Exchange-traded derivatives are standardized contracts backed by a clearinghouse (which
verifies the parties and the transaction, facilitates settlement, and requires margin deposits).
They tend to have higher liquidity and protections.
OTC derivative markets are created via an informal network of market participants that usually
hedge their risks by creating offsetting transactions. OTC derivatives can be fully customized.
Without a clearinghouse, market participants create contracts directly with a counterparty and
thus have default risk.

Explain the division of derivatives into forward commitments and contingent claims. What are
they/how are they different?
Forward commitments are a legally binding commitment to perform an action in the future.
Forward commitments are written on equities, bonds, indexes, currencies, physical assets, and
interest rates. Types include forward and futures contracts, &swaps.
Contingent claims are a claim to a payoff in the event that a particular event happens. They are
binary—either there is or is not a payoff. Options are a great example of a contingent claim.
Credit defaults are also contingent claims—they pay off if a credit event (like a downgrade)
occurs.

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Explain the basic mechanics of a forward contract…

Who is long the asset and who is short the asset, how does one party gain over the life of the
contract etc..
A forward contract is where one party agrees to buy and a counterparty agrees to sell an
asset at a specified price on a specific date in the future. The motive is often to hedge a
specific risk (e.g. an airline uses a forward contract to lock in the price they pay for jet fuel).
• The buyer of the asset in the future islong the asset
• The seller of the asset in the future is short the asset
If the expected future price goes up (↑) over the life of the forward contract, the right to buy the
asset at the pre-specified (and lower) price becomes more valuable and has a positive value.
The party that is short the asset faces a loss equal to the gain of the long party.
Forward contracts are azero-sum game between the two parties.

What are the differences between a futures contract and a forward contract?
A futures contract is a standardized and exchange-traded forward contract facilitated/backed by
a clearinghouse.
Think of the clearinghouse as the centralized counterparty that acts as a buyer to every seller
and a seller to every buyer.
Compared to a forward contract a futures contract:
• Is less customizable because it has standardized contract terms
• Is more liquid
• Does not face counterparty (default) risk
• Is regulated by the government

Define the settlement price, initial margin, maintenance margin, and price limits within a futures
contract
• Settlement price – The average price of the final futures trade of the day. This is used for daily
G/L and cash settlement purposes
• Initial margin is the initial amount a clearinghouse requires to be deposited to initiate a futures
trade
• Maintenance margin is the minimum amount a participant must maintain in their account after a
trade is initiated. This value is set as a % of contract, if market moves cause the margin balance
to go below the maintenance margin the participant will need to add additional funds in response
to a margin call
• Price limits – Most futures markets limit the daily price movements. If the market prices go
above the daily limit the market is limit up. If it declines below the limit the market is limit down. In
either case the market is locked limit since to no trades can happen

What is a swap?
A swap is an OTC derivative contract in which two parties agree to exchange a series of cash
flows on periodic settlement dates for a set length of time (tenor). At each settlement date the
payments are netted, so that only one net payment is made by the party with the greater liability.
The payments are determined based off of a notional principal specified in the contract.
Most swaps are used to convert fixed interest payments into floating or vice versa.
Plain Vanilla Interest Rate Swaps – Pay-floating (1) and Pay-fixed (2)
1. Receive fixed, pay floating - converts floating payments into fixed
2. Receive floating, pay fixed – converts fixed receipts into floating
Basis swaps
1. Receive fixed, pay fixed
2. Receive floating, pay floating
Currency and equity swaps are also prevalent (but covered more in L2/L3)

How are swaps similar to forward contracts?

• Swaps are fully customized derivate instruments

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• Swaps do not (typically) require any payment at the start of the contract
• Default risk / counterparty risk is a vital consideration
• Swaps do not trade in an organized secondary exchange market
• Swaps are largely unregulated
• Most swap participants are large institutions

What are the key characteristics and vocab of options?

Buying an option contract gives the owner the right, but not the obligation, to either buy or sell the
underlying asset at a given price (exercise/strike price) within a set amount of time.
• Call option – The right to buy the asset (Right to “call the asset” away)
• Put option – The right to sell the asset (Right to put the asset to you)
You can be either long or short a call or put. A long call is equivalent to a short put
American options – Can be exercised at any time up to the expiration date
European options – Can only be exercised on the contract’s expiration date

An option is said to be in the moneywhen the option value is positive for the buyer. It is at the
money when the strike price = the market price and out of the money when it is less.

What is a credit derivative? What are the two main types?

A credit derivative gives the buyer protection from a downgrade or default from a borrower.
• Credit default swaps (CDS) are basically insurance contracts against default. The buyer of a
CDS pays a set amount each month in return for a payment in case the credit eventhappens
• Credit Spread options – A call option based on a bond’s yield spread, it will payoff if the credit
spread widens

What is arbitrage? How does it relate to market efficiency?

