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CFA Level 1 - Derivatives
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CFA Level 1 - Derivatives
Terms in this set (34)
Foward Contract
Fwd K is a K negotiated in the present that gives the contract holder both the right and full legal obligation to conduct a transaction at a specific fut time involving a specific quantity and type of asset at a predetermined price.
Futures Contract
Fut K is a Fwd K that has been highly standardized and closely specified. As w/ a Fwd K, a Fut K calls for the exchange of some good at a future date for cash, w/ the pmt for the good to occur at fut delivery date
Differences
between
Futures and Forwards
Options Contract
Options K gives its owner the right, but not the legal obligation, to conduct a transaction involving an underlying asset at a predetermined fut date and at a predetermined price (called the exercise or strike price).
Option
on a
Futures Contract
Option on a futures contract is an option that uses a Fut K as the underlying physical asset supporting the option.
Swaps
A swap is an agreement btwn two or more counterparties to exchange sets of cash over a period in the future. Cash flows that the counterparties make are generally tied to the value of debt instruments or the value of foreign currencies. Therefore, the two basic kinds of swaps are int rate swaps and currency swaps.
Futures Markets
Open Interest
Whenever determining open int, there must be a long and a short transaction that takes place. Open int represents the total number of contracts that are outstanding.
Futures Markets
Margin
Three Types
Initial Margin
Maintenance Margin
Variation Margin
Futures Markets
Initial Margin
and
Marking to Market
The first deposit is called the initial margin. Initial margin must be posted before any trading takes place. Initial margin is fairly low and equals about one day's maximum price fluctuation. The margin requirement is low because at the end of every day there is a daily settlement process called marking to mkt. In marking to mkt, any losses for the day are removed from the trader's acct, and any gains are added to the trader's acct.
Futures Market
Maintenance Margin
and
Variation Margin
If the margin balance in the trader's acct falls below a certain level (called the maintenance margin), the trader will get a margin call and must deposit more money (called the variation margin) into the acct to bring the acct back up to the initial margin level.
Futures Market
Margin Calls
Price when futures trader will receive a maintenance margin call is simply expressed as a percentage of the initial margin. However, if a margin call occurs because the acct is below the level of the maintenance margin, the trader will have to deposit enough in cash or secs to bring the acct up to the level of the full initial margin-not just back to the maintenance margin.
Options Market
Basics
Calls and Puts
Call Option:
Long pos - right to buy underlying stk at strike price (X) on fut date
Short pos - obligation to sell underlying stk to call option buyer
Put Option:
Long pos - right to sell underlying stk at strike price (X) on fut date
Short pos - obligation to buy underlying stk to put option buyer
Options Market
Moneyness
Stocks Price (S) compared to Strike Price (X)
Options Market
American
vs.
European
Options
American options allow the owner to exercise the option at any time before or at expiration. European options can only be exercised at expiration.
Two options identical in all ways (amt, underlying stk, strike price, etc...), except one is a European Option and other is an American Option, the value of the American Option will equal or exceed the value of the European Option. The American Option has more flexibility than the European Option, so it should be worth more.
Option Payoffs
and
Option Strategies
Interpretation of Option Payoff diagrams (two types: intrinsic and profit).
Intrinsic Value Graphs represent intrinsic (at-exp or mat) value of options for both buyer and writer.
Intrinsic value call option = max[0, S - X]
Intrinsic value put option = max[0, X - S]
Profit Graphs include cost of the option (premium).
Option buyer pays premium to option seller and if the option finishes out-of-the-money, writer keeps premium and buyer loses premium.
Calculate profit, loss, or breakeven point for option transactions.
Options considered zero-sum game because whatever amt buyer gains, seller loses, and vice versa.
Buyer of call option - long pos.
Writer/Seller of call option - short pos.
Buyer of put option - long pos.
Writer/Seller put option - short pos.
Intrinsic Value Graph
Call Option
Profit Graph
Call Option
For call option:
breakeven = strike price + premium
strike price = breakeven - premium
Maximum
Gain/Loss
&
Breakeven
Call Option
Intrinsic Value Graph
Put Option
Profit Graph
Put Option
For put option:
breakeven = strike price - premium
strike price = breakeven + premium
Maximum
Gain/Loss
Put Option
Margin and Options
Contracts
For options, only writers of options must post margin because they are the only parties with an obligation to fulfill. Buyer of either a put or call does not need to post margin because they have purchased a right.
