CFA Derivatives Syllabus

Derivatives syllabus — full chapter and topic list

Expand any chapter to see its topics and sub-topics. This is the whole examinable outline for Derivatives in CFA, not a summary of it.

1. 1

   Derivative Markets and Instruments

   2 topics

   • Types of Derivatives
   • Uses of Derivatives
2. 2

   Forward Markets and Contracts

   2 topics

   • Pricing and Valuation of Forward Contracts
   • Forward Rate Agreements
3. 3

   Option Markets and Contracts

   2 topics

   • Option Pricing Models
   • Greeks in Option Pricing

Derivatives flashcards for CFA

25 of 51 cards from the Derivatives deck — real questions with worked answers.

1. What is a derivative?

   A financial instrument that derives its value (its performance) from the value of an underlying asset, rate, or index. Its price is contingent on, and settled at a future date based on, that underlying.

2. What is the fundamental distinction between a forward commitment and a contingent claim?

   A forward commitment obligates both parties to transact in the future at an agreed price (e.g., forwards, futures, swaps). A contingent claim gives one party a right but not an obligation, payoff contingent on an event (e.g., options).

3. List the four main types of forward commitments and the two main types of contingent claims.

   Forward commitments: forwards, futures, swaps (and FRAs). Contingent claims: options (calls and puts), and credit derivatives such as credit default swaps.

4. How does a forward contract differ from a futures contract?

   Forwards are customized, traded over-the-counter, have counterparty (default) risk, and settle at expiration. Futures are standardized, exchange-traded, marked-to-market daily through a clearinghouse, and have margin requirements.

5. What is a swap in derivatives terms?

   An OTC agreement to exchange a series of cash flows on periodic settlement dates over a set time; equivalent to a series of forward contracts. Example: a plain-vanilla interest rate swap exchanges fixed for floating payments.

6. Define a European option versus an American option.

   A European option can be exercised only at expiration. An American option can be exercised at any time up to and including expiration; therefore an American option is worth at least as much as an otherwise identical European option.

7. What is the difference between exchange-traded and OTC derivatives?

   Exchange-traded derivatives are standardized, transparent, and centrally cleared (low default risk). OTC derivatives are customized, privately negotiated, less transparent, and historically carried greater counterparty risk (now often centrally cleared).

8. What is a credit default swap (CDS)?

   A contingent claim in which the protection buyer pays periodic premiums to the protection seller, who compensates the buyer if a specified reference entity experiences a credit event (e.g., default).

9. State the payoff at expiration to the long position of a forward contract.

   $$\Pi_{long} = S_{T} - F_{0}(T)$$ where $S_{T}$ is the underlying spot price at expiration and $F_{0}(T)$ is the contracted forward price. The short payoff is the negative of this.

10. What are the main purposes (uses) of derivatives?

    Risk management/hedging, speculation, arbitrage, gaining low-cost exposure, price discovery, and creating exposures otherwise difficult or costly to obtain in cash markets.

11. What is hedging with derivatives?

    Taking a derivative position whose payoff offsets losses in an existing or anticipated cash-market exposure, reducing (or eliminating) risk. Example: a producer shorting futures to lock in a sale price.

12. How do derivatives provide operational advantages over cash markets?

    Lower transaction costs, greater liquidity (less capital required due to leverage), ease of short selling, and the ability to gain exposure quickly without transacting in the underlying asset itself.

13. Distinguish speculation from arbitrage as uses of derivatives.

    Speculation takes on risk to profit from an expected price move (a directional bet). Arbitrage exploits a mispricing to earn a riskless profit with no net investment by simultaneously buying cheap and selling dear.

14. State the law of one price and its role in derivative pricing.

    Two assets or portfolios with identical future cash flows must have the same price today; otherwise arbitrage is possible. It underpins no-arbitrage derivative pricing.

15. What criticisms are commonly leveled against derivatives?

    They can be used for excessive speculation (gambling), their leverage and complexity can create systemic destabilization, and they have been called a source of hidden risk. Proponents counter these are misuses, not inherent flaws.

16. How can derivatives improve market efficiency and price discovery?

    Futures and options prices aggregate market expectations of future spot prices and volatility, and arbitrage links derivative and cash prices, keeping markets informationally efficient.

17. State the no-arbitrage forward price for an asset with no income or costs.

    $$F_{0}(T) = S_{0}(1+r)^{T}$$ where $S_{0}$ is the current spot price, $r$ is the risk-free rate, and $T$ is time to expiration. The forward price is the future value of the spot price.

18. How is the forward price adjusted for carrying costs and benefits?

    $$F_{0}(T) = \left[S_{0} - PV(\text{income}) + PV(\text{costs})\right](1+r)^{T}$$ Benefits (income) reduce the forward price; carrying costs increase it.

19. Using continuous compounding, express the forward price with a continuous dividend/convenience yield.

    $$F_{0}(T) = S_{0}\,e^{(r+c-i)T}$$ where $r$ is the risk-free rate, $c$ the carrying cost rate, and $i$ the income/convenience yield (all continuously compounded).

20. What is the value of a forward contract at initiation, and why?

    Zero. The forward price is set so that neither party pays the other at inception; no arbitrage requires the initial value to be zero for both long and short.

21. State the value of a long forward position at time $t$ before expiration.

    $$V_{t}(T) = S_{t} - \frac{F_{0}(T)}{(1+r)^{T-t}}$$ i.e., the current spot minus the present value of the originally contracted forward price (adjusting for any income).

22. Give the value of a long forward at time $t$ in terms of forward prices.

    $$V_{t}(T) = \frac{F_{t}(T) - F_{0}(T)}{(1+r)^{T-t}}$$ the present value of the difference between the current forward price and the original contracted forward price.

23. Why does the forward price generally not equal the expected future spot price?

    Under no-arbitrage the forward price equals the cost-of-carry future value of the spot, not the expected spot. Differences reflect a risk premium; forward = expected spot only if the underlying's risk is unpriced.

24. What is contango versus backwardation?

    Contango: the forward/futures price is above the current spot price ($F_{0} > S_{0}$). Backwardation: the forward/futures price is below the current spot price ($F_{0} < S_{0}$), often associated with a high convenience yield.

25. How does a positive convenience yield affect the forward price?

    A convenience yield is a benefit of holding the physical asset; it acts like income, lowering the forward price: $$F_{0}(T) = S_{0}\,e^{(r+c-y)T}$$ where $y$ is the convenience yield.

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