CHAPTER 1 - INTRODUCTION TO DERIVATIVES - 4 QUESTIONS

CHAPTER OVERVIEW

Basic Futures
• The core concepts of futures, forwards and CFDs
• Purpose, risk and return
• Profit and loss of long and short positions
Speculating and Hedging with Futures
• Open interests vs volume
• Hedging with futures
Basic Options
• The core concepts of options
• Purpose, risk and return
• Profit and loss of long and short positions
Other considerations with options
• The significance of gearing
• Over-the-counter products vs exchange-traded products

2. FUTURES AND FORWARDS

(2.1) WHAT IS A FUTURE?

A futures contract is an agreement to buy or sell a specified quantity of a specified asset on a specified future date at a price
agreed today. The buyer The seller
(Long position) (Short position)

‘I agree to buy one tonne of cocoa ‘I agree to sell one tonne of cocoa
(the underlying asset) from you, in to you, in three months, for £500.’
three months, for £500.’

Note: Nothing is bought (or sold) today. The terms and conditions are fixed today regarding a transaction to be completed in the
future.

FURTHER INFORMATION
• Contingent liability: A contingent liability transaction describes a derivative position where an investor may lose more
money than they originally invested. All futures transactions are contingent liability transactions.
• Hints: The Exchange sets all the terms of a futures contract except the price.

(2.2) FORWARDS
• Over-the-counter (OTC) futures
• Advantages over futures
o Flexibility
o Wide range of underlying assets

(2.3) CONTRACT FOR DIFFERENCES (CFD)

• Cash settled contract
• Designed for when physical delivery is impossible or impractical
 o Interest rates
o Indices

(2.4) SPREAD BETTING

• Informal CFD
• Up bet/Down bet

FURTHER INFORMATION
Spread betting versus contract for differences: In most jurisdictions, spread betting is classed as gambling and as such it is not
subject to capital gains tax. However contract for differences are classified as investments and subject to capital gains tax.

(2.5) USES OF FUTURES

Speculation
• Seek to make profits from price movements
• Take on risk
Hedging
• Protection against adverse price movements
• Reducing risk
Arbitrage
• Profiting from differing prices of equivalent assets

FURTHER INFORMATION
2.5 Uses of futures
The four most common forms of arbitrage are:
• Intertemporal – for example, when the prices between the one-month and six-month LME zinc contracts are ‘out-of-
line’
• Geographic – as between two identical contracts across multiple exchanges; for example, when the prices of the
Singapore Exchange’s June Eurodollar future is different from the CME’s June contract
• Value-chain – as between the prices of crude oil and refined product
• Index arbitrage – if the weighted constituents of an index can be bought or sold at a significantly different price from
where the index is trading

(2.6) FUTURES PROFIT AND LOSS PROFILES Long futures position

The long futures position makes money in a rising market but loses money in Pr
a falling market. ofi Profit

500 Price
Loss
Lo
ss
Prices falling Prices rising

FURTHER INFORMATION
Payoff assumptions - Profit and loss profiles (or payoffs) show graphically the gains and losses that can be made by different
derivative positions. They work on the following assumptions:
• Speculation – the investor neither has nor wants the asset
• No frictional costs – there are no transactional fees or taxes
Rule of law – Contract: A future/forward is a contract and, once the terms are agreed, the conditions set out are binding upon
the parties involved.
(2.6) FUTURES PROFIT AND LOSS PROFILES Short futures position

The short futures position makes money in a falling market but loses moneyProin a
fit Profit
rising market.
Price
500
Loss
Lo
ss
Prices falling Prices rising

FURTHER INFORMATION
An investor with an open futures position, either long or short, has two choices:
• To hold the future to expiry and then take/make delivery of the underlying, or cash (where CFD).
• To sell/buy the future before the expiry date. This is known as closing out. Closing out is achieved by entering into an
equal but opposite contract in order to offset the terms of the first.

(2.6) FUTURES PROFIT AND LOSS PROFILES

Price risk / Market risk
Max gain Max loss
Long futures Unlimited Limited to the price of the future
Short futures Limited to the price of the future Unlimited
The long and short positions are mirror images of each other. Consequently, futures contracts are sometimes called a ‘zero sum
game’.

(2.7) OTHER RISKS

• Counterparty risk: The risk of loss resulting from your counterparty not meeting their contractual obligations
• Liquidity risk: The risk of loss resulting from being unable to enter or exit a contract at a fair price within a reasonable
timeframe
• Operational risk: The risk of loss resulting from inadequate or failed internal processes, people and systems, or from
external events

FURTHER INFORMATION
Liquidity risk - Key elements of a liquid market
• Many buyers and sellers
• Small bid/offer spreads
• Low commissions
• Low price elasticity

(2.5) CLOSING OUT

$275
B Sells Buys
A

Buys Sells

$300 $290

Sells C Buys
FURTHER INFORMATION
• Hints: The aggregate total of the individual profits and losses is zero (each person's profits must come from someone
else's losses). Even when there are more than two participants in the market, the futures market is still a zero sum
game.
• Links: In the chapter ‘Exchange-traded Futures and Options’ you will learn that exchanges need to be transparent
markets. To achieve this, they are required to show the volume and open interest on each type of contract.
• Volume: This represents the current liquidity as it shows the number of contracts that have been opened.
• Open interest: This gives an idea of future liquidity as it shows the number of contracts that remain open, indicating

(2.5) HEDGING Short future at Long cash at

£75 per tonne £60 per tonne

Overall profit of £15 per tonne

Profit

60 75
Loss

e.g.,1
e.g.,2
e.g.,3
By producing barley at £60 per tonne and selling barley futures at £75 per tonne, the farmer is ‘locking in’ a profit of £15 per
tonne.

FURTHER INFORMATION
Keeping on target: Which of the following best describes hedging?
a. Taking an opposite position in futures to your position in the underlying
b. Buying and selling futures or options
c. Taking a matching position in futures to your position in the underlying
d. Buying futures in anticipation of a rise in the value of the underlying asset
Answer = A - Taking an opposite position in futures to your position in the underlying.

(2.5) HEDGING
Summary
Long underlying Short underlying
Concerned about Falling prices Rising prices
Hedging strategy Short hedge (Selling futures) Long hedge (Buying futures)

3. OPTIONS

(3.1) WHAT IS AN OPTION?

An option gives the buyer the right (but not the obligation) to buy or sell a specified quantity of a specified asset at a fixed price
on, or before, a specified future date

£ pays premium

Buyer Confers rights Seller

Holder long Writer short
Has rights Has obligations
(If the buyer exercises their rights)
FURTHER INFORMATION
Key differences between an option and a future
• Futures – both buyer and seller have an obligation
• Options – buyer has a right; seller has a potential obligation
• Options – buyer pays a premium to the seller

Holder (Bullish) Call Writer

Right to sell
1 share for
£2 on x
date

Premium = 10p

Holder (Bearish) Put Writer (Bullish)

Right to sell
1 share for
£2 on x
date

Premium = 60p

Rule of law – Contracts: An option is a contract and once the terms are agreed, the conditions set out are binding upon the
parties involved. However, remember that one of those conditions is to confer rights to the buyer.

(3.2) OPTIONS TERMINOLOGY

• Holder/Writer
• Call/Put
• Strike price/Exercise price
o Price at which the underlying asset will be bought or sold
• Expiry style
o European: Exercised on expiry only
o American: Exercised on any business day up to and including expiry
o Bermudan: Exercised on a series of pre-specified dates up to and including expiry

FURTHER INFORMATION
Hints: Although not on the learning objective, the examiner may use Bermudan options as a distractor answer.

(3.3.1) OPTIONS PROFIT AND LOSS PROFILES 20

Long call Breakeven (110) = strike + premium
Pro 10
fit
0
60 70 80 90 100 110 120 130 140
Los -10
A long call position is a bullish strategy. It makes money in a s Option abandoned Option exercised
rising market. -20

FURTHER INFORMATION
Moneyness of call options: The moneyness of any option is determined solely by considering the relationship between the strike
price and the price of the underlying asset. Moneyness has nothing to do with the premium.
 Call Moneyness
Asset price < Strike price Out-of-the-money (OTM)
Asset price = Strike price At-the-money (ATM)
Asset price > Strike price In-the-money (ITM)

(3.3.2) OPTIONS PROFIT AND LOSS PROFILES

Short call

20

Breakeven (110) = Strike + Premium

A short call position is a bearish / neutral strategy. The writer Pr 10
keeps the premium if the market falls. ofi
t
0
60 70 80 90 100 110 120 130 140
FURTHER INFORMATION
Los -10
Keeping on Target: A market maker writes a call option with an exercise
s price of 210 and sells it for 20. If on expiry the asset
Option abandoned Option exercised
price is 220, what profit or loss is made?
-20
a. 10 loss
b. No loss, no gain
c. 10 profit
d. 20 profit
Answer: C - The call option will be exercised by the holder, losing the market maker 10. However, this only reduced the 20-
premium collected at the start, so the market maker is still in profit by 10.

120
(3.3.3) OPTIONS PROFIT AND LOSS PROFILES
Breakeven (140) = Strike - Premium
Long put Pro 60
fit
0
80 140 200 260 320 380 440 500 560

Los -60
A long-put option is a bearish strategy. You make money in a s Option exercised Option abandoned
falling market. -120

FURTHER INFORMATION
Put Moneyness
Asset price < Strike price In-the-money (ITM)
Asset price = Strike price At-the-money (ATM)
Asset price > Strike price Out-of-the-money (OTM)
The moneyness of put options: Notice the relationship between the strike price and the asset price for the moneyness of put
options is the opposite of that with call options.
Hints: Notice that the moneyness of an option does not consider the premium paid for the option. Only the strike price and the
asset price is considered.

120
(3.3.4) OPTIONS PROFIT AND LOSS PROFILES
Breakeven (140) = Strike - Premium
Short put
Prof 60
it
0
80 140 200 260 320 380 440 500 560

Los -60
A short put position is a bullish/neutral strategy. The writer s Option exercised Option abandoned
keeps the premium if the market rises. -120
FURTHER
• Compound
INFORMATION
option – an option to buy (or sell) another option
Keeping
• onRainbow
Target:option
An investor
– an option
buys a where
put option
the with
underlying
an exercise
is a number
price of of
365different
for a premium
asset. AKA
of 17.
multi-asset
If on expiry
option,
the asset
correlation
price is
355, whatoption,
profit basket
or loss option
is made?
a. 10 profit
b. 7 loss
c. 10 loss
d. 17 loss
Answer: B - The put option will be exercised, making 10 for the investor. However, this only reduced the 17-premium paid at the
start, so the investor makes a loss of 7.

(3.4) RISK AND REWARD SUMMARY Call Put

Options profiles: Summary
Pr Pr
Holder ofi ofi
Long
Buyer Underlying Underlying
Lo Lo
ss ss

Pr Pr
Writer ofi ofi Underlying
Short
Seller Underlying
Lo Lo
ss ss

FURTHER INFORMATION
Hints: The key elements of the option payoff profiles are summarised in the table below.
Position Strategy Max loss Max gain Breakeven
Long call Bullish Premium Unlimited Strike plus premium
Short call Bearish/ neutral Unlimited Premium Strike plus premium
Long put Bearish Premium Strike minus premium Strike minus premium
Short put Bullish/ neutral Strike minus premium Premium Strike minus premium
Keeping on Target: Which two of the following would receive the underlying upon exercise of the option?
a. Long call and long put
b. Long call and short call
c. Long call and short put
d. Short call and short put
Answer: C Long call = right to buy; Short put = potential obligation to buy

(3.2) OPTIONS TERMINOLOGY

Other forms of option
• Binary (digital) option: Pays a fixed amount or nothing at all depending on the price of the underlying asset
• Lookback option: Allows the holder to exercise against the highest (or lowest) price of the underlying asset over a
predetermined period
• Asian (known as Trade Average Priced Option on LME): Allows the holder to exercise against an average price of the
underlying asset over a predetermined period
• Barrier option: Where the option is activated at a set price of the underlying asset (knock-in price) or deactivated at a
set price of the underlying asset (knock-out price)
FURTHER INFORMATION
Hints: Lookbacks and Asian options are sometimes called path-dependent options.
Other options - Mentioned in the workbook, but not on the syllabus are the following options:
• Chooser option – where the holder buys into a strike price, but gets to choose whether the option is a call or a put on a
set future date Long put Long underlying
(Strike £65, (Potatoes at £62
15 premium £5) per tonne)

10
(8.4.1) HEDGING WITH OPTIONS

A farmer has one tonne of potatoes and is worried that their price may fall. To protect himself against this they buy a put option.

FURTHER INFORMATION
• Hedging with options - covered in Chapter 8, Section 4, of your manual. Physically delivered options – match the
contract size (e.g., 25 tonnes, 1,000 shares) to the underlying assets being held. Cash settled options – match the
exercise value (e.g., 7,400 points x £10 per point) to the value of the underlying asset being held.
• Synthetics: In chapters 3 and 8 you will look at the concept of synthetic positions. Synthetic positions are created when
combining two or more investments together to mimic the payoff profile of another. On the slide we have an investor
who has a long underlying position. They hedge this with a long put. The resultant payoff looks like the payoff of a long
call. A long position in the asset with a long put creates a synthetic long call.

Keeping on Target - Which of the following is true of a call option?

a. The buyer receives a premium
b. It is used to hedge a short underlying position
c. The holder expects the underlying value to fall
d. There is no limit to the potential downside loss for the holder
Answer: B - Instead of a long future and hedger of a short position (e.g., I need the asset in 3 months) could use a long call

(3.6) FLEX OPTIONS

OTC elements
• Negotiated
Strike/Exercise prices
Expiry dates
Expiry styles

(3.7) OPTIONS ON FUTURES

‘Futures style’ options settle into futures positions
• Unlike ‘upfront-style’ options (long pays premium T+1), these futures style option premiums are paid on close (i.e. on
exercise or abandonment)
Long call
Short put Long future

Long put Short future

Short call
FURTHER INFORMATION
Hints: Like futures, contract specifications apply to exchange-traded options too.

