ST6 Pu 14 PDF

ST6: CMP Upgrade 2013/14 Page 1
Subject ST6
CMP Upgrade 2013/14
CMP Upgrade
This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2013 study material to
make it suitable for study for the 2014 exams. It includes replacement pages and
additional pages where appropriate. Alternatively, you can buy a full replacement set of
up-to-date Course Notes at a significantly reduced price if you have previously bought
the full price Course Notes in this subject. Please see our 2014 Student Brochure for
more details.
This CMP Upgrade contains:
all changes to the Syllabus objectives and Core Reading
changes to the ActEd Course Notes, Series X Assignments and Question and
Answer Bank that will make them suitable for study for the 2014 exams.
The Actuarial Education Company IFE: 2014 Examinations

Page 2 ST6: CMP Upgrade 2013/14
1 Changes to the Syllabus objectives and Core Reading
1.1 Syllabus objectives
There have been no changes to the Syllabus objectives.
1.2 Core Reading
Unit and section references are to the separate Core Reading included at the end of the
Course Notes.
Unit 1
In Section 1, the final three paragraphs about Central Counterparties (CCPs) have been
replaced. Replacement pages for this unit are included at the end of this document.
This material is reflected in the changes to Chapter 1, described in the next section.
Unit 4
In Section 1.2, the penultimate two paragraphs on property derivatives have been
updated. Replacement pages 3 and 4 for this unit are included at the end of this
document.
Unit 15
Section 1.1 on Gilt STRIPS has been expanded to cover interest only and principal
only strips. Replacement pages 1-2b for this unit are included at the end of this
document.
This material is reflected in the changes to Chapter 14, described in the next section.
Unit 16
In section 1.1.2, the following has been inserted after the first paragraph:
Each method is illustrated using an example VaR at the 95% confidence level.
In the penultimate paragraph of sub-section B of the same section, the figure 99% has
been amended to 95%.
Charts have been inserted into each of sub-sections A, B and C.
IFE: 2014 Examinations The Actuarial Education Company

Replacement pages 3-4b, covering these changes to Section 1.1.2 of this unit are
included at the end of this document.
In section 4.3, the start of the third paragraph under the sub-heading Regulators has
been amended to the following:
Under the Basel Accord from the Basel Committee on Banking Supervision, ...
In section 4.4, in the first sentence of the third paragraph below the bullet points, the
bracketed phrase (particularly Basel II) has been amended to (particularly under
the Basel Accord).
In section 5, in the paragraph below the first list of bullet points, the reference to the UK
Actuarial Profession has been amended to the Institute and Faculty of Actuaries.
Also in Section 5, the following has been added to the second list of bullet points:
the use of collateral.

2 Changes to the ActEd Course Notes
Chapter 1
Page 4
Section 1.2 on OTC derivatives has been expanded, including new material on EMIR.
Replacement pages 3-4a are included at the end of this document.
Page 16
FAQs 1 and 2 have been updated and now read:
Q1 Where can I find out more about CCPs?
The May 2012 edition of The Actuary magazine contains an article A clearer
view, which considers the impact that CCPs will have on pension funds and
insurers. It is available online at:
www.theactuary.com/features/2012/05/risk-a-clearer-view-on-otc-derivatives/
Hull wrote a paper in April 2010 entitled OTC Derivatives and Central
Clearing: Can All Transactions Be Cleared?, which may also be of interest.
Performing an online search for Hull OTC should give a link to the paper
within the top half dozen results listed.
Q2 Where can I find out more about options exchanges and their products?
Options on UK equities are traded on NYSE Liffe, which is the global

derivatives business of the NYSE Euronext group and a good place to start. You
can go to the website globalderivatives.nyx.com and explore the various menu
items. For example, the Products tab will provide details of all the derivatives
available on NYSE Liffe.
Replacement pages 15-16 are included at the end of this document.
Page 17
The following item has been added after the second bullet in the first section of the
checklist:
Give an overview of the OTC legislation introduced since the credit crisis
A replacement checklist is included at the end of this document.

Chapter 2
Page 24
A short section on tailing the hedge has been added. Replacement pages 23-26 are
Page 27
The new Q1.15 is listed in Section 4.1, as:
Q1.15 Optimal hedge ratio, tailing the hedge
Page 29-30
Entries relating to hedge effectiveness and tailing the hedge have been added to the
checklist. Replacement pages 29-30 are included at the end of this document.
Chapter 3
Page 16
FAQ 1 has been updated and now reads:
Q1 Id like to take a closer look at the types of option available on exchanges.

Can you help me?
Yes. NYSE Euronext is a leading global operator of financial markets and has
exchanges in the US and Europe. Its website (globalderivatives.nyx.com)
contains lots of relevant information. By looking under the Products tab, you
can explore the various options available on the different exchanges.
An alternative is the Chicago Board Options Exchange (CBOE) website

(www.cboe.com). The Products tab is the best place to start, although theres
lots of other interesting features if you explore.

Chapter 5
Page 12
The product rule for correlated processes has been added explicitly to the product rule
section:
d ( X t Yt ) = X t dYt + Yt dX t + dX t dYt
Chapter 12
Page 19
The swaption box has had the terms payer and receiver swaption added in brackets, and
now appears as follows:
Payoffs from a swaption

L
Option on pay-fixed swap (a payer swaption): max( R - RX , 0)
m
L
Option on pay-floating swap (a receiver swaption): max( RX - R, 0)
m
(These terms were previously not introduced until Chapter 14.)
Page 27
The first section of the checklist has been expanded slightly. A replacement page 27 is
Chapter 14
Page 3
In Section 1.1, the strip example has been expanded to reflect the additional Core
Reading. Replacement pages 3-6 are included at the end of this document.

Chapter 15
Pages 12-13
The material on The Risks of Derivative Exposures Information Bulletin has been
updated in the same way as the Core Reading. Replacement pages 11-14 are included
at the end of this document.
Page 35
The fifth fact you should know has been updated from List 11 issues ... to List 12
issues ....

3 Changes to the Q&A Bank
Part 1
The following question has been added to the Q&A Bank:
Pages to replace the final pages of Q&A Bank Part 1 Questions and Solutions are
Part 4
The solution to Q&A Bank Question 4.16 had some log terms missing on page 37. This
has been corrected and replacement pages 37-38 are included at the end of this
document.

4 Changes to the X Assignments

Assignment X6
Question X6.2 has been updated to refer to the Institute and Faculty of Actuaries
Information Bulletin rather than the UK Actuarial Professions. The bullet points in the
solution have had the following addition:
the use of collateral.

5 Other tuition services

In addition to this CMP Upgrade you might find the following services helpful with
your study.
5.1 Study material
We offer the following study material in Subject ST6:

Mock Exam
Additional Mock Pack
ASET (ActEd Solutions with Exam Technique) and Mini-ASET.
For further details on ActEds study materials, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.2 Tutorials
We offer the following tutorials in Subject ST6:

a set of Regular Tutorials (lasting three full days)
a Block Tutorial (lasting three full days).
For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.
5.3 Marking
You can have your attempts at any of our assignments or mock exams marked by
ActEd. When marking your scripts, we aim to provide specific advice to improve your
chances of success in the exam and to return your scripts as quickly as possible.
For further details on ActEds marking services, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

6 Feedback on the study material

ActEd is always pleased to get feedback from students about any aspect of our study
programmes. Please let us know if you have any specific comments (eg about certain
sections of the notes or particular questions) or general suggestions about how we can
improve the study material. We will incorporate as many of your suggestions as we can
when we update the course material each year.
If you have any comments on this course please send them by email to ST6@bpp.com
or by fax to 01235 550085.

All study material produced by ActEd is copyright and is sold
for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire

out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material.
You must take care of your study material to ensure that it is

not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In

addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using

the course.

