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CFA® Level I · Derivatives · free lesson
Forward Commitment and Contingent Claim Features and Instruments
Every derivative is either a firm commitment to transact or a right that its holder may or may not exercise. This module separates the two families, then works through the main instruments in each: forwards, futures and swaps on one side, options and credit default swaps on the other. You will learn to compute settlement payments, option payoffs and profits, and CDS payouts, which are the building blocks for all later pricing work.
What you will learn
1. Distinguish forward commitments from contingent claims by their obligations, payoff profiles and initial cost.
- Forward commitments (forwards, futures, swaps) bind both parties; contingent claims (options, CDS) give one party a right.
- Forward commitments have symmetric, linear payoffs; contingent claims have asymmetric payoffs.
- Forward commitments are usually priced to have zero value at inception; contingent claims require a premium.
- The seller (writer) of a contingent claim receives the premium and bears the obligation to perform.
- Hedging with a forward removes upside and downside; hedging with an option keeps upside for a cost.
2. Describe forward and futures contracts, calculate their payoffs at maturity, and explain how futures differ from forwards.
- Forward payoff to the long at maturity: S_T - F_0(T); the short receives the opposite.
- Combining a forward with the spot transaction locks in the forward price as the effective price.
- Futures are standardized, exchange-traded, centrally cleared and marked to market daily.
- Margin accounts: initial margin, maintenance margin, variation margin to restore to initial.
- Daily settlement reduces counterparty risk but creates interim cash-flow (liquidity) needs.
3. Describe interest rate, currency and other swaps and calculate the net periodic payment on a plain-vanilla interest rate swap.
- A swap is a series of forward commitments; payments are exchanged on several dates.
- Plain-vanilla interest rate swap: fixed swap rate versus a floating market reference rate on the same notional.
- Payments are netted; the notional of an interest rate swap is not exchanged.
- The fixed-rate payer benefits when the floating rate rises above the swap rate.
- Currency swaps usually exchange notional principal; equity and commodity swaps exchange returns or prices.
4. Calculate the value at expiration and the profit of long and short positions in calls and puts, and identify their breakeven prices and maximum gains and losses.
- Call payoff = max(0, S_T - X); put payoff = max(0, X - S_T).
- Profit = payoff minus premium for buyers; premium minus payoff for writers.
- Breakeven: X + c_0 for calls, X - p_0 for puts (for both long and short).
- Long call: unlimited gain, loss limited to premium. Short call: gain limited to premium, unlimited loss.
- Long put: maximum gain X - p_0, because the underlying cannot fall below zero.
5. Describe credit default swaps and calculate the premium payments and the payout following a credit event.
- The protection buyer pays a periodic spread; the protection seller pays only if a credit event occurs.
- Payout after a credit event = notional x (1 - recovery rate).
- A CDS is a contingent claim that resembles insurance or a put on the reference entity's debt.
- Protection seller is long credit risk; protection buyer is short credit risk.
- Standardized coupons are adjusted with an upfront payment to reflect the market spread.
Module at a glance
- Forward commitments bind both parties and have symmetric payoffs; contingent claims give a right and cost a premium.
- Forward payoff to the long = S_T - F_0(T); a hedger who combines it with a spot trade locks in F_0(T).
- Futures are standardized, cleared and marked to market daily, which creates interim cash-flow needs.
- An interest rate swap nets fixed against floating payments on a notional that is never exchanged.
- Call payoff max(0, S_T - X), put payoff max(0, X - S_T); profit subtracts the premium.
- Breakevens: X + c_0 for calls and X - p_0 for puts; option writers face large potential losses.
- A CDS pays notional x (1 - recovery) after a credit event; the protection buyer is short credit risk.
This free module has 5 lessons, 14 practice questions with full explanations.