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You are on page 1of 149

Dean Faculty of Management Sciences

MAJU ISLAMABAD

2015

WASEEM A. QURESHI

MM 141063

0344-5599155

waseemqurashi@hotmail.com

6/16/2015

ACKNOWLEDGEMENT

I would like to express my sincere gratitude to Dr. Arshad Hassan, Dean, Faculty of

Management science Muhammad Ali Jinnah University, Islamabad for his guidance,

constant inspiration and valuable suggestions during writing of these notes on FRM

based on class lectures of the legend professor.

The completion of this task could not have been possible without the backing and

guidance of Sir Arshad Hassan whose contributions are gratefully acknowledged.

MM 141063

2

Waseem A. Qureshi MM141063

CONTENTS:

S.NO.

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

PARTICULARS

Risk, Systematic & unsystematic

Risk Management, sources of risk

Exchange rate factors

Artificial Hedging

Financial derivatives

Margin Call

Hedging & speculation

Examples (forwards, futures ,options)

Assignment No. 1(Hedging)

Assignment No. 2(Hedging)

Pricing & Evaluation of Forwards

Commodity forward

Equity forward

Bond forward

Currency forward

Interest rate forward

Questions from book (forwards chapter)

Swap markets and contracts

Interest rate swap

Currency swaps

Equity swaps

Credit default, subordinate risk swaps

Options market & Evaluation

Concepts and basic strategies of options

Duration of bond

Valuation of options

Valuation of options (Binomial model, one period)

Valuation of options (Binomial model, Two period)

The Black-Scholes-Merton Model

The Merton model

Option Sensitivities (Greeks)

Assignment No. 3 (Option sensitivities)

Valuation at Risk (VaR)

Credit risk

Credit risk, Estimation Techniques

Operation Risk

Sovereign Risk

Country Ratings

Page No.

04

05

08

09

12

14

20

21-40

41

44

46

49

51

55

54

55

56-68

69

70

71

75

78

79

79

93

93

94

98

100

104

105

109

111

117

124

143

146

148

3

Waseem A. Qureshi MM141063

RISK:

It is defined as uncertainty about future outcomes. Or it is the probability of loss, probability

that actual return may differ from expected return. The risk may be categorized as Systematic

risk and unsystematic risk.

A. SYSTEMATIC RISK:

() beta

Risk which is common to an entire market because of the economic changes or other events

that impacts large portion of the market. for example a significant political event may affect

several securities. This risk is based on macro economic variables so no individual business

can have control over it. Therefore it is unavoidable, uncontrollable and undiversifiable.

cov (Rm - Rf) / 2m

Volatility due to the overall stock market

Since this risk cannot be eliminated through diversification, this is often called non

diversifiable risk.

it has four components. Business risk, financial risk, liquidity risk, country risk.

B. UNSYSTEMATIC RISK:

It is company or industry specific risk that is inherent in each investment. It is also known as

diversifiable, avoidable, controllable and specific risk.

Volatility due to firm-specific events

Can be eliminated through diversification

Also called firm-specific risk and diversifiable risk

An investor can only reduce unsystematic risk. This can be done by spreading

investments over a number of different assets

REDUCING UNSYSTEMATIC RISK THROUGH DIVERSIFICATION:Risk

0

0

Unsystematic

0

0

0

Systematic

0

0

0

Number of

Investments

8-12

30

Risk management

Businesses, nonprofits, governments, and individuals engage in risk-taking activities.

Although they may hedge their risks on occasion, they should not restrict their activities to

those that are risk free. The fact that these entities engage in risky activities raises a number of

important questions:

- How is risk defined?

- How does one recognize and measure risk?

- Which risks are worth taking on a regular basis, which are worth taking on occasion, and

which should never be take?

- How are risks reduced or eliminated? What strategies should be used?

- How are the processes of risk taking and risk elimination monitored?

4

Waseem A. Qureshi MM141063

These questions and many others collectively define the process of risk management. In short,

how is risk managed? To understand this concept, we start with a formal definition of risk

management.

Risk management is the process of identifying the level of risk that an entity wants,

measuring the level of risk that an entity currently has, taking actions that bring the actual

level of risk to the desired level of risk, and monitoring the new actual level of risk so that it

continues to be aligned with the desired level of risk. The process is continuous and may

require alterations in any of these activities to reflect new policies, preferences, and

information.

An important thing to note is that, risk management not means always decreasing the risk, as it

is done through hedging. Sometimes we need to increase the risk to go for some extra rewards.

Risk management is a general practice that can entail reducing or increasing risk.

Risk Management Process:

Sources of Risk:

The sources of risk can be divided in two broad categories.

A. Financial risk.

1. Exchange rate risk

2. Interest rate risk

3. Credit risk

4. Equity risk

5. Liquidity risk

6. Commodity risk

B. Non-financial risk

1. Operational risk

2. Legal risk

3. Regulation risk

4. Accounting risk

5. Settlement risk

6. Taxation risk

7. Model risk

5

Accounting

Liquidity

Taxes

Credit

Legal

Commodity

Regulatio

ns

Non-Financial

Financial

Company

Equity

Settlement

Exchange

rate

Mode

l

Operational

Interest

rate

Financial risk

Financial risk is an umbrella term for multiple types of risk associated with financing. It is a

risk that a firm will be unable to meet its financial obligations. Five categories under financial

risk are discussed below:

a. Exchange Rate Risk:

Uncertainty about future Changes in exchange rates of one currency in relation to another

currency is exchange rate risk. It may be further classified in three categories.

Translation risk, transaction risk, economic risk.

i. Transaction risk: It is the risk that an exchange rate will change unfavorably over time. It

deals with imports and exports. If rates move unfavorably, the receivables may decrease or

payables may increase.

ii. Translation risk:

A firm's translation exposure is the extent to which its financial

reporting is affected by exchange rate movements. As all firms generally must prepare

consolidated financial statements for reporting purposes, the consolidation process for

multinationals entails translating foreign assets and liabilities or the financial statements of

foreign subsidiary / subsidiaries from foreign to domestic currency. While translation exposure

may not affect a firm's cash flows, it could have a significant impact on a firm's reported

earnings and therefore its stock price. Translation exposure is distinguished from transaction

risk as a result of income and losses from various types of risk having different accounting

treatments.

6

Waseem A. Qureshi MM141063

iii. Economic risk: A firm has economic exposure (also known as forecast risk) to the degree

that its market value is influenced by unexpected exchange rate fluctuations. Such exchange

rate adjustments can severely affect the firm's market share position with regards to its

competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure

can affect the present value of future cash flows. Any transaction that exposes the firm to

foreign exchange risk also exposes the firm economically, but economic exposure can be

caused by other business activities and investments which may not be mere international

transactions, such as future cash flows from fixed assets. A shift in exchange rates that

influence the demand for a good in some country would also be an economic exposure for a

firm that sells that good.

Example:

The cost of a product per unit is Rs. 100 in Pakistan. Sales price is cost plus 20%. The

dollar rate is Rs. 100 / $ today. The international market price of the product is $1.3.

It means they want to sell it for Rs. 120 or $1.2 in the market which is feasible as it is

below than international price of $1.3. suppose dollar price goes down to Rs. 80 / $ . Now the

product cost becomes $ 1.25 and selling price will be cost plus 20%, i.e. $1.5 now it becomes

more than $1.3 and cannot be sold in international market.

b. Interest rate risk:

The risk that an investment's value will change due to a change in the absolute level of interest

rates, in the spread between two rates, in the shape of the yield curve or in any other interest

rate relationship. Such changes usually affect securities inversely and can be reduced by

diversifying (investing in fixed-income securities with different durations) or hedging).

c. Credit risk:

Credit risk refers to the risk that a borrower will default on any type of debt by failing to make

required payments. The risk is primarily that of the lender and includes lost principal and

interest, disruption to cash flows, and increased collection costs.

d. Market risk / equity risk:

Market risk is the risk that the value of an investment will decrease due to moves

in market factors. Volatility frequently refers to the standard deviation of the change in value

of a financial instrument with a specific time horizon.

e. Liquidity risk:

Liquidity risk is the risk that a financial instrument may not be traded without a significant

concession in price due to the size of the market. This risk manifests itself much more on the

sell side of a transaction than on the buy side.

NON FINANCIAL RISKS:

These are the risks that may not cause some direct financial losses but the results can cause

some serious affects for the continuation of business and ultimately cause financial loss.

Following are some sources of non financial risk faced by organizations.

7

Waseem A. Qureshi MM141063

a. Operational risk:

Operational risk is defined as the risk of loss resulting from inadequate or failed processes,

people and systems or from external events. This definition includes legal risk, but excludes

strategic and reputational risk.

b. Regulation risk:

The risk that a change in laws and regulations will materially impact a security, business,

sector or market. A change in laws or regulations made by the government or a regulatory

body can increase the costs of operating a business, reduce the attractiveness of investment

and/or change the competitive landscape.

c. Legal Risk:

The potential loss that may occur to an investment as a result of insufficient, improperly applie

d, or simply unfavorable legalproceedings in the country in which the investment is made. For

example, a country may have inadequate bankruptcy protection or, inan extreme circumstance,

the government may be able to seize property without provocation. On the other hand, legal ri

sk existseven in countries that operate under the rule of law: a court, for instance, may find aga

inst a company in a given lawsuit, creating aprecedent for other companies with similar operati

ons.

d. Taxation risk:

The risk that tax laws relating to dividend income and capital gains on shares and other

securities might change, making stocks less attractive.

e. Accounting risk:

It is the risk associated with the financial statements of an organization that can be affected

by exchange rate fluctuations. It is also called accounting exposure or translation risk.

f. Settlement risk:

The payments involved in swaps, forward contracts and options are referred to as settlements.

The process of settlement involves one or both parties making payments. Any bankruptcy

from any side can cause breach of agreement and creates risk of losses.

Exchange rate factors: / factors influencing exchange rates.

The exchange rate is one of the most important determinants of a country's relative level of

economic health. It plays a vital role in trade, which is critical to most free market economies.

But exchange rates matter on a smaller scale too. They even impact the real return of an

investor's portfolio. Here well look at the main factors influencing exchange rates.

Factor 1: Differentials in Inflation. As a general rule, a country with a consistently lower

inflation rate exhibits a rising currency value, as its purchasing power increases relative to

other currencies. Those countries with higher inflation typically see depreciation in their

currency's value in relation to the currencies of their trading partners.

8

Waseem A. Qureshi MM141063

Factor 2: Differentials in Interest Rates. By manipulating interest rates, central banks exert

influence over both inflation and exchange rates. Higher interest rates offer lenders a higher

return relative to other countries. The impact of higher interest rates is mitigated, however, if a

country's inflation is much higher than other countries', or if additional factors serve to drive

their currency value down. The opposite relationship exists for decreasing interest rates.

Factor 3: Current-Account Deficits. The current account is the balance of trade between a

country and its trading partners, reflecting all payments between countries for goods, services,

interest and dividends. A deficit in the current account shows a country is importing goods and

services more than it is exporting them. The country will then typically borrow capital from

foreign sources to make up the deficit, causing its currency to depreciate relative to its trading

partner.

Factor 4: Public Debt. Countries will engage in large-scale deficit financing to pay for

public sector projects using governmental funding. While such activity stimulates the domestic

economy, nations with large public deficits and debts are less attractive to foreign investors.

This is because a large debt encourages more inflation, and higher inflation translates into

lower currency value.

Factor 5: Terms of Trade. A country's terms of trade is a ratio comparing export prices to

import prices. If the price of a country's exports rises by a greater rate than that of its imports,

its terms of trade have favorably improved, which tends to show currency appreciation.

However, if the price of a country's imports rises more than the rate of exports, their currency's

value will decrease in relation to trading partners.

Factor 6: Political Stability and Economic Performance. Foreign investors inevitably seek

out stable countries with strong economic performance in which to invest their capital.

Political turmoil, for example, can cause a loss of confidence in a currency, and a movement

of capital to the currencies of more stable countries.

Choices available to address instability in the exchange rate.

1.

2.

3.

4.

5.

Invoice in some stable anchor currency.

Matching the imports and exports in same currency.

Artificial matching. / Money market hedge.

Financial derivatives. (forwards, futures, swaps, options)

A hedge is an investment position intended to offset potential loss that may be incurred by a

companion investment. In simple language, a hedge is used to reduce any substantial losses

suffered by an individual or an organization.

It can also be defined as A risk management strategy used in limiting or offsetting probability

of loss from fluctuation in the prices of commodities, currencies, or securities. In effect,

hedging is a transfer of risk without buying insurance policies.

Hedging is always bidirectional. It has two positions in every case. It may be receivable and

payable, buy or sell, long or short. When there is a receivable, hedger need to create a payable

for the same amount to hedge that amount.

9

Waseem A. Qureshi MM141063

1. Calculate Present value (PV)

2. Change the amount in home currency

3. Calculate future value (FV)

EXAMPLE 1:

UK Company is exporting $100 million goods receivable in 6 months. Spot rate 1 = 1.5$.

UK

US $

Lending

5%

6%

Borrowing

7%

8%

What is effective conversion rate?

Solution:

Whenever a company needs to hedge, it must create receivable for every payable or

payable for receivables to meet the hedge conditions, as hedge is always bilateral. Here we

need to create a 100m payable account for the receivable amount.

Step 1: calculate PV of $100m using borrowing rate.

= PV(1 + i)

=

(1+i)

PV = 100 / (1 + .08)1/2

96.2250m $

Step 2: Change the amount in home currency ($ into )

1 = 1.5$

$ 96.2250m = ? , 96.2250 / 1.5 = 64.15m

Step 3: calculate FV for investable amount in the home currency at lending rate.

= PV(1 + i)

,

FV = 64.14(1 + .05)1/2 = 65.73m

What is effective rate at which it is actually replaced.

$ amount / amount = effective rate :

$ 100 / 65.73 = $ 1.513 /

It means 1 is replace with $1.5213

EXAMPLE 2:

A UK exporter has following transactions to be settled in following 6 months.

A

B

C

Exports

500m

$ 400m

50m

Imports

-- 50m

$ 200m

10

Waseem A. Qureshi MM141063

US $

UK

Lending

8%

10%

Borrowing

10%

13%

Inflation

5%

8%

Spot rate

1.5 =

1

Q 1. What is effective exchange rate.

Q 2. Do they need to hedge.

Solution:

500m receivable is an amount in home currency, so we dont need to hedge for this amount.

50m is receivable and at the same amount is payable, so no need to hedge for this amount.

$ 400m is receivable and $ 200m is payable. So there is a need to hedge for this $ 200m

difference amount.

Step 1: calculate PV of $200m using borrowing rate.

= PV(1 + i)

PV = 200 / (1 + .10)1/2

,

=

190.6925m $

Step 2: Change the amount in home currency ($ into )

1 = 1.5$

$ 190.6925 m = ? , 190.6925 / 1.5 = 127.1283m

Step 3: calculate FV for investable amount in the home currency at lending rate.

= PV(1 + i)

,

FV = 127.1283(1 + .10)1/2 = 133.33m

What is effective rate at which it is actually replaced?

200 / 133.33 = 1.5

It means 1 is replace with $1.50

Whether we need to hedge for this or not. It can be calculated by the inflation rate. We see

what will be effective exchange rate if we dont hedge.

=

PV (1+ )

(1+ )

1.5(1+.05)1/2

(1+.08)1/2

$ 1.4790

is interest rate of foreign currency

The rate calculated through inflation is $ 1.4790/ which is lower than 1.5, means we dont

need to hedge. If we convert $200 at 1.4790 per pound, we will get ($200 / 1.4790 = 135 m)

which is more than 133.33

This is the formula we use to calculate the future prices of currency.

HINT 2: sometimes direction of the currency becomes basis for decision. In depreciation

exporters dont need and importers must hedge to save their position.

11

Waseem A. Qureshi MM141063

EXAMPLE 3:

Suppose for example 2, exports are replaced with imports. Do we need to hedge?

A

B

C

Imports

500m

$ 400m

50m

Exports

-- 50m

$ 200m

Lending

Borrowing

Inflation

Spot rate

US $

8%

10%

5%

1.5

=

UK

10%

13%

8%

1

Solution:

Now we need to invest those $ 200m for future payables.

Step 1: calculate PV of $200m using lending rate.

= PV(1 + i)

Pv = 200 / (1 + .08)1/2

192.45m $

Step 2: Change the amount in home currency ($ into )

1 = 1.5$

$ 192.45 m = ? , 192.45 / 1.5 = 128.30m

Step 3: calculate FV for investable amount in the home currency at borrowing rate.

= PV(1 + i)

,

FV = 128.30(1 + .13)1/2 = 136.3847m

What is effective rate at which it is actually replaced?

200 / 136.3847 = $ 1.4664

It means 1 is replaced with $1.4664

Decision: Importer should not hedge as it is lower than inflation exchange rate which is 1.4790

Financial Derivatives

Derivatives are the securities that extract their value from some underlying entity. This

underlying can be an asset, index or interest rate and is often called the underlying.

Derivatives can be used for a number of purposes, including insuring against price movements

(hedging), increasing exposure to price movements, for speculation or getting access to

otherwise hard to trade assets or markets. Some of the more common derivatives include

forwards, futures, options, and swaps.

The price of the underlying instrument, in whatever form, is paid before control of the

instrument changes.

12

Waseem A. Qureshi MM141063

Categories of derivative.

There are two categories of derivatives.

1.

Forward commitments

2. Contingent claims

These are the obligations to be paid in the future. They have two main types on the

basis of trading.

These are traded over the counter and not in the exchange markets. (OTC options, also called

"dealer options") are traded between two private parties, and are not listed on an exchange.

The terms of an OTC option are unrestricted and may be individually tailored to meet any

business need. In general, at least one of the counterparties to an OTC option is a wellcapitalized institution.

B. Exchange traded.

These are traded in the market or different forums. It has two types. Exchange traded options

have standardized contracts, and are settled through a clearing house with fulfillment

guaranteed by the Options Clearing Corporation (OCC)

A. FORWARD COMMITMENTS

A forward commitment is an agreement between two parties in which one party agrees to buy

and the other agrees to sell an asset at a future date at a price agreed on today. The three types

of forward commitments are forward Contracts, futures contracts, and swaps.

1. FORWARD CONTRACT

Forward contract or simply a forward is a non-standardized / customized contract between

two parties to buy or to sell an asset at a specified future time at a price agreed upon today,

making it a type of derivative instrument.

This is in contrast to a spot contract, which is an agreement to buy or sell an asset on its Spot

Date, which may vary depending on the instrument. A non-standardized or customized means

according to the customer requirements.

Three things to be considered in contracts.

Quantity, Rate and Date.

Settlements

The settlement is made by physical delivery or cash settlements. As physical deliveries are

normally not carried out these days most of the settlements are done by cash settlements which

is also called synthetic forward. In this case difference of the amount is to be paid to make the

settlements. As a rule all the currency transactions are settled through cash settlements.

Example:

A contract is made today to buy 1000 ounce of gold at a price of $ 1350 after 60days.

Suppose on maturity the rate is $1370, seller will pay $20 to buyer and suppose the rate is

$1310 the buyer will pay $40 to seller to settle the transaction.

It means buyer is gain is the loss of seller and vice versa, therefore the sum of derivative

would always be zero.

13

Waseem A. Qureshi MM141063

The party agreeing to buy the underlying asset in the future assumes a long position, and the

party agreeing to sell the asset in the future assumes a short position. The price agreed upon is

called the delivery price, which is equal to the forward price at the time the contract is entered

into.

Margin

All day trading markets have margin requirements which set the minimum amount of cash

and/or securities that need to be deposited in a trading account in order to trade that market.

What is a Margin Call?

A margin call is when your day trading brokerage contacts you to inform you that the balance

of your trading account has dropped below the margin requirements for one of your active

trades. For example, if you have an active trade on the ZG (Gold) futures market, and your

trading account goes below $4,455, your brokerage would contact you with a margin call.

An example:

Consider a futures contract in which the current futures price is $82. The initial margin

requirement is 45, and the maintenance margin requirement is $2. You go long 20 contracts

and meet all margin calls but do not withdraw any excess margin. Assume that on the first day,

the contract is established at the settlement price, so there is no mark-to-market gain or loss on

the day.

Following are the prices for 6 days.

DAY:

0

1

2

3

4

5

6

Future price

82

84

78

73

79

82

84

Solution:

Day

Beginning

Balance

Funds

deposited

Futures

price

Price

change

Gain / loss

Ending

balance

100

82

100

100

84

40

140

140

78

-6

-120

20

20

80

73

-5

-100

100

79

120

220

220

82

60

280

280

84

40

320

On day 0, you deposit $100 because the initial margin requirement is 45 per contract and you

go long 20 contracts. At the end of day 2, the balance is down to $20, which is $20 below the

$40 maintenance margin requirements ($2 per contract times 20 contracts). You must deposit

enough money to bring the balance up to the initial margin requirement of $100. So on day 3,

you deposit $80. The price change on day 3 causes a gain/loss of -100, leaving you with a

balance of $0 at the end of day 3. On day 4, you must deposit $100 to return the balance to the

initial margin level.

14

Waseem A. Qureshi MM141063

A price decrease to $79 would trigger a margin call. This calculation is based on the fact that

the difference between the initial margin requirement and the maintenance margin requirement

is $3. If the futures price starts at $82, it can fall by $3 to $79 before it triggers a margin call.

Types of forwards

Following are the main types of forwards.

1.

Equity forward

It is a forward contract where underlying is a stock, portfolio of stock or stock market index.

2.

Commodity forward

3.

Currency forward

4.

Bond forward

5.

It is a forward contract where underlying is a loan. The FRA is written as 3 x 9. It means one

will take a loan after 3 months for a period of 6 months. The transaction will take 9 months to

be completed.

2. FUTURE CONTRACT

Future contract or simply a future is a standardized contract between two parties, to buy or to

sell an asset at a specified future time at a price agreed upon today, making it a type of

derivative instrument.

These contracts are standardized and market specific.

Types of futures

All the forward contracts type is replaced with future contracts.

1. Equity future

It is a future contract where underlying is a Stock, Portfolio of stock or stock market index.

2. Commodity future

It is a future contract where underlying is a commodity.

3. Currency future

It is a future contract where underlying is a currency or basket of currencies.

4. Bond future

It is a future contract where underlying is a bond or bond market index.

5. Interest rate future.

It is a future contract where underlying is a loan.

15

Waseem A. Qureshi MM141063

Differences:

The forward market is a private and largely unregulated market. Any transaction

involving a commitment between two parties for the future purchase/sale of an asset is a

forward contract. They are private transactions for a reason that, parties want to keep them

private and want little government interference.

A future contract is a variation of a forward contract that has essentially the same basic

definition but some additional features that clearly distinguish it from a forward contract.

Difference between forward and future.

Difference

Contract size

Forward

Customer specific

Future

Market specific

Maturity period

Customer specific

Market specific

In Pakistan it is last Friday

of the following month.

Settlement

On maturity

Daily settlement

Marking to market

Tradability

Risk management

mechanism

Traded in market

No mechanism, chance of Mechanism available.

default is greater

e.g. Banks / clearing

houses

Financial intermediary

No

Yes,

Liquidity

No

Yes

Marking to market

No

Yes/ Daily settlements

a. Contract specification / size

A forward contract is a customized and customer specific contract. The two parties

establish all the terms of contract, including the identity of the underlying, the expiration date

and the manner in which the contract is settled as well as the price. In a future contract price is

the only term established by the two parties, the exchange established all other terms. The

terms established by the exchange are standardized and exchange selects a number of choices

for underlying, expiration dates and a variety of other contract-specific items.

b. Maturity Period

The period of a forward contract is decided at the time of its orientation with the

consensus of parties involved while the period of a future contract is decide by the market in

which it is traded. In Pakistan the normal maturity period of futures is 30 to 60 days. Futures

are settled on the last Friday of the following month.

c. Settlements

All the forwards are settled on the maturity or where both the parties agree to settle their

contract any time before the maturity period. Futures are settled through the exchanges that

work like a clearing house on the daily basis. The clearing house requires that all the parties

settle their gains and losses to exchange on the daily basis. This process, referred to as the

daily settlement or marking to market is a critical distinction between future and forward

contracts.

16

Waseem A. Qureshi MM141063

An example:

Following is an example of marking-to-market process that occurs over a period of six days.

We start with the assumption that the futures price is $100 when the transaction opens, the

initial margin requirement is $5 and the maintenance margin requirement is $3. The trader

takes a long position of 10 contracts on day 0, depositing $50. ($5 per contract).

Initial future price $100. Initial margin requirement $5. Maintenance margin requirement $3.

Day

Beginning

Balance

Funds

deposited

Futures

price

Price

change

Gain / loss

Ending

balance

50

100

50

50

99.20

-.80

-8

42

42

96.00

-3.20

-32

10

10

40

101.00

5.00

50

100

100

103.50

2.50

25

125

125

103.00

-0.50

-5

120

120

104.00

1.00

10

130

d. Tradability

The forwards are not tradable and settled over the counter while futures are traded on

the floor of exchange.

e. Risk management mechanism

The most important difference in management of default risk associated with the

contracts. In a forward contract, the risk of default is a major concern. Specifically, the party

with a loss on the contract could default. In a future contract, however, the future exchange

guarantees to each party that if the other fails to pay, the exchange will pay.

f. Financial intermediary.

A forward is a customized contract between two parties and involves no intermediary

while futures are actually contracts organized by exchanges or banks who work as

intermediaries and clearing houses. They are the agents and guarantors of the futures.

g. Liquidity.

Futures are the contracts with generally accepted terms. Standardizing the instrument

makes it more acceptable to a broader group of participants with the advantage being the

instrument can then more easily trade in a type of secondary market. In contrast, forward

contracts are quite heterogeneous because they are customized.

A futures contract is therefore said to have liquidity in contrast to forward contract,

which does not generally trade after it has been created.

17

Waseem A. Qureshi MM141063

3. SWAP

A swap is a derivative in which two counter parties exchange cash flows of one

party's financial instrument for those of the other party's financial instrument. It is an

agreement between two parties to exchange a series of future cash flows. Typically at least one

of the two series of cash flows is determined by a later outcome. In other words, one party

agrees to pay the other a series of cash flows whose value will be determined by the unknown

future course of some underlying factor, such as interest rate, exchange rate, stock price or

commodity price.

Types of SWAPS.

1.

2.

3.

4.

5.

Currency swaps / exchange rate swaps

Commodity swaps

Credit default swaps

Subordinate risk swaps

(Detailed discussion will be available in the following lectures)

B. CONTINGENT CLAIMS

A claim that can be exercised when certain specified outcome occurs. It depends on the state

of nature of the financial claim. These claims may be OTC or exchange traded. Option is a

type of exchange traded contingent claims.

OPTIONS:

An option is a contract which gives the buyer (the owner) the right, but not the obligation, to

buy or sell an underlying asset or instrument at a specified strike price on or before a

specified date. The seller has the corresponding obligation to fulfill the transaction that is to

sell or buy if the buyer (owner) "exercises" the option. The buyer pays a premium to the

seller for this right.

An option which conveys to the owner the right to buy something at a specific price is referred

to as a call; an option which conveys the right of the owner to sell something at a specific price

is referred to as a put. Both are commonly traded, but for clarity, the call option is more

frequently discussed.

A. CALL OPTION

A Call Option is security that gives the owner the right to buy a fix no. of shares of a stock or

an index at a certain price by a certain date. That "certain price" is called the strike price, and

that "certain date" is called the expiration date.

The buyer of a call option is called long call and the seller is called short call.

A call option is defined by the following 4 characteristics:

There is an expiration date of the option

There is a strike price of the option

The option is the right to BUY the underlying stock or index. This contrasts to a put

option, which is the right to sell the underlying stock

18

A call option is called a "call" because the owner has the right to "call the stock away" from

the seller. It is also called an "option" because the owner has the "right", but not the

"obligation", to buy the stock at the strike price. In other words, the owner of the option (also

known as "long a call") does not have to exercise the option and buy the stock--if buying the

stock at the strike price is unprofitable, the owner of the call can just let the option expire

worthless.

B. PUT OPTION

A put option is the right to SELL a fix no. of shares of a stock or an index at a certain price by

a certain date. That "certain price" is known as the strike price, and that "certain date" is

known as the expiry or expiration date. A put option is a security that you buy when you think

the price of a stock or index is going to go down.

