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HALL
F T Prenticc Hall
A Complimentary Copy
from
SOLUTIONS MANUAL
AND STUDY GUIDE
Fundamentals of Futures
and Options Markets
Sixth Edition
John C.Hull
Maple Financial Group Professor of
Derivatives and Risk Management
Joseph L. Rotman School of Management
University of Toronto
Prentice Hall, Upper Saddle River, NJ 07458
Project Manager, Editorial: Mary Kate 红
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ISBN13: 当
ISBN lO: 0132425742
Contents
Preface V
Chapter 1 Introduction 1
Chapter 2 Mechanics of Futures Markets 7
Chapter 3 Hedging Strategies Using Futures 13
Chapter 4 Interest Rates 19
Chapter 5 Determination of Forward and Futures Prices 26
Chapter 6 Interest Rate Futures 34
Chapter 7 Swaps 41
Chapter 8 Mechanics of Options Markets 49
Chapter 9 Properties of Stock Options 56
Chapter 10 ￥ Strategies Involving Options 63
Chapter 11 Introduction to Binomial Trees 69
Chapter 12 Valuing Stock Options: The BlackScholes Model 77
Chapter 13 Options on Stock Indices and Currencies 87
Chapter 14 Futures Options 93
Chapter 15 The Greek Letters 100
Chapter 16 Binomial Trees in Practice 112
Chapter 17 Volatility Smiles 121
Chapter 18 Value at Risk 128
Chapter 19 Interest Rate Options 135
Chapter 20 Exotic Options and Other Nonstandard Products 140
Chapter 21 Credit Derivatives 145
Chapter 22 Weather, Energy, and Insurance Derivatives 151
Chapter 23 如 Mishaps and What We Can Learn from Them 153
III
Preface
This book contains solutions to the questions and problems that appear at the ends
of chapters in my book α α of α Options α ， 6th edition. The
questions and problems have been designed to help readers study on their own and test
their understanding of the material. They 仕 quick checks on whether a key
point is understood to much more challenging applications of analytical techniques. To
maximize the benefits from this book readers are urged to sketch out their own solutions
to the problems before consulting mine.
At the beginning of each chapter 1 have included a summary of the main points in the
chapter and suggested ways readers should approach studying the material in the chapter.
You should find this material useful both when 且 cover the material in the chapter
and when you are studying for exams.
1 welcome comments on either α α of α Options α ， 6th
edition or this book. My email address is
悦 utoronto. ca
John C. Hul1
Joseph L. Rotman School of Management
University of Toronto
V
CHAPTER 1
Introduction
This chapter introduces futures, forward, and option contracts and explains the types
of traders that use them. If you already know how futures, forward, and options work
you will not have to spend too much time on this chapter. Note that Chapter 1 does not
distinguish between futures and forward contracts. Both are agreements to buy or sell an
asset at a certain time in the future for a certain price. It is Chapter 2 that covers the
dai1y settlement feature of futures contracts and itemizes the differences between the two
sorts of contracts.
Make sure you understand the key difference between futures (or forwards) and op
tions. Futures and forward contracts are obligations to enter into a transaction in the
future. An option is the right to enter into a transaction in the future. A futures or for
ward contract may prove to be an asset or a liabi1ity (depending on the future price of the
underlying asset). An option contract is a always an asset to the buyer of the option and
a liabi1ity to the seller of the contract. It costs money (the option premium) to purchase
an option. Normally no money (except margin requirements which are discussed in 咿
ter 2) change hands when a futures or forward contract is entered into. Table 1. 1 shows
forward foreign exchange quotes. Table 1. 2 show the prices of options on Intel. Make sure
you understand what the numbers in these tables mean and how the profit diagrams in
Figure 1. 3 are constructed.
The distinction between overthecounter and exchangetraded markets is important.
伽 markets are markets where the contracts are 且 by an exchange such
as the Chicago Board of ￥ How trading is done, how payments fl.ow from one side to
the other, and so on is 昭 by the exchange. The overthecounter (OTC) market
is primari1y a market between financial institutions, non.financial corporations, and fund
managers. They typically communicate and agree on trades by phone. An exchange is
not involved. As Figure 1. 2 indicates, the OTC market is much bigger than the exchange
traded market. The openoutcry system in exchanges is an arrangement where traders
meet on the fl.oor of the exchange and use hand signals to indicate the trades they would
like to do. This is increasingly being replaced by electronic trading where traders sit at
terminals and use a keyboard to indicate the trades they would like to do.
The chapter identifies the three main types of traders tha
1
money before superiors find out what is going on.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 1.8.
Suppose you own 5,000 shares that are worth $25 each. How can put options be used
to provide you with insurance against a dec1ine in the value of your holding over the next
four months?
You should buy 50 put option contracts (each on 100 shares) with a strike price of
$25 and an expiration date in four months. If at the end of four months the stock price
proves to be less than $25, you can exercise the options and sell the shares for $25 each.
Problem 1.9.
A stock when it is fìrst issued provides funds for a company. 1s the same true of an
exchangetraded stock option? Discuss.
An exchangetraded stock option provides no funds for the company. It is a security
sold by one investor to another. The company is not involved. By contrast, a stock when it
is first issued is sold by the company to investors and does provide funds for the company.
Problem 1.10.
Explain why a futures contract can be used for either speculation or hedging.
If an investor has an exposure to the price of an asset, he or she can hedge with
futures contracts. If the investor will gain when the price decreases and 10se when the
price increases, a 10ng futures position will hedge the risk. If the investor will10se when
the price decreases and gain when the price increases, a short futures position will hedge
the risk. Thus either a 10ng or a short futures position can be entered into for hedging
purposes.
If the investor has no exposure to the price of the under1ying asset, entering into a
futures contract is specu1ation. If the investor takes a 10ng position, he or she gains when
the asset 's price increases and 10ses when it decreases. If the investor takes a short position,
he or she loses when the asset's price increases and gains when it decreases.
Problem 1.11.
A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months.
The livecattle futures contract on the Chicago Mercanti1e Exchange is for the delivery
of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the
farmer's viewpoint, what are the pros and cons of hedging?
The farmer can short 3 contracts that have 3 months to maturity. If the price of
cattle falls, the gain on the futures contract will offset the 10ss on the sa1e of the cattle.
If the price of catt1e rises, the gain on the sa1e of the catt1e will be offset by the 10ss on
the futures contract. Using futures contracts to hedge has the advantage that it can at no
cost reduce risk to a1most zero. Its disadvantage is that the farmer no 10nger g a i n s 仕 o m
favorable movements in cattle prices.
2
Problem 1.12.
It is Ju1y 2007. A mining company has just discovered a small deposit of g01d. It wil1
take six months to construct the mine. The g01d wil1 then be extracted on a more or 1ess
continuous basis for one year. Futures contracts on gold are avai1ab1e on the New York
Commodity Exchange. There are delivery months every two 丘 。 A ugust 2007 to
December 2008. Each contract is for the delivery of 100 ounces. Discuss how the mining
company might use futures markets for hedging.
The mining company can estimate its production on a month by month basis. It can
then short futures contracts to lock in the price received for the gold. For example, if a
total of 3,000 ounces are expected to be produced in 8eptember 2007 and October 2007,
the price received for this production can be hedged by shorting a total of 30 October 2007
contracts.
Problem 1.13.
Suppose that a March call option on a stock with a strike price of $50 costs $2.50 and
is held until March. Under what circumstances wil1 the h01der of the option make a gain?
Under what circumstances wil1 the option be exercised? Drawa diagram showing how the
profìt on a 10ng position in the option depends on the stock price at the maturity of the
option.
The holder of the option will gain if the price of the stock is above $52.50 in March.
(This ignores the time value of money.) The option will be exercised if the price of the
stock is above $50.00 in March. The profit as a function of the stock price is shown in
Figure 81.1.
8
亏 咱 』 L 国
4
2
O
岛
45
4
Figure 8 1.1 自 from long position in Problem 1. 13
3
Problem 1.14.
Suppose that a June put option on a stock with a strike price of $60 costs $4 and
is held unti1 June. Under what circumstances wil1 the holder of the option make a gain?
Under what circumstances wil1 the option be exercised? Drawa diagram showing how the
profit on a short position in the option depends on the stock price at the maturity of the
option.
The seller of the option willlose if the price of the stock is below $56.00 in June. (This
ignores the time value of money.) The option will be exercised if the price of the stock is
below $60.00 in June. The 自 as a function of the stock price is shown in Figure 81.2.
6
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oJ
/ 后 阳
在 中 仍
ω 臼 70
4
6
8
Figure 81.2 Profit from short position In Problem 1. 14
Problem 1.15.
It is May and a trader writes a September call option with a strike price of $20. The
stock price is $18, and the option price is $2. Describe the investor's cash Bows if the
option is held until September and the stock price is $25 at this time.
The trader has an inflow of $2 in May and an outflow of $5 in 8eptember. The $2 is the
cash received from the sale of the option. The $5 is the result of the option being exercised.
The investor has to buy the stock for $25 in 8eptember and sell it to the purchaser of the
option for $20.
4
Problem 1. 16.
An investor writes a December put option with a strike price of $30. The price of the
option is $4. Under what circumstances does the investor make a gain?
The investor makes a gain if the price of the stock is above $26 at the time of exercise.
(This ignores the time value of money.)
Problem 1.17.
The Chicago Board of Trade offers a futures contract on longterm Treasury bonds.
Characterize the investors 1ikely to use this contract.
Most investors will use the contract because they want to do one of the following:
(a) Hedge an exposure to longterm interest rates.
(b) Speculate on the future direction of longterm interest rates.
(c) Arbitrage between the spot and futures markets for Treasury bonds
Problem 1.18.
An airline executive has argued: "There is no point in our using oil futures. There is
just as much chance that the price of oil in the future wil1 be less than the futures price
as there is that it wil1 be greater than this price." Discuss the executive's viewpoint.
It may well be true that there is just as much chance that the price of oil in the future
will be above the futures price as that it will be below the futures price. This means
that the use of a futures contract for speculation would be like betting on whether a coin
comes up heads or tails. But it might make sense for the airline to use futures for hedging
rather than speculation. The futures contract then has the effect of reducing risks. It can
be argued that an air1ine should not expose its shareholders to risks associated with the
future price of oil when there are contracts available to hedge the risks.
Problem 1.19.
"Options and futures are zerosum games." What do you think is meant by this
statement?
The statement means that the gain (loss) to the party with the short position is equal
to the loss (gain) to the party with the 吨 In total, the gain to all parties is
zero.
Problem 1.20.
A trader enters into a short forward contract on 100 mil1ion yen. The 再 exchange
rate is $0.0080 per yen. How much does the trader gain or lose if the exchange rate at the
end of the contract is (a) $0.0074 per yen; (b) $0.0091 per yen?
(a) The trader sells 100 million yen for $0.0080 per yen when the exchange rate is $0.0074
per yen. The gain is 100 x 0.0006 millions of dollars or $60,000.
(b) The trader sells 100 million yen for $0.0080 per yen when the exchange rate is $0.0091
per 丑 The loss is 100 x 0.0011 millions of dollars or $110,000.
5
Problem 1.21.
A trader enters into a short cotton futures contract when the futures price is 50 cents
per pound. The contract is for the delivery of 50,000 pounds. How much does the trader
gain or lose if the cotton price at the end of the contract 但 48.20 cents per pound; (b)
51.30 cents per pound?
(a) The trader sells for 50 cents per pound 吨 is worth 48.20 cents 凹
Gain = 一 x 50,000 = $900.
(b) 仕 sells 如 50 臼 盹
Loss = 仰 一 ∞ ∞ 创 x ， ∞ ∞
Problem 1.22.
A company knows that it is due to receive a certain amount of a foreign currency in
four months. What type of option contract is appropriate for hedging?
A long position in a four.month put option can provide insurance against the exchange
rate falling below the strike price. It ensures that the foreign currency can be sold for at
least the strike price.
Problem 1.23.
A United States companyexpects to have to pay 1 mil1ion Canadian dollars in six
months. Explain how the exchange rate risk can be hedged using (a) a forward contract;
(b) an option.
The company could enter into a long forward contract to buy 1 million Canadian
dollars in six months. This would have the effect of locking in an exchange rate equal to the
current forward exchange rate. Alternatively the company could buy a call option giving
it the right (but not the obligation) to purchase 1 million Canadian dollar at a certain
exchange rate in six months. This would provide insurance against a strong Canadian
dollar in six months while still allowing the company to 仕 a weak Canadian
dollar at that time.
6
CHAPTER 2
Mechanics of Futures Markets
This chapter covers the details of how futures markets work. Three key things you
should understand are a) how futures contracts are entered into and closed out, b) how
the daily sett1ement procedures work, and c) the operation of margin accounts.
A long futures contract is an agreement to buy a certain amount of the underlying asset
during a future month; a short futures contract is an agreement to sell a certain amount of
the underlying asset during a future month. You can enter into a futures contract (long or
short) by issuing appropriate instructions to your broker. Let's use the hogslean futures
contracts in Table 2.2 as an example. Each contract is on 40,000 pounds of hogs. Suppose
you short (i.e. , sell) one April contract on January 8, 2007. (The High and Low columns in
Table 2.2 indicate that the futures price at the time of your transaction is between 63.750
and 64.725 丑 per pound.) Your broker wi1l ask you to prove that you are capable of
honoring your commitments by making a deposit. This deposit is known as the initial
margin and minimum initial margin levels per contract are 且 by the exchange. The
broker uses the initial margin deposit to open a margin account for you.
The settlement price on the contract (fifth column in Table 2.2) determines the daily
sett1ement process (known as marking to market the contract). The sett1ement price for a
day is the price at which the contract trades at the close of trading on that day. It is 63.950
for the contract we are considering on January 8, 2007. If the settlement price on April
hogs increases by 2 cents per pound from one day to the next you lose 0.02 x 40, 000 = $800
仕 your margin account. (Because you have a short position, futures price increases cost
you money). Similarly, if the settlement price on April hogs decreases by 2 cents per pound
仕 one day to the next $800 would be added to your margin account. A maintenance
margin (usually about 75% of the initial margin) is 且 If the balance in the margin
account falls below the maintenance margin level you get a margin call from your broker
requiring you to bring the balance in your margin account up to the initial margin level. If
you do not provide the necessary funds within 24 hours your position is closed out. Study
the gold futures example in Table 2.1 and make sure you understand all the entries in the
table.
When you instruct your broker to close out your futures position (or when the broker
closes
7
delivery. It is the possibility of final delivery that ties the futures price to the spot price.
When delivery takes place it is the party with the short futures position that initiates
delivery. The party with the short position may have some choices to make on exactly
what is delivered, where it is delivered, and when it is delivered. Some contracts such
as futures on stock indices are settled 丑 rather than by physical delivery. In these
circumstances a single delivery date is specified for the contract. The contract is marked
to market until this delivery date. On the delivery date there is a final daily settlement,
based on the spot value of the underlying asset, and all contracts are declared closed out.
One of the attractions of futures contracts for speculators is that they have built in
leverage. The amount of cash you have to provide to do a trade (the initial margin) is a
relatively small percentage of the value of asset being traded (perhaps only 10%).
When you trade stocks there are many different types of orders that can be placed
with a broker: market orders, limit orders, stop orders, stoploss orders, and so on. As
Section 2.7 indicates, the same types of orders can be placed in futures markets. The
accounting and tax treatment of futures and other derivatives is complicated, but Section
2.9 provides an overview of the issues that are important in many jurisdictions. Normal
accrual accounting leads to the profit or loss on a futures transaction being recognized
throughout the life of the contract for both accounting and tax purposes. However, if a
trader can show that a contract is entered into for hedging purposes, then the profit or
loss on the contract is recognized when the contract is closed out. (See Example 2. 1.) The
idea here is that for a hedger the cash 仕 the futures contract should be matched
with the cash f:l. ows from the underlying asset being hedged.
You should by now be fully comfortable with the differences between futures and
forward contracts. These are summarized in Table 2.3. Both futures and forwards are
agreements to buy or sell an asset at a future time for a future price. Futures contracts are
traded on an exchange; forward contracts are traded overthe counter. Futures contracts
have standard terms defined by the exchange for the size of the contract, delivery dates,
etc; forward contracts are not standardized. Delivery in a futures contract can often take
place on a num
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 2.8.
The party with a short position in a futures contract sometimes has options as to the
precise asset that wil1 be delivered, where delivery wil1 take place, when delivery wil1 take
place, and so on. Do these options increase or decrease the futures price? Explain your
reasonlllg.
These options make the contract less attractive to the party with the long position
8
and more attractive to the party with the short position. They therefore tend to reduce
the futures price.
Problem 2.9.
Wbat are tbe most important aspects of tbe design of a new futures contract?
The most important aspects of the design of a new futures contract are the specifica
tion of the underlying asset , the size of the contract , the delivery arrangements, and the
delivery months.
Problem 2.10.
Explain bow margins protect investors against tbe possibility of default.
A margin is a sum of money deposited by an investor with his or her broker. It acts
as a guarantee that the investor can cover any losses on the futures contract. The balance
in the margin account is adjusted daily to refl.ect gains and losses on the futures contract.
If losses are above a certain level, the investor is required to deposit a further margin.
This system makes it unlikely that the investor will default. A similar system of margins
makes it unlikely that the investor's broker wi11 default on the contract it has with the
clearinghouse member and unlikely that the clearinghouse member will default with the
clearinghouse.
Problem 2.11.
An investor enters into two long July futures contracts on 丘 。 orange juice. Eacb
contract is for tbe delivery of 15,000 pounds. 1'be current futures price is 160 cents per
pound, tbe initial margin is $6,000 per contract, and tbe maintenance margin is $4,500
per contract. Wbat price cbange would lead to a margin call? Under wbat circumstances
could $2,000 be 企 tbe margin account?
There is a margin call if $1,500 is lost on one contract. This happens if the futures
price of frozen orange juice falls by 10 cents to 150 cents per lb. $2,000 can be withdrawn
from the margin account if there is a gain on one contract of $1,000. This will happen if
the futures price rises by 6.67 cents to 166.67 cents per lb.
Problem2.12.
Show tbat if tbe futures price of a commodity is greater tban tbe spot price during
the delivery period tbere is an arbitrage opportunity. Does an arbitrage opportunity exist
if tbe futures price is less tban tbe spot price? Explain your answer.
If the futures price is greater than the spot price during the de1ivery period, an ar
bitrageur buys the asset , shorts a futures contract, and makes delivery for an immediate
profit. If the futures price is less than the spot price during the delivery period, there
is no similar perfect arbitrage strategy. An arbitrageur can take a long futures position
but cannot force immediate delivery of the asset. The decision on when delivery will be
made is made by the party with the short position. Nevertheless companies interested 丑
acquiring the asset will find it attractive to enter into a long futures contract and wait for
delivery to be made.
9
Problem 2.13.
Exp1ain the difference between a marketiftouched order and a stop order.
A ι order is executed at the best available price after a trade occurs
at a 且 price or at a price more favorable than the specified price. A stop order is
executed at the best available price after there is a bid or offer at the specified price or at
a price less favorable than the 且 price.
Problem 2.14.
Exp1ain what a stop1imit order to sell at 20.30 with a limit of 20.10 means.
A stoplimit order to sell at 20.30 with a limit of 20.10 means that as soon as there is
a bid at 20.30 the contract should be sold providing this can be done at 20.10 or a higher
pnce.
Problem 2.15.
At the end of one daya c1earinghouse member is 10ng 100 contracts, and the sett1ement
price is $50,000 per contract. The origina1 margin is $2,000 per contract. On the following
day the member becomes responsib1e for c1earing an additiona1 20 10ng contracts, entered
into at a price of $51,000 per contract. The sett1ement price at the end of this day is
$50,200. How much does the member have to add to its margin account with the exchange
c1earinghouse?
The clearinghouse member is required to provide 20 x $2,000 = $40,000 as initial
margin for the new contracts. There is a gain of ， 一 切 ， x 100 = $20,000 on the
existing contracts. There is also a loss of (51,000  50, 200) x 20 = $16,000 on the new
contracts. The member must therefore add
40,000  ， 十 ， = $36,000
to the margin account.
Problem 2.16.
On Ju1y 1, 2007, a U.8. company enters into a forward contract to buy 10 mi11ion
British pounds on January 1, 2008. On 8eptember 1, 2007, it enters ω forward contract
to sell 10 million British pounds on January 1, 2008. Describe θ or 10ss the
company wi11 make in dollars as a function of the forward exchange rates on July 1, 2007
and 8eptember 1, 2007.
Suppose F
1
and F
2
are the forward exchange rates for the contracts entered into July
1, 2007 and September 1, 2007, and 8 is the spot rate on January 1, 2008. (All exchange
rates are measured as dollars 町 The 仕 the first contract is 10(8  F
1
)
million dollars and the 丘 the second contract is 10(F
2
 8) million dollars. The
total payoff is therefore 10(8  F
1
) + 几 8) = 10(F
2
 F
1
) million dollars.
10
Problem 2.17.
The forward price on the 企 for delivery in 45 days is quoted as 1.2500. The
futures price for a contract that wil1 be delivered in 45 days is 0.7980. Explain these two
quotes. Which is more favorable for an investor wanting to sell 企
The 1.2500 forward quote is the number of 仕 per dollar. The 0.7980 futures
quote is the number of dollars per 仕 When quoted in the same way as the futures
price the forward price is 1/1.2500 = 0.8000. The 仕 is therefore more valuable
in the forward market than in the futures market. The forward market is therefore more
attractive for an investor wanting to sell 仕
Problem 2.18.
Suppose you call your broker and issue instructions to sell one July hogs contract.
Describe what happens.
Hog futures are traded on the Chicago Mercantile Exchange. (See Table 2.2). The
broker will request some initial margin. The order will be relayed by telephone to your
broker's 鸣 。 川 fl.oor of the exchange (or to the 鸣 of another broker).
It will be 丑 by messenger to a commission broker who will execute the trade ac
cording to your instructions. Confirmation of the trade eventually reaches you. If there are
adverse movements in the futures price your broker may contact you to request additional
margm.
Problem 2.19.
"Speculation in futures markets is pure gamb1ing. It is not in the public interest to
allow speculators to trade on a futures exchange." Discuss this viewpoint.
Speculators are important market participants because they add liquidity to the mar
ket. However, contracts must be useful for hedging as well as speculation. This is because
regulators generally only approve contracts when they are likely to be of interest to hedgers
as well as speculators.
Problem 2.20.
Identify the two commodities whose futures contracts have the highest open interest
in Table 2.2.
Looking at open interest for the two contracts with the shortest maturity, corn is the
most actively traded and crude oil is second.
Problem 2.21.
What do you think would happen íf an exchange started trading a contract in which
the qua1ity of the underlying asset was incompletely specified?
The contract would not be a success. Parties with short positions would hold their
contracts until delivery and then 出 cheapest form of the asset. This might well be
viewed by the party with the long position as garbage! Once news of the quality problem
became widely known no one would be prepared to buy the contract. This shows that
11
futures contracts are feasible only when there are rigorous standards within an industry
for defining the quality of the asset. Many futures contracts have in practice failed because
of the problem of defining quality.
Problem 2.22.
"When a futures contract is traded on the Boor of the exchange, it may be the c 挝 e
that the open interest increases by one, stays the same, or decreases by one." Explain this
statement.
If both sides of the transaction are entering into a new contract, the open interest
increases by one. If both sides of the transaction are closing out existing positions, the
open interest decreases by one. If one party is entering into a new contract while the other
party is closing out an existing position, the open interest stays the same.
Problem 2.23.
Suppose that on October 24, 2007, you take a short position in an April 2008 live
cattle futures contract. You c10se out your position on January 21, 2008. The futures price
(per pound) is 91. 20 cents when you enter into the contract, 88.30 cents when you c10se
out your position, and 88.80 cents at the end of December 2007. One contract is for the
delivery of 40,000 pounds of cattle. What is your total profìt? How is it taxed if you are
(a) a hedger and (b) a speculator?
The total p r o 且 t is
40,000 x (0.9120  0.8830) = $1, 160
If you are a hedger this is all taxed in 2008. If you are a speculator
40, 000 x (0.9120  0.8880) = $960
is taxed in 2007 and
40,000 x (0.8880  0.8830) = $200
is taxed in 2008.
12
CHAPTER 3
Hedging Strategies Using Futures
This chapter discusses how futures contracts can be used for hedging. If a company
knows it will buy a certain asset at a certain future time, it can hedge its risk with a 10ng
futures position. The futures position is chosen so that a) if the asset price increases, the
gain on the futures position offsets the extra price that has to be paid for the asset and b)
if the asset price decreases the 10ss on the futures position is offset by the gain resu1ting
from the 10wer price paid for the asset. Similarly, if a company knows it will sell a certain
asset on a certain future date, it can hedge its risk with a short futures position. In this
case the futures position is chosen so that a) if the asset price decreases the gain on the
futures position offsets the 10ss on the amount realized for the asset and b) if the asset
price increases, the 10ss on the futures position is offset by the gain resu1ting from the
higher price realized for the asset.
Hedging is designed to reduce risk. As such it shou1d be attractive to corporations.
The chapter discusses three reasons why corporations in practice often do not hedge. These
reasons are
1. In some instances shareholders prefer companies not to hedge a risk. This might be
because the shareholders want exposure to the risk. (For examp1e, many shareh01ders
buy the stock of particu1ar g01d mining companies because they want an exposure to
the price of g01d. They do not want those companies to hedge their go1d price risk.
See Business Snapshot 3. 1. ) It may a1so because shareholders can diversify away the
risk within their own portfolios.
2. Sometimes a company may appear to have exposure to a particular market variab1e
when a "big picture" view of its risks indicates litt1e or no exposure. (See for example
the gold jewe1ry manufacturer example in Tab1e 3.1 or the farmer in Prob1em 3.17.)
3. Corporate treasurers are liab1e to be criticized if money is lost on the futures position
and gained on the underlying position being hedgedeven though this was part of the
risk reduction strategy. The imaginary dialogue between a treasurer and a president
at the end of Section 3.2 illustrates the problem. Note that we expect to lose money on
about half of the futures contracts we enter into. The purpose of the futures contracts
is to reduce risk not to increase expected profits.
An important concept is b ω i s risk. This arises because a futures contract that is held
for hedging purposes is almost always closed out prior t
13
tl to hedge the sale of an asset at time t2 , the effective price you receive is the futures
price at time tl plus the basis at time t2. Examples illustrating this are Example 3.3 and
Example 3.4. The futures price at time tl is known for certain when you initiate the hedge
at time tl. However, the basis at time t2 is not known. The uncertainty associated with
the price you pay or receive is therefore the uncertainty associated with the basis. Hence
the term basis risk.
The hedge ratio is the ratio of the size of the futures position to the size of the exposure
being hedged. The normal situation is to use a hedge ratio of 1.0. The chapter describes
two situations where a hedge ratio of 1.0 is not appropriate. One is when there is cross
hedging; the other is when stock index futures are used. Cross hedging is not hedging
done in anger! It involves a situation where the asset underlying the futures contract is
different from the asset being hedged. In cross hedging the optimal hedge ratio is given
byequation (3.1).
Stock index futures are often used by portfolio managers. They can be used to hedge a
portfolio so that the manager is out of the market for a period of time. Alternatively they
can be used to change the beta of a portfolio. A short futures position reduces the beta
of the portfolio; a long futures position increases the beta of a portfolio. The number of
contracts that should be traded is the desired change in beta multiplied by the ratio of the
value of the portfolio to the value of the assets underlying one contract. Note that a full
hedge (giving the portfolio manager no exposure to the market) corresponds ω 鸣 丑
the beta of the portfolio to zero. You should study Table 3.4 to make sure you understand
how the capital asset pricing model works and how futures contracts can eliminate market
risk.
且 丑 part of the chapter discusses rolling hedges forward. This is a way of creating
a hedge that lasts a relatively long time from shortdated futures contracts. The way hedges
are rolled forward is as follows. You enter into a shortdated futures contract, close it out
just before the delivery month, immediately replace it with another shortdated futures
contract, close it out just before the delivery month, and so on. (Metallgesellschaft in
Business Snapshot 3.2 illustrates potential problems in rolling a hedge forward.) It is
worth noting that hedges created in this way do not qualify for hedge accounting the
United State
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 3.8.
In the Chicago Board of Trade's corn futures contract, the following delivery months
are available: March, May, July, September, and December. State the contract that should
be used for hedging when the expiration of the hedge is in
a. June
b. July
c. January
A good rule of thumb is to choose a futures contract that has a delivery month as
close as possible to, but later than, the month containing the expiration of the hedge. The
contracts that should be used are therefore
14
(a) July
(b) September
(c) March
Problem 3.9.
Does a perfect hedge always succeed in locking in the current spot price of an asset
for a future transaction? Explain your answer.
No. Consider, for example, the use of a forward contract to hedge a known cash infiow
in a foreign currency. The forward contract locks in the forward exchange rate  which
is in general different from the spot exchange rate.
Problem 3.10.
Explain why a short hedger's position improves when the basis strengthens unexpect
edly and worsens when the basis weakens unexpectedly.
The basis is the amount by which the spot price exceeds the futures price. A short
hedger is long the asset and short futures contracts. The value of his or her position
therefore improves as the basis increases. Similarly it worsens as the basis decreases.
Problem 3.11.
Imagine you are the treasurer of a Japanese company exporting electronic equipment
to the United States. Discuss how you would design a foreign excbange bedgíng strategy
and the arguments you would use to sell the strategy to your fellow executives.
The simple answer to this question is that the treasurer should
1. Estimate the company's future cash fiows in Japanese yen and U.S. dollars
2. Enter into forward and futures contracts to lock in the exchange rate for the U.S.
dollar cash fiows.
However, this is not the whole story. As the gold jewelry example in Table 3.1 shows, the
company should examine whether the magnitudes of the foreign cash fiows depend on the
exchange rate. For example, will the company be able to raise the price of its product in
U.S. dollars if the yen appreciates? If the company can do so, its foreign exchange exposure
may be quite low. The key estimates required are those showing the overall effect on the
company's profitability of changes in the exchange rate at various times in the future.
Once these estimates have been produced the company can choose between using futures
and options to hedge its risk. The results of the analysis should be presented carefully to
other executives. It should be explained that a hedge does not ensure that p r o 直 t s will be
higher. It means that profit will be more certain. When futuresjforwards are used both
the downside and upside are eliminated. With options a premium is paid to eliminate only
the downside.
Problem 3.12.
Suppose that in Example 3.4 the company decides to use a hedge ratio of 0.8. How
does the decision afIect the way in which the hedge is implemented and the result?
15
If the hedge ratio is 0.8, the company takes a long position in 16 NYM December oil
futures contracts on June 8 when the futures price is $68.00. It closes out its position on
November 10. The spot price and futures price at this time are $75.00 and $72. The gain
on the futures position is
(72  68.00) X 16, 000 = 64, 000
The effective cost of the oil is therefore
20,000 X 75  64,000 = 1,436,000
or $71.80 per barrel. (This 缸 with $71.00 per barrel when the company is fully
hedged.)
Problem 3.13.
"If the minimumvariance hedge ratio is calculated as 1.0, the hedge must be perfect."
Is this statement true? Explain your answer.
The statement is not true. The minimum variance hedge ratio is
It is 1.0 when ρ 0.5 and σ σ Since ρ 1.0 the hedge is clearly not perfect.
Problem 3.14.
"If there is no basis risk, the minimum variance hedge ratio is always 1. 0." Is this
statement true? Explain your answer.
The statement is true. Using the notation in the text , if the hedge ratio is 1.0, the
hedger locks in a price of Fl + b
2
• Since both Fl and b
2
are known this has a variance of
zero and must be the best hedge.
Problem 3.15
"For an asset where futures prices are usually less than spot prices, long hedges are
likely to be particularly attractive." Explain this statement.
A company that knows it will purchase a commodity in the future is able to lock in a
price close to the futures price. This is likely to be particularly attractive when the futures
price is less than the spot price. An illustration is provided by Example 3.2.
Problem 3.16.
The standard deviation of monthly changes in the spot price of live cattle is (in cents
per pound) 1.2. The standard deviation of monthly changes in the futures price of live
cattle for the c10sest contract is 1.4. The correlation between the futures price changes
and the spot price changes is 0.7. It is now October 15. A beef producer is committed to
purchasing 200,000 pounds of live cattle on November 15. The producer wants to use the
16
December Jiy,• cattle futures contracts ω its risk. Each contract is for the delivery
of 40,000 pounds of cattle. What strategy should the beef producer follow?
The optimal hedge ratio is
1.2
0.7 一 一
1.4
The beef producer requires a long position in 200000 x 0.6 = 120,000 lbs of catt1e. The
beef producer should therefore take a long position in 3 December contracts closing out
the position on November 15.
Problem 3.17.
A corn farmer 吁 not use futures contracts for hedging. My real risk is not
the price of corn. It is that my whole crop gets wiped out by the weather. "Discuss this
viewpoint. Should the farmer estimate his or her expected production of corn and hedge
to try to lock in a price for expected production?
If weather creates a significant uncertainty about the volume of corn that will be
harvested, the farmer should not enter into short forward contracts to hedge the price risk
on his or her expected production. The reason is as follows. Suppose that the weather
is bad and the farmer's production is lower than expected. Other farmers are likely to
have been affected similarly. Corn production overall will be low and as a consequence the
price of corn will be relatively high. The farmer's problems arising from the bad harvest
will be made worse by losses on the short futures position. This problem emphasizes the
importance of looking at the big picture when hedging. The farmer is correct to question
whether hedging price risk while ignoring other risks is a good strategy.
Problem 3.18.
On July 1, an investor holds 50,000 shares of a certain stock. The market price is $30
per share. The investor is interested in hedging against movements in the market over the
next month and decides to use the September Mini S&P 500 futures contract. The index
is currently 1,500 and one contract is for de1i very of $50 times the index. The beta of the
stock is 1.3. What strategy should the investor follow?
A short position in
吨 。 x 30
1.3 x . ,    __ = 26
50 x 1, 500
contracts is required.
Problem 3.19.
Suppose that in Table 3..5 the company decides to use a hedge ratio of 1.5. How does
the decision afIect the way the hedge is implemented and the result?
If the company uses a hedge ratio of 1. 5 in Table 3.5 it would at each stage short 150
contracts. The gain from the futures contracts would be
1. 50 x 1. 70 = $2.55 per barrel
17
and the company would be $0.85 per barrel better off.
Problem 3.20.
A futures contract is used for hedging. Explain why the marking to market of the
contract can give rise to cash fJ. ow problems.
Suppose that you enter into a short futures contract to hedge the sale of a asset in
six months. If the price of the asset rises sharply during the six months, the futures price
will also rise and you may get margin calls. The margin calls willlead to cash outflows.
Eventually the cash outfl.ows will be offset by the extra amount you get when you sell the
asset , but there is a mismatch in the timing of the cash outflows and infl.ows. Your cash
outflows occur earlier than your cash inflows. A similar situation could arise if you used
a long p o s i t i o 丑 i n a futures contract to hedge the purchase of an asset and the asset's
price fell sharply. An extreme example of what we are talking about here is provided by
Metallgesellschaft (see Business Snapshot 3.2).
18
CHAPTER 4
Interest Rates
This chapter provides background material on interest rates. Understanding this
material is essential for the rest of the book. The chapter starts by discussing three
interest rates that are important to derivatives markets: Theasury rates, LIBOR rates,
and repo rates. Throughout the book we use the term 仕 rate". For a derivatives
trader shortterm riskfree rates are LIBOR rates, not Theasury rates. This is explained
in Business Snapshot 4. 1. (As we discuss in later chapters 旧 futures quotes and
swap rates are used to calculate 仕 rates for longer maturities.)
It is important that you understand the compounding frequency material in Section
4.2. It cannot be emphasized enough that the 仕 is nothing more
than a unit of measurement. Consider two interest rates. One is 10% with semiannual
compounding; the other is 10.25% with annual compounding. The interest rates are the
same. They are just measured in different units. Converting an interest rate from one
compounding frequency to another is like converting a distance from miles to kilometers.
The concept of a continuously compounded interest rate is likely to be new to many readers.
As we increase the 仕 when measuring interest rates, in the 1imit we
get a unit of measurement known as continuous compounding. The formulas in options
markets involve rates measured with continuous compounding and, except where otherwise
stated, the rates in the book are measured with continuous compounding. It is therefore
important that you make sure you become comfortable with continuously compounded
rates. Equations (4.3) and (4.4) show how to convert a rate from a 仕
of m times per year to continuous compounding and vice versa.
The rates that are quoted 且 markets are often the rates corresponding to
a situation where interest payments are made regularly ι six months). The
rates important in derivatives markets are 啕 rates. These are the rates that
correspond to a situation where money is invested at time 0 and all the return (interest
and principal) is realized at some future time T. Plotting the zero rate as a function of
the maturity T gives the zerocoupon term structure of interest rates. The discount rate
that should be used for a cash fiow occurring at time T is the zerocoupon interest rate
for maturity T.
Two definitions should be noted. A bond yield i
19
longer maturity rates.
Forward rates are the future rates of interest implied by 任 丑 rates.
For example, if the oneyear rate is 6% and the two.year rate is 8%, the forward rate for the
second year is 10%. This is because 10% for the second year combined with 6% for the first
year gives 8% for the two years. Note that this calculation is exact if the interest rates are
measured with continuous compounding and only approximate when other compounding
仕 are used. A forward rate agreement (FRA) is an agreement that a certain
interest rate will apply to a certain principal for a certain future time period. If the
interest rate in the FRA is the forward rate, the value of the FRA is zero. Otherwise the
value must be calculated using equations (4.9) and 4.10).
The chapter concludes by discussing the determinants of the term structure of interest
rates. If market participants expect interest rates to rise in the future, the term structure
will tend to be upward sloping and if market participants expect interest rates to fall it
will tend to be downward sloping. However, as Section 4.8 points out this is not the whole
story. There is a natural tendency for people to want to borrow for long periods of time
and lend for short periods of time. In order to encourage more people to borrow for short
periods and invest their money for long periods banks tend to raise the longterm interest
rates they offer relative to the expectations of market participants.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 4.8.
The cash prices of sixmonth and oneyear Treasury bil1s are 94.0 and 89.0. A 1.5year
bond that wil1 pay coupons of $4 every six months currently sel1s for $94.84. A twoyear
bond that wil1 pay coupons of $5 every six months currently sells for $97.12. Ca1culate the
sixmonth, 萨 ， 1.5year, and twoyear zero rates,
The 6month Theasury bill provides a return of 6/94 = 6.383% in six months. This is
2 x 6.383 = 12.766% per annum with semiannual compounding or 2In(1.06383) = 12.38%
per annum with continuous compounding. The 12..month rate is 11/89 = 12.360% with
annual compounding or In( 1. 1236) = 11.65% with continuous compounding.
For the 1 year bond we must have
一 十 十
工
where R is the 1 year zero rate. It follows that
3.76 + 3.56 + 一 工
e
15R
= 0.8415
R = 0.115
or 11.5%. For the 2year bond we must have
5e
o
1238x05 + 一 + 5e0115X15 + 105e
2R
= 97.12
20
where R is the 2year zero rate. It follows that
e
2R
= 0.7977
R = 0.113
or 11.3%.
Problem 4.9.
What rate of interest with continuous compounding is equivalent to 15% per annum
with monthly compounding?
The rate of interest is R where:
♂
l. e. ,
山 节
The rate of interest is therefore 14.91% per annum.
Problem 4.10.
A deposit account pays 12% per annum with continuous compounding, but interest is
actually paid quarterly. How much interest wi11 be paid each quarter on a $10,000 deposit?
The equivalent rate of interest with quarterly compounding is R where
4
\
飞
1
1
1
/
R4
+
唱
，

4
/It\
一
一
呵
，
"
'i nu
OU
or
R = 4(e
003
.. 1) = 0.1218
The amount of interest paid each quarter is therefore:
0.1218
10, 000 x. 4 一 304.55
or $304.55.
Problem 4.11.
Suppose that 6month, 12month, 18month, 24month, and 30month zero rates are
4%, 4.2%, 4.4%, 4.6%, and 4.8% per annum with continuous compounding respectively.
Estimate the cash price of a bond with a face value of 100 that wi11 mature in 30 months
and pays a coupon of 4% per annum semiannually.
21
The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The cash price
IS
一 + 一 + 一 + 2e0046X2 + 一 = 98.04
Problem 4.12.
A thre• year bond provides a coupon of 8% semiannually and has a cash price of 104.
What is the bond's yield?
The bond pays $4 in 6, 12, 18, 24, and 30 months, and $104 in 36 months. The bond
yield is the value of y that solves
一 十
十
十 ε
十 ι ν ε = 104
Using the Goal Seek tool in Excel y = 0.06407 or 6.407%.
Problem 4.13.
Suppose that the 6month, 12month, 18month, and 24month zero rates are 5%, 6%,
6.5%, and 7% respectively. What is the twoyear par yield?
Using the notation in the text , m = 2, d = 一 = 0.8694. Also
A = eO.05XO 5 + 一 十 十
07x20 = 3.6935
The formula in the text gives the par yield as
(100  100 x 0.8694) x 2
一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 7.072
3.6935
To verify that this is correct we calculate the value of a bond that pays a coupon of 7.072%
per year (that is 3.5365 every six months). The value is
3.536e005x05 + ε 0 + 一 + 103.536e
o
07x2 0 = 100
马 that 7.072% is the par yield.
Problem 4.14.
Suppose that zero interest rates with continuous compounding are as follows:
Maturity (years) Rate (% per annum)
12345
2.0
3.0
3.7
4.2
4.5
22
The forward rates with continuous compounding are as follows:
Year 2: 4.0%
Year 3: 5.1%
Year 4: 5.7%
Year 5: 5.7%
Problem 4.15.
Use the rates in Problem 4.14 to value an FRA where you wil1 pay 5% for the third
year on $1 mil1ion.
The forward rate is 5.1% with continuous compounding or eO.051Xl  1 5.232%
with annual compounding. The 3year interest rate is 3.7% with continuous compounding.
From equation (4.10) , the value of the FRA is therefore
[1 , 000, 000 x 一 x 1]e0037x3 = 2, 078.85
or $1,964.67.
Problem 4.16.
A 10year, 8% coupon bond currently sells for $90. A 10year, 4% coupon bond
currently sells for $80. What is the 10year zero rate? (Hint: Consider taking a long
position in two of the 4% coupon bonds and a short position in one of the 8% coupon
bonds.)
Taking a long position in two of the 4% coupon bonds and a short position in one of
the 8% coupon bonds leads to the following cash flows
Year 0 : 90  2 x 80 =  70
Year 10 : 200  100 = 100
because the 丑 cancel out. $100 in 10 years time is equivalent to $70 today. The
10year rate, R, (continuously compounded) is therefore given by
100 = 70e
lOR
The rate is
1 _ 100
一 一 0.0357
10 70
or 3.57% per annum.
Problem 4.17.
Explain carefully why liquidity preference theory is consistent with the observation
that the term structure of interest rates tends to be upward sloping more 丘 than it is
downward sloping.
If long..term rates were simply a reflection of expected future shortterm rates, we
would expect the term structure to be downward sloping as often as it is upward sloping.
23
(This is based on the assumption that half of the time investors expect rates to ω
and half of the time investors expect rates to decrease). Liquidity preference theory argues
that long term rates are high relative to expected future shortterm rates. This means
that the term structure should be upward sloping more often than it is downward sloping.
Problem 4.18.
"When the zero curve is upward sloping, the zero rate for a particular maturity is
greater than the par yield for that maturity. When the zero curve is downward sloping the
reverse is true." Explain why this is so.
The par yield is the yield on a couponbearing bond. The zero rate is the yield on a
zerocoupon bond. When the yield curve is upward sloping, the yield on an Nyear coupon
bearing bond is less than the yield on an N year 叮 bond. This is because the
coupons are discounted at a lower rate than the Nyear rate and drag the yield down
below this rate. Similarly, when the yield curve is downward sloping, the yield on an
Nyear coupon bearing bond is higher than the yield on an Nyear φ bond.
Problem 4.19.
Why are U.S. '1Teasury rates signifìcantly lower than other rates that are c10se to risk
企
There are three reasons (see Business Snapshot 4.1).
1. Theasury bills and Theasury bonds must be purchased by financial institutions to
直 a variety of regulatory requirements. This increases demand for these Theasury
instruments driving the price up and the yield down.
2. The amount of capital a bank is required to hold to support an investment in Theasury
bills and bonds is substantia11y smaller than the capital required to support a similar
investment in other verylow..risk instruments.
3. In the United States, Theasury instruments are given a favorable tax treatment com
pared with most other fixed income investments because they are not taxed at the
state level.
Problem 4.20.
Why does a loan in the repo market involve very 1ittle credit risk?
A repo is a contract where an investment dealer who owns securities agrees to sell
them to another company now and buy them back later at a slightly higher price. The
other company is providing a loan to the investment dealer. This loan involves very little
credit risk. If the borrower does not honor the agreement , the lending company simply
keeps the securities. If the lending company does not keep to its side of the agreement ,
the original owner of the securities keeps the cash.
Problem 4.21.
Explain why an FRA is equivalent to the exchange of a fl. oating rate of interest for a
fìxed rate of interest?
24
A FRA is an agreement that a certain 直 interest rate, RK, will apply to a
certain principal, L , for a certain specified future time period. Suppose that the rate
observed in the market for the future time period at the beginning of the time period
proves to be RM. If the FRA is an agreement that RK will apply when the principal is
invested, the holder of the FRA can borrow the principal at RM and then invest it at RK.
The net cash f:l.ow at the end of the period is then an inf:l.ow of RK L and an 丑 of
RML. If the FRA is an agreement that RK will apply when the principal is borrowed,
the holder of the FRA can invest the borrowed principal at RM. The net cash f:l.ow at the
end of the period is then an inf:l.ow of RML and an outf:l.ow of RKL. In either case we see
that the FRA involves the exchange of a fixed rate of interest on the principal of L for a
f:l.oating rate of interest on the principal.
25
CHAPTER 5
Determination of Forward and Futures Prices
This chapter explores the relationship between 盯 prices and spot prices.
An important distinction is between investment and consumption assets. Investment assets
are assets held solely for investment by significant numbers of traders (not necessarily all
traders). Consumption assets are assets that are held primarily for consumption.
Investment assets can be divided into three categories:
1. Those that provide no income (A Treasury bill falls into this category)
2. Those that provide a known cash income (A 町 falls into this category)
3. Those that provide a known yield (Stock indices and 丑 fall into this
category.)
For investment assets in 直 category the relationship between the forward price
and the spot price is given by equation (5.1); for those in the second category it is given
by equation (5.2); for those in the third category it is given by equation (5.3). The
relationships can be proved by no arbitrage arguments. If a forward price is higher than
that the price given by equations (5.1) to (5.3) , market participants willlock in a profit by
shorting the forward contract and buying the asset. If the forward price is lower than this
price, market participants willlock in a profit by doing the reverse: taking a long position
in the forward contract and se11ing (or 吨 the asset.
The difference between the forward price of an asset and the value of a forward contract
often causes confusion. The forward price of an asset for a particular maturity date is the
delivery price that would be negotiated today for a forward contract with that maturity
date. The value of a forward contract with a certain maturity date and a certain delivery
price is the contract's economic value. When a forward contract is first entered into the
value of the forward contract is zero and the delivery price is set equal to the forward price.
As time goes by the forward price changes but the delivery price of the contract remains
the same. The value of the contract is liable to become positive or negative. Equation
(5.4) gives the value of a 吨 contract in terms of the forward price. If you are
still unclear about the difference between the forward price and the value of the forward
contract, try Problem 5.9.
Futures prices are more di:fficult to determine than forward prices because of the daily
settlement in futures contracts. However, it turns out that for most purposes the futu
26
and the spot prices. The relationship that exists for an investment asset provides an upper
bound for consumption assets. If the futures price is above this upper bound an arbitrageur
can short futures and buy the asset to lock in a profit. However, if the futures price is
below the upper bound there is no arbitrage opportunity. This is because the asset is not
held for investment purposes. As a result there may well be no traders who own the asset
and are prepared to forego the opportunity to consume the asset by selling it and buying
the futures contract. For consumption assets an important concept is the convenience
yield. This is a measure of the amount by which the futures price is less than its upper
bound. (See equation 5.17.)
The last part of the chapter discusses the relationship between futures prices and
expected future spot prices. If the asset has no systematic risk, the futures price equals
the expected future spot price. If the asset has positive systematic risk, the futures price
understates the expected future spot price. If it has negative systematic risk, the futures
price overstates the expected future spot price.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 5.8.
1s tbe futures price of a stock index greater tban or less tban tbe expected future value
of tbe index? Explain your answer.
The futures price of a stock index is always less than the expected future value of the
index. This 仕 Section 5.14 and the fact that the index has positive systematic
risk. For an alternative argument , let μ the expected return required by investors on
the index so that E(ST) = μ Because μ γ Fo = 俨 ， follows that
E(ST) > Fo.
Problem 5.9.
Aon•year long forward contract on a nondivídendpayíng stock is entered into wben
tbe stock price is $40 and tbe 企 rate of interest ís 10% per annum witb contínuous
compounding.
a. Wbat are tbe forward price and tbe initial value of tbe forward contract?
b. Six montbs later, tbe príce of θ ís $45 and tbe 企 interest rate ís
stíl1 10%. Wbat are tbe forward príce and tbe value of tbe forward contract?
(a) The forward price, Fo , is given by equation (5.1) as:
Fo = 40e
01X1
= 44.21
or $44.21. The initial value of the forward contract is zero.
(b) The delivery price K in the contract is $44.21. The value of the contract, J, after six
months is 丑 equation (5.5) as:
J = 45 . 一
= 2.95
27
i. e. , it is $2.95. The forward price is:
45eOlX05 = 47.31
or $47.31.
Problem 5.10.
The 仕 rate of interest is 7% per annum with continuous compounding, and the
dividend yield on a stock index is 3.2% per annum. The current value of the index is 150.
What is the sixmonth futures price?
Using equation (5.3) the six month futures price is
一 xO.5 = 152.88
or $152.88.
Problem 5.11.
Assume that the 企 interest rate is 9% per annum with continuous compounding
and that the dividend yield on a stock index varies throughout the year. In February, May,
August, and November, dividends are paid at a rate of 5% per annum. In other months,
dividends are paid at a rate of 2% per annum. Suppose that the value of the index on
July 15 is 1,300. What is the θ price for a contract deliverable on December 1.5 of
the same year?
The futures contract lasts 且 months. The dividend yield is 2% for three of the
months and 5% for two of the months. The average dividend yield is therefore
十 x 5) = 3.2%
The futures price is therefore
1300e(0090032) x0 .4167 = 1,331.80
or $1331.80.
Problem 5.12.
Suppose that the 企 interest rate is 10% per annum with continuous compound.
ing and that the dividend yield on a stock index is 4% per annum. The index is standing at
400, and the futures price for a contract deliverable in four months is 405. What arbitrage
opportunities does this create?
The theoretical futures price is
一 X4/12 = 408.08
28
The actual futures price is only 405. This shows that the index futures price is too low
relative to the index. The correct arbitrage strategy is
1. Buy futures contracts
2. Short the shares underlying the index.
Problem 5.13.
Estimate the difference between shortterm interest rates in Mexico and the United
States on January 8, 企 the information in Table 5.4.
The settlement prices for the futures contracts are
Jan 0.91250
Mar 0.91025
The March 2007 price is about 0.25% below the January 2007 price. This suggests that
the shortterm interest rate in the Mexico exceeded shortterm interest rates in the United
States by about 0.25% per two months or about 1. 5% per year.
Problem 5.14.
The twomonth interest rates in Switzerland and the United States are 2% and 5%
per annum, respectively, with continuous compounding. The spot price of the 企
is $0.8000. The futures price for a contract deliverable in two months is $0.8100. What
arbitrage opportunities does this create?
The theoretical futures price is
一 = 0.8040
The actual futures price is too high. This suggests that an arbitrageur should buy Swiss
仕 and short Swiss francs futures.
Problem 5.15.
The current price of silver is $9 per ounce. The storage costs are $0.24 per ounce per
year payable quarterly in θ Assuming that interest rates are 10% per annum for
all maturities, calculate the futures price of silver for delivery in nine months.
The present value of the storage costs for nine months are
十 一 25 + 一 = 0.176
or $0.176. The futures price is from equation (5.11) given by Fo where
Fo = 十 = 9.89
i.e. , it is $9.89 per ounce.
29
Problem 5.16.
Suppose that F
1
and 马 two futures contracts on the same commodity with times
to maturity, tl and t2, where t2 > tl. Prove that
F
2
::; F
1
e
T
(t2 h)
where r is the interest rate (assumed constant) and there are no storage costs. For the
purposes of this problem, assume that a futures contract is the same as a forward contract.
If
F
2
> F
1
er( t2
t
l)
an investor could make a riskless 且 by
1. Taking a long position in a futures contract which matures at time tl
2. Taking a short position in a futures contract which matures at time t2
When the first futures contract matures, the asset is purchased for F
1
using funds borrowed
at rate r. It is then held until time t2 at which point it is exchanged for 马 the
second contract. The costs of the funds borrowed and accumulated interest at time t2 is
F
1
ë(t
2
t
1
) A positive 且 of
F
2
 F
1
e
r
(t 2 t 1 )
is then realized at time t2. This type of arbitrage opportunity cannot exist for long. Hence:
乌 兰
Problem 5.17.
When a known future cash outfJ. ow in a foreign currency is hedged by a company
using a forward contract, there is no foreign exchange risk. When it is hedged using
futures contracts, the markingto.market process does leave the companyexposed to some
risk. Explain the nature of this risk. In particular, consider whether the company is better
off using a futures contract or a forward contract when
a. The value of the foreign currency falls rapidly during the life of the contract
b. The value of the foreign currency rises rapidly during the life of the contract
c. The value of the foreign currency nrst rises and then falls back to its initial value
d. The value of the foreign currency 丘 falls and
then rises back to its initial value
Assume that the forward price equals the futures price.
In total the gain or loss under a futures contract is equal to the gain or loss under the
corresponding forward contract. However the timing of the cash fiows is different. When
the time value of money is taken into account a futures contract may prove to be more
valuable or less valuable than a forward contract. Of course the company does not know in
advance which will work out better. The long forward contract provides a perfect hedge.
The long futures contract provides a slightly imperfect hedge.
(a) In this case the forward contract would lead to a slightly better outcome. The ∞ 丑
will make a 10ss on its hedge. If the hedge is with a forward contract the whole of
30
the loss will be realized at the end. If it is with a futures contract the loss will be
realized day by day throughout the contract. On a present value basis the former is
preferable.
(b) In this case the futures contract would lead to a slightly better outcome. The ∞
will make a 创 丑 on the hedge. If the hedge is with a forward contract the gain will be
realized at the end. If it is with a futures contract the gain wi1l be realized day by day
throughout the life of the contract. On a present value basis the latter is preferable.
( c) In this case the futures contract would lead to a slightly better outcome. This is
because it would involve positive cash flows early and negative cash flows later.
( d) In this case the forward contract would lead to a slightly better outcome. This is
because, in the case of the futures contract, the early cash flows would be negative
and the later cash flow would be positive.
Problem 5.18.
It is sometimes argued that a forward exchange rate is an unbiased predictor of future
exchange rates. Under what θ is this so?
From the discussion in Section 5.14 of the text, the forward exchange rate is an
unbiased predictor of the future exchange rate when the exchange rate has no systematic
risk. To have no systematic risk the exchange rate must be uncorrelated with the return
on the market.
Problem 5.19.
Show that the growth rate in an index futures price equals the excess return of the
index over the 企 rate. Assume that the 企 interest rate and the dividend yield
are constant.
Suppose that Fo is the futures price at time zero for a contract maturing at time T
and F
1
is the futures price for the same contract at time t1. It follows that
Fo = 8
0
e(r
q
)T
F
1
= 8
1
e(r
q
)(Th)
where 8
0
and 8
1
are the spot price at times zero and iI, r is the riskfree rate, and q is
the dividend yield. These equations imply that
F', 8,
一 ρ 一 俨
Fo 80
Define the excess return of the index over the 击 rate as x. The total return is
r + x and the return realized in the form of capital gains is 十  q. It follows that
8
1
= 8oe(r+x
q
)h and the equation for F1/ Fo reduces to
z
e 
RA
which is the required result.
31
Problem 5.20.
Sbow tbat equation (5.3) is true by considering an investment in tbe asset combined
witb a sbort position in a futures contract. Assume tbat all 企 tbe asset is
reinvested in tbe asset. Use an argument similar to tbat in footnotes 2 and 4 and explain
in detai1 wbat an 盯 do if equation (5.3) did not hold.
Suppose we buy N units of the asset and invest the income from the asset in the asset.
The 仕 the asset causes our holding in the asset to grow at a continuously com
pounded rate q. By time T our holding has grown to N e
qT
units of the asset. Analogously
to 丑 2 and 4 of Chapter 5, we therefore buy N units of the asset at time zero at a
cost of So per unit and enter into a forward contract to sell N e
qT
unit for Fo per unit at
time T. This generates the following cash flows:
Time 一
Time T: N Foe
qT
Because there is no uncertainty about these cash flows, the present value of the time
T inflow must equal the time zero outflow when we discount at the 仕 rate. This
means that
NS
o
= (NFoeqT)erT
or
月 Soe(rq)T
This is equation (5.3).
If Fo > 一 ， an arbitrageur should borrow money at rate r and buy N units of
the asset. At the same time the arbitrageur should enter into a forward contract to sell
N e
qT
units of the asset at time T. As income is received, it is reinvested in the asset. At
time T the loan is repaid and the arbitrageur makes a profit of N(Foe
qT
 Soe
rT
) at time
T.
If Fo <
厅
， an arbitrageur should short N units of the asset investing the
proceeds at rate r. At the same time the arbitrageur should enter into a forward contract to
buy N e
qT
units of the asset at time T. When income is paid on the asset , the arbitrageur
owes money on the short position. The investor meets this obligation from the cash
proceeds of shorting further units. The result is that the number of units shorted grows at
rate q to N e
qT
. The cumulative short position is closed out at time T and the arbitrageur
makes a 自 of N(Soe
rT
 Foe
qT
).
Problem 5.21.
Explain carefully what is meant by tbe expected price of a commodity on a particular
future date. Suppose tbat tbe futures price of crude oi1 dec1ines witb the maturity of tbe
contract at the rate of 2% per year. Assume tbat speculators tend to be sbort crude oil
futures and bedgers tended to be long crude oil futures. Wbat does tbe Keynes and Hicks
argument imply about tbe expected future price of oil? Use Table 2.2.
To understand the meaning of the expected future price of a commodity, suppose that
there are N different possible prices at a particular future time: ， 巧 ， ..., PN. Define
32
的 the (subjective) probability the price being (with ql + 十 十 = 1). The
expected future price is
N
二
Different people may have different expected future prices for the commodity. The
φ future price in the market can be thought of as an average of the opinions of
different market participants. Of course, in practice the actual price of the commodity at
the future time may prove to be higher or lower than the expected price.
Keynes and Hicks argue that speculators on average make money from commodity
futures trading and hedgers on average lose money from commodity futures trading. If
speculators tend to have short positions in crude oil futures, the Keynes and Hicks argu
ment implies that futures prices overstate expected future spot prices. If crude oi1 futures
prices decline at 2% per year the Keynes and Hicks argument therefore implies an even
faster decline for the expected price of crude oil if speculators are short.
Problem 5.22.
The 与 Line Index is designed to ref1ect changes in the value of a portfolio of over
1,600 equally weighted stocks. Prior to March 9, 1988, the change in the 企 one
day to the next was calculated as the geometric average of the changes in the prices of the
stocks under1ying the index. In these circumstances, does equation (5.8) correctly relate
the futures price of the index to its cash price? If not, does the equation overstate or
understate the futures price?
When the geometric average of the price relatives is used, the changes in the value of
the index do not correspond to changes in the value of a portfolio that is traded. Equation
(5.8) is therefore no 吨 correct. The 鸣 in the value of the portfolio is monitored by
an index calculated from the arithmetic average of the prices of the stocks in the portfolio.
Since the geometric average of a set of numbers is always less than the arithmetic average,
equation (5.8) overstates the futures price. It is rumored that at one time (prior to 1988),
equation (5.8) did hold for the Value Line Index. A major Wall Street firm was 曲 的
to recognize that this represented a trading opportunity. It made a financial killing by
buying the stocks under lying the index and shorting the futures.
33
CHAPTER 6
Interest Rate Futures
This chapter discusses how interest rate futures work and how they are used for hedg
ing. To understand the way interest rate futures are quoted it is necessary to understand
day count conventions. The day count convention defines the number of days that the
interest rate applies to and the way in which the interest earned accrues through time.
Actual/ Actual in period, 30/360, and Actual/360 are popular day count conventions in
the United States. Look at Business Snapshot 6.1 and Problem 6.19 to check that you
understand how Actual/ Actual in period (which applies to 峦 bonds) and 30/360
(which applies to corporate bonds) work.
The most important longterm ￥ bond futures contracts in the United States
are the Treasury bond and τ note futures contracts. These have some interesting
delivery arrangements. In the case of the τ bond futures contract, any Treasury
bond with a maturity of at least 15 years and not callable within 15 years can be delivered.
In the case of the Treasury note futures contract, any τ bond with a maturity of
between and 10 years can be delivered. (The party with the short position chooses
which bond will be delivered and when during the delivery month it will be delivered.)
To calculate how much is paid and received for the bond the most recent futures prices is
mu1tiplied by a conversion factor and there is then an adjustment for accruals. Roughly
speaking, the conversion factor is the price the bond would have if the zerocoupon yield
curve were f:l. at a τ ￥ ， who hold short futures positions and want to make delivery,
typically look at all the different bonds that can be delivered and calculate a cheapestto
deliver bond.
The most important shortterm futures contracts 丑 United States are the three
month Eurodollar futures contracts. These contracts trade with delivery months as much
as 10 years in the future. The underlying in a threemonth Eurodollar futures contract
is 100 minus the threemonth LIBOR percentage rate of interest. The contract is settled
in cash. It is marked to market daily unti1 the third Wednesday of the delivery month.
At that time the settlement price is calculated as 100 minus the threemonth LIBOR
percentage rate observed in the market. A futures contract is structured so that when the
futures quote increases by one basis point (e.g. from 95.22 to 95.23) there is a gain of $25
on one long contract.
Because Eurodollar futures c
34
points as the contract maturity 的 0 to 10 years. (See Table 6.2.)
The last part of the chapter covers duration. The duration of an instrument describes
its sensitivity to interest rates. 且 it describes the sensitivity to a small parallel
shift in the yield curve. The key equation is equation (6.7) when interest rates are expressed
with continuous compounding and equation (6.9) when interest rates are expressed with a
compounding frequency of m times per year. Suppose that the duration of an instrument
is 4 years and we are considering the effect of a 0.05% increase in all interest rates. In
this case D = 4 and ßy = 0.0005. Equation (6.7) shows that change in the price of the
instrument being considered is 4 x 0.0005 or 0.002 times the price. This means that the
percentage change is 0.2%.
When hedging an interest rate exposure using a futures contract the hedge ratio is
determined by a) the duration of the instrument 吨 futures contract and b)
the duration of the exposure being hedged. For example if the duration of the bond that
is expected to be delivered in a τ note futures contract is 8 years and the duration
of the exposure that is being hedged is 12 years, the hedge ratio should be 1. 5; that is
the size of the futures position should be 50% greater than the size of the position being
hedged. (See equation 6.10.)
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 6.8.
The price of a 90, day Treasury bi11 is quoted as 10.00. What continuously compounded
return (on an actual/365 basis) does an investor earn on the Treasury bi11 for the 向
period?
The cash price of the Theasury bi1l is
90
一 一 一 10 = $97.50
360
The annualized continuously compounded return is
苦 仆 十 羔 = 10.27%
Problem 6.9.
It is May 5, 2007. The quoted price of a government bond with a 12% coupon that
matures on July 咒 ， is 110, 17. What is the cash price?
The number of days between January 27, 2007 and May 5, 2007 is 98. The number of
days between January 27, 2007 and July 27, 2007 is 181. The accrued interest is therefore
98
一 一 3.2486
181
The quoted price is 110.5312. The cash price is therefore
十 = 113.7798
35
or $113.78.
Problem 6.10.
Suppose that the Treasury bond futures price is 10112. Which of the following four
bonds is cheapest to deliver?
Bond Price Conversion Factor
7
i
q
A
9
d
d
经
12505
14215
11531
14402
1.2131
1.3792
1.1149
1.4026
The cheapesttodeliver bond is the one for which
Quoted Price  Futures Price x Conversion Factor
is least. Calculating this factor for each of the 4 bonds we get
Bond 1: 125.15625  101.375 x 1. 2131 = 2.178
Bond 2: 142.46875 101. 375 x 1.3792 = 2.652
Bond 3: 115.96875  101. 375 x 1. 1149 = 2.946
Bond 4: 144.06250  101. 375 x 1.4026 = 1.874
Bond 4 is therefore the cheapest to deliver.
Problem 6.11.
It is July 30, 2009. The cheapesttodeliver bond in a September 2009 Treasury bond
且 contract is a 13% coupon bond, and delivery is expected to be made on September
30, 2009. Coupon payments on the bond are made on February 4 and August 4 each year.
The term structure is flat , and the rate of interest with semiannual compounding is 12%
per annum. θ factor for the bond is 1.5. The current quoted bond price is
$110. Calculate the quoted futures price for the contract.
There are 176 days between February 4 and July 30 and 181 days between February
4 and August 4. The cash price of the bond is, therefore:
176
十 一 一 工
181
The rate of interest with continuous compounding is 21n 1.06 0.1165 or 11.65% per
annum. A coupon of 6.5 will be received in 5 days (= 0.01366 years) time. The present
value of the coupon is
ε 一 1165 = 6.490
36
The futures contract lasts for 62 days (= 0.1694 years). The cash 盯 price if the
contract were written on the 13% bond would be
(116.32  6.490)e01694XO.1165 = 112.02
At delivery there are 57 days of accrued interest. The quoted futures price if the contract
were written on the 13% bond would therefore be
57
112.02  6.5 一 一 110.01
184
Taking the conversion factor into account the quoted futures price should be:
Problem 6.12.
110.01
一 一 一 一 73.34
1.5
An investor is looking for arbitrage opportunities in the Treasury bond futures market.
What complications are created by the fact that the party with a short position can choose
to deliver any bond with a maturity of over 15 years?
If the bond to be delivered and the time of delivery were known, arbitrage would be
straightforward. When the futures price is too high, the arbitrageur buys bonds and shorts
an equivalent number of bond futures contracts. When the futures price is too low, the
arbitrageur sells bonds and goes long an equivalent number of bond futures contracts.
Uncertaintyas to which bond will be delivered introduces complications. The bond
that appears cheapesttodeliver now may not in fact be cheapesttc• deliver at maturity.
In the case where the futures price is too high, this is not a major problem since the party
with the short position (i. e. , the arbitrageur) determines which bond is to be delivered. In
the case where the futures price is too low, the arbitrageur's position is far more difficu1t
since he or she does not know which bond to bUYi it is unlikely that a 直 can be locked
in for all possible outcomes.
Problem 6.13.
Suppose that the ninemonth LIBOR interest rate is 8% per annum and the six
month LIBOR interest rate is 7.5% 盯 (both with actual/365 and continuous
compounding). Estimate the three.month 且 price quote for a contract
maturing in six months.
The forward interest rate for the time period between months 6 and 9 is 9% per
annum with continuous compounding. This is because 9% per annum for three months
when combined with 7 % per annum for six months gives an average interest rate of 8%
per annum for the ninemonth period.
With quarterly compounding the forward interest rate is
4(e009j4  1) = 0.09102
37
or 9.102%. This assumes that the day count is actualjactual. With a day count of
actual/360 the rate is 9.102 x 360/365 = 8.977. The threemonth Eurodollar quote for
a contract maturing in six months is therefore
100  8.977 = 91.02
Problem 6.14.
A 1ìveyear bond with a yield of 11% (continuously compounded) pays an 8% coupon
at the end of each year.
a. What is the bond 's price?
b. What is the bond 's duration?
c. Use the duration to calculate the effect on the bond's price of a 0.2% decrease in
its yield.
d. Recalculate the bond's price on the basis of a 10.8% per annum yield and 命
that the result is in agreement with your answer to (c).
