Financial Derivatives
Domain 1 tests how well you distinguish the building blocks of derivatives and apply payoff and pricing logic rather than recite definitions. Expect forwards, futures, options, swaps, margins, basis and hedging.
Core rules
- A forward is OTC and bilateral; a futures contract is exchange-traded, standardised and cleared through a CCP.
- Long futures gain when price rises; short futures gain when price falls. An option buyer pays premium and has a right, not an obligation; the writer has an obligation.
- Fair futures = spot + cost of carry − income (dividends, storage, convenience). Basis = spot − futures; it converges to zero at expiry.
- Margin is collateral, not a fee. Initial margin opens a position; variation margin settles daily mark-to-market.
Worked example
A PSX stock trades at PKR 100. Three-month futures; risk-free rate 10% p.a.; dividend yield 4% p.a.; use simple carry. Fair futures = 100 + 100 × (0.10 − 0.04) × 3/12 = PKR 101.50. If futures trade at 103, the contract is rich: a cash-and-carry arbitrageur borrows, buys spot and shorts futures; at expiry this locks in 103 − 101.50 = PKR 1.50 per share before costs. If futures were 100.50, reverse cash-and-carry may be indicated, subject to short-sale and financing constraints.
Traps
- Treating option premium as margin; premium is a sunk cost.
- Forgetting dividends or income in stock and index futures.
- Confusing European exercise (expiry only) with American exercise (any time before expiry).
- Treating notional value as capital at risk.