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CFA® Level I - Derivatives: Derivative Markets and Instruments
CFA® Level I - Derivatives: Derivative Markets and Instruments
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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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Contents and Introduction
1. Introduction
4. Types of Derivatives
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2. Derivatives: Definitions and Uses
Derivative: a financial instrument which derives its value from an
underlying (asset)
Underlying
Legal contract
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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
Clearing and settlement process Informal network of market
All contract terms standardized, except participants
for price Dealer market
More liquid Less liquid
More transparent Less transparent
Credit guarantee Customized
Margin or performance bonds
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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.
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.
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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.
Options
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.
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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
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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.
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Example 7
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Example 7 (Cont)
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Summary
What is a derivative
Purposes of derivatives
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Conclusion
Read the summary
Examples
Practice problems
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