Comprehensive guide to Element 3 covering options mechanics, futures vs forwards, swaps, listed vs OTC derivatives, physical vs cash settlement, and exotic options for the Derivatives Exam.
Derivatives Element 3: Types and Features (~18%)
This is the technical core of the exam, focusing on mechanics, terminology, and structural differences of various derivative instruments traded in Canada.
Listed vs. OTC Derivatives
Understanding where and how a contract trades is fundamental to assessing risk:
Listed (Exchange-Traded)
Standardized contracts traded on an exchange (like the Montreal Exchange) and cleared by a central counterparty (CDCC). Features include:
- High liquidity
- Price transparency
- Virtually zero counterparty credit risk
OTC (Over-the-Counter)
Customized, bilateral agreements between two parties. They allow for precise tailoring of terms (dates, amounts, underlyings) but carry:
- Significant counterparty risk
- Lower liquidity
Options Mechanics
Options provide the right, but not the obligation, to perform an action:
Call Options
The right to BUY the underlying asset at a specific strike price.
Put Options
The right to SELL the underlying asset at a specific strike price.
Exercise Styles
- American Style: Can be exercised at any time up to and including expiration (standard for most equity options)
- European Style: Can only be exercised on the expiration date (standard for most index options)
Moneyness
- In-the-Money (ITM): Option has intrinsic value (e.g., Call with strike $50 when stock is at $55)
- At-the-Money (ATM): Strike price equals current market price
- Out-of-the-Money (OTM): No intrinsic value, only time value
Futures and Forwards
These instruments represent an obligation for both parties to transact at a future date:
Forwards
Private, non-standardized OTC agreements. Settlement usually occurs only at the end of the contract.
Futures
Standardized, exchange-traded versions of forwards. They are marked-to-market daily, meaning profits and losses are settled in cash every day through the clearinghouse.
Position Types
- Long Position: Party obligated to BUY the asset (benefits from price increases)
- Short Position: Party obligated to SELL the asset (benefits from price decreases)
Swaps
Private agreements to exchange series of cash flows over time:
Interest Rate Swaps
Usually involve exchanging a fixed interest rate for a floating rate (like CDOR or CORRA) to manage debt costs.
Equity Swaps
Exchanging the total return of an equity index for a fixed or floating interest rate.
Currency Swaps
Exchanging principal and interest payments in one currency for those in another.
Other Derivative Types
Rights and Warrants
Instruments issued by corporations giving shareholders the right to buy additional shares at a fixed price.
Contracts for Difference (CFDs)
Popular in OTC retail markets, these allow speculation on price movements without owning the physical asset.
Exotic Options
- Barrier Options: "Knock-in" or "Knock-out" based on price hitting certain level
- Asian Options: Payoff based on average price over period rather than single point
- Binary Options: All-or-nothing payouts based on yes/no event
Physical vs. Cash Settlement
- Physical Settlement: Actual underlying asset is delivered (e.g., 100 shares or 1,000 barrels of oil)
- Cash Settlement: No physical delivery; "loser" pays "winner" the cash difference (standard for index derivatives)
Key Exam Tips for Element 3
- Options = RIGHT; Futures/Forwards = OBLIGATION
- American options: exercise anytime; European: only at expiry
- Listed = exchange-traded, standardized, CDCC cleared
- OTC = customized, counterparty risk, bilateral
- Futures are marked-to-market DAILY; Forwards settle at end
- Index derivatives typically cash-settled