Margin and Futures
Contracts
For Futures, both buyer and seller have entered into an obligation to either buy or sell underlying at a prespecified price. Both buyer and seller will post initial margin (determined by Fed Reserve and the exchange) and the marking to market daily gains and losses on their positions are deposited into or removed from this initial margin account.
Covered Calls
Covered call is the combination of a long stk and a short call. A stk owner may write a covered call if she believes that the stk price will decline.
Portfolio Insurance
Portfolio insurance is the combination of a long stk and a long put.
With portfolio insurance:
If stk is up, make money on stk's movement and lose put premium.
If stk is down, only lose put premium, because loss on stk offset by put gain.
Swaps
Market
Futures
vs.
Swaps
Swaps
Market
Plain Vanilla
Interest Rate Swaps
Plain vanilla interest rate swaps involves trading fixed int rate payments for floating-rate pmts (paying fixed and receiving floating).
Swaps
Market
Plain Vanilla
Interest Rate Swaps
Counterparties
Parties involved in a swap agreement are called counterparties.
The counterparty that wants variable-rate interest agrees to pay fixed-rate interest and is thus called the pay-fixed side of the swap.
The counterparty that receives the fixed payment by agreeing to pay variable-rate interest is called the receive-fixed side of the swap.
Note: swaps are a zero-sum game. What one counterparty gains, the other counterparty loses.
Swaps
Market
Plain Vanilla
Interest Rate Swaps
Terms
Time frame covered by deal is called the tenor of the swap.
The settlement dates are when the int pmts are to be made.
The amt used to calculate the pmt streams to be exchanged is called the notional principal.
The floating rate quoted is generally LIBOR flat or LIBOR plus a spread.
Swaps
Market
Plain Vanilla
Interest Rate Swaps
Cash Flows
(1) Notl prin is generally not swapped (same for both counterparties and denominated in same currency units).
(2) Determination of variable LIBOR flat int rate is usually set at the beginning of the settlement period, and the cash int pmt is made at the end of the settlement period. This is called the arrears method. Since the int pmts are in the same currency, there is no need for both counterparties to actually transfer the cash. The difference btwn fixed-rate pmt and variable-rate pmt is calculated and paid to the appropriate counterparty. Net int is paid by the one who owes it.
(3) At conclusion of swap, since notl prin was not swapped, there is no transfer of funds.
In a swap, the floating-rate pmt is made based on what the floating rate was at the beginning of the settlement period. Hence, when a swap is negotiated (beginning of first period), you know what the net cash flow will be at the end of the first period. However, cash flows for all other periods are indeterminate as of the start of the swap and are based on future movements in the floating rate.
Note: swaps are a zero-sum game. What one counterparty gains, the other counterparty loses.
Swaps
Market
Plain Vanilla
Interest Rate Swaps
Net Fixed-Rate Payment
Basic forumla for the net fixed-rate payment in an int-rate swap:
(Fixed-Rate Pmt)t = (Swap Fixed Rate - LIBORt-1)
(Number of Days/360)
(Notl Prin)
* If positive, fixed-rate payer owes a net pmt to floating-rate counterparty.
* If negative, fixed-rate payer receives a net flow from floating-rate counterparty.
Currency Swaps
In a currency swap, the counterparties swap their currency positions at the current spot exchange rate. Because currency swaps are actually a type of international int rate swap, there are four possible types of currency swaps:
*Pay fixed int on currency1 and receive fixed int on currency 2.
*Pay floating int on currency 1 and receive fixed int on currency 2.
*Pay fixed on currency 1 and receive floating on currency 2.
*Pay floating on currency 1 and receive floating on currency 2.
Currency Swaps
Plain Vanilla Currency Swap
A plain vanilla currency swap is one where you pay floating USD and receive fixed foreign currency.
Currency Swaps
Cash Flows
The cash flows that would occur in a currency swap are as follows:
* Unlike an int-rate swap, the notl prin actually changes hands at the beginning of the swap.
* Int pmts are made without netting. Full int pmts are exchanged at each settlement date.
* At the termination of the swap agreement (maturity), the counterparties give each other back the exchanged notional amounts. Notional principal is swapped again at the termination of the agreement.
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