The buyer of a put option is called long put and the seller is called short put.

A put option, like a call option, is defined by the following 4 characteristics:

There is an expiration date of the put option

There is a strike price of the put option

The put option is the right to SELL the underlying stock or index at the strike price.

This contrasts with a call option which is the right to BUY the underlying stock or

index at the strike price.

It is called a "put" because it gives you the right to "put", or sell, the stock or index to

someone else. A put option differs from a call option in that a call is the right to buy the stock

and the put is the right to sell the stock.

C. EXOTIC OPTION

An exotic option is an option which has features making it more complex than commonly

traded vanilla options. Like the more general exotic derivatives they may have several triggers

relating to determination of payoff. An exotic option may also include non-standard

underlying instrument, developed for a particular client or for a particular market. Exotic

options are more complex than options that trade on an exchange, and are generally

traded over the counter (OTC).

Option general categories

American option an option that may be exercised on any trading day on or before

expiry.

Bermudan option an option that may be exercised only on specified dates on or

before expiration.

Asian option an option whose payoff is determined by the average underlying price

over some preset time period.

Barrier - option with the general characteristic that the underlying security's price must

pass a certain level or "barrier" before it can be exercised.

Binary option An all-or-nothing option that pays the full amount if the underlying

security meets the defined condition on expiration otherwise it expires worthless.

19

Exotic option any of a broad category of options that may include complex financial

structures.

Vanilla option any option that is not exotic.

(Further details on pricing and types of options is available in the topic of options at page 80)

HEDGING:

A hedge is an investment position intended to offset potential losses/gains that may be

incurred by a companion investment. In simple language, a hedge is used to reduce any

substantial losses/gains suffered by an individual or an organization.

A hedge can be constructed form many types of financial instruments, including stocks,

exchange-traded funds, insurance, forward contracts, swaps, options and many types of over

the counter and derivative products and future contracts.

SPECULATION:

Speculation is the practice of engaging in risky financial transactions in an attempt to

profit from fluctuations in the market value of a tradable good such as a financial instrument,

rather than attempting to profit from the underlying financial attributes embodied in the

instrument such as capital gains, interest, or dividends. Many speculators pay little attention to

the fundamental value of a security and instead focus purely on price movements. Speculation

can in principle involve any tradable good or financial instrument. Speculators are particularly

common in the markets for stocks, bonds, commodity, futures, currencies, fine art,

collectibles, real estate and derivatives.

Hedger and Speculator

Hedger seeks to eliminate risk and need speculator to assume risk, but such is not

always the case. Hedgers often trade with other hedgers and speculator often trade with other

speculator. All one needs to hedge or speculate is a party with opposite beliefs or opposite risk

exposure.

Why corporations need to hedge?

Hedgers shun the risk of price change and look for ways to transfer it, while speculators

assume the risk of price change by taking one position (either long or short) in a market, and

waiting for the price of their commodity to go in their direction. Hedger, on the other hand,

have a position, either long of short usually in the cash market, and attempt to limit their risk

of price change loss by entering into an opposite and approximately equal position in another

market (usually futures or options).

A short hedger is someone who has a long position (owns the commodity) in the cash market

and transfer the risk of price decline by selling a futures contract or buying a put option. If the

cash market price declines and the futures market price also declines, the loss he suffers in the

cash market will be offset by the gain he realizes in the futures market.

The main advantage of hedge is that it lowers the risk of an investment significantly. If an

investor makes an investment in which variables are out of his control, as is the case in nearly

20

Waseem A. Qureshi MM141063

any investmentthen he stands to lose money if things do not go as he planned. A hedge can

help his offset these losses and thus reduce any unwanted risk.

The main disadvantage of a hedge is that, in reducing risk, the hedge is also cutting into the

investors potential reward. Hedges are not free, but must be purchased from another party.

Like an insurance policy, a hedge costs money, and if the main position produces profits as

planned, then the hedge will have been an unnecessary expenditure. Some investors would

question the benefit of second-guessing the original investment in this way.

The relative advantages and disadvantages of a hedge will depend greatly on the situation in

which the hedge is applied, as well as the hedges cost. In some situations, a hedge will be

absolutely necessary to make sure that an investor will remain financially solvent, regardless

of what happens. In other cases, it merely signals an overcautious investor cutting into his own

position.

Following are the main reasons for which corporations go for hedging.

Price risk transfer

Cash market prices change and theres nothing you can do about it. Whats more, they

are going to keep changing, no matter what you do. So you have three choices: assume

the risk (be a speculator), transfer the risk of price change to a speculator (be a hedger),

or get out of the market.

Instead of waiting until you have the cash market product in hand, you can do a

substitute sale in the future market, this is called hedging. This means that you sell

now in the future market, substituting your actions in the future market today and

transfer the price risk.

Profit potential

It is possible (but not guaranteed) that after a short hedge has been put in place, both the

cash and futures prices will drop, with the futures price dropping more than the cash

price. This is a favorable change and a basis for profit potential.

Cash flow smoothing

If you establish a hedge six months before your cash market transaction and then prices

move unfavorably, your futures market position will start to earn you cash in the short

run. The reason is that futures positions are marked to market daily. If your futures

position has a gain during todays trading, the gained amount will be deposited to your

account at the close of business day. This cash may help your cash flow until your cash

market transactions.

21

Waseem A. Qureshi MM141063

EXAMPLE 4:

Friends Co. is a UK based company that regularly trades with companies in the USA.

Several large transactions are due in four months time. The transactions are shown below. The

transactions are in 000 units of the currencies shown. Assume that it is now 1 st July and that

futures and options contracts mature at the relevant month end.

Friends Co.

Exports $ 490

Imports $150

Exchange Rates:

$/

Spot :

1.5166

3 months forward:

1.5286

6 months forward:

1.5401

CME $ / Currency futures ( 75,500) , contract size

Future rates:

September 1.5245

December 1.5586

CME currency options prices, $ / options 31,250 (cents per pound)

Strike price

1.5200

1.5500

September

3.55

2.38

Call

December

4.50

3.76

September

2.30

3.50

Put

December

4.50

6.50

Required: prepare a report for the managers of Friends co. on how the five month risk should

be hedged by using financial derivatives.

Solution:

We need to decide whether to hedge or not. If we need to hedge what is the best choice out the

four available choices.

1.

2.

3.

4.

5.

Hedge or not

Money market hedge

Forwards

Futures

Options

1. Hedge or not

Net exposure

$490,000 - $150,000 = $340,000

An amount of $ 340,000 is receivable in four months time. So we need to hedge for this

amount.

2. Money market hedge

We are not given the borrowing and lending rates, so we cannot use this money market

hedge option.

22

Waseem A. Qureshi MM141063

3. Forwards

First calculate 4 month future rate.

3 months forward:

6 months forward:

1.5286

1.5401

-------Increase in rates

0.0115

-------Average rate per month = 0.0115 / 3 = .0038

4 months forward

= 1.5286 + 0.0038 = 1.5324

Conversion in with rate 1.5324

$ 340,000 / 1.5324 = 221,874

Forward option will give 221,874 for investment.

4. Futures

CME $ / Currency futures ( 75,500) , contract size

Spot rate:

1.5166

Future rates:

September 1.5245

December 1.5586

4 month period ends

October 31st

Position

long call

First calculate 4 month future rate on Basis risk.

Basis risk = spot rate future rate

Basis risk = 1.5166 1.5586 = 0.0420

(rate is increasing in future time)

Basis risk per month = 0.0420 / 6 = 0.0070

Expected future price = 1.5166 +4(.0070) = 1.5446 (used plus sign as rates increased)

Conversion of amount in home currency , 340,000 / 1.5446 = 220,121

Contract size = 75,500

No. of contracts = 220,121 / 75,500 = 2.91 means 2 or 3 contracts.

Here we take 2 contracts: 75,500 x 2 = 151,000

Convert in dollars 151,000 x 1.5446 = $ 233,235

Unhedged amount = $ 340,000 233,235 = $ 106,765 (amount covered by forwards)

Convert unhedged amount in = $ 106,765 / 1.5324 = 69,672

Total amount received through this choice =

Amount received in futures

=

151,000

+ Amount in forwards

=

69,672

Total

220,672

Decision: 220,672 is amount received through futures and 221,874 is amount received

using the choice of forwards calculate in previous situation. When there is a nominal or no

difference in these two choice we will opt the forwards, as it more customized and bears less

restrictions.

23

Waseem A. Qureshi MM141063

5. options

CME currency options prices, $ / options 31,250 (cents per pound)

Strike price

Call

September

December

September

1.5200

3.55

4.50

2.30

1.5500

2.38

3.76

3.50

Put

December

4.50

6.50

Hint: while selecting the rates always use that rates which are in the benefit of the bank. Bank

will charge higher rates we borrow and will give the lower rates when we lend or invest in the

bank.

Contract size:

31,250 (cents per pound)

Exercise price:

1.5200 $ / ( we use this price as it is lower than 1.5324 of forwards)

Position:

long call (because we need to buy)

Contract used:

December as the contracts mature in October)

Amount in

= 340,000 / 1.5200 = 223,684

No. of contracts

= 223,684 / 31,250 = 7.16 contracts ( we take 7 contracts)

Amount covered in options = 31,250 x 7 = 218,750

Convert in dollars

= 218,750 x 1.5200 = $ 332,500 (option rate is used)

Unhedged amount

= 340,000 332,750 = $ 7,500 ( covered in forwards)

Unhedged amount in

= $ 7,500 / 1.5324 = 4,894 (forwards rate used)

Cost of options (premium) = 218,750 x .045 = $ 9844

Convert option premium in , $ 9844 / 1.5166 = 6491

(spot rate used)

Net value received from options:

Amount covered in 7 contracts

= 218,750

+

Amount covered in forwards

= 4,894

Cost of options (premium)

= (6,491)

=

Net amount receive in option

= 217,153

Decision:

amount received through options is 217,153 which is lower than all other

choices, therefore forward is the best choice in all cases.

EXAMPLE 5:

Lammer Co. is a UK based company that regularly trades with companies in the USA.

Lammer co. has exported goods worth $ 120 m which is receivable in five months time. These

are shown below. Assume that its 1st June and that, future contracts mature at the relevant

month end.

Exchange Rates:

Spot :

November forward:

December forward:

$/

1.9156 1.9210

1.9066 1.9120

1.8901 1.8945

24

Waseem A. Qureshi MM141063

Borrowing

Investing

UK

5.5%

4.2%

USA

4.0%

2.0%

Chicago money exchange $ / currency futures ( 62,500)

September 1.9045 December 1.8986

Required: Prepare a report for the managers of Lammer Co. on how the five month currency

risk should be hedged. Include in your report all relevant calculations relating to the alternative

types of hedge.

1. Money market hedge

Money market hedge is always based and calculated through borrowing and lending

rates. Here the rates are available so we first check this option.

Annual interest rates available to ABC co.

Borrowing

Lending

UK

5.5%

4.2%

USA

4.0%

2.0%

Following are three steps for money market hedge for $ 120,000,000 receivables.

Step 1: calculate PV of $120 using borrowing rate.4%

= PV(1 + i)

,

5/12

Pv = 120,000,000 / (1.04)

=

$ 118,054,886

1 = 1.9210$

$ 118,054,886 = ? , 118,054,886 / 1.9210 = 61,454,912

Hint: Here we use rate 1.9210 because we are taking loan and bank will charge higher rates.

Step 3: calculate FV for investable amount in the home currency at lending rate. 4.2%

= PV(1 + i)

, FV = 61,454,912(1.042)5/12 = 62,517,491

Decision: final amount received through money market hedge is 8,866,897 we need to

compare it with other choices, so we move to next calculations.

2. Forwards

First calculate 5 month future rate.

Spot Rate:

November forward:

Decrease in rates

Average rate per month =

1.9210

1.9120

-------0.0090

0.0090 / 6 = .0015

25

5 months forward

= 1.9210 5(0.0015) = 1.9135

Conversion in with rate 1.9135

$ 120,000,000 / 1.9135 = 62,712,307

It means forward will give a sum of 62,712,307 which is better than amount of money market

hedge that gives 62,517,491. Therefore forward is better choice than money market hedge.

3. Futures

CME $ / Currency futures ( 62,500) , contract size

Spot rate:

1.9156 1.9210

Future rates:

September 1.9045

December 1.8986

5 month period ends

October 31st

Position

long call

First calculate 5 month future rate on Basis risk.

Basis risk = spot rate future rate

Basis risk = 1.9210 1.8986 = 0.0224

(rate is decreasing in future time)

Basis risk per month = 0.0224 / 7 = 0.0032

Expected future price = 1.9210 5(.0032) = 1.9050

Conversion of amount in home currency 120,000,000 / 1.9050 = 62,992,126

Contract size = 62,500

No. of contracts = 62,992,126 / 62,500 = 1007.87 means 1007 contracts.

Here we take 2 contracts: 62,500 x1007 = 62,937,500

Convert in dollars 62,937,500 x 1.9050 = $ 119,895,938

Unhedged amount = $ 120,000,000 119,895,938 = $ 104,062 (amount covered by forwards)

Convert unhedged amount in = $ 104,062 / 1.9135

= 54,383

Total amount received through this choice

Amount received in futures

=

62,937,500

+ Amount in forwards

=

54,383

Total

62,991,883

Decision: future choice will give a sum of 62,991,883 that is best of all three choices. So we

will consider the future option.

EXAMPLE 6:

ABC Co. is a UK based company that regularly trades with companies in the USA. Several

large transactions are due in five months time. The transactions are shown below. The

transactions are in 000 units of the currencies shown. Assume that it is now 1st June and that

futures and options contracts mature at the relevant month end.

LMN Co.

PQR Co.

XYZ Co.

Exports

$ 890

150

Imports

150

$ 490

$ 50

26

Waseem A. Qureshi MM141063

Exchange Rates:

$/

Spot :

1.9156 1.9210

3 months forward:

1.9066 1.9120

1 year forward:

1.8901 1.8945

Annual interest rates available to ABC co.

Borrowing

Investing

UK

5.5%

4.2%

USA

4.0%

2.0%

CME $ / Currency futures ( 62,500) ,

Future rates:

September 1.9065

contract size

December 1.8985

Strike price

1.8800

1.9000

1.9200

September

4.70

3.53

2.28

Call

December

5.90

4.70

3.56

September

1.60

2.36

3.40

Put

December

2.95

4.34

6.55

Required: Prepare a report for the managers of ABC Co. on how the five month currency

risk should be hedged. Include in your report all relevant calculations relating to the alternative

types of hedge.

Solution:

We need to decide whether to hedge or not. If we need to hedge what is the best choice out the

four available choices.

1.

2.

3.

4.

5.

Hedge or not

Money market hedge

Forwards

Futures

Options

1. Hedge or not

150 is receivable and the same amount is payable, so we dont need to hedge for that. In

dollars $ 890 is receivable and $ 540 (490+50) is payable. A net of $ 350m (350,000) is

receivable and it is the amount for which we need to hedge. Now we have to decide what

the best available option for this hedge is.

2. Money market hedge

Money market hedge is always based and calculated through borrowing and lending

rates. Here the rates are available so we first check this option.

27

Waseem A. Qureshi MM141063

Borrowing

Lending

UK

5.5%

4.2%

USA

4.0%

2.0%

Following are three steps for money market hedge for $ 350,000 receivables.

Step 1: calculate PV of $350m using borrowing rate.4%

= PV(1 + i)

Pv = 350,000 / (1.04)5/12

,

=

$344,328

1 = 1.9210$

$ 344,328 = ? , 344,328 / 1.9210 = 179,243

Hint: Here we use rate 1.9210 because we are taking loan and bank will charge higher of the

spot rates.

Step 3: calculate FV for investable amount in the home currency at lending rate. 4.2%

= PV(1 + i)

, FV = 179,243(1.042)5/12 = 182,343

3. Forwards

First calculate 5 month future rate.

3 months forward:

1 year forward:

1.9120

1.8945

-------Decrease in rates

0.0175

-------Average rate per month = 0.0175 / 9 = .0019

5 months forward

= 1.9120 2(0.0019) = 1.9082

Conversion in with rate 1.9082

$ 350,000 / 1.9082 = 183,419

Hint: Here we use minus sign 1.9120 2(0.0019) because rates are decreasing. If the rates

were increased we should use the + sign in this equation.

It means forward will give a sum of 183,419 which is better than amount of money market

hedge that gives 182,343. Therefore forward is better choice than money market hedge.

4. Futures

CME $ / Currency futures ( 62,500) , contract size

Spot rate:

1.9156 1.9210

Future rates:

September 1.9065

December 1.8985

st

5 month period ends

October 31

Position

long call

28

Waseem A. Qureshi MM141063

Basis risk = spot rate future rate

Basis risk = 1.9210 1.8985 = 0.0225

(rate is decreasing in future time)

Basis risk per month = 0.0225 / 7 = 0.0032 ( 7 months is total period June to Dec.)

Expected future price = 1.9210 5(.0032) = 1.905 (used minus sign as rates decreased)

Conversion of amount in home currency $ 350,00 / 1.905 = 183,727

Contract size = 62,500

No. of contracts = 183,727 / 62,500 = 2.93 means 2 or 3 contracts.

Here we take 2 contracts: 62,500 x 2 = 125,000

Convert in dollars 125,000 x 1.9050 = $ 238,125

Unhedged amount = $ 350,000 238,125 = $ 111,875 (amount covered by forwards)

Convert unhedged amount in = $ 111,875 / 1.9082 = 58629

Total amount received through this choice =

Amount received in futures

=

125,000

+ Amount in forwards

=

58,629

Total

183,629

Decision: 183,629 is amount received through futures and 183,419 is amount received

using the choice of forwards calculate in previous situation. When there is a nominal or no

difference in these two choice we will opt the forwards, as it more customized and bears less

restrictions.

5. options

CME currency options prices, $ / options 31,250 (cents per pound)

Strike price

1.8800

1.9000

1.9200

September

4.70

3.53

2.28

Call

December

5.90

4.70

3.56

September

1.60

2.36

3.40

Put

December

2.95

4.34

6.55

Hint: while selecting the rates always use that rates which are in the benefit of the bank. Bank

will charge higher rates when we borrow and will give the lower rates when we lend or invest

in the bank.

Contract size:

31,250

Exercise price:

1.8800 $ / ( we use this price as it is lower than 1.9082 calculated)

Position:

long call (because we need to buy)

Contract used:

December ( as the contracts mature in October)

Amount in

= 350,000 / 1.8800 = 186,170

No. of contracts

= 186,170 / 31,250 = 5.95 contracts ( we take 5 contracts)

Amount covered in options = 31,250 x 5 = 156,250

Convert in dollars

= 156,250 x 1.8800 = $ 293,750

Unhedged amount

= 350,000 293,750 = $ 56,250 ( covered in forwards)

29

Waseem A. Qureshi MM141063

Unhedged amount in

= $ 56,250 / 1.9082 = 29,478 (forward rate used)

Cost of options (premium) = 156,250 x .059 = $ 9219

Convert option premium in $ 9219 / 1.9156 = 4812

(used spot rate)

= PV(1 + i) = = 4812.46(1 + .042)5/12 = 4896

Net value received from options:

Amount covered in 5 contracts

= 156,250

+

Amount covered in forwards

= 29,478

Cost of options (premium)

=

4896

=

Net amount receive in option

= 180,832

Decision:

amount received through options is 180,832 which is lower than all other

choices, therefore forward is the best option in all cases.

EXAMPLE 7:

Casasophia co, base in a European country that uses euro , constructs and maintains

advanced energy efficient commercial properties around the world. It has just completed a

major project in the USA and is due to receive the final payment of us$ 20 million in four

months.

Casasophia Co. is planning to commence a major construction and maintenance project in

mazabia, a small African country, in six months time. This government owned project is

expected to last for three years during which time Casasophia Co. will complete the

construction of state of the art energy efficient properties and provide training to a local

mazabian company in maintaining the properties. The carbon neutral status of the building

project has attracted some grand funding from the European Union and these fund will be

provided to the mazabian government in mazabian Shillings (MShs).

Casasophia co. intends to finance the project using the US# 20 million it is due to receive and

borrow the rest through a loan. It is intended that the US $ receipts will be converted into

and invested in short dated treasury bills until they are required. These funds plus the loan will

be converted in t MShs on the date required, at the spot rate at that time.

Mazabias government requires Casasophia co. to deposit the MShs 2.64 billion it needs for

the project with mazabian central bank, at the commencement of the project. In return,

Casasophia co. will receive a fixed sum of MShs 1.5 billion after tax at the end of each year.

Neither of these amounts is subject to inflationary increases. The relevant risk adjusted

discount rate for the project is assumed to be 12%. Following are the financial information

available.

Exchange Rates:

$/

MShs /

Spot :

1.3585 1.3618

MShs 116 MShs 128

4 months forward:

1.3588 1.3623

Not available

Futures:

CME $ / Currency futures ( 125,000) , $ / contract size

Future rates:

2 months expiry 1.3633

5 months expiry 1.3698

30

Waseem A. Qureshi MM141063

Options:

Contract size:

Calls, Puts.

exercise price

1.36

1.38

Call

2 month expiry 5 month expiry

2.35

2.80

1.88

2.23

Mazabian government base rate:

Yield on short dated Euro treasury bills

Assume 360 days a year.

2 month expiry

2.47

4.23

Put

5 month expiry

2.98

4.64

2.20%

10.80%

1.80%

Mazabias current annual inflation rate is 9.7% and is expected to remain at this level for the

next six years. However, after that, there is considerable uncertainty about the future and the

annual level of inflation and it could be anywhere between 5% and 15% for the next few years.

The country where Casasophia co is based is expected to have a stable level of inflation at

1.2% per year for the foreseeable future. A local bank in mazabia has offered Casasophia co

the opportunity to swap the annual income of MShs 1.5 billion receivable in each of the next

three years for Euro, at the estimated annual MShs / forward rates based on the current

government base rates.

Required:

a. Advise Casasophia co on, and recommend an appropriate hedging strategy for the US$

income it is due to receive in four months. Include all relevant calculations.

b. Provide a reasoned estimate of the additional amount of loan finance Casasophia so

needs to obtain to undertake the project in Mazabia in six months.

c. Given that Casasophia co agrees to the local banks offer of the swap, calculate the net

present value of the project in six months time in . Discuss whether the swap would

be beneficial to Casasophia co.

Solution:

Query (a) Recommend the hedging strategy.

We need to decide whether to hedge or not. If we need to hedge what is the best choice out the

four available choices.

1.

2.

3.

4.

5.

Hedge or not

Money market hedge

Forwards

Futures

Options

We need to decide whether to hedge or not. If we need to hedge what is the best choice out the

four available choices.

31

Waseem A. Qureshi MM141063

1. Hedge or not

An amount of $ 20,000,000 is receivable in four months time. So we need to hedge for

this amount.

2. Money market hedge

We are not given the borrowing and lending rates, so we cannot use this money market

hedge option.

3. Forwards

As opposed to previous examples, here forward rates for future are given. So we not

need to calculate these rates and use the higher rate to convert the dollar amount in

Euro. Rates given are:Exchange Rates:

Spot :

4 months forward:

$/

1.3585 1.3618

1.3588 1.3623

MShs /

MShs 116 MShs 128

Not available

Convert $ amount in =

4. Futures

CME $ / Currency futures ( 125,000) , $ / contract size

Spot rate:

1.3585 1.3618

Future rates:

2 months expiry 1.3633

5 months expiry 1.3698

Period:

4 months

Contract period used:

5 months future 1.3698

Position:

Long call

First calculate 5 month future rate on Basis risk.

Basis risk = spot rate future rate

Basis risk = 1.3618 1.3698 = 0.008 (rate is increasing in future time)

Basis risk per month = 0.008 / 5 = 0.0016

Expected future price = 1.3618 + 4(.0016) = 1.3682 (used plus sign as rates increased)

Conversion of amount in home currency $ 20,000,00 / 1.3682 = 14,617,746

Contract size = 125,000

No. of contracts = 183,734 / 125,000 = 116.96 contracts.

Here we take 116 contracts: 125,000 x 116 = 14,500,000 amount covered

Convert in dollars 14,500,000 x 1.3682 = $ 19,838,900

Unhedged amount = $ 20,000,000 19,838,900 = $ 161,100 (covered by forwards)

Convert unhedged amount in = $ 161,100 / 1.3623 = 118,255 (forward rate used)

Total amount received through this choice =

Amount received in futures

=

14,500,000

+ Amount in forwards

=

118,255

Total

14,618,255

32

Waseem A. Qureshi MM141063

received using the choice of forwards calculated in previous situation. When there is a nominal

or no difference in these two choices we will opt the forwards, as it is more customized and

bears fewer restrictions and also low risk of marked to market settlement losses.

5. Options

125,000, exercise price quotation US$ per , cents per Euro

Contract size:

exercise price

1.36

1.38

Call

2 month expiry 5 month expiry

2.35

2.80

1.88

2.23

Put

2 month expiry 5 month expiry

2.47

2.98

4.23

4.64

Contract size:

125,000

Exercise price:

1.3600 $ / ( we use this price as it is lower than 1.3682 calculated)

Position:

long call (because we need to buy)

Contract used:

5 months

Amount in

= 20,000,000 / 1.3600 = 14,705,882

No. of contracts

= 14,705,882/ 125,000 = 117.64 contracts

Amount covered in options = 125,000 x 117 = 14,625,000

Convert in dollars

= 14,625,000 x 1.3600 = $ 19,890,000

Unhedged amount

= 20,000,000 19,890,000 = $110,000 ( covered in forwards)

Unhedged amount in

= $ 110,000 / 1.3623 = 80,746 (forward rate used)

Cost of options (premium) = 14,625,000 x .028 = $ 409,500

Convert option premium in $ 409,500 / 1.3585 = 301,435 (lower of spot rate used)

Now see it on time line: (future value) = = PV(1 + i)

= PV(1 + i) = = 301,435(1 + .022)4/12 = 303,630

Net value received from options:

Amount covered in 5 contracts

+

Amount covered in forwards

Cost of options (premium)

=

Net amount receive in option

= 14,625,000

=

80,746

=

303,630

= 14,402,116

Decision:

amount received through options is 14,402,116.which is lower than all other

choices, therefore forward is the best option in all cases.

Query (b)

Provide a reasoned estimate of the additional amount of loan finance Casasophia so needs to

obtain to undertake the project in Mazabia in six months.

33

Waseem A. Qureshi MM141063

Solution:

Mazabian government requires Casasophia to deposit MShs 2.64 Billion as security.

We receive 14,681,054 from forwards at the end of month 4. These should be invested for 2

months in a bank. The risk free lending rate on treasury bills is 1.80%.

First see what will be value of this amount after 2 months investment.

= PV(1 + i) = = 14,681,054(1 + .018)4/12 = 14,724,770

Convert into MShs at spot rate 116/ (here we use purchasing power parity theory)

=

PV (1+ )

(1+ )

116(1+.097)1

(1+.012)1

MShs 125.74

125.74116

=

116 + (

) =

MShs 120.86

2

Required amount in

=

2,640,000,000 / 120.86 = 21,843,455

(less)

Available amount

= 14,724,770

Short amount in

7,118,685

This short amount will be borrowed from bank. A local bank in mazabia has offered

Casasophia co the opportunity to swap the annual income of MShs 1.5 billion receivable in

each of the next three years for Euro, at the estimated annual MShs / forward rates based on

the current government base rates. 10.80%.

Query (c)

Given that Casasophia co agrees to the local banks offer of the swap, calculate the net present

value of the project in six months time in . Discuss whether the swap would be beneficial to

Casasophia co.

We need to calculate the value of the funds of 1.5 billion to be received every year with the

future rates of MShs to Euro.

We need rates for these periods.

0____________1___________2________3___________4__________

Spot 116

6 month

1.5 year

2.5year

3.5 year

=

PV (1+ )

(1+ )

=

116 + (

116(1+.108)

MShs 125.74

) =

MShs 120.86

(1.022)

125.74116

2

--------------------- =

PV (1+ )

(1+ )

=

=

PV (1+ )

(1+ )

=

128 + (

=

128(1.108)

(1.022)

138.77128

2

) =

133.38(1.108)

(1.022)

MShs 138.77

MShs 133.38

MShs 144.60

34

=

=

PV (1+ )

(1+ )

PV (1+ )

(1+ )

=

=

144.60(1.108)

(1.022)

156.77(1.108)

(1.022)

MShs 156.77

MShs 169.96

MShs to

PVF(1/(1+i)n

PV

Year 1

Year 2

1500 / 144.60 = 10.37 1500 / 156.77 = 9.57

.893

.797

9.25

7.63

PV of cash flows

= 9.25+7.63+6.30 = 23.1m

21.8 m

1.3 m

Decision:

Year 3

1500 / 169.96 = 8.83

.712

6.30

NPV is positive, therefore project is favorable and they should go for it.

