Comprehensive Guide to Derivatives: Study Plans, Exam Tips, and Risk Management
Delve into the world of derivatives with this comprehensive guide covering course outlines, study plans, exam preparation tips, and risk management strategies. Learn about futures, options, profit and loss profiles, as well as forwards and Contracts for Differences (CFDs). Understand the exam process, study recommendations, and key concepts in derivatives trading. Prepare effectively for a CISI computer-based exam and gain insights into mitigating risks associated with derivatives trading.
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Course Outline Course materials Study plans Taking a CISI computer-based exam Exam preparation course
Study Plans Recommended study plan for candidates: Read workbook prior to attending a course Attend a course Take sufficient time to revise prior to the exam Book the exam on time to avoid disappointment
Taking the Exam Available by computer-based testing (CBT) at centres globally for more information see Exam preparation in the Qualification section on the CISI website (www.cisi.org) Required to gain access: Confirmation letter and Proof of ID (both signature and photographic) Place all belongings in a designated locker Staff member will take candidate to the workstation Make sure personal details are correct
Taking the Exam 1 Hour, 50 questions Pass mark: 70% No negative marks When in doubt flag a question for review Questions can be reviewed if time permits Result will be provided almost immediately
Chapter 1 Introduction to Derivatives Exam Questions: 6
Futures A derivative is a financial instrument whose price is derived from another asset, exchange-traded derivatives come in two forms: Futures Options What is a future? How do futures work? Forwards Contracts for Differences (CFDs) Spread betting Uses of futures: Speculation Hedging Arbitrage
Futures Profit and Loss Profiles Long futures Short futures Risks associated with derivatives Counterparty risk Liquidity risk Operational risk
Forwards and Contracts for Differences (CFDs) Forward contact: An OTC transaction in which delivery of the commodity/asset is deferred until a date in the future that is specified in the contract Similar to futures contracts Settled only on the delivery date Contracts for Differences (CFDs): Allows investor to benefit from capital gains from an underlying index, stock, currency or commodity without having to physically own it or pay for it Trading on the price movement Subject to Capital Gains Tax Spread betting in the UK is considered gambling and therefore has different tax implications
Options What is an option? Options terminology: Calls, puts Strike or exercise price Premium Exercise style Exotic options
Risk and reward summary Out-of-the-money (OTM) At-the-money (ATM) In-the-money (ITM)
Other option features FLEX options: Reduces credit risk exchange's use of a clearing house Exchange for physicals (EFPs) Exchange for Swap (EFS) Options on futures
Gearing Gearing is the measure of the amount of cash/initial investment spent on establishing a futures or options position, compared to the actual value of the underlying position Options gearing: Options can be volatile offering high potential returns and losses Options value erodes as the expiry date approaches Futures gearing Comes through the margining system Also referred to as leverage
Liquidity Main elements of a liquid market: Many buyers and sellers Small bid/offer spreads Low commissions Large amounts can be traded without causing major price movements Two measures of market liquidity: Immediacy Resilience
Exchange-Traded versus OTC-Traded Standardised contracts on derivatives exchanges for example: ICE Futures Europe CME Group Osaka Exchange Negotiated and entered into away from any exchange, directly between the two counterparties: OTC transactions See comparison table in the workbook
Swaps Exchange of cash flows or liabilities Typically based on notional principal amount Traded on a wide range of underlying assets
Other Swaps Asset and total return swaps Amortising, accreting and rollercoaster swaps Inflation swaps Inflation swaps Constant Maturity swaps (CMSs) Arrears swaps Forward start swaps Overnight Index Swaps (OISs) Mark to Market (MTM) swaps Commodity swaps Equity, volatility, variance and dividend swaps Property and environmental swaps Zero coupon inflation products
Markets and Participants Derivatives are based on a wide range of underlying markets including: Money markets/short-term interest rates (STIRS) Bonds government and corporate Equities (indices) Foreign exchange (FX) Commodities softs, agricultural, energy and metals Credit credit default swaps and swaptions Exotics emissions, carbon credits
Markets and Participants Sovereign Wealth Funds Market makers: Price maker Price taker Sell-side Buy-side Order-driven markets Quote-driven markets
Different Market Participant Roles Prime broker Clearing broker Introducing broker Executing broker Inter-dealer broker (IDB) Futures Commission Merchant (FCM)
Chapter 2 Underlying Markets Exam Questions: 12
