Derivatives
What you must know
Forwards, futures, options and swaps: payoffs and profits, determination of forward and futures prices, the value of a forward at initiation (zero) versus later, option payoffs, intrinsic versus time value, put-call parity, binomial option pricing in a risk-neutral framework, and swap pricing as a series of forward contracts. Understand margin, daily settlement for futures, and the role of credit default swaps.
Traps
(1) Payoff versus profit: profit subtracts the premium paid (options) or is measured relative to the forward price agreed. (2) A forward has zero value at initiation but a non-zero payoff at expiry. (3) Put-call parity is c + PV(X) = p + S0 for European options on a non-dividend-paying stock; with dividends add the present value of dividends to the right side. (4) A long forward's payoff at expiry is ST - F0, not ST - S0. (5) American options can be exercised early; European cannot.
Worked example
Stock trades at $50, the one-year risk-free rate is 5%, and a one-year European call with strike $50 costs $4. From parity: p = c - S0 + PV(X) = 4 - 50 + 50/1.05 = 4 - 50 + 47.62 = $1.62. If the market put traded at $2.50, the call would be relatively cheap and an arbitrage would be available.