Block E · Derivatives
‹ NadirAlpha financial markets handbook: overview
Independent NadirAlpha working reference. Product and feature names mentioned are trademarks of their respective owners. No investment advice.
Derivatives derive their value from an underlying; they shift risks between market participants; the same instrument can hedge or speculate, what matters is the offsetting position in the portfolio.
59 · Futures
Exchange-traded, standardized forward transactions with daily margin settlement via a central counterparty.
Fast, cheap steering of allocations (equity beta, duration) without moving cash holdings; hedging.
High liquidity; hardly any counterparty risk (clearing); low costs.
Leverage; margin calls; roll costs.
Underestimating the contract value; one future moves a multiple of the posted margin.
146 · Duration management & bond laddering · 163 · Hedging with derivatives
60 · Forwards
Individually agreed, over-the-counter (OTC) forward transactions without standardization.
Tailor-made hedging (amount, date); the standard in FX hedging.
Exact fit.
Counterparty risk; no daily valuation transparency; commitment until maturity.
Reading the forward rate as a market forecast; it follows from the interest rate differential, not from an expectation.
61 · Options (call/put, basics)
The right (not the obligation) to buy (call) or sell (put) an underlying at the strike; price = intrinsic value + time value.
Hedging with limited cost (put), yield enhancement (option writing), asymmetric positions.
Defined maximum loss as a buyer; flexibility.
Time decay; volatility as a risk source of its own; as a writer, theoretically unlimited risk.
Thinking about options only through price direction; volatility and remaining maturity co-determine the price.
200 · Option pricing theory basics · 110 · Volatility (historical/implied)
62 · Option strategies (covered call, protective put, collar)
Combinations of underlying and options: covered call (holding + call sold), protective put (holding + put bought), collar (both).
Extra income on holdings, hedging, cost-reduced partial protection.
Plannable profiles; premium income.
A covered call caps the upside; put costs erode return; a collar freezes both sides.
Perceiving covered calls in strongly rising markets as "loss-free"; the opportunity costs are real.
110 · Volatility (historical/implied) · 147 · Hedging strategies (overview)
63 · Warrants
Securitized options of a bank (issuer product), mostly for retail investors; like certificates, they are notes.
Small-scale options access without a futures account.
Small denominations.
Issuer risk; spreads and implied vol set by the issuer; cost opacity.
Not benchmarking warrant prices against the exchange-traded option.
64 · Interest rate swaps (IRS)
Exchange of fixed for floating interest payments on a notional amount; the core instrument of the rates market.
Steering the fixed/floating mix, duration overlay, valuation reference (swap curve).
Deep liquidity; no capital movement.
Present value fluctuation; clearing/margin obligations (EMIR); basis risks.
Calling a swap "free"; the fixed rate contains the market's rate expectation plus a margin.
146 · Duration management & bond laddering · 90 · Policy rates & rate decisions
65 · Currency swaps (cross currency)
Exchange of principal and interest payments in two currencies; contains the cross-currency basis as a price factor of its own.
Hedging long-term funding/investment in foreign currency.
Complete FX and rate hedging.
Basis fluctuations; counterparty/collateral effort.
Estimating hedging costs from the rate differential only and forgetting the basis.
66 · Credit default swaps (CDS)
Insurance against the default of a debtor; a premium (spread) against a compensation payment in a credit event.
Hedging credit risk or taking it deliberately; a market barometer for credit quality (CDS spread).
Credit risk tradable separately.
Definition of the credit event; basis to the bond; counterparty risk.
Equating CDS spread and bond spread; the basis between them can be large and persistent.
153 · Credit risk parameters (PD, LGD, EAD) · 118 · S&P Global Ratings (AAA-D scale)
67 · Total return swaps
Exchange of an asset's total return (price + income) against a reference rate.
Synthetic exposure without ownership (e.g. in funds/certificates); financing; short sale substitute.
Access and efficiency.
Counterparty and collateral risk; opacity (Archegos 2021 as the object lesson).
Overlooking synthetic replication in products; check the KID/prospectus.
68 · Swaptions
An option to enter into an interest rate swap (payer/receiver).
Conditional rate protection (e.g. hedging against a rate rise only if needed); steering convexity.
Flexibility for a premium.
Premium decay; complexity of the vol surface.
Judging swaption premiums without looking at implied rate volatility.
69 · Caps/floors
An interest rate ceiling (cap) or floor on a reference rate for a premium; a series of interest rate options (caplets).
Capping floating rate funding; securing a minimum interest rate.
Protection while keeping the upside.
Premium costs; effect only beyond the strike.
Not converting cap costs into the effective interest rate of the funding.
70 · Structured products (construction)
A combination of an interest instrument + derivatives into a payoff profile (see certificates, topic 57); here the construction logic: zero bond + options.
Profiles made to measure (protection level, participation, coupon).
Almost any profile can be constructed.
Price of the components opaque; liquidity; issuer risk.
Buying products whose profile one cannot sketch from components oneself.
57 · Certificates (structure, issuer risk)
71 · Leverage products (knock-outs, factor)
Products with constant leverage (factor) or a barrier (knock-out: worthless when touched).
Short-term speculation/tactical trading; not an investment instrument.
High leverage on gains; little capital.
Total loss via knock-out; path dependence in factor products (sideways losses); issuer risk.
Holding factor certificates longer; the daily leveraging destroys return in sideways markets.