Estimated reading time: 11 minutes

## Introduction

We now turn our attention to part 3 of the learning outcomes, as prescribed by GARP.

## Financial Markets and Products

This area tests your knowledge of financial products and the markets in which they trade, more specifically, the following knowledge areas:

Structures and functions of financial institutions

Structure and mechanics of over-the-counter (OTC) and exchange markets

Structure, mechanics and valuation of forwards, futures, swaps, and options

Hedging with derivatives

Interest rates and measures of interest rate sensitivity

Foreign exchange risk

Corporate bonds

Mortgage-backed securities

## Banks

Identify the major risks faced by banks and explain ways in which these risks can arise.

Distinguish between economic capital and regulatory capital.

Summarize the Basel Committee regulations for regulatory capital and their motivations.

Explain how deposit insurance gives rise to a moral hazard problem.

Describe investment banking financing arrangements including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches.

Describe the distinctions between the banking book and the trading book of a bank.

Explain the originate-to-distribute banking model and discuss its benefits and drawbacks.

## Insurance Companies and Pension Plans

Describe the key features of the various categories of insurance companies and identify the risks facing insurance companies.

Describe the use of mortality tables and calculate the premium payment for a policy holder.

Distinguish between mortality risk and longevity risk and describe how to hedge these risks.

Describe defined benefit plans and defined contribution plans and explain the differences between them.

Compare the various types of life insurance policies.

Calculate and interpret loss ratio, expense ratio, combined ratio, and operating ratio for a property-casualty insurance company.

Describe moral hazard and adverse selection risks facing insurance companies, provide examples of each, and describe how to overcome these problems.

Evaluate the capital requirements for life insurance and property-casualty insurance companies.

Compare the guaranty system and the regulatory requirements for insurance companies with those for banks.

## Fund Management

Differentiate among open-end mutual funds, closed-end mutual funds, and exchange-traded funds (ETFs).

Identify and describe potential undesirable trading behaviors at mutual funds.

Calculate the net asset value (NAV) of an open-end mutual fund.

Explain the key differences between hedge funds and mutual funds.

Calculate the return on a hedge fund investment and explain the incentive fee structure of a hedge fund, including the terms hurdle rate, high-water mark, and clawback.

Describe various hedge fund strategies.

Describe characteristics of mutual fund and hedge fund performance and explain the effect of measurement biases on performance measurement.

## Introduction to Derivatives

Define derivatives, describe the features and uses of derivatives, and compare linear and non-linear derivatives.

Describe exchange-traded and over-the-counter markets, and evaluate the advantages and disadvantages of each.

Differentiate between options, forwards, and futures contracts.

Identify and calculate option and forward contract payoffs.

Differentiate among the broad categories of traders: hedgers, speculators, and arbitrageurs.

Calculate and compare the payoffs from hedging strategies involving forward contracts and options.

Calculate and compare the payoffs from speculative strategies involving futures and options.

Calculate an arbitrage payoff and describe how arbitrage opportunities are temporary.

Describe some of the risks that can arise from the use of derivatives.

## Exchanges and OTC Markets

Describe how exchanges can be used to alleviate counterparty risk.

Explain the developments in clearing that reduce risk.

Describe netting and describe a netting process.

Describe the implementation of a margining process; explain the determinants of and calculate initial and variation margin requirements.

Compare exchange-traded and OTC markets and describe their uses.

Identify the classes of derivative securities and explain the risk associated with them.

Identify risks associated with OTC markets and explain how these risks can be mitigated.

Describe the role of collateralization in the OTC market and compare it to the margining system.

Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market.

## Central Clearing

Provide examples of the mechanics of a central counterparty (CCP).

Describe the role of CCPs and distinguish between bilateral and centralized clearing.

Describe advantages and disadvantages of central clearing of OTC derivatives.

Explain regulatory initiatives for the OTC derivatives market and their impact on central clearing.

Compare margin requirements in centrally cleared and bilateral markets and explain how margin can mitigate risk.

Compare and contrast bilateral markets to the use of novation and netting.

Assess the impact of central clearing on the broader financial markets.

Identify and explain the types of risks faced by CCPs.

Identify and distinguish between the risks to clearing members and to non-members.

## Futures Markets

Define and describe the key features and specifications of a futures contract.

Explain the convergence of futures and spot prices.

Describe the role of an exchange in futures transactions.

Explain the differences between a normal and inverted futures market.

Describe the mechanics of the delivery process and contrast it with cash settlement.

Evaluate the impact of different trading order types.

Describe the application of marking to market and hedge accounting for futures.

Compare and contrast forward and futures contracts.

## Using Futures for Hedging

Define and differentiate between short and long hedges and identify their appropriate uses.

