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Derivatives

Hi guys

So I worked really hard and spent the maximum time on Derivatives for Level 1 yet ended up understanding nothing. Needless to say I scored the least in that. I’m dreading Level 2’s derivatives. How do I strengthen my concept and understand what in the world is going on in the derivatives world? Any tips would be appreciated. 

"Wiley's prep material was a huge part of my success." - Lindsey G., USA

I’ve tutored a number of Level II candidates on derivatives (the most recent was a candidate from Riyadh, Saudi Arabia who flew to Los Angeles just so that I could tutor him (well, and something about being on vacation with his wife).  I’ve also written a number of articles on pricing derivatives (http://www.financialexamhelp123.com/pricing-derivatives/) and valuing derivatives (http://www.financialexamhelp123.com/valuing-derivatives/).  Those are all good places to start.

(Full disclosure: as of 4/25/16 there is a charge to read the articles on my website.  You can get an idea of the quality of the articles by looking at the free samples here: http://www.financialexamhelp123.com/sample-articles/.)

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

I too had difficulty in L1 . In L2 apart from swaps the rest was pretty straight forward. Solving multiple problems on swaps will definitely help. 

Swaps aren’t really all that difficult: there’s only one formula for pricing all swaps, and valuing swaps is no more difficult than valuing bonds.

Doing practice problems will definitely help, especially if you don’t make them more difficult than they really are.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

Ak****a Jain wrote:

Hi guys

So I worked really hard and spent the maximum time on Derivatives for Level 1 yet ended up understanding nothing. Needless to say I scored the least in that. I’m dreading Level 2’s derivatives. How do I strengthen my concept and understand what in the world is going on in the derivatives world? Any tips would be appreciated. 

I find deriviaties the easiest because of some past experience.. Part of the problem is the derivatives material is very skimpy and very limited # of practice questions. The explanation is very brief compared to other topics.

Series 7 exam goes A LOT more into option derivatives with background. Might want to start reading other material where the explanation in CFAI is brief.

Also, I think it helps if you have a programming/engineer background :)

S2000magician wrote:

Swaps aren’t really all that difficult: there’s only one formula for pricing all swaps, and valuing swaps is no more difficult than valuing bonds.

For swaps, not sure how others do this.. but I found it best to ignore all the formulas altogether.. I just calculate the cash flow from one side and then use the discount factors.. Then calculate the cash flow from the other side and use the discount factors.. Then do some math. Works every time.

Sometimes, the formulas get tricky because the question requires some work to get to the format of the formulas.

125mph wrote:

S2000magician wrote:

Swaps aren’t really all that difficult: there’s only one formula for pricing all swaps, and valuing swaps is no more difficult than valuing bonds.

For swaps, not sure how others do this.. but I found it best to ignore all the formulas altogether.. I just calculate the cash flow from one side and then use the discount factors.. Then calculate the cash flow from the other side and use the discount factors.. Then do some math. Works every time.

Sometimes, the formulas get tricky because the question requires some work to get to the format of the formulas.

could you elaborate with an example …would be really heplfull .

Hull, J. (2011). Options, Futures, and Other Derivatives (8th ed). Pearson / Prentice Hall.

offers a friendly introduction to derivatives for people with imperfect quantitative training. If at times it seems too advanced for you, let me know and I will suggest some preliminary reading.

Okay thank you all 

As of now i don’t think I’ll have time to read a book . Is there any short version ???

georgekv14 wrote:

could you elaborate with an example …would be really heplfull .

If the question is asking for a semi-annual 2 year swap, and the fixed rate is let say 4.4% on a notation of $1M and they want to know the value just after the first payment (180 days)… SO you have two sides: fixed and float.

The fixed said is paying 4.4% which is 2.2% every 180 days. The cash flow for that would be 4 payments of $22,000 (2.2% of $1M) plus the notion. It’s 4 payments because this is semi-annual and its for 2 years. However, since 180 days just passed, you have 3 payments to compare against. Now you know the cash flow on the fixed side, however, you have to discount it using the discount factors that’s provided at the 6 month mark. 

For the float side, you find the cash flow in a similar way either by the new fixed rate that they give, or just the floating payments.

Then you have to do the subtraction. Fixed Cash flow - Float cash flow. Be careful, the question could ask what is the value for the fixed guy, or it could ask what is the value from the float guy. 

If you review the formula, we just broke down the formula into logical steps that I feel is more intuitive.

The same technique can be used for equity swap (actually this one is easier because its just equity index value divided by original value), and currency swap.

You need to try to make common sense of everything as simple as it sounds.

For example I think what should be done with option strategies is to understand the basic idea behind them, and know that positive signs are cash inflows and negative signs are cash outflows.

For example, I have no idea what the profit formula is for a straddle. I do know that a straddle consists of a long call and a long put with the same strike price on the same underlying stock.

Knowing that, I know that the profit for a long call is =max (0,S-X) and the profit for a long put is =max(0,X-S) and since I bought the options, I have to pay a premium on the call and put. Therefore, profit for a straddle= max(0,S-X)+max(0, X-S)-C-P. Someone please correct me if I’m wrong.