Last Revised: 08/14/2023

2024 Level 2 - Derivatives

Learning Modules Page

Pricing and Valuation of Forward Commitments 2

Valuation of Contingent Claims 20

Review 44

M.M134813896.

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curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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 Last Revised: 08/14/2023

Pricing and Valuation of Forward Commitments

a. describe the carry arbitrage model without underlying cashflows and with
underlying cashflows

b. describe how equity forwards and futures are priced, and calculate and interpret
their no-arbitrage value

c. describe how interest rate forwards and futures are priced, and calculate and
interpret their no-arbitrage value

d. describe how fixed-income forwards and futures are priced, and calculate and
interpret their no-arbitrage value

e. describe how interest rate swaps are priced, and calculate and interpret their no-
arbitrage value

f. describe how currency swaps are priced, and calculate and interpret their no-
arbitrage value

g. describe how equity swaps are priced, and calculate and interpret their no-
arbitrage value

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

M.M134813896.

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 Last Revised: 08/14/2023

Forwards/Futures Prices
Page 1
⇒ Arbitrage-free pricing & valuation LOS a, b
- describe
assumptions/ replicating instruments are identifiable
- compare
and investable - calculate
market frictions are nil - interpret
short selling is allowed with full use of proceeds
borrowing & lending are available at a known risk-
free rate
Notation: S – underlying
F – forward V – value of forward
f – futures v – value of futures

V0 = 0
- at contract initiation, the value of a futures/forward
contract = 0 (i.e. no money changes hands)
- at expiration, FT = fT = ST (called convergence)

VT = FT – F0 = ST – F0 (long) VT = F0 - FT = F0 – ST (short)

Page 2
- futures/ vt = ft – ft-1 futures are marked- LOS a, b
(before) to-market daily - describe
vt = 0 (after) - compare
- calculate
1/ no underlying cash flows F0 = S0erT - cont. comp. - interpret
or/ F0 = S0(1 + r)T - periodic comp.

e.g./ S0 = 100 Step #1. Borrow $100 for one year

rf = 5% Step #2. Buy S0
T = 1 yr. Step #3. Sell F0
Step #4. Payback loan of S0erT at time T
M.M134813896.

F0 = S0e = 100e
rT
= 105.127
.05(1)

F0 = S0(1 + r) = 100(1.05)1 = 105

T

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 Last Revised: 08/14/2023

Page 3
e.g./ S0 = 100
F0 = S0erT = 100e.05(1) = 105.127 LOS a, b
rf = 5% - describe
or/ F0 = S0(1 + r)T = 100(1.05)1 = 105
T = 1 yr. - compare
general rule : buy low, sell high - calculate
- interpret
Case 1: F0 = 110 Case 2: F0 = 90
- sell F0 (i.e. short) - Sell S0 for $100, invest @ 5%
- borrow $100, buy S0 - Buy F0 (i.e. long)
- at T, deliver S0 for $110 - at T, take delivery of S for $90, cover
- pay back $105 short position
- at time 0, borrow - profit = $15
reverse
5/1.05 = 4.762 - at time 0, borrow
carry carry
(get paid today) 15/1.05 = 14.286
arbitrage arbitrage
(get paid today)

Page 4
An Australian stock paying no dividends is trading in LOS a, b
Australian dollars for A$63.31, and the annual Australian - describe
interest rate is 2.75% with annual compounding. Based on - compare
the current stock price and the no-arbitrage approach, what - calculate
is the equilibrium three-month forward price? - interpret

S0 = 63.31 F0 = S0(1 + r)T

rf = 2.75% = 63.31(1.0275).25 = 63.74
T = .25

If the interest rate immediately falls 50 bps to 2.25%,

the three-month forward price will: ↓
63.31(1.0225).25 = 63.66
M.M134813896.

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 Last Revised: 08/14/2023

Page 5
1/ no underlying cash flows Key point: the LOS a, b
quoted forward price does not directly - describe
reflect expectations of future underlying prices - compare
- calculate
long
⇒ Value × × F0 = S0(1 + r)T - interpret
–

–
0 𝒕 short T
Ft = St(1 + r)T-t
𝐒𝐭
𝐅𝐭 − 𝐅𝟎 𝐅
𝐕𝐭 = 𝐨𝐫/ 𝐕𝐭 = 𝐒𝐭 − 𝟎>
(𝟏 + 𝐫)𝐓,𝐭 (𝟏 + 𝐫)𝐓,𝐭

