Financial Markets and Products
Financial Markets and Products tests how instruments are priced, hedged, and settled. You must know the mechanics of forwards, futures, FRAs, swaps, repos, options, and securitized products, and be able to compute a price or payoff from the contract terms alone.
Core rules
- Forward price with income yield q: F = S e^{(r−q)T}. With a known cash income, subtract the present value of the income from S.
- Futures are marked to market daily; forwards are not. Convexity makes futures rates exceed forward rates when rates and bond prices move together.
- A 3×6 FRA settles at month 3 the interest differential for months 3–6, discounted back from month 6.
- Put-call parity for European options: C − P = S e^{−qT} − K e^{−rT}. Violations imply arbitrage.
- An interest rate swap is a portfolio of FRAs; a currency swap combines a spot FX transaction with two bond positions; a repo is collateralized short-term borrowing.
Worked example
A firm buys a 3×6 FRA on USD 10 million at 4.00%. At settlement, 3-month LIBOR is 5.00%. Interest differential over the 3-month loan period: (0.05 − 0.04) × 10,000,000 × 0.25 = 25,000. The payoff is made at month 3 but represents month-6 interest, so discount 3 months at 5%: 25,000/(1 + 0.05 × 0.25) = 24,691. The long FRA receives roughly USD 24,691.
Traps
- Forgetting to discount the FRA settlement amount.
- Applying put-call parity to American options, which may be exercised early.
- Confusing a bond futures quote with the invoice price, which uses the conversion factor and cheapest-to-deliver.
- Using a discrete dividend amount in the continuous formula instead of the dividend yield.