Money markets Interbank money markets for short-term liquidity and investment purposes Short-dated up to one year, cash instruments ICE LIBOR no longer in use in money markets - replacement rates: EURIBOR, EONIA, SONIA, SOFR Essential role in the global financial system
Money market contracts Risk implications: Credit limits Credit ratings Counterparty risk Treasury Bills: Short-term debt issued by a number of governments Certificates of Deposit (CD): Time deposit offered to consumers by banks Commercial Paper (CP): Issued by large financial and non-financial institutions
Certificate of Deposit & Commercial Paper Certificate of Deposit Time deposit Issued by financial institutions Promissory note Typical maturity 3 6 months Commercial Paper Issued by large (non)financial institutions Maturities 2 9 months Typically minimum of $500,000 or equivalent
Foreign exchange market Forex, FX or currency market Dominated by banks, unique nature, geography and volume Decentralised over-the-counter (OTC) financial market for the trading of currencies Forward FX rates Interest rate parity (IRP)
Non-deliverable forwards (NDFs) Cash-settled, short-term forward contract on a thinly traded or non-convertible international currency Fixing date and a settlement date Various uses for example for both hedging and speculating on interest rate movements
Government and corporate debt Bonds can be classified by: Maturity - short/medium/long Coupon - eg, zero coupon, step-up, floating rate Issuer - domestic government, overseas government, corporate, industrial - emerging market Risk level - investment grade, high yield (junk) Other characteristics - debentures, index linked, convertible Exact market conventions vary by country and region
Government Bonds Picture 8 Picture 4 Picture 7 Picture 6 Picture 9 Picture 5
Yield curves Yield of a bond is the rate of interest it provides based on the current market price Normal yield curve Inverted yield curve Horizontal yield curve if short term rates are the same as long-term ones
Corporate bonds Corporate bonds: Issued by a corporation In any currency Often listed on major exchanges and electronic communications networks (ECNs) Generally pay a higher yield than the respective government bond Higher risk of default Credit rating major factor in determining the coupon or yield
Equities Companies raise their initial capital through: Share capital Loan stock Ordinary shares: Shareholder s rights Voting and non-voting shares Partly paid shares Preference shares: Cumulative or non-cumulative Participating Redeemable Convertible preference shares
Warrants Gives holder the right to buy a company s shares over the life of the warrant at a fixed exercise price: Price usually at a premium over its current price at the time the warrant was issued Similar to equity options Conversion ratio
Valuation techniques Gordon s Growth Model: Attempts to determine a share s value based on the forecasts of its future dividend payments Assumption they will grow at a constant rate Wide range of other models
Corporate Actions Rights issues Bonus issues Stock split Mergers and acquisitions Share buybacks
Major stock exchanges Largest stock exchanges: NYSE NASDAQ Shanghai Stock Exchange Japan Exchange Group (Tokyo & Osaka Stock Exchange) Hong Kong Exchanges and Clearing Euronext Shenzhen Stock Exchange London Stock Exchange Toronto & Montreal Stock Exchanges National Stock Exchange of India Emerging markets
Commodities Softs and agriculturals: Coffee, cocoa, sugar, soya bean, frozen concentrated orange juice, wheat, rape seed oil, grains, livestock Base and precious metals: Copper, nickel, aluminium, zinc, tin, lead, gold and silver Energy: Crude, refined oil, natural gas and electricity Crypto currency Others: Weather, freight, emissions, EFTs, Volatility
Commodity trading Main global commodity derivatives markets: CME Group Euronext Derivatives Dubai Mercantile Exchange ICE (Intercontinental exchange) LME Tokyo Commodities Exchange (TOCOM) Dalian Commodity Exchange (DCE) Shanghai Metal Exchange Multi Commodity Exchange of India (MCX) Mumbai New York Mercantile Exchange (NYMEX) European Climate Exchange (ECX)
Chapter 3 Market Structure Exam Questions: 14
Derivatives exchanges - UK Exchange Description ICE Futures Europe All trading is done electronically. Trades futures and options on a wide range of energy products, such as Brent Crude, West Texas Intermediate (WTI), gas oil, electricity, coal and natural gas. It also trades a range of index and single stock futures, as well as short-term interest and bond futures, such as Long Gilts and currencies, such as GBP/USD and EUR/USD. Trades are cleared via ICE Clear Europe. London Stock Exchange (LSE) Derivatives All trading is done electronically. Trades standardised and flexible futures and options of the shares and indices on the FTSE 100, FTSE Super Liquid (largest 35 shares) and the Norwegian OBX index. It also has contracts linked to the most liquid Russian shares and indices. Trades are processed, cleared and guaranteed by CCP Clearing with LCH.