2014 Derivatives markets Subject ST6
UNIT 1 DERIVATIVES MARKETS

Syllabus objectives
(a) Show an awareness of the basic characteristics of the derivatives markets.
(i) Define and describe exchange traded contracts and over-the-counter

contracts.
(ii) Describe the payoffs of forwards and futures, calls and puts (American
and European).
(iii) Describe the uses of forwards, futures and options by hedgers, speculators
and arbitrageurs.
(iv) Demonstrate an understanding of how futures markets work.
The material required for this unit is covered in:
Options, futures and other derivatives. Hull, J. C.

Chapter 1 Introduction (all)
Chapter 2 Mechanics of futures markets (all)
excluding the following:
8th edition:
business snapshots 1.1 and 1.3 (these may be of interest, but are not directly
examinable)
sections 2.9 Regulation and 2.10 Accounting and tax
sub-section The use of clearing houses in OTC markets within section 2.5
(also therefore excluding business snapshot 2.3)
7th edition:
business snapshot 1.2 (this may be of interest, but is not directly examinable)
sections 2.8 Regulation and 2.9 Accounting and tax
supplemented by the additional material below:
1 Central Counterparties (CCPs)

During the credit crisis of 2007/08, governments became increasingly concerned about the
risks posed by the expansion of the OTC derivatives (OTCs) market. Based on
problems experienced at AIG and in the Lehman default, new regulation in the US was
proposed in 2009 (the Dodd Frank Act) aiming to reduce the systemic risk inherent in the
counterparty risk management of OTCs. (The Dodd Frank legislation is very extensive
and has many other aims.) Since each derivative position can be replicated several times
Institute and Faculty of Actuaries Unit 1, Page 1

Subject ST6 Introduction 2014
across multiple counterparts, if one of those counterparts were to default the effect could
be propagated around the market, leading to instability and possibly further failures.
The main proposal in the US is to require a derivatives trade between two counterparties to
be cleared by an independent Central Counterparty (CCP), in a similar way to the clearing
of futures at futures exchanges. Margin is placed to provide protection against the risk of
default. In this context, each CCP is like a dedicated futures exchange for swaps and
options.
The legislation is being adopted by other jurisdictions in Europe and Asia/Japan. The
European Union confirmed its European Market Infrastructure Regulation (EMIR) in
August 2012, requiring standard derivative contracts to be cleared through CCPs. Further
regulatory and technical standards were adopted in December 2012.
Once most OTCs are cleared through a few large CCPs, major economies of scale will be
achieved and the resulting process will substantially mitigate counterparty risk.
Information flow will be improved, especially for regulators. However, systemic
concentrations will be significant, with the failure of a CCP being an extremely unlikely
event but one that is potentially catastrophic for market liquidity. Economists have
commented that moving to CCPs from bilateral OTCs might not in fact decrease pro-
cyclicality (the risk of exacerbation of credit cycles) or reduce liquidity risk.
Furthermore, a competitive environment amongst CCPs is being allowed, albeit with

stringent organisational, business conduct and prudential requirements, so that only a few
major global CCPs are expected to thrive.
Other residual problems being resolved are: standardisation of risk assessment methods,
backstop liquidity arrangements for CCPs, a robust mechanism for segregating client
money and interoperability between CCPs.
END
Unit 1, Page 2 Faculty and Institute of Actuaries

2014 Traded derivatives contracts Subject ST6
to enable property owners to reduce their exposure to the market without physically
selling their individual properties.
In summary, the uses are:
Buying Selling
Fast and efficient asset allocation Hedging against a market downturn
Diversification using an index Portfolio re-balancing / reduction in
portfolio gearing
Lower cost international diversification Reduction of concentration risk
Reduction of time lag in using new cash Alpha retention (long physical property,
short index, to lock in outperformance)
Options and other tailored solutions Options and other tailored solutions
The advantages of property derivatives are that they are a good proxy for the risk of
physical real estate, are relatively liquid, have price transparency, and are unencumbered
by the costs of physical real estate. Traditional forms of property have high transactional
costs and are illiquid, hence limiting effective risk management. Even indirect property
investment has relatively high fees and low liquidity. With property derivatives the costs
are isolated and there is ease of entry to and exit from the market, allowing for quick,
efficient and cost effective risk management or portfolio readjustment.
In 2004 the property synthetics market was very small but subsequently grew rapidly,
particularly in the UK. By far the largest number of transactions reference commercial
property, since this is where institutional investment is centred and hedging capacity is
most required. Commercial deal sizes can range from 10 million to over 300 million.
Maturities are typically between one and five years, with the average at two years.
Residential deals are usually smaller in size but longer in maturity.
Around 26 billion worth of commercial property derivatives have been executed in the
UK since 2004. Trading volumes, and therefore liquidity of property derivatives, initially
grew quickly, reaching 7 billion in 2008, although have fallen since then to around 1
billion in 2012. At December 2012 the total outstanding notional amount was around 2.6
billion ($4.2 billion), compared with a total global derivative market of around $650,000
billion.
Residential market volumes are much harder to determine as there are no official statistics
to measure this market, but the volumes are much lower than for commercial property
derivatives.
1.3 Risks
Physical property is the largest asset class in the world (residential and commercial) and
yet the risk management of property is relatively poor. As a consequence, it exposes every
economy in the world to significant risk.

Subject ST6 Introduction 2014
Top Risk Factors in Real Estate
The chart above identifies the main risks to property, of which two of the biggest
liquidity and macroeconomic are extremely difficult to manage. Property derivatives
allow investors to address these risks so they can adopt more comprehensive risk
management strategies surrounding their physical property holdings, potentially leading to
better risk-adjusted returns.
Other risk features inherent in property derivatives are:
basis are there basis differences between using a property index as a hedge and the
underlying physical property?
liquidity are swaps liquid enough to trade in large size?
transparency are consistent swap prices readily available?
volatility are swaps more volatile than the underlying market?
credit risk is the counterparty to the swap sufficiently creditworthy?
Basis risk can work in favour of the derivative holder (e.g. buying the index when it is
cheap) or against.
Otherwise, property swaps generally perform well on comparisons with the direct or
indirect physical property markets on the above criteria. Costs of dealing are lower,
resulting in higher liquidity and transparency. Volatility of the two forms of exposure is
similar, and often derivatives are the better predictor of future property returns than expert
forecasts. Counterparty credit risk is mitigated by documentation (see below) and, where
appropriate, priced into the contract.
Unit 4, Page 4 Institute and Faculty of Actuaries

2014 Structured derivatives and synthetic securities Subject ST6
UNIT 15 STRUCTURED DERIVATIVES AND

SYNTHETIC SECURITIES
Syllabus objectives
(l) Demonstrate an awareness of the characteristics of different types of structured

derivatives and synthetic securities that can be encountered in actuarial work.
(i) Define the following securities and OTC contracts and describe how each can
be used to hedge certain types of liability:
Gilt STRIPS
Interest-rate swaps
Interest-rate swaptions
Index-linked gilts
Inflation swaps
Limited Price Indexation (LPI) swaps
LPI bonds
(ii) Describe how non-economic risks such as longevity risk can be hedged using
suitable index-linked securities and OTC contracts.
(iii) Describe how the following issues affect the suitability of traded securities and
OTC contracts for liability hedging:
Basis risk
Capital structure
Credit risk
(iv) Describe how special purpose vehicles can be used as part of a mechanism for
risk transfer, including the role of a credit enhancement agency.