(a) The bond's price is
十 ε
一
+ 8e
0
11x3 + 8e
0 l1 X4
+ 一 x5 = 86.80
(b) The bond's duration is
一
+ 2 x
口
+ 3 x. 一 山 + 4 x 一 山 + 5 x 一 11X5]
86.80 L
= 4.256 years
( c) Since, with the notation in the chapter
6:. B = BD6:. y
the effect on the bond's price of a 0.2% decrease in its yield is
86.80 x 4.256 x 0.002 = 0.74
The bond's price should increase from 86.80 to 87.54.
(d) With a 10.8% yield the bond's price is
一 + 8eo 十 + 十 一 108x5 = 87.54
This is consistent with the answer in (c).
Problem 6.15.
Suppose that a bond portfolio with a duration of 12 years is hedged using a futures
contract in which the underlying asset has a duration of four years. What is likely to be
38
the impact on the hedge of the fact that the 12year rate is less volati1e than the fouryear
rate?
Durationbased hedging procedures assume parallel shifts in the yield curve. Since
the 12year rate 丑 to move by less than the 4year rate, the portfolio manager may
且 that he or she is overhedged.
Problem 6.16.
Suppose that it is February 20 and a 町 that on July 17 the company
wi11 have to issue $5 mi11ion of commercial paper with a maturity of 180 days. If the
paper were issued today, the company would realize $4,820,000. (In other words, the
company would receive $4,820,000 for its paper and have to redeem it at $5,000,000 in 180
days' time.) The September 盯 futures price is quoted as 92.00. How should the
treasurer hedge the company's exposure?
The company treasurer can hedge the company's exposure by shorting Eurodollar
futures contracts. The Eurodollar futures position leads to a profit if rates rise and a loss
if γ
The duration of the commercial paper is twice that of the Eurodollar deposit under.
lying the Eurodollar futures contract. The contract price of a Eurodollar futures contract
is 980,000. The number of contracts that should be shorted is, therefore,
4.820.000
一 ， 一 町 2 = 9.84
980,000
Rounding to the nearest whole number 10 contracts should be shorted.
Problem 6.17.
On August 1 a portfo1io manager has a bond portfo1io worth $10 million. The duration
of the portfolio in October wi11 be 7.1 years. The December Treasury bond futures price
is currently 91.,, 12 and the cheapesttodeliver bond wi11 have a duration of 8.8 years at
maturity. How should the portfolio manager immunize the portfolio against changes in
interest rates over the next two months?
The treasurer should short ￥ bond futures contract. If bond prices go down,
this futures position wi1l provide offsetting gains. The number of contracts that should be
shorted is
‘ 吨 。 x 7.1
]    7 一 一 = 88.30
91,375 x 8.8
Rounding to the nearest whole number 88 contracts should be shorted.
Problem 6.18.
How can the portfolio manager change the duration of the portfolio to 3.0 years in
Problem 6.18?
The answer in Problem 6.17 is designed to reduce the duration to zero. To reduce the
仕 7.1 to 3.0 instead of from 7.1 to 0, the treasurer should short
4.1
一 一 88.30 = 50.99
7.1
39
飞
or 51 contracts.
Problem 6.19.
Between October 30, 2009, and November 1, 2009, you have a choice between owning
a U.8. government bond paying a 12% coupon and a U.8. corporate bond paying a 12%
coupon. Consider carefully the day count conventions discussed in this chapter and decide
which of the two bonds you would prefer to own. Ignore the risk of default.
You would prefer to own the 峦 础
there is one day between October 30, 2009 and November 1, 2009. Under the actual/actual
(in period) day count convention, there are two days. Therefore you would earn approxi
mately twice as much interest by holding the Treasury bond.
Problem 6.20.
主 苟 一 古 二 回 一 臼 芦 一 一 一
What is the LIBOR forward rate for the 60 to 150day period? θ difference
between futures and forwards for the purposes of this question.
The Eurodollar futures contract price of 88 means that the Eurodollar futures rate
is 12% per annum with quarterly compounding. This is the forward rate for the 60 to
150day period with quarterly 吨 an actual/360 day count convention.
Problem 6.21.
The threE• month Eurodollar futures price for a contract maturing in six years is quoted
as 95.20. The standard deviation of the change in θ interest rate in one year
is 1.1%. Estimate the forward LIBOR interest rate for the period between 6.00 and 6.25
years in the future.
Using the notation of Section ， σ 0.011, tl = 6, and t2 = 6.25. The convexity
adjustment is
:×00112 ×6 ×625=0002269
or about 23 basis points. The futures rate is 4.8% with quarterly compounding and an
actual/360 day count. This becomes 4.8 x 365/360 = 4.867% with an actual/actual day
count. It is 十 = 4.84% with continuous compounding. The forward rate
is therefore 4.84  0.23 = 4.61% with continuous compounding.
Problem 6.22.
Explain why the forward interest rate is less than the corresponding futures interest
rate 企 a Eurodollar futures contract.
Suppose that the contracts apply to the interest rate between times T
1
and T
2
. There
are two reasons for a difference between the forward rate and the futures rate. The first
is that the futures contract is settled daily whereas the forward contract is settled once at
time T
2
• The second is that without daily settlement a futures contract would be settled
at time T
1
not T
2
• Both reasons tend to make the futures rate greater than the forward
rate.
40
月
i
R
E
泊
T
叫
PW
A
他
n
b
H C
This chapter covers how interest rate swaps and currency swaps work and how 币
are valued. A plain vanilla interest rate swap is an agreement to exchange interest at
a fixed rate for interest at LIBOR. Table 7.1 provides an example of a threeyear swap
where 5% is paid and sixmonth LIBOR is received with payments being exchanged every
six months. The exchange made on September 5, 2007 is known on March 5, 2007 when the
swap is initiated. The other exchanges depend on the LIBOR rates at future times. Note
that the sixmonth LIBOR rate observed on a date determines the cash fiows exchanged
six months later.
An interest rate swap can be used to transform an asset or a liability. (See Example
7. 1.) A swap 自 is received and fioating is paid can be used to convert a liability
where a company is paying a fixed rate of interest to one where it is paying a fioating
rate of interest. The same swap can be used to convert an asset earning a fioating rate
of interest to an asset earning 自 rate of interest. A swap where fioating is received
and fixed is paid can be used to convert a liability where a company is paying a fioating
rate of interest to one where it is paying 且 rate of interest. The same swap can
be used to convert an asset earning a fixed rate of interest to an asset earning a fioating
rate of interest. This is illustrated in Figures 7.2 and 7.3 where ο and Intel trade
with each other without a financial intermediary being involved and in Figures 7.4 and 7.5
where an intermediary is involved.
You should make sure you understand Table 7.3 and Business Snapshot 7. 1. Table
7.3 shows quotes as they might be made by a swap market maker such as Goldman Sachs
and Business Snapshot 7.1 shows an extract from a hypothetical swap 自
The comparative advantage argument is sometimes used in an attempt to persuade
corporate treasurers to enter into swaps. It is a 自 compelling argument. It says
that companies should borrow in the market where they have a comparative advantage
(AAArated companies should borrow at a fixed rate of interest; BBBrated companies
should borrow at a 吨 of interest). They should then use swaps to exchange the
liability for what they want. In the case 且 currency swaps, as discussed
in Section 7.8, this type of argument can have some validity. However, in the case of
interest rate swaps it is seriously fiawed because it ignores the possibility of a company's
creditworthiness decli
41
are used in the construction of the LIBOR/swap zero curve. Banks and other fi.nancial
institutions calculate this zero curve at least once a day and use it as their 仕 zero
curve. (As pointed out in Chapter 4 出 叮 ω not 田 the 础 盯 zero 町 臼 the 此 】 仕 倪 e
zero curve.)
You should understand both ways of valuing interest rate swaps 1isted in Section 7.7.
An interest rate swap can be regarded as the exchange of a bond paying LIBOR for a
bond paying a fi.xed rate of interest. It can also be regarded as a portfolio of forward rate
agreements (FRAs). Valuing an interest rate ω portfolio of forward rate agreements
involves calculating the cash flows on the assumption that forward LIBOR interest rates
are rea1ized and then 吨 cash flows at the swap/LIBOR zero rates. Examples
7.4 and 7.5 illustrate the two approaches.
且 for fi.xed currency swap is an agreement to exchange a fi.xed rate in one cur
rency for 且 rate in another currency. It can be used to transform borrowings in one
出 岛 由 注 册 四 丑
one currency to an asset earning interest in another currency. Similarly to an interest
rate swap, a currency swap can be valued either in terms on bonds or in terms of forward
foreign exchange agreements. Examples 7.6 and 7.7 illustrate this.
Swap transactions entail a small amount of credit risk. A swap has zero value when
it is fi.rst negotiated. As time passes its value is liable to become positive or negative. The
credit exposure of a 町 ， the amount it could lose if the counterparty defaults)
is max(V, 0) where V is the value of the swap (see Figure 7.13). Part of the spread earned
by a swap market marker (see Table 7.3) is to compensate for potential defaults by its
counterparties.
Many different types of swaps are traded in practice. 且 section of the chapter
introduces you to some of the more important swap products.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 7.8.
Explain whya bank is subject to credit risk when it enters into two offsetting swap
contracts.
At the start of the swap, both contracts have a value of approximately zero. As time
passes, it is likely that the swap values wi1l change, so that one swap has a positive value
to the bank and the other has a negative value to the bank. If the counterparty on the
other side of the positivevalue swap defaults, the bank still has to honor its contract with
the other counterparty. It is liable to lose an amount equal to the positive value of the
swap.
Problem 7.9.
Companies X and Y have been offered the following rates per annum on a $5 mi11ion
10year investment:
42
Company X
Company Y
Fixed Rate
8.0%
8.8%
Floating Rate
LIBOR
LIBOR
Company X requires a fixedrate investment; company Y requires a Boatingrate 崎
vestment. Design a swap that wil1 net a bank, acting as intermediary, 0.2% per annum
and wil1 appear equa11y attractive to X and Y.
The spread between the interest rates offered to X and Y is 0.8% per annum on fixed
rate investments and 0.0% per annum on fioating rate investments. This means that the
total apparent benefit to all 仕 the swap is 0.8% per annum. Of this 0.2% per
annum will go to the bank. This leaves 0.3% per annum for each of X and Y. In other
words, company X should be able to get a ι return of 8.3% per annum while
company Y should be able to get a fioatingrate return LIBOR + 0.3% per annum. The
required swap is shown in Figure 87. 1. The bank earns 0.2%, company X earns 8.3%, and
company Y earns LIBOR + 0.3%.
一 一 一 一 一 一 ， 83% 一 一 ， 8.5% ,
1.... 1... 1 88%
目 一 一 一 一
一 一 一 时 咆 广 I BANK 广 叩 忡 一 一 一
LIBOR 1 儿 卡 一 一 一 一 一 一 酬 ← 一 一 一 一 一 一 … Y
一 一 一 一 LIBOR 一 一 一 一 一 一 LIBOR 一 一 一 一 一
Figure 87.1 8wap for Problem 7.9
Problem 7.10.
A financial institution has entered into an θ rate swap with company X. Un,
der the terms of the swap, it receives 10% per annum and pays sixmonth LIBOR on a
principal of $10 million for five years. Payments are made every six months. Suppose
that company X defaults on the sixth payment date (end of year 3) when the interest
rate (with semiannua1 compounding) is 8% per annum for all maturities. What is the 10ss
to 丘 institution? Assume that sixmonth LIBOR was 9% per annum ha1fway
through year 3_
At the end of year 3 且 丑 due to receive $500,000 (= 0.5 x 10%
of $10 million) and pay $450,000 (= 0.5 x 9% of $10 million). The immediate loss is
therefore $50,000. To value the remaining swap we assume than forward rates are realized.
All forwafd rates are 8% per annum. The remaining cash fiows are therefore valued on
the assumption that the fioating payment is 0.5 x 0.08 x 10,000,000 = $400,000 and the
net payrnent that would be received is 500,000 ' 400,000 = $100,000. The total cost of
default is therefore the cost of foregoing the following cash fiows:
43
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Problem 7.11.
A fi.nancial institution has entered into a 10year currency swap with company Y.
Under the terms of the swap, the fi.nancial institution receives interest at 3% per annum
in Swiss francs and pays interest at 8% per annum in U.S. dollars. Interest payments are
exchanged once a year. The principa1 amounts are 7 mil1ion dollars and 10 企
Suppose that company Y dec1ares bankruptcy at the end of year 6, when the exchange
rate is $0.80 per franc. What is the cost to 丘 institution? Assume that, at the
end ofyear 6, the interest rate is 3% per annum in 企 and 8% per annum in U.S.
dollars for all maturities. All interest rates are quoted with annual compounding.
When interest rates are compounded annually
月 8
0
二
where Fo is the Tyear forward rate, 8
0
is the spot rate, r is the domestic risk.free rate,
and rf is the foreign riskfree rate. As r = 0.08 and rf = 0.03, the spot and forward
exchange rates at the end of year 6 are
dJud.d
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0.8000
0.8388
0.8796
0.9223
0.9670
The value of the swap at the time of the default can be calculated on the assumption
that forward rates are realized. The cash flows lost as a result of the default are therefore
as follows:
一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一
Dollar Swiss Franc Forward Dollar Equivalent Cash Flow
Year Paid Received Rate of Swiss Franc Received Lost
6 560,000 300,000 0.8000 240,000
?20000;
7 560,000 300,000 0.8388 251,600 308,400
8 560,000 300,000 0.8796 263,900 296,100
9 560,000 300,000 0.9223 276,700 283,300
10 7,560,000 10,300,000 0.9670 9,960,100 2,400,100
Discounting the numbers in 且 丑 column to the end of year 6 at 8% per annum,
the cost of the default is $679,800.
44
Note that, if this were the only contract entered into by company Y, it would make
no sense for the company to default at the end of 町 as the exchange of payments
at that time has a positive value to company Y. In practice company Y is likely to be
defaulting and declaring bankruptcy for reasons unrelated to this particular contract and
payments on the contract are likely to stop when bankruptcy is declared.
Problem 7.12.
Companies A and B face the fol1owing interest rates 司 for the differential
impact of taxes):
u. s. dol1ars (floating rate)
Canadian dollars (fìxed rate)
A
十
5.0%
B
十
6.5%
Assume that A wants to borrow U. S. dol1ars at a Boating rate of interest and B wants
to borrow Canadian dollars at a fìxed rate of interest. A fìnancial institution is planning
to arrange a swap and requires a 50basispoint spread. If the swap is equal1y attractive
to A and B, what rates of interest wil1 A and B end up paying?
Company A has a comparative advantage in the Canadian 且 market.
Company B has a comparative advantage in the U.8. dollar floatingrate market. (This
may be because of their tax positions.) However, company A wants to borrow in the
U.8. dollar fioatingrate market and company B wants to borrow in the Canadian dollar
fixedrate market. This gives rise to the swap opportunity.
The differential between the U.8. dollar floating rates is 0.5% per annUffi, and the
differential between the Canadian dollar fixed rates is 1. 5% per annum. The difference
between the differentials is 1 % per annum. The total potential gain to all 仕 the
swap is therefore 1% per annum, or 100 basis points. If the financial intermediary requires
50 basis points, each of A and B can be made 25 basis points better off. Thus a swap can
be designed so that it provides A with U.8. dollars at LIBOR + 0.25% per annum, and B
with Canadian dollars at 6.25% per annum. The swap is shown in Figure 87.2.
一 一
Figure S7.2 8wap for Problem 7.12
Principal payments flow in the opposite direction to the arrows at the start of the life
of the swap and in the same direction as the arrows at the end of the life of the swap.
The 恒 的 would be exposed to some foreign exchange risk which could be
hedged using forward contracts.
45
Problem 7.13.
After it hedges its foreign exchange risk using forward contracts, is the nnancial in
stitution 's average spread in Figure 7.10 likely to be greater than or less than 20 basis
points? Explain your answer.
The financial institution will have to buy 1. 1% of the AUD principal in the forward
mar ket for each 町 the life of the swap. Since AUD interest rates are higher than
dollar interest rates, AUD is at a discount in forward markets. This means that the AUD
purchased for year 2 is less expensive than that purchased for year 1; the AUD purchased
for year 3 is less expensive than that purchased for year 2; and so on. This works in favor
of 直 institution and means that its spread increases with time. The spread is
always above 20 basis points.
Problem 7.14.
"Companies with higb credit risks are the ones that cannot access nxedrate markets
directly. They are the companies that are most likely to be paying nxed and receiving
floating in an interest rate swap." Assume that tbis statement is true. Do you think it
increases or decreases the risk of a nnancial institution 's swap portfolio? Assume that
companies are most likely to default when interest rates are higb.
Consider a plainvanilla interest rate swap involving two companies X and Y. We
suppose that X is 也 and receiving floating whi1e Y is paying floating and receiving
fixed.
The quote suggests that company X will usually be less creditworthy than company
Y. (Company X might be a 刊 company that has 山 in accessing fixed
rate markets directly; company Y might be a AAArated company that has no 自
accessing fixed or floating rate markets.) Presumably 町 自 funds
and company Y wants floatingrate funds.
The financial institution wi1l realize a loss if company Y defaults when rates are high
or if 町 defaults when rates are low. These events are relatively unlikely since (a)
Y is unlikely to defau1t in any circumstances and (b) defaults are less likely to happen when
rates are low. For the purposes of illustration, suppose that the probabilities of various
events are as follows:
Default by Y: 0.001
Defau1t by X: 0.010
Rates high when default occurs: 0.7
Rates low when defau1t occurs: 0.3
The probability of a loss is
0.001 x 0.7+ 0.010 x 0.3 = 0.0037
If the roles of X and Y in the swap had been reversed the probability of a loss would
be
0.001 x 0.3 + 0.010 x 0.7 = 0.0073
46
Assuming companies are more likely to defau1t when interest rates are high, the above
argument shows that the 飞 in quotes has the effect of decreasing the risk of a
自 institution's swap portfo1io. It is worth noting that the assumption that de
faults are more likely when interest rates are high is open to question. The assumption
is motivated by the thought that high interest rates often lead to financial diffi.culties for
corporations. However, there is often a time lag between interest rates being high and the
resultant defau1t. When the default actually happens interest rates may be relatively low.
Problem 7.15.
Why is the expected 企 a defau1t on a swap 1ess than the expected 企
the defau1t on a 10an with the same principa1?
In an interestrate swap a financial institution's exposure depends on the difference
between 且 of interest and a floatingrate of interest. It has no exposure to the
notional principal. In a loan the whole principal can be lost.
Problem 7.16.
A bank nnds that its assets are not matched with its liabilities. It is taking f1oating
rate deposits and making nxedrate 1oans. How can swaps be used to 岛 the risk?
The bank is paying a floatingrate on the deposits and receiving 且 rate on the
loans. It can offset its risk by entering into interest rate swaps (with other financial
institutions or corporations) in which it contracts to pay fixed and receive floating.
Problem 7.17.
Exp1ain how you would value a swap that is the exchange of a f10ating 古 in one
currency for a nxed rate in another currency.
The floating payments can be valued in currency A by (i) assuming that the forward
rates are realized, and (ii) discounting the resu1ting cash flows at appropriate currency
A discount rates. Suppose that the value is VA. 且 payments can be valued in
currency B by discounting them at the appropriate currency B discount rates. Suppose
that the value is VB. If Q is the current exchange rate (number of units of currency A per
unit of currency B), the value of the swap in currency A is VA  QVB. Alternatively, it is
VA/Q  VB in currency B.
Problem 7.18.
The LIBOR zero curve is f1at at 5% (continuously compounded) out to 1.5 years. Swap
rates for 2. and 3year semiannual pay swaps are 5.4% and 5.6%, respectively. Estimate
the LIBOR zero rates for maturities of 2.0, 2.5, and 3.0 years. (Assume that θ
swap rate is the average of the 2. and 3year 叩
The twc• year swap rate is 5.4%. This means that a twoyear LIBOR bond paying
a semiannual coupon at the rate of 5.4% per annum sells for par. If R2 is the twoyear
LIBOR zero rate
一 + 十 十 = 100
47
Solving this gives R
2
= 0.05342. The 2.5year swap rate is assumed to be 5.5%. This
means that a 2.5year LIBOR bond paying a semiannual 丑 the rate of 5.5% per
annum sells for par. If R
25
is the 2.5year LIBOR zero rate
一 十 一 05xLO +2.75e
o
05xl.5 + 一 05342x2 0 + 102.75eR2 5 x2.5 = 100
Solving this gives R
2
..
5
= 0.05442. The 3.year swap rate is 5.6%. This means that a 3year
LIBOR bond paying a semiannual coupon at the rate of 5.6% per annum sells for par. If
R3 is the threeyear LIBOR zero rate
一 + 2.8e005xI0 + ε 一 十 一 + 2.8e005442X2.5
+102.8eR3x3o = 100
Solving this gives R3 = 0.05544. The zero rates for maturities 2.0, 2.5, and 3.0 years are
therefore 5.342%, 5.442%, and 5.544%, respectively.
48
CHAPTER 8
Mechanics of Options Markets
If you already understand how options work you wi1l not have to spend a lot of time
on Chapter 8. Bear in mind that, for every trader buying an option, there is another trader
selling it. Make sure you understand the profit diagrams in Figures 8.1 to 8.4. Figure 8.5
shows the 仕 the four different option strategies in Figures 8.1 to 8.4. Whereas
the profit takes account of the initial amount paid for the option, the payoff does not.
Make sure you understand the terminology of option markets: American options,
European options, strike price, expiration date, intrinsic value, option class, option series,
inthemoney, atthemoney, outofthemoney, fiex options, option writing and so on.
Except in special circumstances (see Business Snapshot 8.1) there is no ， 句 剧 剖 臼
ω the terms of an option for cash dividends. Stock dividends and stock splits do lead to
adjustments. For example, a 3for..1 stock split leads to the strike price being reduced to a
third of what it was before and the number of options held being mu1tiplied by 3. A 10%
stock dividend is like a 1. 1 for 1 stock split. lt leads to the strike price being reduced to
10/11 of what it was before and the number of options held being increased by 10%.
Traders who sell (i. e. , write) options must 川 margin accounts similar to the
margin accounts for futures traders. Traders who buy options pay for the options 仕
and 丑 maintain margin accounts.
Warrants issued by a company on its own stock are 仕 regular call options
in that exercise of the warrants leads to the 町 吨 shares. (When a regular
call option on a stock is exercised, the option writer buys shares of the stock in the market
and delivers them to the option holder.) Executive stock options and convertible bonds
are similar to warrants in this respect. Executive stock options are discussed in Business
Snapshot 8.3. An important difference between executive stock option and regular call
options is that executive stock options cannot be sold. As a result they are liable to be
exercised much ear1ier than would otherwise be the case.
Options trade in the overthe.counter market as 部 exchangetrade market.
lndeed for many types ofunderlyings (e.g. , exchange rates and interest rates) the overthe
counter market is much bigger than the exchangetraded market. The options traded over
the counter do not have to have the standard terms 且 by exchanges. Th
49
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 8.8.
A corporate treasurer is designing a hedging program involving foreign currency op
tions. What are the ω cons of using (a) the Philadelphia Stock Exchange and (b)
the overthecounter market for trading?
The Philadelphia Exchange offers European and American options with standard
strike prices and times to maturity. Options in the overthecounter market have the
advantage that they can be tailored to meet the precise needs of the treasurer. Their
disadvantage is that they expose the treasurer to some credit risk. Exchanges organize
their trading so that there is virtually no credit risk.
Problem 8.9.
Suppose that a European call option to buy a share for $100.00 costs $5.00 and is
held until 市 Under what circumstances wi11 the holder of the option make a profit?
Under what circumstances wi11 the option be exercised? Drawa diagram illustrating how
the 企 a long position in the option depends on the stock price at maturity of the
option.
Ignoring the time value of money, the holder of the option will make a profit if the
stock price at maturity of the option is greater than $105. This is because the payoff to
the holder of the option is, in these circumstances, greater than the $5 paid for the option.
The option will be exercised if the stock price at maturity is greater than $100. Note that
if the stock price is between $100 and $105 the option is exercised, but the holder of the
option takes a loss overall. The profit from a long position is as shown in Figure 88. 1.
「 Ill
nvRU 21
D
10
5
。
#
眶
。
』
也
Profit from long position in Problem 8.9
50
5
10
Figure S8.1
Problem 8.10.
Suppose that a European put option to sell a share for $60 costs $8 and is held until
抄 Under what circumstances wil1 the seller of the option (the 句 with the short
position) make a proEt? Under what circumstances wil1 the option be exercised? Draw
a diagram illustrating how the 企 a short position in the option depends on the
stock price at 句 of the option.
Ignoring the time value of money, the seller of the option will make a profit if the
stock price at maturity is greater than $52.00. This is because the cost to the seller of the
option is in these circumstances less than the price received for the option. The option
will be exercised if the stock price at maturity is less than $60.00. Note that if the stock
price is between $52.00 and $60.00 the seller of the option makes a profit even though the
option is exercised. The 仕 the short position is as shown in Figure 88.2.
70
Stock Price
65
10
5
。
5
丁
H
e
。
』
也
Profit from short position in Problem 8.10
15
Figure S8.2
Problem 8.11.
Describe the terminal value ûf the fûllûwing pûrtfolio: a newly enteredinto long 酣
ward contract on an asset and a long position in a European put option on the asset with
the same maturity as the forward contract and a strike price that is equal to the forward
price of the asset at the time the portfolio is set up. Show that the European put option
has the same value as a European call option with the same strike price and maturity.
The terminal value of the long forward contract is:
STF
o
51
where ST is the price of the asset at maturity and Fo is the forward price of the asset at
the time the portfolio is set up. (The delivery price in the forward contract is 马
The terminal value of the put option is:
max (F
o
 ST, 0)
The terminal value of the portfolio is therefore
一 几 十 (F
o
 ST, 0)
= max (0, ST Fol
This is the same as the terminal value of a European call option with the same maturity
as the forward contract and an exercise price equal to Fo. This result is illustrated in the
Figure 88.3.
旦
L
F
。
』
也
/
/
/
Asset Price
/
/
/
/
/
/
/
/
/
Figure 88.3 Profit from portfolio in Problem 8.11
We have shown that the forward contract plus the put is worth the same as a call
with the same strike price and time to maturity as the put. The forward contract is worth
zero at the time the portÍoÌÏo is set up. It Íollows that the put is worth the same as the
call at the time the portfolio is set up.
52
Problem 8.12.
A trader buys a ca11 option with a strike price of $45 and a put option with a strike
price of $40. Both options have the same maturity. The call costs $3 and the put costs $4.
Draw a diagram showing the variation of the trader's profìt with the asset price.
Figure 88.4 shows the variation of the trader's position with the asset price. We can
divide the alternative asset prices into three ranges:
(a) When the asset price less than $40, the put ∞ a payoff of 40  ST and the
call option provides no payoff. The options cost $7 and so the total 且 is 33  ST.
(b) When the asset price is between $40 and $45, neither option provides a payoff. There
is a net loss of $7.
(c) When the asset price greater than $45, the call option provides a payoff of ST  45
and the put option provides no payoff. Taking into account the $7 cost of the options,
the total profit is 一
The trader makes a 缸 the time value of money) if the stock price is less
than $33 or greater than $52. This type of trading strategy is known as a strangle and is
discussed in Chapter 10.
15
罩
。
』
Q. 5
。
5
10
Figure 88.4 Profit from trading strategy in Problem 8.12
Problem 8.13.
Explain why an American option is always worth at least as much as a European
option on the same asset with the same strike price and exercise date.
The holder of an American option has all the same rights as the holder of a European
option and more. It must therefore be worth at least as much. If it were not , an arbitrageur
could short the European option and take a long position in the American option.
53
Problem 8.14.
Explain why an American option is always worth at least as much as its intrinsic
value.
The holder of an American option has the right to exercise it immediately. The
American option must therefore be worth at least as much as its intrinsic value. If it
were not an arbitrageur could lock in a sure 缸 buying the option and exercising it
immediately.
Problem 8.15.
Explain carefully the difIerence between writing a put option and buying a ca11 option.
Writing a put gives a payoff of min(ST  K, 0). 鸣 call gives a payoff of
max(ST  K, 0). In both cases the potential payoff is ST  K. The difference is that for a
written put the counterparty chooses whether you get the payoff (and wi1l allow you to get
it only when it is negative to 啡 a 吨 you decide whether you get the payoff
(and you choose to get it when it is positive to you.)
Problenl 8.16.
The treasurer of a corporation is trying to choose between options and forward con
tracts to hedge the corporation 's foreign exchange risk. Discuss the advantages and disad
vantages of each.
Forward contracts lock in the exchange rate that wi1l apply to a particular transaction
in the future. Options provide insurance that the exchange rate will not be worse than
some level. The advantage of a forward contract is that uncertainty is eliminated as far
as possible. The disadvantage is that the outcome with hedging can be significant1y worse
than the outcome with no hedging. This disadvantage is not as marked with options.
However, unlike forward contracts, options involve an upfront cost.
Problem 8.17.
Consider an exchangetraded call option contract to buy 500 shares with a strike price
of $40 and maturity in four months. Explain how the terms of the option contract change
when there is
a" A 10% stock dividend
b. A 10% cash dividend
c. A 4.forl stock split
(a) The option contract becomes one to buy 500 x 1. 1 = 550 shares with an exercise price
40/ 1. 1 = 36.36.
(b) There is no effect. The terms of an options contract are not normally adjusted for
cash 丑
(c) The option contract becomes one to buy 500 x 4 = 2, 000 shares with an exercise price
of 40/4 = $10.
54
Problem 8.18.
"If most of the cal1 options on a stock are in the money, it is likely that the stock price
has risen rapidly in the last few months." Discuss this statement.
The exchange has certain rules governing when trading in a new option is initiated.
These mean that the option is φ when it is first traded. If all call options
are in the money it is therefore likely that the stock price 础 since trading in the
option began.
Problem 8.19.
What is the effect of an unexpected cash dividend on (a) a cal1 option price and (b)
a put option price?
An unexpected cash dividend would reduce the stock price on the exdividend date.
This stock price reduction would not be anticipated by option holders. As a result there
would be a reduction in the value of a call option and an increase the value of a put option.
(Note that the terms of an option are adjusted for cash dividends only in exceptional
circumstances. )
Problem 8.20.
Options on General Motors stock are on a March, June, September, and December
cyc1e. What options trade on (a) March 1, (b) June 30, and 例 5?
(a) March, April, June and September
(b) July, August , September, December
(c) 吨 ， September, December, March. 鸣 dated options may also trade.
Problem 8.21.
Explain why the market maker's bidoffer spread represents a real cost to options
investors.
A "fair" price for the option can reasonably be assumed to be half way between the
bid and the offer price quoted by a market maker. An investor typically buys at the market
maker's offer and sells at the market maker's bid. Each time he or she does this there is a
hidden cost equal to half the bidoffer spread.
Problem 8.22.
A United States investor writes nve naked call option contracts. The option price is
$3.50, the strike price is $60.00, and the stock price is $57.00. What is the initial margin
requirement?
The two calculations are necessary to determine the initial margin. The first gives
500 x (3.5 + 0.2 x 57  3) = 5, 950
The second gives
500 x (3.5 + 0.1 x 57) = 4,600
The initial margin is the greater of these, or $5,950. Part of this can be provided by the
initial amount of 500 x 3.5 = $1, 750 received for the options.
55
CHAPTER 9
Properties of Stock Options
This chapter starts by considering the general way in which an option price depends
on the stock price, strike price, time to expiration, volatility, 此 】 仕 倪 rate, and dividends.
Make sure you understand Table 9. 1. An important point that often causes confusion is
that Table 9.1 considers the change in a variable with all the other variables remaining the
same. (This the usual assumption in ca1culus when partial derivatives are ca1culated.) For
example, when considering interest rates it is assumed that interest rates change without
any other variables changing. In practice when interest rates increase (decrease) stock
prices tend to decrease (increase).
The rest of the chapter considers what we can say about option prices without mak
ing any assumptions about volatility or the way in which the stock price behaves. The
arguments used are no arbitrage arguments. Section 9.3, for example, derives upper and
lower bounds for call and put options. If the price of an option is outside the range given
by the upper and lower bound there is a clear arbitrage opportunity. For example, if a call
option is below the lower bound an arbitrageur buys the option and shorts the stock; if it
is above the upper bound the arbitrageur buys the stock and sells the option.
Putcall 缸 (see equations 9.3 and 9.7) is a very important resu1t. It shows that
there is a relationship between the price of a European call option with a certain strike
price and time to maturity and the price of a European put option with the same strike
price and time to maturity. As illustrated in Table 9.2 there is an arbitrage opportunity if
putcall parity does not hold. For American options putcall parity does not hold, but an
inequa1ity relationship can be derived (see 时 9.4 and 9.8)
An American call option on a stock that will not pay dividends during the 1ife of
the option should never be exercised ear ly. This is because a) delaying exercise has the
advantage that it delays paying the strike price and b) exercising early would give up the
protection that the option holder has against the possibi1ity of the stock price falling below
the strike price by the end of the life of the option. American put options on stocks that
do not pay a dividend are liable to be exercised early. lndeed, it can be shown that at any
give time there is always a critical stock price below which it is optimal for the holder of
the put option to exercise.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 9.8.
Explain why the arguments leading to putcall parity for European options cannot
be used to give a similar result for American options.
When early exercise is not possible, we can argue that two portfolios that are worth
the same at time T must be worth the same at earlier times. When early exercise is
possible, the argument falls down. Suppose that 十 > C + K eT'T. This situation does
56
not lead to an arbitrage opportunity. If we buy the call, short the put, and short the stock,
we cannot be sure of the result because we do not know when the put will be exercised.
Problem 9.9.
What is a lower bound for the price of a sixmonth call option on a nondividend
paying stock when the stock price is $80, the strike price is $75, and the riskfree interest
rate is 10% per annum?
The lower bound is
80  75eOlX05 = $8.66
Problem 9.10
What is a lower bound for the price of a twomonth European put option on a non
dividendpaying stock when the stock price is $58, the strike price is $65, and the 企
interest rate is 5% per annum?
The lower bound is
一 ._ 58 = $6.46
Problem 9.11.
A four.month European call option on a dividendpaying stock is currently selling for
$5. The stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one
month. The 企 interest rate is 12% per annum for all maturities. What opportunities
are there for an arbitrageur?
The present value of the strike price is 一 12x4/12 = $57.65. The present value of
the dividend is 0.80e
o
12xl/12 = 0.79.. Because
5 < 64  57.65. 0.79
the condition in equation (9.5) is violated. An arbitrageur should buy the option and short
the stock. This generates 64  5 = $59. The arbitrageur invests $0.79 of this at 12% for
one month to pay the dividend of $0.80 in one month. The remaining $58.21 is invested
for four months at 12%. Regardless of what happens a profit will materialize.
If the stock price declines below $60 in four months, the arbitrageur loses the $5 spent
on the option but gains on the short position. The arbitrageur shorts when the stock price
is $64, has to pay dividends with a present value of $0.79, and closes out the short position
when the stock price is $60 or less. Because $57.65 is the present value of $60, the short
position generates at least 64  57.65  0..79 = $5.56 in present value terms. The present
value of the arbitrageur's gain is therefore at least 5.56  5.00 = $0.56.
If the stock price is above $60 at the expiration of the option, the option is exercised.
The arbitrageur buys the stock for $60 in four months and closes out the short position.
The present value of the $60 paid for the stock is $57.65 and as before the dividend has a
present value of $0.79. The 仕 the short position and the exercise of the option is
therefore exactly 64 _. 57.65  0.79 = $5.56. The arbitrageur's gain in present value terms
is exactly 5.56  5.00 = $0..56.
57
Problem 9.12.
萨 European put option on a nondividendpaying stock is currently selling
for $2.50. The stock price is $47, the strike price is $50, and the riskfree interest rate is
6% per annum. What opportunities are there for an arbitrageur?
In this case the present value of the strike price is 50e006xl/12 = 49.75. Because
2:5 < 49.75  47.00
the condition in equation (9.2) is violated. An arbitrageur should borrow $49.50 at 6%
for one month, buy the stock, and buy the put option. This generates a profit in all
circumstances.
If the stock price is above $50 in one month, the option expires worthless, but the
stock can be sold for at 邸 $50. A sum of $50 received in one month has a present value
of $49.75 today. The strategy therefore generates profit with a present value of at least
$0.25.
If the stock price is below $50 in one month the put option is exercised and the stock
owned is sold for exactly $50 (or $49.75 in present value terms). The trading strategy
therefore generates a 直 of exactly $0.25 in present value terms.
Problem 9.13.
Give an intuitive explanation of why the early exercise of an American put becomes
more attractive as the 企 rate increases and volatility decreases.
The early exercise of an American put is attractive when the interest earned on the
strike price is greater than the insurance element lost. When interest rates increase, the
value of the interest earned on the strike price ω making early exercise more attrac
tive" When volati1ity decreases, the insurance element is less valuable. Again this makes
early exercise more attractive.
Problem 9.14.
The price of a European call that expires in six months and has a strike price of $30 is
$2. The underlying stock price is $29, and a dividend of $0.50 is expected in two months
and again in nve months. The term structure is f1at, with all 企 interest rates being
10%. What is the price of a European put option that expires in six months and has a
strike price of $30?
Using the notation in the chapter, putcall parity [equation (9.7)] gives
c+
十 =p+ 8
0
or
p = c + Ke
rT
+ D  8
0
In this case
十 十 一 十 一 叫 一 = 2.51
58
In other words the put price is $2.51.
Problem 9.15.
Explain carefully the arbitrage opportunities in Problem 9.14 if the European put
price is $3.
If the put price is $3.00, it is too high relative to the call price. An arbitrageur should
buy the cal1, short the put and short the stock. This generates  2 + 十 = $30 in cash
which is invested at 10%. Regardless of what happens a profit with a present value of
3.00  2.51 = $0.49 is locked in.
If the stock price is above $30 in six months, the call option is exercised, and the
put option expires worthless. The call option enables the stock to be bought for $30, or
一 = $28.54 in present value terms. The dividends on the short position cost
一 + 一 = $0.97 in present value terms so that there is a 且 with
a present value of 30  28.54  0.97 = $0.49.
If the stock price is below $30 in six months, the put option is exercised and the call
option expires worthless. The short put option leads to the stock being bought for $30, or
30e0.l0x6/12 = $28.54 in present value terms. The dividends on the short position cost
ε + 一 = $0.97 in present value terms so that there is a 且 with
a present value of 一  0.97 = $0.49.
Problem 9.16.
The price of an American call on a nondividendpaying stock is $4. The stock price
is $31, the strike price is $30, and the expiration 优 in three months. The 企
interest rate is 8%. Derive upper and lower bounds for the price of an American put on
the same stock with the same strike price and expiration date.
From equation (9.4)
二 二  Ke
rT
In this case
31  30 < 4 _. P < 31 30e,008XO.25
or
1.00 < 4.00  P < 1. 59
or
2.41 < P < 3.00
Upper and lower bounds for the price of an American put are therefore $2.41 and $3.00.
Problem 9.17.
Explain carefully the arbitrage opportunities in Problem 9.16 if the American put
price is greater than the calculated upper bound.
If the American put price is greater than $3.00 丑 can sell the American
put , short the stock, and buy the American call. This rea1izes at least 十  4 = $30
59
which can be invested at the 仕 interest rate. At sorne stage during the 3rnonth
period either the Arnerican put or the Arnerican call will be exercised. The arbitrageur
then pays $30, receives the stock and closes out the short position. The cash flows to the
arbitrageur 十 at tirne zero 一 at sorne future tirne. These cash flows have a
positive present value.
Problem 9.18.
Prove the 山 equation (9.4). 饥 For the fìrst part of the relationship consider
但 a portfolio consisting of a European call plus an amount of cash equal to K and (b) a
portfolio consisting of an American put option plus one share.)
As in the text we use c and p to denote the European call and put option price, and
C and P to denote the Arnerican call and put option prices. Because P 三 ， it follows
仕 putcall parity that
三 Ke
rT
 8
0
and since c = C,
or
三 + Ke
rT
 8
0
C  P ::; 8
0
 K e
rT
For a further relationship between C and P, consider
Portfolio 1: One European call option plus an arnount of cash equal to K.
Portfolio J: One Arnerican put option plus one share.
Both options have the sarne exercise price and expiration date. Assurne that the cash in
portfolio 1 is invested at the riskfree interest rate. If the put option is not exercised early
portfolio J is worth
rnax (8T , K)
at tirne T. Portfolio 1 is worth
rnax(8T  K , 0) + Ke
rT
= rnax (8T ,K)  K + Ke
rT
at this tirne. Portfolio 1 is therefore worth rnore than portfolio J. Suppose next that the
put option in portfolio J is exercised early, say, at tirne T. This rneans that portfolio J is
worth K at tirne T. However, even if the call option were worthless, portfolio 1 would be
worth Ke
rT
at tirne T. It follows that portfolio 1 is worth at least as rnuch as portfolio J
in all circurnstances. Hence
c+K 二 三 P+80
Since c = C,
三 十
or
三
Cornbining this with the other inequality derived above for C  P , we obtain
8
0
 K::; C  三  Ke
rT
60
Problem 9.19.
Prove the 山 equation (9.8). (Hint: For the nrst part ofthe relationship consider
(a) a portfolio consisting of a European call plus an amount of cash equal to D + K and
(b) a portfolio 吨 。 an American put option plus one share.)
As in the text we use c and p to denote the European call and put option price, and
C and P to denote the American call and put option prices. The present value of the
dividends will be denoted by D. As shown in the answer to Problem 9.18, when there are
no dividends
二  Ke
rT
Dividends reduce C and increase p" Hence this relationship must also be true when there
are dividends.
For a further relationship between C and P, consider
扩 1: one European call option plus an amount of cash equal to D + K
Portfolio J: one American put option plus one share
Both options have the same exercise price and expiration date. Assume that the cash in
portfolio 1 is invested at the riskfree interest rate. If the put option is not exercised early,
portfolio J is worth
max (5T, K) + De
rT
at time T. Portfolio 1 is worth
max(5T  K , 0) + (D + K)e
TT
= max(5T, K) + De
TT
+ Ke
TT
 K
at this time. Portfolio 1 is therefore worth more than portfolio J. Suppose next that the
put option in portfolio J is exercised early, say, at time T. This means that portfolio J
is worth at most K + De
rT
at time T. However , even if the call option were worthless,
portfolio 1 would be worth (D + γ γ at time T. It follows that portfolio 1 is worth more
than portfolio J in all circumstances. Hence
C 卡 二 三 十
Because C > c
CP 二 三 5
0
DK
Problem 9.20.
Regular call options on nondividend. paying stocks should not be exercised early. But
there 1S a tendency for 实 的 可 面 目 如 市 百 回 阳 门 加 而
pays no dividends. (See Business Snapshot 8.3 for a discussion 侃 的 stock options.)
Give a possible reason for this.
Executive stock options may be exercised early because the executive needs the cash or
because he or she is uncertain about the company's future prospects. Regular call options
can be sold in the market in either of these two situations, but executive stock options
cannot be sold. In theory an executive can short the company's stock as an alternative to
exercising. In practice this is not usually encouraged and may even be illegal.
61
Problem 9.21.
Use the software DerivaGem to 命 Figures 9.1 and 9.2 are correct.
The graphs can be produced from the first worksheet in DerivaGem. Select Equity
as the Underlying Type. Select Analytic European as the Option Type. Input stock price
as 50, volatility as 30%, 仕 rate as 5%, time to exercise as 1 year, and exercise price
as 50. Leave the dividend table blank because we are assuming no dividends. Select the
button corresponding to call. Do not select the implied volatility button. Hit the Enter
key and c1ick on calculate. DerivaGem will show the price of the option as 7.15562248.
Move to the Graph Results on the right hand side of the worksheet. Enter Option Price
for the vertical axis and Asset price for the horizontal axis. Choose the minimum strike
price value as 10 (software will not accept 0) and the maximum strike price value as 100.
Hit Enter and click on Draw ， α This will produce Figure 9.1a. Figures 9.1c, 9.1e,
9.2a, and 9.2c can be produced similarly by changing the horizontal axis. By selecting put
instead of call and recalculating the rest ofthe figures can be produced. You are encouraged
to experiment with this τ different parameter values and different types of
options.
62
CHAPTER 10
￥ Strategies lnvolving Options
This is 缸 丑 that should not cause you too many problems. It describes
some of the ways options can be used to produce interesting profit patterns. Figure 10.1
shows what can be achieved by taking a position in the option and the underlying asset.
As putcall parity shows, a long or short position in the underlying asset can be used to
convert a) a short put to something that looks like a short call, b) a long call to something
that looks like a long put, c) a long put to something that looks like a long call, and d) a
short put to something that looks like a short call.
Spread is the word used to describe a position in two or more calls or two or more
puts.. Putcall parity shows that a spread created using calls can also be created using
puts. This is shown for four types of spreads in the chapter: bull spreads (see Figures 10.2
and 10.3); bear spreads (see Figures 10..5 and 10.4); butterfiy spreads (see Figures 10.6
and 10.7); and calendar spreads (see Figures 10.8 and 10.9).
Combination is the word used to describe a position involving both calls and puts. A
straddle involves buying a call and an put with the same strike price and maturity date.
A strangle involves buying a call and a put when the strike price of the call is greater than
that of the put.
In theory any payoff pattern can be created by using calls and puts with different
strike prices in an appropriate way. Figure 10.13 shows that a butterfiy spread can be
used to create a payoff 丑 is a small "spike". Any specified payoff pattern can
be by combining spikes judiciously.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 10.8.
Use putcall parity to relate the initial investment for a bull spread created using calls
to the initial investment for a bull spread created using puts.
A bull spread using calls provides a profit pattern with the same general shape as a
bull spread using puts (see Figures 10.2 and 10.3 in the text). Define Pl and Cl as the
prices of put and call with strike price K
1
and P2 and C2 as the prices of a put and call
with strike price K
2
. From putcall parity
TT
俨
ee
几
问
十
内
，
pupu 
SS
++
门
，
pp
Hence:
Pl  P2 = Cl  一
 K
1
)e
rT
This shows that the initial investment when the spread is 仕 puts is less than
the initial investment when it is created frorn calls by an arnount (K
2
 K
1
)e
rT
. In fact
63
as rnentioned in the text the initial investrnent when the bull spread is 仕 puts
is negative, while the initial investrnent when it is 仕 calls is positive.
The profit when calls are used to create the bull spread is higher than when puts are
used by (K
2
 K
1
)(1  e
rT
). This refl.ects the fact that the call strategy involves an
additional 仕 investrnent of (K
2
 Kl )e
rT
over the put strategy. This earns interest
of (K
2
 Kl)erT(e
rT
1) = (K
2
 KI) (l e
rT
).
Problem 10.9.
Explain how an aggressive bear spread can be created using put options.
An aggressive bull spread using call options is discussed in the text. Both of the
options used have relatively high strike prices. Sirnilarly, an aggressive bear spread can
be created 吨 options. Both of the options should be out of the rnoney (that is,
they should have relatively low strike prices). The spread then costs very little to set up
because both of the puts are worth close to zero. In rnost circurnstances the spread will
provide zero payoff" However, there is a srnall chance that the stock price will fall fast so
that on expiration both options will be in the rnoney. The spread then provides a payoff
equal to the difference between the two strike prices, K
2
 K
1
.
Problem 10.10.
Suppose that put options on a stock with strike prices $30 and $35 cost $4 and 代
respectively. How can the options be used to create (a) a bull spread and (b) a bear
spread? Construct a table that shows the pront and payoff for both spreads.
A bull spread is created by buying the $30 put and selling the $35 put. This strategy
gives rise to an initial cash infl.ow of $3. The outcorne is as follows:
Stock Price Payoff Profit
ST 2:: 35
三 < 35
ST < 30
O
ST  3,)
5
3
ST32
2
A bear spread is created by selling the $30 put and buying the $35 put. This strategy
costs $3 initially. The outcorne is as follows:
Stock Price Payoff 且
ST 三 。 3
三 < 35 35 ST 32 ST
ST < 30 5 2
64
Problem 10.11.
Use putcal1 parity to show that the cost of a butterBy spread 丘 。
puts is identica1 to the cost of a butterBy spread 企 European cal1s.
Define Cl , C2 , and C3 as the prices of calls with strike prices Kl , K
2
and K3. Define Pl,
P2 and 内 部 prices of puts with strike prices Kl , K2 and K3' With the usual notation
Hence
十
C2+K2eTT=P2+S
十
= P3 + S
十  2C2 +
十  2K
2
)e
rT
= Pl + P3  2P2
Because K
2
 K
1
= K3  K2 , it follows that
十  2K2 = 0 and
十  2C2 = 十  2P2
The cost of a butterfly spread created using European calls is therefore exact1y the same
as the cost of a butterfly spread created using European puts.
Problem 10.12.
A cal1 with a strike price of $60 costs $6. A put with the same strike price and
expiration date costs $4. Construct a tab1e that shows the 企 a straddle. For
what range of stock prices wou1d the straddle 1ead to a 1oss?
A stradd1e is created by buying both the call and the put. This strategy costs $10.
The 缸 is shown in the 吨
Stock Price
ST > 60
ST 60
Payoff
ST 60
60 ST
Profit
ST 70
50 ST
This shows that the stradd1e will 1ead to a 10ss if the fina1 stock price is between $50 and
$70.
Problem 10.13.
Construct a tab1e showing the 企 a bul1 spread when puts with strike prices
K
1
and K
2
are used (K2 > K
1
).
The bull spread is created by buying a put with strike price Kl and selling a put with
strike price K
2
. The payoff is ca1cu1ated as follows:
65
Stock Price
Range
Payoff from
Short Put Option
Tota1
Payoff
n o
m
划
的
句
涩
的
m
u
归
P
叫
。
L
ST 二 三 K2
K 1 < ST < K 2
ST 二
O
STK
2
STK
2
。
一
 ST)
一
K
1
)
。
O
K
1
S
T
Problem 10.14.
An investor believes that there wi11 be a big jump in a stock price, but is uncertain
as to the direction. 命 different strategies the investor can follow and explain the
differences among them.
Possib1e strategies are:
Strang1e
Stradd1e
Strip
Strap
Reverse ca1endar spread
Reverse butterfly spread
The strategies all provide positive profits when there are large stock price moves. A
strang1e is 1ess expensive than a stradd1e, but requires a bigger move in the stock price in
order to provide a positive profit. Strips and straps are more expensive than stradd1es but
provide bigger profits in certain CÎrcumstances. A strip will provide a bigger profit when
there is a 1arge downward stock price move. A strap will provide a bigger profit when
there is a 1arge upward stock price move , In the case of strang1es, stradd1es, strips and
straps, the 且 increases as the size of the stock price movement increases. By contrast
in a reverse ca1endar spread and a reverse butterfly spread there is a maximum potentia1
缸 of the size of the stock price movement.
Problem 10.15.
How can a forward contract on a stock with a particular delivery price and delivery
date be 丘 。 options?
Suppose that the delivery price is K and the delivery date is T. The forward contract
is created by buying a European call and selling a European put when both options have
strike price K and exerCÎse date T" This portfolio provides a payoff of ST  K under all
circumstances where ST is the stock price at time T. Suppose that Fo is the forward price.
lf K = Fo , the forward contract that is created has zero va1ue. This shows that the price
of a call equa1s the price of a put when the strike price is Fo.
66
Problem 10.16.
"A box spread comprises four options. Two can be combined to create a long for
ward position and two can be combined to create a short forward position." Explain this
statement.
A box spread is a bull spread created using calls and a bear spread created using
puts. With the notation in the text it consists of a) a long call with strike K l, b) a short
call with strike K2 , c) a long put with strike K2 , and d) a short put with strike Kl' a)
and d) give a long forward contract with delivery price K 1; b) and c) give a short forward
contract with delivery price K
2
. The two forward contracts taken together give the payoff
of K
2
 Kl.
Problem 10.17.
研 is the result if the strike price of the put is higher than the strike price of the
cal1 in a strangle?
，
… Cal\
\
\l ……Put !
… 口
、 气 、 ‘ 四 … 回 … … 嗣
飞 、
、 、
一 ， 一 一 → ι
'\
、 、
The result is shown in Figure 810. 1. The profit 仕 a long position in a call
and a put when the put has a higher strike price than a call is much the same as when the
call has a higher strike price than the put. Both the initial investment and the final payoff
are much higher in the first case
H
Z
O
」
h
h
,
‘ 时 _ _ _ ..J
且 Pattern in Problem 10.17 Figure 810.1
Problem 10.18.
One Australian dol1ar is currently worth $0.64. A onE• year butterßy spread is set up
using European cal1 options with strike prices of $0.60, $0.65, and $0.70. The 企
interest rates in the United States and Australia are 5% and 4% respectively, and the
67
volati1ity ofthe exchange rate is 15%. Use the DerivaGem software to calculate the cost of
setting up the butterf1y spread position. Show that the cost is the same if European put
options are used instead of European call options.
To use DerivaGem select 直 worksheet and choose Currency as the Underlying
Type. Select Analytic European as the Option Type. Input exchange rate as 0.64, volatility
as 15%, riskfree rate as 5%, foreign 仕 interest rate as 4%, time to exercise as 1
year, and exercise price as 0.60. Select the button corresponding to call. Do not select the
implied volatility button. Hit the Enter key and click on calculate. DerivaGem will show
the price of the option as 0.0618. Change the exercise price to 0.65, hit Enter, and click
on calculate again. DerivaGem will show the value of the option as 0.0352. Change the
exercise price to 0.70, hit Enter, and click on calculate. DerivaGem will show the value of
the option as 0.0181.
Now select the button corresponding to put and repeat the procedure. DerivaGem
shows the values of puts with strike prices 0.60, 0.65, and 0.70 to be 0.0176, 0.0386, and
0.0690, respectively.
The cost of setting up the butterfiy spread when calls are used is therefore
0.0618 + 一 x 0.0352 = 0.0095
The cost of setting up the butterfiy spread when puts are used is
0.0176 + 0.0690  2 x 0.0386 = 0.0094
Allowing for rounding errors these two are the same.
68
CHAPTER 11
Introduction to Binomial Trees
This chapter introduces binomial trees. There are a number of reasons why binomial
trees are covered at this relatively early stage in the book:
1. Binomial trees illustrate the noarbitrage arguments that can be used to derive the
BlackScholes model (Chapter 12)
2. Binomial trees illustrate the delta hedging strategies that can be used to hedge a
position in an option with a position in the underlying asset (Chapter 15)
3. Binomial trees illustrate the riskneutral valuation argument. This is of central im
portance in derivatives' pricing
4. Binomial trees constitute an important numerical procedure for valuing American
options. (Chapter 16.)
The chapter starts by considering onestep binomial trees for call options on a stock
(see, for example, Figure 11. 1). The option lasts until time T and there are assumed to be
only two possible stock prices at time T and therefore and only two possible option prices.
We consider portfo1ios consisting of a short position in one call option and a long position
in (delta) shares of the stock. For some value of the portfo1io has the same value
for both of the possible final stock prices. We 创 町 口 山
口 斗 For this value of the portfolio is riskless because its payoff at time T is known
for certain. As such it must earn the riskfree rate. The value of the portfolio today is the
口 value of the portfolio at time T. The value of the stock price is known today. The
value of the option price can therefore be calculated. (See equations 11.2 and 11.3.)
Section 11. 2 shows that in the case of a onestep binomial tree the option can be
valued by
1. Assuming that the expected return on the stock is the riskfree rate; and
2. Discounting the expected payoff on the option at the 仕 rate.
This is the riskneutral valuation argument. It is a very important argument in option
pricing. It says that if we assume that all market participants are riskneutral (in the
sense that they require the 仕 rate as the expected return on all risky assets) then
we get the right price for options. The price is not just correct in a riskneutral world. It
is correct in all other worlds as well.
Section 11.3 covers twostep binomial trees. In these the life of the option is divided
into two equal time steps. The change in the stock price during each time step is assumed to
be given by a onestep binomial tree (with the 此 ∞ up 缸 时 时 盹 bein
the same
69
compare Figures 11. 7 and 11.8 and make sure you understand the difference. They are
being used to value the same option except that in Figure 11.7 the option is European
whereas in Figure 11.8 it is American.
Once you have mastered twostep trees it is not difficult to extend the ideas in the
chapter to multistep trees. Section 11.7 gives formulas for calculating the proportional up
movement , u , the proportional down movement , d, and the riskneutral probability of an
up movement , p, from the stock price ， σ ， the length of the time step, ßt, and
the riskfree rate, r. The formulas are:
飞 ßt
u = e 一
1MU

JU
dd
α

u
p
where
rßt
α
The last part of the chapter looks ahead to later chapters and explains how the
binomial tree methodology can be used to value call and put options on stock indices,
currencies, and futures contracts. The formulas are the same as those given above except
that
γ
α
where
1. In the case of an option on a stock index, q is the average dividend yield on the index
during the life of the option
2. In the case of an option on a foreign currency, q is the foreign 仕 rate
3. In the case of an option on a futures contract, q γ α
You are strongly recommended to use the DerivaGem software and inspect the bino
mial trees it produces. A step by step procedure for using the software is at the end of
Section 11. 8. Examples 11.1, 11.2, and 11.3 in Section 11.9 show DerivaGem output.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 11.8.
Consider the situation in which stock price movements during the life of a European
option are governed bya twostep binomial tree. Explain why it is not possible to set up
a position in the stock and the option that remains riskless for the whole of the life of the
option.
The riskless portfolio consists of a short position in the option and a long position in
ß shares. Because ß changes during the life of the option, this riskless portfolio must also
change.
70
Problem 11.9.
A stock price is currently $50. It is known that at the end of two months it wil1 be
either $53 or $48. The 企 interest rate is 10% per annum with continuous compound
ing. What is the value of a twc• month European call option with a strike price of $49?
萨 arguments.
At the end of two months the value of the option will be either $4 (if the stock price
is $53) or $0 (if the stock price is $48). Consider a portfo1io consisting of:
+ß shares
1 option
The value of the portfolio is either 48ß or 53ß  4 in two months. If
48ß = 53ß4
l. e. ,
ß =0.8
the value of the portfolio is certain to be 38.4. For this value of ß the portfolio is therefore
riskless. The current value of the portfolio is:
0.8 x 50 _.!
where ! is the value of the option. Since the portfolio must earn the riskfree rate of
interest
(0.8 x 50  !)eOl0X2/12 = 38.4
l. e. ,
! = 2.23
The value of the optio:ri is therefore $2.23.
This can also be calculated directly from equations (11. 2) and (11.3). u 1. 06,
d = 0.96 so that
。
。
ρ
o
vhu nu

no
n
u
u 一
。
一
侃
1
一
一
队
2=o xAU
e
一
一
"r
and
一 ， x 0.5681 x 4 = 2.23
Problem 11.10.
A stock price is currently $80. It is known that at the end of four months it wil1 be
either $75 or $85. The 企 interest rate is 5% per annum with continuous compound
ing. What is the value of a fourmonth European put option with a strike price of $80?
φ arguments.
At the end of four months the value of the option will be either $5 (if the stock price
is $75) or $0 (if the stock price is $85). Consider a portfolio consisting of:
ß shares
十 option
71
(Note: The delta, .60 of a put option is negative. We have constructed the portfolio so that
it is +1 option and .60 shares rather than 1 option and +.60 shares so that the initial
investment is positive.)
The value of the portfolio is either 85.60 or 75.60 + 5 in four months. If
85.60 = 75.60 + 5
l. e. ,
.60 = 0.5
the value of the portfolio is certain to be 42.5. For this value of .6o the portfolio is therefore
riskless. The current value of the portfolio is:
0.5 x 80 + f
where f is the value of the option. Since the portfolio is riskless
(0..5 x 80 + f) e
o
05x4/12 = 42.5
l. e. ,
f = 1.80
The value of the option is therefore $1. 80.
This can also be calculated 仕 equations (1 1. 2) and (11.3). u = 1. 0625,
d = 0.9375 so that
eO 一 。
一 一 一 一  = 0.6345
一
1  p = 0.3655 and
f = e005X4/12 x 0.3655 x 5 = 1. 80
Problem 11.11.
A stock price is currently $40. It is known that at the end of three months it wi11
be either $45 or $35. The 企 rate of interest with quarterly compounding is 8%
per annum. Calculate the value of a threemonth European put option on the stock with
an exercise price of $40. 非 no.arbitrage arguments and riskneutral valuation
arguments give the same answers.
At the end of three months the value of the option is either $5 (if the stock price is
$35) or $0 (if the stock price is $45).
Consider a portfolio consisting of:
qunu
吧
。
aH
KOA
qunU A
、

t
i
「
+
(Note: The delta, .60, of a put option is negative. We have constructed the portfolio so that
it is + 1 option and.60 shares rather than 1 option and +.60 shares so that the initial
investment is positive.)
72
The value of the portfolio is either + 5 or If:
+ 5 =
l. e. ,
= 0.5
the value of the portfolio is certain to be 22.5. For this value of the portfolio is therefore
riskless. The current value of the portfolio is
+ f
where f is the value of the option. 8ince the portfolio must earn the 仕 rate of
interest
(40 x 0.5 + f) x 1. 02 = 22.5
Hence
f = 2.06
i. e. , the value of the option is $2.06.
This can also be calculated using riskneutral valuation. 8uppose that p is the prob
ability of an upward stock price movement in a riskneutral world. We must have
45p + 35(1  p) = 40 x 1. 02
l. e. ,
lOp = 5.8
or:
p = 0.58
The expected value of the option in a riskneutral world is:
This has a present value of
。 0.58 + 5 x 0.42 = 2.10
2.10
一 一 = 2.06
1.02
This is consistent with the noarbitrage answer.
Problem 11.12.
A stock price is currently $50. ， 月 each of the next two thre• month periods it is
臼 to go up by 6% or down by 5%. The 丘 interest rate is 5% per annum with
continuous compounding. What is the value of a sixmonth European call option with a
strike price of $51?
A tree describing the behavior of the stock price is shown in Figure 811.1. The risk
neutral probability of an up move, p, is given by
e005x3/12  0.95
p = , "" ^ "'" = 0.5689
1. 06  0.95
73
There is a 仕 the option of 56.18  51 = 5.18 for the 直 node (which
corresponds to two up moves) zero in all other cases. The value of the option is therefore
5.18 X 0.5689
2
ε 一
= 1. 635
This can also be calculated by working back through the tree as indicated in Figure 811. 1.
The value of the call ootion is the lower number at each node in the fi!!ure.
50
1.635
Problem 11.13.
56.18
5.18
50.35
0
45.125
0
Figure τ for Problem 11. 12
For the situation considered in Problem 11.12, what is the va1ue of a sixmonth Euro
pean put option with a strike price of $51? 命 the European call and European put
prices 命 parity" If the put option were American, would it ever be optimal
to exercise it early at any of the nodes on the tree?
The tree for valuing the put option is shown in Figure 811.2. We get a payoff of
51  50.35 = 0.65 if the middle final node is reached and a payoff of 51 ...45.125 = 5.875 if
the 且 node is reached. The value of the option is therefore
(0.65 x 2 x 0.5689 x 0.4311 + 5.875 x 0.43112)e005X6/12 = 1.376
This can also be calculated by working back through the tree as indicated in Figure 811.2.
The value of the put plus the stock price is from Problem 11. 12
十 = 51.376
The value of the call plus the present value of the strike price is
十 = 51.376
This verifies that putcall parity holds
To test whether it worth exercising the option early we compare the value calculated
for the option at each node with the payoff from immediate exercise. At node C the payoff
74
from immediate exercise is 51 47.5 = 3.5. Because this is greater than 2.8664, the option
should be exercised at this node. The option should not be exercised at either node A or
node B.
50
1.376
Problem 11.14.
56.18
0
50.35
0.65
45.125
5.875
Figure S11.2 Tree for Problem 11. 13
A stock price is currently $25. It is known tbat at tbe end of two montbs it wi11
be eitber $23 or $27. Tbe r i s k  企 e e ínterest rate is 10% per annum witb continuous com
pounding" Suppose ST is tbe stock price at tbe end of two montbs. Wbat ís tbe value of
a derivative tbat pays off Sf at tbis time?
At the end of two months the value of the derivative will be either 529 (if the stock
price is 23) or 729 (if the stock price is 27). Consider a portfolio consisting of:
+ß shares
1 derivative
The value of the portfolio is either 27 ß  729 or 23ß  529 in two months. If
27ß  729 = 23ß  529
l. e" ,
ß = 50
the value of the portfolio is certain to be 621. For this value of ß the portfolio is therefore
riskless. The current value of the portfolio is:
50 x 25  f
where f is the value of the derivative. Since the portfolio must earn the r i s k  仕 e e rate of
interest
(50 x 25  f) e
o
10x2j12 = 621
75
l. e. ,
f = 639.3
The value of the option is therefore $639,, 3.
This can also be calculated directly from equations (11.2) and (11.3). u 1. 08,
d = 0.92 so that
nu vo nu nu hu

。
Qu nu
qG J'f qLA
×
A
nu 'i nu
…
pu
 p
and
f = eO. lOx2j12(0.6050 x 729 + 0.3950 x 529) = 639.3
Problem 11.15.
Calculate u, d, and p when a binomial tree is constructed to value an option on a
foreign currency. The tree step size is one month, the domestic ínterest rate is 5% per
annum, the foreign interest rate is 8% per annum, and the volati1i ty is 12% per annum.
In this case
α ε = 0,, 9975
u = e
012
Jï/12 = 1.0352
nd
问
vhU
哇
nu
刷
90O E'hponhu
、
=9od EAUnU
一
一
tiwhunL
町
一
历
dQuo
AUtA
一
p
76
CHAPTER 12
Valuing Stock Options: The BlackScholes Model
This is the point at which the book begins to get a little more technical! Chapter 12
presents the pathbreaking stock option pricing model published by Fischer Black, Myron
Scholes, and Robert Merton in 1973. The BlackScholes model is based on the assumption
that the stock price at any future time has a lognormal probability distribution (see Figure
12.1). This assumption is valid in a world where the return on the stock (not the stock
price itself) follows a random walk.
The BlackScholes model is given by equations (12.5) and (12.6):
where
c = 5
0
N(d
1
)  Ke
rT
N(d
2
)
p = Ke
rT
N(d
2
)  5
0
N(d
1
)
也 一 旦 十 巳 σ
一
σ 飞
十  (72/2)T J _ 石
一 一 一 出 一 σ
σ 飞
In these equations, c and p are the prices of European call and put 丑 on the stock, 50
is the current stock price, K is the strike price, r is the riskfree ， σ the volatility, and
T is the time to maturity. The function N (x) is the cumulative probability distribution
function for a normally distributed variable with a mean of zero and a standard deviation
of 1. (See Figure 12.4.)
The stock is assumed to pay no dividends in the basic BlackScholes model. The
European option price depends on five variables: 8 , ， 飞 σ ， and T. Of these, two are
properties of the option and therefore known (K and T) , two are market variables that
can be readily observed (50 and r). Only the volatility σ 臼 problems when the
formula is used. Section 12.4 explains how volatility can be estimated from historical data.
Section 12.9 explains how volatility can be 仕 the mar ket prices of options.
You should make sure you understand the noarbitrage arguments 丑 12.6.
They are similar to the noarbitrage arguments used in Chapter 11 to price options when
there is onestep binomial tree. The difference is that in this case the portfolio that is set
up remains riskless for only a very short (theoretically an infinitesimally short) period of
time.
Another important section is Section 12.8. This extends the riskneutral valuation
ideas introduced in Chapter 11. Make sure you understand how riskneutral valuation can
be used to get the
f = 50  Ke
rT
77
formula for valuing a forward contract with delivery price K. The BlackScholes formula
can be derived using riskneutral valuation. The methodology is analogous to the method
ology for valuing a forward contract with delivery price K , but the math is much more
involved.
The last part of the chapter discusses how the BlackScholes formula can be modified
to allow for dividends. The basic approach is to calculate D, the present value of the
dividends that will be paid during the life of the option. The variable 80 is then replaced
by 80  D in the BlackScholes formula. Black's approximation for valuing American call
options involves setting the price equal to the greater of the prices of two European call
options. The first expires at the same time as the American option; the second expires just
before the final exdividend date (i.e. , the exdividend date that is closest to, but before,
the American option's maturity).
