Derivatives is one of the lighter sections at CFA Level 1 with a 5-8% weight, but it has an outsized reputation for difficulty. Candidates who haven’t encountered derivatives before often find the concepts unfamiliar and intimidating — payoff diagrams, put-call parity, and forward pricing can feel alien compared to the relatively intuitive world of equity valuation.
Here’s what I tell my mentees: Derivatives at Level 1 is not as hard as people make it out to be. The curriculum covers the basics, and the exam tests fundamental understanding rather than complex calculations. If you approach it methodically, this section becomes very manageable — and it builds a critical foundation for Levels 2 and 3, where derivatives carry much more weight.
What Derivatives Covers at Level 1
What Is a Derivative?
A derivative is a financial instrument whose value is derived from the value of an underlying asset. That’s it. The underlying asset could be a stock, a bond, a commodity, an interest rate, or even another derivative.
The four main types at Level 1 are forwards, futures, options, and swaps.
Forward Contracts
A forward contract is a private agreement between two parties to buy or sell an asset at a specific price on a future date.
Key characteristics:
- Customized and traded over-the-counter (OTC)
- No exchange or clearinghouse involvement
- Counterparty risk is present
- No daily settlement (profit/loss realized at expiration)
The forward price formula: Forward Price = Spot Price x (1 + Risk-free Rate)^T
For assets with income (dividends, coupons) — such as those covered in our Fixed Income guide — you subtract the present value of that income. For storage costs (commodities), you add them.
Exam focus: You need to calculate the forward price and understand the value of a forward contract at different points in its life. At initiation, the value of a forward contract is zero. As the underlying price moves, one party gains and the other loses.
Futures Contracts
Futures are standardized forward contracts traded on exchanges. The key differences from forwards:
- Standardized terms (contract size, expiration dates)
- Exchange-traded with clearinghouse guarantee
- Daily mark-to-market settlement (margin accounts)
- Minimal counterparty risk
- Much higher liquidity
What the exam tests: The differences between forwards and futures, the margin system (initial margin, maintenance margin, margin calls), and how daily settlement affects the economics compared to forwards.
Options
Options give the holder the right — but not the obligation — to buy or sell an asset at a specified price by a specified date.
Call options: Right to buy. You profit when the price goes up. Put options: Right to sell. You profit when the price goes down.
Key concepts:
- Strike price (exercise price)
- Premium (the cost of the option)
- Intrinsic value vs. time value
- In-the-money, at-the-money, out-of-the-money
- American vs. European options
- Moneyness and its relationship to the underlying price
Payoff diagrams are essential. The exam may not literally ask you to draw one, but understanding the shape of payoff profiles for long calls, short calls, long puts, and short puts is fundamental to answering options questions correctly.
Put-Call Parity: c + PV(X) = p + S
Where c is the call price, PV(X) is the present value of the strike price, p is the put price, and S is the current stock price. This relationship is tested frequently and is one of the most important formulas in the Derivatives section.
Swaps
A swap is an agreement to exchange a series of cash flows over time. The most common type at Level 1 is the plain vanilla interest rate swap.
- One party pays a fixed rate
- The other pays a floating rate (typically LIBOR or its replacement)
- Only the net difference is exchanged
Conceptual framework: Think of a swap as a series of forward contracts bundled together. Each payment date is essentially a forward agreement on an interest rate. This mental model helps in understanding swap valuation.
Basics of Derivative Pricing and Valuation
At Level 1, pricing focuses on the no-arbitrage principle: if two portfolios produce identical cash flows, they must have the same price. If they don’t, an arbitrage opportunity exists.
Key principles:
- Replication: Create a portfolio that replicates the derivative’s payoff
- No-arbitrage: Price the derivative to prevent riskless profit
- Risk neutrality: A simplifying assumption used in derivative pricing
Why Derivatives Matter
Foundation for advanced levels: At Level 2, derivatives expand to include the binomial option pricing model, Black-Scholes-Merton, and complex swap structures. At Level 3, derivatives become tools for portfolio risk management. A weak Level 1 foundation creates serious problems later.