Specified on flex option

Quantity Asset
Specified on standard
exchange -traded options
Strike Expiry date
Expiry style
Premium
A lot of options tend to settle into futures and so premiums are not required upfront. These are sometimes called ‘future style’
options. Premium Payment

Upfront (T+1) On close – ‘future

style’ options

Options on the Options on futures

asset/cash settled
contracts

4. GEARING

(4.1) OPTIONS GEARING

Initial investment compared to actual value of the position
• E.g., long $10.50 call on silver for a premium of $0.10 when silver is at $10.00 per troy ounce (unit of trading: 5,000 troy
ounces)
• Silver on expiry: $10.80
Comparison
• Situation 1 – invest in silver
o Buy silver at $10.00 per troy ounce
o Sell silver at $10.80 per troy ounce
o Percentage return = $0.80 / $10.00 = 8%
• Situation 2 – invest in the option
o Buy option at $0.10 per troy ounce
o Close out option to capture $0.30 intrinsic value ($0.20 profit)
o Percentage return = $0.20 / $0.10 = 200%

FURTHER INFORMATION
Hints: Gearing is, unfortunately, not always a positive thing. Consider the same investment but at expiry silver is trading at
$10.50.
Situation 1 – invest in silver
• Buy silver at $10.00 per troy ounce
• Sell silver at $10.50 per troy ounce
• Percentage return = $0.50 / $10.00 = 5%
Situation 2 – invest in the option
• Buy option at $0.10 per troy ounce
• Abandon the ATM option with no gain
• Percentage return = - $0.10 / $0.10 = -100% (or a 100% loss)
Individual Liberty: Capital markets give investors the ability to invest in many different instruments including derivatives. It is key
that investors understand the risks and are able to afford those risks. Derivatives are geared instruments and they are also
contingent liability instruments. This poses hidden risks to those who do not understand them. Whilst UK regulations will protect
investors to a certain degree, we also have to make sure we are comfortable that we understand those risks and are able to live
with them should we suffer any losses.
 6. EXCHANGE-TRADED VS. OTC-TRADED PRODUCTS

OTC Traded on exchange

Contract specifications standardised by the
Contract terms Bespoke: tailored to meet the needs of the investor.
exchange.
Liquidity Can be limited leading to slower execution. Excellent on major contracts.
Margin No standardised margin process. Margin normally required.
Historically less stringent regulation of products.
Regulation This is changing based on legislations like Dodd- Exchanges subject to significant regulation.
Frank Act and EMIR.
Counterparty Exposed to default risk, however clearing of OTC
No member default risk due to clearing house.
risk products will increase under EMIR.
EMIR imposes regulatory reporting to a trade Market transparency due to regulatory obligations
Reporting
repository. on exchanges.
Price Limited transparency. Need to shop around. Highly transparent, public dissemination.
Hedges based on standardised contracts need to be
Hedging Specific hedging requirements can be met.
actively managed.

FURTHER INFORMATION
Chapter 4, OTC Derivatives: An OTC market is a decentralised market in which market participants can trade certain instruments
like derivatives without a central exchange yet trading can be conducted electronically due to advanced trading systems.
Historically OTC markets are considered less transparent but as a result, liquidity in the OTC market may come at a premium.
However, due to changes in regulations such as EMIR and MIFID II, OTC trades and even dark pools now have to report trades to
a facility bringing transparency to the market. So the gap between exchange trades and OTC is narrowing.

CHAPTER 2 - UNDERLYING ASSETS - 10 QUESTIONS

CHAPTER OVERVIEW

Money Market Instruments (home study) • Spot and forward prices

• Characteristics and risks of T-bills, interbank Equities and equity-based investments
deposits and certificates of deposit • Characteristics and risk of classes of equity
Fixed income securities • Factors affecting equity markets and valuation
• Characteristics and risk of government debt and • Warrants vs options
corporate debt
• The role indices play
• Relationship between interest rates and bond
• Exchange-traded funds
prices
Commodities and other assets
• Determinants of bond prices and valuation
• Main commodities and influences on supply
Foreign exchange instruments
• Softs, agricultural, metals, energy
• FX market

2. MONEY MARKET INSTRUMENTS

(2.3) SHORT-TERM RATES

London Inter-Bank Offered Rate (LIBOR)
• An average of rates at which banks borrow from each other
• Five currencies and seven maturities
Other variants
• EURIBOR - Eurozone
• TIBOR - Japan
• CNY HIBOR – China
• Fed Funds – US
Development in short-term rates market
• UK – SONIA = Sterling overnight index average based on unsecured overnight borrowing published by the Bank of
England
• US – SOFR = Secured overnight financing rate based on an overnight repo rate - Eurozone – €STR = Euro short-term rate
based on the previous day’s unsecured overnight borrowing settled through Target2

FURTHER INFORMATION
Short-term interest rate future (STIR): ICE Futures Europe allows trading of an interest rate future called a STIR. This is based on
a notional £500,000 deposit for three months. It is quoted at a value of 100 – r, which means it moves inversely to the rate that
it tracks.

Debt Management Office

(2.3) TREASURY BILLS
UK Treasury bills (UK T-bills)
• Weekly auctions 4. Investor redeems T-bill and
• Typical life of 91 days (some 182 days) 1. DMO issues a 90-day receives the full-face value. The
T-bill with a face value difference between this and the
• Promissory notes of £100,000. £98,500 originally paid is the
• Benchmark level of risk-free returns investor’s return:
US Treasury bills £100,000 - £98,500 = £1,500
£1,500 x 12 = 6.1 %
• Issued by Treasury Department
£98,500 3
• Life of one, three and six months 2. Investor pays £98,500 for
the bill (after deducting a
£1,500 discount, which is
approx three months’ 3. Investor holds the T-bill
interest at 6% pa). for the entire 90-day
period.

(2.4) CERTIFICATE OF DEPOSIT (CDS)

• Time deposit
• Short-term
o Three to six months
• Purchased at face value

(2.5) COMMERCIAL PAPER

• Discount security issued by companies
• Unsecured, short-term debt: Maturities of two to nine months
• Typically, high denominations - E.g., $500,000
• US is the biggest market
£5m on deposit for three months at 6% pa

INVESTOR BANK X
Certificate of Deposit
£5m deposit deposited at Bank X for
three months at 6% pa

Zero coupon bonds: Like T-bills and commercial paper, zero-coupon bonds pay no coupons, are issued at discount and
redeemed at par value. However, they can be much longer-dated.
 3. FIXED INCOME SECURITIES

(3.1) GOVERNMENT BONDS

FURTHER INFORMATION
 Coupon and PSNCR: The coupon is generally a fixed, gross annual percentage of the nominal value. The government
borrows through gilts to cover their long-term spending plans. This is often referred to as the public sector net cash
requirement (PSNCR).
 Respect and tolerance – welfare society: The government raises taxes to redistribute the money through public sector
spending, providing public goods, such as street lighting and law enforcement, and merit goods, such as schools and
libraries. Any deficit between government spending and the money it raises is called the PSNCR.

(3.1) GOVERNMENT BONDS Gilts

Index-linked Non-index-linked
• Inflation protected • Shorts (fewer than seven
• Linked to the RPI years to redemption)
• Coupon and redemption • Mediums (seven to fifteen
linked years to redemption)
• Longs (more than fifteen
years to redemption)
• Undated
Strips market: Separate Trading of Registered Interest and Principal

FURTHER INFORMATION
 GEMMs and the DMO: Gilt-edged market makers (‘GEMMs’) register with the Debt Management Office to provide
liquidity in the secondary gilt markets. The Debt Management Office (DMO) is an executive agency of the Treasury
responsible for the issuance and redemption of government debt. Whilst in the UK index linked gilts are linked to RPI,
this is not true for all other countries since some governments use CPI.
 Hints: The coupons from different gilts can be grouped together to create a larger value zero coupon bond, which can
be useful for liability driven investors

(3.1) GOVERNMENT BONDS

Germany France
UK (Gilts) Italy (BTPs) USA (T-bonds) Japan (JGBs)
(Bunds) (OATs)
Legal form Registered Bearer Bearer Bearer Registered Registered or bearer
Life when Up to 50 Up to 30 Normal: 10 years
Over 10 years 3-30 years Over 10 years
issued (years) years years Superlong: 20 years
Coupons Semi-annual Annual Annual Semi-annual Semi-annual Semi-annual
Settlement T+1 T+2 T+2 T+2 (primary) T+1 T+1 (domestic) T+3
 time T+3 (secondary) (International)
FURTHER INFORMATION
Other government bonds

Brazil (NTN) South Korea (KTB)

Legal form Registered Registered
Life when issued (years) Up to 20 years 3 to 50 years
Coupons Semi-annual Semi-annual
Settlement time T+1 T+1

(3.2) OTHER BOND ISSUERS Corporate bonds

Corporate bonds
Debentures Loan stock
Secured debt securities Unsecured debt securities

Fixed charge Floating charge

over assets over assets

FURTHER INFORMATION
 Convertible bond: A convertible bond is a type of corporate bond that allows the investor to convert into the
company’s ordinary shares, at a fixed ratio, at some future point in time (the ‘conversion window’). The company
benefits by issuing the bond for a lower initial yield than a vanilla corporate bond. The investor has to accept a lower
coupon due to the benefit gained from enjoying conversion rights.
 Floating rate bond: A floating rate bond is a bond whose coupon is linked to an interest rate benchmark such as LIBOR.
This makes the bond less sensitive to interest rates and provides capital protection.

(3.2) ASSET-BACKED SECURITIES

 Secured by a pool of assets, e.g., property, loans
 Underlying assets securitised

Summary
 The mortgagee agrees to a monthly payment reflecting capital plus interest for a fixed time period, e.g., 25 years
 The lender sells the repayments on to an SPV
 The SPV pools the mortgage with others and securitises them by producing an ABS
 The ABS is sold on to an investment company
 The money raised is passed on to the lender as payment for the mortgage repayments

(3.3) WHAT AFFECTS BOND PRICES?

Liquidity risk
 Being unable to sell the bond at a fair market value
 Less of a problem with bigger issues
Interest rate risk

Inflation risk
 The redemption value is eroded with time due to inflation When interest rates rise
fall bond
bondprices
pricesrise:
fall:
  Does not apply to index-linked gilts

FURTHER INFORMATION
Issuer risk and credit rating agencies

(3.1.3) YIELD CURVES

 The yields currently available to investors across different time horizons:
Normal/upward Inverted
Yield Yield

Maturity Maturity
(3.3.5) YIELD SPREADS
 Spreads and benchmarks
o Difference between the yield on one investment and the yield on another investment.
o Measured in basis points (0.01%).
 Example: A corporate bond yields 100bp above the benchmark gilt. The benchmark gilt is currently yielding 3.8% and
LIBOR is 4.1%. What is the corporate bond’s spread to LIBOR?

FURTHER INFORMATION
Keeping on target - Yield Spread: Spread trading fixed income is via the yield curve. This is a form of spread trading where one
takes opposing long and short positions with the expectation that the yield curve will either flatten or get steeper. Example: An
investor expects a normal yield curve to steepen. Which of the following bond spread strategies would profit most if the investor
is correct?
a. Sell near; Sell far
b. Buy near; Buy far
c. Buy near; Sell far
d. Sell near; Buy far
Answer = C - If the yield were to steepen, short term yields will fall (so price will rise) and long term yields will rise (so prices will
fall). Buying the shorter bonds when they are expected to rise and selling the longer duration bonds when they are expected to
fall, will give greater potential for profit. By contrast, if a normal yield curve is expected to flatten – sell near-dated bonds and
buy far.
Liquidity preference theory – this explains upward or normal yield curves. It is based on the assumption that longer dated bonds
are more risky than near dated bonds. For this reason investors will require a higher rate of interest for a longer loan.

4. FOREIGN EXCHANGE INSTRUMENTS

(4.1) FOREIGN EXCHANGE (‘FX’)

 OTC market
 Major international banks
 Spot market and forward market
FX: The role of the US dollar
GBP 1 = USD 1.2900
USD 1 = JPY 108.50
  FX spot markets
o Standard settlement T+2

FURTHER INFORMATION
Determinants of spot FX rates
Economic factors
 Government budget deficit or surplus
 Balance of trade
 Inflation
 Economic growth and productivity
Political conditions
 Reactions to strong/weak governments
Market psychology
 Flight to quality
 Long-term trends
 ‘Buy the rumour, sell the fact’
 Economic figures

(4.1) SPOT FX MARKET

GBP against USD spot
Two-way price quotes rate please

GBP against USD for

spot is 1.3010 / 1.3015

FURTHER INFORMATION
Keeping on target: A company wishes to exchange $850,000 into GBP at a spot rate of 1.2505/15USD. How much will the
company receive?
Answer: First ask, are you buying or selling the base currency? Buying, therefore use the offer rate. $850,000 / 1.2515 =
679,184.98 GBP.

(4.2) FORWARD FX RATES AND INTEREST RATE PARITY (IRP)

Example: A bank quotes a spot rate of 1.2720/40 and a forward adjustment of 10/20 pips. The forward rate is calculated as
follows:
Spot Rate GBP 1 = USD 1.2720/40
Forward Adjustment (bid < offer, so add) 10/20
Forward Rate GBP 1 = USD 1.2730/60
Note: The spread on the forward rate is always wider than the spread on the spot rate.

FURTHER INFORMATION
Applying the forward adjustment: In this example, had the adjustment to the bid been greater than the adjustment to the offer,
we would have subtracted the adjustment. So, for instance, an adjustment of 20/10 would have created a forward rate of £1 =
$1.2700/30.

(4.2) FORWARD FX RATES AND INTEREST RATE PARITY (IRP)

12 months at 2.2% pa
$1,250,000 $1,277,500

Exchange rate Exchange rate

£1=$1.2500 £1=$1.2586

£1,000,000 £1,015,000
12 months at 1.5% pa

Dollars are cheaper (you get more for £1) for

forward delivery
FURTHER INFORMATION
Hints: Interest rate parity is an arbitrage-free method of pricing forward FX rates. The bank calculates the forward adjustment in
such a way as to take away any arbitrage profits from the carry trade. In the example on the slide, the carry trade would be:
Borrow GBP at 1.5%; convert into USD; and deposit USD at 2.2%
Keeping on target: The GBP/EUR spot rate is 1.15. What is the three-month forward rate if interest rates in the UK are at 1.25%
and in the Eurozone rates are 0.5%?
a. 1.1414
b. 1.1438
c. 1.1479
d. 1.1522
Answer = C - As EUR is variable and the rate is less than the rate in the UK, we must have a figure which is going to be lower than
the spot of 1.15. The equation is (1 + (0.005 x 3 / 12)) divided by (1 + (0.0125 x 3 / 12)); the result is the multiplied by the spot,
which is 1.15. 1.00125 / 1.003125 x 1.15 = 1.1479

(4.2) FORWARD FX RATES AND INTEREST RATE PARITY (IRP)

F  (1 + rvariable)

S (1 + rbase)
Where F: the forward rate
S: the spot rate
rvariable; rbase: the interest rates for each currency variable and base

(4.3) NON-DELIVERABLE FORWARD

 Cash-settled forward contract: Does not settle into the traded currency

FURTHER INFORMATION
Non-deliverable forwards: These cash-settled forwards are typically used for thinly traded or nonconvertible foreign currencies
and are an example of an OTC contract for differences. They are normally quoted and settled in USD, although GBP and EUR
settlement is fairly common.

