FINM6041 · Applied Derivatives
Credit, Weather/Energy/Insurance Derivatives & Market Integrity
Credit, Weather/Energy/Insurance Derivatives & Market Integrity merges Lectures 11 and 12 into the exam's most narrative-heavy territory. On the products side you meet credit default swaps — a CDS pays the protection buyer (100 − Q)% × notional on a credit event, where Q is the post-default recovery price per 100 of par — plus total return swaps and credit spread options; weather derivatives built on degree-days (HDD = max(0, 65 − A), CDD = max(0, A − 65), with A the day's average of high and low in °F); energy contracts on non-storable electricity (the 5×8 off-peak and 5×16 on-peak blocks); and insurance-linked products — pro-rata reinsurance and catastrophe (CAT) bonds whose risk is uncorrelated with the market. Lecture 12 then turns to capital-market integrity: the CFA rules on material non-public information (MNPI) and the mosaic theory, plus market manipulation. The real-world case studies — Archegos and total return swaps, Michael Burry's CDS 'Big Short', and Adrian's Optiver guest lecture — are examinable, but their model answers live in the lecture recordings and the examinable Canvas Q&A forum, so this chapter keeps them at the conceptual level the decks support.
What this chapter covers
- 01CDS mechanics: the premium leg (bps × notional), credit events, and cash settlement = (100 − Q)% × notional vs physical delivery
- 02Total return swaps and credit spread options — transferring credit risk (the Archegos/TRS story, at concept level)
- 03Weather derivatives: HDD = max(0, 65 − A), CDD = max(0, A − 65); A = average of the day's high and low in °F
- 04Energy derivatives: non-storable electricity, 5×8 off-peak vs 5×16 on-peak, and daily vs monthly exercise
- 05Insurance-linked products: pro-rata reinsurance (liability = cover% × loss) and CAT bonds (diversifiable, market-uncorrelated risk)
- 06Capital-market integrity: material non-public information (MNPI), the mosaic theory, and market manipulation
- 07Derivatives mishaps and risk lessons: risk limits, separation of duties, don't let hedgers become speculators
- 08The examinable real-world narratives: Michael Burry's CDS 'Big Short' and Adrian's Optiver guest lecture (concept level)
Cash flows on a credit default swap
- 2 marksAnnual premium = spread × notional = 0.0120 × $80,000,000 = $960,000, payable each 1 March.
- 2 marks(a) With no credit event the buyer simply pays $960,000 on 1 March 2026, 2027, 2028 and 2029 and receives nothing — the CDS expires worthless, like an insurance policy that never pays out.
- 2 marks(b) Cash settlement pays (100 − Q)% × notional, where Q = 40 is the recovery price per 100 of par: (100 − 40)% × $80,000,000 = 0.60 × 80,000,000 = $48,000,000.
- 2 marks(b) Accrued premium: the last scheduled payment was 1 March 2027, so the buyer still owes premium for 1 March → 1 August 2027 = 5 months: (5/12) × $960,000 = $400,000.
- 2 marks(b) Net receipt at default = $48,000,000 − $400,000 = $47,600,000. (c) Under physical settlement the buyer instead delivers $80,000,000 face value of the defaulted bond and receives the full $80,000,000 notional in cash.
Key terms
- Credit default swap (CDS)
- Insurance against default of a reference entity: the protection buyer pays a periodic spread (bps on notional) until maturity or a credit event; on default the seller settles by physical delivery (bond for par) or cash = (100 − Q)% × notional, and the buyer still owes accrued premium to the event date.
- Recovery rate (Q)
- The post-default value of the reference obligation per 100 of par, typically set by a dealer poll; the CDS cash payoff is (100 − Q)% × notional, so a lower Q means a larger payout to the protection buyer.
- Total return swap (TRS)
- A swap that exchanges the total return (income plus capital gain/loss) on an asset or pool for a funding rate such as LIBOR, transferring credit and market exposure without transferring ownership — the structure at the centre of the Archegos episode.
