Derivatives Part 2

Question 1

Forward Contracts

Answer 1

 An agreement to buy or sell an asset at a certain price at a certain future time
 The buyer takes a long position and is obliged to buy the asset at the agreed price on the agreed
date
 The seller assumes a short position and is obliged to supply the asset at the agreed price on the
agreed date
 OTC contract similar to futures

Bespoke, unique to your

Question 2

Forward Rate Agreements

Answer 2

 Fixes a short-term interest rate for a specified term
in the future
 3 v 6 FRA starts in 3 months and ends in 6 months
 OTC so flexible terms
 Helps protect variable rate loans from interest rises
and deposits from interest rate cuts
 Cash payment made on the difference between
the agreed FRA rate (fixed rate) and the level of a
benchmark rate (floating rate such as Euribor) on
the agreed future date

Buy an FRA - Pay fixed rate, benefit if rates rise
Sell an FRA - Receive fixed rate, benefit if rates fall

Question 3

FRAs Net Settlement amount

Answer 3

NP x ((BR - FRArate) x d/days in year)/(1 + (BR x d/days in year))

NP = notional principal
BR = benchmark rate such as Euribor
d = days in FRA period
B = days in year
FRArate = fixed FRA rate

Question 4

Day count conventions

Answer 4

ACT/365 - UK
ACT/360 - US/EU
ACT/ACT
30/360

Question 5

Calculating FRA rates

Answer 5

= (r2n2 –r1n1)/
nFRA(1+ (r1n1 / B))

rFRA = the FRA quoted rate
r1 = rate from today to the FRA start date
r2 = rate from today to FRA end date
n1 = num days from today to the FRA start date
n2 = num days from today to the FRA end date
nFRA = num days in FRA period
B = basis (365 for UK, 360 for EU and US)

Question 6

Caps, floors and collars

Answer 6

Cap = call on interest rates, bought to protect a loan

Floor = put on interest rates, bought to protect a deposit

Collars = buy a cap and sell a floor, bought to protect a loan

Question 7

Contracts for Difference

Answer 7

An agreement between two counterparties where the parties exchange the difference between the
opening and closing prices of a specified financial instrument, including shares, indices or commodities.

 Enable investors to take long or short positions without owning the underlying asset
 Cash settled
 Daily funding charge

Trade on margin
 Initial margin
 Variation margin
 Leveraged so maximum loss not limited to limited investment

CGT not payable on spread betting but is on CFDs

Question 8

Advantages of CFDs

Answer 8

Exposure to foreign markets
Long/short exposure
Gearing
No set maturity date
No stamp duty

Question 9

Interest Rate Swaps

Answer 9

Fixed rate payer pays fixed rate of interest on a notional principal for a set maturity

Floating rate payer pays floating rate of interest on the same notional principal for the same maturity

used to hedge out interest rate risk

 On each payment date, a net payment based on the
difference between the fixed rate and the benchmark
rate will be made
 If the fixed rate > the benchmark rate, the fixed rate
receiver will receive the net payment
 If the fixed rate < the benchmark rate, the fixed rate payer
will receive the net payment

 The swap can be terminated/cancelled with the agreement of both parties
 The mark-to-market value of the swap will be calculated and the value exchanged between the parties

Question 10

Interest rate swaps - Liability Swaps

Answer 10

Blue Chip company issues a 3.5% bond
receives 3.75% from bank and pays 6m Sonia

Small business pays 4% to bank and receives 6m Sonia
to hedge their 6m SONIA + 100bp loan they have e.g. they have locked in effectively 5% on their loan

Question 11

Swaptions

Answer 11

Receivers
the right to receive fixed on an interest rate swap
call on a fixed rate bond
put on interest rates

Payers
the right to pay fixed on an interest rate swap
put on a fixed rate bond
call on interest rates

Question 12

Basis Swaps

Answer 12

Floating rate vs Floating rate
hedge out any differences in interest rate exposure

 Each payment stream is referenced to a floating rate

Range of possibilities

 Single currency, one period rate to another period rate
 e.g. 3-month EURIBOR vs 6-month Euribor

