Derivatives Essentials — CFA Level I

On the exam, the forward-vs-futures fork is the highest-yield pattern: a vignette describes a contract and asks which features apply. The “tell” is words like customized, OTC, single settlement at expiration, or counterparty credit risk — all point to a forward, whereas standardized, exchange-traded, daily mark-to-market, or margin call signal a future. A classic trap is the forward price vs. forward value distinction: the locked-in forward price is set at initiation and never changes, while the contract’s value drifts from zero as the spot price moves and is realized only at expiry. Don’t confuse the two — questions deliberately swap the labels.

A second trap pairs forward with notional: the notional sizes the contract’s payoff but is never the amount at risk, so a forward on a large notional can carry tiny mark-to-market value. Memory hook: a forward is a handshake (private, tailor-made, trust-based), a future is a turnstile (standardized, cleared, settled every day).

The exam loves to make you sign that price gap by the correlation: when futures prices are positively correlated with interest rates, daily gains are reinvested at higher rates and losses funded at lower rates, so longs prefer futures and the futures price ends up higher than the otherwise-identical forward price; negative correlation flips it (forward priced higher); zero correlation makes them equal. Note the curriculum frames this as a price difference, not a value one. A second pattern asks who bears default risk: the clearinghouse acts as central counterparty, novating the trade so neither original party faces the other.

The classic trap is conflating price with value: a futures position’s value is reset to zero at each daily settlement, whereas a forward’s value accumulates between settlements until expiration. Students also wrongly treat margin as a down payment — it is a refundable performance bond, not borrowed money (see margin and forward). Don’t assume futures always command a higher price than forwards; that holds only under positive rate correlation.

The exam loves to make you sort a payoff diagram by who holds the right and who owes the obligation. The tell is the kinked, hockey-stick shape: a long position’s profit line is flat then sloped (loss floored at the premium paid), and a short position is the vertical mirror (gain capped at the premium received). A favorite trap pairs an option against a forward or futures — the give-away is that forwards have a linear, symmetric payoff with no premium, so each party carries two-sided risk (a long forward’s loss is bounded only because the asset can’t fall below zero), whereas only options buy that asymmetry with an upfront cost.

Do not confuse the option (the contract) with the strike (the fixed exercise price baked into it) or the premium (what you pay to own it) — questions deliberately blur the three. Remember that moneyness compares spot to strike, yet the premium stays positive even out-of-the-money, because time value survives when intrinsic value is zero. Hook: you buy the option, you pay the premium, you exercise at the strike — three words, three roles.

Exam items lean on the strip-of-forwards view to test direction: in a receive-fixed/pay-floating swap, you gain when rates fall (your fixed receipts now exceed the lower floating payments), so the tell is matching a rate move to which leg benefits. A second favorite asks for value mid-life — since each embedded forward reprices, the swap takes on positive or negative value as the term structure shifts after initiation. Watch the netting rule: only the net interest difference (sized by the notional) changes hands each settlement, not gross flows.

The classic trap is conflating a swap with a single forward — a swap settles periodically over multiple dates, whereas a vanilla forward is one exchange at expiration. Don’t confuse the notional (the multiplier, never exchanged in a vanilla rate swap) with what’s actually paid (the net interest). Note the exception: currency swaps do exchange principal, usually at start and at maturity. Memory hook: a swap is a forward contract that keeps coming back — same engine, repeated dates.

Level I tests the strike as a plug in payoff and parity formulas, not as a definition. Expect a question giving spot, strike, and premium and asking for profit at expiration: a call buyer’s payoff is max(0, S − X), a put’s is max(0, X − S), then subtract the premium. The classic discriminator is put-call parity for European options — memorize c + X/(1+r)^T = p + S₀ — where the strike enters discounted as the present value of a bond paying X at expiration (the fiduciary-call leg). Forgetting to discount X is the single most common parity error. Another favorite: holding spot and volatility fixed, a higher strike raises a put’s value and lowers a call’s — the answer hinges on that directional sign.

Don’t confuse the strike (a fixed contract term that never changes) with the premium, the market price that moves continuously; the strike sets where payoff begins, the premium is what you paid to get there. Also distinguish exercise (acting at the strike) from expiration — a deep out-of-the-money option simply lapses worthless, unexercised. Hook: the strike is the line in the sand; the premium is the ticket to stand on it.