Professional relevance: Derivatives are used extensively in risk management, hedging, and structured product design. Understanding them is essential for any career in institutional finance, including hedge funds where derivatives are core tools.
Efficient scoring: Despite the intimidation factor, Derivatives questions at Level 1 tend to be formulaic. If you learn the core concepts and practice the calculations, these become reliable points.
Study Strategy for Derivatives
Start with forwards — they’re the simplest
Forwards are the most basic derivative. Once you understand how a forward contract works — the obligation, the pricing, the payoff — futures and swaps become natural extensions.
Draw every payoff diagram by hand
For options, the single best study technique is drawing payoff diagrams repeatedly. Draw the payoff for:
- Long call
- Short call
- Long put
- Short put
- Covered call (long stock + short call)
- Protective put (long stock + long put)
Do this on paper until you can sketch any payoff diagram from memory in under 10 seconds. This visual fluency translates directly into faster, more accurate exam answers.
Memorize put-call parity and practice rearranging it
Put-call parity can be tested in many ways:
- Given three of the four variables, solve for the fourth
- Identify an arbitrage opportunity when parity is violated
- Determine the appropriate arbitrage strategy
Practice rearranging the formula to isolate each variable. This flexibility is what the exam rewards.
Understand swaps as a series of forwards
Don’t try to learn swaps as an entirely new concept. A plain vanilla interest rate swap is just a bundle of forward rate agreements (FRAs). Each payment date represents one forward contract. This framing makes swap valuation and the economics of swaps much more intuitive.
Common Mistakes in Derivatives
Mistake 1: Confusing the positions in options. The buyer of a call has the right to buy. The seller of a call has the obligation to sell. The buyer of a put has the right to sell. The seller of a put has the obligation to buy. Mixing these up leads to incorrect payoff calculations.
Mistake 2: Forgetting that the forward contract has zero value at initiation. Many candidates confuse forward price with forward value. The forward price is set so the contract has zero value at initiation. The value changes over the life of the contract as the underlying price moves.
Mistake 3: Ignoring the cost of the option premium in profit calculations. Payoff is not the same as profit. Payoff = Intrinsic value at expiration. Profit = Payoff minus the premium paid. The exam may ask for either, and using the wrong one costs marks.
Mistake 4: Misapplying put-call parity to American options. Put-call parity in its standard form applies only to European options. American options have early exercise features that can break the equality. The exam will specify European options when testing put-call parity.
Mistake 5: Not understanding margin mechanics in futures. A margin call happens when the margin account falls below the maintenance margin. The amount deposited brings the account back to the initial margin (not the maintenance margin). This is a subtle but frequently tested distinction.
Practical Exam Tips
Tip 1: For forward pricing questions, always check whether the underlying pays income (dividends, coupons). If it does, adjust the formula by subtracting the present value of the income.
Tip 2: For options questions, quickly determine whether the option is in-the-money, at-the-money, or out-of-the-money before attempting any calculation. This framing prevents errors.
Tip 3: Swap questions at Level 1 are mostly conceptual — they test your understanding of the mechanics rather than complex valuation. Focus on understanding who pays what and when.
Tip 4: When in doubt about a derivative’s risk exposure, think about who benefits when the underlying price goes up vs. down. This directional thinking clarifies most questions.
Time Allocation
Budget 20-30 hours for Derivatives:
- Forward contracts: 4-5 hours
- Futures contracts: 3-4 hours
- Options (including put-call parity): 7-10 hours
- Swaps: 3-4 hours
- Derivative pricing principles: 3-4 hours
- Practice problems: 4-6 hours
Options deserve the most time because they have the most complexity and the most question variety.
Final Thoughts
Derivatives at Level 1 is about building a vocabulary and framework, not about mastering complex pricing models. The exam tests whether you understand what each derivative does, how it’s priced, what its payoff looks like, and the key differences between types.
Approach it with the right mindset — methodical, visual (draw those payoff diagrams), and connected to what you already know from other sections like Quantitative Methods — and Derivatives becomes one of your more efficient study subjects.
If derivatives feel overwhelming or you want structured guidance on building intuition for these instruments, reach out for a free mentorship session. A few hours of targeted coaching can turn Derivatives from a feared section into a reliable source of exam points.