Subject ST6 Structured derivatives and synthetic securities 2014
1 Definitions
1.1 Gilt STRIPS
Gilt STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-
coupon bonds that are created by securitising the individual cashflows arising under a
fixed-interest gilt (UK government bond). They are often simply termed strips.
For example, a single unit of the bond Treasury 4% 2055 makes coupon payments of
2.125 on 7 June and 7 December each year until 7 June 2055 and has a final coupon, also
of 2.125, payable on 7 December 2055 along with the redemption payment of 100 on 7
December 2055. Each of the coupons of 2.125 and the single redemption payment of 100
can be traded as individual zero-coupon bonds.
Each coupon becomes an individual interest only (IO) strip. Coupons from different
bonds that are payable on the same date can be amalgamated into the same strip issue. To
enhance liquidity in the strip market, the UK government has deliberately issued bonds
with coupons payable on the same sets of dates in the year.
Each maturity amount becomes a principal only (PO) strip. To avoid altering the
balance between the smaller coupons and much larger final payments, the principal cannot
be combined with coupons payable on the same date.
A gilt may be reconstituted from its individual strips by combining a complete set of IO
strips for the coupons and one PO strip for the principal at maturity.
Gilt strips can be used, for example, to help an annuity portfolio match its expected
liability cashflows. However, the market in gilt strips is not especially liquid and so they
are typically not used for dynamic hedging.

2014 Structured derivatives and synthetic securities Subject ST6
1.2 Interest-rate swaps

The material required for this section is covered in:
Options, futures and other derivatives. Hull, J. C.

Chapter 7 Swaps, sections 7.1 Mechanics of interest rate swaps.
1.3 Interest-rate swaptions

An interest-rate swaption or swap option is an over-the-counter (OTC) contract that gives
the holder the right but not the obligation to enter into an interest-rate swap at a future
date. For European swaptions the exercise date is fixed; for Bermudan swaptions there is a
series of exercise dates. Like interest-rate swaps, most interest-rate swaptions are heavily-
traded, standardised contracts.
A payer swaption is a swaption where the option lies with the party that will pay the fixed
rate under the swap contract. A receiver swaption is a swaption where the option lies with
the party that will receive the fixed rate under the swap contract.
Interest-rate swaptions can be used for a variety of purposes. For example, they can be
used to help hedge insurance contracts that incorporate some form of interest-rate
guarantee. Often the interest-rate-contingent payoff under the insurance contract is similar
to a swaption payoff. The payoff profile might not be exactly the same as a standardised
interest-rate swaption, but since the latter is liquid and heavily traded it can be used to help
hedge the interest-rate-contingent payoff under the insurance contract. Interest-rate
swaptions have been used, for example, to help hedge the interest-rate risk embedded in
annuity guarantee contracts.
Institute and Faculty of Actuaries Unit 15, Page 2a

Subject ST6 Structured derivatives and synthetic securities 2014
1.4 Index-linked gilts

An index-linked gilt is a UK government bond under which coupon and redemption
payments are increased in proportion to increases in the UK Retail Prices Index. In the
past the notional coupon payable in month T would be multiplied by RPI(T-8
months)/RPI(base month). Recent and future UK index-linked gilts have a shorter time lag
of 3 months, and other national governments issue index-linked bonds with 2 or 3 months'
time lag.
Index-linked gilts are used, for example, by pension funds to match, approximately, RPI-
linked cashflows for pensions in payment. They can also be used to help hedge LPI-linked
pensions in payment, although this requires a greater degree of dynamic hedging than RPI-
linked pensions.
Unit 15, Page 2b Institute and Faculty of Actuaries

2014 Risk management Subject ST6
model to be less accurate. The qualitative standard introduced other risk processes for
market risk, including requirements for an independent risk control unit, robust systems
and controls, and periodic stress testing to supplement the VaR measure.
1.1.2 Methods of Calculating VaR
There are three main practical methods of calculating VaR: Parametric (variance-
covariance), Historical simulation and Monte Carlo simulation. Each method has its
advantages and disadvantages, and there is no approach that is best in all circumstances.
However, the Historical simulation method has been adopted most widely as the one best
suited to the Basel / CAD2 regulatory regime.
Each method is illustrated using an example VaR at the 95% confidence level.
A. Parametric (variance-covariance)
The Parametric method assesses the VaR directly from the assumption of
normality of price changes in all the constituent risk factors.
Distribution of Daily Returns

Frequency (out of 1,400 actual returns)
300
Fitted Normal
250 distribution
Actual daily returns
200
Lowest 5% per Normal
150 distribution
5% Cumulative Normal
100
50
0
-9% -7% -5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 15%
A linear combination of multiple normal distributions is also normal, so the loss

distribution of the entire portfolio can be derived from a combination of
underlying correlated values.
A variance-covariance (VCV) matrix is compiled, usually from historical data

over a certain observation period. This requires taking variances of, and
correlations between, every possible risk factor relevant to the portfolio. The
resulting matrix is then used to derive the residual variance of the total weighted
normal distribution. The weights are the portfolio sensitivities to each risk factor.
The VCV matrix can have thousands of rows, but matrix multiplication is a
relatively efficient process for computers. Once the overall portfolio variance is

Subject ST6 Risk management 2014
calculated, together with the average return (often assumed to be zero over a one
day time horizon, as random normal up and down moves will broadly cancel out),
a suitable confidence level for the normal distribution is easily calculated, and this
is the VaR.
The Parametric method has the advantage that VaR can be calculated quickly and
simply. The historical data requirements are relatively low volatilities and the
appropriate correlation matrix are all that is needed.
One fundamental weakness is the low level of accuracy for options and other non-
linear derivative instruments, where risk sensitivities that apply at current levels
will change significantly under extreme movements. Another weakness is the
assumption that returns are normally distributed, so the method does not allow for
non-normal fat tails which have been observed empirically, although recent
techniques have enabled some modifications of the normal VaR to take account of
excess skewness and kurtosis (e.g. using the Cornish-Fisher expansion).
B. Historical simulation
The Historical simulation method assesses the loss distribution of the portfolio
based on a set of actual historical scenarios from the recent past.
Distribution of Daily Returns
300
250
Frequency (out of 1,400)
200 Lowest 5% of actual daily

returns
150
Actual daily returns
100
50
0
-9% -7% -5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 15%
Firstly, historical time series data of daily market values is compiled over an
observation period of at least one year. This observation period is usually recent,
but can be from any point in the past, such as one of extreme volatility (to
calculate stress VaR). The dataset is chosen to enable the entire portfolio to be
recalculated on each of the days in the observation period, using either exact
prices or proxy values for those instruments that cannot be valued precisely.
Then the portfolio profit/loss is obtained for each scenario as a change from the
previous day across the entire dataset. Profit/loss can be obtained by direct

2014 Risk management Subject ST6
recalculation best for non-linear instruments such as options or by Taylor

expansions of risk sensitivities (delta and gamma). The resulting profit/loss
vectors are ordered from greatest loss to greatest profit, forming a distribution
from which a particular confidence level (say 95%) is obtained, which is the VaR.
The premise is that history will repeat itself in a similar pattern of losses, but note
that there is no assumption that the distribution is normal, so this method partly
also allows for non-normal fat tails.
C. Monte Carlo simulation
This method involves modelling future price returns of the portfolio and running
many hypothetical trials to obtain a distribution of portfolio losses. Monte Carlo
simulation is the most commonly employed approach for multiple random trials.
Monte Carlo Simulation

100 random trials (using historical volatility)
Frequency (out of 100 random trials)
20
18
16
14
Lowest 5% of simulated daily
12
returns
10
Simulated daily returns
8
6
4
2
0
%
%
%
%
%
%
%
%
%
%
5%
0%
5%
0%
0%
5%
10
15
20
25
30
35
40
45
50
-5
-2
-2
-1
-1
Price returns are usually best modelled separately by risk factor, so the resulting
portfolio simulation is multi-dimensional and requires correlation assumptions as
in the Parametric method. However, the use of Monte Carlo means that less
tractable distributions than the normal can be used, which enables better
modelling of fat tails. The Monte Carlo simulation method is also well suited to
portfolios of complex options where simulation-based pricing models are already
available and cannot be reduced to analytical calculations or vectors of
sensitivities. This method can therefore be seen as a more advanced
implementation of the Parametric method.
Institute and Faculty of Actuaries Unit 16, Page 4a