EXAMPLE: 8

Tertial company of UK has recently commenced exports to Buldonia, a developing country. A

payment of 100 million pesos is due from a customer in Buldonia in three months time. The

Buldonia government sometimes restricts the movement of funds from the country, but has

indicated that payment to Tertial has a good chance of receiving approval. No forward market

or derivatives market exist for the Buldonian peso. The Buldonian peso is currently liked to

the US Dollar.

Exchange rates:

Spot rate B. Peso / $

Spot rate $ /

3 month forward rate B Peso /

3 month forward rate $ /

126.4 128.2

1.775 1.782

not available

1.781 1.789

Tertial can borrow at 6% per annum or invest at 4% per annum in the UK, can borrow at 7%

and invest at 4.5% in the USA, and at 14% and 10% respectively in Buldonia.

Inflation rates: UK 3%, USA 4%,

Buldonia 14%

Tertials Buldonian customer has indicated that it might be willing to make a lead payment in

return for a 1.5% discount on the sale price.

Required:

Discuss the advantages and disadvantages of the alternative currency hedges that are available

to Tertial. Calculate the expected outcome of each hedge and recommend which hedge should

be selected.

35

Waseem A. Qureshi MM141063

Solution:

We have three choices available to hedge the amount.

1. Discounting

2. Money market hedge

3. Forwards

1. Allow a discount of 1.5% and receive the amount.

Customer is willing to pay a lead payment at a discount of 1.5%. (payment today)

For three months discount = 1.5% x 3/12 =

0.375

Net amount received will be :

100 0.375 = 99.625 m BP. (Buldonia Peso)

Convert in US$:

99.625 / 128.2

= 0.7771 m US$

Convert in :

0.7771 / 1.782

= 0.4360 m (PV)

0.4360 m will be net amount received today, if we allow a discount of 5% to customer.

We can calculate FV using investment rate, 4% per annum (net received through discount)

= PV(1 + i)

,

FV = 0.4360(1 + .04)3/12 = 0.4402m

2. Money Market Hedge

Annual interest rates available to ABC co.

Borrowing

Lending

UK

6%

4%

USA

7%

4.5%

Buldonia

14%

10%

Step 1: calculate PV of 100m using borrowing rate.

= PV(1 + i)

Pv = 100 / (1.14)3/12

96.78 m BP

We use this because we dont have any direct conversion rates of BP to .

1$ = 128.20 BP

BP96.78 = $?

1$ = 1.782

$0.7548 = ?

, 0.7548 / 1.782 = 0.4236 m

Step 3: calculate FV for investable amount in the home currency at lending rate in UK.

= PV(1 + i)

, FV = 0.4236(1.04)3/12 = 0.4278m

3. Forwards

Convert 100 m BP in $ with conversion rate 131.28 =

Convert in = 0.7621 / 1.789 = 0.4260 m

36

Waseem A. Qureshi MM141063

Conversion rates for Buldonian Peso after 3 months (inflation rate Buldonia 14%, USA 4%)

$ =

PV (1+ )

(1+ )

$ 3 =

128.2(1+.14)

(1.04)

128.2 + (

140.53128.2

12

BP 140.53 / $

) x 3 = BP 131.28 /$

Conversion rates for dollar $ to Pound after 3 months (inflation rate USA 4%, UK 3%)

$ =

PV (1+ )

(1+ )

$ 3 =

1.782(1+.04)

1.782 + (

(1.03)

1.79991.7822

12

$1.7999 /

) x 3 = $1.7863 /

Convert 100 m BP in $ with conversion rate 131.28 =

Convert in = 0.7617 / 1.7863 = 0.4264 m

Decision: 0.4402m is amount received through discount option, through money market

hedge it is 0.4277m and forward choice will give 0.4264 m. Form the all three situations

money market hedge is the better choice.

HINT: we can calculate exchange rates for 3 months directly as well: (calculated below).

Rates for peso after 3 months:

$ =

PV (1+ )

(1+ )

128.2(1+.14)3/12

(1+.04)3/12

BP 131.28/ $

$ 3 =

PV (1+ )

(1+ )

1.78(1+.04)3/12

(1+.03)3/12

$1.7863 /

EXAMPLE 9:

Awan co. is expecting to receive $48,000,000 on 1st February 2014, which will be invested

until it is required for a large project on 1st June 2014. Due to uncertainty in the market, the

company is of the opinion that it is likely that interest rates will fluctuate significantly over

the coming months, although it is difficult to predict whether they will increase or decrease.

Awan cos treasury team want to hedge the company against adverse movements in interest

rate futures; or options on interest rate futures.

Awan co. can invest funds at the relevant inter-bank rate less 20 basis points. The current

inter-bank rate is 4.09% over the coming months.

The following information and quotes are provided from an appropriate exchange on $ futures

and options. Margin requirements can be ignored.

Three month $ futures, $2,000,000 contract size.

Prices are quoted in basis points at 100- % yield.

December 2013:

March 2014:

June 2014:

94.80

94.76

94.69

37

Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual %.

Calls

strike

Puts

December March

June

December

March

June

0.342

0.432

0.523

94.50

0.090

0.119

0.271

0.097

0.121

0.289

95.00

0.312

0.417

0.520

Vobalka bank has offered the following FRA rates to Awan co.

1 7: 4.37%

3 4: 4.78%

3 7: 4.82%

4 7: 4.87%

It can be assumed that settlement for the futures and options contracts is at the end of month

and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time

intervals. Assume that it is 1st November 2013 now and that there is no basis risk.

Required:

(a) Based on the three hedging choices Awan Co is considering, recommend a hedging

strategy for the $48,000,000 investment, if interest rates increase or decrease by 0.9%. support

your answer with appropriate calculations and discussions.

(b) A member of Awan cos treasury team has suggested that if option contracts are

purchased to hedge against the interest rate movements, then the number of contracts

purchased should be determined by a hedge ratio based on the delta value of the option.

(c) Discuss how the delta value of an option could be used in determining the number of

contracts purchased.

Query (a)

1. Making investment in the bank / FRA

Using FRA forward rate agreements. (Interest rate 0.9% in the coming months)

Selection of FRA / Period.

Today its November 1st, 2013

Cash receivable on February 1st, 2014 (after 3 months)

Needed to invest in project on June 1st, 2014 (after 7 months)

Our FRA will be: 3 7 , that has the rate of: 4.82%

Situation a. If interest increases by 0.9%(rate is 4.99%)

(if invested in bank at 20 basis points less)

Current rate + rate after 3 months = 4.09 + 0.9 = 4.99%

Lending rate is 20 basis points less = 4.99 - .20 = 4.79% (rate at which to invest)

Return on investment = $48,000,000 x (4.79/100) x (4/12) = $766,400

(if opted to use FRA, 3 7 , 4.82%)

38

Waseem A. Qureshi MM141063

Payment to Bank: 48,000,000 x .17/100 x 4/12 = $27,200 cost for using FRA

Net gain =

766,400 27,200 = $ 739,200

Effective rate = 739,200 / 48,000,000 x 12/4 = 4.62%

Situation b. If interest decreases by 0.9%(rate is 3.19%)

(if invested in bank at 20 basis points less)

Current rate + rate after 3 months = 4.09 - 0.9 = 3.19%

Lending rate is 20 basis points less = 3.19 - .20 = 2.99% (rate at which to invest)

Return on investment = $48,000,000 x (2.99/100) x (4/12) = $478,400

(if opted to use FRA, 3 7 , 4.82%)

Difference in rates = 3.19 4.82 = 1.63 (gain / increase in FRA)

Payment to Bank: 48,000,000 x 1.63/100 x 4/12 = $260,800 gain using FRA

Net gain =

478,400 + 260,800 = $ 739,200

Effective rate = 739200 / 48,000,000 x 12/4

= 4.62%

Result: Net gain is $739,200 and effective rate is 4.62% , which is same in both conditions

whether interest rate increases or decreases in the market.

2. Futures

Contract size :

$2,000,000

Relevant contract:

March, 2014 94.76

Basis risk : spot rate future rate

Current spot rate / base rate = 100- % yield = 100 4.09 = 95.91

Basis risk = 95.91 94.76 = 1.15

Basis risk per month = 1.15 / 5 = 0.2300

Expected future price = 100- 4.99 2(0.2300) = 94.55

Contract size = 2,000,000

No. of contracts = 48,000,000 / 2,000,000 x (4/3) = 32 contracts.

Hint: We used 4/3 because 4 months is loan life and 3 months is future contract period.

Gain/loss = (94.55-94.76)/100 x 2,000,000x 3/12 x32 = $33,600 loss

Return on investment:

48,000,000 x (4.79/100) x(4/12) = 766,400 gain

Net gain =

766,400 33,600 = 732,800

Effective rate = 732,800 / 48,000,000 x 12/4 = 4.58%

Expected future price = 100- 3.19 2(0.2300) = 96.35

Contract size = 2,000,000

No. of contracts = 48,000,000 / 2,000,000 x (4/3) = 32 contracts.

Hint: We used 4/3 because 4 months is loan life and 3 months is future contract period.

39

Waseem A. Qureshi MM141063

Return on investment:

48,000,000 x (2.99/100) x(4/12) = $ 478,400

Net gain =

478,400 + 245,400 = 732,800

Effective rate = 732,800 / 48,000,000 x 12/4 = 4.58%

Result: Net gain is $732,800 and effective rate is 4.58% , which is same in both conditions

whether interest rate increases or decreases in the market.

3. Options

Contract size :

No. of contracts:

Position

$2,000,000

48,000,000 / 2,000,000 x (4/3) = 32 contracts.

Long call

Expected future price = 100- 4.99 2(0.2300) = 94.55

Exercise price:

Expected future price

Decision to exercise

Gain / loss

Investment return at 4.99%

Total gain (.005x2,000,000x32x(3/12) =

Option premium (.00432x2,000,000x32x(3/12) =

(.00121x2,000,000x32x(3/12) =

Net position gain (loss)

Net percentage: 705,280/48,000,000x(12/4) =

747,040/48,000,000x(12/4) =

94.50

94.55

Yes

.05%

766,400

8,000

(69,120)

705,280

4.40%

95.00

94.55

No

-766,400

0

(19,360)

747,040

4.67%

Expected future price = 100- 3.19 2(0.2300) = 96.35

Exercise price:

Expected future price

Decision to exercise

Gain / loss

Investment return at 3.19%

Total gain (.0185x2,000,000x32x(3/12) =

(.0135x2,000,000x32x(3/12) =

Option premium (.00432x2,000,000x32x(3/12) =

(.00121x2,000,000x32x(3/12) =

Net position gain (loss)

Net percentage: 705,280/48,000,000x(12/4) =

675,040/48,000,000x(12/4) =

94.50

96.35

Yes

1.85%

478,400

296,000

95.00

96.35

Yes

1.35%

478,400

216,000

(69,120)

705,280

4.40%

(19,360)

675,040

4.22%

40

Waseem A. Qureshi MM141063

National co. is a large multinational company based in the UK with a number of subsidiary

companies around the world. Currently, foreign exchange exposure as a result of transactions

between National Co. and its subsidiary companies is managed by each company individually.

National co is considering whether or not to manage the foreign exposure using multinational

netting form the UK, with the pound as the base currency. If multilateral netting is

undertaken, spot mid-rates would be used.

The following cash flows are due in three months between National co and three of its

subsidiary companies. The subsidiary companies are Lakama co, based in the United States

(currency US$), Jaia co, based in Canada (currency CAD) AND Gochiso co, based in Japan

(currency JPY).

Owed by

Owed to

Amount

National co.

Lakama co.

US$ 4.5 million

National co.

Jaia co.

CAD 1.1 million

Gochiso co.

Jaia co.

CAD 3.2 million

Gochiso co.

Lakama co.

US$ 1.4 million

Jaia co.

Lakama co.

US$ 1.5 million

Jaia co.

National co.

CAD 3.4 million

Lakama co.

Gochiso co.

JPY 320 million

Lakama co.

National co.

US$ 2.1 million

Exchange rates available to National co.

US$ /

CAD /

JPY /

Spot rate

1.5983-1.5962

1.5690-1.5710

131.91-133.59

3 month forward

1.5996-1.6037

1.5652-1.5678

129.15-131.05

Currency options available to National co.

Contract size 62,500, exercise price quotation: US$/, premium: cents per pound.

Call options

Put options

Exercise price

3 month

6 month

3 month

6 month

Expiry

expiry

expiry

expiry

1.60

1.55

2.25

2.08

2.23

1.62

0.98

1.58

3.42

3.73

It can be assumed that option contracts expire at the end of the relevant month.

Annual interest rates available to National co. and subsidiaries.

Borrowing rate

Lending rate

UK

4.0%

2.8%

USA

4.8%

3.1%

Canada

3.4%

2.1%

Japan

2.2%

0.5%

41

Waseem A. Qureshi MM141063

Required:

Advise National co on, and recommend an appropriate hedging strategy for the US$ cash

flows it is due to receive or pay in three months, form Lakama co. show all relevant

calculations to support the advice given.

Solution:

We need to decide whether to hedge or not. If we need to hedge what is the best choice out the

three available choices.

1.

2.

3.

4.

Hedge or not

Money market hedge

Forwards

Options

Hedge or not

National company has two bilateral transactions with Lakama Co. after three months.

Payable amount is US$ 4.5 million and receivable amount is US$ 2.1 million. Net

exposure is US$ 2.4 million payable after three months, for which company needs to

hedge.

Money market hedge

Borrowing

Lending

UK

4.0%

2.8%

USA

4.8%

3.1%

Canada

3.8%

2.1%

Japan

2.2%

0.5%

National company needs to hedge an amount of $ 2,400,000 payable.

Step 1: calculate PV of $ 2,400,000 using lending rate.

= PV(1 + i)

PV = 2,400,000 / (1.031)3/12

=

$ 2,381,752

1 = $ 1.5938

$ 2,381,752 = ?

2,381,752 / 1.5938 = 1,494,386

Step 3: calculate FV for investable amount in the home currency at borrowing rate. 4.0%

= PV(1 + i)

, FV = 1,494,386(1.04)3/12 = 1,509,110

42

Waseem A. Qureshi MM141063

Forwards

3 month forward

1.5996-1.6037

We use the 1.5996 which is the buying rate for dollar in the market.

Conversion in with rate 1.5996

Options

CME currency options prices, $ / options 62,500 (cents per pound)

Exercise price

1.60

1.62

Call options

3 month

6 month

Expiry

expiry

1.55

2.25

0.98

1.58

Put options

3 month

6 month

expiry

expiry

2.08

2.23

3.42

3.73

Contract size:

62,500

Exercise price:

1.62 $/

Position:

long put

Contract used:

three months ( as the contracts mature at same period)

Amount in

= 2,400,000 / 1.62 = 1,481,481

No. of contracts

= 1,481,481 / 62,500 = 23.70 contracts ( we take 23 contracts)

Amount covered in options = 62,500 x 23 = 1,437,500

Convert in dollars

= 1,437,500 x 1.62 = $ 2,328,750

Unhedged amount

= 2,400,000 2,328,750 = $ 71,250 ( covered in forwards)

Unhedged amount in

= $ 71,250 / 1.5996 = 44,542

Cost of options (premium) = 1,437,500 x .0342 = $ 49,162

Convert option premium in $ 49,162 / 1.5938 = 30,846

Now see it on time line: (future value) = = PV(1 + i)

= PV(1 + i) = = 30,846(1 + .028)3/12 = 31,060

Net value from options:

Amount covered in 23 contracts

+

Amount covered in forwards

+

Cost of options (premium)

=

Net amount receive in option

= 1,437,500

=

44,542

=

31,060

= 1,513,102

Hint: we add all three amounts as it is payable and cost is also an expense payable.

Decision: Amount required through options is 1,513,102 through money market hedge it is

1,509,110 and through forwards it is 1,500,375. For forward choice it is lower in all three

cases, means we need lowest amount to pay an amount of $2.4 million payable after 3 months.

Therefore forward is the best choice.

43

Waseem A. Qureshi MM141063

National company is a large multinational company with a number of international subsidiary

companies. A centralized treasury department manages National company and its subsidiaries

borrowing requirements, cash surplus investments and financial risk management. Financial

risk is normally managed using conventional derivative products such as forwards, futures,

options and swaps.

Assume it is 1st December 2014 today and National co. is expecting to borrow $18,000,000 on

1st February 2015 for a period of seven months. it can either borrow the funds at a variable rate

of LIBOR plus 40 basis points or a fixed rate of 5.5%. LIBOR is currently 3.8% but National

Co. feels that this could increase or decrease by 0.5% over the coming months due to

increasing uncertainty in the markets.

The treasury department is considering whether or not to hedge the $18,000,000, using either

exchange traded March options or over-the-counter swaps offered by Prime Bank.

The following information and quotes for $ March options are provided from an appropriate

exchange. The options are based on three-month $ futures, $1,000,000 contract size and

options premiums are in annual %.

March Calls

0.882

0.648

Strike Price

95.50

96.00

March Puts

0.662

0.902

Options prices are quoted in basis point at 100 minus the annual % yield and settlement of the

options contracts is at the end of March, 2015. The current basis on the March futures prices is

44 points, and it is expected to be 33 points on 1st January 2015, 22 points on 1st February

2015 and 11 basis points on 1st march 2015.

Prime Bank has offered National co. a swap on a counterparty variable rate of LIBOR plus 30

basis points or a fixed rate of 4.6%, where National Co. receives 70% of any benefits accruing

from undertaking the swap, prior to any bank charges. Prime Bank will charge National co 10

basis points for the swap.

National cos chief executive officer believes that a centralized treasury department is

necessary in order to increase shareholder value, but National cos new chief financial officer

(CEO) thinks that having decentralized treasury departments operating across the subsidiary

companies could be more beneficial. The CFO thinks that this is particularly relevant to the

situation which Omega Co., a company owned by Nation Co. is facing. Omega Cooperates in

a country where most companies conduct business activities based on Islamic finance

principles. It produces confectionery products including chocolates. It wants to use Salam

contracts instead of commodity futures contracts to hedge its exposure to price fluctuations of

cocoa. Salam contracts involve a commodity which is sold based on currently agreed prices,

quantity and quality. Full payment is received by the seller immediately, for an agreed

delivery to be made in the future.

44

Waseem A. Qureshi MM141063

Required: Based on the two hedging choices National Co. is considering, recommend a

hedging strategy for the $18,000,000 borrowing. Support your answer with appropriate

calculations and discussion.

Solution:

4. Options

Contract size :

No. of contracts:

Position

$1,000,000

18,000,000 / 1,000,000 x (7/3) = 42 contracts.

Long Put

Expected future price = 100 + 4.30 .22 = 95.48

Company will borrow at 3.8 +.5 +.4 = 4.7% (at plus 40 basis point)

Exercise price:

Expected future price

Decision to exercise

Gain / loss

Borrowing at 4.30 + .40 = 4.7%

$18,000,000 x (4.70/100) x (7/12) =

Total gain (1,000,000,000x.0002x42x(3/12) =

(1,000,000,000x.0052x42x(3/12) =

Option premium (.00662x1,000,000x42x(3/12) =

(.00902x1,000,000x42x(3/12) =

Net position (gain/loss)

Net percentage: 560,910/18,000,000x(12/7) =

533,410/18,000,000x(12/7) =

95.50

95.48

Yes

.02%

96.00

95.48

Yes

0.52%

$493,500

2,100

$493,500

54,600

69,510

560,910

5.34%

94,710

533,410

5.08%

Expected future price = 100- 3.30 .22 = 96.48

Company will borrow at 3.8 -.5 +.4 = 3.7%

Exercise price:

Expected future price

Decision to exercise

Gain / loss

Borrowing at 3.30 + .40 = 3.7%

$18,000,000 x (3.70/100) x (7/12) =

Option premium (.00662x1,000,000x42x(3/12) =

(.00902x1,000,000x42x(3/12) =

Net position (gain/loss)

Net percentage: 458,010/18,000,000x(12/7) =

483,210/18,000,000x(12/7)

95.50

96.48

No

0

96.00

96.48

No

0

$388,500

69,510

$388,500

458,010

4.36%

94,710

483,210

4.60%

45

SWAP:

National Co.

Fixed Rate

Prime Bank

5.5%

Floating Rate

4.6%

LIBOR + .4%

0.9%

LIBOR + .3%

0.8%

0.56%

Bank Charges:

0.10%

Net gain:

0.465

National Co.

Prime Bank

LIBOR+0.4%

Adjustment for variable rate:

Net effect:

0.1%

Loan

Basis Difference

(4.6%)

(4.6%)

4.6%

LIBOR+0.6%

LIBOR+0.6%

-------------------

------------------

4.94%

LIBOR+0.6%

Book: Analysis of derivatives for the CFA program,

Before getting into the actual mechanics of pricing and valuation, the astute reader might

wonder whether we are being a bit redundant. Are pricing and valuation not the same thing?

An equity analyst often finds that a stock is priced at more or less than its fair market value

and uses this conclusion as the basis for a buy or sell recommendation. In an efficient market,

the price of a stock would always equal its value or the price would quickly converge to the

value. Thus, for all practical purposes, pricing and valuation would be the same thing. In

general, when we speak of the value and price of an asset, we are referring to what that asset is

worth and what it sells for. With respect to certain derivatives, however, value and price take

on slightly different meanings.

46

Waseem A. Qureshi MM141063

So let us begin by defining value: Value is what you can sell something for or what you must

pay to acquire something. This applies to stocks, bonds, derivatives, and used cars.'"

Accordingly, valuation is the process of determining the value of an asset or service. Pricing

is a related but different concept; let us explore what we mean by pricing a forward contract.

A forward contract price is the fixed price or rate at which the transaction scheduled to occur

at expiration will take place. This price is agreed to on the contract initiation date and is

commonly called the forward price or forward rate. Pricing means to determine the forward

price or forward rate. Valuation, however, means to determine the amount of money that one

would need to pay or would expect to receive to engage in the transaction. Alternatively, if

one already held a position, valuation would mean to determine the amount of money one

would either have to pay or expect to receive in order to get out of the position. Let us look at

a generic example.

The price of the underlying asset in the spot market is denoted as So at time 0, St at time t, and

ST at time T. The forward contract price, established when the contract is initiated at time 0, is

F(0,T). This notation indicates that F(0,T) is the price of a forward contract initiated at time 0

and expiring at time T. The value of the forward contract is Vd0,T). This notation indicates

that Vo(O,T) is the value at time 0 of a forward contract initiated at time 0 and expiring at time

T. In this book, subscripts always indicate that we are at a specific point in time.

We have several objectives in this analysis. First, we want to determine the forward price

F(0,T). We also want to determine the forward contract value today, denoted Vo(O,T), the

value at a point during the life of the contract such as time t, denoted Vt(O,T), and the value at

expiration, denoted VT(O,T). Valuation is somewhat easier to grasp from the perspective of

the party holding the long position, so we shall take that point of view in this example. Once

that value is determined, the value to the short is obtained by simply changing the sign.

'' From your study of equity analysis, you should recall that we often use the discounted cash

flow model, sometimes combined with the capital asset pricing model, to determine the fair

market value of a stock.

'' Be careful. You may think the "value" of a certain used car is $5,000, hut if no one will give

you that price, it can hardly be called the value.

If we are at expiration, we would observe the spot price as ST. The long holds a position to

buy the asset at the already agreed-upon price of F(0,T). Thus, the value of the forward

47

Waseem A. Qureshi MM141063

contract at expiration should be obvious: ST - F(0,T). If the value at expiration does not equal

this amount, then an arbitrage profit can be easily made.

A forward contract may be for any one of the five assets, i.e. commodity forward, equity

forward, bond forward, currency forward and loan or interest rate forward. Here, we will see

separate calculations in either case or asset. In every case we need to find three results.

a. Fair price of the forward

b. Settlement price at maturity

c. Settlement price at any time before maturity

1. Commodity forward.

Calculations:

Fair price:

(0, ) = 0 (1 + )T

0, =

Settlement on maturity:

(0, ) = T (0, )

F(0,T)

(1+)

2. Equity forward.

Calculations:

Fair price:

(0, ) = {0 (, 0, )} (1 + )T

0, = {t (, , )}

Settlement on maturity:

(0, ) = T (0, )

F(0,T)

(1+)

3. Bond forward.

Calculations:

Fair price:

(0, ) = {0 (, 0, )} (1 + )T

0, = {t (, 0, )}

Settlement on maturity:

(0, ) = T (0, )

F(0,T)

(1+)

4. Currency forward.

Calculations:

Fair price:

d = domestic risk free rate,

(0, ) =

0(1+ )

(1+ )

48

0, =

F(0,T)

(1+ )

(1+ )

Settlement on maturity:

(0, ) = T (0, )

Calculations:

h +m

0, , =

1+Lg + 360

h

1+L0

360

0, , =

1

1+Lg

h g

360

360

m

m

360

h +m g

360

1+(0,, )

1+Lg +

Settlement at maturity:

0, , = 1

1+(0,,) 360

m

1+Lh 360

EXAMPLE 12:

1. Commodity forward.

An investor holds title to an asset worth 125.72. To raise money for an unrelated purpose, the

investor plans to sell the asset in nine months. The investor is concerned about uncertainty in

the price of the asset at that time. The investor learns about the advantages of using forward

contracts to manage this risk and enters into such a contract to sell the asset in nine months.

The risk-free interest rate is 5.625 percent.

A. Determine the appropriate price the investor could receive in nine months by means of the

forward contract.

B. Suppose the counterparty to the forward contract is willing to engage in such a contract at a

forward price of 140. Explain what type of transaction the investor could execute to take

advantage of the situation. Calculate the rate of return (annualized), and explain why the

transaction is attractive.

C. Suppose the forward contract is entered into at the price you computed in Part A. Two

months later, the price of the asset is 118.875. The investor would like to evaluate her

position with respect to any gain or loss accrued on the forward contract. Determine the

market value of the forward contract at this point in time from the perspective of the investor

in Part A.

49

Waseem A. Qureshi MM141063

D. Determine the value of the forward contract at expiration assuming the contract is entered

into at the price you computed in Part A and the price of the underlying asset is 123.50 at

expiration. Explain how the investor did on the overall position of both the asset and the

forward contract in terms of the rate of return.

Solution:

Forward price in the market is 140 and fair price is 131. It is overvalued. Therefore, the

decision is to short sell.

Rf = 5.625%

maturity = 9 months,

rate 123.50

S0____________________ t_____________________________ ST

125.72

2 months, 118.875

9 months, 123.50

Position: Short sell

Period: 9 months or .75 year (converted in year as Rf is given in annual rate)

Calculations:

a.

(0, ) = 0 (1 + )T

Fair price:

Forward price in the market is 140 and fair price is 131. It is overvalued. Therefore, the

decision is to short sell.

0, =

F(0,T)

(1+)

0, = 118.875

131

(1+.05625)92

0, = 118.875 126.90 =

-8.025

Result is -8.025, which shows that it is loss for long/buyer. Our position is Short, and it is a

profit for short seller after 2 months time.

(0, ) = T (0, )

c. Settlement on maturity:

Result is -7.5, which shows that it is loss for long/buyer. Our position is Short, and it is a profit

for short seller at the time of maturity.

50

Waseem A. Qureshi MM141063

d.

F.V. = PV(1+g)n or (FV / PV)1/n -1 = g

(140/125.72) 1/.75 -1 = g

= 0.154 , 15.4%

EXAMPLE 13:

2. Equity forward

An asset manager anticipates the receipt of funds in 200 days, which he will use to

purchase a particular stock. The stock he has in mind is currently selling for $62.50 and

will pay a $0.75 dividend in 50 days and another $0.75 dividend in 140 days. The risk-free

rate is 4.2 percent. The manager decides to commit to a future purchase of the stock by

going long a forward contract on the stock.

A. At what price would the manager commit to purchase the stock in 200 days through a

forward contract?

