KASNEB Derivatives Analysis Notes - Kenya Online Library

CIFA ADVANCED LEVEL

This paper is intended to equip the candidate with the knowledge, skills and attitudes that will enable him/her to analyse and trade in derivatives.

Contents

A candidate who passes this paper should be able to:

Build the conceptual framework for understanding the basic derivatives and derivative markets.
Apply the key valuation concepts and models for forward commitments and contingent claims
Evaluate the features, structure and operations of derivatives markets
Demonstrate and explain risk management applications of derivatives strategies
Understand the framework for risk management so as to enable identification, assessment and control of numerous sources of risk.

Introduction: Delivery and settlement of a forward contract; default risk and forward contracts; termination of a forward contract
The structure of global forward markets
Types of forward contracts: equity forwards; bond and interest rate forward contracts; currency forward contracts; other types of forward contracts
Pricing and valuation of forward contracts: generic pricing and valuation of a forward contracts; pricing and valuation of equity forward contracts; pricing and valuation of fixed-income and interest rate forward contracts; pricing and valuation of currency forward contracts
Credit risk and forward contracts
The role of forward markets

Introduction: brief history of futures markets; public standardised transactions; homogenisation and liquidity; the clearinghouse; daily settlement; and performance guarantee; regulation
Futures trading: the clearinghouse, margins, and price limits; delivery and cash settlement; futures exchanges
Types of futures contracts: short-term interest rate futures contracts; intermediate- and long-term interest rate futures contracts; stock index futures contracts; currency futures contracts
Pricing and valuation of futures contracts: generic pricing and valuation of a futures contract; pricing interest rate futures, stock index futures, and currency futures
The role of futures markets and exchanges

Introduction
Strategies and applications for managing interest rate risk: managing the interest rate risk of a loan using an FRA; strategies and applications for managing bond portfolio risk
Strategies and applications for managing equity market risk: measuring and managing the risk of equities; managing the risk of an equity portfolio; creating equity out of cash; creating cash out of equity
Asset allocation with futures: adjusting the allocation among asset classes; pre- investing in an asset class
Strategies and applications for managing foreign currency risk: managing the risk of a foreign currency receipt; managing the risk of a foreign currency payment; managing the risk of a foreign-market asset portfolio

Introduction: characteristics of swap contracts; termination of a swap
The structure of global swap markets
Types of swaps: currency swaps; interest rate swaps; equity swaps; commodity and other types of swaps
Pricing and valuation of swaps; equivalence of swaps and other instruments; pricing and valuation
Swaptions: basic characteristics of swaptions; uses of swaptions; swaption payoffs; pricing and valuation of swaptions
Forward swaps
Credit risk and swaps
The role of swap markets

Introduction
Strategies and applications for managing interest rate risk: using interest rate swaps to convert a floating-rate loan to a fixed-rate loan (and vice versa); using swaps to adjust the duration of a fixed-income portfolio; using swaps to create and manage the risk of structured notes
Strategies and applications for managing exchange rate risk: converting a loan in one currency into a loan in another currency; converting foreign cash receipts into domestic currency; using currency swaps to create and manage the risk of adual- currency bond
Strategies and applications for managing equity market risk; diversifying a concentrated portfolio; achieving international diversification; changing an asset allocation between stocks and bonds; reducing insider exposure
Strategies and applications using swaptions; using an interest rate swaption in anticipation of a future borrowing; using an interest rate swaption to terminate a swap;

Introduction
Basic definitions and illustrations of options contracts: basic characteristics of options; some examples of options; the concept of moneyness of an option
The structure of global options markets: over-the-counter options markets; exchange-listed option markets
Types of options: financial options; options on futures; commodity options; other types of options

Principles of option pricing; payoff values: boundary conditions; the effect of a difference in exercise price; the effect of a difference in time to expiration; put-call parity; American options, lower bounds, and early exercise; the effect of cash flows on the underlying asset; the effect of interest rates and volatility; option price sensitivities
Discrete-time option pricing: the binomial model; the one-period binomial model; the two-period binomial model; binomial put option pricing; binomial interest rate option pricing; American options: extending the binomial model
Continuous-time option pricing: the Black-Scholes-Merton model; assumptions of the model; the black-Scholes-Merton formula; inputs to the black-Scholes-Merton model; the effect of cash flows on the underlying; the critical role of volatility
Pricing options on forward and futures contracts and an application to interest rate option pricing: put-call parity for options on forwards; early exercise of American options on forward and futures contracts; the black model; application of the black model to interest rate options
The role of options markets

Introduction
Option strategies for equity portfolios: standard long and short positions; risk management strategies with options and the underlying; money spreads; combinations of calls and puts
Interest rate option strategies using: interest rate calls with borrowing; interest rate puts with lending; an interest rate cap with a floating-rate loan; an interest rate floor with a floating-rate loan; an interest rate collar with a floating-rate loan
Option portfolio risk management strategies: delta hedging an option over time; gamma and the risk of delta; vega and volatility risk; the Greeks.