CIRO Derivatives Exam cheat sheet

A derivative is a contract whose value derives from an underlying asset, rate, index or event; no principal need change hands at inception.

Four core instrument families: forwards (private, OTC, bespoke), futures (exchange-traded, standardised, cleared), options (right but not obligation), swaps (exchange of cash-flow streams).

Exchange-traded contracts carry standardised size, expiry, tick and quality; OTC contracts are bilaterally negotiated and carry counterparty exposure unless cleared.

Linear payoffs (forwards, futures, swaps) change one-for-one with the underlying; non-linear payoffs (options) change at a rate that itself varies with the underlying.

Market participants: hedgers transfer price risk, speculators accept it for expected return, arbitrageurs enforce no-arbitrage pricing relationships across venues and maturities.

Price discovery and liquidity concentrate where trading costs, margin efficiency and clearing access are best; fragmentation across venues raises implicit costs such as wider effective spreads.

Initial margin is a performance bond, not a down payment; variation margin settles daily gains and losses and prevents loss accumulation.

Delivery versus cash settlement: physically settled contracts require deliverable supply and logistics; cash-settled contracts reference an index and remove delivery optionality.

Futures are marked to market daily: profit or loss is credited or debited to the margin account each settlement cycle, so contract value resets to zero.

Basis = spot price minus futures price; convergence to zero at expiry is enforced by the delivery mechanism and arbitrage.

Cost-of-carry model: F = S x e^((r + storage - convenience yield) x T), or F = S(1 + rT) in simple discrete form for non-dividend assets.

Contango: futures above spot, typically when carry costs exceed convenience yield; backwardation: futures below spot, typical of scarce nearby supply.

Roll yield for a long position is positive in backwardation and negative in contango; it explains part of the divergence between spot and futures returns.

Contract specifications include contract unit, quotation and minimum tick, expiry and last trading day, deliverable grades, position limits and settlement method.

Order types: market, limit, stop, stop-limit; a stop becomes a market order when triggered, so slippage is possible in fast markets.

Open interest counts outstanding contracts; rising open interest with rising price indicates new long positioning rather than short covering.

Payoff at expiry: call = max(S - K, 0); put = max(K - S, 0); long option maximum loss is the premium paid.

Put-call parity for European options on non-dividend assets: C - P = S - K x e^(-rT); violations permit conversion or reversal arbitrage.

Black-Scholes inputs are spot, strike, time, volatility, rate and dividend yield; only volatility is unobservable, so implied volatility is the market's price of uncertainty.

The Greeks: delta measures change in premium per unit underlying; gamma the change in delta; theta time decay; vega sensitivity to volatility; rho to rates.

Moneyness: in-the-money, at-the-money, out-of-the-money; intrinsic value plus time value equals premium, and time value tends to zero at expiry.

American options may be exercised early; early exercise of a call is generally optimal only just before an ex-dividend date, and of a deep in-the-money put when carry favours it.

Implied volatility surface varies by strike and expiry; skew and term structure reflect crash demand, supply shocks and event risk.

Option strategies: spreads limit cost and payoff, straddles and strangles trade volatility direction-neutral, covered calls and protective puts modify linear exposure.

Minimum-variance hedge ratio = covariance(spot, futures) / variance(futures), equal to beta when hedging an equity portfolio with index futures.

Hedge effectiveness is measured by R-squared of the spot-futures regression; residual risk is basis risk and cannot be eliminated by hedging.

Number of futures contracts = (hedge ratio x exposure value) / (futures price x contract multiplier); round to whole contracts and note the residual.

Short hedge protects a future sale or long inventory; long hedge protects a future purchase or short exposure.

Value at Risk estimates a loss threshold at a confidence level over a horizon; it says nothing about the size of losses beyond that threshold.

Expected shortfall (conditional VaR) is the average loss in the tail beyond VaR and is sub-additive, unlike VaR, so it behaves as a coherent risk measure.

Stress testing applies historical or hypothetical shocks, including correlation breakdown, to complement VaR's normal-period assumptions.

Cross-hedging uses a related but imperfectly correlated instrument; the difference between the two prices is the cross-hedge basis.

Clearing stands between counterparties: the central counterparty becomes buyer to every seller and seller to every buyer, mutualising default risk.

Novation replaces the original bilateral contract with two contracts to the CCP; open offer or agency models achieve similar legal effect.

Settlement: payment versus delivery for cash instruments, delivery versus payment for securities, and daily cash settlement of variation margin for futures.

Trade lifecycle: execution, capture and affirmation, confirmation, clearing submission, margin calculation, settlement and post-trade reporting.

