# Greenwicher's WikiFRM - Financial Markets and Products 2017-10-30

[Last Update: Nov 7, 2017]

## Banks

### Types of Banks

- Commercial banks
- Investment banks

### Major Risks Faced by Banks

#### LO 31.1: Identify the major risks faced by a bank.

- credit risk
- market risk
- operational risk

### Economic Capital vs. Regulatory Capital

#### LO 31.2: Distinguish between economic capital and regulatory capital.

### Deposit Insurance and Moral Hazard

#### LO 31.3: Explain how deposit insurance gives rise to a moral hazard problem.

### Investment Banking Financing Arrangements

#### LO 31.4: Describe investment banking financing arrangements including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches.

### Poential Conflicts of Interest

#### LO 31.5: Describe the potential conflicts of interest among commercial banking, securities services, and investment banking divisions of a bank and recommend solutions to the conflict of interest problems.

### Banking Book vs. Trading Book

#### LO 31.6: Describe the distinctions between the “banking book” and the “trading book” of a bank.

### The Originate-to-Distribute Model

#### LO 31.7: Explain the originate-to-distribute model of a bank and discuss its benefits and drawbacks.

## Insurance Companies and Pension Plans

### Categories of Insurance Companies

#### LO 32.1: Describe the key features of various categories of insurance companies and identify the risks facing incusrance companies.

### Life Insurance

### Property and Casualty (P&C) Insurance

### Health Insurance

### Risks Facing Inssurance Companies

- Insufficient funds to satisfy policyholder’s claim
- poor return on investment
- liquidity risk of investments
- credit risk
- operational risk

### Mortality Tables

#### LO 32.2: Describe the use of mortality tables and calculate the premium payment for a policy holder.

### P&C Insurance Ratios

*LO 32.3: Calculate and interpret loss ratio, expense ratio, combined ratio, and operating ratio for a property-casualty insurance company.*

### Moral Hazard and Adverse Selection

#### LO 32.4: Describe moral hazard and adverse selection risks facing insurance companies, provide examples of each, and describe how to overcome the problems.

### Mortality Risk vs. Longevity Risk

#### LO 32.5: Distinguish between mortality risk and longevity and describe how to hedge these risks.

### Hedging Mortality and Longevity Risks

### Capital Requirements for Insurance Companies

#### LO 32.6: Evaluate the capital requirements for life insurance and property-casualty insurance companies.

### Guaranty System For Insurance Companies

#### LO 32.7: Compare the guaranty system and the regularoty requirements for insurance companies with those for banks.

### Pension Funds

#### LO 32.8: Describe a defined benefit plan and a defined contribution plan for a pension fund and explain the differences between them.

## Mutual Funds and Hedge Funds

### Types of Mutual Funds

#### LO 33.1: Differentiate among open-end mutual funds, closed-end mutual funds, and exchange -traded funds (ETFs).

### Net Asset Value

#### LO 33.2: Calculate the net asset value (NAV) of an open-end mutual fund.

### Hedge Funds vs. Mutual Funds

#### LO 33.3: Explain the key differences between hedge funds and mutual funds.

### Hedge Fund Expected Returns and Fee Structures

#### LO 33.4: Calculate the return on a hedge fund investment and explain the incentive fee structure of a hedge fund including the terms hurdle rate, high-water mark and clawback.

### Hedge Fund Strategies

#### LO 33.5: Describe various hedge fund strategies, including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures, and idenfity the risks faced by hedge funds.

### Hedge Fund Performance and Measurement Bias

#### LO 33.6: Describe hedge fund performance and explain the effect of measurement biases on performance measurement.

## Introduction (Options, Futures, and Other Derivatives)

### Derivative Markets

#### LO 34.1: Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its advantages and disadvantages.

### Basics of Derivative Securities

#### LO 34.2: Differentiate between options, forwards, and futures contracts.

#### LO 34.3: Identify and calculate option and forward contract payoffs.

### Hedging Strategies

#### LO 34.4: Calculate and compare the payoffs from hedging strategies involving forward contracts and options.

### Speculative Strategies

#### LO 34.5: Calculate and compare the payoffs from speculative strategies involving futures and options.

### Arbitrage Opportunities

#### LO 34.6: Calculate an arbitrage payoff and describe how arbitrage opportunities are temporaty.

### Risk from Derivatives

#### LO 34.7: Describe some of the risks that can arise from the use of derivatives.

## Mechanics of Futures Markets

#### LO 35.1: Define and describe the key features of a futures contract, including the asset, the contract price and size, delivery, and limits.

