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**Manual for SOA Exam FM/CAS Exam 2.
**

Chapter 7. Derivatives markets. Section 7.1. Derivatives. c 2009. Miguel A. Arcones. All rights reserved.

Extract from: ”Arcones’ Manual for the SOA Exam FM/CAS Exam 2, Financial Mathematics. Fall 2009 Edition”, available at http://www.actexmadriver.com/

1/52

c 2009. Miguel A. Arcones. All rights reserved.

Manual for SOA Exam FM/CAS Exam 2.

Chapter 7. Derivatives markets.

Section 7.1. Derivatives.

Risk sharing

A risk is a contingent ﬁnancial loss. Changes in commodity prices, currency exchange rates and interest rates are potential risks for a business. A farmer faces the possible fall of the price of his/her crop. Surging oil prices can wipe out airlines’ proﬁts. Manufacturing companies face high rising prices of commodities. These changes in prices could hurt the viability of a business.

2/52

c 2009. Miguel A. Arcones. All rights reserved.

Manual for SOA Exam FM/CAS Exam 2.

Chapter 7. Derivatives markets.

Section 7.1. Derivatives.

Risk sharing

A risk is a contingent ﬁnancial loss. Changes in commodity prices, currency exchange rates and interest rates are potential risks for a business. A farmer faces the possible fall of the price of his/her crop. Surging oil prices can wipe out airlines’ proﬁts. Manufacturing companies face high rising prices of commodities. These changes in prices could hurt the viability of a business. Many of the risks faced by business are diversiﬁable. A risk is diversiﬁable if it is unrelated to another risk. Markets permit diversiﬁable risks to be widely shared.

3/52

c 2009. Miguel A. Arcones. All rights reserved.

Manual for SOA Exam FM/CAS Exam 2.

Chapter 7. Derivatives markets.

Section 7.1. Derivatives.

Risk sharing

A risk is a contingent ﬁnancial loss. Changes in commodity prices, currency exchange rates and interest rates are potential risks for a business. A farmer faces the possible fall of the price of his/her crop. Surging oil prices can wipe out airlines’ proﬁts. Manufacturing companies face high rising prices of commodities. These changes in prices could hurt the viability of a business. Many of the risks faced by business are diversiﬁable. A risk is diversiﬁable if it is unrelated to another risk. Markets permit diversiﬁable risks to be widely shared. Risk is nondiversiﬁable when it does vanish when spread across many investors.

4/52

c 2009. Miguel A. Arcones. All rights reserved.

Manual for SOA Exam FM/CAS Exam 2.

Chapter 7. Derivatives markets.

Section 7.1. Derivatives.

Risk sharing

A risk is a contingent ﬁnancial loss. Changes in commodity prices, currency exchange rates and interest rates are potential risks for a business. A farmer faces the possible fall of the price of his/her crop. Surging oil prices can wipe out airlines’ proﬁts. Manufacturing companies face high rising prices of commodities. These changes in prices could hurt the viability of a business. Many of the risks faced by business are diversiﬁable. A risk is diversiﬁable if it is unrelated to another risk. Markets permit diversiﬁable risks to be widely shared. Risk is nondiversiﬁable when it does vanish when spread across many investors. A way to do risk sharing for companies is to do contracts to avoid risks.

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c 2009. Miguel A. Arcones. All rights reserved.

Manual for SOA Exam FM/CAS Exam 2.

Section 7.Chapter 7. Arcones. Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. The value of a derivative contract depends on the value of another asset.1. Derivatives markets. Manual for SOA Exam FM/CAS Exam 2. Derivatives. Miguel A. . All rights reserved. 6/52 c 2009.

Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. Derivatives markets.Chapter 7. Section 7. All rights reserved. Derivatives. Miguel A. They are several possible reasons to enter into a derivative market: 7/52 c 2009.1. The value of a derivative contract depends on the value of another asset. . Arcones. Manual for SOA Exam FM/CAS Exam 2.

Derivatives. All rights reserved. Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. Manual for SOA Exam FM/CAS Exam 2. 8/52 c 2009. Derivatives markets. Miguel A. Arcones.Chapter 7. They are several possible reasons to enter into a derivative market: Risk management. Section 7. .1. The value of a derivative contract depends on the value of another asset. Parties enter derivatives to avoid risks.

Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. Manual for SOA Exam FM/CAS Exam 2.1. Speculation. 9/52 c 2009. A market–maker enters into derivatives to make money. Parties enter derivatives to avoid risks. Arcones. All rights reserved. Derivatives markets. . They are several possible reasons to enter into a derivative market: Risk management. Section 7. Parties enter derivatives to make money. Miguel A.Chapter 7. Derivatives. The value of a derivative contract depends on the value of another asset.

Derivatives can be used to reduce commodity costs. borrowing costs. Derivatives. Derivatives markets. Manual for SOA Exam FM/CAS Exam 2. Reduce transaction costs. They are several possible reasons to enter into a derivative market: Risk management. Parties enter derivatives to avoid risks.Chapter 7. . Parties enter derivatives to make money. etc. A market–maker enters into derivatives to make money. Miguel A.1. Speculation. Section 7. 10/52 c 2009. Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. Arcones. All rights reserved. The value of a derivative contract depends on the value of another asset.

1. borrowing costs. The value of a derivative contract depends on the value of another asset. Section 7. . All rights reserved. Arbitrage. Parties enter derivatives to make money. investors can make a proﬁt. Reduce transaction costs. etc. Arcones. Manual for SOA Exam FM/CAS Exam 2. Derivatives can be used to reduce commodity costs. A market–maker enters into derivatives to make money. 11/52 c 2009. When derivatives are miss priced. Derivatives. They are several possible reasons to enter into a derivative market: Risk management. Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. Speculation. Parties enter derivatives to avoid risks. Miguel A.Chapter 7. Derivatives markets.

A market–maker enters into derivatives to make money. The value of a derivative contract depends on the value of another asset. accounting regulations and taxes. investors can make a proﬁt. Speculation. Sometimes business enter into derivatives to get around regulatory limitations.1. borrowing costs. When derivatives are miss priced.Chapter 7. They are several possible reasons to enter into a derivative market: Risk management. Section 7. Derivatives Deﬁnition 1 A derivative is a contract which speciﬁes the right or obligation to receive or deliver certain asset for a certain price. 12/52 c 2009. Miguel A. . All rights reserved. Reduce transaction costs. Regulatory arbitrage. Manual for SOA Exam FM/CAS Exam 2. Derivatives. Derivatives can be used to reduce commodity costs. etc. Parties enter derivatives to make money. Arcones. Derivatives markets. Arbitrage. Parties enter derivatives to avoid risks.

Arcones. It is a win–win contract for both of them. the farmer and the baker can agree to sell/buy wheat one year from now at a certain price. Example 1 Suppose that a farmer grows wheat and a baker makes bread using wheat and other ingredients. All rights reserved. Derivatives. In order to avoid possible ﬁnancial losses which may jeopardy their businesss proﬁtability. Section 7. . Miguel A. Manual for SOA Exam FM/CAS Exam 2.Chapter 7.1. If the price of the wheat increases. If the price of the wheat decreases. the baker loses money. 13/52 c 2009. The two risks are diversiﬁable. Derivatives markets. The contract they enter is a derivative. the farmer loses money.

If the price of the wheat increases. . Section 7. Arcones. The contract they enter is a derivative. 14/52 c 2009.1. the baker loses money. Derivatives. The two risks are diversiﬁable. the farmer and the baker can agree to sell/buy wheat one year from now at a certain price. Manual for SOA Exam FM/CAS Exam 2. Example 1 Suppose that a farmer grows wheat and a baker makes bread using wheat and other ingredients. All rights reserved. Usually. A market–maker or scalper makes a contract with the farmer and another with the baker. The farmer and the baker enter into this contract to do hedging.Chapter 7. the farmer loses money. the contract is not made directly between them. Derivatives markets. In order to avoid possible ﬁnancial losses which may jeopardy their businesss proﬁtability. Miguel A. It is a win–win contract for both of them. If the price of the wheat decreases.