Subject ST6 Risk management 2014
1.1.3 Weaknesses of VaR
A full study of all the features of the many different VaR models would fill a book. In the
credit crisis of 2007/08, and particularly in the three months after the collapse of Lehman
Brothers (Sep-Dec 2008), VaR became partly discredited as a risk measure since it failed
to allocate anywhere near enough risk capital to cover the heightened market volatility that
ensued. All the major banks reported back-testing exceptions, where actual losses
exceeded VaR on many more days than the 1-in-100 assumed by a 99% confidence
interval.
The G30 issued a new report in October 2010, Enhancing Financial Stability and
Resilience: Macroprudential Policy, Tools, and Systems for the Future. This showed that
much of the confidence in VaR as an all-purpose solution to measuring market risk had
diminished. The G30 report noted the procyclical effects of VaR, mentioned above, and
also commented:
Unit 16, Page 4b Institute and Faculty of Actuaries

ST6-01: Background to derivatives Page 3
0 Introduction
The stated aim of the ST6 course is to instil in successful candidates the ability:
to value financial derivatives
to assess and manage the risks associated with a portfolio of derivatives,
including credit derivatives
to value credit derivatives using simple models for credit risk.
A derivative is a financial instrument whose value depends on some underlying asset(s)

or variable(s).
In this chapter, we set the background to achieving this aim by looking at:
derivatives markets
types of derivative
types of derivatives trader.
We also remind you of some key concepts from Subject CT8.
Warning!
Using derivatives can lead to very large losses due to the large exposures to market
movements that can be gained for relatively little capital outlay. For this reason it is
vital for all organisations that use derivatives to have proper processes in place to
control their use. Youll be reminded of this again in Chapter 15 of the ActEd Notes,
which covers risk management.
1 Derivatives markets
1.1 Exchange-traded derivatives
Key features of derivatives exchanges are:

Contracts are standardised
Margin is required as security, to reduce credit risk
Exchanges exist in many different countries
Trading is usually carried out electronically by entering the trades on a computer
The alternative to electronic trading is open outcry, where trades are carried
out through dealers at the exchange, in a pit using specified hand signals.

Page 4 ST6-01: Background to derivatives
1.2 Over-the-counter (OTC) derivatives
Key features of the OTC market are:

Trades are carried out directly with a counterparty, rather than through an
exchange
Traders might be banks, insurers, pension funds, corporate treasurers
Contracts are not standardised
Contracts are typically much larger than those on exchanges
Credit risk is present in (non-collateralised) OTC trades.
Following the credit crisis of 2007/08, regulators worldwide have sought to strengthen
the financial system by proposing changes for certain types of OTC derivative contracts.
An example of the problems in the OTC market was that AIG was able to issue over
$400 billion of unhedged credit risk protection without having the capacity to absorb
anything like these losses. They then ran into difficulty when bond default rates
increased, triggering greater claims than expected.
In the US, the Dodd-Frank Act was signed into federal law in July 2010 and aims to
reduce the systemic risk present in the OTC derivatives market.
For certain types of OTC transaction, the trades will need to be cleared by an
independent central counterparty (CCP), which means that after the trade is executed,
it is then replaced by two new contracts, between the CCP and each of the two original
counterparties. (In practice, this will happen by transferring the contract to a clearing
member, who then registers it with a CCP.)
When a trade is cleared with a CCP, margin will be required to protect against default.
In the EU, the European Market Infrastructure Regulation (EMIR) came into force in
August 2012.
Under EMIR, OTC contracts will still be negotiated between counterparties in the usual
way, but with the requirement for all counterparties to all OTC trades to report the
deal to a central body (known as a trade repository). This will help regulators keep
track of how much risk is present in the financial system.
As in the US, for certain types of OTC transaction, the trades will need to be cleared
by an independent CCP and margin will be required to protect against default. This is
likely to affect interest rate derivatives and credit default swaps first, starting in 2014.

ST6-01: Background to derivatives Page 4a
The benefits of having a few large CCPs to clear these OTC trades include:
economies of scale
mitigation of counterparty risk
improved information flow concerning OTC trades.
Issues raised by the introduction of CCPs include:

consistency of risk assessment methods across CCPs
backstop liquidity arrangements for CCPs to reduce the risk of them failing
the need for a robust mechanism for segregating client money
interoperability between CCPs.
This legislation affects EU insurers in three main areas:

Reporting all OTC trades must be reported to a trade repository within 1 day
and daily exposure information is needed, including mark-to-market or mark-to-
model values and collateral values.
Clearing as mentioned above some OTCs need to be cleared by a CCP.
Risk mitigation (for non-cleared trades) this includes timely confirmation of
all OTC trades, regular reconciliation of data (the frequency of which depends
on the number of open trades with each counterparty) and margin requirements.

5 Questions
5.1 Questions from Q&A Bank
Q1.1 Arbitrage-free markets

Q1.2* Role of speculators, hedgers and arbitrageurs
Q1.3 Payoffs from call and put options
Q1.13(i) OTC vs exchange-traded derivative products
Q1.14 Impact of introducing CCPs
* This question is based on a past Specimen CiD question.
5.2 Past exam questions
Past exam questions from ST6
S06 Q1(i) Role of arbitrageurs

A08 Q1(iii) Role of arbitrageurs
S11 Q1(i) Arbitrage and the role of arbitrageurs
S11 Q7 PCP, early exercise, bounds for American options, graph of
European and American put values
A12 Q6(iii) Impact of introducing central clearing houses for OTC trades
Most ST6 exam questions will go beyond the basics covered in much of this introductory
chapter.
Past exam questions from CiD
A99 Q7** No-arbitrage principle, finding an arbitrage opportunity
** This question also appears on the ST6 specimen paper.

Page 16 ST6-01: Background to derivatives
5.3 FAQs*
Q1 Where can I find out more about CCPs?
The May 2012 edition of The Actuary magazine contains an article A clearer
view, which considers the impact that CCPs will have on pension funds and
insurers. It is available online at:
www.theactuary.com/features/2012/05/risk-a-clearer-view-on-otc-derivatives/
Hull wrote a paper in April 2010 entitled OTC Derivatives and Central
Clearing: Can All Transactions Be Cleared?, which may also be of interest.
Performing an online search for Hull OTC should give a link to the paper
within the top half dozen results listed.
Q2 Where can I find out more about options exchanges and their products?
Options on UK equities are traded on NYSE Liffe, which is the global

derivatives business of the NYSE Euronext group and a good place to start. You
can go to the website globalderivatives.nyx.com and explore the various menu
items. For example, the Products tab will provide details of all the derivatives
available on NYSE Liffe.
Q3 The Business Snapshot entitled Hedge Funds in Chapter 1 of Hull refers

to mutual funds. What are these?
In the US (Hull is an American book), a mutual fund is a particular form of

collective investment that pools money from many investors and invests the
money in various financial instruments. Further details arent required for the
ST6 course.
Outside the US, mutual fund is just a generic term for various types of collective
investment.
In the UK we have unit trusts, which work in a similar way.
* Each of the FAQs at the end of the chapters has been answered by an ActEd tutor.

6 Checklist
Definitions and concepts you should know
State the key features of derivatives exchanges

State the key features of OTC markets
Give an overview of the OTC legislation introduced since the credit crisis
Explain the role of a CCP in the OTC derivative market
Define a forward, a future and an option
State 6 differences between forward and futures contracts
Define and give examples of:
hedger
speculator
arbitrageur
Define the following terms from CT8:
risk-free interest rate
conditional expectation
filtration
martingale (in discrete and in continuous time)
Facts and formulae you should know
State the payoff from a forward contract

State the payoffs from the various types of option contracts
Results and proofs you should know
Derive the put-call parity relationship for European options





the course.