#### LO 35.9: Compare and contrast forward and futures contracts.

### Futures/Spot Convergence

#### LO 35.2: Explain the convergence of futures and spot prices.

### Operation of Margins

#### LO 35.3: Describe the rationale for margin requirements and explain how they work.

### Clearinghouses in Futures Transactions

#### LO 35.4: Describe the role of a clearinghouse in futures and over-the-counter market transactions.

### Over-the-Counter Markets

#### LO 35.5: Describe the role of collateralization in the over-the-counter market and compare it to the margining system.

### Normal and Inverted Futures Market

#### LO 35.6: Identify the differences between a normal and inverted futures market.

### The Delivery Process

#### LO 35.7: Describe the mechanics of the delivery process and contrast it with cash settlement.

### Types of Orders

#### LO 35.8: Evaluate the impact of different trading order types.

### Regulatory, Accounting, and Tax Frameworks

## Hedging Strategies Using Futures

### Hedging with Futures

#### LO 36.1: Define and differentiate between short and long hedges and identify their appropriate uses.

### Advantages and Disadvantages of Hedging

#### LO 36.2: Describe the arguments for and against hedging and the potential impact of hedging on firm profitability.

### Basis Risk

#### LO 36.3: Define the basis and explain the various sources of basis risk, and explain how basis risks arise when hedging with futures.

#### LO 36.4: Define cross hedging, and compute and interpret the minimum variance hedge ratio and hedge effectiveness.

- $HR = \rho
*{\mbox{spot, futures}} \frac{\sigma*{\mbox{spot}}}{\sigma_{\mbox{futures}}}$

### The Optimal Hedge Ratio

### Hedging with Stock Index Futures

#### LO 36.5: Compute the optimal number of futures contracts needed to hedge an exposure, and explain and calculate the “tailing the hedge” adjustment.

- # of contracts = $\beta_{\mbox{portfolio}} \frac{\mbox{portfolio value}}{\mbox{futures price * contract multiplier}}$

### Adjusting the Portfolio Beta

#### LO 36.6: Explain how to use stock index futures contracts to change a stock portfolio’s beta.

- # of contracts = $(\beta^{
*} - \beta)*\frac{\mbox{portfolio value}}{\mbox{value of futures contract}}$

### Rolling a Hedge Forward

#### LO 36.7: Explain the term “rolling the hedge forward” and describe some of the risks that arise from this strategy.

## Interest Rates

### Types of Rates

#### LO 37.1: Describe Treasury rates, LIBOR, and repo rates, and explain what is meant by the “risk-free” rate

### Compounding

#### LO 37.2: Calculate the value of an investment using different compounding frequences

#### LO 37.3: Convert interest rates based on different compounding frequencies

### Spot (Zero) Rates and Bound Pricing

#### LO 37.4: Calculate the theoretical price of a bond using spot prices

### Bond Pricing

### Boud Yield

### Bootstrapping Spot Rates

### Forward Rates

#### LO 37.5: Derive forward interest rates from a set of spot rates.

### Forward Rate Agreements

#### LO 37.6: Derive the value of the cash flows from a forward rate agreement (FRA)

### Duration

*LO 37.7: Calculate the duration, modified duration and dollar duration of a bond*

### Convexity

*LO 37.8: Evaluate the limitations of duration and explain how convexity addresses some of them.*

### Using Convexity to Improve Price Change Estimates

#### LO 37.9: Calculate the change in a bond’s price given its duration, its convexity, and a change in interest rates.

### Theories of the Term Structure

#### LO 37.10: Compare and contrast the major theories of the term structure of interest rates.

## Determination of Forward and Future Prices

### Investment and Consumption Assets

#### LO 38.1: Differentiate between investments and consumption assets.

### Short-Selling and Short Squeeze

#### LO 38.2: Define short-selling and calculate the net profit of a short sale of a dividend-paying stock.

### Forward and Futures Contracts

#### LO 38.3: Describe the differences between forward and futures contracts and explain the relationship between forward and spot prices.

#### LO 38.4: Calculate the forward price given the underlying asset’s spot price, and describe an arbitrage argument between sport and forward prices.

