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# 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)

### 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.

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

Cov s,f

2

### Hedging with stock index future:

Number of contracts = β portfolio ×

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

Number of contracts = (β* - β)

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

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

2 2 1 1

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

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)

Eurodallar Future Price:

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

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

R forward

2 2 1 1

2 1

### = 2+ 2− 1×

1

2 1

Properties of Stock Options

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

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

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

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:

( ) × ( # )