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 12.8.
A stock price is currently $40. Assume that the expected 企 the stock is
15% and its volati1ity is 25%. What is the probability distribution for the rate of return
(with continuous compounding) earned over a oneyear period?
In this μ 0.15 and σ 0.25. From equation (12.4) the probability distribution
for the rate of return over a oneyear period with continuous compounding is:
\111I/
VKJU
巧
，
"
nu
2l
22
n
u
一
严
气
U
4·i nu
, /III\
AV
l.e. ,
功 ， 0.25)
The expected value of the return is 11.875% per annum and the standard deviation is
25.0% per annum.
Problem 12.9.
A stock price has an expected return of 16% and a volati1ity of 35%. The current
price is $38.
a. What is the probabi1i ty that a European call option on the stock with an exercise
price of $40 and a maturity date in six months wi11 be exercised?
b. What is the probabi1ity that a European put option on the stock with the same
exercise price and maturity wi11 be exercised?
(a) The required probability is the probability of the stock price being above $40 in six
months time. Suppose that the stock price in six months is .. 'h
0.35
2
ln 8T f'V cþ(ln38 + 一 ， 而 王
l. e. ,
ln ST f'V cþ(3.687, 0.247)
78
Since ln 40 = 3.689, the required probability is
1N 飞 = 1 川
Frorn norrnal distribution tables N(0.008) = 0.5032 so that the required probability is
0.4968.
(b) In this case the required probability is the probability of the stock price being less
than $40 in six rnonths tirne. It is
1  0.4968 = 0.5032
Problem 12.10.
Prove that, with the notation in the chapter, a 95% confìdence interval for ST is
between
μ 一 σ σ and μ 一 σ σ
Frorn equation (12.2):
ln ST ""' cþ[ln So + μ 一 二 ， σ
95% 直 intervals for ln ST are therefore
lnSo + μ 一 伽
and
_2
1nSo + μ 一 亏 伽
95% confidence intervals for ST are therefore
e1n μ 一 σ 一 σ
and
十 μ
σ 吁
l. e.
μ 一 σ σ
and
μ 一 σ 十 σ 于
Problem 12.11.
A portfolio manager announces that the average of the returns realized in each of the
last 10 years is 20% per annum. In what respect is this statement misleading?
This problern relates to the rnaterial in Section 12.2. The staternent is rnisleading in
that a certain surn of rnoney, say $1000, when invested for 10 years in the fund would have
realized a return (with annual cornpounding) of less than 20% per annurn.
79
The average of the returns realized in each year is always greater than the return
per annum (with annual compounding) realized over 10 years. The first is an arithmetic
average of the returns in each yearj the second is a geometric average of these returns.
Problem 12.12.
Assume that a nondividendpaying stock has an expected return μ a volatility
of σ An 亘 institution has just announced that it wi11 trade a derivative
that pays off a dollar amount equal to
去
at time T. The variables 8
0
and 8
T
denote the values of the stock price at time zero
and time T.
a. Describe the 企 this derivative.
b. Use riskneutral valuation to calculate the price of the derivative at time zero.
(a) The derivative will pay off a dollar amount equal to the continuously compounded
return on the security between times 0 and T.
(b) The expected value of ln(8
T
/80) ， 仕 equation (12.4), μ 一 σ The expected
仕 the derivative is therefore μ 一 σ In a riskneutral world this becomes
一 σ The value of the derivative at time zero is therefore:
一
Problem 12.13.
What is the price of a European call option on a nondividendpaying stock when the
stock price is $52, the strike price is $50, the 企 interest rate is 12% per annum, the
volatility is 30% per annum, and the time to maturity is three months?
In this case 8
0
= 52, K = 50, r = ， σ 0.30 and T = 0.25.
ln(52/50) + (0.12 + 0.3
2
/2)0.25
一 一 一 = 0.5365
10.3odz
d
2
= d
1
 0.30)0.25 = 0.3865
The price of the European call is
or $5.06.
52N(0.5365)  50e012X025 N(0.3865)
= 52 x 0.7042  一 x 0.6504
= 5.06
80
Problem 12.14.
司 is the price of a European put option on a nondividendpaying stock when the
stock price is $69, the strike price is $70, the 企 interest rate is 5% per annum, the
volatility is 35% per annum, and the time to maturity is six months?
In this case 80 = 69, K = 70, 'f' = ， σ 0.35 and T = 0.5.
ln(69/70) + (0.05 + 0.35
2
/2) X 0.5
一 一 一 rT =0.1666
飞
d
2
= d
1
 0.35VG.5 = ω
The price of the European put is
or $6.40.
Problem 12.15.
一 N(0.0809) _. 69N( 0.1666)
= 70e
0025
x 0.5323  69 x 0.4338
= 6.40
A call option on a nondividendpaying stock has a market price of $2.50. The stock
price is $15, the exercise price is $13, the time to maturity is three months, and the 企
interest rate is 5% per annum. What is the implied volati1ity?
In the case c = 2.5, 8
0
= 15, K = 13, T = 0.25, 二 The implied volatility must
be calculated using an iterative procedure.
A volatility of 0.2 (or 20% per annum) gives c = 2.20. A volatility of 0.3 gives c = 2.32.
A volatility of 0.4 gives c = 2.507. A volatility of 0.39 gives c = 2.487. By interpolation
the implied volatility is about 0.396 or 39.6% per annum.
The implied volatility can also be calculated using DerivaGem. Select equity as the
Underlying Type in the first worksheet. Select Analytic European as the Option Type.
Input stock price as 15, the riskfree rate as 5%, time to exercise as 0.25, and exercise
price as 13. Leave the dividend table blank because we are assuming no dividends. Select
the button corresponding to call. Select the imp1ied volatility button. Input the Price as
2.5 in the second half ûf the optiûn data table. Hit the Enteï key and click on calculate.
DerivaGem will show the volatility of the option as 39.64%.
Problem 12.16.
Show that the BlackScholes formula for a call option gives a price that tends to
max (80 K , 0) as T • O.
。 + ('f' σ
i σ
ln(8
0
/K) , 十 σ 今 后
一 一 一 一 一 6
σ σ 
81
As T • 0, the second term on the right hand side tends to zero. 且 term tends to
∞ K) > 0 and 。 一 ∞ ln(8
0
/ K) < O. Since ln(8
0
/ K) > 0 when 8
0
> K and
ln(80 / K) < 0 when 8
0
< K , it follows that
→ ∞
T • o when 8
0
> K
→ 一 ∞
T • o when 8
0
< K
Similarly
→ ∞
T • o when 8
0
> K
→ 一 ∞
T • o when 8
0
< K
Under the BlackScholes formula the call price, c is given by:
c = 8
0
N(dI)  Ke
rT
N(d
2
)
From the above results, when 8
0
> K , N(d
1
) •1. 0 and N(d
2
) •1. 0 as T • o so that
C• 8
0
 K. Also, when 8
0
< K , N(d
1
) • o and N(d
2
) • o as T • o so that c • O.
These results show that 一 步
 K , 0) as T • O.
Problem 12.17.
Explain carefully why Black's approach to evaluating an American call option on a
dividendpaying stock may give an approximate answer even when only one dividend is
anticipated. Does the answer given by Black's approach understate or overstate the true
option value? Explain your answer.
Black's approach in effect assumes that the holder of option must decide at time zero
whether it is a European option maturing at time tn 直 exdividend date) or a
European option maturing at time T. In fact the holder of the option has more flexibi1ity
than this. The holder can choose to exercise at time tn if the stock price at that time is
above some level but not 趴 ， if the option is not exercised at time t
n
,
it can still be exercised at time T.
It appears that Black's approach should understate the true option value. This is
because the holder of the option has more alternative strategies for deciding when to
exHCise tAe 址 。 且 也 ttle tewo stBEategies i111plicitly assumed by ξ 且
alternative strategies add value to the option.
However, this is not the whole story! The standard approach to valuing either an
American or a European option on a stock paying a single dividend applies the volatility
to the stock price less the 臼 value of the dividend. (The procedure for valuing an
American option is explained in Chapter 16.) Black's approach when 吨
just prior to the dividend date applies the volatility to the stock price itself. Black's
approach therefore assumes more stock price variability than the standard approach in
some of its calculations. In some circumstances it can give a higher price than the standard
approach.
82
Problem 12.18.
Consider an American call option on a stock. The stock price is $70, the time to
maturity is eight months, the 企 rate of interest is 10% per annum, the exercise price
is $65, and the volati1ity is 32%. A dividend of $1 is expected 丘 θ three months and again
丘 six months. Use the results in the appendix to show that it can never be optima1 to
exercise the option on either of the two dividend dates. Use DerivaGem to calculate the
price of the option.
With the notation in the text
D
1
= D
2
= 1, iI = 0.25, t2 = 0.50, T = 0.6667, r = 0.1 and K = 65
K(1  e
r
(Tt
2
)) = 65(1 一 = 1.07
Hence
D
2
< K(1 → 一 切
Also:
K(1 
一 ω
= 65(1  e
O
1 X025) = 1.60
Hence:
D
1
< K(1  e
r
(t
2
t
1
))
It follows from the conditions established in the Appendix to Chapter 12 that the option
should never be exercised early. The option can therefore be value as a European option.
The present value of the dividends is
Also:
一 + e050XOl = 1.9265
8
0
= 68.0735, K = ， σ 0.32, r = 0.1, T = 0.6667
ln 十 + 0.32
2
/2)0.6667
1= 一 一 厅 一 一 一 一 一 一 0.5626
飞
d
2
= d
1
 而 高 百 0.3013
N(dd = 0.7131, N(d
2
) = 0.6184
and the call price is
68.0735 x 0.7131 一 x 0.6184 = 10.94
or $10.94.
DerivaGem can be used to calculate the price of this option. Select equity as the
Underlying Type in the first worksheet. Select Analytic European as the Option Type.
Input stock price as 70, the volatility as 32%, the 仕 rate ω ， time to exercise
as =8/12, and exercise price as 65. In the dividend table, enter the times of dividends
as 0.25 and 0.50, and the 日 of the dividends in each case as 1. Select the button
83
corresponding to call. Hit the Enter key and click on calculate. DerivaGem will show the
value of the option as $10.942.
Problem 12.19.
A stock price is currently $50 and the riskfree interest rate is 5%. Use the DerivaGem
software to translate the following table of European call options on the stock into a table
of implied volati1ities, assuming no dividends. Are the option prices consistent with the
assumptions underlying BlackScholes?
Maturity (months)
Strike Price ($) 3 6 12
45 7.00 8.30 10.50
50 3.50 5.20 7.50
55 1.60 2.90 5.10
Using DerivaGem we obtain the following table of implied volatilities
Maturity (months)
Strike Price ($) 3 6 12
505 455
37.78
34.15
31.98
34.99
32.78
30.77
34.02
32.03
30.45
To calculate first number, select equity as the Underlying Type in the first worksheet.
Select Analytic European as the Option Type. Input stock price as 50, the 仕 rate
as 5%, time to exercise as 0.25, and exercise price as 45. Leave the dividend table blank
because we are assuming no dividends. Select the button corresponding to call. Select
the implied volatility button. Input the Price as 7.0 in the second half of the option data
table. Hit the Enter key and click on calculate. DerivaGem will show the volatility of the
option as 37.78%. Change the strike price and time to exercise and recompute to calculate
the rest of the numbers in the table.
The option prices are not exactly consistent with BlackScholes. If they were, the
implied volatilities would be all the same. We usually find in practice that low strike
price options on a stock have 且 higher implied volatilities than high strike price
options on the same stock. This phenomenon is discussed in Chapter 17.
Problem 12.20.
Show that the BlackScholes formulas for call and put options 牛 parity.
The BlackScholes formula for a European call option is
c = SoN(d
1
)  K e
rT
N(d
2
)
84
so that
c + Ke
rT
=
一
十
or
c + Ke
rT
= 8
0
N(d
1
) + Ke
rT
[l  N(d
2
)]
or
C 十
= 8
0
N(d
1
) + Ke
rT
N( d
2
)
The BlackScholes formula for a European put option is
p = K e
rT
N( d
2
)  8
0
N( dI)
so that
p + 8
0
= Ke
rT
N( d
2
)  8
0
N(dI) + 8
0
or
p + 80 = Ke
rT
N(d
2
) + 8
0
[1
月
or
卡
=
十
This shows that the putcall parity result
c+ Ke
rT
= p+ 8
0
holds.
Problem 12.21.
Show that the 剖 ， that a European call option wi11 b θ exercised in a 归 占 仨 ← 町 咀
world 必 ， 时 由 由 θ introduced 扭 由 归 chapter, N (d
2
). What is an expression for
the value of a derivative that pays off $100 ifthe price of a stock at time T is greater than
K?
The probability that the call option will be exercised is the probability that 8
T
> K
where 8
T
is the stock price at time T. In a risk neutral world
ln8T r..J cþ[ln80 + 一 σ ， σ 于
The probabi1ity that 8T > K is the same as the probability that ln 8T > ln K. This is
1N 旦 二 节
川
川
一
叶

d
叫
一
一
一
N
85
The expected value at time T in a risk neutral world of a derivative security which
pays off $100 when ST > K is therefore
100N(d
2
)
From risk neutral valuation the value of the security at time t is
100e
rT
N(d2)
Problem 12.22.
The notes accompanying a company's B.nancial statements say: "Our executive stock
options 1 ω t 10 years and vest after 4 years. We valued the options granted this year using
the BlackScholes model with an expected life of 5 years and a volatility of 20%." What
does this mean? Discuss the modeling approach used by the company.
It means that the price of the option was valued using BlackScholes with T = 5
and σ = 20%. As explained in Section 12.11 this "quick and dirty" approach to valuing
executive stock options has no theoretical basis. There is no reason why a European option
with a time to maturity equal to the expected life should be worth about the same as an
executive stock option that can be exercised any time between 4 years and 10 years and
on average is exercised after 5 years. However the results from using the quick and dirty
approach are usually not too unreasonable.
86
CHAPTER 13
Options on Stock lndices and Currencies
If you have a good understanding of Chapter 12, this chapter should 丑 few
problems. The chapter provides some examples of how index options and foreign currency
options are used and then moves on to extend the 仕 Chapter 12 so that they
can be used to value European options on indices and foreign currencies.
As explained in Section 13.1, index put options can be used to provide portfolio
insurance (i. e. , ensure that the value of a portfolio does not fall below a certain level). The
assets underlying the option should equal the beta of the portfolio times the assets being
insured. The strike price should be chosen so that when the index equals the strike price
the value of portfolio can be expected to be equal to the insured value. (This is a capital
asset pricing model calculation.) Section 13.2 introduces range forward contracts. These
are products designed to ensure that the exchange rate applicable to a foreign currency
transaction in the future lies between two levels. Range forward contracts can be created
by buying a put and 吨 call (Figure 13.1a) or buying a call and selling a put (Figure
13.1b)
The key material for valuation is in Section 13.3. This shows that, if an investment
asset provides a yield at rate q, then the BlackScholes formula applies for a European
option with 80 replaced by 80e
qT
(see equations 13.4 and 13.5). What is ω ， the lower
bounds on option prices in Chapter 9 apply with 8
0
replaced by 8
0
e
qT
(see equations 13.1
and 13.2). Also 叶 一 parity applies with 8
0
replaced by 80e
qT
(see equation 13.3).
For American options we must arrange the tree so that on average the asset price
grows at r  q rather than r in the riskneutral world represented by the tree. This means
that the growth factor variable α defined as e(• q)At rather than as e
TAt
.
When valuing options on stock indices we set q equal to the average dividend yield on
the index during the life of the option. Most exchangetraded options on stock indices are
European. An exception is the OEX (American option on the S&P 100).
When valuing options on currencies we set q equal to the foreign riskfree rate, rf.
Make sure you understand why a currency is analogous to an asset providing a known
yield. The key point is that interest income on the foreign currency is earned in the foreign
currency not the domestic currency, As equations (13,, 11) and (13.12) show, the pricing
formulas for European currency options can be expressed in
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 13.8.
Suppose that an exchange constructs a stock index that tracks the return, inc1uding
dividends, on a certain portfolio. Explain η would value (a) futures contracts and
(b) European options on the index.
87
A total return index behaves like a stock paying no dividends. In a riskneutral world
it can be expected to 万 on average at the 仕 rate. Futures contracts and options
on total return indices should be valued using the ω futures contracts and options
on nondividendpaying stocks with 8
0
equal to the current value of the index.
Problem 13.9.
A foreign currency is currently worth $1. 50. The domestic and foreign 企
rates are 5% and 9%, respectively. Calculate a lower bound for the value of a sixmonth call
option on the currency with a strike price of $1 .40 if it 但 European and (b) American.
Lower bound for European option is
8
0
e
rfT
 K e
rT
= 一 _ 1.4e005x05 = 0.069
Lower bound for American option is
80 K = 0.10
Problem 13.10.
Consider a stock index currently standing at 250. The dividend yield on the index
is 4% per annum, and the 企 rate is 6% per annum. A three month European call
option on the index with a strike price of 245 is currently worth $10. What is the value of
a threemonth put option on the index with a strike price of 2457
In this case 8
0
= 250, q = 0.04, r = 0.06, T = 0.25, K = 245, and c = 10. Using
putcall parity
c + Ke
rT
= p + 8
0
e
qT
or
p = c + Ke
rT
 8
0
e
qT
Substituting:
p = 10 + 一 _ 250e0 25xO04 = 3.84
The put price is 3.84.
Problem 13.11.
An index currently stands at 696 and has a volati1i ty of 30% per annum. The 企
rate of interest is 7% per annum and the index provides a dividend yield of 4% per annum.
Calculate the value of a threemonth European put with an exerCÍse price of 700.
In this case 8
0
= 696, K = 700, r = ， σ 0.3, T = 0.25 and q = 0.04. The option
can be valued 鸣 (13.5).
ln (696/700) + (0.07  0.04 + 0.09/2) x 0.25
d1 一 一 一 一 一 一 一 一 一 一 一 二 一 一 一 一 一 一 一 一 = 0.0868
飞
d
2
= d
1
. 旷 日 = 0.0632
88
and
N(dI) = 0.4654, 一 句 = 0.5252
The value of the put, p, is given by:
p = 700e0.07X025 x 0.5252  696e004x025 x 0.4654 = 40.6
i. e. , it is $40.6.
Problem 13.12.
Show that if C is the price of an American call with exercise price K and maturity
T on a stock paying a dividend yield of q, and P is the price of an American put on the
same stock with the same strike price and exercise date,
Soe qT  K < C  P < 8
0
 K e rT
where 8
0
is the stock price, r is the 丘 rate, and r > O. (Hint: To obtain the
first half of the inequality, consider possible va1ues of:
Portfolio A: a European call option plus an amount K invested at the 企 rate
叫 B: an American put option plus e
qT
of stock with dividends being rein
vested in the stock
To obtain the second half of the inequality, consider possible values of:
Portfolio C: an American call option plus an amount K 一 叩 at the 企
rate
时 D: a European put option plus one stock with dividends being ， 臼
in the stock)
Following the hint , 且 consider
扩 A: A European call option plus an amount K invested at the riskfree
rate
付 B: An American put option plus 吁 of stock with dividends being
reinvested in the stock.
Portfo1io A is worth c + K while portfo1io B is worth P + 8
0
e
qT
. If the put option
is exercised at time T 三 < T) , portfo1io B becomes:
K  8T' +
三
where S7 is the stock price at time T. Portfo1io A is worth
十
;:::: K
Hence portfo1io A is worth at least as much as portfo1io B. If both portfo1ios are held to
maturity (time T) , portfo1io A is worth
max(8T  K, 0) + 叮
= max(8T, K) + K(e
rT
 1)
89
Portfolio B is worth max(8T, K). Hence portfolio A is worth more than portfolio B.
Because portfolio A is worth at least as much as portfolio B in all circumstances
p + 8
0
e
qT
二 十
Because c < c:
三
十
or
8
0
e
qT
 三
This proves 且 part of the inequality.
For the second part consider:
矿 C: An American call option plus an amount K e
rT
invested at the
仕 rate
旷 D: A European put option plus one stock with dividends being rein
vested in the stock.
Portfolio C is worth 十 e rT while portfolio D is worth 十 If the call option
is exercised at time T 三 < T) portfolio C becomes:
8
r
 K + γ < 8
T
while portfolio D is worth
p + 8
T
é(Tt) 三
Hence portfolio D is worth more than portfolio C. If both portfolios are held to maturity
(time T) , portfolio C is worth max(8T, K) while portfolio D is worth
max(K  8
T
, 0) + 8Te
qT
= max(8T, K) + 8T(e
qT
 1)
Hence portfolio D is worth at least as much as portfolio C.
Since portfolio D is worth at least as much as portfolio C in all circumstances:
十
三
8
0
Since p 二
十
三
十
or
c  三
_ Ke
rT
This proves the second part of the inequality. Hence:
8
0
e
qT
 三 二
_ Ke
rT
90
Problem 13.13.
Show that a European call option on a currency has the same price as the φ
sponding European put option on the currency when the 再 price equals the strike
pnce.
This 仕 putcall parity and the 丑 between the forward ， 岛 ，
and the spot price, 8
0
.
c+ Ke
rT
斗
、
and
Fo = 8
0
e(rr,)T
so that
十 e
rT
= p + Foe
rT
If K = Fo this reduces to c = p. The resu1t that c = p when K = Fo is true for options on
all under1ying assets, not just options on currencies. An 噜 option 仕
defined as one where K = Fo (or c = p) rather than one where K = 8
0
.
Problem 13.14.
Would you expect the volatility of a stock index to be greater or less than the volatility
of a typical stock? Explain your answer.
The v01atility of a stock index can be expected to be 1ess than the v01atility of a
typical stock. This is because some risk (i. e. , return uncertainty) is diversified away when
a portfolio of stocks is created. In capita1 asset pricing mode1 termin010gy, there exists
systematic and unsystematic risk in the 仕 an individual stock. However, in
a stock index, unsystematic risk has been diversified away and on1y the systematic risk
contributes to volatility.
Problem 13.15.
Does the cost of portfolio insurance increase or decrease as the beta of a portfolio
increases? Explain your answer.
The cost of portfolio insurance increases as the beta of the portfolio increases. This
is because portfolio insurance inv01ves the purchase of a put option on the portfolio. As
beta ω ， the volatility of the portfo1io increases causing the cost of the put option
to increase. When index options are used to provide portfolio insurance, both the number
of options required and the strike price increase as beta increases.
Problem 13.16.
Suppose that a portfo1io is worth $60 mil1ion and the S&P 500 is at 1200. If the
value of the portfo1io mirrors the value of the index, what options should be purchased to
provide protection against the value of the portfolio falling below $54 mil1ion in one year's
time?
If the va1ue of the portfolio mirrors the value of the index, the index can be expected
to have dropped by 10% when the va1ue of the portfolio drops by 10%. Hence when the
91
value of the portfolio drops to $54 million the value of the index can be expected to be
1080. This indicates that put options with an exercise price of 1080 should be purchased.
The options should be on:
60.000.000
一 」 一 一 」 一 一 、
1200
times the index. Each option contract is for $100 times the index. Hence 500 contracts
should be purchased.
Problem 13.17.
Consider again the situation in Problem 13.16. Suppose that the portfolio has a beta
of 2.0, the 企 interest rate is 5% per annum, and the dividend yield on both the
portfolio and the index is 3% per annum. What options should be purchased to provide
protection against the value of the portfolio fa1ling below $54 mil1ion in one year's time?
When the value of the portfolio falls to $54 million the holder of the portfolio makes a
capitalloss of 10%. After dividends are taken into account the loss is 7% during the year.
This is 12% below the 仕 interest rate. According to the capital asset pricing model:
Excess expected return of portfolio n. Excess expected return of market
=ßx
above riskless interest rate above riskless interest rate
Therefore, when the portfolio provides a return 12% below the 仕 interest rate, the
market's expected return is 6% below the 仕 interest rate. As the index can be
assumed to have a beta of 1.0, this is also the excess expected return (including dividends)
仕 the index. The expected return from the index is therefore 1% per annum. Since
the index provides a 3% per annum dividend yield, the expected movement in the index
is .4%. Thus when the portfolio's value is $54 million the expected value of the index
0.96 x 1200 = 1152. Hence European put options should be purchased with an exercise
price of 1152. Their maturity date should be in one year.
The number of options required is twice the number required in Problem 13.16. This is
because we wish to protect a portfolio which is twice as sensitive to changes in market con
ditions as the portfolio in Problem 13.16. Hence options on $100,000 (or 1,000 contracts)
should be purchased. To check that the answer is correct consider what happens when
the value of the portfolio declines by 20% to $48 mi1lion. The return including dividends
is 17%. This is 22% less than the riskfree interest rate. The index can be expected to
provide a return (including dividends) which is 11% less than the 仕 interest rate,
i.e. a return of 6%. The index can therefore be expected to drop by 9% to 1092. The
仕 the put options is (1152. 1092) x 100,000 = $6 million. This is exactly what
is required to restore the value of the portfolio to $54 million.
92
CHAPTER14
Futures Options
The first part of this chapter describes how futures options work. A call futures option
is the right to enter into a long futures contract by a certain future date. The cash payoff
when the option is exercised is F  K where F is the most recent settlement futures price
and K is the strike price. The exerciser also obtains a long futures contract. A put futures
option is the right to enter into a short futures contract by a future date. The cash payoff
when the option is exercised is K  F. The exerciser also obtains a short futures contract.
(See Examples 14.1 and 14.2). When the value ofthe futures contract is taken into account
the payoff on a call is the excess of the futures price at the time of exercise over the strike
price and the payoff on a put is the excess of the strike price over the futures price at the
time of exercise.
It turns out that a futures price can be treated like an asset that provides a yield
equal to the riskfree rate, r. The reason is that, because it costs nothing to enter into
a futures contract, the contract must on average give zero 缸 a 咀 world.
Hence its expected growth rate in a riskneutral world must be zero. This is the same as
the expected growth rate for an asset providing a yield at rate r.
Bounds for futures options (equations 14.3 and 吗 ， putcall parity for futures 啕
tions (equation 14.1), pricing formulas for European futures options (equations 14.7 and
14.8) , and binomial trees for 鸣 futures options (equations 14.5 and 14.6)
are all exactly the same as in Chapter 13 except that we set q γ In particular, when a
binomial tree is constructed for futures ， α
The equations to value European options on futures are known as Black's model. A
European option on a futures has the same price as a regular European option on the
spot price of an asset when the futures contract and the option expire at the same time.
Similarly, a European option on a forward price has the same price as a regular European
option on the spot price of an asset when the forward contract and the option expire
at the same time. As a result Black's model can be (and frequently is) used to value a
European option on the spot price of an asset in terms the the futures or forward price of
the underlying asset. (See Example 14.5.)
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 14.8.
Suppose you buy a put option contract on October gold futures with a strike price
of $400 per ounce. Each contract is for the delivery of 100 ounces. What happens if you
exercise when the October futures price is $3807
An amount (400  380) x 100 = $2, 000 is added to your margin account and you
acquire a short futures position giving you the right to sell 100 ounces of gold in October.
This position is marked to market in the usual way until you choose to close it out.
93
Problem 14.9.
Suppose you sell a call option contract on April 1ive cattle futures with a strike price
of 70 cents per pound. Each contract is for the delivery of 40,000 pounds. What happens
if the contract is exercised when the futures price is 75 cents?
In this case an amount (0.75 , 0.70) x 40, 000 = $2, 000 is 齿 。 your
margin account and you acquire a short position in a live cattle futures contract to sell
40,000 pounds of cattle in April. This position is marked to marked in the usual way until
you choose to close it out.
Problem 14.10.
Consider a twomonth call futures option with a strike price of 40 when the riskfree
interest rate is 10% per annum. The current futures price is 47. What is a lower bound
for the value of the futures option if it 但 European and (b) American?
Lower bound if option is European is
(F
o
 K)e
rT
= (47  40)eOlX2/12 = 6.88
Lower bound if option is American is
Fo  K = 7
Problem 14.11.
Consider a fourmonth put futures option with a strike price of 50 when the 企
interest rate is 10% per annum. The current futures price is 47. What is a lower bound
for the value of the futures option if it is (a) European and (b) American?
Lower bound if option is European is
(K  Fo)e
rT
= (50  一 lx4/12 = 2.90
Lower bound if option is American is
K  Fo = 3
Problem 14.12.
A futures price is currently 60. It is known that over each of the next two 令
month periods it wi11 either rise by 10% or fall by 10%. The 企 interest rate is 8%
per annum. What is the value of a sixmonth European call option on the futures with a
strike price of 60? If the call were American, would it ever be worth exercising it early?
In this case the riskneutral probability of an up move is
1 0.9
一 一 一 一 一
1. 1 , 0.9
94
In the tree shown in Figure 814.1 the middle number at each node is the price of the
European option and the lower number is the price of the American option. The tree shows
60..0000
3..0265
3.0265
72.6000
12.6000
12.6000
59.4000.
0.00.00.
0.00.00.
48..6000
0..0000
000.0.0
Figure τ to evaluate European and American call options in Problem 14.12.
Problem 14.13.
In Problem 14.12 what is the value of a sixmonth European put option on futures
with a strike príce of 607 If the put were Amerícan, would ít ever be worth exercising ít
early7 命 the call príces calculated ín Problem 14.12 and the put príces calculated
here 命 parity relationships.
In this case the riskneutral probability of an up move is
1 ._ 0.9
一 一 一 一 一
1. 1  0.9
The tree in Figure 814.2 shows that the price of the European option is 3.0265 whi1e the
price of the American option is 3.0847.
Using the result in the previous problem
c + Ke
rT
= 十
= 60.6739
From this problem
p + Foe
rT
= 3.0265 + 一 = 60.6739
This 且 that the putcall parity relationship in equation (14.1) holds for the European
option prices. For the American option prices we have:
c  P = 0.0582; Foe
rT
 K = 2.353; Fo  Ke
rT
= 2.353
The put.call inequalities for American options in equation (14.2) are therefore 自
95
叶
3., 0265
3.0847
72.6000
0.0000
0 , 0000
59, 4000
0 , 6000
0., 6000
48.6000
114000
11 .4000
Figure 听 to evaluate European and American put options in Problem 14.13.
Problem 14.14.
A futures price is currently 25, its volatility is 30% per annum, and the riskfree
interest rate is 10% per annum. What is the va1ue of a ninemonth European call on the
futures with a strike price of 267
In this case Fo = 25, K = ， σ 0.3, r = 0.1, T = 0.75
Problem 14.15.
ln(Fo/K) σ
一 一 一 一 ， .   1 = ,.0.0211
σ 飞
ln(Fo/ 一 σ
一 一 一 一 一 一 一 一 一 一 0.2809
σ 飞
c = e
0075
[25N( 0.0211)  26N( 0.2809)]
= e
O
, 075[25 x 一 x 0.3894] = 2.01
A futures price is currently 70, its volatility is 20% per annum, and the 企
interest rate is 6% per annum. What is the value of a fìvemonth European put on the
futures with a strike price of 657
In this case Fo = 70, K = ， σ 0.2, r = 0.06, T = 0.4167
ln(Fo/K) σ
一 一 一 一 节 一 一 一 一 0.6386
σ 飞
d? = ln(Fo/ 二 σ
一 一 一 0.5095
σ 飞
一 025 [65N( ， 一 0.6386)]
= e
0025
[65 x 0.3052  70 x 0.2615] = ω
96
Problem 14.16.
Suppose tbat a oneyear futures price is currently 35. A oneyear European cal1 option
and a oneyear European put option on the futures witb a strike price of 34 are botb priced
at 2 in tbe market. The 企 interest rate is 10% per annum. 命 arbitrage
opportunity.
In this case
十
= 十 一 lxl = 32.76
十
= 2 + 一 lxl = 33.67
Putcall parity shows that we should buy one call, short one put and short a futures
contract. This costs nothing 仕 丑 In one year , either we exercise the call or the put
is exercised against us. In either case, we buy the asset for 34 and close out the futures
position. The gain on the short futures position is 35  34 = 1.
Problem 14.17.
"Tbe price of an 田 European call futures option always equals tbe price of
a similar 萨 European put futures option." Explain wby this statement is true.
The put price is
一 也  FoN( d
1
)]
Because N(x) = 1 N(x) for all ♂ put price can also be written
erT[K 
一 月 十
Because Fo = K this is the same as the call price:
e
rT
[F
o
N(d
1
) KN(d
2
)]
This result can also be 仕 putcall parity showing that it is not model dependent.
Problem 14.18.
Suppose tbat a futures price is currently 30. The 企 interest rate is 5% per
annum. A thre• montb American call futures option with a strike price of 28 is worth 4.
Calculate bounds for tbe price of a tbreemontb American put futures option with a strike
price of 28.
From equation (14.2) , C  P must lie between
30e005X3/12  28 = 1. 63
and
30  28e005x3/12 = 2.35
Because C = 4 we must have 1.63 < 4  P < 2.35 or
1.65 < P < 2.37
97
Problem 14.19.
Show that if C is the price of an American call option on a futures contract when the
strike price is K and the maturity is T , and P is the price of an American put on the same
futures contract with the same strike price and exercise date,
Foe
rT
 K < C  P < Fo  K e
rT
where Fo is the futures price and r is the 企 rate. Assume that r > 0 and that there
is no difference between forward and futures contracts. (Hint: Use an ana1ogous approach
to that indicated for Problem 13.12.)
In this case we consider
Portfolio A: A European call option on futures plus an amount K invested at the
仕 interest rate
付 B: An American put option on futures plus an amount Foe
rT
invested
at the 仕 interest rate plus a long futures contract maturing at time T.
Following the arguments in Chapter 5 we will treat all futures contracts as forward
contracts. Portfolio A is worth 十 while portfolio B is worth 卡
If the put
option is exercised at time T 三 < T) , portfolio B is worth
K  FT + 十 F
o
=K + Foer(TT)  Fo < K
at time T where FT is the futures price at time T. Portfolio A is worth
c+ Ke
rT
三
Hence Portfolio A more than Portfolio B. If both portfolios are held to maturity (time T) ,
Portfolio A is worth
Portfolio B is worth
max(FT  K , 0) + Ke
rT
=max(FT, K) + K(e
rT
 1)
max(K  FT , 十 月 十  Fo = max( FT , K)
Hence portfolio A is worth more than portfolio B.
Because portfolio A is worth more than portfolio B in all circumstances:
十 < c + K
Because c < C it follows that
十
< C+K
or
Foe
rT
 K < C P
98
This proves the first part of the inequality.
For the second part of the inequality consider:
时 C: An American call futures option plus an amount K e
rT
invested at
the 唱 interest rate
Portfolio D: A European put futures option plus an amount Fo invested at the
riskfree interest rate plus a long futures contract.
Portfolio C is worth C + K e
rT
while portfolio D is worth 十 If the call option
is exercised at time T (0 :::; T < T) portfolio C becomes:
Fr  K + Ker(Tr) < Fr
while portfo1io D is worth
p + Foer'T' + 一 凡
= p+ Fo(e
rr
1) + 三 瓦
Hence portfolio D is worth more than portfolio C. If both portfolios are held to maturity
(time T) , portfo1io C is worth max(FT, K) while portfolio D is worth
max(K  FT, 十
斗
=max(K, 十 月
 1)
>max(K, FT)
Hence portfolio D is worth more than portfolio C.
Because portfolio D is worth more than portfo1io C in all circumstances
C + Ke
rT
< 十
Because 三 it follows that
十
< P+Fo
or
C  P < Fo  Ke
rT
This proves the second part of the inequality. The result:
一
< C  P < Fo K e
rT
has therefore been proved.
Problem 14.20.
Calculate the price of a threemonth European call option on the spot price of silver.
The threemonth futures price is $12, the strike price is $13, the 企 rate is 4%, and
the volati1ity of the price of silver is 25%.
This has the same value as a threemonth call option on silver futures where the
futures contract expires in three months. It can therefore be valued using equation (14.7)
with Fo = 12, K = 13, r = ， σ 0.25 and T = 0.25. The value is 0.244.
99
CHAPTER 15
The Greek Letters
This chapter considers a trader working as an options market maker at a bank or at
an exchange. The trader is responsible for trading financial instruments that depend on
one particular market variable (e.g the sterlingdollar exchange rate). The chapter covers
the approaches used by the trader to manage risk.
The trader must monitor a number of risk measures 位 α ∞ 丑 邸 咆 此 王 忱 町 矿 叫 η ， 丁 丑
try to ensure 由 创 ， they remain within reasonable bounds. The most important Greek letter
is delta. This is the rate of change of the value of the trader's portfolio with respect to the
market variable. The trader can make delta zero by doing a trade in the underlying asset.
Suppose for example that the trader responsible for the sterlingdollar exchange rate ω
a portfolio with a delta of 100,000 when the exchange rate is 1.90. This means that the
portfolio increases in value by 100, 000 x 0.01 = $1000 when the exchange rate increases
仕 1.90 to 1.91. Delta can be changed to zero by buying 100,000 pounds sterling. A
portfolio with a delta of zero is known as a deltaneutral portfolio.
Option traders usually make their portfolios delta neutral (or close to delta neutral)
as a matter of course at the end of each day. This is known as rebalancing the portfolio.
It makes their portfolios relatively insensitive to small changes in the underlying market
variable (the dollarsterling exchange rate in our example). Tables 15.2 and 15.3 provide
examples of how a trader with a portfolio consisting of a single option might fare if the
portfolio is rebalanced, bringing delta to zero, every week. You should study these tables
carefully and make sure you understand them. The process of bringing delta to zero at
regular intervals is known as delta hedging. It underlies the no arbitrage argument for
丑 options.
Delta hedging provides protection against small changes in the underlying variable.
Gamma measures a trader's exposure to large jumps. Gamma is defined as the rate of
change of delta with respect to the underlying variable. Figure 15.7 illustrates how gamma
risk arises. The value of the option is assumed to 仕 0 to 0' when delta hedging
is used. In fact it moves from 0 to 0".
Vega measures the sensitivity of a portfolio to changes in volatility. Both gamma and
vega can be changed only by taking a 卫 an option. Taking a position in the
underlying asset has no impact on gamma and ve
100
explained in Section 15.13 the creation of a synthetic put option on a portfolio of stocks
involves buying stocks (or index futures) just after a price rise and selling stocks (or index
futures) just after a price fall. As traders found in October 1987, if too many portfolio
managers are attempting to create put options synthetically at the same time, the strategy
may not produce the desired results.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 15.8.
What does it mean to assert that the theta of an option position is 0.1 when time
is measured in years? If a trader feels that neither a stock price nor its implied volatility
wil1 change, what type of option position is appropriate?
A theta of 0.1 means that if ßt units of time pass with no change in either the stock
price or its volatility, the value of the option declines by 0.1ßt. A trader who feels that
neither the stock price nor its implied volatility will change should write an option with
as high a negative theta as possible. Relatively shortlife atthemoney options have the
most negative thetas.
Problem 15.9.
The BlackScholes price of an ι ← call option with an exercise price of
$40 is $4. A trader who has written the option plans to use a stoploss strategy. The
trader's plan ís to buyat $40.10 and to sell at $39.90. Estimate the expected number of
times the stock wil1 be bought or sold.
The strategy costs the trader 0.10 each time the stock is bought or sold. The total
expected cost of the strategy, in present value terms, must be $4. This means that the
expected number of times the stock will be bought or sold is approximately 40. The
expected number of times it will be bought is approximately 20 and the expected number
of times it will be sold is also approximately 20. The buy and sell transactions can take
place at any time during the life of the option. The above numbers are therefore only
approximately correct because of the effects of discounting. Also the estimate is of the
number of times the stock is bought or sold in the riskneutral world, not the real world.
Problem 15.10.
Suppose that a stock price is currently $20 and that a call option with an exercise
price of $25 is created synthetically using a continually changing position in the stock.
Consider the following two scenarios:
a. Stock price increases 企 ω during the life of the option.
b. Stock price oscillates wildly, ending up at $35.
Which scenario would make the synthetically created option more expensive? Explain
your answer.
The holding of the stock at any given time must be N(dd. Hence the stock is bought
just after the price has risen and sold just after the price has fallen. (This is the buy
high selllow strategy referred to in the text.) 丑 直 scenario the stock is continually
101
bought. In second scenario the stock is bought, sold, bought again, sold again, etc. The
且 holding is the same in both scenarios. The buy, sell, buy, sell... situation clearly
leads to higher costs than the buy, buy, buy... situation. This problem emphasizes one
disadvantage of creating options synthetically. Whereas the cost of an option that is
purchased is known 仕 and depends on the forecasted volatility, the cost of an option
that is created synthetically is not known 仕 and depends on the volatility actually
encountered.
Problern 15.11.
What is the delta of a short position in 1,000 European call options on 且
The options mature in eight months, and the futures contract underlying the option ma
tures in nine months. The current ninemonth futures price is $8 per ounce, the exercise
price of the options is $8, the 企 interest rate is 12% per annum, and the volatility
of si1ver is 18% per annum.
The delta of a European futures call option is usually defined as the rate of change of
the option price with respect to the futures price (not the spot price). It is
e
rT
N(dI)
In this case Fo = 8, K = 8, r = ， σ 0.18, T = 0.6667
ln (8/8) + (0.18
2
/2) X0.6667
一 一 一 一 一 一 一 「 一 一 一 一 一 一 一 0.0735
飞
N(d
1
) = 0.5293 and the delta of the option is
已 12x06667 X 0.5293 = 0.4886
The delta of a short position in 1,000 futures options is therefore 488.6.
Problern 15.12.
In Problem 15.11, what initial position in φ silver futures is necessary for
delta hedging? If si1ver itself is used, what is the initial position? If φ silver futures
are used, what is the initial position? Assume no storage costs for silver.
In order to answer this problem it is important to distinguish between the rate of
change of the option with respect to the futures price and the rate of change of its price
with respect to the spot price.
The former will be referred to as the futures delta; the latter will be referred to as the
spot delta. The futures delta of a ninemonth futures contract to buy one ounce of silver is
by definition 1. 0. ， 仕 the answer to Problem 15.11, a long position in ninemonth
futures on 488.6 ounces is necessary to hedge the option position.
The spot delta of a ninemonth futures contract is eO.12X075 1.094 assuming no
storage costs. (This is because silver can be treated 丑 same way as a nondividend
paying stock when there are no storage costs. Fo = Soe
rT
so that the spot delta is the
102
futures delta times e
rT
) Hence the spot delta of the option position is 488.6 x 1.094 =
534.6. Thus a long position in 534.6 ounces of silver is necessary to hedge the option
posítion.
The spot delta of a oneyear silver futures contract to buy one ounce of silver is
e
O
.
12
= 1. 1275. Hence a long position in e
012
x 534.6 = 474.1 ounces of oneyear silver
山 is necessary to hedge the option position.
Problem 15.13.
A company uses delta hedging to hedge a portfo1io of long positions in put and call
options on a currency. Which of the following would give the most favorable result?
a. A virtually constant spot rate
b. Wi1d movements in the spot rate
Explain your answer.
A long position in either a put or a call option has a positive gamma. From Figure
15.8, when gamma is positive the hedger gains from a large change in the stock price and
仕 a small change in the stock price. Hence the hedger will fare better in case (b).
Problem 15.14.
Repeat Problem 15.13 for a B.nancial institution with a portfolio of short positions in
put and call options on a currency.
A short position in either a put or a call option has a negative gamma. From Figure
15.8, when gamma is negative the hedger gains from a small change in the stock price and
仕 a large change in the stock price. Hence the hedger will fare better in case (a).
Problem 15.15.
A B.nancial institution has just sold 1,000 sevenmonth European call options on the
Japanese yen. Suppose that θ exchange rate is 0.80 cent per yen, the exercise price
is 0.81 cent per yen, the 企 interest θ the United States is 8% per annum, the
企 interest rate in Japan is 5% per 刀 ， and the volatility of the yen is 15% per
annum. Calculate the delta, gamma, vega, tbeta, and rbo of the B.nancial institution's
position. Interpret eacb number.
In this case 8
0
= 0.80, K = ， γ 0.08, r f = ， σ 0.15, T = 0.5833
ln (0.80/0.81) + (0.080.05+0.15
2
/2) X 0.5833
d1 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 = 0.1016
0.15vO.5833
d2 =
一
而 页 页 一
N(d
1
) = 0.5405; N(d2) = 0.4998
The delta of one call option is er,T N(dI) = e005X05833 X 0.5405 = 0.5250.
Nf(d1)=Ledi/2:Leooom=0.3969
石 王
103
so that the gamma of one call option is
N '(d
1
)e
rfT
σ
0.3969 x 0.9713
一 一 一 一 4.206
0.80 x 0.15 飞
The vega of one call option is
于
= 页 页 0.3969 x 0.9713 = 0.2355
The theta of one call option is
σ
一
一 一 rj8
0
N(dI)e
rjT
 rKe
rT
N(d
2
)
飞
0.8 x 0.3969 x 0.15 x 0.9713
日 苟 言
+ 0.05 x 0.8 x 0.5405 x 0.9713  0.08 x 0.81 x 0.9544 x 0.4948
=  0.0399
The rho of one call option is
。
。
哇
QU
蚀
。
×
吐
丛
同
υ
AU
飞
吃
/MVqO Nm
队
矿
，
但
同
…
白
，
啊
」
民
，
，
ZAOO
一
一
一
一
Delta can be interpreted as meaning that, when the spot price increases by a small
amount (measured in cents) , the value of an option to buy one yen increases by 0.525 times
that amount. Gamma can be interpreted as meaning that, when the spot price increases
by a small amount (measured in cents) , the delta increases by 4.206 times that amount.
Vega can be interpreted as meaning that, when the volatility (measured in decimal form)
increases by a small amount, the option's value increases by 0.2355 times that amount.
When volatility increases by 1% (= 0.01) the ∞ increases by 0.002355. Theta
can be interpreted as meaning that, when a small amount of time (measured in years)
passes, the option's value decreases by 0.0399 times that amount. In particular when one
calendar day passes it decreases by 0.0399/365 = 0.000109. Finally, rho can be interpreted
as meaning that, when the interest rate (measured in decimal form) increases by a small
amount the option's value increases by 0.2231 times that amount. When the interest rate
increases by 1% (= 0.01) , the options value increases by 0.002231.
Problem 15.16.
Under what circumstances is it possible to make a European option on a stock index
both gamma neutral and vega neutral by adding a position in one other European option?
Assume that 8
0
, K , ， σ ， T , q are the parameters for the option held and 8
0
, 斤 ，
σ ， T* , q are the parameters for another 丑 Suppose that d
1
has its usual meaning and
is calculated on the basis of the first set of parameters while di is the value of d
1
calculated
104
on the basis of the second set of parameters. Suppose further that W of the second option
are held for each of the first option held. The gamma of the portfolio is:
α 川 叫 气 呐 付 仙 ι
岛 σ 叫 ♂ 于 ，
where α the number of the first option held.
Since we require gamma to be zero:
…
m
The vega of the portfolio is:
α
N'
十 ω
(di)eq(T*
Since we require vega to be zero:
巾

r
m
一
在
Equating the two expressions for w
T* =T
Hence the maturity of the option held must equal the maturity of the option used for
hedging.
Problem 15.17.
且 manager has a ， 再 portfolio that mirrors the performance of the
S&P 500 and is worth $360 mil1ion. The value of the S&P 500 is 1,200, and the portfolio
manager would like to buy insurance against a reduction of more than 5% in the value of
the portfolio over the next six months. The 企 interest rate is 6% per annum. The
dividend yield on both the portfolio and the S&P 500 is 3%, and the volatility of the index
is 30% per annum.
a. If the fund manager buys traded European put options, how much would the insurance
cost?
b. Explain carefully alternative strategies open to the fund manager involving traded
European call options, and show that they lead to the same result.
c. If the fund manager decides to provide insurance by keeping part of the portfolio in
riskfree securities, what should the initial position be?
d. If the fund manager decides to provide insurance by using nin• month index futures,
what should the initia1 position be?
The fund is worth $300,000 times the value of the index. When the value of the
portfolio falls by 5% (to $342 million) , the value of the S&P 500 also falls by 5% to 1140.
105
The fund manager therefore requires European put options on 300,000 times the S&P 500
with exercise price 1140.
(a) 8
0
= 1200, K = 1140, r = ， σ 0.30, T = 0.50 and q = 0.03. Hence:
d
1
旦 旦 十 二 + 0.3
2
/2) X 05=04186
飞
d
2
=
一
而 王 0.2064
N(d
1
) = 0.6622; N(d
2
) = 0.5818
N( d
1
) = 0.3378; N( d
2
) = 0.4182
The value of one put option is
1140e
rT
N(d
2
)  1200e
qT
N(d
1
)
=1140e006x05 X 0.4182  1200e
0
03xO 5 X 0.3378
=63.40
The total cost of the insurance is therefore
300, 000 X 63.40 = $19, 020, 000
(b) From putcall parity
8
0
e
qT
+ p = c + Ke
rT
or:
p = c  Soe
qT
+ Ke
rT
This shows that a put option can be created by selling (or 鸣 一 of the
index, buying a call option and investing the remainder at the 击 rate of interest.
Applying this to the situation under consideration, the fund manager should:
1) Sell 一 03x05 = $354.64 million of stock
2) Buy call options on 300,000 times the S&P 500 with exercise price 1140 and
maturity in six months.
3) Invest the remaining cash at the risk.free interest rate of 6% per annum.
This strategy gives the same result as buying put options directly.
( c) The delta of one put option is
e
qT
[N(d
1
)  1]
一  1)
一
This indicates that 33.27% of the portfolio (i.e. , $119.77 million) should be initially
sold and invested in riskfree securities.
106
( d) The delta of a ninemonth index futures contract is
e(rq)T = eO.03X075 = 1.023
The spot short position required is
啕 ‘
  , " " ,    = 同
1200
times the index. Hence a short position in
nu ny qo
一
一
AU vhU
GOqL
创
一
×
轧
一
归
9
一
α
一
咱
E
4
futures contracts is required.
Problem 15.18.
Repeat Problem 15.17 on the assumption that the portfolio has a beta of 1.5.. Assume
that the dividend yield on the portfolio is 4% per annum.
When the value of the portfolio goes down 5% in six months, the total return from
the portfolio, including dividends, in the six months is
一 十 = 3%
， 一 per annum. This is 12% per annum 1ess than the riskfree interest rate. Since the
portfolio has a beta of 1. 5 we would expect the market to provide a return of 8% per annum
1ess than the riskfree interest rate, i.e. , we would expect the market to provide a return of
2% per annum. Since dividends on the market index are 3% per annum, we would expect
the market index to have dropped at the rate of 5% per annum or 2.5% per six months; i. e. ,
we would expect the market to have dropped to 1170. A total of 450, 000 = (1. 5 x 300, 000)
put options on the S&P 500 with exercise price 1170 and exercise date in six months are
therefore required.
(a) 8
0
= 1200, K = ， γ ， σ 0.3, T = 0.5 and q = 0.03. Hence
ln 十  0.03 + 0.09/2) X 0.5
d1 一 一 一 一 一 一 一 一 一 一 一 0.2961
飞
d
2
=
…
而 王 0.0840
N(d
1
) = 0.6164; N(d
2
) = 0.5335
N( d
1
) = 0.3836; N( d
2
) = 0.4665
The value of one put option is
Ke
rT
N( d
2
)  Soe
qT
N(d
1
)
=1170e006X05 X 0.4665  一 X 0.3836
=76.28
107
The total cost of the insurance is therefore
450, 000 X 76.28 = $34, 326, 000
N ote that this is 日 丑 greater than the cost of the insurance in Problem 15.17.
(b) As 丑 15.17 the fund manager can 1) sell $354.64 million of stock, 2) buy call
options on 450,000 times the S&P 500 with exercise price 1170 and exercise date in
six months and 3) invest the remaining cash at the 仕 interest rate.
(c) The portfolio is 50% more volatile than the S&P 500. When the insurance is considered
as an option on the portfolio the parameters are as follows: 8
0
360, K = 342,
r = ， σ 0.45, T = 0.5 and q = 0.04
ln 十  0.04 + 0.452/2)xO.5
d
1
= 一 一 一 一 一 一 τ 一 一 一 / . = 0.3517
飞
N(d
1
) = 0.6374
The delta of the option is
、
、
，
，
14
月
叫
一
配
、
唱
，
，
.•
、
、
d5
叫
AXVO
『
吨
川
ee
一
一
一
一
This indicates that 35.5% of the portfolio (i.e. , $127.8 million) should be sold and
invested in riskless securities.
(d) We now return to the situation considered in (a) where put options on the index are
required. The delta of each put option is
e
qT
(N(dt)  1)
=e
O
03X05(0.6164  1)
=  0.3779
The delta of the total position required in put options is 450,000 X 0.3779
170,000. The delta of a nine month index futures is (see Problem 15.17) 1.023.
Hence a short position in
no
民
二
ω
一
约
。
一
队
『
吁
中
izu
index futures contracts.
Problem 15.19.
Show by 鸣 the various terms in equation (15.4) that the equation is true
for:
a. A single European call option on a nondividendpaying stock
b. A single European put option on a 啕 stock
108
c. Any portfolio of European put and call options on a nondividendpaying stock
( a) For a call option on a 坠 吨
= N(dI)
r = N'(dI)

8
0
(Jff
8
0
N'(d
1
)
一 σ rKe
rT
N(d
2
)
飞
Hence the lefthand side of equation (15.7) is:
80 N'(dI)(J __ T/' _rT 7\ Tf J \ , __0 7\ Tf _1 \ , 1 _0 N'(d1)
一 届 σ rKe
rT
十 γ
十 一 σ
一 言 一
飞
 \  / ' .. v  \  i / ' 2  . V .J T
=r[8
0
N(dI)  一 叮
月
=rII
(b) For a put option on a 吨
二
r =

σ
8
0
N'(d
1
)
。 σ γ e
rT
N( d
2
)
2vT
Hence the lefthand side of 川 (15.7) is:
SoN'(d1 ) (J , __T/ _rT 7\ Tf .1 \ __0 7\ Tf .1 \ , 1_0 N'(d1 )
一 后 σ 十
N(d
2
) 
十 一 σ
一 τ
王 一
飞
 \ . 'V \ i/ . 2 v .JT
=r[K e
rT
N(d
2
)  8
0
N(
月
=rII
(c) For a portfolio of ， 日 ， ， 8 and r are the sums of their values for the individual
options in the portfolio. It follows that equation (15.7) is true for 町 of
European put and call options.
Problem 15.20.
8uppose that $70 billion of equity assets are the subject of portfolio insurance schemes.
Assume that the schemes are designed to provide insurance against the value of the assets
dec1íning by more than 5% within one year. Making whatever estimates you 丘 necessary,
use the DerivaGem software to calculate the value of the stock or futures contracts that
the administrators of the portfolio insurance schemes will attempt to sell if the market
falls by 23% in a single day.
109
We can regard the position of a11 portfolio insurers taken together as a single put
option. The three known parameters of the option, before the 23% decline, are 8
0
= 70,
K = 66.5, T = 1. Other parameters can be estimated γ ， σ 0.25 and q = 0.03.
Then:
d, 叫 十 0.03 + 0.25
2
/2)
1 ,. / _._, "_._ _._, _._ ,, = 0.4502
0.25
N(d
1
) = 0.6737
The delta of the option is
、
、
1
,
4
一
7
叮
17
吁 α
、
β
仆
月
也
、
才
ftG3
川
。
一
一
一
ρ
一
一
一
一
This shows that 31. 67% or $22.17 billion of assets should have been sold before the decline.
These numbers can also be 仕 DerivaGem by selecting Underlying Type and
Index and Option Type as Analytic European.
After the decline, 8
0
= 53.9, K = 66.5, T = 1, r = ， σ 0.25 and q = 0.03.
d, 叫 十  十
1 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 。 ， ，
0.25
N(d
1
) = 0.2758
The delta of the option has dropped to
e
O
03xO 5(0.2758  1)
=  0.7028
This shows that cumulatively 70.28% of the assets originally held should be sold. An
additional 38.61 % of the original portfo1io should be sold. The sales measured at precrash
prices are about $27.0 billion. At post crash prices they are about 20.8 billion.
Problern 15.21.
Does a forward contract on a stock index have the same delta as the corresponding
futures contract? Explain your answer.
With our usual notation the value of a forward contract on the asset is 8
o
e
qT

Ke
rT
. When there is a small change, ， 丑
the value of the forward contract
changes by e
qT
.6. 8. The delta of the forward contract is therefore e
qT
. The futures
price is
γ When there is a small change, .6. 8 , in 8
0
the futures price changes
by .6. 8e(r.q)T. Given the daily settlement procedures in futures contracts, this is also
the immediate change in the wealth of the holder of the futures contract. The delta of
the futures contract is therefore e(rq)T. We conclude that the deltas of a futures and
forward contract 丑 the same. The delta of the futures is greater than the delta of
the corresponding forward by a factor of e rT .
110
Problem 15.22.
A bank's position in options on the dollareuro exchange rate has a delta of 30,000
and a gamma of 80, 000. Explain how these numbers can be interpreted. The exchange
rate (dollars per euro) is 0.90. What position would you take to make the position delta
neutral? After a short period of time, the exchange rate moves to 0.93. Estimate the new
delta. What additional trade is necessary to keep the position delta neutral? Assuming
the bank did set up a deltaneutral position originally, has it gained or lost 企
the 萨 movement?
The de1ta indicates that when the value of the euro exchange rate increases by $0.01,
the va1ue of the bank's 日 by 0.01 x 30, 000 = $300. The gamma indicates
that when the euro exchange rate increases by $0.01 the de1ta of the portfolio decreases
by 0.01 x 80, 000 = 800. For de1ta neutrality 30,000 euros shou1d be shorted. When
the exchange rate moves up to 0.93, we expect the de1ta of the portfo1io to decrease by
(0.93  0.90) x 80, 000 = 2, 400 so that it becomes 27,600. To maintain de1ta neutrality, it
is therefore necessary for the bank to unwind its short position 2,400 euros so that a net
27,600 have been shorted. As shown in the text (see Figure 15.8), when a portfolio is de1ta
neutral and has a negative gamma, a 10ss is experienced when there is a 1arge movement
in the underlying asset price. We can conclude that the bank is like1y to have 10st money.
111
CHAPTER16
￥ in Practice
This chapter provides more detail on the use of binomial trees than Chapter 11. It
starts by explaining where the formulas for u, d and p 仕 The formulas ensure
that
1. The expected return on the stock in time !:lt is the 仕 rate, r.
2. The standard deviation of the return in time !:lt is (Jyí5j σ the volatility
Make sure you understand the calculations in Figure 16.3.
The chapter shows how the Greek letters discussed in Chapter 15 can be calculated.
For delta we look at the two nodes at time !:l t. We calculate the change in the option
price when we move from the lower node to the upper node and the change in the stock
price when we do so. Delta is the ratio of the option price change to the stock price
change. Gamma is calculated from the three nodes at time 2!:lt" The upper two nodes
produce one delta estimate and the lower two nodes produce another delta estimate. These
two estimates of delta can be used to provide an estimate of gamma. Theta can be
calculated from the tree by comparing option prices at time zero with the option price at
the middle node at time 2!:l t.. Vega is calculated by making a small change to the volatility,
recomputing the tree, and observing the option value calculated.
An important issue for stock options is how to deal with dividends. On approach is to
assume a known dividend yield (i.e. , to assume that the dividend as a percent of the stock
price is known).. This is fairly straightforward.. In 町 it is more accurate to
assume the cash amount of the dividend is known. As indicated in Figure 16.6, the tree
does not naturally recombine when this assumption is made. An approach that ensures a
recombining tree is constructed in two stages:
1.. Build a tree for the stock price less the present value of future dividends during the
life of the option, and
2. Add the present value of future dividends at each node to construct the final tree
In Example 16.3, 自 stage results in the tree in Figure 16.3. The second stage results
in the tree attached to the Example.
Sections 16.4 and 16..5 discuss a number of extensions of the basic treebuilding ap
proach. They show that:
1. We can make the shortterm interest rate a function oftime by making the probability
of an up movement a function of time
2. We can improve accuracy by using the same tree to value both an American option and
the corresponding European option. The error in the price of the European option is
assumed to be the same as that of the American option
112
8ection 16.6 points out that instead of working 仕 the end of the tree to the
beginning, we can use Monte Carlo simulation to sample paths starting at the beginning
of the tree. 8tudy the example in 8ection 16.6 to make sure you understand how to use
this technique to price pathdependent options.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 16.8.
Consider an option that pays off the amount by which the fìnal stock price exceeds
the average stock price achieved during the life of the option. Can this be 丘 。
binomial tree using backwards induction?
No! This is an example of a α dependent option. The payoff depends on the path
followed by the stock price as well as on its final value. The option cannot be valued by
starting at the end of the tree and working backward, because the payoff at 自 branch
depends on the path used to reach it. European options for which the payoff depends
on the average stock price can be valued using Monte Carlo simulation, as described in
8ection 16.6.
Problem 16.9.
A 萨 American put option on a nondividendpaying stock has a strike price
of $49. The stock price is $50, the ι 企 rate is 5% per annum, and the volati1ity is 30%
per annum. Use a threestep binomial tree to calculate the option price.
In this case, SO = 50, K = 49, 士 。 ， ， ， σ 0.30, T = 0.75, and ßt = 0., 25. Also
ε σ 互 = e
03o
v'õ25 = 1. 1618
d =1=0.8607
u
α eT .ð. t = e005XO 25 = 1. 0126
户 主
一 α
1 _. p = 0.4957
The output from DerivaGem for this example is shown in the Figure 816. 1. The calculated
price of the option is $4.29. Using 100 steps the price obtained is $3.91
113
G rowth factor per step. a = 1 0126
Probability of up move. p = 0.5043
Up step size. u = 1 1618
Down step size. d = 0.8607
Node Time:
0.0000 0.2500 0.5000 。
Figure 816.1 Thee for Problem 16.9
Problem 16.10.
Use a thre• timestep tree to value a ninemonth American call option on wheat fu
tures. The current futures price is 400 cents, the strike price is 420 cents, the riskfree rate
is 6%, and the volatility is 35% per annum. Estimate the delta of the 企 your
tree.
In this case Fo = 400, K = 420, r = ， σ 0.35, T = 0.75, and f:,. t = 0.25. AIso
。
血
节
QU
吐
no
咱
气
υ
币
‘
，
们
也
=DIJ
一
咱
缸
:
ω
白
二
α
队
一
一
一
一
一
一
一
一
一
α
184
The output from DerivaGem for this example is shown in the Figure 816.2. The calculated
price of the option is 42.07 cents. Using 100 time steps the price obtained is 38.64. The
option's delta is 仕 the tree is
一  335., 783) = 0.487
When 100 steps are used the estimate of the option's delta is 0.483.
114
Problem 16.11.
Growth factor per step, a = 1..0000
P robability 01 up m ove , p = 0.4564
u p s te p s iz e, U = 11912
Down step size , d = 0.8395
Node Time:
o 0000 02500 05000 。 咱
Figure 816.2 Tree for Problem 16.10
A threemonth American call option on a stock has a strike price of $20. The stock
price is $20, the 企 rate is 3% per annum, and the volati1ity is 25% per annum. A
dividend of $2 is expected in 1.5 months. Use a threestep binomial tree to calculate the
option price.
In this case the present value of the dividend is 2e
o
03xO 125 = 1.. 9925 . 自 build
a tree for 8
0
= 20 •1.. 9925 = 18, 0075, K = ， 俨 ， ， ， σ 0.25, and T = 0.25 with
b.t = 0,, 08333. This gives Figure 816.3. For nodes between times 0 and 1. 5 months we
then add the present value of the dividend to the stock 相 result is the tree in
Figure 816.4. The price of the option calculated from the tree is ， ， 明 100 steps
are used the price obtained is 0.690.
115
Problem 16.12.
Time step, dt = 0.0833 years , 30 .42 days
Growth factor per step, a = 1..0025
Probability of up move, p = 04993
υ step size, U = 1..0748
Down step size, d = 0.9304
Node Time:
0..0000 0..0833 0.1667 02500
Figure 816.3 First tree for Problem 16.11
Time step, dt = 0..0833 years, 3042 days
Growth factor per step, a = 1.0025
Probability of up move, p = 04993
Up step size, U = 1.0748
Down step size, d = 0..9304
Node Time:
0.0000 0.0833 0..1667 0..2500
Figure 816.4 Final Tree for Problem 16.11
A oneyear American put option on a nondividendpaying stock has an exercise price
of $18. The current stock price is $20, the 企 interest rate is 15% per annum, and
the volatility of the stock is 40% per annum. Use the DerivaGem software with four three
month time steps to estimate the value of the option.. Display the tree and 命
116
the option prices at the B.nal and penultimate nodes are correct. Use DerivaGem to value
the European version of the option. Use the control variate technique to improve your
estimate of the price of the American option.
In this case 8
0
= 20, K = 18, r = ， σ 0.40, T = 1, and D..t = 0.25. The
parameters for the tree are
ε σ 互 = e
04
VQ:25 = 1. 2214
d = l/u = 0.8187
α eT'D. t = 1.0382
α d 1.0382  0.8187
一 一 一 一 一 一 一 一 一 一 一 一 一 一 二
u  d 1. 2214  0.8187
The tree produced by DerivaGem for the American option is shown in Figure 816.5. The
estimated value of the American option is $1. 29.
As shown in Figure 816.6, the same tree can be used to value a European put option
with the same parameters. The estimated value of the European option is $1. 14. The
option parameters are 8
0
= 20, K = ， 俨 工 ， σ 0.40 and T = 1
丑 + 0.15 + 0.40
2
/2
一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 0.8384
ι
d
2
= d
1
 0.40 = 0.4384
N( dr) = 0,, 2009; 一 句 = 0.3306
The true European put price is therefore
18e
015
x 0.3306  20 x 0.2009 = 1. 10
This can also be obtained from DerivaGem. The control variate estimate of the American
put price is therefore 1. 29 + 1. 10  1. 14 = $1. 25.
Problern 16.13.
A twomonth American put option on a stock index has an exercise price of 480.
The current level of the index is 484, the 企 interest rate is 10% per annum, the
dividend yield on the index is 3% per annum, and the volati1ity of the index is 25% per
annum. Divide the life of the option into four 二 periods and use the binomial
tree approach to estimate the value of the option.
In this case 8
0
= 484, K = 480, r = ， σ 0.25 q = 0.03, T = 0.1667, and
D.. t = 0.04167
σ 互 = 于 1. 0524
d =1=09502
U
α ε = 1.00292
α d 1. 0029  0.9502
一 一 一 一 一 一 一 一 一 = 0.516
u  d 1.0524  0.9502
117
Growth factor per step, a 才
Probability ofup move, p = 丁
Up step size, U = 1 2214
Down step size, d = 0.8187
口 Time:
00000 0..2500 0.5000 07500 1..0000
Figure S16.5 Tree to evaluate American option for Problem 16..12
Growth factor per step, a = 1.0382
Probability of up move, p = 0 5451
Up step size, U = 1.2214
Down step size, d = 0.8187
Node Time
00000 0.2500 0.5000 0.7500 1.0000
Figure S16.6 Tree to evaluate European option in Problem 16.12
The tree produced by DerivaGem is shown in the Figure 816.7. The estimated price of the
118
option is $14.93.
Growth factor per step, a = 日
Probability ofup move, p = 0.5159
Up step size, U = 10524
Down step size, d = 0.9502
Node Time:
00000 00417 00833 o 1250 01667
Figure 816.7 Thee to evaluate option in Problem 16., 13
Problem 16.14.
How would you use the control variate approach to improve the estimate of the delta
of an American option when the binomial tree approach is used?
First the delta of the American option is estimated in the usual way from the tree.
Denote this by D. Â. Then the delta of a European option which has the same parameters
as the American option is calculated in the same way using the same 阐 this by
D. Ê. Finally the true European delta, D. B , is calculated using the formulas in Chapter 15.
The control variate estimate of delta is then:
D. Â D. Ê • D. B
Problem 16.15.
How would you use the binomial tree approach to value an American option on a stock
index when the dividend yield on the index is a functíon of tíme?
