FRM Part 1 - Book 3 - Financial Markets and Products (2/2)

After completing this reading, you should be able to:

• Describe the types, positions variations, and typical underlying assets of options.

• Explain the specification of exchange-traded stock option contracts, including that of non-standard products.

• Describe how trading, commissions, margin requirements, and exercise typically work for exchange-traded options.

After completing this reading, you should be able to:

• Identify the six factors that affect an option’s price and describe how these six factors affect the price for both European and American options.

• 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.

• Explain the early exercise features of American call and put options.

After completing this reading, you should be able to:

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

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

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

After completing this reading, you should be able to:

• Define and contrast exotic derivatives and plain vanilla derivatives.

• Describe some of the factors that drive the development of exotic 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 structure of the following exotic options: gap, forward start, compound, chooser, barrier, binary, lookback, shout, and Asian, exchange, rainbow, 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.

After completing this reading, you should be able to:

• Describe what interest rates are and the factors that determine interest rate

• Describe the various categories of interest rates (Treasury rates, LIBOR, Secured Overnight Financing Rate (SOFR) and repo rates, Swaps, 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 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.

After completing this reading, you should be able to:

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

• Explain a bond’s maturity date and how it impacts bond retirements.

• Describe the main types of interest payment classifications.

• Describe zero-coupon bonds and explain the relationship between original-issue discount and reinvestment risk.

• Distinguish among the following security types relevant for corporate bonds: mortgage bonds, collateral trust bonds, equipment trust certificates, subordinated and convertible debenture bonds, and guaranteed bonds.

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

• Differentiate between credit default risk and credit spread risk.

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

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

• Define and differentiate between an issuer default rate and a dollar default rate.

• Define recovery rates and describe the relationship between recovery rates and seniority.

After completing this reading, you should be able to:

• 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 TBAs.

• Calculate weighted average coupon, weighted average maturity, and conditional prepayment rate (CPR) for a mortgage pool.

• 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.

After completing this reading, you should be able to:

• 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.

• 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.

After completing this reading, you should be able to:

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

• Describe advantages and disadvantages of central clearing of OTC derivatives.

• 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.