Prepare for CDSA-2 by building one decision map that connects the six syllabus areas instead of revising them as isolated chapters. Derivative advice in practice is a traversal: name the instrument, select the pricing relation it depends on, decide whether the strategy is a hedge, speculation or arbitrage given the client's existing exposure, and confirm the advice stays inside Sri Lanka's securities regulatory framework. Rehearse that traversal with paper scenarios until it is automatic, and use the self-check rubric in the final section to measure whether you can complete it unaided.
One map for six syllabus areas: instrument, price, strategy, rule
The six syllabus areas form a single chain: identify the derivative instrument, apply its pricing relation, match a strategy to the client's exposure, and check the regulatory constraint. Study them as one decision sequence rather than six separate topics.
Revising each topic separately leaves a gap exactly where the concepts interlock. Applied derivative advice requires moving from classification to valuation to strategy without prompts: given an instrument and a client goal, you must connect them yourself. For example, recognising a swap as a strip of forward exchanges is what lets you reuse forward-pricing tools for swap valuation — a link invisible if 'instruments' and 'pricing' live in different mental folders.
Draw the map physically: list forwards, futures, options and swaps across the top; below each, write its pricing relation (cost of carry for forwards and futures, payoff asymmetry and delta for options, discounted forward legs for swaps); then a strategy grid for hedging, speculation and arbitrage; finally a regulatory overlay row for Sri Lankan rules. Rebuild this map from blank paper once a week until nothing is missing.
Forwards, futures, options and swaps: classification decisions that drive everything else
Forwards are custom agreements settled at maturity, futures are exchange-standardised, options grant rights without obligations, and swaps package multiple future exchanges. Classify first, because payoff logic and the correct pricing relation both follow from the classification.
The distinctions that change answers are obligation versus right, standardisation versus customisation, and who carries counterparty risk. A forward and a future on the same underlying can share a cost-of-carry logic, but the future's daily settlement and standardised terms alter how gains, losses and margin are handled. An option buyer pays a premium for the right, not the duty, to transact — so an option's worst case is the premium, while a forward's losses are open-ended.
Train the classification by drawing the four payoff diagrams from memory: long and short forward, long call, long put. Then connect them: a long call plus a short put at the same strike reproduces a long forward payoff — the relationship formalised in put-call parity. If you can reconstruct these diagrams and the parity identity without notes, classification and combination practice becomes an exercise in matching the diagram to the scenario rather than searching memory.
| Instrument | Obligation at expiry | Core pricing relation | Typical scenario use |
|---|---|---|---|
| Forward | Both parties must settle at the agreed rate | Cost of carry / covered interest parity | Locking a future exchange rate for a known cash flow |
| Future | Both parties settle via the exchange mechanism | Cost of carry, adjusted for daily settlement | Standardised directional exposure on an exchange |
| Call option | Buyer chooses; seller must perform if exercised | Value = intrinsic + time value; parity with puts | Insuring downside or gaining leveraged upside |
| Swap | Both parties exchange scheduled cash flows | Sum of the underlying forward legs, discounted | Converting floating obligations to fixed, or vice versa |
Forward price versus forward value: the valuation pair tested together
The forward price is the rate fixed at inception that makes the contract worth zero; the value at a later date is the discounted difference between the current and original forward prices. Confusing the two breaks every mid-life valuation question.
At inception, no cash changes hands and the contract value is zero — the forward price is chosen to make it so. The price comes from cost of carry: for a currency forward, the spot rate grossed up by the domestic rate and down by the foreign rate over the contract term. Value during the life of the contract is what the long position would receive by closing out now, discounted back to today. The difficulty is built into the concepts themselves: price and value use the same inputs — a spot rate, two interest rates and a date — but answer different questions, so the discipline of reading which one a problem requests is a core competency to train deliberately.
Worked scenario (hypothetical figures): a Sri Lankan exporter expects USD 100,000 in six months. Spot is LKR 300 per USD, the LKR rate is 10% annually, the USD rate 3%. The covered-parity six-month forward is 300 x sqrt(1.10/1.03) = 300 x 1.0334, about LKR 310. Plausible mistake: the advisor tells the client to 'hedge at spot, 300, since hedging is free' — an error of roughly 3% of the receivable and, if quoted as an actual forward rate, an arbitrage opportunity against the dealer. Better decision: budget at the parity forward near 310 and explain that the contract's initial value is zero even though its price is not spot. Why it matters: the budget rate drives the client's pricing and margin planning, so a spot-versus-forward confusion flows straight into business decisions.
Option value decomposition and delta: keeping intrinsic value, time value and direction straight
An option's value splits into intrinsic value and time value, and its delta measures how the option price moves with the underlying. The sign of delta decides whether the option offsets a client's exposure or reinforces it.
Intrinsic value is what the option would be worth if exercised immediately; time value is the remainder and it erodes toward expiry. Delta links the two sides of the syllabus: it is the option's sensitivity to the underlying, so it tells you the hedge ratio. A put has negative delta, a call positive delta — which is why puts protect a long position and calls protect a short one. Put-call parity, C minus P equals S minus the present value of the strike, doubles as a checking tool: rearrange it to build synthetic forwards and to spot inconsistent option quotes.