B. Suppose the manager enters into the contract at the price you found in Part A. Now, 75

days later, the stock price is $55.75. Determine the value of the forward contract at this

point.

C. It is now the expiration day, and the stock price is $58.50. Determine the value of the

forward contract at this time.

Solution:

Rf = 4.2%

62.50

50 days

75 days, 55.75

140 days

200 days, 58.50

Position: Long call (he wants to buy stock after 200 days)

Calculations:

(0, ) = {0 (, 0, )} (1 + )T

a. Fair price:

(, , ) =

0, =

(1+g)

(1+g)

0.75

(1+.042)50/365

200/365

(1+g)

0.75

(1+.042)140/365

= 1.483

= 62.41

51

0, = {t (, , )}

F(0,T)

(1+)

First calculate present value of Dividend for one period =

(, , ) =

(1+g)

0.75

(1+.042)65/365

0, = {t (, , )}

(1+g)

= 0.74

F(0,T)

(1+)

= {55.75 0.74}

62.41

(1+.042)125 /365

= -6.5

c. Settlement on maturity:

(0, ) = T (0, )

(0, ) = 58.50 62.41 = -3.91

EXAMPLE 14:

3. Bond forward.

An investor purchased a bond when it was originally issued with a maturity of five years.

The bond pays semiannual coupons of $50. It is now 150 days into the life of the bond.

The investor wants to sell the bond the day after its fourth coupon. The first coupon occurs

181 days after issue, the second 365 days, the third 547 days, and the fourth 730 days. At

this point (150 days into the life of the bond), the price is $1,010.25. The bond prices

quoted here include accrued interest.

A. At what price could the owner enter into a forward contract to sell the bond on the day

after its fourth coupon? Note that the owner would receive that fourth coupon. The riskfree rate is currently 8 percent.

B. Now move forward 365 days. The new risk-free interest rate is 7 percent and the new

price of the bond is $1,025.375. The counterparty to the forward contract believes that it

has received a gain on the position. Determine the value of the forward contract and the

gain or loss to the counterparty at this time. Note that we have now introduced a new riskfree rate, because interest rates can obviously change over the life of the bond and any

52

Waseem A. Qureshi MM141063

calculations of the forward contract value must reflect this fact. The new risk-free rate is

used instead of the old rate in the valuation formula.

Solution:

Rf = 8%

maturity = 5 years

Coupon value = 50

At what price to enter the bond if he wants to sell after 4th coupon.

S0___Bo_______C,50 _______C,50______t________C,50______C,50______sell point____ ST

0 150 days 181 days

Position: short sell (he wants to sell the bond 731 days)

Calculations:

(0, ) = {0 (, 0, )} (1 + )T

a. Fair price:

(, , ) =

(, , ) =

(1+g)

(1+g)

50

(1+.08)31/365

(1+g)

50

(1+.08)215 /365

(1+g)

50

(1+.08)397 /365

50

(1+.08)580 /365

= 187.50

0, = {t (, , )}

F(0,T)

(1+)

(, , )

Calculate PV of coupon.

(, , ) =

(, , ) =

(1+g)

50

(1+.07)32/365

(1+g)

50

(1+.07)215/365

0, = {1025.375 97.75}

97.75

929.97

216/365

(1+.07)

= 34.36

Result is 34.36, it is gain for long, our position is short. It is loss for our short position.

53

Waseem A. Qureshi MM141063

(0, ) = T (0, )

a. Settlement on maturity:

(0, ) = T 929.97

As no value of BT is given in the example, it is left blank.

EXAMPLE 15:

4. Currency forward.

A corporate treasurer needs to hedge the risk of the interest rate on a future transaction.

The risk is associated with the rate on 180-day Euribor in 30 days. The relevant term

structure of Euribor is given as follows:

30-day Euribor 5.75%

2 10-day Euribor 6.15%

A. State the terminology used to identify the FRA in which the manager is interested.

B. Determine the rate that the company would get on an FRA expiring in 30 days on 180day Euribor.

C. Suppose the manager went long this FRA. Now, 20 days later, interest rates have moved

significantly downward to the following:

10-day Euribor 5.45%

190-day Euribor 5.95%

The manager would like to know where the company stands on this FRA transaction.

Determine the market value of the FRA for a 20 million notional principal.

D. On the expiration day, 180-day Euribor is 5.72 percent. Determine the payment made to

or by the company to settle the FRA contract.

Solution:

Spot rate: 1 = $ 1.76

Current forward rate: $1.75

USA Rf = 5.1%

Time = 1 year

UK Rf = 6.25

short sell after 1 month.

Calculations:

a.

(0, ) =

Fair price:

(0, ) =

1.76(1+.051)1

(1+.062)1

0(1+ )

(1+ )

Market quoted value is $1.75 and fair value is $1.74, means it is overvalued. Position will be

short / sell. Sell the forward and buy currency.

What is the present value of and $.

0 ------------------------------------------ $1.75 / 1

54

(present value of 1 )

(1+g)

(present value of 1 $)

(1+.062)1

= 0.9416

0.9416 x 1.76 =

$ $ 1.6752

g=

1/

PV

1 =

1.75

1.6572

1 =

0.056

= 5.6%

b. Settlement before maturity:

0, =

(1+ )

T = 1 year , $ 1.75

0, =

1.72

(1+.062)11/12

F(0,T)

(1+ )

t = 1 month , $ 1.72

1.75

(1+.051)11/12

= -0.045

Result is -0.045, which is loss for long and ultimately a profit to short.

c. Settlement on maturity:

On expiry the rate of is $1.69/

(0, ) = T (0, )

ST = 1.69

EXAMPLE 16:

5. Loan / interest rate forward. (FRA)

The spot rate for British pounds is $1.76. The U.S. risk-free rate is 5.1 percent, and the

U.K. risk-free rate is 6.2 percent; both are compounded annually. One-year forward

contracts are currently quoted at a rate of $1.75.

A. Identify a strategy with which a trader can earn a profit at no risk by engaging in a

forward contract, regardless of her view of the pound's likely movements. Carefully

describe the transactions the trader would make. Show the rate of return that would be

earned from this transaction. Assume the trader's domestic currency is U.S. dollars.

B. Suppose the trader simply shorts the forward contract. It is now one month later.

Assume interest rates are the same, but the spot rate is now $1.72. What is the gain or loss

to the counterparty on the trade?

55

Waseem A. Qureshi MM141063

C. At expiration, the pound is at $1.69. What is the value of the forward contract to the

short at expiration?

Solution:

Agreement for taking a loan after 30 days for a period of 180 days. FRA = 1x7

h = 30

m = 180

h+m = 210 L0(h) = 5.75%

Lg(h+m) = 6.15%

Calculations:

h +m

1+Lg + 360

h

1+L0

0, , =

360

0, , =

210

360

30

1+.0575 360

1+.0615

360

1.0359

180

1.0048

360

1

h g

1+Lg 360

= 0.0619

180

360

m

360

h +m g

1+Lg + 360

1+(0,, )

0, , =

1

10

1+.0545 360

180

360

180

1+.0595 360

1+.0619

1

1.01513

1.0310

1.0314

= - 0.0011 (loss)

-0.0011 x 20,000,000 = -22,000 (loss to long)

m

c. Settlement at maturity:

0, , = 1

180

360

180

1+.0572

360

1+.0619

0, , = 1

=1

1.0310

1.0286

1+(0,, ) 360

m

1+Lh 360

1. A. Calculate the price for a T-bill with a face value of $10,000, 153 days to maturity, and a

discount yield of 1.74 percent.

B. Calculate the asked discount yield for a T-bill that has 69 days to maturity, a face value of

$ 10,000 and a price of $9,950.

56

Waseem A. Qureshi MM141063

Solution:

a. Calculate PV of the T-Bill.

=

=

=

10,000

= $ 9,926.95

(1+0.0174)153/360

(1+g)

Here n = 69/360 = 0.1917 ,

g=

PV

1/

1 g=

5.2174

10,000

9950

1 = 0.0261 = 2.61%

2. Assume that 60-day LIBOR is 4.35 percent. You are based in London and need to borrow

$20,000,000 for 60 days. What is the total amount you will owe in 60 days?

Solution:

Calculate FV of amount after 60 days.

= PV(1 + i) =

= 20,000,000 1 + .0435 60/360 = 20,142,440

3. The treasurer of Company A expects to receive a cash inflow of $15,000,000 in 90 days.

The treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge

against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on

90-day LIBOR. The FRA is quoted at 5 percent. At expiration, LIBOR is 4.5 percent. Assume

that the notional principal on the contract is $ l5, OOO, OOO.

A. Indicate whether the treasurer should take a long or short position to hedge interest rate risk

B. Using the appropriate terminology, identify the type of FRA used here.

C. Calculate the gain or loss to Company A as a consequence of entering the FRA.

Solution:

a. Taking short position will short will hedge the interest rate risk for company A. The

gain on the contract will offset the reduced interest rate that can be earned when rates

fall.

b. This is a 3 x 6 FRA.

m

1+(0,,) 360

0, , = 1

c. Settlement at maturity:

1+Lh 360

90

0, , = 1

1+.05 360

90

1+.045360

= 1

1.0125

1.01125

m = 90

= - 0.001236

The negative sign indicates a gain to the short position.

4. Suppose that a party wanted to enter into a FRA that expires in 42 days and is based on 137day LIBOR. The dealer quotes a rate of 4.75 percent on this FRA. Assume that at expiration,

the 137-day LIBOR is 4 percent and the notional principal is I $20,000,000.

A. What is the term used to describe such nonstandard instruments?

B. Calculate the FRA payoff on a long position.

Solution:

57

Waseem A. Qureshi MM141063

b. Calculate position at maturity.

h = 42, m = 137

FRA(o,h,m) = .0475

m

Settlement at maturity:

0, , = 1

137

0, , = 1

1+.0475 360

137

1+.04 360

= 1

1.01817

1.01522

1+(0,,) 360

m

1+Lh 360

= - 0.002811

The negative sign indicates a loss to the long.

5. Assume Sun Microsystems expects to receive 20,000,000 in 90 days. A dealer provides a

quote of $0.875 for a currency forward contract to expire in 90 days. Suppose that at the end

of 90 days, the rate is $0.90. Assume that settlement is in cash. Calculate that the cash flows at

expiration if Sun Microsystems enters into a forward contract expiring in 90 days to buy

dollars at $0.875.

Solution:

The contract is settled in cash, so the settlement would be 20,000,000(0.875 - 0.90) =

-$500,000. This amount would be paid by Sun Microsystems to the dealer. Sun would convert

Euros to dollars at the spot rate of $0.90, receiving 20,000,000 X (0.90) = $18,000,000. The

net cash receipt is $17,500,000, which results in an effective rate of $0.875.

6. Consider a security that sells for $1,000 today. A forward contract on this security that

expires in one year is currently priced at $1,100. The annual rate of interest is 6.75 percent.

Assume that this is an off-market forward contract.

A. Calculate the value of the forward contract today,V0(O,T).

B. Indicate whether payment is made by the long to the short or vice versa.

Solution:

a. Find V0(O,T) when,

S0 = 1,100 F(O,T) = $1000

T = 1 Rf = 6.75%

V0(O,T) means PV of the security = =

(1+g)

1100

(1+.0675)

= $ 1030.40

b. Because the value is negative the payment will be made by short to long.

7. Assume that you own a security currently worth $500. You plan to sell it in two months. To

hedge against a possible decline in price during the next two months, you enter into a forward

contract to sell the security in two months. The risk-free rate is 3.5 percent.

B. Suppose the dealer offers to enter into a forward contract at $498. Indicate how you could

earn an arbitrage profit.

C. After one month, the security sells for $490. Calculate the gain or loss to your position.

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Waseem A. Qureshi MM141063

Solution:

a. Find F(O,T) when,

S0 = $500

.16667

Rf = 3.5%

= $502.88

b. Sell the security for $500 and invest at 3.5 percent for two months. At the end of two

months, you will have $502.88. Enter into a forward contract now to buy the security at

$498 in two months. Arbitrage profit = $502.88 - $498 = $4.88

c. Calculate the value after one month:

St = $490 t = 1/12 = 0.0833 T = 2/12 = 0.1667

0, = {t (, , )}

F(0,T)

(1+)

T - t = 1/12 = 0.0834

= 490

502.88

(1+.035)0.0834

r = 0.035

= $ - 11.44

8. Consider an asset currently worth $100. An investor plans to sell it in one year and is

concerned that the price may have fallen significantly by then. To hedge this risk, the investor

enters into a forward contract to sell the asset in one year. Assume that the risk-free rate is 5

percent.

A. Calculate the appropriate price at which this investor can contract to sell the asset in one

year.

B. Three months into the contract, the price of the asset is $90. Calculate the gain or loss that

has accrued to the forward contract.

C. Assume that five months into the contract, the price of the asset is $107. Calculate the gain

or loss on the forward contract.

D. Suppose that at expiration, the price of the asset is $98. Calculate the value of the forward

contract at expiration. Also indicate the overall gain or loss to the investor on the whole

transaction.

E. Now calculate the value sf the forward contract at expiration assuming that at expiration,

the price of the asset is $1 10. Indicate the overall gain or loss to the investor on the whole

transaction, 1s this mount more or less than the overall gain or loss from Part D.

Solution:

a. Find F(O,T) when,

S0 = $100 T = 1 year Rf = 5%

(0, ) = {0 (, 0, )} (1 + )T = 100 1 + .05

b. Calculate the value after three months:

St = $90 t = 3/12 T = 12 months T - t = 9/12 = 0.75

0, = {t (, , )}

F(0,T)

(1+)

= 90

= $105

r = 0.035

105

(1+.035)0.075

= $ - 11.23

c. Calculate the value after three months:

St = $107 t = 5/12 T = 12 months T - t = 7/12 = 0.5834

r = 0.035

F(0,T)

105

0, = {t (, , )}

= 107

= $4.95

0.583

(1+)

(1+.035)

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Waseem A. Qureshi MM141063

ST = $98

T = 12 months

F(O,T) = $105

r = 0.035

This is a $7 gain, there is a loss on asset (100 98 = $2), net gain is $5.

9. A security is currently worth $225. An investor plans to purchase this asset in one year and

is concerned that the price may have risen by then. To hedge this risk, the investor enters into

a forward contract to buy the asset in one year. Assume that the risk-free rate is 4.75 percent.

A. Calculate the appropriate price at which this investor can contract to buy the asset in one

year.

B. Four months into the contract, the price of the asset is $250. Calculate the gain or loss that

has accrued to the forward contract.

C. Assume that eight months into the contract, the price of the asset is $200. Calculate the gain

or loss on the forward contract.

D. Suppose that at expiration, the price of the asset is $190. Calculate the value of the forward

contract at expiration. Also indicate the overall gain or loss to the investor on the whole

transaction.

E. Now calculate the value of the forward contract at expiration assuming that at expiration,

the price of the asset is $240. Indicate the overall gain or loss to the investor on the whole

transaction. Is this amount more or less than the overall gain or loss from Part D?

Solution:

a. Find F(O,T) when,

S0 = $225 T = 1 year Rf = 4.75%

(0, ) = {0 (, 0, )} (1 + )T = 225 1 + .0475

b. Calculate the value after four months:

St = $250 t = 4/12 T = 12 months T - t = 8/12 = 0.6667

0, = {t (, , )}

F(0,T)

(1+)

= 250

= $235.69

r = 0.0475

235.69

(1+.0475)0.6667

= $21.49

c. Calculate the value after eight months:

St = $200 t = 8/12 T = 12 months T - t = 4/12 = 0.3333

0, = {t (, , )}

F(0,T)

(1+)

= 200

r = 0.0475

235.69

(1+.0475)0.3333

= $-32.07

d. Calculate the value at expiration:

ST = $190

T = 12 months

F(O,T) = $235.69

r = 0.0475

This is a $-45.69 loss, there is a gain on asset (225 190 = $35), net loss is -$1069

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Waseem A. Qureshi MM141063

10. Assume that a security is currently priced at $200. The risk-free rate is 5 percent.

A. A dealer offers you a contract in which the forward price of the security with delivery in

three months is $205. Explain the transactions you would undertake to take advantage of the

situation.

B. Suppose the dealer were to offer you a contract in which the forward price of the security

with delivery in three months is $198. How would you take advantage of the situation?

Solution:

a. The no-arbitrage forward price is F(0,T) = $200(1.05)3112 = $202.45. Because the

forward contract offered by the dealer is overpriced, sell the forward contract and buy the

security now. Doing so will yield an arbitrage profit of $2.55.

Borrow $200 and buy security, at the end of three months, repay

$202.45

At the end of three months, deliver the security for

$205.00

Arbitrage profit

$2.55

b. At a price of $198.00, the contract offered by the dealer is underpriced relative to the

no-arbitrage forward price of $202.45. Enter into a forward contract to buy in three months at

$198.00. Short the stock now, and invest the proceeds. Doing so will yield an arbitrage profit

of $4.45.

Short security for $200 and invest proceeds for three months

$202.45

At the end of three months, buy the security for

$198.00

Arbitrage profit

$4.45

11. Assume that you own a dividend-paying stock currently worth $150. You plan to sell the

stock in 250 days. In order to hedge against a possible price decline, you wish to take a short

position in a forward contract that expires in 250 days. The risk-free rate is 5.25 Over the next

250 days, the stock will pay dividends according to the following schedule:

Days to next dividend

dividends per share

30

$ 1.25

120

$ 1.25

210

$ 1.25

A. Calculate the forward price of a contract established today and expiring in 250 days.

B. It is now 100 days since you entered the forward contract. The stock price is $1 15.

Calculate the value of the forward contract at this point.

C. At expiration, the price of the stock is $130. Calculate the value of the forward contract at

expiration.

Solution:

a. Find F(O,T) when, S0 = $150 T = 250/365

Rf = 5.25% Dividend = 1.25

(0, ) = {0 (, 0, )} (1 + )T

First calculate PV of each dividend paid at different times:

Dividend after 30, 120 and 140 days is $1.25

S0_________D__________D____________ D_____________ ST

$ 150

30 days

120 days

210 days

250 days

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Waseem A. Qureshi MM141063

(, , ) =

(1+g)

0, =

(1+g) (1+g)

1.25

(1+.0525)30/365

250/365

St = $115 t = 100/365

T = 250/365

0.75

(1+.0525)120/365

0.75

(1+.0525)210 /365

= 3.69

= $ 151.53

T - t = 150/365

r = 0.0525

62.50

30 days

100 days 120 days 210 days

250 days

After 100 days price is 115 and fair price calculated is 151.53 and two dividends remain: the

first one in 20 days, and the second one in 110 days.

=

(1+g)

, , =

1+g

(1+g)

0, = {t (, , )}

1.25

(1+.0525)20/365

F(0,T)

(1+)

0.75

(1+.0525)110/365

= {115 2.48}

= 2.48

151.53

(1+.0525)150 /365

= -35.86

c. Settlement at expiration.

ST = $130

F(0,T) = $151.53

VT(0,T) = $130.00 - $151.53 = -$21.53

The contract expires with a value of negative $21.53, a gain to the short.

12. A portfolio manager expects to purchase a portfolio of stocks in 90 days. In order to hedge

against a potential price increase over the next 90 days, she decides to take a long position on a

90-day forward contract on the S&P 500 stock index. The index is currently at 1145. The

continuously compounded dividend yield is 1.75 percent. The discrete risk-free rate is 4.25

percent.

A. Calculate the no-arbitrage forward price on this contract.

B. It is now 28 days since the portfolio manager entered the forward contract. The index value

is at 1225. Calculate the value of the forward contract 28 days into the contract.

C. At expiration, the index value is 1235. Calculate the value of the forward contract.

Solution:

a. Calculate fair value F(O,T).

S0 = $1145

T = 90/365

b. Calculate the value after 90 days:

St = $1225 t = 28/365

T = 90/365

rc = ln(1.0425) = 0.0416

T - t = 62/365

r = 0.0425

c = 0.0175

This is a gain to the long position.

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Waseem A. Qureshi MM141063

ST= $1235 T = 90/365 r = 0.0425

VT(0,T) = 1235 1151.83 = $ 83.17 gain for long.

13. An investor purchased a newly issued bond with a maturity of 10 years 200 days ago. The

bond carries a coupon rate of 8 percent paid semiannually and has a face value of $1,000. The

price of the bond with accrued interest is currently $1,146.92. The investor plans to sell the

bond 365 days from now. The schedule of coupon payments over the first two years, from the

date of purchase, is as follows:

Coupon

Days after Purchase

Amount

First

181

$40

Second

365

$40

Third

547

$40

Fourth

730

$40

A. Should the investor enter into a long or short forward contract to hedge his risk exposure?

Calculate the no-arbitrage price at which the investor should enter the forward contract.

Assume that the risk-free rate is 6 percent.

B. The forward contract is now 180 days old. Interest rates have fallen sharply, and the riskfree rate is 4 percent. The price of the bond with accrued interest is now $1,302.26. Determine

the value of the forward contract now and indicate whether the investor has accrued a gain or

loss on his position.

Solution:

a. Find F(O,T) when, S0 = $1146.92 T = 365 days

Rf = 6% Dividend = $40

(0, ) = {0 (, 0, )} (1 + )T

First calculate PV of each dividend paid at different times:

The investor should enter into a short forward contract, locking in the price at which he can

sell the bond in 365 days. Between now (i.e., 200 days since the original purchase) and the

next 365 days, the investor will receive two coupons, the first 165 days from now and the

second 347 days from now.

, , =

0, =

1+g

(1+g)

40

(1+.06)165/365

365/365

St = $1302.26 t = 180/365

T = 365/365

40

(1+.06)347 /365

= $ 76.80

= $ 1134.32

T - t = 185/365

r = 0.04

Div. $40

We are now on the 380th day of the bond's life. One more coupon payment remains until the

expiration of the forward contract. The coupon payment is in 547 - 380 = 167 days.

First calculate present value of Dividend for remaining period =

, , =

1+g

40

(1+.04)167/365

0, = {t (, , )}

(1+g)

= $39.29

F(0,T)

(1+)

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Waseem A. Qureshi MM141063

= {1302.26 39.29}

1134.32

= -$510.98

(1+.04)185/365

14. A corporate treasurer wishes to hedge against an increase in future borrowing costs due to

a possible rise in short-term interest rates. She proposes to hedge against this risk by entering

into a long 6 X 12 FRA. The current term structure for LIBOR is as follows:

Term

Interest Rate

30 day

5.10%

90 day

5.25%

180 day

5.70%

360 day

5.95%

A. Indicate when this 6 X 12 FRA expires and identify which term of the LIBOR this FRA is

based on.

B. Calculate the rate the treasurer would receive on a 6 x 12 FRA.

C. Suppose the treasurer went long this FRA. Now, 45 days later, interest rates have risen and

the LIBOR term structure is as follows:

Term

Interest Rate

135 day

5.90%

315 day

6.15%

Calculate the market value of this FRA based on a notional principal of $10,000,000.

D. At expiration, the 180-day LIBOR is 6.25 percent. Calculate the payoff on the FRA. Does

the treasurer receive a payment or make a payment to the dealer?

Solution:

a. 6 X 12 FRA expires in 180 days and is based on 180-day LIBOR.

b. value of FRA(o,h,m)

h = 180

m = 180

h + m = 360

LO(h + m) = 0.0595

h +m

0, , =

1+Lo + 360

h

1+L0 360

360

m

360

0, , =

0, , =

1

1+Lg

h g

360

1

1+0.0590

1+.0595 360

180

1+.057 360

0, , =

135

360

Lo(h) = 0.057

1

1+Lg

h g

360

360

180

= 0.0603

m

360

h +m g

360

1+(0,, )

1+Lg +

m

360

h +m g

360

1+(0,, )

1+Lg +

180

360

315

1+0.0615

360

1+0.0603

0.0081

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Waseem A. Qureshi MM141063

h = 180 m = 180

m

0, , = 1

Settlement at maturity:

180

0, , = 1

1+.0625 360

180

1+.0625 360

1+(0,,) 360

m

1+Lh 360

= 0.001067

Based on a notional principal of $10,000,000, the corporation, which is long, will receive

$10,000,000 X 0.001067 = $10,670 from the dealer.

15. A financial manager needs to hedge against a possible decrease in short term interest rates.

He decides to hedge his risk exposure by going short on an FRA that expires in 90 days and is

based on 90-day LIROR. The current term structure for LIBOR is as follows:

Term

Interest Rate

30 day

5.83%

90 day

6.00%

180 day

6.14%

360 day

6.51%

A. Identify the type of FRA used by the financial manager using the appropriate terminology.

B. Calculate the rate the manager would receive on this FRA.

C. It is now 30 days since the manager took a short position in the FRA. Interest rates have

shifted down, and the new term structure for LIBOR is as follows:

Term

Interest Rate

60 day

5.50%

150 day

5.62%

Calculate the market value of this FRA based on a notional principal of $15,000,000.

Solution:

a. 3 X 6 FRA expires in 90 days and is based on 90-day LIBOR.

b. value of FRA(o,h,m)

h = 90

m = 90

h + m = 180

0, , =

1+Lo + 360

h

1+L0 360

LO(h + m) = 0.06

h +m

360

m

0, , =

1

1+Lg

180

1+.0614 360

0, , =

h g

360

Lo(h) = 0.0614

90

1+.06 360

1

1+Lg

h g

360

360

90

= 0.0619

m

360

h +m g

360

1+(0,, )

1+Lg +

m

360

h +m g

360

1+(0,, )

1+Lg +

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Waseem A. Qureshi MM141063

0, , =

1

1+0.055

60

360

90

360

150

1+0.0562

360

1+0.0619

- 0.001323

-0.001323 X 15,000,000 = -$19,845. Because the manager is short, this represents a gain.

16. Consider a U.S.-based company that exports goods to Switzerland. The U.S. Company

expects to receive payment on a shipment of goods in three months. Because the payment will

be in Swiss francs, the U.S. Company wants to hedge against a decline in the value of the

Swiss franc over the next three months. The U.S. risk-free rate is 2 percent, and the Swiss riskfree rate is 5 percent. Assume that interest rates are expected to remain fixed over the next six

months. The current spot rate is $0.5974.

A. Indicate whether the US. Company should use a long or short forward contract to hedge

currency risk.

B. Calculate the no-arbitrage price at which the U.S. Company could enter into a forward

contract that expires in three months.

C. It is now 30 days since the U.S. Company entered into the forward contract. The spot rate is

$0.55. Interest rates are the same as before. Calculate the value of the US companys forward

position.

Solution:

a. The risk to the U.S. Company is that the value of the Swiss franc will decline and it

will receive fewer U.S. dollars on conversion. To hedge this risk, the company should enter

into a contract to sell Swiss francs forward.

b. Fair value of Currency.

Rfd = domestic risk free rate,

So = $0.5974

(0, ) =

0(1+ )

(1+ )

0.5974(1+.02)90/365

1+.05 90/365

0, =

$0.5931

(1+ )

St = $0.55

0, =

0.55

(1+.05)

60/365

0.5931

(1+.02)60/365

F(0,T)

(1+ )

= - $ 0.0456

This represents a gain to the short position of $0.0456 per Swiss franc. In this problem, the

U.S. company holds the short forward position.

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Waseem A. Qureshi MM141063

17. The euro currently trades at $1.0231. The dollar risk-free rate is 4 percent and the euro

risk-free rate is 5 percent. Six-month forward contracts are quoted at a rate of $1.0225.

Indicate how you might earn a risk-free profit by engaging in a forward contract. Clearly

outline the steps you undertake to earn this risk-free profit.

Solution:

a. Fair value of Currency.

Rfd = domestic risk free rate,

So = $1.0231

(0, ) =

0(1+ )

(1+ )

1+.05 180 /365

$1.0183

Decision: F(O,T) is less then Spot rate: The dealer quote for the forward contract is $1.0225;

thus, the forward contract is overpriced. To earn a risk-free profit, you should enter into a

forward contract to sell Euros forward in six months at $1.0225. At the same time, buy Euros

now.

Calculate PV of 1 :

1+g

1

1+.05 6/12

= 0.9759

Calculate yield rate using forward rate available after 3 months i.e. $ 1.0225

g=

1/

PV

1=

1.0225

0.9984

1/0.5

1 = 0.0489 = 4.98%

18. Suppose that you are a U.S.-based importer of goods from the United Kingdom. You

expect the value of the pound to increase against the U.S. dollar over the next 30 days. You

will be making payment on a shipment of imported goods in 30 days and want to hedge your

currency exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is 4.5

percent. These rates are expected to remain unchanged over the next month. The current spot

rate is $1.50.

