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CFA Level 1 Derivatives: Complete Study Guide (2026)

All 10 Learning Modules at a Glance

Block 1: Features and Markets (LM 1–3)

LM 1: Derivative Instrument and Market Features

A derivative is a financial contract whose value is derived from the performance of an underlying asset. That underlying can be virtually anything: equities, fixed-income instruments, interest rates, currencies, commodities, or credit. The curriculum establishes two fundamental categories right away — firm commitments (both parties are obligated to transact) and contingent claims (one party has the right but not the obligation).

OTC vs. exchange-traded derivatives: OTC derivatives are customized contracts negotiated between two parties — flexible but carrying counterparty credit risk. Exchange-traded derivatives (ETDs) are standardized contracts traded on organized exchanges with clearinghouses that absorb counterparty risk through margin requirements. Central clearing has expanded since the 2008 financial crisis — even many OTC contracts now go through central counterparties (CCPs) that require collateral and mark positions to market daily.

LM 2: Forward Commitments and Contingent Claims

This module introduces the four core derivative types — the building blocks for everything that follows.

Forward contracts: A customized OTC agreement to buy or sell an asset at a specified future date at a price agreed upon today. No cash changes hands at inception (the forward value is zero at initiation). At expiration, the long position profits if the spot price exceeds the forward price, and the short position profits if it’s below. Forwards carry counterparty risk — if one side can’t pay, the other is exposed.

Futures contracts: The standardized, exchange-traded version of forwards. Key differences: futures are marked to market daily (gains and losses settled each day through margin accounts), standardized in terms of contract size, expiration dates, and delivery terms, and guaranteed by the clearinghouse. Daily settlement means futures have effectively zero counterparty risk but different cash flow timing than forwards.

Swap contracts: A series of forward contracts packaged together. The most common is an interest rate swap, where one party pays a fixed rate and receives a floating rate (or vice versa). The party paying fixed is effectively short a fixed-rate bond and long a floating-rate note. Swaps are used to transform the nature of cash flows — converting floating-rate debt to fixed-rate exposure (or the reverse).

Option contracts: The holder (buyer) has the right but not the obligation to buy (call option) or sell (put option) an underlying at a specified exercise price (strike price) on or before the expiration date. The seller (writer) is obligated to transact if the holder exercises. The holder pays an option premium for this right.

Credit derivatives: The curriculum also introduces credit default swaps (CDS) — the buyer pays periodic premiums and receives a payment if a credit event (default, restructuring) occurs on a reference entity. Think of it as insurance on a bond issuer’s creditworthiness. This connects directly to credit risk concepts from Fixed Income.

LM 3: Derivative Benefits, Risks, and Uses

Benefits: Risk management (hedging unwanted exposures), price discovery (derivatives markets often incorporate new information faster than spot markets), operational advantages (lower transaction costs, easier to take short positions, leverage enables capital efficiency), and market efficiency (arbitrage activity keeps prices aligned).

Risks: The flip side of leverage — small price movements create large gains or losses relative to the capital invested. Counterparty credit risk (especially for OTC contracts), liquidity risk (some derivatives trade thinly), basis risk (the derivative doesn’t perfectly track the exposure being hedged), and operational risk (model errors, trade execution failures).

Issuer uses: Companies use derivatives to hedge financial exposures — a corporation with floating-rate debt enters an interest rate swap to lock in a fixed rate; an exporter uses currency forwards to hedge foreign revenue. Investor uses: Modifying portfolio exposure (increasing equity beta with futures, adding downside protection with puts), generating income (writing covered calls), and exploiting relative value opportunities.

Block 2: Pricing Foundations (LM 4–7)

LM 4: Arbitrage, Replication, and Cost of Carry

This module establishes the three principles that underpin all derivative pricing. It’s conceptually the most important module in the entire Derivatives section.

Arbitrage: The law of one price says that two assets with identical cash flows must have the same price. If they don’t, arbitrageurs will buy the cheap one and sell the expensive one, earning a riskless profit. In well-functioning markets, arbitrage activity eliminates mispricings quickly. Derivative prices are set by no-arbitrage conditions — if the derivative price deviates from its theoretical value, an arbitrage opportunity exists.

Replication: Any derivative can be replicated by combining the underlying asset and risk-free borrowing or lending. A forward contract on a stock, for example, can be replicated by buying the stock today and financing the purchase with borrowed money. Since the forward and the replicating portfolio have identical payoffs, they must have the same cost — otherwise you can arbitrage.

Cost of carry: The forward price reflects the spot price adjusted for the costs and benefits of holding the underlying until delivery. Costs include financing (interest), storage (for commodities), and insurance. Benefits include income received (dividends, coupons) and convenience yield (for commodities). The general forward pricing framework:

Or equivalently: the forward price equals the spot price compounded at the risk-free rate, minus the future value of any benefits (like dividends), plus the future value of any carrying costs. This single framework prices forwards on stocks, bonds, currencies, and commodities.

LM 5: Pricing and Valuation of Forward Contracts

This module applies the cost-of-carry framework to specific types of forwards. A critical distinction: pricing determines the forward price at inception (what the agreed-upon delivery price should be). Valuation determines the value of an existing forward contract after inception (which can be positive or negative).

