Build your review around a classification-first habit. Before computing any payoff or hedge, state in one line who is bound, in which direction, settling when, and on what venue. Terminal payoffs of forwards, futures, and options can look deceptively similar; the obligations behind them are not. This article walks the six topic areas with worked scenarios, a payoff-diagram exercise, a decision table, and a six-week sequence you can adapt to your syllabus.
Classifying the Instrument Before Any Calculation
Name four attributes before computing: obligation (binding both sides or optional for one), payoff shape (linear or kinked), settlement timing (single date or periodic), and venue (exchange or OTC). Misclassifying any of these turns a solvable item into a wrong answer.
The obligation axis separates the whole syllabus into two families. Forwards, futures, and swaps bind both counterparties: whoever holds the position must transact at the agreed terms no matter where the underlying moves. An option binds only the writer; the holder pays a premium for the right, not the duty, to exercise. Once you identify which family a position belongs to, the correct payoff formula follows almost automatically, because the formula is just the obligation written in symbols.
Venue and timing matter as much as obligation. An exchange-traded instrument is standardised, margined, and settled through a clearing house, so its price and cash flows follow contract specifications. An OTC instrument is negotiated, so amount, date, and terms fit the client but carry counterparty exposure. A swap settles periodically rather than at one date. Exams test whether you can match these features to a described situation, so practise stating all four attributes aloud for every position you draw.
- Obligation first: who must act if the underlying moves against them?
- Direction second: is the position long or short the underlying?
- Timing third: one settlement date or a stream of dates?
- Venue last: exchange standardisation or OTC customisation?
| Instrument | Who is bound | Payoff shape at expiry | Settlement pattern | Typical use in questions |
|---|---|---|---|---|
| Forward | Both parties | Linear, unlimited both ways | Single date, negotiated terms | Locking a price for a specific future need |
| Futures | Both parties | Linear, unlimited both ways | Standardised contract; margin account marked periodically | Exchange-traded hedging with interim cash flows |
| Call option (long) | Writer only | Kinked; loss capped at premium | Premium paid upfront; exercise decision at or before expiry | Insuring against a price rise |
| Interest rate swap | Both parties | No single payoff diagram; net periodic payments | Notional never exchanged; net settled each period | Converting floating-rate debt to fixed or the reverse |
Forwards and Futures: Identical Payoff, Different Cash Flow
Forwards and futures produce the same terminal payoff but differ in standardisation, counterparty arrangement, and margin timing. In hedging scenarios, the binding difference is interim cash flow: futures can demand cash mid-life even when the hedge is working.
A forward is a private agreement: customised quantity, customised date, settled once at maturity between the two named parties. A futures contract trades on an exchange with standardised size, dates, and quality, and its gains and losses flow through a margin account as the price moves, not only at the end. The terminal economics can be nearly identical, which is exactly why the two instruments are easy to blur. Test yourself by describing, period by period, when money actually changes hands under each.
Worked scenario: an importer must pay USD 100,000 in three months; spot is LKR 295 per USD and a three-month forward is quoted at 300. The forward locks a cost of LKR 30,000,000. Suppose the treasurer instead buys futures near the same rate, and the USD weakens to 292 in month one. The hedge is on track, yet the long futures position shows a mark-to-market loss that day and triggers a margin top-up. Plausible mistake: assuming terminal equivalence means no interim funding need. Better decision: match the instrument to liquidity; choose the forward when the exact amount and date are known and cash is tight. Why it matters: an unhedged margin call can force the hedge to be closed early, destroying the protection.
- Forward: customised, single settlement, counterparty risk, no margin account
- Futures: standardised, margined, cleared, cash flows arrive during the contract's life
Option Payoffs: Why the Kink Breaks Linear Habits
A long option's loss is capped at the premium while its upside stays open; a short option earns the premium but carries an uncapped obligation. Breakeven sits at the strike adjusted by the premium, in the direction of the position.
Draw the long call first: below the strike the payoff line is flat at minus the premium; above the strike it rises one-for-one with the underlying. The kink at the strike is the option's defining feature, and every option diagram you draw should show it. A long put mirrors this: flat upside at minus the premium, rising as the underlying falls below the strike. Because the forward's line never kinks, mixing the two families on one axis is a reliable way to see which instrument you are actually holding.