When the dividend yield is constant
σ 互
ι
A
ddAW
•
α
一
一
一
一
一
α
119
Making the dividend yield, q, a function of time makes α ， and therefore p, a function of
time. However , it does not affect U or d. It follows that if q is a function of time we can
use the same tree by making the probabilities a function of time. The interest rate r can
also be a function of time as described in Section 16.4.
120
CHAPTER 17
Volatility Smiles
The BlackScholes model and binomial trees assume that the probability distribution
of the underlying asset at a future time is lognormal. If traders wanted to make that
assumption they would use the same volatility to price options with different strike prices.
In practice the implied volatility of an option is a function of the strike price. Figure 17.1
shows the typical situation for options on a foreign currency (The relationship between
implied volatility and strike price is Ushaped). Figure 17.2 shows the future probability
distribution for an exchange rate that is consistent with the implied volatilities that traders
are using for foreign currency options. It has heavier right and left tails than the lognormal
distribution. Figure 17.3 shows the typical situation for options on stocks and stock indices.
(The implied volatility is a declining function of strike price.) Figure 17.4 shows the future
probability distribution that is consistent with the implied volatilities that traders are
using for stocks and stock indices. It has a heavier left tail and a less heavy right tail than
the lognormal distribution.
Note that we do not have to worry about whether we are talking about put or call
options when constructing diagrams such as Figure 17,, 1 and 17.3. This is because putcall
parity shows that the implied volatility of a European put should be the same as that of
a European call. (See Appendix to Chapter 川 The same is usually approximately tru
of American options.
The volatility smile for options on foreign 臼 in Figure 17.1 is likely a result of
jumps and the fact that volatility is not constant. The volatility smile for options on equity
in Figure 17.3 can be explained by the impact of leverage. (As the stock price declines
the 町 more highly levered 时 increases.) 口 explanation
is crashophobia. (Since 1987 traders have been very concerned about the possibility of
another stock market crash and have as a result increased the prices of deepout.ofthe
money put options.)
The BlackScholes and similar models are in practice used to communicate the prices
of European and American call and put τ use a volatility surface such a
that shown in Table 17.2 when trading options. The volatility surface enables them to
estimate the appropriate implied volatility for any standard option trade that is proposed.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 17.8.
A stock price is currently $20. Tomorrow, news is expected to be announced that wi11
either increase the price by $5 or decrease the price by $5. What are the problems in using
BlackScholes to value onemonth options on the stock?
The probability distribution of the stock price in one month is not lognormal. Possibly
it consists of two lognormal distributions superimposed upon each other and is bimodal.
121
BlackScholes is clearly inappropriate, because it assumes that the stock price at any future
time is lognormal.
Problem 17.9.
What volati1ity smile is likely to be observed for sixmonth options when the volati1ity
is uncertain and posítively correlated to the stock price?
When the asset price is positively correlated with volatility, the volatility tends to
increase as the asset price increases, producing less heavy left tails and heavier right tails.
Implied volatility then increases with the strike price.
Problem 17.10.
What problems do you think would be encountered ín testíng a stock optíon prícíng
model empirícally?
There are a number of problems in testing an option pricing model empirically. These
include the problem of obtaining synchronous data on stock prices and option prices, the
problem of estimating the 口 that will be paid on the stock during the option 's
life, the problem of distinguishing between situations where the market is inefficient and
situations where the option pricing model is incorrect, and the problems of estimating
stock price volatility.
Problem 17.11.
Suppose that a central bank's policy is to allow an exchange rate to B. uctuate between
0.97 and 1.03. What pattern of implied volatilities for options on the exchange rate would
you expect to see?
In this case the probability distribution of the exchange rate has a thin left tail and a
thin right tail relative to the lognormal distribution. We are in the opposite situation to
that described for foreign currencies in Section 17. 1. Both outofthemoney and inthe
money calls and puts can be expected to have lower implied volatilities 瓜
calls and puts. The pattern of implied volatilities is likely to be similar to Figure 17.7
Problem 17.12.
Option traders sometimes refer to deepoutofthemoney options as being options on
volati1ity. Why do you thínk θ do this?
A deepoutofthemoney option has a low value. Decreases in its volatility reduce
its value. However, this reduction is small because the value can never go below zero.
Increases in its ， 。 丑 other hand, can lead to 且 percentage increases
in the value of the option. The 丑 ， therefore, have some of the same attributes
as an option on volatility.
Problem 17.13.
A European call optíon on a certain stock has a strike price of $30, a time to maturity
of one year, and an implied volatility of 30%. A European put option on the same stock
has a strike price of $30, a time to maturity of one year, and an implied volatility of 33%.
122
What is the 古 opportunity open to a trader? Does the arbitrage work only when
the lognormal assumption underlying BlackScholes holds? Explain the reasons for your
answer carefully.
As explained in the appendix to the chapter, putcall parity implies that European put
and call options have the same implied volatility. If a call option has an implied volatility
of 30% and a put option has an implied volatility of 33%, the call is priced too low relative
to the put. The correct trading strategy is to buy the call, sell the put and short the stock.
This does not depend on the lognormal assumption underlying BlackScholes. Putcall
parity is true for any set of assumptions.
Problem 17.14.
Suppose that the result of a major lawsuit affecting a company is due to be announced
tomorrow. The company's stock price is currently $60. If the ruling is favorable to the
company, the stock price is expected to jump to $75. If it is unfavorable, the stock is
expected to jump to $50. What is the riskneutral probabi1ity of a favorable ruling?
Assume that the volati1ity of the company's stock wi11 be 25% foI' six months after the
ruling if the ruling is favorable and 40% if it is unfavorable. Use DerivaGem to calculate
the relatíonship between implied volati1i ty and strike price for sixmonth European options
on the company today. The company does not pay dividends. Assume that the sixmonth
riskfree rate is 6%. Consider call options with strike prices of 30, 40, 50, 60, 70, and 80.
Suppose that p is the probability of a favorable ru1ing. The expected price of the
company's stock tomorrow is
75p + 50(1 _. p) = 50 + 25p
This must be the price of the stock today. (We ignore the expected return to an investor
over one day.) Hence
50 + 25p = 60
or p = 0.4.
If the ruling is favorable, the ， σ ， will be 25%. Other option parameters are
二 ， 7' = 0.06, and T = 0.5. For a value of K equal to 50, DerivaGem gives the value
of a European call option price as 26.502.
If the ruling is unfavorable, the ， σ be 40% Other option parameters are
50 = 50, 7' = 0.06, and T = 0.5. For a value of K equal to 50, DerivaGem gives the value
of a European call option price as 6.310.
The value today of a European call option with a strike price today is the weighted
average of 26.502 and 6.310 or:
0.4 x 十 x 6.310 = 14.387
DerivaGem can be used to calculate the implied volatility when the option has this price.
The parameter values are 50 = 60, K = 50, T = 0.5, 7' = 0.06 and c = 14.387. The implied
volatility is 47.76%.
123
These calculations can be repeated for other strike prices. The results are shown in
the table below. The pattern of implied volatilities is shown in Figure 817. 1.
Call Option Price Call Option Price Implied
8trike Price Favorable Outcome Unfavorable Outcome Weighted Price Volatility (%)
30 45.887 21.001 30.955 46.67
40 36.182 12.437 21.935 47.78
50 26.502 6.310 14.387 47.76
60 17.171 2.826 8.564 46.05
70 9.334 1. 161 4.430 43.22
80 4.159 0.451 1. 934 40.36
50
支
A
『
A
『
mus
42
。
>
c..
E 40
38
20 40 60 80
Strike Price
Figure 817.1 Implied Volatilities in Problem 17.14
Problem 17.15.
An exchange rate is currently 0,, 8000. The volatility of the exchange rate is quoted as
12% and interest rates in the two countries are the same. Using the lognormal assumption,
estimate the probabi1ity that the exchange rate in three months wil1 be (a) less than 0.7000,
(b) between 0.7000 and 0.7500, (c) between 0.7500 and 0.8000, (d) between 0.8000 and
0.8500, (e) between 0.8500 and 0.9000, and (f) greater than 0.9000. Based on the volatility
smi1e usually observed in θ for exchange rates, which of these estimates would
you expect to be too low and which would you expect to be too high?
124
As pointed out in Chapters 5 and 13 an exchange rate behaves like a stock that
provides a dividend yield equal to the foreign 仕 rate. Whereas the growth rate in
a nondividendpaying stock in a riskneutral world is r , the growth rate in the exchange
rate in a riskneutral world is r  rf' Exchange rates have low systematic risks and so we
can reasonably assume that this is also the growth rate in the real world. In this case the
foreign 击 rate equals the domestic 击 rate γ r f ). The expected growth rate
in the exchange rate is therefore zero. If 8r is the exchange rate at time T its probability
distribution is given by equation (12.2) μ
ln 8r rv </>(ln 8
0
 o2T ， σ
where 8
0
is the exchange rate at time zero and σ the volatility of the exchange rate. In
this case 80 = 0.8000 and σ 0.12, and T = 0.25 so that
ln 8r rv 丑 一
x 0.25/2, 0.12JO.25)
or
ln 8r rv </>(0.2249,0.06)
(a) ln 0.70 = 0.3567. The probabi1ity that 8r < 0.70 is the same as the probability that
丑 < 0.3567. It is
二 坐 飞 旦 旦 = 叫
This is 1.41%.
(b) ln 0.75 = 0.2877. The probability that 8r < 0.75 is the same as the probability that
ln 8r < 0.2877. It is
吨 俨 些 川
This is 14.79%. The probability that the exchange rate is between 0.70 and 0.75 is
therefore 14.79  1.41 = 13.38%.
(c) ln 0.80 = 0.2231. The probability that 8r < 0.80 is the same as the probability that
ln 8r < 0.2231. It is
主 气 气 巨 型 叫
This is 51.20%. The probabi1ity that the exchange rate is between 0.75 and 0.80 is
therefore 51. 20  14.79 = 36.41%.
(d) ln 0.85 = 0.1625. The probability that 8r < 0.85 is the same as the probabi1ity that
lnSr < 0.1625. It is
二 生 叫 川 ω
125
This is 85.09%. The probability that the exchange rate is between 0.80 and 0.85 is
therefore 85.09  51.20 = 33.89%.
(e) 丑 = 0.1054. The probability that 8T < 0.90 is the same as the probability that
ln8T < 0.1054. It is
二 些 吨
This is 97.69%. The probability that the exchange rate is between 0.85 and 0.90 is
therefore 97.69  85.09 = 12.60%.
(f) The probability that the 吨 rate is greater than 0.90 is 100  97.69 = 2.31 %
The volatility smile encountered for foreign exchange options is shown in Figure 17.1
of the text and implies the probability distribution in Figure 17.2. Figure 17.2 suggests
that we would expect the probabilities in (a) , (c) , (d) , and (f) to be too low and the
probabilities in (b) and (e) to be too high.
Problem 17.16.
The price of a stock is $40. A sixmonth European call option on the stock with a
strike price of $30 has an implied volatility of 35%. A six month European call option on
the stock with a strike price of $50 has an implied volatility of 28%. The sixmonth risk
free rate is 5% and no dividends are expected. Explain why the two implied volatilities are
different. Use DerivaGem to calculate the prices of the two options. Use putcall parity to
calculate the prices of sixmonth European put options with strike prices of $30 and $50.
Use DerivaGem to calculate the implied volatilities of these two put options.
The difference between the two implied volatilities is consistent with Figure 17.3 in
the text. For equities the volatility smile is downward sloping. A high strike price option
has a lower implied volatility than a low strike price option. The reason is that traders
consider that the probability of a large downward movement in the stock price is higher
than that predicted by the lognormal probability distribution. The implied distribution
assumed by traders is shown in Figure 17.4.
To use DerivaGem to calculate the price of 直 option, proceed as follows. Select
Equity as the Underlying Type in the first worksheet. Select Analytic European as the
Option Type. Input the stock price as 40, volatility as 35%, 仕 rate as 5%, time
to exercise as 0.5 year, and exercise price as 30. Leave the dividend table blank because
we are assuming no dividends. Select the button corresponding to call. Do not select the
implied volatility button. Hit the Enter key and click on calculate. DerivaGem will show
the price of the option as 11. 155. Change the volatility to 28% and the strike price to 50.
Hit the Enter key and click on calculate. DerivaGem will show the price of the option as
0.725.
Putcall parity is
c+ Ke
rT
= p+ 8
0
so that
十
8
0
126
For the first option, c = 11. 155, 8
0
= 40, r = 0.054, K = 30, and T = 0.5 so that
p = 11. 155 + 30e
0
05xO.5  40 = 0.414
For the second option, c = 0.725,
工
， r = 0.06, K = 50, and T = 0.5 so that
p = 十 一 40 = 9.490
To use DerivaGem to calculate the imp1ied volatility of 且 put option, input the
stock price as 40, the 仕 rate as 5%, time to exercise as 0.5 year, and the exercise
price as 30. Input the price as 0.414 in the second half of the Option Data table. Select the
buttons for a put option and implied volatility. Hit the Enter key and click on calculate.
DerivaGem will show the implied volatility as 34.99%.
Similarly, to use DerivaGem to calculate the implied volatility of 且 put option,
input the stock price as 40, the 仕 rate as 5%, time to exercise as 0.5 year , and the
exercise price as 50. Input the price as 9.490 in the second half of the Option Data table.
Select the buttons for a put option and imp1ied volatility. Hit the Enter key and click on
calculate. DerivaGem will show the implied volatility as 27.99%.
These results are what we would expect. DerivaGem gives the implied volatility of a
put with strike price 30 to be almost exactly the same as the implied volatility of a call
with a strike price of 30. Similarly, it gives the implied volatility of a put with strike price
50 to be almost exactly the same as the implied volatility of a call with a strike price of
50.
Problem 17.17.
"Tbe BlackScboles model is used by traders as an interpolation tool." Discuss tbis
Vlew.
When plain vanilla call and put options are being priced, traders do use the Black
Scholes model as an interpolation tool. They calculate implied volatilities for the options
whose prices they can observe in the market. By interpolating between strike prices and
between times to maturity, they estimate implied volatilities for other options. These
implied volatilities are then substituted into BlackScholes to calculate prices for these
options. In practice much of the work in producing a table such as Table 17.2 in the
overthecounter market is done by brokers. Brokers often act as intermediaries between
participants in the overthecounter market and usually have more information on the
trades taking place than any individual financial institution. The brokers provide a table
such as Table 17.2 to their clients as a service.
Problem 17.18
Using Table 17.2 calculate tbe implied volati1ity a trader would use for an 8montb
option witb a strike price of 1.04.
13.45%. We get the same answer 忡 ω 叫 凶 川 町 州 吨 strike 严 让 臼 of ω 丑
1. 05 and 由 丑 创 臼 丑 肮 矶 ， 山 扰 挝 创 six mo 时 hs and one year and (b) interpolati 吨 between
maturities of six months and one year and then between strike prices of 1. 00 and 1. 05.
127
CHAPTER 18
Value at Risk
Value at risk (VaR) has becorne a very irnportant risk rneasure since the ear1y 1990s. It
is the loss on a portfolio that, with a certain 且 level, will not be exceeded. Suppose
that the 10day, 99% VaR is $5.6 rnillion for a bank. This rneans that the probability of the
bank's losses over the next 10 days being greater than $5.6 rnillion is 1%. Bank regulators
base the capital they require for rnarket risk on a calculation of the 10day, 99% VaR.
There are two ways of calculating VaR. The first is historical sirnulation. The second
is the "rnodel building" or "variancecovariance" approach. Historical sirnulation involves
using the history of how rnarket variables have behaved during the last N days to estirnate
VaR. It 丑 N scenarios. The first scenario assurnes that the percentage change in
all variables between today and tornorrow is the sarne as that between day 0 and day 1 of
the historical data; the second scenario assurnes that the percentage change in all variables
between today and tornorrow is the sarne as that between day 1 and day 2 of the historical
data; and so on. The scenarios are used to create a probability distribution for the change
in the value of the current portfolio between today and tornorrow. This in turn allows
the oneday value at risk to be deterrnined. The 10day value at risk is calculated as the
oneday value at risk rnultiplied by jIO.
The rnodel building approach uses a rnodel for the daily change in the values of rnarket
variables. Like the historical sirnulation approach its initial focus is on the oneday VaR.
The rnost cornrnon assurnption is that the changes have a rnultivariate norrnal distribution.
If the change in the value of the portfolio is linearly related to the changes in the values
of the variables, the oneday change in the value of the portfolio is norrnally distributed.
The rnean change is usually assurned to be zero. The standard deviation of the change
can be calculated frorn the standard deviations of, and correlations between, the rnarket
variables. This enables the oneday value at risk to be calculated. As in the case of the
historical sirnulation approach, the 10day value at risk is assurned to be VïO tirnes the
one...day value at risk.
Options create problerns for the rnodel building approach. This is because the change
in the value of an option is not linearly related to the change in the value of the under1ying
variables. One approach is to use the delta of the option to 且 an ap
128
estimate all we need is the most recent change in the market variab1e. (See equation
18.10). Similarly to update an estimate of the corre1ation between two variab1es all we
need are the most recent changes in the variab1es. (See equation 18.12) The updating is
actually carried out in terms of variances and covariances. The variance is the square of
the vo1atility. The covariance is the corre1ation multiplied by the product of the volatilities
of the two variab1es.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 18.8.
A company uses an EWMA model for forecasting volatility. It decides to change the
λ 企 0.95 to 0.85. Explain the likely impact on the forecasts.
Reducing λ 仕 0.95 to 0.85 means that more weight is put on recent observations
of u; and 1ess weight is given to older observations. Vo1atilities ca1cu1ated with λ 0.85
will react more quick1y to new information and will "bounce around" much more than
volatilities calcu1ated with λ 0.95.
Problem 18.9.
Explain the difference between value at risk and expected shortfall.
Va1ue at risk is the 10ss that is expected to be exceeded (100  X)% of the time in
N days for 自 parameter va1ues, X and N. Expected shortfall is the expected 10ss
conditional that the loss is greater than the Value at Risk.
Problem 18.10.
Consider a position consisting of a $100,000 investment in asset A and a $100,000
investment in asset B. Assume that the dai1y volatilities of both assets are 1 % and that
the coeflìcient of correlation between their returns is 0.3. What is ι 99% value at
risk for the portfolio?
The standard deviation of the daily change in the investment in each asset is $1,000.
The variance of the portfolio's daily change is
1,000
2
+ 1,000
2
+ 2 x 0.3 x 1,000 x 1,000 = 2,600,000
The standard deviation of the portfolio's daily change is the square root of this or $1,612.45.
The standard deviation of the 5day change is
1, 612.45 x J5 = $3, 605.55
From the tab1es of N(x) we see that N(2.33) = 0.01.. This means that 1% of a norma1
distribution lies more than 2.33 standard deviations below the mean. The 5day 99 percent
va1ue at risk is therefore 2.33 x 3,605.55 = $8, 400.93.
129
Problem 18.11.
The volati1ity of a certain market variable is 30% per annum. Calculate a 99% confi
dence interval for the size of the percentage dai1y change in the variable.
The volatility per day is 30/V252 = 1.89%. There is a 99% chance that a normally
distributed variable willlie within 2.57 standard deviations. We are therefore 99% confident
that the daily change will be less than 2.57 x 1.89 = 4.86%.
Problem 18.12.
Explain how an interest rate swap is mapped into a portfolio of zerocoupon bonds
with standard maturities for the purposes of a VaR calculation.
且 exchange of principal is added in, the fioating side is equivalent a zero
coupon bond with a maturity date equal to the date of the next payment. 五 side
is a couponbearing bond, which is equivalent to a portfolio of φ bonds. The
swap can therefore be mapped into long and short positions in zerocoupon bonds with
maturity dates corresponding to the payment dates. Each of the zerocoupon bonds can
then be mapped into positions in the adjacent standardmaturity zerocoupon bonds. One
way of doing this is described in the Appendix to Chapter 18.
Problem 18.13.
Explain why the linear model can provide only approximate estimates of VaR for a
portfolio containing options.
The change in the value of an 丑 not linearly related to the percentage change
in the value of the underlying variable. The linear model assumes that the change in the
value of a portfolio is linearly related to percentage changes in the underlying variables. It
is therefore only an approximation for a portfolio containing options.
Problem 18.14.
命 the 0.3year zerocoupon bond in the cashBow mapping example in the
Appendix at the end of this chapter is mapped into a $37,397 position in a 幡
bond and a $11,793 position in a sixmonth bond.
The 0.3year cash fiow is mapped into a 3month zerocoupon bond and a 咀
zerocoupon bond. The 0.25 and 0.50 year rates are 5.50 and 6.00 respectively. Linear
interpolation gives the 0.30year rate as 5.60%. The present value of $50,000 received at
time 0.3 years is
50.000
一 ____A 二
I.OS6U 3U'
The volatility of 0.25year and 缸 bonds are 0.06% and 0.10% per
day respectively. The interpolated volatility of a 0.30year 丑 is therefore
0.068% per day.
Assume that W of the value of the 0.30year cash fiow gets allocated to a 3month
丑 and 一 ω a sixmonth zero coupon bond. To match variances we
must have
0.00068
2
=
ω
十
 W)2 + 2 x 0.9 x 0.0006 x 切 。 一 ω
130
or
ω _ ω 0.5376 = 0
Using the formula for the solution to a quadratic equation
十 飞
 4 x 0.28 x 0.5376
一 0.760259
2 x 0.28
this means that a value of 0.760259 x 49, 189.32 = $37, 397 is allocated to the threemonth
bond and a value of 0.239741 x 49, 189.32 = $11, 793 is allocated to the sixmonth bond.
The 0.3year 丑 is therefore equivalent to a position of $37,397 in a 3month zero
coupon bond and a position of $11,793 in a 6month zerocoupon bond. This is consistent
with the results in the Appendix to Chapter 18.
Problem 18.15.
Suppose that the 5year rate is 6%, the 7year rate is 7% (both expressed with annual
compounding), the daiJy volati1ity of a 5year zero.coupon bond is 0.5%, and the daily
volatility of a 7year zerocoupon bond is 0.58%. The correlation between dai1y returns on
the two bonds is 0.6. Map a cash f10w of $1,000 received at time 6.5 years into a position
in a 5year bond and a position in a 7year bond using the approach in the Appendix at
the end of this θ What cash f10ws in 5 and 7 years are equivalent to the ， θ
cash H.ow?
The 6.5year 丑 is mapped into a 5year zerocoupon bond and a 7year zero
丑 The 5year and 乍 rates are 6% and 7% respectively. Linear interpolation
gives the 6.5year rate as 6.75%. The present value of $1,000 received at time 6.5 years is
1, 000
一 ι τ 654.05
1.0675
ö5
The volatility of 5year and 7year zerocoupon bonds are 0.50% and 0..58% per day re
spectively. The interpolated volati1ity of a 6.5year 丑 is therefore 0.56%
per day.
Assume that ω the value of the 6.5year cash fiow gets allocated to a 5year zero
coupon bond and 1  w to a 7year zero coupon bond. 1b match variances we must
have
.56
2
=
ω
+ 一 ω 十 x 0.6 X .50 X ω w)
or
ω 一 ω .0228 = 0
Using the formula for the solution to a quadratic equation
.3248  ， 豆 花 丁 王 丁 克 互 艾 刀
四 一 一 一 一 一 一 一 一 一 一 一 一 一 一 一 0.074243
2 X .2384
this means that a value of 0.074243 X 654.05 = $48.56 is allocated to the 5year bond and
a value of 0.925757 X 654.05 = $605.49 is allocated to the 7year bond. The 6.5year cash
131
丑 is therefore equivalent to a position of $48.56 in a 5year zerocoupon bond and a
position of $605.49 in a 7year zerocoupon bond.
The equivalent 5year and 7year cash fl.ows are 48.56 x 1.06
5
= 64.98 and 605.49 x
1. 07
7
= 972.28.
Problem 18.16.
Some time ago a company entered into a forward contract to buy ,E 1 million for $1.5
mi111on. The contract now has six months to maturity. The daily volatility of a six
month zerocoupon sterling bond (when its price is translated to dollars) is 0.06% and the
dai1y volatility of a sixmonth zerocoupon dollar bond is 0.05%. The correlation between
企 the two bonds is 0.8. The current exchange rate is 1.53. Calculate the
standard deviation of the change in the dollar value of the forward contract in one day.
What 1s the 10day 99% VaR? Assume that the sixmonth interest rate 1n both sterling
and dollars 1s 5% per annum with continuous compounding.
The contract is a long position in a sterling bond combined with a short position in a
dollar bond. The value of the sterling bond is 1. 53e005xO.5 or $1. 492 million. The value
of the dollar bond is 一 or $1. 463 million. The variance of the change in the
value of the contract in one day is
1.492
2
X
斗
X 0.0005
2
 2 x 0.8 x 1.492 x 0.0006 x 1.463 x 0.0005
= 0.000000288
The standard deviation is therefore $0.000537 million. The 10day 99% VaR is 0.000537 x
Y'ïO x 2.33 = $0.00396 million
Problem 18.17.
The most recent estimate of the daily volatility of the U.S. dollarsterling exchange
rate is 0.6%, and the exchange rate at 4 p.m. yesterday was 1.5000. The parameter λ
the EWMA model 1s 0.9. Suppose that the exchange rate at 4 p.m. today proves to be
1.4950. How would the estimate of the dai1y volati1ity be updated?
The daily 盯 is 0.005/ 1. 5000 = 0.003333. The current daily variance estimate
is 0.006
2
= 0.000036. The new daily variance estimate is
0.9 x 0.000036 + 0.1 x 0.003333
2
= 0.000033511
The new volatility is the square root of this. It is 0.00579 or 0.579%.
Problem 18.18.
Suppose that the daily volati1i ties of asset A and asset B calculated at close of trading
yesterday are 1.6% and 2.5%, respectively. The prices of the assets at close of trading
yesterday were $20 and $40, and the estimate of the coeffìcient of correlation between the
returns on the two assets made at close of trading yesterday was 0.25. The parameter λ
used in the EWMA model 1s 0.95.
(a) Calculate the current estimate of the covariance between the assets.
132
(b) On the assumptíon that the príces of the assets at c10se of tradíng today are $20.5
and $40.5, update the correlatíon estímate.
(a) The volatilities and correlation imply that the current estimate of the covariance is
0.25 x 0.016 x 0.025 = 0.0001.
(b) If the prices of the assets at close of trading today are $20.5 and $40.5, the returns
are 0.5/20 = 0.025 and 0.5/40 = 0.0125. The new covariance estimate is
0.95 x 十 x 0.025 x 0.0125 = 0.0001106
The new variance estimate for asset A is
0.95 X
十 X 0.025
2
= 0.00027445
so that the new volatility is 0.0166. The new variance estimate for asset B is
0.95 X
十 X 0.0125
2
= 0.000601562
so that the new volatility is 0.0245. The new correlation estimate is
。
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Problem 18.19.
8uppose that the daíly volatility of the FT8E 100 stock index (measured in pounds
ster1ing) ís 1. 8% and the dai1y volatilíty of the dollar/ster1ing exchange rate is 0.9%. 8up
pose further that the correlation between the FT8E 100 and the 鸣
rate is 0.4. What is the volatility of the FTSE 100 when it is translated to U.8. dol1ars?
Assume that the 鸣 rate is expressed as the number of U.8. dol1ars
per pound sterling. (Hint: When Z = XY, the percentage dai1y change in Z is approx
imately equal to the percentage dai1y change in X plus the percentage dai1y change in
Y.)
The FTSE expressed in dollars is XY where X is the FTSE expressed in sterling
and Y is the exchange rate (value of one pound in dollars). Define Xi as the proportional
change in X on day i and Yi as the proportional change in Y on day i. The proportional
change in XY is approximately 十 趴 The standard deviation of 町 0.018 and the
standard deviation of Yi is 0.009. The correlation between the two is 0.4. The variance of
十 is therefore
十
+ 2 x 0.018 x 0.009 x 0.4 = 0.0005346
so that the volatility of 十 的 0.0231 or 2.31%. This is the volatility of the FTSE
expressed in dollars. Note that it is greater than the volatility of the FTSE expressed in
ster1ing. This is the impact of the positive correlation. When the FTSE increases the
133
value of sterling measured in dollars also tends to increase. This creates an even bigger
increase in the value of FTSE measured in dollars. Similarly for a decrease in the FTSE.
Problem 18.20.
Suppose that in Problem 18.19 the correlation between the 让 500 lndex (measured
in dollars) and the FTSE 100 lndex (measured in ster1ing) is 0.7, the correlation between
the S&P 500 index (measured in dollars) and the dollarster1ing exchange rate is 0.3, and
the daily volati1ity of the S&P 500 lndex is 1.6%. What is the correlation between the
S&P 500 lndex (measured in dollars) and the FTSE 100 lndex when it is translated to
dollars? (Hint: For three variables X, Y, and Z , the covariance between X + Y and Z
equals the covariance between X and Z plus the covariance between Y and Z.)
Continuing with the notation in Problem 18.19, 且 Zi as the proportional change
in the value of the S&P 500 on day i. The covariance between Xi and Zi is 0.7 x 0.018 x
0.016 = 0.0002016. The covariance between Yi and Zi is 0.3 x 0.009 x 0.016 = 0.0000432.
The covariance between 十 如 Zi equals the covariance between Xi and Zi plus the
covariance between 的 Zi. It is
0.0002016 + 0.0000432 = 0.0002448
The correlation between 十 如 Zi is
0.0002448
一 一 一 一 一 一 一 一 0.662
0.016 x 0.0231
134
CHAPTER 19
Interest Rate Options
The chapter describes the most common interest rate options and the standard market
models that are used to price them. The exchangetraded interest rate options that are
most common are options on interest rate futures (for example, options on Eurodollar
futures and options 卫 町 futures). They can be valued 鸣 approach
in Chapter 14. The commonest overthecounter products are European bond options,
interest rate caps, and European swap options.
European options on bonds are traded in the overthe.counter market. Typicallyan
implied yield volatility is quoted. This yield volatility is converted into a price volatility
(see equation 19.6) using an approximate duration result and the price volatility is used
in a BlackScholes type of formula where the bond price at the maturity of the option is
assumed to be lognormal.
An interestrate cap is an instrument that provides insurance against the rate paid
on a 吨 loan going above a certain level. The level (known as the cap rate) is
analogous to the strike price in a regular option. The rate on the floating rate loan is reset
every month, every quarter, every six months, or every year. An interest rate cap therefore
consists of a series of call options on future interest rates, one corresponding to each time
the fl.oating rate is reset. The individual options are referred to as caplets. Each caplet is
valued using a BlackScholes type of formula where the future interest rate is assumed to
be lognormally distributed. (See equation 19.8.)
For any call option there is a corresponding put option. Interest rate caps are no
exception. Just as an interest rate cap is a series of call options on interest rates, an interest
rate floor is a series of put options on interest rates. As shown in Business Snapshot 19.1
there is a relationship between the values of an interest rate floor , an interest rate cap, and
a swap. This is similar to the putcall parity relationship for regular call and put options.
A European 叩 (often called a European swaption) is an option to enter into
a swap at a particular future time. In the swap 直 rate is exchanged for LIBOR. The
自 rate is analogous to the strike price in a regular option and is specified at the time
the swap option is entered into. A 丑 the holder has the right to 且
and receive floating can be viewed as a call option on the swap rate (or as a put option
on a par yie
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 19.8.
A bank uses Black's model to price European bond options. Suppose that an implied
price volati1ity for a 5year option on a bond maturing in 10 years is used to price a 9year
135
option on the bond. Would you expect the resultant price to be too high or too low?
Explain your answer.
A oneyear forward bond price has a lower volati1ity than a fiveyear forward bond
price. The volatility used to price a nineyear option on a tenyear bond should therefore
be less than that used to price 直 option on a tenyear bond. Using the volati1ity
backed out from the fiveyear option to price the 令 option is therefore likely to
produce a price that is too high.
Problem 19.9.
Consider a fouryear European call option on a bond that will mature in fìve years.
ThefìvE• year bond price is $105, the price of a fouryear bond with the same coupon as the
丘 bond is $102, the strike price of the option is $100, the fouryear 企 interest
rate is 10% per annum (contínuously compounded), and the volatility of the forward príce
of the bond underlying the option is 2% per annum. What is the present value of the
principal in the fouryear bond? What is the present value of the coupons in the fouryear
bond? What is the forward price of the bond underlying the option? What is the value of
the option?
The present value of the principal in the four year bond is 100e
4xO
.
1
= 67.032. The
present value of the coupons is, therefore, 102  67.032 = 34.968. The coupons on the
fouryear bond are the income on the fiveyear bond during the life of the option. This
means that the forward price of the bond underlying the option is
(105  34.968)e
01X4
= 104.475
The parameters in Black's model are therefore Fo = 104.475, K = 100, r = 0.1, T = 4,
and σ 0.02.
日 + 0.5 x 0.02
2
X 4
一 一 一 一 一 一 一 … 一 一 一 一 一 一 一 一 1. 1144
飞
d
2
出 一 = 1.0744
The price of the European call is
e
01X4
[104.475N( 1. 1144)  100N(1. 0744)] = 3.19
or $3.19.
Problem 19.10.
θ volatility for a ， 萨 put option on a bond maturing in 10 years time is
specifìed as 22%, how should the option be valued? Assume that, based on today's interest
rates the modifìed duration of the bond at the maturity of the option wil1 be 4.2 years and
the forward yield on the bond is 7%.
The relationship between the yield volatility and the price volatility is given by equa
tion (19.6). In this case, the price volatility is
0.07 x 4.2 x 0.22 = 6.47%
136
This is the volatility substituted into equation (19.2).
Problem 19.11.
A corporation knows that in three months it wil1 have $5 mi11ion to invest for 90 days
at LIBOR minus 50 basis points and wishes to ensure that the rate obtained wil1 be at
least 6.5%. What position in exchang• traded interestrate options should the corporation
take?
The rate received will be less than 6.5% when LIBOR is less than 7%. The corporation
requires a threemonth call option on a Eurodollar futures option with a strike price of 93.
If threemonth LIBOR is greater than 7% at the option maturity, the Eurodollar futures
quote at option maturity will be less than 93 and there will be no payoff from the option. If
the three month LIBOR is less than 7%, one Eurodollar futures options provide a payoff of
$25 per 0.01%. Each 0.01% of interest costs the corporation $500 (= 5,000,000 x 0.0001).
A total of 500/25 = 20 contracts are therefore required.
Problem 19.12.
Explain carefully how you would use (a) spot volatilities and (b) B. at volatilities to
va1ue a fiveyear cap.
When spot volatilities are used to value a cap, a 旺 volati1ity is used to value
each caplet. When fiat volatilities are used, the same volatility is used to value each caplet
within a given cap. Spot volatilities are a function of the maturity of the caplet.. Flat
volatilities are a function of the maturity of the cap.
Problem 19.13.
VVhat other instrument is the same as a fiveyear zero.cost col1ar ín which the strike
price of the cap equals the strike price of the B. oor? What does the common strike price
equal?
A 5year zerocost collar where the strike price of the cap equals the strike price of the
fioor is the same as an interest rate swap agreement to receive fioating and pay 自 rate
equal to the strike price. The common strike price is the swap rate. Note that the swap
is actually a forward swap that excludes 直 exchange of payments. (See Business
Snapshot 19. 1.)
Problem 19.14.
Suppose tbat tbe l..year, 2year, 3year, 4year and 5year zero rates are 6%, 6.4%,
6.7%, 6.9%, and 7%. Tbe price of a 5year semiannual cap with a principal 0 1' $100 at a
cap rate of 8% is $3. Use DerivaGem to determine
a. The 5…year B. at volatility for caps and B.oors
b. The B.oor rate in a zero.cost 5year col1ar wben the cap rate is 8%
We choose the Caps and Swap Options worksheet of DerivaGem and choose Cap/Floor
as the Underlying Type. We enter the 飞 鸟 ， 鸟 ， ， 5year zero rates as 6%, 6.4%, 6.7%,
6.9%, and 7.0% in the Term Structure table. We enter Semiannual for the Settlement
Frequency, 100 for the Principal, 0 for the Start (Years) , 5 for the End (Years) , 8% for the
137
Cap/Floor Rate, and $3 for the Price. We select BlackEuropean as the Pricing Model
and choose the Cap ∞ We check the Imply Volatility box and Calculate. The
implied volatility is 24.79%. We then uncheck Implied Volatility, select Floor, check Imply
Breakeven Rate. 丑 rate that is calculated is 6.71%. This is the fioor rate for which
丑 is worth $3. A collar when 丑 rate is 6.71 % and the cap rate is 8% ω
cost.
Problem 19.15.
Sbow tbat V
1
+ f 巧 气 tbe value of a swap option to pay 丘 rate
of RK and receive LIBOR between times T
1
and 巧 ， f is tbe value of a forward swap to
receive a fì.xed rate of RK and pay LIBOR between times T
1
and 玛 ， 与 tbe value of
a swap option to receive a fì.xed rate of RK between times T
1
and T
2
. Deduce tbat V
1
巧
wben RK equals the current forward swap rate.
We prove this resu1t by considering two portfolios. 且 consists of the swap
option to receive RK; the second consists of the swap option to pay RK and the forward
swap. Suppose that the actual swap rate at the maturity of the options is greater than
RK. The swap option to pay RK will be exercised and the swap option to receive RK will
not be exercised. Both portfolios are then worth zero since the swap option to pay RK is
neutralized by the forward swap. Suppose next that the actual swap rate at the maturity
of the options is less than RK. The swap option to receive RK is exercised and the swap
option to pay RK is not exercised. Both portfolios are then equivalent to a swap where RK
is received and fioating is paid. In all states of the world the two portfolios are worth the
same at time T
1
. They must thereÍore be worth the same today. This proves the result.
When R
K
equals the current forward swap rate f = 0 and V
1
巧 A swap option to pay
fixed is therefore worth the same as a similar swap option to receive fixed when the fixed
rate in the swap option is the forward swap rate.
Problem 19.16.
Explain wby tbere is an arbitrage opportunity if tbe implied Black (fJ. at) volatility for
a cap is different from tbat for a fJ. oor. Do tbe broker quotes in Table 19.1 present an
arbítrage opportuníty?
The putcall parity relationship in Business Snapshot 19.2 is
十 自
must hold for market prices. It also holds for Black's model. An argument similar to that
in Section 17., 1 shows that the implied volatility of the cap must equal the implied volatility
of the calL If this is not the case there is an arbitrage opportunity. The broker quotes in
Table 19.1 do not present an arbitrage opportunity because the cap offer is always higher
than the fioor bid and the fioor offer is always higher than the cap bid.
Problem 19.17.
Suppose tbat zero rates are as in Problem 19.14. Use DerivaGem to determine tbe
value of an option to pay a fì.xed rate of 6% and receive LIBOR on a fì. veyear swap
138
starting in one year. Assume that the principal is $100 mi11ion, payments are exchanged
semiannually, and the swap rate volatility is 21 %.
We choose the Caps and Swap Options worksheet of DerivaGem and choose Swap
Option as the U nder l y i 鸣 T y p e . We enter 100 as the Principal, 1 as the Start (Years) , 6
as the End (Years) , 6% as the Swap Rate, and Semiannual as the Settlement Frequency.
We choose BlackEuropean as the pricing model, enter 21% as the Volati1ity and check
the Pay Fixed button. We do not check the Imply Breakeven Rate and Imply Volatility
boxes. The value of the swap option is 5.63.
139
CHAPTER 20
Exotic Options and Other Nonstandard Products
Derivatives traders have been very imaginative in designing new derivative instru
ments. This chapter attempts to give the reader a fiavor for the nonstandard products
that exist. It introduces exotic options, mortgagE• backed securities, and nonstandard
swaps. Some of the instruments covered are designed to meet the 丑 of corpo
rate treasurers or fund managersi some are designed for tax, accounting, legal or regulatory
reasonsi some are simply interesting alternatives to the "plain vanilla" products.
The exotic options discussed include Bermudan options, forward start options, com
pound options, chooser options, barrier options, binary options, lookback options, shout
options, and Asian options. You should make sure you understand how each of these work.
Mortgagebacked securities (MBSs) are very important instruments 丑 United
States. They are created when a financial institution securitizes part of its residential
mortgage portfolio. The mortgages are put in a pool and investors acquire a stake in the
pool by buying units. The mortgages are guaranteed against defaults by a government
agency, but there is prepayment risk. As rates decline there is a tendency for mortgage
holders to prepay. The prepayments are passed on to the MBS holders who then have
to reinvest the funds at a lower rate of interest than they were earning before. Often
mortgagebacked securities are designed so that different investors bear different amounts
of prepayment risk.
The final part of the chapter discusses nonstandard swaps. These are variations on
the swaps discussed in Chapter 7. Among the different types of swaps discussed are those
where the principal changes through time, where 丑 interest rate is not LIBOR,
where interest is compounded forward rather than being paid out, LIBORin.arrears swaps,
CMS and CMT swaps, 旺 swaps, equity swaps, accrual swaps, cancelable swaps,
index amortizing swaps, commodity swaps and volatility swaps. You should make sure
you understand how they wor k.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problern 20.8.
Descríbe tbe 企 a portfolío consístíng of a lookback call and a lookback put
wítb tbe same maturity.
A lookback call provides a payoff of ST  Smin' A lookback put provides a payoff
of Smax  ST. A combination of a lookback call and a lookback put therefore provides a
payoff of Smax  Smin'
Problern 20.9.
Consíder a cbooser option wbere tbe bolder bas tbe rígbt to cboose between a European
call and a European put at any tíme duríng a twoyear períod. Tbe maturíty dates and
140
strike prices for the calls and puts are the same regardless of when the choice is made. 1s
it ever optimal to make the choice before the end of the tWDyear period? Explain your
answer.
No, it is never optimal to choose early. The resulting cash fl.ows are the same regardless
of when the choice is made. There is no point in the holder making a commitment earlier
than necessary. This argument also applies when the holder chooses between two American
options providing the options cannot be exercised before the twoyear point. If the early
exercise period starts as soon as the choice is made, the argument does not hold. For
example, if the stock price fell to almost nothing in 且 six months, the holder would
choose a put option at this time and exercise it immediately.
Problem 20.10.
Suppose that C1 and P1 are the prices of a European average price call and a European
average price put with strike price K and maturity T , C2 and P2 are the prices of a European
average strike call and European average stríke put wíth maturíty 1', and C3 and P3 are
the príces of a regular European call and a regular European put wíth strike príce K and
maturíty 1'. Show that
斗  C3 = 十  P3
The payoffs are as follows:
C1 : max(Save  K, 0)
C2 : max(ST  Save, 0)
句 max(ST  K , 0)
P1 : max(K  Save, 0)
P2 : max(Save  ST, 0)
P3 : max(K ST, 0)
The payoff from C1  P1 is always Save " K; The 仕 C2  P2 is always ST " Save;
The payoff from C3 P3 is always ST  K; It follows that
C1  十 " P2 = C3  P3
or
斗 " C3 = 十  P3
Problem 20.11.
The text deríves a decomposítíon of a particular type of chooser optíon into a call
maturíng at time 1'2 and a put maturíng at tíme 1'1' By usíng putcall paríty to obtain
an expression for c instead of p, derive an alternative decomposítion ínto a call maturíng
at tíme 1'1 and a put maturing at time T
2
•
Substituting for c, putcall parity gives
max(c,p) = 缸 卡 ， 十
巧 一 一 俨 斗
]
141
十 [0,
一 e
r
(T2
T
l)]
巧 一 旦 以 ，
一 川 川
This shows that the chooser option can be decomposed into
1. A put option with strike price K and maturity 巧 and
2. e
q
(T
2
T
1
) call options with strike price K 一
and maturity T
1
.
Problem 20.12.
Explain why a downandout put is worth zero when the barrier is greater than the
strike price.
The option is in the money only when the asset price is less than the strike price.
However, in these circumstances the barrier has been hit and the option has ceased to
exist.
Problem 20.13.
Prove that an at 仔 forward start option on a nondividendpaying stock that
wil1 start in three years and mature in fìve years is worth the same as a two.year 自 由 φ
money option starting today.
Suppose that c is the value of a twoyear option starting today. 自 8
0
as the stock
price today and 8T as its value in three years. The BlackScholes formula in Chapter 12
shows that the value of an at 圃 option is proportional to the stock price when
there are no dividends. It follows that the value of the forward start 日 three years
is C8T / 8
0
, We can now use riskneutral valuation. The expected value of the option in
three years in a riskneutral world is c8
0
e
rT
/8
0
= ce
rT
. Discounting this to today at the
riskfree rate gives c, proving the required resu1t.
Problem 20.14.
Suppose that the strike price of an American call option on a nondividendpaying
stock grows at rate g. Show that if 9 is less than the 企 rate, r, it is never optimal
to exercise the call early.
The argument is similar to that given in Chapter 9 for a regular option on a non.
dividendpaying stock. Consider a portfo1io consisting of the option and cash equal to the
present value of the terminal strike price. The initial cash position is
一 俨
By time T 三 三 ， the cash grows to
Ke9TrTerr = 一 才
Since r > g , this is less than K e
9T
and therefore is less than the amount required to
exercise the option. It follows that, if the option is exercised early, the terminal value of
the portfolio is less than 8
T
. At time T the cash balance is K e
9T
. This is exactly what is
142
required to exercise the option. If the early exercise decision is delayed until time T , the
terminal value of the portfolio is therefore
max[ST, KegTj
This is at least as great as ST. It follows that early exercise cannot be optimal.
Problem 20.15.
Answer the following questions about compound options:
(a) What putcall parity relationship exists between the price of a European call on
a call and a European put on a call?
(b) What putcall parity relationship 归 the price of a European cal1 on
a put and a European put on a put?
(a) The putcall relationship is
cc+KHTT1=pc+C
where cc is the price of the call on the call, pc is the price of the put on the call, c is
the price today of the call into which the options can be exercised at time T
1
, and Kl
is the exercise price for cc and pc. The proof is similar to that for the usual putcall
parity relationship in Chapter 9. Both sides of the equation represent the values of
portfolios that will be worth max(c, K
1
) at time T
1
.
(b) The putcall relationship is
cp + K
1
e
rT1
= 十
where cp is the price of the call on the put, pp is the price of the put on the put, p is
the price today of the put into which the options can be exercised at time T
1
, and Kl
is the exercise price for cp and pp. The proof is similar to that in Chapter 9 for the
usual putcall parity relationship. Both sides of the equation represent the values of
portfolios that will be worth max(p, KJ) at time T
1
.
Problem 20.16.
Does a lookback cal1 become more valuable or less valuable as we increase the frequency
with which we observe the asset price in calculating the minimum?
As we increase the frequency we observe a more extreme minimum. This increases
the value of a lookback call.
Problem 20.17.
Does a downandout call become more valuable or less valuable as we increase the
企 with which we observe the asset price in determining whether the barrier has
been crossed? What is the answer to the same question for a downandin cal1?
As we increase the frequency with which the asset price is observed, the asset price
becomes more likely to hit the barrier and the value of a down..andout call 咱
a similar reason the value of a downandin call increases.
143
Problem 20.18.
Explain why a regular European call option is the sum of a downandout European
call and a downandin European call.
If the barrier is reached the downandout option is worth nothing while the down
丑 has the same value as a regular option. If the barrier is not reached the
downandin option is worth nothing while the downand.out option has the same value as
a regular option. This is why a downandout call option plus a downandin call option
is worth the same as a regular option.
Problem 20.19.
What is the value of a derivative that pays off $100 in six months ifthe S&P 500 index
is greater than 1,000 and zero otherwise. Assume that the current level ofthe index is 960,
the 企 rate is 8% per annum, the dividend yield on the index is 3% per annum, and
the volatility of the index is 20%.
This is a cashornothing call. The value is
一 ， where
ln(960/1000) + (0.08  0.03 0.2
2
/2) X 0.5
d
2
一 一 一 一 一 一 一 一 一 户 一 一 一 一 一 一 一 一 一 = 0.1826
0.2 X \/0.5
Because N(d
2
) = 0.4276 the value of the derivative is $41.08.
Problem 20.20.
Estimate the interest rate paid by P&G on the 5/30 swap in Business Snapshot 20.4
if a) the CP rate is 6.5% and the 'freasury yield curve is f1at at 6% and b) the CP rate is
7.5% and the 'freasury yield curve is f1at at 7%.
When the CP rate is 6.5% and Treasury rates are 6% with semiannual compounding,
the CMT% is 6% and an Excel spreadsheet can be used to show that the price of a 30
year bond with a 6.25% 丑 about 103.46. The spread is zero and the rate paid by
P&G is 明 the CP rate is 7.5% and Treasury rates are 7% with semiannual
compounding, the CMT% is 7% and the price of a 30year bond with a 6.25% coupon is
about 90.65. The spread is therefore
max[O, (98.5 X 7/5.78  90.65)/100)
or 28.64%. The rate paid by P&G is 35.39%.
144
CHAPTER 21
Credit Derivatives
Credit derivatives are contracts where the payoff depends on the creditworthiness of
companies or countries. Usually the payoff is triggered by a default on outstanding debt
obligations.
The most popular credit derivative is a credit default swap (CDS). This is designed to
provide bond holders with insurance against defau1ts by a particular company or country
for a period of time. The company or country is known as the reference entity. A notional
principal is specified. The buyer of a CDS makes regular payments to the seller of the
CDS. The payments are a certain percentage of the notional principal each year. This
percentage is referred to as the CDS spread. (Thus if the CDS spread is 200 basis points
the payments are 2% of the notional principal each year.) If there is no default , the buyer
of the CDS gets nothing in return for the payments. If there is a default , the buyer has
the right to sell bonds issued by the reference entity for their face value. The total face
value of the bonds that can be sold equals the notional principal. You should study Tables
21. 2 to 21. 5 carefully to make sure you understand all the details of how CDSs work and
how they are valued.
Note that the valuation of a credit default swap really involves nothing more than
present value arithmetic. We calculate the present value of the expected payments and
the present value of the expected payoffs. The CDS spread quoted for a new deal is the
CDS spread per annum that equates the present value of expected payments to the present
value of expected payoffs. Note also how the recovery rate is 且 It is estimated as the
ratio of the value of a bond just after a default to the face value of the bond. It follows that
the 企 a CDS in the event of a default is L(l R) where L is the principal and R
is the recovery rate. Sometimes the payoff is made in cash rather than by the delivery of a
bond. A calculation agent is then used to observe bond prices immediately after a default
and estimate R.
The valuation of a credit defau1t swap requires estimates of the risk neutral proba
bilities of defau1t during each year of its life. These are sometimes estimated from bond
prices and sometimes implied from the spreads quoted for credit defau1t swaps themselves.
鸣 from actively traded CDSs and using them to price other CDSs is anal
ogous to what traders do when estimating volatilities for valuing options.) Make sure you
understand the difference between co
145
LIBOR plus a spread. A credit default swap forward is an obligation to buy or sell a credit
default swap in the future. A credit default swap option is the right to buy or sell a credit
default swap in the future. Collateralized debt obligations are arrangements whereby the
default risk on a portfolio of bonds is shared between different investors. Typically some
investors have very little default risk exposure while others have high exposures.
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 21.8.
Suppose that the r i s k  . 企 e e zero curve is ß.at at 7% per annum with continuous com
pounding and that defaults can occur half way through each year in a new fì. v• year credit
default swap. Suppose that the recovery rate is 30% and the default probabilities each year
conditionalon no earlier default is 3% Estimate the credit default swap spread? Assume
payments are made annually.
The table corresponding to Tables 21.2, giving unconditional default probabilities, is
Time
(years)
VU
4L
宁
嘀
嘀
旧
pHMa
uub
Dm
P
Survival
Probability
白
哇
，
。
0.0300
0.0291
0.0282
0.0274
0.0266
0.9700
0.9409
0.9127
0.8853
0.8587
The table corresponding to Table 21. 3, giving the present value of the expected regular
payments (payment rate is 8 per year) , is
一 一 一 … 一 一 一  
Time Probability Expected Discount PV of Expected
(years) of Survival Payment Factor Payment
一 一 一 一  一 一 一 一 一
1 0.9700 0.97008 0.9324 0.90448
2 0.9409 0.94098 0.8694 0.81808
3 0.9127 0.91278 0.8106 0.73988
4 0.8853 0.88538 0.7558 0.66918
5 0.8587 0.85878 0.7047 0.60518
Total 3.73648
The table corresponding to Table 21.4, giving the present value of the expected payoffs
(notional principal =$1) , is
146
Time Probability Recovery
Exppaeycotf ed
Discount
PV oPf aEyxopf ected
(years) of Default Rate Factor
0.5 0.0300 0.3 0.0210 0.9656 0.0203
1. 5 0.0291 0.3 0.0204 0.9003 0.0183
2.5 0.0282 0.3 0.0198 0.8395 0.0166
3.5 0.0274 0.3 0.0192 0.7827 0.0150
4.5 0.0266 0.3 0.0186 0.7298 0.0136
Total 0.0838
The table corresponding to Table 21.5, giving the present value of accrual payments,
lS
一 一
Time Probability Expected Discount PV of Expected
(years) of Default Accrual Payment Factor Accrual Payment
0.5 0.0300 0.01508 0.9656 0.01458
1.5 0.0291 0.01468 0.9003 0.01318
2.5 0.0282 0.01418 0.8395 0.01188
3.5 0.0274 0.01378 0.7827 0.01078
4.5 0.0266 0.01338 0.7298 0.00978
Total 0.05988
The credit default swap spread 8 is given by:
3.73648 + 0.05988 = 0.0838
It is 0.0221 or 221 basis points.
Problem 21.9.
What is the value of the swap in Problem 21.8 per dollar of notional principal to the
protection buyer if the credit default swap spread is 150 basis points?
If the credit default swap spread is 150 basis points, the value of the swap to the buyer
of protection is:
0 . 0 8 3 8 一 ( 3 . 7 3 6 4 + 0.0598) x 0.0150 = 0.0269
per dollar of notional principal.
Problem 21.10.
What is the credit default swap spread in Problem 21.8 if it is a binary CDS?
If the swap is a binary CDS, the present value of expected payoffs is calculated as
follows
147
Time
Probeafbaiuliltt y
Expected Discount
PV opf aEyxopf ected
(years) ofD Payoff Factor
0.5 0.0300 0.0300 0.9656 0.0290
1.5 0.0291 0.0291 0.9003 0.0262
2.5 0.0282 0.0282 0.8395 0.0237
3.5 0.0274 0.0274 0.7827 0.0214
4.5 0.0266 0.0266 0.7298 0.0194
Total 0.1197
The credit default swap spread 8 is given by:
十 = 0.1197
It is 0.0315 or 315 basis points.
Problem 21.11.
How does a nveyear nth.todefault credit default swap work. Consider a basket of
100 reference entities where each reference entity has a probabi1ity of defaulting in each
year of 1 %. As the default correlation between the reference entities increases what would
you expect to happen to the value ofthe swap when a) n = 1 and η 25. Explain your
answer.
且 nth to default credit default swap works in the same way as a regular credit
default swap except that there is a basket of companies. The payoff occurs when the nth
仕 the companies in the basket occurs. After the nth default has occurred the
swap ceases to exist. When η 1 (so that the swap is a 直 to default") an increase in
the default correlation lowers the value of the swap. When the default correlation is zero
there are 100 independent events that can lead to a payoff. As the correlation increases
the probability of a payoff decreases. In the limit when the correlation is perfect there is
in effect only one company and therefore only one event that can lead to a payoff.
When n 25 (so that the swap is a 25th to default) an increase in the default
correlation increases the value of the swap. When the default correlation is zero there is
virtually no chance that there will be 25 defaults and the value of the swap is very close
to zero. As the correlation increases the probability of multiple defaults increases. In the
limit when the correlation is perfect there is in effect only one company and the value of
a 25thtodefault credit default swap is the same as the value of a firsttodefault swap.
Problem 21.12.
How is the recovery rate of a bond usually denned?
The recovery rate of a bond is usually 且 as the value of the bond a few days
after a default occurs as a percentage of the bond's face value.
148
Problem 21.13.
Show that the spread for a new plain vanil1a CDS should be 1  R times the spread
for a simi1ar new binary CDS where R is the recovery rate.
The 仕 a plain vanilla CDS is 1  R times the 旺 a binary CDS with
the same principal. The payoff always occurs at the same time on the two instruments.
It follows that the regular payments on a new 丑 CDS must be 1  R times the
payments on a new binary CDS. Otherwise there would be an arbitrage opportunity.
Problem 21.14.
命 if the CDS spread for the example 1n Tables 21.2 to 21.5 1s 100 basis
po1nts and the probabi1i ty of default in a year (conditional on no earlier default) must be
1.61%. How does the probability of default change when the recovery rate 1s 20% instead
of 40%. 命 your answer 1s consistent with the implied probabi1i ty of default being
approximately proportional to 1/(1  R) where R 1s the recovery θ
The 1. 61% implied default probability can be calculated by setting up a worksheet in
Excel and using Solver. To 句 that 1. 61% is correct we note that , with a conditional
default probability of 1.61 %, the unconditional probabilities are:
Time
(years)
y
4L
4Lii
咽
，
，
』
旧
廿
唱
。
Dm
P
Survival
Probability
。
中
0.0161
0.0158
0.0156
0.0153
0.0151
0.9839
0.9681
0.9525
0.9371
0.9221
The present value of the regular payments becomes 4.1170s, the present value of the
expected payoffs becomes 0.0415, and the present value of the expected accrual payments
becomes 0.0346s. When s = 0.01 the present value of the expected payments equals the
present value of the expected payoffs.
When the recovery rate is 20% the implied default probability (calculated using Solver)
is 1.21 % per year. Note that 1. 21/ 1. 61 is approximately equal ω υ 一 一 钊 口 一 勾 由 旧 坦
that the implied default probability is approximately proportional to 1/(1 R)"
In passing we note that if the CDS spread is used to imply an unconditional default
probability (assumed to be the same each year) then this implied unconditional default
probability is exactly proportional to 1/(1 R). When we use the CDS spread to imply a
conditional 山 (assumed to be the same each year) it is only approximately
proportional to 1/(1  R).
Problem 21.15.
A company enters into a total return swap where it receives the return on a corporate
bond paying a coupon of 5% and pays LIBOR Explain the difference between this and a
regular swap where 5% 1s exchanged for LIBOR.
149
In the case of a total return swap a company receives (pays) the increase (decrease)
in the value of the bond. In a regular swap this does not happen.
Problem 21.16.
Explain how forward contracts and options on credit default swaps are structured.
When a company enters into a long (short) forward contract it is obligated to buy
(sell) the protection given by a specified credit defau1t swap with a specified spread at a
specified future time. When a company buys a call (put) option contract it has the option
to buy (sell) the protection given by a 且 credit default swap with a specified spread
at a specified future time. Both contracts are normally structured so that they cease to
exist if a default occurs during the life of the contract.
Problem 21.17.
"The position of a buyer of a credit default swap is simi1ar to the position of someone
who is long a riskfree bond and short a corporate bond." Explain this statement.
A credit default swap insures a corporate bond issued by the reference entity against
default. Its approximate effect is to convert the corporate bond into a 仕 bond. The
buyer of a credit default swap has therefore chosen to exchange a corporate bond for a
仕 bond. This means that the buyer is long a riskfree bond and short a similar
corporate bond.
Problem 21.18.
Why is there a potential asymmetric information problem in credit default swaps?
Payoffs from credit default swaps depend on whether a particular company defaults.
Arguably some market participants have more information about this that other market
participants. (See Business Snapshot 21.2.)
Problem 21.19.
Does valuing a CDS using actuarial default probabilities rather than riskneutral de
fault probabi1i ties overstate or understate its value? Explain your answer.
Real world defau1t probabilities are less than riskneutral default probabilities. It
follows that the use of real world default probabilities will tend to understate the value of
a CDS.
150
CHAPTER 22
飞 ， Energy, and Insurance Derivatives
This chapter describes some nontraditional derivatives products. It considers how
weather, energy, and insurance derivatives are typically structured.
The most common weather derivatives have payoffs dependent on the temperature at
a particular weather station during a particular month. The temperature variable for a
month is typically calculated as the cumulative coo1ing degree days (CDD) or cumulative
吨 days (HDD). The CDD for a day is 一 ， 0) where A is the average
of the highest and lowest temperature in degrees Fahrenheit during the day. The HDD for
a day is max(65  A, 0). Popular contracts are forwards and options on the cumulative
CDD or HDD during a month.
The three most important types of energy derivatives are oil derivatives, gas deriva
tives, and electricity derivatives. The oil derivatives market is a well established market
where a variety of different contracts (such as futures , forwards , swaps, and options) trade
actively in both exchanges and overthecounter markets. Contracts typically relate to the
delivery of a certain number of gallons of a certain type of oil at a certain location. The
gas derivatives market typically involves forward contracts or options for the delivery of
gas at a certain rate to a certain hub for the whole of a month. The electricity derivatives
contract also typically involves forward contracts or options for the delivery of electricity
at a certain rate to a specific location for the whole of a month. However, in the case of
electricity the supplier may have the right the change the rate at which power is supplied
during the month in certain ways.
Energy prices exhibit volatility and mean reversion. This means that prices fluctuate
randomly, but tend to be pulled back to a longrun average level. Oil has a relatively
low volatility and a relatively low rate mean reversion. For gas the volatility and mean
reversion are somewhat higher. Electricity has a very high volati1ity and a very high rate
of mean reversion. (This is largely because it is not possible to store electricity and so a
day's demand must be met by electricity 坦 白 day.)
In a traditional reinsurance contract an insurance company pays other companies to
take on risks it does not want to bear itself. An alternative to traditional reinsurance
is a CAT bond. CAT bonds typically offer a higher rate of interest than regular bonds.
However, the bond principal m
SOLUTIONS TO QUESTIONS AND PROBLEMS
Problem 22.8.
"HDD and CDD can be regarded as 企 options on temperature." Explain
this statement.
HDD is max(65  A, 0) where A is the average of the maximum and minimum tem
perature during the day. This is the payoff from a put option on A with a strike price of
151
65. CDD is max(A  65, 0). This is the payoff from cal1 option on A with a strike price of
65.
Problem 22.9.
Suppose that you have 50 years of temperature data at your disposal. Explain the
analysis you would you carry out to calculate the forward cumulative CDD for next July.
It would be useful to calculate the cumulative CDD each July each year for the last
50 years. A linear regression relationship
α 十 十 ε
could then be estimated where α b are constants, t is the time in years measured from
the start of the 50 years, and e is the error. This relationship allows for linear trends in
temperature through time. The expected CDD for next year (year 51) is α 51b.
This could be used as an estimate of the forward CDD.
Problem 22.10.
Would you expect mean reversion to cause the volati1ity of the 令 再
price of an energy source to be greater than or less than the volatility of the spot price?
Explain your answer.
The volatility of the threemonth forward price will be less than the volatility of the
spot price. This is because, when the spot price changes by a certain amount , mean
reversion will cause the forward price will change by a lesser amount.
Problem 22.11.
Explain how a 5 x 8 option contract for May 2008 on electricity with dai1y exercise
works. Explain how a 5 x 8 option contract for May 2008 on electricity with monthly
exercise works. Which is worth more?
A 5 x 8 contract for May, 2008 is a contract to provide electricity 且 days per week
吨 offpeak period (l1pm to 7am). When daily exercise is 且 时 ， the holder
of the option is able to choose each weekday whether he or she will buy electricity at the
strike price at the agreed rate. When there is monthly exercise, he or she chooses once at
the beginning of the month whether electricity is to be bought at the strike price at the
agreed rate for the whole month. The option with daily exercise is worth more.
Problem 22.12.
Consider two bonds that have the same coupon, time to maturity and price. One is a
Brated corporate bond. The other is a CAT bond. An analysis based on historical data
shows that the expected losses on the two bonds in each year of their life is the same.
Which bond would you advise a portfolio manager to buy and why?
The CAT bond has very little systematic risk. Whether a particular type of catastro.
phe occurs is independent of the return on the market. The risks in the CAT bond are
likely to be largely 且 away" by the other investments in the portfo1io. A Brated
bond does have systematic risk that cannot be 直 away. It is likely therefore that
the CAT bond is a better addition to the portfolio.
152
CHAPTER 23
Derivatives Mishaps 认
We Can Learn from Them
Derivatives markets have been responsible for some spectacular losses. It is important
to understand what went wrong and how similar catastrophes can be avoided in the future.
This is the focus of this final chapter.
The most important point to understand is that derivatives can be used in many
different ways. They can be used to reduce the risks that arise from a company's operations
or to take risks. It is important for all companies 缸 and 硝 to define
clear and unambiguous risk limits and to set up internal controls to ensure that the limits
are adhered to.
It is hard to believe that some of the events outlined in this chapter actually happened.
It is important to recognize that the events are not representative of how derivatives are
used most of the time. Most derivatives trades are entered into for sensible reasons.
Overall the derivatives industry has been a huge multitrillion dollar success story. It wi1l
be fascinating to see how it evolves in the years to come.
153
SOLUTIONS MANUAL AND STUDY GUIDE
Fundamentals of Futures and Options Markets
Sixth Edition
John C.Hull
Maple Financial Group Professor of Derivatives and Risk Management Joseph L. Rotman School of Management University of Toronto
Prentice Hall , Upper Saddle River, NJ 07458
Project Manager , Editorial: Mary Kate Mu红ay Project Manager , Production: Carol Sarnet Buyer: Arn old Vila
Copyright @ 2008 by Pearson Education , Inc. , Upper Saddle River , New Jersey , 07458. Pearson Prentice Hall. All rights reserved. Printed in the United States of America. This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction , storage in a retrieval system, or transmission in any form or by any means , electronic, mechanica1, photocopying , recording , or likewise. For information regarding permission(s) , write to: Rights and Permissions Department. work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part ofthis work (inc1uding on the World Wide Web) will destroy 由e integrity of the work and is not pe口时仗时. The work and materials from it should never be made available to students except by instructors using the accompanying tβxt in their c1asses. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogica1 purposes and the needs of other instructors who rely on these materia1 s. Pearson Prentice Ha l1™ is a trademark of Pearson Education , Inc.
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ISBN13: 978013242当742 ISBN lO: 0132425742
Contents Preface Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Introduction Mechanics of Futures Markets Hedging Strategies Using Futures Interest Rates Determination of Forward and Futures Prices Interest Rate Futures Swaps Mechanics of Options Markets Properties of Stock Options T￥ ading Strategies Involving Options Introduction to Binomial Trees Valuing Stock Options: The BlackScholes Model Options on Stock Indices and Currencies Futures Options The Greek Letters Binomial Tr ees in Practice Volatility Smiles Value at Risk Interest Rate Options Exotic Options and Other Nonstandard Products Credit Derivatives Weather . Energy. and Insurance Derivatives Der如atives Mishaps and What We Can Learn from Them V 1 7 13 19 26 34 41 49 56 63 69 77 87 93 100 112 121 128 135 140 145 151 153 III .
My email address is hull@r悦man. Hu l1 Joseph L. The questions and problems have been designed to help readers study on their own and test their understanding of the material. Rotman School of Management University of Toronto V .Preface This book contains solutions to the questions and problems that appear at the ends of chapters in my book Fundαmentαls of Futures αnd Options Mαrkets， 6th edition. You should find this material useful both when you 且rst cover the material in the chapter and when you are studying for exams. ca John C. To maximize the benefits from this book readers are urged to sketch out their own solutions to the problems before consulting mine. At the beginning of each chapter 1 have included a summary of the main points in the chapter and suggested ways readers should approach studying the material in the chapter. They range 仕om quick checks on whether a key point is understood to much more challenging applications of analytical techniques. utoronto. 1 welcome comments on either Fundαmentαls of Futures αnd Options Mαrkets ， 6th edition or this book.
ow from one side to the other . If you already know how futures . The chapter identifies the three main types of traders tha 1 . A futures or forward contract may prove to be an asset or a liabi1i ty (depending on the future price of the underlying asset). 2 indicates . The openoutcry system in exchanges is an arrangement where traders meet on the fl. the OTC market is much bigger than the exchangetraded market. 2 show the prices of options on Intel. Exchange伽 traded markets are markets where the contracts are de且ned by an exchange such as the Chicago Board of 'I￥ade. This is increasingly being replaced by electronic trading where traders sit at terminals and use a keyboard to indicate the trades they would like to do. and so on is 0昭anized by the exchange. oor of the exchange and use hand signals to indicate the trades they would like to do. How trading is done . forward .CHAPTER 1 Introduction This chapter introduces futures . It is Chapter 2 that covers the dai1y settlement feature of futures contracts and itemizes the differences between the two sorts of contracts. An exchange is not involved. and options work you will not have to spend too much time on this chapter. Normally no money (except margin requirements which are discussed in Chap咿 ter 2) change hands when a futures or forward contract is entered into. Both are agreements to buy or sell an asset at a certain time in the future for a certain price. and option contracts and explains the types of traders that use them. Futures and forward contracts are obligations to enter into a transaction in the future. The overthecounter (OTC) market is primari1y a market between financial institutions . Make sure you understand what the numbers in these tables mean and how the profit diagrams in Figure 1. An option is the right to enter into a transaction in the future. 1 shows forward foreign exchange quotes. Note that Chapter 1 does not distinguish between futures and forward contracts. non. An option contract is a always an asset to the buyer of the option and a liabi1ity to the seller of the contract. 3 are constructed. It costs money (the option premium) to purchase an option. The distinction between overthecounter and exchangetraded markets is important. They typically communicate and agree on trades by phone. Make sure you understand the key difference between futures (or forwards) and options. Table 1.financial corporations . As Figure 1. forward . Table 1. how payments fl. and fund managers.
