r57 derivative markets and instruments.pdf

8/10/2019 R57 Derivative Markets and Instruments.pdf

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CFA Level I Derivatives

Derivative Markets and Instruments

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Instit

Reproduced and republished with permission from CFA Institute. All rights re


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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 Use

Derivative: a financial instrument which derives its value from

underlying (asset)

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Underlying

Legal contract

Long and short

Risk management is the process by which an organization or individual de

the level of risk it wishes to take, measures the level of risk it is taking, an

adjusts the latter to equal the former.


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Example 1

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3. The Structure of Derivative Marke

Exchange-Traded Derivatives Markets Over-the-Counter Derivative

Informal network of mark

participants

Dealer market

Less liquid

Less transparent

Customized

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Clearing and settlement process

All contract terms standardized, except

for price

More liquid

More transparent

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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f


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4. Types of Derivatives

Forward Commitments

Contingent Claims

Hybrids

Derivatives Underlyings

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F C


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Futures Contracts

A futures contract is a standardized derivative contract created and traded on a futures e

which two parties agree that one party, the buyer, will purchase an underlying asset from

party, the seller, at a later date and at a price agreed on by the two parties when the con

initiated and in which there is a daily settling of gains and losses and a credit guarantee

exchange through its clearinghouse.

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S


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Swaps

A swap is an over-the-counter derivative contract in which two parties agree to exchang

cash flows whereby one party pays a variable series that will be determined by an under

rate and the other party pays either a variable series determined by a different underlyi

or a fixed series.

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E l 3


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Example 3

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4 2 C ti t Cl i


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4.2 Contingent Claims

Holder of a contingent claim has the right, but not an obligation, to make a final paymen

the performance of the underlying.

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Types of contingent claims:

Options

Credit default swaps

Asset-backed securities

Options


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Options

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

party, the seller or writer, and receives the right to either buy or sell an underlying asset

either on a specific expiration date or at any time prior to the expiration date.

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Credit Derivatives


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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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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.

Example 4


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Example 4

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4 3 Hybrids


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4.3 Hybrids

Hybrid instruments combine derivatives, fixed-income securities, currenc

and commodities

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4 4 Derivatives Underlyings


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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 Deriva


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5. The Purposes and Benefits of Deriva

Risk Allocation, Transfer, and Management

Information Discovery Price discovery

Implied volatility

Operational Advantages

Market Efficiency

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6 Criticism and Misuses of Derivativ


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6. Criticism and Misuses of Derivativ

Speculation and Gambling

Destabilization and Systemic Risk

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Example 6


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Example 6

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Example 7 (Cont )


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Example 7 (Cont)

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Summary


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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


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Conclusion

Read the summary

Review learning objectives

Examples

Practice problems

Practice questions from other sources

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