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Crash Course for Derivatives CFA Level-I Exam

Derivatives

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Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

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Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

Definitions

Comparison

Forward contract One party agrees to buy (counterparty sells) or sell (counterparty buys) a physical asset / security at a specific price on a specific future date. If asset's future price increases, buyer (at the older, lower price) incurs gain & seller losses. Futures contract Standardized, exchangetraded forward contract. Different from forwards. Futures trade in active secondary market, are regulated, backed by clearing house. & require daily settlement of gains / losses.

Forwards

Futures

contracts Exchange-traded This files has Private expired at 30-Jun-13 Unique contacts Standardized contracts Default risk Little or no regulation Guaranteed by clearinghouse Regulated

Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

Long must pay a certain amount at specific future date to short, who will deliver the underlying asset.

A cash settlement fwd contract does not require actual delivery of the underlying asset, but a cash payment of the difference b/w market price of the asset & contract price at settlement date to the counterparty

Early termination can be achieved by entering into a new forward contract with the opposite position. This will fix the amount of payment to be made/received at settlement date.

Q.6-month forward on gold is quoted at $990/oz. Size of contract =100 oz. Ans. At maturity, long pays short $99000, short delivers 100oz of gold to long

Ans. If spot price at maturity = $1010, short pays long $2000 ($20 * 100) This files has expired at 30-Jun-13

Q. 6-month forward on gold is quoted at $990/oz. Size of contract =100 oz.

Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

Second type of arbitrage: two assets with uncertain returns can be combined in a portfolio that will have a certain payoff. If a portfolio of A & B has a certain payoff, the portfolio should yield the risk-free rate.

Law of one price: two assets with identical cash flows in the future, regardless of future events, should have the same price. If A & B have identical future payoffs, and A is priced lower than B; buy A & sell B. Q. For a European Call c=3 S0 = 20 T=1 r = 10% X = 18 D=0 Is there an arbitrage opportunity? Ans: Yes, there is a arbitrage opportunity, as the minimum price of the option is 3.63. 20- 18/1.1= 3.63.

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Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

Interest Rate Swap

Forward Rate Agreements (FRA)

Exchanges fixed for floating rate payments over the life of the swap. At inception, the value of a swap is 0. After inception, the value for the swap is the difference b/w the PV of the remaining fixed & floating rate payments. Value of a swap to pay fixed =Bfloat - Bfixed Value of a swap to receive fixed =Bfixed - Bfloat

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Can be viewed as a forward contract to borrow / lend money at a certain rate at some future date. Formula for payment to the long at settlement is: (notional principal)* [{(floating rate-forward rate)*(days/360)}/{1+(floating rate)*(days/360)}]

Q. FRA that settles in 30 days, $1 mn notional, Based on 90-day LIBOR, Forward rate of 5%, Actual 90-day LIBOR at settlement is 6% Ans. I = (6% - 5%) * (90/360)* $1m = $2,500 PV= 2,500 / (1 + (90/360)*6%) = $2,463

Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

Lower & Upper Bounds for Options

Option Minimum Value Maximum Value

American option let the owner exercise the any time before or at expiration. European can be exercised only at expiration. Value American option will equal / exceed value European option.

option option of the of the

European call (c)

American Call (C) European put (p) American put (P)

ct Max(0,St-(X/(1+RFR)T-t)
Ct Max(0, St-(X/(1+RFR)T-t) pt Max(0,(X/(1+RFR) T-t)-St)
t t

St
St X/(1+RFR) T-t

Put-Call Parity

P Max(0, (X-S )) This files has Xexpired at 30-Jun-13 Put call parity holds that portfolio with identical payoffs must sell for the same price to prevent arbitrage, the put-call parity relationship c + X/(1+RFR)T = S+p Buyer of a call option - long position in Call Writer of a call option - short position in Call Buyer of a put option - long position in Put Writer of a put option - short position in Put Intrinsic value of a call option = Max [O, S - X] Intrinsic value of a put option = Max [O, X - S] Q. The stock of a company is trading at $108. 1 year European call options with a strike price of $100 has a premium of $5 Interest rate is 8%. Find the premium of a 1 year European put option with a strike of $100. Ans: $5