ST6-02: Forwards and futures Page 23
3.6 Hedge ratios
The hedge ratio is the ratio of the size of the position taken in futures contracts to the
size of the exposure in the underlying asset.
Hedgers seek to minimise the variance of the change in the value of their combined
position. If there is no cross-hedging, then a hedge ratio of 1 would be sensible.
However, this is not optimal when cross-hedging.
Minimum variance hedge ratio

sS
The minimum variance hedge ratio h* is given by h* = r
sF
where:
r = coefficient of correlation between DS and DF
DS , DF = change in spot and futures prices over the term of the hedge
sS ,s F = standard deviation of S and F
h* is sometimes referred to as the optimal hedge ratio.
Proof of minimum variance hedge ratio formula
Consider a portfolio consisting of a long position in the underlying asset and a short
position in the future, with h futures for each unit of the underlying, ie the hedge ratio
is h .
The change in the portfolio value over the term of the hedge will be:
D( S - hF ) = DS - hDF
This has variance:
V = var( DS - hDF ) = var( DS ) + h 2 var( DF ) - 2h cov( DS , DF )

= s S2 + h 2s F2 - 2h rs Ss F
Differentiating with respect to h to find the minimum variance gives:
dV s
= 2hs F2 - 2 rs Ss F = 0 h* = r S
dh sF
The second derivative is 2s F2 > 0 , confirming that h* is a minimum.

Page 24 ST6-02: Forwards and futures
The hedge effectiveness is the proportion of the variance eliminated by hedging
( )
2s2
ie r 2 = h* F
s S2
This is the R 2 value from a regression analysis of DS against DF and a value

of 0.8 or higher is regarded as highly effective.
Number of futures contracts to use
The number of futures contracts required is given by:
h*Q A
N* =
QF
where:
QA = size of position being hedged (ie quantity of units of the asset)
QF = size of one futures contract (ie quantity of units of the asset)
Tailing the hedge
Tailing the hedge is a procedure for the number of futures contracts used for hedging to
reflect daily settlement.
The formula for N * given above does not allow for the impact of daily settlement of
futures contracts. An adjustment, known as tailing the hedge can be used to achieve
this, which involves multiplying by the spot price over the futures price ( S / F ) to give:
h*QA S h*VA
N* = =
QF F VF
where:
VA = current value of the position being hedged (ie QA S )
VF = current value of one futures contract (ie QF F )
In theory, the number of contracts should be adjusted as S / F changes, but this usually
wouldnt make a significant difference.

3.7 Stock index futures
It is usual for a stock index to have weights proportional to market capitalisation and to
reflect capital gains only, although other types are possible, eg a total return index.
The FTSE 100 is based on the share prices of the UKs largest 100 listed companies.
Stock index futures can be used to hedge a well-diversified portfolio of equities. To do

this, a suitable future needs to be chosen and the appropriate number of contracts
shorted. A perfect hedge would result in the portfolio locking in a return equal to the
risk-free rate.
Reasons for wanting to hedge in this way include:
The hedger might think the short-term outlook for equities is poor, but not want
the expense of selling the portfolio and then buying it back at a later date.
(Dealing costs are lower in futures markets.)
Hedging removes the impact of overall market movements from the portfolio,
whilst leaving any impact from outperformance of the portfolio.
It is easier and quicker to establish and close out positions on futures exchanges
than in the underlying cash market.
In general, futures markets are more volatile than the underlying markets.
Some equity index futures contracts ranked in ascending order of basis risk (compared
with the corresponding underlying cash market) are:
S&P 500 (USA)
FTSE 100 (UK)
DAX 30 (Germany)
Hang Seng (Hong Kong)
Nikkei (Japan).
If the portfolio is exactly the same as that underlying the index, then the minimum
variance hedge ratio will be 1 and the desired number of contracts will be:
V P
N* = A = in Hull 7th edition
VF F
where:
VA = current value of the portfolio
VF = current value of one futures contract

If the two portfolios are different, then CAPM can be used to find the beta ( b ) of the
well-diversified portfolio and, assuming the future maturity is close to the hedge
maturity, the number of contracts to short is approximately:
V
N* = b A
VF
This will reduce the beta of the portfolio to zero, but its also possible to change the beta
to a different lower value, b * say, by shorting a different number of contracts:
(
N = b - b* ) VV
F
A
To increase beta instead to b , say, a long futures position would be needed. The
number of contracts required would be:
V
N = (b - b ) A
VF
These techniques can also be used with an individual equity, to hedge the risk from
overall market movements whilst leaving the effect of any over or under-performance.

4 Questions
Q1.4 Futures prices and option prices

Q1.5 Arbitrage in commodities markets, pattern of futures prices
Q1.6 Relationships between futures prices and spot prices
Q1.7 Interest rate futures and forwards
Q1.8* Commodities and forward prices
Q1.9* Explanation / use of published information for futures, cashflows
Q1.10 Hedge ratio, minimum variance hedge ratio
Q1.11* Hedge ratio, derivation of minimum variance hedge ratio, hedging
Q1.13(ii)(iii) Forward price for a currency, cost of carry, convenience yield,
hedge ratio
Q7.1 Formula for forward price, futures price
* These questions are based on past CiD questions.
S05 Q1 Definition of commodity forward terms, derivation of forward

price on consumption commodity, spot vs futures prices
A08 Q2 Forward price versus value, differences between forwards and
futures, derivation of forward price for a currency, hedging
using futures
S09 Q5(i)(a) Convenience yield description and when its negative
S10 Q8 Futures versus forwards, basis risk, hedge ratio, hedging
S11 Q1(ii)(iii) Basis risk, arbitrage profit
A12 Q6(i) Exchange-traded futures contracts
S12 Q2 Hedging currency exposure, modifying target assets
A13 Q3 Definition of various hedging terms, hedging calculation,
inferences about storage costs from futures prices

A99 Q8 Forward prices for an equity index

A00 Q5 Derivation of forward price of gold
A01 Q2 Derivation of currency forward price, relationship with spot rate
A01 Q3 Hedging with futures, derivation of minimum variance hedge
ratio
A01 Q6 Explanation and use of published information for futures
A02 Q2** Forward vs futures prices when risk-free rate is constant,
stochastic
A04 Q5 Forward vs futures contracts, currency forwards and futures
** This question also appears on the ST6 specimen paper.
4.3 FAQs
Q1 I think the equation for a forward price on a consumption commodity

( )
should be F0 = S0 e - yT + U erT rather than F0 = ( S0 + U ) e( r - y )T since its just
the commodity that has a convenience yield and not the storage costs. Am I
missing something?
Your equation does make sense assuming the convenience yield y can be
treated in the same way as a continuous income q . However, it doesnt quite
work like this. The e yT factor is used as a convenient adjustment to apply to F0
to restore the equality in the equation for the forward price. So the equation
given is the one usually seen in textbooks.
Q2 Rather than enter into a long hedge to reduce market risk, why cant you
simply buy the asset now? Then you wouldnt be affected by future
movements.
You could do this and, yes, market risk would be avoided. However, youd have
to pay storage and financing costs immediately and it would be less easy to
adjust the position at a later date. So, if its a long time before you actually want
the asset, using futures would be a better method to reduce market risk.

