Derivatives CFA Level 1

Level
I of the CFA® Exam

Study Notes - Derivatives
Offered by AnalystPrep
Last Updated: Feb 8, 2021
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© 2014-2021 AnalystPrep.
Table of Contents
48 - Derivative Markets and Instruments 3

49 - Basics of Derivative Pricing and Valuation 28
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Reading 48: Derivative Markets and Instruments
LOS 48a: define a derivative and distinguish between exchange-traded

and over-the-counter derivatives
Derivatives are a class of financial instruments which derive their value from the performance of
basic underlying assets. These underlying assets can be equities (stocks), fixed income
instruments (bonds), currencies, or commodities which are said to trade in cash or spot markets
at cash or spot prices.
Defining Derivatives
The widely used definition of derivative is that they derive their performance from underlying
assets. However, this definition could apply to exchange-traded funds (ETFs) or even mutual
funds. A better distinction would be to say derivatives usually transform the performance of the
underlying asset.
Derivatives are similar to insurance in that they allow for the transfer of risk from one party to
another. The risk itself does not change, but the party bearing the risk does. It is the underlying
asset that is the source of the risk, referred to as the "underlying" – which does not always have
to be an asset. The underlying could also include interest rates, credit, energy, weather, etc.
Legal Nature
Derivatives are created in the form of legal contracts involving two parties, the buyer, and the
seller. The seller is sometimes known as the writer or the "short" party in the contract. The
buyer, who purchases the derivative, is referred to as the "long" or the holder. The derivative
contract always defines the rights and obligations of each party and these are recognized by a
legal system.
Classes of Derivatives
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There are two classes of derivatives – forward commitments and contingent claims. Forward
commitments provide the ability to lock-in a future price in the form of a forward contract,
futures contract, or swap. A contingent claim is an option. It provides for the right but not the
obligation to transact at a pre-determined price.
Benefits of Derivatives
Derivatives can be used to implement strategies that cannot be achieved with their underlying's
alone. Derivatives have as an inherent feature a high degree of leverage. This means that
investors typically only commit small amounts of money to a derivative position relative to the
equivalent position in the underlying asset. Small movements in the underlying can lead to large
movements in the derivative – both positive and negative. This has the effect of attracting lots
of speculators in the derivative market looking for large gains. Furthermore, derivatives
generally trade at low transaction costs in liquid markets.
There are numerous applications in the practice of risk management where the use of derivatives
provides a useful tool for managing exposure to particular risks. Many financial institutions act
as hedgers, meaning they use derivatives to reduce or eliminate certain forms of risk.
In addition, arbitrageurs use the derivative market to simultaneously buy and sell similar assets
in different markets, creating a riskless profit while at the same time improving market
efficiency.
The Derivative Market
Derivatives can trade on organized exchanges like the New York Stock Exchange or the Chicago
Board of Trade (CBOT), or they can trade over-the-counter (OTC). Increasingly, there is less
distinction between exchange-traded and OTC markets as exchanges move towards fully
electronic systems.
Exchange-Traded Markets
The key feature of exchange-traded derivative contracts is the standardization of the contracts.
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This means the terms and conditions are precisely specified by the exchange. This specification
applies to features like the schedule of expiry dates and contract magnitude. The market
participants in the exchange-traded derivatives markets are the market-makers (dealers) and
speculators who are typically members of the exchange. The interplay between market makers
and speculators creates a more liquid and more orderly market.
The standardization also ensures clearing (verification of transaction and identities) and
settlement (transfer of money) of derivatives contracts happens efficiently and allows for the
provision of a credit guarantee by the clearing house. The clearinghouse is able to provide this
guarantee through the requirement of a cash deposit called a margin bond or performance bond.
Exchange-traded markets are said the have transparency as full information on the transactions
is disclosed to the exchange and regulatory bodies. This does mean a loss of privacy and, coupled
with the standardization, a loss of flexibility. As an alternative to standardization, OTC markets
provide a substitute for firms wishing to trade non-standardized products.
Over-the-counter (OTC) Markets
The OTC derivative market is made up of a number of informal participants, the backbone of
which are typically dealer banks such as JP Morgan Chase. Dealers are not obligated to
participate which makes the market an informal one.
As OTC derivative contracts are not standardized, risk management activities become more
complicated. It can be difficult for a dealer to find a contract which is a perfect match to hedge a
position and they usually have to rely on similar transactions in which they can lay off their risk.
The ability to customize OTC contracts does not necessarily make the market less liquid than the
standardized exchange-traded contracts. As many of the OTC instruments can be easily created,
an offsetting instrument can be created, oftentimes between the same two transacting parties to
terminate the position.
OTC markets do have a lower level of regulation than exchange-traded markets. However, post
the 2007 financial crisis, regulatory oversight has been increasing and on full implementation of
new rules, a number of OTC transactions will have to be cleared through central clearing
agencies with information reported to the regulatory authorities.
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Question
Which statement best describes the OTC derivatives market?
A. Contracts are standardized and typically cleared and settled through a centralized
clearing house
B. Contracts are flexible and there is a high degree of reporting to the regulatory
authorities
C. Contracts are flexible, often cleared and settled between transacting parties with a
low level of regulatory oversight
Solution
The correct answer is C.
Exchange-traded derivative contracts are standardized, cleared and settled through a
centralized clearinghouse and accompanied by a high level of regulatory reporting.
OTC contracts are far more flexible and less regulated.
Reading 48 LOS 48a:
Define a derivative and distinguish between exchange-traded and over-the-counter derivatives
Derivatives - Learning Sessions
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LOS 48b: contrast forward commitments with contingent claims
Derivatives typically fall into one of two classifications, either forward commitments or
contingent claims. The primary difference between the two is around obligations. Forward
commitments carry an obligation to transact whereas contingent claims confer the right to
transact, but not the obligation.
Forward Commitments
Forward commitments are contracts entered into between two parties that require both parties
to transact in the future at a pre-specified price known as the forward price. The parties and the
identity and quantity of the underlying are specified as well as the date of the future transaction
(expiration) and the nature of the settlement. The parties have to transact, they are obligated to
do so. In the event of non-performance, because of the obligation of the forward contract, a legal
remedy is possible to enforce the obligation.
The payoff profiles of forward commitments are linear in nature and move upwards or
downwards in direct relation to the price of the underlying asset. Forward commitments include
futures contracts and forwards contracts.
Contingent Claims
A contingent claim is a type of option where the payoff profile is dependent on the outcome of
the underlying asset. This is not dissimilar to a forward commitment, however with a contingent
claim, there is the right to transact but not the obligation. Given that the holder of the contingent
claim has the option as to whether to transact or not, contingent claims have become
synonymous with the term “option”.
Due to this choice, the payoff profile of an option contract is not linear. Options limit losses in
one direction and therefore transform the payoff profile of the underlying asset.
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Question
Which statement best describes the key difference between a forward commitment
and a contingent claim?
A. A forward commitment allows the holder to choose whether to transact whereas a
contingent claim is always enforceable
B. A forward commitment creates an obligation to transact whereas a contingent
claim allows for transacting to be optional
C. A forward commitment is enforceable and a party must transact whereas a
contingent claim allows the seller to choose whether to enforce the transaction
Solution
The correct answer is B.
A forward commitment creates an obligation between the transacting parties
whereas a contingent claim creates the right but not the obligation to transact at a
future date.
Reading 48 LOS 48b:
Contrast forward commitments with contingent claims
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LOS 48c: define forward contracts, futures contracts, options (calls and
puts), swaps, and credit derivatives and compare their basic
characteristics
There are multiple types of derivative contracts that are classified as forward commitments or
contingent claims. Within the forward commitment universe, we find forward contracts, futures
contracts, and swaps. On the other side of the spectrum, options (calls and puts), credit
derivatives, and asset-backed securities are contingent claims. Contracts can be traded on
regulated exchanges or on over-the-counter (OTC) markets and provide a pre-defined payoff
profile to both the buyers and sellers of the contracts.
Forward Commitments
Forward contracts, futures contracts, and swaps are types of forward commitment derivatives
which create the obligation to transact in the future.
Forward Contracts
A forward contract is a commitment in the form of an OTC derivative contract in which the buyer
agrees to purchase an underlying asset from the seller at a later date at a fixed price agreed at
the time of the contract inception. If one of the parties reneges on their commitment, it is
considered a default and legal proceedings can be instituted to force performance. The amount
owed is always the net value between the two parties.
When we consider the payoff profile of a forward contract, we denote the payoff profiles as
follows:
Payoff for the buyer = ST − F0 (T )
Payoff for the seller = −[ST − F0 (T )]
Where:
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ST = the price of the underlying asset at the contract expiration (time T)
