Derivatives and Structured Products
Key Concepts
- Options: Calls and puts, strike price, premium, intrinsic vs. time value, payoff diagrams. Know buyer vs. writer rights and obligations.
- Futures and forwards: Standardized vs. customized, margin, mark-to-market, and hedging applications.
- Swaps: Interest rate swaps, currency swaps; plain vanilla mechanics.
- Structured products: Principal-protected notes, reverse convertibles, and their risk-return profiles.
- Risk management: Hedging with derivatives, leverage, and counterparty risk.
Traps
- Confusing the right (option) with the obligation (futures).
- Misidentifying the maximum loss for an option writer (unlimited for naked calls).
- Overlooking counterparty risk in OTC derivatives.
Worked Example / Rule of Thumb
Rule of thumb: Option buyer risk = premium paid; option writer risk can be unlimited. Example: An investor writes a naked call on a stock at strike $50, receives $2 premium. If the stock rises to $70, the writer loses ($70 - $50) - $2 = $18 per share.