P1 Focus Review 5th of 8: Products
I think the assignment (Hull) divides into three: comparative advantage; swap mechanics; and swap valuation. We have several practice questions on comparative advantage (it reduces to the observation that the total net gain equals the difference between fixed and floating rate differentials), but historically this tricky idea has barely been tested to my knowledge. You clearly need to be comfortable with swap mechanics so you can answer a very basic, non-quantitative question like one I included in the FR:
Some key (exam) points to keep in mind with respect to swap mechanics:
Options
In collecting the three-year sample of exam-type questions, I was surprised at the high prevalence of put-call parity in the FRM. Historically, put-call parity questions are very common. (please note this is a T3 summary and does not include discussion of option pricing models, OPM, which are T4 topics). It is essential that you memorize, and are utterly comfortable with, the put-call parity formula; for example, can you, without any reference, quickly produce the formula's equivalent of a covered call or protective put?
After you have mastered the usage of the put-call parity, c + K*exp(-rT) = p + S, you might take a look at my method for dealing with an arbitrage exploitation question, see http://forum.bionicturtle.com/threads/how-to-work-put-call-parity-arbitrage-problems.6167/
Finally, I would be familiar with Hull's rules about the optimality of early exercise under the four permutations of call/put and European/American.
Option Trading Strategies
In my opinion, the section (a single Hull chapter) requires some of your time, if you want to be fully ready. So far, it's always been included in the exam. And, as i mentioned in the FR audio, to illustrate how we lack a shortcut here, last year GARP asked a question about box spreads, which totally surprised me as it's a really minor strategy. With respect to mechanics, Hull parses them into:
- The 5th (of 8) Part 1 Focus Review video (Products) is here at http://www.bionicturtle.com/how-to/video/2012.p1.-focus-review-5/
- Swaps
- Options
- Option Trading Strategies
I think the assignment (Hull) divides into three: comparative advantage; swap mechanics; and swap valuation. We have several practice questions on comparative advantage (it reduces to the observation that the total net gain equals the difference between fixed and floating rate differentials), but historically this tricky idea has barely been tested to my knowledge. You clearly need to be comfortable with swap mechanics so you can answer a very basic, non-quantitative question like one I included in the FR:
Some key (exam) points to keep in mind with respect to swap mechanics:
- The vanilla interest rate swap (IRS) references notional; i.e., the notional is not exchanged (But the principal is exchanged in a currency swap, hence the maximum potential future [credit] exposure of a currency swap occurs at maturity)
- By default, the floating rate is determined at the beginning of each period and paid at the end; e.g., the first fixed-rate settlement is known at swap inception
- The duration of a swap position can be inferred from its valuation treatment as consisting of two bond legs: just as value[swap, POV of fixed-rate receiver, floating-rate payer] = value[fixed-rate bond] - value[floating-rate bond], the duration of the IRS from the perspective of the fixed-rate receiver (who is effectively long the fixed-rate bond-equivalent and short the floater) is approximately equal to the duration of the fixed-rate bond-equivalent. For example, the (modified) duration of a swap with a 3-year tenor, from the perspective of a 4.0% fixed rate payer is about 2.8 years at settlement because the duration equals 2.8 years (i.e., fixed rate bond) minus about zero (duration of floating-rate bond is time-to-next-coupon).
Options
In collecting the three-year sample of exam-type questions, I was surprised at the high prevalence of put-call parity in the FRM. Historically, put-call parity questions are very common. (please note this is a T3 summary and does not include discussion of option pricing models, OPM, which are T4 topics). It is essential that you memorize, and are utterly comfortable with, the put-call parity formula; for example, can you, without any reference, quickly produce the formula's equivalent of a covered call or protective put?
After you have mastered the usage of the put-call parity, c + K*exp(-rT) = p + S, you might take a look at my method for dealing with an arbitrage exploitation question, see http://forum.bionicturtle.com/threads/how-to-work-put-call-parity-arbitrage-problems.6167/
Finally, I would be familiar with Hull's rules about the optimality of early exercise under the four permutations of call/put and European/American.
Option Trading Strategies
In my opinion, the section (a single Hull chapter) requires some of your time, if you want to be fully ready. So far, it's always been included in the exam. And, as i mentioned in the FR audio, to illustrate how we lack a shortcut here, last year GARP asked a question about box spreads, which totally surprised me as it's a really minor strategy. With respect to mechanics, Hull parses them into:
- Asset + option; e.g., protective put, covered call
- Spread strategies
- Combinations
- Which of the strategies are long volatility?
- Which of the strategies are directional; ie., benefit from an increase/decrease in asset price?
- Which have capped or uncapped payouts?
- Which produce an initial cash inflow?