#### LO 38.9: Calculate, using the cost-of-carry model, forward prices where the underlying asset either does or does not have interim cash flows.

### Forward Prices

### Forward Price with Carrying Costs

### The Effect of a Known Dividend

### Value of a Forward Contract

### Currency Futures

#### LO 38.6: Calculate a forward foreign exchange rate using the interest rate parity relationship.

### Forward Prices vs. Future Prices

#### LO 38.5: Explain the relationship between forward and futures prices.

### Commodity Futures

#### LO 38.7: Define income, storage costs, and convenience yield.

#### LO 38.8: Calculate the futures price on commodities incorporating income/storage costs and/or convenience yields.

### Income and Storage Costs

### Convience Yield

### Delivery Options in the Futures Market

#### LO 38.10: Describe the various delivery options available in the futures markets and how they can influence futures prices.

### Futures and Expected Future Spot Prices

#### LO 38.11: Explain the relationship beween current future prices and expected future spot prices, including the impact of systematic and nonsystematic risk.

### Cost of Carry vs. Expectations.

### Contango and Backwardation

#### LO 38.12: Define and interpret contango and backwardation, and explain how they relation to the cost-of-carry model.

- contango: futures price > current spot price
- backwardation: opposite of the above

## Interest Rate Futures

### Day Count Conventions

#### LO 39.1: Identify the most commonly used day count conventions, describe the markets that each one is typically used in, and apply each to an interest calculation

- T-bond: actual/actual
- corporate bond & municipal bonds: 30/360
- money market instruments: actual/360

### Quotations for T-Bonds

#### LO 39.3: Differentiate between the clean and dirty price for a US Treasury bond; calculate the accrued interest and dirty price on a US Treasury bond.

- dirty price = clean price + accrued interest

### Clean and Dirty Prices

###Quotations for T-Bills

#### LO 39.2: Calculate the conversion of a discount rate to a price for a US Treasury bill.

### Treasury Bond Futures

*LO 39.4: Explain and calculate a US Treasury bond futures contract conversion factor.*

#### LO 39.5: Calculate the cost of delivering a bond into a Treasury bond futures contract.

#### LO 39.6: Describe the impact of the level and shape of the yield curve on the cheapest-to-deliver Treasury bond decision.

#### Cheapest-to-Deliver Bond

### Treasury Bond Futures Price

#### LO 39.7: Calculate the theoretical futures price for a Treasury bond futures contract.

### European Futures

*LO 39.8: Calculate the final contract price on a Eurodollar futures contract.*

*LO 39.9: Describe and compute the Eurodollar futures contract convexity adjustment.*

### Convexity Adjustment

#### LO 39.10: Explain how Eurodollar futures can be used to extend the LIBOR zero curve.

### Duration-based Hedging

#### LO 39.11: Calculate the duration-based hedge ratio and create a duration-based hedging strategy using interest rate functions.

- number of contracts = $-\frac{\mbox{portfolio of value
*duration of portfolio}}{\mbox{futures value*duration of futures}}$

### Limitations of Duration

#### LO 39.12: Explain the limitations of using a duration-based hedging strategy.

## Swaps

### Mechanics of Interest Rate Swaps

#### LO 40.1: Explain the mechanics of a plain vanilla interest rate swap and compute its cash flows.

#### LO 40.2: Explain how a plain vanilla interest rate swap can be used to transform an asset or a liability and calculate the resulting cash flows.

### Financial Intermediaries

#### LO 40.3: Explain the role of financial intermediaries in the swaps market.

#### LO 40.4: Describe the role of the confirmation in a swap transaction.

### Comparative Advantage

#### LO 40.5: Describe the comparative advantage argument for the esistence of interest rate swaps and evaluate some of the criticisms of this argument.

### Problems with Comparative Advantage

### Valuing Interest Rate Swaps

#### LO 40.6: Explain how the discount rates in a plain vanilla interest rate swap are computed.

### Valuing an Interest Rate Swap with Bonds

#### LO 40.7: Calculate the value of a plain vanilla interest rate swap based on two simultaneous bond positions.

### Valuing an Interest Rate Swap with FRAs

#### LO 40.8: Calculate the value of a plain vanilla interest rate swap from a sequence of forward rate agreements (FRAs).