Worked scenario (paper exercise): a fund manager holds a long equity portfolio and fears a downturn, but also does not want to miss a rally. Plausible mistake: buying calls 'as protection' — calls add positive delta to a positive-delta portfolio, doubling upside exposure, costing premium, and protecting nothing on the downside. Better decision: buy puts as a protective put, accepting the premium as an insurance cost, or construct a collar by writing a financed call against the bought put if the client accepts a capped upside. Why it matters: the direction of the hedge delta must oppose the exposure delta; checking that single sign before recommending the trade catches the error.
Hedging, speculation and arbitrage: same instruments, three different tests
Hedging offsets an existing exposure, speculation expresses a directional view, and arbitrage exploits a price inconsistency for approximately riskless profit. Decide which test the scenario applies before selecting any instrument.
Apply three diagnostic questions in order. First, does the client already hold the exposure the derivative cash flow would offset? If yes, you are in hedging territory and the payoff must be opposite in sign. Second, is the client accepting open-ended risk in exchange for a view on direction? That is speculation and should be labelled, sized and disclosed as such, not dressed up as protection. Third, is there a parity violation — for instance, a call-put price gap inconsistent with C minus P equal to S minus the discounted strike? Then a structured long-and-short combination targets the inconsistency itself.
Arbitrage deserves its own drill because it is the only one of the three with a mechanical recipe. If calls are rich relative to puts and the underlying, the parity-based combination is: sell the call, buy the put, buy the underlying, borrow the strike's present value — locking the price gap while the payoffs cancel. Practise by rearranging put-call parity into all four synthetic positions and describing what each combination is guaranteed to deliver. That fluency also sharpens hedging answers, because a hedge is simply a parity-consistent package placed on the opposite side of an existing exposure.
Risk management and regulation: where the SEC Act No. 19 of 2021 fits in your advice
Sri Lankan securities regulation now rests on the Securities and Exchange Commission Act No. 19 of 2021, which repealed and replaced the Act of 1987. An advisor's recommendations must sit inside the licensed-intermediary and investor-protection framework that Act establishes.
For the regulatory syllabus area, anchor on the structure rather than memorising section numbers you have not verified: the SEC of Sri Lanka is the regulator, the current governing statute is Act No. 19 of 2021, and the Commission licenses and supervises market intermediaries, publishes investor alerts and enforcement actions, and operates a registered investment adviser regime. When a scenario asks whether an advisory activity is permissible, the reasoning pattern is: identify the activity, identify whether it falls within a licensed or registered category, and check whether disclosure and client-protection duties are met.
Connect this overlay to the strategy chapters rather than treating it as a separate topic. A hedging recommendation is incomplete until you can state who may lawfully provide that advice and to whom; a speculative trade recommended to a client raises suitability and disclosure questions that a hedge may not; and an arbitrage described to a client must reflect what the regulated intermediary can actually execute. Treat the regulatory check as the last step of your decision map, applied to every scenario you practise. For current directives and administrative details, consult the SEC directly.
Sri Lankan applications: a classification exercise, self-check rubric and study sequence
Ground the syllabus in the Sri Lankan market by drilling paper scenarios against the SEC's licensed-intermediary framework, then follow a sequence that cycles classification, pricing, strategy and regulation weekly until the map is automatic.
The practical exercise: write six short client scenarios of your own — an exporter with a future foreign-currency receipt, a fund with a long equity book, a borrower with floating-rate obligations, a trader with a view that a call is overpriced, an importer with a future payment, a client asking to double exposure before results season. For each, record four lines: the instrument you would use, the pricing relation it depends on, whether the strategy is hedge, speculation or arbitrage, and the regulatory question raised. Run this drill weekly and swap scenarios with a study partner so the answers are not memorised.
Self-check rubric — award yourself a point per scenario for each of: (1) exposure direction stated before the instrument is named; (2) the correct pricing relation identified, distinguishing price from value where relevant; (3) the strategy label justified with the offset-versus-view-versus-parity test; (4) at least one Sri Lankan regulatory or suitability question flagged. A suggested learning milestone is full marks across all six scenarios twice in a row before you treat the decision map as secure — this measures map fluency, not exam performance. Adaptable sequence: weeks one to two, instruments and payoff diagrams; week three, forward pricing and parity with numeric drills; week four, options, delta and hedge direction; week five, swaps as forward strips; week six, regulation overlay and full scenario runs; final stretch, timed map rebuilds and the rubric above. Concrete readiness checks: reproduce the instrument table from memory, solve a fresh price-versus-value forward question in one pass, explain why a call cannot hedge a long book, and state the current Sri Lankan securities statute without notes.
- Weekly scenario drill: six self-written client cases, four decision lines each, scored against the rubric
- Rubric milestones: exposure direction, pricing relation, strategy test, regulatory flag — one point each per scenario
- Map rebuild test: redraw the instrument-pricing-strategy-regulation map on blank paper weekly
- Readiness signal: two consecutive full-mark drill runs indicate map fluency, not a pass prediction
References and further reading
Use these references to explore the concepts and check the latest information from the relevant organizations.