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

After completing this reading, you should be able to:

• Distinguish between the two major types of banking.

• Identify the major risks faced by a bank and how to hedge against those risks.

• Distinguish between economic capital and regulatory capital.

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

• Differentiate between standardized and internal models of calculating capital.

• 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.

• Understand Initial Public Offering and how to estimate share prices.

• Describe the potential conflicts of interest among commercial banking, securities services, and investment banking divisions of a bank and recommend solutions to the conflict of interest problems.

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

• Explain the originate-to-distribute model of a bank and discuss its benefits and drawbacks.

After completing this reading, you should be able to:

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

• Understand what annuity contracts are

• Describe how life insurance companies invest their funds

• Describe the use of mortality tables and calculate the premium payment for a policyholder

• Describe property and casualty Insurance and the risks faced by property and casualty Insurance

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

• Describe the major expenses incurred by an Insurance Company.

• Understand Health Insurance

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

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

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

• Describe a defined benefit plan and a defined contribution plan for a pension fund and explain the differences between them

After completing this reading, you should be able to:

• Understand who a fund manager is and the benefits of using fund managers

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

• Describe the various categories of open end mutual funds

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

• Understand the various undesirable behaviors in trading

• 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.

• Understand who a prime broker is

• Describe various hedge fund strategies, including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures, and identify the risks faced by hedge funds.

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

• Explain the findings of the research carried out on returns of mutual and hedge funds.

After completing this reading, you should be able to:

• Describe what a derivative is.

• Differentiate between the two major types of derivatives.

• Understand the various uses of derivatives.

• Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its advantages and disadvantages.

• Differentiate between options, forwards, and futures contracts.

• Identify and calculate option and forward contract payoffs.

• 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.

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

After completing this reading, you should be able to:

• 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 and explain the determinants of 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 over-the-counter market and compare it to the margining system.

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

After completing this reading, you should be able to:

• 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.

• 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 the term “rolling the hedge forward” and describe some of the risks that arise from this strategy.

After completing this reading, you should be able to:

• Define and describe the key features of a futures contract, including the underlying asset, the contract
  price and size, trading volume, open interest, delivery and limits.

• Explain the convergence of futures and spot prices.

• Describe the role of an exchange in futures and over-the-counter market transactions.

• Identify the differences between a normal and inverted futures market.

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

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

• Understand how and why the future markets are being regulated.

• Compare and contrast forward and futures contracts.

After completing this reading, you should be able to:

• 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.

• 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 long term hedges using the stack and roll strategies.

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:

• Differentiate between investment and consumption assets.

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

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

• Understand why the value and prices of forward contracts vary with those of futures contracts

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

After completing this reading, you should be able to:

• 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 illustrate 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 the modern theory

• 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.