This blog is an extension of our blog on Quantitative Methods.
In this session, we will share with you Tips on ‘Financial Market Products’
Futures and Forwards:
1. ‘Over the Counter’ has no intermediary and no standardized contracts, parties can be created their own T&Cwith each other
2. Clearing House is an important institution that acts as intermediary for financial transactions
3. Variation Margin is the additional margin required to deposit on ‘Margin Call’ to make the amount equal to ‘Initial Margin’. Don’t confuse ‘Initial Margin’ with ‘Maintenance Margin’
4. You can expect at least one question on ‘Basis Risk’ concept
5. Optimal Hedge Ratio , is used in calculating optimal number of contracts in the formula:
6. The main difference between Future and Forward is that Future is traded on Exchange and Forward is traded on OTC. If you understand the difference between Exchange and OTC, you know the difference between Future and Forward
7. In determining Forward price, if you understand the concept of ‘Income’, and Cost; you will be able to do every type of forward price questions: F0 = S0e(r-q+c)t. Anything which is a cost shall be added and income shall be deducted
Bonds:
1. It is always good to draw the timeline to visualize the cash-flow. Especially in case of forward rates
2. While asked to find the YTM of a bond, don’t forget to adjust the outcome of I/Y on calculator with frequency of coupon payments. If you are calculating YTM using semi-annual coupon payments, multiply the outcome of I/Y * 2.
3. Always put PMT = 0, in case of Zero Coupon bonds otherwise calculator will take the PMT value of the previous calculation
4. Macaulay and Modified duration ignore the embedded options in the bond whereasEffective Duration calculations takes into account a bond’sembedded options
5. Duration is good for small changes in yield and parallel shift in the Yield curve
Options:
1. There is a difference between Long Call and Short Put. Long Call is the Right to buy and Short Put is the Obligation to buy
2. Put Call parity is only applicable to European options: p + Se-qt = c + Xe-rt
3. When calculating for lower and upper bounds, X will be discounted only in European options with an exception of American call
4. Understand the formula of option (put and call) delta under replicating option
5. Remember the Max profit and Max loss of all option strategies. If you are not able to memorize, just try to draw the diagram and it will be clear to you. Even if it is not clear, then just take any stock price (towards extremes) as example to calculate the loss and profit. It will be crystal clear
6. Delta is the most important option greek. It is also considered as the probability of the option expiring in the money
7. An option with large gamma has large negative theta
Swaps:
1. Interest rate swaps can be used to change/transform a liability to asset and vice versa
2. In the valuation of Interest rate swap, one can consider it like long in fixed rate bond and short in floating rate bond
3. Currency Swaps has more credit risk than IRS has, because in currency swap there is exchange of actual principal
After reading about FMP, you could ensure further enhancement of your FRM knowledge by reading about Value at Risk.
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