Explain why a futures contract can be used for either speculation or hedging. Problem 1. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 1. How can put options be used to provide you with insurance against a dec1ine in the value of your holding over the next four months? You should buy 50 put option contracts (each on 100 shares) with a strike price of $25 and an expiration date in four months. The company is not involved. the gain on the sa1e of the catt1e will be offset by the 10ss on the futures contract. 8. a short futures position will hedge the risk. he or she gains when the asset 's price increases and 10ses when it decreases. Problem 1. It is a security sold by one investor to another.000 pounds of cattle. An exchangetraded stock option provides no funds for the company. If the investor takes a 10ng position . If the price of catt1e rises . A cattle farmer expects to have 120. 10. 9.money before superiors find out what is going on. he or she loses when the asset's price increases and gains when it decreases. Problem 1. If the price of cattle falls . Using futures contracts to hedge has the advantage that it can at no cost reduce risk to a1most zero. The livecattle futures contract on the Chicago Mercan ti1 e Exchange is for the delivery of 40. what are the pros and cons of hedging? The farmer can short 3 contracts that have 3 months to maturity. Thus either a 10ng or a short futures position can be entered into for hedging purposes. 1s the same true of an exchangetraded stock option? Discuss. you can exercise the options and sell the shares for $25 each. A stock when it is fìrst issued provides funds for a company. a 10ng futures position will hedge the risk. the gain on the futures contract will offset the 10ss on the sa1e of the cattle.000 shares that are worth $25 each. How can the farmer use the contract for hedging? Fr om the farmer's viewpoint. If the investor will gain when the price decreases and 10se when the price increases . By contrast .000 pounds of live cattle to sell in three months. If at the end of four months the stock price proves to be less than $25 . If the investor will10se when the price decreases and gain when the price increases . 2 . 1 1. If the investor takes a short position . If an investor has an exposure to the price of an asset . Suppose you own 5. Its disadvantage is that the farmer no 10nger gains 仕om favorable movements in cattle prices. he or she can hedge with futures contracts. If the investor has no exposure to the price of the under1ying asset . entering into a futures contract is specu1ation. a stock when it is first issued is sold by the company to investors and does provide funds for the company.
Problem 1. Suppose that a March call option on a stock with a strike price of $50 costs $2. The profit as a function of the stock price is shown in Figure 81.50 and is held until March.1. (This ignores the time value of money. 1 Pro自t from long position in Problem 1. Each contract is for the delivery of 100 ounces. the price received for this production can be hedged by shorting a total of 30 October 2007 contracts. It is Ju1y 2007. For example . It can then short futures contracts to lock in the price received for the gold. The holder of the option will gain if the price of the stock is above $52. A mining company has just discovered a small deposit of g01d.00 in March. Under what circumstances wil1 the h01der of the option make a gain? Under what circumstances wil1 the option be exercised? Drawa diagram showing how the profìt on a 10ng position in the option depends on the stock price at the maturity of the option.Problem 1. if a total of 3 .50 in March. The g01d wil1 then be extracted on a more or 1ess continuous basis for one year. There are delivery months every two months 丘。m A ugust 2007 to December 2008. It wil1 take six months to construct the mine. 8 亏咱 6 E』 L 国 4 2 2 岛 4 O 45 Figure 8 1.000 ounces are expected to be produced in 8eptember 2007 and October 2007 . Discuss how the mining company might use futures markets for hedging. The mining company can estimate its production on a month by month basis.13 3 . 13. Fu tures contracts on gold are avai1ab1e on the New York Commodity Exchange.) The option will be exercised if the price of the stock is above $50. 12.
00 in June. Describe the investor's cash Bows if the option is held until September and the stock price is $25 at this time. 14 Problem 1. 14. Under what circumstances wil1 the holder of the option make a gain? Under what circumstances wil1 the option be exercised? Drawa diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option. The $5 is the result of the option being exercised. 4 . The $2 is the cash received from the sale of the option. and the option price is $2. 15. Suppose that a June put option on a stock with a strike price of $60 costs $4 and is held un ti1 June. The seller of the option willlose if the price of the stock is below $56. The pro自t as a function of the stock price is shown in Figure 8 1. The stock price is $18.Problem 1. The investor has to buy the stock for $25 in 8eptember and sell it to the purchaser of the option for $20.00 in June. (This ignores the time value of money. 2 Profit from short position In Problem 1. The trader has an inflow of $2 in May and an outflow of $5 in 8eptember. 2. It is May and a trader writes a September call option with a strike price of $20.) The option will be exercised if the price of the stock is below $60. 6 E』 4 号2 L oJ 在中 4 6 8 / /仍 ω stc后k 阳ce 臼 70 Figure 8 1.
) Problem 1.0011 millions of dollars or $110 . It can be argued that an ai r1ine should not expose its shareholders to risks associated with the future price of oil when there are contracts available to hedge the risks.0080 per yen. This means that the use of a futures contract for speculation would be like betting on whether a coin comes up heads or tails." What do you think is meant by this statement? The statement means that the gain (loss) to the party with the short position is equal to the loss (gain) to the party with the 10吨 position. (This ignores the time value of money. (b) Speculate on the future direction of longterm interest rates.Problem 1.000. Problem 1. The Chicago Board of Trade offers a futures contract on longterm Tr easury bonds. 16. (b) $0. An airline executive has argued: "There is no point in our using oil futures. In total . Characterize the investors 1ikely to use this contract. Problem 1. (c) Arbitrage between the spot and futures markets for Tr easury bonds Problem 1. Most investors will use the contract because they want to do one of the following: (a) Hedge an exposure to longterm interest rates. It may well be true that there is just as much chance that the price of oil in the future will be above the futures price as that it will be below the futures price. 19. The fon再rard exchange rate is $0. "Options and futures are zerosum games. 5 . But it might make sense for the airline to use futures for hedging rather than speculation.0080 per yen when the exchange rate is $0.0006 millions of dollars or $60 . The gain is 100 x 0. An investor writes a December put option with a strike price of $30. 18. 20. The price of the option is $4. the gain to all parties is zero. Under what circumstances does the investor make a gain? The investor makes a gain if the price of the stock is above $26 at the time of exercise. The loss is 100 x 0.0074 per yen. There is just as much chance that the price of oil in the future wil1 be less than the futures price as there is that it wil1 be greater than this price. A trader enters into a short forward contract on 100 m il1ion yen. The futures contract then has the effect of reducing risks.0080 per yen when the exchange rate is $0.000.0091 per ye丑." Discuss the executive's viewpoint. (b) The trader sells 100 million yen for $0. How much does the trader gain or lose if the exchange rate at the end of the contract is (a) $0.0091 per yen? (a) The trader sells 100 million yen for $0.0074 per yen. 17.
4820) x 50 .Problem 1. This would provide insurance against a strong Canadian dollar in six months while still allowing the company to benefit 仕om a weak Canadian dollar at that time.20 cents p凹 Gain = ($0.5130 一 $0. Problem 1. $ ∞创 ∞ 00 ∞ pound. (b) 51. Alternatively the company could buy a call option giving it the right (but not the obligation) to purchase 1 million Canadian dollar at a certain exchange rate in six months. Problem 1. The contract is for the delivery of 50. A company knows that it is due to receive a certain amount of a foreign currency in four months. It ensures that the foreign currency can be sold for at least the strike price. 22.50 0 0) x 50 ， ∞ 0=$650. A United States companyexpects to have to pay 1 mil1ion Canadian dollars in six months. (b) Thetrader sells :D如 50 臼盹{ 仕 Dr c en Loss = (仰 0. The company could enter into a long forward contract to buy 1 million Canadian dollars in six months. Explain how the exchange rate risk can be hedged using (a) a forward contract.000 pounds. A trader enters into a short cotton futures contract when the futures price is 50 cents per pound.30 cents per pound? (a) The trader sells for 50 cents per pound somethi吨 that is worth 48. What type of option contract is appropriate for hedging? A long position in a four. 2 1.5000 一 $0 . 6 .20 cents per pound. (b) an option. How much does the trader gain or lose if the cotton price at the end of the contract is 但) 48. 000 = $900.month put option can provide insurance against the exchange rate falling below the strike price. This would have the effect of locking in an exchange rate equal to the current forward exchange rate. 23.
Let's use the hogslean futures contracts in Table 2.1.02 x 40 .and make sure you understand all the entries in the table. a short futures contract is an agreement to sell a certain amount of the underlying asset during a future month. b) how the daily sett1ement procedures work . If the balance in the margin account falls below the maintenance margin level you get a margin call from your broker requiring you to bring the balance in your margin account up to the initial margin level.2 indicate that the futures price at the time of your transaction is between 63. The broker uses the initial margin deposit to open a margin account for you. e. and c) the operation of margin accounts.2) determines the daily sett1ement process (known as marking to market the contract). Each contract is on 40 . Three key things you should understand are a) how futures contracts are entered into and closed out . if the settlement price on April hogs decreases by 2 cents per pound 仕om one day to the next $800 would be added to your margin account. This deposit is known as the initial margin and minimum initial margin levels per contract are speci且ed by the exchange. It is 63.2 as an example. .) Your broker wi1l ask you to prove that you are capable of honoring your commitments by making a deposit. Similarly. The settlement price on the contract (fifth column in Table 2. Study the gold futures example in Table 2. futures price increases cost you money). If the settlement price on April hogs increases by 2 cents per pound from one day to the next you lose 0.CHAPTER 2 Mechanics of Futures Markets This chapter covers the details of how futures markets work.000 pounds of hogs. The sett1ement price for a day is the price at which the contract trades at the close of trading on that day. (Because you have a short position . Suppose you short (i.725 ce丑ts per pound.950 for the contract we are considering on January 8 . You can enter into a futures contract (long or short) by issuing appropriate instructions to your broker. 000 = $800 仕om your margin account. sell) one April contract on January 8. When you instruct your broker to close out your futures position (or when the broker closes 7 . 2007. (The High and Low columns in Table 2. A long futures contract is an agreement to buy a certain amount of the underlying asset during a future month.750 and 64. If you do not provide the necessary funds within 24 hours your position is closed out. 2007. A maintenance margin (usually about 75% of the initial margin) is speci且ed.
1. and so on. the same types of orders can be placed in futures markets. However .7 indicates . then the profit or loss on the contract is recognized when the contract is closed out. where it is delivered . The party with a short position in a futures contract sometimes has options as to the precise asset that wil1 be delivered . ows from the underlying asset being hedged. Futures contracts are traded on an exchange. when delivery wil1 take place. if a trader can show that a contract is entered into for hedging purposes .9 provides an overview of the issues that are important in many jurisdictions. and so on. Normal accrual accounting leads to the profit or loss on a futures transaction being recognized throughout the life of the contract for both accounting and tax purposes. As Section 2. These are summarized in Table 2. When delivery takes place it is the party with the short futures position that initiates delivery. Futures contracts have standard terms defined by the exchange for the size of the contract . On the delivery date there is a final daily settlement . delivery dates . forward contracts are traded overthe counter. When you trade stocks there are many different types of orders that can be placed with a broker: market orders . The accounting and tax treatment of futures and other derivatives is complicated . Both futures and forwards are agreements to buy or sell an asset at a future time for a future price. (See Example 2. stop orders . The party with the short position may have some choices to make on exactly what is delivered . but Section 2. These options make the contract less attractive to the party with the long position 8 .delivery. Delivery in a futures contract can often take place on a num SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 2. stoploss orders . and when it is delivered. based on the spot value of the underlying asset .ows 仕om the futures contract should be matched with the cash f:l. limit orders . It is the possibility of final delivery that ties the futures price to the spot price.) The idea here is that for a hedger the cash f:l.8. Do these options increase or decrease the futures price? Explain your reasonlllg.3. forward contracts are not standardized. In these circumstances a single delivery date is specified for the contract. where delivery wil1 take place. You should by now be fully comfortable with the differences between futures and forward contracts. and all contracts are declared closed out. etc. Some contracts such as futures on stock indices are settled i丑 cash rather than by physical delivery. The amount of cash you have to provide to do a trade (the initial margin) is a relatively small percentage of the value of asset being traded (perhaps only 10%). The contract is marked to market until this delivery date. One of the attractions of futures contracts for speculators is that they have built in leverage.
$2 . the investor is required to deposit a further margin.10.000 be witbdrawn 企om tbe margin account? There is a margin call if $1 . An investor enters into two long July futures contracts on 丘。'zen orange juice.500 per contract. Does an arbitrage opportunity exist if tbe futures price is less tban tbe spot price? Explain your answer.9. tbe initial margin is $6.1 1. Problem 2.67 cents per lb. It acts as a guarantee that the investor can cover any losses on the futures contract.000. and makes delivery for an immediate profit. and tbe maintenance margin is $4 . If losses are above a certain level . They therefore tend to reduce the futures price.000 can be withdrawn from the margin account if there is a gain on one contract of $1 . A margin is a sum of money deposited by an investor with his or her broker. This system makes it unlikely that the investor will default. shorts a futures contract . A similar system of margins makes it unlikely that the investor's broker wi11 default on the contract it has with the clearinghouse member and unlikely that the clearinghouse member will default with the clearinghouse. the size of the contract .67 cents to 166. 9 . The balance in the margin account is adjusted daily to refl. there is no similar perfect arbitrage strategy. an arbitrageur buys the asset . Explain bow margins protect investors against tbe possibility of default.500 is lost on one contract. and the delivery months. If the futures price is greater than the spot price during the de1ivery period . This happens if the futures price of frozen orange juice falls by 10 cents to 150 cents per lb. 1'be current futures price is 160 cents per pound. An arbitrageur can take a long futures position but cannot force immediate delivery of the asset. the delivery arrangements . This will happen if the futures price rises by 6. Eacb contract is for tbe delivery of 15. If the futures price is less than the spot price during the delivery period .12. ect gains and losses on the futures contract.and more attractive to the party with the short position. The decision on when delivery will be made is made by the party with the short position. Show tbat if tbe futures price of a commodity is greater tban tbe spot price during the delivery period tbere is an arbitrage opportunity.000 pounds. Nevertheless companies interested i丑 acquiring the asset will find it attractive to enter into a long futures contract and wait for delivery to be made.000 per contract . Problem 2. Problem2. Wbat are tbe most important aspects of tbe design of a new futures contract? The most important aspects of the design of a new futures contract are the specification of the underlying asset . Problem 2. Wbat price cbange would lead to a margin call? Under wbat circumstances could $2.
Problem 2.13. Exp1ain the difference between a marketiftouched order and a stop order. order is executed at the best available price after a trade occurs at a speci且ed price or at a price more favorable than the specified price. A stop order is executed at the best available price after there is a bid or offer at the specified price or at a price less favorable than the speci且ed price. Problem 2.14. Exp1ain what a stop1imit order to sell at 20.30 with a limit of 20.10 means. A stoplimit order to sell at 20.30 with a limit of 20.10 means that as soon as there is a bid at 20.30 the contract should be sold providing this can be done at 20.10 or a higher pnce. Problem 2.15. At the end of one daya c1 earinghouse member is 10ng 100 contracts, and the sett1ement price is $50,000 per contract. The origina1 margin is $2,000 per contract. On the following day the member becomes responsib1e for c1 earing an addition a1 20 10ng contracts , entered into at a price of $51 ,000 per contract. The sett1ement price at the end of this day is $50,200. How much does the member have to add to its margin account with the exchange c1 earinghouse? The clearinghouse member is required to provide 20 x $2 , 000 = $40 , 000 as initial margin for the new contracts. There is a gain of (50 ， 200 一切， 000) x 100 = $20 ,000 on the existing contracts. There is also a loss of (51 , 000  50 , 200) x 20 = $16 , 000 on the new contracts. The member must therefore add
40 , 000 20 ， 000 十 16 ， 000 =
A
marketiιtouched
$36 , 000
to the margin account. Problem 2.16. On Ju1y 1, 2007, a U.8. company enters into a forward contract to buy 10 mi11ion British pounds on January 1, 2008. On 8eptember 1, 2007, it enters inωa forward contract to sell 10 million British pounds on January 1, 2008. Describe thθ profit or 10ss the company wi11 make in dollars as a function of the forward exchange rates on July 1, 2007 and 8eptember 1, 2007. Suppose F 1 and F 2 are the forward exchange rates for the contracts entered into July 1 , 2007 and September 1, 2007 , and 8 is the spot rate on January 1, 2008. (All exchange rates are measured as dollars p町 pound). The payoff 仕om the first contract is 10(8  F 1 ) million dollars and the payoff 丘om the second contract is 10(F2  8) million dollars. The total payoff is therefore 10(8  F1 ) + 1O(几 8) = 10(F2  F 1 ) million dollars.
10
Problem 2.17. The forward price on the Swiss 企anc for delivery in 45 days is quoted as 1.2500. The futures price for a contract that wil1 be delivered in 45 days is 0.7980. Explain these two quotes. Which is more favorable for an investor wanting to sell Swiss 企ancs? The 1. 2500 forward quote is the number of Swiss 仕ancs per dollar. The 0.7980 futures quote is the number of dollars per Swiss 仕anc. When quoted in the same way as the futures price the forward price is 1/ 1. 2500 = 0.8000. The Swiss 仕 anc is therefore more valuable in the forward market than in the futures market. The forward market is therefore more attractive for an investor wanting to sell Swiss 仕ancs. Problem 2.18. Suppose you call your broker and issue instructions to sell one July hogs contract. Describe what happens. Hog futures are traded on the Chicago Mercantile Exchange. (See Table 2.2). The broker will request some initial margin. The order will be relayed by telephone to your broker's tradi鸣 desk 。川he fl. oor of the exchange (or to the tradi鸣 desk of another broker). It will be se丑t by messenger to a commission broker who will execute the trade according to your instructions. Confirmation of the trade eventually reaches you. If there are adverse movements in the futures price your broker may contact you to request additional margm. Problem 2.19. "Speculation in futures markets is pure gamb1ing. It is not in the public interest to allow speculators to trade on a futures exchange." Discuss this viewpoint. Speculators are important market participants because they add liquidity to the market. However , contracts must be useful for hedging as well as speculation. This is because regulators generally only approve contracts when they are likely to be of interest to hedgers as well as speculators. Problem 2.20. Identify the two commodities whose futures contracts have the highest open interest in Table 2.2. Looking at open interest for the two contracts with the shortest maturity, corn is the most actively traded and crude oil is second. Problem 2.2 1. What do you think would happen íf an exchange started trading a contract in which the qua1ity of the underlying asset was incompletely specified? The contract would not be a success. Parties with short positions would hold their contracts until delivery and then deliver 出e cheapest form of the asset. This might well be viewed by the party with the long position as garbage! Once news of the quality problem became widely known no one would be prepared to buy the contract. This shows that
11
futures contracts are feasible only when there are rigorous standards within an industry for defining the quality of the asset. Many futures contracts have in practice failed because of the problem of defining quality. Problem 2.22. "When a futures contract is traded on the Boor of the exchange, it may be the c挝e that the open interest increases by one, stays the same, or decreases by one." Explain this statement.
If both sides of the transaction are entering into a new contract , the open interest increases by one. If both sides of the transaction are closing out existing positions , the open interest decreases by one. If one party is entering into a new contract while the other party is closing out an existing position , the open interest stays the same.
Problem 2.23. Suppose that on October 24 , 2007, you take a short position in an April 2008 livecattle futures contract. You c10se out your position on January 21 , 2008. The futures price (per pound) is 91. 20 cents when you enter into the contract, 88.30 cents when you c10se out your position , and 88.80 cents at the end of December 2007. One contract is for the delivery of 40,000 pounds of cattle. What is your total profìt? How is it taxed if you are (a) a hedger and (b) a speculator? The total
pro且t
is
40 , 000 x (0.9120  0.8830)
= $1 , 160
If you are a hedger this is all taxed in 2008. If you are a speculator
40 , 000 x (0.9120  0.8880) = $960
is taxed in 2007 and
40 , 000 x (0.8880  0.8830) = $200
is taxed in 2008.
12
Note that we expect to lose money on about half of the futures contracts we enter into. The futures position is chosen so that a) if the asset price increases . ) It may a1so because shareholders can diversify away the risk within their own portfolios. This might be because the shareholders want exposure to the risk. the 10ss on the futures position is offset by the gain resu1ting from the higher price realized for the asset.CHAPTER 3 Hedging Strategies Using Futures This chapter discusses how futures contracts can be used for hedging. As such it shou1d be attractive to corporations. Sometimes a company may appear to have exposure to a particular market variab1e when a "big picture" view of its risks indicates lit t1e or no exposure. These reasons are 1. The purpose of the futures contracts is to reduce risk not to increase expected profits.) 3. if a company knows it will sell a certain asset on a certain future date . This arises because a futures contract that is held for hedging purposes is almost always closed out prior t 13 .1 or the farmer in Prob1em 3. Similarly. Corporate treasurers are liab1e to be criticized if money is lost on the futures position and gained on the underlying position being hedgedeven though this was part of the risk reduction strategy. The chapter discusses three reasons why corporations in practice often do not hedge. An important concept is bωis risk. many shareh01ders buy the stock of particu1ar g01d mining companies because they want an exposure to the price of g01d. it can hedge its risk with a short futures position.17. In some instances shareholders prefer companies not to hedge a risk. 1. 2.2 illustrates the problem. They do not want those companies to hedge their go1d price risk. (For examp1e . (See for example the gold jewe1ry manufacturer example in Tab1e 3. The imaginary dialogue between a treasurer and a president at the end of Section 3. Hedging is designed to reduce risk. See Business Snapshot 3. If a company knows it will buy a certain asset at a certain future time . the gain on the futures position offsets the extra price that has to be paid for the asset and b) if the asset price decreases the 10ss on the futures position is offset by the gain resu1ting from the 10wer price paid for the asset. In this case the futures position is chosen so that a) if the asset price decreases the gain on the futures position offsets the 10ss on the amount realized for the asset and b) if the asset price increases . it can hedge its risk with a 10ng futures position.
Examples illustrating this are Example 3.4 to make sure you understand how the capital asset pricing model works and how futures contracts can eliminate market risk. the effective price you receive is the futures price at time tl plus the basis at time t2. You enter into a shortdated futures contract . The 且丑al part of the chapter discusses rolling hedges forward. Alternatively they can be used to change the beta of a portfolio.3 and Example 3 . the following delivery months are available: March . and December. They can be used to hedge a portfolio so that the manager is out of the market for a period of time. the month containing the expiration of the hedge. Stock index futures are often used by portfolio managers. In cross hedging the optimal hedge ratio is given byequation (3. The normal situation is to use a hedge ratio of 1.8. A short futures position reduces the beta of the portfolio. State the contract that should be used for hedging when the expiration of the hedge is in a. Note that a full 丑 1 hedge (giving the portfolio manager no exposure to the market) corresponds tωo cha鸣in the beta of the portfolio to zero. and so on. immediately replace it with another shortdated futures contract . (Metallgesellschaft in Business Snapshot 3. but later than . January A good rule of thumb is to choose a futures contract that has a delivery month as close as possible to .1). the other is when stock index futures are used. July c. May. June b. Cross hedging is not hedging done in anger! It involves a situation where the asset underlying the futures contract is different from the asset being hedged. 0 is not appropriate. One is when there is cross hedging. However .4.) It is worth noting that hedges created in this way do not qualify for hedge accounting the United State SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 3. close it out just before the delivery month . The way hedges are rolled forward is as follows. This is a way of creating a hedge that lasts a relatively long time from shortdated futures contracts. July. 0. The number of contracts that should be traded is the desired change in beta multiplied by the ratio of the value of the portfolio to the value of the assets underlying one contract. In the Chicago Board of Trade's corn futures contract. Hence the term basis risk.tl to hedge the sale of an asset at time t2 . The uncertainty associated with the price you pay or receive is therefore the uncertainty associated with the basis.2 illustrates potential problems in rolling a hedge forward. September. a long futures position increases the beta of a portfolio. The hedge ratio is the ratio of the size of the futures position to the size of the exposure being hedged. the basis at time t2 is not known. close it out just before the delivery month . You should study Table 3. The futures price at time tl is known for certain when you initiate the hedge at time tl. The contracts that should be used are therefore 14 . The chapter describes two situations where a hedge ratio of 1.
for example . this is not the whole story. When futuresjforwards are used both the downside and upside are eliminated. As the gold jewelry example in Table 3. will the company be able to raise the price of its product in U. It means that profit will be more certain. Once these estimates have been produced the company can choose between using futures and options to hedge its risk. Suppose that in Example 3. dollars if the yen appreciates? If the company can do so .S. Similarly it worsens as the basis decreases. It should be explained that a hedge does not ensure that pro直ts will be higher.S. Discuss how you would design a foreign excbange bedgíng strategy and the arguments you would use to sell the strategy to your fellow executives.1 1. Consider . Does a perfect hedge always succeed in locking in the current spot price of an asset for a future transaction? Explain your answer.S. The results of the analysis should be presented carefully to other executives. Imagine you are the treasurer of a Japanese company exporting electronic equipment to the United States.8. The key estimates required are those showing the overall effect on the company's profitability of changes in the exchange rate at various times in the future.which is in general different from the spot exchange rate.10. However . Problem 3. The basis is the amount by which the spot price exceeds the futures price. For example .12. dollars 2. The forward contract locks in the forward exchange rate . Explain why a short hedger's position improves when the basis strengthens unexpectedly and worsens when the basis weakens unexpectedly. Problem 3. Enter into forward and futures contracts to lock in the exchange rate for the U. How does the decision afIect the way in which the hedge is implemented and the result? 15 . dollar cash fiows.1 shows . Estimate the company's future cash fiows in Japanese yen and U. A short hedger is long the asset and short futures contracts.(a) July (b) September (c) March Problem 3. its foreign exchange exposure may be quite low. The simple answer to this question is that the treasurer should 1. Problem 3. the company should examine whether the magnitudes of the foreign cash fiows depend on the exchange rate. The value of his or her position therefore improves as the basis increases.4 the company decides to use a hedge ratio of 0.9. the use of a forward contract to hedge a known cash infiow in a foreign currency. With options a premium is paid to eliminate only the downside. No.
000 or $71.0.00 per barrel when the company is fully hedged. the hedger locks in a price of Fl + b2 • Since both Fl and b2 are known this has a variance of zero and must be the best hedge. 0 . "If the minimumvariance hedge ratio is calculated as 1. (This comp缸es with $71.14. An illustration is provided by Example 3. The statement is true. This is likely to be particularly attractive when the futures price is less than the spot price. the minimum variance hedge ratio is always 1.15 "For an asset where futures prices are usually less than spot prices . The gain on the futures position is (72 .13. the hedge must be perfect.If the hedge ratio is 0.2.5 and σ8=2σF. The spot price and futures price at this time are $75. long hedges are likely to be particularly attractive. Problem 3.000 pounds of live cattle on November 15. The producer wants to use the 16 . 436 . "If there is no basis risk.0 when ρ= 0.00 and $72. A company that knows it will purchase a commodity in the future is able to lock in a price close to the futures price." Is this statement true? Explain your answer." Explain this statement. 000 75 .2. 000 = 1 . Since ρ< 1. if the hedge ratio is 1. 000 X X 16 . Problem 3. Problem 3.80 per barrel.7.64 . It closes out its position on November 10.0 the hedge is clearly not perfect. The minimum variance hedge ratio is It is 1.) Problem 3." Is this statement true? Explain your answer.68.4. A beef producer is committed to purchasing 200. The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1. The standard deviation of monthly changes in the futures price of live cattle for the c10sest contract is 1.00) The effective cost of the oil is therefore 20 . the company takes a long position in 16 NYM December oil futures contracts on June 8 when the futures price is $68.16.8 . 000 = 64 . It is now October 15. Using the notation in the text .00. The correlation between the futures price changes and the spot price changes is 0. The statement is not true. 0.
6 1.5 it would at each stage short 150 contracts. Each contract is for the delivery of 40. an investor holds 50. On July 1.000 shares of a certain stock. 000 lbs of catt1e.18. 2 1. The market price is $30 per share. the farmer should not enter into short forward contracts to hedge the price risk on his or her expected production. This problem emphasizes the importance of looking at the big picture when hedging.500 and one contract is for de1ivery of $50 times the index. 4 The beef producer requires a long position in 200000 x 0.5 the company decides to use a hedge ratio of 1. The beef producer should therefore take a long position in 3 December contracts closing out the position on November 15. What strategy should the beef producer follow? The optimal hedge ratio is 0. "Discuss this viewpoint. The gain from the futures contracts would be 1.17.. How does the decision afIect the way the hedge is implemented and the result? If the company uses a hedge ratio of 1. 500 contracts is required.7 x 一一 =0. My real risk is not the price of corn.吨。00 x __. A corn farmer argues 吁 do not use futures contracts for hedging.19.55 per barrel 17 . It is that my whole crop gets wiped out by the weather. 50 x 1.• cattle futures contracts ω hedge its risk. The investor is interested in hedging against movements in the market over the next month and decides to use the September Mini S&P 500 futures contract.000 pounds of cattle. Other farmers are likely to have been affected similarly. Suppose that the weather is bad and the farmer's production is lower than expected. Should the farmer estimate his or her expected production of corn and hedge to try to lock in a price for expected production? If weather creates a significant uncertainty about the volume of corn that will be harvested . Suppose that in Table 3. What strategy should the investor follow? A short position in 50 30 1. The beta of the stock is 1.3. 5 in Table 3. Problem 3.5. The reason is as follows. Corn production overall will be low and as a consequence the price of corn will be relatively high.50 x 1. The index is currently 1. Problem 3.6 = 120. The farmer is correct to question whether hedging price risk while ignoring other risks is a good strategy. The farmer's problems arising from the bad harvest will be made worse by losses on the short futures position. 3 x ..= 26 ..December Jiy. Problem 3. 70 = $2.
the futures price will also rise and you may get margin calls. Your cash outflows occur earlier than your cash inflows. A similar situation could arise if you used a long positio丑 in a futures contract to hedge the purchase of an asset and the asset's price fell sharply. If the price of the asset rises sharply during the six months . Eventually the cash outfl.2). 18 .20. ows. An extreme example of what we are talking about here is provided by Metallgesellschaft (see Business Snapshot 3. ows will be offset by the extra amount you get when you sell the asset . ow problems. A futures contract is used for hedging.85 per barrel better off. The margin calls willlead to cash outflows. Explain why the marking to market of the contract can give rise to cash fJ. Problem 3. Suppose that you enter into a short futures contract to hedge the sale of a asset in six months.and the company would be $0. but there is a mismatch in the timing of the cash outflows and infl.
For a derivatives trader shortterm riskfree rates are LIBOR rates . This is explained in Business Snapshot 4. in the 1imit we get a unit of measurement known as continuous compounding. The interest rates are the same. The chapter starts by discussing three interest rates that are important to derivatives markets: Theasury rates . 1. The rates important in derivatives markets are zero啕 coupon rates.3) and (4. Two definitions should be noted. It cannot be emphasized enough that the compounding 仕equency is nothing more than a unit of measurement.2. Converting an interest rate from one compounding frequency to another is like converting a distance from miles to kilometers.coupon term structure of interest rates. The formulas in options markets involve rates measured with continuous compounding and .) It is important that you understand the compounding frequency material in Section 4. except where otherwise stated . The concept of a continuously compounded interest rate is likely to be new to many readers. the rates in the book are measured with continuous compounding.25% with annual compounding. These are the rates that correspond to a situation where money is invested at time 0 and all the return (interest and principal) is realized at some future time T. The rates that are quoted in 且nancial markets are often the rates corresponding to a situation where interest payments are made regularly (eιevery six months). and repo rates. It is therefore important that you make sure you become comfortable with continuously compounded rates. Throughout the book we use the term "risk仕ee rate". A bond yield i 19 . Understanding this material is essential for the rest of the book. Plotting the zero rate as a function of the maturity T gives the zer o. (As we discuss in later chapters E旧odollar futures quotes and swap rates are used to calculate risk仕ee rates for longer maturities. LIBOR rates . The discount rate that should be used for a cash fiow occurring at time T is the zerocoupon interest rate for maturity T. the other is 10.CHAPTER 4 Interest Rates This chapter provides background material on interest rates.4) show how to convert a rate from a compounding 仕equency of m times per year to continuous compounding and vice versa. One is 10% with semiannual compounding. Equations (4. Consider two interest rates. not Th easury rates. As we increase the compounding 仕equency when measuring interest rates . They are just measured in different units.
There is a natural tendency for people to want to borrow for long periods of time and lend for short periods of time. The 12.84 e. A forward rate agreement (FRA) is an agreement that a certain interest rate will apply to a certain principal for a certain future time period. A twoyear bond that wil1 pay coupons of $5 every six months currently sells for $97.766% per annum with semiannual compounding or 2In( 1.360% with annual compounding or In( 1. if the oneyear rate is 6% and the two.9) and 4. In order to encourage more people to borrow for short periods and invest their money for long periods banks tend to raise the longterm interest rates they offer relative to the expectations of market participants. For the 1 ~ year bond we must have 4e 一 o 1238xO. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 4.8.8415 R = 0.84. For the 2year bond we must have 5e.5 十 4e0 1l 65x 1 十 104e. This is 2 x 6. 1236) = 1 1. A 1. the term structure will tend to be upward sloping and if market participants expect interest rates to fall it will tend to be downward sloping. The 6month Th easury bill provides a return of 6/94 = 6.8 points out this is not the whole story.76 + 3.longer maturity rates.383 = 12. Note that this calculation is exact if the interest rates are measured with continuous compounding and only approximate when other compounding 仕equencies are used. the forward rate for the second year is 10%. the value of the FRA is zero. For example . If the interest rate in the FRA is the forward rate . 5R 工 94. 06383) = 12.L5R 工 94.0 and 89. The cash prices of sixmonth and on eyear Tr easury bil1 s are 94. This is because 10% for the second year combined with 6% for the first year gives 8% for the two years. Ca1culate the sixmonth . Forward rates are the future rates of interest implied by zer任 coupo丑 interest rates.year rate is 8% . as Section 4. The chapter concludes by discussing the determinants of the term structure of interest rates. However . Otherwise the value must be calculated using equations (4.. It follows that 3.5year.383% in six months.12 .month rate is 11/89 = 12.0. 1l 65xl + 5e0115X15 + 105e. 65% with continuous compounding.12. 5%.o 1238x05 + 5e 一 O.84 where R is the 1 ~ year zero rate. If market participants expect interest rates to rise in the future . and twoyear zero rates .5year bond that wil1 pay coupons of $4 every six months currently sel1 s for $94. on萨year， 1.15R = 0.38% per annum with continuous compounding.115 or 11.56 + 104e一1.2R 20 = 97.10).
21 .where R is the 2year zero rate..55 or $304. 24month . 12month . Problem 4. 18month .91% per annum. e. A deposit account pays 12% per annum with continuous compounding. 4 0. R= 山 (1 +节) The rate of interest is therefore 14.4%.1 1. Problem 4.55.000 deposit? The equivalent rate of interest with quarterly compounding is R where OU nu 'i 呵 ， " /It\ 一 唱 一 ， 4 + \ 4 R4 飞 1 1 1 / or R = 4(e 003 . and 30month zero rates are 4% . 000 x.一= 304.8% per annum with continuous compounding respectively. It follows that e. How much interest wi11 be paid each quarter on a $10. Suppose that 6month . 3%. and 4. 4. but interest is actually paid quarterly.1218 The amount of interest paid each quarter is therefore: 10 ..2% .9.113 or 11. Estimate the cash price of a bond with a face value of 100 that wi11 mature in 30 months and pays a coupon of 4% per annum semiannually. Problem 4.1) = 0. .6% . What rate of interest with continuous compounding is equivalent to 15% per annum with monthly compounding? The rate of interest is R where: ♂ =(1+:2) l.2R = 0.7977 R = 0.10. 4.1218 . 4.
048x2.5365 every six months).5% .The bond pays $2 in 6.0y 十 4ι2. The bond yield is the value of y that solves 4e 一 O. and 24 months . Suppose that the 6month . 18month.8694) x 2 3.0y = 104 Using the Goal Seek tool in Excel y = 0.. Problem 4.7 4.L5y 十 4ε 2.042xLO + 2e 一 O. 12 .8694.100 x 0.6935 The formula in the text gives the par yield as 一一一一一一一一一一一一一一一= (100 . 18 .072% per year (that is 3. A thre year bond provides a coupon of 8% semiannually and has a cash price of 104.5365εO.072% is the par yield.. 12month.5ν+ 104ε 3. Problem 4.12. 24 .5y 十 4e. d = e 一 007x2 = 0.13.14.065x15 + 103. and 24month zero rates are 5% .LOy 十 4e.5 + 2e 一 O.536e.04 Problem 4.06407 or 6 .06xl 0+ 3. 12 . and $104 in 36 months. and 30 months .5 22 .05XO 5 + e 一 O. 6% .6935 7. 5 + 2e0046X2 + 102e 一 O. 18 .5 = 98. What is the bond's yield? • The bond pays $4 in 6 .0 3.536e005x05 + veri马ring 3.536e 一 O. and 7% respectively.O = 3.06xlO 十 e0065x15 十 e.0 3.072 To verify that this is correct we calculate the value of a bond that pays a coupon of 7.044x 1. Suppose that zero interest rates with continuous compounding are as follows: Maturity (years) 12345 Rate (% per annum) 2. 6. and $102 in 30 months. The cash price IS 2e 一 004xO. 07x20 Also = eO.407%. What is the twoyear par yield? Using the notation in the text .o 07x2 0 = 100 that 7.2 4. m A = 2. The value is 3.
the value of the FRA is therefore [1 .2 x 80 1]e0037x3 = 2 . The 3year interest rate is 3.57% per annum. Problem 4.232% with annual compounding.100 = 100 because the coupo丑s cancel out.051Xl .14 to value an FRA where you wil1 pay 5% for the third year on $1 m il1ion.7% with continuous compounding. The 10.16. A 10year.70 Year 10 : 200 . The forward rate is 5. 4% coupon bond currently sells for $80.0% Year 2: Year 3: 5. From equation (4.term rates were simply a reflection of expected future shortterm rates .1 5.05) x or $1 . we would expect the term structure to be downward sloping as often as it is upward sloping.0357 or 3.) Taking a long position in two of the 4% coupon bonds and a short position in one of the 8% coupon bonds leads to the following cash flows Year 0 : 90 . 000 x (0.7% Problem 4. 8% coupon bond currently sells for $90.1% Year 4: 5.85 = .67. If long. 078. (continuously compounded) is therefore given by 100 = 70e lO R The rate is 1 _ 100 10 70 ~ln 一一= 0.17. Problem 4.1% with continuous compounding or eO.10) . 23 . $100 in 10 years time is equivalent to $70 today. Explain carefully why liquidity preference theory is consistent with the observation that the term structure of interest rates tends to be upward sloping more 0丘en than it is downward sloping.. R . 000 .7% Year 5: 5. A 10year.15.05232 一 0.964.year rate . What is the 10year zero rate? (Hint: Consider taking a long position in two of the 4% coupon bonds and a short position in one of the 8% coupon bonds.The forward rates with continuous compounding are as follows: 4. Use the rates in Problem 4.
. the zero rate for a particular maturity is greater than the par yield for that maturity. In the United States . "When the zero curve is upward sloping. Th easury bills and Th easury bonds must be purchased by financial institutions to ful直11 a variety of regulatory requirements. The par yield is the yield on a couponbearing bond. Problem 4. The zero rate is the yield on a zerocoupon bond. Problem 4. This increases demand for these Th easury instruments driving the price up and the yield down.(This is based on the assumption that half of the time investors expect rates to increωe and half of the time investors expect rates to decrease). the lending company simply keeps the securities.18. This loan involves very little credit risk. Th easury instruments are given a favorable tax treatment compared with most other fixed. when the yield curve is downward sloping . 1. '1Teasury rates signifìcantly lower than other rates that are c10se to risk 企ee? There are three reasons (see Business Snapshot 4.S.19. the yield on an Nyear couponbearing bond is less than the yield on an N year zero叮oupon bond. This is because the coupons are discounted at a lower rate than the Nyear rate and drag the yield down below this rate. The other company is providing a loan to the investment dealer. oating rate of interest for a fìxed rate of interest? 24 ." Explain why this is so. Problem 4.20. Liquidity preference theory argues that long term rates are high relative to expected future shortterm rates. This means that the term structure should be upward sloping more often than it is downward sloping. If the borrower does not honor the agreement . 3. When the yield curve is upward sloping . Explain why an FRA is equivalent to the exchange of a fl. Problem 4.risk instruments. Why does a loan in the repo market involve very 1ittle credit risk? A repo is a contract where an investment dealer who owns securities agrees to sell them to another company now and buy them back later at a slightly higher price. the original owner of the securities keeps the cash. When the zero curve is downward sloping the reverse is true.2 1. If the lending company does not keep to its side of the agreement .1).income investments because they are not taxed at the state level. 2. Why are U. Similarly. The amount of capital a bank is required to hold to support an investment in Theasury bills and bonds is substantia11y smaller than the capital required to support a similar investment in other verylow. the yield on an Nyear coupon bearing bond is higher than the yield on an Nyear zerφcoupon bond.
A FRA is an agreement that a certain speci直ed interest rate . the holder of the FRA can invest the borrowed principal at RM. ow of RKL. ow of RK L and an out丑ow of RML. L . Suppose that the rate observed in the market for the future time period at the beginning of the time period proves to be RM. the holder of the FRA can borrow the principal at RM and then invest it at RK. RK . will apply to a certain principal. oating rate of interest on the principal. The net cash f:l. In either case we see that the FRA involves the exchange of a fixed rate of interest on the principal of L for a f:l. If the FRA is an agreement that RK will apply when the principal is borrowed . for a certain specified future time period. ow at the end of the period is then an inf:l. If the FRA is an agreement that RK will apply when the principal is invested . 25 . ow at the end of the period is then an inf:l. The net cash f:l. ow of RML and an outf:l.
The difference between the forward price of an asset and the value of a forward contract often causes confusion. As time goes by the forward price changes but the delivery price of the contract remains the same. Those that provide no income (A Tr easury bill falls into this category) 2. for those in the second category it is given by equation (5. The value of the contract is liable to become positive or negative. Equation (5 . If the forward price is lower than this price . try Problem 5. Those that provide a known yield (Stock indices and foreig丑 currencies fall into this category.CHAPTER 5 Determination of Forward and Futures Prices This chapter explores the relationship between forwardjfut盯es prices and spot prices. An important distinction is between investment and consumption assets. Investment assets are assets held solely for investment by significant numbers of traders (not necessarily all traders). However . Those that provide a known cash income (A Tr easl町 bond falls into this category) 3. Futures prices are more di:fficult to determine than forward prices because of the daily settlement in futures contracts.9.1) to (5. If you are still unclear about the difference between the forward price and the value of the forward contract . If a forward price is higher than that the price given by equations (5.2).4) gives the value of a 10吨 forward contract in terms of the forward price. The relationships can be proved by no arbitrage arguments. market participants willlock in a profit by shorting the forward contract and buying the asset. Investment assets can be divided into three categories: 1.3) .3).) For investment assets in the 直rst category the relationship between the forward price and the spot price is given by equation (5. The value of a forward contract with a certain maturity date and a certain delivery price is the contract's economic value.1). When a forward contract is first entered into the value of the forward contract is zero and the delivery price is set equal to the forward price. it turns out that for most purposes the futu 26 . The forward price of an asset for a particular maturity date is the delivery price that would be negotiated today for a forward contract with that maturity date. Consumption assets are assets that are held primarily for consumption. market participants willlock in a profit by doing the reverse: taking a long position in the forward contract and se11ing (or shorti吨) the asset. for those in the third category it is given by equation (5.
1) as: Fo = 40e 01X1 = 44. As a result there may well be no traders who own the asset and are prepared to forego the opportunity to consume the asset by selling it and buying the futures contract. the futures price overstates the expected future spot price. is given by equation (5. after six months is give丑 by equation (5. J. For consumption assets an important concept is the convenience yield.and the spot prices.) The last part of the chapter discusses the relationship between futures prices and expected future spot prices.21 or $44. (b) The delivery price K in the contract is $44. The futures price of a stock index is always less than the expected future value of the index.2 1.5) as: J= 45 . Problem 5. the futures price understates the expected future spot price. This is because the asset is not held for investment purposes. If the asset has no systematic risk . This follows 仕om Section 5. Fo .2 1. let μbe the expected return required by investors on the index so that E(ST) = Soe(μ q)T Because μ>γand Fo = Soe(俨q)T ， it follows that E(ST) > Fo.. If it has negative systematic risk . the futures price equals the expected future spot price.14 and the fact that the index has positive systematic risk.21e 一 O. Six montbs later .8. However . If the futures price is above this upper bound an arbitrageur can short futures and buy the asset to lock in a profit. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 5.9.lx05 = 2. The value of the contract . This is a measure of the amount by which the futures price is less than its upper bound. 44.17. 1s tbe futures price of a stock index greater tban or less tban tbe expected future value of tbe index? Explain your answer. a. If the asset has positive systematic risk . For an alternative argument . tbe príce of tbθ stock ís $45 and tbe risk企ee interest rate ís stíl1 10%. Wbat are tbe forward príce and tbe value of tbe forward contract? • (a) The forward price .95 27 . Aon year long forward contract on a nondivídendpayíng stock is entered into wben tbe stock price is $40 and tbe risk企ee rate of interest ís 10% per annum witb contínuous compounding. The relationship that exists for an investment asset provides an upper bound for consumption assets. The initial value of the forward contract is zero. if the futures price is below the upper bound there is no arbitrage opportunity. (See equation 5. Wbat are tbe forward price and tbe initial value of tbe forward contract? b.
3) the six month futures price is 150e(007 一 0.88. Problem 5.12.(3 × 2 十 2 The futures price is therefore x 5) = 3.08 28 . and the dividend yield on a stock index is 3.88 or $152. In other months . The forward price is: 45eOlX05 = 47. Suppose that the risk企ee interest rate is 10% per annum with continuous compound.. The average dividend yield is therefore .. The current value of the index is 150.10. 33 1. Suppose that the value of the index on July 15 is 1. dividends are paid at a rate of 5% per annum. ing and that the dividend yield on a stock index is 4% per annum.31 or $47. Assume that the risk企ee interest rate is 9% per annum with continuous compounding and that the dividend yield on a stock index varies throughout the year. Problem 5. The risk仕ee rate of interest is 7% per annum with continuous compounding. What arbitrage opportunities does this create? The theoretical futures price is 400e(0. The dividend yield is 2% for three of the months and 5% for two of the months.032) xO.3 1.5 of the same year? The futures contract lasts for 且ve months.5 = 152. 1O一 0.2% per annum. it is $2. 80.4 167 = 1. In February. May.1 1. The index is standing at 400. 80 or $133 1. dividends are paid at a rate of 2% per annum. What is the futurθs price for a contract deliverable on December 1.2% 1300e(0090032) x0 . e. Problem 5. August.95.300. and the futures price for a contract deliverable in four months is 405. What is the sixmonth futures price? Using equation (5.04) X4/12 = 408. and November . .i.
25% below the January 2007 price. The twomonth interest rates in Switzerland and the United States are 2% and 5% per annum . it is $9.8000.4. Short the shares underlying the index.11) given by Fo where Fo i.176 or $0. The storage costs are $0.13.lOxO. = (9.02)x2j12 = 0.06 十 0.06e 一 O. Assuming that interest rates are 10% per annum for all maturities .06e 一 O. Problem 5. This suggests that the shortterm interest rate in the Mexico exceeded shortterm interest rates in the United States by about 0.24 per ounce per year payable quarterly in advancθ. The correct arbitrage strategy is 1. The current price of silver is $9 per ounce. This shows that the index futures price is too low relative to the index.14. What arbitrage opportunities does this create? The theoretical futures price is 0. calculate the futures price of silver for delivery in nine months.The actual futures price is only 405.5 = 0.lOxO 25 + 0. The futures price is from equation (5.91250 Mar 0.25% per two months or about 1.176)eOlX075 = 9.15. Problem 5.89 29 .000 十 0. Buy futures contracts 2. 2007 企om the information in Table 5.8100. with continuous compounding.e.89 per ounce.8000e<005 一 O. . 5% per year.8040 The actual futures price is too high. The present value of the storage costs for nine months are 0. This suggests that an arbitrageur should buy Swiss 仕ancs and short Swiss francs futures. The settlement prices for the futures contracts are Jan 0. The spot price of the Swiss 企anc is $0. The futures price for a contract deliverable in two months is $0. Estimate the difference between shortterm interest rates in Mexico and the United States on January 8. respectively.176. Problem 5.91025 The March 2007 price is about 0.
tl and t2 . Of course the company does not know in advance which will work out better. The value of the foreign currency 丘rst falls and then rises back to its initial value Assume that the forward price equals the futures price. If the hedge is with a forward contract the whole of 30 .16. the asset is purchased for F 1 using funds borrowed at rate r. the markingto. Suppose that F1 and 马 are two futures contracts on the same commodity with times to maturity. For the purposes of this problem . When the time value of money is taken into account a futures contract may prove to be more valuable or less valuable than a forward contract. there is no foreign exchange risk. The value of the foreign currency nrst rises and then falls back to its initial value d. The long futures contract provides a slightly imperfect hedge. Taking a long position in a futures contract which matures at time tl 2. Hence: 乌兰 F1 e r (t 2 t 1 ) Problem 5.market process does leave the companyexposed to some risk. where t2 > tl. The value of the foreign currency rises rapidly during the life of the contract c. consider whether the company is better off using a futures contract or a forward contract when a. It is then held until time t2 at which point it is exchanged for 马 under the second contract. However the timing of the cash fiows is different. This type of arbitrage opportunity cannot exist for long. ow in a foreign currency is hedged by a company using a forward contract .17.F 1 er (t 2 t 1 ) is then realized at time t2. When it is hedged using futures contracts. If F 2 > F 1 er( t2. The long forward contract provides a perfect hedge. When a known future cash outfJ. In particular. The value of the foreign currency falls rapidly during the life of the contract b. In total the gain or loss under a futures contract is equal to the gain or loss under the corresponding forward contract. Taking a short position in a futures contract which matures at time t2 When the first futures contract matures .t l) an investor could make a riskless pro且t by 1. F 1 eT (t 2 h) where r is the interest rate (assumed constant) and there are no storage costs.Problem 5. (a) In this case the forward contract would lead to a slightly better outcome. Explain the nature of this risk. assume that a futures contract is the same as a forward contract. The costs of the funds borrowed and accumulated interest at time t2 is F 1 ë(t 2 t 1 ) A positive pro且t of F 2 . Prove that F2 ::. The ∞ c ompa丑 will make a 10ss on its hedge.
the forward exchange rate is an unbiased predictor of the future exchange rate when the exchange rate has no systematic risk. 80 Fo Define the excess return of the index over the risk击ee rate as x. Under what circumstancθs is this so? From the discussion in Section 5. It follows that 8 1 = 8oe(r+x.14 of the text . This is because it would involve positive cash flows early and negative cash flows later. 一 ''1ρ 一(俨 q)h 8.q )(Th) where 8 0 and 8 1 are the spot price at times zero and iI. (b) In this case the futures contract would lead to a slightly better outcome.q. It follows that Fo = 8 0 e(r. If the hedge is with a forward contract the gain will be 创丑 realized at the end. r is the riskfree rate . Suppose that Fo is the futures price at time zero for a contract maturing at time T and F 1 is the futures price for the same contract at time t1. This is because .19.q )T F1 = 8 1e(r. The ∞ c ompan will make a gair1 on the hedge. To have no systematic risk the exchange rate must be uncorrelated with the return on the market. Assume that the risk企ee interest rate and the dividend yield are constant. e z 31 . and q is the dividend yield. It is sometimes argued that a forward exchange rate is an unbiased predictor of future exchange rates. ( c) In this case the futures contract would lead to a slightly better outcome. the early cash flows would be negative and the later cash flow would be positive. Show that the growth rate in an index futures price equals the excess return of the index over the risk企ee rate. in the case of the futures contract .18. Problem 5.q )h and the equation for F1/ Fo reduces to RA which is the required result. (d) In this case the forward contract would lead to a slightly better outcome.L 'l F'. If it is with a futures contract the gain wi1l be realized day by day throughout the life of the contract. On a present value basis the latter is preferable. If it is with a futures contract the loss will be realized day by day throughout the contract.the loss will be realized at the end. These equations imply that . On a present value basis the former is preferable. The total return is r + x and the return realized in the form of capital gains is r 十 x . Problem 5.
Soe rT ) at time T. Define 32 .. As income is received . suppose that there are N different possible prices at a particular future time: Pl ， 巧， .Foe qT ). If Fo < Soe(r. the present value of the time T inflow must equal the time zero outflow when we discount at the risk仕ee rate. The cumulative short position is closed out at time T and the arbitrageur makes a pro自t of N(Soe rT . Explain carefully what is meant by tbe expected price of a commodity on a particular future date. the arbitrageur owes money on the short position.20. At the same time the arbitrageur should enter into a forward contract to sell N e qT units of the asset at time T. This means that NSo = (NFoeqT)erT or 月 = Soe(rq)T This is equation (5.3) did not hold. At time T the loan is repaid and the arbitrageur makes a profit of N(Foe qT . The income 仕om the asset causes our holding in the asset to grow at a continuously compounded rate q. Assume tbat speculators tend to be sbort crude oil futures and bedgers tended to be long crude oil futures. Sbow tbat equation (5. we therefore buy N units of the asset at time zero at a cost of So per unit and enter into a forward contract to sell N eqT unit for Fo per unit at time T.2 1.3). Problem 5. By time T our holding has grown to N eqT units of the asset. it is reinvested in the asset.3) is true by considering an investment in tbe asset combined witb a sbort position in a futures contract. To understand the meaning of the expected future price of a commodity. Assume tbat all income 企om tbe asset is reinvested in tbe asset. The investor meets this obligation from the cash proceeds of shorting further units. This generates the following cash flows: Time 0: 一 NSo Time T: N Foe qT Because there is no uncertainty about these cash flows . When income is paid on the asset .. At the same time the arbitrageur should enter into a forward contract to buy N eqT units of the asset at time T.Problem 5. Suppose we buy N units of the asset and invest the income from the asset in the asset. Use an argument similar to tbat in footnotes 2 and 4 and explain in detai1 wbat an arbitrage盯 would do if equation (5.2.. PN. If Fo > Soe(r一 q)T ， an arbitrageur should borrow money at rate r and buy N units of the asset. Suppose tbat tbe futures price of crude oi1 de c1ines witb the maturity of tbe contract at the rate of 2% per year.q 厅 ， an arbitrageur should short N units of the asset investing the proceeds at rate r. Wbat does tbe Keynes and Hicks argument imply about tbe expected future price of oil? Use Table 2. The result is that the number of units shorted grows at rate q to N eqT . Analogously to foot丑otes 2 and 4 of Chapter 5 .
in practice the actual price of the commodity at the future time may prove to be higher or lower than the expected price.600 equally weighted stocks.8) did hold for the Value Line Index. 33 . the change in the index 企om one day to the next was calculated as the geometric average of the changes in the prices of the stocks under1ying the index. 1988. The cha鸣es in the value of the portfolio is monitored by an index calculated from the arithmetic average of the prices of the stocks in the portfolio. the changes in the value of the index do not correspond to changes in the value of a portfolio that is traded. Keynes and Hicks argue that speculators on average make money from commodity futures trading and hedgers on average lose money from commodity futures trading. In these circumstances. Of course . does equation (5. A major Wall Street firm was the 曲的 to recognize that this represented a trading opportunity. Problem 5.8) correctly relate the futures price of the index to its cash price? If not . The V与lue Line Index is designed to ref1 ect changes in the value of a portfolio of over 1. the Keynes and Hicks argument implies that futures prices overstate expected future spot prices. Equation (5. equation (5. It made a financial killing by buying the stocks under lying the index and shorting the futures. The expected future price is N E二 qiPi Different people may have different expected future prices for the commodity.8) overstates the futures price.22.十 qN = 1). equation (5. It is rumored that at one time (prior to 1988) . The e)φected future price in the market can be thought of as an average of the opinions of different market participants. If crude oi1 futures prices decline at 2% per year the Keynes and Hicks argument therefore implies an even faster decline for the expected price of crude oil if speculators are short. Prior to March 9.的 as the (subjective) probability the price being ~ (with ql + q2 十.. Since the geometric average of a set of numbers is always less than the arithmetic average . If speculators tend to have short positions in crude oil futures . .8) is therefore no 10吨er correct. does the equation overstate or understate the futures price? When the geometric average of the price relatives is used .
These contracts trade with delivery months as much as 10 years in the future. at a 6%. (The party with the short position chooses which bond will be delivered and when during the delivery month it will be delivered.) To calculate how much is paid and received for the bond the most recent futures prices is mu1tiplied by a conversion factor and there is then an adjustment for accruals.g. It is marked to market daily unti1 the third Wednesday of the delivery month. The day count convention defines the number of days that the interest rate applies to and the way in which the interest earned accrues through time. and Actual/360 are popular day count conventions in the United States. The contract is settled in cash.23) there is a gain of $25 on one long contract. In the case of the Treasury note futures contract . any Treasury bond with a maturity of at least 15 years and not callable within 15 years can be delivered. 30/360 . Because Eurodollar futures c 34 . Roughly speaking . any τreasury bond with a maturity of between 6~ and 10 years can be delivered.CHAPTER 6 Interest Rate Futures This chapter discusses how interest rate futures work and how they are used for hedging. These have some interesting delivery arrangements. Look at Business Snapshot 6.τ￥aders ， who hold short futures positions and want to make delivery. The underlying in a threemonth Eurodollar futures contract is 100 minus the threemonth LIBOR percentage rate of interest. the conversion factor is the price the bond would have if the zerocoupon yield curve were f:l.19 to check that you understand how Actual/ Actual in period (which applies to 峦easury bonds) and 30/360 (which applies to corporate bonds) work. A futures contract is structured so that when the futures quote increases by one basis point (e. typically look at all the different bonds that can be delivered and calculate a cheapesttodeliver bond. from 95. The most important shortterm futures contracts i丑 the United States are the threemonth Eurodollar futures contracts. To understand the way interest rate futures are quoted it is necessary to understand day count conventions.22 to 95. At that time the settlement price is calculated as 100 minus the threemonth LIBOR percentage rate observed in the market. Actual/ Actual in period . In the case of the τreasury bond futures contract .1 and Problem 6. The most important longterm T￥easury bond futures contracts in the United States are the Tr easury bond and τreasury note futures contracts.
that is the size of the futures position should be 50% greater than the size of the position being hedged.9.) SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 6. 5. The quoted price of a government bond with a 12% coupon that matures on July 2咒 2011 ， is 110.17. Speci且cally it describes the sensitivity to a small parallel shift in the yield curve.7798 35 . The cash price of the Th easury b i1l is 100 一一一 x 90 360 10 = $97.0005.00. The number of days between January 27 .2486 = 113.5312.10. It is May 5. This means that the percentage change is 0.50 The annualized continuously compounded return is 苦仆十羔) = 10. The accrued interest is therefore 6x 一一= 98 181 3. In this case D = 4 and ßy = 0. the hedge ratio should be 1. What continuously compounded return (on an actual/365 basis) does an investor earn on the Tr easury bi11 for the 90. The key equation is equation (6. When hedging an interest rate exposure using a futures contract the hedge ratio is determined by a) the duration of the instrument underlyi吨 the futures contract and b) the duration of the exposure being hedged.05% increase in all interest rates. The number of days between January 27.5312 十 3. What is the cash price? .7) shows that change in the price of the instrument being considered is 4 x 0.向y period? . (See equation 6.7) when interest rates are expressed with continuous compounding and equation (6.2486 The quoted price is 110. (See Table 6. The price of a 90.points as the contract maturity increases 的m 0 to 10 years. 2007 is 18 1.8. 2007 is 98. 2007. 2007 and July 27 . The cash price is therefore 110.) The last part of the chapter covers duration.day Tr easury bi11 is quoted as 10. Equation (6.27% Problem 6. For example if the duration of the bond that is expected to be delivered in a τ'r easury note futures contract is 8 years and the duration of the exposure that is being hedged is 12 years .2%.9) when interest rates are expressed with a compounding frequency of m times per year.0005 or 0.2.002 times the price. Suppose that the duration of an instrument is 4 years and we are considering the effect of a 0. The duration of an instrument describes its sensitivity to interest rates. 2007 and May 5.
Problem 6. The present value of the coupon is 6.3792 1. Wh ich of the following four bonds is cheapest to deliver? Bond 7 i q A 9 d d 经 Price 12505 14215 11531 14402 Conversion Factor 1.4026 The cheapesttodeliver bond is the one for which Quoted Price . Calculating this factor for each of the 4 bonds we get Bond 1: 125. A coupon of 6.15625 . 375 x 1. It is July 30.946 Bond 4: 144. Coupon payments on the bond are made on February 4 and August 4 each year. 06 0.10 1. Suppose that the Tr easury bond futures price is 10112. 4026 = 1. therefore: 110 十一一 x 6. There are 176 days between February 4 and July 30 and 181 days between February 4 and August 4. and delivery is expected to be made on September 30.101.06250 .32 176 181 The rate of interest with continuous compounding is 21n 1.5 工 116. Problem 6. 2009.Futures Price x Conversion Factor is least. 375 x 1. and the rate of interest with semiannual compounding is 12% per annum.or $113.46875.1149 1 . The cheapesttodeliver bond in a September 2009 Tr easury bond 且ltures contract is a 13% coupon bond. 2131 = 2. The cash price of the bond is . 874 Bond 4 is therefore the cheapest to deliver. The current quoted bond price is $110.1165 or 11.490 36 . 375 x 1.178 Bond 2: 142.01366xO 1165 = 6. 3792 = 2.2131 1.10 1. 1149 = 2.5 will be received in 5 days (= 0.65% per annum.5ε 一 O. Thθ conversion factor for the bond is 1. 2009.10. The term structure is flat .01366 years) time.652 Bond 3: 115.101. Calculate the quoted futures price for the contract.5. 375 x 1.96875 .78.1 1.
01 Taking the conversion factor into account the quoted futures price should be: 110. The cash contract were written on the 13% bond would be (116. When the futures price is too high .34 1. Problem 6.490)e01694XO. In the case where the futures price is too high. An investor is looking for arbitrage opportunities in the Treasury bond futures market. the arbitrageur buys bonds and shorts an equivalent number of bond futures contracts.month Eurodollar 且ltures price quote for a contract maturing in six months.02 .month period. Estimate the three. When the futures price is too low .02 At delivery there are 57 days of accrued interest.09102 . The forward interest rate for the time period between months 6 and 9 is 9% per annum with continuous compounding. Suppose that the ninemonth LIBOR interest rate is 8% per annum and the sixmonth LIBOR interest rate is 7.The futures contract lasts for 62 days (= 0.12.1165 fut盯es price if the = 112.01 一一一一= 73. The bond that appears cheapesttodeliver now may not in fact be cheapesttc• deliver at maturity. Uncertaintyas to which bond will be delivered introduces complications.1694 years). the arbitrageur sells bonds and goes long an equivalent number of bond futures contracts.5 x 一一= 57 184 110. the arbitrageur's position is far more difficu1t since he or she does not know which bond to bUYi it is unlikely that a pro直t can be locked in for all possible outcomes. the arbitrageur) determines which bond is to be delivered. With quarterly compounding the forward interest rate is 4(e009j4  1) 37 = 0. This is because 9% per annum for three months when combined with 7 ~ % per annum for six months gives an average interest rate of 8% per annum for the nine. this is not a major problem since the party with the short position (i. In the case where the futures price is too low . arbitrage would be straightforward. .6 .6. e.13. What complications are created by the fact that the party with a short position can choose to deliver any bond with a maturity of over 15 years? If the bond to be delivered and the time of delivery were known .32 .5% p盯 annum (both with actual/365 and continuous compounding). The quoted futures price if the contract were written on the 13% bond would therefore be 112. 5 Problem 6.
What is the bond 's price? b.15.80 (b) The bond's duration is J一 r8e.2% decrease in its yield.year bond with a yield of 11% (continuously compounded) pays an 8% coupon at the end of each year. B = BD 6:. with the notation in the chapter 6:. What is the bond 's duration? c.2% decrease in its yield is 86.256 x 0.102%.0108x3 + 8e0108X4 十 108e一 o 108x5 = 87. 02 Problem 6.0 11x3 + 8e.or 9.o 口 x2 + 3 x. 11 十 8ε 一 0.54. What is likely to be 38 . This assumes that the day count is actualjactual.80 to 87. l1 x2 + 8e.80 L = 4. d.0 l1 X4 + 108e 一 011 x5 = 86. a.80 x 4. (d) With a 10. The threemonth Eurodollar quote for a contract maturing in six months is therefore 100 . (a) The bond's price is 8e.74 The bond's price should increase from 86. Recalculate the bond's price on the basis of a 10.14.977 = 91..011 + 2 x 8e. A 1ì ve. 8e一O 山 3 + 4 x 8e一0 山 4 + 5 x 108e 一o 11X5] 86. Suppose that a bond portfolio with a duration of 12 years is hedged using a futures contract in which the underlying asset has a duration of four years. Use the duration to calculate the effect on the bond's price of a 0. y the effect on the bond's price of a 0.102 x 360/365 = 8.8.8% yield the bond's price is 8e 一 0. Problem 6. With a day count of actual/360 the rate is 9.54 This is consistent with the answer in (c).108 + 8eo 108x2 十 8e.002 = 0.256 years ( c) Since .8% per annum yield and veri命 that the result is in agreement with your answer to (c).977.O .
4.0 years in Problem 6.30 91 .) The September E盯odollar futures price is quoted as 92. the portfolio manager may 且nd that he or she is overhedged.8 years at maturity.1 一一=.30 39 = 50. The duration of the commercial paper is twice that of the Eurodollar deposit under. On August 1 a portfo1io manager has a bond portfo1io worth $10 million. the treasurer should short 一一 x 4. If bond prices go down . (In other words .17. How should the portfolio manager immunize the portfolio against changes in interest rates over the next two months? . To reduce the duration 仕 om 7. The contract price of a Eurodollar futures contract is 980 . The number of contracts that should be shorted is 10 ‘ 000 吨。00 x 7.18.17 is designed to reduce the duration to zero.1 to 0 . Problem 6. Suppose that it is February 20 and a treasur町 rea1izes that on July 17 the company wi11 have to issue $5 mi11ion of commercial paper with a maturity of 180 days.000 for its paper and have to redeem it at $5 .820.1 88. the company would receive $4 . 375 x 8. The number of contracts that should be shorted is .820.16.000. How should the t reasurer hedge the company's exposure? The company treasurer can hedge the company's exposure by shorting Eurodollar futures contracts. The treasurer should short T￥easury bond futures contract. therefore . The Eurodollar futures position leads to a profit if rates rise and a loss if theγfall.000 一，一町 980 .lying the Eurodollar futures contract.1 to 3.000 in 180 days' time.. this futures position wi1l provide offsetting gains.00. Since the 12year rate te丑ds to move by less than the 4year rate .820. How can the portfolio manager change the duration of the portfolio to 3. ] 7 Problem 6. The December Tr easury bond futures price is currently 91.0 instead of from 7.8 Rounding to the nearest whole number 88 contracts should be shorted. 12 and the cheapesttodeliver bond wi11 have a duration of 8.000.= 88. If the paper were issued today. 000 x 2 = 9. the company would realize $4.99 . Problem 6.1 years.the impact on the hedge of the fact that the 12year rate is less volati1e than the fouryear rate? Durationbased hedging procedures assume parallel shifts in the yield curve.1 7.84 Rounding to the nearest whole number 10 contracts should be shorted.000.18? The answer in Problem 6. The duration of the portfolio in October wi11 be 7.
