Derivatives Fundamentals and Market Structure
Core concepts
A derivative is a contract whose value derives from an underlying rate, price, index, or event. Candidates must distinguish forwards (bilateral, customizable, no upfront premium, linear payoff), futures (exchange-traded, standardized, cleared, margined daily, marked to market), options (asymmetric payoff, premium paid upfront, buyer has a right not obligation), and swaps (series of cash-flow exchanges, typically netted). Know the roles of exchanges, clearinghouses, brokers, and dealers in the market structure, and the difference between exchange-traded and OTC markets in terms of customization, credit exposure, and transparency.
Pricing intuition
Understand cost-of-carry, forward vs. futures price differences (rate-convexity, dividends, storage), and put-call parity as a no-arbitrage identity. Know the payoff diagrams for long/short forwards, futures, and the four basic option positions. Be comfortable with the concept of intrinsic vs. time value and the Greeks at a conceptual level.
Traps in questions
- Confusing notional with market value or cash flow.
- Assuming futures eliminate risk-they transfer and standardize it but introduce basis risk and margin/liquidity demands.
- Forgetting that option buyers have limited loss (premium) while sellers have potentially unlimited loss.
- Misreading long vs. short exposure direction.
Rule of thumb
For a forward on a non-dividend asset: F = S × (1 + r)^T (continuous: F = S·e^(rT)). If F trades above this, cash-and-carry arbitrage (borrow, buy spot, sell forward) is profitable-memorize the direction of the arbitrage, not just the formula.