Derivatives E-Book
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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: The CFA Institute Series
- Sprache: Englisch
The complete guide to derivatives, from experts working with CFA Institute Derivatives is the definitive guide to derivatives and derivative markets. Written by experts working with CFA Institute, this book is an authoritative reference for students and investment professionals interested in the role of derivatives within comprehensive portfolio management. General discussion of the types of derivatives and their characteristics gives way to detailed examination of each market and its contracts, including forwards, futures, options, and swaps, followed by a look at credit derivative markets and their instruments. The companion workbook (sold separately) provides problems and solutions that align with the text and allows students to test their understanding while facilitating deeper internalization of the material. Derivatives have become essential for effective financial risk management and for creating synthetic exposure to asset classes. This book builds a conceptual framework for grasping derivative fundamentals, with systematic coverage and thorough explanations. Readers will: * Understand the different types of derivatives and their characteristics * Delve into the various markets and their associated contracts * Examine the role of derivatives in portfolio management * Learn why derivatives are increasingly fundamental to risk management CFA Institute is the world's premier association for investment professionals, and the governing body for CFA¯® Program, CIPM¯® Program, CFA Institute ESG Investing Certificate, and Investment Foundations¯® Program. Those seeking a deeper understanding of the markets, mechanisms, and use of derivatives will value the level of expertise CFA Institute brings to the discussion, providing a clear, comprehensive resource for students and professionals alike. Whether used alone or in conjunction with the companion workbook, Derivatives offers a complete course in derivatives and their use in investment management.
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Seitenzahl: 2086
Veröffentlichungsjahr: 2021
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DERIVATIVES
Cover image: © bgblue/Getty Images
Cover design: Wiley
Copyright © 2021 by CFA Institute. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data
Names: Pinto, Jerald E., author. | Pirie, Wendy L., author.
Title: Derivatives / Jerald E. Pinto, CFA, Wendy L. Pirie, CFA.
Description: Hoboken, New Jersey : John Wiley & Sons, Inc., [2017] | Series:
CFA Institute investment series | Includes index. |
Identifiers: ISBN 9781119850588 (pdf) | ISBN 9781119850595 (epub) | ISBN 9781119850571
(cloth)
Subjects: LCSH: Derivative securities.
Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 P535 2017 (print) | DDC
332.64/57—dc23
CONTENTS
Foreword
Preface
Acknowledgments
About the CFA Institute Investment Series
CHAPTER 1 Derivative Markets and Instruments
Learning Outcomes
1. Derivatives: Introduction, Definitions, and Uses
2. The Structure of Derivative Markets
2.1. Exchange-Traded Derivatives Markets
2.2. Over-the-Counter Derivatives Markets
3. Types of Derivatives: Introduction, Forward Contracts
3.1. Forward Commitments
4. Types of Derivatives: Futures
5. Types of Derivatives: Swaps
6. Contingent Claims: Options
6.1. Options
7. Contingent Claims: Credit Derivatives
8. Types of Derivatives: Asset-Backed Securities and Hybrids
8.1. Hybrids
9. Derivatives Underlyings
9.1. Equities
9.2. Fixed-Income Instruments and Interest Rates
9.3. Currencies
9.4. Commodities
9.5. Credit
9.6. Other
10. The Purposes and Benefits of Derivatives
10.1. Risk Allocation, Transfer, and Management
10.2. Information Discovery
10.3. Operational Advantages
10.4. Market Efficiency
11. Criticisms and Misuses of Derivatives
11.1. Speculation and Gambling
11.2. Destabilization and Systemic Risk
12. Elementary Principles of Derivative Pricing
12.1. Storage
12.2. Arbitrage
Summary
Problems
CHAPTER 2 Basics of Derivative Pricing and Valuation
Learning Outcomes
1. Introduction
2. Basic Derivative Concepts, Pricing the Underlying
2.1. Basic Derivative Concepts
2.2. Pricing the Underlying
3. The Principle of Arbitrage
3.1. The (In)Frequency of Arbitrage Opportunities
3.2. Arbitrage and Derivatives
3.3. Arbitrage and Replication
3.4. Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing
3.5. Limits to Arbitrage
4. Pricing and Valuation of Forward Contracts: Pricing vs. Valuation; Expiration; Initiation
4.1. Pricing and Valuation of Forward Commitments
5. Pricing and Valuation of Forward Contracts: Between Initiation and Expiration; Forward Rate Agreements
5.1. A Word about Forward Contracts on Interest Rates
6. Pricing and Valuation of Futures Contracts
7. Pricing and Valuation of Swap Contracts
8. Pricing and Valuation of Options
8.1. European Option Pricing
9. Lower Limits for Prices of European Options
10. Put–Call Parity, Put–Call–Forward Parity
10.1. Put–Call–Forward Parity
11. Binomial Valuation of Options
12. American Option Pricing
Summary
Problems
CHAPTER 3 Pricing and Valuation of Forward Commitments
Learning Outcomes
1. Introduction to Pricing and Valuation of Forward Commitments
1.1. Principles of Arbitrage-Free Pricing and Valuation of Forward Commitments
1.2. Pricing and Valuing Generic Forward and Futures Contracts
2. Carry Arbitrage
2.1. Carry Arbitrage Model When There Are No Underlying Cash Flows
2.2. Carry Arbitrage Model When Underlying Has Cash Flows
3. Pricing Equity Forwards and Futures
3.1. Equity Forward and Futures Contracts
3.2. Interest Rate Forward and Futures Contracts
4. Pricing Fixed-Income Forward and Futures Contracts
4.1. Comparing Forward and Futures Contracts
5. Pricing and Valuing Swap Contracts
5.1. Interest Rate Swap Contracts
6. Pricing and Valuing Currency Swap Contracts
7. Pricing and Valuing Equity Swap Contracts
Summary
Problems
CHAPTER 4 Valuation of Contingent Claims
Learning Outcomes
1. Introduction and Principles of a No-Arbitrage Approach to Valuation
1.1. Principles of a No-Arbitrage Approach to Valuation
2. Binomial Option Valuation Model
3. One-Period Binomial Model
4. Binomial Model: Two-Period (Call Options)
5. Binomial Model: Two-Period (Put Options)
6. Binomial Model: Two-Period (Role of Dividends & Comprehensive Example)
7. Interest Rate Options & Multiperiod Model
7.1. Multiperiod Model
8. Black–Scholes–Merton (BSM) Option Valuation Model, Introduction and Assumptions of the BSM Model
8.1. Introductory Material
8.2. Assumptions of the BSM Model
9. BSM Model: Components
10. BSM Model: Carry Benefits and Applications
11. Black Option Valuation Model and European Options on Futures
11.1. European Options on Futures
12. Interest Rate Options
13. Swaptions
14. Option Greeks and Implied Volatility: Delta
14.1. Delta
15. Gamma
16. Theta
17. Vega
18. Rho
19. Implied Volatility
Summary
Problems
CHAPTER 5 Credit Default Swaps
Learning Outcomes
1. Introduction
2. Basic Definitions and Concepts
2.1. Types of CDS
3. Important Features of CDS Markets and Instruments, Credit and Succession Events, and Settlement Proposals
3.1. Credit and Succession Events
3.2. Settlement Protocols
3.3. CDS Index Products
3.4. Market Characteristics
4. Basics of Valuation and Pricing
4.1. Basic Pricing Concepts
4.2. The Credit Curve and CDS Pricing Conventions
4.3. CDS Pricing Conventions
4.4. Valuation Changes in CDS during Their Lives
4.5. Monetizing Gains and Losses
5. Applications of CDS
5.1. Managing Credit Exposures
6. Valuation Differences and Basis Trading
Summary
Problems
CHAPTER 6 Introduction to Commodities and Commodity Derivatives
Learning Outcomes
1. Introduction
2. Commodity Sectors
2.1. Commodity Sectors
3. Life Cycle of Commodities
3.1. Energy
3.2. Industrial/Precious Metals
3.3. Livestock
3.4. Grains
3.5. Softs
4. Valuation of Commodities
5. Commodities Futures Markets: Participants
5.1. Futures Market Participants
6. Commodity Spot and Futures Pricing
7. Theories of Futures Returns
7.1. Theories of Futures Returns
8. Components of Futures Returns
9. Contango, Backwardation, and the Roll Return
10. Commodity Swaps
10.1. Total Return Swap
10.2. Basis Swap
10.3. Variance Swaps and Volatility Swaps
11. Commodity Indexes
11.1. S&P GSCI
11.2. Bloomberg Commodity Index
11.3. Deutsche Bank Liquid Commodity Index
11.4. Thomson Reuters/CoreCommodity CRB Index
11.5. Rogers International Commodity Index
11.6. Rebalancing Frequency
11.7. Commodity Index Summary
Summary
References
Problems