. stock indexes. silver. ethanol. lead. currency exchange rates and interest rates. Section 7. platinum) and energy (crude oil. All rights reserved. copper. aluminum. Derivatives. wheat. Common commodities in derivatives are agricultural (corn. Derivatives are often traded on commodities. Manual for SOA Exam FM/CAS Exam 2. sugar. metals (gold. Arcones. Derivatives in Practice.Chapter 7. gasoline). orange juice).1. soybeans. Miguel A. natural gas. live cattle. 15/52 c 2009. Derivatives markets. stock. coﬀee. hogs lean. cattle feeder.

platinum) and energy (crude oil. The biggest markets in derivatives are the Chicago Board for Trade. Miguel A. Arcones. natural gas. stock indexes. live cattle.Chapter 7. wheat. silver. Derivatives markets. metals (gold. Derivatives in Practice. coﬀee. Derivatives are often traded on commodities.S. 16/52 c 2009. currency exchange rates and interest rates. ethanol. soybeans. Common commodities in derivatives are agricultural (corn. and the Eurex (Frankfurt. Manual for SOA Exam FM/CAS Exam 2. for more than 100 years. sugar. aluminum. Derivative contracts for agricultural commodities have been traded in the U. Germany). orange juice). Section 7. the Chicago Mercantile Exchange. All rights reserved. Derivatives. . gasoline).1. lead. cattle feeder. hogs lean. stock. the New York Mercantile Exchange. copper.

orange juice). Derivatives are often traded on commodities. hogs lean. platinum) and energy (crude oil. Derivatives. ethanol. lead.S. . All rights reserved. stock. soybeans. aluminum. copper. and the Eurex (Frankfurt. wheat. the New York Mercantile Exchange. sugar. 17/52 c 2009. Common commodities in derivatives are agricultural (corn. currency exchange rates and interest rates. The market in derivatives is regulated by the (SEC) Securities and Exchange Commission and the (CFTC) Commodity Futures Trading Commission. Manual for SOA Exam FM/CAS Exam 2. gasoline). Derivatives markets. Germany). live cattle. the Chicago Mercantile Exchange. metals (gold. coﬀee. Derivative contracts for agricultural commodities have been traded in the U. for more than 100 years. Derivatives in Practice.1. Miguel A. stock indexes. silver. cattle feeder.Chapter 7. Section 7. natural gas. Arcones. The biggest markets in derivatives are the Chicago Board for Trade.

Chapter 7. Derivatives. Arcones. Usually. . Section 7. Manual for SOA Exam FM/CAS Exam 2. All rights reserved. scalpers are ﬁnancial institutions. 18/52 c 2009.1. Buying an asset (Scalpers) Market–makers buy/sell stock and derivatives making transactions possible. Miguel A. Derivatives markets.

Section 7. Buying an asset (Scalpers) Market–makers buy/sell stock and derivatives making transactions possible. scalpers buy low and sell high. scalpers are ﬁnancial institutions. All rights reserved. 19/52 c 2009.Chapter 7. Manual for SOA Exam FM/CAS Exam 2. In order to make a living. Derivatives markets. Usually. .1. Derivatives. Miguel A. Arcones.

Derivatives. The bid price of an asset is the price at which a scalper takes bids for an asset (a bid is an oﬀer).Chapter 7. Usually. Miguel A. scalpers buy low and sell high. All rights reserved. Buying an asset (Scalpers) Market–makers buy/sell stock and derivatives making transactions possible.1. Derivatives markets. In order to make a living. 20/52 c 2009. . The price at which the scalper buys is called the bid price. Manual for SOA Exam FM/CAS Exam 2. scalpers are ﬁnancial institutions. Arcones. Section 7.

The price at which the scalper buys is called the bid price. Derivatives. 21/52 c 2009. Arcones. scalpers are ﬁnancial institutions. The price at which the scalper sells is called the oﬀer price or ask price.Chapter 7. .1. scalpers buy low and sell high. Section 7. Manual for SOA Exam FM/CAS Exam 2. In order to make a living. All rights reserved. The bid price of an asset is the price at which a scalper takes bids for an asset (a bid is an oﬀer). Usually. Buying an asset (Scalpers) Market–makers buy/sell stock and derivatives making transactions possible. Miguel A. Derivatives markets.

scalpers are ﬁnancial institutions. The diﬀerence between the bid price and the oﬀer price is called the bid–ask spread. The price at which the scalper buys is called the bid price. Manual for SOA Exam FM/CAS Exam 2. In order to make a living. scalpers buy low and sell high. .Chapter 7. Buying an asset (Scalpers) Market–makers buy/sell stock and derivatives making transactions possible. The bid price of an asset is the price at which a scalper takes bids for an asset (a bid is an oﬀer). Derivatives markets.1. Usually. Derivatives. Section 7. All rights reserved. The bid price is lower than the oﬀer price. Miguel A. The price at which the scalper sells is called the oﬀer price or ask price. Arcones. 22/52 c 2009.