× F0 = 105
e.g./ F0 = 105 V0 = 0
–

–
0 St = 110 T
T = 1 yr.
𝐅𝐭 = 𝐒𝐭 (𝟏 + 𝐫)𝐓&𝐭 = 𝟏𝟏𝟎(𝟏. 𝟎𝟓).𝟐𝟓
St = 110
𝟏𝟏𝟎 − 𝟏𝟎𝟓5 = 111.3499
𝒕 = 9 mos. (𝟏. 𝟎𝟓).𝟐𝟓
(𝟏𝟏𝟏. 𝟑𝟒𝟗𝟗 − 𝟏𝟎𝟓)
= 𝟔. 𝟐𝟕𝟐𝟗 𝐕𝐭 = = 𝟔. 𝟐𝟕𝟐𝟗
rf = 5% (𝟏. 𝟎𝟓).𝟐𝟓

Page 6
2/ Underlying with cash flows LOS a, b
𝛄 – gamma ⇒ benefits - describe
𝛉 – theta ⇒ costs 𝐅𝟎 = [𝐒𝟎 + 𝐏𝐕(𝛉) − 𝐏𝐕(𝛄)](𝟏 + 𝐫)𝐓 - compare
- calculate
increase decrease F0
- interpret
F0
e.g./ S0 = 100
𝟐. 𝟗𝟐𝟕𝟕
rf = 5% 𝐅𝟎 = %𝟏𝟎𝟎 + 𝟎 − 1 (𝟏. 𝟎𝟓)𝟏
(𝟏. 𝟎𝟓).𝟓
T = 1
= 102
CF = 2.9277 @ t = .5
𝟐.𝟗𝟐𝟕𝟕
- 3 mos. later St = 105 𝐅𝐭 = 3𝟏𝟎𝟓 + 𝟎 − (𝟏.𝟎𝟓).𝟐𝟓 6 (𝟏. 𝟎𝟓).𝟕𝟓 = 𝟏𝟎𝟓. 𝟗𝟏𝟑𝟒
(𝟏𝟎𝟓. 𝟗𝟏𝟑𝟒 − 𝟏𝟎𝟐)
𝐕𝐭 = >(𝟏. = 𝟑. 𝟕𝟕𝟐𝟖
𝟎𝟓).𝟕𝟓
𝟐. 𝟗𝟐𝟕𝟕 M.M134813896.
𝟏𝟎𝟐
B𝟏𝟎𝟓 − C− D(𝟏. 𝟎𝟓).𝟕𝟓 = 𝟑. 𝟕𝟕𝟐𝟖
(𝟏. 𝟎𝟓).𝟐𝟓

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 Last Revised: 08/14/2023

Page 7
2/ Underlying with known yield LOS a, b
- describe
assumed to be continuous
- compare
𝐅𝟎 = 𝐒𝟎 𝐞(𝐫 𝐜 .𝛉,𝛄)𝐓 𝐫𝐜 - calculate
𝛉 all continuous rates - interpret
𝛄
Recall/ (𝟏 + 𝐫)𝐓 = 𝐞𝐫𝐜 𝐓 ⇒ 𝐥𝐧[(𝟏 + 𝐫)𝐓 ] = 𝐫𝐜 𝐓
𝐓 𝐥𝐧(𝟏.𝐫)
𝐓
= 𝐫𝐜

𝐫𝐜 = 𝐥𝐧 (𝟏 + 𝐫)
e.g./ rf = 5% annual

rc = ln (1.05) = 4.897% & e.04897 = 1.05

Page 8
A. Equities/ LOS a, b
- describe
The continuously compounded dividend yield on the EURO
- compare
STOXX 50 is 3%, and the current stock index level is 3,500.
- calculate
The continuously compounded annual interest rate is 0.15%.
- interpret
Based on the carry arbitrage model, the three-month futures
price will be closest to:
𝛄 = 3% rc = .15% 𝐅𝟎 = 𝐒𝟎 𝐞(𝐫𝐜 ,𝛄)𝐓
S0 = 3500 T = .25 = 𝟑𝟓𝟎𝟎𝐞(.𝟎𝟎𝟏𝟓,.𝟎𝟑).𝟐𝟓 = 𝟑𝟒𝟕𝟓. 𝟏𝟓