CHAPTER 7 Currency Management: An Introduction
Learning Outcomes
1. Introduction
2. Review of Foreign Exchange Concepts
2.1. Spot Markets
2.2. Forward Markets
2.3. FX Swap Markets
2.4. Currency Options
3. Currency Risk and Portfolio Risk and Return
3.1. Return Decomposition
3.2. Volatility Decomposition
4. Strategic Decisions in Currency Management: Overview
4.1. The Investment Policy Statement
4.2. The Portfolio Optimization Problem
4.3. Choice of Currency Exposures
5. Strategic Decisions in Currency Management: Spectrum of Currency Risk Management Strategies
5.1. Passive Hedging
5.2. Discretionary Hedging
5.3. Active Currency Management
5.4. Currency Overlay
6. Strategic Decisions in Currency Management: Formulating a Currency Management Program
7. Active Currency Management: Based on Economic Fundamentals, Technical Analysis, and the Carry Trade
7.1. Active Currency Management Based on Economic Fundamentals
7.2. Active Currency Management Based on Technical Analysis
7.3. Active Currency Management Based on the Carry Trade
8. Active Currency Management: Based on Volatility Trading
9. Currency Management Tools: Forward Contracts, FX Swaps, and Currency Options
9.1. Forward Contracts
9.2. Currency Options
10. Currency Management Strategies
10.1. Over-/Under-Hedging Using Forward Contracts
10.2. Protective Put Using OTM Options
10.3. Risk Reversal (or Collar)
10.4. Put Spread
10.5. Seagull Spread
10.6. Exotic Options
10.7. Section Summary
11. Hedging Multiple Foreign Currencies
11.1. Cross Hedges and Macro Hedges
11.2. Minimum-Variance Hedge Ratio
11.3. Basis Risk
12. Currency Management Tools and Strategies: A Summary
13. Currency Management for Emerging Market Currencies
13.1. Special Considerations in Managing Emerging Market Currency Exposures
13.2. Non-Deliverable Forwards
Summary
References
Problems
CHAPTER 8 Options Strategies
Learning Outcomes
1. Introduction
2. Position Equivalencies
2.1. Synthetic Forward Position
2.2. Synthetic Put and Call
3. Covered Calls and Protective Puts
3.1. Investment Objectives of Covered Calls
4. Investment Objectives of Protective Puts
4.1. Loss Protection/Upside Preservation
4.2. Profit and Loss at Expiration
5. Equivalence to Long Asset/Short Forward Position
5.1. Writing Puts
6. Risk Reduction Using Covered Calls and Protective Puts
6.1. Covered Calls
6.2. Protective Puts
6.3. Buying Calls and Writing Puts on a Short Position
7. Spreads and Combinations
7.1. Bull Spreads and Bear Spreads
8. Straddle
8.1. Collars
8.2. Calendar Spread
9. Implied Volatility and Volatility Skew
10. Investment Objectives and Strategy Selection
10.1. The Necessity of Setting an Objective
10.2. Criteria for Identifying Appropriate Option Strategies
11. Uses of Options in Portfolio Management
11.1. Covered Call Writing
11.2. Put Writing
11.3. Long Straddle
11.4. Collar
11.5. Calendar Spread
12. Hedging an Expected Increase in Equity Market Volatility
12.1. Establishing or Modifying Equity Risk Exposure
Summary
Problems
CHAPTER 9 Swaps, Forwards, and Futures Strategies
Learning Outcomes
1. Managing Interest Rate Risk with Swaps
1.1. Changing Risk Exposures with Swaps, Futures, and Forwards
2. Managing Interest Rate Risk with Forwards, Futures, and Fixed-Income Futures
2.1. Fixed-Income Futures
3. Managing Currency Exposure
3.1. Currency Swaps
3.2. Currency Forwards and Futures
4. Managing Equity Risk
4.1. Equity Swaps
4.2. Equity Forwards and Futures
4.3. Cash Equitization
5. Volatility Derivatives: Futures and Options
5.1. Volatility Futures and Options
6. Volatility Derivatives: Variance Swaps
7. Using Derivatives to Manage Equity Exposure and Tracking Error
7.1. Cash Equitization
8. Using Derivatives in Asset Allocation
8.1. Changing Allocations between Asset Classes Using Futures
8.2. Rebalancing an Asset Allocation Using Futures
8.3. Changing Allocations between Asset Classes Using Swaps
9. Using Derivatives to Infer Market Expectations
9.1. Using Fed Funds Futures to Infer the Expected Average Federal Funds Rate
9.2. Inferring Market Expectations
Summary
Problems
CHAPTER 10 Introduction to Risk Management
Learning Outcomes
1. Introduction
2. The Risk Management Process
3. The Risk Management Framework
4. Risk Governance – An Enterprise View
4.1. An Enterprise View of Risk Governance
5. Risk Tolerance
6. Risk Budgeting
7. Identification of Risk – Financial and Non-Financial Risk
7.1. Financial Risks
7.2. Non-Financial Risks
8. Identification of Risk – Interactions Between Risks
9. Measuring and Modifying Risk – Drivers and Metrics
9.1. Drivers
9.2. Metrics
10. Methods of Risk Modification – Prevention, Avoidance, and Acceptance
10.1. Risk Prevention and Avoidance
10.2. Risk Acceptance: Self-Insurance and Diversification
11. Methods of Risk Modification – Transfer, Shifting, Choosing a Method for Modifying
11.1. Risk Shifting
11.2. How to Choose Which Method for Modifying Risk
Summary
Problems
CHAPTER 11 Measuring and Managing Market Risk
Learning Outcomes
1. Introduction
1.1. Understanding Value at Risk
2. Estimating VaR
3. The Parametric Method of VaR Estimation
4. The Historical Simulation Method of VaR Estimation
5. The Monte Carlo Simulation Method of VaR Estimation
6. Advantages and Limitations of VaR and Extensions of VaR
6.1. Advantages of VaR
6.2. Limitations of VaR
6.3. Extensions of VaR
7. Other Key Risk Measures – Sensitivity Risk Measures; Sensitivity Risk Measures
7.1. Sensitivity Risk Measures
8. Scenario Risk Measures
8.1. Historical Scenarios
8.2. Hypothetical Scenarios
9. Sensitivity and Scenario Risk Measures and VaR
9.1. Advantages and Limitations of Sensitivity Risk Measures and Scenario Risk Measures
10. Using Constraints in Market Risk Management
10.1. Risk Budgeting
10.2. Position Limits
10.3. Scenario Limits
