CISI Diploma: Financial Derivatives - Session 2 Outline

Accredited CISI Training

Session 2 of the CISI Financial Derivatives training course builds on the learning points from Session 1 and focusses on the pricing and valuation of the various derivative instruments. This session is 4 days in length.

Day 1: Principles of Valuing FRA's, Swaps: The cash flow approach to valuation

Principles of Valuing Forwards & Swaps

  • Nature of cash flow analysis
  • Representing an FRA in notional cash flows
  • Marking-to-market an FRA
  • De-compounding the swap into a bond and a FRN
  • Equating the value of the fixed and floating legs

Deriving the Discount Curve

  • Where do the discount factors come from?
  • Recent market developments in the choice of instruments
    • Role of the Credit Support Annex (CSA) and other credit mitigation developments
  • Calculating the zero-coupon discount function
    • Deriving discount factors from money market instruments
    • Deriving discount factors from market swap rates: bootstrapping explained
  • Problems in deriving the discount function
    • Instrument choice
    • Interpolation methodologies

Marking-to-Market Interest Rate & Currency Swaps

  • Identifying the cash flows
  • Representing the floating cash flows as notional cash flows
  • Extending the principle: pricing a deferred start swap
  • Marking-to-market a currency swap
  • Pricing an asset swap

Pricing Equity Swaps

  • Determining the fair price of an equity swap
  • What if market hedge instruments are mis-priced?

Day 2: Principles of valuing Forwards and Futures - The arbitrage-free approach to valuation

General Principles of Valuing Futures

  • Valuation principles for futures contracts
    • Cost of carry and carry return
  • Forward/forwards versus futures
  • Arbitrage bounds on futures
  • Applying the principle to equity forwards and futures
  • Can arbitrage happen in practice?

Pricing Short-Term Interest Rate Contracts

  • Understanding the role of the cash rates on the forward rate
  • Deriving the forward/forward bid and offer rates
  • Calculating the arbitrage-free futures price channel

Forward FX

  • Applying cost of carry/carry return to determining the forward FX rate
  • Quoting forward FX rates: the concept of forward points
  • Marking-to-market forward FX:
    • Using the cash flow approach
    • Using the hedge approach
  • FX swaps explained

Pricing Bond Futures Contracts & the Bond Futures Basis

  • Calculating the arbitrage free bond futures price
  • Implied repo rate versus the actual repo rate
  • Understanding the "basis"
  • Determining the CTD and the factors that cause it to change
  • What is the "net basis"?
  • Calculating the Swapnote© futures EDSP
  • Factors affecting the Swapnote© price
    • Determining the "fair" value prior to expiry

Day 3: Principles of Pricing Options 1

Theoretical Option Pricing: Numerical Models Approach

  • The importance of correct valuation
  • The model inputs
  • Approaches to valuation explained:
    • Self-financing, replication approach
    • Probabilistic approach and "risk-neutral" valuation
  • The Binomial model explained
    • The first building block: A one-step model for valuing European style options
    • Adding realism: A multi-step model
    • Demonstrating the equivalence between the hedge and probabilistic approaches
    • Deriving the model parameters:
      • Cox, Ross, Rubinstein (CRR) model v the equal probability [Jarrow, Rudd (JR)] model
      • Alternative models: the Leisen-Reimer model
    • Applying the approach to valuing American style put and call options
    • What happens when there is a term structure of interest rates
    • Introducing dividends
    • Interest rate option valuation

Theoretical Option Pricing: Continuous Time Approach

  • The Black Scholes option pricing model for European style call options explained
    • Understanding the terms: N(d1) and N(d2)
    • The model written in hedge form and probabilistic form
    • Using the model: deriving an option price
    • Extensions to the standard Black-Scholes model:
      • The put option formula and put-call parity
      • Writing the formula in forward form
      • Incorporating a continuous time dividend yield

Special Cases: Valuing Currency & Interest Rate Options

  • Adapting Black-Scholes to valuing currency options: the Garman – Kohlhagen model
    • Understanding the model inputs
    • Identifying the domestic and foreign interest rate
    • Interpreting the output
  • Adapting the CRR binomial model to price currency options
  • The problem with pricing options on interest rates
  • Pricing interest rate options using Black 76
    • Bond options
    • Swaptions, caps & floors
  • Using term structure models
    • The Black-Derman-Toy (BDT) model v Hull and White model

Day 4: Principles of Pricing Options 2

Models, the Real World & Volatility

  • Identifying the theoretical model assumptions
  • Implications for option prices
  • Measuring volatility
    • Implied v historic
    • Understanding the volatility smile
    • Understanding the term structure of volatility

Understanding the Risk Sensitivities

  • Defining "delta"
    • Using delta
    • Understanding the influence of time and volatility changes on delta
  • Curvature risk: understanding gamma
    • How time and volatility affect gamma
  • Understanding Vega
  • The impact of time on option prices

A Prima on Exotic Options

  • Categorising exotic options
  • Special profile options
    • Pricing digitals (binary; all-or-nothing) options using a Black-Scholes approach
    • Understanding the digital's Greeks
    • Digitals as call or put spreads
    • Risk management of digitals
  • Path dependent options
    • Barrier options explained
    • Understanding the delta and gamma of a down-and-out call and up-and-in call
    • Asian style options
  • Correlation based instruments
    • Basket options
      • Determining the volatility input
      • Calculating the correlation sensitivity
    • Exchange one asset for another
      • Determining the volatility input
      • Adapting the Black-Scholes formula
      • Relationship to "Best Of" option

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