• Arbitrage is the opportunity to earn riskless profits above the risk free rate while holding a
portfolio of risky assets. It only arises if assets are mispriced.
• The theory of efficient markets/prices posits that when an arbitrage opportunity exists
arbitrageurs will trade on it until the asset prices go to their efficient level and the opportunity
disappears.
• Arbitrage is built on two key assumptions
• The law of one price – Two assets with the same guaranteed future cash flows should have the
same price
• With derivative contracts, if there is a certain payoff in the future in order to prevent arbitrage
from existing the return must equal the risk free rate

Basics of Derivative Pricing and Valuation

What is the equation that models the no-arbitrage price for a futures/forward contract?

Explain replication.
How do we combine the risk free asset, risky asset, and derivative to replicate certain payoffs?

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Because of the no-arbitrage price (where we can create a riskless portfolio by hedging using a
derivative) we can duplicate the payoff of a derivative position using a combo of the risk free
asset and the underlying asset.We can also duplicate the payoff of the underlying asset with a
combo position in the risk free asset and the derivative. This is what we mean by replication.
Long the risky asset & long the derivative = risk free return
Long the risky asset & short (borrowing) the risk free asset = short derivative position
Long derivative & short risk free = short risky asset
(A short position can also be depicted using a negative signs)

What is the difference between the value & price of forward and futures contracts?
What is the equation for the value of a forward contract?
The value of a futures or forward contract at inception is zero. Mathematically assuming no-
arbitrage pricing the value of the contract at initial
V0(T)

That value then fluctuates as the pricesof the underlying asset change over the life of the
contract. At any given time the long or short position may have a gain equal to the other’s loss.
The price of a futures contract is the forward price specified in the contract. In other words it is
the price the long position is agreeing to buy the underlying asset for at the end of the contract.
In short, the price is constant specified in the contract whereas the value will fluctuate throughout
the life of the contract.

How do we calculate the value of a forward/futures contract at any given time?

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What are the nonmonetary and monetary costs/benefits of holding an asset? How do they impact
the value and price of a forward contract?
Holding an asset can have either positive or negative value to the holder.
Negative: If you have to store an asset (like gold) it will have storage costs. When there are
storage costs the futures price increases to reflect a premium for avoiding the cost of holding the
underlying asset.
Positive: Holding an asset can also be convenient and this convenience yieldserves to increase
the value of the spot rate and decrease the futures price.
Mathematically we add and subtract the net cost/benefit from the spot rate:

Why do forward and futures prices differ?

Gains and losses on futures contractsare settled every day, which lead to gains and losses in the
margin account that, in the case of gains, can be withdrawn and used elsewhere. Forwards are
not marked-to-market. Thus:
• If positive correlation, Futures price > Forward price
• If negative correlation, Futures price < Forward price
Why?
If interest rates and futures prices are positive correlated a long position will increase in
value, letting the owner invest the excess deposits in his or her portfolio and earn a spread.
When they have to deposit more money for losses, interest rates will be low, and the
opportunity cost of the money will be lower.

What is a forward rate agreement?

A forward rate agreement (FRA) is a derivative contract based on interest rates and set
according to an agreed upon notional principal. Think of it as an agreement to enter into two
loans in the future—one short, one long—where one is a fixed rate loan and the other is a
floating-rate loan.Soa 3 x 12 FRA is an agreement to enter into two9 month loans starting
three months from now.
FRAs are netted so that only one party will pay the other based on the difference between
the specified interest rate and the market interest rate on the settlement date (which is at the
beginning of the loan period).
FRAs are often used by firms to hedge risk/remove uncertainty about future borrowing and
lending

How do you calculate the payoff of a forward rate agreement?

1. You are given the fixed-rate and floating-rates at the beginning of the loan period, mm months
from today
2. Discount the net payment from the END of the loan (n)(n) to the beginning (n-mn−m months
from today)
3. Always discount at the market rate, which is the floating-rate

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4.

What FRA position will a firm that will lend vs borrow in the future take?

• If a firm plans to borrow in the futurethat means it is (most likely) taking on a future floating rate
liability. Taking a long position in an FRA (pay fixed, receive floating) will lock in a maximum
interest rate.
• A firm planning on lending in the future can take a short position in an FRA (pay floating,
receive fixed) to hedge their interest rate risk. A decline in rates will reduce the return on funds
loaned but the FRA payoff would offset that decline.

Compare and contrast swap contracts with forward contracts.

Swap contracts are very similar to forward contracts, in particular interest rate swaps are very
similar to FRAs with one notable difference:
The swap agreements are not zero-value forward contracts at initiation. Thus they are similar
to off-market forwards, which are FRAs with non-zero values at initiation.
Note: a swap still has zero value at initiation, but each individual forward contract will have
positive or negative values that in aggregate sum to zero, i.e. PV(Fixed payments) = PV(Floating
payments)

• If rr ↑, fixed-payer will have a positive value

• If rr ↓, fixed-payer will have a negative value

What are the components of the option premium and how does its price change over the life of
the option?