10.4. Stop-Loss Limits
10.5. Risk Measures and Capital Allocation
11. Applications of Risk Measures
11.1. Market Participants and the Different Risk Measures They Use
12. Pension Funds and Insurers
12.1. Insurers
Summary
Reference
Problems
CHAPTER 12 Risk Management for Individuals
Learning Outcomes
1. Introduction
2. Human Capital, Financial Capital, and Economic Net Worth
2.1. Human Capital
2.2. Financial Capital
2.3. Economic Net Worth
3. A Framework for Individual Risk Management
3.1. The Risk Management Strategy for Individuals
3.2. Financial Stages of Life
4. The Individual Balance Sheet
4.1. Traditional Balance Sheet
4.2. Economic (Holistic) Balance Sheet
4.3. Changes in Economic Net Worth
5. Individual Risk Exposures
5.1. Earnings Risk
5.2. Premature Death Risk
5.3. Longevity Risk
5.4. Property Risk
5.5. Liability Risk
5.6. Health Risk
6. Life Insurance: Uses, Types, and Elements
6.1. Life Insurance
7. Life Insurance: Pricing, Policy Cost Comparison, and Determining Amount Needed
7.1. Mortality Expectations
7.2. Calculation of the Net Premium and Gross Premium
7.3. Cash Values and Policy Reserves
7.4. Consumer Comparisons of Life Insurance Costs
7.5. How Much Life Insurance Does One Need?
8. Other Types of Insurance
8.1. Property Insurance
8.2. Health/Medical Insurance
8.3. Liability Insurance
8.4. Other Types of Insurance
9. Annuities: Types, Structure, and Classification
9.1. Parties to an Annuity Contract
9.2. Classification of Annuities
10. Annuities: Advantages and Disadvantages of Fixed and Variable Annuities
10.1. Volatility of Benefit Amount
10.2. Flexibility
10.3. Future Market Expectations
10.4. Fees
10.5. Inflation Concerns
10.6. Payout Methods
10.7. Annuity Benefit Taxation
10.8. Appropriateness of Annuities
11. Risk Management Implementation: Determining the Optimal Strategy and Case Analysis
11.1. Determining the Optimal Risk Management Strategy
11.2. Analyzing an Insurance Program
12. The Effect of Human Capital on Asset Allocation and Risk Reduction
12.1. Asset Allocation and Risk Reduction
Summary
References
Problems
CHAPTER 13 Case Study in Risk Management: Private Wealth
Learning Outcomes
1. Introduction and Case Background
1.1. Background of Eurolandia
1.2. The Schmitt Family in Their Early Career Stage
2. Identification and Analysis of Risk Exposures: Early Career Stage
2.1. Specify the Schmitts’ Financial Objectives
2.2. Identification of Risk Exposures
2.3. Analysis of Identified Risk
3. Risk Management Recommendations: Early Career Stage
3.1. Recommendations for Managing Risks
3.2. Monitoring Outcomes and Risk Exposures
4. Risk Management Considerations Associated with Home Purchase
4.1. Review of Risk Management Arrangements Following the House Purchase
5. Identification and Analysis of Risk Exposures: Career Development Stage
5.1. Case Facts: The Schmitts Are 45
5.2. Financial Objectives in the Career Development Stage
5.3. Identification and Evaluation of Risks in the Career Development Stage
6. Risk Management Recommendations: Career Development Stage
6.1. Disability Insurance
6.2. Life Insurance
6.3. Investment Risk Recommendations
6.4. Retirement Planning Recommendation
6.5. Additional Suggestions
7. Identification and Analysis of Risk Exposures: Peak Accumulation Stage
7.1. Review of Objectives, Risks, and Methods of Addressing Them
8. Assessment of and Recommendations concerning Risk to Retirement Lifestyle and Bequest Goals: Peak Accumulation Stage
8.1. Analysis of Investment Portfolio
8.2. Analysis of Asset Allocation
8.3. Recommendations for Risk Management at Peak Accumulation Stage
9. Identification and Analysis of Retirement Objectives, Assets, and Drawdown Plan: Retirement Stage
9.1. Key Issues and Objectives
9.2. Analysis of Retirement Assets and Drawdown Plan
10. Income and Investment Portfolio Recommendations: Retirement Stage
10.1. Investment Portfolio Analysis and Recommendations
10.2. The Advisor’s Recommendations for Investment Portfolio in Retirement
Summary
Problems
CHAPTER 14 Integrated Cases in Risk Management: Institutional
Learning Outcomes
1. Introduction
2. Financial Risks Faced by Institutional Investors
2.1. Long-Term Perspective
2.2. Dimensions of Financial Risk Management
2.3. Risk Considerations for Long-Term Investors
2.4. Risks Associated with Illiquid Asset Classes
2.5. Managing Liquidity Risk
2.6. Enterprise Risk Management for Institutional Investors
3. Environmental and Social Risks Faced by Institutional Investors
3.1. Universal Ownership, Externalities, and Responsible Investing
3.2. Material Environmental Issues for an Institutional Investor
3.3. Material Social Issues for an Institutional Investor
References
Glossary
About the Editors and Authors
Index
End User License Agreement
Guide
Cover
Table of Contents
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FOREWORD
Since the breakthrough introduction of the Black–Scholes–Merton options pricing model in 1973, the field of financial derivatives has evolved into an extensive and highly scientific body of theoretical knowledge alongside a vast and vibrant market where economic producers, investors, finance professionals, and government regulators all interact to seek financial gains, manage risk, or promote price discovery. It is hard to imagine how even the most thoughtful and diligent practitioners can come to terms with such a broad and complex topic—until they read this book.
CFA Institute has compiled into a single book those parts of its curriculum that address this critically important topic. And it is apparent from reading this book that CFA Institute attracted preeminent scholars to develop its derivatives curriculum.
This book has several important virtues:
It is detailed, comprehensive, and exceptionally accessible.