A. Indicate whether you should use a long or short forward contract to hedge the currency risk.

B. Calculate the no-arbitrage price at which you could enter into a forward contract that

expires in 30 days.

C. Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the

value of your forward position.

Solution:

a. The risk to you is that the value of the British pound will rise over the next 30 days

and it will require more U.S. dollars to buy the necessary pounds to make payment. To hedge

this risk you should enter a forward contract to buy British pounds.

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Waseem A. Qureshi MM141063

b. So = $1.50

(0, ) =

0(1+ )

(1+ )

1.50(1+.055)30/365

1+.045 30/365

$1.5012

t

0, =

(1+ )

St = $1.53

0, =

1.53

(1+.55)

20/365

1.5012

(1+.055)20/365

F(0,T)

(1+ )

19. Consider the following: The U.S. risk-free rate is 6 percent, the Swiss risk-free rate is 4

percent, and the spot exchange rate between the United States and Switzerland is $0.6667.

A. Calculate the continuously compounded U.S. and Swiss risk-free rates.

B. Calculate the price at which you could enter into a forward contract that expires in 90 days.

C. Calculate the value of the forward position 25 days into the contract. Assume that the spot

rate is $0.65.

Solution:

a. Continuously compounded rates:

rfc = ln(1.04) = 0.0392

S0 = $0.0667

T = 90/365

c. Calculate the value after 25 days into contract:

St = $0.65 t = 25/365

T = 90/365 T - t = 65/365

rfc = 0.0392

rdc = 0.0583

20. The Japanese yen currently trades at $0.00812. The U.S. risk-free rate is 4.5 percent, and

the Japanese risk-free rate is 2.0 percent. Three-month forward contracts on the yen are quoted

at $0.00813. Indicate how you might earn a risk-free profit by engaging in a forward contract.

Outline your transactions.

Solution:

a. Fair value of Currency.

So = $0.00812 /

(0, ) =

0(1+ )

(1+ )

.00812 (1+.045)90/365

1+.02 90/365

$0.00817

68

Decision: F(O,T) is more than Spot rate: The dealer quoted rate for the forward contract is

$0.008 13. Therefore, the forward contract is underpriced. To earn a risk-free profit, you

should enter into a forward contract to buy yen in three months at $0.00813. At the same time,

sell yen now.

The spot rate of $0.00812 per yen is equivalent toV123.15 per U.S. dollar.

123.15

Calculate PV of 1 :

= 121.82

3/12

1+g

Calculate PV of 1 $:

1+.045

1+g

1+.045 3/12

= 0.9892

Calculate yield rate using forward rate available after 3 months i.e. 123 and spot rate

for 121.82

g=

1/

PV

1=

123

121.82

1/0.25

1 = 0.0393 = 3.93%

Because we began our transactions in yen, the relevant comparison for the return from our

transactions is the Japanese risk-free rate. The 3.93 percent return above exceeds the Japanese

risk-free rate of 2 percent. Therefore, we could borrow yen at 2 percent and engage in the

above transactions to earn a risk-free return of 3.93 percent that exceeds the rate of borrowing.

Chapter: 5 Book: Analysis of derivatives for the CFA program,

In simple, SWAP is an agreement between two parties to exchange a series of cash flows. To

explain, a swap is a derivative in which two counter parties exchange cash flows of one

party's financial instrument for those of the other party's financial instrument. Typically at

least one of the two series of cash flows is determined by a later outcome.

In other words, one party agrees to pay the other a series of cash flows whose value will

be determined by the unknown future course of some underlying factor, such as interest rate,

exchange rate, stock price or commodity price. These payments are commonly referred to as

variable or floating. The other party makes fix payment.

The swap market is almost exclusively an over-the-counter market, so swap contracts

are customized to the parties specific needs When a swap is initiated, neither party pays any

amount to the other. Therefore, a swap has zero value at the start of the contract, although this

is not necessary in all cases. Each date on which the parties make payments is called a

settlement date and the time between settlement dates is called settlement period. It always

have an expiration date, the date of final payment. The swap can be terminated through cash

payment on expiry or any time before expiration, terminating early by entering into a separate

and off setting swap, or by selling the swap to some other counterparty.

.

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Waseem A. Qureshi MM141063

8.65%

ABC Co.

8.50%

BANK

KIBOR + 0.55%

XYZ Co.

KIBOR+0.70%

KIBOR+

1.50%

FLOATIN

G 9.60%

NET:

8.50%

FIXED

NET: KIBOR + 0.70%

ABC is currently paying floating, but wants to pay fixed. XYZ is currently paying fixed but

wants to pay floating. By entering into an interest rate swap, the net result is that each party

can 'swap' their existing obligation for their desired obligation. Normally, the parties do not

swap payments directly, but rather each sets up a separate swap with a financial intermediary

such as a bank. In return for matching the two parties together, the bank takes a spread from

the swap payments.

There are three transactions involved in interest rate swap.

i. Initial exchange.

( it may be cash or notional basis)

ii. Interim exchange. (it is always cash basis).

iii. Terminal exchange. ( it may be cash or notional basis).

Types of SWAPS.

1. Interest rate swaps

2. Currency swaps / exchange rate swaps

3. Equity swaps

4. Credit default swaps

5. Subordinate risk swaps

1. Interest rate swaps. / Plain vanilla

The most common type of swap is a "plain Vanilla" interest rate swap. It is the exchange of

a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15

years.

The reason for this exchange is to take benefit from comparative advantage. Some companies

may have comparative advantage in fixed rate markets, while other companies have a

comparative advantage in floating rate markets. When companies want to borrow, they look

for cheap borrowing, i.e. from the market where they have comparative advantage. However,

this may lead to a company borrowing fixed when it wants floating or borrowing floating

when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a

fixed rate loan into a floating rate loan or vice versa.

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Waseem A. Qureshi MM141063

Examples:

Following are the options for company A and B to borrow from the market.

A

B

Difference

Variable

k + 2%

k + 4%

Fix

12%

16%

( 2%)

4%

Total difference between two is 4% 2% = 2%. Two parties can take only advantage

from swap when there is a difference between two answers. When the net is zero, there is no

advantage of swap. This 2% is the gain which can be divided between two parties involved

according to their agreement.

EXAMPLE 17:

Currently company A is paying a fix rate of 12% and B is on floating rate of K+ 4%,

where K is 11%. They want to exchange their series of cash flows.

Solution:

A

Loan

(12%)

(K+4%)

12%

(12%)

Difference gain(cost)

(K+1%)

K+1%

Net effect

(k+ 1%)

(15%)

When, K is 11%.

12% FIX

A

11%

BANK A

k%

KIBOR + 4%

BANK B

A currency swap is a foreign-exchange agreement between two institutions to exchange

aspects (namely the principal and/or interest payments) of a loan in one currency for

equivalent aspects of an equal in net present value loan in another currency.

A currency swap involves exchanging principal and fixed rate interest payments on a loan in

one currency for principal and fixed rate interest payments on an equal loan in another

currency. Just like interest rate swaps, the currency swaps are also motivated by comparative

advantage. Currency swaps entail swapping both principal and interest between the parties,

71

Waseem A. Qureshi MM141063

with the cash flows in one direction being in a different currency than those in the opposite

direction. It is also a very crucial uniform pattern in individuals and customers.

Currency swaps have three main uses:

EXAMPLE 18:

Investment :

Rate

:

Interest rate :

Interest rate :

Interest on Bond:

30m in

1 = 1.6

4.5%

3.25%

3%

Investment in

30 x 1.6 = 48.6 m

Return on investment:

30 m @ 4.5%

Exposure to loan:

48.6 m @3.25%

Bond holder will give:

30 m @ 5%

30 m @ 4.5%

Company

BANK A

48.6 m @3.25%

30m

@ 5%

Bond Holder

b. Calculation of interest:

Interest income

Expense on loan in :

Bond holder interest exp.:

Cost in :

Cost in :

30 m @ 4.5%= 1.35 m

48.6 m @3.25% = 1.5726 m

30 m @ 5% = 1.5 m

1.5 m 1.35m = 0.15 m

1.5795 m

(income) 1.35 m

Company

BANK A

(expense) 1.5726 m

1.5 m

Interest expense

Bond Holder

72

Waseem A. Qureshi MM141063

c. Termination:

Company will repay its loan of 48.6 m to bank and in return bank will pay 30m to

company which is payable to bond holder.

30 m

Company

BANK A

48.6 m

30m

Bond Holder

EXAMPLE 19:

A USA company exports products to Japan. An amount of 1.20 Billion is receivable.

Amount will be received in 4 quarterly installments of 300 m . Interest rate in USA is 6.8%

and in Japan it is 6%. Spot rate is, 1 $ = 132 .

Quarterly interest rate Japan:

Quarterly interest rate USA:

1.5% of loan :

Loan in :

Convert loan in $:

6%/ 4 = 1.5%

6.8%/ 4 = 1.7%

300 m

300 / .015 = 20,000 m

20,000 / 132 = 151.5 m $

Investment in $

Borrowing in :

151.5m $@6.8%

20,000 m @ 6%

151.5 m $ @ 6.8%

Company

USA BANK

20,000 m @ 6%

b. Calculation of interest:

Quarterly Interest in $:

Quarterly Interest in :

20,000 X .06 X 3/12 = 300 m

(Income) 2.5755 m $

Company

USA BANK

(Expense) 300m

300 m

JAPAN BANK

Waseem A. Qureshi MM141063

73

c. Termination:

Company will clear its position by paying 20,000 and receiving 151.1 m $.

151.5 m $

Company

USA BANK

20,000 m

Dual currency bonds are those, which are issued in one currency and coupon rate is in

another currency.

Example 20:

Omega company wants to invest 10 m $ which is equal to 12.5 m at a rate of 4.5%.

TMAR is the bank of Omega Company. TMAR invests its funds in KINS and wants to

swap its cash flows. For the purpose they invest in bank in euro and borrow amount in

dollars. Other information is as under:Principal:

10 m $ or 12.5 m

12.5 m @ 4.5%

12.5 m @ 4.5%

10 m $ @ 5%

10 m $ @ 5.25%

Borrow 10m $ @ 5%

TMAR

10 m $= 12.5 m

Omega Co

BANK

10 m $ @ 5.25%

KINS

74

Waseem A. Qureshi MM141063

b. Calculation of interest:

Interest on borrowing in $:

Interest on investment in :

Interest on investment in $:

Interest on investment in :

Net position:

10 m $ @ 5% = 0.5 m

12.5 m @4.5% = 0.563 m

10 m $ @ 0.525% = 0.525 m $

12.5 m @4.5% = 0.563 m

0.525 0.5 = 0.025 m $ gain.

0.5 m $ @ 5%

TMAR

BANK

0.563m @ 4.5%

0.563 m @ 4.5%

0.525 m $ @ 5.25%

Omega Co

KINS

c. Termination:

10m $

TMAR

BANK

12.5m

10 m $

10 m $

Omega Co

KINS

3. Equity swaps

A swap where the rate considered is, the rate of return on a stock or stock index. Following are

the main uses of equity swaps.

Example 21:

a. Diversifying a concentrated portfolio.

CWF is a company that wants to hedge its non-diversified stock of 30m $. There

total concentrated portfolio is 80m $, the difference 50m$ is diversified.

JAN-1

100

5000

ZYKT

S&P 500

Difference in return:

Amount of difference:

DEC-31

RETURN

120

20%

5300

16%

20% - 16% = 4%

4% of 30m$ = 1.2 m$

75

Return of S&P 500

CWF

CAPS

80 m

Concentrated portfolio = 80m $

Diversified stock = 50m $, non-diversified = 30m$

b. Achieving international diversification.

JAN-1

DEC-31

RETURN

Russle 3000

5000

5500

10%

E&FE index

6000

6700

11%

Difference in return:

10% - 11% = 1%

Amount of difference:

1% of 50m$ = 0.5 m$

This 1% of 50m $ will be paid by A&B to USR-M

USR-M

A&B

Return

Concentrated portfolio 500m $

LMS

No. of shares :

Share Market Value:

Total Wealth:

Diversification 5000 shares:

Invest in Stock 80%:

Invest in Bond 20%:

Bench mark for stock:

Bench mark for bond:

10.2 m

35 $ / share

10.2 x 35 = 357 m $

0.5 x 35 = 17.5 m $

17.5 x 0.80 = 14 m $

17.5 x 0.20 = 3.5 m $

Russle 3000

LGBI

76

Waseem A. Qureshi MM141063

M.S.

Return on 14m @ Rwell

Return on 3.5m @ LGBI

SSI

357 m $

SPST

d. Changing asset allocation between stocks and bonds.

A company invests in endowment fund (waqf funds). Endowment is a type of fund for

which only returns are utilized and the original amount remains in the investment for

life time. Principal amount cannot be used. Following info is available:Size of fund:

200 m $

Invests in stocks:

75%

Invests in bonds:

25%

Benchmark for stock:

S&P 500 on large Cap

Benchmark for stock:

S&P 600 on small Cap

Benchmark for Govt. bond:

LLTBI

Benchmark for corporate bond: MLCBI

Description

Size of fund

75% in stock

60% large caps

30% mid caps

10% small caps

25% in Bonds

Govt. Bonds

Corporate Bonds

Current Investments

200 m $

150 m $

90 m

45 m

15 m

50 m $

40 m

10 m

JAN-1

Description

Proposed Investments

Size of fund

200 m $

90% in stock

180 m $

65% large caps 117 m

25% mid caps

45 m

105 Small caps

18 m

25% in Bonds

20 m $

Govt. Bonds

15 m

Corporate Bond 5 m

DEC-31

RETURN

S&P 500

10000

S&P 600

8000

LLTBI

5000

MLCBI

7000

RETURNS: S&P 500

27 x 7% =

S&P 600

3 x 10% =

Total receivable:

LLTBI

25 x 5% =

MLCBI

5 x 6% =

Total payable:

Net Receivable / gain.

10700

8800

5250

7420

1.89 m

0.30 m

Change

-+ 30m$

+ 27 m

--+3 m

-25 m

-5 m

7%

10%

5%

6%

2.19m $

1.25 m

0.30 m

1.55m $

0.64m $

77

Waseem A. Qureshi MM141063

M.S.

Return on 300m @ S&P 600

Return on 25m @ LLTBI

Return on 500m @ MLCBI

SSI

Portfolio 200 m$

A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of

payments to the seller and, in exchange, receives a payoff if an instrument, typically a

bond or loan, goes into default (fails to pay). Less commonly, the credit event that triggers the

payoff can be a company undergoing restructuring, bankruptcy or even just having its credit

rating downgraded.

been

compared

the buyer pays a premium and, in return, receives a sum of money if one of the events

specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to

profit from the contract and may also cover an asset to which the buyer has no direct exposure.

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or

equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain

risks. These can include any form of equity, management or legal risk of the underlying (for

example a company). Through execution the equity holder can (for example) transfer shares,

management responsibilities or else. Thus, general and special entrepreneurial risks can be

managed, assigned or prematurely hedged. Those instruments are traded over-thecounter (OTC) and there are only a few specialized investors worldwide.

78

Waseem A. Qureshi MM141063

An option is a contract which gives the buyer (the owner) the right, but not the obligation, to

buy or sell an underlying asset or instrument at a specified strike price on or before a

specified date. The seller has the corresponding obligation to fulfill the transaction that is to

sell or buy if the buyer (owner) "exercises" the option. The buyer pays a premium to the

seller for this right.

Some basic concepts:

Exercise price / Strike price:

The price at which the underlying security can be purchased (call option) or sold (put option).

The exercise price is determined at the time the option contract is formed. It is also known as

strike price.

Spread:

A spread position is entered by buying and selling equal number of options of the same class

on the same underlying security but with different strike prices or expiration dates.

At the Money: ATM (current market price = strike price)

An option is said to be at the money if the current stock price is equal to the strike price.

It doesn't matter if we are talking about calls or puts. Any call or put whose underlying

stock price equals the strike price is said to be at the money. Sometimes you will see "At

The Money" abbreviated as "ATM." You may also see "OTM" which mean "Out of the

Money" and ITM which means "In the Money".

In the Money: ITM (current market price > strike price)

A call option is said to be in the money when the current market price of the stock is above the

strike price of the call. It is "in the money" because the holder of the call has the right to buy

the stock below its current market price. When you have the right to buy anything below the

current market price, then that right has value. That value is also referred to as the option's

"intrinsic value."

Out of the money: OTM (current market price < strike price)

A call option is said to out of the money if the current price of the underlying stock is

below the strike price of the option.

Exercise price and premium relation:

Both have opposite direction. When exercise price is high premium will be low and

vice versa, because the chance of exercise is associated with the price of stock.

Decision to exercise the option: The decision to exercise the option is always made by the

Long because he has the right to exercise and the short is obligated to obey the transaction.

79

Waseem A. Qureshi MM141063

Party

Requirements Position

Expectation

Premium

profit

Long

Call

He wants to

buy some

particular

asset on a

future date.

Asset Price

will rise in

the future.

Cost/expense.

The

difference

between

market

price and

strike price

minus

premium

paid

Asset Price

will decrease

in the future.

Cost/expense.

Asset Price

will decrease

in the future.

Profit/gain.

Asset Price

will rise in

the future.

Profit/gain.

Bullish

Right to buy

an asset at a

future time at

specific rate.

(Buy a

contract)

Long

Put

He wants to

Sell particular

asset on a

future date.

Bearish

Short

Call

Bearish

Short

Put

Bullish

Right to sell

an asset at a

future time at

specific rate.

(Buy a

contract)

He wants to

earn the profit

when contract

expires

worthless.

Obligated to

He wants to

earn the profit

when contract

expires

worthless.

Obligated to

sell

an asset at a

future time at

specific rate.

buy

an asset at a

future time at

specific rate.

He will pay

the premium

to

counterparty

that is a short

call.

He will pay

the premium

to

counterparty

that is a short

put.

He will

receive the

premium from

the

counterparty

that is a long

call.

He will

receive the

premium from

the

counterparty

that is a long

put.

The

difference

between

market

price and

strike price

minus

premium

paid

The only

profit is

premium

received if

contract

expires

worthless.

The only

profit is

premium

received if

contract

expires

worthless.

Main Party

Counterparty

(cost for)

(gain for)

Long call

short call

long call

short put

Long put

short put

long put

short call

80

HINT: premium is always paid by long to short, whether the position of long is call or put. It

is an expense for long and gain for short. And the decision always lies with long because he

buys the right.

Strategies for long and short positions:

1. Long call option strategy

The long call option strategy is the most basic option trading strategy whereby the options

trader buys call options with the belief that the price of the underlying security will rise

significantly beyond the strike price before the option expiration date.

However, call options have a limited lifespan. If the underlying stock price does not move

above the strike price before the option expiration date, the call option will expire worthless.

The long put option strategy is a basic strategy in options trading where the investor buy put

options with the belief that the price of the underlying security will go significantly below the

striking price before the expiration date.

81

Waseem A. Qureshi MM141063

The index short call strategy is a bearish strategy designed to earn from the premiums for

selling the index call options with the hope that they expire worthless. The options trader

employing the index short call strategy expects the underlying index level to be below the call

strike price on option expiration date.

Maximum profit is limited to the premiums received for selling the index calls.

Max Profit = Premium Received - Commissions Paid

The index short put strategy is a bullish strategy designed to earn from the premiums for

selling the index put options with the hope that they expire worthless. The options trader

employing the index short put strategy expects the underlying index level to be above the put

strike price on option expiration date.

Maximum profit is limited to the premiums received for selling the index puts.

82

Waseem A. Qureshi MM141063

STRATEGIES:

Long calls (right to buy) = when you believe the underlying stock will go up.

Long puts (right to sell) =when you believe the underlying stock will go down.

Short on calls (obligated to sell) = when you believe the underlying stock go down.

Short on puts (obligated to buy) = when you believe the underlying stock go up.

Uses of options:

There are two main uses op options.

1. Hedging

2. Speculation

Following may be some different situations that may occur on the basis of situation a

speculator or hedger expects in the future.

1.

2.

3.

4.

5.

6.

7.

8.

9.

Buy 1 call option at low price and sell one call option at high price. (Bull Spread)

Buy 1 call option at low, 1 call at high and sell 2 call options at middle. (Butterfly)

Buy 1 call option and 1 put option at same exercise price. (V-Shape)

Buy 1 call option and 1 put option when these are out of money. (Strangle)

Buy 2 call option and 1 put option at same exercise price. (Strip)

Buy 1 call option and 2 put option at same exercise price. (Strap)

Buy 1 call option at high price and sell 1 call option at low price. (Bear Spread)

Buy 1 put option at low price and sell 1 put option at high price. (Spread)

Buy 1 put option at high and sell 1 put option at high price. (Bear Spread)

1. Buy 1 call option at low price and sell one call option at high price. (Bull Spread)

Bull spread, the investor who expects a rise of prices in the future.

Exercise price

call option

90

6

Long

100

4.5

110

4

short

What decision will be taken with different market prices?

Buy 1 Call option at low price = 90 at a premium of 6

Sell 1 call option at high price = 100 at a premium of 4

MPS

70

80

90

100

110

120

130

140

Long Call

(6)

(6)

(6)

4

14

24

34

44

Short Call

4

4

4

4

4

(6)

(16)

(26)

Net position

(2)

(2)

(2)

8

18

18

18

18

83

20

18 --------16

12

8

4

0

70

80

90

100

110

120

130

140

-2

-4

-8

HINT: when ever Market price is lower to exercise price, the option will not be exercised and

the contract will be closed. The only expense or cost is premium which is paid in start or at the

time of contract.

For situation 1, where MPS is 70, exercise price is 90 and premium is 6 for long call, the

option will not be exercised and the buyer will pay 6 to leave the contract. At the same price

the decision for short call will be made by long. Here contract price is 110 and market price is

70, it is unfavorable for long as he can buy at lower price from market and will not exercise

the option. He will leave the contract and only $4 will be loss to him which is a gain for short

position. Result is, 6 loss for long call and 4 gain for short call.

For situation 6, where MPS is 120, exercise price is 90 and premium is 6 for long call, the

option will be exercised and the buyer will receive $30 by selling at 120 which is bought for

90. The cost is $6 for premium, so net gain is 30-6 = 24. At the same price the decision for

short call will be made by long. Here contract price is 110 and market price is 120, it is

favorable for long and he will not exercise the option. He will earn a profit of $10 by selling at

120 and his cost is 4. So net for long is 10-4 = 6, a gain for long is loss for short. Here our

position is short, so 6 is a loss for short.

Net position:

Minimum loss is $2 and maximum gain is $18 for the combination. This combination is called

Bull Spread.

84

Waseem A. Qureshi MM141063

2. Buy 1 call option at low, 1 call option at high and sell 2 call options at middle.

(Butterfly spread)

Exercise price

Call option

90

Long

100

4.5

Short

110

Long

90 at a premium of 6

Sell 2 call option at middle price = 100 at a premium of 4.5 (4.5 x 2= 9)

MPS

70

Long Call-I

(6)

Long Call-II

(4)

Short Call

9

Net position

(1)

80

(6)

(4)

(1)

90

(6)

(4)

(1)

100

(4)

110

14

(4)

(11)

(1)

120

24

(31)

(1)

130

34

16

(51)

(1)

140

44

26

(71)

(1)

9

7

5

3

=Counter party

1

0

70

-1

80

90

100

110

120

130

140

=

Main

party

-3

-5

-7

-9

85

3. Buy 1 call option and 1 put option at same exercise price. (V-shape)

Exercise price

call option

90

put option

100

4.5

3.5

110

MPS

Long Call

Long Put

Net position

70

(6)

17

11

80

(6)

90

(6)

(3)

(9)

100

(3)

110

14

(3)

11

120

24

(3)

21

130

34

(3)

31

140

44

(3)

41

25

20

15

10

5

0

70

80

90

100

110

120

130

140

-5

-10

-15

86

Waseem A. Qureshi MM141063

4. Buy 1 call option and 1 put option when these are out of money. (Strangle)

Exercise price

call option

90

Put option

100

4.5

3.5

110

MPS

Long Call

Long Put

Net position

70

(4)

17

13

80

(4)

90

(4)

(3)

(7)

100

(4)

(3)

(7)

110

(4)

(3)

(7)

120

(3)

130

16

(3)

13

140

26

(3)

23

25

20

15

10

5

0

70

80

90

100

110

120

130

140

-5

-10

-15

87

Waseem A. Qureshi MM141063

5. Buy 2 call option and 1 put option at same exercise price. (Strip)

Exercise price

call option

90

Put option

100

4.5

3.5

110

Buy 2 Call options and 1 put option at 90 on a premium of 6 (same exercise price).

MPS

Long Call

Long Put

Net position

70

(12)

17

80

(12)

(5)

90

(12)

(3)

(15)

100

(3)

110

28

(3)

25

120

48

(3)

45

130

68

(3)

65

140

88

(3)

85

Here the investor expects an abnormal movement in future, but probability of increase is

double to probability of decrease. Chance of movement on either sides are not equal.

28

20

15

10

5

0

-2

70

80

90

100

110

120

130

140

-5

-10

-15

This is called STRIP.

88

Waseem A. Qureshi MM141063

6. Buy 1 call option and 2 put option at same exercise price. (Strap)

Exercise price

call option

90

Put option

100

4.5

3.5

110

Buy 2 Call options and 1 put option at 90 on a premium of 6 (same exercise price).

MPS

Long Call

Long Put

Net position

70

(6)

34

28

80

(6)

14

90

(6)

(6)

(12)

100

(6)

(2)

110

14

(6)

120

24

(6)

18

130

34

(6)

28

140

44

(6)

38

Here the investor expects an abnormal movement in future, but probability of increase is

double to probability of decrease. Chance of movement on either sides are not equal.

28

24

20

15

10

5

0

-2

70

80

90

100

110

120

130

140

-6

-10

-16

89

Waseem A. Qureshi MM141063

7. Buy 1 call option at high price and sell 1 call option at low price. (Bear Spread)

Exercise price

call option

50

Put option

60

5.5

70

MPS

Long Call

Long Put

Net position

30

(4)

40

(4)

50

(4)

60

(4)

(2)

(6)

70

(4)

(12)

(16)

80

(22)

(16)

90

16

(32)

(16)

24

20

16

12

8

4

0

-4

70

80

90

100

110

120

130

140

-8

-12

-16

90

Waseem A. Qureshi MM141063

8. Buy 1 put option at low price and sell 1 put option at high price. (Spread)

Exercise price

call option

Put option

50

60

5.5

70

MPS

Long Put

Short Put

Net position

30

14

17

40

50

(6)

(3)

60

(6)

(3)

70

(6)

(3)

80

(6)

(7)

(13)

90

(6)

(17)

(23)

24

20

16

12

8

4

0

-4

30

40

50

60

70

80

90

100

-8

-12

-16

91

Waseem A. Qureshi MM141063

9. Buy 1 put option at high and sell 1 put option at low price. (Bear Spread)

Exercise price

call option

Put option

50

60

5.5

70

Buy 1 Call option and 1 put option at 70 on a premium of 3, and sell 1 put option at 70 on a

premium of 3, both at high rates.

MPS

Long Put

Short Put

Net position

30

37

43

40

27

33

50

17

23

60

(4)

70

(3)

(14)

(17)

80

(3)

(24)

(27)

90

(3)

(34)

(37)

48

40

32

24

16

8

0

-8

30

40

50

60

70

80

90

100

-16

-24

-32

92

Waseem A. Qureshi MM141063

Duration:

Duration is the average life of Bond. The life of bond is inversely related with bond

value. Longer the life, lower will be the value of bond and vice versa.

EXAMPLE 22:

An 8% bond is traded in the market. The maturity period is 5 years. Interest is payable on

annual basis. Market yield rate is 10%. What is fair value of bond? What is duration of bond?

What is convexity of bond if interest rate increases to 11%.

YEAR

1

2

3

4

5

a.

