Day 1
Introduction to Derivative Instruments and Markets
• Evolution and development of the derivatives markets
• Derivatives defined: characteristics of derivative instruments
• The range and diversity of the derivatives markets
• Linear and non-linear derivatives
• Outright (forwards, futures and swaps) and option derivatives
• Over-the-counter vs exchange traded derivatives
• OTC derivatives documentation and legal issues
• Applications of derivatives: risk transfer
• An overview of applications in trading, hedging and arbitrage
• Benefits and shortcomings of derivatives
– Accounting for derivatives – Impact of
IAS39/FAS133
– Hedge accounting
‘Delta 1.0’ Derivatives: Forward and Futures Markets
• Forward contracts
– Definitions and nomenclature - market practices
– Generic characteristics of forward contracts
– Pricing principles of forward/futures contracts
– Arbitrage-free pricing
– Backwardations and the breakdown of arbitrage free valuation
– Credit risk exposure and forward contracts
• Futures contracts
• The mechanics of futures contracts and futures markets
• The role of the clearing house
• Margining: definition and operation
• Credit risk and futures contracts
• Interest rate forward contracts and futures
– Forward Rate Agreements (FRAs)
– The FRA market – conventions: price, quotation and settlement
– Pricing and valuation of FRAs
– Applications of FRAs in trading and interest rate risk management
– Contract features - short term interest-rate futures
(STIRs)
– Applications of futures in trading and hedging; managing basis risk
CASE STUDY 1: Pricing and valuation of FRAs – Application to exposure management
Swaps Markets
• Evolution and development of the swaps market
• Swaps market dynamics
• Swaps market participants and roles
• Business drivers – applications of swaps to trading, portfolio risk management and funding (ALM)
• Generic characteristics of swap contracts
– Interest rate, currency & basis swaps
– Equity swaps
• Swaps documentation and legal issues
– Termination, assignment by novation
– Netting agreements
– Legal enforceability of netting arrangements
Interest Rate and Currency Swaps
• Generic swap structures
– Par interest rate swaps
– Basis swaps
• Generic and non-generic swaps – a classification of types
• Cross-currency swaps
– Cross currency basis swaps
– Principal exchanges – implications for removal of initial and/or final amounts
• Swaps market conventions and practices
– Nomenclature, terminology and market quotation conventions
– Interest rate accrual and payment conventions
– Stub interest calculation periods (long/short)
– Off-market contract terms and margins
Day 2
Pricing and Valuation of Interest Rate and Currency Swaps
• Basic foundations of swap valuation - nil value of par swaps
• Discounted cash flow (DCF) methodology
• Estimation of zero coupon discount factors from market based data
– Yield curve construction using FRA rates and the futures strip
– Yield curve construction using par swap rates and bond yields
• Pricing and Valuation techniques
– Practical pricing and valuation applications
– Mark to market - swap portfolio valuation
– Swap terminations and assignments - fee estimation
– Off-market swap structures - margin and fixed coupon calculation
Interest Rate and Currency Swaps - Funding, Risk
Management and Trading Applications
• Applications of interest rate derivatives to client risk management strategies
– Hedging currency and interest rate exposures
– Hedging fixed and floating interest rate assets and liabilities
– Creating ‘synthetic’ assets and liabilities
• Applications of swaps and options in liability management
– Credit risk arbitrage – identifying and realizing comparative advantages
– Funding diversification
Applications of swaps and options in asset management
– Asset swaps
• Exposure management - identifying client risk profiles
– Selection of appropriate risk management strategies using OTC solutions
– Outright hedges (swaps, FRAs) vs option-based hedges
• Comparative analysis of risk management strategies
– Advantages/shortcomings of risk management solutions; opportunity gains and losses
– Tailoring interest rate options to client interest rate risk management strategies
– The use of options in hedging contingent liabilities
• Trading Strategies using interest rate derivatives
– Interest rate swaps as a substitute for fixed income bond trading
– Credit trading: yield curve arbitrage strategies
– Option trading strategies
– Directional trading strategies
– Premium generation (yield enhancement) strategies
– Costs and benefits of using derivatives in trading and portfolio management strategies
CASE STUDY 2: Pricing a new bond issue structured with a currency swap. Structuring an asset swap Swap Risks – Market Risk and Counterparty
Credit Risk
• Measurement of swap risks
• PV01, Delta
• Hedging a swap transaction with bonds, futures
• Counterparty Credit Risk Exposure
• Credit risk mitigation
– Collateral agreement
– “Swapclear”
• Credit and regulatory capital requirements
CASE STUDY 3: Risk analysis of swap portfolio – Risk measurement and construction of hedge relationship
Day 3
Non-linear Derivatives: Options
• Option characteristics, terminology and market conventions
– Put and call options
– European, American, Asian and Bermudan option styles
– Intrinsic and time value
– Put-call parity
• Global option markets
– Exchange traded and OTC option markets
– FX options; interest rate options; equity options; equity index options; warrants
• Pay-off profiles and their interpretation
Understanding Option Valuation - Option Pricing
Models
• Intuitive approach to understanding option valuation and value drivers
– Option valuation: intrinsic value, time value and ‘moneyness’
• Option pricing models
– Advantages and shortcomings of Black-Scholes
– a critical analysis
– Simulation methods of option valuation –
Monte Carlo methods
– Volatility in option valuation
– Time value: impact on option values
• Volatility estimation
– Historic, implied and realized volatility measures
– Volatility smiles and skews
Option Risks
• Dynamic risk characteristics of options
• The Greeks (Delta, Gamma, Theta, Vega, Rho and
Phi risks)
• Interpretation of Delta - cash equivalent risk representation
• Delta hedging
• Market impact of Delta hedging
• Why Delta hedge – a brief overview of volatility risks
(Gamma, Vega)
• Time decay
• Carry related risks (Rho, Phi)
Interest Rate Options
• Caps, floors and swaptions
• Pricing techniques: Black Vs. term structure models
• Cap/floor market conventions, terminology, price quotation basis
• European and American style swap options
• Swap option market conventions, terminology, price quotation basis
• Applications in trading, investment and portfolio management
CASE STUDY 4: Corporate exposure management applications of caps and floors
Hedging and Trading Strategies Using Options
• Risk-reward profiles of naked option strategies
• Put-call parity:
– Risk reversals, range forwards, participating forwards, synthetic forwards and options
• Hedging and arbitrage strategies using options
• Creating trading and hedging strategies using options
– Spreads: vertical (call and put) and horizontal (calendar) spreads
• Volatility trading strategies
– Straddles, strangles and butterflies
• Analysis of trading strategies
– Payoff profiles
– Instantaneous risks (delta, gamma etc.)