The premium is the maximum loss for the buyer and the maximum gain for the seller. Sellers (“writers”) collect it in exchange for the obligation side of the contract — limited reward, potentially large loss.

The exam tests the direction each driver pushes value, not computation. The reliable trap is interest rates: a higher risk-free rate raises calls but lowers puts — students who memorized “higher rates raise premiums” miss the put. A higher dividend or yield on the underlying is the mirror image: it lowers calls and raises puts (only the call “likes” higher rates, since deferring the strike payment is worth more when money earns more). Don’t confuse premium with the strike (a fixed contractual term) or with intrinsic value alone: a deep out-of-the-money option has zero intrinsic value yet a positive premium from time value, so for American options the premium never falls below intrinsic value. Finally, a premium is paid upfront at initiation — unlike a forward or futures, which has zero value and costs nothing to enter.

At Level I the testable pattern is instrument selection: given an exposure and a view, pick the cheapest fitting hedge. The “tell” is whether the manager wants to keep favorable moves. To protect the downside while retaining upside, buy an option (a contingent claim — pay the premium); to lock a price with no upfront premium while giving up gains, use a forward or future (a forward commitment). A second pattern asks why a hedge underperforms: it almost always hinges on basis risk — imperfect correlation between hedge and exposure — not the hedge “failing.”

The classic trap is calling a hedge “free.” A forward costs nothing at initiation but surrenders all upside — an opportunity cost, not a free lunch. Don’t confuse hedging with speculation: a hedge offsets an existing exposure, while the same naked position is a bet. It also differs from diversification, which lowers unsystematic risk across many assets — a hedge neutralizes one specific risk via an offsetting derivative. Memory hook: a hedge is insurance, and insurance always has a price.

The exam loves to make you separate notional from value (mark-to-market): notional is fixed and contractual, while a forward commitment’s value is zero at initiation and then drifts as the underlying moves. A classic item gives a “$50 million notional” swap or forward and asks for the at-initiation value — the trap answer is $50 million; the correct answer is zero (the fixed/forward rate is set so the two legs have equal present value). Another favorite uses notional to back out a payment: a floating-leg cash flow equals the reference rate (now SOFR, not legacy LIBOR) times notional times the day-count fraction — notional is a multiplier, never the cash transferred.

Don’t conflate notional with the forward/swap price, nor with margin or premium. With a forward, notional reflects the quantity of the underlying; a swap behaves like a strip of off-market forwards, scaling every periodic payment. The student error is treating gross notional as exposure — but counterparty credit exposure tracks net replacement value. Notional sizes the bet; it is never the bet itself.

The exam’s favorite item is a mark-to-market walk-through: given initial and maintenance levels plus a sequence of settlement prices, compute the running balance and identify the day the call is triggered — the balance closing at or below maintenance. The tell is a maintenance level set below initial; the top-up that day brings the account back to the initial level, and the funds posted are often called variation margin (some sources reserve that term for the daily mark-to-market cash flow that flows both ways). A move in your favor credits the account, and you may withdraw the excess above initial rather than leave it idle.

The classic trap is importing equity-margin logic: here there is no borrowing and no interest charged, so the deposit is a good-faith bond, not financed leverage. Don’t confuse margin (the collateral mechanism) with the futures contract itself or with a hedge (the risk-offsetting purpose) — margin is what makes the clearinghouse’s performance guarantee credible. Memory hook: maintenance is the floor; touch it and you climb the whole ladder back to initial.

Exam items lean on the payoff at expiration, where time value is zero so an option is worth exactly its intrinsic value — calls pay max(0, S − X), puts max(0, X − S). The classic vignette gives you the spot at expiry and asks for the buyer’s or seller’s profit; the “tell” is that you must subtract the premium — the Level I convention is simply profit = payoff − premium (a few treatments compound the premium to its future value, but the exam formula does not). A frequent trap pairs this with the European-vs-American distinction: early exercise only matters before expiry, so at the terminal date both styles collapse to the same intrinsic-value payoff.

Don’t confuse an option’s expiration outcome with a futures settlement: at expiry the futures price converges to spot, but daily mark-to-market has already settled gains along the way, so there is no lump premium and no “expire worthless” branch — the obligation is symmetric, unlike an option’s one-sided right. Memory hook: at expiration, time value dies but intrinsic value pays — only the money already in the money survives.