It is efficiently organized in its coverage of topics.
It makes effective use of visualization with diagrams of transactions and strategy payoffs.
It includes numerous practice problems along with well-explained solutions.
And finally, unlike many academic textbooks, its focus is more practical than theoretical, although it does provide more-than-adequate treatment of the relevant theory.
The book begins by addressing the basics of derivatives, including definitions of the various types of derivatives and descriptions of the markets in which they trade.
It goes on to address the purpose of derivatives and the benefits they impart to society, including risk transfer, price discovery, and operational efficiency. It also discusses how derivatives can be misused to enable excessive speculation and how derivatives could contribute to the destabilization of financial markets.
The book provides comprehensive treatment of pricing and valuation with discussions of the law of one price, risk neutrality, the Black–Scholes–Merton options pricing model, and the binomial model. It also covers the pricing of futures and forward contracts as well as swaps.
The book then shifts to applications of derivatives. It discusses how derivatives can be used to create synthetic cash and equity positions along with several other positions. It relies heavily on numerical examples to illustrate these equivalencies.
It offers a comprehensive treatment of risk management with discussions of market risk, credit risk, liquidity risk, operational risk, and model risk, among others. It describes how to measure risk and, more importantly, how to manage it with the application of forward and futures contracts, swaps, and options.
This summary of topics is intended to provide a flavor of the book's contents. The contents of this book are far broader and deeper than I describe in this foreword.
Those who practice finance, as well as those who teach it, in my view, owe a huge debt of gratitude to CFA Institute—first, for assembling this extraordinary body of knowledge in its curriculum and, second, for organizing this knowledge with such cohesion and clarity. Anyone who wishes to acquire a solid knowledge of derivatives or to refresh and expand what they have learned about derivatives previously should certainly read this book.
Mark Kritzman
PREFACE
We are pleased to bring you Derivatives, 1st Edition, which focuses on key tools that are needed for today's professional investor. The book sets out the key features of derivatives, their purpose, benefits and risks for individuals, firms and society. The text teaches critical skills in the treatment of pricing and valuation of derivatives that challenge many professionals. It also provides a comprehensive treatment of risk management and shows how these techniques can be applied to manage risk with the application of forward and futures contracts, swaps, and options.
The content was developed in partnership by a team of distinguished academics and practitioners, chosen for their acknowledged expertise in the field, and guided by CFA Institute. It is written specifically with the investment practitioner in mind and is replete with examples and practice problems that reinforce the learning outcomes and demonstrate real-world applicability.
The CFA Program Curriculum, from which the content of this book was drawn, is subjected to a rigorous review process to assure that it is:
Faithful to the findings of our ongoing industry practice analysis
Valuable to members, employers, and investors
Globally relevant
Generalist (as opposed to specialist) in nature
Replete with sufficient examples and practice opportunities
Pedagogically sound
The accompanying workbook is a useful reference that provides Learning Outcome Statements, which describe exactly what readers will learn and be able to demonstrate after mastering the accompanying material. Additionally, the workbook has summary overviews and practice problems for each chapter.
We are confident that you will find this and other books in the CFA Institute Investment Series helpful in your efforts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran striving to keep up to date in the ever-changing market environment. CFA Institute, as a long-term committed participant in the investment profession and a not-for-profit global membership association, is pleased to provide you with this opportunity.
THE CFA® PROGRAM
If the subject matter of this book interests you and you are not already a CFA charterholder, we hope you will consider registering for the CFA Program and starting progress toward earning the Chartered Financial Analyst designation. The CFA designation is a globally recognized standard of excellence for measuring the competence and integrity of investment professionals. To earn the CFA charter, candidates must successfully complete the CFA Program, a global graduate-level self-study program that combines a broad curriculum with professional conduct requirements as preparation for a career as an investment professional.
Anchored in a practice-based curriculum, the CFA Program Body of Knowledge reflects the knowledge, skills, and abilities identified by professionals as essential to the investment decision-making process. This body of knowledge maintains its relevance through a regular, extensive survey of practicing CFA charterholders across the globe. The curriculum covers 10 general topic areas, ranging from equity and fixed-income analysis to portfolio management to corporate finance—all with a heavy emphasis on the application of ethics in professional practice. Known for its rigor and breadth, the CFA Program curriculum highlights principles common to every market so that professionals who earn the CFA designation have a thoroughly global investment perspective and a profound understanding of the global marketplace.
CFA INSTITUTE
CFA Institute is the premier association for investment professionals around the world, with over 170,000 members from more than 160 countries. Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst® Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice.
Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.
ACKNOWLEDGMENTS
Special thanks to all the reviewers, advisors, and question writers who helped to ensure high practical relevance, technical correctness, and understandability of the material presented here.
We would like to thank the many others who played a role in the conception and production of this book: the Curriculum and Learning Experience team at CFA Institute with special thanks to the curriculum directors, past and present, who worked with the authors and reviewers to produce the chapters in this book, the Practice Analysis team at CFA Institute, and the Publishing and Technology team for bringing this book to production.
ABOUT THE CFA INSTITUTE INVESTMENT SERIES
CFA Institute is pleased to provide you with the CFA Institute Investment Series, which covers major areas in the field of investments. We provide this best-in-class series for the same reason we have been chartering investment professionals for more than 50 years: to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence.