Describe the arguments for and against hedging and the potential impact of hedging on firm profitability.

Define the basis and explain the various sources of basis risk and explain how basis risks arise when hedging with futures.

Define cross hedging and compute and interpret the minimum variance hedge ratio and hedge effectiveness.

Calculate the profit and loss on a short or long hedge.

Compute the optimal number of futures contracts needed to hedge an exposure and explain and calculate the “tailing the hedge” adjustment.

Explain how to use stock index futures contracts to change a stock portfolio’s beta.

Explain how to create a long-term hedge using a stack and roll strategy and describe some of the risks that arise from this strategy.

## Foreign Exchange Markets

Explain and describe the mechanics of spot quotes, forward quotes, and futures quotes in the foreign exchange markets; distinguish between bid and ask exchange rates.

Calculate a bid-ask spread and explain why the bid-ask spread for spot quotes may be different from the bid-ask spread for forward quotes.

Compare outright (forward) and swap transactions.

Define, compare, and contrast transaction risk, translation risk, and economic risk.

Describe examples of transaction, translation, and economic risks and explain how to hedge these risks.

Describe the rationale for multi-currency hedging using options.

Identify and explain the factors that determine exchange rates.

Calculate and explain the effect of an appreciation/depreciation of one currency relative to another.

Explain the purchasing power parity theorem and use this theorem to calculate the appreciation or depreciation of a foreign currency.

Describe the relationship between nominal and real interest rates.

Describe how a non-arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem.

Distinguish between covered and uncovered interest rate parity conditions.

## Pricing Financial Forwards and Futures

Differentiate between investment and consumption assets.

Define short-selling and calculate the net profit of a short sale of a dividend-paying stock.

Describe the differences between forward and futures contracts and explain the relationship between forward and spot prices.

Calculate the forward price given the underlying asset’s spot price and describe an arbitrage argument between spot and forward prices.

Distinguish between the forward price and the value of a forward contract.

Calculate the value of a forward contract on a financial asset that does or does not provide income or yield.

Explain the relationship between forward and futures prices.

Calculate a forward foreign exchange rate using the interest rate parity relationship.

Calculate the value of a stock index futures contract and explain the concept of index arbitrage.

## Commodity Forwards and Futures

Explain the key differences between commodities and financial assets.

Define and apply commodity concepts such as storage costs, carry markets, lease rate, and convenience yield.

Identify factors that impact prices on agricultural commodities, metals, energy, and weather derivatives.

Explain the basic equilibrium formula for pricing commodity forwards.

Describe an arbitrage transaction in commodity forwards and compute the potential arbitrage profit.

Define the lease rate and explain how it determines the no-arbitrage values for commodity forwards and futures.

Describe the cost of carry model and determine the impact of storage costs and convenience yields on commodity forward prices and no-arbitrage bounds.

Compute the forward price of a commodity with storage costs.

Compare the lease rate with the convenience yield.

Explain how to create a synthetic commodity position and use it to explain the relationship between the forward price and the expected future spot price.

Explain the relationship between current futures prices and expected future spot prices, including the impact of systematic and nonsystematic risk.

Define and interpret normal backwardation and contango.

## Options Markets

Describe the various types, uses, and typical underlying assets of options.

Explain the payoff function and calculate the profit and loss from an options position.

Explain the specification of exchange-traded stock option contracts, including that of nonstandard products.

Explain how dividends and stock splits can impact the terms of a stock option.

Describe the application of commissions, margin requirements, and exercise procedures to exchange-traded options and explain the trading characteristics of these options.

Define and describe warrants, convertible bonds, and employee stock options.

## Properties of Options

Identify the six factors that affect an option’s price.

Identify and compute upper and lower bounds for option prices on non-dividend and dividend paying stocks.

Explain put-call parity and apply it to the valuation of European and American stock options, with dividends and without dividends, and express it in terms of forward prices.

Explain and assess potential rationales for using the early exercise features of American call and put options.

## Trading Strategies

Explain the motivation to initiate a covered call or a protective put strategy.

Describe principal protected notes (PPNs) and explain necessary conditions to create a PPN.

Describe the use and calculate the payoffs of various spread strategies.

Describe the use and explain the payoff functions of combination strategies.

## Exotic Options

Define and contrast exotic derivatives and plain vanilla derivatives.

Describe some of the factors that drive the development of exotic derivative products.

Explain how any derivative can be converted into a zero-cost product.

Describe how standard American options can be transformed into nonstandard American options.

Identify and describe the characteristics and payoff structures of the following exotic options: gap, forward start, compound, chooser, barrier, binary, lookback, Asian, exchange, and basket options.

