Derivatives, Structured Products and Alternative Investments
What a candidate must understand
Derivatives derive value from an underlying. Know forwards, futures, options and swaps. Futures are standardised, exchange-traded, margined and marked to market daily; forwards are bespoke OTC contracts with counterparty risk. Options give the right, not the obligation, to buy (call) or sell (put); buyers pay a premium and have limited loss, sellers have potentially unlimited loss. Understand intrinsic vs time value, in/at/out of the money, delta as directional exposure, and basic hedging vs speculation motives. Structured products combine a bond with derivatives: capital-protected notes, reverse convertibles, autocallables. Know that capital protection depends on the issuer's creditworthiness, not just the payoff formula. Alternatives include hedge funds, private equity, real estate, commodities and infrastructure: typically illiquid, less transparent, with lock-ups and valuation challenges, but offering diversification.
Traps that appear in questions
- Believing capital-protected notes are risk-free; issuer default risk remains.
- Confusing the option buyer's limited loss with the seller's unlimited liability.
- Assuming futures require full payment upfront; they require margin only.
- Treating an OTC forward as free of counterparty risk.
- Overlooking illiquidity and stale valuations in alternatives.
Worked example / rule of thumb
A call option with strike 100 trades at 6 when the stock is 104. Intrinsic value is 4; time value is 2. Rule of thumb: buyers of options risk the premium; sellers risk far more. For structured products, always ask: who is the counterparty, and what happens if they fail?