Core Instruments

A. Forwards

Definition: A forward is an OTC contract between two parties to buy or sell an underlying asset at a pre-agreed price (the forward price) on a future date. It is fully customizable but carries counterparty credit risk as it is not centrally cleared or marked-to-market daily.

Example: A 6-month forward on oil with a spot price of $80 and a risk-free rate of 5% would have a forward price of approximately $82.02. If the spot price at expiry is $90, the long position gains $7.98 per barrel. If the spot is $75, the long position loses $7.02 per barrel.

B. Futures

Definition: A futures contract is a standardized forward contract traded on an exchange and cleared through a central counterparty (CCP). This eliminates counterparty risk.

Key Characteristics: Standardized terms (size, expiry), exchange-traded, no counterparty risk, and requires daily margining (Initial and Variation Margin). Profits and losses are realized daily through the mark-to-market process.

Example: You buy 1 S&P 500 futures contract at 4,500 index points (with a multiplier of $250). If the index rises to 4,520 the next day, your gain is 20 points × $250/point = $5,000, which is credited to your margin account.

Special Topics

• Basis: The difference between the spot price and the futures price (Basis = Spot - Futures). The basis converges to zero as the contract approaches expiry.
• Convenience Yield: The non-monetary benefit of physically holding a commodity, which can cause futures prices to be lower than the spot price (backwardation).
• Cheapest-to-Deliver (CTD): In bond futures, the short party can choose from a basket of eligible bonds to deliver. They will choose the one that is cheapest for them to deliver.

A. Vanilla Options

Definition: A contract giving the holder the right, but not the obligation, to buy (a call option) or sell (a put option) an underlying asset at a specified strike price on or before a certain expiry date.

Example (European Call): You buy a 3-month call option on a stock with a strike price of $105 for a premium of $3. If the stock price at expiry is $120, your payoff is $120 - $105 = $15, for a net profit of $12 ($15 payoff - $3 premium). If the stock is below $105, the option expires worthless, and your loss is the $3 premium.

B. Option Styles (Exotics)

C. The Greeks (Sensitivities)

A. Interest Rate Swaps (IRS)

An agreement to exchange fixed-rate interest payments for floating-rate payments on a notional principal amount.

Example: On a $100m notional, Party A pays a fixed 3% and receives a floating rate (e.g., 3-month SOFR). Each quarter, only the net difference between the fixed and floating payments is exchanged.

B. FX Swaps / Forwards

An FX Forward locks in an exchange rate for a future date. An FX Swap involves a simultaneous spot and forward transaction, effectively swapping currencies now and agreeing to reverse the transaction later.

C. Total Return Swaps (TRS)

One party receives the total return (price appreciation + dividends) of a reference asset, while the other party receives a floating interest rate plus a spread. This is used to gain synthetic long exposure, often with leverage.

D. Inflation Swaps

An agreement to exchange a fixed-rate payment for a payment linked to a realized inflation rate (e.g., CPI).

A. Swaption

An option to enter into an interest rate swap in the future. A Payer Swaption is the right to pay a fixed rate (valuable if rates rise), and a Receiver Swaption is the right to receive a fixed rate (valuable if rates fall).

B. Caps & Floors

A Cap is a series of call options on an interest rate (caplets) that protects a borrower from rates rising above a certain level. A Floor is a series of put options (floorlets) that guarantees a minimum income for a lender.

A. Credit Default Swap (CDS)

An insurance-like contract against the credit default of a reference entity. The protection buyer pays a periodic premium (the spread), and the protection seller agrees to compensate the buyer if a credit event (like a default) occurs.

Example: On a $10m notional with a 1.5% spread, the buyer pays $150,000 per year. If the referenced entity defaults, the seller pays the loss given default to the buyer.

B. CDS Indices

These are baskets of single-name CDSs that allow investors to trade the overall credit risk of a market segment efficiently. Examples include iTraxx (Europe) and CDX (US).

A. Exotic Options

Options with more complex features than standard vanilla options, such as Barrier, Asian, and Lookback options.

B. Structured Notes

Debt instruments with embedded derivatives that create customized payoff profiles. Examples include:

• Principal-Protected Note: A zero-coupon bond combined with a call option to provide downside protection with upside participation.
• Reverse Convertible: A note with a high coupon that exposes the investor to downside risk in an underlying stock (effectively selling a put option).

C. Variance & Volatility Products

Instruments used to trade volatility itself. A Variance Swap has a payoff based on the difference between realized variance and a strike variance. VIX Futures/Options allow investors to trade the implied volatility of the S&P 500.