F0(T) = the price that the buyer agrees to buy the asset for (or the seller agrees to sell the asset
for) at the inception of the contract (at time T=0)
For the buyer of the contract, if the price of the underlying asset at contract expiry (ST) is
greater than the price that they agreed to pay at contract inception F0(T) then clearly they are
able to purchase the asset for less than the prevailing price and thus they have profited. The
mirror image is true for the seller. If ST is greater than F0(T) then the seller has an equal but
opposite loss on the transaction. The buyer and seller are the counterparties in a zero-sum game
outside of the transaction costs incurred. If one party loses USD 100,000 on a forward contract,
the counterparty gains USD 100,000.
However, an important element of a forward contract is that no money is exchanged when the
contract is initiated. Forward contracts can be thought of as having zero value at the start and
they are neither assets nor liabilities. The value deviates from zero as the price of the underlying
moves. The ability to "lock-in" a future price for an asset has important practical benefits as well
as being used as an instrument for financial speculation.
Forward contracts do not need to be settled by the delivery of the physical underlying asset, they
may be cash-settled, also referred to as non-deliverable forwards (NDFs) or contracts for
differences (CFDs).
Futures Contracts
Futures contracts are specialized versions of forward contracts that are standardized and trade
on a futures exchange. Futures exchanges are highly regulated and the contracts have specific
underlying assets, times to expiration, delivery, and settlement conditions and quantities.
An important distinction is the daily settlement of gains and losses and the credit guarantee
provided by the exchange through its clearing house. This daily settlement process is known as
mark-to-market where the clearinghouse determines an average of the final futures trades of the
day and designates that price the settlement price. Each party's account in the transaction will
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be debited or credited with the losses or gains for the day. The account is referred to as a margin
account which is different in nature to an equity margin account.
In a futures margin account, both parties to the transaction deposit an initial amount of money,
typically less than 10% of the futures price and this is the initial margin. There is no formal loan
created for the balance as is the case with equity markets, the futures margin is more of a "good
faith" amount to cover possible future losses. Associated with the initial margin is the
maintenance margin, the amount of money each party must deposit after the trade is initiated.
The maintenance margin is assessed daily by the clearinghouse if, after the mark-to-market
process, the balance in the account is below the maintenance margin amount, the participant
will receive a margin call requiring them to deposit additional funds. In fast-moving markets, the
clearinghouse can make margins calls intra-day.
Some futures contracts contain price limit which is essentially a price range or band relative to
the previous day's price. If a party wants to transact above this band (limit up), the trading is
halted until the parties can agree on a price below the upper band. If a party wants to transact
below the band (limit down) then trading also stops until a price above the lower band can be
agreed on. When the market hits these bands and trading stops, it is known as locked limit. The
limits are important in helping the clearinghouse manage credit exposure.
At any given time, the number of outstanding contracts is known as the open interest. Futures
contracts can be settled by physical delivery of the underlying or cash on the expiration day. The
futures price converges towards the spot price at expiration. In cash-settled transactions, there
is a final mark-to-market at expiration with the futures price set to the spot price to ensure
convergence:
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Forward vs. Futures Contracts
Besides the obvious difference in standardization, forward contracts realize the full amount of ST
- F0(T) at expiration but futures contacts realize this amount in parts on a day-to-day basis. Due
to the time value of money, these are not equivalent amounts. However, the difference tends to
be small for shorter duration contracts in low-interest-rate environments. Waiting until
expiration to settle as is the case with forward contracts, does introduce more credit risk than
with a daily settled and high regulated futures contract.
Swaps
The concept of a swap is that two parties exchange a series of cash flows. One set of cash flows
is variable or floating and the other can be variable or fixed. A swap is an OTC contract that is
privately negotiated and is subject to default.
The most commonly used swap is a fixed-for-floating interest rate swap, also referred to as a
"plain vanilla swap". The notional principal is the loan balance on which the interest rate
payments are determined. As with futures and forwards, no money changes hands at the start of
the contract and the value of the swap is zero. As market conditions change, the value of the
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swap will change being positive for one party and negative for the other.
Swaps are subject to default but as the notional principal is not exchanged, the credit risk of a
swap is much lower than that of a loan. The only money that passes from one party to another is
the net difference between the fixed and floating rate of interest.
Contingent Claims
Options, credit derivatives, and asset-backed securities are all types of contingent claims,
meaning one of the parties has the right, but not the obligation, to transact at a predetermined
price at expiration
Options
The right to buy is referred to as a call option while the right to sell is a put option. An option
contract may also be exercised before the contract expiry date. Early exercise options are
American-style while European-style options are those that can only be only exercised at expiry.
However, it is important to note that both types of options trade in all geographies. The fixed
price at which the underlying asset can be bought or sold at expiry is known as the exercise
price or strike price.
The purchaser of an option contract pays the writer of the option contract an option premium.
The premium represents the value of the option in a well-functioning market. As the buyer has
no obligation beyond the premium, only the seller of the option can trigger a default if the buyer
exercises the option and the seller does not deliver the underlying.
We will learn more about the value at expiration and profit for call and put options in the next
learning objective.
Credit Derivatives
A credit derivative provides credit protection for the buyer in the event of loss from a credit
event. There are a number of types of credit derivatives.
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Total return swap
In a total return swap, the underlying is typically a loan or a bond. The credit protection buyer
pays the credit protection seller the total return on the bond (interest plus capital) in return for a
fixed or floating rate of interest. If the bond defaults, the credit protection seller must continue
to pay the interest while receiving no (or very little) return from the buyer.
Credit spread option
In a credit spread option, the underlying is the yield spread between the yield on a bond and the
yield of benchmark default-free bond. This yield spread, or credit spread, is a reflection of
investors' perception of credit risk. The credit protection buyer selects the strike spread and
pays an option premium to the seller. At expiration, the spread is compared with the strike
spread and if the option is in-the-money, the seller pays the buyer the determined payoff.
Credit-linked note
In a credit-linked note, the credit protection buyer usually holds a bond that may be subject to
default and in order to offset that risk, issues a credit-linked note with the condition that if the
bond defaults, the principal payoff is reduced accordingly. The buyer of the credit-linked note
takes on the credit risk of the underlying bond.
Credit default swap (CDS)
In a CDS, the credit protection buyer makes a series of regularly scheduled payments to the
credit protection seller. The seller makes no payments until a credit event occurs. A credit event
could be a declaration of bankruptcy, a failure to make a scheduled payment or a restructuring.
The CDS contract will explicitly define what constitutes a credit event. A CDS is essentially a
form of insurance and provides loss coverage in return for the premium paid by the buyer to the
seller.
Asset-backed Securities
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Asset-backed securities (ABS) alter the payment stream of the underlying asset. They typically
divide payments into tranches (slices) in which the priority of the claims changes from all being
equivalent to some tranches taking preference on the payments. The differential nature of these
claims becomes relevant when prepayments or defaults occur.
When a portfolio of mortgage assets is assembled into an ABS, the resulting instrument is called
a collateralized mortgage obligation (CMO). When homeowners pay off their mortgages early
(prepayment) the holders of the mortgage suffer and an expected stream of returns has been
terminated early. The funds now have to be reinvested at a typically lower rate. CMOs typically
partition the mortgages into A, B and C classes and class C will bear the first wave of
prepayment risk followed by class B and class A. As the risk on the tranches is not equal (class C
bears the most prepayment risk) the expected returns on the classes vary to compensate
investors for the varying risk.
When bonds or loans are assembled into an ABS, they are referred to as collateralized bond
obligations (CBO) or collateralized loan obligations (CLO) which collectively are collateralized
debt obligations (CDO). A CDO does not have much prepayment risk but does have credit risk. A
CDO allocates this risk to different tranches, senior, mezzanine or junior tranches. When a
default occurs, the junior tranche bears the risk first followed by the mezzanine and then senior
tranche. Therefore, senior tranches have the lowest risk but also the lowest expected return.
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Question
Which statement is true when the stock price is above the exercise price (ST > X) on
a put option at expiration?
A. The option seller would suffer a loss equivalent to the difference between the stock
price and the exercise price
B. The option buyer would suffer a loss equivalent to the difference between the stock
price and the exercise price
C. The option seller will show a profit equivalent to the option premium amount, the
option buyer will show a loss equivalent to the option premium amount
Solution
If the stock price is above the exercise price at expiration, the put option expires out-
the-money and is worthless. The option buyer has lost the premium paid while the
option seller has made a gain equivalent to the premium received.
Reading 48 LOS 48c:
Define forward contracts, futures contracts, options (calls and puts), swaps, and credit
