BOOK -DERIVATIVES AND PORTFOLIO MANAGEMENT Readings and Learning Outcome Statements Study Session 16 - Derivative Investments: Forwuds and Futures •.•.•.•.•.•.•.•.••••.•.• Study Session 17 - Derivative Investments: Options, Swaps, and Interest Rate and Credit Derivatives 58 Self-Test - Derivatives •.•.••••.•.•.•.•.•.•.•.• •.•.•.•.•.•.•.•.••••.•.•.•.•.•.•.•.• •.•.•.•.•.•.•.•.•••• 145 Study Session 18 - Portfolio Management: Capital Market Theory and the Portfolio Management Process 148 Self-Test- Portfolio Management 278 Fortnulas 281 Index 286 SCHWESERNOTESTM 2012 CFA LEVEL II BOOK 5: DERIVATIVES AND PORTFOUO MANAGEMENT ©20 11 Kaplan, Inc All rights reserved Published in 20 II by Kaplan Schweser Printed in the United States of America ISBN: 978-1-4277-3616-1/1-4277-3616-2 PPN: 3200-1733 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation of global copyright laWN Your assistance in pursuing potential violators of this law is greatly appreciated Required CFA Institute® disclaimer: "CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the producu or services offered by Kaplan Schweser." Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2012, CFA Institute Reproduced and republished from 2012 Learning Outcome Statements, Level I, II, and III questions from CFA~ Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute's Global Investment Performance Standards with permission from CFA Institute All Rights Reserved." These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violarion of global copyright laws and the CFA lnstirure Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Nares should be used in conjunction with the original readings as ser forth by CFA Institute in their 2012 CFA Level II Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is bdieved to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate aa.m success The authors of the referenced readings have not endorsed or sponsored these Notes READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review ofthe Derivatives and Portfolio Management principles designed to address the learning outcome statements set forth by CPA Institute STUDY SESSION 16 Reading Assignments Derivatives and Portfolio Management, CFA Program Curriculum, Volume 6, Levd II (CFA Institute, 20 12) 54 Forward Markets and Contracts 55 Futures Markets and Contracts page9 page 37 STUDY SESSION 17 Reading Assignments Derivatives and Portfolio Management, CFA Program Curriculum, Volume 6, Levd II (CFA Institute, 20 12) 56 57 58 59 Option Markets and Contracts Swap Markets and Contracts Interest Rate Derivative Instruments Using Credit Derivatives to Enhance Return and Manage Risk page 58 page 99 page 127 page 135 STUDY SESSION 18 Reading Assignments Derivatives and Portfolio Management, CFA Program Curriculum, Volume 6, Levd II (CFA Institute, 2012) 60 Portfolio Concepts 61 A Note on Harry M Markowitz's "Market Efficiency: A Theoretical Distinction and So What?" 62 International Asset Pricing 63 The Theory of Active Portfolio Management 64 The Portfolio Management Process and the Investment Policy Statement ©20 11 Kaplao, Inc page 148 page 213 page 219 page 250 page 264 Page3 Book - Derivatives and Portfolio Management Reading< and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS) Tht CFA lmtitutt Ltarning Outcomt Stattmmts art listtd btlow Thtst art rtptattd in tach topic rtVitw; howtvtr, tht ordtr may havt bun changtd in order to gtt a bttttr fit with tht flow oftht rtvitw STUDY SESSION 16 Tht topical covtragt com:sponds with tht following CFA lnstitutt assigntd rtading: 54 Forward Markets and Contracts The candidate should be able to: a explain how the value of a forward contract is determined at initiation, during the life of the contract, and at expiration (page 14) b calculate and interpret the price and value of an equity forward contract, assuming dividends are paid either discretdy or continuously (page 16) c calculate and interpret the price and value of 1) a forward contract on a fixedincome security, 2) a forward rate agreement (FRA), and 3) a forward contract on a currency (page 20) d evaluate credit risk in a forward contract, and explain how market value is a measure of exposure to a party in a forward contract (page 29) Tht topical covtragt com:sponds with tht following CFA lnstitutt assigntd rtading: 55 Futures Markets and Contracts The candidate should be able to: a explain why the futures price must converge to the spot price at expiration (page 37) b determine the value of a futures contract (page 38) c explain why forward and futures prices differ (page 39) d describe monetaty and nonmonetary benefits and costs associated with holding the underlying asset, and explain how they affect the futures price (page 43) e describe backwardation and contango (page 44) f explain the rdation between futures prices and expected spot prices (page 44) g describe the difficulties in pricing Eurodollar futures (page 47) h calculate and interpret the prices ofTreasury bond futures, stock index futures, and currency futures (page 47) STUDY SESSION 17 Tht topical covtragt com:sponds with tht following CFA lnstitutt assigntd rtading: 56 Option Markets and Contracts The candidate should be able to: a calculate and interpret the prices of a synthetic call option, synthetic put option, synthetic bond, and synthetic underlying stock, and explain why an investor would want to create such instruments (page 59) b calculate and interpret prices of interest rate options and options on assets using c Page4 one- and two-period binomial models (page 62) explain and evaluate the assumptions underlying the Black-Scholes-Merton model (page 75) ©2011 Kaplan, Inc Book - Derivatives and Portfolio Management Readings and Learning Outcome Statemeots d explain how an option price, as represented by the Black-Scholes-Metton model, is affected by a change in the value of each of the inputs (page 77) e explain the delta of an option, and demonstrate how it is used in dynamic f hedging (page SO) explain the gamma effect on an option's delta and how gamma can affect a delta hedge (page 85) g explain the effect of the underlying asset's cash flows on the price of an option (page 85) h demonstrate the historical volatility and implied volatility methods for estimating the future volatility of the underlying asset (page 86) i demonstrate how put-call parity for options on forwards (or futures) is established (page 87) j compare American and European options on forwards and futures and identify the appropriate pricing model for European options (page 89) The topical coverttge cormponds with the following CPA lmtitute assigned reading: 57 Swap Markets and Contracts The candidate should be able to: a distinguish between the pricing and valuation of swaps (page 99) b explain the equivalence of 1) interest rate swaps to a series of off·market forward c interest rate call and an interest rate put (page 100) calculate and interpret the fixed rate on a plain vanilla interest rate swap and the rate agreements (FRAs) and 2) a plain vanilla swap to a combination of an market value of the swap during its life (page I I) d calculate and interpret the fixed rate, if applicable, and the foreign notional principal for a given domestic notional principal on a currency swap, and e estimate the market values of each of the different types of currency swaps during their lives (page lOS) calculate and interpret the fixed rate, if applicable, on an equity swap and the market values of the different types of equity swaps during their lives (page 112) f explain and interpret the characteristics and uses of swaptions, including the difference between payer and receiver swaptions (page 114) g calculate the payoffs and cash flows of an interest rate swaption (page 114) h calculate and interpret the value of an interest rate swaption at expiration i (page 115) evaluate swap credit risk for each party and during the life of the swap, j swap credit risk is reduced by both netting and marking to market (page 116) define swap spread and explain its relation to credit risk (page 117) distinguish between current credit risk and potential credit risk, and explain how The topical coverage corresponds with the following CPA Institute assigned reading: 58 Interest Rate Derivative Instruments The candidate should be able to: a demonstrate how both a cap and a Boor are packages of 1) options on interest rates and 2) options on fixed-income instruments (page 127) b calculate the payoff for a cap and a floor, and explain how a collar is created (page 129) ©20 11 Kaplan, Inc PageS Book - Derivatives and Portfolio Management Reading< and Learning Outcome Statements Th• topical cov