5. EQUITIES

(5.1) ORDINARY SHARES

 Variable dividends dependent on profits
 Generally have voting rights
 Last to be paid in dividends and on liquidation
 Types
o ‘A’ shares – ordinary share with different rights
o Partly-paid – investors pay only a portion of the sum due. The issuer will call additional payments until the full
value is paid

FURTHER INFORMATION
5.5 Valuation techniques: Assessing the present value of future cashflows, for example a dividend discount model, e.g.,
Gordon’s Growth Model. There are three equity ratios on the Derivatives syllabus:

Earnings per share = Earnings available to ordinary shareholders

Number of ordinary shares in issue
Price/Earnings ratio = Market price per share
Earnings per share
Net asset value per share = Total assets – Total Liabilities
Number of ordinary shares in issue

Democracy – joint decision making: Voting rights give shareholders the ability to vote on company decisions.
(5.2) PREFERENCE SHARES
 Fixed dividends (normally)
 Generally no voting rights
 First shareholder to be paid (still paid after creditors)
 Types
o Cumulative – dividend can be rolled on
o Participating – opportunity for further dividend
o Convertible – into ordinary shares
o Redeemable – callable by the issuer

FURTHER INFORMATION
Keeping on Target - Which of the following statements relating to preference shares is/are normally true?
(i) They pay a dividend that is a fixed percentage of nominal value.
(ii) They take priority over subordinated bonds on liquidation of a company’s assets.
(iii) They take priority over the equity shares on dividend payments and on liquidation of the company assets.
(iv) They are considered less risky than subordinated debt.
a. (i) and (ii) only
b. (i) and (iii) only
c. (ii) and (iii) only
d. (iii) and (iv) only
Answer: B
Summary
Features Ordinary Shares Preference Shares
Priority 2nd 1st
Dividends Variable Fixed
Voting Yes No
 Cumulative
 Redeemable
 Participating
Special Features  A shares/B shares
 Convertible
 Partly paid shares
 Redeemable

(5.6) AMERICAN AND GLOBAL DEPOSITORY RECEIPTS

Shares ADRs

££££s $$$$s American

Overseas plc Bank A
Investor

Overseas USA
Overseas plc will pay dividends in its local currency to Bank A. Bank A will convert this into US dollars and pass on to the ADR
holder.

FURTHER INFORMATION
Comparing equity warrants with options - Warrants are like a long-term call option issued by a company on its own shares:
Warrants Options
Issued by Companies Writer
Shares delivered New shares Existing shares
Typical maturity Greater than one year Three to 12 months
Traded on Stock exchange Derivative exchange
Right to buy the underlying share only Call and put options available (right to buy or
Types
American or European right to sell) American or European
Exercise/ Settlement Physically settled contracts Cash and physically settled contracts available
 6. FINANCIAL AND OTHER INDICES

(2.6) INDICES
 A measurement of the performance of a country’s stock market, or a section of that market
o A simple way of summarising market movements
o Can be used as a bell-weather of that country’s economy as a whole
 An index is maintained and published by a sponsor who may or may not have a direct relationship with the exchange
Country Index Sponsor
UK FTSE 100 FTSE Group
US S&P 500 S&P Dow Jones Indices
US NASDAQ 100 Nasdaq Stock Market
Japan Nikkei 225 The Nihon Keizai Shinbun (newspaper)
Global MSCI ACWI MSCI

FURTHER INFORMATION
Exchange-traded funds: Many exchange-traded funds track a specific index.

7. SOFT AND AGRICULTURALS

Exchange Product
Chicago Board of Trade for agricultural and soft commodities, gold, metals and
Chicago Mercantile Exchange (CME) ethanol.
Group Chicago Mercantile Exchange for hot-rolled steel
NYMEX for energy products including gas oil, crude oil and natural gas.
Soft commodities, e.g., cocoa, sugar, coffee, cocoa, cotton, wood Crude oil,
Intercontinental Exchange (ICE)
refined energy products, and natural gas.
Soft commodities, e.g., cocoa, sugar, coffee; and agricultural commodities, e.g.,
Euronext Derivatives
wheat, corn, barley.
Dubai Mercantile Exchange (DME) Crude oil.
Base metals; steel billet, ferrous and minor metals (cobalt and molybdenum).
London Metals Exchange (LME)
Precious metals; gold and silver.
Tokyo Commodities Exchange (TOCOM) Base metals, oil and rubber.
Shanghai Metal Exchange (SHFE) Base and ferrous metals.
Multi Commodity Exchange (MCX)
Soft and agricultural commodities, gold, ferrous and base metals, and energy.
Mumbai
Singapore Exchange (SGX) Iron ore, rubber, coal, oil and petrochemicals.
European Climate Exchange (ECX) Environmental contracts.
Johannesburg Stock Exchange (JSE) Agriculturals, livestock, metals and energy
Dalian Commodity Exchange (DCE) Agricultural commodities, iron ore, and plastics.

Soft and agricultural commodities

 Soft commodity includes: Cocoa, sugar, coffee
 Agricultural commodity includes: Grains (wheat, soya beans), seed oil and livestock
Factors influencing price of soft and agricultural commodities
 Supply
o Land
o Natural factors: Weather, disease
o Production costs: Technology, location
 o Government intervention: Subsidies, tariffs
 Demand
o Wealth
o Growth
o Tastes

8. BASE AND PRECIOUS METALS

Factors influencing price of metals

 Supply
o Availability
o Cost of extraction/production
o Government intervention: Subsidies, tariffs
o Environmental considerations
 Demand
o Economic growth/decline
o Substitutes

INFORMATION
Metal Major uses
Non-Ferrous Metal
Copper Electrics, building
Cobalt Lithium-ion batteries (electric transport)
Gold Jewellery, electronics, investments, dentistry
Molybdenum Steelmaking
Palladium Cars, jewellery, dentistry
Platinum Cars, catalytic converters, medical equipment
Silver Jewellery, electronics, photography, dentistry
Aluminium Aerospace, packaging, kitchen equipment, building
Zinc Galvanising, production of brass
Nickel Production of stainless steel and other alloys
Lead Batteries, petrol, buildings
Tin Packaging, pewter
Precious
Iron ore Steel making
Steel (hot- rolled coil) Construction and car manufacture
Steel (rebar) Construction

FURTHER 9. ENERGY PRODUCTS

Factors influencing price of energy products

 Supply
o Availability
o Natural disasters
o Cost of discovery and extraction
o Government intervention: Political unrest
o Transport and storage
 Demand
o Consumption
o Economic expansion
 o Weather
(9.1) ELECTRICITY AND POWER MARKETS
Unique features of the electricity market
 Cannot easily be stored: Difficult to maintain large inventory
 Difficult to transport without loss: Can lead to areas where delivery is not viable
 Subject to large price moves: Variation in seasonal demand
Electricity futures
 Tick size, EUR 0.01 per megawatt hour
 Some physically delivered, some cash settled

FURTHER INFORMATION
Crude oil is defined by three primary factors:
 Field of origin, for example, Brent, West Texas, Dubai
 Density, i.e., low-density or ‘light’, high-density or ‘heavy’
 Sulphur content, i.e., low-sulphur (known as ‘sweet’) or high-sulphur (known as ‘sour’)

10. OTHER PRODUCTS

(10.1) FREIGHT
 Forwards, options and swaps on freight indices: E.g., Baltic Dry Index

(10.2) EMISSIONS ALLOWANCE CONTRACTS

 Artificial ‘cap and trade’ market
 Certified emission reduction (CER)
o Bankable global carbon currency

(10.3) WEATHER DERIVATIVES

 In reference to a weather index over a period of time
 Heating degree days (HDD)/Cooling degree days (CDD)

(10.4) CRYPTOCURRENCY
 Digital asset/virtual currency
o Decentralised control mechanism limiting supply and recording ownership
o Relatively new asset with increasing regulatory attention
Currency or transferable security?

FURTHER INFORMATION
 Hints: Weather, freight and property derivatives are based on indices.
 Property Derivatives: Swaps, Forwards and Options contracts on a property index.
 Volatility Derivatives: Swaps, futures and options on a volatility index, such as CBOE VIX contracts on the S&P500 index.
 Hybrid derivative: A derivative on a derivative, sometimes a multi-asset derivative. For example, a contract that gives its
owner the right to sell a bill paying LIBOR + 200bps for a quantity of an individual company’s shares when a specific
share index reaches certain point.

CHAPTER 3 - EXCHANGE-TRADED FUTURES AND OPTIONS - 14 QUESTIONS

CHAPTER OVERVIEW

Derivatives Exchanges  Membership and Platforms

 Overview of international exchanges Derivative Platforms
  Platforms
 How orders are processed
 Types of orders
Reporting and Monitoring (home study)
 Wholesale trading mechanisms
 Trade reporting and monitoring
Basic Futures Pricing
 Fair value of a future: components
Cash and Carry Arbitrage
 Fair value of a future: implications, arbitrage
Basis Risk and Basis Trading
 Basis risk and hedging
Basic Options Pricing
 Inputs for pricing options: intrinsic value and time
value
Put-Call Parity
 Put-call parity and arbitrage
Option Greeks
 Option Greeks and their uses
 Exchange Trading Clearing Products
Europe
Energy. Major futures and options include: Brent crude
Electronic oil, coal, electricity, emissions, gas oil, natural gas and
ICE Futures Europe ICE Clear Europe
Wholesale trades emissions. Also trades range of interest rates, bond and
equity index and single stock futures.
Euronext (Amsterdam, Financials. Major futures and options include: Interest
Universal Trading
Brussels, Lisbon, London LCH rates (EURIBOR), bonds (long gilt), equities (universal
Platform (order book)
and Paris) stock futures), currency (EUR/USD) and commodities
London Metal Exchange Inter-office (telephone) Base metals. Major futures and options include:
(LME), part of HKEX Select (order book) The LME Clear aluminium, copper, lead, tin, steel, zinc and nickel. Also,
group. Ring (open outcry) precious metals: Gold, Silver, Metal index (LMEX).
Futures and options on equity and equity indices from
LSE Derivatives Electronically traded LCH Norwegian, Russian and Turkish markets. Also, FTSE 100,
FTSE Super Liquid (35)
Eurex System (electronic) Full range of financial derivatives and credit derivatives,
Eurex Eurex Clearing
Wholesale trading System including FLEX options.
MEFF – (Spain) Exchange
MEFF Derivatives Trading Interest rates, bonds, the IBEX-35 index and leading
for Financial Futures and Own Clearing
Platform Spanish shares.
Options
Swedish, Danish, Finnish and Norwegian options and
NASDAQ Nordic Not tested Not tested
futures
United States
CME Group (CME, NYMEX & CBOT)
Chicago Mercantile CME Globex (electronic) Financials. E.g., FX & short term I/R + indices,
CME Clearing
Exchange (CME) Open outcry platform commodities, weather and real estate.
Electronically via:
• NYMEX ClearPort,, CME
NYMEX (part of CME Wide range of metals, energy products and option
Global, and NYMEX Clearing House
group) spreads, e.g., Brent/West Texas Intermediate.
CME Globex
• As well as open outcry
EOS Trader (electronic) Wide range including Agricultural, Financial, Dow
Chicago Board of Trade Front-end Clearing
Floor trading (open indices, interest rates, Gold and Silver Mutual offset
(CBOT) System (FEC or EC+)
outcry) trading available with SGX
Largest US Options
Chicago Board ptions exchange, established Options Clearing
Financials: Equity, Indices, ETFs, and credit options
Exchange (CBOE) by CBOT Electronically Corporation (OCC)
traded
PHLX – Philadelphia Stock Electronically traded Financials. E.g., Stock, index, Equity sector and Currency
Own Clearing
Exchange (PHLX XL) Floor trading options. Both offer standard and flex options.
Electronically: CBOE
OneChicago CME Clearing or OCC Financials: single stock futures, index futures and ETFs.
Direct or CME Globex
ICE Clear US, part of the Agricultural, energy (inc. electricity), and financial (inc.
ICE Futures US Electronic
ICE Global Clearing House indices). Also, major and emerging market currencies.

Exchange Trading Clearing Products

Asia & other emerging markets
Major products include futures and options on
SGX-DC (Derivatives
Singapore Exchange (SGX) SGX QUEST (Electronic) indices (Nikkei 225), and interest rates (Euroyen,
Clearing )
Eurodollar).
Osaka Securities Exchange (Part Open outcry and electronic Futures and options on Nikkei 225 index and
Own clearing house
of Japan Exchange Group) trading system individual Japanese shares
Japanese Securities
Tokyo Stock Exchange (TSE) (Part Major products include futures and options on
T-dex+ Clearing Corporation
of Japan Exchange Group) indices (TOPIX and TSE), JGB and equity.
(JSCC)
Korea Exchange (KRX) Futures Futures and options on several Korean and US
Electronic trading system Own clearing house
Market Division indices as well as gold and interest rate futures
China Financial Futures Exchange CFFEX electronic trading
Own clearing house CSI 200 index future
(CFFEX) system
China Securities Central ‘B’ shares and equity indices
Shanghai Stock Exchange (SSE) SSE electronic trading system Clearing and Registration ‘B’ share are available in dollars to international
Corporation (CSCCRC) investors.
Shanghai Futures Exchange Trades futures contracts on a number of metals
Open outcry and electronic Own system
(SHFE) (aluminium, copper, zinc), rubber and fuel oil.
Shanghai International Energy Electronic Not tested CNY – denominated crude oil futures
Exchange (INE)
Dubai Mercantile Exchange Major contract is Oman crude oil. Has spread trades
DME Direct (electronic) NYMEX Clearing House
(DME) with other oils (Brent and WTI).
Dubai Gold & Commodities Dubai Commodities Wide range of commodity and currency futures, as
DGCX electronic system
Exchange (DGCX) Clearing Corporation well as options on gold and Indian rupee futures
DTSS (electronic) Internet-
Bombay Stock Exchange (BSE) Own clearing house Equity, equity index and currencies
base trading also
NSE 25 index futures and selected single stock
Nairobi Securities Exchange Electronic Not tested
futures
Futures in wide range of commodities, including
Multi Commodity Exchange
Electronic trading system Demat@MCX bullion, energy, ferrous and non-ferrous metals, oil
(MCX – India)
seeds, spices and plastics
National Stock Exchange of India Electronic trading system – Wide range of equity, currency and interest rate
Own clearing house
(NSE) NEAT derivatives.
National Commodities & Trades futures on agricultural products, precious,
Depository Clearing
Derivatives Exchange (India) Automated Trading System base and ferrous metals, energy products and
System
(NYDEX) polymers
Wide range of futures contracts on agricultural
South African Futures Exchange JSE’s TALX system LSE’s SETS
No tested products, gold, interest rates, FX, the JSE index and
(SAFEX) system
Single Stock futures
Open outcry (some Futures and options on gold, coffee, corn, soybeans,
B3 (Brazil) agricultural derivatives) NSC BM&F Clearing Bovespa share index and a range of
USD, the
screen trading for the rest
domestic interest rates.

