Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

CFA > CFA L1 Derivatives > Flashcards

CFA L1 Derivatives Flashcards

1
Q

What is arbitrage?

A
  • Opportunity for riskless profit
  • Derivatives are priced so that there is no possibilty for arbitrage on it

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What is discrete compoundign versus continuous compounding?

A
  • Discrete compounding defines a set number of periods
  • Continuous compounding is continous, so no number of periods.
  • CC formula is e^(rT)

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is continuous compounding used for?

A
  • Forex portfolios, and indices for equity, fixed income, and commodities

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What rate is used to calculate derivative price?

A
  • Strictly speaking interbank offered rates are used (SOFR). This is continuously compounded already
  • However in the curriculum risk free rate is used
  • Therefore in the curriculum risk free rate needs to be continously compounded to arrive at derivative pricing rate (MRR)

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What return would a trader earn if they perfectly matched off a long position with a short position?

A
  • The risk-free rate
  • If you hedge perfectly you remove all risk
  • Therefore rate earned would be risk free rate

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q
A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q
A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What is the cost of carry?

A
  • The net of costs and benefits of holding the underlying asset for a specified period of time
  • If the benefits (ie convenience, dividend) outweigh costs, cost of carry is negative
  • Therefore futures price will be LESS than the spot price
  • If the benefits are less than the costs (ie high storage, transportation, insurance costs, like gold) the futures price will be MORE than the futures price, and cost of carry is positive

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

How you do you find the continuously compounded rate?

A
  • Add 1 to the rate
  • use ln()
  • So: ln(1 + rate) = continuously compounded rate

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What is the difference between long and short?

A
  • Long means you take delivery of the underlying asset
  • Short means you deliver the underlying asset
  • So traditionally, to be short you would have to own the underlying asset, and be creating a contract to give it away

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What does it mean to say the base trades at a discount or premium?

A
  • base trades at a discount = forward price is less than spot price
  • base trades at a premium = forward price is higher than the spot price

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

How do you calculate currency price?

A
  • Spot price of two currencies
  • Interest rates on the two currencies
  • Spot price x (yield1/yield2) = forward price

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

How do interest rate differences between currencies affect FX forward rate value?

A
  • Higher interest rate in currency A means FX forward will show devaluation
  • Lower interest rate in currency B means FX forward will show appreciation
  • This is because less of currency A will be needed to buy a given amount of currency B in future

Forward Rate = Spot Rate x (1 + Foreign Interest Rate) / (1 + Domestic Interest Rate)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What do contango and backwardation imply?

A
  • Contango = well functioning market.
  • Convenience yield is low since supply is unconstrained. Market is well supplied
  • Storage costs are greater than convenience yield
  • Therefore, spot prices are below forward prices
  • Backwardation implies poorly functioning market
  • Convenience yield is high since supply is constrained
  • Market is is poorly supplied, therefore spot price high and storage costs comparatively lower than convenience yield
  • Futures trade at a discount

2025 L1 DE LM4 - Arbitrage, Replication, and the Cost of Carry

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What is the value of a derivative after issue before maturity?

A
  • For short derivatives Value at maturity T = spot price - payoff amount
  • For long derivatives, reverse: Value at maturity T = payoff amount - spot price
  • At time t after issue, Value = spot price - [payoff amount / (1+r)^(T-t)

So divide payoff amount by rate compounded by time left before expiration

2025 L1 DE LM5 Pricing and Valuation of Forward Contracts with Varying Maturities

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

How do you calculate value of a derivative involving income?

A
  • Discount all income back to start point

2025 L1 DE LM5 Pricing and Valuation of Forward Contracts with Varying Maturities

17
Q

What is the value of a future or forward contract at issue?

A

Zero

2025 L1 DE LM6 Pricing and Valuation of Futures Contracts

18
Q

What is the difference between value of forward and futures contracts?

A
  • Futures value is 0 at the end of each day
  • Because difference between price and value is settled every day
  • Forward contrast is not settled every day, it is settled at maturity
  • So forward value changes over life of contract, is only 0 at issue

2025 L1 DE LM6

19
Q

What conditions would create indifference between forward and futures contracts for investors?