Problem 6. 飞3 Problem 6. Ignorθ the difference The Eurodollar futures contract price of 88 means that the Eurodollar futures rate is 12% per annum with quarterly compounding. Problem 6.011 . tl = 6 .to 150day period? between futures and forwards for the purposes of this question. government bond paying a 12% coupon and a U. Consider carefully the day count conventions discussed in this chapter and decide which of the two bonds you would prefer to own. and November 1.8 x 365/360 = 4. Estimate the forward LIBOR interest rate for the period between 6.1%.8% with quarterly compounding and an actual/360 day count. 40 . Suppose that the contracts apply to the interest rate between times T1 and T 2 . there are two days. It is 41n(1 十 .23 = 4. Using the notation of Section adjustment is 6. 2009. 2009 and November 1 .19.8.8. corporate bond paying a 12% coupon.00 and 6. This is the forward rate for the 60.84% with continuous compounding. You would prefer to own the 峦:'reaS T 础 there is one day between October 30 .0. The threE• month Eurodollar futures price for a contract maturing in six years is quoted as 95. 2009. Problem 6.to 150day period with quarterly compoundi吨 and an actual/360 day count convention.25. 2009.61% with continuous compounding. and t2 = 6.20. The forward rate is therefore 4.20.84 . Between October 30. 8apposet主苟ta一古urorloHm二futur回一quoteið88farac臼rtrnct~matt1rrngrn6Ðda芦7一一一 What is the LIBOR forward rate for the 60. There are two reasons for a difference between the forward rate and the futures rate.867% with an actual/actual day count. The first is that the futures contract is settled daily whereas the forward contract is settled once at time T 2 • The second is that without daily settlement a futures contract would be settled at time T 1 not T 2 • Both reasons tend to make the futures rate greater than the forward rate.04867/4) = 4. The convexity :× 00112 ×6 ×625=0002269 or about 23 basis points. Ignore the risk of default. Therefore you would earn approximately twice as much interest by holding the Tr easury bond. The futures rate is 4. The standard deviation of the change in thθ shortterm interest rate in one year is 1. you have a choice between owning a U. This becomes 4.3 ， σ= 0. Explain why the forward interest rate is less than the corresponding futures interest rate calculated 企om a Eurodollar futures contract. Under the actual/actual (in period) day count convention .22.or 51 contracts.25 years in the future.2 1.
1 shows an extract from a hypothetical swap con自rmation.8 . It is a super自cially compelling argument. 1. In the case of 且xedfor. They should then use swaps to exchange the liability for what they want. A plain vanilla interest rate swap is an agreement to exchange interest at a fixed rate for interest at LIBOR. This is illustrated in Figures 7.) A swap where 自xed is received and fioating is paid can be used to convert a liability where a company is paying a fixed rate of interest to one where it is paying a fioating rate of interest.1 provides an example of a threeyear swap where 5% is paid and sixmonth LIBOR is received with payments being exchanged every six months. (See Example 7.fixed currency swaps .3 and Business Snapshot 7. An interest rate swap can be used to transform an asset or a liability. Note that the sixmonth LIBOR rate observed on a date determines the cash fiows exchanged six months later. BBBrated companies should borrow at a fioati吨 rate of interest).3 shows quotes as they might be made by a swap market maker such as Goldman Sachs and Business Snapshot 7.3 where Microsοft and Intel trade with each other without a financial intermediary being involved and in Figures 7 . The other exchanges depend on the LIBOR rates at future times. It says that companies should borrow in the market where they have a comparative advantage (AAArated companies should borrow at a fixed rate of interest. A swap where fioating is received and fixed is paid can be used to convert a liability where a company is paying a fioating rate of interest to one where it is paying a 且xed rate of interest. Table 7. The same swap can be used to convert an asset earning a fioating rate of interest to an asset earning a 自xed rate of interest. You should make sure you understand Table 7. as discussed in Section 7.5 where an intermediary is involved. The same swap can be used to convert an asset earning a fixed rate of interest to an asset earning a fioating rate of interest. 2007 when the swap is initiated. 1. However .CH他 PWR 月 T E A i n b 叫 泊 This chapter covers how interest rate swaps and currency swaps work and how the币f are valued. Table 7. this type of argument can have some validity.2 and 7. The exchange made on September 5 .4 and 7. The comparative advantage argument is sometimes used in an attempt to persuade corporate treasurers to enter into swaps. in the case of interest rate swaps it is seriously fiawed because it ignores the possibility of a company's creditworthiness decli 41 . 2007 is known on March 5 .
a currency swap can be valued either in terms on bonds or in terms of forward foreign exchange agreements.13). It is liable to lose an amount equal to the positive value of the swap. Examples 7. Many different types of swaps are traded in practice.xed currency swap is an agreement to exchange a fi. Examples 7. Similarly to an interest rate swap .4 and 7. Problem 7. the bank still has to honor its contract with the other counterparty. An interest rate swap can be regarded as the exchange of a bond paying LIBOR for a bond paying a fi.xed rate of interest. A 且xed.tI'ans岛E由&注册setea:四i:nginteresti丑 one currency to an asset earning interest in another currency. At the start of the swap . 0) where V is the value of the swap (see Figure 7.3) is to compensate for potential defaults by its counterparties. As time passes its value is liable to become positive or negative. Valuing an interest rate swapωa portfolio of forward rate agreements involves calculating the cash flows on the assumption that forward LIBOR interest rates are rea1ized and then discounti吨 the cash flows at the swap/LIBOR zero rates.5 illustrate the two approaches.7 illustrate this. ， the amount it could lose if the counterparty defaults) is max( V. e.fi.) You should understand both ways of valuing interest rate swaps 1isted in Section 7. Part of the spread earned by a swap market marker (see Table 7. The credit exposure of a compa町(i. It can also be regarded as a portfolio of forward rate agreements (FRAs). If the counterparty on the other side of the positivevalue swap defaults . nancial institutions calculate this zero curve at least once a day and use it as their risk仕ee zero curve.7. Explain whya bank is subject to credit risk when it enters into two offsetting swap contracts. A swap has zero value when it is fi. As time passes . (As pointed out in Chapter 4 出叮 t heydωo not 田e the Treasury zero curveas the risk仕ee 础盯 町 臼 此】 倪 zero curve. both contracts have a value of approximately zero. It can be used to transform borrowings in one CUFl'eneytoÐ&Fl'0WingsinanEr出ereUFl'eneY0fto.are used in the construction of the LIBOR/swap zero curve. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 7.8. it is likely that the swap values wi1l change .for. so that one swap has a positive value to the bank and the other has a negative value to the bank. Banks and other fi.6 and 7.9.rst negotiated. Companies X and Y have been offered the following rates per annum on a $5 mi11ion 10year investment: 42 . Swap transactions entail a small amount of credit risk. The 且nal section of the chapter introduces you to some of the more important swap products.xed rate in one currency for a 且xed rate in another currency.
it receives 10% per annum and pays sixmonth LIBOR on a principal of $10 million for five years.3% .5 x 10% of $10 million) and pay $450 . The remaining cash fiows are therefore valued on the assumption that the fioating payment is 0. This leaves 0. Y 1 88% I LIBOR BANK 广 IC叩 any 忡一一一 L一一一一一_J 卡一一一一一一1酬 ←一一一一一一…ÞÞj L一一一一.000 (= 0. Under the terms of the swap . 000.8% per annum. 000 .8% Floating Rate LIBOR LIBOR Company X requires a fixedrate investment. Payments are made every six months.0% per annum on fioating rate investments.2% per annum will go to the bank.2% .5% 一一一 . A financial institution has entered into an interθst rate swap with company X.. 000 = $100 . All forwafd rates are 8% per annum.1 8wap for Problem 7. acting as intermediary.9 Problem 7.2% per annum and wil1 appear equ a11y attractive to X and Y. 000 and the net payrnent that would be received is 500 . 000 = $400 . Suppose that company X defaults on the sixth payment date (end of year 3) when the interest rate (with semiannua1 compounding) is 8% per annum for all maturities.Fixed Rate Company X Company Y 8..J LIBOR Figure 87.3% per annum.5 x 0..3%. At the end of year 3 the 且nancial institutio丑 was due to receive $500 . 000 ' 400 . This means that the total apparent benefit to all parties 仕om the swap is 0.J L一一一一一一.0% 8.8% per annum on fixed rate investments and 0.5 x 9% of $10 million). What is the 10ss to the 丘nancia1 institution? Assume that sixmonth LIBOR was 9% per annum ha1fway through year 3_ . Of this 0. and company Y earns LIBOR + 0. company Y requires a Boatingrate in崎 vestment.10.. The spread between the interest rates offered to X and Y is 0.000. To value the remaining swap we assume than forward rates are realized. 0. In other words .3% per annum for each of X and Y.08 x 10 . 1. The required swap is shown in Figure 87. company X should be able to get a fixeιrate return of 8. 8.. The bank earns 0. The total cost of default is therefore the cost of foregoing the following cash fiows: 43 . Design a swap that wil1 net a bank.3% per annum while company Y should be able to get a fioatingrate return LIBOR + 0. 83% r 一一， 1. r一一一一一一， 一一一时 Co咆any 广 LIBOR 1 儿 目一 1. The immediate loss is therefore $50 .000 (= 0. company X earns 8.
and rf is the foreign riskfree rate.000 560 .000 0.9670 The value of the swap at the time of the default can be calculated on the assumption that forward rates are realized.400 296 . nancial institution receives interest at 3% per annum in Swiss francs and pays interest at 8% per annum in U. when the exchange rate is $0.000 300 . 308 . 8 0 is the spot rate .9223 0.000 7.y y y y y 缸 r 3 eeeeenl 3 r 巾 、ψ ooooowu nununununU+LU nununununu 500003 00000o ' 4 Z A a a a a o b A A r i r r 4 4 G ψ G ψ 唱 咱 刮 Dd uk ψ ·43J mPMni 到 e 丘 出 口 吐 习 @ ，" ψ e ' ' 噜 B & 咱 G ou soc ω… eo nu h σ au 川 ψ E A U ar nJ a'+b 哇 % per·A 口 D 咽 · ' A x mon4'uLU QU We hu o。τ &La n +LU e co .9670 且丑al 240 .700 9.960 . the interest rate is 3% per annum in Swiss 企ancs and 8% per annum in U.100 283 . nancial institution has entered into a 10year currency swap with company Y.• · 唱 ， 45U QU 0 p+i +bLU e Problem 7.8796 0.d WWWW aaaa u n ? i o ‘ 晶 0. column to the end of year 6 at 8% per annum .08 and rf = 0.8388 0.000 560 . All interest rates are quoted with annual compounding. dollars.000 251 . the spot and forward exchange rates at the end of year 6 are S. The cash flows lost as a result of the default are therefore as follows: 一一一一一一一一一 Year Dollar Paid Swiss Fr anc Received 一一一一一 一一一一一一 Forward Rate Dollar Equivalent of Swiss Fr anc Received Cash Flow Lost 6 7 8 9 10 560 .000 10.1234 的 +t 二 V u a U o a V uρ a U u a V ρ U U V U ρ 专 。 F VAVATArviVAVAVA A i F 。 r T A V P l AV 札 H o  p dJud. r is the domestic risk. When interest rates are compounded annually 月= 8 (11二) 0 where Fo is the Tyear forward rate .400 .300 .9223 0. Under the terms of the swap. at the end ofyear 6. What is the cost to the 丘nancial institution? Assume that .03 .900 276 .100 Discounting the numbers in the the cost of the default is $679 .560 . 44 .000 300 . Interest payments are exchanged once a year.8388 0. the fi.free rate .8000 0.000 300 .8000 0.000 300. dollars for all maturities.100 ?20000.300 2. Suppose that company Y de c1 ares bankruptcy at the end of year 6. The principa1 amounts are 7 m il1ion dollars and 10 mil1ion 企ancs.800. As r = 0.600 263 .8796 0. A fi.S.000 560 .80 per franc.1 1.S.
5% 5. Figure S7.5% per annUffi . s. The difference between the differentials is 1% per annum. In practice company Y is likely to be defaulting and declaring bankruptcy for reasons unrelated to this particular contract and payments on the contract are likely to stop when bankruptcy is declared. If the swap is equal1y attractive to A and B . The financial 恒的itution would be exposed to some foreign exchange risk which could be hedged using forward contracts. 一一. If the financial intermediary requires 50 basis points . dollar fioatingrate market and company B wants to borrow in the Canadian dollar fixedrate market. LIBOR 十 0. (This may be because of their tax positions.8. The swap is shown in Figure 87. what rates of interest wil1 A and B end up paying? Company A has a comparative advantage in the Canadian dollar 且xedrate market. it would make no sense for the company to default at the end of ye町 six as the exchange of payments at that time has a positive value to company Y. 45 .12. if this were the only contract entered into by company Y . This gives rise to the swap opportunity.5% Assume that A wants to borrow U. Company B has a comparative advantage in the U. Companies A and B face the fo l1 owing interest rates impact of taxes): A (a司justed for the differential B LIBOR 十 1. dollars at LIBOR + 0. and the differential between the Canadian dollar fixed rates is 1.2 8wap for Problem 7.) However . The differential between the U. Problem 7. S. dollar floatingrate market.12 Principal payments flow in the opposite direction to the arrows at the start of the life of the swap and in the same direction as the arrows at the end of the life of the swap. or 100 basis points. do l1 ars at a Boating rate of interest and B wants to borrow Canadian dollars at a fìxed rate of interest.2. A fìnancial institution is planning to arrange a swap and requires a 50basispoint spread. each of A and B can be made 25 basis points better off.25% per annum.8.Note that . The total potential gain to all parties 仕 om the swap is therefore 1% per annum .0% dol1 ars (floating rate) Canadian dollars (fìxed rate) u.0% 6. Thus a swap can be designed so that it provides A with U. and B with Canadian dollars at 6. dollar floating rates is 0. company A wants to borrow in the U. 5% per annum.25% per annum .8.8.
For the purposes of illustration .13. The quote suggests that company X will usually be less creditworthy than company Y. We suppose that X is paying 也ced and receiving floating whi1e Y is paying floating and receiving fixed. (Company X might be a BBB刊ted company that has difficl山y in accessing fixedrate markets directly. Consider a plainvanilla interest rate swap involving two companies X and Y.001 0.010 x 0. After it hedges its foreign exchange risk using forward contracts . and so on.0037 0. suppose that the probabilities of various events are as follows: Default by Y: Defau1t by X: Rates high when default occurs: Rates low when defau1t occurs: The probability of a loss is 0. is the nnancial institution 's average spread in Figure 7. the AUD purchased for year 3 is less expensive than that purchased for year 2.3 If the roles of X and Y in the swap had been reversed the probability of a loss would be 0.001 x 0. The spread is always above 20 basis points. Do you think it increases or decreases the risk of a nnancial institution 's swap portfolio? Assume that companies are most likely to default when interest rates are higb. "Companies with higb credit risks are the ones that cannot access nxedrate markets directly. This works in favor of the 直nancial institution and means that its spread increases with time.7 = 0.Problem 7.) Presumably compa町 X wants 自xedrate funds and company Y wants floatingrate funds. Problem 7. They are the companies that are most likely to be paying nxed and receiving floating in an interest rate swap. These events are relatively unlikely since (a) Y is unlikely to defau1t in any circumstances and (b) defaults are less likely to happen when rates are low.7+ 0.010 x 0.14.001 x 0. The financial institution wi1l realize a loss if company Y defaults when rates are high or if compa町 X defaults when rates are low. company Y might be a AAArated company that has no di自culty accessing fixed or floating rate markets." Assume that tbis statement is true. The financial institution will have to buy 1. This means that the AUD purchased for year 2 is less expensive than that purchased for year 1.3 + 0. 1% of the AUD principal in the forward mar ket for each ye町 of the life of the swap.0073 46 . AUD is at a discount in forward markets.010 0. Since AUD interest rates are higher than dollar interest rates .10 likely to be greater than or less than 20 basis points? Explain your answer.3 = 0.7 0.
It is worth noting that the assumption that d efaults are more likely when interest rates are high is open to question. the value of the swap in currency A is VA .005xI0 十 2. It is taking f1oatingrate deposits and making nxedrate 1oans. Problem 7. If R2 is the twoyear LIBOR zero rate 2. The 且xed payments can be valued in currency B by discounting them at the appropriate currency B discount rates. The assumption is motivated by the thought that high interest rates often lead to financial di ffi.0 years. The LIBOR zero curve is f1at at 5% (continuously compounded) out to 1.QVB.5 years. Exp1ain how you would value a swap that is the exchange of a f10ating currency for a nxed rate in another currency. Why is the expected 10ss 企om a defau1t on a swap 1ess than the expected the defau1t on a 10an with the same principa1? 10ss 企om In an interestrate swap a financial institution's exposure depends on the difference between a 且xedrate of interest and a floatingrate of interest.05X15 十 47 102. and (ii) discounting the resu1ting cash flows at appropriate currency A discount rates.6% . there is often a time lag between interest rates being high and the resultant defau1t.15. Problem 7. It can offset its risk by entering into interest rate swaps (with other financial institutions or corporations) in which it contracts to pay fixed and receive floating. and 3year semiannual pay swaps are 5. When the default actually happens interest rates may be relatively low.5.o = 100 . Problem 7.7e 一 O. culties for corporations.7e.5 + 2.5year swap rate is the average of the 2. However . This means that a twoyear LIBOR bond paying a semiannual coupon at the rate of 5. In a loan the whole principal can be lost. Estimate the LIBOR zero rates for maturities of 2. It has no exposure to the notional principal. Suppose that the value is VB. Problem 7. Alternatively. Suppose that the value is VA.7eR2x2. and 3. (Assume that thθ2.05xO. How can swaps be used to 0岛et the risk? The bank is paying a floatingrate on the deposits and receiving a 且xed.Assuming companies are more likely to defau1t when interest rates are high .7eo.17.rate on the loans.4% per annum sells for par. respectively.0. it is VA/Q .) The twc• year swap rate is 5.18.VB in currency B. If Q is the current exchange rate (number of units of currency A per unit of currency B) . 2. Swap rates for 2. ra古e in one The floating payments can be valued in currency A by (i) assuming that the forward rates are realized .16. the above argument shows that the obser飞ration in quotes has the effect of decreasing the risk of a 自nancial institution's swap portfo1io. A bank nnds that its assets are not matched with its liabilities. and 3year sw叩 rates.4% and 5.4%.
8eR3x3o = 100 Solving this gives R3 = 0.5 十 2. If R 25 is the 2.05544. This means that a 2.o 05xl.544% .5 + 2.75e一 o 05xLO +2.year LIBOR zero rate 2.6%. 48 .0 + 2.05342.05x15 十 2.0 years are therefore 5.75eR2 5 x2.8e 一 O.75e 一 O.Solving this gives R 2 = 0. This means that a 3year LIBOR bond paying a semiannual coupon at the rate of 5.05xO. The 3. 5 = 0. and 3. The 2. If R3 is the three. 5.8e005442X2.75e 一 o 05342x2 0 + 102.8e005xI0 + 2.05xO.0 .8e 一 005342x2.5year LIBOR zero rate 2.05442. and 5.5 .5%.5% per annum sells for par.442% .5 +102. respectively.5 + 2.5year swap rate is assumed to be 5.75e.5year LIBOR bond paying a semiannual coupo丑 at the rate of 5.8ε 一 O.5 = 100 Solving this gives R 2 .6% per annum sells for par. 2.342% . The zero rates for maturities 2.year swap rate is 5.
expiration date . the option writer buys shares of the stock in the market and delivers them to the option holder. Warrants issued by a company on its own stock are different 仕om regular call options in that exercise of the warrants leads to the compa町 issui吨 more shares. Make sure you understand the terminology of option markets: American options . Make sure you understand the profit diagrams in Figures 8. a 3for. An important difference between executive stock option and regular call options is that executive stock options cannot be sold.1 stock split leads to the strike price being reduced to a third of what it was before and the number of options held being mu1tiplied by 3. A 10% stock dividend is like a 1. Stock dividends and stock splits do lead to adjustments. fiex options . Tr aders who buy options pay for the options up 仕ont and do 丑ot maintain margin accounts. option writing and so on. atthemoney. the payoff does not. option class . . Except in special circumstances (see Business Snapshot 8. intrinsic value .CHAPTER 8 Mechanics of Options Markets If you already understand how options work you wi1l not have to spend a lot of time on Chapter 8. . Figure 8.1 to 8 .) Executive stock options and convertible bonds are similar to warrants in this respect. Options trade in the overthe. strike price .counter market as well 部 the exchangetrade market.g. The options traded over the counter do not have to have the standard terms de且ned by exchanges. lt leads to the strike price being reduced to 10/11 of what it was before and the number of options held being increased by 10%.4. For example . Executive stock options are discussed in Business Snapshot 8. e.. inthemoney. outofthemoney.1 to 8. Bear in mind that .1) there is no ad句 剧 臼 ， juS tme n 剖 tωo the terms of an option for cash dividends. European options . (When a regular call option on a stock is exercised . exchange rates and interest rates) the overthecounter market is much bigger than the exchangetraded market.4. lndeed for many types ofunderlyings (e. option series . write) options must mai川ain margin accounts similar to the margin accounts for futures traders. 1 for 1 stock split.3. Th 49 . for every trader buying an option . Whereas the profit takes account of the initial amount paid for the option . there is another trader selling it. As a result they are liable to be exercised much ear1ier than would otherwise be the case.5 shows the payoffs 仕om the four different option strategies in Figures 8. Tr aders who sell (i.
00 and is held until maturi市~ Under what circumstances wi11 the holder of the option make a profit? Under what circumstances wi11 the option be exercised? Drawa diagram illustrating how the profit 企om a long position in the option depends on the stock price at maturity of the option.9 50 . Problem 8.00 costs $5. This is because the payoff to the holder of the option is . Note that if the stock price is between $100 and $105 the option is exercised .1 Profit from long position in Problem 8. What are the prω and cons of using (a) the Philadelphia Stock Exchange and (b) the overthecounter market for trading? The Philadelphia Exchange offers European and American options with standard strike prices and times to maturity. The option will be exercised if the stock price at maturity is greater than $100. but the holder of the option takes a loss overall. 21 nvRU 「 I l l # 眶 。 』 也 10 5 。 D 5 10 Figure S8. the holder of the option will make a profit if the stock price at maturity of the option is greater than $105.9. 1. Ignoring the time value of money. A corporate treasurer is designing a hedging program involving foreign currency options. in these circumstances . The profit from a long position is as shown in Figure 88. Options in the overthecounter market have the advantage that they can be tailored to meet the precise needs of the treasurer. Exchanges organize their trading so that there is virtually no credit risk. Their disadvantage is that they expose the treasurer to some credit risk. greater than the $5 paid for the option.SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 8.8. Suppose that a European call option to buy a share for $100.
Ignoring the time value of money. Note that if the stock price is between $52. the seller of the option will make a profit if the stock price at maturity is greater than $52.10 Problem 8.1 1. Show that the European put option has the same value as a European call option with the same strike price and maturity. 10 H e。 』 也 5 Stock Price 。 65 5 .Problem 8.2.00.丁 0 70 15 Figure S8.00 and $60.2 Profit from short position in Problem 8. The option will be exercised if the stock price at maturity is less than $60. Describe the terminal value ûf the fûllûwing pûrtfolio: a newly enteredinto long for 酣 ward contract on an asset and a long position in a European put option on the asset with the same maturity as the forward contract and a strike price that is equal to the forward price of the asset at the time the portfolio is set up. The profit 仕om the short position is as shown in Figure 88. Suppose that a European put option to sell a share for $60 costs $8 and is held until maturi抄: Under what circumstances wil1 the seller of the option (the par句r with the short position) make a proEt? Under what circumstances wil1 the option be exercised? Draw a diagram illustrating how the profìt 企om a short position in the option depends on the stock price at maturi句r of the option. The terminal value of the long forward contract is: STFo 51 .00.10. This is because the cost to the seller of the option is in these circumstances less than the price received for the option.00 the seller of the option makes a profit even though the option is exercised.
where ST is the price of the asset at maturity and Fo is the forward price of the asset at the time the portfolio is set up. 0) = max (0 . 0) The terminal value of the portfolio is therefore ST 一几十 max (Fo .3 Profit from portfolio in Problem 8.11 We have shown that the forward contract plus the put is worth the same as a call with the same strike price and time to maturity as the put. The forward contract is worth zero at the time the portÍoÌÏo is set up. This result is illustrated in the Figure 88. 旦 / L F。 』 也 / / Asset Price / / / / / / / / / Figure 88.ST . It Íollows that the put is worth the same as the call at the time the portfolio is set up. ST.ST .) The terminal value of the put option is: max (Fo .Fol This is the same as the terminal value of a European call option with the same maturity as the forward contract and an exercise price equal to Fo. (The delivery price in the forward contract is also 马.3. 52 .
This type of trading strategy is known as a strangle and is discussed in Chapter 10. an arbitrageur could short the European option and take a long position in the American option. Both options have the same maturity. There is a net loss of $7. The call costs $3 and the put costs $4.45 and the put option provides no payoff.12 Problem 8. the put opti∞ provides a payoff of 40 . 5 。 5 10 Figure 88. 15 罩 10 』 。 Q.ST and the call option provides no payoff. the total profit is ST 一 52. 53 . The trader makes a pro缸 (ignoring the time value of money) if the stock price is less than $33 or greater than $52. We can divide the alternative asset prices into three ranges: (a) When the asset price less than $40 .4 Profit from trading strategy in Problem 8. Taking into account the $7 cost of the options . Figure 88. The options cost $7 and so the total pro且t is 33 . The holder of an American option has all the same rights as the holder of a European option and more.Problem 8.ST. (b) When the asset price is between $40 and $45 . It must therefore be worth at least as much. Draw a diagram showing the variation of the trader's profìt with the asset price. (c) When the asset price greater than $45 .13.4 shows the variation of the trader's position with the asset price. If it were not . neither option provides a payoff.12. A trader buys a ca11 option with a strike price of $45 and a put option with a strike price of $40. the call option provides a payoff of ST . Explain why an American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date.
Explain why an American option is always worth at least as much as its intrinsic value. The holder of an American option has the right to exercise it immediately. The disadvantage is that the outcome with hedging can be significant1y worse than the outcome with no hedging. Options provide insurance that the exchange rate will not be worse than some level. Consider an exchangetraded call option contract to buy 500 shares with a strike price of $40 and maturity in four months. Writing a put gives a payoff of min(ST . Explain how the terms of the option contract change when there is a" A 10% stock dividend b. 0). unlike forward contracts . In both cases the potential payoff is ST .15. 1 = 550 shares with an exercise price 40/ 1. A 10% cash dividend c.14. The treasurer of a corporation is trying to choose between options and forward contracts to hedge the corporation 's foreign exchange risk.forl stock split (a) The option contract becomes one to buy 500 x 1.Problem 8. However . This disadvantage is not as marked with options.36.K. Problem 8.) Problenl 8. A 4. The advantage of a forward contract is that uncertainty is eliminated as far as possible. 1 = 36. Forward contracts lock in the exchange rate that wi1l apply to a particular transaction in the future. The difference is that for a written put the counterparty chooses whether you get the payoff (and wi1l allow you to get it only when it is negative to yo啡 For a 10吨 call you decide whether you get the payoff (and you choose to get it when it is positive to you. (c) The option contract becomes one to buy 500 x 4 = 2 . Problem 8. Discuss the advantages and disadvantages of each.K . 54 .K . The American option must therefore be worth at least as much as its intrinsic value. Buyi鸣 a call gives a payoff of max(ST . 000 shares with an exercise price of 40/4 = $10. (b) There is no effect. The terms of an options contract are not normally adjusted for cash divide丑ds. Explain carefully the difIerence between writing a put option and buying a ca11 option. 0).17. If it were not an arbitrageur could lock in a sure pro缸 by buying the option and exercising it immediately.16. options involve an upfront cost.
Problem 8. These mean that the option is closetφthemoney when it is first traded. it is likely that the stock price has risen rapidly in the last few months. As a result there would be a reduction in the value of a call option and an increase the value of a put option. 600 The initial margin is the greater of these . or $5 . Lo鸣er dated options may also trade. 55 .50. (Note that the terms of an option are adjusted for cash dividends only in exceptional circumstances. and 例 August 5? (a) March . Each time he or she does this there is a hidden cost equal to half the bidoffer spread. An investor typically buys at the market maker's offer and sells at the market maker's bid. 750 received for the options. If all call options are in the money it is therefore likely that the stock price h础 risen since trading in the option began. March.18. Problem 8.00.22. The first gives 500 x (3. December (c) A吨ust ， September . What is the effect of an unexpected cash dividend on (a) a cal1 option price and (b) a put option price? An unexpected cash dividend would reduce the stock price on the exdividend date. A "fair" price for the option can reasonably be assumed to be half way between the bid and the offer price quoted by a market maker. ) Problem 8. and the stock price is $57.5 + 0." Discuss this statement.19. and December cyc1 e. December . Problem 8. (b) June 30.Problem 8. A United States investor writes nve naked call option contracts.5 = $1 .2 x 57 . The exchange has certain rules governing when trading in a new option is initiated.20. The option price is $3. Part of this can be provided by the initial amount of 500 x 3.3) = 5 .2 1. September . Options on General Motors stock are on a March . June and September (b) July. "If most of the cal1 options on a stock are in the money.1 x 57) = 4 . This stock price reduction would not be anticipated by option holders. What is the initial margin requirement? The two calculations are necessary to determine the initial margin. August . What options trade on (a) March 1. June . the strike price is $60. Explain why the market maker's bidoffer spread represents a real cost to options investors.950.5 The second gives + 0. April . 950 500 x (3. September .00.
As illustrated in Table 9. lndeed . The rest of the chapter considers what we can say about option prices without making any assumptions about volatility or the way in which the stock price behaves. when considering interest rates it is assumed that interest rates change without any other variables changing. but an inequa1ity relationship can be derived (see eql时ions 9. This is because a) delaying exercise has the advantage that it delays paying the strike price and b) exercising early would give up the protection that the option holder has against the possib i1i ty of the stock price falling below the strike price by the end of the life of the option. Section 9. 此】 倪 Make sure you understand Table 9. An important point that often causes confusion is that Table 9. it can be shown that at any give time there is always a critical stock price below which it is optimal for the holder of the put option to exercise. This situation does T' 56 . the argument falls down.8. Explain why the arguments leading to putcall parity for European options cannot be used to give a similar result for American options. strike price .3 .) For example . Putcall p缸 ity (see equations 9. For example . If the price of an option is outside the range given by the upper and lower bound there is a clear arbitrage opportunity.2 there is an arbitrage opportunity if putcall parity does not hold. and dividends.4 and 9. When early exercise is possible .CHAPTER 9 Properties of Stock Options This chapter starts by considering the general way in which an option price depends on the stock price . American put options on stocks that do not pay a dividend are liable to be exercised early. if a call option is below the lower bound an arbitrageur buys the option and shorts the stock. ris k仕e e rate . In practice when interest rates increase (decrease) stock prices tend to decrease (increase). volatility. (This the usual assumption in ca1culus when partial derivatives are ca1culated. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 9. time to expiration .8) An American call option on a stock that will not pay dividends during the 1ife of the option should never be exercised ear ly.7) is a very important resu1t. It shows that there is a relationship between the price of a European call option with a certain strike price and time to maturity and the price of a European put option with the same strike price and time to maturity. for example .1 considers the change in a variable with all the other variables remaining the same. we can argue that two portfolios that are worth the same at time T must be worth the same at earlier times.T. 1. The arguments used are no arbitrage arguments. For American options putcall parity does not hold . Suppose that P 十 s > C + K e. if it is above the upper bound the arbitrageur buys the stock and sells the option. derives upper and lower bounds for call and put options. When early exercise is not possible .3 and 9.
79 = $5.56._ 58 = $6 . 57 = $57.not lead to an arbitrage opportunity. and the riskfree interest rate is 10% per annum? The lower bound is 80 . we cannot be sure of the result because we do not know when the put will be exercised.. and a dividend of $0. If the stock price is above $60 at the expiration of the option . the strike price is $75.00 = $0. What is a lower bound for the price of a sixmonth call option on a nondividendpaying stock when the stock price is $80.1 1. has to pay dividends with a present value of $0. The gain 仕om the short position and the exercise of the option is therefore exactly 64 _. Regardless of what happens a profit will materialize.57. the strike price is $65. The remaining $58. 57. short the put .65. If the stock price declines below $60 in four months .65 .10 What is a lower bound for the price of a twomonth European put option on a nondividendpaying stock when the stock price is $58.. The arbitrageur's gain in present value terms is exactly 5.56. the strike price is $60. The present value of the arbitrageur's gain is therefore at least 5.46 Problem 9.75eOlX05 = $8. If we buy the call .65 . Because 5 < 64 .79 the condition in equation (9. The present value of the $60 paid for the stock is $57.79 .79 of this at 12% for one month to pay the dividend of $0. Because $57.5. the arbitrageur loses the $5 spent on the option but gains on the short position.9. Problem 9.79 = $5.56. An arbitrageur should buy the option and short the stock.56 . What opportunities are there for an arbitrageur? The present value of the strike price is 60e一 o 12x4/12 the dividend is 0. the option is exercised.65 and as before the dividend has a present value of $0. This generates 64 ..5 = $59. The risk企ee interest rate is 12% per annum for all maturities.80 is expected in one month. The arbitrageur shorts when the stock price is $64 .o 12xl/12 = 0.0.5) is violated.. The arbitrageur invests $0. the short position generates at least 64 .80 in one month.79.0. A four.21 is invested for four months at 12%. and the risk企ee interest rate is 5% per annum? The lower bound is 65e 一 005x2/12 .80e.65. and closes out the short position when the stock price is $60 or less.month European call option on a dividendpaying stock is currently selling for $5. and short the stock .00 = $0.65 is the present value of $60 .56 in present value terms.0. The present value of .79. The stock price is $64.66 Problem 9.5.57.56 . The arbitrageur buys the stock for $60 in four months and closes out the short position.
Again this makes early exercise more attractive. buy the stock . Give an intuitive explanation of why the early exercise of an American put becomes more attractive as the risk企ee rate increases and volatility decreases. The early exercise of an American put is attractive when the interest earned on the strike price is greater than the insurance element lost. the value of the interest earned on the strike price increωes making early exercise more attractive" When volati1ity decreases . This generates a profit in all circumstances.75 today. The strategy therefore generates profit with a present value of at least $0.5e一 01x2/12 十 O.13. An arbitrageur should borrow $49.2) is violated. Because 2:5 Aon萨month < 49.75 . A sum of $50 received in one month has a present value of $49. The underlying stock price is $29. and the riskfree interest rate is 6% per annum.5e 一 01x5/ 叫一 29 = 2. Problem 9.25 in present value terms. the option expires worthless . What is the price of a European put option that expires in six months and has a strike price of $30? Using the notation in the chapter . The stock price is $47. The term structure is f1 at . but the stock can be sold for at le邸t $50. Problem 9.51 58 . and buy the put option.47.50.Problem 9. If the stock price is below $50 in one month the put option is exercised and the stock owned is sold for exactly $50 (or $49. The trading strategy therefore generates a pro直t of exactly $0. When interest rates increase . The price of a European call that expires in six months and has a strike price of $30 is $2. If the stock price is above $50 in one month .rT + D  80 In this case p=2 十 30eOlX6/12 十 (O.00 the condition in equation (9. putcall parity [equation (9. What opportunities are there for an arbitrageur? In this case the present value of the strike price is 50e006xl/12 = 49. with all risk企ee interest rates being 10%. and a dividend of $0. European put option on a nondividendpaying stock is currently selling for $2.50 at 6% for one month .12.75. the strike price is $50.14.7)] gives c+ KerT 十 D =p+ 8 0 or p = c + Ke.75 in present value terms).25. the insurance element is less valuable.50 is expected in two months and again in nve months.
2 + 3 十 29 = $30 in cash which is invested at 10%.5e一 01X2/12 + 0.16 if the American put price is greater than the calculated upper bound.10x6/12 = $28. short the stock . the put option is exercised and the call option expires worthless.97 = $0 . The dividends on the short position cost 0.lX5/12 = $0. Derive upper and lower bounds for the price of an American put on the same stock with the same strike price and expiration date.In other words the put price is $2.5ε01x2/12 + 0. P < 31.16.30 < 4 _. 00 < 4.5 1.15. If the stock price is above $30 in six months .54 . If the American put price is greater than $3. and the put option expires worthless. If the stock price is below $30 in six months .0. The short put option leads to the stock being bought for $30 . or 30e0.5e一 01x5/12 = $0.4 9. or 30e一 0.4 1 < P < 3.Ke. and the expiration da优 is in three months.4 = $30 59 .00 . or 1.97 in present value terms so that there is a pro且t with a present value of 30 .5e一0. it is too high relative to the call price.0.00 .14 if the European put price is $3. The call option enables the stock to be bought for $30 .00.4) 80K~二 CP~二 80 . The dividends on the short position cost 0.30e 008XO.49 is locked in. the call option is exercised . Problem 9.17.00 Upper and lower bounds for the price of an American put are therefore $2 . This generates . the strike price is $30.. and buy the American call. This rea1izes at least 3 十 31 . The stock price is $31 . 59 or 2.49.25 .00 . If the put price is $3.rT In this case 31 . short the put and short the stock.28. From equation (9 .00 a丑 arbitrageur can sell the American put .54 .51 = $0 .97 in present value terms so that there is a pro且t with a present value of 30 一 28. Regardless of what happens a profit with a present value of 3.54 in present value terms.54 in present value terms.97 = $0 .4 1 and $3. The risk企ee interest rate is 8%. An arbitrageur should buy the cal1.P < 1. Explain carefully the arbitrage opportunities in Problem 9.l0x6/12 = $28. Problem 9. Explain carefully the arbitrage opportunities in Problem 9. Problem 9. The price of an American call on a nondividendpaying stock is $4.2.
K . 0) + Ke rT = rnax (8T . These cash flows have a positive present value.which can be invested at the risk仕ee interest rate.) As in the text we use c and p to denote the European call and put option price . receives the stock and closes out the short position.Ke.18.) a portfolio consisting of a European call plus an amount of cash equal to K and (b) a portfolio consisting of an American put option plus one share.rT . K) at tirne T. Hence c+K 二三 P+80 Since c = C .K::. consider Portfolio 1: One European call option plus an arnount of cash equal to K. It follows that portfolio 1 is worth at least as rnuch as portfolio J in all circurnstances.P . we obtain 8 0 . Portfolio 1 is worth rnax(8T . If the put option is not exercised early portfolio J is worth rnax (8T . portfolio 1 would be worth Ke rT at tirne T.4).rT . 8 0 . even if the call option were worthless . (H饥t: For the fìrst part of the relationship consider 但. C+K~三 P 十 80 or CP~三 80 K Cornbining this with the other inequality derived above for C .P 三 80 . However . Both options have the sarne exercise price and expiration date. Assurne that the cash in portfolio 1 is invested at the riskfree interest rate.K + Ke rT at this tirne. Because P ~三 p ， it follows 仕orn putcall parity that P~三 c+ Ke. At sorne stage during the 3rnonth period either the Arnerican put or the Arnerican call will be exercised. Prove the reSl山 in equation (9. Portfolio 1 is therefore worth rnore than portfolio J. and C and P to denote the Arnerican call and put option prices. K) .K e. Problem 9. Suppose next that the put option in portfolio J is exercised early.rT 60 . The arbitrageur then pays $30 .rT For a further relationship between C and P . say. Portfolio J: One Arnerican put option plus one share. C .P ::.8 0 and since c = C .8 0 or C . at tirne T. This rneans that portfolio J is worth K at tirne T. The cash flows to the arbitrageur are 十 $30 at tirne zero and 一 $30 at sorne future tirne. P~三 C + Ke.
Hence C 卡 D+K 二三 P 十 50 Because C > c CP 二三 5 0 DK Problem 9. Executive stock options may be exercised early because the executive needs the cash or because he or she is uncertain about the company's future prospects. 61 . at time T. (Hint: For the nrst part ofthe relationship consider (a) a portfolio consisting of a European call plus an amount of cash equal to D + K and (b) a portfolio consisti吨。f an American put option plus one share.De rT at time T.K at this time. But there 1S a tendency for e实的1tíve stock 可t1面目o bee如rcised eaI市百回rw阳门加而rnpany pays no dividends. Assume that the cash in portfolio 1 is invested at the riskfree interest rate. However . Suppose next that the put option in portfolio J is exercised early.) Give a possible reason for this. but executive stock options cannot be sold.K .rT Dividends reduce C and increase p" Hence this relationship must also be true when there are dividends. Regular call options can be sold in the market in either of these two situations .) As in the text we use c and p to denote the European call and put option price .3 for a discussion of 侃的ltive stock options. As shown in the answer to Problem 9. In practice this is not usually encouraged and may even be illegal. 0) + (D +. say. Portfolio 1 is worth max(5T . Regular call options on nondividend. paying stocks should not be exercised early. For a further relationship between C and P . Portfolio 1 is therefore worth more than portfolio J. K) + De rT at time T. when there are no dividends CP~二 50 . This means that portfolio J is worth at most K +. K) + De TT + Ke TT . consider Por扩olio 1: one European call option plus an amount of cash equal to D + K Portfolio J: one American put option plus one share Both options have the same exercise price and expiration date. The present value of the dividends will be denoted by D. Prove the reSI山 in equation (9.19.K)e TT = max(5T . and C and P to denote the American call and put option prices.Problem 9. portfolio J is worth max (5T . even if the call option were worthless .8).20. If the put option is not exercised early. It follows that portfolio 1 is worth more than portfolio J in all circumstances. portfolio 1 would be worth (D + K)eγγ at time T.Ke.18 . (See Business Snapshot 8. In theory an executive can short the company's stock as an alternative to exercising.
9. volatility as 30% .2a . Select Analytic European as the Option Type. You are encouraged to experiment with this worksheet. Hit Enter and click on Draw Gr，α. and 9. This will produce Figure 9. Select the button corresponding to call. Input stock price as 50 . The graphs can be produced from the first worksheet in DerivaGem.2 are correct. By selecting put instead of call and recalculating the rest ofthe figures can be produced. Use the software DerivaGem to veri命 that Figures 9. Figures 9.Problem 9. Hit the Enter key and c1ick on calculate.15562248.1 and 9.1c .ph.1a.2c can be produced similarly by changing the horizontal axis. risk仕ee rate as 5% . 62 . time to exercise as 1 year . DerivaGem will show the price of the option as 7. Do not select the implied volatility button.τ'ry different parameter values and different types of options. Select Equity as the Underlying Type. Move to the Graph Results on the right hand side of the worksheet. Enter Option Price for the vertical axis and Asset price for the horizontal axis. Leave the dividend table blank because we are assuming no dividends. and exercise price as 50. 9.2 1.1e . Choose the minimum strike price value as 10 (software will not accept 0) and the maximum strike price value as 100.
butterfiy spreads (see Figures 10. b) a long call to something that looks like a long put . In theory any payoff pattern can be created by using calls and puts with different strike prices in an appropriate way.8.rT This shows that the initial investment when the spread is created 仕om puts is less than the initial investment when it is created frorn calls by an arnount (K2 . A bull spread using calls provides a profit pattern with the same general shape as a bull spread using puts (see Figures 10. Combination is the word used to describe a position involving both calls and puts. Fr om putcall parity TT SS ++ 十+ pp pupu 几 ee 俨 1 4 t a A 内 ， " 门 ， " v 问 7 Hence: Pl . and calendar spreads (see Figures 10. bear spreads (see Figures 10. Figure 10. Putcall parity shows that a spread created using calls can also be created using puts. As putcall parity shows .2 and 10.rT .9).4). Define Pl and Cl as the prices of put and call with strike price K 1 and P2 and C2 as the prices of a put and call with strike price K 2 . and d) a short put to something that looks like a short call.3 in the text).CHAPTER 10 T￥ading Strategies lnvolving Options This is a 缸丑 chapter that should not cause you too many problems.7).5 and 10 . A straddle involves buying a call and an put with the same strike price and maturity date..K 1 )e. Any specified payoff pattern can be by combining spikes judiciously.1 shows what can be achieved by taking a position in the option and the underlying asset. In fact 63 . A strangle involves buying a call and a put when the strike price of the call is greater than that of the put. Spread is the word used to describe a position in two or more calls or two or more puts. It describes some of the ways options can be used to produce interesting profit patterns.2 and 10. c) a long put to something that looks like a long call . Figure 10.P2 = Cl .3).C2 一 (K2  K 1 )e. Use putcall parity to relate the initial investment for a bull spread created using calls to the initial investment for a bull spread created using puts.13 shows that a butterfiy spread can be used to create a payoff patter丑 that is a small "spike". SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 10. This is shown for four types of spreads in the chapter: bull spreads (see Figures 10.. a long or short position in the underlying asset can be used to convert a) a short put to something that looks like a short call .6 and 10.8 and 10.
This strategy costs $3 initially. How can the options be used to create (a) a bull spread and (b) a bear spread? Construct a table that shows the pront and payoff for both spreads.as rnentioned in the text the initial investrnent when the bull spread is created 仕orn puts is negative .9. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $代 respectively. ow of $3. while the initial investrnent when it is created 仕orn calls is positive.ST 5 3 32.) ST < 30 5 2 A bear spread is created by selling the $30 put and buying the $35 put. Sirnilarly. an aggressive bear spread can be created usi吨 put options.Kl)erT(e rT 1) = (K 2 . This earns interest of (K2 .rT over the put strategy. The profit when calls are used to create the bull spread is higher than when puts are used by (K2 . In rnost circurnstances the spread will provide zero payoff" However . they should have relatively low strike prices).K 1 . The outcorne is as follows: Stock Price ~三 35 30 三 ST Payoff 。 Pro且t ST < 35 ST < 30 35.ST 2 64 . Both of the options used have relatively high strike prices.K 1 )(1 . Problem 10. The spread then costs very little to set up because both of the puts are worth close to zero. This re fl.rT ).3. An aggressive bull spread using call options is discussed in the text.10. The outcorne is as follows: Stock Price Payoff O Profit 3 ST32 ST 2:: 35 30 三 ST < 35 ST . A bull spread is created by buying the $30 put and selling the $35 put.Kl )e. Both of the options should be out of the rnoney (that is . K 2 .K I) (l. Problem 10.e. ects the fact that the call strategy involves an additional risk仕ee investrnent of (K2 . The spread then provides a payoff equal to the difference between the two strike prices .rT ). This strategy gives rise to an initial cash infl. Explain how an aggressive bear spread can be created using put options.e. there is a srnall chance that the stock price will fall fast so that on expiration both options will be in the rnoney.
2K2 = 0 and . Construct a tab1e that shows the profìt 企om a straddle. Define Cl .ST Profit ST 70 50.Problem 10. This strategy costs $10. C2 . For what range of stock prices wou1d the straddle 1ead to a 1oss? A stradd1e is created by buying both the call and the put.2C2 + (K1 十 K3 .2P2 The cost of a butterfly spread created using European calls is therefore exact1y the same as the cost of a butterfly spread created using European puts. payoff 企om a bul1 spread when puts with strike prices The bull spread is created by buying a put with strike price Kl and selling a put with strike price K 2 . P2 and 内部 the prices of puts with strike prices Kl .2C2 = . The payoff is ca1cu1ated as follows: 65 . Construct a tab1e showing the K 1 and K 2 are used (K2 > K 1 ). Problem 10. it follows that Cl 十 C3 K1 十 K3 Pl 十 P3 .13.ST This shows that the stradd1e will 1ead to a 10ss if the fina1 stock price is between $50 and $70.K2 . Define P l.2K2 )e. K2 and K3' With the usual notation C1+K1eTT=PI 十 S C2+K2eTT=P2+S C3 十 K3 e. K 2 and K3.2P2 Because K 2 . The pro缸 /10ss is shown in the followi吨 tab1e: Stock Price ST > 60 ST ~ 60 Payoff ST 60 60.1 1.12.K 1 = K3 . and C3 as the prices of calls with strike prices Kl .rT = Pl + P3 . Use putcal1 parity to show that the cost of a butterBy spread created 丘。mEuropean puts is identica1 to the cost of a butterBy spread created 企om European cal1s.rT = P3 + S Hence Cl 十 C3 . A cal1 with a strike price of $60 costs $6. A put with the same strike price and expiration date costs $4. Problem 10.
This shows that the price of a call equa1s the price of a put when the strike price is Fo. the forward contract that is created has zero va1ue. Strips and straps are more expensive than stradd1es but provide bigger profits in certain CÎrcumstances. A strap will provide a bigger profit when there is a 1arge upward stock price move In the case of strang1es . Problem 10. A strang1e is 1ess expensive than a stradd1e .14. lf K = Fo .Stock Price Range P L。 叫 归u 的 m 涩 的 句 划 on m Payoff from Short Put Option O Tota1 Payoff 。 K2 K 1 < ST < K 2 ST ~二 K1 ST 二三 。 O K 1 ST STK2 STK2 一 (K2 一 (K2  ST) K 1) Problem 10.15. Possib1e strategies are: Strang1e Stradd1e Strip Strap Reverse ca1endar spread Reverse butterfly spread The strategies all provide positive profits when there are large stock price moves. An investor believes that there wi11 be a big jump in a stock price. Identi命 six different strategies the investor can follow and explain the differences among them. How can a forward contract on a stock with a particular delivery price and delivery date be created 丘。m options? Suppose that the delivery price is K and the delivery date is T. A strip will provide a bigger profit when there is a 1arge downward stock price move. strips and straps . . the pro且t increases as the size of the stock price movement increases. The forward contract is created by buying a European call and selling a European put when both options have strike price K and exerCÎse date T" This portfolio provides a payoff of ST . By contrast in a reverse ca1endar spread and a reverse butterfly spread there is a maximum potentia1 pro缸 regard1ess of the size of the stock price movement. but requires a bigger move in the stock price in order to provide a positive profit. but is uncertain as to the direction. Suppose that Fo is the forward price. 66 . stradd1es .K under all circumstances where ST is the stock price at time T.
18.，. One Australian dol1 ar is currently worth $0. b) a short call with strike K2 .16.、、 、、' _. . The risk." Explain this statement.一一→ι_..1 Pro且t Pattern in Problem 10. Two can be combined to create a long forward position and two can be combined to create a short forward position. and the 67 . With the notation in the text it consists of a) a long call with strike K l. b) and c) give a short forward contract with delivery price K 2 . A onE• year butterßy spread is set up using European cal1 options with strike prices of $0.. A box spread is a bull spread created using calls and a bear spread created using puts.70. and $0. The two forward contracts taken together give the payoff of K 2 . 1.. Problem 10.17 Problem 10.J Figure 810.60. and d) a short put with strike Kl' a) and d) give a long forward contract with delivery price K 1. c) a long put with strike K2 .企ee interest rates in the United States and Australia are 5% and 4% respectively.Kl..64.65. 时_ ___ . The profit pattern 仕om a long position in a call and a put when the put has a higher strike price than a call is much the same as when the call has a higher strike price than the put.Ca l\ \ \ l … … Put 、气、‘四…·回……嗣 飞、 1… T口 tal ! 一. $0.17..Problem 10..~‘_. Both the initial investment and the final payoff are much higher in the first case H Z O」 h h \r~~，  … . 研!hat is the result if the strike price of the put is higher than the strike price of the cal1 in a strangle? The result is shown in Figure 810.::. '\ . "A box spread comprises four options..
60.70 to be 0. and click on calculate again. and exercise price as 0. DerivaGem will show the price of the option as 0.0181 一 2 x 0. To use DerivaGem select the 直rst worksheet and choose Currency as the Underlying Type.0386 .0352 = 0.0690 .0094 68 .0176 . hit Enter.60 .64 . Now select the button corresponding to put and repeat the procedure.65 . riskfree rate as 5% .0176 + 0.018 1. Do not select the implied volatility button. and 0. and click on calculate. hit Enter. Hit the Enter key and click on calculate. Show that the cost is the same if European put options are used instead of European call options. DerivaGem shows the values of puts with strike prices 0. Select Analytic European as the Option Type.0095 The cost of setting up the butterfiy spread when puts are used is 0. foreign risk仕ee interest rate as 4% . Change the exercise price to 0. time to exercise as 1 year . 0.0352. and 0.0386 Allowing for rounding errors these two are the same. Change the exercise price to 0. = 0.65 . The cost of setting up the butterfiy spread when calls are used is therefore 0.70 .2 x 0. Input exchange rate as 0. DerivaGem will show the value of the option as 0. respectively.0618. Select the button corresponding to call.0618 + 0. volatility as 15% . DerivaGem will show the value of the option as 0.volati1i ty ofthe exchange rate is 15%. 0. Use the DerivaGem software to calculate the cost of setting up the butterf1 y spread position.0690 .
) Section 11. 斗). for example . The change in the stock price during each time step is assumed to be given by a one. Figure 11.缸 downmovements bein 此 ∞ aI 时 时盹 the same 69 . Discounting the expected payoff on the option at the risk仕ee rate. For this value of ~ the portfolio is riskless because its payoff at time T is known 口 1 for certain. The value of the stock price is known today. Binomial trees constitute an important numerical procedure for valuing American options. 3 covers twostep binomial trees. It is a very important argument in option pricing. This is of central importance in derivatives' pricing 4. It is correct in all other worlds as well. 2 and 1 1.仕ee rate as the expected return on all risky assets) then we get the right price for options. There are a number of reasons why binomial trees are covered at this relatively early stage in the book: 1. 2 shows that in the case of a onestep binomial tree the option can be valued by 1. and 2. The value of the option price can therefore be calculated. The price is not just correct in a riskneutral world. We determi 创 町 口山 m 11. The value of the portfolio today is the prese口t value of the portfolio at time T. We consider portfo1ios consisting of a short position in one call option and a long position in ~ (delta) shares of the stock. In these the life of the option is divided into two equal time steps. The option lasts until time T and there are assumed to be only two possible stock prices at time T and therefore and only two possible option prices.) The chapter starts by considering onestep binomial trees for call options on a stock (see . Binomial trees illustrate the noarbitrage arguments that can be used to derive the BlackScholes model (Chapter 12) 2. 1). It says that if we assume that all market participants are riskneutral (in the sense that they require the risk. As such it must earn the riskfree rate. Binomial trees illustrate the riskneutral valuation argument. (Chapter 16. Assuming that the expected return on the stock is the riskfree rate. For some value of ~ the portfo1io has the same value for both of the possible final stock prices. (See equations 11.CHAPTER 11 Introduction to Binomial Trees This chapter introduces binomial trees. 3. This is the riskneutral valuation argument. Binomial trees illustrate the delta hedging strategies that can be used to hedge a position in an option with a position in the underlying asset (Chapter 15) 3.step binomial tree (with the propor tional up. Section 11.
3 in Section 11.1 . 70 . SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 1 1. They are being used to value the same option except that in Figure 11. Explain why it is not possible to set up a position in the stock and the option that remains riskless for the whole of the life of the option. Examples 11. The formulas are the same as those given above except that α =e (γ q)ßt where 1. this riskless portfolio must also change. The riskless portfolio consists of a short position in the option and a long position in ß shares.飞/ ßt 1MU . and futures contracts. 8 it is American. The formulas are: u = e.7 gives formulas for calculating the proportional up movement . In the case of an option on a stock index . Consider the situation in which stock price movements during the life of a European option are governed bya twostep binomial tree. In the case of an option on a foreign currency. d . u . and the riskneutral probability of an up movement . Once you have mastered twostep trees it is not difficult to extend the ideas in the chapter to multistep trees.compare Figures 1 1. p .7 the option is European whereas in Figure 11. currencies . and 11. and the riskfree rate . Section 11. q = γso thatα=1 You are strongly recommended to use the DerivaGem software and inspect the binomial trees it produces.9 show DerivaGem output. ßt . In the case of an option on a futures contract . A step by step procedure for using the software is at the end of Section 1 1. q is the average dividend yield on the index during the life of the option 2. q is the foreign risk.8. r.2 . Because ß changes during the life of the option .仕ee rate 3. 一 JU α u dd p where α =e rßt The last part of the chapter looks ahead to later chapters and explains how the binomial tree methodology can be used to value call and put options on stock indices . 11. 7 and 1 1. the proportional down movement . 8 and make sure you understand the difference. from the stock price volati1ity， σ ， the length of the time step . 8.
23 Problem 1 1. At the end of four months the value of the option will be either $5 (if the stock price is $75) or $0 (if the stock price is $85). At the end of two months the value of the option will be either $4 (if the stock price is $53) or $0 (if the stock price is $48). It is known that at the end of four months it wil1 be either $75 or $85. The current value of the portfolio is: 0.! where ! is the value of the option.23 The value of the optio:ri is therefore $2.8 x 50 .4 l.8 the value of the portfolio is certain to be 38 . A stock price is currently $50. What is the value of a fourmonth European put option with a strike price of $80? Usenφ arbitrage arguments. 2) and (11.3). e. . Consider a portfolio consisting of: ß 十1 shares option 71 . This can also be calculated directly from equations (1 1. 06 . Consider a portfo1io consisting of: +ß 1 shares option The value of the portfolio is either 48ß or 53ß . If 48ß = 53ß4 l.Problem 1 1.4. 9. e.23. ! = 2. A stock price is currently $80.!)eOl0X2/12 = 38 . u d = 0.xAU 一 。 nu no. ß =0. 10. The risk企ee interest rate is 5% per annum with continuous compounding.5681 x 4 = 2. The risk企ee interest rate is 10% per annum with continuous compounding.nuvhu 。 ρ 1. For this value of ß the portfolio is therefore riskless. Since the portfolio must earn the riskfree rate of interest (0.8 x 50 _.4 in two months. "r 一 一 一 队 一 侃 一u  o 。 and !=e一 O ， 10x2/12 x 0.96 so that 1 2=o e. It is known that at the end of two months it wil1 be either $53 or $48. What is the value of a twc• month European call option with a strike price of $49? Usen萨arbitrage arguments. .
e. f = 1. = 75 . Since the portfolio is riskless (0. 2) and (11. The current value of the portfolio is: 0. At the end of three months the value of the option is either $5 (if the stock price is $35) or $0 (if the stock price is $45)..60 or 75 .60 of a put option is negative. 80. We have constructed the portfolio so that it is + 1 option and.(Note: The delta .60 shares so that the initial investment is positive.60 + 5 in four months.6o the portfolio is therefore riskless. eO 05x4/12 一。 . 0625 一 0. u d = 0. If 85 .6345 1.9375 = 0. The risk企ee rate of interest with quarterly compounding is 8% per annum. For this value of .3).9375 1. We have constructed the portfolio so that it is +1 option and .3655 and f = e005X4/12 x 0. .) The value of the portfolio is either 85 .p = 0. 0625 . Consider a portfolio consisting o f: 「 A + t i  、 qunU KOA 吧 qunu aH 。 (Note: The delta .60 shares rather than 1 option and +. .60 shares rather than 1 option and +. e.5 the value of the portfolio is certain to be 42. 1 1.) 72 . Calculate the value of a threemonth European put option on the stock with an exercise price of $40.5 x 80 + f) eo 05x4/12 = 42.60 l. This can also be calculated directly 仕om equations (1 1.60 = 0. 80 The value of the option is therefore $1. . Veri非 that no.3655 x 5 = 1.60.arbitrage arguments and riskneutral valuation arguments give the same answers. It is known that at the end of three months it wi11 be either $45 or $35.5 x 80 where +f f is the value of the option.60 shares so that the initial investment is positive.9375 so that p= 一一一一_ ~ _~_  = 1.5 l. ..60 + 5 . of a put option is negative.5.. 80 Problem 1 1. A stock price is currently $40.
5 . .10 This has a present value of 2. This can also be calculated using riskneutral valuation.8 or: p = 0. e. = Problem 1 1.4 2 = 2.p) = 40 x 1. p . e. The current value of the portfolio is 40~ +f risk仕ee where f is the value of the option. We must have 45p + 35(1 .5689 73 . + 5 = 45~ = 0.5 Hence rate of f = 2. The riskneutral probability of an up move . 02 l. 0，月er each of the next two thre month periods it is 臼cpected to go up by 6% or down by 5%. What is the value of a sixmonth European call option with a strike price of $51? • A tree describing the behavior of the stock price is shown in Figure 81 1. "" ^ "'" 1. The risk丘ee interest rate is 5% per annum with continuous compounding.The value of the portfolio is either 35~ + 5 or 45~.0. the value of the option is $2. 一一:.95 p = . If: 35~ l. e. 02 This is consistent with the noarbitrage answer. 12. For this value of ~ the portfolio is therefore riskless. 8uppose that p is the probability of an upward stock price movement in a riskneutral world.58 + 5 x 0 .06 i. lOp = 5.5 + f) x 1. ~ the value of the portfolio is certain to be 22.95 = 0. 06 .0. is given by e005x3/12 .58 The expected value of the option in a riskneutral world is: 。 x 0.06.5. 02 = 22.1. A stock price is currently $50.06 1.10 2. 8ince the portfolio must earn the interest (40 x 0. .
875 x 0.4311 + 5.43112)e005X6/12 = 1.18 for the highest 直nal node (which corresponds to two up moves) zero in all other cases. The value of the option is therefore 5.45. would it ever be optimal to exercise it early at any of the nodes on the tree? The tree for valuing the put option is shown in Figure 811. For the situation considered in Problem 11. 1.35 0 45.125 0 Figure 81 1.635 50.12. 376 The value of the call plus the present value of the strike price is 1. 376 十 50 = 51. what is the va1 ue of a sixmonth European put option with a strike price of $51? Veri命 that the European call and European put prices satis命 putcall parity" If the put option were American .2.51 = 5. The value of the put plus the stock price is from Problem 1 1. 376 This verifies that putcall parity holds To test whether it worth exercising the option early we compare the value calculated for the option at each node with the payoff from immediate exercise.35 = 0.50.18 5. We get a payoff of 51 . 12 Problem 1 1.18 X 0.125 = 5. 376 This can also be calculated by working back through the tree as indicated in Figure 811.18 50 1. 635 This can also be calculated by working back through the tree as indicated in Figure 811. The value of the option is therefore (0. 635 十 51e005X6/12 = 5 1.5689 x 0.5689 2 Xε一 005x6/ 12 = 1.. At node C the payoff 74 . The value of the call ootion is the lower number at each node in the fi!!ure. 12 1.875 if the lowest 且nal node is reached.18 ..2.There is a payoff 仕om the option of 56.65 x 2 x 0. 1τ'ree for Problem 11. 56.65 if the middle final node is reached and a payoff of 51 . 13.
ß = 50 the value of the portfolio is certain to be 62 1. For this value of ß the portfolio is therefore riskless.5. A stock price is currently $25.from immediate exercise is 51. 56.18 0 50 1.376 50. the option should be exercised at this node. Consider a portfolio consisting of: +ß 1 shares derivative The value of the portfolio is either 27 ß .529 in two months.47. It is known tbat at tbe end of two montbs it wi11 be eitber $23 or $27. 2 Tr ee for Problem 11.529 l. Tbe risk企ee ínterest rate is 10% per annum witb continuous compounding" Suppose ST is tbe stock price at tbe end of two montbs.仕ee where f is the value of the derivative. If 27ß .f) eo 10x2j12 = 621 rate of 75 . The option should not be exercised at either node A or node B.8664 .35 0.125 5.875 Figure S1 1. Because this is greater than 2. 13 Problem 1 1.65 45. The current value of the portfolio is: 50 x 25  f risk. Since the portfolio must earn the interest (50 x 25 . 14. e" .5 = 3.729 = 23ß .729 or 23ß . Wbat ís tbe value of a derivative tbat pays off Sf at tbis time? At the end of two months the value of the derivative will be either 529 (if the stock price is 23) or 729 (if the stock price is 27).
. the foreign interest rate is 8% per annum . and p when a binomial tree is constructed to value an option on a foreign currency.l. . This can also be calculated directly from equations (11. f . 0352 i 、 p 一 J dQuoEAUnU 刷 90O = tiwhunL E'hponhu =9od / 町 = n AUtA 一 h 一 nu哇 u 一 历 R A v vhU 问 u nd H V 76 .。 pu" hunu vo nu nu p A … u 1. u = e012 Jï/12 = 1. the domestic ínterest rate is 5% per annum .3950 x 529) = 639. 15. e. d = 0.3 The value of the option is therefore $639 3.2) and (11.92 so that nu 'i× J'fnuQunu. The tree step size is one month .. 08 .3 Problem 1 1. Calculate u . and the volati1ity is 12% per annum.6050 x 729 + 0.3). = 639.  qLA qG  and f = eO. In this case α=ε (005008)xlj12 = 0 9975 . lO x2j12(0. d.
two are market variables that can be readily observed (50 and r).Ke. Section 12.) The stock is assumed to pay no dividends in the basic BlackScholes model. c and p are the prices of European call and put optio丑s on the stock . The BlackScholes model is based on the assumption that the stock price at any future time has a lognormal probability distribution (see Figure 12. This assumption is valid in a world where the return on the stock (not the stock price itself) follows a random walk. Make sure you understand how riskneutral valuation can be used to get the f = 50 .rT N(d 2 ) 5 0 N(d 1 ) where 也一 ln(50 /旦十巳 +σ2/2)T 一 σ 飞/T 2= 一一一~出一 σýT σ 飞/T ln(50 /K) 十 (r  (7 2/2)T J _ /石 In these equations . The function N (x) is the cumulative probability distribution function for a normally distributed variable with a mean of zero and a standard deviation of 1. The European option price depends on five variables: 8 . The difference is that in this case the portfolio that is set up remains riskless for only a very short (theoretically an infinitesimally short) period of time. and T is the time to maturity. K is the strike price . (See Figure 12 .8. Of these . The BlackScholes model is given by equations (12.1). They are similar to the noarbitrage arguments used in Chapter 11 to price options when there is onestep binomial tree.5) and (12. K ， 飞 σ ， and T.4.6): c = 5 0 N(d 1 )  Ke.9 explains how volatility can be implied 仕 om the mar ket prices of options.rT 77 . and Robert Merton in 1973.4 explains how volatility can be estimated from historical data. Only the volatility σcaus臼 any problems when the formula is used. r is the riskfree rate ， σis the volatility. 50 is the current stock price .6. This extends the riskneutral valuation ideas introduced in Chapter 11. You should make sure you understand the noarbitrage arguments i丑 Section 12. Section 12 . Myron Scholes . two are properties of the option and therefore known (K and T) . Another important section is Section 12.rT N(d 2 )  p = Ke.CHAPTER 12 Valuing Stock Options: The BlackScholes Model This is the point at which the book begins to get a little more technical! Chapter 12 presents the pathbreaking stock option pricing model published by Fischer Black .
Suppose that the stock price in six months is .e. The first expires at the same time as the American option. a. Fr om equation (12 . The current price is $38. but before . the present value of the dividends that will be paid during the life of the option.25. f'V 0.(0.0% per annum. the second expires just before the final exdividend date (i. 功 (0. ln ST f'V cþ(3. The variable 80 is then replaced by 80 . What is the probabi1i ty that a European call option on the stock with an exercise price of $40 and a maturity date in six months wi11 be exercised? b.35 2 cþ(ln38 +.9. What is the probabi1i ty that a European put option on the stock with the same exercise price and maturity wi11 be exercised? (a) The required probability is the probability of the stock price being above $40 in six months time. AV nu4·i严 气U 一 nu巧 ， " VKJU l.formula for valuing a forward contract with delivery price K. Assume that the expected return 企om the stock is 15% and its volati1ity is 25%.247) 78 . A stock price is currently $40.D in the BlackScholes formula.15 and σ= 0. the exdividend date that is closest to . . but the math is much more involved. The last part of the chapter discusses how the BlackScholes formula can be modified to allow for dividends. Problem 12.8. The methodology is analogous to the methodology for valuing a forward contract with delivery price K . The BlackScholes formula can be derived using riskneutral valuation. What is the probability distribution for the rate of return (with continuous compounding) earned over a oneyear period? In this caseμ= 0..35而王) . e.5， 0.25) The expected value of the return is 11.16 一 T)0. 875% per annum and the standard deviation is 25.11875 ， 0. The basic approach is to calculate D . A stock price has an expected return of 16% and a volati1ity of 35%. the American option's maturity). SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 12.4) the probability distribution for the rate of return over a oneyear period with continuous compounding is: 2l\111I/ /III\ n 22 u .687 . Black's approximation for valuing American call options involves setting the price equal to the greater of the prices of two European call options. 0. .'h ln 8T l. e.