The bid price is lower than the oﬀer price. Derivatives. The price at which the scalper sells is called the oﬀer price or ask price. Scalpers also ask for commissions. 23/52 c 2009. In order to make a living. Buying an asset (Scalpers) Market–makers buy/sell stock and derivatives making transactions possible. bid–ask percentage spread is the bid–ask spread divided over the ask price. . Arcones. Derivatives markets.Chapter 7. Manual for SOA Exam FM/CAS Exam 2. scalpers are ﬁnancial institutions. Miguel A. The bid price of an asset is the price at which a scalper takes bids for an asset (a bid is an oﬀer). Usually. All rights reserved. The diﬀerence between the bid price and the oﬀer price is called the bid–ask spread. Section 7.1. The price at which the scalper buys is called the bid price. scalpers buy low and sell high.

. Arcones.1.Chapter 7. Derivatives. Miguel A. All rights reserved. 24/52 c 2009. Section 7. bid ask or oﬀer price price at which the scalper buys price at which the scalper sells The bid price is lower than the oﬀer price. Manual for SOA Exam FM/CAS Exam 2. Derivatives markets.

Chapter 7. Derivatives. Example 2 An online currency exchange service’s bid rate for Japanese yens is $0. Section 7.1. Miguel A. Find the bid–ask percentage spread. Derivatives markets. Arcones. 25/52 c 2009.00838 and its ask rate is $0.00847. . Manual for SOA Exam FM/CAS Exam 2. All rights reserved.

Chapter 7. Example 2 An online currency exchange service’s bid rate for Japanese yens is $0. Find the bid–ask percentage spread.00847 26/52 c 2009. Section 7. Derivatives markets. 0.00847. Derivatives. . Manual for SOA Exam FM/CAS Exam 2.00847−0. Arcones. Miguel A. All rights reserved. Solution: The ask percentage spread is 0.00838 and its ask rate is $0.1.00838 = 1.062574%.

All rights reserved. Manual for SOA Exam FM/CAS Exam 2. . (iii) Find the bid–ask percentage spread.94% (i) Find the price the dealer is asking for the T bill (ii) Find the price the dealer is buying the T bill.96% Ask 4.Chapter 7. Derivatives. Miguel A. Derivatives markets. Section 7. 27/52 c 2009. Arcones. Example 3 $1 million face value six month T bill is traded by a government security dealer who give the following annual nominal discount yield convertible semiannually: Bid 4.1.

(iii) Find the bid–ask percentage spread.96% Ask 4. Solution: (i) (1000000)(1 − (0. Arcones.94% (i) Find the price the dealer is asking for the T bill (ii) Find the price the dealer is buying the T bill. Manual for SOA Exam FM/CAS Exam 2.1. Section 7. . Example 3 $1 million face value six month T bill is traded by a government security dealer who give the following annual nominal discount yield convertible semiannually: Bid 4. All rights reserved. Miguel A. Derivatives. Derivatives markets.0494/2)) = 975300 28/52 c 2009.Chapter 7.

94% (i) Find the price the dealer is asking for the T bill (ii) Find the price the dealer is buying the T bill.0496/2)) = 975200. Example 3 $1 million face value six month T bill is traded by a government security dealer who give the following annual nominal discount yield convertible semiannually: Bid 4. . Derivatives.Chapter 7. Arcones. (iii) Find the bid–ask percentage spread. 29/52 c 2009. All rights reserved. Solution: (i) (1000000)(1 − (0.0494/2)) = 975300 (ii) (1000000)(1 − (0. Section 7. Manual for SOA Exam FM/CAS Exam 2.1. Miguel A.96% Ask 4. Derivatives markets.