The books in the CFA Institute Investment Series contain practical, globally relevant material. They are intended both for those contemplating entry into the extremely competitive field of investment management as well as for those seeking a means of keeping their knowledge fresh and up to date. This series was designed to be user friendly and highly relevant.
We hope you find this series helpful in your efforts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran ethically bound to keep up to date in the ever-changing market environment. As a long-term, committed participant in the investment profession and a not-for-profit global membership association, CFA Institute is pleased to provide you with this opportunity.
THE TEXTS
Corporate Finance: A Practical Approach is a solid foundation for those looking to achieve lasting business growth. In today’s competitive business environment, companies must find innovative ways to enable rapid and sustainable growth. This text equips readers with the foundational knowledge and tools for making smart business decisions and formulating strategies to maximize company value. It covers everything from managing relationships between stakeholders to evaluating merger and acquisition bids, as well as the companies behind them. Through extensive use of real-world examples, readers will gain critical perspective into interpreting corporate financial data, evaluating projects, and allocating funds in ways that increase corporate value. Readers will gain insights into the tools and strategies used in modern corporate financial management.
Fixed Income Analysis has been at the forefront of new concepts in recent years, and this particular text offers some of the most recent material for the seasoned professional who is not a fixed-income specialist. The application of option and derivative technology to the once staid province of fixed income has helped contribute to an explosion of thought in this area. Professionals have been challenged to stay up to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage-backed securities, and other vehicles, and this explosion of products has strained the world’s financial markets and tested central banks to provide sufficient oversight. Armed with a thorough grasp of the new exposures, the professional investor is much better able to anticipate and understand the challenges our central bankers and markets face.
International Financial Statement Analysis is designed to address the ever-increasing need for investment professionals and students to think about financial statement analysis from a global perspective. The text is a practically oriented introduction to financial statement analysis that is distinguished by its combination of a true international orientation, a structured presentation style, and abundant illustrations and tools covering concepts as they are introduced in the text. The authors cover this discipline comprehensively and with an eye to ensuring the reader’s success at all levels in the complex world of financial statement analysis.
Investments: Principles of Portfolio and Equity Analysis provides an accessible yet rigorous introduction to portfolio and equity analysis. Portfolio planning and portfolio management are presented within a context of up-to-date, global coverage of security markets, trading, and market-related concepts and products. The essentials of equity analysis and valuation are explained in detail and profusely illustrated. The book includes coverage of practitioner-important but often neglected topics, such as industry analysis. Throughout, the focus is on the practical application of key concepts with examples drawn from both emerging and developed markets. Each chapter affords the reader many opportunities to self-check his or her understanding of topics.
One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process. The third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their libraries. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, performance presentation standards, portfolio execution, and, very importantly, individual investor portfolio management. Focusing attention away from institutional portfolios and toward the individual investor makes this edition an important and timely work.
Quantitative Investment Analysis focuses on some key tools that are needed by today’s professional investor. In addition to classic time value of money, discounted cash flow applications, and probability material, there are two aspects that can be of value over traditional thinking. The first involves the chapters dealing with correlation and regression that ultimately figure into the formation of hypotheses for purposes of testing. This gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the overwhelming quantity of available data. Second, the final chapter of Quantitative Investment Analysis covers portfolio concepts and takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory.
The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets is an updated version of Harold Evensky’s mainstay reference guide for wealth managers. Harold Evensky, Stephen Horan, and Thomas Robinson have updated the core text of the 1997 first edition and added an abundance of new material to fully reflect today’s investment challenges. The text provides authoritative coverage across the full spectrum of wealth management and serves as a comprehensive guide for financial advisors. The book expertly blends investment theory and real-world applications and is written in the same thorough but highly accessible style as the first edition. The first involves the chapters dealing with correlation and regression that ultimately figure into the formation of hypotheses for purposes of testing. This gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the overwhelming quantity of available data. Second, the final chapter of Quantitative Investment Analysis covers portfolio concepts and takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory.
All books in the CFA Institute Investment Series are available through all major booksellers. And, all titles are available on the Wiley Custom Select platform at http://customselect.wiley.com/ where individual chapters for all the books may be mixed and matched to create custom textbooks for the classroom.
CHAPTER 1DERIVATIVE MARKETS AND INSTRUMENTS
Don M. Chance, PhD, CFA
LEARNING OUTCOMES
The candidate should be able to:
define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
contrast forward commitments with contingent claims;
define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
determine the value at expiration and profit from a long or a short position in a call or put option;
describe purposes of, and controversies related to, derivative markets;
explain arbitrage and the role it plays in determining prices and promoting market efficiency.
1. DERIVATIVES: INTRODUCTION, DEFINITIONS, AND USES
Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an economy. Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government or central bank. Commodities are natural resources, such as oil or gold. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash prices or spot prices, though we usually just refer to them as stock prices, bond prices, exchange rates, and commodity prices. These markets exist around the world and receive much attention in the financial and mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.
Somewhat less familiar are the markets for derivatives, which are financial instruments that derive their values from the performance of these basic assets. This reading is an overview of derivatives. Subsequent readings will explore many aspects of derivatives and their uses in depth. Among the questions that this first reading will address are the following:
What are the defining characteristics of derivatives?
What purposes do derivatives serve for financial market participants?
What is the distinction between a forward commitment and a contingent claim?
What are forward and futures contracts? In what ways are they alike and in what ways are they different?