derivatives and compare their basic characteristics
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LOS 48d: determine the value at expiration and profit from a long or a
short position in a call or put option
In an options contract, two parties transact simultaneously. The buyer of a call or a put option is
the long position in the contract while the seller of the option, also known as the writer of the
option, is the short position.
Here is it important to differentiate between the long and the short party in a contract. The
buyer is always said to be long the option. This is quite easy to see for a call option. However, for
a put option, the long position in a put is betting that the underlying price will drop. As such, the
long position in a put option is synonymous to being short the underlying.
Call options
Value at Expiration of a Call Option
The payoff profiles of a call option are represented as follows:
Payoff for a call buyer = max(0 , ST – X)
Payoff for a call seller = −max(0, ST – X)
Where
ST is the price of the underlying at expiration; and
X is the exercise price.
Profit of a Call Option
Using the payoff profile and the price paid for the option, the profit equation can be written as
follows:
Profit for a call buyer = max(0, ST – X) − c0
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Profit for a call seller = −max(0, ST – X) + c 0
where c0 is the call premium.
The buyer of the call option has no upper limit on its potential profit and a fixed downside loss
equal to the premium. The seller has unlimited losses and a gain limited to the premium:
Put Options
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By now, if you have well understood the basic characteristics of call options, then the payoff and
profit for put option buyers and sellers should be quite easy – you simply replace "ST − X" by "X
− ST".
Value at Expiration of a PutOption
The payoff and profit profiles of a put option are represented as follows:
Payoff for a put buyer = max(0, X − ST )
Payoff for a put seller = −max(0 , X − ST )
Profit for a put buyer = max(0, X − ST ) − p0
Profit for a put seller = −max(0, X − ST ) + p0
Where p0 is the put premium.
The put buyer has a limited loss and, while not completely unlimited gains, as the price of the
underlying cannot fall below zero, the put buyer does gain as the price falls. As such, purchasing
a put option is like purchasing insurance. In the same vein as for call options, the put seller has
nearly unlimited losses and his gains are limited to the put premium paid to him by the put
buyer:
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Call and put options can be used in combination with each other and with the underlying asset to
produce a wide range of potential payoff profiles.
Reading 48 LOS 48d:
Determine the value at expiration and profit from a long or a short position in a call or put option
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LOS 48e: describe purposes of, and controversies related to derivative
markets
The primary purpose behind derivative contracts is the transfer of risk without the need to trade
the underlying. This allows for more effective risk management within companies and the
broader economy. In addition, the derivatives market plays a role in information discovery and
market efficiency. Despite the benefits, there are criticisms that derivatives are misused and add
to market volatility.
Benefits of Derivative Markets
Information Discovery
The futures market aids in price discovery. Futures prices can be thought of as a forecast of
future spot prices, but in reality, they only provide a little more information than the spot price.
However, they do so in an efficient manner. A futures price also provides an indication of what
price would be acceptable to avoid uncertainty.
In the case of options, one of the characteristics of the asset underlying the option is volatility
and by using option pricing models, the volatility of the underlying asset can be determined. This
is the volatility implied by the price of the option. The level of implied volatility is a good measure
of general uncertainty in the market or a measure of fear.
Operational Advantages
There are some operational advantages to the derivative market:
Derivatives have lower transaction costs than transacting in the equivalent underlying
asset.
Derivatives markets typically have greater liquidity than the underlying market.
Derivatives allow short positions to be entered into easily.
Market Efficiency
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Markets can be thought of as reasonably efficient. When prices do deviate from fundamental
values, the derivatives market offers a low-cost way to exploit the mispricing. Less capital is
required, transaction costs are lower, and shorting is made possible.
Investors are also far more willing to trade if they know they can manage their risks. This
increased willingness to trade increases the number of market participants which increases
market liquidity.
Criticisms of Derivative Markets
Speculation and Gambling
In order for hedging to work, there must be speculators on the other side of the trade. The more
speculators the market attracts, the cheaper it becomes to hedge. Unfortunately, the perception
of speculators is not a good one. They are thought to be short-term traders who seek to make
a short-term profit and engage in price manipulation and trade at extreme prices. The profit from
short-term trading is taxed more heavily than profit from long-term trading – a way of
"punishing" these activities.
Many view derivatives trading as a form of legalized gambling, however, there are notable
differences. Gambling benefits only a limited number of participants and does not generally help
society as a whole while the derivatives market bring extensive benefits to the financial services
industry.
Destabilization and Systemic Risk
Opponents of the derivatives market claim the operational benefits result in an excessive amount
of speculative trading and that brings instability to the financial markets. They argue that as
speculators use large amounts of leverage, they are subjecting themselves and their creditors to
high risk if the market moves against them. Defaults by speculators can lead to defaults by their
creditors and these chain-reaction events can be systemic. Instability can, therefore, be spread
through the market.
Another criticism of derivatives is their complexity. Although it is unclear why the need for
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complex mathematics should create criticism, when the models on which derivative pricing is
based break down due to sometimes irrational actions by financial market participants, the
model builders are often blamed for failing to accurately capture financial market reality.
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Question
Which statement best reflects how derivatives are said to destabilize financial
markets?
A. Derivatives are highly liquid and expose price inefficiencies
B. Due to the high amounts of leverage embedded in derivatives, losses can be large
leading to potential default which can cascade through financial markets
C. Derivatives allow for short transactions which can drive market prices downwards
Solution
The highly leveraged nature of derivatives can lead to large losses resulting in
defaults from speculators which are passed on to their creditors. A massive wave of
defaults can destabilize financial markets.
Reading 48 LOS 48e:
Describe purposes of, and controversies related to derivative markets
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LOS 48f: explain arbitrage and the role it plays in determining prices and
promoting market efficiency
In well-functioning markets with low transaction costs and a free flow of information, the same
asset cannot sell for more than one price. If the same asset trade at a higher price in one place
and a lower price in another, then market participants would sell the higher-priced asset and buy
the lower-priced asset. In doing so, they would earn a riskless profit and the combined action
would force the two prices to converge. This simultaneous transacting to take advantage of a
price mismatch is known as arbitrage.
The Law of One Price
The fact that the arbitrage process forces prices to converge is often referred to as the law of
one price. In order for the strategy to be feasible, the ability to go both long and short of an asset
is important.
Arbitrage Strategies
The simplest opportunity for arbitrage might be if a particular stock is trading on two different
exchanges for two different prices. The lower-priced stock would be bought and immediately sold
at the higher price netting a profit with no capital commitment. It is important to note that
arbitrage does not give us information on which price (higher or lower) reflects the fundamental
value of a stock. Arbitrage is not an absolute valuation methodology, but it provides a relative
valuation – the correct price of one asset relative to another.
An arbitrage strategy could be applied to two stocks where the relative valuation between the
two is mispriced. Again, we would short sell the overpriced stock and buy the underpriced stock.
The proceeds from the short sale would cover the cost of the long position enabling the position
to be entered without capital commitment. As the prices converged at some time in the future,
the short and long positions are unwound to generate a profit.
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Arbitrage opportunities do exist temporarily but tend to be quickly exploited to bringing relative
prices back into line with each other. Some apparent arbitrage opportunities may be too small to
be worth exploiting given transaction costs.
Arbitrage Impact on Market Pricing
The law of one price and the lack of arbitrage opportunities is only upheld when there are
market participants actively seeking out such opportunities. In order for arbitrage opportunities
to be eliminated, traders must closely follow and compare prices. Although abnormal returns can
be earned in a variety of ways, arbitrage profits are definitely examples of abnormal returns and
violate the principle of market efficiency. We typically assume that arbitrage opportunities
cannot exist for any great length of time and that one investor cannot consistently capture them.
Thus, prices must conform to a model that assumes no arbitrage.
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Question
Which statement best describes arbitrage?
A. Arbitrage is the opportunity to make consistent abnormal returns due to market
inefficiency
B. Arbitrage, also known as the law of one price, means the ability to profit from price
mismatches lasting for a very short time
C. Arbitrage allows market participants to determine the true, fundamental price of
an asset
Solution
Arbitrage opportunities do allow investors to make risk-free returns without capital
commitment but such opportunities do not persist for any length of time and cannot
be consistently captured.
Reading 48 LOS 48f:
Explain arbitrage and the role it plays in determining prices and promoting market efficiency
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Reading 49: Basics of Derivative Pricing and Valuation
LOS 49a: explain how the concepts of arbitrage, replication, and risk
neutrality are used in pricing derivatives
The concepts of arbitrage, replication and risk neutrality are important to comprehend when