Solution: (i) (1000000)(1 − (0.Chapter 7. (iii) Find the bid–ask percentage spread.96% Ask 4.0496/2)) = 975200. Section 7.1. Example 3 $1 million face value six month T bill is traded by a government security dealer who give the following annual nominal discount yield convertible semiannually: Bid 4. All rights reserved. Notice that the dealer sells the T bill for money than he buys it. Manual for SOA Exam FM/CAS Exam 2. Derivatives. Arcones. Derivatives markets. 30/52 c 2009.94% (i) Find the price the dealer is asking for the T bill (ii) Find the price the dealer is buying the T bill.0494/2)) = 975300 (ii) (1000000)(1 − (0. Miguel A. .

Derivatives. 975300 31/52 c 2009. Derivatives markets. (iii) Find the bid–ask percentage spread.1. Arcones. Section 7.96% Ask 4. .94% (i) Find the price the dealer is asking for the T bill (ii) Find the price the dealer is buying the T bill. Notice that the dealer sells the T bill for money than he buys it. Manual for SOA Exam FM/CAS Exam 2.0494/2)) = 975300 (ii) (1000000)(1 − (0. All rights reserved. (iii) The bid–ask percentage spread is 975300−975200 = 0.Chapter 7.01025325541%.0496/2)) = 975200. Solution: (i) (1000000)(1 − (0. Miguel A. Example 3 $1 million face value six month T bill is traded by a government security dealer who give the following annual nominal discount yield convertible semiannually: Bid 4.

Buying an asset means to make an investment. Later. Section 7. 32/52 c 2009. Derivatives markets.Chapter 7. Buying an asset is like lending money. we say to this person has a long position in this asset. Long and short positions When some one owns an asset. he may sell the asset and receive cash. Arcones.1. . Manual for SOA Exam FM/CAS Exam 2. All rights reserved. Miguel A. Derivatives.

Derivatives. 33/52 c 2009.Chapter 7. Section 7. Manual for SOA Exam FM/CAS Exam 2. . When some one needs to buy an asset in the future. All rights reserved. Later. Arcones. Long and short positions When some one owns an asset. it is said that this person has a short position in the asset. we say to this person has a long position in this asset. Buying an asset means to make an investment. Buying an asset is like lending money.1. Derivatives markets. Miguel A. he may sell the asset and receive cash.

Section 7. 34/52 c 2009. Later. All rights reserved.Chapter 7.1. Manual for SOA Exam FM/CAS Exam 2. Arcones. The act of buying the replacement asset and return it to the lender is called to close or cover the short position. the short seller must buy back the asset paying cash for it and return it to the lender. Short sale A short sale of an asset entails borrowing an asset and then immediately selling the asset receiving cash. Derivatives markets. Derivatives. Miguel A. .

Miguel A.Chapter 7. Section 7. 35/52 c 2009. the short seller must buy back the asset paying cash for it and return it to the lender. Derivatives markets. All rights reserved. Later. The act of buying the replacement asset and return it to the lender is called to close or cover the short position. Short sale A short sale of an asset entails borrowing an asset and then immediately selling the asset receiving cash. believe price will increase price will decrease derivative purchase short sale desired outcome buy low now and sell high later sell high now and buy low later Table: An investor makes money buying low and selling high. Derivatives. Arcones. .1. Manual for SOA Exam FM/CAS Exam 2.

Miguel A.Chapter 7. Arcones. All rights reserved. Section 7. .1. Derivatives markets. Manual for SOA Exam FM/CAS Exam 2. There are three main reasons to short sell: 36/52 c 2009. Derivatives.

Arcones. Section 7. An investor enters a short sale because he believes that the price of the stock will drop and desires to proﬁt from this price movement. . Derivatives markets.1. There are three main reasons to short sell: Speculation. 37/52 c 2009. All rights reserved. Manual for SOA Exam FM/CAS Exam 2. Derivatives. Miguel A.Chapter 7.

Derivatives. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.1. Arcones.Chapter 7. A short sale is a way to borrow money. An investor enters a short sale because he believes that the price of the stock will drop and desires to proﬁt from this price movement. Financing. Section 7. 38/52 c 2009. Miguel A. There are three main reasons to short sell: Speculation. . Derivatives markets.

