FOUNDATION 11 / Markets & risk
Instruments, leverage & payoff
Recognize basic instrument structures and separate payoff from profit before discussing risk.
By the end of this lesson
- Distinguish obligations from options.
- Calculate a simplified terminal payoff.
- Explain leverage, liquidity and omitted costs.
IBBC Capital Finance Foundations · Original content drafted with AI assistance. IBBC Capital is responsible for editorial review and content. General education, not an official CFA Institute curriculum or credential.
Map the claim before modeling
A share is a residual ownership claim; a bond is a debt claim; a pooled fund holds assets under a mandate. A fund wrapper does not determine its risk by itself: inspect underlying assets, leverage, fees, liquidity and valuation practices.
Alternative assets can differ widely. Real assets, private equity and private debt have distinct cash flows and constraints. Infrequent reported prices may make measured volatility look low without making economic risk low.
Forwards and futures: obligations
A simplified long forward agrees to buy at delivery price K. Its terminal payoff per unit is Sₜ−K; the short side is K−Sₜ. Entering a forward does not mean receiving an option to walk away.
Futures have standardized exchange arrangements and typically daily settlement; forwards are commonly bilateral. Margin, collateral and counterparty arrangements matter. This lesson’s terminal formula omits daily cash-flow timing, financing and contract-specific details.
Options: rights with a price
At expiry, a long call payoff is max(Sₜ−K,0); a long put payoff is max(K−Sₜ,0). Simplified profit subtracts the premium paid. This ignores the time value of premium financing, fees and taxes.
For the buyer, paying premium can lead to a total premium loss if the option expires worthless. A writer’s risk is different and can be large. Do not infer writer risk from the buyer’s limited-premium-loss diagram.
Leverage and liquidity constraints
Notional exposure can greatly exceed initial cash posted. A small price move can create a large percentage change relative to capital committed. Margin calls may require cash before a hedge’s economic benefit is realized.
A hedge changes a chosen exposure; basis risk, timing mismatch and transaction costs can remain. Identify the underlying exposure and measure the combined position rather than labeling a derivative safe or dangerous in isolation.
Long call at expiry
- Strike 100; premium 5; terminal underlying price 112; one unit.
- Payoff = max(112−100,0) = 12. Simplified profit = 12−5 = 7.
- At terminal price 95, payoff is 0 and simplified profit is −5. The premium is not refunded.
Try before looking at the explanation
Change one input in the practice tool below. Predict the direction first, calculate second, then explain why it changed.
Work the numbers
Common mistakes to catch
- Reporting option payoff as profit without the premium.
- Assuming initial margin is the maximum possible loss.
- Calling stale reported prices evidence of low risk.
Knowledge check · 6 original questions
Answer all six. At least five correct marks the lesson complete for self-study. You can retry; this is not a credential.
Keep these ideas
- Understand obligations, cash timing and costs before using a payoff formula.
- A simple payoff model is not a trading recommendation.