At inception, the forward contract has zero value — the forward price is set so neither party has an advantage. After inception, if the underlying price rises, the long position gains value (and the short loses). The value of a long forward position at time t:

Interest rate forward contracts (FRAs): A forward rate agreement is a forward contract on an interest rate. The buyer agrees to pay a fixed rate and receive a floating rate on a notional amount for a specified future period. FRAs are priced using the forward rates derived from the spot curve — connecting directly to the term structure concepts in Fixed Income LM 9. Settlement is typically in advance (discounted to the settlement date).

LM 6: Pricing and Valuation of Futures Contracts

At inception, futures prices are essentially the same as forward prices (with an adjustment for daily settlement). The curriculum covers mark-to-market (MTM) valuation: because futures settle daily, the contract value resets to zero each day. The cumulative gain or loss flows through the margin account. This means the value of a futures contract is always approximately zero immediately after each day’s settlement — unlike a forward, which accumulates value over time.

Forwards vs. futures price differences: If interest rates are correlated with the underlying asset price (positive correlation), futures prices will be slightly higher than forward prices (and vice versa). In practice, for most assets and short time horizons, the difference is negligible — but the concept is testable.

LM 7: Pricing and Valuation of Swaps

A swap is a series of forward contracts. An interest rate swap where you pay fixed and receive floating is economically equivalent to a series of FRAs — each covering one reset period of the swap. The swap fixed rate (SFR) is set at inception so the swap has zero value — the present value of fixed payments equals the present value of expected floating payments.

After inception, the swap’s value changes as interest rates move. If rates rise, the pay-fixed side gains (receiving higher floating payments than expected); if rates fall, the pay-fixed side loses. The curriculum walks through the pricing of the SFR using the spot rate curve and the valuation of an existing swap by computing the difference in present values.

Block 3: Options (LM 8–10)

LM 8: Pricing and Valuation of Options

Option value has two components: exercise value (intrinsic value) and time value.

Exercise value: The payoff if exercised immediately. For a call: max(S − X, 0). For a put: max(X − S, 0). If exercise value is positive, the option is in the money. If zero, it’s at the money (S = X) or out of the money.

Time value: The additional value beyond exercise value, reflecting the possibility that the option could become more valuable before expiration. Time value is always non-negative for American options and decreases as expiration approaches (time decay).

Six Factors Affecting Option Value

The volatility effect is particularly important: unlike forward commitments (where higher volatility doesn’t change the expected payoff), options benefit from higher volatility because they capture the upside while limiting the downside to the premium. More uncertainty = more option value.

LM 9: Option Replication Using Put–Call Parity

One of the most elegant and testable relationships in all of finance.

A call plus a risk-free bond (present value of the exercise price) equals a put plus the underlying stock. This means any one of the four components can be replicated using the other three. The curriculum walks through the synthetic positions:

Synthetic call = put + stock − bond (borrow PV(X)). Synthetic put = call + bond − stock (short stock, invest PV(X)). Synthetic stock = call + bond − put. Synthetic bond = stock + put − call.

These relationships create arbitrage opportunities when violated — if the left side of the equation doesn’t equal the right side, you can buy the cheap side and sell the expensive side for a riskless profit.

Put–call forward parity: Substitutes the forward contract for the underlying: c + PV(X) = p + PV(F). This is useful when the underlying is difficult or expensive to trade directly. The curriculum also introduces the option approach to firm value — equity can be viewed as a call option on the firm’s assets (with exercise price equal to the face value of debt), and debt can be viewed as a risk-free bond minus a put option.

LM 10: One-Period Binomial Model

The final module introduces a simple but powerful option pricing model. The key idea: the underlying can move to one of two states (up or down) in one period. By constructing a portfolio of the underlying and a risk-free bond that replicates the option’s payoff in both states, we can determine the option’s fair value.

The risk-neutral probability framework eliminates the need to know actual probabilities of up and down moves. Instead, we calculate the probability that makes the expected return on the underlying equal to the risk-free rate. Option value = PV of the probability-weighted expected payoff under risk-neutral probabilities:

Where π = risk-neutral probability of an up move = (1 + r − d) / (u − d), c_u = option value in the up state, c_d = option value in the down state, u = up factor, d = down factor.

This model is the foundation for multi-period binomial trees (Level 2) and ultimately the Black-Scholes-Merton model. At Level 1, you need to calculate option values using the one-period model and understand the concept of risk-neutral valuation.

Study Strategy for Derivatives

The study plan allocates 18 hours in Week 14. Here’s the priority:

LM 4 (arbitrage/replication/cost of carry) is the single most important module. If you understand these three principles, every pricing formula becomes intuitive rather than memorized. Spend extra time here.

LM 5 and LM 9 are the highest-computation modules. Forward pricing/valuation and put–call parity are heavily tested with numerical questions. Practice until the formulas are automatic.

LM 1–3 are conceptual foundations. Read for comprehension — the distinction between forward commitments and contingent claims, OTC vs. exchange-traded, and the uses/risks of derivatives. These generate straightforward conceptual questions.

LM 8 and LM 10 (options pricing, binomial model) are important but more conceptual at Level 1. Know the six factors affecting option value, the binomial model mechanics, and risk-neutral probabilities. The heavy option math comes at Level 2.

If you’ve built solid TVM and Fixed Income foundations, derivatives will click — the pricing framework is just cost of carry applied to different underlyings.