Derivatives covers forward contracts, futures, swaps, and options — their pricing, payoffs, and uses in risk management. At Level I the emphasis is on understanding no-arbitrage pricing principles and the payoff profiles for each instrument. The Black-Scholes-Merton (BSM) model inputs and put-call parity are frequently tested. Derivatives account for 5–8% of the exam and rewards candidates who understand the conceptual logic of pricing.
No-arbitrage pricing: the forward price is the price that makes the present value of entering the contract equal to zero. Any price above or below allows riskless profit — the exam tests whether you can identify and exploit the arbitrage.
Option moneyness: in-the-money (intrinsic value > 0), at-the-money (intrinsic value = 0), out-of-the-money (intrinsic value = 0). Only ITM options have intrinsic value; time value exists for all options before expiration.
BSM inputs and sensitivities: option value increases with stock price (call), time to expiration (usually), volatility (both), and risk-free rate (call). Call and put values move in opposite directions with respect to underlying price and risk-free rate.
Swaps as a series of forwards: a fixed-for-floating interest rate swap can be replicated as a portfolio of forward rate agreements (FRAs). The swap rate is the fixed rate that makes the swap's NPV equal to zero at initiation.
Confusing the forward price (the contracted delivery price) with the value of the forward contract (which starts at zero and changes over time as market prices move).
Getting put-call parity wrong under different scenarios — memorise the relationship C + PV(X) = P + S₀ and practice rearranging it to isolate each variable.
Forgetting that options can only be exercised at expiration for European options, while American options can be exercised any time. American calls on non-dividend-paying stocks are never optimally exercised early.
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