pricing derivatives. We can use assumptions about arbitrage and investor risk preferences to
determine derivative pricing.
Arbitrage
Arbitrage is the practice of exploiting a price imbalance in the same asset that exists between
two or more markets. For derivatives, this is taking advantage of the differences in prices of a
unique asset, to make a risk-free profit. Arbitrage opportunities tend to be exploited very quickly
which forces the convergence of prices. This is why identical assets should have just one price
and gives rise to the law of one price. There are circumstances where the cost of exploiting the
arbitrage opportunity may exceed the benefit in which case, the price discrepancy (which tends
to be small) will persist.
Consider this simple example: Company ABC’s stock trades on the New York Stock Exchange for
$10.00, and the equivalent of $11.00 on the London Stock Exchange. This sets up a perfect, risk-
free arbitrage opportunity. The ‘arbitrageur’ can buy ABC’s stock on the New York Stock
Exchange for $10.00 and simultaneously sell the stock on the London Stock Exchange for
$11.00, making a $1 per share ‘riskless’ profit. This action by market participants would force
the two prices to converge back to one price.
Replication
Replication is the creation of an asset or portfolio by using a combination of another asset,
portfolio, and/or derivative. The following combinations produce the equivalent single asset:
Long asset + Short derivative = Long risk free asset
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For example, let’s say an investor has just bought one troy ounce of gold at USD 1,500. Then, he
short sells a futures contract on a troy ounce of gold at USD 1575 for one year so that he can sell
his troy ounce of gold in twelve months at a higher price. This means that his return should be
equivalent to the return he would earn on a risk-free asset:
US D1500 − USD1575 = USD75
In other words, if the investor were to buy a risk-free bond for the same amount of USD 1500
and sell it one year later, he would earn an equivalent risk-free profit of USD 75 (or USD 75/USD
1500 = 5%).
We can rearrange the same formula as:
Long asset + Short risk free asset = Long derivative
Short derivative + Short risk free asset = Short asset
If assets are priced correctly to prohibit arbitrage, replication would seem to be a pointless
exercise. However, if we relax the no-arbitrage assumption, we may identify opportunities where
replication may be more profitable or have a lower transaction cost.
Risk Neutrality
Most investors are risk averse and will not accept risk without the commensurate returns.
However, as risk aversion is not relevant to the pricing of a derivative (unlike other assets), we
can assume the investor is risk-neutral. This means the expected payoff of the derivative can be
discounted at the risk-free rate rather than having to use the risk-free rate plus some premium.
Risk neutrality, otherwise known as risk-neutral derivative pricing, uses the fact that arbitrage
opportunities guarantee that a risk-free portfolio consisting of the underlying and the derivative
must earn the risk-free rate. The overall process of pricing derivatives by arbitrage and risk
neutrality is called arbitrage-free pricing. We effectively determine the price of the derivative by
assuming the market is free of arbitrage opportunities, sometimes referred to as the principle of
no arbitrage.
29
Question
When an arbitrage opportunity presents itself, what is most likely to happen?
A. Investors trade quickly and prices adjust to eliminate the opportunity
B. Clearinghouses will restrict the transactions that can be arbitraged
C. An investor has the opportunity to earn a risk premium in the short run
Solution
The correct answer is A.
The increased buying and selling by traders will eventually adjust the price to
eliminate any arbitrage. As demand for the cheaper asset goes up, so does the price.
When selling this asset in another market, the supply of that asset goes up, and the
price of the asset goes down. Increased arbitrage activity will eventually neutralize
the opportunity to take advantage of any price discrepancy.
Reading 49 LOS 49a:
Explain how the concepts of arbitrage, replication, and risk neutrality are used in pricing
derivatives
30
LOS 49b: distinguish between value and price of forward and futures
contracts
By assessing the difference between the investors' determination of the value of a stock or option
versus the prevailing market price, investors can either buy or sell the asset to attempt to profit
from this discrepancy. However, the same terminology and principles do not apply to forward,
futures or swap derivative contracts.
Value versus Price
Typically, in equity market analysis, the objective is to determine the value (fundamental value)
of a stock. When a stock trades at a price different from the investor determination of
fundamental value, the investor will buy or sell the stock. Thus, the value may not necessarily
correspond with the price. Options can be analyzed to determine their fundamental value and
differences between price and value exploited.
However, forward, futures and swaps use different terminology with respect to price and
value. Forwards and futures both start out with a value of zero since they do not require an
outlay of cash at initiation. As the underlying asset moves in price, the value of the contract
becomes positive or negative. However, since the price is one of the parameters of the
initial agreement signed by both parties, its value is embedded into the contract at inception and
remains fixed. This is why the value of both forward and futures contracts fluctuate throughout
the life-cycle.
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32
Question
Which of the following best describes the difference between the price of a futures
contract and its value?
A. The futures price is fixed at the start, and the value starts at zero and then
changes throughout the life-cycle of the contract.
B. The price determines the profit to the buyer, and the value determines the profit to
the seller.
C. The futures contract value is a benchmark against which the price is compared for
the purposes of determining whether a trade is advisable.
Solution
The futures price is fixed at the start, whereas the value starts at zero and then
changes, either positively or negatively, throughout the life of the contract.
Reading 49 LOS 49b:
Distinguish between value and price of forward and futures contracts
Derivatives – Learning Sessions
33
LOS 49c: explain how the value and price of a forward contract are
determined at expiration, during the life of the contract, and at initiation
This learning outcome covers how to differentiate forward price and forward value, as well as
how these are affected differently during the initiation, life cycle, and expiration of the contract.
It is crucial to understand the difference between forward price and forward value first before
moving on to calculating a forward contract value throughout the different stages of its life cycle.
Forward Value versus Forward Price
The price of a forward contract is fixed, meaning that it does not change throughout the life
cycle of the contract because the underlying will be purchased at a later date. We can consider
the price of the forward contract “embedded” into the contract. The forward value is the
opposite and fluctuates as the market conditions change. At initiation, the forward contract value
is zero, and then either becomes positive or negative throughout the life-cycle of the contract.
Value and price are completely different from each other, and that is crucial to understand.
At Initiation
At the initiation of the forward contract, no money is exchanged and the contract at initiation is
valueless (V0(T)). The forward price that the parties have agreed at the initiation is a special
price that results in the contract having zero value and thus no arbitrage opportunities. The
forward price at initiation is the spot price of the underlying compounded at the risk-free rate
over the life of the contract.
V0 (T ) = 0
F0 (T ) = S0 (1 + r)T
During the Life of the Contract
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The value of the forward contract is the spot price of the underlying asset minus the present
value of the forward price:
VT (T ) = ST − F0 (T )(1 + r)−(T −r )
Remember, that this is a zero-sum game: The value of the contract to the short position is the
negative value of the long position.
At Expiration
At expiration, the discounting we would normally compute on the forward price does not take
place, since the time remaining on the contract is zero. Therefore, the value of the forward
contract (long position) will be:
VT (T ) = ST − F0 (T )
35
Question
Consider a forward contract that has a term of 2 years. The price of the asset
underlying the contract is currently $200 and the risk-free rate is 9%. Given the
forward price of $220, the value of the forward contract at initiation is closest to:
A. $14.83
B. -$1.83
C. $31.66
Solution
In this scenario, the value of the forward contract at initiation is the difference
between the price of the underlying asset today and the forward price discounted at
the risk-free rate:
200 – [220 / (1 + 0.09)2] = $14.83
Note that the forward price at contract initiation is the unique price that would
induce traders to participate in arbitrage until the price of the forward contract
equals the non-arbitrage forward price.
Reading 49 LOS 49c:
Explain how the value and price of a forward contract are determined at expiration, during the
life of the contract, and at initiation
36
LOS 49d: describe monetary and nonmonetary benefits and costs
associated with holding the underlying asset and explain how they affect
the value and price of a forward contract
The value and price of forward contracts are affected by the benefits and costs of holding its
underlying asset. Carrying costs and opportunity costs can affect the value of holding the asset,
and it is sometimes beneficial to hold the physical asset underlying the contract rather than the
forward contract itself.
Opportunity Cost
Opportunity cost is important to consider when investing in a forward contract. Opportunity cost
is simply the loss or potential gain from other alternatives when one alternative is already
chosen. Fortunately, this effect is most likely included in the present value calculation.
Carrying Cost
Carrying costs, or storage costs, is another cost to consider when investing in an asset. There are
costs associated with physically holding the asset, insurance costs, etc.
If the storage costs are taken into account, the forward price must equal the spot price
compounded over the life of the forward contract at the given risk-free rate, plus the future value
of the storage costs over the life of the contract. The avoidance of the storage costs is essentially
a benefit to transacting via a futures contract rather than purchasing the underlying asset
upfront.
F0 (T ) = S0 (1 + r)T + F V (SC , 0, T )
Where FV(SC, 0, T) is the value at time T (expiration) of the storage costs.
It is assumed that the costs associated with storage are known when the storage is initiated.
Therefore, the final value of the contract is simply the price of the underlying today discount
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back to the present plus the costs associated with holding the asset.