The staternent is rnisleading in that a certain surn of rnoney. say $1000 . and Soe( μ 一 σ2/2)T.2. In what respect is this statement misleading? This problern relates to the rnaterial in Section 12. 96σ VT l. (b) In this case the required probability is the probability of the stock price being less than $40 in six rnonths tirne.4968 = 0.10.5032 so that the required probability is 0. 96σJT and Soe(μ 一 σ2/2)T+ 1.2): ln ST ""' cþ[ln So + (μ 一二 )T， σVT] 95% con直dence intervals for ln ST are therefore lnSo + (μZ)T 一 1 伽VT and 1nSo + (μ 一亏 )T+ 1 伽d e1nSo 十 (μ a 2 /2)T+ 1.689 . 79 . with the notation in the chapter. a 95% confìdence interval for ST is between Soe(μ一 σ2/2)T. It is 1 . the required probability is 1N (~飞~.5032 Problem 12. Prove that .0.1.Since ln 40 = 3. when invested for 10 years in the fund would have realized a return (with annual cornpounding) of less than 20% per annurn. 96σ VT and Soe( μ 一 σ 2/2)T十 196σJ于 Problem 12.1 1.1.4968.687) = 1 N川) Fr orn norrnal distribution tables N(0. 96σv吁 _2 95% confidence intervals for ST are therefore e1n So+(μ 一 σ 2/2)T 一1. 96σ VT Fr orn equation (12.008) = 0. e. A portfolio manager announces that the average of the returns realized in each of the last 10 years is 20% per annum.
(a) The derivative will pay off a dollar amount equal to the continuously compounded return on the security between times 0 and T.The average of the returns realized in each year is always greater than the return per annum (with annual compounding) realized over 10 years. the risk企ee interest rate is 12% per annum .3865 The price of the European call is 52N(0. b. ln(52/50) + (0. Use riskneutral valuation to calculate the price of the derivative at time zero. (b) The expected value of ln(8T /80) is ，仕om equation (12 .3865) = 52 x 0.5365) . What is the price of a European call option on a nondividendpaying stock when the stock price is $52.06 or $5. and the time to maturity is three months? In this case 8 0 = 52 .12. r = 0.= 0.5365 10.25. The first is an arithmetic average of the returns in each yearj the second is a geometric average of these returns.06. (μ 一 σ2/2)T. Problem 12.25 = 0.12 + 0. the volatility is 30% per annum . K = 50 . Assume that a nondividendpaying stock has an expected return of μ and a volatility of σ . 80 . Describe the payoff 企om this derivative. The variables 8 0 and 8 T denote the values of the stock price at time zero and time T.4).30)0. The value of the derivative at time zero is therefore: (r 一 ?)fTT Problem 12.6504 = 5.7042 .3 2/2)0.25 一一 一==.13. In a riskneutral world this becomes r 一 σ2/2.30 and T = 0.50e一 003 x 0.12 ， σ= 0. The expected payoff 仕om the derivative is therefore μ 一 σ2/2.3odz d2 = d 1  0. a.50e012X025 N(0. the strike price is $50. An innovative 亘nancial institution has just announced that it wi11 trade a derivative that pays off a dollar amount equal to ~ln (去) at time T.
14.08ω The price of the European put is 70e一 0.05. the risk企ee interest rate is 5% per annum .1666 d 2 = d1  0.Problem 12. the riskfree rate as 5% .15. 8 0 = 15 .0809) _.4 338 = 6 .487. A call option on a nondividendpaying stock has a market price of $2.5 . A volatility of 0.5 0.40. Hit the Enteï key and click on calculate.35 2 /2) rT 0. the exercise price is $13. Select Analytic European as the Option Type. time to exercise as 0.32. By interpolation the implied volatility is about 0.5 in the second half ûf the optiûn data table. 'f'十 σ2/2 今后 σÝTσ.35 VG. The implied volatility can also be calculated using DerivaGem. What is the implied vola ti1ity? In the case c = 2.40 or $6 . K = 70 . K = 13 .05xO. the strike price is $70. A volatility of 0. Problem 12.5323 .5 N(0.20.5.39 gives c = 2. A volatility of 0 . DerivaGem will show the volatility of the option as 39.396 or 39. Input stock price as 15 . 'f' = 1= 一一一0.3 gives c = 2. 69N( 0. A volatility of 0. Leave the dividend table blank because we are assuming no dividends. Show that the BlackScholes formula for a call option gives a price that tends to max (80.  6 81 .6% per annum.507.0025 x 0. 'f'二 0.05 ， σ= 0. Select the imp1ied volatility button.J ln(80 /K) . The stock price is $15. Select the button corresponding to call.16. and exercise price as 13.50. Problem 12.1666) = 70e. 1司!hat is the price of a European put option on a nondividendpaying stock when the stock price is $69. X ln(69/70) + (0.35 飞/0.25 . and the time to maturity is six months? In this case 80 = 69 . Select equity as the Underlying Type in the first worksheet. and the risk企ee interest rate is 5% per annum.K .64%.2 (or 20% per annum) gives c = 2.05 + 0. the volatility is 35% per annum .69 x 0 . the time to maturity is three months. T = 0. d1=!!?。 /K) + i ('f' +σ2/2)T σÝT 一一一一一 __'\.35 and T = 0. The implied volatility must be calculated using an iterative procedure.4 gives c = 2.5 = 0. Input the Price as 2.5 =0. 0) as T • O.25 .
The holder can choose to exercise at time tn if the stock price at that time is above some level but not otherwise. this is not the whole story! The standard approach to valuing either an American or a European option on a stock paying a single dividend applies the volatility to the stock price less the pr臼ent value of the dividend. Problem 12.Ke. This is because the holder of the option has more alternative strategies for deciding when to exHCise tAe op 址。且也azl ttle tewo stBEategies i111plicitly assumed by tbξapproach. Black's approach therefore assumes more stock price variability than the standard approach in some of its calculations. 0 as T • o so that C• 8 0 .rT N(d 2 ) From the above results . T且ese alternative strategies add value to the option. N(d 1 ) • o and N(d 2 ) • o as T • o so that c • O. (The procedure for valuing an American option is explained in Chapter 16.K . 趴lrthermore ， if the option is not exercised at time t n . These results show that c 一步 max(80 . Explain carefully why Black's approach to evaluating an American call option on a dividendpaying stock may give an approximate answer even when only one dividend is anticipated. Does the answer given by Black's approach understate or overstate the true option value? Explain your answer. Since ln(80 / K) > 0 when 8 0 > K and ln(80 / K) < 0 when 8 0 < K . 0 and N(d 2 ) •1. when 8 0 < K .K. In some circumstances it can give a higher price than the standard approach. when 8 0 > K . N(d 1 ) •1. Black's approach in effect assumes that the holder of option must decide at time zero whether it is a European option maturing at time tn (the 直nal exdividend date) or a European option maturing at time T. Also . It appears that Black's approach should understate the true option value. 0) as T • O. In fact the holder of the option has more flexib i1ity than this. The 且rst term tends to +∞ ifln(80 / K) > 0 and t。一∞ if ln(80 / K) < O.) Black's approach when consideri吨 exercise just prior to the dividend date applies the volatility to the stock price itself. it follows that As T d1 d1 • →∞ →一∞ as T T • o when 8 0 > K • o when 8 0 < K as Similarly • o when 8 0 > K d 2 →一∞ as T • o when 8 0 < K d2 →∞ as T Under the BlackScholes formula the call price . 82 .17. the second term on the right hand side tends to zero. However . it can still be exercised at time T. c is given by: c = 8 0 N(d I) .0 .
e.50 . r = 0.r (t 2 一 ω ) = 65(1 . In the dividend table .r (Tt 2 )) = 65(1 Hence D 2 < K(1. and the call price is 68.0735 . The present value of the dividends is e 一 025xOl + e050XOl σ= = 1.e. Use the results in the appendix to show that it can never be optim a1 to exercise the option on either of the two dividend dates.50 .1 .lx06667 x 0.e.仕ee rate ω10% ， time to exercise as =8/12 . 60 D 1 < K(1 . Consider an American call option on a stock. Select Analytic European as the Option Type.÷ + 0.32 飞/0. With the notation in the text D 1 = D 2 = 1.6184 65e 一 O. T = 0.e →(T一切)) Also: Hence: K(1 . e一 01X01667) r = 0.3013 N(dd = 0. and exercise price as 65. The stock price is $70.25 .94 or $10.1 = 1. the risk.6184 = 10. The option can therefore be value as a European option.0735/65) 十 (0.5626 d2 = d 1 0.32 .1  0.0735 x 0.6667 . T = 0. and the vola ti1ity is 32%.32而高百= 0.7131 . Input stock price as 70 . the exercise price is $65. iI = 0.O1X025) = 1.6667 一一厅. Use DerivaGem to calculate the price of the option. A dividend of $1 is expected a丘θ'r three months and again a丘er six months. 1= K = 65 ， 0. and the amou日ts of the dividends in each case as 1.Problem 12.94. Select the button 83 .6667 一一一一一一= ln (68.r (t 2 t 1 )) It follows from the conditions established in the Appendix to Chapter 12 that the option should never be exercised early. t2 = 0.07 and K = 65 K(1 . the time to maturity is eight months.18. 9265 Also: 8 0 = 68.7131 N(d 2 ) = 0.e.6667 0.32 2/2)0. the volatility as 32% . Select equity as the Underlying Type in the first worksheet. DerivaGem can be used to calculate the price of this option.25 and 0. enter the times of dividends as 0. the risk企ee rate of interest is 10% per annum .
The option prices are not exactly consistent with BlackScholes.20 2.50 1. This phenomenon is discussed in Chapter 17. Select the button corresponding to call.942. and exercise price as 45.50 5. Problem 12.15 31.78 30. Problem 12.rT N(d 2 ) . Hit the Enter key and click on calculate.03 30 . the implied volatilities would be all the same. Show that the BlackScholes formulas for call and put options The BlackScholes formula for a European call option is c satis牛 putcall parity. Hit the Enter key and click on calculate. DerivaGem will show the value of the option as $10. Change the strike price and time to exercise and recompute to calculate the rest of the numbers in the table.60 8. Leave the dividend table blank because we are assuming no dividends. We usually find in practice that low strike price options on a stock have signi且cant1y higher implied volatilities than high strike price options on the same stock. A stock price is currently $50 and the riskfree interest rate is 5%. time to exercise as 0. the risk仕ee rate as 5% .90 10.77 12 34.25 . Select Analytic European as the Option Type. Input stock price as 50 . assuming no dividends. If they were .00 3. = SoN(d 1 ) 84 K e.78 34. Use the DerivaGem software to translate the following table of European call options on the stock into a table of implied volati1ities. Select the implied volatility button.78%.19. Input the Price as 7.45 455 505 To calculate first number .corresponding to call.10 Using DerivaGem we obtain the following table of implied volatilities Maturity (months) Strike Price ($) 3 37.20.02 32. Are the option prices consistent with the assumptions underlying BlackScholes? Maturity (months) Strike Price ($) 45 50 55 3 6 12 7. select equity as the Underlying Type in the first worksheet.99 32.0 in the second half of the option data table. DerivaGem will show the volatility of the option as 37.50 7.98 6 34.30 5.
rT = 8 0 N(d 1 ) + Ke.rT = 80 N(d 1 ) 一 Ke. What is an expression for is， w"ith thθ in this the value of a derivative that pays off $100 ifthe price of a stock at time T is greater than K? The probability that the call option will be exercised is the probability that 8 T > K where 8 T is the stock price at time T. N (d 2 ). In a risk neutral world ln8T The probabi1ity that 8T r.rT N( d 2 )  so that p + 8 0 = Ke.町咀' 剖 归占 仨 E world 必 时 由 由 notation introduced 扭 由归 chapter.rT N( d 2 ) or  8 0 N(d I) + 80 p + 80 = Ke.rT N( d2 ) 8 0 N( d I) The BlackScholes formula for a European put option is p = K e.rT = p+ 8 0 holds.rT [l  N(d 2 )] or C 十 Ke.rT = 80 N(d 1 ) + Ke.N(d 1 月 or P 卡 80 = Ke rT N(d 2 ) 十 80 N(dI) This shows that the putcall parity result c+ Ke.rT N(d 2 ) 十 Ke. Show that the probab，ility that a European call option wi11 bθ exercised in a risk←.2 1..J cþ[ln80 + (r 一 σ2/2)T， σJ于] > K is the same as the probability that ln 8T > ln K. Problem 12.so that c + Ke.rT N(d 2 ) + 8 0[1.rT or c + Ke. This is 1N [旦二 ln 节_=~/2)~] N 叫 一 一 一 叶 川 川 一 85 d .
nancial statements say: "Our executive stock options 1ωt 10 years and vest after 4 years. 86 . There is no reason why a European option with a time to maturity equal to the expected life should be worth about the same as an executive stock option that can be exercised any time between 4 years and 10 years and on average is exercised after 5 years.11 this "quick and dirty" approach to valuing executive stock options has no theoretical basis. As explained in Section 12. However the results from using the quick and dirty approach are usually not too unreasonable. It means that the price of the option was valued using BlackScholes with T = 5 and σ= 20%." What does this mean? Discuss the modeling approach used by the company. We valued the options granted this year using the BlackScholes model with an expected life of 5 years and a volatility of 20%.The expected value at time T in a risk neutral world of a derivative security which pays off $100 when ST > K is therefore 100N(d2 ) Fr om risk neutral valuation the value of the security at time t is 100e.rT N(d2) Problem 12. The notes accompanying a company's B.22.
The assets underlying the option should equal the beta of the portfolio times the assets being insured.. Range forward contracts can be created by buying a put and selli吨 a call (Figure 13. . e. 87 . (This is a capital asset pricing model calculation.CHAPTER 13 Options on Stock lndices and Currencies If you have a good understanding of Chapter 12 .2 introduces range forward contracts. For American options we must arrange the tree so that on average the asset price grows at r .1b) The key material for valuation is in Section 13.) Section 13. When valuing options on currencies we set q equal to the foreign riskfree rate .4 and 13. The key point is that interest income on the foreign currency is earned in the foreign currency not the domestic currency As equations (13 11) and (13. Suppose that an exchange constructs a stock index that tracks the return .1 . These are products designed to ensure that the exchange rate applicable to a foreign currency transaction in the future lies between two levels.2).qT (see equation 13. This shows that . What is Ilωre ， the lower bounds on option prices in Chapter 9 apply with 8 0 replaced by 8 0 e. This means that the growth factor variable αis defined as e(• q)At rather than as eTAt . rf.8.3). As explained in Section 13. this chapter should prese丑t few problems. Also p叶一call parity applies with 8 0 replaced by 80e. When valuing options on stock indices we set q equal to the average dividend yield on the index during the life of the option. Make sure you understand why a currency is analogous to an asset providing a known yield.5). Explain hmηTOU would value (a) futures contracts and (b) European options on the index.1a) or buying a call and selling a put (Figure 13. The strike price should be chosen so that when the index equals the strike price the value of portfolio can be expected to be equal to the insured value. on a certain portfolio.12) show . The chapter provides some examples of how index options and foreign currency options are used and then moves on to extend the results 仕om Chapter 12 so that they can be used to value European options on indices and foreign currencies. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 13. . in c1 uding dividends .q rather than r in the riskneutral world represented by the tree. index put options can be used to provide portfolio insurance (i.qT (see equations 13.1 and 13.3. An exception is the OEX (American option on the S&P 100). then the BlackScholes formula applies for a European option with 80 replaced by 80e.qT (see equations 13 . ensure that the value of a portfolio does not fall below a certain level). Most exchangetraded options on stock indices are European. if an investment asset provides a yield at rate q . the pricing formulas for European currency options can be expressed in .
rT  8 0e.A total return index behaves like a stock paying no dividends. What is the value of a threemonth put option on the index with a strike price of 2457 In this case 8 0 = 250 .rT = 1.25 d2 = d 1 .25 .4e005x05 = 0. Futures contracts and options on total return indices should be valued using the formulωfor futures contracts and options on nondividendpaying stocks with 8 0 equal to the current value of the index.qT p = 10 + 245e 一 025x006 _ 250e0 25xO04 = 3.10. The dividend yield on the index is 4% per annum . A foreign currency is currently worth $1. T = 0.04 + 0.25 d 1 = 一一一一一一一一一一一二=一一一一一一一一. 50. 0.3旷日5 = 0.3 飞/0. r = 0.. 0. 5e一 0.0632 88 .= 0. Using putcall parity c + KerT = p + 8 0e. K = 245 .04.qT or p Substituting: = c + Ke.84 The put price is 3. K = 700 . In a riskneutral world it can be expected to g万 ow on average at the risk仕ee rate. q = 0.07 .5).rfT  K e. Lower bound for European option is 8 0 e.0868 0. r = can be valued usi鸣 equation (13.9. and c = 10. and the risk企ee rate is 6% per annum.0.04 . The risk企ee rate of interest is 7% per annum and the index provides a dividend yield of 4% per annum.06 .. Calculate a lower bound for the value of a sixmonth call option on the currency with a strike price of $1 .month European call option on the index with a strike price of 245 is currently worth $10.1 1.09/2) x 0.09xO. T = 0. Calculate the value of a threemonth European put with an exerCÍse price of 700.3 . Problem 13. Consider a stock index currently standing at 250.07 ， σ= 0. In this case 8 0 = 696 .25 and q = 0. respectively. An index currently stands at 696 and has a volati1i ty of 30% per annum. The domestic and foreign risk企eeinterest rates are 5% and 9% .069 Lower bound for American option is 80 K = 0.4 0 if it is 但) European and (b) American.5 _ 1.10 Problem 13. The option ln (696/700) + (0.84. A three. Problem 13.
p . portfo1io B becomes: K . r is the risk丘ee rate.:::: K Hence portfo1io A is worth at least as much as portfo1io B.K .qT of stock with dividends being reinvested in the stock To obtain the second half of the inequality. Show that if C is the price of an American call with exercise price K and maturity T on a stock paying a dividend yield of q. . portfo1io A is worth max(8T .5252 The value of the put . (Hint: To obtain the first half of the inequality.696e004x025 x 0 . 0) = max(8T .6 i. N(一句) = 0. Problem 13.P < 80  K e rT where 8 0 is the stock price. is given by: p = 700e0.qT . and r > O.6. Soe qT  K < C .and N(d I) = 0.q (TT) 三 K where S7 is the stock price at time T. e. + Ke叮  K) + K(e rT 1) 89 .4654 = 40. it is $40.8 T' + 8T e. Portfo1io A is worth c + K while portfo1io B is worth P + 8 0 e. consider possible va1 ues of: Portfolio A: a European call option plus an amount K invested at the risk企ee rate PO叫folio B: an American put option plus e. and P is the price of an American put on the same stock with the same strike price and exercise date . Portfo1io A is worth C 十 Ke rT .4654 . If the put option is exercised at time T (0 三 T < T) . we 且rst consider Por扩olio A: A European call option plus an amount K invested at the riskfree rate PO付'folio B: An American put option plus e吁T of stock with dividends being reinvested in the stock.07X025 x 0. consider possible values of: Portfolio C: an American call option plus an amount K e一叩 invested at the risk企ee rate PO时'folio D: a European put option plus one stock with dividends being reinv，臼 ted in the stock) Following the hint .12.5252 . If both portfo1ios are held to maturity (time T) .
Hence: 8 0 e.qT . If both portfolios are held to maturity (time T) .rT 三 p+ 8 0 Since p or ::二 P: C 十 Ke.8 T .Portfolio B is worth max(8T . Because portfolio A is worth at least as much as portfolio B in all circumstances p + 8 0 e. For the second part consider: Por矿"olío C: An American call option plus an amount K e. K) while portfolio D is worth max(K . K). 0) = max(8T . K) + 8Te qT + 8T(e qT . Since portfolio D is worth at least as much as portfolio C in all circumstances: C 十 Ke.qT  K 三 cP This proves the 且rst part of the inequality.K 三.γ (TT) < 8 T :::三 8T p + 8 Té(Tt) Hence portfolio D is worth more than portfolio C. If the call option is exercised at time T (0 三 T < T) portfolio C becomes: 8r while portfolio D is worth  K + Ke.qT ::二 C 十 K Because c < or c: P+80 e.P 三 80 _ Ke.cP::二 80 _ Ke. portfolio C is worth max(8T .rT invested at the risk仕ee rate Por旷"olío D: A European put option plus one stock with dividends being reinvested in the stock. Hence portfolio A is worth more than portfolio B.rT This proves the second part of the inequality.rT 90 . Portfolio C is worth C 十 K e rT while portfolio D is worth p 十 80.qT 三C十K 8 0 e.1) Hence portfolio D is worth at least as much as portfolio C.rT 三 P 十 80 c .
Problem 13.rT The resu1t that c = p when K = Fo Problem 13.rT = p . what options should be purchased to provide protection against the value of the portfolio falling below $54 m il1ion in one year's time? If the va1ue of the portfolio mirrors the value of the index . the index can be expected to have dropped by 10% when the va1ue of the portfolio drops by 10%. there exists systematic and unsystematic risk in the returns 仕om an individual stock. = Fo + Foe. As beta increωes ， the volatility of the portfo1io increases causing the cost of the put option to increase. is true for options on all under1ying assets . This is because some risk (i. unsystematic risk has been diversified away and on1y the systematic risk contributes to volatility. . in a stock index . 8 0 .80 e. )T If K this reduces to c = p.14. The v01atility of a stock index can be expected to be 1ess than the v01atility of a typical stock. Hence when the 91 . This is because portfolio insurance inv01ves the purchase of a put option on the portfolio.. However . An at噜 the. Would you expect the volatility of a stock index to be greater or less than the volatility of a typical stock? Explain your answer.16.rT =p 斗.15. e. This follows 仕om putcall parity and the and the spot price . The cost of portfolio insurance increases as the beta of the portfolio increases.r fT and so that Fo = 8 0 e(rr C 十 K e. In capita1 asset pricing mode1 termin010gy. Problem 13. not just options on currencies. Does the cost of portfolio insurance increase or decrease as the beta of a portfolio increases? Explain your answer. When index options are used to provide portfolio insurance . Show that a European call option on a currency has the same price as the corrφ sponding European put option on the currency when the fon再rard price equals the strike pnce.13. Suppose that a portfo1io is worth $60 m il1ion and the S&P 500 is at 1200. re1atio丑ship 、 between the forward price ，岛， c+ Ke. both the number of options required and the strike price increase as beta increases.Problem 13. return uncertainty) is diversified away when a portfolio of stocks is created. If the value of the portfo1io mirrors the value of the index.money option is 仕 equent1y defined as one where K = Fo (or c = p) rather than one where K = 8 0 .
Each option contract is for $100 times the index. The options should be on: 60. The payoff 仕om the put options is (1152.16. Consider again the situation in Problem 13. when the portfolio provides a return 12% below the risk仕ee interest rate .16. To check that the answer is correct consider what happens when the value of the portfolio declines by 20% to $48 mi1lion.000 contracts) should be purchased. the market' s expected return is 6% below the risk仕ee interest rate.000 (or 1. Hence options on $100 . Problem 13. Hence European put options should be purchased with an exercise price of 1152. the expected movement in the index is . this is also the excess expected return (including dividends) 仕om the index. Hence 500 contracts should be purchased.17. This indicates that put options with an exercise price of 1080 should be purchased. Suppose that the portfolio has a beta of 2. The number of options required is twice the number required in Problem 13. According to the capital asset pricing model: Excess expected return of portfolio above riskless interest rate =ßx n. 92 .0. This is 22% less than the riskfree interest rate.1092) x 100 . Thus when the portfolio's value is $54 million the expected value of the index 0. As the index can be assumed to have a beta of 1. The expected return from the index is therefore 1% per annum. What options should be purchased to provide protection against the value of the portfolio fa1ling below $54 mil1ion in one year's time? When the value of the portfolio falls to $54 million the holder of the portfolio makes a capitalloss of 10%. This is exactly what is required to restore the value of the portfolio to $54 million. 000 = $6 million. i. After dividends are taken into account the loss is 7% during the year.. a return of 6%.4%.e. 0 .96 x 1200 = 1152.value of the portfolio drops to $54 million the value of the index can be expected to be 1080. and the dividend yield on both the portfolio and the index is 3% per annum. Their maturity date should be in one year. Since the index provides a 3% per annum dividend yield . The index can therefore be expected to drop by 9% to 1092. This is because we wish to protect a portfolio which is twice as sensitive to changes in market conditions as the portfolio in Problem 13.000 一」一一」一一= $50 、 000 1200 times the index. The index can be expected to provide a return (including dividends) which is 11% less than the risk仕ee interest rate .000. Excess expected return of market above riskless interest rate Therefore .16. the risk企ee interest rate is 5% per annum . The return including dividends is 17%. This is 12% below the risk仕 ee interest rate.
5. the contract must on average give zero pro缸 in a risk咀 eutral world. What happens if you exercise when the October futures price is $3807 An amount (400 .1) . It turns out that a futures price can be treated like an asset that provides a yield equal to the riskfree rate . Each contract is for the delivery of 100 ounces. Hence its expected growth rate in a riskneutral world must be zero. The exerciser also obtains a long futures contract.380) x 100 = $2 . A put futures option is the right to enter into a short futures contract by a future date. (See Examples 14. when a binomial tree is constructed for futures options ， α= 1.K where F is the most recent settlement futures price and K is the strike price. a European option on a forward price has the same price as a regular European option on the spot price of an asset when the forward contract and the option expire at the same time. and binomial trees for valui鸣 American futures options (equations 14. (See Example 14. 000 is added to your margin account and you acquire a short futures position giving you the right to sell 100 ounces of gold in October.6) are all exactly the same as in Chapter 13 except that we set q = γ.8.) SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 14. When the value ofthe futures contract is taken into account the payoff on a call is the excess of the futures price at the time of exercise over the strike price and the payoff on a put is the excess of the strike price over the futures price at the time of exercise. In particular . because it costs nothing to enter into a futures contract . A European option on a futures has the same price as a regular European option on the spot price of an asset when the futures contract and the option expire at the same time. This is the same as the expected growth rate for an asset providing a yield at rate r. Suppose you buy a put option contract on October gold futures with a strike price of $400 per ounce.7 and 14. r.3 and 14. The cash payoff when the option is exercised is K .F. 吗， putcall parity for futures op啕 tions (equation 14.5 and 14. As a result Black's model can be (and frequently is) used to value a European option on the spot price of an asset in terms the the futures or forward price of the underlying asset. The equations to value European options on futures are known as Black's model.8) . Similarly. The exerciser also obtains a short futures contract. This position is marked to market in the usual way until you choose to close it out. The cash payoff when the option is exercised is F .CHAPTER14 Futures Options The first part of this chapter describes how futures options work.2). 93 . pricing formulas for European futures options (equations 14. A call futures option is the right to enter into a long futures contract by a certain future date. Bounds for futures options (equations 14. The reason is that .1 and 14.
Problem 14.9. Suppose you sell a call option contract on April 1i ve cattle futures with a strike price of 70 cents per pound. Each contract is for the delivery of 40,000 pounds. What happens if the contract is exercised when the futures price is 75 cents? In this case an amount (0.75 , 0.70) x 40 , 000 = $2 , 000 is subtracted 齿。m your margin account and you acquire a short position in a live cattle futures contract to sell 40 ,000 pounds of cattle in April. This position is marked to marked in the usual way until you choose to close it out. Problem 14.10. Consider a twomonth call futures option with a strike price of 40 when the riskfree interest rate is 10% per annum. The current futures price is 47. What is a lower bound for the value of the futures option if it is 但.) European and (b) American? Lower bound if option is European is
(Fo  K)e rT = (47  40)eOlX2/12 = 6.88
Lower bound if option is American is
Fo  K = 7
Problem 14.1 1. Consider a fourmonth put futures option with a strike price of 50 when the risk.企ee interest rate is 10% per annum. The current futures price is 47. What is a lower bound for the value of the futures option if it is (a) European and (b) American? Lower bound if option is European is
(K  Fo)e rT = (50  47)e一 o lx4/12 = 2.90
Lower bound if option is American is
K  Fo = 3
Problem 14.12. A futures price is currently 60. It is known that over each of the next two thre令 month periods it wi11 either rise by 10% or fall by 10%. The risk企ee interest rate is 8% per annum. What is the value of a sixmonth European call option on the futures with a strike price of 60? If the call were American , would it ever be worth exercising it early? In this case the riskneutral probability of an up move is
一一一一一 =0.5
1 0.9 1. 1 , 0.9
94
In the tree shown in Figure 814.1 the middle number at each node is the price of the European option and the lower number is the price of the American option. The tree shows
72.6000 12.6000 12.6000 59 .4 000. 0.0 0.0 0. 0.0 0. 0 0.
60..0000 3..0265 3.0265
4 8..6000 0..0000 00 0.0. 0
Figure
814.1τ'ree
to evaluate European and American call options in Problem 14.12.
Problem 14.13. In Problem 14.12 what is the value of a sixmonth European put option on futures with a strike príce of 607 If the put were Amerícan , would ít ever be worth exercising ít early7 Verí命 that the call príces calculated ín Problem 14.12 and the put príces calculated here satís命 putcall parity relationships. In this case the riskneutral probability of an up move is
一一一一一 =0.5
1 ._ 0.9 1. 1  0.9
The tree in Figure 814.2 shows that the price of the European option is 3.0265 whi1e the price of the American option is 3.0847. Using the result in the previous problem
c + Ke rT
= 3.0265 十 60e
004
= 60.6739
Fr om this problem
p + Foe rT
= 3.0265 + 60e 一 004 = 60.6739
This veri且es that the putcall parity relationship in equation (14.1) holds for the European option prices. For the American option prices we have:
c
P = 0.0582;
Foe rT

K = 2.353;
Fo  Ke rT = 2.353
satis自ed
The put.call inequalities for American options in equation (14.2) are therefore
95
72.6000 0.0000 0 0000
,
60 叶 0000
3., 0265 3.0847
59 4000 0 , 6000 0. 6000
, ,
48.6000 114000 11 .4000
Figure
814.2
听ee
to evaluate European and American put options in Problem 14.13.
Problem 14.14. A futures price is currently 25, its volatility is 30% per annum , and the riskfree interest rate is 10% per annum. What is the va1 ue of a nin e month European call on the futures with a strike price of 267 In this case Fo
= 25 , K = 26 ， σ= 0.3 , r = 0.1 , T = 0.75
1= 一一一一，
ln(Fo/K) + σ2T/2 .   1σ 飞/T
=
,.0.0211
2= 一一一一一一一一一一=
σ飞/T
ln(Fo/ K) 一 σ2T/2
0.2809
c = e 0075 [25N( 0.0211)  26N( 0.2809)]
= e O, 075[25
x 0 .4916 一 26 x 0.3894] = 2.01
Problem 14.15. A futures price is currently 70 , its volatility is 20% per annum , and the risk企ee interest rate is 6% per annum. What is the value of a fìve month European put on the futures with a strike price of 657 In this case Fo
= 70, K = 65 ，
σ=
0.2 , r
= 0.06 , T = 0.4167
0.6386
1= 一一一一节E一一一一=
σ 飞IT
ln(Fo/K) + σ2T/2
d? = ln(Fo/ K) 二 σ2T/2
σ飞/T
?一
一一=
0.5095
p=e一 o 025 [65N( ， 0.5095) 一 70N( 0.6386)]
= e 0025 [65 x 0.3052  70 x 0.2615] = 1ω5
96
A thre montb American call futures option with a strike price of 28 is worth 4. Suppose tbat a futures price is currently 30. we buy the asset for 34 and close out the futures position.P must lie between 30e005X3/12 . A oneyear European cal1 option and a oneyear European put option on the futures witb a strike price of 34 are botb priced at 2 in tbe market. short one put and short a futures contract. C .37 97 . The put price is erT[KN(一也) .34 = 1. In this case C 十 Ke. The risk. The gain on the short futures position is 35 .rT = 2 十 34e一 o lxl = 32. In either case . Calculate bounds for tbe price of a tbreemontb American put futures option with a strike price of 28. 63 = 2. The risk企ee interest rate is 10% per annum.28 and 30 .N(x) for all ♂ the put price can also be written erT[K . • Fr om equation (14.67 p 十 Foe.2) .P < 2.28e005x3/12 = 1.17.16.企ee interest rate is 5% per annum.35 or 1. Problem 14.FoN( d 1 )] Because N(x) = 1.76 = 2 + 35e一o lxl = 33. Identi命 an arbitrage opportunity.KN(d 2 )] This result can also be proved 仕om putcall parity showing that it is not model dependent. 63 < 4 .KN(d2 ) 一月十 FoN(dd] Because Fo =K this is the same as the call price: e." Explain wby this statement is true. This costs nothing up 仕0丑t.Problem 14.18. In one year .rT Putcall parity shows that we should buy one call . Suppose tbat a oneyear futures price is currently 35. 65 < P < 2.35 Because C = 4 we must have 1. "Tbe price of an atthe田money European call futures option always equals tbe price of a similar atth萨money European put futures option. Problem 14.rT [FoN(d 1 ) . either we exercise the call or the put is exercised against us.
) In this case we consider Portfolio A: A European call option on futures plus an amount K invested at the risk仕ee interest rate PO付folio B: An American put option on futures plus an amount Foe. portfolio B is worth K . 十 FT Fo + Foer(TT) c+ Ke rT Fo < K Portfolio A is worth at time T where FT is the futures price at time ::三 K Hence Portfolio A more than Portfolio B.K e.K < C . 0) +. Following the arguments in Chapter 5 we will treat all futures contracts as forward contracts.Problem 14.P < Fo . Assume that r > 0 and that there is no difference between forward and futures contracts.1) Portfolio B is worth max(K .P 98 .12. If the put option is exercised at time T (0 三 T < T) . Show that if C is the price of an American call option on a futures contract when the strike price is K and the maturity is T .Fo = max( FT .rT .K .rT < C+K or Foe.FT =K + Foe.Ke rT =max(FT . K) + K(e rT . Portfolio A is worth max(FT . If both portfolios are held to maturity (time T) .19. 0) 十月十 FT . (Hint: Use an an a1ogous approach to that indicated for Problem 13. Because portfolio A is worth more than portfolio B in all circumstances: P 十 Foer(Tt) < c+K Because c < C it follows that P 十 Foe.rT . Foe. Portfolio A is worth c 十 K while portfolio B is worth P 卡 Foe.FT .rT where Fo is the futures price and r is the risk企ee rate.rT invested at the risk仕ee interest rate plus a long futures contract maturing at time T.K < C.T'(TT) T. K) Hence portfolio A is worth more than portfolio B.rT . and P is the price of an American put on the same futures contract with the same strike price and exercise date .
If the call option is exercised at time T (0 :::. It can therefore be valued using equation (14.244. 99 .04 ， σ= 0. FT) Hence portfolio D is worth more than portfolio C.K e has therefore been proved.rT invested at the risk唱 free interest rate Portfolio D: A European put futures option plus an amount Fo invested at the riskfree interest rate plus a long futures contract.P < Fo. K) while portfolio D is worth max(K . This has the same value as a three.month European call option on the spot price of silver.20.rT This proves the second part of the inequality. Problem 14. The value is 0. If both portfolios are held to maturity (time T) . T < T) portfolio C becomes: Fr . The threemonth futures price is $12.1) >max(K. the risk企ee rate is 4% .month call option on silver futures where the futures contract expires in three months. Portfolio C is worth C + K e. the strike price is $13.25.rT < p 十 Fo < P+Fo it follows that C 十 Ke. FT) 十月 (e rT .rT Foe.rT while portfolio D is worth p 十 Fo. and the volati1i ty of the price of silver is 25%.This proves the first part of the inequality. Calculate the price of a three. 0) 十 Foe rT 斗 FTFO =max(K .FT .7) with Fo = 12 . For the second part of the inequality consider: PO时Jolio C: An American call futures option plus an amount K e.Ke.25 and T = 0. K = 13 .rT or C .P < Fo .K while portfo1io D is worth + Ker(Tr) < Fr p + Foer 'T' + Fr 一凡 = p+ Fo(e rr 1) + Fr 三瓦 Hence portfolio D is worth more than portfolio C. Because portfolio D is worth more than portfo1io C in all circumstances C Because p 三 P + Ke. r = 0. portfo1io C is worth max(FT . The result: rT 一 K < C .
2 and 15. This is the rate of change of the value of the trader's portfolio with respect to the market variable.7 illustrates how gamma risk arises. In fact it moves from 0 to 0". The trader can make delta zero by doing a trade in the underlying asset. Taking a position in the underlying asset has no impact on gamma and ve 100 . 9 1. Figure 15. Suppose for example that the trader responsible for the sterlingdollar exchange rate hω a portfolio with a delta of 100 .g the sterlingdollar exchange rate). The value of the option is assumed to move 仕om 0 to 0' when delta hedging is used. You should study these tables carefully and make sure you understand them. The most important Greek letter t hat is delta.3 provide examples of how a trader with a portfolio consisting of a single option might fare if the portfolio is rebalanced . Delta hedging provides protection against small changes in the underlying variable. The process of bringing delta to zero at regular intervals is known as delta hedging. It makes their portfolios relatively insensitive to small changes in the underlying market variable (the dollarsterling exchange rate in our example).000 pounds sterling. The chapter covers the approaches used by the trader to manage risk. Gamma is defined as the rate of change of delta with respect to the underlying variable. every week. Gamma measures a trader's exposure to large jumps. Tables 15. It underlies the no arbitrage argument for pncl丑g options. 90 to 1. Both gamma and vega can be changed only by taking a positio卫 in an option. The trader must monitor a number of risk measures (位∞wr1 邸 "咆 此 let ters "η a丑 kαI 丑 as Greek 忱町 矿，丁) 王 叫 C try to ensure 由创， they remain within reasonable bounds. This is known as rebalancing the portfolio. This means that the portfolio increases in value by 100 . Vega measures the sensitivity of a portfolio to changes in volatility. 000 x 0. 90. Delta can be changed to zero by buying 100 .CHAPTER 15 The Greek Letters This chapter considers a trader working as an options market maker at a bank or at an exchange.000 when the exchange rate is 1.01 = $1000 when the exchange rate increases 仕om 1. Option traders usually make their portfolios delta neutral (or close to delta neutral) as a matter of course at the end of each day. A portfolio with a delta of zero is known as a deltaneutral portfolio. bringing delta to zero . The trader is responsible for trading financial instruments that depend on one particular market variable (e.
1ßt. (This is the buy high selllow strategy referred to in the text. in present value terms .money options have the most negative thetas. Suppose that a stock price is currently $20 and that a call option with an exercise price of $25 is created synthetically using a continually changing position in the stock. A trader who feels that neither the stock price nor its implied volatility will change should write an option with as high a negative theta as possible. This means that the expected number of times the stock will be bought or sold is approximately 40.1 means that if ßt units of time pass with no change in either the stock price or its volatility. The strategy costs the trader 0.13 the creation of a synthetic put option on a portfolio of stocks involves buying stocks (or index futures) just after a price rise and selling stocks (or index futures) just after a price fall. A trader who has written the option plans to use a stoploss strategy. Which scenario would make the synthetically created option more expensive? Explain your answer.10 each time the stock is bought or sold. The total expected cost of the strategy. Hence the stock is bought just after the price has risen and sold just after the price has fallen. if too many portfolio managers are attempting to create put options synthetically at the same time .90. Consider the following two scenarios: a. Problem 15. what type of option position is appropriate? A theta of 0. b.Scholes price of an outoι th←money call option with an exercise price of $40 is $4.10 and to sell at $39. not the real world. The buy and sell transactions can take place at any time during the life of the option. the strategy may not produce the desired results. Also the estimate is of the number of times the stock is bought or sold in the riskneutral world . The expected number of times it will be bought is approximately 20 and the expected number of times it will be sold is also approximately 20. The holding of the stock at any given time must be N(dd. the value of the option declines by 0.1 when time is measured in years? If a trader feels that neither a stock price nor its implied volatility wil1 change. Stock price oscillates wildly. The Black.) 1丑 the 直rst scenario the stock is continually 101 . Estimate the expected number of times the stock wil1 be bought or sold. The trader's plan ís to buyat $40.9. ending up at $35.explained in Section 15. must be $4. Stock price increases steadily 企om $20 ω $35 during the life of the option. As traders found in October 1987. What does it mean to assert that the theta of an option position is 0. The above numbers are therefore only approximately correct because of the effects of discounting. Relatively shortlife atthe.8. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 15. Problem 15.10.
the cost of an option that is created synthetically is not known up 仕ont and depends on the volatility actually encountered. what initial position in ninφmonth silver futures is necessary for delta hedging? If si1ver itself is used. Problern 15. The current nin emonth futures price is $8 per ounce. Problern 15. (This is because silver can be treated i丑 the same way as a nondividendpaying stock when there are no storage costs. sell. In second scenario the stock is bought .12X075 1.18 . sell .11 . and the volatility of si1ver is 18% per annum. buy. what is the initial position? Assume no storage costs for silver. T 「一一一 = 0. the risk企ee interest rate is 12% per annum. buy. etc. K = 8. situation clearly leads to higher costs than the buy.1 1. The futures delta of a ninemonth futures contract to buy one ounce of silver is by definition 1. The spot delta of a ninemonth futures contract is eO. r = 0. what is the initial position? If onφyear silver futures are used.6667 0.12 ， ln (8/8) σ= 0. The delta of a European futures call option is usually defined as the rate of change of the option price with respect to the futures price (not the spot price). The buy.6667 一一一一= 1= 一一一一一一一 + (0.4886 The delta of a short position in 1 . Whereas the cost of an option that is purchased is known up 仕ont and depends on the forecasted volatility.12.rT N(d I) In this case Fo = 8. Fo = Soe rT so that the spot delta is the 102 . buy.6 ounces is necessary to hedge the option position. In Problem 15. the latter will be referred to as the spot delta.bought..18 2 /2) X0. Hence ，仕om the answer to Problem 15.11 .. This problem emphasizes one disadvantage of creating options synthetically. The former will be referred to as the futures delta.000 European call options on si1ver 且ltures? The options mature in eight months. 0.5293 and the delta of the option is 已 0 12x06667 X 0. situation.5293 = 0. What is the delta of a short position in 1. sold .000 futures options is therefore 488.6667 0. 094 assuming no storage costs. In order to answer this problem it is important to distinguish between the rate of change of the option with respect to the futures price and the rate of change of its price with respect to the spot price. It is e. a long position in ninemonth futures on 488. the exercise price of the options is $8.0735 N(d 1 ) = 0. The 且nal holding is the same in both scenarios. and the futures contract underlying the option matures in nine months..6.18 飞/0.. bought again . sold again .
5833 ln (0.80 . vega. A virtually constant spot rate b. Interpret eacb number.80 cent per yen .8 .08 . Hence the hedger will fare better in case (b).0130 N(d 1 ) = 0.8 .5405 = 0.5250.05 ， σ= X 0.5833 = 0. Hence a long position in e. A short position in either a put or a call option has a negative gamma.012 x 534.13 for a B. when gamma is positive the hedger gains from a large change in the stock price and loses 仕om a small change in the stock price.1 ounces of oneyear silver fut山es is necessary to hedge the option position.81 ， γ= 0. r f = 0. Fr om Figure 15. The delta of one call option is er N(d2) = 0. Nf(d1)=Ledi/2:Leooom=0. 1275.1016 d2 = d 1 一 0. A company uses delta hedging to hedge a portfo1io of long positions in put and call options on a currency. Hence the hedger will fare better in case (a). nancial institution's position.15而页页=一 0.6. when gamma is negative the hedger gains from a small change in the stock price and loses 仕om a large change in the stock price.nancial institution has just sold 1.15 2/2) 0. the risk企ee interest rate in Japan is 5% per annm刀 ， and the volatility of the yen is 15% per annum. T = 0.3969 d石 d王 103 . Fr om Figure 15. Which of the following would give the most favorable result? a. Problem 15. Problem 15.year silver futures contract to buy one ounce of silver is eO. A long position in either a put or a call option has a positive gamma. W i1 d movements in the spot rate Explain your answer. The spot delta of a one. Calculate the delta .080.4998 .80/0. K = 0. 094 = 534.14.5405. the exercise price is 0. the risk企ee interest ratθ in the United States is 8% per annum. In this case 8 0 = 0. A B.futures delta times erT ) Hence the spot delta of the option position is 488. and rbo of the B. Thus a long position in 534. tbeta . Suppose that thθ spot exchange rate is 0.6 x 1. gamma.6 = 474.000 sevenmonth European call options on the Japanese yen. Problem 15.15 .81) + (0. Repeat Problem 15.5833 一 d1 = 一一一一一一一一一一一一一一一 0. nancial institution with a portfolio of short positions in put and call options on a currency.81 cent per yen .15vO.05+0.13.T N(d I) = e005X05833 X 0. 12 = 1.15.6 ounces of silver is necessary to hedge the option posítion.
q are the parameters for another optio丑. Under what circumstances is it possible to make a European option on a stock index both gamma neutral and vega neutral by adding a position in one other European option? Assume that 8 0 .525 times that amount. the delta increases by 4.81 x 0.9713 .rlT 2 飞/T 一 r.::. Suppose that d 1 has its usual meaning and is calculated on the basis of the first set of parameters while di is the value of d1 calculated 104 . when the volatility (measured in decimal form) increases by a small amount .0.206 times that amount.16. Vega can be interpreted as meaning that .8 x 0.rJT = 0.4948 = .0. when a small amount of time (measured in years) passes .3969 x 0.000109.2231 times that amount. Problem 15.5405 x 0. In particular when one calendar day passes it decreases by 0.::.9713 一一一一= 4.01) the opti∞ price increases by 0.9713 x 0. r ， σ ， T . the option's value increases by 0.01) .5833 The vega of one call option is 80 )于N'(dI) e.15 x 0.0399 times that amount.206 0.9713 = 0. K .rfT 80σ V'T 0.rT N(d 2 ) 0.2355 The theta of one call option is 80 N'(d 1 )σe. When the interest rate increases by 1% (= 0.3969 x 0.9544 x 0.3969 x 0. Finally. K* 斤， σ ， T* .80 x 0. when the spot price increases by a small amount (measured in cents) .2355 times that amount. rho can be interpreted as meaning that .08 x 0.so that the gamma of one call option is N '(d 1 )e.002355. Gamma can be interpreted as meaning that . the value of an option to buy one yen increases by 0. when the spot price increases by a small amount (measured in cents) . 一一 + rj80 N(d I) e.80 vo. when the interest rate (measured in decimal form) increases by a small amount the option's value increases by 0.05 民 u q 一 一 一 一 ， " ， E /MVqO Nm飞/ 吃 J 3 1 i × 但 队 × AU Q υ U V 同 A 丛I A 吐 × 。 U 蚀 A A QU 哇 。 。 白 ， " Delta can be interpreted as meaning that . the options value increases by 0. the option's value decreases by 0.0399/365 = 0.0399 The rho of one call option is T 啊 同 ZAOO A 」 … 矿 ， + 0.页页 x 0. q are the parameters for the option held and 8 0 .00223 1.15 x 飞/0. When volatility increases by 1% (= 0.8 x 0. Theta can be interpreted as meaning that .rjT 2)日苟言  rKe.
a. Problem 15.q (T) 十 ω8o #N' (di)eq(T* Since we require vega to be zero: 在 Equating the two expressions for w T* =T Hence the maturity of the option held must equal the maturity of the option used for hedging. A 且md manager has a ，再relldiversifìed portfolio that mirrors the performance of the S&P 500 and is worth $360 mil1ion. If the fund manager decides to provide insurance by using nin month index futures . 105 . and show that they lead to the same result.200.on the basis of the second set of parameters. The risk企ee interest rate is 6% per annum. When the value of the portfolio falls by 5% (to $342 million) . If the fund manager decides to provide insurance by keeping part of the portfolio in riskfree securities . and the volatility of the index is 30% per annum. what should the initial position be? d.000 times the value of the index. Explain carefully alternative strategies open to the fund manager involving traded European call options .17. the value of the S&P 500 also falls by 5% to 1140. Suppose further that W of the second option are held for each of the first option held. how much would the insurance cost? b. The dividend yield on both the portfolio and the S&P 500 is 3%. and the portfolio manager would like to buy insurance against a reduction of more than 5% in the value of the portfolio over the next six months. If the fund manager buys traded European put options . what should the initia1 position be? • The fund is worth $300 . The value of the S&P 500 is 1. c. The gamma of the portfolio is: α [~r (d1)eι1 川叫 呐 1 气 F (付仙 岛叫 SOσ J 于，♂ 8o~v'T* where αis the number of the first option held. Since we require gamma to be zero: … m 一 m 巾 r The vega of the portfolio is: α [80 FTN' (d 1 )e.
Soe.1) =e 一 003X05(0.3飞/0.o~ 二 0.3 而王= 0. Hence: d = 旦旦00/1140) 十 (o.3327  1] . . 3) Invest the remaining cash at the risk.free interest rate of 6% per annum.rT This shows that a put option can be created by selling (or shorti鸣) e 一 qT of the index .6622 This indicates that 33. N( d 1 ) = 0. 000 (b) Fr om putcall parity X X 1200e.27% of the portfolio (i.40 = $19 .2064 N(d 1 ) = 0.3 2 /2) X 05=04186 0. $119.qT [N(d 1 ) 一 0. r = 0.3378.77 million) should be initially sold and invested in riskfree securities. K = 1140 .6622.64 million of stock 2) Buy call options on 300 .4182 . the fund manager should: 1) Sell 360e 一 o 03x05 = $354.5 d2 = d 1 一 0.06 ， σ= 0. buying a call option and investing the remainder at the risk击ee rate of interest.03 1 + 0.000 times the S&P 500 with exercise price 1140 and maturity in six months.50 and q = 0. (a) 8 0 = 1200 .rT N(d 2 ) =1140e006x05 =63.qT N(d 1 ) 0.30 . e.0 03xO 5 X 0. 000 8 0e.3378  63. N(d 2 ) = 0.40 The total cost of the insurance is therefore 300 . T = 0.1200e. This strategy gives the same result as buying put options directly. 106 .qT or: + p = c + Ke.qT + Ke.03.4182 The value of one put option is 1140e. Applying this to the situation under consideration .5818 N( d 2 ) = 0. ( c) The delta of one put option is e.rT p = c . 020 .The fund manager therefore requires European put options on 300 .000 times the S&P 500 with exercise price 1140.
e. 023 The spot short position required is 119 啕 770 ‘ 000 .e. in the six months is 一5 十 2 = 3% per annum. i. When the value of the portfolio goes down 5% in six months .17 on the assumption that the portfolio has a beta of 1.3836. = 99 同 808 1200 times the index.0. i. we would expect the market to provide a return of 2% per annum. (a) 8 0 = 1200. Hence ln (1200/1170) 十 (0. Problem 15.5.0840 N(d 1 ) = 0. ，一 6% d 2 = d 1 … 0.18.06 ， σ= 0.03.6164.5 and q = 0.3836 107 .4 665 .5% per six months. we would expect the market index to have dropped at the rate of 5% per annum or 2.03 + 0. " " . Assume that the dividend yield on the portfolio is 4% per annum.4665 Ke.qT N(d 1 ) =1170e006X05 X 0 . T = 0. A total of 450 .06 . N( d 1 ) = 0.( d) The delta of a ninemonth index futures contract is e(rq)T = eO. we would expect the market to have dropped to 1170. The value of one put option is N(d 2 ) = 0. . 000 = (1.1200e 一 003x05 =76.03X075 = 1.3而王= 0.28 X 0... Repeat Problem 15. . 5 x 300 . Since the portfolio has a beta of 1.3 飞/0.5335 N( d 2 ) = 0.Soe. This is 12% per annum 1ess than the riskfree interest rate. e. Hence a short position in 9 轧 创 GOqL 一 ny 一 vhU 一 qo nu AU 一α 归 一 × 一 咱E 4 futures contracts is required.09/2) X 0. Since dividends on the market index are 3% per annum ..rT N( d 2 ) .3 . including dividends .5 d1 = 一一 一一 f?T 一一一一一一一= 0..2961 0.5 i. . the total return from the portfolio . 5 we would expect the market to provide a return of 8% per annum 1ess than the riskfree interest rate . K = 1170 ， γ= 0. 000) put options on the S&P 500 with exercise price 1170 and exercise date in six months are therefore required.
Problem 15.3517 / .19. 000 X 0.0.× U A吁 中 3 约 U index futures contracts. $127.5 d1 =一一一一一一τ=一一一 I = 0. .45 飞/0. K = 342 .1) =e. 000 Note that this is sig日i丑cantly X 76.O 03X05(0.0. Show by substituti鸣 for the various terms in equation (15 .45 . T = 0.qT (N(d t) . (c) The portfolio is 50% more volatile than the S&P 500. r = 0.06 ， σ= 0 . The delta of each put option is e. (b) As i丑 Problem 15.17.The total cost of the insurance is therefore 450 . 000.17 the fund manager can 1) sell $354.8 million) should be sold and invested in riskless securities.3779 The delta of the total position required in put options is 450 .6164 .64 million of stock.04 ln (360/342) 十 (0.17) 1.452/2)xO.5 N(d 1 ) = 0.5% of the portfolio (i. (d) We now return to the situation considered in (a) where put options on the index are required. 2) buy call options on 450 . 023.4) that the equation is true for: a.04 + 0 . A single European put option on a nondividend啕paying stock 108 .3779 170 .28 = $34 .叫 d5一 月 1 / 『 、 l L 唱 川 ' A 吨 5 0 B .1) = .6374 The delta of the option is 一 一 一 一 0 q d p AXVO ee. A single European call option on a nondividendpaying stock b.06 .000 times the S&P 500 with exercise price 1170 and exercise date in six months and 3) invest the remaining cash at the risk仕ee interest rate. e. When the insurance is considered as an option on the portfolio the parameters are as follows: 8 0 360 . 000 greater than the cost of the insurance in Problem 15. 0 . The delta of a nine month index futures is (see Problem 15.5 and q = 0. Hence a short position in 『 队 izu 。 ω t 一 民 no 一 二 .• U ， ， A 配 叫 、 14 、 ， ， / 、 、 This indicates that 35. 326 .
rKe.20. use the DerivaGem software to calculate the value of the stock or futures contracts that the administrators of the portfolio insurance schemes will attempt to sell if the market falls by 23% in a single day.rT .' .JT 2飞 7\ Tf J \ 7\ Tf /1' ~ v  \  i / ' V =r[80 N(d I) . N(d __T/ 7\ Tf .\ 2 ) 后 (J .2 . Any portfolio of European put and call options on a nondividendpaying stock ( a) For a call option on a no坠 dividendpayi吨 stock ~ = N(d I) N'(d I) 8 0 (J ff 8 N'(d 1 ) 8= 一 0 ~σ . 2τ王一 7\ Tf \ .rT N(d 2 ) =rII  8 0 N( d 1 月 (c) For a portfolio of options ，日， ~， 8 and r are the sums of their values for the individual options in the portfolio. Problem 15.7) is: _rT 一 SoN'(d 1 ) σ 十 rKe. 8uppose that $70 billion of equity assets are the subject of portfolio insurance schemes.2 ) 十 γ80 N(d 1 \) 十一 σ80 一言一 届 σ __ T/' _rT N(d / .rT .. v =r[K e.1 \ 2飞 /T ~/  __0 . 1_0 N'(d r80 N(d 1 ) 十一 σ80 一.7) is: __0 _1 .1 \ 'V i/ . 1 _ 0 N'(d 1 ) =一 8 0 N'(d I)(J .\.JT1 ) . Making whatever estimates you 丘nd necessary.c..rKe.rT N(d 2 ) 2 飞/T r= Hence the lefthand side of equation (15.rT N( d 2 ) 2vT Hence the lefthand side of eql川ion (15. It follows that equation (15.Ke 一叮 N(d 2 月 =rII (b) For a put option on a nondividendpayi吨 stock ~=N(dl)l 二 N(d 1 ) r 。 =  80σ VT ~ldl) 8 0 N'(d 1 ) ~σ+γK e.7) is true for a町 portfolio of European put and call options. 109 . Assume that the schemes are designed to provide insurance against the value of the assets de c1íning by more than 5% within one year..
8._.06 ， σ= 0. T = 1. r = 0. The delta of the forward contract is therefore e.03 十 0.25 2 /2) 1 =一一一一一 一一一一一一一一一=一。，， 5953 0. Given the daily settlement procedures in futures contracts . before the 23% decline .. 8 . / _. 、 、 l j 4 This shows that 3 1. The delta of the futures contract is therefore e(rq)T.25 N(d 1 ) = 0.6. The sales measured at precrash prices are about $27.2 /2) 0.5 . The futures price is 80 e(γ q)T When there is a small change .qT Ke. Problern 15.9 .0. = 0 . 8 ，丑 80 the value of the forward contract changes by e.6. _. d .8 billion. Then: d 1 =!叫 70/66._.0.. 8e(r. =!叫53.2 1. At post crash prices they are about 20. 110 . Does a forward contract on a stock index have the same delta as the corresponding futures contract? Explain your answer.We can regard the position of a11 portfolio insurers taken together as a single put option. These numbers can also be produced 仕om DerivaGem by selecting Underlying Type and Index and Option Type as Analytic European.rT . T = 1. K = 66. We conclude that the deltas of a futures and forward contract are 丑ot the same.03.5 . K = 66.6737 The delta of the option is ρ U P 一 一 U J ftG3 吁α 月 ' 也 一 P 川 。 仆 0 6 、 17 7 / 1 1 一 一 一 一  / 1 β 7 叮 J 、 才 i 一 1 . The three known parameters of the option .03.06. 8 0 = 53.qT .q)T. are 8 0 = 70 .0.5) 十 (0.25 .25 N(d 1 ) = 0.4 502 . in 8 0 the futures price changes by . .qT .6.25 and q = 0. ._.9/66. When there is a small change . The delta of the futures is greater than the delta of the corresponding forward by a factor of erT .0 billion.03 + 0._.5) 十 (0. An additional 38.06 ._.7028 This shows that cumulatively 70.1) = . . With our usual notation the value of a forward contract on the asset is 8 oe.06 ， σ= 0. After the decline . Other parameters can be estimated asγ= 0.6.28% of the assets originally held should be sold.17 billion of assets should have been sold before the decline.O 03xO 5(0. "_.25 and q = 0.2758 .61 % of the original portfo1i o should be sold. this is also the immediate change in the wealth of the holder of the futures contract. 67% or $22.2758 The delta of the option has dropped to e.
93 . We can conclude that the bank is like1y to have 10st money.22. What position would you take to make the position delta neutral? After a short period of time .93 . Estimate the new delta.600 have been shorted.0. A bank's position in options on the dollareuro exchange rate has a delta of 30. The gamma indicates that when the euro exchange rate increases by $0. 400 so that it becomes 27 . To maintain de1ta neutrality. 000 = $300. a 10ss is experienced when there is a 1arge movement in the underlying asset price.8) . Explain how these numbers can be interpreted. As shown in the text (see Figure 15. The exchange rate (dollars per euro) is 0. 000.90. 000 = 800. What additional trade is necessary to keep the position delta neutral? Assuming the bank did set up a deltaneutral position originally. For de 1ta neutrality 30 .000 and a gamma of 80 . 000 = 2. it is therefore necessary for the bank to unwind its short position 2 . has it gained or lost money 企om the exchang萨rate movement? The de1ta indicates that when the value of the euro exchange rate increases by $0. When the exchange rate moves up to 0.01 the de1ta of the portfolio decreases by 0.01 x 80 .93.01 .400 euros so that a net 27 .01 x 30 .000 euros shou1d be shorted.90) x 80 .Problem 15. 111 . the exchange rate moves to 0. the va1ue of the bank's positio日 increases by 0. when a portfolio is de1ta neutral and has a negative gamma .600. we expect the de1ta of the portfo1io to decrease by (0.
3. In ma町 instances it is more accurate to assume the cash amount of the dividend is known. .4 and 16. The expected return on the stock in time !:lt is the risk仕ee rate ..3 . These two estimates of delta can be used to provide an estimate of gamma. An approach that ensures a recombining tree is constructed in two stages: 1. the 自rst stage results in the tree in Figure 16. Gamma is calculated from the three nodes at time 2!:l t" The upper two nodes produce one delta estimate and the lower two nodes produce another delta estimate. Build a tree for the stock price less the present value of future dividends during the life of the option . We can improve accuracy by using the same tree to value both an American option and the corresponding European option. Theta can be calculated from the tree by comparing option prices at time zero with the option price at the middle node at time 2!:l t. and 2.5 discuss a number of extensions of the basic treebuilding approach. Delta is the ratio of the option price change to the stock price change.. r. Vega is calculated by making a small change to the volatility. The error in the price of the European option is assumed to be the same as that of the American option 112 . As indicated in Figure 16. 2. We calculate the change in the option price when we move from the lower node to the upper node and the change in the stock price when we do so. Add the present value of future dividends at each node to construct the final tree In Example 16. The standard deviation of the return in time !:lt is (Jyí5j whereσis the volatility Make sure you understand the calculations in Figure 16.. to assume that the dividend as a percent of the stock price is known). recomputing the tree . An important issue for stock options is how to deal with dividends. The second stage results in the tree attached to the Example.3.CHAPTER16 BinomialT￥ees in Practice This chapter provides more detail on the use of binomial trees than Chapter 11.. On approach is to assume a known dividend yield (i.. It starts by explaining where the formulas for u . d and p come 仕om.6 . The formulas ensure that 1. the tree does not naturally recombine when this assumption is made. For delta we look at the two nodes at time !:l t. The chapter shows how the Greek letters discussed in Chapter 15 can be calculated. and observing the option value calculated.e. This is fairly straightforward. We can make the shortterm interest rate a function oftime by making the probability of an up movement a function of time 2. Sections 16 . They show that: 1.
p = 0.8ection 16. because the payoff at a 自nal branch depends on the path used to reach it. Using 100 steps the price obtained is $3. In this case . and ßt = 0. T = 0. u= εσJ互t = e03o v'õ25 = 1. 25. 1618 d =1=0. Consider an option that pays off the amount by which the fìnal stock price exceeds the average stock price achieved during the life of the option. The calculated price of the option is $4.6 to make sure you understand how to use this technique to price pathdependent options. Also . SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 16.8607 u α = eT .9. and the volati1ity is 30% per annum. The stock price is $50. The option cannot be valued by starting at the end of the tree and working backward . 0126 户主:1=05043 u 一 α 1 _. K = 49 . SO = 50 .30 .4957 The output from DerivaGem for this example is shown in the Figure 816.6 points out that instead of working back 仕om the end of the tree to the beginning .29. Use a threestep binomial tree to calculate the option price. The payoff depends on the path followed by the stock price as well as on its final value. t = e005XO 25 = 1.dependent option. as described in 8ection 16. 8tudy the example in 8ection 16. Can this be valued 丘。ma binomial tree using backwards induction? No! This is an example of a pαth.8.91 113 . 1. we can use Monte Carlo simulation to sample paths starting at the beginning of the tree. r 士。，， 05 ， σ= 0. the risι企ee rate is 5% per annum .6. A nin萨month American put option on a nondividendpaying stock has a strike price of $49.75 .. Problem 16.ð. European options for which the payoff depends on the average stock price can be valued using Monte Carlo simulation .
483.5043 Up step size. Using 100 time steps the price obtained is 38. The option's delta is calculated 仕om the tree is (79. When 100 steps are used the estimate of the option's delta is 0 .G rowth factor per step.64. The calculated price of the option is 42.07 cents.9 Problem 16.10.75 . d = 0. 783) = 0 . a = 1 0126 Probability of up move.. p = 0. t = 0. r = u u d α P P 0.25. AIso 一 一 一 一 一 一 一 一 一 U A N 队 白 1 l M U 1 α  = 4 二 0 d d M M 一 =DIJ E:‘ 节 E 咱 F ， = a 咱 1iA QU 4 缸 们 币 A F 也 = ω A U 4 υ 气 no 吐 184 The output from DerivaGem for this example is shown in the Figure 816. the riskfree rate is 6% .35 . • In this case Fo = 400 .5000 。 7500 Figure 816.971 一 11 .4 19)/(476 .487 . Use a thre timestep tree to value a ninemonth American call option on wheat futures.0000 0. the strike price is 420 cents . The current futures price is 400 cents . K = 420 . and 。 血 f:. 114 . and the volatility is 35% per annum.2. T = 0.06 ， σ= E e 0. Estimate the delta of the option 企om your tree.1 Th ee for Problem 16.2500 0.498 .8607 Node Time: 0.335. u = 1 1618 Down step size.
d = 0.3.4564 up s te p s iz e . U = 11912 Down step size . The stock price is $20. a = 1. We 自rst build a tree for 8 0 = 20 •1. For nodes between times 0 and 1. .4. 9925 = 18 0075 .5 months.0000 P robability 01 up m ove .. K = 20 ，俨= 0 ， 03 ， σ= 0.2 Tree for Problem 16. A threemonth American call option on a stock has a strike price of $20.5 months we then add the present value of the dividend to the stock price 相 The result is the tree in Figure 816 . and T = 0. In this case the present value of the dividend is 2e.8395 Node Time: o 0000 02500 05000 。咱 7500 Figure 816.. t = 0 08333.25 with b. This gives Figure 816.10 Problem 16. 明lhen 100 steps are used the price obtained is 0. A dividend of $2 is expected in 1. The price of the option calculated from the tree is 0 ， 674.. . p = 0. the risk企ee rate is 3% per annum ..o 03xO 125 = 1.1 1. 115 . and the vola ti1ity is 25% per annum.690.25 . 9925 . Use a threestep binomial tree to calculate the option price.Growth factor per step .
0833 0.0025 Probability of up move .9304 Node Time: 0. Use the DerivaGem software with four threemonth time steps to estimate the value of the option. U = 1. dt = 0.0748 Down step size .0025 Probability of up move .0000 0.0833 years .9304 Node Time: 0...11 Problem 16.0748 Down step size .. 30 . A oneyear American put option on a nondividendpaying stock has an exercise price of $18.0000 0. 3042 days Growth factor per step . d = 0. a = 1.12. and the volatility of the stock is 40% per annum. U = 1. the risk企ee interest rate is 15% per annum ...3 First tree for Problem 16.1667 0.4 Final Tree for Problem 16. a = 1.Time step .2500 Figure 816 . dt = 0. d = 0.. The current stock price is $20.1667 02500 Figure 816..42 days Growth factor per step . p = 04993 υp step size .. Display the tree and veri命 that 116 .0833 years .0833 0. p = 04993 Up step size .11 Time step ..