Section 7. Derivatives markets. Financing. Manual for SOA Exam FM/CAS Exam 2.1. 39/52 c 2009. A short sale is a way to borrow money.Chapter 7. Miguel A. There are three main reasons to short sell: Speculation. A short sale can be undertaken to oﬀset the risk of owning an asset. An investor enters a short sale because he believes that the price of the stock will drop and desires to proﬁt from this price movement. Derivatives. All rights reserved. Hedging. . Arcones.

Chapter 7. . Section 7. Derivatives markets. Miguel A. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.1. In order to a short sale to take place several conditions must be taken into account: 40/52 c 2009. Arcones. Derivatives.

. Derivatives markets. All rights reserved.1. In order to a short sale to take place several conditions must be taken into account: Availability of a lender of stock.Chapter 7. A lender must interested in making some money and losing temporarily his voting rights on the company issuing the stock. Arcones. 41/52 c 2009. Derivatives. Manual for SOA Exam FM/CAS Exam 2. Miguel A. Section 7.

Manual for SOA Exam FM/CAS Exam 2. In order to a short sale to take place several conditions must be taken into account: Availability of a lender of stock. . Section 7.1. Derivatives. 42/52 c 2009. Arcones. The short seller make be required to set–up a bank account with a deposit as collateral. All rights reserved. A lender must interested in making some money and losing temporarily his voting rights on the company issuing the stock. Credit risk of the short seller.Chapter 7. Miguel A. Derivatives markets.

Derivatives. Scarcity of shares. Credit risk of the short seller.1. Miguel A. . Derivatives markets. If the stock pays dividends. Manual for SOA Exam FM/CAS Exam 2. the short seller must return the paid dividend payments to the stock lender. Arcones. In order to a short sale to take place several conditions must be taken into account: Availability of a lender of stock. 43/52 c 2009. The short seller make be required to set–up a bank account with a deposit as collateral.Chapter 7. A lender must interested in making some money and losing temporarily his voting rights on the company issuing the stock. Section 7. All rights reserved.

1.93. Mary covers her position 6 months later when the bid price is $15. The commission to close the short sale is $15. How much does Mary earn in this short sale? 44/52 c 2009.12 and ask price of $18. All rights reserved.Chapter 7. Manual for SOA Exam FM/CAS Exam 2. XYZ stock did not pay any dividends in those six months.74 and the ask price is $15. Arcones. Derivatives markets.56. Miguel A. Derivatives. . Example 4 Mary short sells 200 shares of XYZ stock which has a bid price of $18. Her broker charges her a 0. Section 7.5% commission to take on the short sale.

Section 7.93) + 15 = $3201.12 and ask price of $18. The commission to close the short sale is $15. How much does Mary earn in this short sale? Solution: Mary short sells the stock for (200)(18. Mary covers her position 6 months later when the bid price is $15. Manual for SOA Exam FM/CAS Exam 2. 45/52 c 2009.5% commission to take on the short sale. Miguel A.88. All rights reserved.74 and the ask price is $15. Her broker charges her a 0. Derivatives.88.93. .Chapter 7. Example 4 Mary short sells 200 shares of XYZ stock which has a bid price of $18.56. XYZ stock did not pay any dividends in those six months.005) = $3605.88 − 3201 = $404. Mary earns 3605.1.12)(1 − 0. Mary covers her position for (200)(15. Arcones. Derivatives markets.

short sellers are required to make a deposit as collateral into an account with the lender. Derivatives. the excess of the margin over the current asset price is called haircut. Miguel A. Section 7. Derivatives markets.Chapter 7. Manual for SOA Exam FM/CAS Exam 2. Usually. Arcones. If this is so. Often. This account is called the margin account. The margin requirement could be bigger than the current asset price. This deposit is called the margin requirement. the margin requirement is a percentage of the current price of the stock. 46/52 c 2009. All rights reserved.1. .