Where t is anytime prior to time to expiration T

If the asset has an underlying stream of cash flows, the minimum value for European Options change to: c0Max{0,[S0-PV(CF,0,T)](X/(1+r)T)} p0Max{0,(X/(1+r)T)- [S0-PV(CF,0,T)]}

If the asset has an underlying stream of cash flows, the put-call parity can change to:

c0+(X/(1+r)T)=p0+[S0-PV(CF,0,T)]
Q. What are the minimum values of an American-style and a European-style 3-month call option with a strike price of $80 on a nondividend-paying stock trading at $86 if the risk-free rate is 3%? Ans. American: $6.59 European: $6.59

Derivatives

Futures & Forward

Arbitrage

Interest Rate Futures & Options

American vs. European Options

Intrinsic Value of Options

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Intrinsic value is the higher of zero and the value of the option if the option were exercised immediately At the money: price of the underlying is the same as the strike price of the option and carries nil payoff In the money: price of the underlying is greater / smaller than the strike price of a call / put option and exercising it results in a positive pay off Out of the money: price of the underlying is smaller / greater than the strike price of a call / put option and exercising it results in a nil pay off

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Question 1
What is the net interest earned by the company in the following transactions? Investment in a bond that earns LIBOR-30 basis points Interest rate swap at LIBOR for a 5% plain vanilla bond Current LIBOR is at 5.5% A. B. C. 4.7% inflow 5.2% inflow This files has expired at 30-Jun-13 5.3% inflow

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Answer 1
A. The company receives 5.2% from the investment pays 5.5% as per the swap and receives 5% fixed rate. Hence net interest received by the company is 4.7%

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Question 2
Which of the following is least likely correct about the price of an American and European options?

A. Both the European and American long life call options must be worth at least as much as the short life call option B. Both the American and European put options should decrease in price with an Increase in the risk free rate C. The price of American and European put option increases in price with an increase in This files has expired at 30-Jun-13 volatility of the stock price

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Answer 2
A. The American put and call option increases in worth with increase in the time to expiration. However the same is not true for an European call and put option. Consider two European call options one with an expiration date of 1 month and the other 2 months. If a dividend is expected in 6 weeks the short life call option will be worth more than the long life call option.

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Question 3
The spot price of a stock is $30. The strike price of a 6 month European put option for the underlying stock is $34. Assuming the risk free interest rate of 5% per annum. What is the option price that is least likely to give rise to an arbitrage opportunity? A. $2.54 B. $4.02 C. $33.45

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Answer 3
B. The lower bound for the price of a European put option is given as[ K*e^(-Rt)- So]. Using this formula the option price of the put comes to $ 3.16. Any value that is lesser than this value would give rise to an arbitrage opportunity. The upper bound for an European put option is K*e^(-Rt) which is $33.45. If the option price is higher than this value an arbitrage opportunity arises.

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Question 4
Which of the following events will lead to an increase in the value of a call option? A. A declining time to maturity B. Declining price of the underlying asset C. An increase in the discount rate

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Answer 4
C. Call Option Value = Stock Value - Present Value of Exercise Price. Consequently,when discount rates increase, the present value of the exercise price decreases, thus increasing the term on the right side, which automatically implies an increase on the left side. Note that in real life, an increase in the discount rate would also have a negative impact on stock values; however, for the purposes of option valuation, the discount rate is only applicable to the present value of the exercise price.

