CIFA Advanced Level

Derivatives Analysis flashcards

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What is the difference between a forward commitment and a contingent claim?

Forward commitment: both parties are obliged to transact at a future date on agreed terms. Forwards, futures and swaps. Contingent claim: one party holds a right, but not an obligation, to transact, and the other is obliged if that right is exercised. Options. The fastest test is symmetry of obligation.

How is the price of a forward contract set by the cost of carry?

F0 = (S0 - PV of income) x (1 + r)^T. S0 is the spot price, r the risk-free rate and T the time to expiration in years. Dividends or coupons paid during the contract's life are stripped out, because the forward buyer does not receive them. Example: a share at KES 100 with no dividend and r = 10% has a one-year forward price of 100 x 1.10 = KES 110.

When is a futures margin call triggered, and how much must be paid in?

Gains and losses are marked to market and settled through the margin account every day. When the balance falls below the maintenance margin, a margin call requires a top-up all the way back to the initial margin, not merely back to the maintenance level. Example: initial KES 20,000, maintenance KES 15,000, balance after losses KES 14,000: the call is KES 6,000.

How many stock index futures contracts change a portfolio's beta to a target?

N = [(target beta - portfolio beta) x portfolio value] / (futures price x multiplier). A negative N means sell; a target beta of zero is a full hedge. Example: KES 80,000,000 at beta 1.3, futures at 4,000 x KES 100 = KES 400,000 a contract: (0 - 1.3) x 80,000,000 / 400,000 = -260, so sell 260 contracts.

How is the fixed rate on a plain interest rate swap calculated?

Fixed rate = (1 - DF_n) / (DF_1 + DF_2 + ... + DF_n), using discount factors from the spot curve for each payment date. It is set so the swap is worth zero to both parties at initiation. Example: discount factors 0.9434 and 0.8734 give (1 - 0.8734) / 1.8168 = 6.97%.

How does a borrower with a floating-rate loan use a swap to fix its interest cost?

It enters a swap to pay fixed and receive floating. The floating payments received offset the loan's own floating payments, leaving a net fixed cost: the swap's fixed rate plus the loan's margin. Example: loan at reference + 1.5%, swap paying 9% fixed and receiving reference: net cost 10.5% fixed.

When is a call, and when is a put, in the money, at the money and out of the money?

Call: in the money when the underlying price is above the strike, out of the money when below. Put: in the money when the underlying price is below the strike, out of the money when above. Both are at the money when the underlying price equals the strike.

State put-call parity for European options and the principle behind it.

C + K / (1 + r)^T = P + S0. C and P are the call and put premiums at the same strike K and expiration, S0 the underlying's price. Both sides replicate the same future payoff, so by no-arbitrage they must cost the same today. It is an exact relationship, not an approximation.

How does a dealer delta-hedge written calls, and why must the hedge be rebalanced?

Shares to hold = delta x number of option shares. Calls on 10,000 shares at a delta of 0.60 need 6,000 shares. Delta changes as the price and time to expiration change (gamma), so the hedge is rebalanced continuously: if delta rises to 0.70, buy another 1,000 shares.

How does a credit default swap work?

The protection buyer pays a periodic premium, the CDS spread, to the protection seller. The seller pays out if a specified credit event, such as default or restructuring, occurs on the reference entity. It lets a party buy or sell credit risk protection without holding, or lending to, the reference entity itself.

What is a derivative?