Derivatives and Structured Finance
Domain 6 tests derivative mechanics, structured note economics and securitisation. The exam focuses on payoff logic, hedging behaviour and where risk actually sits in a structured product - a subject with particular Korean resonance given ELS/DLS issuance and past corporate hedging losses.
Building blocks
- Linear: forwards, futures, interest rate swaps, cross-currency swaps. Non-linear: options, caps and floors, swaptions.
- Structured notes: autocallable ELS and DLS with knock-in barriers; principal risk sits with the investor, layered on top of issuer credit risk.
- Securitisation: true sale to an SPV, tranching and credit enhancement; derecognition under K-IFRS requires genuine transfer of risks and rewards.
Worked example
An importer buys a USD 1m call at a strike of 1,350 with a premium of KRW 20 per dollar, costing KRW 20m. Breakeven is 1,370. At 1,420 the payoff is KRW 70m less the KRW 20m premium, a net KRW 50m; at 1,340 the option expires worthless and dollars are bought at spot, for an effective cost of 1,360 including premium. The premium is a sunk cost: the correct comparison is the effective rate against the budget rate, not against spot alone.
Traps that cost marks
Confusing delta (a hedge ratio and instantaneous sensitivity) with the probability of exercise; believing the notional of a swap is at risk when exposure is the mark-to-market; treating a knock-in barrier as protection when it removes it; ignoring counterparty risk, collateral agreements and CVA; overlooking early-redemption features that cap structured note upside.