1. DERIVATIVES EXCHANGES

(1.7.1/3.1.2) MEMBERSHIP STRUCTURE AND TRADING RIGHTS

Agency trade Principal trade

Client Member Exchange Member

Client account House account
 Dual capacity
 Cross trades
Principal Principal
Trade Trade

Client A Member Client B

FURTHER INFORMATION
 Price makers: Price makers (givers) are often referred to as market makers: those that provide a market in the product
by quoting two-way prices.
 Price takers: A price taker is a market participant who requests the price or deals on another participant’s price. They
deal on a price provided by someone else. E.g., asset manager.
 Cross trades: A broker may act on behalf of two clients. This is known as a 'cross-trade'. The broker may buy from one
client and sell to another. Although in performing this trade the firm has effectively created a flat position for itself, it
must report both sides of the trade into the exchange.

(1.7.1/3.1.2) MEMBERSHIP STRUCTURE AND TRADING RIGHTS

 General clearing members (GCMs) can clear trades on behalf of:
o Themselves
o Their clients
o Non-clearing members and other members of the exchange
 Individual clearing members (ICMs) can clear trades on behalf of:
o Themselves
o Their clients
  Non-clearing members (NCMs) cannot clear trades, so ‘give up’ trades to GCMs for clearing (they can have a maximum
of two agreements)
o Process
Pre-registration by executing firm
Registered to clearing firm’s accounts

FURTHER INFORMATION
Electronic order driven trading - ICE trading platform, CME Globex, CME Direct, etc.

Deal via order book

Buyer Seller
(Clearing member) (Clearing member)

Trade Registration System

Buy Buy
Sell CCP Sell

Give up: ‘Give up’ is more formally known as ‘pre-registration’ or ‘allocation’. This involves separation of execution (by the NCM)
and clearing (by the relevant GCM, on behalf of the NCM). The NCM ‘pre-registers’ the trade at the clearing house so that the
clearing house knows what is happening. Once the trade is ‘given up’ for clearing, the trade is then registered with the GCM’s
account at the clearing house.

2. TRADING PLATFORMS

(1.7.1/3.2.1) TRADING PLATFORMS

Quote driven
 Price makers
 Bid/Offer spreads
 Screen and phone based
Order driven
 Negotiated prices
 Electronic trading

FURTHER INFORMATION
 Hints: Whilst order driven systems are expected to have high liquidity, there is no guarantee of trades being executed.
However, in a quote driven platform, there is guaranteed liquidity (assuming price is irrelevant) with the presence of
market makers.
 The European Markets Infrastructure Regulation (EMIR) recognises three different types of trading venue, as follows:
o Regulated market – such as an exchange
o Multilateral trading facility (MTF) – These are alternatives to traditional stock exchanges where markets are
made in securities, typically using electronic systems.
o Organised trading facility (OTF) – a system which is neither a regulated market nor an MTF, but allows
multiple third parties buying and selling bonds, structured finance products, emissions allowances or
derivatives are able to interact in a way which results in a contract.

London Metal Exchange: LME trading

 Open outcry and order book
Official LME prices set Closing prices set

Ring 1 Ring 2 Kerb 1 Ring 3 Ring 4 Kerb 2

Open outcry session 1 Open outcry session 2

LME Select is open from 01.00 to 19.00

 5,000 210 - 214 3,000
 24-hour inter- 5,000 210 214 3,000 office market
1,000 209 215 5,000
FURTHER INFORMATION 11,000 208 216 7,000
3,000 207 217 6,000
 Kerb trading, in general, refers to trading outside of normal trading hours on many other derivatives exchanges e.g., ICE
Futures Europe. 2,000 206 218 1,000

 The CBoT is also mentioned in the manual as having pit trading.

(6.1) TRADE EXECUTION

Open out-cry Order book

Client Client

Placement
Broker Broker
Order slip

Booth clerk
Dealing slip
Execution
Pit trader
Electronic
Dealing slip Order Book
System
Booth clerk
Matching

Broker

Registration

Clearing house Clearing house

FURTHER INFORMATION
When the trade is registered with the clearing house clearing member will use either:
 Segregated ‘client’ account: Client positions protected in the case of the firm’s default
 Non-segregated ‘house’ account: Client positions not protected in the case of the firm’s default
 Most exchanges and major market regulators require firms to hold client assets in segregated accounts. Where non-
segregated accounts are permitted, they are used only at the choice of the client.

6. ORDER/INSTRUCTION FLOW AND ORDER TYPE

(6.2) ORDER TYPES

 Limit order
 Iceberg

Example
Note

1,000 209 - 210 1,000

1,000 209 210 1,000
11,000 208 214 3,000
3,000 207 touch215
: The 5,000
price now
Limit order: 2,000 206 216 7,000
Sell 6,000 at 210 limit
 217 6,000
218 1,000

FURTHER INFORMATION
Hints: The term ‘iceberg’ comes from the fact that visible orders are just the ‘tip of the iceberg’ given the greater number of limit
orders waiting to be placed. Iceberg orders are also referred to as ‘reserve orders’.
Level 1 and Level 2 Screens
 Level 1 screen is the name given to the touch strip of the screen where best buy and sell orders are displayed.
 Level 2 screens are where all buy and sell orders are displayed.

(6.2) ORDER TYPES

 Market order
 Market if touched
Example
1,000 209 - 210 1,000
1,000 209 210 1,000
11,000 208 214 3,000
3,000 207 215 5,000
2,000 206 216 7,000
217 6,000
218 1,000

Market order:
1,000 209 - 215 1,000
1,000 209 215 1,000
11,000 208 216 7,000
3,000 207 217 6,000
2,000 206 218 1,000

FURTHER INFORMATION
 Auctions: At the beginning and end of the trading day on an order book system there is typically an auction period.
During the auction there is no immediate execution of the trade. Instead, the orders build up until a set time when a
matching algorithm will run. The matching algorithm will look for a price at which the largest number of contracts could
be executed. It is possible to place orders for execution in these sessions only. These would be opening or closing
orders. These may or may not have a price. If they are not executed in the opening or closing auctions, they will be
cancelled.
 Market on open and market on close can also be used in these sessions.
 Market if touched order: A combination of a limit order and a market order. Initially, the trade specifies a limit. If the
market trades at or through the price, the order becomes a market order and will be executed at the best prevailing
price.

(6.2) ORDER TYPES

 Immediate and cancel
Example
Tesco TSCO Currency GBX
1,000 209 - 215 1,000
1,000 209 215 1,000
11,000 208 216 7,000
3,000 207 217 6,000
2,000 206 218 1,000

Sell 2,000 at 209 limit

immediate and cancel
FURTHER INFORMATION
Tesco TSCO Currency GBX
Stop orders: Stop orders are to limit losses on open positions. If an investor holds a long position, they lose money in a falling
11,000 208 - 215 1,000
market, so would place a sell stop order at a lower price than the market price. If an investor holds a short position, they lose
11,000 208 215 1,000
money in a rising market, so would place a buy stop order 3,000
at a higher price
207
in the 216
market price.
7,000
Stop limit orders would be used
in a similar way. 2,000 206 217 6,000
218 1,000

Example
Tesco TSCO Currency GBX
11,000 208 - 215 1,000
(6.2) ORDER TYPES 11,000 208 215 1,000
 Immediate or 3,000 207 216 7,000 cancel/complete volume/fill or kill
2,000 206 217 6,000
218 1,000
FILL OR KILL: Buy 2,000
at 215 limit fill or kill
Tesco TSCO Currency GBX
11,000 208 - 215 1,000
FURTHER INFORMATION 11,000 208 215 1,000
3,000 207 216 7,000
Minimum volume: MinimumOrdervolume is an
cannot attachment to an order that states a volume to execute, but also a minimum volume
be executed, 2,000 206 217 6,000
that would make the order worthwhile. If theunaltered.
order book remains broker can achieve the minimum volume 218
then the1,000
order can be partially filled. If
the broker cannot achieve the minimum volume the whole order is cancelled.

(6.2) ORDER TYPES

Other order types:
 Spread orders
o Simultaneous purchase and sale of futures or options to create (or liquidate) a spread
 Scale (stepped) order
o To gain a gradual entry into, or exit from, a position
 Stop (or ‘stop-loss’)
o Uses a market order to close the position, to limit trading losses
o Closes out a position when the market moves against a trader, past a certain point
 Stop limit
o Uses a limit order to close the position, also to limit trading losses
o Closes out a position when the market moves against a trader, past a certain point
 Guaranteed stop
o Offered by some brokers, a guarantee that a stop price will be achieved
 Good-till-cancelled (GTC), Good for the day (GFD), Day order

2. TRADING PLATFORMS

(2.1) WHOLESALE TRADES

Block trades
 Large deals ‘on-exchange’
  Negotiated price and volume bilaterally
 Trade details reported to the exchange (five minutes on ICE Futures Europe)
 Published trade details distinguished from order book execution
o On ICE Futures Europe prices published with the letter ‘K’
Basis trades
 Transactions involving future and corresponding cash instrument
 The basis trade can be negotiated away from the order book
 Trade details reported to the exchange (15 minutes on ICE Futures Europe)

FURTHER INFORMATION
Hints: In block trades, price does not necessarily have to be the current price on the order book.

(2.1) WHOLESALE TRADING FACILITIES

Exchange for physicals (EFP)

 Exchanging an OTC position for a futures position
o Non-financial (generally commodity)
o OTC position and future position must be substantially similar in terms of either value and / or quantity
o Sometimes also called ‘against actuals’
Exchange for swaps (EFS)
 Exchanging an OTC interest rate swap for a series of futures contracts
o Uses future to hedge cash market transaction
o Swap must have price correlation with future
Benefits
 Flexibility in trading with standardisation of clearing process
o Reduced counterparty credit risk for OTC position
o Reduced margin requirements – netting off OTC and futures position

FURTHER INFORMATION
Hints: CME and Eurex have adopted total return futures to facilitate EFS in the total return market.

8. MARKET TRANSPARENCY, TRADE REPORTING AND MONITORING

(8.1) TRADE REPORTING

 Automatic on electronic trading systems
 ICE Futures Europe
o Block trades (5 minutes)
o Basis trades (15 minutes)
 Exchange price feeds
o Real-time price and trade information
o Disseminated by quote vendor, e.g., Reuters and Bloomberg

(8.3) MONITORING VOLUME AND OPEN INTEREST

 Requirement by most exchanges
 Consequences of poor monitoring
o Unwanted delivery situations
o Breaching credit limits
o Unexpected margin calls

FURTHER INFORMATION
Price screen codes
The price screens will generally include the following information:
 Buying and selling price; and
 4. FUTURES PRICING

(4.3) FAIR VALUE (‘ARBITRAGE FREE VALUE’)

FAIR VALUE OF FUTURE = CASH PRICE OF UNDERLYING + COST OF CARRY

What it would cost to buy What it would cost to hold the asset until the delivery
the asset today (spot price) date (i.e., finance charge, storage, insurance)

FURTHER INFORMATION
Need cocoa in three months’ time

Buy cocoa today and hold it Buy three-month cocoa

for three months future

Cost in the cash market

+
Storage Insurance Interest Cost of carry
rate Benefit of carry?

(4.3) CALCULATING FAIR VALUE

 Example
The price of wheat today (cash or spot) £65/tonne
Interest rates 6% pa
Storage and insurance £0.8/tonne per month
Delivery date Three months

The fair value is calculated as:

Buy wheat today £65.00

Cost of three months’ foregone interest £65 x 0.06 x 3/12 = £0.97
Storage and insurance for three months £0.8 x 3 = £2.40
Theoretical fair value for three-month delivery £68.37

FURTHER INFORMATION
Calculate the fair value of a 3 month future, if the price of the underlying asset is $3,500 per tonne and interest rates are 3%
p.a. The cost of storage and insurance are 0.4% p.a per tonne.
a. $3,619.00
b. B. $3,591.00
c. C. $3,529.75
d. D. $3,522.75
Answer: C
 Annual % cost of carry = 3% + 0.4% = 3.4%
 % Cost of carry for a 3-month future = 3.4% / 4 = 0.85%
 Cost of carry = 3,500 x 0.85% = 29.75
 Fair Value = 3,500 + 29.75 = 3,529.75
(4.3) PRICING EQUITY INDEX FUTURES
Components of calculation
 Cash index
 Foregone interest
 Dividend yield
FTSE 100 Index Future – a contract for differences
 Quotation: Index points
 Valuation: £5 per 0.5 index points

FURTHER INFORMATION
Calculate the fair value of a three-month FTSE 100 index future if the cash index is 7,200pts, interest rates are 4% pa and
dividend yields are 3% pa. What if interest rates are unchanged, but the dividend yield rises to 5%?
Answer:
 Net cost of carry = 4% - 3% = 1% pa or 0.25% per quarter. So fair value of the future = 7,200 x 1.0025 = 7,218 pts.
 If the dividend yield was 5%, the net cost of carry = 4% - 5% = -1% pa or -0.25% per quarter.
 So fair value = 7,200 x 0.9975 = 7,182 pts.

(4.4) CONTANGO AND BACKWARDATION

Contango
 Net cost of carry
 Normal situation in equity markets
Financing cost usually higher than dividend yields
Backwardation
 Net benefit of carry
 More common in bond/interest rate markets or commodity markets
Yields vs. financing cost
Supply problems

(4.5) CONVERGENCE
 Definition: As the future approaches delivery, the fair value converges with the cash price
Pric
Fair value of future
e

Costs of Constant cash

carry price

Time

Delivery date
 Note: The closer the future gets to delivery, the less the costs of carry

FURTHER INFORMATION
To ensure convergence with futures, an exchange will base their exchange delivery settlement price (EDSP) for the future on the
price of the underlying asset

(4.7) CASH AND CARRY ARBITRAGE

Taking the details from the fair value calculation in the previous slide, what if the future was trading at GBP70.00 per tonne?
Today
1. Investor buys wheat at a cost of GBP65.00
2. Sells three-month future at GBP70.00
Three months’ time
1. Pays storage costs (GBP2.40) and loses three months’ interest (GBP0.97) totalling GBP3.37
2. Delivers wheat through future and receives GBP70.00
3. Total net profit over three months: GBP70.00 - GBP65.00 - GBP3.37 = GBP1.63

FURTHER INFORMATION
Arbitrage trades
Future > fair value
 Trade: Cash and carry arbitrage
Actions:
 Buy cash and hold
 Sell future
Future < fair value
 Trade: Reverse cash and carry arbitrage
Actions:
 Sell cash and deposit
 Buy future

(4.7) ARBITRAGE CHANNEL

 Definition: The range of values through which a future can trade away from its fair value where arbitrage is not
profitable

Actual futures price
Pri
ce Fair value of future

*
** Arbitrage channel

Cash price

Time
Delivery Date

* Although cash and carry arbitrage is theoretically possible here, the costs of doing it will outweigh the benefits
** When the actual price of the future breaks from the arbitrage channel, cash and carry arbitrage will force the price back
within the ranges of the channel

FURTHER INFORMATION
The significance of the arbitrage channel is:
a. That futures' prices are supposed to trade within this range
b. That, within this range, transaction costs outweigh the profit from an arbitrage transaction
c. That the future’s price and the price of the underlying are outside this range
d. That an arbitrage transaction will only take place within this range
Answer: B

(4.6) BASIS Basis = Cash price - Futures price

Usually negative because the futures price is normally greater

than the cash price (as it includes the costs of carry)
  Contango market: Basis is negative
 Backwardation: Basis is positive

FURTHER INFORMATION
 Basis risk: Basis behaviour (i.e. whether it strengthens or weakens) is unpredictable. Unpredictability leads to
uncertainty, and uncertainty leads to risk. Basis would be equal to the cost of carry if the future was trading at its fair
value. In reality, they hardly trade at the fair value, which means basis is changing constantly and poses a risk to
hedgers.
 Hints: Basis is not necessarily the cost of carry.