Derivatives exchanges - US US Chicago Board of Trade (CBOT) part of the CME Group Both open outcry physical trading and electronic via EOS Trader and CME Direct. Trades futures on a wide range of agricultural products, gold, silver, interest rates (US notes, bonds, swaps), the Dow Jones indices, and has a joint trading agreement with SGX to trade several of its contracts. All trades processed under the JADE agreement. All trades processed by the Front End Clearing (FEC) System and Front End Clearing Plus (FEC+), which are based on CME Direct. Chicago Board Options Exchange (CBOE) Chicago Mercantile Exchange (CME) The CBOE is the largest US options exchange, established by the CBOT in 1973. It was the first exchange to list standardised, exchange-traded stock options and its contracts are cleared by the Options Clearing Corporation (OCC). Both open outcry physical trading, and via CME Globex electronic trading platform. Trades futures on a wide range of commodities, short-term interest rates, FX, US economic data, equity indices, weather and real-estate. All trades processed via CME Direct system. New York Mercantile Exchange (NYMEX) part of the CME Group NASDAQ (PHLX) Both open outcry physical trading, and via CME Globex and NYMEX ClearPort, for OTC transactions: also after-hours trading on CME Global electronic trading platform for futures only. Trades futures and options on a wide range of metals, energy products and options on spreads between different grades of oil such as Brent/WTI spread. All trades are processed via the exchange s clearing house. Combination of floor trading PHLX XL, the exchange s electronic trading platform. Trades stock index, equity sector and currency options. Both offer standardised and FLEX options. All trades are processed via the exchange s clearing house. ICE Futures Electronic trading of financial, agriculatural, metals and soft contracts. ICE expanded through Trades are cleared via ICE clearing.
Derivatives exchanges - Europe Exchange Description EUREX An electronically traded market and Europe s largest derivatives exchange. Trades a wide range of futures and options on: STIRs, equities, index and single stock futures, volatility index, credit derivatives and exchange-traded funds. Also FLEX options. All trades processed via Eurex Clearing AG. Euronext Exchanges (Amsterdam, Brussels, Lisbon, Paris) Electronic trading can be carried out via Optiq and the Universal Trading Platform (UTP). Trades futures and options on currencies, swaps, equities and commodities. MEFF Spanish Exchange for Financial Futures and Options Subsidiary of BME Group. All trading is done via the MEFF Derivative Trading Platform. Trades futures and options on interest rates, bonds, the IBEX 35 index and leading Spanish shares. Trades are processed directly from the MEFF Derivatives Trading Platform by the exchange s clearing house. Nasdaq Nordic Subsidiary of NASDAQ operating markets in Nordic, Baltic and Caucasian regions
Derivatives exchanges emerging markets B3 (formerly Brazilian Mercantile & Futures Exchange) Dubai Mercantile Exchange (DME) National Commodities & Derivatives Exchange (NCDEX) Ltd (India) South African Futures Exchange (Safex) part of the Johannesburg Stock Exchange (JSE) Shanghai Futures Exchange (SHFE) China Financial Futures Exchange (CFFEX) National Stock Exchange (NSE) (India) Bombay Stock Exchange (BSE) (India) Multi Commodity Exchange of India Ltd (MCX) Burs Malaysia Tadawul (Saudi Arabia)) Nairobi Securities Exchange (Kenya) FMDQ Nigeria
Membership structure and trading rights Membership categories: Brokers trading for others (clients and members) Dealers (trading for own account and other members) Broker-dealers (trading for both third parties and own account) All exchanges will have specific membership structures All exchanges have a clearing house (CCP) and exchange members may or may not be members of that Clearing members typically divided up as follows: General clearing members (GCMs) Individual clearing members (ICMs) Every exchange transaction must be registered and supported by a clearing member