Convenience Yield
The main non-monetary benefit of holding the underlying asset is referred to as the convenience
yield. The convenience yield is defined as the benefit of holding the physical product, rather than
a contract or derivative product. Sometimes, holding the physical underlying good rather than a
contract is more beneficial. An example of this would be holding actual barrels of oil rather than
a forward contract. Should there be a sudden oil shortage, the demand for oil increases and the
difference between the price you paid for the oil and the current price after the proclaimed
shortage would be your convenience yield.
38
Question
What will the forward price be if a barrel of oil is currently priced at $50, has an
interest rate of 3.5%, expires in 10 months and has a future value cost of $1.72 for
storage?
A. $42.17
B. $53.03
C. $53.17
Solution
F0 = S0(1 + r)T + FV(SC, 0, T)
Fo = $50(1 +.035)(10/12) + $1.72 = $53.17
Reading 49 LOS 49d:
Describe monetary and nonmonetary benefits and costs associated with holding the underlying
asset and explain how they affect the value and price of a forward contract
39
LOS 49e: define a forward rate agreement and describe its uses
A forward rate agreement (FRA) is ideal for an investor or company who would like to lock-in an
interest rate. They allow participants to make a known interest payment at a later date and
receive an unknown interest payment. This helps in protecting investors from volatility in future
interest rate movements. By entering into an FRA, the parties agree on an interest rate for a
stated period starting on a future date, based on the specified principal amount at the contract
initiation.
The buyer of a forward rate agreement enters into the contract to protect himself from any
future increase in interest rates. The seller, on the other hand, enters into the contract to protect
himself from any future decline in interest rates. For example, a German bank and a French bank
might enter into a semiannual forward rate agreement contract where the German bank will pay
a fixed rate of 4.2% and receive the floating rate on the principal of €700 million.
Since FRAs are cash-settled on the settlement date – the start date of the notional loan or deposit
– the interest rate differential between the market rate and the FRA contract rate determines the
exposure to each party. It’s important to note that as the principal is a notional amount, there are
no principal cash flows.
40
FRA contracts are over-the-counter (OTC), meaning that the contract can be structured to meet
the specific needs of the user. FRA’s are often based on the LIBOR rate, and they represent
forward rates, not spot rates. Remember, spot rates are necessary for determining the forward
rate, but the spot rate is not equal to the forward rate.
41
Question
Two parties enter an agreement to borrow $15 million in 90 days for a period of 180
days at 2.5% interest. Which of the following choices describes the time frame of this
FRA?
A. The settlement date is in 90 days, and the interest period is 180 days
B. The settlement date is in 90 days, and the contract expires in 180 days
C. The settlement date is in 90 days, and there will be reinitiation of the contract
every 90 days for 180 days (2 settlements)
Solution
The party in the long position agrees to borrow $15 million in 90 days (settlement
date). Then, it will incur a 2.5% interest rate for the remaining 180 days of the
contract.
Reading 49 LOS 49e:
Define a forward rate agreement and describe its uses
42
LOS 49f: explain why forward and futures prices differ
Forward and futures contracts share a number of similar features, but the way in which they are
traded and the resulting cash flows mean forward and futures contracts with the same
underlying asset may trade at a different price.
Exchange-traded vs. OTC
One of the main differences between the two is that the forward contract is an over-the-counter
agreement between two parties, i.e., it is a private transaction. On the other hand, futures
contracts trade on a highly regulated exchange, according to standardized features and terms of
the contract.
Risk Associated with Trading OTC
The primary risk for these two derivatives is different because of how they trade. For the forward
contract, the principal risk is counterparty risk, which is the risk that one party will default on
the agreement. With a forward contract, the mark-to-market and determination and payment of
the net gain take place at contract expiration. In a high-interest rate environment, the time value
of money component to the end-of-contract cash flow can be material.
Exchange-traded Futures Contracts
Futures contract are traded on an exchange, and the exchange acts as the counterparty in the
agreement, so there is little to no worry about default risk. Futures contracts also have daily
settlement through the daily mark-to-market process. Each day, the parties to the transaction
must maintain their margin accounts. This daily cash flow means there isn't a "lump sum" to
exchange at contract expiration and this differing cash flow pattern can produce a pricing
difference relative to an equivalent forward contract.
Pricing Differential
43
If interest rates were constant, futures and forwards would have the same prices. The pricing
differential between the two varies with the volatility of interest rates. Practically, the derivatives
industry makes virtually no distinction between futures and forward prices.
44
Question
Which of the following best describes why future and forward prices differ?
A. The forward contract has essentially no counterparty risk since it is a private
agreement between two parties, which is why forward contracts are more expensive
B. Futures contracts, since traded on an exchange, have more liquidity, hence why it
is cheaper to invest in a futures contract
C. Futures contracts settle daily, which means investors in futures contract must hold
a margin account
Solution
Futures contracts settle daily which requires the investor to have a margin account.
Since futures settle daily, any increase in value will lead to an increase in the excess
margin which can then be reinvested.
Reading 49 LOS 49f:
Explain why forward and futures prices differ
45
LOS 49g: explain how swap contracts are similar to but different from a
series of forward contracts
Since a swap involves a series of payments over a fixed period of time, it can be viewed as a
series of forward contracts expiring at various times over the life of the swap contract.
Series of Forward Contracts
The forward price is determined by the spot price and the net cost of carry where the net cost of
carry is dependent on the length of time of the contract. The cost of carrying an asset over
different time periods will vary with the length of the period. Therefore, the prices of the series
of forward contracts that "make up" the swap contract will not be equal. However, for a swap, all
of the fixed payments are equal.
In order to equate a swap with a series of forward contracts we need to assume that the forward
transaction starts with a nonzero value (known as an off-market forward). Each forward contract
will be created at a price that corresponds to the fixed price of the swap. Some of our forward
contracts would have negative initial values and some positive, but in aggregate, they would
have a zero value.
We can determine the nonzero price by using the principles of arbitrage and replication, the
details of which are not covered at this point.
Illustrative Example of a SWAP Contract
Consider a 3-year swap which settles every year. The notional principal is 25 million and the
fixed interest rate of the swap is 7%. For simplicity, let’s say that you are the fixed rate payer and
need to pay 1.75 million at the end of every year. If interest rates go up, you benefit because you
are paying 1.75 million even though the market rates are higher. If interest rates go down that is
bad because you are paying a 7% rate even though the market rate is lower.
The swap above is similar to following series of forward agreements:
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1. Paying 7% on a 25 million 1-year loan;
2. Forward rate agreement to pay 7% on a 25 million 1-year loan which will start one year
from today;
3. Forward rate agreement to pay 7% on a 25 million 1-year loan which will start two years
from today;
4. Etc.
47
Question
Why can a swap be viewed as a combination of forward contracts?
A. Because each forward contract is created at the swap price
B. Because forward contracts are created at different forward prices, which will
equal the fixed price of the swap at the end of the contract
C. Because swaps and forward contracts are exactly the same as long as the value at
the initiation of both contracts are the same
Solution
A swap is equivalent to a series of forward contracts because each individual forward
contract is said to be off-market since it is created at the swap price.
Reading 49 LOS 49g:
Explain how swap contracts are similar to but different from a series of forward contracts
48
LOS 49h: distinguish between the value and price of swaps
A swap is agreements between two parties to exchange a series of cash flows, which can also be
viewed as a series of forward contracts. Swap pricing is the determination of the initial terms of
the swap at the inception of the contract. On the other hand, swap valuation is the determination
of market value during the life of the swap contract.
Swaps are equivalent to a series of forward contracts, each created at the swap price. If the
present value of the payments in a swap or forward contract is not zero, then the party who will
receive the greater stream of payments has to pay the other party the present value of the
difference, i.e., the net value.
Interest Rate Swaps
An interest rate swap is an agreement to exchange one stream of interest payments for another,
based on a specified principal amount, over a specified period of time. Here is an example of a
plain vanilla interest rate swap with Bank A paying the LIBOR + 1.1% and Bank B paying a fixed
4.7%:
As in most financial transactions, a swap dealer is in between the two parties taking a
commission on the trade.
49
At inception, the value of an interest rate swap is zero. Therefore, the fixed rate on the swap has
to be such that the present value of the fixed payments is equal to the present value of the
floating payments. A received fixed rate swap should be treated as buying a fixed-rate bond and
issuing a floating rate bond:
Value of swap (receiving fixed) = Value of fixed rate bond (long)– Value of floating rate bond (short)
50
Question
What is the difference between the price and the value of a swap?
A. The price of the swap refers to the initial terms of the swap at the start of the
swap’s life and value refers to determining the market value of the swap at any point
in its life
B. The price of the swap refers to the fluctuating positive/negative prices throughout
the lifecycle of the swap and the value is the price of the swap at initiation
C. The price and the value of the swap are exactly the same and they both fluctuate
throughout the life of the swap.
Solution
The value of a swap is its market value at any point in time. At inception, the value of
an interest rate swap is zero. The price of the swap refers to the initial terms of the
swap at the start of the swap’s life.
Reading 49 LOS 49h:
Distinguish between the value and price of swaps
51
LOS 49i: explain how the value of a European option is determined at
expiration
European options only allow for the exercise of options at the expiry date while American options
allow for early exercise. The terms do not convey any information about where, geographically,
the options are traded. The right to exercise is a complex feature of an option and as such,
European options with a fixed exercise date are dealt with first.
Standard Notation
The following notion is used:
cT = Price of European call at expiration
ST = Price of the underlying at time T
X = Exercise price
pT = Price of a European put option at expiration
Value at Expiration
European Call Options
The value of a European call option at expiration is the exercise value, which is the greater of
zero or the underlying price at expiration minus the exercise price:
cT = max(0,ST − X)
European Put Options
The value of a European put option at expiration is simply the opposite – the greater of zero or
the exercise price minus the underlying price at expiration:
52
p T = max(0, X − ST )
53
Question
There is a European call option that gives the holder the right to buy 100 shares of
company XYZ at $100 in 3 months’ time. What is the value of this call option if the
spot price at expiration is $110.15?
A. $1,015
B. $0
C. -$1,015
Solution
CT = 100 × max($0, $110.15-$100) = $100 × $10.15 = $1,015
Since we have a call option with a strike price of $100, it makes sense that if the
price at expiration is higher than the strike price, our option has gained in value.
Reading 49 LOS 49i:
Explain how the value of a European option is determined at expiration
54
LOS 49j: explain the exercise value, time value, and moneyness of an
option
The exercise value, time to expiry and price of the underlying relative to the exercise price of the
option all affect the price of the option.
Exercise Value of an Option
The exercise value of American and European options is different because of early exercise that
is unique to American options. Early exercise gives the holder of an American option the right to
buy/sell their contract earlier than the expiration date if the option is at-the-money or in-the-
money. European option holders do not have this luxury, and their exercise value is the value of
the contract at expiration.
Time Value of an Option
Time value also affects the value of options. A greater length of time until expiration provides
further opportunities for the underlying to move in a favorable direction for the option holder.
The simplest way to remember this is that as the time to expiry increases, so does the value of
both call and put options.
Moneyness of an Option
The moneyness of an option is dependent on where the underlying price is relative to the
exercise price. When the price of the underlying is above the exercise price in the case of a call
option (ST > X), or below the exercise price for a put option (ST < X), the option is said to be in-
the-money.
When the price of the underlying is below the exercise price for a call option (ST < X), or above
the exercise price for a put option (ST > X), the option is out-of-the-money.
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When the exercise price is equal to the underlying price (ST = X), the option is at-the-money.
Example of the Moneyness of an Option
A great way to visualize this concept is with a graph. Let's say we have a call option on AAPL
with a strike price of USD 150. Whenever the price of the underlying (AAPL stock) is above USD,
the option is in the money:
Note that for a put option with a strike price of USD 150, it would be the exact opposite – the
option would be out of the money anytime the underlying stock is above USD 150.
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Question
What is the difference between a call option being at-the-money and being in-the-
money?
A. An option that has a stock price that is less than the exercise price of the option is
in the money and when the stock price equals that of the exercise price of the option,
it is at-the-money
B. An option that has a stock price equal to its exercise price is at-the-money and if
the option’s stock price exceeds that of the exercise price that is called in-the-money
C. An option that is in the money has a stock price that exceeds the exercise price
and the option is considered at the money when the stock price is less than the
exercise price
Solution
For call options:
At-the-money: Option's strike price = Market price of the underlying security
In-the-money: Call option's strike price < Market price of the underlying security
Reading 49 LOS 49j:
Explain the exercise value, time value, and moneyness of an option
57
LOS 49k: identify the factors that determine the value of an option and
explain how each factor affects the value of an option
Aside from the moneyness, time to expiration and exercise price, there are other factors that
determine the value of an option. The risk-free rate, volatility of the underlying as well as cash
flows from the underlying and cost-of-carry have an impact on option values.
Time expiration
With American style options as the time to expiration increases, the value of the option
increases. This makes perfect sense: with more time before the expiration date, there are higher
chances of the option moving in-the-money.
As the time to expiration increases, the value of a call option increases.
As the time to expiration increases, the value of a put option also increases.
Risk-free Rate
Here, the simplest way to think about this is as a rate of return on a stock. Let's say you have the
choice between buying a bond worth $1000 or one share of stock priced at $1000. If you know
the risk-free rate of interest is a known 5%, you would expect the stock price to increase by more
than 5% on average. Otherwise, why would you buy a share of stock instead of investing in a
risk-free bond? Therefore,
As the time the risk-free rate increases, the value of a call option increases.
However, as the risk-free rate increases, the value of a put option decreases.
Volatility of the Underlying
Volatility is considered the most significant factor in the valuation of options. As volatility
58
increases, the value of all options increases. Since the maximum loss for the buyer of a call or
put option is limited to the premium paid we can conclude that as volatility increases, there are
higher chances of the option expiring in-the-money.
As volatility increases, the value of a call option increases.
As volatility increases, the value of a put option increases.
The combined effects of time to expiration and volatility of the underlying give rise to the
concept of the time value of an option. This reflects the value of the uncertainty that arises from
the volatility of the underlying. The value of an option declines as expiration approaches and can
be measured as a time value decay factor.
Dividends on Stocks
Payments from an underlying may include dividends. As we've seen previously, immediately after
payment of a dividend the stock price falls by the amount of the dividend. However, the benefits
of these cash flows to the holders of the underlying security do not pass to the holder of a call
option. Therefore,
As dividends increase, the value of a call option decreases.
However, as dividends increase, the value of a put option decreases.
Carrying Cost of the Underlying
Some options can also be written on commodities such as oil, gold, corn, etc. Holders of a call
option are able to participate in the upside movement of the underlying without having to incur
the carrying costs of the asset (storage costs, insurance costs, etc.). As such:
As carrying costs increase, the value of a call option increases.
However, as carrying costs decrease, the value of a put option decreases.
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Pricing Bounds for Options
A call option gives the holder the right to buy the stock at a specified price. The value of the call
is always less than the value of the underlying stock. Thus,
c ≤ S0
If the value of a call were to be higher than the value of the underlying stock, arbitrageurs would
sell the call and buy the stock, earning an instant risk-free profit in the process.
A put option gives the holder the right to sell the underlying stock at a specified price. The value
of a put is always less than the strike price. Thus,
p≤K
If the value of a put were to be higher than the strike price, everyone would move swiftly to sell
the option and then invest the proceeds at the risk-free rate throughout the life of the option.
Lower Pricing Bounds
Call options can never be worth less than zero as the call option holder cannot be forced to
exercise the option. The lowest value of a call option has a price which is the maximum of zero
and the underlying price less the present value of the exercise price. This is written as follows:
X
c0 ≥ max(0,S0 − )
(1 + r)T
A put option has an analogous result. A put option can never be worth less than zero as the
option owner cannot be forced to exercise the option. The lowest value of a put option is the
maximum of zero and the present value of the exercise price less the value of the underlying.
This is expressed as follows:
X
p 0 ≥ max(0, − S0 )
(1 + r)T
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Question
Both a European call and European put options expire in 90 days, with the same
exercise price of $70 and the same underlying asset. The current price of the
underlying asset is $60. The risk-free rate of return is 5%. Find the lower bounds of
both options.
A. European call = max(0, -9.13) = 0; European Put = max(0,9.13) = 9.13
B. European Call = max(0, -9.43) = 0; European Put = max(0,9.43) = 9.43
C. European Call = max(0, -9.13) = 0; European Put = max(0,9.13) = -9.13
Solution
European call (c0): max[0, 60 - 70/(1 + 5%)0.2465] = max[0, -9.13] = 0
European put (p0): max[0, 70/(1 + 5%)0.2465 - 60] = max[0, 9.13] = 9.13
Reading 49 LOS 49k:
Identify the factors that determine the value of an option and explain how each factor affects the
value of an option
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LOS 49l: explain put–call parity for European options
Although parity means equivalence, puts and calls are not equivalent. However, there is a
relationship between the price of a call and its corresponding put option. This is referred to as
put-call parity.
Protective Puts and Fiduciary Calls
First, let's consider a protective put strategy where an investor who holds the underlying asset
purchases a protective put option. At inception, the investor commits S0, the cost of the
underlying asset and p0, the put premium.
Value at inception = p0 + S0
A protective put gives the holder a limited downside but reduces a bit his upside because of the
cost paid to buy the put option. Graphically, it can be represented as:
A strategy where an investor enters into a fiduciary call means an investor buys a call option on
an underlying asset and a risk-free zero-coupon bond with a face value equal to the exercise
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price.
X
Value at inception = c 0 +
(1 + r)T
The payoff graph from this strategy will be the exact same as that of the protective put strategy.
Put-Call Parity Arbitrage
By examing the payoff profiles of a protective put and a fiduciary call, we note that they are
identical. If two combinations of assets or portfolios of assets have the exact same payoff, their
