Examiner Report - Summer 2014

CHIEF EXAMINER’S REPORT
SUMMER 2014
FINANCIAL DERIVATIVES
Again rather few candidates took the paper on this occasion, the pass rate was 75%,
and there were three distinctions. As always, and I wonder why I have to repeat this
in every Examiner’s Report, the difference between passing and failing was largely
attributable to candidates’ performance in Section A. Passing candidates scored an
average of 17.5 marks on Section A, while the rest only scored an average of 9.5
marks. Again I urge candidates to practice previous Section A questions until they
are sure they can answer them all in examination conditions. For Section C the
average grade was only 7.5 marks for passing candidates. This is another area of
weakness candidates need to address.
The Section A questions were straightforward. Question 1 required candidates to
remember N  d 2  represents the probability of exercise in the Black Scholes
framework for a call option, and that the value of a digital call would be:
C = Payoff x Discount factor x N(d2)
Several candidates thought they further needed to multiply this expression by the
value of a standard call option – I do not know why. Most candidates knew how to
calculate VAR in Question 2, although two candidates decided the direction of lower
risk represented the VAR, which was rather perverse. Question 3 required the
identification of put-call parity violations– there was no violation of convexity
arbitrage despite the conclusions of several candidates. Some candidates overcomplicated Question 4, which simply required estimating the 2-yr/3-yr forward rate
from the ratio of the discount factors (0.961074/0.933759) and then estimating the
fixed versus floating cash flows. Finally Question 5 was a very plain binomial
question, though a couple of candidates seemed to think delta was the probability of
going down after one period.
In Section B, the most popular questions were numbers 6 and 8. Question 6, a
straightforward equity hedging question was answered well by most candidates,
though one candidate thought the index size of the S+P 500 futures was $10, and one
candidate thought it was still $500. Candidates must remember they need to know the
basic features of the most important and highly traded futures and options contracts.
In Question 8, which was well answered, several candidates did not go through the
simple process of noting whether the NPV found in (a) matched the result of the
pyramid hedging in (c). Several candidates did not take time to find the equivalent
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cash flows correctly in (b). Only two candidates answered Question 7, and neither
appeared very confident about the differential rule of correlation in the three products.
Candidates should note that correlation based products are of increasing importance in
derivatives markets. Question 9 was answered by very few candidates, which
surprises me, since it merely required the calculation of two put option prices by
Black-Scholes, and the estimation of the fixed cash flow available for a given
investment. This was rather a gift question in some ways. I was surprised at how few
candidates answered Questions 10 and 11. The answers suggested that knowledge of
how to mark to market a credit default swap was not widely present, and startlingly
that basic calculations for bond futures were feasible for few candidates. Standard
futures calculations are an important part of the Financial Derivatives syllabus.
As mentioned Section C answers were weak. Most candidates concentrated on
Question 12, not surprisingly, but most simply listed everything they knew about asset
swaps, CDSs and total returns swaps, without really displaying a deeper knowledge of
the interactions and relationships between them. Not so many candidates considered
the different exposures to market risk, credit risk, and funding risk. Only one
candidate answered Question 13, which baffled me, since these AutoCall products
seem all the rage at the moment, and I had thought candidates would have
encountered them in the Press or financial websites, and thought about how they were
constructed. This is always a useful exercise for candidates to carry out with popular
structured products. Not a single candidate answered Question 14, which I guess is a
measure of how quickly great frauds are forgotten. However, candidates should be
aware that a split-strike conversion strategy is merely a zero cost collar strategy by
another name, and hence will display returns which are in line with equity market
movements though dampened. Answers to Question 15 were generally good though
candidates tended to be happier describing VAR methods generally, than addressing
the specific issues of FX risk.
Overall the results of the summer 2014 paper suggest a bifurcated candidate group.
Some papers were really good including three papers worthy of distinction. Some
were pretty bad, submitted by candidates whose knowledge made it clearly unlikely
they would pass. In the latter group, as mentioned, the lack of the fundamental
knowledge required to pass the paper was revealed by their Section A results
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