Describe and contrast volatility and variance swaps.

Explain the basic premise of static option replication and how it can be applied to hedging exotic options.

## Properties of Interest Rates

Describe Treasury rates, LIBOR, Secured Overnight Financing Rate (SOFR), and repo rates, and explain what is meant by the “risk-free” rate.

Calculate the value of an investment using different compounding frequencies.

Convert interest rates based on different compounding frequencies.

Calculate the theoretical price of a bond using spot rates.

Calculate the Macaulay duration, modified duration, and dollar duration of a bond.

Evaluate the limitations of duration and explain how convexity addresses some of them.

Calculate the change in a bond’s price given its duration, its convexity, and a change in interest rates.

Derive forward interest rates from a set of spot rates.

Derive the value of the cash flows from a forward rate agreement (FRA).

Calculate zero-coupon rates using the bootstrap method.

Compare and contrast the major theories of the term structure of interest rates.

## Corporate Bonds

Describe features of bond trading and explain the behavior of bond yield.

Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.

Define high-yield bonds and describe types of high-yield bond issuers and some of the payment features unique to high-yield bonds.

Differentiate between credit default risk and credit spread risk.

Describe event risk and explain what may cause it to manifest in corporate bonds.

Describe the different classifications of bonds characterized by issuer, maturity, interest rate, and collateral.

Describe the mechanisms by which corporate bonds can be retired before maturity.

Define recovery rate and default rate, and differentiate between an issue default rate and a dollar default rate.

Evaluate the expected return from a bond investment and identify the components of the bond’s expected return.

## Mortgages and Mortgage-Backed Securities

Describe the various types of residential mortgage products.

Calculate a fixed-rate mortgage payment and its principal and interest components.

Describe the mortgage prepayment option and the factors that influence prepayments.

Summarize the securitization process of mortgage-backed securities (MBS), particularly the formation of mortgage pools, including specific pools and to-be-announceds (TBAs).

Calculate the weighted average coupon, weighted average maturity, single monthly mortality rate (SMM), and conditional prepayment rate (CPR) for a mortgage pool.

Describe the process of trading pass-through agency MBS.

Explain the mechanics of different types of agency MBS products, including collateralized mortgage obligations (CMOs), interest-only securities (IOs), and principal-only securities (POs).

Describe a dollar roll transaction and how to value a dollar roll.

Explain prepayment modeling and its four components: refinancing, turnover, defaults, and curtailments.

Describe the steps in valuing an MBS using Monte Carlo simulation.

Define Option Adjusted Spread (OAS) and explain its challenges and its uses.

## Interest Rate Futures

Identify the most commonly used day count conventions, describe the markets that each one is typically used in, and apply each to an interest calculation.

Calculate the conversion of a discount rate to a price for a US Treasury bill.

Differentiate between the clean and dirty price for a US Treasury bond; calculate the accrued interest and dirty price on a US Treasury bond.

Explain and calculate a US Treasury bond futures contract conversion factor.

Calculate the cost of delivering a bond into a Treasury bond futures contract.

Describe the impact of the level and shape of the yield curve on the cheapest-to-deliver Treasury bond decision.

Calculate the theoretical futures price for a Treasury bond futures contract.

Calculate the final contract price on a Eurodollar futures contract and compare Eurodollar futures to FRAs.

Describe and compute the Eurodollar futures contract convexity adjustment.

Explain how Eurodollar futures can be used to extend the LIBOR zero curve.

Calculate the duration-based hedge ratio and create a duration-based hedging strategy using interest rate futures.

Explain the limitations of using a duration-based hedging strategy.

## Swaps

Explain the mechanics of a plain vanilla interest rate swap and compute its cash flows.

Explain how a plain vanilla interest rate swap can be used to transform an asset or a liability and calculate the resulting cash flows.

Explain the role of financial intermediaries in the swaps market.

Describe the role of the confirmation in a swap transaction.

Describe the comparative advantage argument for the existence of interest rate swaps and evaluate some of the criticisms of this argument.

Explain how the discount rates in a plain vanilla interest rate swap are computed.

Calculate the value of a plain vanilla interest rate swap based on two simultaneous bond positions.

Calculate the value of a plain vanilla interest rate swap from a sequence of FRAs.

Explain the mechanics of a currency swap and compute its cash flows.

Explain how a currency swap can be used to transform an asset or liability and calculate the resulting cash flows.

Calculate the value of a currency swap based on two simultaneous bond positions.

Calculate the value of a currency swap based on a sequence of forward exchange rates.

Identify and describe other types of swaps, including commodity, volatility, credit default, and exotic swaps.

Describe the credit risk exposure in a swap position.

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