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Derivatives Compass

PractitionerAdvanced

Front Office

Who this is for
For salespeople, traders and structurers who want to understand pricing and sensitivities and explain products to clients.
How to read it
Newcomers read the foundations first. Practitioners start at stage 1. If you already work with valuation and hedging, start at stage 3.

  1. Stage 1Products in depthPractitioner

    Swap valuation, basis, rate and FX options and option combinations: the terms and pricing of the products you handle.

    1. PractitionerValuing an Interest Rate SwapThe value is the present value of what you receive minus the present value of what you pay, and it is zero at the time the swap is traded at market rates.Interest Rate Derivatives
    2. PractitionerBasis SwapsIn an exchange of compounded TONA for 3-month TIBOR, the TIBOR rate is set before the period and the compounded TONA rate at the end of the period.Interest Rate Derivatives
    3. PractitionerCaps and FloorsCap payments are set separately for each interest period (each caplet), and nothing is received for a period in which the floating rate is at or below the strike rate.Interest Rate Derivatives
    4. PractitionerSwaptionsThe expiry and the swap term are quoted in that order, as in "1 month into 10 year."Interest Rate Derivatives
    5. IntroductoryFX SwapsThe same amount of foreign currency is bought and sold in opposite directions in the near leg, which settles first, and the far leg, which settles later.FX Derivatives
    6. PractitionerCovered Interest Parity and FX Forward PointsThe forward exchange rate is set by the cost of a combination of trades that borrows yen, buys dollars at the spot exchange rate, and deposits the dollars.FX Derivatives
    7. PractitionerCross-Currency SwapsThe principal exchange at maturity also uses the spot exchange rate at the start, so a trade that starts with USD 100 million and 15 billion yen exchanges the same amounts back at maturity.FX Derivatives
    8. PractitionerFX Option Market ConventionsCurrency option prices are quoted as implied volatilities in the Garman-Kohlhagen model, and the strike is backed out from the specified delta.FX Derivatives
    9. PractitionerPut-Call ParityFor an underlying asset that pays no dividends, call price − put price = underlying price − strike price × discount factor.Product Building Blocks
    10. PractitionerOption StrategiesThe profit and loss of a combination at expiry is the sum of each trade's profit and loss, and the net premium shifts the break-even points.Product Building Blocks

  2. Stage 2Valuation and hedgingPractitioner

    From no-arbitrage to Black-Scholes and the Greeks, then how volatility is read and how delta, gamma and vega are managed in market making.

    1. IntroductoryNo-Arbitrage and ReplicationWith no arbitrage opportunities, two things whose future cash flows are the same in every outcome have the same price today (the law of one price).Valuation
    2. IntroductoryBinomial TreesIn a one-period model, buying the underlying and borrowing money reproduces the payoff of a call option (call), and the cost of doing so is the call's price.Valuation
    3. PractitionerThe Black-Scholes ModelThe model assumes that the underlying price follows geometric Brownian motion, that volatility and interest rates are constant, and that trading is continuous and free of costs.Valuation
    4. IntroductoryThe GreeksA hypothetical call (price 8.43) has a delta of 0.5596, so its price is estimated to rise about 0.56 when the underlying price rises by 1.Valuation
    5. PractitionerImplied VolatilityImplied volatility restates an option's price as a volatility, much as a yield restates the price of a bond.Valuation
    6. PractitionerVolatility Smiles and SurfacesEquity options usually show a downward-sloping shape (a skew): implied volatility is higher at lower strikes, and the slope is steeper at shorter expiries.Valuation
    7. PractitionerSensitivities: DV01, Vega and Key Rate SensitivitiesRisk factors depend on the product, and each maturity's interest rate is treated as a separate risk factor.Market Risk
    8. PractitionerDelta HedgingEven when the same option is hedged, the profit or loss up to expiry depends on the path the underlying price takes.Trading and Hedging
    9. PractitionerManaging Gamma and VegaThe one-day profit or loss of a delta-hedged position is gamma times the gap between the squared return and a value set by the implied volatility.Trading and Hedging
    10. PractitionerMarket MakingThe revenue is the difference between the bid and the ask, but price moves on inventory and trades with better-informed counterparties can cause losses.Trading and Hedging

  3. Stage 3Client business and conductPractitioner

    From needs assessment to proposals, suitability, documents and mark-to-market reporting, plus the conduct rules the front office must follow.

