CFA Level 1 - Deri - Derivative Instrument And Derivative Market

A derivative can best be described as a financial instrument that:

• duplicates the underlying asset’s performance.

• transforms the underlying asset’s performance.

• passes through the underlying asset’s returns.

Answer explanation

1. A. Incorrect. A derivative transforms the performance of the underlying asset rather than duplicating the performance of the underlying asset.

2. B. Correct. The best characterization of a derivative is that it typically transforms the underlying asset’s performance.

3. C. Incorrect. A derivative transforms the performance of the underlying asset rather than passing through the returns of the underlying asset.

Which of the following statements best describes why Montau AG should consider a derivative rather than a spot market transaction to manage the financial risk of this commercial contract?

• Montau AG is selling a machine at a contract price in KRW and incurs costs based in EUR.

• 1. Montau AG faces a 75-day timing difference between the commercial contract date and the delivery date when Montau AG is paid for the machine in KRW.

• Montau AG is unable to sell KRW today in order to offset the contract price of machinery delivered to Jeon Inc.

Answer explanation

B is correct. A 75-day timing difference exists between the commercial contract date and the delivery date when Montau AG is paid for the machine in KRW. A is true but does not explain why the use of a derivative is preferable to a spot market transaction. If as in C Montau were to sell the KRW it receives and buy EUR in a spot market transaction on the delivery date, it would be exposed to unfavorable changes in the KRW/EUR exchange rate over the 75-day period. A derivative contract in which the underlying KRW/EUR forward rate is agreed today and exchanged on the delivery date allows Montau to hedge or offset the EUR value of the future KRW payment. The derivative is therefore a more suitable contract to address the financial risk of the commercial transaction than a spot market sale of KRW.

Which of the following types of derivative and underlyings are best suited to hedge Montau’s financial risk under the commercial transaction?

• Montau AG should consider a firm commitment derivative with currency as an underlying, specifically the sale of KRW at a fixed EUR price.

• Montau AG should consider a contingent claim derivative with the price of the machine as its underlying, specifically an A-series laser cutting machine.

• 1. Montau AG should consider a contingent claim derivative with currency as an underlying, specifically the sale of EUR at a fixed KRW price.

Answer explanation

A is correct. The derivative best suited to hedge Montau’s financial risk is a firm commitment derivative in which a pre-determined amount is exchanged at settlement. The derivative underlying should be currencies, specifically the sale of KRW at a fixed EUR price in the future to offset or hedge the financial risk of the commercial contract. The machine price referenced under B is not considered an underlying, and C hedges the opposite of Montau’s underlying exposure.

Which of the following derivative contracts is best described as a contingent claim?

• A swap contract

• A forward contract

• 1. An option contract

Answer explanation

1. A. Incorrect because derivative contracts can be classified as either firm commitments or contingent claims. Firm commitments include forward contracts, futures contracts, and swaps involving a periodic exchange of cash flows and an option is the primary contingent claim.

2. B. Incorrect because derivative contracts can be classified as either firm commitments or contingent claims. Firm commitments include forward contracts, futures contracts, and swaps involving a periodic exchange of cash flows and an option is the primary contingent claim.

3. C. Correct because another type of derivative is a contingent claim, in which one of the counterparties determines whether and when the trade will settle. An option is the primary contingent claim.

Identify A, B, and C in the correct order in the following diagram, as in Exhibit 1, for the derivative to hedge Montau's financial risk under the commercial transaction.

• A: Financial intermediary, B: KRW650,000,000, C: Fixed EUR amount

• 1. A: Jeon Inc., B: KRW650,000,000, C: Fixed EUR amount

• A: Financial intermediary, B: Fixed EUR amount, C: KRW650,000,000.

Which of the following derivatives is least likely to be classified as a contingent claim?

• A futures contract

• A call option contract

• A credit default swap

Answer explanation

1. A. Correct. A futures contract is classified as a forward commitment in which the buyer undertakes to purchase the underlying asset from the seller at a later date and at a price agreed on by the two parties when the contract is initiated.

2. B. Incorrect. A call option contract is a contingent claim in which the buyer of the option has a right to purchase the underlying asset at a fixed price on or before a pre-specified expiration date.

3. C. Incorrect. A credit default swap is a contingent claim in which the credit protection seller provides protection to the credit protection buyer against the credit risk of a third party.

Which of the following statements about the most appropriate derivative market to hedge Montau AG’s financial risk under the commercial contract is most accurate?

• 1. The OTC market is most appropriate for Montau, as it is able to customize the contract to match its desired risk exposure profile.

• 1. The ETD market is most appropriate for Montau, as it offers a standardized and transparent contract to match its desired risk exposure profile.

• Both the ETD and OTC markets are appropriate for Montau AG to hedge its financial risk under the transaction, so it should choose the market with the best price.

Answer explanation

A is correct. The OTC market is most appropriate for Montau, as OTC contracts may be customized to match Montau’s desired risk exposure profile. This is important to end users seeking to hedge a specific underlying exposure based upon non-standard terms. Montau would be unlikely to find an ETD contract under B that matches the exact size and maturity date of its desired hedge, which also makes C incorrect.

In contrast to over-the-counter options, futures contracts most likely:

• 1. are not exposed to default risk.

• 1. are private, customized transactions.

• represent a right rather than a commitment.

Answer explanation

1. A. Correct. Over-the-counter options are exposed to default risk, but futures contracts are standardized transactions that take place on futures exchanges and are not exposed to default risk.

2. B. Incorrect. Futures contracts are not private; they are standardized instruments that trade on organized exchanges.

3. C. Incorrect. Futures contracts are commitments, but options represent a right.

Which of these is best classified as a forward commitment?

• 1. A call option

• 1. A swap agreement

• 1. A convertible bond

Answer explanation

1. A. Incorrect. A call option is an example of a contingent claim.

2. B. Correct. A swap agreement is equivalent to a series of forward agreements, which can be described as forward commitments.

3. C. Incorrect. A convertible bond does not meet the definition of a forward commitment.

If Montau enters into a centrally cleared derivative contract on the OTC market, which of the following statements about credit risk associated with the derivative is most likely correct?

• 1. Montau faces credit risk associated with the possibility that its counterparty to the contract may not fulfill its contractual obligation.

• Montau poses a credit risk to its counterparty because it may fail to fulfill its contractual obligation.

• 1. Montau poses a credit risk to a derivative contract end user holding a contract with the opposite features of Montau’s.

Answer explanation

B is correct. In a centrally cleared OTC derivative contract, the central counterparty becomes the counterparty in all contracts and assumes the credit risk associated with individual derivative contracts. A is likely incorrect because the CCP takes actions to ensure that it can fulfill its obligations to its counterparties. C is incorrect because the CCP inserts itself between parties with opposite positions.