3306 . 29 + 1.8187 The tree produced by DerivaGem for the American option is shown in Figure 816.015 x 0.13.4384 N( d r) = 0 2009. 0524 . t = 1..t = 1.8187 α = eT'D.8384 d2 = d1 . r = 0.1. t = 0. K = 480 .03 . 0382 . Use DerivaGem to value the European version of the option. A twomonth American put option on a stock index has an exercise price of 480. The current level of the index is 484. T = 0. N( 一句) = 0. 14 = $1.0. 10 This can also be obtained from DerivaGem.2009 = 1. t = 0. In this case 8 0 = 20 . 29. The estimated value of the European option is $1.0.25 q = 0. the risk企ee interest rate is 10% per annum .25. 10 .3306 The true European put price is therefore 18e.8187 1.the option prices at the B.nal and penultimate nodes are correct. 2214 d = l/u = 0.6 . r = parameters for the tree are 0. 00292 1.0.20 x 0. the dividend yield on the index is 3% per annum. and the vola ti1ity of the index is 25% per annum.40 = 0.4 0 一一一一一一一一一一一一一一一一= + 0. Divide the life of the option into four half二 month periods and use the binomial tree approach to estimate the value of the option.402 /2 0. 0382 p= 一一一一=一一一一一一一一一一二 0. The u= εσJ互t = e04 VQ:25 = 1.0. As shown in Figure 816. K = 18 ，俨工 0. K = 18 . 0524 d =1=09502 U α=ε (rq) D..545 d u.d α  117 .. Problern 16.15 + 0. and D. The option parameters are 8 0 = 20 . In this case 8 0 = 484 .40 .0. the same tree can be used to value a European put option with the same parameters. The control variate estimate of the American put price is therefore 1.516 1. 14.d α  1. The estimated value of the American option is $1. Use the control variate technique to improve your estimate of the price of the American option.15 ， σ= 0. . 2214 .5.15 ， σ= 0.1667 .04167 u=eσJ互t = e025 v'00416于= 1.9502 p= 一一一=一一一一一一== d u . 25. 0029 .40 and T = 1 d11丑 (20/18) ι0 .9502 = 0. and D.10 ， σ= 0. T = 1.
d = 0.545 丁 Up step size .2500 0. U = 1 .0000 00000 Figure S16.7.12 The tree produced by DerivaGem is shown in the Figure 816.12 Growth factor per step . p = 0. a = 1..5 Tree to evaluate American option for Problem 16.2 214 Down step size . The estimated price of the 118 .7500 1.5000 07500 1.6 Tr ee to evaluate European option in Problem 16.0000 Figure S16.0382 Probability of up move .5000 0. a =才 0382 Probability ofup move .Growth factor per step ...2500 0.8187 Node Time 00000 0. p = 0 5451 Up step size .8187 N 口 de Time: 0. d = 0. U = 1 2214 Down step size .
option is $14. Growth factor per step . a = 1 日 029 Probability ofup move . Finally the true European delta . Ê. Â.9502 Node Time: 00000 00417 00833 o 1250 01667 Figure 816.14. Denote this by D. How would you use the control variate approach to improve the estimate of the delta of an American option when the binomial tree approach is used? First the delta of the American option is estimated in the usual way from the tree.15. d = 0. U = 10524 Down step size . p = 0.5159 Up step size . Then the delta of a European option which has the same parameters as the American option is calculated in the same way using the same tree 阐 Denote this by D. Â.93. B . How would you use the binomial tree approach to value an American option on a stock index when the dividend yield on the index is a functíon of tíme? When the dividend yield is constant u=eσJ互E d p α 1 一 一 一 一 一 u α U A U ddAW • A 4 ι 119 . is calculated using the formulas in Chapter 15. 13 .D. Ê • D. Problem 16. D. B Problem 16.7 Th ee to evaluate option in Problem 16. The control variate estimate of delta is then: D.
Making the dividend yield .4. a function of time. The interest rate r can also be a function of time as described in Section 16 . q . However . a function of time makes α ， and therefore p . 120 . It follows that if q is a function of time we can use the same tree by making the probabilities a function of time. it does not affect U or d.
(Since 1987 traders have been very concerned about the possibility of another stock market crash and have as a result increased the prices of deepout. news is expected to be announced that wi11 either increase the price by $5 or decrease the price by $5.8. Figure 17. The same is usually approximately tru 川. It has a heavier left tail and a less heavy right tail than the lognormal distribution. (The implied volatility is a declining function of strike price. The volatility smile for options on foreign cun臼lcies in Figure 17.2 when trading options.τ'r aders use a volatility surface such a that shown in Table 17.3. 121 . If traders wanted to make that assumption they would use the same volatility to price options with different strike prices. The volatility surface enables them to estimate the appropriate implied volatility for any standard option trade that is proposed.ofthemoney put options. Possibly it consists of two lognormal distributions superimposed upon each other and is bimodal.) A口other explanation is crashophobia. Tomorrow . Figure 17. (See Appendix to Chapter 17. The volatility smile for options on equity in Figure 17. (As the stock price declines the compa町 becomes more highly levered a时 volatility increases.) The BlackScholes and similar models are in practice used to communicate the prices of European and American call and put options. Note that we do not have to worry about whether we are talking about put or call options when constructing diagrams such as Figure 17 1 and 17. It has heavier right and left tails than the lognormal distribution. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 17.1 shows the typical situation for options on a foreign currency (The relationship between implied volatility and strike price is Ushaped).3 can be explained by the impact of leverage.2 shows the future probability distribution for an exchange rate that is consistent with the implied volatilities that traders are using for foreign currency options. What are the problems in using BlackScholes to value onemonth options on the stock? The probability distribution of the stock price in one month is not lognormal.) of American options. .4 shows the future probability distribution that is consistent with the implied volatilities that traders are using for stocks and stock indices. This is because putcall parity shows that the implied volatility of a European put should be the same as that of a European call.3 shows the typical situation for options on stocks and stock indices. A stock price is currently $20..CHAPTER 17 Volatility Smiles The BlackScholes model and binomial trees assume that the probability distribution of the underlying asset at a future time is lognormal.1 is likely a result of jumps and the fact that volatility is not constant. Figure 17. In practice the implied volatility of an option is a function of the strike price.) Figure 17.
Problem 17. Implied volatility then increases with the strike price. the problem of distinguishing between situations where the market is inefficient and situations where the option pricing model is incorrect . a time to maturity of one year.BlackScholes is clearly inappropriate . and an implied volatility of 30%. 122 .13. A European put option on the same stock has a strike price of $30.money options as being options on volati1ity.12. These include the problem of obtaining synchronous data on stock prices and option prices . Both outofthemoney and inthemoney calls and puts can be expected to have lower implied volatilities than 瓜themoney calls and puts. the volatility tends to increase as the asset price increases . The pattern of implied volatilities is likely to be similar to Figure 17. can lead to signi且cant percentage increases in the value of the option. Suppose that a central bank's policy is to allow an exchange rate to B. uctuate between 0. What pattern of implied volatilities for options on the exchange rate would you expect to see? In this case the probability distribution of the exchange rate has a thin left tail and a thin right tail relative to the lognormal distribution.97 and 1. What volati1ity smile is likely to be observed for sixmonth options when the volati1ity is uncertain and posítively correlated to the stock price? When the asset price is positively correlated with volatility. The optio丑 does ， therefore . A European call optíon on a certain stock has a strike price of $30. Problem 17. Problem 17. a time to maturity of one year. Increases in its volatility，。丑 the other hand . What problems do you think would be encountered ín testíng a stock optíon prícíng model empirícally? There are a number of problems in testing an option pricing model empirically.1 1. and the problems of estimating stock price volatility.10. Option traders sometimes refer to deepoutofth e. Why do you thínk thθy do this? A deepoutoft hemoney option has a low value. and an implied volatility of 33%. 1. this reduction is small because the value can never go below zero. because it assumes that the stock price at any future time is lognormal. have some of the same attributes as an option on volatility.03. producing less heavy left tails and heavier right tails. However .7 Problem 17. the problem of estimating the divide口ds that will be paid on the stock during the option 's life .9. Problem 17. We are in the opposite situation to that described for foreign currencies in Section 17. Decreases in its volatility reduce its value.
Use DerivaGem to calculate the relatíonship between implied volati1i ty and strike price for sixmonth European options on the company today. If the ruling is favorable to the company. sell the put and short the stock. DerivaGem gives the value of a European call option price as 6. Assume that the sixmonth riskfree rate is 6%.4 x 26.4.310.) Hence 50 + 25p = 60 or p = 0. 70 . the volatility， σ ， will be 25%.06 and c = 14. The implied volatility is 47. T = 0. (We ignore the expected return to an investor over one day. Suppose that the result of a major lawsuit affecting a company is due to be announced tomorrow. the volatility， σwill be 40% Other option parameters are 50 = 50 . p) = 50 + 25p This must be the price of the stock today. The parameter values are 50 = 60 . 7' = 0. The company does not pay dividends. the call is priced too low relative to the put. and 80.502. The company's stock price is currently $60. Other option parameters are 50 二 75 ， 7' = 0. Suppose that p is the probability of a favorable ru1ing.5 . As explained in the appendix to the chapter . Putcall parity is true for any set of assumptions. The correct trading strategy is to buy the call . DerivaGem gives the value of a European call option price as 26. the stock price is expected to jump to $75. This does not depend on the lognormal assumption underlying BlackScholes.6 x 6. 40.387.310 = 14. and T = 0. 7' = 0. putcall parity implies that European put and call options have the same implied volatility. If it is unfavorable. K = 50 .5. Consider call options with strike prices of 30.5.310 or: 0 . 123 . For a value of K equal to 50 . The expected price of the company's stock tomorrow is 75p + 50(1 _.387 DerivaGem can be used to calculate the implied volatility when the option has this price. For a value of K equal to 50 . Problem 17. and T = 0.76%. If the ruling is favorable . What is the riskneutral probabi1i ty of a favorable ruling? Assume that the vola ti1ity of the company's stock wi11 be 25% fo I' six months after the ruling if the ruling is favorable and 40% if it is unfavorable. If the ruling is unfavorable .06 .What is the arbi古rage opportunity open to a trader? Does the arbitrage work only when the lognormal assumption underlying BlackScholes holds? Explain the reasons for your answer carefully.502 十 0.06 . 60 . The value today of a European call option with a strike price today is the weighted average of 26.502 and 6. 50.14. the stock is expected to jump to $50. If a call option has an implied volatility of 30% and a put option has an implied volatility of 33% .
310 2. (b) between 0.7000 and 0. The results are shown in the table below.8500 and 0. The pattern of implied volatilities is shown in Figure 817. (c) between 0.14 Problem 17. and (f) greater than 0.387 8.8000 and 0.159 21.These calculations can be repeated for other strike prices.36 50 支 。 > 48 46 A mus 『 A 『 c. 124 .171 9.9000.78 47.67 47.8000. E 42 40 38 20 40 60 80 Strike Price Figure 817.430 1. 1.05 43. 161 0.955 21. 934 46.22 40.1 Implied Volatilities in Problem 17. Based on the volatility smi1 e usually observed in thθ market for exchange rates.7500 and 0. Using the lognormal assumption .. (e) between 0.437 6.76 46.7500. which of these estimates would you expect to be too low and which would you expect to be too high? .9000.502 17.15. The volatility of the exchange rate is quoted as 12% and interest rates in the two countries are the same.887 36.7000.564 4. 001 12.826 1.334 4.8500. estimate the probabi1 ity that the exchange rate in three months wil1 be (a) less than 0.451 30. Implied Call Option Price Call Option Price 8trike Price Favorable Outcome Unfavorable Outcome Weighted Price Volatility (%) 30 40 50 60 70 80 45.182 26. 935 14. (d) between 0.. An exchange rate is currently 0 8000.
79%. The probab i1ity that the exchange rate is between 0. The probability that 8r < 0.75 = 0.12 2 x 0.79 .25 so that ln 8r or ln 8r rv rv </>(1丑 0.2249 . The probability that 8r < 0.70 = 0.80 is therefore 5 1. Whereas the growth rate in a nondividendpaying stock in a riskneutral world is r .3567. 0. and T = 0.80 is the same as the probability that ln 8r < 0. The probability that the exchange rate is between 0. the growth rate in the exchange rate in a riskneutral world is r .2T/2 ， σ VT) where 8 0 is the exchange rate at time zero and σis the volatility of the exchange rate. It is = N( 叫5) < 0.85 is the same as the probab i1ity that lnSr < 0.4 1%.79 = 36 .1.12JO. It is N(二生lPZ叫 =N川ω) 125 .As pointed out in Chapters 5 and 13 an exchange rate behaves like a stock that provides a dividend yield equal to the foreign risk仕ee rate.rf' Exchange rates have low systematic risks and so we can reasonably assume that this is also the growth rate in the real world.25/2 .2877. 20 . 20%.3567. (c) ln 0. It is N(二坐飞旦旦) This is 1. 41%.70 is the same as the probability that l丑 8r < 0.14. 0. If 8r is the exchange rate at time T its probability distribution is given by equation (12. The probability that 8r ln 8r < 0.1625. 41 = 13.06) (a) ln 0.8 一 0. The probabi1ity that 8r < 0.1625.2) withμ=0: ln 8r rv </>(ln 8 0  o. In this case the foreign risk击ee rate equals the domestic risk击ee rate (γ = r f ).25) </>(0.223 1.70 and 0.12 .80 = 0.75 and 0.85 = 0. (b) ln 0.8000 and σ= 0. (d) ln 0.75 is the same as the probability that NCO吨俨些)=N川456) This is 14.2877.75 is therefore 14. In this case 80 = 0. It is N(主气气巨型) =N(O 叫 This is 5 1. The expected growth rate in the exchange rate is therefore zero.38%.223 1.
Putcall parity is c+ Ke.725. For equities the volatility smile is downward sloping. Hit the Enter key and click on calculate. (e) 1丑 0. Select Equity as the Underlying Type in the first worksheet.3 in the text.16.80 and 0.51.90 is therefore 97.1 of the text and implies the probability distribution in Figure 17.90 is the same as the probability that ln8T < 0.2 suggests that we would expect the probabilities in (a) . The probability that the exchange rate is between 0. A high strike price option has a lower implied volatility than a low strike price option. (d) . 155. Explain why the two implied volatilities are different. time to exercise as 0. A sixmonth European call option on the stock with a strike price of $30 has an implied volatility of 35%. Use putcall parity to calculate the prices of sixmonth European put options with strike prices of $30 and $50. (c) .90 is 100 . The price of a stock is $40.1054. The difference between the two implied volatilities is consistent with Figure 17. The implied distribution assumed by traders is shown in Figure 17 .85 and 0. Problem 17.89%.90 = 0.31 % The volatility smile encountered for foreign exchange options is shown in Figure 17. The probability that 8T < 0. proceed as follows.85 is therefore 85.09%.rT = p+ 8 0 so that p=c 十 Ke. Change the volatility to 28% and the strike price to 50. 20 = 33. It is N(二些吨 This is 97. Do not select the implied volatility button. Select Analytic European as the Option Type. Leave the dividend table blank because we are assuming no dividends.09 . and (f) to be too low and the probabilities in (b) and (e) to be too high.69 .69%.This is 85.rT 80 126 . Figure 17. A six month European call option on the stock with a strike price of $50 has an implied volatility of 28%.69 = 2.仕ee rate as 5% .60%. The probability that the exchange rate is between 0. volatility as 35% . risk.5 year .85.2.1054. (f) The probability that the excha吨e rate is greater than 0. The sixmonth riskfree rate is 5% and no dividends are expected. Use DerivaGem to calculate the prices of the two options. DerivaGem will show the price of the option as 1 1. DerivaGem will show the price of the option as 0. Hit the Enter key and click on calculate. Select the button corresponding to call.4. Use DerivaGem to calculate the implied volatilities of these two put options. Input the stock price as 40 . The reason is that traders consider that the probability of a large downward movement in the stock price is higher than that predicted by the lognormal probability distribution. and exercise price as 30.97.09 = 12. To use DerivaGem to calculate the price of the 直rst option .
and the exercise price as 50.18 Using Table 17.5 year . 80 p 40 ， r = 0. These results are what we would expect. 155 .490 = 0. c = 0. input the stock price as 40 . In practice much of the work in producing a table such as Table 17. The brokers provide a table such as Table 17. Similarly.99%. We get the same answer 忡 (ωa 凶 町 州 between strike 严 让臼 of 1." Discuss tbis Vlew. These implied volatilities are then substituted into BlackScholes to calculate prices for these options.counter market is done by brokers. 0ωOan by 叫) i川 rpolat nt te ti吨 p ri ce s 丑 1 1.4 14 in the second half of the Option Data table. 13 . Select the buttons for a put option and imp1ied volatility. the risk仕ee rate as 5% .725 十 50e 一 0. DerivaGem will show the implied volatility as 27.490 in the second half of the Option Data table. 05 and 由 丑 be twe er1 matu ties six mo时 hs and one year and (b) interpolati吨 between t her1 创 臼丑 肮矶，lrÍ扰挝创 山 maturities of six months and one year and then between strike prices of 1. they estimate implied volatilities for other options. DerivaGem gives the implied volatility of a put with strike price 30 to be almost exactly the same as the implied volatility of a call with a strike price of 30. DerivaGem will show the implied volatility as 34. 00 and 1.4 14 工 For the second option .5 so that 40 = 9 . They calculate implied volatilities for the options whose prices they can observe in the market. Problem 17.40 = 0 . Select the buttons for a put option and implied volatility.05xO. it gives the implied volatility of a put with strike price 50 to be almost exactly the same as the implied volatility of a call with a strike price of 50.5 so that p = 11. By interpolating between strike prices and between times to maturity. Input the price as 9 .2 to their clients as a service.4 5%.06 . and T = 0. time to exercise as 0. 155 + 30e. 05. Hit the Enter key and click on calculate.5 . Input the price as 0 .17. "Tbe BlackScboles model is used by traders as an interpolation tool.725 . time to exercise as 0. to use DerivaGem to calculate the implied volatility of the 且rst put option . the risk仕ee rate as 5% .2 calculate tbe implied vola ti1ity a trader would use for an 8montb option witb a strike price of 1.0 05xO. r = 0. traders do use the BlackScholes model as an interpolation tool. input the stock price as 40 . Problem 17.04. and T = 0. When plain vanilla call and put options are being priced .99%.2 in the overthe. K = 30 . K = 50 .For the first option .054 . Brokers often act as intermediaries between participants in the overt hecounter market and usually have more information on the trades taking place than any individual financial institution. and the exercise price as 30. Similarly. Hit the Enter key and click on calculate.5 year . 127 . c = 11.5_ To use DerivaGem to calculate the imp1ied volatility of the 且rst put option . 8 0 = 40 .
the 10day value at risk is assurned to be VïO tirnes the one. Options create problerns for the rnodel building approach. The rnean change is usually assurned to be zero. The rnost cornrnon assurnption is that the changes have a rnultivariate norrnal distribution. Suppose that the 10day. This is because the change in the value of an option is not linearly related to the change in the value of the under1ying variables. It ge丑erates N scenarios. The rnodel building approach uses a rnodel for the daily change in the values of rnarket variables. Historical sirnulation involves using the history of how rnarket variables have behaved during the last N days to estirnate VaR. Like the historical sirnulation approach its initial focus is on the oneday VaR. This rneans that the probability of the bank's losses over the next 10 days being greater than $5. If the change in the value of the portfolio is linearly related to the changes in the values of the variables .. will not be exceeded. As in the case of the historical sirnulation approach . The first is historical sirnulation.6 rnillion is 1%. and correlations between .day value at risk. The scenarios are used to create a probability distribution for the change in the value of the current portfolio between today and tornorrow. The standard deviation of the change can be calculated frorn the standard deviations of. There are two ways of calculating VaR.CHAPTER 18 Value at Risk Value at risk (VaR) has becorne a very irnportant risk rneasure since the ear1y 1990s. The first scenario assurnes that the percentage change in all variables between today and tornorrow is the sarne as that between day 0 and day 1 of the historical data. The second is the "rnodel building" or "variancecovariance" approach. 99% VaR is $5. One approach is to use the delta of the option to de且ne an ap 128 . Bank regulators base the capital they require for rnarket risk on a calculation of the 10day. It is the loss on a portfolio that . the rnarket variables.6 rnillion for a bank. and so on. with a certain con且dence level . This enables the oneday value at risk to be calculated. the oneday change in the value of the portfolio is norrnally distributed. The 10day value at risk is calculated as the oneday value at risk rnultiplied by jIO. 99% VaR. the second scenario assurnes that the percentage change in all variables between today and tornorrow is the sarne as that between day 1 and day 2 of the historical data. This in turn allows the oneday value at risk to be deterrnined..
000. The variance is the square of the vo1atility.33) = 0.000 investment in asset A and a $100.612. It decides to change the parameter λ 企om 0.estimate all we need is the most recent change in the market variab1e.. 000 The standard deviation of the portfolio's daily change is the square root of this or $1 . (See equation 18. 600 .85. u.0 1. Problem 18.9. Consider a position consisting of a $100.95. A company uses an EWMA model for forecasting volatility.X)% of the time in N days for speci自ed parameter va1ues .12) The updating is actually carried out in terms of variances and covariances.000 investment in asset B.3 x 1.8.10). 400. 000 2 + 1. 605.85 of will react more quick1y to new information and will "bounce around" much more than volatilities calcu1ated with λ= 0. Explain the difference between value at risk and expected shortfall. 000 x 1.33 x 3 . This means that 1% of a norma1 distribution lies more than 2. The standard deviation of the 5day change is 1. Reducing λ 仕om 0.45 x J5 = $3 . Assume that the dai1y volatilities of both assets are 1 % and that the coeflìcient of correlation between their returns is 0.93. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 18.85 means that more weight is put on recent observations and 1ess weight is given to older observations. X and N. The 5day 99 percent va1ue at risk is therefore 2.95 to 0. Vo1atilities ca1cu1ated with λ= 0. Explain the likely impact on the forecasts. 605.3.33 standard deviations below the mean. 612 . The variance of the portfolio's daily change is 1.55 Fr om the tab1es of N(x) we see that N(2.95 to 0. Expected shortfall is the expected 10ss conditional that the loss is greater than the Value at Risk. Problem 18. The covariance is the corre1ation multiplied by the product of the volatilities of the two variab1es. Similarly to update an estimate of the corre1ation between two variab1es all we need are the most recent changes in the variab1es. 129 .45. 000 2 + 2 x 0. What is the ι day 99% value at risk for the portfolio? The standard deviation of the daily change in the investment in each asset is $1 .10.55 = $8 . (See equation 18. 000 = 2. Va1ue at risk is the 10ss that is expected to be exceeded (100 .
The vola ti1ity of a certain market variable is 30% per annum. The change in the value of an optio丑 is not linearly related to the percentage change in the value of the underlying variable. The 0.0006 2ω2 十 0.3year zerocoupon bond in the cashBow mapping example in the Appendix at the end of this chapter is mapped into a $37.1 1. The 0. Assume that W of the value of the 0.U 3U. exchange of principal is added in . O____A. which is equivalent to a portfolio of zerφcoupon bonds.50 and 6.. the fioating side is equivalent a zerocoupon bond with a maturity date equal to the date of the next payment.3 years is 50.30year rate as 5.30year cash fiow gets allocated to a 3month zerocoupo丑 bond and 1 一 ωto a sixmonth zero coupon bond.068% per day.000 一__ S. 793 position in a sixmonth bond.00 respectively. There is a 99% chance that a normally distributed variable willlie within 2. The linear model assumes that the change in the value of a portfolio is linearly related to percentage changes in the underlying variables. Calculate a 99% confidence interval for the size of the percentage da i1y change in the variable. We are therefore 99% confident that the daily change will be less than 2.12.W)2 130 + 2 x 0.000 received at time 0. Problem 18. The interpolated volatility of a 0.Problem 18.9 x 0.397 position in a three幡month bond and a $11 . 89 = 4.30year zerocoupo丑 bond is therefore 0.3year cash fiow is mapped into a 3month zerocoupon bond and a 6咀lOnth zerocoupon bond. Each of the zerocoupon bonds can then be mapped into positions in the adjacent standardmaturity zerocoupon bonds.60%.50 year rates are 5. The 五xed side is a couponbearing bond .10% per day respectively.001切。一 ω) .001 2 (1 . The swap can therefore be mapped into long and short positions in zerocoupon bonds with maturity dates corresponding to the payment dates. One way of doing this is described in the Appendix to Chapter 18. Linear interpolation gives the 0.86%.' 6 The volatility of 0.14.57 x 1.25year and 0.06% and 0.49~189.50ye缸 zerocoupon bonds are 0.57 standard deviations.. Problem 18.13. To match variances we must have 0. Explain how an interest rate swap is mapped into a portfolio of zerocoupon bonds with standard maturities for the purposes of a VaR calculation.25 and 0.32 I. Veri命 that the 0. The present value of $50 . Explain why the linear model can provide only approximate estimates of VaR for a portfolio containing options. Whena 且nal Problem 18. It is therefore only an approximation for a portfolio containing options. 89%.0006 x 0.=A二 .00068 2 = 0. The volatility per day is 30/V252 = 1.
582(1 一 ω)2 十 2 x 0.56 is allocated to the 5year bond and a value of 0.w) or .56 2 = .58ω (1.56% per day.3year cash 丑ow is therefore equivalent to a position of $37 .5year zerocoupo丑 bond is therefore 0.760259 x 49 . 397 is allocated to the threemonth bond and a value of 0. 189. 000 1.3248ω+ .w to a 7year zero coupon bond.28 x 0.28 0. What cash f1 0ws in 5 and 7 years are equivalent to the 6. Suppose that the 5year rate is 6% .05 = $48. ow? The 6.32 = $37 .3248 . 一ιτ= 1.925757 X 654.58% per day respectively.5year cash fiow gets allocated to a 5year zerocoupon bond and 1 . The correlation between da i1 y returns on the two bonds is 0.92ω+ 0.074243 this means that a value of 0. Linear interpolation gives the 6.6.05 The volatility of 5year and 7year zerocoupon bonds are 0.92 十飞10.5y，θar cash H.32 = $11 . The 0. The interpolated volat i1i ty of a 6.92 2  4 x 0.2384 .760259 this means that a value of 0.. 1b match variances we must have .239741 x 49 . Assume that ωof the value of the 6.28ω2 _ 0.2384ω2 一 .05 = $605 .0228 = 0 Using the formula for the solution to a quadratic equation 四=一一一一一一一一一一一一 2 X . the da iJy vola ti1 ity of a 5year zero.5year rate as 6. 793 is allocated to the sixmonth bond.5year cash 丑ow is mapped into a 5year zerocoupon bond and a 7year zeroThe 5year and 乍 year rates are 6% and 7% respectively. The present value of $1 .49 is allocated to the 7year bond.5 years into a position in a 5year bond and a position in a 7year bond using the approach in the Appendix at the end of this chaptθr.75%. This is consistent with the results in the Appendix to Chapter 18. The 6. and the daily volatility of a 7year zerocoupon bond is 0.50 X .58%.5376 = 0 Using the formula for the solution to a quadratic equation w= 一= 0.5% .000 received at time 6.5year cash 131 .v，3豆花7丁Z王丁克互艾刀228 一一一= 0. 0675 ö5 654.5 years is coupo丑 bond.6 X .50% and 0.50 2ω 2 + .5376 2 x 0.074243 X 654. Map a cash f1 0w of $1 .15. Problem 18.397 in a 3month zerocoupon bond and a position of $11 . 189.000 received at time 6.or 0. the 7year rate is 7% (both expressed with annual compounding) .793 in a 6month zerocoupon bond.coupon bond is 0.
000000288 The standard deviation is therefore $0. The contract now has six months to maturity.4 950. and the estimate of the coeffìcient of correlation between the returns on the two assets made at close of trading yesterday was 0.006 2 = 0.0006 x 1.003333 2 = 0.53. How would the estimate of the dai1y volati1ity be updated? The daily ret盯n is 0. 132 .56 in a 5year zerocoupon bond and a position of $605 .6% and 2. The current daily variance estimate is 0. The value of the dollar bond is 1.003333. 5000 = 0. Calculate the standard deviation of the change in the dollar value of the forward contract in one day. today proves to be 1. (a) Calculate the current estimate of the covariance between the assets.5000.9.5 or $1.000036 + 0. 06 5 = 64. and the exchange rate at 4 p.9 x 0. The parameter λ in the EWMA model 1s 0. 5e 一 005xO.05%.000033511 The new volatility is the square root of this.. The variance of the change in the value of the contract in one day is 1. The 10day 99% VaR is 0.95. The parameter λ used in the EWMA model 1s 0. yesterday was 1.49 x 7 1. The equivalent 5year and 7year cash fl.丑ow is therefore equivalent to a position of $48. 53e005xO.25.98 and 605 .16.0005 2  2 x 0. Problem 18.579%. The correlation between returns 企om the two bonds is 0.5 mi111on.S. The current exchange rate is 1. 463 2 X 0.5% . dollarsterling exchange rate is 0. 463 x 0. respectively. Suppose that the daily volati1ities of asset A and asset B calculated at close of trading yesterday are 1. Suppose that the exchange rate at 4 p. The value of the sterling bond is 1. The most recent estimate of the daily volatility of the U. 492 2 X 0. The daily volatility of a sixmonth zerocoupon sterling bond (when its price is translated to dollars) is 0.56 x 1.28.m.m.8.33 = $0.005/ 1. Problem 18.000036. 07 = 972. The prices of the assets at close of trading yesterday were $20 and $40. What 1s the 10day 99% VaR? Assume that the sixmonth interest rate 1n both sterling and dollars 1s 5% per annum with continuous compounding. ows are 48.17. 463 million.00396 million Problem 18.49 in a 7year zerocoupon bond.000537 million.0005 = 0. It is 0. The new daily variance estimate is 0.8 x 1. Some time ago a company entered into a forward contract to buy . 492 million. 492 x 0.0006 2 斗 1.00579 or 0.1 x 0.18.E 1 million for $1.06% and the dai1y volatility of a sixmonth zerocoupon dollar bond is 0.6% . The contract is a long position in a sterling bond combined with a short position in a dollar bond.5 or $1.000537 x Y'ïO x 2.
000601562 so that the new volatility is 0.19.9%. What is the volatility of the FTSE 100 when it is translated to U.018 x 0.31%. The standard deviation of 町 is 0. This is the impact of the positive correlation.0125 2 = 0. Define Xi as the proportional change in X on day i and Yi as the proportional change in Y on day i.025 x 0. When the FTSE increases the 133 . dol1 ars per pound sterling.016 x 0. The correlation between the two is 0 .8.0125.000 1.4.(b) On the assumptíon that the príces of the assets at c10se of tradíng today are $20.8.00027445 so that the new volatility is 0.5 and $40.5/40 = 0.009 x 0. The variance of Xi 十 Yi is therefore 0.4. (a) The volatilities and correlation imply that the current estimate of the covariance is 0.009 2 + 2 x 0. 8% and the dai1y volatilíty of the dollar/ster1ing exchange rate is 0.0001 十 0.25 x 0.95 X 0.) The FTSE expressed in dollars is XY where X is the FTSE expressed in sterling and Y is the exchange rate (value of one pound in dollars).5 .025 2 = 0.0231 or 2.025 2 十 0.0005346 so that the volatility of Xi 十的 is 0. The new variance estimate for asset B is 0. (Hint: When Z = XY . The proportional change in XY is approximately Xi 十趴.5 .018 2 十 0.95 x 0. The new correlation estimate is nunu AUi 。 t n nuU 一 一 nhu 20 × .0001106 The new variance estimate for asset A is 0.4 = 0.016 2 十 0. Note that it is greater than the volatility of the FTSE expressed in ster1ing.025 and 0.05 x 0. The new covariance estimate is 0. This is the volatility of the FTSE expressed in dollars.5/20 = 0.018 and the standard deviation of Yi is 0.0125 = 0. (b) If the prices of the assets at close of trading today are $20.05 X 0.5 and $40.025 = 0.009.95 X 0.0245.0 6 一 一2 且 A 川 70 1  AU 9" 。 用 i " Problem 18. 8uppose further that the correlation between the FT8E 100 and the dollar/sterli鸣 exchange rate is 0 . do l1 ars? Assume that the dol1ar/sterli鸣 exchange rate is expressed as the number of U.0166. 1inu 4. update the correlatíon estímate. 8uppose that the daíly volatility of the FT8E 100 stock index (measured in pounds ster1ing) ís 1. the percentage dai1y change in Z is approximately equal to the percentage dai1y change in X plus the percentage dai1y change in Y. the returns are 0.05 X 0.
009 x 0.6%.7 x 0.0000432 = 0.0002016.) Continuing with the notation in Problem 18. and the daily volati1ity of the S&P 500 lndex is 1.20. What is the correlation between the S&P 500 lndex (measured in dollars) and the FTSE 100 lndex when it is translated to dollars? (Hint: For three variables X .0000432. This creates an even bigger increase in the value of FTSE measured in dollars.3 x 0.3. It is 0. Similarly for a decrease in the FTSE. The covariance between Yi and Zi is 0. The covariance between Xi 十如 and Zi equals the covariance between Xi and Zi plus the covariance between 的 and Zi. the covariance between X + Y and Z equals the covariance between X and Z plus the covariance between Y and Z.19 .19 the correlation between the SJ让P 500 lndex (measured in dollars) and the FTSE 100 lndex (measured in ster1ing) is 0.0231 134 .0002448 0. and Z .0002448 The correlation between Xi 十如 and Zi is 0.016 = 0.018 x 0.value of sterling measured in dollars also tends to increase.7. de且ne Zi as the proportional change in the value of the S&P 500 on day i.016 = 0. Suppose that in Problem 18. Y . The covariance between Xi and Zi is 0.016 x 0.662 一一一一一一一一= 0.0002016 + 0. the correlation between the S&P 500 index (measured in dollars) and the dollarster1ing exchange rate is 0. Problem 18.
or every year. options on Eurodollar futures and options 0卫Theasl町 bond futures). An interestrate cap is an instrument that provides insurance against the rate paid on a floati吨 rate loan going above a certain level. (See equation 19. This is similar to the putcall parity relationship for regular call and put options. Each caplet is valued using a BlackScholes type of formula where the future interest rate is assumed to be lognormally distributed. an interest rate cap . This yield volatility is converted into a price volatility (see equation 19. A swaptio丑 where the holder has the right to pay 且xed and receive floating can be viewed as a call option on the swap rate (or as a put option on a par yie SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 19. an interest rate floor is a series of put options on interest rates. Interest rate caps are no exception. The 自xed rate is analogous to the strike price in a regular option and is specified at the time the swap option is entered into. An interest rate cap therefore consists of a series of call options on future interest rates . The rate on the floating rate loan is reset every month. Typicallyan implied yield volatility is quoted. every quarter . The individual options are referred to as caplets.CHAPTER 19 Interest Rate Options The chapter describes the most common interest rate options and the standard market models that are used to price them. As shown in Business Snapshot 19.6) using an approximate duration result and the price volatility is used in a BlackScholes type of formula where the bond price at the maturity of the option is assumed to be lognormal. Suppose that an implied price volati1ity for a 5year option on a bond maturing in 10 years is used to price a 9year 135 . They can be valued usi鸣 the approach in Chapter 14. The commonest overthecounter products are European bond options . interest rate caps . In the swap a 直xed rate is exchanged for LIBO R.8. every six months . The exchangetraded interest rate options that are most common are options on interest rate futures (for example . Just as an interest rate cap is a series of call options on interest rates . and European swap options. oating rate is reset. and a swap. The level (known as the cap rate) is analogous to the strike price in a regular option.8. A bank uses Black's model to price European bond options. one corresponding to each time the fl.1 there is a relationship between the values of an interest rate floor .) For any call option there is a corresponding put option. European options on bonds are traded in the overthe.counter market. A European sw叩 option (often called a European swaption) is an option to enter into a swap at a particular future time.
9. The relationship between the yield volatility and the price volatility is given by equation (19.032.19. 1 = 67. based on today's interest rates the modifìed duration of the bond at the maturity of the option wil1 be 4. d11日1. 04475 + 0. 0744)] = 3. Consider a fouryear European call option on a bond that will mature in fìve years. A oneyear forward bond price has a lower volati1ity than a fiveyear forward bond price.22 = 6 .67. In this case . The present value of the coupons is .4 75 .02 2 X 4 一一一一一一一…一一=一一一一一一= 1.968.4xO . the price of a fouryear bond with the same coupon as the 丘 veyear bond is $102.2 years and the forward yield on the bond is 7%. Using the volat i1ity backed out from the fiv e.year option to price the nin令 year option is therefore likely to produce a price that is too high. T = 4 . the fouryear risk企ee interest rate is 10% per annum (contínuously compounded) . the price volatility is 0.100N( 1. The volatility used to price a nineyear option on a tenyear bond should therefore be less than that used to price a 直veyear option on a tenyear bond. 0744 The price of the European call is e. ThefìvE• year bond price is $105 .10.6). If thθ yield volatility for a fìv，萨year put option on a bond maturing in 10 years time is specifìed as 22% .968)e01X4 = 104 . how should the option be valued? Assume that. What is the present value of the principal in the fouryear bond? What is the present value of the coupons in the fouryear bond? What is the forward price of the bond underlying the option? What is the value of the option? The present value of the principal in the four year bond is 100e. d2 = 出一 0.032 = 34. therefore .47% 136 . K = 100 .02 V4 = 1.2 x 0.475 The parameters in Black's model are therefore Fo = 104 .07 x 4. This means that the forward price of the bond underlying the option is (105 .02 飞/4 = 0.34. r and σ= 0. and the volatility of the forward príce of the bond underlying the option is 2% per annum. Problem 19.5 x 0.19 or $3. Problem 19. the strike price of the option is $100.1 . 102 .01X4 [104 .02.475N( 1.option on the bond. Would you expect the resultant price to be too high or too low? Explain your answer. 1144) . 1144 0. The coupons on the fouryear bond are the income on the fiveyear bond during the life of the option.
If the thre e. oor? What does the common strike price equal? A 5year zerocost collar where the strike price of the cap equals the strike price of the fioor is the same as an interest rate swap agreement to receive fioating and pay a 自xed rate equal to the strike price. The common strike price is the swap rate. the same volatility is used to value each caplet within a given cap.. 6. A corporation knows that in three months it wil1 have $5 m i11ion to invest for 90 days at LIBOR minus 50 basis points and wishes to ensure that the rate obtained wil1 be at least 6. Flat volatilities are a function of the maturity of the cap. Suppose tbat tbe l. We enter Semiannual for the Settlement Frequency.5% when LIBOR is less than 7%.This is the volatility substituted into equation (19. at volatilities to va1ue a five.5%.9% .0% in the Term Structure table. one Eurodollar futures options provide a payoff of $25 per 0.4%. When spot volatilities are used to value a cap . When fiat volatilities are used .oors b.， 5year zero rates as 6% .2).13.cost 5year col1 ar wben the cap rate is 8% We choose the Caps and Swap Options worksheet of DerivaGem and choose Cap/Floor as the Underlying Type. 0 for the Start (Years) .4%. Tbe price of a 5year semiannual cap with a principal 0 1' $100 at a cap rate of 8% is $3.) Problem 19. 1. oor rate in a zero. Explain carefully how you would use (a) spot volatilities and (b) B. 5 for the End (Years) . Each 0. We enter the 1飞鸟，鸟， 4. 100 for the Principal . 6. The 5… year B. 6. The corporation requires a three. Note that the swap is actually a forward swap that excludes the 直rst exchange of payments. at volatility for caps and B. The B.7% . 3year.01%.cost col1 ar ín which the strike price of the cap equals the strike price of the B. 6.12. VVh at other instrument is the same as a fiveyear zero.year. 6. (See Business Snapshot 19. 6 .year cap. A total of 500/25 = 20 contracts are therefore required. 2year. Problem 19.1 1..month LIBOR is less than 7% . Problem 19. the Eurodollar futures quote at option maturity will be less than 93 and there will be no payoff from the option. What position in exchang traded interestrate options should the corporation take? • The rate received will be less than 6. 4year and 5year zero rates are 6% . and 7%. If threemonth LIBOR is greater than 7% at the option maturity.01% of interest costs the corporation $500 (= 5 .7% . Problem 19. 000 .14. Spot volatilities are a function of the maturity of the caplet. and 7.month call option on a Eurodollar futures option with a strike price of 93. a di旺'erent volat i1i ty is used to value each caplet.9% .0001). 8% for the 137 . 000 x 0. Use DerivaGem to determine a.
Explain wby tbere is an arbitrage opportunity if tbe implied Black (fJ. Suppose tbat zero rates are as in Problem 19. xed rate of RK between times T1 and T 2 . When R K equals the current forward swap rate f = 0 and V1 =巧. Both portfolios are then worth zero since the swap option to pay RK is neutralized by the forward swap. Problem 19.2 is cap 十 swap= 自001 must hold for market prices.15. The implied volatility is 24. The swap option to pay RK will be exercised and the swap option to receive RK will not be exercised. Do tbe broker quotes in Table 19. A collar when the 丑oor rate is 6.17. Deduce tbat V1 =巧 wben RK equals the current forward swap rate. An argument similar to that in Section 17..1 present an arbítrage opportuníty? The putcall parity relationship in Business Snapshot 19. The 且rst consists of the swap option to receive RK.1 do not present an arbitrage opportunity because the cap offer is always higher than the fioor bid and the fioor offer is always higher than the cap bid.16.71 % and the cap rate is 8% hωzero cost. We select BlackEuropean as the Pricing Model and choose the Cap butt∞. and $3 for the Price. Sbow tbat V1 + f = 巧 wbere ~气 is tbe value of a swap option to pay a 丘xed rate of RK and receive LIBOR between times T1 and 巧 ， f is tbe value of a forward swap to receive a fì. Use DerivaGem to determine tbe value of an option to pay a fì.71%. Problem 19.Cap/Floor Rate . We then uncheck Implied Volatility. This proves the result. at) volatility for a cap is different from tbat for a fJ. the second consists of the swap option to pay RK and the forward swap. The swap option to receive RK is exercised and the swap option to pay RK is not exercised. xed rate of 6% and receive LIBOR on a fì. 1 shows that the implied volatility of the cap must equal the implied volatility of the calL If this is not the case there is an arbitrage opportunity. They must thereÍore be worth the same today. select Floor . xed rate of RK and pay LIBOR between times T1 and 玛， and V与 is tbe value of a swap option to receive a fì. check Imply Breakeven Rate. Problem 19. We check the Imply Volatility box and Calculate.79%. oor. We prove this resu1t by considering two portfolios. Suppose that the actual swap rate at the maturity of the options is greater than RK. A swap option to pay fixed is therefore worth the same as a similar swap option to receive fixed when the fixed rate in the swap option is the forward swap rate. This is the fioor rate for which the 丑oor is worth $3. The broker quotes in Table 19.14. In all states of the world the two portfolios are worth the same at time T1 . Both portfolios are then equivalent to a swap where RK is received and fioating is paid. veyear swap 138 . It also holds for Black's model. Suppose next that the actual swap rate at the maturity of the options is less than RK. The 丑oor rate that is calculated is 6.
starting in one year. Assume that the principal is $100 m i11ion , payments are exchanged semiannually, and the swap rate volatility is 21 %.
We choose the Caps and Swap Options worksheet of DerivaGem and choose Swap Option as the Under lyi鸣 Type. We enter 100 as the Principal , 1 as the Start (Years) , 6 as the End (Years) , 6% as the Swap Rate , and Semiannual as the Settlement Frequency. We choose BlackEuropean as the pricing model , enter 21% as the Volati1ity and check the Pay Fixed button. We do not check the Imply Breakeven Rate and Imply Volatility boxes. The value of the swap option is 5.63.
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CHAPTER 20 Exotic Options and Other Nonstandard Products
Derivatives traders have been very imaginative in designing new derivative instruments. This chapter attempts to give the reader a fiavor for the nonstandard products that exist. It introduces exotic options , mortgagE• backed securities , and nonstandard swaps. Some of the instruments covered are designed to meet the hedging 丑eeds of corporate treasurers or fund managersi some are designed for tax , accounting , legal or regulatory reasonsi some are simply interesting alternatives to the "plain vanilla" products. The exotic options discussed include Bermudan options , forward start options , compound options , chooser options , barrier options , binary options , lookback options , shout options , and Asian options. You should make sure you understand how each of these work. Mortgagebacked securities (MBSs) are very important instruments i丑 the United States. They are created when a financial institution securitizes part of its residential mortgage portfolio. The mortgages are put in a pool and investors acquire a stake in the pool by buying units. The mortgages are guaranteed against defaults by a government agency, but there is prepayment risk. As rates decline there is a tendency for mortgage holders to prepay. The prepayments are passed on to the MBS holders who then have to reinvest the funds at a lower rate of interest than they were earning before. Often mortgagebacked securities are designed so that different investors bear different amounts of prepayment ris k. The final part of the chapter discusses nonstandard swaps. These are variations on the swaps discussed in Chapter 7. Among the different types of swaps discussed are those where the principal changes through time , where the 丑oating interest rate is not LIBOR , where interest is compounded forward rather than being paid out , LIBORin.arrears swaps , CMS and CMT swaps , di旺'erential swaps , equity swaps , accrual swaps , cancelable swaps , index amortizing swaps , commodity swaps and volatility swaps. You should make sure you understand how they wor k. SOLUTIONS TO QUESTIONS AND PROBLEMS Problern 20.8. Descríbe tbe payoff 企om a portfolío consístíng of a lookback call and a lookback put wítb tbe same maturity. A lookback call provides a payoff of ST  Smin' A lookback put provides a payoff of Smax  ST. A combination of a lookback call and a lookback put therefore provides a payoff of Smax  Smin' Problern 20.9. Consíder a cbooser option wbere tbe bolder bas tbe rígbt to cboose between a European call and a European put at any tíme duríng a twoyear períod. Tbe maturíty dates and
140
strike prices for the calls and puts are the same regardless of when the choice is made. 1s it ever optimal to make the choice before the end of the tWD year period? Explain your answer.
No , it is never optimal to choose early. The resulting cash fl. ows are the same regardless of when the choice is made. There is no point in the holder making a commitment earlier than necessary. This argument also applies when the holder chooses between two American options providing the options cannot be exercised before the twoyear point. If the early exercise period starts as soon as the choice is made , the argument does not hold. For example , if the stock price fell to almost nothing in the 且rst six months , the holder would choose a put option at this time and exercise it immediately. Problem 20.10.
Suppose that C1 and P1 are the prices of a European average price call and a European average price put with strike price K and maturity T , C2 and P2 are the prices of a European average strike call and European average stríke put wíth maturíty 1', and C3 and P3 are the príces of a regular European call and a regular European put wíth strike príce K and maturíty 1'. Show that
C1 斗 C2  C3
= P1 十 P2
 P3
The payoffs are as follows: C1 : max(Save  K , 0) C2 : max(ST  Save , 0)
max(ST  K , 0) P1 : max(K  Save , 0) P2 : max(Save  ST , 0) P3 : max(K ST , 0)
The payoff from C1  P1 is always Save " K; The payoff 仕om The payoff from C3 P3 is always ST  K; It follows that
C1  P1 十 C2 "C2  P2
句 :
is always ST " Save;
P2 =
C3 
P3
or
C1 斗 C2 " C3
= P1 十 P2 
P3
Problem 20.1 1.
The text deríves a decomposítíon of a particular type of chooser optíon into a call maturíng at time 1'2 and a put maturíng at tíme 1'1 ' By usíng putcall paríty to obtain an expression for c instead of p , derive an alternative decomposítion ínto a call maturíng at tíme 1'1 and a put maturing at time T 2 •
Substituting for c , putcall parity gives
max(c , p) = m缸卡， p 十 Sle Q (巧 Td 一 Ke一俨(斗T1 ) ]
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th仔money forward start option on a nondividendpaying stock that wil1 start in three years and mature in fìve years is worth the same as a two.14.year at自由φ money option starting today. We can now use riskneutral valuation. A put option with strike price K and maturity 巧. Suppose that c is the value of a twoyear option starting today.q(T2T1 ) call options with strike price K e一 (rq)(T2 T1 ) and maturity T 1 .13. Discounting this to today at the riskfree rate gives c . this is less than K e 9T and therefore is less than the amount required to exercise the option. At time T the cash balance is K e9T . It follows that the value of the forward start optio日 in three years is C8T / 8 0 . The argument is similar to that given in Chapter 9 for a regular option on a non. Consider a portfo1io consisting of the option and cash equal to the present value of the terminal strike price.=p 十 max [0 . De自ne 8 0 as the stock price today and 8T as its value in three years. e.the圃. Problem 20. Explain why a downandout put is worth zero when the barrier is greater than the strike price.q (T2 Td 一 K e.q (巧一旦 )m以 [0， 8 1 Ke一川(川)] This shows that the chooser option can be decomposed into 1. 8 1 e. proving the required resu 1t.money option is proportional to the stock price when there are no dividends.Tl)] =p+e. However . The BlackScholes formula in Chapter 12 shows that the value of an at. Prove that an at.12. in these circumstances the barrier has been hit and the option has ceased to exist. and 2. the terminal value of the portfolio is less than 8 T . This is exactly what is 142 . Show that if 9 is less than the risk企ee rate. The initial cash position is Ke 9T 一俨T By time T (0 三 T 三 T) ， the cash grows to Ke9TrTerr = Ke 9r e 一 (r 才)(Tr) Since r > g . It follows that . r . Problem 20. it is never optimal to exercise the call early.r(T2. Suppose that the strike price of an American call option on a nondividendpaying stock grows at rate g. The option is in the money only when the asset price is less than the strike price. The expected value of the option in three years in a riskneutral world is c80 erT /80 = ce rT . if the option is exercised early. dividendpaying stock. Problem 20.
Answer the following questions about compound options: (a) What putcall parity relationship exists between the price of a European call on a call and a European put on a call? (b) What putcall parity relationship exis归 between the price of a European cal1 on a put and a European put on a put? (a) The putcall relationship is cc+KHTT1=pc+C where cc is the price of the call on the call . This increases the value of a lookback call.. It follows that early exercise cannot be optimal. (b) The putcall relationship is cp + K 1 e. If the early exercise decision is delayed until time T . and Kl is the exercise price for cp and pp. pc is the price of the put on the call . Both sides of the equation represent the values of portfolios that will be worth max(p .16. c is the price today of the call into which the options can be exercised at time T1 .andout call decreases 咱 For a similar reason the value of a downandin call increases. Problem 20. Does a lookback cal1 become more valuable or less valuable as we increase the frequency with which we observe the asset price in calculating the minimum? As we increase the frequency we observe a more extreme minimum.required to exercise the option.17. the asset price becomes more likely to hit the barrier and the value of a down. K J) at time T1 . Both sides of the equation represent the values of portfolios that will be worth max(c . KegTj This is at least as great as ST. The proof is similar to that for the usual putcall parity relationship in Chapter 9. the terminal value of the portfolio is therefore max[ST . K 1 ) at time T 1 . Problem 20. The proof is similar to that in Chapter 9 for the usual putcall parity relationship. Problem 20. 143 . Does a downandout call become more valuable or less valuable as we increase the 企equency with which we observe the asset price in determining whether the barrier has been crossed? What is the answer to the same question for a downandin cal1? As we increase the frequency with which the asset price is observed . and Kl is the exercise price for cc and pc. pp is the price of the put on the put . p is the price today of the put into which the options can be exercised at time T 1 .15.rT1 = pp 十 p where cp is the price of the call on the put .
5% and Tr easury rates are 6% with semiannual compounding . Explain why a regular European call option is the sum of a downandout European call and a downandin European call.65.90.65)/100) or 28.19. the CMT% is 7% and the price of a 30year bond with a 6.5 Because N(d 2 ) = 0. Estimate the interest rate paid by P&G on the 5/30 swap in Business Snapshot 20 .18. What is the value of a derivative that pays off $100 in six months ifthe S&P 500 index is greater than 1. 144 .25% coupon is about 90. The value is 100N(d 2 )e 一 O ， 08x05 where d2 = + (0.78 . = 0. The rate paid by P&G is 35.1826 \/0.企ee rate is 8% per annum . 明Then the CP rate is 7.5 X 7/5. Problem 20.2 2 /2) X 0. The spread is therefore max[O .2 X 0. This is a cashornothing call.08 一一一一一一一一一 ln(960/1000) 0.75%.0. If the barrier is not reached the downandin option is worth nothing while the downand.46. If the barrier is reached the downandout option is worth nothing while the downandi丑 option has the same value as a regular option.Problem 20.5 户一 一一一一一一一一::.4 if a) the CP rate is 6. (98.64%. When the CP rate is 6.03.out option has the same value as a regular option.39%. This is why a downandout call option plus a downandin call option is worth the same as a regular option.000 and zero otherwise.5% and the 'fr easury yield curve is f1 at at 7%. Assume that the current level ofthe index is 960.20. 08. the CMT% is 6% and an Excel spreadsheet can be used to show that the price of a 30year bond with a 6.4276 the value of the derivative is $4 1. and the volatility of the index is 20%.5% and Tr easury rates are 7% with semiannual compounding . the risk. the dividend yield on the index is 3% per annum .5% and the 'fr easury yield curve is f1 at at 6% and b) the CP rate is 7.25% coupo丑 is about 103. Problem 20. The spread is zero and the rate paid by P&G is 5.
We calculate the present value of the expected payments and the present value of the expected payoffs. This is designed to provide bond holders with insurance against defau1ts by a particular company or country for a period of time. The CDS spread quoted for a new deal is the CDS spread per annum that equates the present value of expected payments to the present value of expected payoffs. Note that the valuation of a credit default swap really involves nothing more than present value arithmetic. Note also how the recovery rate is de且ned. (Estimati鸣 spreads from actively traded CDSs and using them to price other CDSs is analogous to what traders do when estimating volatilities for valuing options. (Thus if the CDS spread is 200 basis points the payments are 2% of the notional principal each year. A notional principal is specified.CHAPTER 21 Credit Derivatives Credit derivatives are contracts where the payoff depends on the creditworthiness of companies or countries. The company or country is known as the reference entity. It follows that the payoff 企om a CDS in the event of a default is L(l.R) where L is the principal and R is the recovery rate. the buyer of the CDS gets nothing in return for the payments. 2 to 21. The total face value of the bonds that can be sold equals the notional principal. These are sometimes estimated from bond prices and sometimes implied from the spreads quoted for credit defau1t swaps themselves. It is estimated as the ratio of the value of a bond just after a default to the face value of the bond. the buyer has the right to sell bonds issued by the reference entity for their face value.) If there is no default . Sometimes the payoff is made in cash rather than by the delivery of a bond. The payments are a certain percentage of the notional principal each year. A calculation agent is then used to observe bond prices immediately after a default and estimate R. 5 carefully to make sure you understand all the details of how CDSs work and how they are valued.) Make sure you understand the difference between co 145 . You should study Tables 2 1. The valuation of a credit defau1t swap requires estimates of the risk neutral probabilities of defau1t during each year of its life. The buyer of a CDS makes regular payments to the seller of the CDS. If there is a default . The most popular credit derivative is a credit default swap (CDS). Usually the payoff is triggered by a default on outstanding debt obligations. This percentage is referred to as the CDS spread.
0291 0. Suppose that the risk.8853 0.66918 0.0300 0. giving unconditional default probabilities .0266 The table corresponding to Table 21.73648 Total The table corresponding to Table 21.9324 0. Typically some investors have very little default risk exposure while others have high exposures.9409 0.9127 0. 2.9700 0.LIBOR plus a spread.企ee zero curve is ß. at at 7% per annum with continuous compounding and that defaults can occur half way through each year in a new fì. v year credit default swap.90448 0.81808 0.88538 0.73988 0.7047 0. A credit default swap forward is an obligation to buy or sell a credit default swap in the future. is 146 .7558 0.0282 0.8853 0. Suppose that the recovery rate is 30% and the default probabilities each year conditionalon no earlier default is 3% Estimate the credit default swap spread? Assume payments are made annually.8587 q d 哇 ， 。 A 0. Collateralized debt obligations are arrangements whereby the default risk on a portfolio of bonds is shared between different investors. A credit default swap option is the right to buy or sell a credit default swap in the future.0274 0. 8. 3 .60518 3.8106 0.9409 0. giving the present value of the expected payoffs (notional principal =$1) .8694 0. is 一一一… 一一一 Time (years) 1 2 3 4 5 Probability of Survival 0.8587 Expected Payment 0.9700 0. giving the present value of the expected regular payments (payment rate is 8 per year) . 4 .85878 Discount Factor 一一一一 PV of Expected Payment 一一一一一 0.9127 0.94098 0.97008 0.91278 0. is Time (years) 1 i q 白 P pHMa Dm 旧 uub 嘀 u m E ' 3 E A i 宁b a  嘀 4L VU Survival Probability 0. SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 2 1. • The table corresponding to Tables 21.
Time (years) 0.5 1. 5 2.5 3.5 4.5 Total
Probability of Default 0.0300 0.0291 0.0282 0.0274 0.0266
Recovery Rate 0.3 0.3 0.3 0.3 0.3
Exppaeycotf ed 0.0210 0.0204 0.0198 0.0192 0.0186
Discount Factor 0.9656 0.9003 0.8395 0.7827 0.7298
PV oPfaEyxopfected 0.0203 0.0183 0.0166 0.0150 0.0136 0.0838
The table corresponding to Table 21. 5, giving the present value of accrual payments ,
lS
一一
Time (years) 0.5 1. 5 2.5 3.5 4.5 Total
Probability of Default 0.0300 0.0291 0.0282 0.0274 0.0266
Expected Accrual Payment 0.01508 0.01468 0.01418 0.01378 0.01338
Discount Factor 0.9656 0.9003 0.8395 0.7827 0.7298
PV of Expected Accrual Payment 0.01458 0.01318 0.01188 0.01078 0.00978 0.05988
The credit default swap spread
8
is given by:
3.73648 + 0.05988 = 0.0838 It is 0.0221 or 221 basis points. Problem 2 1. 9. What is the value of the swap in Problem 21.8 per dollar of notional principal to the protection buyer if the credit default swap spread is 150 basis points?
If the credit default swap spread is 150 basis points , the value of the swap to the buyer of protection is: 0.0838 一 (3.7364 + 0.0598) x 0.0150 = 0.0269
per dollar of notional principal. Problem 2 1. 10. What is the credit default swap spread in Problem 21.8 if it is a binary CDS?
If the swap is a binary CDS , the present value of expected payoffs is calculated as
follows 147
Time (years) 0.5 1. 5 2.5 3.5 4.5 Total
Probeafbaiuliltty ofD 0.0300 0.0291 0.0282 0.0274 0.0266
Expected Payoff 0.0300 0.0291 0.0282 0.0274 0.0266
Discount Factor 0.9656 0.9003 0.8395 0.7827 0.7298
PV opfaEyxopfected 0.0290 0.0262 0.0237 0.0214 0.0194 0.1197
The credit default swap spread 8 is given by:
3.73648 十 0.05988
= 0.1197
It is 0.0315 or 315 basis points.
Problem 2 1. 1 1. How does a nveyear nth.todefault credit default swap work. Consider a basket of 100 reference entities where each reference entity has a probabi1ity of defaulting in each year of 1 %. As the default correlation between the reference entities increases what would you expect to happen to the value ofthe swap when a) n = 1 and b)η= 25. Explain your answer.
A 且veyear nth to default credit default swap works in the same way as a regular credit default swap except that there is a basket of companies. The payoff occurs when the nth default 仕om the companies in the basket occurs. After the nth default has occurred the swap ceases to exist. When η= 1 (so that the swap is a "直rst to default") an increase in the default correlation lowers the value of the swap. When the default correlation is zero there are 100 independent events that can lead to a payoff. As the correlation increases the probability of a payoff decreases. In the limit when the correlation is perfect there is in effect only one company and therefore only one event that can lead to a payoff. When n 25 (so that the swap is a 25th to default) an increase in the default correlation increases the value of the swap. When the default correlation is zero there is virtually no chance that there will be 25 defaults and the value of the swap is very close to zero. As the correlation increases the probability of multiple defaults increases. In the limit when the correlation is perfect there is in effect only one company and the value of a 25thtodefault credit default swap is the same as the value of a firsttodefault swap.
Problem 2 1. 12. How is the recovery rate of a bond usually denned? The recovery rate of a bond is usually de且ned as the value of the bond a few days after a default occurs as a percentage of the bond's face value.
148
Problem 2 1. 13. Show that the spread for a new plain vanil1 a CDS should be 1  R times the spread for a simi1 ar new binary CDS where R is the recovery rate. The payoff 仕om a plain vanilla CDS is 1  R times the payo旺 from a binary CDS with the same principal. The payoff always occurs at the same time on the two instruments. It follows that the regular payments on a new plai丑 vanilla CDS must be 1  R times the payments on a new binary CDS. Otherwise there would be an arbitrage opportunity. Problem 2 1. 14. Veri.命 that if the CDS spread for the example 1n Tables 21.2 to 21.5 1s 100 basis po1nts and the probabi1i ty of default in a year (conditional on no earlier default) must be 1.61%. How does the probability of default change when the recovery rate 1s 20% instead of 40%. Ver1命 that your answer 1s consistent with the implied probabi1i ty of default being approximately proportional to 1/(1  R) where R 1s the recovery ratθ. The 1. 61% implied default probability can be calculated by setting up a worksheet in Excel and using Solver. To veri句T that 1. 61% is correct we note that , with a conditional default probability of 1. 61 %, the unconditional probabilities are: Time (years)
1 i
P
Dm 旧 c 廿M
p
'
唱 。
u
a
u m
， 』 ，
·
4Lii
·
咽A
4L
y
Survival Probability 0.9839 0.9681 0.9525 0.9371 0.9221
。
q J A H i v h d
中
0.0161 0.0158 0.0156 0.0153 0.0151
The present value of the regular payments becomes 4.1170s , the present value of the expected payoffs becomes 0.0415 , and the present value of the expected accrual payments becomes 0.0346s. When s = 0.01 the present value of the expected payments equals the present value of the expected payoffs. When the recovery rate is 20% the implied default probability (calculated using Solver) is 1. 21 % per year. Note that 1. 21/ 1. 61 is approximately equal tωo (υ1 一一0 .4钊)/(口 一 0.2) 由 owi n 1 勾 s ho 坦 旧 that the implied default probability is approximately proportional to 1/(1 R)" In passing we note that if the CDS spread is used to imply an unconditional default probability (assumed to be the same each year) then this implied unconditional default probability is exactly proportional to 1/ (1 R). When we use the CDS spread to imply a conditional defal山 probability (assumed to be the same each year) it is only approximately proportional to 1/(1  R). Problem 2 1. 15. A company enters into a total return swap where it receives the return on a corporate bond paying a coupon of 5% and pays LIBOR Explain the difference between this and a regular swap where 5% 1s exchanged for LIBOR. 149
Why is there a potential asymmetric information problem in credit default swaps? Payoffs from credit default swaps depend on whether a particular company defaults. 18.) Problem 2 1. (See Business Snapshot 21." Explain this statement. 16. When a company buys a call (put) option contract it has the option to buy (sell) the protection given by a speci且ed credit default swap with a specified spread at a specified future time. Problem 2 1. "The position of a buyer of a credit default swap is simi1 ar to the position of someone who is long a riskfree bond and short a corporate bond. 17.In the case of a total return swap a company receives (pays) the increase (decrease) in the value of the bond. Explain how forward contracts and options on credit default swaps are structured. It follows that the use of real world default probabilities will tend to understate the value of a CDS. 2. In a regular swap this does not happen. Problem 2 1. 150 . Its approximate effect is to convert the corporate bond into a risk仕ee bond. This means that the buyer is long a riskfree bond and short a similar corporate bond. When a company enters into a long (short) forward contract it is obligated to buy (sell) the protection given by a specified credit defau1t swap with a specified spread at a specified future time. The buyer of a credit default swap has therefore chosen to exchange a corporate bond for a risk仕ee bond. 19. Real world defau1t probabilities are less than riskneutral default probabilities. Problem 2 1. A credit default swap insures a corporate bond issued by the reference entity against default. Does valuing a CDS using actuarial default probabilities rather than riskneutral default probabi1i ties overstate or understate its value? Explain your answer. Arguably some market participants have more information about this that other market participants. Both contracts are normally structured so that they cease to exist if a default occurs during the life of the contract.
Veather ， CHAPTER 22 Energy. swaps . For gas the volatility and mean reversion are somewhat higher. It considers how weather . CAT bonds typically offer a higher rate of interest than regular bonds. Contracts typically relate to the delivery of a certain number of gallons of a certain type of oil at a certain location. However . forwards . and Insurance Derivatives This chapter describes some nontraditional derivatives products.A . This means that prices fluctuate randomly. (This is largely because it is not possible to store electricity and so a day's demand must be met by electricity generation 坦 白at day. the bond principal m SOLUTIONS TO QUESTIONS AND PROBLEMS Problem 22. 0) where A is the average of the maximum and minimum temperature during the day. An alternative to traditional reinsurance is a CAT bond. This is the payoff from a put option on A with a strike price of 151 . The CDD for a day is max(A 一 65 ， 0) where A is the average of the highest and lowest temperature in degrees Fahrenheit during the day. However . gas derivatives .飞. The temperature variable for a month is typically calculated as the cumulative coo1ing degree days (CDD) or cumulative heati吨 degree days (HDD). Popular contracts are forwards and options on the cumulative CDD or HDD during a month. The most common weather derivatives have payoffs dependent on the temperature at a particular weather station during a particular month. and insurance derivatives are typically structured. Energy prices exhibit volatility and mean reversion. energy.) In a traditional reinsurance contract an insurance company pays other companies to take on risks it does not want to bear itself. "HDD and CDD can be regarded as this statement. in the case of electricity the supplier may have the right the change the rate at which power is supplied during the month in certain ways. Oil has a relatively low volatility and a relatively low rate mean reversion." Explain HDD is max(65 . The gas derivatives market typically involves forward contracts or options for the delivery of gas at a certain rate to a certain hub for the whole of a month.8. The electricity derivatives contract also typically involves forward contracts or options for the delivery of electricity at a certain rate to a specific location for the whole of a month. The three most important types of energy derivatives are oil derivatives . and options) trade actively in both exchanges and overthecounter markets. 0). The HDD for a day is max(65 .A . Electricity has a very high volati1ity and a very high rate of mean reversion. but tend to be pulled back to a longrun average level. and electricity derivatives. payoffs 企om options on temperature. The oil derivatives market is a well established market where a variety of different contracts (such as futures .
when the spot price changes by a certain amount . and e is the error. The risks in the CAT bond are likely to be largely "diversi且ed away" by the other investments in the portfo1io. Suppose that you have 50 years of temperature data at your disposal. Problem 22. Problem 22. 2008 is a contract to provide electricity for 且ve days per week duri吨 the offpeak period (l1 pm to 7am). 152 . Explain how a 5 x 8 option contract for May 2008 on electricity with dai1y exercise works. Problem 22. phe occurs is independent of the return on the market.1 1. A linear regression relationship CDD=α 十 bt 十 ε could then be estimated where αand b are constants . This is because . Would you expect mean reversion to cause the volati1ity of the thre令month fon再rard price of an energy source to be greater than or less than the volatility of the spot price? Explain your answer. Explain the analysis you would you carry out to calculate the forward cumulative CDD for next July. Whether a particular type of catastro. The expected CDD for next year (year 51) is thenα + 51b. 0).12. The volatility of the threemonth forward price will be less than the volatility of the spot price. This could be used as an estimate of the forward CDD. It would be useful to calculate the cumulative CDD each July each year for the last 50 years. One is a Brated corporate bond. t is the time in years measured from the start of the 50 years .65. When daily exercise is speci且时， the holder of the option is able to choose each weekday whether he or she will buy electricity at the strike price at the agreed rate. An analysis based on historical data shows that the expected losses on the two bonds in each year of their life is the same. When there is monthly exercise . It is likely therefore that the CAT bond is a better addition to the portfolio. A Brated bond does have systematic risk that cannot be diversi直ed away. The other is a CAT bond. Explain how a 5 x 8 option contract for May 2008 on electricity with monthly exercise works. Consider two bonds that have the same coupon .9. mean reversion will cause the forward price will change by a lesser amount. Which bond would you advise a portfolio manager to buy and why? The CAT bond has very little systematic ris k.65 . This is the payoff from cal1 option on A with a strike price of 65. The option with daily exercise is worth more. time to maturity and price. he or she chooses once at the beginning of the month whether electricity is to be bought at the strike price at the agreed rate for the whole month. Which is worth more? A 5 x 8 contract for May. Problem 22.10. This relationship allows for linear trends in temperature through time. CDD is max(A .
153 . The most important point to understand is that derivatives can be used in many different ways. It is important to understand what went wrong and how similar catastrophes can be avoided in the future. Most derivatives trades are entered into for sensible reasons. It is hard to believe that some of the events outlined in this chapter actually happened. It is important to recognize that the events are not representative of how derivatives are used most of the time. Overall the derivatives industry has been a huge multitrillion dollar success story. It is important for all companies (缸lancial and no硝nancial) to define clear and unambiguous risk limits and to set up internal controls to ensure that the limits are adhered to. They can be used to reduce the risks that arise from a company's operations or to take risks.CHAPTER 23 Derivatives Mishaps and 认That We Can Learn from Them Derivatives markets have been responsible for some spectacular losses. It wi1l be fascinating to see how it evolves in the years to come. This is the focus of this final chapter.
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