### Currency Swaps

#### LO 40.9: Explain the mechanics of a currency swap and compute its cash flows.

#### LO 40.11: Calculate the value of a currency swap based on two simultaneous bond positions.

#### LO 40.12: Calculate the value of a currency swap based on a sequence of FRAs.

### Using a Currency Swap to Transform Existing Positions

#### LO 40.10: Explain how a currency swap can be used to transform an asset or liability and calculate the resulting cash flows.

### Comparative Advantage

### Swap Credit Risk

#### LO 40.13: Describe the credit risk exposure in a swap position

### Other Types of Swaps

#### LO 40.14: Identify and describe other types of swaps, including commodity, volatility and exotic swaps.

## Mechanics of Options Markets

### Option Types

#### LO 41.1: Describe the types, position variations, and typical underlying assets of optioins.

- Call options
- Put options
- Underlying assets
- stock options
- currency options
- index options

### Stock Options Specifications

#### LO 41.2: Explain the specification of exchange-traded stock option contracts, including that of nonstandard products.

- expiration
- strike prices
- moneyness, time value, and intrinsic value

### Nonstandard Products

### The Effect of Dividends and Stock Splits

### Position and Exercise Limits

### Option Trading

#### LO 41.3: Describe how trading, commissions, margin requirements, and exercise typically work for exchange-traded options.

## Properties of Stock Options

### Six Factors that Affect Option Prices

#### LO 42.1: Identify the six factors that affect an option’s price and describe how these six factors affect the price for both European and American options.

- current stock price
- strike price
- time to maturity
- short-term risk-free interest
- present value of the dividend of the underlying stock
- expected volatility of stock prices

### Upper and Lower Pricing Bounds

*LO 42.2: Identify and compute upper and lower bounds for option prices on non-dividend and dividend paying stocks.*

### Computing Option Values Using Put-Call Parity

#### LO 42.3: Explain put-call parity and apply it to the valuation of European and American stock options.

- $c + Xe^{-rT} = S + p$

### Lower Pricing Bounds for an American Call Option on A Nondividend-paying Stock

#### LO 42.4: Explain the early exercise features of American call and put options.

- do not exercise an American call option on nondividend-paying stock prior to expiration

### Lower Pricing Bounds for an American Put Option on A Nondividend-paying Stock

### Relationship Between American Call Options and Put Options

### The Impact of Dividends on Option Pricing Bounds

### Impact of Dividends of Early Exercise for American Calls and Put-Call Parity

## Trading Strategies Involving Options

### Covered Calls and Protective Puts

#### LO 43.1: Explain the motivation to initiative a covered call or a protective put strategy.

#### Spread Strategies

#### LO 43.2: Describe the use and calculate the payoffs of various spread strategies.

### Combination Strategies

#### LO 43.3: Describe the use and explain the payoff functions of combination strategies.

## Exotic Options

### Evaluating Exotic Options

#### LO 44.1: Define and contrast exotic derivatives and plain vanilla derivatives.

#### LO 44.2: Describe some of the factors that derive the development of exotic products.

### Using Packages to Formulate a Zero-cost Product

#### LO 44.3: Explain how any derivative can be converted into a zero-cost product

#### LO 44.4: Describe how standard American options can be transformed into nonstandard American options.

### Exotic Option Payoff Structures

#### LO 44.5: Identify and describe the characteristics and pay-off structure of the following exotic options: gap, forward start, compound, chooser, barrier, binary, lookback, shout, Asian, exchange, rainbow, and basket options.

### Volatility and Variance Swaps

#### Lo 44.6: Describe and contrast volatility and variance swaps.

### Issues in Hedging Exotic Options

#### LO 44.7: Explain the basic premise of static option replication and how it can be applied to exotic options.

## Commodity Forwards and Futures

### Pricing Commodity Forward and Futures

#### LO 45.1: Apply comodity concepts such as storage costs, carry markets, lease rate, and convenience yield.

#### LO 45.2: Explain the basic equilibrium formula for pricing commodity forwards.

#### LO 45.13: Explain how to create a synthetic commodity position, and use it to explain the relationship between the forward price and the expected future spot price.

### Commodity Arbitrage

#### LO 45.3: Describe an arbitrage transaction in commodity forwards, and compute the potential arbitrage profit.

### Lease Rates

*LO 45.4: Define the lease rate and explain how it determines the no-arbitrage values of commodity forwards and futures.*

### Contango and Backwardation

### Storage Costs

#### LO 45.5: Define carry markets, and illustrate the impact of storage costs and convenience yields on commodity forward prices and no-arbitrage bounds.