- Degree-days (HDD/CDD)
- The building blocks of weather derivatives: HDD = max(0, 65 − A) and CDD = max(0, A − 65), where A is the average of the day's high and low temperature in °F (not the median); contracts are usually a forward or option on the monthly cumulative HDD or CDD.
- Catastrophe (CAT) bond
- A high-coupon bond whose holder effectively provides excess-of-loss reinsurance: principal or coupon is forfeited if a defined catastrophe occurs. Its risk is uncorrelated with the market, so it carries no systematic risk and is diversifiable.
- MNPI & mosaic theory
- Material non-public information is information that would likely move prices and has not been disseminated; acting on it breaches CFA Standard II(A). The mosaic theory permits combining public and non-material-non-public information to reach a conclusion, even if that conclusion itself would be material.
Credit, Weather/Energy/Insurance Derivatives & Market Integrity FAQ
Does FINM6041 really test credit default swaps?
Yes — directly. Quiz 5 was explicitly 'one question on the mechanics of CDS', and both sample finals include a credit / real-world question. You need the cash-flow mechanics cold: premium = spread × notional paid each period, cash settlement = (100 − Q)% × notional on a credit event, and the accrued premium owed from the last payment date to the default. Physical settlement (deliver the bond for par) is the alternative you should be able to state.
What are HDD and CDD in the weather-derivative questions?
Heating and cooling degree-days measure how far the day's temperature sits below or above 65°F: HDD = max(0, 65 − A) and CDD = max(0, A − 65), where A is the average of the day's high and low. The planted trap (seen in the 2022 sample) is to use the median instead of the average — A is always the average. Products are typically a forward or option on the month's cumulative HDD or CDD.
Do I have to know the Michael Burry 'Big Short' and Archegos stories for the exam?
Yes, conceptually. Both sample finals reward a real-world subpart: what Burry feared, which product and underlying he used, whether he was long or short, and his ongoing premium obligation; and how Archegos used total return swaps to build hidden leverage. The detailed model answers live in the Echo360 recordings and the examinable Canvas Q&A forum rather than the slide PDFs, so learn the narrative-to-mechanics link and don't expect a formula.
Is the Optiver guest lecture examinable?
It is. Adrian's guest market-maker session (tied to the Week-11 Optiver trading simulation) is examined in both sample papers — what market makers do and why they matter, how they handled pandemic-era data when estimating volatility, and the intensity of the role. Keep it at the conceptual level the lectures support; the specifics come from the recording and the Canvas forum.
What is the reinsurance pro-rata trap?
Under a pro-rata (proportional) reinsurance treaty the reinsurer's liability = cover% × loss. So 80% cover on a $130 million loss is $104 million, not $26 million — the 2022 sample plants the wrong figure to catch students who subtract instead of scaling. Also remember a daily-exercise electricity option is worth more than an otherwise identical monthly one, and a CAT bond's risk is diversifiable because it is uncorrelated with the market.
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Exam move
Treat this chapter as two mark pools that reward memory, not maths. The mechanical pool is CDS cash flows — lock in cash = (100 − Q)% × notional plus the accrued premium from the last payment date, the exact shape Quiz 5 tested — together with the degree-day formulas (HDD = max(0, 65 − A), CDD = max(0, A − 65), A = average of the day's high and low in °F, never the median) and the reinsurance rule (liability = cover% × loss, so 80% of a $130m loss is $104m, not $26m). The concept pool is the second half of the MCQ bank plus the real-world question: electricity is non-storable, so a daily-exercise option beats an otherwise identical monthly one; a CAT bond's risk is diversifiable because it is uncorrelated with the market; and mosaic theory permits trading on public plus non-material-non-public information but never on MNPI. Keep the Archegos/TRS, Burry/CDS and Optiver narratives at the conceptual level the decks support — the detailed model answers live in the recordings and the examinable Canvas Q&A forum — and you will bank the 10-15 marks these 'story' subparts are worth every year.
