PAPER NO.16 DERIVATIVES ANALYSIS

UNIT DESCRIPTION

This paper is intended to equip the candidate with the knowledge and skills that will enable him/her to analyse and trade in the various types of derivative investments.

LEARNING OUTCOMES

• Demonstrate an understanding of the features, structure and operations of derivatives markets

• Develop a framework for pricing various types of derivatives

• Value derivative instruments using discrete time and continuous time valuation principles.

• Price and hedge interest rate swaps

• Use financial derivative instruments for managing and hedging portfolio risk.

• Apply the framework for risk management so as to enable identification, assessment and control of numerous sources of risk

CONTENT

1. Introduction to Derivative Markets and Instruments

1.1 Introduction to Derivatives

1.2 Derivative specific definitions and terminologies

1.3 Types of Derivatives: forward commitments, contingent claims, financial futures, forward contracts, options, swaps, Exotic Derivatives, Forwards: Range forward contract, break forward contract; Options: Asian or average-rate options, Look back options, Barrier options, Rainbow options, Compound options, Chooser options; Swaps: Interest rate swap variants, Currency swap variants, Equity swap variants

1.4 Overview of derivative markets; regulation, players, Trading of financial derivatives, Trading of commodities derivatives, Buying and shorting financial assets

1.5 The Structure and purpose of derivative markets

1.6 Users and uses of financial derivatives

1.7 Criticisms of derivative markets

1.8 Elementary principles of derivative pricing

1.9 Size and Scope of derivatives markets; Global and regional derivatives markets

2. Forward Markets and Contracts

2.1 Introduction to forward markets and contracts

2.2 The structure and role of forward markets

2.3 Types of forward contracts: equity forwards contracts; bond and interest rate forward contracts; currency forward contracts; other types of forward contracts

2.4 Mechanics of Forward Markets and Contracts; Delivery and settlement of a forward contract; default risk and forward contracts; termination of a forward contract; cost of carry and transaction costs

2.5 Pricing and valuation of forward contracts: generic pricing and valuation of 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

2.6 Credit risk and forward contracts

3. Futures Markets and Contracts

3.1 Introduction: Definition of Futures, Brief history of futures markets;

3.2 Types of futures contracts: short-term interest rate futures contracts; intermediate- and long-term interest rate futures contracts; Bond futures contracts; stock index futures contracts; currency futures contracts; Commodities futures contracts – Agricultural, Energy, Precious and Industrial metal futures

3.3 Characteristics of Futures markets: Public standardized transactions; homogenisation and liquidity; the clearinghouse; daily settlement; and performance guarantee; regulation

3.4 Futures trading: the clearinghouse, margins, and price limits; delivery and cash settlement; futures exchanges. Mechanics of trading in futures markets; Long and short positions, Profit and loss at expiration, Closing of positions, Delivery procedures, marking to market of futures contracts, leverage effect, futures quotes

3.5 Pricing and valuation of futures contracts: generic pricing and valuation of a futures contract; pricing interest rate futures, stock index futures, and currency futures; Factors determining contract price – CAPM, hedging pressure theory and cost of carry model; Theoretical and Reality price of futures; Comparing the calculated value of the future vs the market

3.6 Uses of financial and non-financial futures

3.7 The role of futures markets and exchanges

4. Risk Management applications of Forward and Futures strategies

4.1 Introduction to risk exposures managed by Forwards and Futures

4.2 Strategies and applications for managing interest rate risk: managing the interest rate risk of a loan using a forward contract; strategies and applications for managing bond portfolio risk

4.3 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

4.4 Asset allocation with futures: adjusting the allocation among asset classes; pre- investing in an asset class

4.5 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

4.6 Hedging strategies using futures: hedge ratio, perfect hedge, basis risk and correlation risk, minimum variance hedge ratio and hedging with several futures contracts.

5. Swap Markets and Contracts

5.1 Introduction: Definition of Swap contracts, Types of swaps: currency swaps; interest rate swaps; equity swaps; commodity and other types of swaps

5.2 Characteristics of swap contracts

5.3 The structure of global swap markets

5.4 Pricing and valuation of swaps; pricing and valuation of swaps

5.5 Swaptions: basic characteristics of swaptions; uses of swaptions; swaption payoffs; pricing and valuation of swaptions

5.6 Termination of a swap

5.7 Forward swaps

5.8 The role of swap markets

5.9 Uses of Swap Contracts: Credit risks and swaps

6. Risk management application of swap strategies

6.1 Introduction to risk exposures managed by Swaps

6.2 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, reducing the cost of debt

6.3 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 a dual-currency bond

6.4 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

6.5 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

7. Option markets and contracts

7.1 Introduction: Basic definitions and illustrations of options contracts:

7.2 Types of options: Financial options; options on futures; commodity options; other types of options

7.3 Characteristics of Options Contracts: some examples of options;

7.4 The concept of moneyness of an option

7.5 The structure of global options markets: over-the-counter options markets; exchange-listed option markets

7.6 Options Valuation: Determinants of option price, Option pricing models, sensitivity analysis options premiums

7.7 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

7.6 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

7.7 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

7.8 Pricing options on forward and futures contracts and 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

7.9 The role of options markets;

7.10 Uses of Options

8. Risk management applications of option strategies

8.1 Introduction to risk exposures managed by options

8.2 Option strategies for equity portfolios: standard long and short positions; risk management strategies with options and the underlying; money spreads; combinations of calls and puts

8.3 Interest rate option strategies using: interest rate calls with borrowing; interest rate puts with lending; an interest rate cap with a floating-rate loan; an interest rate floor with a floating-rate loan; an interest rate collar with a floating-rate loan

8.4 Option portfolio risk management strategies: delta hedging an option over time; gamma and the risk of delta; vega and volatility risk; the Greeks.

9. Contemporary issues and emerging trends in derivatives Contracts

9.1 Numerical methods of Pricing Options: binomial model, finite difference method and Monte Carlo method.

9.2 Credit derivatives: Credit default swaps (CDS), Credit linked notes (CLN), role of credit derivatives, market participants, Valuation of credit derivatives, credit derivatives institutional framework, spread volatility of credit default swaps

9.3 Financial Engineering; Construction, Uses and Abuses of Derivatives

9.4 Applications of Artificial intelligence and financial technology in derivatives markets

9.5 Benefits and Indispensability of derivatives

9.6 Trends and future of derivatives market globally

9.7 Effects of Crises and Pandemic on global derivatives market

Sample reading and reference material

1. Hull, J. C. (2011). Options, Futures and Other Derivatives (10th edition). New Delhi: Prentice Hall.

2. Gupta, D. S. (2005). Financial Derivatives: Theory, Concepts and Problems. New Delhi: Prentice Hall India.

3. Rendleman, R. (2008). Applied Derivatives: Options, Futures and Swaps. Wiley-Blackwell.

4. Solnik, B., & McLeavey, D. (2008). Global Investments (6th edition). Pearson.

5. Kasneb e-learning resources (link on the Kasneb website).

6. Kasneb approved study packs.