cost of acquisition must be identical. In any other case, there is an arbitrage opportunity. In
other words, someone can make a risk-free profit by buying the cheaper one and selling the most
expensive one.
As a result of the no-arbitrage principle, we can set the value at the inception of the protection
call equal to the value at the inception of the protective put as follows:
X
c0 + = p 0 + S0
(1 + r)T
This equation is a key concept in derivatives pricing called put-call parity. This formula equates
the value of calls and puts through equivalent portfolios. It must be assumed that since these are
European options, they have the same strike, same expiry date, and the same underlying asset.
By re-arranging the prior equation:
X
c0 = p 0 + S0 −
(1 + r)T
The right side of this equation is equivalent to a call option, and is referred to as a synthetic
call. It consists of a long put, a long position in the underlying asset, and a short position in the
risk-free bond.
Another re-arrangement can be made to isolate the put option:
X
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X
p0 = c 0 + − S0
(1 + r)T
The right side of this equation is now referred to as a synthetic put which consists of a long
call, a short position in the underlying, and a long position in the risk-free bond.
64
Question
European put and call options both have an exercise price of $50 that expires in 120
days. The underlying asset is priced at $52 and makes no cash payments during the
life of the option. The risk-free rate is 4.5% and the put is selling for $3.80. According
to the put-call parity, the price of the call option should be closest to:
A. $6.52
B. $6.32
C. $7.12
Solution
c0 = p0 + S0 – X/(1+r)T
c0 = 3.80 + 52 – (50/1.045120/365) = 6.52
Reading 49 LOS 49l:
Explain put-call parity for European options
65
LOS 49m: explain put–call–forward parity for European options
Another important concept in the pricing of options has to do with put-call-forward parity for
European options. This involves buying a call and bond (fiduciary call) and a synthetic protective
put, which requires buying a put option and a forward contract on the underlying that expires at
the same time as the put option.
Put-Call-Forward Parity
An alternative structure for a protective put is to buy a forward contract and a risk-free bond in
which the face value is the forward price, rather than purchasing the underlying asset. As we
have established that a fiduciary call is equivalent to a "regular" protective put, it holds that a
fiduciary call must also be equivalent to a protective put with a forward contract.
The fiduciary call consists of a long call and a long position in a zero-coupon bond:
X
Value at inception = c 0 +
(1 + r)T
The synthetic protective put is made up of a long put and a long forward:
F0 (T )
Value at inception = p0 +
(1 + r)T
As the two portfolios have precisely the same payoff, their original investments should be the
same as well. By setting the fiduciary call equal to the synthetic protective put, we establish the
put-call parity for options on forward contracts.
X F0 (T )
c0 + = p0 +
(1 + r) T (1 + r)T
Solving for Fo(T), we acquire the equation for the forward price in terms of the call, put, and
riskless bond.
F (T ) X
66
F0 (T ) X
= c0 + − p0
(1 + r)T (1 + r)T
Where f racF0 (T )(1 + r)T is the value of the forward today multiplied by (1+r)T to get its value at
expiration.
Therefore, a synthetic forward is a combination of a long call, a short put, and a zero-coupon
bond with a face value of X - Fo(T).
67
Question
A European put has an exercise price of $58 that expires in 120 days. The long
forward is priced at $55 (also expires in 120 days) and makes no cash payments
during the life of the options. The risk-free rate is 4.5% and the put is selling for
$3.00. According to the put-call-forward parity, what is the price of a call option with
the same strike price and expiration date as the put option?
A. $50.43
B. $3.31
C. $0.83
Solution
c0 = p0 + Fo/(1 + r)T - X/(1 + r)T
c0 = 3.00 + 55(1.045)120/365/(1.045)120/365 - 58/(1.045)120/365
c0 = 0.83
Reading 49 LOS 49m:
Explain put-call-forward parity for European options
68
LOS 49n: explain how the value of an option is determined using a one-
period binomial model
As the option payoff is determined by the value of the underlying, if we know the outcome of the
underlying, we know the value of the option. If the underlying is above the exercise price at
expiration, then the payoff is ST - X for calls and zero for puts. The converse is true if the
underlying is below the exercise price at expiration. The derivation of an option pricing model
requires the specification of a model of random processes that describe the movements in the
underlying.
The Binomial Model for Stocks
A model with two possible outcomes is a binomial model. We start with the underlying at S0 and
let the price move up to S1+ and down to S1-. We don't know which outcome will occur but we
can assign probabilities. Assuming the probability of the move to S1+ is q, then the probability of
a move to S1- is 1 - q.
q S1 +
╱
S0
╲
1− q S1 −
We then specify the returns implied by these moves up and down as factors u and d where u =
S1+/S0 and d = S1-/S0.
q S0 u
╱
S0
╲
1− q S0 d
69
Deriving the Value of a Call Option Using a Binomial Model
We now consider a European call option with price co today and price c1+ and c1- at expiration.
Assume we sell a call and buy h units of the underlying asset with portfolio value at inception V0
= hS0 - co. At time 1, the portfolio will either be worth:
V1+ = hS1+ − c +
1
; or
V1− = hS1− − c−
1
If the portfolio was hedged then:
V1+ = V1−
Which could be re-written as:
hS1+ − c +
1 =
hS1− − c −
1
c+ −
1 − c1
Where h =
S 1+−S1−
We also know that a perfectly hedged portfolio will earn the risk-free rate so:
V1+ or V 1− = V0 (1 + r)
We can finally obtain the formula for the option price as:
πc +
1
+ (1 − π)c−
1
c0 =
1 +r
1+r −d
Where π = u−d
How do we Interpret this Equation?
Having worked through all of the above, we have arrived at an equation for the value of a call
option today which takes the form of an expected future value (the numerator) discounted at the
70
risk-free rate (the denominator). The volatility of the underlying is an important factor in
determining the value of the option. If the volatility increases, the difference between S1+ and
S1- increases which widens the range between c1+ and c1- leading to a higher option value.
How did q become π?
We note that our actual probabilities of q and (1 - q) are not used but instead, we have π and (1
- π) which are called risk-neutral probabilities. If the option is trading at a price too high relative
to the formula, investors can sell the call, buy h shares of the underlying and earn a return in
excess of the risk-free rate while funding the transaction by borrowing at the risk-free rate. This
action will put downward pressure on the call price until it conforms with the model price once
more.
The Value of a Put Option Using a Binomial Model
Following the same methodology as above, we can derive a model for a put option as follows:
πp+
1
+ (1 − π)p−
1
p0 =
1+r
1+r −d
Where π = u−d
71
Question
Which factors are the most relevant to determine an option's value using a binomial
pricing model?
A. The probability that the underlying will go up or down, the risk-free rate, and the
initial value of the option
B. The risk-free rate, the volatility of the underlying, and the exercise price
C. The probability that the underlying will go up or down, the risk-free rate, and the
risk-neutral probability
Solution
The probability that the underlying will go up or down is not a factor in determining
the price of an option using a binomial model because we derive it from the formula
1+r−d
π= .
u −d
The volatility of the underlying asset is an important factor, as is the risk-free rate,
the risk-neutral probability, and the exercise price.
Reading 49 LOS 49n:
Explain how the value of an option is determined using a one-period binomial model
72
LOS 49o: explain under which circumstances the values of European and
American options differ
European options can only be exercised at the expiry date while American options can be
exercised ahead of the expiry date. This leads to some circumstances in which the pricing of the
two different option types differs.
American Options
Early exercise if not required, so the right to exercise early embedded in the American option
cannot have a negative value. Thus, American options cannot sell for less than European options.
Using capital letters to denote American options and lowercase letters for European option, we
have:
C0 ≥ c0
P0 ≥ p0
The minimum values for American options are as follows:
C0 = max(0,S0 − X)
P 0 = max(0, X − S0 )
The minimum values for European options were previously established as:
X
c0 ≥ max(0,S0 − )
(1 + r)T
X
p 0 ≥ max(0, − S0 )
(1 + r)T
How can we use these Formulas?
By comparing the minimum values of American options with European options, we see that So -
73
X/(1 + r)T is greater than So - X. (For example, $110 - $100/1.05 = $14.96 ≥ $110 - $100 = 10.)
Given that the American price cannot be less than the European price, we re-establish the
American call price minimum as equivalent to the European call price minimum.
Comparing X - S0 with (X/(1 + r)T) - So shows that the American put price is never less than the
European put price meaning the American minimum put price is Max(0, X - S0).
The somewhat counterintuitive finding is that an American call is always worth more in the
market than exercised which means an American call option should basically never be exercised.
Exceptions
Call Options
However, a possible factor that can affect early exercise is when the underlying asset is a
dividend-paying stock. When a stock goes ex-dividend, its price falls by the amount of the
dividend and an investor holding a call option may find it worthwhile to exercise the call just
before the stock goes ex-dividend. If the underlying is a bond paying a coupon, a similar
argument may hold. However, if there are significant carrying costs associated with the
underlying (such as in the case of an option written on a commodity), then the motivation for
early exercise is weakened.
Put Options
As the minimum value of the American put exceeds the minimum value of the European put, the
motivation for early exercise is stronger. Dividends and coupons would discourage the early
exercise of a put option but carrying costs would encourage the early exercise.
74
Question
In considering an American call option, which statement is least accurate?
A. An American call option will be exercised early if the underlying price is trading at
less than the exercise price
B. An American call option will be exercised early if the underlying asset carries
significant holding costs
C. An American call option will be exercised early if the underlying stock is about to
go ex-dividend
Solution
An American call option is likely to be exercised early just prior to the underlying
going ex-dividend.
Option A is incorrect. As the option holder cannot be forced to exercise early, they
would never choose to do if the exercise price was higher than the price of the
underlying.
Option C is incorrect. Significant holding costs make owning the option preferable to
owning the underlying asset.
Reading 49 LOS 49o:
Explain under which circumstances the values of European and American options differ
75