(4.6) BASIS
Speculating on strengthening or weakening basis
Contango Backwardation

-4 -2 0 2 4
Strengthening basis
Weakening basis

Expectation: Basis weakening

FURTHER INFORMATION
 Trade:
Speculating on Sell
basisbasis
changes
 Action
Expectation: Basis strengthening
o
 Trade: buy Sellbasis
cash
 o Buy future
Action
o Buy cash
o Sell future

(4.6/4.8) BASIS AND BASIS RISK

Short hedge Long hedge
Basis strengthens Gain Loss
Basis weakens Loss Gain

Basis movement Basis tends to be less

is non-linear volatile than the cash
market

5. OPTIONS PRICING

(5.1) THE PREMIUM

Premium = Intrinsic value + Time value

The price of an option

FURTHER INFORMATION
 Intrinsic value: The intrinsic value is the in-built profit a particular option has were it to be exercised now. Intrinsic
value is the difference between the strike price of the option and the underlying asset price.
 Time value: Time value is the amount over and above the intrinsic value that an investor will pay to buy an option. This
additional value is based on what might happen to the price of the underlying between now and the end of the life of
the option.

(5.1) INTRINSIC VALUE

Price
Call option
550
(Intrinsic value 50p)
In-the-money (ITM)
Share price

Strike 500 At-the-money (ATM)

(Intrinsic value 0)
 FURTHER INFORMATION
Links: In chapter one we learned about the moneyness of an option. Below is a quick reminder.
Call Moneyness Put
Asset price < Strike price OTM Asset price > Strike price
Asset price = Strike price ATM Asset price = Strike price
Asset price > Strike price ITM Asset price < Strike price
If the underlying is priced at 246, what is the intrinsic value of the September 330 put option with 180 days to expiry and a
premium of 100?
a. 100
b. 84
c. 16
d. 0
Answer: B - Intrinsic value of a put = Strike price – asset price = 330 – 246 = 84

(5.1) MAIN FACTORS DETERMINING TIME VALUE

 Time to expiry Tim
e
valu
e/£

Time

Expiry date

o The erosion of time value acts against the holder and in favour of the writer
o For the holder, if everything else remains the same, their option is losing value each day
 Volatility of underlying asset price
o Historic
o Future
o Implied
FURTHER INFORMATION
Options pricing models
FURTHER INFORMATION
 Black-Scholes Model – Uses the variables that influence options pricing to compute an option’s premium. Good for
European
Hints: Hedgers are options.
protected from market risk, but become exposed to basis risk. The only way to eliminate basis risk is to hold
the contract
 Binomialtill delivery,
Pricing but this–isStates
model not always possible.
the current Speculators
value mayequals
of an option take a the
viewpresent
on what theyofbelieve
value will happen to the
the probability-weighted
basis andfuture
conduct trades:
payoffs from the options.
If basisfor
 Good strengthens, buying basis = buy cash and sell future
American options.
If basis weakens,
 Stocastic sellingrho
alpha, beta, basis = sell -cash
(SABR) Usesand buy future
different levels of implied volatility to price options on the same underlying
asset,expects
If an investor as implied volatility
the basis is considered
to strengthen, tothink
they be greater
that: for options with strike prices that are well ITM and very much
a. OTM.
Basis will become more positive: buy the cash and sell the future
[Link]
Basisvolatility is sometimes
will become known
more positive: as the
buy ‘realised’
futurevolatility.
and sell the cash
[Link]
Basis will become more negative: buy the cash and sellifthe
to the premium of an at-the money put option thefuture
price of the underlying rises?
a.
d. No change
Basis will become more negative: buy the future and sell the cash
b. Increase
Answer: A
c. Decrease
d. It depends on whether the premium is settled up front or on exercise
Answer: C
(5.1) OTHER FACTORS DETERMINING TIME VALUE
Dividend yield
Call option Put option
Dividends rise Time value falls Time value rises
Dividends fall Time value rises Time value falls
Interest rates
Call option Put option
Interest rates rise Time value rises Time value falls
Interest rates fall Time value falls Time value rises

FURTHER INFORMATION
Variables affecting options premiums
Call Premiums Put Premiums Sensitivity Measure
Underlying Delta
Time Theta
Volatility Vega
Interest Rates Rho
Dividends -

(5.1) TIME VALUE AND MONEYNESS OF OPTIONS

Graphical representation of a call option’s intrinsic and time value
Premi
um Total
premi
Time value is greatest
when the option is at-
the-money
Intrinsic value
(increases at a rate
of 1:1)
Time value

Strike price Price of underlying

OTM ATM IT
M

FURTHER INFORMATION
 When the call option is out-of-the-money, the premium is made up entirely of time value (i.e. there is no intrinsic
value).
 When the call option is at-the-money, the premium is still made up entirely of time value, and time value is at its
greatest because uncertainty (and therefore risk) is at its greatest.
 When the call option is in-the-money, the premium is made up of time value and intrinsic value.

(5.2) PUT/CALL PARITY THEORY

Options on futures
C-P= S-K
Options on underlying asset
C
-P= S -K

(1+
FURTHER INFORMATION
Put-call parity rationale: The basic rationale of put-call parity theory is that, if there are two methods of reaching the same
payoff, those two methods should cost the same. As we can combine a long call with a short put to create the pay off of a long
future (a synthetic long future), put-call parity theory can provide an alternate way of calculating a premium of a call or a put in a
 Long call
Short put
Synthetic long future

(5.2) PUT/CALL PARITY THEORY – CALCULATE A PREMIUM

Call option premium = £0.30
Underlying share price = £1.75
Strike price = £1.60
Interest rates = 10% pa
Time to expiry = Three months
Calculate the fair value of a put option premium, on the same underlying, with the same strike price and expiry date.
Solution:
C
-P= S -K

0.30 – P = (1 + – 1.60
1.75
(1+0.1)0.25

0.30 – P = 1.75 – 1.60

1.024

0.30 – P = 1.5625

0.30 – 0.1875 = P

Put premium = 0.1125

FURTHER INFORMATION
 Put premium = 23p
 Call option premium = 35p
 Strike price = 140p
 Interest rates = 9% pa
 Time to expiry = three months
 Underlying cash price = 150p
From what trade would an arbitrager profit?
Answer
35 – 23 = 150 – (140/(1.09^0.25))
12 = 150 – 137.02
12 = 12.98
This statement is wrong. Either C is too low, or P is too high. So, the arbitrager buys a call and sells a put (which creates a
synthetic long) and sells the underlying. This trade is referred to as a ‘reversal’.

(5.2) PUT/CALL PARITY THEORY – ARBITRAGE TRADE

 Synthetic < future/underlying
 Trade: Reversal
 Actions:
o Synthetic long (buy call and sell put)
o Sell future/underlying
Synthetic > future/underlying
 Trade: Conversion
 Actions:
o Synthetic short (sell call and buy put)
o Buy future/underlying

FURTHER INFORMATION
Put-call parity practice
 Call premium = 3p
 Put premium = 1p
 Interest rates = 10% pa
 Time to expiry = three months
 Underlying cash price = 31p
Assuming all calls and puts on the underlying asset have the same strike price of 30p, from what trade would an arbitrager
profit?
A. Sell the underlying, buy a call and sell a put
B. Buy the underlying, sell a put and buy a call
C. Buy the underlying, sell a call and buy a put
D. Sell the underlying, buy a put and sell a call
Answer = C
3 – 1 = 31 – (30/(1.10^0.25))
2 = 31 – 29.29
2 = 1.71
This statement is wrong. Either C is too high, or P is too low. So, the arbitrager sells a call and buys a put (which creates a
synthetic short) and buys the underlying. This trade is referred to as a ‘conversion’.

(5.3) DELTA
Definition: The sensitivity of an option premium to a change in the price of the underlying
 = Change in value of option
premium
Delta sign Change in value of underlying
 Call deltas are positive – premium rises when underlying rises
 Put deltas are negative – premium falls when underlying rises

FURTHER INFORMATION
Keeping on target: If the delta of an option is 0.28 and the underlying on which the option is based moves in price from 80p to
85p, what would be impact on the premium of a call option and the premium of a put option?
Answer: The change in the option premium would be the change in the price of the underlying divided by the option’s delta.
5p x 0.28 = 1.4p.
 The call premium would increase by 1.4p.
 The put premium would fall by 1.4p.

(5.3) DELTA
Delta as the probability of an option expiring in-the-money
Here the gradient is
Premium almost 1 in 1, so the
When the
option is ATM Delta is nearly1
The slope of the the gradient is   + 0.9
curve is nearly approximately
flat so the Delta 50% so Delta is
of the option is roughly 0.5
nearly zero   + 0.5
  + 0.1

Time value

Price of underlying
Strike price

Premium   - 0.9

  - 0.5

  - 0.1
Time value

Strike price Price of underlying

FURTHER INFORMATION
Hints: If a long call strike 100 on asset A, June expiry has a delta of +0.34, we can deduce from this the other three option
positions.
 The short call strike 100 on asset A, June expiry will have a delta or -0.34.
 The long put strike 100 on asset A, June expiry will have a delta of -0.66.
 The short put strike 100 on asset A, June expiry will have a delta of +0.66.
Which of the following will most likely expire in-the-money?
E. +0.29
F. -0.42
G. +0.50
H. -0.59
Answer: D

(5.3) DELTA
 Options as a relative number of futures positions
 Example:
Long 2 units of the underlying = 2 x (+1) = +2
Short 1 ATM call = 1 x (-0.5) = -0.5
Long 2 deeply OTM puts =2x0 =0
+1.5
The portfolio’s delta is 1.5. This reflects a bullish portfolio i.e. if the price of the underlying increases by £1, the value of the
portfolio will increase by £1.50

FURTHER INFORMATION Position

(5.4) OTHER GREEK MEASURES
Delta definitions Deeply ITM option
Gamma
 Delta hedging refers
Deeply OTM option
ATM option  The sensitivity of an option’s delta to a change in the price of the underlying
to a portfolio manager
attempting to Bullish
achievepositions  For an ATM option, gamma increases as the remaining life decreases
a delta neutral
Bearish positions  Gamma is negative for short options and positive for long options
portfolio.  = 0.506 for
Futures/Unit inPrethe underlying six-month Six-month option
 Delta neutral refers tomiu  = 0.5 for
option
both options
a portfolio wherem ATM
Three-month option

 = 0.511 for three-

month option
FURTHER INFORMATION
If delta measures the gradient of the premium curve, gamma measures the rate of change of that gradient. For deeply OTM and
deeply ITM options the premium curve is almost linear, which indicates a very low gamma.

(5.4) OTHER GREEK MEASURES

Vega
 Sensitivity of an option premium to a 1% change in implied volatility
 Positive for long positions
 Greatest for at-the-money options
 Higher for longer dated options
Theta
 Sensitivity of an option premium to a change in a unit of time
 Negative theta for long positions, positive theta for short positions
 Greatest for at-the-money options
 Increases as options approach expiry
Rho
 Sensitivity of an option premium to a 1% change in interest rates
 Increase in interest rates: rho is positive for calls, and negative for puts
 At-the-money and in-the-money options have relatively higher rho
 Higher for longer dated options

What about the highest gamma, vega or theta?

CHAPTER 4 - OTC DERIVATIVES - 14 QUESTIONS

CHAPTER OVERVIEW

Forwards and FRAs Credit derivatives

 Characteristics and applications  Credit default swaps, credit linked notes and
 OTC derivative pricing collateralised debt obligations
 FX Forwards and swaps OTC Options and Option-based Investments
Interest Rate Swaps  Main types and features
 Purpose and characteristics of IRS  OTC vs FLEX vs ETD
Other Swaps  Caps, floors and collars
 Purpose and characteristics of asset, total return,  Structured products
commodity swaps OTC Documentation, Processes and Platforms (Home
study)

FURTHER INFORMATION
The month is July, and the trader is considering the following put options. If the underlying price is 110, which option has the
highest absolute value of delta?
Expiry months
Put option
November December January
100 A B C
Strike price 110 D E F
120 G H I
  Documentation: Types and purpose  Main platforms and mechanisms
 Collateral management  Main control processes

2. FORWARDS AND FRAS

(2.1) FORWARDS
OTC future
 Flexibility
 Wide range of underlying
 Confidentiality

(2.2) FORWARD RATE AGREEMENTS (FRAS)

OTC interest rate future
 Referenced interest rate period is expressed as ratio:
‘Start month’ (or effective date) vs. ‘end month’ (or termination date), e.g. 1v4
 Payout on effective date

FURTHER INFORMATION
An FRA is effectively an agreement to buy or sell an interest rate which is fixed today and which will be revalued against
prevailing market rates, using a benchmark rate, e.g. Long an FRA at 4% on £1m against 3mth LIBOR.

4. INTEREST RATE SWAPS

(4.1) SWAPS: THE BASICS

Definition
 Where two counterparties exchange (swap) one stream of a cash flow against another. These payment streams are
called the legs of the swap.
Components of a swap
 The term: This is the length of time the swap lasts for.
 The notional amount: This is the size of the swap. The notional is a reference amount and not paid by anyone to
anyone else.
 The frequency: This is how often each year the payments are swapped.
 A swap rate: This is typically the fixed rate component of the swap.
• For example: Agreement to exchange a fixed rate of 4% for 3 month LIBOR on £1m every 3 months for the next two years.

FURTHER INFORMATION
The exchange of cash flows does not have to occur at the same time. One leg could be monthly, the other every three months.