CASH FLOWS

80

80

80

80

1080

PVF = 1/ (1+i)n

.909

.826

.751

.683

.621

PV of CF

72.72

66.08

60.08

54.64

670.68

= 924.20

PV of CF * t

72.72

132.16

180.24

218.40

3353.40

= 3956.92

PV Factor = 1/ (1+i)n

PV of bond = 924.20 (it is net present value of cash flows from bond in 5 years)

b.

Duration of Bond

CF T/(1+i)n

=

=

b.

or

CF /(1+i)n

3956.92

924.20

(PV of CF t)

(PV of CF )

4.32 years

Convexity of Bond

Change in Bond value due to change in interest rate.

New interest rate is 11%, old is 10%, it is denoted by R

Convexity = -

R

1+

= -4.32 *

.11.10

1+.10

= -.39 , -3.9%

It means every 1% increase in interest rate will decrease a value of bond by 3.9%.

Valuation of Options

Until now, we have looked only at some basic principles of option pricing. Other than put-call

parity, all we examined were rules and conditions, often suggesting limitations, on option

prices. With put-call parity, we found that we could price a put or a call based on the prices of

the combinations of instruments that make up the synthetic version of the instrument. If we

wanted to determine a call price, we had to have a put; if we wanted to determine a put price,

we had to have a call. What we need to be able to do is price a put or a call without the other

instrument. In this section, we introduce a simple means of pricing an option. It may appear

93

Waseem A. Qureshi MM141063

that we oversimplify the situation, but we shall remove the simplifying assumptions gradually,

and eventually reach a more realistic scenario.

Binomial Model

The word "binomial" refers to the fact that there are only two outcomes. In other words, we let

the underlying price move to only one of two possible new prices. As noted, this framework

oversimplifies things, but the model can eventually be extended to encompass all possible

prices. In addition, we refer to the structure of this model as discrete time, which means that

time moves in distinct increments. This is much like looking at a calendar and observing only

the months, weeks, or days. Even at its smallest interval, we know that time moves forward at

a rate faster than one day at a time. It moves in hours, minutes, seconds, and even fractions of

seconds, and fractions of fractions of seconds. When we talk about time moving in the tiniest

increments, we are talking about continuous time. We will see that the discrete time model

can be extended to become a continuous time model.

Two models:

1. Discrete model

Discrete model can be

b. Two period binomial model

2. Continuous model.

Continuous model can be a. Black-Schole Model

b. Merton Model

Some basic calculations, signs & formulas and model:

We start with a call option. If the underlying goes up to S+, the call option will be worth c+.

If the underlying goes down to S, the option will be worth C. We know that if the option

is expiring, its value will be the intrinsic value.

S0 = Spot price

S+ =

Su

S = Sd

= S0(1+u)

= S0(1-d)

C+ = Max(0, S+ - X)

Maximum of 0 or S+ - X

C = Max(0, S - X)

Maximum of 0 or S - X

X= exercise price

+ + 1

1+r

1+

ud

It is,

+

+

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Waseem A. Qureshi MM141063

H = nS C

(initial outlay)

H+ = nS+ C+

H= nS C

S+ = S0(1+u)

S0

C=?

C+ = Max(0, S+ - X)

S = S0(1-d)

1-

C = Max(0, S - X)

The call price today is C, which is weighted average of the next two possible call prices, C+

and C+. The weights are and 1-. This weighted average is then discounted one period at the

risk free rate.

Example 23: (One period binomial)

Suppose the underlying is a non-dividend-paying stock currently valued at $50. It can either

go up by 25 percent or go down by 20 percent. Thus, u = 1.25 and d = 0.80.

S+ = Su = 50(1.25) = 62.50

S = Sd = 50(0.80) = 40

Assume that the call option has an exercise price of 50 and the risk-free rate is 7 percent.

Thus, the option values one period later will be:

Option values at expiration:

C+ = Max(0, S+ - X) = Max(0, 62.50 - 50) = 12.50

C = Max(0, S - X) = Max(0, 4O - 50) = 0

S+ = 50(1.25) = 62.50

S0 = 50

C=?

S = 50(0.80) = 40

1-

C = Max(0, 4O - 50) = 0

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Waseem A. Qureshi MM141063

=

First we calculate

=

1+.07

1+

ud

+ + 1

1+r

1+.07.80

1.25.80

= 0.60

ARBITRAGE OPPORTUNITY:

Suppose the option is selling for $8. If the option should be selling for $7.01 and it is selling

for $8, it is overpriced-a clear case of price not equaling value. Investors would exploit this

opportunity by selling the option and buying the underlying. The number of units of the

underlying purchased for each option sold would be the value n:

Calculate no. of underlying to be purchased or sold against one unit of option.

=

12.50

62.540

= 0.556

Thus, for every option sold, we would buy 0.556 units of the underlying. Suppose we sell

1,000 calls and buy 556 units of the underlying. Doing so would require an initial outlay of :H = nS C = 556(50) - 1,000(8) = $19,800.

One period later, the portfolio value will be either

H+ = nS+ C+ = 556(62.5) - 1,000(12.5) = $22,250.

OR

These two values are not exactly the same, but the difference is due only to rounding the

hedge ratio, n. We shall use the $22,250 value. If we invest $19,800 and end up with $22,250,

the return is:-

g=

22,250

19,800

1 = 0.1237 = 12.37%

The arbitrage will give 12.37% risk free which is better to risk free of 7%.

Example 24: (One period binomial)

Consider a one-period binomial model in which the underlying is at 65 and can go up 30

percent or down 22 percent. The risk-free rate is 8 percent.

A. Determine the price of a European call option with exercise prices of 70.

B. Assume that the call is selling for 9 in the market. Demonstrate how to execute an arbitrage

transaction and calculate the rate of return. Use 10,000 call options.

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Waseem A. Qureshi MM141063

Solution:

First find underlying prices in the binomial tree. We have u = 1.30 and d = 1 - 0.22 =0.78.

S+ = Su = 65(1.30) = 84.50

S = Sd = 65(0.78) = 50.70

Option values at expiration:

C+ = Max(0, S+ - X) = Max(0, 84.50 - 70) = 14.50

C = Max(0, S - X) = Max(0, 50.70 - 70) = 0

The risk-neutral probability is

=

1+.08

ud

=

1+

1+.08.78

1.30.78

= 0.5769

+ + 1

1+r

ARBITRAGE OPPORTUNITY:

Suppose the option is selling for $9. If the option should be selling for $7.75 and it is selling

for $9, it is overpriced-a clear case of price not equaling value. The number of units of the

underlying purchased for each option sold would be the value n:

Calculate no. of underlying to be purchased or sold against one unit of option.

=

14.50

84.550.70

= 0.4290

Thus, for every option sold, we would buy 0.4290 units of the underlying. Suppose we sell

10,000 calls and buy 4290 units of the underlying. Doing so would require an initial outlay of:

n= 10,000 x .4290 = 4290 options

H = nS C = 4290(65) - 10,000(9) = $188,850.

One period later, the portfolio value will be either

H+ = nS+ C+ = 4290(84.5) - 10,000(14.5) = $217,505.

OR

These two values are not exactly the same, but the difference is due only to rounding the

hedge ratio, n. We shall use the $217,505 value. If we invest $188,850 and end up with

$217,505, the return is:g=

217,505

188,850

1 = 0.1517 = 15.17%

The arbitrage will give 15.17% risk free which is better to risk free of 8%.

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Waseem A. Qureshi MM141063

S+ +

C+ +

S+

C+

S+

C+

S +

C+

S0

C=?

1-

S

C

S

C

S0 =

spot price

S+ =

Su = S0(1+u)

S =

Sd = S0(1-d)

C+ =

Max(0, S+ - X)

Maximum of 0 or S+ - X

C =

Max(0, S - X) Maximum of 0 or S - X

S+ + =

= S0(1+u)2

S+ = S+d = Sud =

S0(1+u) (1-d)

S + = Su = Sdu =

S0(1+u) (1-d)

S = Sd = sdd =

Sd2 = S0(1-d)2

C+ + = Max(0, S+ + - X)

C+ = Max(0, S+ - X)

C = Max(0, S - X)

=

1+

ud

+ =

=

=

++ + 1 +

1+r

+ + 1

1+r

+ + 1

1+r

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Waseem A. Qureshi MM141063

+

+ =

=

++ +

++ +

+

+

Consider a two-period binomial model in which the underlying is at 30 and can go up 14

percent or down 11 percent each period. The risk-free rate is 3 percent per period.

A. Find the value of a European call option expiring in two periods with an exercise price of

30.

B. Find the number of units of the underlying that would be required at each point in the

binomial tree to construct a risk-free hedge using 10,000 calls.

SOLUTION:

First find underlying prices in the binomial tree: We have u = 1.14 and d =1- 0.1 1 = 0.89.

S+ =

Su = S0(1+u)

S =

Sd = S0(1-d)

30(1.14) = 34.20

= 30(0.89) = 26.70

S = Sd2 = S0(1-d)2

S+ =

Sud =

= 30(0.89) 2= 23.76

30(1.14)(0.89) = 30.44

C+ + = Max(0, S+ + - X) = Max(0, 38.99- 30) = 8.99

C+ = Max(0, S+ - X) = Max(0, 30.44 - 30) = 0.44

C = Max(0, S - X) = Max(0, 23.76 - 30) = 0

We will need the value of :

=

1+

ud

1- =

1+.030.89

= 0.56

1.140.89

1 - 0.56

0.44

+ =

++ + 1 +

+ =

1+r

+ + 1

1+r

1.03

0.56(0.44)+ 0.44 0

1.03

99

+ + 1

1+r

1.03

HINT: value of + and used for calculation of C are taken from above formula calculation

Where + = 5.08 and = 0.24

Number of units of underlying for each unit of option.

=

+

+

+ =

=

++ +

5.080.24

34.2026.70

+ =

++ +

+

8.990.44

38.9930.44

0.440

30.4423.76

= 0.6453

= 1.00

= 0.0659

(when price goes up)

(when price goes down)

The number of units of the underlying required for 10,000 calls would thus be 6,453 today,

10,000 at time 1 if the underlying is at 34.20, and 659 at time 1 if the underlying is at 26.70.

Putting the values in the tree:

S+ + = 39.98

C+ + = 8.99

S+ = 34.20

= 0.56

C+ = 5.08

S+ = 30.44 or S +

C+ = 0.44 or C+

S + = 30.44

C+ = 0.44

S0 = 30

C = 2.86

1- =0.44

S = 26.70

C = 0.24

S = 23.76

C = 0

BLACK-SCHOLES-MERTON MODEL or Continuous model can be divided in two

categories.

a. Black-Schole Model

b. Merton Model

When we move to a continuous-time world, we price options using the famous Black-ScholesMerton model. Named after its founders Fischer Black, Myron Schole: and Robert Merton.

The model can be derived either as the continuous limit of the binomial model, or through

taking expectations, or through a variety of highly complex mathematical procedures.

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Waseem A. Qureshi MM141063

Black-Schole Model gives a closed-form solution for the price of a European option on a nondividend stock while Merton model provides a solution for the price of a European option on a

stock paying a continuous dividend.

ASSUMPTIONS OF THE MODEL:

1. The underlying price follows a log normal diffusion process.

This assumption is probably the most difficult to understand, but in simple terms, the

underlying price follows a lognormal probability distribution as it evolves through time

Log returns are often called continuously compounded returns. If the log or continuously

compounded return follows the familiar normal or bell-shaped distribution, the return is said to

be log normally distributed.

2. The risk free rate is known and constant.

The Black-Scholes-Merton model does not allow interest rates to be random. Generally, we

assume that the risk-free rate is constant. This assumption becomes a problem for pricing

options on bonds and interest rates, and we will have to make some adjustments then.

3. The volatility of the underlying is known and constant.

The volatility of the underlying asset, specified in the form of the standard deviation of the log

return, is assumed to be known at all times and does not change over the life of the option.

This assumption is the most critical. In reality, the volatility is definitely not known and must

be estimated or obtained from some other source. In addition, volatility is generally not

constant. Obviously, the stock market is more volatile at some times than at others.

Nonetheless, the assumption is critical for this model.

4. There are no taxes and transaction cost.

We have made this assumption all along in pricing all types of derivatives. Taxes and

transaction costs greatly complicate our models and keep us from seeing the essential financial

principles involved in the models. It is possible to relax this assumption, but we shall not do so

here.

5. There no cash flows on the underlying.

There are no any cash flows like dividend on the securities during the period.

6. The options are European.

With only a few very advanced variations, the Black-Scholes-Merton model does not price

American options. Users of the model must keep this in mind, or they may badly misprice

these options.

Black-Scholes-Merton formula:

The input variables are some of those we have already used: So is the price of the underlying,

X is the exercise price, rC is the continuously compounded risk-free rate, (that is ln of r) and T

is the time to expiration. The one other variable we need is the standard deviation of the log

return on the asset. We denote this as and refer to it as the volatility.

HINT: r is always used after calculating natural log of r. that is , rc = ln(1+r)

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Waseem A. Qureshi MM141063

Black-Scholes-Merton formulas for the prices of call and put options are:Call option value,

C= S0 N(d1) Xe

P = Xe-

rT

-rT

N(d2)

1 N(d2) S0 1 N(d1)

rT

P = Xe- S0 + C

1 =

So

2

+ r+

T

x

2

d2 = d1 T

N(d1) = Value of d1 from normal distribution table.

N(d2) = Value of d2 from normal distribution table.

Put-Call Parity.

In financial mathematics, putcall parity defines a relationship between the price of

a European call option and European put option, both with the identical strike price and

expiry, namely that a portfolio of a long call option and a short put option is equivalent to (and

hence has the same value as) a single forward contract at this strike price and expiry.

In simple when we calculate the price of put option through price of call option, it is called

put-call parity.

NORMAL DISTRIBUTION:

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103

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Use the Black-Scholes-Merton model to calculate the prices of European call and put options

on an asset priced at 52.75. The exercise price is 50, the continuously compounded risk-free

rate is 4.88 percent, the options expire in 9 months, and the volatility is 0.35. There are no cash

flows on the underlying.

Solution:

2 = 0.1225

S0 = 52.75 = 0.35

Call option value,

C= S0 N(d1) Xe

P = Xe-

rT

-rT

T = 9/12

N(d2)

1 N(d2) S0 1 N(d1)

1 =

So

2

+ r+

T

x

2

1 =

d2 = d1 T

52.75

.1225

+ 0.0488+

.75

50

2

.35 (0.87)

0.4489 = 0.45

N(d2) = Value of d2, 0.15from normal distribution table. = 0.5596

-(.0488)(.75)

C= 52.75(.6736) -50 e

C = 35.50 48.20 (.5596) =

P = Xe-

rT

.5596

8.53

1 N(d2) S0 + C

-(.0488)(.75)

P = 50 e

1 0.5596) 52.75+8.53

P = 48.2 52.75 + 8.53 =

3.98

Merton Model:

Merton added the concept of interim cash flows. He said that we can calculate the value

of option even if there are some cash flows involved. E.g. dividends. The only difference

between Black-Schole and Merton is the calculation of So. For Merton model So is denoted as

So/ and is calculated by:So/ = So e

-rT

Example 27:

So = 100 T = 180/365 Dividend rate = 8%

So/ =

So e

-rT

The formula will be same as Black-Schole model. Only change is, we use value

of So/ instead of So.

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Waseem A. Qureshi MM141063

OPTION SENSITIVITIES

Determinants of option price / factors influencing option price.

Following are the five factors or inputs of Black-Schole-Merton Model, that influence the

price of options to change.

1.

2.

3.

4.

5.

The exercise price.

The risk free ratio. (RHO)

Time to expiration. (Theta)

Volatility.

(Vega).

Now, we explore, what is the response of option price to these factors that determine the price.

This is called sensitivity of option prices to these factors.

The option price sensitivities all derive from calculus. For example, the sensitivity of

the option price with respect to the stock price is simply the first derivative of the option

pricing formula with respect to the stock price. The first derivative of the call price with

respect to the stock price is just the change in the call price for a change in the stock price.

C / S

These sensitivities are calculated through Greeks.

GREEKS

In mathematical finance, the Greeks are the quantities representing the sensitivity of the price

of derivatives such as options to a change in underlying parameters on which the value of an

instrument or portfolio of financial instruments is dependent. The name is used because the

most common of these sensitivities are denoted by Greek letters (as are some other finance

measures). Collectively these have also been called the risk sensitivities, risk measures

or hedge parameters.

USE OF THE GREEKS

The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the

value of a portfolio to a small change in a given underlying parameter, so that component risks

may be treated in isolation, and the portfolio rebalanced accordingly to achieve a desired

exposure; see for example delta hedging.

The Greeks in the BlackScholes model are relatively easy to calculate, a desirable property

of financial models, and are very useful for derivatives traders, especially those who seek to

hedge their portfolios from adverse changes in market conditions. For this reason, those

Greeks which are particularly useful for hedging--such as delta, theta, and vega--are welldefined for measuring changes in Price, Time and Volatility. Although rho is a primary input

into the BlackScholes model, the overall impact on the value of an option corresponding to

changes in the risk-free interest rate is generally insignificant and therefore higher-order

derivatives involving the risk-free interest rate are not common.

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Waseem A. Qureshi MM141063

1. Delta

Change in option premium due to change in spot price is called Delta .

HINT: is used for partial change. It is a sign of partial derivative.

Delta =

C

So

= N (d1)

2. Theta

Change in option premium due to change in time to expiration is called Theta

Theta =

C

T

S0 N(d1)

2 T

- r x e-rT N(d2)

3. Vega

Change in option premium due to change in risk or volatility is called Vega

Vega =

change in risk

= S0T N(d1)

4. Rho

Change in option premium due to change in risk free rate is called Rho

Rho =

change in risk free rate

= x T e-rT N(d2)

5. Gamma

Change in option premium due to change in Delta is called Gamma

Gamma =

Change in Delta

change in spot price

So

N(d1)

So T

Whereas:N(d1) =

1

2

e-0.5 (d1)

DIRECTOIN

Increase in spot price

Increase in exercise price

Increase in risk free rate

Decrease / passing time to expiry

Increase in volatility

CALL OPTOIN

Increase

Decrease

Increase

Decrease

Increase

PUT OPTION

Decrease

Increase

Decrease

Increase

decrease

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Waseem A. Qureshi MM141063

Example 28:

Suppose spot price for an underlying is 100, exercise price is 100, compounded risk free is

8%, volatility is 30% and time is 180 days. Calculate all the sensitivities.

Solution:

S0 = 100

= 0.30

-(.08)(.5)

0.9608

2 = 0.09

T = 180/365

Xe-

rT

C= S0 N(d1) Xe

P = Xe-

rT

= 100e-(.08)(.5) = 96.08

-rT

N(d2)

1 N(d2) S0 1 N(d1)

1 =

So

2

+ r+

T

x

2

1 =

d2 = d1 T

100

.09

+ 0.08+

.493

100

2

.30 (0.70)

= 0.29

0.08

N(d2) = Value of d2, 0.08 from normal distribution table. = 0.5319

Call option value,

C = 61.41 51.10 = 10.31

P = Xe- S0 + C

rT

HINT: Sometimes the value of d1 may be negative. In this case the calculation will be done

using this formula. Suppose in above case delta is -.29

N(-d) or 1 N(d) where N(d) = .6141 and 1 .6141 = .3859 now d1 = 0.39

Sensitivity measures:

1. Delta

=

= N (d1)

So

.6141

2. Theta

C

T

S0 N(d1)

2 T

- r x e-rT N(d2)

Whereas:107

Waseem A. Qureshi MM141063

N(d1) =

2(3.142)

2 0.5

-0.5 (0.29)2

1

2.50

- .08(96.08)(.5319)

3. Vega

4. Rho

C

r

5. Gamma

=

So

N(d1)

So T

.3836

100 .30 (.70)

= .018

Changes in values.

Call option is 10.31 and the spot price is 100. Calculate the changes.

1. Change in delta due to change in spot price. (Delta through Gamma) = .6141

New price is 101, old was 100.

New = .6141 + .018 = .6321

New C = 10.31 + . 6141 = 10.92

2. Change in call option premium due to change in expiry. (Theta) = -12.22

It is 37 days from start of period, t=180 = 37/365 = 0.1014

New C = 10.31 + .1014(-12.22) = 9.07

3. Change in call option premium due to change in risk / volatility. (Vega) = 26.85

increase by 1%, from 0.3 to 0.4 ,

New C = 10.31 + .1(26.85) = 12.98

(call premium increases due to increase in risk)

4. Change in call option premium due to change in risk free rate (Rho). = 25.50

Risk free increases by 1%.

New C = 10.31 + .01(25.50) = 10.55

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Waseem A. Qureshi MM141063

Monthly data for the period of 2014-2015

MONTH

PRICE

April-15

99.74

May-15

102.2

June-15

116.3

July-15

106.9

August-15

108.5

September-15 100.6

October-15

97.63

November-15

85.05

December-15

84.91

January-15

81.91

February-15

84.16

March-15

83.44

April-15

94.61

R

0.024

0.129

-0.085

0.015

-0.075

-0.03

-0.138

-0.002

-0.036

0.027

-0.009

0.126

S.D.

0.0786

Annualized S.D. 0.2722

2

0.741

r

0.08

ln(1+r)

0.077

So

94.61

X

104.07

T

180/365

T

0.5

T

0.71

Solution:

S0 = 94.61

= 0.27 2 = 0.741

X = So + 10% = 104.07

T = 180/360

-(.077)(.50)

= .9622

-rT

C= S0 N(d1) Xe

P = Xe-

OR

P = Xe- S0 + C

rT

Xe-

rT

= 104.07e-(.077)(.50) = 100.14

N(d2)

1 N(d2) S0 1 N(d1)

rT

1 =

94.61

So

2

+ r+

T

x

2

1 =

.27 (0.71)

d2 = d1 T

1 =

.741

.27 (0.71)

0.1288

0.1917

.50

= 0.67

0.48

N(d2) = Value of d2, 0.48 from normal distribution table. = 0.6844

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Waseem A. Qureshi MM141063

C= S0 N(d1) Xe

-rT

N(d2)

C = 70.82 68.53 = 2.28

rT

P = Xe- S0 + C

P = 100.14 94.61 + 2.28 = 7.81

Sensitivity measures:

1. Delta

C

= N (d1)

So

0.7486

2. Theta

S0 N(d1)

2 T

- r xe-rT N(d2)

Whereas:N(d1) =

N(d1) =

1

2

e-0.5 (d1)

1

2(3.142)

-0.5 (0.67)2

1

2.50

(.7153)

20.50

7.30

1.42

- .077(100.14)(.6844)

3. Vega

=

4. Rho

C

r

5. Gamma

=

So

N(d1)

So T

.2861

94.61 .27 (.71)

= .016

110

Changes in values

Call option is 2.28 and the spot price is 94.61. Calculate the changes.

1. Change in delta when spot price increase by Re.1.

Delta = .7486

New =

New C = 2.28 + 0.7486 = 3.03

2. Change in call option premium after 60 days.

(Theta) = -10.42

It is 60th day from start of period, t=180 = 60/360 = 0.1667

New C = 2.28 + .1667(-10.42) = 0.543

3. Change in call option premium when risk increase by 10%

(Vega) = 19.22

increase by 10%, from 0.27 to 0.30 ,

New C = 2.28 + .10(19.22) = 4.20

(call premium increases due to increase in risk)

4. Change in call option premium when risk free rate increases by 2%.

(Rho). = 32.90

Risk free increases by 2%.

New C = 2.28 + .02(32.90) = 2.94

A statistical technique used to measure and quantify the level of financial risk within a firm or

investment portfolio over a specific time frame. Value at risk is used by risk managers in order

to measure and control the level of risk which the firm undertakes. The risk manager's job is to

ensure that risks are not taken beyond the level at which the firm can absorb the losses of a

probable worst outcome. The VaR is measured either at 95% confidence level or at 99%

confidence level.

Value at Risk is measured in three variables:

The amount of potential loss, the probability of that amount of loss, and the time frame.

For example, a financial firm may determine that it has a 5% one month value at risk of $100

million. This means that;

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Waseem A. Qureshi MM141063

a. There is a 5% chance that the firm could lose more than $1000 million in any given

month.

b. There is a 95% chance that in any given month the firm will not suffer a loss of $1000.

Suppose $1000 represents 12% chance of a loss, we say that;

a. There is a 5% chance that the loss will exceed 12%.

b. There is a 95% chance the loss will not exceed 12%.

Methods for computing the VaR.

Calculating VaR is a simple matter but requires assuming that asset returns conform to

a standard normal distribution. Recall that a standard normal distribution is defined by two

parameters, its mean (=0) and standard deviation (=1), and is perfectly symmetric with 50%

of the distribution lying to the right of the mean and 50% lying to the left of the mean. The zscore may be measured at any one of two confidence levels. i.e. 95% or 99%. The z-score at

these two levels are:z-score at 95% confidence level is 1.65

z-score at 99% confidence level is 2.31

There are three methods to measure the VaR.

1. Historical method

2. Monte Carlo Method.

3. Variance, covariance method / parametric method.

1. Historical method

The fundamental assumption of the Historical Simulations methodology is that you base your

results on the past performance of your portfolio and make the assumption that the past is a

good indicator of the near-future. The data should be for last 200 to 500 days.

For example, we take the data for last 240 days. Our confidence level is 95%. We compute it

is as under:

Steps:

a. Pick the data for last 240 days.

b. Arrange the data in descending order.

c. Take 5% of 240, 240 x 5% = 12

d. Now see the 12th value from bottom. (in the return column)

Suppose the 12th value from bottom is -.17. It means that there is a 5% chance that the loss will

be more than 17% in a day.

2. Monte Carlo Method.

Monte Carlo Simulations correspond to an algorithm that generates random numbers that are

used to compute a formula that does not have a closed (analytical) form this means that we

need to proceed to some trial and error in picking up random numbers/events and assess what

the formula yields to approximate the solution. Drawing random numbers over a large number

of times (a few hundred to a few million depending on the problem at stake) will give a good

indication of what the output of the formula should be.

The only difference from historical simulation is to use the random numbers instead of

continuous series of returns.

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Waseem A. Qureshi MM141063

Calculating VaR on percentage basis and VaR on dollar basis:

VaR on percentage basis.

In order to calculate VaR on %age basis, we would use a critical z-value of -1.65 and multiply

by the standard deviation of percent returns. The resulting VaR estimate would be the

percentage loss in asset value that would only be exceeded 5% of the time.

Formula:

VaR(%) = - z (where value of z at 5% is 1.65 and at 1% is 2.31)

VaR on dollar basis.

VaR can also be estimated on a dollar rather than a percentage basis. To calculate we simply

multiply the percent VaR by the asset value. It is interpreted as; the dollar loss in asset value

that will only be exceeded 5% of the time.

Formula:

VaR($) = - z (p)

(where p is the value of asset / portfolio)

Example 30:

Calculating percentage and dollar VaR.

A risk management officer at a bank is interested in calculating the VaR of an asset that

he is considering adding to the banks portfolio. If the asset has a daily standard deviation of

returns equal to 1.4% and the asset has a current value of $5.3 million . calculate the VaR (5%)

on both a percentage and dollar basis.

Solution:

= 1.4% p= 5.3 million

VaR(%) = - z

VaR($) = - z (p) =

-1.65(.014)(5.3)

= -.0122430

Thus, there is a 5% chance that, on a given day, the loss in the value of asset will exceed from

2.31% or $122,430.

Time Conversion of VaR

VaR, as calculated above measures the risk of a loss over a period of one day. We can

calculate it for longer periods such as a week, month, quarter or year. It can be converted

simply by multiplying the daily VaR to the required period.

HINT: (always consider 5 days in a week, 20 days in a month and 240 days in a year)

To calculate multiply the daily value with n

Example 31:

VaR(5%)daily = - z

-1.65(.014) = -.0231

VaR(5%)weekly = VaR(5%)daily n

= -.0231 x 5 =

-.052

VaR(5%)month = VaR(5%)daily n

-.0231 x 20 =

-.10

VaR(5%)quarter = VaR(5%)daily n

-.0231 x 60 =

-.18

113

VaR(5%)year = VaR(5%)daily n

-.0231 x 240 =

-.358

VaR(5%)quarter = VaR(5%)monthly n

-.10 x 3 =

-.18

VaR(5%)year = VaR(5%)monthly n

-.10 x 3 =

-.358

HINT: in the same way VaR($) can be calculated by simply multiplying the value of VaR%

to asset value.