Now apply the asymmetry to a combination. You hold a share at 100 and write a 105 call for a premium of 3. If the share stays at or below 105, you keep the 3; if it rises to 112, you must deliver at 105, earning 5 plus the premium, and no more. Plausible mistake: describing a covered call as a protected position because a premium was collected. The downside is still the full fall in the share, softened only by the 3. The better habit is to name the short call's obligation explicitly: you may be forced to sell at 105 regardless of the market price. Writing the obligation in words before the numbers prevents capping errors on both ends of the diagram.
- Long call: loss capped at premium; profit grows with S above strike
- Long put: loss capped at premium; profit grows as S falls below strike
- Short options: premium is the maximum gain; obligations are potentially large
- Breakevens: call at strike plus premium; put at strike minus premium
Swaps: A Strip of Forward Obligations, Not a Single Bet
An interest rate swap exchanges fixed-rate for floating-rate payments on a notional that never changes hands. Treat each period as a forward-style obligation and remember only the net difference is settled each period.
The cleanest mental model is a strip of forward obligations: on each settlement date, one party owes an amount computed from the fixed rate and the other owes an amount computed from the floating reference rate, and only the difference moves. The notional principal exists purely to size the payments. This model explains why a swap has no single payoff diagram like an option or forward: it has one small payoff per period, each depending on where the floating rate sets relative to the fixed rate.
Value a toy swap to make the mechanics stick. On a notional of 10,000,000 with a fixed rate of 10% against a floating reference, the fixed payer owes 1,000,000 per year regardless of anything else. If the reference sets at 8%, the fixed payer pays the net 200,000; if it sets at 11.5%, the fixed payer receives 150,000. Practise computing two periods with different reference settings until the direction of the net payment is automatic. Then note what moves a swap's value between resets: expectations of future floating rates. A swap agreed when rates were low gains value for the fixed receiver if expected rates rise, which is the same logic you will need in the hedging scenario below.
- Notional is a sizing convention; it is never exchanged
- Each period nets to one payment in one direction
- Swap value between resets moves with expected future floating rates
Hedging Scenarios: Getting the Direction of the Obligation Right
Match the exposure to the derivative's direction: the party who will buy later goes long or buys a call; the party who will sell later goes short or buys a put; a floating-rate borrower who fears rising rates pays fixed in a swap.
Worked scenario: a company pays benchmark plus 2% on a floating-rate loan and expects rates to rise. Plausible mistake: entering a receive-fixed, pay-floating swap, reasoning that receiving fixed sounds like receiving security. In fact the company already pays floating, so adding a floating-receiving leg cancels nothing; the net borrowing cost keeps floating. Better decision: pay fixed and receive floating. The floating received offsets the loan's floating cost, leaving an effective rate of roughly the fixed rate plus the 2% margin. Why it matters: the swap direction converts the exposure or doubles it, and the payment legs, not the labels, decide which.
The same directional logic separates option hedges from forward or futures hedges. A protective put suits wording about insuring a holding: premium paid, downside covered, upside retained. A short futures or forward position suits wording about locking a sale price: no premium, but a firm obligation both ways. When you read a scenario, underline whether the decision-maker needs certainty (obligation instruments) or protection with flexibility (options), then check that the derivative's obligation points toward the exposure rather than away from it. Practise stating the exposure in one sentence, the instrument's obligation in one sentence, and only then confirm they neutralise each other.
- Will buy the underlying later: go long, or buy a call for insured exposure
- Will sell the underlying later: go short, or buy a put for insured exposure
- Floating-rate borrower fearing rises: pay fixed, receive floating
- Direction check: the derivative's obligation must offset, not replicate, the exposure
Regulation and Ethics: The Sri Lankan Framework
In Sri Lanka, securities regulation rests with the Securities and Exchange Commission, whose current statutory basis is the SEC Act No. 19 of 2021, which replaced the 1987 Act. Study regulation as duties attached to roles and market conduct.
The SEC was first established under the Securities and Exchange Commission Act No. 36 of 1987, amended in 1991 and 2003, and that Act has been repealed and replaced by the Securities and Exchange Commission Act No. 19 of 2021. For this topic, anchor your reading to that sequence, because the 2021 Act is the reference point a Sri Lankan derivatives credential sits within. Frame your study around the regulator's published functions: oversight of market intermediaries, investor protection and education, and enforcement actions, all of which appear on the SEC's website.
