Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Derivatives - Chartered Financial Analyst Level I/Forward Commitment and Contingent Claim Features and Instruments

Forward Commitment and Contingent Claim Features and Instruments

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Forwards and Futures5 min

This section contrasts forward contracts with futures contracts. Forwards are customized, OTC instruments with higher counterparty risk and no daily settlement. Futures are standardized, exchange-traded instruments backed by a clearinghouse. Key concepts include the daily mark-to-market process and the margin system. The text explains that the settlement price is the average of trades in the closing period. It defines initial margin as the deposit required to open a trade and maintenance margin as the minimum balance required. If the balance drops below the maintenance level, the investor must deposit funds (variation margin) to bring the account back to the initial margin, not just the maintenance level.

Key Points

Forwards are private, customized, and carry default risk.
Futures are standardized, exchange-traded, and require margins.
Futures are marked to market daily.
Variation margin restores the account to the Initial Margin level.

Options Mechanics and Valuation6 min

Options provide the right, but not the obligation, to buy (call) or sell (put) an underlying asset. The buyer pays a premium to the seller (writer). The section breaks down the maximum profit and loss potential for long and short positions. A long call has infinite profit potential, while a short call has infinite loss potential. A long put's profit is limited by the stock falling to zero. Breakeven points are calculated as Strike + Premium for calls and Strike - Premium for puts. The text also differentiates between American options (exercisable anytime), European options (exercisable only at expiration), and Bermudan options (exercisable on specific dates).

Key Points

Call Buyer: Right to buy; pays premium.
Put Seller: Obligation to buy; receives premium.
Breakeven Call = Strike Price + Premium.
Breakeven Put = Strike Price - Premium.
American options offer the most exercise flexibility.

Swaps, Credit Derivatives, and Instrument Classification5 min

Swaps involve exchanging cash flows on periodic dates, often netting the amounts. Plain vanilla interest rate swaps exchange fixed for floating rates. Swaps are OTC instruments and carry default risk. Credit derivatives, like CDS, act as insurance against default events. The chapter concludes by categorizing instruments into Forward Commitments (legally binding promises like forwards, futures, swaps) and Contingent Claims (claims dependent on events like options and credit derivatives).

Key Points

Swaps settle on a net basis and are unregulated OTC instruments.
Credit Default Swaps (CDS) protect against credit events.
Forward Commitments: Obligation to act (Futures, Swaps).
Contingent Claims: Right to act depending on an event (Options).

Questions

Question 1

Which of the following best describes a forward contract?

Forward Commitment and Contingent Claim Features and Instruments

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