Level I CFA® Program exam: Derivatives cheat sheet
In this series of revision posts, we ask AB Maximus CFA® Program exam trainers to give you quick tips and essential advice for different chapters in the curriculum. Handy for revision or simply for a last minute review to make sure you’re thoroughly prepared – don't miss the chance to brush up on your knowledge and do a little extra prep!
3 key concepts are: how to structure derivatives, how leverage works, and how to estimate the intrinsic value of a derivative.
1. How to structure derivatives
A derivative is best described as a financial instrument that derives its performance from changes in the price of underlying assets, whether physical or financial.
The structure of derivatives can be divided into forward commitments (forwards, futures and swaps) or contingent claims (options and credit default swaps). In forward commitments, both buyers and sellers are obliged to fulfill their respective obligations on the expiry date of the derivatives. In contingent claims, the payoff is asymmetric, as sellers are obliged to fulfill their obligations only when buyers exercise their rights on or before the derivatives’ expiry date.
Derivatives can be combined with the underlying instruments to form more complex structured products that offer enhanced returns – or capital protection for sophisticated investors. However, derivatives products are often misunderstood or misused and can lead to financial disasters.
In 1995, Barings Bank was brought down single-handedly by its employee Nick Leeson, who saddled the bank with a debt of S$2.2 billion through derivatives trading. More recently in 2015, AIG nearly collapsed because of credit default swaps, and had to be bailed out by the America federal reserve.
2. How leverage works when dealing with derivatives
Leverage is often used to magnify the potential outcome of a derivative. Consequently, derivatives exchanges and trading platforms require an equity margin and put in place a mark-to-market system to control trading risks of market participants.
3. How to estimate the intrinsic value of a derivative during its lifetime
The estimation of intrinsic value of a derivative depends on several factors:
long/short position taken
cost of carry
volatility of the underlying instruments
When using a covered call or protective put option strategy, note the ultimate change in payoff from the original payoff of a stand-alone call or put option.
Students often get confused when it comes to: estimate the intrinsic value of a derivative during its lifetime.
It is difficult to estimate the intrinsic value of derivatives because they are based on any number of things: stocks, bonds, indices, currencies, interest rates, energy, metals, agricultural commodities, carbon emission and even the weather. Although derivatives take a pricing lead from physical or financial markets, it becomes difficult to price the potential outcomes or risks when uncertainty increases, and when the underlying instruments are more exotic and less predictable.
For example, the prices for orange juice deliveries for November surged 4.8% at $1.9285 a pound in September 2016 on ICE Futures U.S., as tropical storm Hermine headed towards Florida threatening to damage the centre of the American citrus industry.
A trader explained:
“We don’t know how much damage there’s going to be, and the market is pricing that fear.”
(Source: Bloomberg 2/9/16)
On another note, derivatives can also be used by sophisticated investors for hedging or speculative trading. For example, hedge funds have boosted the bullish bets on cattle futures due to a robust global demand for beef. On CME, cattle futures climbed 11% since the end of Aug 2017 to settle at $1.20825 a pound on 27/10/17.