CASE STUDY 5: Analysis of option trading and hedging strategies
Day 4
Derivatives Applications
Interest Rate and FX linked Structured Products
Interest Rate Linked Structured Products
• Callable/Puttable bonds
• European/Bermudan (step-up) callable bonds
• Range Accrual notes
• CMS-linked notes
• Capped, floored FRNs
• Inverse FRNs
• Callable, non-callable
• TARNs
• Ladders’ (LIFTS) and ‘Snowblade’ structures
CASE STUDY 6: Analyzing and reverse engineering an inverse floater with embedded options
CASE STUDY 7: Pricing a cancellable swap; Bermudan stepup
Callable Bond
FX Derivatives
Forward foreign exchange
• Outrights and FX swaps
• Pricing using interest rate differentials
• Quotation conventions
• Calculating outright forward FX rates
• Cross rate forwards
• Determination of synthetic interest rates using forwards
• Applications of forward FX in hedging transaction and translation exposure
• Non-deliverable forwards (NDFs)
• Uses and benefits of NDFs
Currency Options
• Market conventions, terminology, price quotation basis
• Puts, Calls; European, American styles
• Hybrid structures: Collars, Range forwards,
Participating Forwards, Knock-In Forwards
• Hedging transaction and economic exposure using FX forwards and options
• Applications to currency exposure management
• Exotics
– Barrier options (Knock-in, knock-out, reverse, double knock-out structures)
– Digital options
– Average rate options
• Currency Linked Structured Products
– Currency linked deposits
– Knock out structured notes
– Dual currency notes
– Reverse dual currency notes
– Power reverse dual currency notes
– Range accrual notes
CASE STUDY 8: Evaluation of currency exposure hedging
strategies; Pricing of FX linked range accrual note structure.
Day 5
Derivatives Applications - The Uses and Benefits
of Equity Derivatives
• Applications in portfolio management
• Corporate applications of equity derivatives
• Index vs. single stock derivatives
• Delta 1.0 derivatives: synthetic equity proxies; market access vehicles
• Asset allocation using equity derivatives
• Arbitrage opportunities: profiting from stock borrow, interest rate, net dividend differentials, market access
• Hedging strategies using options
– Puts/Calls
– Put spreads
– Collars, put-spread collars
• Portfolio strategies using options
• Yield enhancement strategies
– Over-writing and under-writing strategies
• Directional trading strategies
– Risk reversals and Synthetics
– Option Spreads
• Volatility and Correlation trading strategies
– Straddles
– Volatility and Variance swaps
– Dispersion trading strategies
Equity Linked Structured Products
• Simple synthetics
– Trackers
– Pricing
• Principal Protected Equity Linked Certificates
• Investment Rationale
• Capital Guaranteed equity linked structured notes
• Equity linked TARN certificates
• Basket ELN’s & ‘Best of ’ and ‘Worst of ’ structures
• Partial-Principal Protection: Notes offering limited downside protection
• Reverse and Mandatory Convertibles
EXERCISE 9: Structuring and pricing capital guaranteed equity linked note structures
The Credit Derivatives Market
• Market overview
• Evolution and market development
• Recent developments and key issues
• Terminology and nomenclature
• Market participants
• Credit indices (iTRAXX) and related products
Credit Derivatives: Default Swaps (CDS)
• Definitions and nomenclature
• Credit Events – Definitions and associated problems
• Documentation (ISDA credit default swap masteragreement)
• Single asset and basket structures
• Settlement mechanisms
• Credit indices (iTRAXX)
• ITRAXX CDS
• Pricing and valuation of CDS
• Arbitrage based methods
• Deriving default curves
• Estimation of default probabilities, hazard rates
EXERCISE 10: Pricing and valuation of CDS
2nd Generation Credit Derivatives
• First to default FTD CDS
• Standardized FTD baskets: analytics and settlement mechanisms
• nth to default basket structures
• CDS options
Derivatives Application - Uses and Benefits of
Credit Derivatives
• Credit (portfolio) risk management
• Using credit derivatives to manage and securitize credit risk
• Regulatory capital management
• Credit risk diversification, risk reduction
• Investment applications (Synthetic asset generation)
• Leverage (unfunded exposures)
• Yield enhancement (exploiting of credit arbitrages)
• Market access (synthetic loan generation)
• Credit trading
Structured Credit Products
• Collateralized debt obligations (CDOs)
• CDO structures
– Cash flow CDOs
– Synthetic CDOs
– Funded and unfunded structures
• Single Tranche CDOs
– DJ Traxx Index tranche CDOs