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The FRM Part I

Formula Guide: Financial Market and Products

2015

The FRM Part I Formula Guide: Financial Market and Products 2015

Hedging with Futures and Options

Basis (Spread) = S t - F o

Here,

S t = Spot price of the underlying asset (Current market price if you pay now in cash) F o = Current market price of the Future Contract

Introduction (Future, Options and Other Derivatives)

Call option payoff: C t = max (0, S t -X) Profit of Call: C t -C o

Put option payoff: Pt = max (0, X-St) Profit of Put: P t -P o

Here,

C t = Call option payoff P t = Put option payoff C o = Premium paid for call option P o = Premium paid for put option

S t = Spot price of underlying at maturity X = Strike price of option contract

*Payoff means the amount option buyer/seller receives at the time of maturity. Net profit will be calculated after deducting option premium cost.

Payoff for Forward Contract: St-K

S t = Spot price of underlying at maturity K = Delivery price of underlying asset set as per the contract at the time of initiating the contract.

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Hedging Strategies Using Futures

Hedge Ratio: ρ s,f

ρ s,f = Correlation between spot and future contract price σs = Standard deviation of the spot price σf= Standard deviation of the future contract price

Beta: β =

Cov s,f

2

Correlation: Cov s,f

Hedging with stock index future:

Number of contracts = β portfolio ×

Value of index future contracts = index future contract price x contract lot size

Adjusting the portfolio Beta:

Number of contracts = (β* - β)

P = Portfolio Value I= Value of the index future contracts

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Interest Rates

Discrete Compounding: FV = A [1 + /] ×

Here,

A = Initial Investment R= Annual Rate of Return m= Number of times compounded per year for t years t= Number of years

Continuous Compunding: FV = Ae r×t

Forward Rate: R forward =

2 2 1 1

2 1

= 2 + 2 1 ×

1

2 1

Forward Rate Agreement:

Cash Flow (When Receiving) Rk = P×(R k R)×(T 2 -T 1 )

Cash Flow (When Paying) Rk = P×(R- R k )×(T 2 -T 1 )

P

= Notional Principal

Rk

= Annualized rate on P, on compounding period T 1 -T 2

R

= Annualized actual rate (Which we get) on compounding period T 1 -T 2

T i

= Time expressed in years

Determination of Forward and Futures Prices

Forward Contract Price: F 0 = Se rt

Forward Contract Price with carriage cost: F 0 = (S-U)e rt Forward Contract Price when underlying pays dividend : F 0 = Se (r-q) t

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F 0 = Forward Price S = Spot Price of underlying e = Value of Exponential, Normally 2.718 U = Carriage Cost r = Annualized rate of return / Risk free return q = Dividend rate

Interest Rate Futures

Accrued Interest =

Coupon ×

# of days from last coupon

to the settlement

date

# of days in coupon

period

Day Count Conventions:

  • U.S. Treasury bonds use actual/actual days

  • U.S. Corporate and municipal bonds use 30/360 days

  • U.S. Money market instrument (Treasury bills) use actual/360 days

Calculating Cash Price of bond:

Cash Price = Quoted Price + Accrued Interest

Calculating Annual rate on T-Bill:

T-Bill Discount rate =

  • 360 100 Y

n

Treasury Bond Futures:

Cash Received by the short = (QFP × CF) + AI

Finding Cheapest to deliver bond:

Quoted bond price (QFP × CF)

Here,

QFP = Quoted future price (recent settlement price) CF = Conversion factor for the bond delivered AI = Accrued interest since the last coupon date (on the bond delivered)

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Eurodallar Future Price:

$10,000 [100-(0.25)(100-z)]

Convexity Adjustment:

Actual Forward rate = forward rate implied by futures – (0.5 × σ 2 × t 1 × t 2 )

Duration Based hedge ratio:

 

P× Dp

N =

F× Df

Here,

N = Number of contracts to hedge P = Value of portfolio Dp = Duration of Portfolio Df = Duration of future contracts

Swaps

Forward Rate between T 1 and T 2 :

R forward

2 2 1 1

=

2 1

= 2 + 2 1 ×

1

2 1

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Properties of Stock Options

Put Call Parity Relationship:

p + S

= c + Xe -rt =

Put-Call Parity:

 

S= c-p + Xe -rt

P= c-S + Xe -rt

c

= S+p - Xe -rt

Xe -rt = S + p-c

Here,

 

S = Spot price or current stock price

X

= Strike price of the option contract

t = Time till expiry of the contract r = Risk free rate

= Call option premium / Value of European call option p= Put option premium / Value of European put option

c

C= Value of American call option P = Value of American put option

Lower and Upper Bound for American and European Options:

Option

Minimum Value

Maximum Value

European call

c max (0, S - Xe -rt )

S

American call

C max (0, S - Xe -rt )

S

European put

p max (0, Xe -rt - s)

Xe -rt

American put

P max (0, - X - S)

X

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Trading Strategies Involving Options

Bull Call Spread: Profit = max (0, S E X L ) max (0, S E X H ) - C L + C H

Bear Put Spread:

Profit = max (0, X H S E ) max (0, X L S E ) - P H + P L

Butterfly Spread with call:

Profit: max (0, S E X L ) 2 max (0, S E X M ) + max (0, S E X H )- C L + 2C M -C H Straddle: Profit = max (0, S E X) + max (0, X S E ) - C P Strangle: Profit = max (0, S E X H ) + max (0, X L S E ) - C P

Here,

S E = Spot price at the time of Expiry / Exercising the call X L = Lower Strike Price X H = Higher Strike Price C L = Lower Call Premium/Price C H = Higher Call Premium / Price P L = Lower Put Premium/Price P H = Higher Put Premium/Price

Commodity Forwards and Futures

Commodity Forward:

Pricing with a lease payment: F 0 = Se (r l)t

Pricing with storage/warehousing cost : F 0 = Se (r + w)t Pricing with convenience Yield: F 0 = Se (r c)t

Here,

F 0 = Forward Rate S = Spot Price of underlying e = Value of Exponential (2.718)

r = Short term risk free rate

  • l = Lease rate

w = storage cost rate

  • c = Convenience yield

Foreign Exchange Risk

Interest Rate Parity:

Forward Price = Spot

(1+)

(1+)

Forward Price = Se()

Exact Method: (1 +r) = (1+Real r) [ 1 + Ei]

Here,

Rd

= Annualized domestic interest rate

Rf

= Annualized foreign interest rate

r

= Annualized nominal interest rate

Real r

= Annualized real interest rate

Ei

= Annualized Expected rate of inflation

T

= Time till maturity

Corporate bonds

The original-issue discount (OID) = face value offering price

Dollar Default Rate:

( ) × ( # )

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Mortgages and Mortgage-Backed Securities

Single monthly mortality rate: SMM = 1 (1 CPR) 1/2 Option Cost = Zero- Volatility spread OAS

Here,

SMM = Single monthly mortality rate OAS = Option Adjusted Spread

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