(4.1) INTEREST RATE SWAPS (IRS)

Producer Interest payment of Swap Institution
6.32% x 3/12 every three
months

Three months’ LIBOR

Three months’ LIBOR

(payments on original loan)

Interest rate swap

Bank

FURTHER INFORMATION
 Features of interest rate swaps: Interest rate swaps (IRSs) are sometimes described as coupon swaps. A specific
example of a coupon swap is a vanilla swap, which is created where two parties swap a fixed rate of interest and a
(4.1) INTEREST RATE SWAPS (IRS) TERMINOLOGY
 Vanilla swaps: Agreement to exchange fixed-for-floating
 Basis swaps: Agreement to exchange floating-for-floating
 Overnight index swap (OIS): Agreement to exchange the swap rate for an overnight index average, e.g., SONIA
 Single currency vs. cross currency swap
 ‘Swaption’ – OTC option on a swap
 ‘Payer’ – long the swap
 ‘Receiver’ – short the swap
 Amortising swap

FURTHER INFORMATION
Other swaps
 Inflation swaps: both legs calculated in reference to an inflation index.
 Constant maturity swap: floating leg fixed against a set point on a swap curve.
 Arrears swap: Floating leg observed at the start of the period and paid at the end of the period.
 Forward start swaps: a swap agreed today to start on a future date.
 Mark-to-market swap: paying any increase or decrease on the value of the swap at set intervals.
For what reason would you exercise a receiver swaption?
a. Interest rates have risen so the option is in the money
b. Interest rates have risen so the option is out of the money
c. Interest rates have dropped so the option is in the money
d. Interest rates have dropped so the option is out of the money
Answer = C

5. OTHER TYPES OF SWAPS

(5.1) ASSET SWAP

 A bond combined with an interest rate swap
Can be used to create a synthetic floating rate note
Coupon (8% pa)
Invest\\or Bond Issuer

LIBOR+75bp Coupon (8% pa)

Swaps Bank

Separates the decisions of:

 Interest payment: Fixed or floating
 Bond choice: Availability, credit quality, issuer, etc.

FURTHER INFORMATION
Coupons on bonds are usually fixed. An increase in interest rates will lead to bond prices falling and bond yields rising. Those
investors that had already bought the bond will suffer the fall in prices and not benefit from the increase in yields. Where
coupons are variable in line with interest rates, the bondholders are directly compensated for the increase in rates. An asset
swap allows the investor to synthetically convert a fixed coupon to a variable coupon and hence gives capital protection on the
bond.

Asset
(5.1) TOTAL RETURN SWAP

Swap bank Purchase price

Fixed or Fixed or
LIBOR + LIBOR +
spread spread
Total return Total return
receiver payer
Total Total
return return
FURTHER INFORMATION
Negative total returns: In the event of negative returns on the asset, the receiver is obligated not just to pass the benchmark
rate to the payer but also any negative returns on the [Link] or LIBOR
spread

Receiver Payer
Negative return
on the asset
Equity Swap: This is a total return swap on equity, equity indices or a basket of equities.
Property swap: This is a total return swap on a property index or collection of properties.
Delta: Total return swaps are assumed to have a delta of 1
Hints: Total return futures are available on CME and Eurex.

(5.1) TOTAL RETURN SWAP

 A transfer of exposure on a portfolio without the actual purchase or sale
Structure and motivation of payer:
 May own a portfolio of assets and believes prices may fall
 Total returns on an asset exchanged for an interest rate based on a notional amount
 No longer exposed to the uncertainty on the portfolio but does not have to sell
Structure and motivation of receiver:
 Would like an exposure to portfolio for a period of time without the purchase
 Pays an interest rate on a notional amount in exchange for the total returns on an asset
 Now exposed to the return (both positive and negative) of the asset

FURTHER INFORMATION
Dividend swap and variance swap
 Actual dividends for expected dividends
 Actual variance/volatility for expected variance/volatility
 Note: Interest rate payments can be used instead of the expected measure.
Zero coupon inflation product: Actual inflation rate over a set period (e.g., CPI) for an expected rate with a single exchange of
cash flow upon maturity.
A fund manager believes the FTSE 100 will increase in value and enters into an equity index swap. During the term of the
swap the index falls in value. Which of the following will the fund manager have to do?
a. Make interest payments to the swap dealer
b. Make interest payments to the swap dealer and additional payments for the decrease in the value of the index
c. Make increased interest payments until the index increases in value
d. Make payments based on the value of the index only to the swap dealer
Answer = B: Make interest payments to the swap dealer and additional payments for the decrease in the value of the index.

(5.7) COMMODITY SWAPS Producer Payment of commodity Swap Institution

index price

Fixed price

Commodity market price

Fixed for floating

commodity swap
FURTHER INFORMATION
Commodity swap: An alternative to futures and options to hedge against a movement in commodities prices
Structure and motivation of producer swap:
 A producer may be concerned with a fall in commodity prices
 Agrees to exchange a price based on a commodity index against receiving a fixed price
 The fixed price being received removes the exposure on prices falling and would gain in the swap if prices fall
Structure and motivation of user swap:
 A user of a commodity may be concerned with a rise in commodity prices
 Agrees to pay a fixed price against receiving a commodity index price
 Paying a fixed prices removes the uncertainty of prices rising and would gain in the swap if prices rise

7. CREDIT DERIVATIVES

(7.1) CREDIT DEFAULT SWAPS (CDSS) Cost of asset

Swap
premium
Reference
asset Swap
Investor
Asset cash flows Cash payment bank
should default
Credit event occur
 Failure to pay (default)
 Significant fall in asset price/value (typically index)
 Bankruptcy
 Debt restructuring
 Merger or demerger
Payout
 Physically delivered: bond exchanged for bond value
 Cash-settled: investor receives bond value less recovery rate

FURTHER INFORMATION
Credit default swap types
 Single name: Where protection is bought on a specific reference asset, such as a particular bond.
 Index: Where the reference asset is a bond, equity or market index. Generally, the protection is bought against a price
fall below a pre-specified level. This type of CDS is closely linked to a total return swap.
 Basket: Where a collection of specific bonds can be pooled into a portfolio and protection is bought against that
portfolio. Payments could be triggered by the first to default, or a pre-specified number to default.
Hints: The International Swaps and Derivatives Association (ISDA) puts in place a Determination Committee who determine:
 Whether a credit event has occurred
 What credit event has occurred
 The process of assessing compensation amounts

(7.1) CREDIT LINKED NOTE

 A funded credit derivative
 Transferring the risk of a debtor
 Seller has no obligation to pay if a specified event occurs
E.g., default of the referenced asset

(7.2) CREDIT DEFAULT OPTIONS AND OTHER INSTRUMENTS

Credit default option
 Option to buy/sell a CDS
Asset backed securities
 Secured by a pool of assets, e.g., property, loans
 Underlying assets securitised
o Collateralised bond obligations (CBOs)
o Collateralised debt obligations (CDOs)
o Synthetic CDOs

FURTHER INFORMATION
Types of asset backed securities
 A collateralised bond obligation (CBO) is an investment-grade bond (i.e. highly rated bond) backed by a pool of high
yielding bonds (i.e. 'junk' bonds).
 A collateralised debt obligation (CDO) is a security secured by the cash flows from a pool of bonds, loans and other
assets.
 In a synthetic CDO, no physical transfer of bonds or loans take place from the credit institution to the SPV. Instead, the
CDO gains exposure to credit risk by selling a credit default swap to the credit institution that holds the bonds or loans.

(7.2) CREDIT SPREADS

 The difference between the yield on a particular asset and the yield on a benchmark
 Credit spread options: Strike based on the spread
o The long is protected against the weakening of an asset in relation to the benchmark (widening spread)

6. OPTIONS

(6.1) OTC OPTIONS PRODUCTS

 European style
 American style
 Bermudan style
 Asian style: The price of the underlying is based on an average price rather than a price on expiry
 Average strike: The strike price of the option is based on an average price of the underlying
 Lookback (or path dependent) options: Enables the long to choose the best available price over the life of the option
 Ratchets/Cliquets: A series of options able to lock in profits at the end of each interval and reset ATM for the next

FURTHER INFORMATION
Barrier options: The activation/deactivation criteria can be directional
 Up and in
 Up and out
 Down and in
 Down and out
Which of the following is a difference between FLEX options and OTC options?
a. The terms are standardised for FLEX contracts
b. OTCs are centrally cleared
c. FLEX contracts have lower credit risk
d. The market maker dictates the contract specifications for a FLEX option
Answer: C
interval

(6.2) CAPS, FLOORS AND COLLARS

 Caps: OTC call on an interest rate or asset
  Floors: OTC put on an interest rate or asset
 Collars
o Cap and a floor combined
o Can be used to hedge against volatility

8. STRUCTURED PRODUCTS

 Callable/Putable bonds
o Callable – can be redeemed early at the discretion of the issuer
o Putable – can be redeemed early at the discretion of the holder
 Convertible bonds
o Convertible corporate bond (loan stock) – convertible into ordinary shares
FURTHER INFORMATION
Convertible
o Company
Collar example: giltscaps
X buys – convertible
at £10,000into
andother
sells gilts
floors at £9,000 to limit the volatility on an asset. Company X still pays
the commodity market price
 Index-linked notes when buying the asset.
o Both coupon and capital linked to an inflation index
o Inflation protection
 Equity-linked note
o Yield determined by performance of equity
 Capital-protected products
o E.g., zero coupon bond and a long option

FURTHER INFORMATION
An investor buys a product whereby they borrow £100,000 over 5 years to purchase equity. The equity is held by the lender as
collateral which reduces the financing cost to the investor. If the value of the equity is below or equal to the £100,000
However, on T1, company X will exercise one of its caps, receiving a profit of £50. At T2, both the floor and cap are abandoned.
borrowed at maturity, the investor has the right to surrender the shares to satisfy the repayment of the loan. What would this
At T3 the holder of the floor exercises and company X has to pay £250. At T4, the holder of the floor exercises and company X
product be called?
has to pay £1,000. The net effect is as follows:
a. Certificated equity
 T1: £10,050 - £50 = £10,000 cost
b. Equity linked note
 T2: £9,100 cost
c. Derivative warrant
 T3: £8,750 + £250 = £9,000 cost
d. Capital protected product
 T4: £8,000 + £1,000 = £9,000 cost
Answer = D: This Buy
isSell
a capital protected product (AKA capital protected borrowings). It is essentially an equity holding with a put
In summary the investor will never pay below
Purchase £9,000
commodityor
at above
£10,050 £10,000 for theT4commodity.
option financed through
Cap a£9,000
loan. The cost
Floor £10,000 ofT1the
Purchase productT2would
Commodity atPurchase
£9,100 T3
be the interest
commodity at payments on the
£8,750 Purchase loan. at £8,000
commodity
FURTHER INFORMATION
ISDA Master Agreements
 Termination events – external circumstances outside the control of the parties, e.g., changes in tax law or illegality,
which allow deals to be terminated early.
 Events of default – events which are generally the fault of one of the two parties, e.g., failing to pay an amount due or
bankruptcy, which allow all deals to be terminated early by the other party.
 Netting – (important for credit risk and for capital adequacy purposes). The master agreement covers two types of
netting:
o Payment netting – netting of amounts due in the same currency on the same day; and
o Close-out netting – netting of all amounts due between the parties upon early termination.
 Note: Local jurisdictions may affect the legality of the contracts.
 Rule of Law: ISDA master agreements considers the law in various jurisdictions to cover rights and obligations of both
parties. However, there is some risk that in the event of default interpretation may depend on the legal jurisdiction of
each party. Therefore, it is important to have these signed between both parties as quickly as possible.

9. MASTER AGREEMENTS

International Swaps and Derivatives Association (ISDA)

Aims of ISDA
 Provide standard market terms
 Minimise administration
 Facilitate cross-border selling

(9.1) MASTER AGREEMENT

 Provides for mutual protection for both parties
o Termination events and default events
o Netting off of payments and positions
 Confirmations
o Supplement to the Master Agreement, set out the specific terms of the deal

(9.3) PROTOCOLS
 A term used to describe a set of documents widely used by the market
o E.g., master agreements
 Regularly updated when necessary
o E.g., adoption of the Euro or implementation of EMIR

11. TRADE PROCESSING

(11.9) THE IMPORTANCE OF CONTROLS

The risks arising from inefficiency are potentially greater than the initial transaction due to:
 Gearing
 Volume of transactions
 Range and complexity of products
This leads to:
 The need for regular valuations and risk monitoring
 Regulatory reporting requirements
(11.10) THE PROCESS FLOW
Trade capture and verification
 Ensuring trade details are verified promptly
Confirmation and documentation
 Trade details confirmed with counterparty
 Reports made to a trade repository (e.g., under EMIR)
Position keeping
 Monitoring profits, losses and on-going risks
 Monitoring value and transfer of collateral
 Reconciliation of cash flows due and cash flows received/paid
Settlement
 Complications for swaps, caps/floors, CDSs, etc.

FURTHER INFORMATION
Risks of inaccurate processes
 Inaccurate evaluation of risk
 Positions in excess of the firm’s risk tolerance
 Losses from unreported positions
 Late settlement
 Poor-quality client servicing
 Rule breaches
 Loss of reputation

Recent developments
 Increasing use of electronic processing and clearing services
 Greater communication between systems
o Improving straight through processing (STP)
Straight through processing
 Linking
o Trade allocation systems: E.g., DTCCs Omgeo OASYS
o Trade capture and confirmation systems: E.g., MarkitWire/MarkitSERV
o Clearing
Central counterparty service, e.g., SwapClear
Allows for standardised margining
May require standardised contracts

FURTHER INFORMATION
The benefits of straight-through processing (STP)
The key areas of improved trade processing include:
 Trade automation
 Document management
 Process connectivity
 Risk management.
The key benefits of straight through processing and central clearing of OTC derivative trades.
1. Reduced counterparty credit evaluations and ongoing credit exposure monitoring
2. Transparency and consistency of pricing for margin and funds settlements
3. Monitoring of multilateral exposures and correlation risks
4. Default resolution
5. Default risk mutualisation and loss allocation
FURTHER INFORMATION
Hints: SwapClear is run by [Link] and what you will learn about the functionality of [Link] is also true of SwapClear.
To be a SwapClear dealer you must be a SWIFT user and have a credit rating of BBB or above.

Summary
Purpose Key Features
Owned by DTCC and Markit.
Single gateway for OTC derivatives trade
MarkitServ Trade confirmation platforms to cover credit, interest
processing
rate, equity and commodity derivatives.
[Link] becomes central counterparty
Provides a clearing house function to OTC  Frees up credit lines
SwapClear
markets.  Reduces risk
 Uses capital – margin
A global service – to automate the entire
Matching and confirmations Clearing and payments
DTCC life cycle of OTC.
Trade information
Affirmation platform.
Reduces operational risk Lowers costs
Allows users to send and receive secure
SWIFTNet FpML Reducing settlement risk
messages and confirmations.
Ease of access – GUI
Portfolio management (TriReduce): The reduction of
To help clients reduce capital, credit and
NEX TriOptima swap inventory and counterparty risk, managing
operational costs with OTC portfolio.
disputes and automatic margin management.
Trade processing service and clearing Provided by Euronext for OTC equity and Commodity
Bclear
service. derivative contracts.
FpML– Financial
A protocol for electronic dealing and Standard data content and structure for interest rate
Products Markup
processing. derivatives, FX, credit swaps, equity swaps.
Language
Provides trade information.
ICE Link Trade matching and processing service.
Novation of credit derivatives on T + 0 basis.
EurexOTC Clear Transaction management and clearing. Provided by Eurex group to clear swaps.