Options derive their values from two factors—intrinsic value and time value.
option premium = intrinsic value + time value
Intrinsic value is the amount an option is in the money (lower bound at zero) while time value is
the speculative value and is the amount the option price exceeds its intrinsic value.
An option will usually trade above its intrinsic value, however, the time value will decrease as we
near expiration. At expiration the option’s value is either zero or equal to its intrinsic value if it is
in the money.

Define moneyness and ID when an option is in the money.

Moneyness is whether an option is in the money or out of the money. If exercising the option
would produce a positive value it is in the money and if it would produce a negative value that
means the option is out of the money. SS = strike price and XX = exercise price.

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What are the factors that determine the value of an option and what is their relationship to the
option value?
• Price of the underlying asset – For call options, the higher the price of the underlying the
greater the option’s intrinsic value. For puts, the lower the price, the greater the value.
• Exercise price – The higher the exercise price the lower the value of a call and the higher the
value of a put.
• Volatility of underlying asset – Higher volatility makes all options more valuable
• Risk-free rate – Increase value of calls & decrease value of puts
• Time to expiration – The greater the time to expiration the higher the time value of options
(exception with deeply in-the-money European puts)
• Costs/Benefits of holding underlying – More value of holding underlying decreases the value
of calls and increases the value of puts (think about missing a dividend payment)

What is put-call parity and how is it calculated?

Put-call parity is a relationship defining how the price of a European put option and European call
option on the same asset are related. It is based on the fact that if any portfolio has the same
payoff in the future than their prices must be equal today (no arbitrage).

You can rearrange the equation to solve for any variable and create a synthetic position
(equivalent payoff). The sign on

How do we use put-call parity to create a synthetic position?

You can rearrange the put-call parity equation to solve for any variable and create a synthetic
position (one that has an equivalent payoff). The sign on the individual securities indicates
whether it as a long or short position.

What is put-call forward parity?

Put-call forward parity is a put-call parity relationship derived using a forward contract on the
underlying asset rather than the asset itself.

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How do we calculate the value of an option using a one-period binomial model?

A binomial model gives us the probability of a stock moving up or down, as well as the magnitude
of the up and down moves over one period. Once we have/calculate those variables we can
use a tree diagram to calculate the expected value at payoff (as the probability weighted
average) and then discount that value to today at the risk free rate.

What causes the value of European and American options to differ?

An American option holder has the right to exercise their option at any time whereas a European
option holder can only exercise the option at maturity. Their values will thus be equal unless the
right to exercise before maturity has a positive value—this is only true if the underlying asset has
cash flows (like dividends).
Exercising a call option before the ex-dividend date would allow the holder to sell the stock at its
pre-dividend price or hold the stock and collect the dividend.
American call option price > European call option price on assets with CFs

What are the key/basic relationships between puts, calls, & the underlying asset? i.e. who
benefits from prices going up/down
• If you are long a call you benefit if the stock increases in price, which is also true if you are short
a put. A long call is equivalent to a short put.
• If you are short a call, you benefit if the stock decreases in price, which is also true when you are
long a put. Being short a call is equivalent to being long a put
• Options are a zero sum game between the long and short.
If you (1) know these facts, (2) can add and subtract premiums, and (3) know the basic positions
for each strategy (i.e. what you are long and short) that’s all you need to answer 95% of any
exam questions. The equations and graphs can be helpful, but you don’t need them and
shouldn’t get bogged down in memorizing the payoffs.

Explain the payoff of a call to the long and short position.

Buying a call involves paying a premium to the option writer. The long position starts down by the
amount of the premium. If the call expires with the price below the strike price it expires worthless
and you lose your premium.

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The breakeven point occurs when the price of the stock exceeds the exercise price by the
amount of the premium. Pay $4 for a call with a $40 strike price and the stock has to go up to
$44 to breakeven. If it keeps going higher, the long postion benefits(and the upside is unlimited).
You buy (sell) a naked call when you expect the stock to rise (fall). The short call position
has a max profit equal to the premium.

Explain the payoff of a put to the long and short position.

Buying a put involves paying a premium to the option writer. The long position starts down by the
amount of the premium. If the put expires with the price over the strike price it expires worthless.
The breakeven point occurs when the price of the stock falls below the exercise price by the
amount of the premium. Pay $4 for a put with a $40 strike price and the stock has to go down to
$36 to breakeven. If it keeps going lower, the long postion benefits with a max profit equal to the
difference between the exercise price and zero.
You buy a naked put when you expect the stock to fall. The short put position has a max
profit equal to the premium.

Explain the use and payoff of a covered call strategy.

A covered call strategy refers to selling calls on a stock you own. This is a protective strategy. It
serves to cap your upside (the stock is called away if it trades above the exercise price) but
allows you to earn income (the option premium) while decreasing the cost basis of your position.
Note that you still have downside exposure if the stock trades below (S 0 – premium).

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Explain the use and payoff of a protective put strategy.

If you think the price of a stock will decrease you would buy a put on the assets you own.
This protective put strategy hedges your downside by giving you the right to sell at the exercise
price. The cost of the strategy is the cost of purchasing the put.

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