Straight-through processing reduces operational risk; failed affirmation before the clearing deadline can force a trade to be rejected or bilaterally held.

Give-up and allocation arrangements let an executing broker act for a clearing broker; the clearing member remains liable to the CCP.

A central counterparty default waterfall: defaulter's margin, defaulter's default fund contribution, CCP skin in the game, then mutualised default fund and assessment powers.

Portability and client asset segregation aim to allow transfer of client positions and collateral if a clearing member fails.

Initial margin covers potential future exposure over the close-out period; variation margin settles current exposure.

Margin models use historical or stressed lookback periods, volatility scaling and diversification offsets; procyclicality is a known weakness.

Collateral haircuts reflect price volatility, liquidity and liquidation horizon; wrong-way risk arises when exposure and collateral quality correlate.

Eligible collateral is typically cash, high-quality government bonds and, subject to limits, equities or gold; concentration limits cap any single issuer.

Bilateral margin rules for non-cleared derivatives use a standardised initial margin schedule or an approved model, plus daily variation margin.

Counterparty credit risk = probability of default x exposure at default x loss given default; netting and collateral reduce exposure at default.

Credit valuation adjustment is the market value of counterparty credit risk and is reduced by collateral and netting agreements.

Segregation protects client collateral in insolvency, but a shortfall in a pooled account is shared pro rata among clients of that account.

Core post-crisis reforms: central clearing of standardised OTC derivatives, trade reporting to repositories, higher capital and margin for non-cleared trades.

Trading obligation requires eligible standardised contracts to trade on organised venues; the clearing obligation applies to specified counterparty and product classes.

Reporting includes counterparty identifiers, product taxonomy, valuation, collateral and lifecycle events, with same-day or next-day deadlines.

Position limits and accountability levels cap speculative positions in commodity derivatives to prevent market distortion and delivery squeezes.

Business conduct rules cover best execution, conflicts of interest, client money protection, recording of communications and prohibition of market abuse.

Market abuse regimes prohibit insider dealing, unlawful disclosure and manipulation, including spoofing, layering and wash trades.

Senior managers and certification regimes assign personal accountability for regulated activities and require fit-and-proper attestation.

Cross-border activity is governed by equivalence, substituted compliance or registration thresholds, and by substituted-compliance relief for margin rules.

Suitability assessment covers knowledge and experience, financial situation including loss-bearing capacity, and investment objectives and risk tolerance.

Appropriateness testing applies to execution-only non-advised sales of complex products; failure to pass permits the firm to warn or refuse the order.

Risk disclosure must state leverage effects, unlimited loss potential on uncovered short options, margin calls and possible total loss of premium.

Product governance: manufacturers define a target market and review the product; distributors must ensure the product fits that target market.

Inducements must not impair the duty to act in the client's best interests; fees must be disclosed and, for independent advice, banned.

Retail restrictions on speculative products include leverage caps, negative balance protection, standardised risk warnings and ban on trading bonuses.

Record keeping must evidence advice, the suitability rationale, costs and charges disclosure, and client instructions.

Vulnerability and capacity for loss are assessed separately from risk appetite; a client may want a product they cannot financially bear.

Reference rate reform replaced interbank offered rates with risk-free rates plus a spread adjustment; legacy contracts required fallback language.

Benchmark regulation requires administrators to publish methodology, govern conflicts and submit to oversight; users must maintain written fallback plans.

Total return swaps and contracts for difference replicate economic exposure without transferring legal ownership of the underlying.

Embedded derivatives are separated from host contracts when their economics are not clearly and closely related to the host.

Central bank digital currencies and tokenised collateral are emerging settlement assets; legal finality and custody treatment remain jurisdiction-specific.

Market transparency regimes publish pre-trade quotes and post-trade prices, with block-trade deferrals for large or illiquid transactions.

Liquidity risk differs from price risk: it is the cost of exiting a position, measured by bid-ask spread and market depth.

Daily price limits and circuit breakers suspend or constrain trading; limit-locked markets can prevent hedging exits.

Position limits apply per contract and aggregated across accounts under common control; exemptions exist for bona fide hedging.

Delivery process: first notice day, last trading day and last delivery day; long holders must decide to close, roll or accept delivery.

Cash settlement uses a final settlement price derived from an index or auction, removing delivery and logistics risk.

Exchange fees and clearing fees are explicit; bid-ask spread, market impact and roll slippage are implicit costs.

Roll timing affects realised return: rolling before expiry avoids delivery but may capture a less favourable calendar spread.

Trading halts and volatility auctions reopen markets at a single clearing price rather than at any limit order price.

