Hedging with Futures and Options
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)
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.
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
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}
Number of contracts = β _{p}_{o}_{r}_{t}_{f}_{o}_{l}_{i}_{o} ×
^{}^{}^{}^{}^{}^{}^{}^{}^{} ^{}^{}^{}^{}^{}
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
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Interest Rates
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}
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 ^{r}^{t}
Forward Contract Price with carriage cost: F _{0} = (SU)e rt Forward Contract Price when underlying pays dividend : F _{0} = Se (rq) 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 TBill:
TBill Discount rate =
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)(100z)]
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
R forward
_{2} _{2} − _{1} _{1}
_{2} − _{1}
^{} ^{1}
_{2} − _{1}
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Properties of Stock Options
p + S
= c + Xe ^{}^{r}^{t} =
S= cp + Xe ^{}^{r}^{t} 

P= cS + Xe ^{}^{r}^{t} 

c 
= S+p  Xe ^{}^{r}^{t} 

Xe ^{}^{r}^{t} = S + pc 

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
Option 
Minimum Value 
Maximum Value 
European call 
c ≥ max (0, S  Xe ^{}^{r}^{t} ) 
S 
American call 
C ≥ max (0, S  Xe ^{}^{r}^{t} ) 
S 
_{E}_{u}_{r}_{o}_{p}_{e}_{a}_{n} _{p}_{u}_{t} 
p ≥ max (0, Xe ^{}^{r}^{t}  s) 
Xe ^{}^{r}^{t} 
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
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
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Foreign Exchange Risk
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 originalissue discount (OID) = face value – offering price
Dollar Default Rate:
( ) × ( # )
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Mortgages and MortgageBacked 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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