CFA Institute Investment Foundations Program: Chapter 11 – Derivatives (Part III)

In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here).  It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing.  Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.

There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations.  This series of articles will highlight the core knowledge of each chapter.

Chapter 11 provides an overview of derivatives. The learning outcome of chapter 11 is as follows:

·       Define a derivative contract;

·       Describe uses of derivative contracts;

·       Describe key terms of derivative contracts;

·       Describe forwards and futures;

·       Distinguish between forwards and futures;

·       Describe options and their uses;

·       Define swaps and their uses.

Options give one party (the buyer) to the contract the right to demand an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the obligation, to buy or sell the underlying. Options are termed unilateral contracts because only one party to the contract (the seller) has a future commitment that, if broken, represents a breach of contract. Unilateral contracts expose only the buyer to the risk that the seller will not fulfil the contractual agreement.

There are two basic types of options: options to buy the underlying, known as call options, and options to sell the underlying, known as put options.

·       An investor who buys a call option has the right (but not the obligation) to buy or call the underlying from the option seller at the exercise price until the option expires.

·       An investor who buys a put option has the right (but not the obligation) to sell or put the underlying to the option seller at the exercise price until expiration.

Call options protect the buyer by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price.

·       A call option is said to be “in the money” if the market price is greater than the exercise price. In this case, the option would be exercised.

·       A call option is “out of the money” if the market price is less than the exercise price. In this case, the option would not be exercised.

·       A call option is “at the money” if the market price and exercise price are the same. In this case, the option may be exercised.

Put options protect the buyer by establishing a minimum price the option buyer will receive when selling the underlying; the minimum price is the exercise price.

·       A put option is said to be “in the money” if the market price is less than the exercise price. In this case, the option would be exercised.

·       A put option is “out of the money” if the market price is greater than the exercise price. In this case, the option would not be exercised.

·       A put option is “at the money” if the market price

Option premiums are expected to compensate option sellers for their risk. The option premium represents the maximum profit that the option seller can make. If an option seller underestimates the risk associated with the option, the premiums may be far less than the losses incurred if the option is exercised.

The following table shows the effects on an option’s premium for a call option and a put option of an increase in each factor.

Swaps are typically derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk.

Swaps in which two parties exchange cash flows include interest rate and currency swaps. An interest rate swap, the most common type, allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs. A currency swap enables borrowers to exchange debt service obligations denominated in one currency for equivalent debt service obligations denominated in another currency. By swapping future cash flow obligations, the two parties can manage currency risk.

Credit default swaps (CDS) are not truly swaps. Like options, credit default swaps are contingent claims and unilateral contracts. One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities; the loss of value is primarily the result of a change in credit risk. The seller is providing protection to the buyer against declines in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract. The contract will specify under what conditions the seller has to make payment to the buyer of the CDS. Similar to sellers of options, sellers of CDS may misjudge the risk associated with the contracts and incur losses far in excess of payments received to enter into the contracts.

Source: https://www.cfainstitute.org/en/programs/investment-foundations

Which of the following options would be described as being in the money?

A A put option in which the underlying’s price is lower than the exercise price.

B A call option in which the underlying’s price is lower than the exercise price.

C A put option in which the underlying’s price is higher than the exercise price.

 

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