Assumptions of VaR

1. Stationarity

Stationary assumes that the probability of experiencing a fluctuation is the same in all

periods. It also assumes that mean and variance do not change over the time.

Stationarity can be defined in precise mathematical terms, but here, we mean a flat

looking series, without trend, constant variance over time, a constant autocorrelation

structure over time and no periodic fluctuation.

2. Random walk

It means, a deviation in one period I independent form a deviation in another period.

Price follow a random behavior.

3. Non-negativity

Limited liability asset values are never negative. This assumption is violated by

derivatives such as futures, forwards and swaps, which can have negative value.

4. Time consistency

All assumptions that apply in one period also apply in a multiple-period scenario. The

assumptions for a 1-day period and a 1-week period are same.

5. Normal distribution

One period fluctuation in return is assumed to be normally distributed with a mean of

zero and standard deviation of one.

Continuously Compounded Rates of Returns

Normally, we calculate VaR on daily basis. A risk manager may be interested in

calculating VaR on a multi-period basis by extending the daily VaR using the square root rule.

In doing so, however, it is important that the distributional assumptions of the single-period

VaR are preserved after transforming the measure into a multiple-period VaR. using

continuously compounded rates of return allows the preservation of the single-period

assumptions. We calculate compounded returns by natural log of returns.

Rt = ln(Pt / Pt-1)

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Waseem A. Qureshi MM141063

Thus, it preserves the assumption that VaR is normally distributed no matter what time period

is used. In addition, continuously compounded returns also preserve the assumptions of

Stationarity and time consistency.

Exception: although it is generally preferable to use continuously compounded rates

of return to calculate VaR, there is one exception. For interest rate related variables (i.e. yield

to maturity, credit spread etc), compounded rates are inappropriate since the focus is on the

absolute yield change in basis points. In this situation, VaR must be adjusted to account for

duration and convexity.

Portfolio VaR

Portfolio risk, as measured by standard deviation, decreases as the correlation among assets

within the portfolio decreases. In a similar manner, VaR is affected by the diversification

effect that assets with low correlation bring to the portfolio. For a two-asset portfolio, VaR(%)

is calculated as follows:

VaR(%)portfolio = - z p

VaR($)portfolio = - z p(a,b) =

Whereas: =

11 + 22 + 21 2 12 r1,2

p2 = 11 + 22 + 21 2 12 r1,2

or

Example 32:

A fund manager manages a portfolio of two investments: A and B. Of the portfolios current

value of $6 million, A make up 4 million and B, 2 million. The standard deviation for A is .06

and for B 0.14. Correlation (r1,2) is -0.5. Calculate the VaR for this portfolio.

Solution:

A = 4 m B= 2 m 1 = 0.06 2 = 0.14 1 = 4/6 = 0.67 2 = 2/6 = 0.33 r1,2 = -.5

VaR(%)portfolio = - z p

=

=

and

VaR($)portfolio = - z p(a,b)

11 + 22 + 21 2 12 r1,2

. 67

. 06

VaR(%)portfolio = - z p

= -1.65(.044) =

.0726

0.43 million

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Waseem A. Qureshi MM141063

There are four primary factors that affect the risk of a portfolio. These factors

Include asset concentration, asset volatility, asset correlation and systematic risk.

1. Asset concentration: Asset concentration means weight of a particular asset in portfolio.

As the portfolio becomes heavily weighted towards one asset, portfolio risk increases.

2. Asset volatility: As the variance of assets within the portfolio increases, portfolio risk

increases.

3. Asset correlation: As the asset correlation between assets increases towards +1,

portfolio risk increases.

4. Systematic risk:

As the number of assets within the portfolio becomes large,

systematic becomes the more relevant factor for assessing additional assets.

Individual VaR

Individual VaR is the VaR of an individual position in isolation. Let the position weight be i,

the portfolio vale be P, the position volatility be i, then the individual VaR is;

VaR = -zi i p

We use the absolute value of the weight because both long and short positions pose risk.

Example:

VaR1 = 2.4, VaR2 = 1.6, what is VaR when r1,2 is 0 ?

Solution:

=

Var + VaR2 =

2.4

+ (1.6)

= 8.32

1. No correlation

=

Var + VaR2

r1,2 =

or

() = W1(Var1) + W2(Var2)

2. Positively correlated

r1,2 = + 1

= W1(Var1) + W2(Var2)

3. Negatively correlated

r1,2 = - 1

= W1 Var1 + W2 Var2

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Waseem A. Qureshi MM141063

VaR for portfolio with more than two assets (n, number of assets)

a. Equally weighted;

=

Whereas

1

N

+ 1

1. Equal investment in all assets.

2. Same risk for each asset class.

3. Same correlation.

b. Unequal weights;

1

11

21

31

12

22

32

13

23

33

1

2

3

Marginal VaR

Marginal VaR is the change in a portfolio VaR that occurs from an additional one dollar

investment in a give position.

=

VaR

P

or

P

Incremental VaR

Incremental VaR is the change in VaR from the addition of a new position in a portfolio. It can

be calculated precisely from a total revaluation of the portfolio.

Component VaR

Component VaR for position I, denoted CVaRi is the amount a portfolio VaR would change

from deleting that position in a portfolio. In a large portfolio with many positions, the

approximation is simply the marginal VaR multiplied by the dollar weight in position.

CVaRi = MVaRi (i x p)

Credit risk

Credit risk refers to the risk that a borrower will default on any type of debt by failing to

make required payments.[1] The risk is primarily that of the lender and includes

lost principal and interest, disruption to cash flows, and increased collection costs. The loss

may be complete or partial and can arise in a number of circumstances. For example:

Bond.

A business or government bond issuer does not make a payment on a coupon or

principal payment when due

Loan.

A consumer may fail to make a payment due on a mortgage loan, credit

card, line of credit, or other loan

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Waseem A. Qureshi MM141063

Firm.

A company is unable to repay asset-secured fixed or floating charge debt

Individual.

A consumer does not pay mortgage loan, credit card, line of credit, or

other loan

There may be two aspects of assessing the probability of default. Qualitative and Quantitative

A. Qualitative Model

Following are some factors that must be evaluated under qualitative model before making

decision about issuance of loan.

1. Collateral. Since collateral backed loan give the debt holder a first claim against

specific assets of the borrower, collateral decreases the probability of default.

2. Leverage.

Above certain debt-to-equity levels, the probability of default increase

dramatically. A large debt burden imposes a drain on cash flows that are used to make

interest and principal payments.

3. Volatility of earnings. As earnings volatility increases, the probability that a borrower

will not be able to make debt payments also increases.

4. Reputation. The borrowers past credit performance is assumed to continue into the

future. A borrower who has consistently made payments on time is more likely to

receive favorable terms from the lender.

5. Business performance.

The phase of business cycle has a significant effect on

default probabilities. The phases under which, the business is currently running will

show its ability to pay or default.

6. Other debts.

The other debts a company is currently paying or requiring to pay

off also decide the credit paying worth of the borrower.

B. Quantitative Model

Quantitative models such as, linear probability model, logit and linear

discriminant models, often use financial and economic variables to estimate default risk

and probabilities. Under this type, we will see how to calculate the Marginal Probability

of default and Cumulative probability of default.

BOND:

Marginal Probability of default

i = T. Bill rate

k = Corporate Bond rate

When interest rate increases, risk will also increase. Default risk on T. Bills is normally

very low as they are Government guaranteed.

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Probability to pay =

1+

1+k

1 P or

Probability to default =

=1

1+

1+k

Example 33:

Compute the Marginal Probability of default for the following data (one period)

T. Bill rate

=

i = 8%

Coupon rate (Company A) =

k = 11%

Coupon rate (Company B) =

k = 13%

Company A

Probability to default

=1

1+

1+k

1+.08

1+.11

= 0.027

Probability to pay =

1d

1 - .027 =

0.973

Company B.

Probability to default

=1

1+

1+k

1+.08

1+.13

= 0.044

Probability to pay =

1d

1 - .044 =

0.956

Example 34: Compute the Probabilities of default for the following data (Two periods)

T. Bill rate (1 year)

=

i = 10%

T. Bill rate (2 years)

=

i2 = 11%

Coupon rate (1 year)

=

k = 14%

Coupon rate (2 years)

=

k2 = 16%

Required:

2. Marginal probability of default (year 2)

3. Cumulative probability of default (2 years)

119

Solution:

Year 1.

=1

Probability to default

1+

1+k

1+.10

1+.14

= 0.035

1d

Probability to pay =

1 - .035 =

0.965

Year 2

We first calculate new rate of interest for year 2. We need an average rate of return for

two years. We denote the T. Bill average interest rate (f1) and corporate Bond rate (c1).

Calculations for 2 years average rates are.:a.

T. Bills

Corporate Bond

1 + 1 =

f1

1 + 1 =

c1

(1+2)2

(1+i)

0.12

1 + 1 =

(1+.11)2

(1+.10)

= 1.12

(1+2)2

(1+k)

0.18

1 + 1 =

(1+.16)2

(1+.14)

= 1.18

Probability to default

=1

1+1

1+c1

1+.12

1+.18

= 0.051

Probability to pay =

1d

1 - .051 =

0.949

b. cumulative Probability of default.

Cumulative probability is the probability that a borrower will default over a

multiyear period. It is calculated by:

Cp = 1 ( P1 x P2 x P3 x ..Pn)

Cp = Cumulative probability of default

Pn = marginal probability to pay in year n

Cumulative Probability of default =

There is 8.4% probability that Bond will default in next two years.

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Waseem A. Qureshi MM141063

Example 35:

Compute the Probabilities of default for the following data (Three periods)

T. Bill rate (1 year)

=

i = 8%

T. Bill rate (2 years)

=

i2 = 7%

T. Bill rate (2 years)

=

i3 = 9%

Coupon rate (1 year)

=

k = 11%

Coupon rate (2 years)

=

k2 = 10%

Coupon rate (2 years)

=

k3 = 12%

Required:

1.

2.

3.

4.

Marginal probability of default (year 2)

Marginal probability of default (year 2)

Cumulative probability of default (3 years)

Solution:

Year 1.

=1

Probability to default

1+

1+k

1+.08

1+.11

= 0.027

1d

Probability to pay =

1 - .027 =

0.973

Year 2

We first calculate new rate of interest for year 2. We need an average rate of return for

two years. We denote the T. Bill average interest rate (f1) and corporate Bond rate (c1).

Calculations for 2 years average rates are.:a.

T. Bills

Corporate Bond

1 + 1 =

f1

1 + 1 =

c1

(1+2)2

(1+i)

0.06

6%

(1+2)2

(1+k)

0.09

9%

1 + 1 =

(1+.07)2

(1+.08)

= 1.06

=

1 + 1 =

(1+.10)2

(1+.11)

= 1.09

Probability to default

=1

1+1

1+c1

1+.06

1+.09

= 0.028

Probability to pay =

1d

1 - .028 =

0.972

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Waseem A. Qureshi MM141063

Year 3

We first calculate new rate of interest for year 3. We need an average rate of return for

three years. We denote the T. Bill average interest rate (f2) and corporate Bond rate

(c2).

Calculations for 3 years average rates are.:b. Marginal Probability of default (year 3)

T. Bills

Corporate Bond

1 + 2 =

F2

1 + 2 =

C2

(1+3)3

(1+2)2

0.13

1 + 2 =

(1+.09)3

(1+.07)2

= 1.13

(1+3)3

(1+2)2

0.16

1 + 2 =

(1+.12)3

(1+.10)2

= 1.16

=1

Probability to default

1+2

1+c2

1+13

1+.16

= 0.025

Probability to pay =

1d

1 - .025 =

0.975

c. cumulative Probability of default.

Cumulative Probability of default = 1 P1 X P2 x p3 = 1- .973 X .972 x .975 = .078

There is 7.8% probability that Bond will default in next three years.

Firms default / Credit risk.

1. Linear probability model

2. Z-Score model

3. Advance credit risk model

Linear probability model

A linear probability model uses linear regression with financial ratios to explain historic

repayment patterns. It is a special case of a binomial regression model. Here the dependent

variable for each observation takes values which are either 0 or 1. The probability of observing

a

0 or 1 in any one case is treated as depending on one or more explanatory variables. For

the "linear probability model", this relationship is a particularly simple one, and allows the

model to be fitted by simple linear regression.

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Waseem A. Qureshi MM141063

Example 36:

Suppose that there are two observed characteristics of the borrower. Fixed cost is 35%

and leverage is 25%. Further suppose that the linear probability model for the probability of

default of borrower A is represented by the equation Z = 0.45(FC) + 0.2(LEV),

The probability of default is Z = 0.45(0.35) + 0.2(0.25) = 20.75%

Z_Score model

The Z-score formula for predicting bankruptcy was published in 1968 by Edward I.

Altman, who was, at the time, an Assistant Professor of Finance at New York University.

The formula may be used to predict the probability that a firm will go

into bankruptcy within two years.

Z-scores are used to predict corporate defaults and an

easy-to-calculate control measure for the financial distress status of companies in academic

studies. The Z-score uses multiple corporate income and balance sheet values to measure

the financial health of a company.

Z Score = 1.2X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5

Whereas:X1 = WC / TA

liquidity

X2 = EBIT / TA

Profitability

X3 = retained earnings / TA

Growth

X4 = MV of equity / BV of debt

leverage

X5 = sales / TA

efficiency

1.81 Z < 2.96

2.96 Z < 4.06

(company is in Gray zone)

(company is in Safe zone)

Hint: Z in this context is a measure of ability to pay, but in other applications Z refers to

default probability.

Example 37:

Income statement of A

Sales

50,000

CGS

30,000

G.P.

20,000

Op. exp. 10,000

EBIT

10,000

Int. exp

2,000

Net Profit 8,000

Balance Sheet of A

cash

20,000

Creditors

A/R

25,000

Accruals

investmnts 35,000

L.T. Debt

F.A.

120,000

Ret. Earning

Capital

Assets total 200,000

Net liabs.

30,000

20,000

80,000

20,000

50,000

200,000

123

Solution:

X1 = WC / TA

30,000 / 200,000 =

0.15

X2 = EBIT / TA

20,000 / 200,000 =

0.10

X3 = retained earnings / TA

10,000 / 200,000 =

0.05

X4 = MV of equity / BV of debt

55,000 / 80,000

0.68

X5 = sales / TA

50,000 / 200,000 =

0.25

2.63

The company is in gray zone. To make decision about credit, when a company lies in

the gray zone, the lender should be very much careful about the lending decision because

the company can go either ways, to safe zone or danger zone in the coming period. To

clarify, it is advised to use 3 years z-score to make the decision.

CREDIT RISK / Estimation Techniques

Measurement of credit risk is an important exercise for financial institutions, more so because

of regulatory requirements. Credit risk can be classified under two categories issuer risk and

counterparty risk.

Issuer risk is the risk that the issuer/obligor defaults and is unable to fulfill payment

obligations.

counterparty risk includes default risk, replacement risk and settlement risk.

default risk -risk that counterparty defaults without any payment / incomplete payment on the

transaction.

replacement risk risk that, after default occurs, replacing the deal under the same conditions

is not possible.

settlement risk, risk that parties involved in the settlement fails before the transaction is settled.

Basel I, II and III.

Basel I is the round of deliberations by central bankers from around the world, in 1988,

the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set

of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and

was enforced by law in the Group of Ten (G-10) countries in 1992. A new set of rules known

as Basel II was later developed with the intent to supersede the Basel I accords. However they

were criticized by some for allowing banks to take on additional types of risk, which was

considered part of the cause of the US subprime financial crisis that started in 2008. In fact,

bank regulators in the United States took the position of requiring a bank to follow the set of

rules (Basel I or Basel II) giving the more conservative approach for the bank. Because of this

it was anticipated that only the few very largest US Banks would operate under the Basel II

rules, the others being regulated under the Basel I framework. Basel III was developed in

response to the financial crisis; it does not supersede either Basel I or II, but focuses on

different issues primarily related to the risk of a bank run.

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Waseem A. Qureshi MM141063

Under Basel I, the risk weights depend on the categorization of obligors. They do not consider

the actual obligor risk rating or the tenor of the facility and do not recognize any form of

collateral. Therefore, the credit risk capital required as a percentage of exposure will be a

constant 8% across all facility ratings.

Under Basel II, banks are expected to employ the standardized approach to estimate their

economic capital for credit risk. In Basel II, banks are allowed to use their own credit risk

models, which enable them to better segregate risk and include diversification effects of the

bank's portfolio.

Focus of the study

This document focuses on issuer risk and the associated parameter estimation techniques

applicable to retail and wholesale banks. Therefore, the term credit risk used is meant to imply

issuer risk. Issuer risk is applicable to loans, exchange-traded products, and OTC-traded

products.

Credit Capital Calculation Approaches

Regulatory framework prescribed by the BIS is used as the foundation for exploring the

calculation structure of credit regulatory capital and the various parameter estimation

techniques.

The three credit capital calculation approaches suggested by the BIS are discussed

Standardized,

Internal Ratings Based-Foundation

Internal Ratings Based-Advanced.

Components of Credit Risk

The integral components of credit risk, as recognized by the Bank of International Settlements

(BIS), are:

Probability of Default (PD): Probability that the obligor will default within a given time

horizon

Exposure at Default (EAD): Amount outstanding with the obligor at the time of default

Loss given Default (LGD): Percentage loss incurred relative to the EAD

Maturity (M)1: Effective maturity of the exposure

Regulatory Framework

Under Basel II, the credit risk measurement techniques proposed under capital adequacy rules

can be classified under:

Standardized Approach: This approach uses a simplistic categorization of obligors,

without considering their actual credit risks; external credit ratings are used

Internal Ratings-Based (IRB) Approach: In this approach, banks that meet certain

criteria are permitted to use their own estimated risk parameters to calculate

regulatory capital required for credit risk

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Waseem A. Qureshi MM141063

Foundation-IRB: Banks are allowed to calculate the probability of default (PD) for each asset;

while the regulator will determine Loss Given Default (LGD) and Exposure at Default (EAD).

Maturity (M) can be assigned by either

Advanced-IRB: Banks are allowed to use their internal models to calculate PD, LGD, EAD,

and M

The primary objective of employing these models is to arrive at the total risk weighted assets

(RWA), which is used to calculate the regulatory capital. The RWA calculation is based on

either Standardized or IRB approach

To determine the minimum capital required for credit risk, banks are required to categorize

their claims into groups mentioned in regulatory guidelines.

These categories are used to calculate/determine their respective risk weights.

The risk weights required for the calculation of credit capital can either be regulator

determined or calculated using credit risk parameters, estimated using internal models.

APPROACH

Standardized

Foundation-IRB

PD

Regulator

determined

Internal model

Advanced-IRB

Internal model

LGC

Regulator

determined

Regulator

determined

Internal model

M

Regulator

determined

Regulator

determined

Formula

provided

EAD

Regulator

determined

Regulator

determined

Internal model

regulator-prescribed risk weights. To determine the EAD for on-balance sheet items, the

balance sheet values of the items are used as exposures. For off-balance sheet items, the

undrawn commitment is multiplied by a regulator-prescribed CCF.

o For the IRB approaches, the risk parameters are inputs to the respective risk weight

formulas. To determine the EAD, on-balance sheet items use the balance-sheet values

and the off-balance sheet items use CCFs suggested by the regulators.

o For the foundation approach, the CCFs are the same as those for the standardized

approach, but with a few exceptions.

o For the advanced approach, the CCFs can be the bank's own internal estimates.

As the Basel II guidelines suggest, banks are allowed to use a variety of internal models

using advanced credit risk estimation techniques, thereby raising concerns of potential

estimation differences across banks. Therefore, those banks that wish to implement the IRB

approach must first apply to the regulators for accreditation. To get a go-ahead from the

regulators, banks internal estimation techniques should meet some stringent quantitative and

qualitative requirements as follows:

o Internal models are expected to be risk-sensitive to the portfolio of the bank.

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Waseem A. Qureshi MM141063

o The internal model should be able to capture obligor characteristics and should have

sufficient information to estimate the key risk parameters within statistical confidence

levels

o There should be proper corporate governance and internal controls

o The modeling and capital estimation framework should be linked to the day-to-day

operations of the bank

o There should be an appropriate validation and testing process, ensuring the estimation of

the precise PD, LGD, EAD, and capital estimates for credit risk.

The following sections discuss the standardized approach, the IRB approach, and the various

internal models that can be employed to estimate credit risk capital.

1. Standardized Approach

In the standardized approach (Basel II), the risk weights for different exposures are specified

by the Basel committee. To determine the risk weights for the standardized approach, the bank

can take the help of external credit rating agencies that are recognized as eligible by national

supervisors in accordance to the criteria specified by the Basel committee.

Types of claims and their risk-weights

Following are the different types of claims and the risk-weights specified by Basel committee.

Sovereign loan, public sector entities, multilateral development banks, banks, securities

firms, and corporate: These categories have different risk weights, specified according to

their ratings e.g. (A+ rated sovereign claim has a risk weight of 20%). Each of the six

categories has tables mentioning the risk weights to be used for different ratings and other

points that should be taken into consideration while deciding on the risk weights.

Regulatory retail portfolio: Claims falling under this category are given risk weight of 75%.

Residential property: Minimum risk weight of 35% is advised by the Basel committee

Commercial real estate: Risk weight of 100% is advised by the Basel committee

Past due loans: Only the unsecured portion of the loan, which is more than 90 days are

considered and different risk weights are assigned depending on the outstanding amount

Higher risk categories: These claims are given risk weight of 150%

Other assets: These claims are given risk weight of 100%

Off balance sheet items: These are converted into credit exposure equivalents by using

credit conversion factors (CCF).

Securitized transactions: Risk weights are assigned according to their ratings and maturity

OTC transactions: Specified guidelines (mathematical formula) are provided to calculate the

exposure

Classifying the securities into different categories and then determining the risk weights

of the instrument is a critical task. This requires an in-depth understanding of all the products

of the bank, and also the Basel norms specifying guidelines for the classification. Furthermore,

while dealing with OTC derivatives, it is essential to go through the terms and conditions of

these products. Sound knowledge of the business as well as legal aspects of the products is

essential.

Once the risk weights are determined, the capital required could be calculated as:

Capital Requirement = Asset Value x Risk-Weight x 8%

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Calculation of credit capital requirement under Standardized Approach for Sovereign Loan is

shown below:

Category

AAA to AAA+ to ABBB+ to

BB+ to

Below unrated

BBBBBRisk Weight 0%

20%

50%

100%

150%

100%

Asset Value

$100m

$100m

$100m

$100m

$100m

$100m

RW * AV

$0m

$20m

$50m

$100m

$150m

$100m

Capital

$0m

$1.6m

$4m

$8m

$12m

$8m

Reqrd

Credit Risk Mitigation

Banks are allowed to use credit risk mitigation (CRM) techniques to reduce their capital

requirement. Below are the CRM techniques that banks can use:

Collateralized transactions

On-balance sheet netting

Guarantees and credit derivatives

Maturity mismatch

The Internal Ratings-Based (IRB) Approach of Basel II allows banks to use their internal

estimates of risk parameters to calculate the required capital related to the exposure.

The IRB approach estimates risk parameters under:

o Foundation approach: Banks estimate PD using internal models, while the other

parameters take supervisory estimates

o Advanced approach: Banks provide their own estimate of PD, LGD, and EAD and their

calculation for M is subject to the supervisory requirements

Under the IRB approach, banks are required to categorize their banking book exposures into

the following asset classes:

Corporate , Sovereign , Bank , Retail and Equity.

Basel provides risk weight formulas for the IRB approach; the PD, LGD, and M are inputs to

these formulas. The formula varies depending on the exposure category. Under the IRB

Foundation, the formula assumes a value for LGD and M, while under the IRBAdvanced, all

parameters are estimated using internal models.

Probability of Default IRB

Probability of default (PD) is an estimate of the likelihood that the obligor will be unable to

meet its debt obligation over a certain time horizon. PD is integral to estimating credit risk and

its associated economic capital/regulatory capital.

According to Basel II, a default event on an obligation would occur if either or both of the

following conditions meet:

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Waseem A. Qureshi MM141063

a. The obligor is unlikely to be able to repay its debt without giving up any pledged

collateral

b. The obligor has passed more than 90 days without paying a material credit obligation.

Estimation of PD depends on two broad categories of information:

Macroeconomic unemployment, GDP growth rate, interest rate

Obligor specific financial ratios/growth (corporate), demographic information (retail)

PD categories and modeling techniques

a. Unstressed/stressed PD. If the PD is estimated considering the current macroeconomic

and obligor-specific information, it is known as unstressed PD. Stressed PD is estimated

using current obligor-specific information and stressed macroeconomic factors

(independent of the current state of the economy).

b. Through-the-cycle/point-in-time PD.

Point-in-time PD estimates incorporate

macroeconomic and the obligors own credit quality, whereas through-the-cycle PD

estimates are mainly determined by factors affecting the obligors long-run credit quality

trends.

Any of the following four modeling techniques can be used to estimate PD:

Pooling estimated empirically using historical default data of a large universe of

obligors

Statistical estimated using statistical techniques through macro and obligor-specific

data

Reduced-form estimated from the observable prices of CDSs, bonds, and equity

options

Structural estimated using company level information

i. Pooling Approach

a. Corporate Exposures

Empirical survey takes into consideration all the historical defaults that have occurred in the

past.

Historical PD is calculated by taking the ratio of the bonds that have defaulted to the total

bonds issued in the past, provided the bonds taken into consideration are identical in nature.

Calculation for this method is divided into two categories:

Cohort method

Duration (intensity)-based method

Under the cohort method, the ratio of default bonds to the total bonds are taken without

considering the time taken to default; only the status at the end of period is taken into

consideration.

=

For example: Total number of bonds is 5,000,000 and bond defaulted during period are

600,000

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Waseem A. Qureshi MM141063

600,000

5,000,000

= .12 =

12%

However, under the duration-based method, the time taken by the bond to default is also

included in the calculation. Therefore, in the duration-based method, the numerator is the

proportion of bond years defaulted and the denominator is the total number of bond years.

1

1

For example: Total number of bonds is 1,000,000 and bond defaulted during year 1 are 20,000

=

1

1

20,000

1,000,000

= .02 =

2%

Calculation of PD would also require the list of all the bonds that have defaulted in the past

and their characteristics. The market price of bond trading in the market after the default gives

its default price. The other data required would be the characteristics of the defaulted bond,

such as its rating, maturity, issuance date, seniority, issuer's rating, covenants, and country.

b. Retail Exposures

For retail exposures, the facilities that have defaulted in the past are considered. Historical PD

is calculated by taking the ratio of the facilities that have defaulted to the total facilities that

existed in the concerned time frame.

In this method, the facilities are divided into different categories/pools based on their risk

drivers.

The primary risk drivers are facility types, delinquency in payment, customer score,

geographical location, etc. The PD for each category is calculated by taking the average PD of

all the loans in that category. The PD calculated for that category is assigned to the exposure

whose PD is to be determined.

ii. Statistical Approach

Historical data on characteristics of retail obligors and corporate obligors can be used to

estimate their respective probability of defaults.

Many statistical techniques can be used to estimate and classify PD of an obligory. Regression

(linear/logit/ probit), discriminant analysis, neural networks, hazard model, decision trees are

some of them. .

To analyze a new loan or an existing loan, we use the output from the model and

compare it with two threshold levels (predetermined), which are used to determine whether the

loan is good, bad, or needs brief evaluation.

The two threshold levels (0<T1<T2<1) are chosen such that it minimizes the cost of

evaluation.

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If the output of the regression is PD< T1 then loan is considered to be of good quality

If the output is PD> T2 then the loan is most likely to default

If the output of the regression Yi is between T1 and T2, then there are less chances of

default and needs more evaluation

Some of the common variable sources used to estimate the PD of a corporate are financial

statements, owners data, type of loan, size of loan, and industry of the company.

Similarly, for retail obligors, variable sources could be customer demographics, income

statistics, age of loan, and the number of late payments.

Calculations:

First calculate Z value and then PD.

Z = 1X1 + 2X2 + 3X3 + nXn

e

1+ e

e

1+ e

e 1.5

1+ e 1.5

4.48

5.48

= 0.83

iii. Structural Approach

Structural models are used to calculate the probability of default for a corporate based on the

value of its assets and liabilities. The central concept of structural model is that a company

(with limited liability) defaults if the value of its assets is less than the debt of the company.