#### LO 45.6: Compute the forward price of a commodity with storage costs.

### Convinence Yield

### Comparing Lease Rates, Storage Costs, and Convenience Yield

#### LO 45.7: Compare the lease rate with the convenience yield

### Commodity Characteristics

#### LO 45.8: Identify factors that impact gold, corn, electricity, natural gas, and oil forward prices.

### Commodity Spread

#### LO 45.9: Compute a commodity spread.

### Basis Risk

#### LO 45.10: Explain how basis risk can occur when hedging commodity price exposure.

### Strip Hedge vs. Stack Hedge

*LO 45.11: Evaluate the differences between a strip hedge and a stack hedge and explain how these differences impact risk management.*

### Cross Hedging

#### LO 45.12: Provide examples of cross-hedging, specifically the process of hedging jet fuel with crude oil and using weather derivatives.

## Exchanges, OTC Derivatives, DPCs and SPVs

### Exchange Functions

#### LO 46.1: Describe how exchanges can be used to alleviate counterparty risk.

### Forms of Clearing

#### LO 46.2: Explain the developments in clearing that reduce risk.

### Exchange-Traded vs. OTC Derivatives

#### LO 46.3: Compare exchange-traded and OTC markets and describe their uses.

### Classes of OTC Derivatives

#### LO 46.4: Identify the classes of derivatives securities and explain the risk associated with them.

### Mitigating Risks of OTC Derivatives

#### LO 46.5: Identify risks associated with OTC markets and explain how these risks can be mitigated.

## Basic Principles of Central Clearing

### The Role of A Central Counterparty

#### LO 47.1: Provide examples of the mechanics of a central counterparty (CCP).

### Central Clearing

#### LO 47.2: Describe advantages and disadvantages of central clearing of OTC derivatives.

### Margining

#### LO 47.3: Compare margin requirements in centrally cleared and bilateral markets, and explain how margin can mitigate risk.

### Novation and Netting

#### Lo 47.4: Compare and contrast bilateral markets to the use of novation and netting.

### Impact of Central Clearing

#### LO 47.5: Assess the impact of central clearing on the broader financial markets

## Risks Caused by CCPs

### Risks Faced by Central Counterparties

#### LO 48.1: Identify and explain the types of risks faced by CCPs.

### Risks to Clearing Members and Non-members

#### LO 48.2: Identify and distinguish between the risks to clearing members as well as non-members.

### Lessons Learned from CCP Failures

#### LO 48.3: Identify and evaluate lessons learned from prior CCP failures.

## Foreign Exchange Risk

### Sources of Foreign Exchange Risk

#### LO 49.1: Calculate a financial institution’s overall foreign excahnge exposure.

*LO 49.2: Explain how a financial institution could alter its net position exposure to reduce foreign exchange risk.*

#### LO 49.3: Calculate a financial institution’s potential dollar gain or loss exposure to a particular currency.

### Foreign Trading Activities

#### LO 49.4: Identify and describe the different types of foreign exchange trading activities.

### Sources of Profits and Losses on Foreign Exchange Trading

#### LO 49.5: Identify the sources of foreign exchange trading gains and losses.

#### LO 49.6: Calculate the potential gain or loss from a foreign currency denominated investment.

### Balance Sheet Hedging

#### LO 49.7: Explain balance-sheet hedging with forwards.

### Off-balance Sheet Hedgin

#### LO 49.8: Drscribe how a non-arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem, and use this theorem to calculate forward foreign exchange rates.

### Diversification in Multicurrency Foreign Asset-liability Positions

#### LO 49.10: Explain why diversification in multicurrency asset-liability positions could reduce portfolio risk.

#### LO 49.11: Describe the relationship between nominal and real interest rates.

## Corporate Bonds

### Bond Indenture and Role of Corporate Trustee

#### Lo 50.1: Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.

### Maturity Date

#### Lo 50.2: Explain a bond’s maturity date and how it impacts bond retirements.

### Interest Payment Classifications

#### LO 50.3: Describe the main types of interest payment classifications.

- straight-coupon bonds
- zero-coupon bonds
- floating-rate bonds