    1. IntroductoryUnderstanding Client NeedsStaff check the purpose of the transaction. If it is a hedge, the institution checks that it will work as one until the contract ends.Client-Facing Business
    2. IntroductoryProposals and ExplanationsThe seller and the client differ in their knowledge of the product and in the information they have, so proposals and explanations help the client make its own decision.Client-Facing Business
    3. PractitionerSuitability ChecksFinancial institutions must not solicit in a way that is inappropriate in light of the client's knowledge, experience, financial situation, and purpose of the contract.Client-Facing Business
    4. PractitionerProduct Explanations and Pre-Contract DisclosuresThe required contents come from the seven items of Article 37-3 of the Financial Instruments and Exchange Act, plus matters for each type of transaction added by a Cabinet Office Order.Client-Facing Business
    5. PractitionerMark-to-Market Reporting to ClientsThe supervisory guidelines list, as a point to check, a framework for telling a client the market value and the termination payment amount on request.Client-Facing Business
    6. PractitionerSuitability and the Duty to ExplainThe FIEA's suitability principle and pre-contract explanation apply depending on whether the client is a professional investor, not on whether it is an individual or a corporation.Regulation: Japan
    7. PractitionerMarket Manipulation and SpoofingJapan's Financial Instruments and Exchange Act prohibits sham transactions, transactions by prior arrangement, and price-moving trading, with criminal penalties, administrative surcharges, and damages for violations.Regulation: Cross-Border Themes
    8. PractitionerBest ExecutionJapan's Financial Instruments and Exchange Act (FIEA) requires firms to set and publish a best execution policy, etc. and to execute client orders in line with it.Regulation: Cross-Border Themes

  4. Stage 4Structured products and exoticsPractitioner

    How structured products decompose into derivatives, and an overview of rate, FX and equity exotics.

    1. IntroductoryWhat Are Structured Products?A structured note's investor is in the same position as if it had traded a derivative with the issuer, which may enter the same trade in the opposite direction with a swap counterparty.Structured Products
    2. IntroductoryExchangeable Bonds (EB)On many exchangeable bonds, if the bond knocks in and is redeemed in shares, the investor receives less than the principal by the amount the share price has fallen.Structured Products
    3. PractitionerOverview of Exotic OptionsEven when the price at expiry is the same, a payoff set by the average or the highest price over the period changes with the path the price took.Product Building Blocks
    4. PractitionerBarrier OptionsCombining whether the barrier is above or below the current price with whether touching it cancels or creates the right gives four types each for calls and puts.Product Building Blocks
    5. PractitionerOverview of Exotic Rate ProductsBermudan swaptions and callable swaps let the holder exercise a right to enter into or terminate a swap before maturity as well.Interest Rate Derivatives
    6. PractitionerOverview of Exotic FX ProductsA currency option with a knock-out has a lower premium, but the right disappears if the exchange rate touches the knock-out level.FX Derivatives
    7. PractitionerOverview of Exotic Equity ProductsIn knock-in structured notes such as exchangeable bonds (EB), the investor sells a put and the institution that issues the note (the dealer) buys it.Equity Derivatives

  5. Stage 5Advanced products and risksAdvanced

    Collateral discounting and an overview of XVA, then products that are hard to hedge: Bermudans, TARFs, autocallables and volatility trading.

    1. PractitionerCollateral and DiscountingThe collateral currency, the interest rate on collateral, the transfer frequency, and the threshold are set in the credit support annex (CSA), and the discount rate changes with these terms.Valuation
    2. PractitionerOverview of XVACVA, FVA, MVA, and KVA lower the value, and DVA raises it.Valuation
    3. AdvancedBermudan SwaptionsFor each exercise date, the swap that starts has the same end date, and the later the start, the shorter the swap.Interest Rate Derivatives
    4. AdvancedTarget Redemption Forward (TARF)Each payment depends on the gap between the spot rate on the observation date and the strike, and on the unfavorable side the gap is multiplied by a constant that is often 1 or 2.FX Derivatives
    5. AdvancedAutocallablesAt or above the early redemption level on an observation date, the note is redeemed at face value plus the coupon, and a rise in the share price earns nothing more.Equity Derivatives
    6. AdvancedHedging Exotic ProductsNear maturity, a digital seller holds far more underlying than the maximum payment, and hedging losses or costs can exceed the maximum liability (pin risk).Trading and Hedging
    7. AdvancedVolatility TradingA delta-hedged long straddle profits when the gamma gain exceeds the theta cost, and a short position is the reverse.Trading and Hedging

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