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Derivatives Compass

Introductory

Newcomer Foundations

Who this is for
For people who have just joined a derivatives business, in any role, and want the overall picture first.
How to read it
Read from the top. Every page is introductory, and each stage builds on the one before. If you have already handled some products, skip the stages you know.

  1. Stage 1What a derivative isIntroductory

    What is being traded, who uses it and why, and how exchange and OTC trading differ.

    1. IntroductoryWhat Is a Derivative?Profit or loss depends on which way the price of the underlying moves after the terms are fixed, and in a forward the buyer's gain is exactly the seller's loss.Product Building Blocks
    2. IntroductoryHedging, Speculation and ArbitrageFor the same price move, the gains and losses on stocks and futures offset each other under a hedge, while speculation produces a profit or a loss depending on whether the view proves right.Market Participants and Uses
    3. IntroductoryExchange-Traded vs OTC DerivativesFor exchange-traded derivatives, the exchange sets terms such as the size of one unit; one unit of Nikkei 225 Futures is the Nikkei 225 value multiplied by 1,000 yen.Listed and OTC Trading
    4. IntroductoryCleared vs Bilateral TradesIn a bilateral trade, you may not receive money you are owed if the other party defaults, and you bear credit risk to each of your counterparties.Listed and OTC Trading
    5. IntroductoryDealers and BrokersIn OTC interest rate swaps, dealers become their customers' counterparties, and trades between dealers are sometimes arranged by brokers.Market Participants and Uses

  2. Stage 2The three basic formsIntroductory

    How forwards and futures, swaps and options work and what their payoffs look like. Every other product is a combination of these three.

    1. IntroductoryForwards and FuturesAt maturity, the buyer's profit or loss is "price at maturity − forward price" and the seller's is the reverse. The seller's loss has no upper limit.Product Building Blocks
    2. IntroductoryHow Swaps WorkEvery swap contract sets a notional amount, a term, payment dates, and how payments are calculated.Product Building Blocks
    3. IntroductoryOption Basics: Calls and PutsThe terms of an option are set by five items: the underlying asset, call or put, the strike price, the expiry, and the premium.Product Building Blocks
    4. IntroductoryOption Payoffs and Profit/LossBuy a call option (call) with a strike price of 100 yen for a premium of 5 yen, and the profit or loss is a constant −5 yen at or below 100 yen at expiry.Product Building Blocks
    5. IntroductoryExercise Styles: European, American and BermudanThe style sets only when the option can be exercised, and it is decided separately from the type of option and the strike price.Product Building Blocks

  3. Stage 3Interest and time valueIntroductory

    How future cash is converted to today's value, how days and business days are counted, and what benchmark rates do. This is the basis of valuation.

    1. IntroductoryCompounding and DiscountingIf you deposit 100 yen for three years at 2%, you end up with 106 yen under simple interest, which pays interest only on the principal, and 106.12 yen with annual compounding.Core Concepts
    2. IntroductoryPresent Value and Discount FactorsAt an interest rate of 2%, the present value of 102 yen received in one year is 100 yen.Core Concepts
    3. IntroductoryDay Count ConventionsInterest is the principal times the rate times "days in the period ÷ days in a year," and the days in the period include the start date but not the end date.Core Concepts
    4. IntroductoryBusiness Day Conventions and Holiday CalendarsIn Japan, banks are closed on Sundays, Saturdays, holidays under the Act on National Holidays, and from December 31 to January 3.Core Concepts
    5. IntroductoryWhat Is a Benchmark Rate?Many financial transactions use benchmark rates as reference rates, and the amount of floating-rate interest depends on the value of the benchmark rate referenced.Benchmark Rates
    6. IntroductoryTONATONA is a rate for borrowing and lending for a single day, and it has been selected as the yen RFR (risk-free rate).Benchmark Rates

  4. Stage 4The main productsIntroductory

    One representative product each for rates, FX, equity and credit, to see how the basic forms are used in practice.

    1. IntroductoryInterest Rate SwapsThe floating rate is set for each interest period from a benchmark rate such as TONA or TIBOR.Interest Rate Derivatives
    2. IntroductoryOvernight Index Swaps (OIS)The notional amount itself is not exchanged, and only the difference between the two interest amounts changes hands at the end of the period.Interest Rate Derivatives
    3. IntroductoryFX ForwardsIf an importer that must pay 1 million US dollars in 6 months agrees to buy them at 148.00 yen per dollar, its payment is fixed at 148 million yen.FX Derivatives
    4. IntroductoryFX OptionsThe right to buy US dollars by paying yen is a USD call from the dollar side and a JPY put from the yen side, and both names describe the same right.FX Derivatives
    5. IntroductoryEquity Index FuturesBecause an index itself cannot be delivered, a trade held to expiry is settled by paying or receiving only the difference between the traded price and the special quotation (SQ value).Equity Derivatives
    6. IntroductoryCredit Default Swaps (CDS)In a 10 billion yen example, the buyer pays 12.5 million yen every 3 months and gets 7 billion yen if a credit event sets the debt's price at 30% of face value.Credit Derivatives

  5. Stage 5What supports a tradeIntroductory

    Who does what from execution to settlement, how client business flows, the contracts, the clearing houses and the shape of Japanese regulation.

    1. IntroductoryFront, Middle and Back Office RolesUnits are separated because, if the people who trade also keep the records and make the payments, no one else can notice hidden losses or misappropriated assets.Internal Operations
    2. IntroductoryThe Client Business FlowA bank puts in place arrangements for explaining the key points of a trade in light of the client's knowledge, experience, financial situation, and purpose of the trade.Client-Facing Business
    3. IntroductoryThe ISDA Master Agreement and ScheduleSigning a master agreement helps make clear that the later trades are conducted on the same terms.Documentation and Law
    4. IntroductoryOverview of Market InfrastructureFinancial market infrastructure clears, settles, and records transactions in one place. This makes participants' risk management more efficient, but it also concentrates risk.Market Infrastructure
    5. IntroductoryCentral Counterparties: JSCC, LCH, CME and OthersWhen a CCP becomes the counterparty to trades, the effects of a counterparty default are concentrated in the CCP, so it covers its credit risk to participants with pre-funded resources.Market Infrastructure
    6. IntroductoryJapan's Derivatives Regulation at a GlanceThe Financial Instruments and Exchange Act divides derivatives transactions into three types (market, over-the-counter, and foreign market), and the Commodity Derivatives Transaction Act governs transactions in commodities.Regulation: Japan

  6. Stage 6Lessons from past failuresIntroductory

    Crises, rogue trading and mis-selling cases explain why today's rules and controls exist.

    1. IntroductoryThe Collapse of Lehman Brothers (2008)Lehman Brothers Holdings Inc. filed for Chapter 11 of the U.S. Bankruptcy Code.History
    2. IntroductoryThe LIBOR Manipulation ScandalLIBOR was a benchmark rate compiled from rates that panel banks submitted every day, and the submissions rested on each bank's judgment.History
    3. IntroductoryRogue Trading Cases: Barings, Societe Generale and OthersAt Barings, losses hidden at its Singapore subsidiary reached GBP 827 million, and the bank collapsed.Operational Risk
    4. IntroductoryMis-Selling CasesThe three cases differ in product, issue, and outcome.Client Protection and Conduct

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