5 Checklist
List the various items that must be specified for a futures contract
Define limit up and limit down
Describe the operation of margin accounts for a futures contract, including
definitions of:
initial margin
maintenance margin
variation margin
clearing margin
Describe a collateralisation arrangement for a forward contract
Distinguish between commission brokers and locals
List 3 types of speculator
Describe the following types of order that can be placed with a broker:
Market order
Limit order
Stop order
Stop-limit order
Stop-and-limit order
Market-if-touched order
Discretionary order
State and define 4 different timing types of order
List 12 items that might be quoted regularly in respect of futures contracts
Distinguish between investment and consumption commodities
Define convenience yield
Define cost of carry
Define a normal market and an inverted market
Define normal backwardation and contango
List 4 factors that might cause forward and futures prices to differ
Define a short hedge and a long hedge
State 4 reasons not to hedge
Give 3 reasons why hedges are less than perfect in practice
Define basis and basis risk
Define what is meant by the basis strengthening or weakening
State 2 reasons why it might not be possible to hedge a position using just one
futures contract
Define the concept of rolling a hedge forward (stack and roll) and explain the
basis risk involved
Define hedge ratio
Define hedge effectiveness
Define the term tailing the hedge

How the assumed delivery date is determined, where there is a range of

possible delivery dates
State the formula for hedge effectiveness
State the number of futures contracts to use for optimal hedging
Derive formulae for the no-arbitrage forward price F0 for:

a non-dividend-paying stock
an asset providing a discrete income stream
an asset providing a continuous income stream
a stock index
a foreign currency
an investment commodity
a consumption commodity
Derive the value ft of a forward contract for times t > 0
Explain why spot and futures prices converge at maturity
Explain the relationship between futures prices and expected spot prices
Explain how forward and futures prices compare when the risk-free rate of
interest is deterministic and also when it is not deterministic
Derive a formula for the minimum variance hedge ratio
Describe how stock index futures can be used to:
hedge a well-diversified portfolio of equities
change the beta of a well-diversified portfolio of equities

ST6-03: Traded derivatives contracts Page 15
5 Questions
Q1.3 Profit or loss on options

Q1.9 Options vs futures
Q1.12 Property derivatives
A11 Q1 Property swap mechanism and benefits, risks of property

derivatives
S12 Q5(i)(a) Conversion of convertible corporate bond
Much of the material in this chapter is just an introduction to options and, as such, is
unlikely to be the sole source of material for many exam questions.
Property derivatives was a new topic introduced for the 2010 exams.
A00 Q1 Payoffs from futures options

A00 Q4 Warrants vs exchange-traded options

Page 16 ST6-03: Traded derivatives contracts
5.3 FAQs
Q1 Id like to take a closer look at the types of option available on exchanges.

Can you help me?
Yes. NYSE Euronext is a leading global operator of financial markets and has
exchanges in the US and Europe. Its website (globalderivatives.nyx.com)
contains lots of relevant information. By looking under the Products tab, you
can explore the various options available on the different exchanges.
An alternative is the Chicago Board Options Exchange (CBOE) website

(www.cboe.com). The Products tab is the best place to start, although theres
lots of other interesting features if you explore.
Q2 I would have thought that an option series referred to a set of options

with different expiry dates, not to a single contract as in Hulls definition.
In what sense is this a series?
Yes, this does seem illogical, and in fact we have seen the word series used
elsewhere in the sense you suggest. However, the US Securities & Exchange
Commission (who produce a lot of legal documentation) use the word series in
the same sense as Hull. Perhaps this could be considered to be a series in the
sense that there will be a succession of trades over time, all on identical terms.
Most people would normally refer to all December call options on British
Airways shares with a strike price of 360p as an options contract. However,
this may not be the correct legal terminology since each trade (which will
involve different people) is really a contract in itself.

ST6-12: Interest rate derivatives Page 27
6 Checklist
Define and describe the key features of a forward rate agreement (FRA)
Describe the key features of a Eurodollar futures contract
Describe the underlying asset used in a Eurodollar futures contract
Describe the difference between a forward interest rate and a futures rate
Describe the key features of a Treasury bond futures contract
Describe the underlying asset used in a Treasury bond futures contract
Define and describe the purpose of conversion factors
Describe the use and key features of a swap
Define and describe the key features of interest rate caps and floors
Define and describe the use of interest rate swaptions
Describe futures options
Describe how delta, gamma and vega are calculated for an interest rate
derivative
Describe the uses of an FRA or a Eurodollar future

Know the formula for the contract value for a Eurodollar future
Know the usual formula for the convexity adjustment
Know how to value the fixed and floating legs of a swap
Know how to apply Blacks formula to value an option on an interest rate, a
bond, a swap rate or a future
Show algebraically that a swap can be constructed from a cap and a floor
Show algebraically that a caplet / floorlet is equivalent to a put / call option on
a zero-coupon bond
Techniques you should know
Calculate the settlement payment or the value for an FRA (either from first
principles or using the formulae from Hull)
Calculate a forward rate from a futures rate (or vice versa)
Calculate the cost of delivery of a bond and identify the cheapest-to-deliver
bond





the course.

ST6-14: Structured derivatives and synthetic securities Page 3
0 Introduction
Many traded securities and OTC contracts have been developed to help various
entities, including pension funds and life insurers, to hedge their exposures to economic
and non-economic risks. In this chapter, we will look at some examples of these.
We will also mention interest rate swaps and swaptions, which were previously
covered in detail in Chapter 12 of the ActEd Notes.
The issues of basis risk, capital structure and credit risk are also covered.
The chapter ends with a description of how a special purpose vehicle can be used to
reduce the credit risk present in a mortality-related security.
1 Products used to hedge certain types of liability
1.1 Gilt strips
Description
Strips are zero-coupon bonds created by separating the individual coupon payments and
the principal repayment of a fixed-interest bond and trading them separately. (Strips
is an acronym for Separate Trading of Registered Interest and Principal of Securities.)
Gilt strips are where the bond being stripped is a UK government bond.
Example
Treasury 6% 2028 is a strippable bond.
The individual coupons are payable on 7 June and 7 December each year until
7 December 2028. Each of these coupons can become an interest only (IO) strip and
can be combined with coupons from other strippable bonds provided theyre payable on
the same date.
The principal is payable on 7 December 2028 (along with the final coupon payment).
The principal can become a principal only (PO) strip and cant be combined with IO
strips.

Page 4 ST6-14: Structured derivatives and synthetic securities
Hedging
Prior to the introduction of gilt strips in 1997, many life insurers tried to hedge their
annuity portfolio by holding gilts (and perhaps corporate bonds) to match the expected
annuity payments. However, producing a smooth graph of cash inflow against time was
impossible due to the spikes caused by redemption amounts and the limited range of
maturity dates. The existence of strips has made this much easier, although static
hedging is more common than dynamic hedging due to the relative illiquidity of the gilt
strips market.
1.2 Interest rate swaps
Description
See Section 2 of Chapter 12 of the ActEd Notes.
Hedging
Interest rate swaps can be used to transform a fixed-rate asset (liability) into a floating-
rate asset (liability), or vice versa.
1.3 Interest rate swaptions
Description
Interest rate swaptions are OTC options to effect an interest rate swap in the future on
set terms.
Under a payer swaption, the holder of the long position would pay fixed (and receive
floating).
Under a receiver swaption, the holder of the long position would receive fixed (and
pay floating).
Hedging
Life insurers can use swaptions to hedge interest rate guarantees, eg guaranteed annuity
rates where the insurer might promise to convert a lump sum into an annuity at
retirement using annuity rates based on interest rates no lower than 6% pa.

ST6-14: Structured derivatives and synthetic securities Page 5
1.4 Index-linked gilts
Description
Index-linked gilts are UK government bonds where the coupon and redemption
payments are increased in line with RPI (the retail prices index, a measure of inflation).
For practical reasons, payments in month t are based on the RPI figure for month t - 3 ,
ie a three-month lag. For gilts issued prior to 2005, an 8-month lag is used.
Other countries also have index-linked government bonds with varying time lags
(typically two or three months).
Hedging
Pension funds can use index-linked gilts to hedge RPI annuities (ie annuities where the
payments are linked to RPI inflation).
1.5 Inflation swaps (or RPI swaps in the UK)
Description
Inflation swaps are OTC contracts, often arranged by pension funds with a bank.
Under an RPI swap, one stream of cashflows is swapped for a stream of floating
cashflows based on RPI. The stream of cashflows being swapped might be:
fixed-interest cashflows (eg from fixed-interest bonds)
equity cashflows (eg from a defined portfolio, or more likely from an equity
index such as the FTSE 100)
other floating-rate cashflows (eg an overseas inflation index).
Any variable cashflows being swapped might be subject to a cap and/or a floor.
Hedging
Pension funds holding fixed-interest bonds can use the first type of RPI swap to hedge
their portfolio of RPI annuities. This approach is more flexible than investing directly
in index-linked gilts, where there is limited choice and less liquidity.
Similarly, if a pension fund holds a widely-diversified portfolio of UK equities or

overseas index-linked bonds, it can use the other types of RPI swap to transform the
income on its assets to hedge its expected RPI annuity outgo.