What are swaps?
What are call and put options and how do they differ from forwards, futures, and swaps?
What are credit derivatives and what are the various types of credit derivatives?
What are the benefits of derivatives?
What are some criticisms of derivatives and to what extent are they well founded?
What is arbitrage and what role does it play in a well-functioning financial market?
This reading is organized as follows. Section 1 explores the definition and uses of derivatives and establishes some basic terminology. Section 2 describes derivatives markets. Sections 3–9 categorize and explain types of derivatives. Sections 10 and 11 discuss the benefits and criticisms of derivatives, respectively. Section 12 introduces the basic principles of derivative pricing and the concept of arbitrage.
Derivatives: Definitions and Uses
The most common definition of a derivative reads approximately as follows:
A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
This definition, despite being so widely quoted, can nonetheless be a bit troublesome. For example, it can also describe mutual funds and exchange-traded funds, which would never be viewed as derivatives even though they derive their values from the values of the underlying securities they hold. Perhaps the distinction that best characterizes derivatives is that they usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast, with the exception of expense deductions, mutual funds and exchange-traded funds simply pass through the returns of their underlying securities. This transformation of performance is typically understood or implicit in references to derivatives but rarely makes its way into the formal definition. In keeping with customary industry practice, this characteristic will be retained as an implied, albeit critical, factor distinguishing derivatives from mutual funds and exchange-traded funds and some other straight pass-through instruments. Also, note that the idea that derivatives take their performance from an underlying asset encompasses the fact that derivatives take their value and certain other characteristics from the underlying asset. Derivatives strategies perform in ways that are derived from the underlying and the specific features of derivatives.
Derivatives are similar to insurance in that both allow for the transfer of risk from one party to another. As everyone knows, insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of transfer of risk. One type of derivative in particular, the put option, when combined with a position exposed to the risk, functions almost exactly like insurance, but all derivatives can be used to protect against loss. Of course, an insurance contract must specify the underlying risk, such as property, health, or life. Likewise, so do derivatives. As noted earlier, derivatives are associated with an underlying asset. As such, the so-called “underlying asset” is often simply referred to as the underlying, whose value is the source of risk. In fact, the underlying need not even be an asset itself. Although common derivatives underlyings are equities, fixed-income securities, currencies, and commodities, other derivatives underlyings include interest rates, credit, energy, weather, and even other derivatives, all of which are not generally thought of as assets. Thus, like insurance, derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset. And like insurance, derivatives have a definite life span and expire on a specified date.
Derivatives are created in the form of legal contracts. They involve two parties—the buyer and the seller (sometimes known as the writer)—each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns (holds) the derivative and holds a long position. The seller is referred to as the short because he holds a short position.1
A derivative contract always defines the rights and obligations of each party. These contracts are intended to be, and almost always are, recognized by the legal system as commercial contracts that each party expects to be upheld and supported in the legal system. Nonetheless, disputes sometimes arise, and lawyers, judges, and juries may be required to step in and resolve the matter.
There are two general classes of derivatives. Some provide the ability to lock in a price at which one might buy or sell the underlying. Because they force the two parties to transact in the future at a previously agreed-on price, these instruments are called forward commitments. The various types of forward commitments are called forward contracts, futures contracts, and swaps. Another class of derivatives provides the right but not the obligation to buy or sell the underlying at a pre-determined price. Because the choice of buying or selling versus doing nothing depends on a particular random outcome, these derivatives are called contingent claims. The primary contingent claim is called an option. The types of derivatives will be covered in more detail later in this reading and in considerably more depth later in the curriculum.
The existence of derivatives begs the obvious question of what purpose they serve. If one can participate in the success of a company by holding its equity, what reason can possibly explain why another instrument is required that takes its value from the performance of the equity? Although equity and other fundamental markets exist and usually perform reasonably well without derivative markets, it is possible that derivative markets can improve the performance of the markets for the underlyings. As you will see later in this reading, that is indeed true in practice.
Derivative markets create beneficial opportunities that do not exist in their absence. Derivatives can be used to create strategies that cannot be implemented with the underlyings alone. For example, derivatives make it easier to go short, thereby benefiting from a decline in the value of the underlying. In addition, derivatives, in and of themselves, are characterized by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount of their own capital relative to the value of the underlying. As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative. Derivatives generally trade at lower transaction costs than comparable spot market transactions, are often more liquid than their underlyings, and offer a simple, effective, and low-cost way to transfer risk. For example, a shareholder of a company can reduce or even completely eliminate the market exposure by trading a derivative on the equity. Holders of fixed-income securities can use derivatives to reduce or completely eliminate interest rate risk, allowing them to focus on the credit risk. Alternatively, holders of fixed-income securities can reduce or eliminate the credit risk, focusing more on the interest rate risk. Derivatives permit such adjustments easily and quickly. These features of derivatives are covered in more detail later in this reading.
The types of performance transformations facilitated by derivatives allow market participants to practice more effective risk management. Indeed, the entire field of derivatives, which at one time was focused mostly on the instruments themselves, is now more concerned with the uses of the instruments. Just as a carpenter uses a hammer, nails, screws, a screwdriver, and a saw to build something useful or beautiful, a financial expert uses derivatives to manage risk. And just as it is critically important that a carpenter understand how to use these tools, an investment practitioner must understand how to properly use derivatives. In the case of the carpenter, the result is building something useful; in the case of the financial expert, the result is managing financial risk. Thus, like tools, derivatives serve a valuable purpose but like tools, they must be used carefully.