 Single currency, one interest rate to another interest rate
 e.g. US 1-month LIBOR vs 1-month SOFR

 Cross-currency, floating rate in one currency for a floating rate in another currency
 E.g. 3-month SONIA (UK) vs 3-month SOFR (US)

Question 13

Long-term currency swaps

Answer 13

 In a currency swap, two parties:
 Exchange principals at the prevailing exchange rate on the spot date
 Then make periodic interest payments to
each other based on a predetermined pair
of interest rates, and then
 Re-exchange the original principal at the
conclusion of the swap

 Currency swaps also exist where there is
no exchange of principals

Three main types
 Fixed-Fixed – exchange fixed rate of
interest in one currency for a fixed rate in
another currency
 e.g. pay 3.74% in US$ and receive 3.975%
in GBP

 Floating-floating – exchange floating rate
of interest in USD for floating rate in
another currency plus/minus a spread
 e.g. USD SOFR vs EURIBOR -20bp

 Fixed-floating– exchange fixed rate in one
currency for floating in another currency
 e.g. 5% Fixed GBP vs USD SOFR

Question 14

Overnight Index Swaps

Answer 14

one leg is fixed the other leg is referenced to an overnight interest rate e.g. Sonia

 Overnight leg is not paid every day – it compounds and pays say monthly

Advantages
 Manage liquidity and interest rate risk
 Arbitrage strategies
 Reduce credit risk
 Asset swap

Bank borrows on an annual basis but lends overnight, they would use an OIS to pay the overnight rate and receive the annual rate, this hedges interest rate exposure

Question 15

Total Return Swap

Answer 15

payer gets the gains or losses from reference asset (e.g. bond or equity or index…)

payer then pays the receiver periodic cash flows and asset gains

receiver pays the payer Libor + spread and any asset losses

payer is hedging as it is if they have sold the asset as they are not affected by gains or losses

Question 16

Equity Swaps

Answer 16

one party promises to pay the return on a specified stock or index on a notional principal e.g. FUTSE 100 return

the other party pays a fixed, floating or another equity index on the same notional principal e.g. 6 month Sonia + 10bp

Party one is hedging
Party two is speculating

Unlike other swaps the notional changes -the periodic settlement feature substantially reduces the
credit risk involved

Question 17

Commodity Swaps

Answer 17

Fixed-for-Floating Swap

 Define the commodity size; e.g. 10,000 oz. of gold
 Define the fixed price
 The commodity is not exchanged
 Payments are made by comparing the actual price of the commodity on the settlement date (or an
average price over the period, or the actual price one period earlier) to the fixed price
 Used for speculation, hedging or arbitrage

Price-for-Interest Swap

 Value of a fixed amount of the commodity is exchanged for a fixed or floating interest payment

Question 18

Variance and Dividend Swaps

Answer 18

Variance Swap

 One leg is linked to the realised variance of an asset over the life of the swap (realised volatility)
 i.e. The price movements of the asset over the life of
the swap
 The other leg pays a fixed amount, agreed upfront (implied volatility)

Dividend Swaps

 One leg is linked to the future dividend payments of an individual equity, basket of equities or equity index
 The other leg pays a fixed payment – an estimate of the market forecasts of dividends

Question 19

Other Swaps

Answer 19

Asset Swap
 A swap that is used to change the interest rate and/or currency exposure of an asset
 e.g. Buy a US$ FRN and swap to GBP fixed coupons
 It refers to the reason for using the swap – ie swapping the income stream on an asset

Amortising, Accreting and Rollercoaster Swaps
 The notional principal decreases (amortising), increases (accreting) or varies (rollercoaster) over the life
of the swap

Forward Start Swaps
 A swap starting at a future date
 e.g. A 3-year swap starting in 1 year’s time, fixed rate of 3.50%

Inflation Swap
 One or both legs referenced to an inflation index such as UK RPI
 Often structured as zero coupon products