Connect the regulatory layer to the instruments you have learned. Derivatives concentrate leverage and defer outcomes, so the ethical questions attach naturally to suitability, disclosure of instrument risk, and honest representation of positions to clients and the market. When reviewing this topic, link each duty to a role: what is owed by an adviser recommending a hedge, by an intermediary handling client collateral, and by any participant whose conduct could mislead the market. One practical note: administrative specifics such as current registration procedures change, so treat the SEC website at sec.gov.lk as the authority for those details rather than memorising them.
- Statutory anchor: SEC Act No. 19 of 2021, replacing the 1987 Act and its amendments
- Core functions to study: intermediary oversight, investor protection, enforcement
- Ethics lens: suitability, risk disclosure, and honest market conduct for leveraged products
Exercise, Sequence, and Readiness Checks
Draw one payoff diagram per instrument on the same underlying, then reclassify every position from memory. Work the six topic areas in order across six weeks. Readiness means fast, accurate classification plus clean payoff mechanics, not memorised formulas.
Exercise: take one underlying priced at 100 and draw expiry payoffs for four positions: a long forward at 100; a long 100 call bought for 5; a short 100 put written for 5; and a pay-fixed swap on a 10,000,000 notional at 10% against a floating reference. Expected observations: the forward's line passes through zero at 100 with no cap either way; the call's loss stops at 5 with breakeven at 105; the short put's profit stops at 5 with breakeven at 95 but its loss grows without limit as the price falls; the swap has no single diagram, only net payments per period. Score each drawing against the rubric below before checking any notes.
Adaptable sequence: spend week one on instrument classification and market structure; week two on forwards and futures including margin mechanics; week three on option payoffs and combinations; week four on swaps and period-by-period valuation; week five on risk-management scenarios in both directions; week six on regulation and ethics in the Sri Lankan framework plus a full mixed review. Compress or stretch each week to fit your syllabus weighting, but keep the order, because each topic reuses the classification habits of the one before it. End every session by re-deriving, without notes, the obligation line for each position you drew that day.
- Rubric per diagram: kink placed correctly at the strike; breakeven labelled; maximum loss and profit marked; obligation stated in words
- Forward diagram: straight line through 100, uncapped both directions
- Call diagram: floor at minus 5, breakeven 105
- Short put diagram: ceiling at 5, breakeven 95, uncapped downside
- Swap: two periods computed with different reference rates, net direction stated
- Readiness checks: classify any described position in under 30 seconds; draw a correct payoff with breakeven in under two minutes; state each swap counterparty's obligation per period; explain the SEC's role and the 2021 Act's place in the statutory sequence
A Six-Week Sequence and Readiness Rubric
Follow the topic order of the syllabus, one payoff diagram per instrument per week, and close each week with a no-notes reclassification drill. Treat rubric scores as learning milestones, not predictions of any result.
Adjust the six-week plan to your actual syllabus weighting rather than following it rigidly: if your syllabus gives options the largest share, extend week three and shorten week one, keeping the build from classification to payoffs to hedging to regulation. Use free practice sets alongside the sequence and log every item you missed by its classification attribute: obligation, direction, timing, or venue. The attribute with the most misses is the next session's first fifteen minutes. This turns the plan into a feedback loop keyed to the concepts this exam sits on.
Recheck readiness with the rubric, not a feeling. You are ready to move past a topic when you can classify unseen positions quickly, produce correct payoff diagrams with labelled breakevens, state swap payment directions per period, and explain the regulatory framework without mixing in details from other markets' rulebooks. Keep self-check scores as personal milestones on the way to the exam; they measure how firmly the concepts are installed, and only the credential issuer's official materials define the actual assessment. When all rubric lines hold across a full mixed review week, your preparation is conceptually complete.
- Log every missed item by attribute: obligation, direction, timing, or venue
- Revisit the weakest attribute at the start of the next session
- Extend weeks to match your syllabus's topic weighting
- Final week: full mixed review, all rubric lines green, regulation framework recited from memory
References and further reading
Use these references to explore the concepts and check the latest information from the relevant organizations.