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Study Notes - Derivatives

Last Updated: Feb 8, 2021

48 - Derivative Markets and Instruments 3

LOS 48a: define a derivative and distinguish between exchange-traded

at cash or spot prices.

obligation to transact at a pre-determined price.

generally trade at low transaction costs in liquid markets.

The Derivative Market

and speculators creates a more liquid and more orderly market.

with the standardization, a loss of flexibility. As an alternative to standardization, OTC markets

provide a substitute for firms wishing to trade non-standardized products.

Over-the-counter (OTC) Markets

participate which makes the market an informal one.

terminate the position.

agencies with information reported to the regulatory authorities.

Which statement best describes the OTC derivatives market?

low level of regulatory oversight

The correct answer is C.

Exchange-traded derivative contracts are standardized, cleared and settled through a

centralized clearinghouse and accompanied by a high level of regulatory reporting.

OTC contracts are far more flexible and less regulated.

Reading 48 LOS 48a:

Define a derivative and distinguish between exchange-traded and over-the-counter derivatives

Derivatives - Learning Sessions

transact, but not the obligation.

remedy is possible to enforce the obligation.

futures contracts and forwards contracts.

synonymous with the term “option”.

and a contingent claim?

A. A forward commitment allows the holder to choose whether to transact whereas a

contingent claim is always enforceable

B. A forward commitment creates an obligation to transact whereas a contingent

claim allows for transacting to be optional

C. A forward commitment is enforceable and a party must transact whereas a

The correct answer is B.

A forward commitment creates an obligation between the transacting parties

Reading 48 LOS 48b:

Contrast forward commitments with contingent claims

Derivatives - Learning Sessions

regulated exchanges or on over-the-counter (OTC) markets and provide a pre-defined payoff

profile to both the buyers and sellers of the contracts.

which create the obligation to transact in the future.

owed is always the net value between the two parties.

Payoff for the buyer = ST − F0 (T )

Payoff for the seller = −[ST − F0 (T )]

for) at the inception of the contract (at time T=0)

the counterparty gains USD 100,000.

as being used as an instrument for financial speculation.

may be cash-settled, also referred to as non-deliverable forwards (NDFs) or contracts for

account which is different in nature to an equity margin account.

clearinghouse can make margins calls intra-day.

limits are important in helping the clearinghouse manage credit exposure.

be small for shorter duration contracts in low-interest-rate environments. Waiting until

with a daily settled and high regulated futures contract.

privately negotiated and is subject to default.

price or strike price.

event. There are a number of types of credit derivatives.

Credit spread option