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Question 5
The additional margin that must be deposited to make the balance up to the initial margin requirement is known as the maintenance margin. The variation margin is the minimum balance that holders of future positions must maintain in their margin accounts. Both the statements are most likely A. Both the statements are Incorrect B. Only one statement is Correct C. Both the statements are Correct This files has expired at 30-Jun-13

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Answer 5
A. Both the statements are incorrect. The variation margin is the amount that is paid to bring the level of the balance to the initial margin while the maintenance margin is the minimum level that has to be kept in the margin account.

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Question 6
An investor shorts 100 shares of a company at $60 and at the same time sells a put option of 100 shares for an exercise price of $58 at a price of $4 per share. Which of the following best explains the investors strategy? A. The investor wants to make good the arbitrage opportunity B. The investor follows a conservative strategy by restricting his profits irrespective of the downside potential of the stock C. The investor makes a profit so long as the stock price does not cross $62.

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Answer 6
C. As the investor has shorted the shares he needs to buy it back to close his position. Hence, by writing the put option he is not only ensuring a profit of $2 per share (60-58) when the stock price goes down but also betting on the upside potential of the stock till it reaches $62 to make a profit of $2 per share (60+4-62). A is not the answer because the profit the investor makes is not risk less.

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Question 7
An investor shorts 100 shares of a company at $50 per share and at the same time writes a put option of the same company with a strike price of $48 for a price of $4 per share. If the spot price of the stock on the expiration date is $52. What is the maximum profit/loss to the writer of this covered put option? A. 0 B. $200 profit C. $400 loss

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Answer 7
B. The put option would not be executed and the writer of the put gets the premium of $ 400. But since it is a naked call option, the investor has to buy the shares in the spot market at $52 and close his short position. In this transaction he makes a profit of $200 (5000+400-5200)

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Question 8
Company X buys 100 shares of company Y at $78 per share. The price of the 1 month call option of the underlying shares of Y is $3.20 and the price of a 1 month put option is $0.92. Both have a strike price of $80. What is the maximum profit/ loss to the company if it writes a call option? A. $200 profit B. $520 profit C. Unlimited loss

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Answer 8
A. Since the call option price is higher than the put option price, the price of the stock is more likely to increase. In such a scenario the call option would be executed. The writer of the call gets $ 80 per share resulting in a profit of $200.

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Question 9
Which of the following statements about options and their underlying assets is TRUE? A. The value of an option, in comparison to its underlying asset, has the potential of creating an arbitrage opportunity B. The owner of the option is legally required to engage in a transaction involving the asset. C. The holder of a short position on an option is one of the party with the right to initiate a transaction involving the asset

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Answer 9
A. When option pricing is not efficient i.e. not in line with the interest rate and other things involved in option pricing theory there remains a chance of arbitrage.

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Question 10
The largest market in terms of outstanding market value for OTC derivatives is most likely A. Interest rate derivatives B. Forex C. Equity

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Answer 10
A. The largest market for derivatives based on market value and also based on notional principal is the one for interest rate derivatives.

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Question 11
The following instruments are available in the market: Share X at $50 Call at strike price $50, maturing in 1 year, at $14.54 Put at strike price $50, maturing in 1 year, at $10 The risk free rate is 10% The share is expected to pay a dividend of $3 in 6 months. Which of the following trades indicates an arbitrage opportunity?

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A. Buy a Call and a Zero Coupon Bond that yields $50 in 1 year, and sell the put option and the share. B. Sell a call and a zero coupon bond that yields $50 in 1 year and buy the put option and the share. C. Market is in equilibrium. No arbitrage opportunity possible

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Answer 11
B. Sell a call and a zero coupon bond that yields $50 in 1 year and buy the put option and the share PV of the required Bond = 50/(1.1) = 45.45 Using put-call parity:

Call + Bond Put + Stock -PV(dividend) This files has expired at 30-Jun-13 14.54 + 45.45 10 + 50 D 60 60 D Therefore, Call + Bond is overpriced and Put + Stock PV(div) is underpriced. To make use of the arbitrage opportunity, we need to Sell the overpriced and buy the underpriced.

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