## PAPER NO. 18 DERIVATIVES ANALYSIS

**GENERAL OBJECTIVE**

This paper is intended to equip the candidate with the knowledge, skillsand attitudes that will enable him/her to analyse and trade in derivatives.

**LEARNING OUTCOMES**

A candidate who passes this paper should be able to:

- Build the conceptual framework for understanding the basic derivatives and derivative
- Apply the key valuation concepts and models for forward commitments and contingent claims
- Evaluate the features, structure and operations of derivatives markets
- Demonstrate and explain risk management applications of derivatives strategies
- Understand the framework for risk management so as to enable identification, assessment and control of numerous sources of

### CONTENT

**Introduction to derivative markets and instruments**

- Introduction
- Types of derivatives: forward commitments; contingent claims
- Overview of derivative markets; regulation, players
- The purposes of derivative markets
- Criticisms of derivative markets
- Elementary principles of derivative pricing

### Forward markets and contracts

- Introduction: Delivery and settlement of a forward contract; default risk and forward contracts; termination of a forward contract
- The structure of global forward markets
- Types of forward contracts: equity forwards; bond and interest rate forward contracts; currency forward contracts; other types of forward contracts
- Pricing and valuation of forward contracts: generic pricing and valuation of a forward contracts; pricing and valuation of equity forward contracts; pricing and valuation of fixed- income and interest rate forward contracts; pricing and valuation of currency forward contracts
- Credit risk and forward contracts
- The role of forward markets

### Futures markets and contracts

- Introduction: brief history of futures markets; public standardised transactions; homogenisation and liquidity; the clearinghouse; daily settlement; and performance guarantee; regulation
- Futures trading: the clearinghouse, margins, and price limits; delivery and cash settlement; futures exchanges
- Types of futures contracts: short-term interest rate futures contracts; intermediate- and long- term interest rate futures contracts; stock index futures contracts; currency futures contracts
- Pricing and valuation of futures contracts: generic pricing and valuation of a futures contract; pricing interest rate futures, stock index futures, and currency futures
- The role of futures markets and exchanges

### Risk management applications of forward and futures strategies

- Introduction
- Strategies and applications for managing interest rate risk: managing the interest rate risk of a loan using an FRA; strategies and applications for managing bond portfolio risk
- Strategies and applications for managing equity market risk: measuring and managing the risk of equities ; managing the risk of an equity portfolio; creating equity out of cash; creating cash out of equity
- Asset allocation with futures: adjusting the allocation among asset classes: pre-investing in an asset class
- Strategies and applications for managing foreign currency risk: managing the risk of a foreign currency receipt; managing the risk of a foreign currency payment; managing the risk of a foreign-market asset portfolio

### Swap markets and contracts

- Introduction: characteristics of swap contracts; termination of a swap
- The structure of global swap markets
- Types of swaps: currency swaps; interest rate swaps; equity swaps; commodity and other types of swaps
- Pricing and valuation of swaps; equivalence of swaps and other instruments; pricing and valuation
- Swaptions: basic characteristics of swaptions; uses of swaptions; swaption payoffs; pricing and valuation of swaptions
- Forward swaps
- Credit risk and swaps
- The role of swap markets

### Risk management application of swap strategies

- Introduction
- Strategies and applications for managing interest rate risk: using interest rate swaps to convert a floating-rate loan to a fixed-rate loan (and vice versa); using swaps to adjust the duration of a fixed-income portfolio; using swaps to create and manage the risk of structured notes
- Strategies and applications for managing exchange rate risk: converting a loan in one currency into a loan in another currency; converting foreign cash receipts into domestic currency; using currency swaps to create and manage the risk of adual-currency bond
- Strategies and applications for managing equity market risk; diversifying a concentrated portfolio; achieving international diversification; changing an asset allocation between stocks and bonds; reducing insider exposure
- Strategies and applications using swaptions; using an interest rate swaption in anticipation of a future borrowing; using an interest rate swaption to terminate a swap;

### Option markets and contracts

- Introduction
- Basic definitions and illustrations of options contracts: basic characteristics of options; some examples of options; the concept of moneyness of an option
- The structure of global options markets: over-the-counter options markets; exchange-listed option markets
- Types of options: financial options; options on futures; commodity options; other types of options
- Principles of option pricing; payoff values: boundary conditions; the effect of a difference in exercise price; the effect of a difference in time to expiration; put-call parity; American options, lower bounds, and early exercise; the effect of cash flows on the underlying asset; the effect of interest rates and volatility; option price sensitivities
- Discrete-time option pricing: the binomial model; the one-period binomial model; the two- period binomial model; binomial put option pricing; binomial interest rate option pricing; American options: extending the binomial model
- Continuous-time option pricing: the Black-Scholes-Merton model; assumptions of the model; the black-Scholes-Merton formula; inputs to the black-Scholes-Merton model; the effect of cash flows on the underlying;the critical role of volatility
- Pricing options on forward and futures contractsand an application to interest rate option pricing: put-call parity for options on forwards; early exercise of American options on forward and futures contracts; the black model; application of the black model to interest rate options
- The role of options markets

### Risk management applications of swap strategies

- Introduction
- Strategies and applications for managing interest rate risk:using interest rate swaps to convert a floating-rateloan to a fixed-rate loan (and vice versa); using swaps to adjust the duration of a fixed-income portfolio; using swaps to create and manage the risk of structured notes
- Strategies and applications for managing exchange rate risk:converting a loan in one currency into a loan in another currency; converting foreign cash receipts into domestic currency; using currency swaps to create and manage the risk of adual-currency bond
- Strategies and applications for managing equity market risk;diversifying a concentrated portfolio; achieving international diversification; changing an asset allocation between stocks and bonds; reducing insider exposure
- Strategies and applications using swaptions; using an interest rate swaption in anticipation of a future borrowing; using an interest rate swaption to terminate a swap

### Emerging issues and trends