“Financial Markets and Products” is one of the four broad topics that GARP tests in its FRM Part 1 exam. This general topic has 30% weight in the exam. This means out of a total of 100 questions asked, you may expect 30 questions from this section. This area tests a candidate’s knowledge of financial products and the markets, more specifically, structures and functions of financial institutions, structure and mechanics of over-the-counter (OTC) and exchange markets, structure, mechanics, and valuation of forwards, futures, swaps, and options, hedging with derivatives, interest rates and measures of interest rate sensitivity, foreign exchange risk, corporate bonds, and mortgage-backed securities. There are twenty chapters or readings in this section. If you go through the GARP-specified learning objectives (LOs) for this section, you will find a good mix of computational and non-computational LOs. As GARP generally asks tricky questions from the non-computational LOs, non-computational LOs are to be equally emphasized to score well in this section.
Let me now take you through the essence of each of the twenty chapters or readings and identify the concepts that GARP might test on exam day.
Chapter 1: Banks
This reading familiarizes several concepts about banks deliberated in more detail elsewhere in the FRM curriculum. For the exam day, your focus should be on understanding the significant types of risk a bank is exposed to and how these risks are addressed, both by banks themselves and by bank regulators. There could be questions on the differences between commercial banking and investment banking and the conflicts that arise in an organization that is into both of these services. Also, be conversant with the distinctions between the lending and trading operations of a bank. Finally, GARP might test your ability to describe the implications of banks originating loans and distributing them to other parties.
Chapter 2: Insurance Companies and Pension Plans
The emphasis in this reading is primarily on concepts related to life insurance and nonlife (property and casualty) insurance, such as moral hazard, adverse selection, mortality risk, and longevity risk. From this reading, GARP might test your ability to apply mortality tables to perform life expectancy computations and breakeven premium computations for life insurance companies and compute ratios relevant to property and casualty insurance companies. In addition, there could be questions on the risks facing insurance companies and how those risks can be mitigated.
Chapter 3: Fund Management
All investors may not have the time or the skill required to manage their financial assets. For this reason, investors often approach professional fund managers. Pooled investment vehicles such as mutual funds and hedge funds offer their investors instant diversification and professional management. Smaller investors often resort to mutual funds, while hedge funds are generally preferred for wealthy individuals. Hedge funds are subject to much less regulation as they are limited only to those who can afford to lose their investment. From this reading, GARP might test your ability to describe various types of mutual funds and hedge funds, including their regulatory environments and typical fee structures.
Chapter 4: Introduction to Derivatives
This reading presents the basic concepts of derivatives securities and derivatives markets. For the exam day, be thorough with the terms of the basic derivative and the terms related to derivatives markets. Also, be at home with the computation of payoffs for the different derivatives securities. Finally, you might get tested on your ability to create a hedge and take advantage of an arbitrage situation.
Chapter 5: Exchanges and OTC Markets
This reading talks about the role of exchanges and the differences between exchange-traded derivatives and over-the-counter (OTC) derivatives trading. Also, it discusses the role of the central counterparty (CCP) in clearing and mitigating counterparty risk. GARP might test your ability to compare and contrast exchange-traded and OTC derivatives on exam day. Also, be conversant with the development of central clearing, including the various mechanisms available for managing risks, including special purpose vehicles (SPVs).
Chapter 6: Central Clearing
This reading addresses the principles of central clearing, including the functions and mechanics of a central counterparty (CCP). Clearing, novation, and netting are essential concepts that GARP might test on exam day. Also, you need to be thorough with the advantages and disadvantages of CCPs, and common terms, including loss mutualisation, moral hazard, adverse selection, and procyclicality.
Chapter 7: Futures Markets
For this reading, do pay special attention to the terminologies of futures markets, how futures differ from forwards, the mechanics of margin deposits, and the process of marking to market. Limit price moves, delivery options, and convergence of spot prices to futures prices are important concepts on which GARP might test your understanding on exam day. Also, be conversant with how a futures position can be terminated before contract expiration and how the final mark-to-market accomplishes cash settlement at contract expiration.
Chapter 8. Using Futures for Hedging
For implementing hedging strategies, futures contracts are used extensively. This reading covers the calculations for determining the optimal hedge ratio. It presents how to determine the number of futures contracts required to hedge a spot market exposure. From this reading, basis risk is a very common testable concept. Basis risk stems from an asset being hedged may not be exactly the same as the asset underlying the futures contract.
Chapter 9. Foreign Exchange Markets
Exposure to foreign exchange risks (transaction, translation, and economic) is inevitable because of the globalization of financial institutions. These risks stem from foreign currency trading and/or foreign asset-liability positions that are mismatched in individual currencies. Unexpected foreign currency volatility can trigger significant losses for the firm, which could, in turn, endanger profitability or even solvency. These risks are often mitigated by direct hedging through matching foreign asset-liability books of business, hedging through forwarding contracts, and other non-financial operational decisions. For the exam day, be conversant with foreign exchange quotes and related calculations. Also, GARP often tests fundamental concepts such as purchasing power parity and covered interest rate parity.