The practice of risk management has taken a prominent role in financial markets. Indeed, whenever companies announce large losses from trading, lending, or operations, stories abound about how poorly these companies managed risk. Such stories are great attention grabbers and a real boon for the media, but they often miss the point that risk management does not guarantee that large losses will not occur. Rather, risk management is the process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the former. Risk management never offers a guarantee that large losses will not occur, and it does not eliminate the possibility of total failure. To do so would typically require that the amount of risk taken be so small that the organization would be effectively constrained from pursuing its primary objectives. Risk taking is inherent in all forms of economic activity and life in general. The possibility of failure is never eliminated.
EXAMPLE 1 Characteristics of Derivatives
Which of the following is the best example of a derivative?
A global equity mutual fund
A non-callable government bond
A contract to purchase Apple Computer at a fixed price
Which of the following is
not
a characteristic of a derivative?
An underlying
A low degree of leverage
Two parties—a buyer and a seller
Which of the following statements about derivatives is
not
true?
They are created in the spot market.
They are used in the practice of risk management.
They take their values from the value of something else.
Solution to 1: C is correct. Mutual funds and government bonds are not derivatives. A government bond is a fundamental asset on which derivatives might be created, but it is not a derivative itself. A mutual fund can technically meet the definition of a derivative, but as noted in the reading, derivatives transform the value of a payoff of an underlying asset. Mutual funds merely pass those payoffs through to their holders.
Solution to 2: B is correct. All derivatives have an underlying and must have a buyer and a seller. More importantly, derivatives have high degrees of leverage, not low degrees of leverage.
Solution to 3: A is correct. Derivatives are used to practice risk management and they take (derive) their values from the value of something else, the underlying. They are not created in the spot market, which is where the underlying trades.
Note also that risk management is a dynamic and ongoing process, reflecting the fact that the risk assumed can be difficult to measure and is constantly changing. As noted, derivatives are tools, indeed the tools that make it easier to manage risk. Although one can trade stocks and bonds (the underlyings) to adjust the level of risk, it is almost always more effective to trade derivatives.
Risk management is addressed more directly elsewhere in the CFA curriculum, but the study of derivatives necessarily entails the concept of risk management. In an explanation of derivatives, the focus is usually on the instruments and it is easy to forget the overriding objective of managing risk. Unfortunately, that would be like a carpenter obsessed with his hammer and nails, forgetting that he is building a piece of furniture. It is important to always try to keep an eye on the objective of managing risk.
2. THE STRUCTURE OF DERIVATIVE MARKETS
Having an understanding of equity, fixed-income, and currency markets is extremely beneficial—indeed, quite necessary—in understanding derivatives. One could hardly consider the wisdom of using derivatives on a share of stock if one did not understand the equity markets reasonably well. As you likely know, equities trade on organized exchanges as well as in over-the-counter (OTC) markets. These exchange-traded equity markets—such as the Deutsche Börse, the Tokyo Stock Exchange, and the New York Stock Exchange and its Eurex affiliate—are formal organizational structures that bring buyers and sellers together through market makers, or dealers, to facilitate transactions. Exchanges have formal rule structures and are required to comply with all securities laws.
OTC securities markets operate in much the same manner, with similar rules, regulations, and organizational structures. At one time, the major difference between OTC and exchange markets for securities was that the latter brought buyers and sellers together in a physical location, whereas the former facilitated trading strictly in an electronic manner. Today, these distinctions are blurred because many organized securities exchanges have gone completely to electronic systems. Moreover, OTC securities markets can be formally organized structures, such as NASDAQ, or can merely refer to informal networks of parties who buy and sell with each other, such as the corporate and government bond markets in the United States.
The derivatives world also comprises organized exchanges and OTC markets. Although the derivatives world is also moving toward less distinction between these markets, there are clear differences that are important to understand.
2.1. Exchange-Traded Derivatives Markets
Derivative instruments are created and traded either on an exchange or on the OTC market. Exchange-traded derivatives are standardized, whereas OTC derivatives are customized. To standardize a derivative contract means that its terms and conditions are precisely specified by the exchange and there is very limited ability to alter those terms. For example, an exchange might offer trading in certain types of derivatives that expire only on the third Friday of March, June, September, and December. If a party wanted the derivative to expire on any other day, it would not be able to trade such a derivative on that exchange, nor would it be able to persuade the exchange to create it, at least not in the short run. If a party wanted a derivative on a particular entity, such as a specific stock, that party could trade it on that exchange only if the exchange had specified that such a derivative could trade. Even the magnitudes of the contracts are specified. If a party wanted a derivative to cover €150,000 and the exchange specified that contracts could trade only in increments of €100,000, the party could do nothing about it if it wanted to trade that derivative on that exchange.
This standardization of contract terms facilitates the creation of a more liquid market for derivatives. If all market participants know that derivatives on the euro trade in 100,000-unit lots and that they all expire only on certain days, the market functions more effectively than it would if there were derivatives with many different unit sizes and expiration days competing in the same market at the same time. This standardization makes it easier to provide liquidity. Through designated market makers, derivatives exchanges guarantee that derivatives can be bought and sold.2
