Study session 17 in the CFA Level 2 curriculum concludes the material on derivatives with four readings (50-53) on options, swaps, and rate derivatives.
Option Markets and Contracts
If you’re familiar with the options markets, the material is pretty basic and will be easy points. For those without prior experience, you’ll need to spend a little more time because it is fairly testable stuff. Understand the difference between European-style and American Options but all the formulas and quant material is based on expiration so there won’t be a difference.
Start with the put-call parity equation and be able to solve for any of the variables; call price, put price or stock price. This will get you through any questions on synthetic positions.
Understand how to create a delta hedge through the number of calls to sell or the total number of shares to purchase. The number of calls to sell equals the number of shares you want to hedge divided by the delta of the option. The total shares to purchase is the number of options you are short times their delta.
You won’t need to do the math for the Black-Scholes Merton equation but you may need to know the assumptions and limitations.
- Lognormal distribution skewed to the right side but limited to zero on the left side of the distribution
- Continuous risk-free rate is constant and known
- Volatility of the underlying asset is constant and known
- Markets are frictionless (no taxes, transaction costs, or restrictions on short sales)
- Underlying asset has no cash flows
- Options valued are European and cannot be exercised early
Know the Greeks and their respective measures. You will need to know how to delta hedge an asset but the rest of the Greeks are just conceptual. Three of the Greeks start with the same letter as the definitional word which is how I remembered them.
- Delta- sensitivity to price change
- Gamma- sensitivity to delta change
- Rho – sensitivity to rate change
- Theta – sensitivity to time change
- Vega – sensitivity to volatility
Swap Markets and Contracts
This was probably one of the most difficult readings for me when studying for the Level 2 exam. There are some lengthy and detailed calculations here and you will probably need to spend some time to get them down. I would start with getting the underlying concept first which will help to remember how to put the formulas together. Flash cards work well for drilling the specific equations until you can remember them.
The fixed rate (swap rate) is determined at the contract initiation date and makes the present value of the fixed rate component equal to the present value of the floating rate component. Determining this rate is called “pricing” the swap. The floating rate is reset at the beginning of each settlement period and is based on the short-term rates (LIBOR).
The market value of the swap at any time is equal to the difference between the value of the float-rate side and the value of the fixed-rate side.
A rate swap is an agreement between two parties to exchange fixed for floating rate payments. There is no exchange of principal at initiation. Since currency swaps are for two notional principals, there is usually an exchange at the beginning and end of the swap.
Payer swaptions are the right to enter into a specific swap as the fixed rate payer while receiver swaptions are the right to enter into a swap as the fixed rate receiver.
Interest Rate Derivative Instruments
Caps or ceilings are agreements where one party pays another the when a reference rate exceeds a contracted point. Basically, the buyer needs to limit their risk that rates will increase and enters into a call option on rates (possibly someone paying on floating-rate debt).
Conversely, Floors are agreements where one party pays another when a reference rate drops below a contracted point. A floor is similar to a put option on rates. The calculations for caps and floors are not too difficult, just tedious because you often need to do calculations for multiple periods. Just remember, the payoff is either (0) where the market rate is higher than the floor or lower than the ceiling, or the payoff is the difference between the market rate and the contract rate times the notational and the time fraction (i.e. 90/360).
Credit Derivatives: An Overview
Like the title says, this is really just an overview and there isn’t too much detail. Make sure you get the concepts along with the terms.
Credit default swaps transfer the default risk of an asset to another party. The protection buyer makes a fixed periodic payment to the seller during the term. If the default ‘event’ occurs then the seller pays the buyer according to the contract. Note- this involves counterparty risk that the seller can deliver.
Defalt triggers on CDS instruments can be a number of events including; failure to make a debt payment, bankruptcy, restructuring, moratoriums, or any technical defaults. The settlement of the CDS may be in delivery or a cash settlement.
Understand the various participants in the CDS market and why they might need protection.
Study session 18 in the CFA Level 2 curriculum covers three readings in portfolio management.
‘til next time, happy studyin’
Joseph Hogue, CFA