This is because the value of equity becomes negative (asset value = equity value + liability

value), which can be given away at zero cost.

Structural model was first suggested by Merton and after that many models with variations

have been designed. The most widely used versions are:

Merton Model

KMV Model (a variant of the Mertons model) (KMV = Kealhofer, McQuown and Vasicek)

Merton's Model the basic set-up of Merton's model considers that the firms liabilities

consist of one zero-coupon bond with notional value L and maturing at T. So, there will be no

payments until T, at which point the default decision is taken. Therefore, the PD is the

probability that the value of the assets is below the value of liabilities, at time T.

Merton model uses an option theoretical framework (Black-Scholes) to model the default

behavior.

In the Black-Scholes framework, the probability of default is the probability that this option

expires out of the money, which is given by the following equation:

At

2

ln

+ (V )(T t)

L

2

PD =

(T t)

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where,

N = Cumulative standard normal distribution (Value in table)

At = Value of the firm/assets at time t

L = loan / debt of the firm

V = mean value of assets

V= standard deviation of log of assets return

Example 38:

At = 100m

V = .10

Loan = 60m

V = 0.30

a. what is PD?

PD =

PD =

ln

At

2

+( V )(Tt)

L

2

(Tt)

.5102+ .0225

PD = 1-0.9948

.21

PD =

N (-2.56) =

= .0052 = .52%

ln

100

.09

+(.10 )(0.5)

60

2

.30(.50)

Probability of default.

= L Max(L A, 0) = 60-Max(60-100,0) = 60

It means the business has the capacity to repay the bond holder.

c. Payment to equity holder.

= Max(A L, 0) = Max(100-60,0)

40

KMV Model (a variant of the Mertons model) (KMV = Kealhofer, McQuown and Vasicek)

Probability of default is

Whereas:-

PD = 1 DD

2

=

ln

V

Defalut Threshold

Whereas:

DD = Distance to default

Ln V = log for value of assets

Default threshold = weighted average loan

E(RoA) = expected rate of return

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Waseem A. Qureshi MM141063

Example 39:

Loan

2,000

3,000

5,000

A

B

Total

=

Time

2 years

5 years

19,000

CF * T

4,000

15,000

19,00

5,000

Threshold value =w1*CF + w2*CF = .5 * 2000 + .5 * 3000 =2500 (assume equal weights)

Asset value = 6,000

ln

m = 3.8

V

Defalut Threshold

Th = 2500

ln

= .30

ROA = .04

6000

.09

+ .04

3.8

2500

2

.303.8

PD = 1 DD = 1. .9279 = .0711 OR 7.11%

vi. Reduced Form Approach

Reduced form PD is calculated using the credit spreads of non-defaulted risky bonds currently

trading in the market. The spread above treasury bonds is the indicator of the risk premium

demanded by the investors. However, this spread reflects the expected loss which includes

both PD and LGD and liquidity premiums.

Therefore, the modeling requires separating PD from the remaining parameters.

In case of p1, as mentioned above, suppose the face value of the bond is 1$ and the one-year

risk-free rate is equal to R1 and the recovery rate is . The value of the one-period corporate

bond is shown as:

= 1 1 P + P

Whereas:

P = Probability of default

1 = 1 in the formula is par value of asset.

= Recovery rate

R = Risk free rate

RR = Rate of return / yield rate

Example 40:

= 0.70

R = .08

= 1 1 P + P

1 - .3P = 0.887/0.923

1 - .3P = .962

.3P = 1 - .962

.3P = .038

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Waseem A. Qureshi MM141063

Loss Given Default (LGD) is defined as the percentage loss rate on EAD, given the obligor

defaults. It provides the loss that a bank is bound to incur when a default occurs. The actual

loss incurred will be the product of LGD and EAD.

The components of the loss that will be incurred, given the obligor defaults are:

Loss of principal

Carrying costs

Workout expenses

The estimation of LGD is crucial to the calculation of the required economic capital because

the value of risk-weighted assets is more sensitive to changes in LGD than in PD.

Value of LGD varies with the economic cycle, so the following variations in LGD are defined:

Cyclical LGD (Point-in-Time LGD)

Long-run LGD (Through-the-Cycle LGD)

Downturn LGD

Cyclical LGD is calculated based on the recent data and its value depends on the economic

cycle.

Long-run LGD represents the average long-term LGD, corresponding to a non-cyclical

scenario that is not dependent on the time the LGD is calculated.

Downturn LGD represents the LGD at the worst time of the economic cycle.

Basel II requires that the LGD must reflect the downturn conditions wherever it is necessary to

capture the relevant risks.

Under the IRB-Foundation approach, senior claims on sovereigns, corporate, and banks

not secured by accepted collateral are given an LGD value of 45% and the subordinated claims

are given LGD value of 75%.

Under the IRB- Advanced approach, LGD needs to be estimated using internal models.

Techniques for LGD

Four broad modeling techniques can be employed for estimating LGD under this approach, as

mentioned below:

Workout LGD: estimated using cash-flows from workout process

Implied Market LGD: estimated from market prices of non-defaulted bonds/loans

Statistical LGD: estimated using regression on historical LGDs and facility

characteristics

1. Market LGD

Market LGD is a historical-data-based method. In this technique, the observable default price

of the bonds and loans that trade in the market after the firm has defaulted are used as the

proxy for LGD.

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Waseem A. Qureshi MM141063

The actual prices of the bonds are based on par and thus can be easily converted into LGD as:

{100% of par value - default price}.

This technique reflects the investors expectations about the recovery (i.e. 100% - LGD)

through market prices of defaulted bonds and marketable loans.

2. Workout LGD

Workout LGD calculates the LGD based on the actual cash flows that can be recovered from

the firm by the workout process, once the firm has defaulted.

The Workout LGD methodology involves prediction of the future cash flows that can be

recovered from the company, after the company has defaulted on its payments.

The forecasted cash flows are discounted using an appropriate discount rate for the defaulted

firm. These discounted cash flows are added to provide the expected recovery amount. The

total exposure of the firm at the time of default minus the expected recovery amount gives the

loss given default in absolute terms. The ratio of loss given default in absolute value to

exposure at default gives the LGD in percentage terms.

Computation of workout LGD can be shown as below:

R ) + (

= t

Ct )

Whereas:

= Exposure at default at time t

= = T is end time of recovery and t=m is start time of recovery

Rt

Ct

= Cost of recovery during workout process

Example 41:

A recovery for loan starts on June 8, 2013. Amount is 100m. recovery during year 1 is

30m and in year 2 is 40m, cost for respective years is 2m and 3m. opportunity cost of capital is

10%. Calculate workout LGD.

R ) + (

= t

Ct )

=

=

30

1.10

2

1.10

+

+

40

(1.10)2

3

(1.10)2

100 60.3+4.28

100

1.8 + 2.48

=

= 4.28

.439 or 43.90%

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Waseem A. Qureshi MM141063

3. Implied LGD

Implied market LGD calculated LGD from market-observable information i.e. market prices.

The assumption in these models is that the market prices incorporate all the risk parameters.

So, by using these prices, the risk parameters such as PD and LGD can be extracted. The

advantage of implied market LGD is that it is forward looking, as the prices incorporate the

future expectation.

Implied LGD can be calculated by the following two methods:

Structural-form model

Reduced-form model

structural model is based on the framework developed by Merton. It uses the option pricing

theory developed by Black and Scholes. Here the term structural is used as these models use

the structural characteristics of the company, such as assets and their volatility, and leverage of

the company.

The basic idea behind these models is that the company will default if the company's assets

value fall below its debt at maturity.

So the company's default risk is driven by the assets value and its volatility, which need to be

estimated.

The value of LGD is calculated as 1 Recover rate (RR). Recovery rate is the estimated value

of assets in case of default i.e. the value of assets if it is less than the value of debt at maturity.

Using the Black Scholes option pricing theory, recovery rate is given by:

Implied LGD = 1 RR

where,

=

d1 =

A0 N(d1)

V (

)

D

N(d2)

ln

A

2

+( V + )T

D

2

d2 = d1 - T

RR = Recovery Rate

N = Cumulative standard normal distribution

A0 = Value of the firm at time t

D = Strike of the option which is the debt of the firm

V = expected growth rate of assets

= standard deviation of log of assets return

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Waseem A. Qureshi MM141063

Example 42:

A0 = 100m D = 70m

= 0.30 T = 6 months

what is RR?

A0 N(d1)

V (

)

D

N(d2)

d1 =

V= 0.05

ln

A

2

+( V + )T

D

2

d2 = d1- T =

d1 =

1.90 - .3(.5)

ln

100

.09

+ .05+

.50

70

2

.30.5

N(-d1) = .0287

N(-d2) = .0401

100

70

.05.5 (

.0287

.0401

) =

1%

4. Statistical LGD

Loss given default can be estimated with the help of statistical techniques using historical data.

The LGD will be the dependent variable and other factors that can change the value of LGD

form the independent variables. LGD of the past facilities for the retail exposure or the default

price for corporate exposure is used as a proxy for LGD.

The independent variables consist of factors such as issuer's rating, rating of the facility,

seniority of the facility, maturity, interest rates, labour market data, and business indicators

such as gross domestic product, consumer price index, and inflation data

Here, is a linear equation formed by the linear combination of independent variables and is

given by the following equation:

Xt= b0+b1Y1+..+bnYn

Xt=ln(LGD/1-LGD)

or it can be written as

Z = 1X1 + 2X2 + 3X3 + nXn

e

1+ e

Following are the points to be kept in mind while implementing this model:

Only the statistically significant variables should be considered in the final model

Variables should have economic meaning in explaining the variation of LGD

Independent variables should be able to explain the LGD significantly

Data should be properly processed. For instance, removal of outliers to get the correct

relationship

137

A key risk parameter to address the banks exposure at the time of default is called exposure at

default (EAD). The amount which the bank is expected to lose in the event of an obligor

defaulting represents the EAD.

Calculation of EAD according to the product type can be divided into two sections:

1. Lines of credit: This is a credit source provided to an entity (obligor) by a bank.

Some types of lines of credit are demand loan, term loan, revolving credit, and overdraft

protection.

Banks are required to estimate EAD for each facility type, which should reflect the chance of

additional drawings by the obligor. The methods used to estimate the EAD for lines of credit

and off-balance sheet items are:

Credit Conversion Factor (CCF) Method

2. Derivatives: These are vanilla and over-the-counter (OTC) instruments, the pay-outs of

which depend on the movements of some asset class (underlying).

The risk of default or counterparty credit risk is prevalent for OTC derivatives.

The EADs of a few derivative products, such as interest rate swap, caps, floors, swaptions,

cross currency swaps, equity swaps, and commodity swaps, are calculated in a different

manner.

EAD estimation methods for derivative products can be done by the below methods:

Current Exposure Method (CEM)

Standardized Method (SM)

Internal Model Method (IMM)

Under the internal ratings-based approach, calculation of EAD is further divided into the

following two sections:

Foundation Approach (F-IRB): In this approach, EAD associated with lines of credit and

off-balance sheet transactions are to be calculated using the CCF method, where the CCFs

are provided in the Basel guidelines; collaterals, guarantees or security are not taken into

consideration while estimating EAD. To estimate EAD of derivatives, any of the

abovementioned methods under the derivatives section can be chosen.

Advanced Approach (A-IRB): For this approach, banks are allowed to use their own models,

and they have the flexibility in choosing their models. For the CCF method, the CCFs are not

provided by the regulatory guidelines and have to be calculated.

1. CCF Method

The amount which the borrower will owe to the bank at the time of default is the EAD. The

following are the two types of credit exposures:

Fixed exposure: Exposures for which the bank has not made any future commitments to

provide credit in the future and the on-balance sheet value gives the value of exposure.

The value of the exposure is given by the following formula:

EAD = Drawn Credit Line

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Waseem A. Qureshi MM141063

EAD for the fixed exposures will equal to the current amount outstanding on the balance sheet

and as a result no modeling is required for Basel ll requirements.

Variable exposure: Exposures in which the bank provides future commitments, in

addition to the current credit. Therefore, the exposure will contain both on- and offbalance sheet values. The value of exposure is given by the following formula:

EAD = Drawn Credit Line + Credit Conversion Factor * Undrawn Credit Line

where,

Drawn Credit Line = Current outstanding amount

Credit Conversion Factor = Expected future drawdown as a proportion of undrawn amount

Undrawn Credit Line = Difference between the total amount which the bank has committed

and the drawn credit line

As the future draw downs are not known, to estimate EAD we need to model for the CCF

factor of each exposure.

Credit Conversion Factor (CCF) Modeling

The CCF is the ratio of the estimated extra drawn amount during 12 months before default

over the undrawn amount at the time of estimation. It can be defined as the percentage of

undrawn credit lines (UCL) which has not been paid out, but can be utilized by the borrower

until the point of default. The CCF should lie between 0 and 1.

=

The CCF is calculated for the default exposures which are used to estimate the CCF for the

non-default exposures.

The following steps are employed to estimate the CCF of non-default exposures:

Exposures which had defaulted in the past are divided into pool on the basis of Exposure at

default risk drivers(EADRD) attributes of the exposure viz. factors affecting borrowers

demand for funding/facilities, nature of particular facility

Each individual default-exposures CCF is estimated within the pools

The average CCF for each pool is calculated the CCF of the pool is defined as the

weighted average of the CCF which were estimated for the defaulted individual exposures

If the volatility of CCFs is low and lies around the average, it is advisable to use the

average CCF; if the CCF values are volatile then it should represent the economic

downturn conditions appropriately

The average CCFs of default-exposure pools is used to estimate the CCFs for the nondefault exposures using lookup tables

The CCF obtained is checked whether it is appropriate for the current macroeconomic

scenario and then used to calculate the EAD

CCF Estimation for Defaulted Exposures

Estimation of the CCF for defaulted exposures is primarily done by two methods:

Fixed-horizon method

Cohort method

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Waseem A. Qureshi MM141063

In both the methods, the observation time period is fixed (as fixed by the regulators) and is

usually one year.

Fixed horizon method

This methodology assumes that all the exposures that are in non-default state will default at

the same time over the time horizon chosen for the estimation. The CCF is calculated with

respect to the time horizon that is always fixed.

The CCF is the ratio of the increase in the exposure until the default day to the maximum

possible increase in exposure. These values are calculated with respect to the fixed time

horizon. Therefore, the numerator indicates how much the exposure of the bank increased

from the exposure at the fixed interval prior to default and the denominator indicates the

maximum increase in the exposure that could have happened during the fixed interval.

Here the amount that will be drawn at the maturity is related to the drawn/undrawn amount at

a fixed time prior to default. The CCF is given by the formula:

_

_

Where,

-EAD: Exposure at the time default occurred

-On_balance (fixed horizon): Exposure of the bank at fixed time horizon (one year) prior to

default

-Limit (fixed horizon): Maximum exposure that the bank can have with the counterparty at

the

fixed horizon

Cohort method

The observed time horizon is divided into different short time windows (default can occur at

any time in the time window). Therefore, the time horizon with respect to which the CCF is

calculated is not fixed.

The CCF is the ratio of the increase in the exposure until the default day to the maximum

possible exposure. These values are calculated with respect to the start of the time window.

The numerator indicates how much the exposure of the bank increased from the exposure at

the start of time window prior to default. The denominator indicates the maximum increase in

the exposure that could have happened during the time window. As the default can occur at

any time within the time window, the time interval between the start of window and the

default is not fixed.

Here the amount that will be drawn at maturity is related to the drawn/undrawn amount at the

beginning of the different time horizons. The CCF is given by the formula:

_

_

where,

-EAD: Exposure at the time default occurred

-On_balance (start of window): Exposure of the bank at the start window period prior to

default

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Waseem A. Qureshi MM141063

-Limit (start of window): Maximum exposure that the bank can have with the counterparty at

the

start of the time window

In the event of the CCF being negative or greater than 1, appropriate adjustment is made to

make it applicable for calculation of EAD.

CCF Estimation for Non-Defaulted Exposures

The CCF for non-default exposure is calculated using the CCFs from the defaulted exposures.

The current non-default EADRD pools are compared with the EADRD pools of the defaulted

exposure whose CCFs have been calculated. The lookup table method is employed to

achieve this. Apart from the approach discussed above, regression analysis can be used to

estimate the non-default exposure CCFs. Once the CCFs for default exposures are calculated,

the EADRDs can be grouped as independent variables and the CCFs calculated as dependent

variable. A regression model for the universe of exposure data can be developed or regression

models for each pool can also be calibrated. On entering the non-default exposure EADRD

data, the corresponding CCF is estimated.

2. Current Exposure Method

The Current Exposure Method comprises of two components: Current Exposure (CE) and

Potential Future Exposure (PFE). The formula for EAD under this method is given by the

formula:

Equation 1: EAD = CE + PFE

where,

Current Exposure is the current market value of the contract or the replacement costs

for a party if counterparty defaults today. It equals the market value if it is positive and zero if

the market value is negative. Therefore, CE = max {market value; 0}

Potential Future Exposure is the maximum amount of exposure expected to occur on a

future date with a high degree of statistical confidence.

The PFE is calculated by multiplying the notional values of the contracts with a fixed

percentage which is the Credit Conversion Factor (CCF) as shown below:

Remaining

Interest rates

FX & gold

Equities

< 1year

1-5 years

>5 years

0.0%

0.5%

1.5%

1.05

5.0%

7.5%

6.0%

8.0%

10.0%

Precious

metal

7.0%

7.0%

8.0%

Other comdty

10.0%

12.0%

15.0%

3. Standardized Method

This method is employed by banks which are not capable of computing their OTC derivative

exposures using the internal model method (discussed in the following section). However, this

method is more risk sensitive than the Current Exposure Method. The Standardized method is

used only for OTC derivatives.

Exposure at Default using the standardized method is calculated according to the following

formula:

EAD = * max [Current Exposure; k(NPRk * CCFk)]

141

Waseem A. Qureshi MM141063

where,

Current Exposure is the mark-to-market value after netting and collateral reduction

NRPs are the absolute value of the net risk positions in the hedging sets

CCFs are the credit conversion factors applied for the k hedging sets

k is the index that designates hedging sets

represents extra reserve for potential downturns in the economy and also captures

model risk; its value is fixed by regulators at 1.4

The CCF values for the standardized method are provided in the following table:

Asset Class

Interest rate

derivatives

Credit derivatives

Debt instruments

CCF

0.2%

Exchange rate

Electricity

2.5%

4%

0.3%

0.6%

Asset Class

Gold

Equity

Precious metal w/o

gold

Other commodities

Other derivatives

CCF

5%

7%

8.5%

10%

10%

The Internal Model Method (IMM) is the most risk-sensitive approach for EAD calculation

available under the Basel II framework. A bank requires approval from local market regulators

to use the IMM to calculate EAD. The IMM calculates the counterparty exposure of the bank

at a future dates. These exposures are calculated for each netting set6. The exposure at default

in IMM is given by the following formula:

EAD = * effective EPE

where,

: multiplier set by regulators to 1.4

Effective EPE: Effective Expected Positive Exposure.

Alpha ()7 accounts for correlations between market and credit risk, credit portfolio

assumptions, concentration risk and model risk. Banks can use their own estimates for which

is subject to floor value of 1.2. Effective EPE is the average of Expected Exposure (EE) for

certain time interval at a future date.

Model Validation

Once complete implementation of the risk framework data integration, capital models, stress

models, stress scenarios takes place, a thorough validation and independent review of the

relevant models is carried out. Also, all the methodologies, processes, system information, key

assumptions, and suggested actions require proper documentation.

Regulatory Perspective

Model risk management is a key component. The regulatory guidelines such as those issued by

the Office of the Comptroller of the Currency (OCC) in the US and Financial Services

Authority (FSA) in the UK need to be strictly adhered to.

Banks are expected to have a robust system to validate the accuracy and consistency of various

models used for capital and risk estimations. They should establish internal validation

processes to assess the performance of such models. The suggested process cycle for models

validation includes the following:

142

Waseem A. Qureshi MM141063

statistical testing of stability of the model and its key coefficients

Identifying and documenting individual fixed relationships in the model that are no longer

appropriate

Periodic testing of model outputs versus outcomes, at least on an annual basis

Demanding change control process, which specifies procedures to be followed before

making changes in the model, as a response to validation outcomes

Model Understanding

The models can be categorized as valuation models (of financial instruments), risk models (to

model risk parameters and estimate risk), and econometric models (on modeling variable

relationships). Typical models used in a retail or commercial banking setup include loan

valuation models, default estimation models, LGD estimation models, EAD models,

prepayment models and lending scorecards.

Proper checking of the models needs to be carried out to ensure that the models are

appropriate, flexible and accurate. Limitations of the models need to be properly understood.

Also, a proper documentation of all assumptions made during the process of modeling is

required.

Operational Risk

Operational risk refers to as the risk of losses resulting from inadequate or failed

internal processes, people and systems or from external events.

Although designed for financial institutions, this definition should be applicable for any

industry, institution or individual. The banking and insurance industries are addressing

operational risk under Basel II and solvency II accords.

The Basel and solvency approach to operational risk breaks it into seven major

categories, 18 secondary categories and 64 subcategories. The great majority is not unique

to financial services and can provide a good framework for addressing operational risk in

any industry.

1. Internal frauds

a. Unauthorized activities

i. Transactions not reported (informational)

ii. Transaction type unauthorized (with monetary loss)

iii. Mismarking of position (international)

b. Theft and Fraud

i. Fraud / credit fraud / worthless deposits

ii. Theft / extortion / embezzlement / robbery

iii. Misappropriation of assets

iv. Forgery

v. Check kiting

vi. Smuggling

vii. Account takeover / impersonation etc.

143

Waseem A. Qureshi MM141063

ix. Bribes / kickbacks

x. Insider trading

2. External Fraud

a. Theft and Fraud

i. Theft / robbery

ii. Forgery

iii. Check kiting

b. System Security

i. Hacking damage

ii. Theft of information

3. Employment Practices

a. Employee relations

i. Compensation, benefit, termination issues

ii. Organized labor activities

b. Safe Environment

i. General facility

ii. Employee health and safety rules, events

iii. Workers compensation

c. Diversity and discrimination

i. All type discrimination

4. Clients, Products and Business Processes

a. Suitability, Disclosure and Fiduciary

i. Fiduciary breaches / guideline violations

ii. Suitability / disclosure issues

iii. Retail consumer disclosure violations

iv. Breach of privacy

v. Aggressive sales

vi. Account churning

vii. Misuse of confidential information

viii. Lender ability

b. Improper Business or Market Practices

i. Antitrust

ii. Improper trade / market practices

iii. Market manipulation

iv. Insider trading (on firms account)

v. Unlicensed activity

144

Waseem A. Qureshi MM141063

c. Product Flaws

i. Product defects

ii. Model errors (poor design)

d. Selection, sponsorship and exposure

i. Failure to investigate client per guidelines

ii. Exceeding client exposure limits

e. Advisory activities

i. Disputes over performance of advisory activities.

5. Damage to physical assets

a. Disaster and other events

i. Natural disaster losses

ii. Human losses from external sources

6. Business Disruptions and Systems Failure

a. Systems

i. Hardware

ii. Software and middleware

iii. Telecommunications

iv. Utility outage / disruptions

7. Execution Delivery and process management

a. Transaction capture, Execution and Maintenance

i. Miscommunication

ii. Data entry, maintenance or loading error

iii. Missed deadline or responsibility

iv. Model / system disoperation

v. Accounting error / entity attribution error

b. Monitoring and Reporting

i. Failed mandatory reporting obligation

ii. Inaccurate external report

c. Customer instate and documentation

i. Client permission / disclaimer missing

d. Customer / client Account Management

i. Unapproved access given to accounts

ii. Incorrect client record (loss incurred)

iii. Negligent loss or damage of client assets

e. Trade counterparties

i. Non client counterparty performance

ii. Miscellaneous non client counterparty disputes

145

Waseem A. Qureshi MM141063

i. Outsourcing

ii. Vendor disputes

Sovereign Risk

The risk that a government could default on its debt (sovereign debt) or other obligations.

Also, the risk generally associated with investing in a particular country, or providing funds to

its government. It is also called country risk.

Economic factors

1.

2.

3.

4.

5.

Import ration

=

Variance of exports =

Investment ratio

=

Money supply growth rate =

imports / foreign reserves

2 exports

real investment / GNP

MSt MSt-1 / MSt-1

Debt rescheduling

Following choice are available for rescheduling.

1. Multiyear restructuring

It involves revisiting the terms and conditions of loan. Revisiting may involve increase

in rates or some debt concessions.

Example 43:

Consider a loan of 300 million for a period of 3 years. The borrower agrees to pay 8%

interest on loan. Cost of fund for lender is 7%. It is agreed to repay 100 million principal every

year plus interest.

The borrower is unable to pay back the loan and lender agrees to restructure the loan.

He agrees to increase the maturity period up to 5 years and allowing a grace period of 1 year.

New loan interest rate will be 8% and borrower will pay 1% upfront restricting fee. Loan is

payable in equal installments and will cost 10% to the lender. Calculate the cash flows in both

conditions.

Solution:

Existing conditions:

Maturity period:

Interest rate:

Loan payable:

Cost to lender:

3 years

8%

100 million per year + interest

7%

146

0

1

0

100

0

24

124

1

.935

116

116 + 101 + 89 =

Principal

Interest 8%

Cash flows

P V F 1/(1.07)n

PV of CF

Net cash flows

=

2

100

16

116

.873

101

306 million

3

100

8

108

.826

89

Restructuring:

Maturity period:

Grace period:

Interest rate:

Upfront fee:

Loan payable:

Cost to lender:

Principal

Interest 8%

Upfront fee

Cash flows

P V F 1/(1.10)n

PV of CF

Net cash flows

5 years

1 year

8%

3 million

equal installments

10%

0

3

3

1

3

=

1

2

3

4

75

75

75

24

24

18

12

24

99

93

87

.909

.826

.751

.683

22

82

70

59

3 + 22 + 82 + 70 + 59 + 50 = 286 million

5

75

6

81

.621

50

Borrower will pay 286 million under new restructured conditions, which is less than 306

million. It means borrower is granted a concession.

2. Debt for development SWAP

Financing part of a development project through the exchange of a foreign-currencydenominated debt for local currency, typically at a substantial discount. The process

normally involves a foreign nongovernmental organization (NGO) that purchases the

debt from the original creditor at a substantial discount using its own foreign currency

resources, and then resells it to the debtor country government for the local currency

equivalent (resulting in a further discount). The NGO in turn spends the money on a

development project, previously agreed upon with the debtor country government.

3. Debt for debt SWAP

Replacement of new loan for an old loan is called debt for debt swap. The country may

take some new loans to repay the old loan and hence no actual cash transactions take

place. Brady bonds are a good example of debt for debt swaps. Under this the state

issues the bonds to repay the loan.

147

Waseem A. Qureshi MM141063

A debt/equity swap is a refinancing deal in which a debt holder gets an equity

position in exchange for cancellation of the debt.

Country Ratings:

International Country Risk Guide Methodology

The International Country Risk Guide (ICRG) rating comprises 22 variables in three

subcategories of risk: political, financial and economic. A separate index is created for each of

the subcategories. The political risk index is based on 100 points, financial risk on 50 points

and economic risk on 50 points. The total points from three indices are divided by two to

produce the weights for inclusion in the composite country risk score. The composite scores,

ranging from zero to 100, are then broken into categories from very low risk (80 to 100) to

very high risk (0 to 49.90) points.

1. Political risk components:

1. Government stability

2. Socioeconomic conditions

3. Investment profile

4. Internal conflict

5. External conflict

6. Corruption

7. Military in politics

8. Religious tensions

9. Law and order

10. Ethnic tensions

11. Democratic accountability

12. Bureaucracy quality

Total

(100 points)

12

12

12

12

12

6

6

6

6

6

6

4

100

1. GDP per head

2. Real GDP growth rate

3. Inflation

4. Budget balance as % of GDP

5. Current account as % of GDP

Total

(50 points)

5

10

10

10

15

50

148

Waseem A. Qureshi MM141063

1. Foreign debt as a % of GDP

2. Foreign debt as a % of export

3. Current account as a % of exports

Of goods and services

4. Net international liquidity as

Months of import cover

5. Exchange rate stability

Total

(50 points)

10

10

15

5

10

50

* BEST OF LUCK *

149

Waseem A. Qureshi MM141063

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