A
  • Interest rate is constant, not changing over life of contracts, as interest rate effects cancel out
  • If futures prices and interest rates are uncorrelated

2025 L1 DE LM6 Pricing and Valuation of Futures Contracts

20
Q

How would we use futures or FRA to hedge interest rates?

A
  • Short futures or long FRA to hedge against increasing interest rates
  • Long futures or short CFA to hedge against decreasing rates
  • If interest rates go up, borrowing costs go up, and futures prices will go down. A short future will earn gains under increasing rates
  • If interest rates go up, borrowing costs increase, but gains on an FRA offset higher costs, as you pay a fixed rate and pay a floating rate

2025 L1 DE LM6 Pricing and Valuation of Futures Contracts

21
Q

What is a swap?

A
  • Agreement to exchenge a series of cash flows whereas a forward contract involves a single exchange
  • In an interest rate swap, there are multiple payments that occur at the end of each interest rate period

2025 L1 DE LM7 - Pricing and Valuation of Interest Rates and Other Swaps

22
Q

How does time to expiration affect value of an option?

A
  • Longer time to expiration increases option value
  • For any option and for any given strike price
  • Because the option has more time to perform, as the underlying has greater volatility

2025 L1 DE LM8 - Pricing and Valuation of Options

23
Q

How does an underlying that pays dividends or income put pressure on call options?

A
  • Each time income is paid out the call value decreases, since the option doesn’t earn income whereas owning the underlying does
  • Put value increases however

2025 L1 DE LM8 - Pricing and Valuation of Options

24
Q

What is a synthetic forward?

A
  • Creating a forward position using options
  • Remember, a forward is an agreement to buy/sell the underlying at time T
  • Using options can replicate that without you having to buy or sell the underlying

2025 L1 DE LM9 - Option Replication using Put-Call Parity

25
Q

How are synthetic forwards constructed?

A
  • Long call short put is a synthetic long forward position
  • ## Short call long put is a synthetic short forward position

2025 L1 DE LM9 - Option Replication using Put-Call Parity

26
Q

What is the gain-to pain ratio?

A
  • Either Calmar ratio or MAR
  • Used instead of Sharpe ratio since Sharpe ratio requires noramlly distributed returns
  • Alternatives tend to have asymmetric and skewed returns profiles so SR doesn’t work well
  • Still, SR of 1-2 is targeted, higher indicating significant volatility smoothing
  • Treynor ratio also has performance appraisal issues: measures excess average return relative to beta to a relative benchmark
  • However Beta is historical and may be different in future

2025 L1 AI LM1 - Alternative Investment Performance and Returns

27
Q

How to calculate Calmar ratio?

A

Avg annual compounded return over 3y / maximum drawdown

2025 L1 AI LM1 - Alternative Investment Performance and Returns

28
Q
A
29
Q

Why is IRR used for alternatives returns?

A
  • Timing is very important for evaluating returns, not just magnitude of returns

2025 L1 AI LM1 - Alternative Investment Performance and Returns

30
Q

Why are quartile ranking used to rank alternative investment funds?

A
  • It’s not fair to compare investment portfolios started in different years
  • So compare portfolios started in same year
  • Quartile ranking gives relative performance based on market conditions from that year onwards over the duration of the fund

2025 L1 AI LM1 - Alternative Investment Performance and Returns

31
Q

What is money-weighted rate of return?

A
  • Calculated similarly to IRR
  • Depends on how much money you put in at each time period
  • Accurately reflects what a specific investor earned, but lacks comparability
  • By investing less per period when market is up, and more per period when market is down, you can achieve higher returns

2025 L1 PM LM1 - Portfolio Risk and Return: Part I

32
Q

What is time weighted rate of return?

A

Returns based on the timing of cash flows invested

2025 L1 PM LM1 - Portfolio Risk and Return: Part I

33
Q
A

CFA (6 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2025 Bold Learning Solutions. Terms and Conditions