Derivatives and Structured Products
The Derivatives and Structured Products domain covers pricing logic, payoff profiles, collateral mechanics and the selling obligations attached to forwards, futures, options, swaps and packaged notes. The exam favours payoff profiles described in words, parity relationships, margin arithmetic and suitability judgement.
Building blocks
- Forwards and futures oblige a trade at a set price; the futures price reflects spot plus cost of carry minus income. Futures are marked to market daily through margin; forwards are bilateral and carry counterparty risk.
- Options: the buyer pays premium for a right; the writer takes premium and the obligation. Long call - loss capped at premium, gain unlimited. Long put - loss capped at premium, gain limited to strike minus premium. Short options mirror this with much larger risk.
- Swaps are series of forward cash flows, used to transform fixed/floating, currency or credit exposure.
Relationships and Greeks
- Put-call parity (European, no dividend): C − P = S − K/(1+r)^T.
- Delta measures value change per unit of underlying; gamma measures change in delta; theta is time decay; vega is volatility sensitivity.
Structured products
Capital-protected notes, equity-linked notes, autocallables and reverse convertibles are a bond plus embedded derivatives. Investors bear issuer credit risk and, where protection is partial, full downside, capped upside, knock-in or knock-out triggers and illiquidity.
Worked example
C = 5, P = 3, S = 100, K = 100, r = 5%, T = 1. Parity right side: 100 − 95.24 = 4.76; left side: 5 − 3 = 2.00. The call is cheap relative to the put. Arbitrage: buy the call, sell the put, sell the stock at 100 and invest 95.24 at 5%. At expiry the long call plus short put nets to S_T − 100, the short stock costs S_T, and the deposit returns 100 - zero net payoff. Today's cash flow is −5 + 3 + 100 − 95.24 = +2.76, a riskless profit before costs.
Traps
- Confusing writer and buyer maximum loss, especially on short puts.
- Forgetting that capital protection depends on the issuer, not the underlying.
- Treating margin calls as losses rather than liquidity demands.
- Applying parity to American options or across dividends without adjustment.
- Ignoring the delta hedge the issuer must trade, which can amplify moves in the underlying.