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