Chapter 10: Pricing Financial Forwards and Futures
Interestingly, both forward and futures contracts relate to future transactions. Because the difference in pricing between these contract types is insignificant, forward contract pricing and futures contract pricing are often used interchangeably. The basic model for forwarding prices essentially establishes a nexus between the forward price and the cost incurred for purchasing and storing the underlying asset until the contract maturity date. Cash flows over the life of the contract can easily be factored into the pricing model. From this reading, GARP frequently tests candidates on the interest rate parity and pricing of financial forwards and futures.
Chapter 11: Commodity Forwards and Futures
This reading addresses the pricing relationships in commodities with characteristics such as lease rates, storage costs, and/or convenience yields. For the exam day, be thorough with the basic futures pricing equation and how it is adjusted for lease rates, storage costs, and/or convenience yields.
Chapter 12: Options Markets
The holder of a stock option has the right, but not the obligation, to buy or sell a stock at a specific price on or before a particular date. The holder of a call option has the right to buy the stock, while the holder of a put option can sell the stock. An option is said to be exercised when the holder exercises the right to buy or sell the stock. This reading discusses the basic mechanics of options trading. For the exam day, be conversant with the different kinds of options and the system by which exchange-traded options are bought and sold.
Chapter 13: Properties of Options
The stock’s current value, the strike price, the time to expiration, the volatility of the stock price, the risk-free rate, and dividends are the six factors that affect a stock option’s price. The prices of stock options have upper and lower pricing bounds. For the exam day, be thorough with these pricing bounds and the relationships between the value of European and American options.
Chapter 14: Trading Strategies
Traders and investors have different option-based trading strategies at their disposal for generating lucrative payoff profiles. This reading talks about the common option trading strategies and implementation. For the exam day, be conversant with the general payoff graphs for each strategy discussed in this reading. In addition, you might get tested on how to calculate profits for some of the more popular strategies, including protective put, covered call, bull call spread, butterfly spread, and straddle.
Chapter 15: Exotic Options
This reading discusses the salient features of different exotic options. The difference between exotic options and more traditional exchange-traded instruments has been emphasized in this reading. For exam day, be thorough with the payoff structures for the various exotic options discussed in this reading.
Chapter 16: Properties of Interest Rates
Bootstrapping method is often used to compute spot, or zero, rates from coupon bonds. Forward rates can then be obtained from the spot or zero curves. For the exam day, be conversant with the bootstrapping method and the computation of forwarding rates from spot rates. Also, be thorough with discrete and continuous compounding methods. In addition, GARP might test your understanding of the concepts of duration and convexity and how they are used to determine the change in a bond’s price.
Chapter 17: Corporate Bonds
This reading provides an overview of principal fixed-income instruments and their payment structures. It also addresses the impact of credit risk and event risk on bond ratings and features. For the exam day, be thorough with the types of bonds discussed in this reading and the methods for retiring bonds. Also, GARP might test your understanding of the terminology associated with high-yield issues.
Chapter 18: Mortgages and Mortgage-Backed Securities
Mortgage-backed securities (MBSs) are debt securities backed by a pool of residential loans, which are used to transform mortgages from illiquid assets into a liquid asset. As the underlying mortgages can be prepaid, prepayment risk is a concern for MBS investors. Monte Carlo simulation is the most widely used methodology for valuing MBSs because it factors in prepayment risk. For the exam day, be conversant with calculating the payments for a fixed-rate, level-paying mortgage. Also, be thorough in understanding the factors that affect prepayment rates, more specifically, the conditional prepayment rate (CPR). Finally, GARP might test your understanding of the steps involved in valuing an MBS using the Monte Carlo methodology and the advantages and disadvantages of using OAS.
Chapter 19: Interest Rate Future
This reading talks about Treasury bonds (T-bonds) and Eurodollar futures contracts. GARP might test your understanding of the cheapest-to-deliver bond for T-bonds and how to use the convexity adjustment for Eurodollar futures. Duration-based hedging using interest rate futures can also be tested on the day. In addition, be conversant with the equation to calculate the number of contracts needed to conduct a duration-based hedge.
Chapter 20: Swaps
An interest rate swap reflects an agreement between two parties to exchange interest payments based on a specified principal over a period of time. In a plain vanilla interest rate swap, one of the interest rates is fixed, while the other is floating. Swaps can be used to efficiently adjust the interest rate risk of existing assets and liabilities. A currency swap involves exchanges of interest rate payments in two different currencies. Swaps can be viewed as a long and short position in two different bonds or as a package of forwarding rate agreements for valuation purposes. From this reading, GARP might test your understanding of swap valuations.