Page 6 ST6-14: Structured derivatives and synthetic securities
There has been talk in the UK of switching the link for some pensions from RPI to CPI
(consumer prices index). As this happens, a new basis risk will be introduced for funds
using RPI swaps. This will increase the demand for derivatives based on CPI, eg CPI
swaps or CPI-RPI basis derivatives.
1.6 LPI swaps
Description
Limited price indexation (LPI) is a form of inflation indexation used in conjunction

with pension benefits, where the level of indexation is capped at a certain level,
eg LPI = min( RPI ,5%) . The increases are usually subject to a minimum of zero.
LPI swaps are similar to RPI swaps, but are based on LPI rather than RPI.
Hedging
This is the same as for RPI swaps, but used where liabilities are linked to LPI.
1.7 LPI bonds
Description
LPI bonds are bonds where the coupon and redemption payments are increased in line
with LPI.
LPI bonds can be synthesised from conventional bonds and LPI swaps.
Hedging
Pension funds can use LPI bonds to hedge LPI annuities.

ST6-15: Risk management Page 11
2.3 Credit risk vs market risk
Credit risk is not independent of market risk. A change in market values can affect
exposure to credit loss and also the likelihood of default.
In general, it is difficult to reduce market risk without introducing further credit risk.
2.4 Measuring credit exposure
Recommendation 10 of the G30 report concerns the measurement of credit exposure.

It says that dealers and end-users should measure credit exposure on derivatives in two
ways:
Current exposure, which is the replacement cost of derivatives transactions,

ie their market value.
Potential exposure, which is an estimate of the future replacement cost of

derivatives transactions. It should be calculated using probability analysis based
on broad confidence intervals (eg two standard deviations) over the remaining
terms of the transactions.
Its important for firms to establish credit exposure limits and then monitor positions
against these limits on a regular basis.
3 Liquidity risk
Liquidity risk is financial risk due to worsening liquidity in investment markets.
A lack of liquidity can increase market risk. The credit crunch displayed an extreme
example of this.
The effect of liquidity risk can be explored using scenario testing to assess the financial
loss that might occur when liquidity dries up.
Liquidity risk is difficult to hedge against.

Page 12 ST6-15: Risk management
4 Derivative risk management

Risks associated with the use of derivatives include:
market risk (see Section 1 above)
credit risk (see Section 2 above)
settlement risk (ie failure of the writer to deliver the correct security at expiry)
aggregation risk (ie where positions are held in different markets)
operational risk
in derivative pricing models (ie using inadequate/inappropriate models)
in the back office administration systems
liquidity risk (ie not being able to buy/sell at a reasonable price)
legal risk (ie contracts not being valid or enforceable)
reputational risk (eg loss to reputation through not being able to honour
obligations or through being seen to have mismanaged a derivative position)
concentration risk (ie large positions held in a small number of similar
derivatives).
The following issues relevant to managing derivatives exposures are set out in the
Institute and Faculty of Actuaries Information Bulletin: The Risks of Derivative
Exposures:
the objectives and policies laid down for the use of derivatives (and how such
guidelines relate to overall investment objectives)
the extent to which compliance with these objectives and policies is monitored
and enforced
the definition of the instruments that may be dealt in and the margining
arrangements required
limits on exposures or volumes
the type of counterparties with which the organisation can deal
the use of collateral
the extent to which the organisations use of derivatives satisfies statutory rules,
prudential guidance and appropriate codes of practice
the independence of the senior management responsible for control of derivative
instruments from those concerned with trading and day-to-day management of
derivatives
the knowledge and understanding of senior management responsible for control
the adequacy of the statistics and summary information provided

ST6-15: Risk management Page 13
the extent to which dynamic management of derivative positions is understood

and applied
access to suitable tax expertise (in a complex area).
If youd like to read the full bulletin, which is under five pages, the easiest way to find it
is to go to the Institute and Faculty of Actuaries website (www.actuaries.org.uk) and
search for derivatives exposures.
Recommendation 2 of the G30 report says that dealers should mark their derivatives
positions to market, on at least a daily basis, for risk management purposes.
Derivatives writers try to maintain hedged positions, leaving them to profit from
differences between their buying and selling prices. However, perfect hedging isnt
achievable in practice, so there will always be a residual market risk.
However well a portfolio appears to be hedged, a change in market volatility can still
lead to losses, so dealers should always measure this risk and have appropriate controls
in place.

Page 14 ST6-15: Risk management
5 Credit ratings
5.1 Credit ratings agencies (CRAs)
CRAs are firms whose main purpose is to assign and maintain credit ratings for certain
types of debt, to provide an indication of its credit-worthiness.
The main CRAs operating in the UK are:

Standard & Poors (S&P)
Moodys
Fitch
A M Best
Dominion Bond Rating Service (DBRS).
Ratings are provided for:

individual debt issues
companies
special purpose vehicles
non-profit organisations
local governments
national governments
countries.
Other CRA activities include the provision of:

credit data
analytical tools
consultancy
training.

ST6: Q&A Bank Part 1 Questions Page 7
Question 1.12
(i) List four types of property derivatives available. [2]
(ii) Describe the advantages of property derivatives over physical property purchase.
[3]
(iii) Give eight examples of how property derivatives might be used. [4]
[Total 9]
Question 1.13
(i) State the key difference between an over-the-counter (OTC) and an exchange-
traded derivative product and outline the relative advantages and disadvantages
of the two types to a derivative user. [6]
(ii) Derive a formula for the forward price of a currency, defining the notation you
use and stating any assumptions on which your formula depends. [4]
(iii) Explain the meaning and the significance of the terms cost of carry,
convenience yield and hedge ratio. [3]
[Total 13]
Question 1.14
Explain the role of a Central Counterparty (CCP) in an OTC derivatives market and
describe the advantages and disadvantages of introducing them to a particular market
for the first time. [7]

Page 8 ST6: Q&A Bank Part 1 Questions
Question 1.15
A UK company wishes to hedge its US dollar exposure at time t , using futures

contracts with expiry at time T , where t < T .
Let r and r f be the constant, continuously-compounded risk-free interest rates in the

UK and US respectively.
Let S0 be the current dollar spot price (in pounds sterling) and F0 be the current
T -year dollar futures price (in pounds sterling).
(i) Determine the companys optimal hedge ratio. [3]
(ii) Show that the optimal hedge ratio for a 1-day hedge is very close to S0 F0 and
explain what this means for maintaining a hedge over a period longer than one
day. [3]
[Total 6]

ST6: Q&A Bank Part 1 Solutions Page 17
Solution 1.14
Without a CCP, one counterparty to an OTC trade is dependent on the other to make
good on any payments required. []
If the trade is cleared with a CCP, each partys contract is then with the CCP, thereby
reducing credit risk relating to the counterparty. []
The credit risk associated with the CCP is mitigated by the requirement to deposit an
initial margin in an account with the CPP, which is then subject to variation margin
payments. [1]
The CCPs will have information on all trades cleared with them and so will be in a good
position to spot any build-up of risk in a particular area. This benefit will be lessened
the more CCPs there are, unless information is freely shared or collected centrally. [1]
If all of a partys trades are cleared with the same CCP, then margin calls can be netted,
which wouldnt be possible if there were separate collateral arrangements with each
different counterparty. [1]
By implementing this CCP requirement, the regulator is seen to be taking action. []
Adding in CCPs to the financial system will add to overall costs for end-users. []
The concentration of risk for large CCPs would be significant, so the failure of such a
CCP would be disastrous for the market. The regulator would need to think about the
need for measures to limit the probability of a CCP failing. [1]
Since OTC contracts are not standardised, CCPs must have the capability to cope with a
wide range of contract details. The alternative would be to restrict the details permitted
in the original contracts, but this would stifle innovation and reduce marketability. [1]
The regulator would want to ensure consistency of risk assessment methods across
CCPs, which becomes harder as the number of CCPs increases. []
If CCPs are introduced for a market in one country, but not for the equivalent market in
another country, this could lead to inconsistencies or arbitrage opportunities. []
[Maximum 7]