. 47/52 c 2009. Derivatives markets. This deposit is called the margin requirement. All rights reserved. The margin requirement could be bigger than the current asset price. Miguel A.Chapter 7. Usually. Manual for SOA Exam FM/CAS Exam 2. Demand on short sales is a factor to determine the margin account interest rate. This margin account generates an interest for the investor. Arcones. Section 7. short sellers are required to make a deposit as collateral into an account with the lender. Often.1. This account is called the margin account. The margin interest rate is called the repo rate for bonds and the short rebate for stock. the excess of the margin over the current asset price is called haircut. If this is so. the margin requirement is a percentage of the current price of the stock. Derivatives.

Demand on short sales is a factor to determine the margin account interest rate. This margin account generates an interest for the investor. Manual for SOA Exam FM/CAS Exam 2. Usually. Usually. the lender can require payment of certain beneﬁts lost by lending the asset. Often. Derivatives markets. the lease rate of a stock is the payment of the dividends obtained while the stock was shorted.Chapter 7. the excess of the margin over the current asset price is called haircut. This payment requirement is called the lease rate of the asset. c 2009. All rights reserved. If this is so. short sellers are required to make a deposit as collateral into an account with the lender. 48/52 . When borrowing. Usually. Derivatives. Section 7. The margin requirement could be bigger than the current asset price. This deposit is called the margin requirement.1. the lease rate of a bond is the payment of the coupons obtained while the bond was shorted. The margin interest rate is called the repo rate for bonds and the short rebate for stock. This account is called the margin account. Miguel A. the margin requirement is a percentage of the current price of the stock. Arcones.

I = Mj interest earned by the short seller on the margin deposit. Manual for SOA Exam FM/CAS Exam 2.1. This margin account generates an interest for the investor.Chapter 7. j = rate of interest earned in the margin account. i = yield rate on the short sale. If the stock which the investor borrows pays a dividend. All rights reserved. D = dividend paid by the short seller to the security’s owner. Section 7. . The investor has to set–up an account with a percentage of the current price of the stock. Miguel A. Derivatives markets. 49/52 c 2009. Sometimes short sales are subject to a margin requirement (or deposit). Arcones. the investor must pay the dividend to the brokerage ﬁrm making the loan. We have the following variables in a short sale of a stock: P = proﬁt on sale=price sold−price bought. M = margin requirement= deposit on the short sale. Derivatives.

Chapter 7. We have that the net proﬁt is Net proﬁt = gain on short sale+interest on margin−dividend on stock = P Hence. Arcones. the yield rate earner in a short sale is i= net proﬁt P +I −D = .1. Miguel A. Section 7. Derivatives. margin M 50/52 c 2009. All rights reserved. Derivatives markets. . Manual for SOA Exam FM/CAS Exam 2.

Jason’s annual eﬀective yield in this investment is 17.25 per share dividend paid on December 31. There is a $0. Jason’s margin account earns an annual eﬀective interest rate of i. All rights reserved. Section 7. Derivatives. On January 2.1. Miguel A. Jason is required to hold a margin account with his broker equal to 50% of the short security’s initial value.Chapter 7. . Example 5 Jason sold short 1. Arcones. Find i. 2007. Jason buys back stock to cover his position at a price of $70 per share.000 shares of FinanTech at $75 a share on January 2. 2006. 51/52 c 2009.6667%. Derivatives markets. 2006. Manual for SOA Exam FM/CAS Exam 2.

M = (75)(1000)(0. M 37500 = 5%. I = 37500i and D = (1000)(0.50) = 37500.6667%. Jason’s annual eﬀective yield in this investment is 17. 2007. Arcones. 2006. Manual for SOA Exam FM/CAS Exam 2. All rights reserved. Miguel A. Find i. Jason’s margin account earns an annual eﬀective interest rate of i. Jason is required to hold a margin account with his broker equal to 50% of the short security’s initial value. Jason buys back stock to cover his position at a price of $70 per share. Derivatives.176667 = Hence. . i = 5000 + 37500i − 250 P +I −D = . Section 7.25) = 250. There is a $0.176667)(37500)−5000+250 37500 c 2009.Chapter 7. 2006. Example 5 Jason sold short 1. On January 2. Derivatives markets. Jason’s annual eﬀective yield is 0.000 shares of FinanTech at $75 a share on January 2.25 per share dividend paid on December 31.1. 52/52 (0. Solution: We have that P = (75)(1000) − (70)(10000) = 5000.

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