Your Cheat Sheet to… CFA Level I: Derivatives

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By Marc

The Cheat Sheet articles are a series of articles, each focusing on one specific topic area of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic area to get you to a flying start.

For this article, we will look at Derivatives for CFA Level I.

Derivatives.

Perhaps no single word has a greater ability to strike fear in the hearts of CFA candidates. The readings on this topic are replete with graphs, formulas, all of which seem indecipherable, and gratuitous references to Greek letters. Studying for this topic can seem as appealing at writing nested IF statements in Excel, or undergoing oral surgery without an anaesthetic.

The other day my two year-old daughter picked up one of my derivatives textbooks and pretended to read a bunch of symbols that meant nothing to her. If I’m being honest, I can’t say that my own experiences with that textbook have been very different.

But with this Cheat Sheet, hopefully your experience will be much better than mine.


What is the weighting of this topic in the CFA exams?
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​Those who cringe at the mere thought of Derivatives can take comfort in the knowledge that this topic has a 5% weighting, so it should only account for 12 of the 240 questions on the Level I exam. However, references to various types of derivatives are sprinkled throughout the curriculum – notably Fixed Income and Equities, which both have significantly larger topic area weightings. Overall, it is certainly possible to pass the Level I exam while remaining blissfully ignorant of Derivatives, but being knowledgeable on this topic never hurt any candidate’s chances of success.

What is Derivatives about, in a nutshell?
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In terms of the CFA curriculum, don’t think of derivatives as tradable securities, such as stocks or bonds. Instead, think of derivatives as tools to help manage finance and business risks. 

​The Level I curriculum is structured to give us a basic conceptual understanding of derivatives, how to value them, and how they can be used to manage risk. The three Derivatives readings are:

Derivative Markets and Instruments
Basics of Derivative Pricing and Valuation
Risk Management Applications of Option Strategies
What kinds of derivatives are out there? What are they used for?
An introduction to pricing and valuing derivatives
A visually intimidating (but still relatively gentle) demonstration of how various options-based strategies are used

Comprehension, not calculation

If you this material is new to you and you’ve only skimmed the pages of these readings, or made attempts to read them that ended in frustration, you may (not unreasonably) wonder how I could use the words “relatively gentle.” Indeed, as noted above, these readings contain no shortage of graphs, formulas, and notation.

But if you accept the (not unreasonable) premise that Practice Problems provide a decent indication of the kinds of questions you can expect to see on exam day, then you are likely to take some comfort in the following observation – none of the Practice Problems in the derivatives readings require the use of a calculator. The Practice Problems for the first two readings are all qualitative, and the Practice Problems for the third reading can be solved by doing calculations in your head.

​So the Derivatives material, in a nutshell, is about developing an understanding of what these instruments are, why you might want to use them, and what your net gain/loss would be over a range of possible outcomes.


Derivatives in real life: how pizza-ordering is connected to derivatives
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Even among the subset of the population that writes CFA exams, the percentage of people who work directly with complex financial derivatives on a daily basis is relatively low, so it’s easy for the rest of us to consider derivatives to be the incredibly complicated domain of rogue traders determined to cause the collapse of a storied financial institution. But the concepts and structure of forward contracts are pretty relatable to everyday experiences. 

Don’t believe me? Have you ever ordered a pizza to be delivered to your home? If so, you’ve been the long party to a (verbal) forward contract. You agreed to accept delivery of an underlying asset (pizza) at a pre-determined time (half an hour from the time that you called to order) for a pre-determined price (say, $20). You also accepted the risk that, in the half hour between placing your order and the pizza being delivered, the market price of pizza plummeted to $1, you’d be stuck paying a much higher price. Alternatively, if the price of pizza had soared to $100 during that time, you would have been able to buy it for $20 and then make a profit $80 by selling it to your neighbour.

More practically, derivatives are very useful risk management tools, which explains their growing popularity. So there’s a good chance that a better understanding of at least some parts of the derivatives material will be relevant to you job – even if that is limited to impressing colleagues with your ability to conceptualize the pizza delivery industry as a derivatives exchange.


Any tips for the exam I should know about?
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​As noted above, there is a good chance that the majority of exam questions on this topic will be qualitative, so your focus when studying the Level I derivatives material should be on grasping concepts rather than committing formulas to memory and then working them through. Once you have a solid command of the rationale for using various derivatives, the formulae will come to you on the basis of logic and understanding rather than on the basis of rote memorization.

​That may sound like a poor attempt at finding Zen in a most un-Zen-like topic, but it really does help to take a step back and look at the material in these readings fits into the bigger picture of the CFA curriculum. Here are two examples, one qualitative and one quantitative, of questions that are representative of what you can expect to see on exam day.

Here’s an example of a Derivatives question:

A fiduciary call strategy most likely involves establishing a:

A. long position in a risk-free bond.
B. long position in the underlying asset.
C. short position in a call option contract.

Choice A is the correct answer because a fiduciary call strategy is executed by taking a long position in a call option contract and lending at the risk-free rate (or taking a long position in a risk-free bond). According to put-call parity, a fiduciary call strategy provides equivalent payoffs to a protective put strategy, which is executed by combining a long position in an underlying asset with a long position in a put option contract based on that asset.

​Here’s another example:

An investor who holds 100 shares of ABC stock, which currently trades at $15.50 per share, decides to implement a covered call strategy using a call option contract that grant the long party the right to purchase 100 shares of ABC for $16.00 per share. This contract is priced at $1.50 per share. If ABC shares are trading for $17.00 at the time the contract expires, the payoff to this covered call strategy on a per share basis is closest to:

A. $1.00.
B. $2.00.
C. $3.00.

Choice B is the correct answer because a covered call strategy is executed by taking a long position in an underlying asset and a short position in a call option contract based on that asset. The formula for calculating payoff for a covered call is as follows:

Π = ST – S0 – max(0,ST – X) + c0

where
Π = profit from covered call strategy
ST = price of the underlying asset at time T
S0 = price of the underlying asset at time 0
X = call option exercise price
c0 = call option price at time 0

In this example,

Π = $17.00 – $15.50 – max(0,$17.00 – $16.00) + $1.50
= $17.00 – $15.50 – $1.00 + $1.50
= $2.00

Choice A is incorrect because it assumes that the investor has gained $1.50 from the appreciation of the underlying asset, but suffered a net loss of $0.50 by taking a long call position when a covered call strategy requires a short call position. Choice C is incorrect because it fails to account for the fact that the investor suffered a loss of $1.00 as a result of having taken a short call position.


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Zee Tan
Author: Zee Tan

 

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