Suppose Nestlé common stock is trading for CHF70 and pays

a CHF2.20 dividend in one month. Further, assume the Swiss
one-month risk-free rate is 1.0%, quoted on an annual 𝐅𝟎 = (𝐒𝟎 − 𝐏𝐕(𝛄))
compounding basis. Assume that the stock goes ex-dividend (𝟏 + 𝒓)𝑻
the same day the single stock forward contract expires. Thus,
M.M134813896.
the single stock forward contract expires in one month.
𝟏5
𝐅𝟎 = 𝐒𝟎 (𝟏 + 𝐫)𝐓 − 𝛄 = 𝟕𝟎(𝟏. 𝟎𝟏) 𝟏𝟐 − 𝟐. 𝟐𝟎 = 𝟔𝟕, 𝟖𝟓𝟖
𝟏
(𝐒𝟎 − 𝐏𝐕(𝛄))(𝟏. 𝟎𝟏) 5𝟏𝟐

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 Last Revised: 08/14/2023

Page 9
Suppose we bought a one-year forward contract at 102 LOS a, b
and there are now three months to expiration. The underlying - describe
is currently trading for 110, and interest rates are 5% on an - compare
annual compounding basis. If there are no other carry cash - calculate
flows, the forward value of the existing contract will be closest to: - interpret

9 F0 = 102
𝐅𝐭 = 𝟏𝟏𝟎(𝟏. 𝟎𝟓).𝟐𝟓 = 𝟏𝟏𝟏. 𝟑𝟒𝟗𝟗
–

–
0 𝒕 T −𝟏𝟎𝟐
St = 110
𝟗. 𝟑𝟒𝟗𝟗
𝟏𝟏𝟎 − 𝟏𝟎𝟐D 𝟗. 𝟑𝟒𝟗𝟗9
(𝟏. 𝟎𝟓).𝟐𝟓 = 𝟗. 𝟐𝟑𝟔𝟓 (𝟏. 𝟎𝟓).𝟐𝟓 = 𝟗. 𝟐𝟑𝟔𝟓

If a dividend payment is announced between the forward’s valuation

and expiration dates, assuming the news announcement does not
change the current underlying price, the forward value will most likely:
↓ [𝐒𝟎 + 𝐏𝐕(𝛉) = 𝐏𝐕(𝛄)] decrease

Page 10
B. Interest Rates LOS a, b
forward rate agreement (OTC) - describe
- underlying is an interest rate on a deposit - compare
- calculate
long = floating rate receiver (pays fixed) - interpret
short = fixed rate receiver (pays floating)

- no exchange of notional amount

- FRA price is the fixed interest rate that eliminates arbitrage

3x9 FRA – the rate on a deposit that begins in 3

months and lasts for 6 months

L(90) f(3,6) = FRA fixed rate

–

M.M134813896.
0 3 9 K𝟑𝟎D𝟑𝟔𝟎L
L(270)

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 Last Revised: 08/14/2023

Page 11
B. Interest Rates LOS a, b
- describe
- compare
L(90) f(3,3) - calculate

–
FRA expires FRA payoff - interpret
L(180)
discounted back advanced
advanced set, advanced settled set, settled
(FRAs) in arrears
swaps
- receive floating interest
𝐝𝐚𝐲𝐬D
𝐍𝐀(𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 − 𝐟𝐢𝐱𝐞𝐝 𝐫𝐚𝐭𝐞) 3 𝟑𝟔𝟎6 rate options
𝐝𝐚𝐲𝐬D
X𝟏 + 𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 3 𝟑𝟔𝟎6Y
- receive fixed
𝐝𝐚𝐲𝐬D
𝐍𝐀(𝐟𝐢𝐱𝐞𝐝 𝐫𝐚𝐭𝐞 − 𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞) 3 𝟑𝟔𝟎6
𝐝𝐚𝐲𝐬D
X𝟏 + 𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 3 𝟑𝟔𝟎6Y

Page 12
B. Interest Rates LOS a, b
In 30 days, a UK company expects to make a bank deposit of - describe
£10,000,000 for a period of 90 days at 90-day Libor set 30 days - compare
from today. The company is concerned about a possible decrease - calculate
in interest rates. Its financial adviser suggests that it negotiates today, - interpret
at Time 0, a 1 × 4 FRA, an instrument that expires in 30 days and is
based on 90-day Libor. The company enters into a £10,000,000 notional
amount 1 × 4 receive-fixed FRA that is advanced set, advanced settled.
The appropriate discount rate for the FRA settlement cash flows is 0.40%.
After 30 days, 90-day Libor in British pounds is 0.55%. rec. fx. = fl.
L(30)
f(1,3)
M.M134813896.
–

0 30 120
L(120) L(90) = .55%

The interest actually paid at maturity on the UK company’s bank deposit will
be closest to:
𝟏𝟎𝐌 3. 𝟎𝟎𝟓𝟓K𝟗𝟎D𝟑𝟔𝟎L6 = 𝟏𝟑, 𝟕𝟓𝟎