Page 18 ST6: Q&A Bank Part 1 Solutions
Solution 1.15
(i) Optimal hedge ratio
Using a hedge ratio of h , the UK company will short h futures contracts at time 0 and
close them out at time t . []
Assuming that the UK company will be receiving dollars, h will be positive. If it is due
to pay the dollars, h will be negative, in which case this would actually be a long
position in futures. []
( r - r f )(T -t )
The futures price at time t is given by Ft = St e [1]
The price received for each dollar at time t , including the effect of the hedge, is:
St + h ( F0 - Ft ) = St + h F0 - St e ( ( r - r f )(T -t )
)

known
(
= hF0 + St 1 - he f

( r - r )(T -t )
) [1]
at t = 0 potentially unknown
To remove all uncertainty in this price, we can choose h to set the second term to zero,
ie:
( r f - r )(T -t )
h=e []
[Maximum 3]
(ii) Optimal hedge ratio for a 1-day hedge and explanation
For a 1-day hedge, t is close to zero, so we have:
( r f - r )T
he []
( r - r f )T
Comparing this with the initial futures price, ie F0 = S0e , we see that:
h F0 S0 , as required. []
A longer hedge using futures can be regarded as a series of 1-day hedges, since the daily
margining process effectively means the hedge is closed out and set up again each day. [1]
This means the hedge ratio should always be the ratio of the current futures price to the
current spot price, so ideally, daily rebalancing is needed. [1]

This process is known as tailing the hedge. []
In practice, this might not be considered worthwhile. []

[Maximum 3]





the course.

Solution 4.16
This question is adapted from Question 9 of the April 2003 paper from Subject 109.
(i) Exchange option value
We use the hint given in the question for the payoff of the option:
s (T )
s2 (T ) max 1 - 1, 0
s2 (T )
s (T )
The second part of this product max 1 - 1, 0 , is exactly the same as the payoff for
s2 (T )
s1 (t )
a call option on an asset , with a strike price of 1.
s2 (t )
We need to calculate the volatility v of this asset. First we calculate the distribution:
s1 (t ) log N (log s1 (0) + m1t ,s 12t ) and s2 (t ) log N (log s2 (0) + m2t ,s 22t )
log s1 (t ) N (log s1 (0) + m1t ,s 12t ) and log s2 (t ) N (log s2 (0) + m2t ,s 22t )
s1 (t )
log s1 (t ) - log s2 (t ) = log
s2 (t )
s (0)
N log 1 + ( m1 - m2 )t , (s 12 + s 22 - 2 rs 1s 2 )t
s2 (0)
s1 (t ) s (0)
log N log 1 + ( m1 - m2 )t , (s 12 + s 22 - 2 rs 1s 2 )t
s2 (t ) s2 (0)
Strictly speaking we are using r as the correlation between the logs of the two stocks.
We shall assume this is what the examiner intended and proceed.
Therefore the square of the volatility, v 2 = s 12 + s 22 - 2 rs 1s 2 .
We can now use page 47 of the Tables to give us the value at time 0 of a call option on
s (t )
this asset 1 with a strike price of 1:
s2 (t )
s1 (0)
F(d1 ) - 1 e - rT F(d 2 )
s2 (0)

Page 38 ST6: Q&A Bank Part 4 Solutions
log s1 (0) s2 (0) + v 2T 2

where d1 = and d 2 = d1 - v T
v T
Here r = 0 because there is no cash. We are really working in units of s2 (0) .
The final answer for the fair price of the exchange option can be obtained by
multiplying this expression by s2 (0) :
s (0)
c0 = 1 F(d1 ) - 1 e - rT F(d 2 ) s2 (0)
s2 (0)
= s1 (0)F(d1 ) - s2 (0)F(d 2 )
log s1 (0) s2 (0) + v 2T 2

v T
[Total 7]
(ii) Expressions for delta
From part (i) we have:
c0 = s1F(d1 ) - s2 F(d 2 )
ln ( s1 s2 ) + v 2T 2
v T
c0 c
We need to calculate two deltas, D1 = and D 2 = 0 .
s1 s2
To do this, we need to prove a result similar to the lemma in Section 2.2 of Chapter 7 of
the ActEd Notes:
1 2 1 2
- d - d 12 - d1 -v T
f (d1 ) e
= 1 =
2 1 2
e

=e
-
1
2
(2 d1v T - v 2T )
f (d 2 ) - d 22
e 2
(
= exp - 2 ln ( s1 s2 ) =
1
2 ) s2
s1
f (d1 ) s1 = f (d 2 ) s2

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ST6: CMP Upgrade 2013/14 Page 1

This CMP Upgrade contains:

all changes to the Syllabus objectives and Core Reading

The Actuarial Education Company IFE: 2014 Examinations

1 Changes to the Syllabus objectives and Core Reading

1.1 Syllabus objectives

There have been no changes to the Syllabus objectives.

1.2 Core Reading

Charts have been inserted into each of sub-sections A, B and C.

IFE: 2014 Examinations The Actuarial Education Company

the use of collateral.

The Actuarial Education Company IFE: 2014 Examinations

2 Changes to the ActEd Course Notes

FAQs 1 and 2 have been updated and now read:

Q1 Where can I find out more about CCPs?

Options on UK equities are traded on NYSE Liffe, which is the global

Replacement pages 15-16 are included at the end of this document.

A replacement checklist is included at the end of this document.

IFE: 2014 Examinations The Actuarial Education Company

The new Q1.15 is listed in Section 4.1, as:

Q1.15 Optimal hedge ratio, tailing the hedge

Replacement pages 27-28 are included at the end of this document.

FAQ 1 has been updated and now reads:

Q1 Id like to take a closer look at the types of option available on exchanges.

An alternative is the Chicago Board Options Exchange (CBOE) website

Replacement pages 15-16 are included at the end of this document.

The Actuarial Education Company IFE: 2014 Examinations

Payoffs from a swaption

(These terms were previously not introduced until Chapter 14.)

IFE: 2014 Examinations The Actuarial Education Company

The Actuarial Education Company IFE: 2014 Examinations

3 Changes to the Q&A Bank

The following question has been added to the Q&A Bank:

Q1.15 Optimal hedge ratio, tailing the hedge

IFE: 2014 Examinations The Actuarial Education Company

4 Changes to the X Assignments

the use of collateral.

The Actuarial Education Company IFE: 2014 Examinations

5 Other tuition services

5.1 Study material

We offer the following study material in Subject ST6:

We offer the following tutorials in Subject ST6:

IFE: 2014 Examinations The Actuarial Education Company

6 Feedback on the study material

The Actuarial Education Company IFE: 2014 Examinations

Unless prior authority is granted by ActEd, you may not hire

You must take care of your study material to ensure that it is

Legal action will be taken if these terms are infringed. In

These conditions remain in force after you have finished using

IFE: 2014 Examinations The Actuarial Education Company

UNIT 1 DERIVATIVES MARKETS

(a) Show an awareness of the basic characteristics of the derivatives markets.

(i) Define and describe exchange traded contracts and over-the-counter

(iv) Demonstrate an understanding of how futures markets work.

The material required for this unit is covered in:

Options, futures and other derivatives. Hull, J. C.

excluding the following:

supplemented by the additional material below:

1 Central Counterparties (CCPs)

Institute and Faculty of Actuaries Unit 1, Page 1

Furthermore, a competitive environment amongst CCPs is being allowed, albeit with

Unit 1, Page 2 Faculty and Institute of Actuaries

In summary, the uses are: