CCM Derivatives cheat sheet

A derivative is a contract whose value derives from an underlying rate, price, index, or event; notional principal is the reference amount, not an amount exchanged.

Forwards are bilateral OTC contracts with customized terms and settlement at maturity; futures are exchange-traded, standardized, daily-marked-to-market, and cleared through a CCP.

An option buyer pays a premium and holds a right; the writer receives the premium and bears the obligation. Intrinsic value plus time value equals option premium.

Put-call parity for European options on a non-dividend asset: C - P = S - K·e^(-rT); violations create arbitrage opportunities.

Swap = series of forward cash flow exchanges; a plain vanilla interest rate swap can be decomposed into a fixed-rate bond minus a floating-rate bond.

Market structure layers: execution venue (exchange or OTC), clearing (CCP novation), and settlement; cleared trades face the CCP, not the original counterparty.

Delta measures change in derivative value per unit change in underlying; gamma is the delta's sensitivity; vega is sensitivity to implied volatility; theta is time decay.

Initial margin is posted at trade inception; variation margin settles daily mark-to-market gains and losses; maintenance margin triggers a call to restore initial margin.

Duration approximates percentage price change per unit rate change: ΔP/P ≈ -D × Δy; modified duration = Macaulay duration / (1 + y/m).

DV01 (dollar value of a basis point) = modified duration × dirty price × 0.0001; hedge notional ratio = DV01 of exposure / DV01 of hedging instrument.

Convexity adjusts duration-based estimates: ΔP/P ≈ -D×Δy + 0.5×C×(Δy)^2; long-convexity positions gain more when rates fall than they lose when rates rise.

A payer swap pays fixed and receives floating; it gains when rates rise and hedges floating-rate liabilities. A receiver swap gains when rates fall.

Forward rate agreement (FRA) locks a single-period future rate; settlement is the discounted difference between the contracted rate and the reference rate at fixing.

Interest rate cap = series of call options on the rate, protecting a floating-rate borrower; floor = series of puts, protecting a floating-rate lender; collar = cap plus floor.

Basis risk arises when the hedging instrument's rate (e.g., SOFR) differs from the exposure's rate; the residual spread movement is unhedged.

Key rate duration isolates sensitivity to shifts at specific maturities on the yield curve, capturing non-parallel curve risk that aggregate duration misses.

FX exposure types: transaction (firm commitments and receivables/payables), translation (foreign subsidiary financial statements), and economic (future competitiveness and cash flows).

Covered interest parity: F/S = (1 + r_domestic)/(1 + r_foreign); the forward premium or discount reflects the interest rate differential.

A forward contract fixes the exchange rate for a future date; an FX swap combines a spot leg and a reversing forward leg to manage timing of currency flows.

FX options give the right but not the obligation to exchange currency; a zero-cost collar combines a purchased cap or floor with a sold offsetting option to fund the premium.

Hedging a foreign-currency receivable: sell the foreign currency forward; hedging a payable: buy the foreign currency forward.

Purchasing power parity relates long-run exchange rates to relative inflation: expected spot change ≈ inflation differential.

Translation exposure is often hedged with a balance-sheet hedge (matching foreign-currency assets and liabilities) or a net investment hedge in equity.

Natural hedging matches foreign-currency revenues with foreign-currency costs; remaining net exposure is what financial instruments must cover.

Commodity exposures include price risk on inventory, forward-priced sales, input costs, and basis risk between a local grade and the benchmark futures contract.

Futures hedging: a short hedge protects inventory or expected production; a long hedge protects future purchase needs against rising prices.

Hedge ratio = (exposure quantity × exposure price volatility) / (futures contract size × futures price volatility), adjusted for correlation.

Contango = futures price above spot; backwardation = futures price below spot. Storage costs, convenience yield, and financing drive the spread.

Costless collar in commodities: buy a call (protect against price rise) and sell a put (give up downside) to fund the premium.

Roll risk: hedging with short-dated futures requires rolling contracts, exposing the hedger to changes in the term structure (roll yield).

Equity and other price exposures can be hedged with index futures, equity swaps, or options; beta-adjusted hedge notional = portfolio value × beta.

Weather and power exposures are location- and time-specific, often illiquid, and frequently hedged with swaps or parametric structures rather than futures.

Current exposure = max(mark-to-market value, 0); potential future exposure (PFE) adds a statistical estimate of future mark-to-market growth.

Credit value adjustment (CVA) = expected loss from counterparty default; CVA reduces the fair value of a derivative asset from the risk-free value.

Wrong-way risk: exposure to a counterparty increases as the counterparty's credit quality deteriorates; it must be identified and limited explicitly.

Collateral agreements (CSA) specify thresholds, minimum transfer amounts, eligible collateral, haircuts, and valuation frequency.

Netting sets reduce exposure: exposure = max(sum of positive and negative mark-to-market values within the enforceable netting set, 0).

Central clearing mutualizes counterparty risk through a CCP; members post initial margin to a default fund and variation margin daily.

Credit limits should be set by counterparty, tenor, and product; monitoring must include current exposure, PFE, and collateral balances.

Settlement risk differs from pre-settlement risk: it is the risk that one leg of a payment is delivered and the other is not, managed through payment-versus-payment mechanisms.

All derivatives are recognized on the balance sheet at fair value; the accounting question is where fair value changes are recorded (earnings or OCI).

Hedge accounting requires formal designation and documentation at inception, plus an expectation that the hedge will be highly effective.

Fair value hedge: the hedging instrument and the hedged item's change in fair value are both recognized in earnings.

Cash flow hedge: the effective portion of the derivative gain/loss is deferred in OCI and reclassified to earnings when the hedged transaction affects earnings; the ineffective portion goes to earnings immediately.

Net investment hedge: gains and losses on the hedging instrument are recognized in OCI (foreign currency translation) to offset translation of the foreign operation.

Fair value hierarchy: Level 1 quoted prices in active markets; Level 2 observable inputs; Level 3 unobservable inputs. Disclosures are required by level.

Disclosures include notional amounts, fair values, gains and losses by hedge type, credit risk, and liquidity arrangements related to derivatives.

A derivative that does not qualify for hedge accounting is classified as held for trading, with all fair value changes recognized in earnings.

A derivatives policy should define permitted instruments, authorized counterparties, exposure limits, approval authorities, and valuation and reporting requirements.

Segregation of duties: the front office executes, the back office confirms and settles, and an independent function values and reports.

Confirmations must be matched with counterparties before or promptly after trade execution; unmatched confirmations are a control exception.

Limit monitoring should cover notional, mark-to-market, DV01, and counterparty credit limits, with escalation procedures for breaches.

Valuation control requires independent price verification, model validation, and documented fallback sources for illiquid inputs.

Regulatory obligations commonly include trade reporting to a repository, clearing mandates for eligible products, and margin requirements for non-cleared derivatives.

An effective compliance program includes periodic policy review, audit testing of controls, training, and a documented exception log with remediation.

Documentation should include ISDA master agreements, credit support annexes, and trade confirmations; missing documentation increases legal and credit risk.