CHAPTER 5: CLEARING - 7 QUESTIONS

CHAPTER OVERVIEW

The Clearing House  Calculation of initial margin

 How clearing reduces risk  Calculation of variation margin
 Independent vs mutual guarantee Other Features of the Margin Process
 The relationship between the CCP and the  Maintenance Margin
members/non-members  Price limits and position limits
Main Features of the Margin Process OTC Collateral Process (Home study)
 Types and how collected

1. THE DEFINITION AND PURPOSE OF CLEARING

(1.1) CLEARING AND RISK

 The process through which derivatives trades are confirmed and registered
 Clearing house as central counterparty (CCP)
o Greatly reduces counterparty risk (credit risk)
o Guarantees the performance of a contract
o Gives high degree of confidence in the system
 Categories of exchange/clearing member:
o General clearing members (GCMs)
o Individual clearing members (ICMs)
 o Non-clearing members (NCMs)
 Clearing house as registrar

FURTHER INFORMATION
 Clearing house as registrar: Clearing houses act as registrars to the marketplace by recording details of all matched
trades. Details of derivatives trades are passed electronically to a clearing house via some form of electronic
communication system
 Rule of Law: Clearing houses, acting as CCP, guarantee the performance of the contract. If a party meets their legal
obligations, the clearing house ensures the other side of the contract is fulfilled.
When does the clearing house become counterparty to a trade?
a. When the trade is struck
b. When the trade is reported
c. When the trade is settled
d. When the trade is registered
Answer: D

(1.2) THE STRUCTURE OF THE CLEARING SYSTEM

 Novation
 Principal to principal guarantee

1. Initial Trade

Deal

Buyer Seller
(Clearing member) (Clearing member)

2. Novation
Buy Buy
Sell CCP Sell

FURTHER INFORMATION
 Principal to principal guarantee: A clearing house guarantees its members' obligations in relation to the trades it clears
for them. However, this guarantee only extends to clearing members, not to clients of a member. If a client of a clearing
member defaults, the member has no recourse to the clearing house. This guarantee structure is known as principal to
principal.
Which of the below does a clearing house guarantee the trades of:
a. All clearing members
b. General clearing members only
c. All clearing members and their customers
d. Clearing member's customers only
Answer: A

(1.3) GUARANTEE
Protection given to counterparties should a default occur
 Mutual guarantee (the default waterfall)
o Defaulting member’s margin
o Defaulting member’s contributions to default fund
o Other member’s contributions to default fund
o Clearing house’s own funds
 Independent guarantee
 o Defaulting member’s margin
o Clearing house’s own funds (including insurance)
Default fund
 Contributions based on proportionate volume and value of average daily trades novated

FURTHER INFORMATION
Default/Clearing fundL The workbook states that the major types of collateral accepted by clearers for the clearing fund are
cash (EUR, USD, GBP, CHF, JPY, SEK, DKK, NOK) and government debt (UK, US, German, French, Italian and Japanese).

Summary of Clearing Houses

Major exchanges Clearing houses
ICE Futures Europe ICE Clear Europe
LME LME Clear
LSE Derivatives EuroCCP, [Link], EMCF, x-clear
CME Group (CBOT, CME, and NYMEX) CME Clearing
Chicago Board Options Exchange (CBOE) Options Clearing Corporation (OCC)
One Chicago CME Clearing or Options Clearing Corporation (OCC)
PHLX – Philadelphia exchange Own clearing house
Eurex Eurex Clearing
Euronext (European Exchanges) LCH Group and Euroclear
Mercado Espanola de Futuros Financieros (MEFF) Own clearing house
SGX – Singapore exchange SGX-DC
Osaka Securities Exchange Own clearing house
B3 – Brazilian mercantile and futures exchange Own clearing house
DME – Dubai mercantile exchange NYMEX clearing house
NCDEX – National commodities and derivatives exchange (India) Own Depository Clearing System
SAFEX – South African futures exchange Own clearing house
SHFE – Shanghai futures exchange Own clearing house

FURTHER INFORMATION
Most exchanges tend to use their own clearing house, therefore when preparing for the exam you only need to learn the
exceptions to reduce your learning:
 LSE Derivatives
 CBOE
 One Chicago
 Euronext
 DME

2. MARGIN

(2.1) INTRODUCTION
 SPAN (Standard Portfolio Analysis of risk)

Long Gilt Portfolio Short Sterling Portfolio

Futures Futures

Long Short Long Short

Options Options

Long Short Long Short

FURTHER INFORMATION
 SPAN collects all the derivative positions of a clearing member into portfolios and calculates the risk of each portfolio
Initial margin calculation
 Scanning risk will be set by looking at the recent price volatility of the contract.
 Intermonth charges – these are for intramarket spreads, e.g., long a June tin contract and short a September tin
contract.
 Intercommodity credits – these are for intercommodity spreads, e.g., long a June gas oil future and short a June Brent
Crude future.
 Spot month charges – to cover a potential increase in volatility as the contract approaches expiry.
Hints: SPAN is not the only system that calculates margin. The Options Clearing Corporation (OCC) has used two systems:
 Theoretical Intermarket Margining System (TIMS)
 System for Theoretical Analysis and Numerical Simulations (STANS)
These calculate:
 Risk margin – similar to initial margin
Premium
(2.1)INITIAL margin – similar to variation margin
MARGIN
Clearing house member firm’s margin bill will be either:
Scanning risk Short option minimum
FURTHER INFORMATION + charge
 Contingent liability transactions and margin: Margin is always payableapplies
Inter-month charges This only if the
on 'contingent liability' transactions. Contingent
Summary + or member has written
liability: where an investor can lose more than their initial investment. Contingent liability investments are:
Spot month charges (i.e., short) deeply out of the
o Long and short futures positions
- money options positions
Inter-commodity credits
o Short option positions and nothing else.
Whichever is greater
Initial margin is payable to the clearing house. Initial margin is described as a returnable good faith deposit. It
represents the worst probable loss that could be made on a bad day. Clearing houses use a computer program to
calculate this; the most common is called SPAN.
 Hints: Margin is demanded by the clearing house separately for the house accounts maintained by the clearing member
(which will include any nonsegregated client positions) and the segregated client accounts.

General Considerations Around  Intangible vs tangible

Clearing  The process of delivery and EDSP
 Commodity contracts Delivery on Options
 Closing contracts  Delivery vs non-delivery
Delivery on Futures  Automatic exercise
 Delivery vs non-delivery Mutual Offset Trading
 Cash vs physical

1. DELIVERY AND SETTLEMENT – FUTURES

 (1.1) INTRODUCTION
 Clearing house manages delivery between clearing members
 Commodity contracts
o Approved warehouse
 Global
o Warehouse receipt
 LME warrant
Proof of ownership
 LMEsword
Secure recording and transfer of warrants

(1.2) CLOSING CONTRACTS

Three choices to a buyer/long position of futures
 To close out
 To roll the position forward
 To proceed to delivery
Where different positions in the same contract are held by the same firm
 First in first out (FIFO)
 Last in first out (LIFO)
 Maximum profit
 Maximum loss
Bust the settlement
 Where a position has been closed out in error
 Clearing house reverses the closing action, and reopens the position

FURTHER INFORMATION
A full rollover changes the position’s maturity, but not its risk. Most exchanges have a specific rollover date, which shifts the
exchange’s price reference to the new contract. The contract used as reference is known as the ‘front month’ and has the
highest open interest.

(1.3) PHYSICAL DELIVERY OR CASH SETTLEMENT

 Exchange delivery settlement price (EDSP)
 Delivery methods
o Contracts for differences (CFDs)
o Physically delivered futures
 Example: An investor is long on a three-month coffee future at £700/tonne:

To T1 T2 T3 (Expiry)
Futures 700 680 650 600
(EDSP)
Price Pay 20 vm Pay 30 vm Pay 50 vm

Decreasing over time as costs of carry decrease Based on cash price at delivery

Total variation margin paid = (20 + 30 + 50) = 100

At expiry pay EDSP = (based on cash price) = 600
Total Paid (agreed futures price) = 700

VM and EDSP together make up the trade price of the future

FURTHER INFORMATION
 EDSP: The EDSP is the price at which the underlying asset will change hands on the delivery date. It is not the agreed
price of the futures contract. The EDSP is based on the cash price of the underlying asset at expiry. In setting the EDSP,
the exchange must use an openly declared mechanism that will prevent any price manipulation. The resulting price
must be fair, and truly representative of spot prices.
 Links: As the EDSP is based on the cash price on the delivery date, it ensures convergence.

(1.3) INVOICE AMOUNT

Invoice amount: General
Invoice amount = EDSP X
Number of contracts X Scale
Invoice amount: factor (contract size) Bonds
Invoice amount = (EDSP X Price
Factor X Scale Factor X
FURTHER INFORMATION of Contracts) +
Number
Accrued Interest
 Exchanges calculate the EDSP but the invoice amount is calculated by the clearing house.
 ‘Cheapest to deliver’ bond: When investing in bond futures, the bond linked to the derivative is a notional bond. The
bond delivered will be one of a basket of deliverable bonds.
The price the seller will deliver to the long for. The price the seller will buy the gilt in the cash market for.

PRICE FACTOR PROFIT (+) OR LOSS (-)

DELIVERABLE COUPON FUTURES x PF CASH
(PF) IF DELIVERED
TREASURY 4.75% 0.91160203 103.01 £103 +0.01
TREASURY 5.25% 0.95592920 108.02 £108 +0.02
CONVERTIBLE 8.00% 1.15039921 129.99 £130 -0.01
TREASURY 8.00% 1.17721501 133.03 £133 +0.03
TREASURY 7.00% 1.12400013 127.01 £127 +0.01

This is the CHEAPEST TO DELIVER (CTD) gilt, the short will profit by £0.03 per £100 nominal if this gilt is delivered.
 A price factor will bring the price of the future in line with the deliverable bond.
 The short chooses which bond to deliver. The bond chosen is the cheapest to deliver (CTD) bond.

(1.3) DELIVERY AND SETTLEMENT OF FUTURES

Physically delivered futures
Informs of
 First intention
Delivery
Chooses
notice
to deliver
Broker
(Clearing CCP
member)
Short Long
 Then
£ invoice £ invoice
amount amount
CCP
Short Asset Asset Long

FURTHER INFORMATION
Hints: The delivery notice is sometimes called the ‘tender notice’, as the seller tenders for delivery.
An investor goes long five physically settled September Universal Stock Futures on ABC shares at GBP3.25. Each contract size
is for 1,000 shares. If in September the exchange delivery settlement price of GBP3.43 is assessed, how much will the investor
need to pay to ensure good delivery?
 a. £3,250
b. £3,430
c. £16,250
d. £17,150
Answer: D - EDSP x contract size x number of contracts = 3.43 x 1,000 x 5 = £17,150

(1.3) TIMETABLE FOR PHYSICAL DELIVERY

First notice day Last trading day Last delivery day

Delivery month

First delivery day Last notice day

If there are choices about delivery, the short has the choices:
 When to give notice
 When to deliver
 What to deliver
 Where to deliver

FURTHER INFORMATION
Physical delivery
 The seller has the choice of when to deliver in the delivery month. In some contracts, usually non-financial derivative
contracts, the seller may also have some flexibility as to the quality of the underlying and the location of delivery.
 The seller sends a delivery notice to the clearing house prior to delivery. The holder, chosen at random by the clearing
house, pays the invoice amount.
 Obviously, the exchange or clearing house does not receive the physical asset on its doorstep in order to transfer them
to the long position. Stocks of the commodity will be held or delivered to exchange-approved warehouses. Delivery is
made from these warehouses. Ownership warrants are used to prove ownership of deliverable assets at these
warehouses. Each warrant entitles the holder to take possession of the specified asset from a specific warehouse.
 Hints: If the long position wishes to guarantee non-delivery on a contract, they must close out their position before the
first notice day.

2. DELIVERY AND SETTLEMENT – OPTIONS

(2.1) EXERCISE OF PHYSICALLY DELIVERABLE OPTIONS

 Holder of a call option informs their broker of intention to exercise:

Holder Broker
 BROKER (Clearing member) sends exercise notice to the clearing house.

Exercise
CPP
notice
Broker
 The clearing house chooses a writer and sends an assignment notice

Assignment
CPP
notice
Writer
 Upon receipt of assignment notice the writer delivers the stock to the clearing house and receives the strike price,
whilst the holder pays the strike to the clearing house and receives the stock.

Stock Stock
CPP
£ Strike £ Strike
Holder Writer
FURTHER INFORMATION
Options on futures
Long call
Short put Long future

Long put Short future

Short call

Put the following actions in order from first to last relating to a holder deciding to exercise an option:
i. The writer receives an assignment notice from their broker and must then honour their obligations
ii. The broker receives an assignment notice from the clearing house and allocates it to a client who holds a position as a writer
iii. The broker completes an exercise notice and forwards it to the clearing house
IV. Upon receipt of the exercise notice, the clearing house assigns it to a member firm
a. III, IV, II, I
b. II, III, IV, I
c. I, II, III, IV
d. IV, I, III, II
Answer: A

(2.1) EXERCISE OF PHYSICALLY DELIVERABLE OPTIONS

Exercise styles
 European
 American
 Bermudan
The long has the choices
 Whether to exercise
 When to exercise

FURTHER INFORMATION
Cash settled options Delivery on a cash settled option is to transfer the intrinsic value of the option from the writer to the holder.

(2.1) EXERCISE OF PHYSICALLY DELIVERABLE OPTIONS

Overall position
 Offset P&L P&L P&L
5p

£1.20 1p
0 U/L 0 £1.20 U/L 0 U/L

4p 4p

2. Then offset this 3. The overall result is the

1. Buy a 120 call for 4p. position by selling a 120 difference between the
call for 5p. premiums i.e., 1p.

 Abandonment

FURTHER INFORMATION
 Cabinet Trades: For tax and accounting purposes it may be beneficial for the investor to realise profits and losses by
closing out a worthless option position. This is known as a cabinet trade.
 Hints: On abandonment of an option
o The holder realises their maximum loss
o The writer realises their maximum profit

(2.5) AUTOMATIC EXERCISE

A clearing house facility to exercise ITM options automatically on the last trading day
 Conditions set by the exchange
 Prevent by filing suppression notice with the clearing house

FURTHER INFORMATION
 Automatic exercise: Automatic exercise is a facility which some clearing houses run but it requires the investor to
 3. CLEARING MECHANISMS AND OTHER FACTORS

(3.1) MUTUAL OFFSET

 Allows common settlement on different exchanges
 Benefits
o Increased liquidity
o Longer opening hours
 Example
o CME group and Singapore Exchange (SGX)
Eurodollar, yen and the US-dollar denominated Nikkei 225, E-micro CNX Nifty

CHAPTER 7: PORTFOLIO RESEARCH AND CONSTRUCTION - 7 QUESTIONS

CHAPTER OVERVIEW

Market Information  Application of derivatives in portfolio management

 Economic and financial information Portfolio Risk and Return
 Research and reports  Assess risk and return
 Factors that influence derivative markets Risk-Adjusted Performance
Portfolio construction  Assess risk-adjusted returns
 Portfolio risk and strategies to manage it

2. MARKET INFORMATION AND RESEARCH

(2.1) INFORMATION AND COMMUNICATION

 Wide range of economic and financial data and analysis available to investors
o Importance of identifying, and separating, fact from opinion

(2.2) MARKET RESEARCH AND REPORTS

 Fundamental analysis
o Use of revenues, earnings, future growth, return on equity, etc. to assess an intrinsic value of a company
 Technical analysis
o Use of past prices and volumes to assess future activity in the security
 Sector-specific reports
o Give an assessment and forecast for the sector and asset class covered
o Ranking and recommendation for each company contained

News
FURTHERservices
INFORMATION
 Bloomberg,
Economic Reuters,
and Financial CNBC, Financial
Communications: Times communications
Financial Government resources and statistics
and reports from numerous bodies, both in the private and
public
 Office for National Statistics (ONS) and the Bank of England Broker researchfunctions
sector, are a vital part of the tools required for the research and analysis that areinformation
and distributor crucial to decision-making
about
 Market commentary and analysis from major investment banks Regulatory resources where relevant from the following
investment strategies and asset allocation. The data needed by an investment manager can be sourced
broad categories:
 Communications from the FCA

3. PORTFOLIO CONSTRUCTION

(3.1) MAIN TYPES OF PORTFOLIO RISK

Systemic risk
 Affects the financial system as a whole
Systematic (market) risk (cannot be diversified away)
  Yield enhancement: Covered call
 Immunisation: The portfolio manager tries to match most of the maturities and expirations within the portfolio with
any future commitments. The strategy is linked to liability driven investing and the avoidance of reinvestment risk. This
type of investment strategy is most popular with bonds and currency swaps.
 Equity risk
 Interest rate risk
 Currency risk
 Commodity risk
Specific risk (can be diversified away)
 Issuer risk (credit risk)
 Liquidity
Diversification
 Combining securities whose returns are not perfectly positively correlated
 Increase the number of holdings
 Invest in different asset classes, different industry sectors, different countries etc.

FURTHER INFORMATION
 Systemic risk: Systemic risk is associated with the interdependencies within a system or market, where the failure of a
single participant or number of participants can cause a cascading failure, which could potentially bankrupt or bring
down the entire system or market. The systemic risk of a financial institution is the likelihood and the degree that the
institution's activities will negatively affect the larger economy so much so that governmental intervention would be
required to correct the effects.
 Hints: Correlation coefficients are useful to portfolio managers in two ways. Assets with a low correlation coefficient
allow the manager to reduce the portfolio’s risk. When a manager identifies an attractive investment asset that may be
too expensive or restricted or illiquid, they can try to find an attractive alternative by using an asset with a high
correlation coefficient.

(3.3) USE OF DERIVATIVES IN PORTFOLIO MANAGEMENT STRATEGIES

Active (market timing) approach
 Constant monitoring of the performance of the individual assets within the portfolio
o Employing fundamental and technical analysis
o Used as a basis for the ongoing buying and selling mispriced assets
 This is mainly used by those portfolio managers that have the goal to outperform a specific index or benchmark
Use of derivatives
 Out of market transactions on the OTC market
 Easy to facilitate short positions
 Buying credit protection on weak assets

(3.3) USE OF DERIVATIVES IN PORTFOLIO MANAGEMENT STRATEGIES

Passive (Indexing) approach
 Assumption that markets are sufficiently efficient
 Long-term view with limited interaction
 Tracking a specific benchmark/index
Use of derivatives
 Synthetic replication of the benchmark/index
 E.g., index futures, total return swaps, etc.
 Reduces further any market interaction
FURTHER INFORMATION
Other investment strategies
 Leveraging: Greater exposure to the underlying asset price for less outlay, using borrowing and margin accounts
 Contrarian: Exploit mispricing due to crowd behaviours distorting the market. E.g. market overreaction increases
volatility, so a contrarian could sell option to take advantage of the correction.
Passive-active combinations
 Core-satellite
 Indexing a portion of the portfolio and actively managing the remainder

FURTHER INFORMATION
 Tracking error: Tracking error is the standard deviation of the series of return differences between the portfolio and the
benchmark. It is typically calculated in percentage terms and annualised.
 Active or passive? The manual describes a shift in preference from active to passive management. This could be down
to:
o High transaction costs
o New types of tracker funds, e.g., exchange-traded products

4. ASSESSING PORTFOLIO RISK AND RETURN

(4.1) RISK REWARD CONNECTION

Risk and potential reward
 Positively correlated
 Low risk investments provide lower expected returns and a lower possibility of loss
 Higher risk investments have the potential for higher returns, and a greater possibility of loss
Holding period return calculations
HPR = ValEND - ValSTART
ValSTART

Example: The value of a portfolio at the start of year one is $97.5m. At the end of the annual period it has grown to $104.5m.
Calculate the holding period return

FURTHER INFORMATION
Benchmarking - A benchmark could be set as:
 Peer group
 Market index
 Custom (or composite) index
It is essential that the portfolio manager and client agree on the frequency with which the portfolio is reviewed, not only to
monitor the portfolio’s performance but also to ensure that it still meets with the client’s objectives and is correctly positioned
given prevailing market conditions.
Holding period return (HPR): Holding period return is a form of total or absolute return. It can be adapted to include cash flows
to and from the fund.
Total Return = (End val – Start val) + Income Received
Start val

4. ASSESSING PORTFOLIO RISK AND RETURN

(4.1) TIME WEIGHTED RATE OF RETURN (TWRR)

 Period of investment is broken into sub-periods based on cash flows
o Unitised approach
 The compound rate of return over these time periods
 Unaffected by timings and size of cash flows in and out of the portfolio
 Preferred industry standard

(4.1) MONEY WEIGHTED RATE OF RETURN (MWRR)

 Considers inflows and outflows of cash to the portfolio
 A single rate of return is attributed to the whole period of investment
 The return is given relative to the length of the period of investment
 Also known as the internal rate of return of cash flows
FURTHER INFORMATION
 Superiority of TWRR versus other return measures: Holding period return does not include the time value of money.
Both TWRR and MWRR are superior to holding period return in that they do take account of the time value of money.
The MWRR is equivalent to the internal rate of return of the portfolio.
The MWRR is designed to take some account of cash inflows and outflows but can still be affected by the timing and
size of flows. This overstates returns when the fund does well and understates returns when the fund does badly. The
TWRR aims to remove the distorting affect of these cash flows.
 TWRR formula - The formula for calculating TWRR compounds the rates of return over each sub-period:

Formula: TWRR = EndVal1 X EndVal2 ….X EndVal - 1

StartVal1 StartVal2 StartValn

(4.2) STANDARD DEVIATION

Stock J Stock K

-J
R -
R
0 K
Time Time

 Stock J is clearly more volatile than Stock K.

 The standard deviation around the mean (RJ) will be larger for stock J.
 Standard deviation (σ) is used to measure the comparative risk of stocks.

FURTHER INFORMATION
 Standard deviation: If returns are ‘normally’ distributed around the mean (the average) return, we can use standard
deviation as a predictor. Approximately two-thirds of the data will appear within one standard deviation of the mean.
Example: The average annual return of a stock is 7%. The standard deviation of the stock is 3%. We can expect (with a
two-thirds probability) that returns will be between 4% and 10%.
 Problems with using standard deviation:
o It is based on past patterns of returns, which may not be representative of future patterns in returns – e.g.,
equity markets produce more extreme positive and negative returns than should statistically be the case.
o It assumes that upside is equally as likely as downside – the standard deviation, by definition, is the average
upside or downside movement
o The predictability of returns can be distorted by the skewness of the curve or by kurtosis.

(4.3) RISK ADJUSTED RETURNS

Sharpe ratio: Portfolio return - Risk-free
Portfolio standard deviation
Treynor Ratio: Portfolio Return – Risk-free
Beta of the Portfolio
Information ratio: Portfolio Return – Benchmark Return
Standard Deviation of Excess Return

Jensen’s Alpha = RtnPortfolio - RtnCAPM

FURTHER INFORMATION
Risk adjusted return measures
Sharpe ratio
 Assumes portfolio is not diversified
 Divides excess returns into total risk (standard deviation)
 Sortino Ratio would use the downside risk as the denominator
Treynor ratio
 Assumes portfolio is fully diversified
 Divides excess returns into systematic risk (Beta)
Information ratio
 Divides outperformance over benchmark (alpha) into the tracking error of the portfolio
 The higher the value, the more successful was the active fund manager in taking on tracking error to beat the
benchmark
Jensen’s Alpha (not a ratio)
 Calculates portfolio outperformance (alpha) versus the return predicted by the CAPM model, given the beta of the
portfolio
Which of the following statements about the Treynor ratio is true?
a. It considers both systematic and non-systematic risks of a portfolio
b. It is calculated as the excess return of the portfolio above the risk-free rate divided by the portfolio’s total risk
c. It cannot be used to make comparisons between undiversified portfolios
d. It compares the portfolio return with the expected Capital Asset Pricing Model return

CHAPTER 8: PORTFOLIO PERFORMANCE AND REVIEW - 5 QUESTIONS

CHAPTER OVERVIEW

Selection and use of benchmarks  Calculating risk-adjusted return

 Benchmarks and stock market indices  Calculating the impact of currency movements
 Performance attribution Portfolio review
Portfolio measurement  The importance of portfolio reviews

1. PURPOSE AND CONCEPT OF BENCHMARKING

(8.1.1) PORTFOLIO EVALUATION

Benchmarks should be:
 Unambiguous
 Investable
 Measurable
 Appropriate
 Specified in advance
Three comparisons:
 Comparison with a relevant bond or stock market index
 Comparison with similar funds or fund universe
 Comparison with a custom benchmark

(8.1.2) STOCK MARKET INDICES

Weighting methods
 Price-weighted – equal number of shares held in each company (e.g., DJIA)
 Market value-weighted – relative market capitalisation used to weight (e.g., FTSE 100)
  Equal-weighted – equal money value invested into each share (e.g., MSCI USA)

FURTHER INFORMATION
Equity indices - The equity indices mentioned in the workbook are as follows:
FTSE 100
 100 biggest UK companies by free-float
 Rebalanced every quarter
 Represents 80% of the UK’s market capitalisation
FTSE All Share
 Contains approximately 700 companies
 Represents approximately 98% of the UK’s market capitalisation
FTSE Actuaries Government Securities Indices
 British government securities
 Divided into conventional gilts and index-linked gilts
 Can be divided into maturities from one year to 50 years
MSCI World
 A measure of 23 developed nations
 Calculated on capital or total returns basis
 Measured in US dollars and other currencies
Dow Jones Industrial Average
 30 stock accounting for 25% of US equity
 Price weighted measure
S&P 500 Index
 Represents 75% of the US equity market trading on NYSE and Nasdaq
 Companies must have at least 50% free-float and minimum market capitalisation of US $4m
Nikkei 225
 Shares trade on the first section of the Tokyo Stock Exchange (TSE)
 Price weighted measure
Nikkei 400
 Japanese companies that meet requirements of global investment standards
 Free float, market capitalisation weighted measure

(8.1.3) COMPOSITE BENCHMARKS

 A ‘customised’ benchmark created to match a fund’s asset allocation
 Mixed funds holding equities, government bonds, corporate bonds, property will need to select relevant indices and
then weight each asset return
 Example – MSCI and the Personal Investment Management and Financial Advice Association (PIMFA Growth)
o UK shares – MSCI UK (27.5%)
o International shares – MSCI World Ex UK (50.0%)
o Gilts – Markit £ Gilts (2.5%)
o Corporate bonds – Markit £ Corporate (5.0%)
o Cash – BoE Base (2.5%)
o Commercial property – MSCI UK Real Estate (5%)
o Hedge funds – MSCI World (7.5%)

FURTHER INFORMATION
PIMFA Wealth Management benchmarks: The asset allocations of the five key benchmarks (Conservative, Income, Growth,
Balanced, and Global Growth) are reviewed quarterly by an internal committee, to reflect the requirements of the private client
management community.
FURTHER INFORMATION
 This section of the chapter covers areas we saw in chapter 3:
 Return: Money-weighted rate of return and time-weighted rate of return
 Risk: Standard deviation
 Risk adjusted returns: Sharpe, Treynor, Jensen, information ratio
 Other indicators: Alpha, Beta, R2, maximum loss/maximum drawdown

(8.1.3) PEER GROUP AVERAGES

Many agencies provide benchmark services to fund managers based on:
 An aggregation of all funds
 Funds with similar investment briefs
 Funds with similar types of owners
 Specialist sub-groups

FURTHER INFORMATION
GIPS standards in the UK: In December 2019, GIPS were approved by the UK’s Competition and Markets Authority (CMA), an
independent non-ministerial government department with responsibility for strengthening business competition in the UK. This
approval means that fund managers of pension schemes must comply with the GIPS standards when presenting historical
performance for those pension schemes to the trustees.

Two such agencies are:

 WM (World Markets)
 CAPS – Combined Actuarial Performance Services
Global Investment Performance Standards (GIPS)
 Developed by the CFA Institute in 1999, enhanced in 2005
 Voluntary investment presentation standards to improve comparability
 Not a way of benchmarking performance

(8.1.4) ATTRIBUTING PERFORMANCE

 Asset allocation
 Sector choice
 Security selection
 Example: A fund manager begins with a portfolio worth £20m, invested 75% in equity and 25% in debt. During the
assessment period the equity market falls by 10% and the debt market falls by 5%, leaving the fund managers portfolio
worth £18.75m.
If the benchmark portfolio was constructed of 50% equity and 50% debt, was the fund manager's asset allocation and
stock selection good or poor?

2. PORTFOLIO MEASUREMENT

(8.2.3) IMPACT OF CURRENCY MOVEMENTS

 Impact of currency movements when investing abroad: A dollar profit does not mean a sterling profit
 Example
o An investor invests £10,000 in 2,000 US shares trading at $8 each
o The exchange rate at time of purchase is 1GBP:1.6USD
o Later the advisor values the shares
o At the point of valuation, the share price has increased to $8.50 and exchange rate has moved to 1GBP:1.7USD
o Calculate the return in sterling

3. PORTFOLIO REVIEW

(8.3.1) THE IMPORTANCE OF PORTFOLIO REVIEWS

Factors that could affect the portfolio include:
 Changes in client circumstances, e.g.
o New job
o Birth of child
 Changes in financial environment, e.g.
o Economic recovery
o Change in interest rates
 New products or services
 Maintaining suitability
o Administrative changes or difficulties
o investment related changes
 Responding to changes
o The portfolio should be rebalanced accordingly; and
o The benchmark should also be reassessed in light of any changes