Question 20

Credit Default Swaps

Answer 20

Similar to insurance contracts

credit protection buyer pays a premium

The seller pays compensation if a credit event relating to another 3rd party occurs

If credit event occurs the swap terminates

Credit event is typically defined as:
 Default
 Significant fall in asset price
 Bankruptcy
 Debt restructuring
 Merger/demerger

Narrowly Tailored Credit Events
 A ‘failure to pay’ credit deterioration requirement – failure to pay must be as a result of deterioration of
creditworthiness
 Amendment to definition of ‘outstanding principal balance’ – sets principal to discounted issue value not
par

cds can be used for hedging or just used for speculation - can trade out of cds at a profit if entity gets upgraded
or downgraded

Question 21

Basic CDS Structure

Answer 21

cash settlement - protection seller pays the protection buyer notional principal x (1-r)
r = recovery rate value

physical delivery - protection sell buys bonds from the protection buyer and pays them 100% FV or discounted value

Question 22

Types of CDS

Answer 22

Basic
 Based on a specific asset

Index
 Based on the movements of an index

Basket
 Based on the default of a basket of securities
 1st to default – pays out after 1 name has defaulted
 ‘nth’ to default – pays out after the nth name has defaulted

Premiums linked to the asset swap spread
 i.e. spread over reference rate to hold the asset (credit spread)

Question 23

Credit Linked notes

Answer 23

A security with an embedded CDS

The investor buys a note (bond) and receives the face value at maturity
unless a third party (reference entity) defaults

If default occurs, then the investor will either receive a reduced amount
or receive bonds that have been issued by the reference entity

Coupon payments will usually be higher to compensate the investor for the additional credit risk

e.g.
At Issuance:
* Bank sells credit protection
* Bank issues CLN
* Investors buy note and receive enhanced coupon

At maturity, no credit event:
* CLN matures with no payment
* Investor receives principal payment

At maturity, credit event:
* Issuer pays par to CDS
counterparty in return for bond issued by reference entity
* Investor receives deliverable bond – worth less than principal repayment

Question 24

Other Credit Derivatives

Answer 24

Credit spread options
 Option on the spread between a benchmark yield (e.g. government bond yield) and a reference yield
(e.g. a corporate bond yield)
 A strike is set and payments are made if the spread is above the strike (put) or below the strike (call)

Collateralised Debt Obligations (CDOs) - start with portfolio of debt e.g. bonds, mortgages and
loans (CBO, CMO and CLO). Establish SPV and debt is
sold to them. SPV then sells securities in tranches
equity tranche - most risky
mezannine tranche - medium risk
Senior tranch - lowest risk

Credit Default Options
 Option to buy (payer) or sell (receiver) protection at a set spread
 Don’t provide protection against default

Question 25

Structured Products

Answer 25

Packaged products based on derivatives  Capital protection  Participation from a high-performing, risky underlying asset  May be listed or traded privately Each Structured product is very unique Frequently structured using a zero-coupon bond plus a derivative contract Listed Structured Products  Traded on LSE  Held and settled in CREST, T+3  Issued by a wide range of major investment banks  Issuers obliged to make continuous prices throughout the lifetime of the product

Question 26

Types of Structured Products

Answer 26

Index-Based Product Trackers  Replicates the performance of an underlying index  Long-dated/undated  No dividends paid Accelerated Trackers (and Boosters)  Investor participates in growth of an index provided its value is above the initial value on maturity  Investors are offered a ratio increase on the level of return  Boosters pay out an accelerated income Reverse Trackers  Similar to index trackers but pay out if the market falls  Known as bear certificates Dual Index Products  Also known as Digitals  Has two reference indices for the basis of the payout  Both indices need to be above predefined levels Capital Protected Trackers  Participate in the growth of an index/asset but with capital protection  Level of protection varies with each product Structured Capital at Risk Products (SCaRPs)  Aim to return original investment at maturity  Have variable floors rather than fixed capital protection  Payout based on barriers  Investors can lose money (potentially their whole investment) OTC e.g. Auto-callable provide potential early redemption with coupon payments while offering conditional capital protection.