Binomial and trinomial trees price American options by backward induction, checking early exercise at each node.

Monte Carlo pricing suits path-dependent payoffs; it is computationally intensive and awkward for early-exercise features.

Delta hedging a short option position requires rebalancing as the underlying moves; gamma measures how often that rebalancing must occur.

Volatility smile: out-of-the-money puts often trade at higher implied volatility than at-the-money options in equity markets.

Dividend yield reduces call value and raises put value; a known discrete dividend causes a step in the forward price.

Exotic options include barriers, digitals, Asians and lookbacks; barrier features create discontinuous payoffs and pin risk near the trigger.

Warrants and structured notes embed options; issuer credit risk is layered on top of the option payoff.

Delta-neutral hedging requires the hedge quantity to equal option delta times the number of options times the contract multiplier.

Gamma scalping: a long-gamma position profits from realised volatility above implied, before transaction costs.

Portfolio hedging with index futures: short futures equal to portfolio beta times portfolio value divided by futures notional.

Rolling hedges creates roll risk; a stack of short-dated contracts must be renewed and may reprice unfavourably.

Scenario analysis and reverse stress testing identify positions that fail under plausible but severe market moves.

Liquidity-adjusted VaR adds the cost of unwinding positions over the assumed liquidation horizon.

Hedge accounting under IFRS 9 or equivalent requires documented effectiveness and a designated hedging relationship.

Correlation risk: diversification benefits assumed in normal markets can reverse in stress, raising portfolio VaR.

Trade affirmation platforms confirm economic terms before the clearing deadline; unaffirmed trades may be rejected from clearing.

Clearing members guarantee client performance to the CCP and must collect margin from clients, often with a buffer above the CCP requirement.

Settlement cycles for securities are now largely T+1 or T+2; derivatives cash settlement occurs on the contractual settlement date.

Collateral movements: intraday margin calls, end-of-day variation margin and periodic initial margin recalculation.

A CCP default fund is sized to cover the simultaneous default of its two largest members under stressed assumptions.

Auction and close-out processes liquidate a defaulted member's portfolio; hedging and porting reduce losses to the fund.

Operational resilience requirements cover cyber, third-party dependencies and tested recovery time objectives.

Reconciliation of positions and collateral between firm, clearing member and CCP prevents breaks that can delay settlement.

Standardised initial margin schedule uses notional by asset class and netting set, with a minimum transfer amount and threshold.

Initial margin is posted gross and cannot be rehypothecated by the recipient under margin rules for non-cleared derivatives.

Variation margin is exchanged at least daily, with intraday calls possible in volatile markets.

Collateral eligibility and haircut grids are set by the CCP or by bilateral credit support annex terms.

Wrong-way risk is specific when collateral is issued by the counterparty or correlated with its creditworthiness.

Potential future exposure is modelled with confidence level and holding period; add-on approaches are used for regulatory capital.

Netting sets and close-out netting enforceability depend on jurisdiction and insolvency law recognition.

Central counterparty margin is designed to cover a member's portfolio to a high confidence level over a two-day to five-day close-out.

Licensing: dealing, arranging, managing investments and advising are separate regulated activities; each needs permission.

Client categorisation into retail, professional and eligible counterparty determines the level of protection and disclosure.

Transaction reporting to a trade repository must use valid identifiers and be reconciled; errors require resubmission.

Record retention periods are typically five to seven years, and telephone recordings cover conversations that lead to a transaction.

Conflicts of interest policy must identify, prevent or manage conflicts; disclosure is a last resort, not a substitute for management.

Anti-money laundering obligations include customer due diligence, beneficial ownership checks and suspicious activity reporting.

Compensation schemes cover eligible retail clients up to a monetary cap in insolvency; professional clients are generally excluded.

Supervisory powers include information requests, on-site inspection, fines, prohibition orders and withdrawal of authorisation.

Costs and charges disclosure must show the total cost of the product and service, aggregated and expressed in cash and percentage terms.

Fair, clear and not misleading communications must balance risk and reward and avoid past-performance guarantees.

Financial promotions require a risk warning, a clear statement of the firm's regulatory status and approval by an authorised person.

Execution quality reporting covers venue selection, price improvement and the likelihood of execution under stated conditions.

Complaints handling: acknowledge promptly, investigate independently and provide a final response within a defined period.

Product intervention powers allow a regulator to ban or restrict a product or practice temporarily or permanently.

Sales incentives must not conflict with suitability; remuneration structures should not reward volume over client outcomes.

Negative balance protection prevents retail clients owing more than their account balance on leveraged derivatives.