Question 27

Adv/Dis of Structured Products

Answer 27

Adv: * Increase investment returns * Customised * Low correlation with other asset classes * Protect capital * No stamp duty * Currency risk managed Dis: * Complex * May lose money if sold before maturity * Credit risk of issuer * Liquidity * Valuation * No income

Question 28

Exotic Options

Answer 28

Path dependent - The return is based not just on where the asset price is on expiry but the path the asset took over the life of the option Lookback Call – owner has the right to buy at the lowest price over some preceding period * Put – owner has the right to sell at the highest price * High premiums Asian Average Price – payoff depends on the average price of the asset over pre-set period of time. * Cheaper than regular options. Binary Pays out a fixed amount * Call - pays out if price > strike * Put pays out if price < strike Average Strike Strike is set at the average of the underlying over the option life. * Cheaper than regular option. Ratchet or Cliquet * Periodic settlement * Strike is reset every period to the price level at that time * Series of ATM options * Can pay out each reset date or accumulate to maturity

Question 29

Barrier Options

Answer 29

Down and out call - a call that ceases to exist once a barrier is reached. Barrier < current price. V bullish, low vol on downside, cheaper than options Up and out call - A call that ceases to exist once a barrier is reached. Barrier > current price. moderately bullish, low vol, cheaper than options Down and in call - A call that comes into existence once a barrier is reached. Barrier < current price. High vol - cheaper than options Up and in call - A call that comes into existence once a barrier is reached. Barrier > Current Price. V bullish, high vol, cheaper than options

Question 30

ISDA Master Agreements

Answer 30

Legally binding agreement negotiated between the two parties Covers:  Termination events  Events of default  Netting - Payment netting and Close out netting

Question 31

European Market Infrastructure Regulation (EMIR)

Answer 31

Enhance Transparency: * Detailed info on derivative contracts to be reported to trade repositories * Trade repositories to publish total positions for each class of derivatives * Monitoring and supervision of repositories undertaken by ESMA Mitigate Credit Risk: Reduce counterparty risk through: * Mandatory central counterparty clearing for standardised OTC contracts * Risk mitigation techniques applied for contracts not centrally cleared * Strict requirements for CCPs Reduce Operational Risk: * Participants must monitor and mitigate operational risks e.g. fraud an human error * Electronic confirmation

Question 32

US Dodd-Frank

Answer 32

 Aims to increase transparency and liquidity of certain OTC transactions following the global financial crisis  Also aims to reduce counterparty risk by requiring a CCP to act as counterparty to certain OTC transactions Created new agencies:  Consumer Financial Protection Bureau  Financial Stability Oversight Council  Office of Financial Research  Has improved financial stability and consumer protection  But regulatory burden in banking sector has harmed lending, investment, jobs and economic growth

Question 33

Collateral Management

Answer 33

refers to the process of handling assets pledged as security in financial transactions to mitigate credit risk Via Credit Support Annex (CSA) or Collateral Support Document (CSD)  Defines rules under which collateral is transferred  Contains timing and procedure for MTM of the contract CSA will also set:  Threshold amounts  Minimum transfer amounts  Haircut

Question 34

Exchange traded vs OTC

Answer 34

ETD * Inflexible due to standardised terms * Fungible * Easily traded on the exchange – liquid * Central counterparty means counterparty risk is low * Regulated * Transparency – real time prices and trading activity published * Hedging may not be precise due to standard features OTC * Flexible due to bespoke nature * Not fungible * Liquidity may be restricted * Some OTC contracts may be cleared through a CCP, others will rely on collateralisation agreements * Regulation improving with Dodd-Frank and EMIR * No real-time publishing of trades – trades will be reported to TR under EMIR * Precise hedging due to customisation OTC is more expensive

Question 35

Risks of Derivatives

Answer 35

Risks Of Derivatives Legal:  ETD: exchange membership  OTC: ISDA agreement  CDS: default definitions  Counterparty  Settlement and Dealing  Market Risk  Gearing/leverage