CH 6 13

Interest Rate Futures
Chapter 6
6.1
Goals of Chapter 6
 Introduce the day count and quotation

conventions for fixed-income securities
 Introduce two interest rate futures
– Treasury bond futures (公債期貨)
 Quotation method
 Delivery options (conversion factors (轉換因子) and
cheapest-to-deliver (最便宜交割) bonds)
– Eurodollar futures (歐洲美元期貨)
 Quotation method
 Futures vs. forward rates and convexity adjustment
 Duration-based hedging (存續期間避險) using
interest rate futures 6.2
6.1 Day Count and Quotation
Conventions for Fixed
Income Securities
6.3
Day Count Conventions in the

U.S.
 Introduction of some fixed-income securities
– Treasury bonds (notes) (長(中)期政府公債) are the
coupon-bearing bonds issued by the U.S. government
with the maturity longer (shorter) than 10 years
– Municipal bonds (地方政府債券) are coupon-bearing
bonds issued by state or local governments, whose
interest payments are not subject to federal and
sometimes state and local tax
– Corporate bonds (公司債) are the coupon-bearing
bonds issued by business firms
– Money market instruments (貨幣市場工具) are short-
term, highly liquid, and relatively low-risk debt
instruments, and no coupon payments during their lives6.4
U.S.
 The day count convention is used to calculate
the interest earned between two dates, i.e.,
# of days between two dates
× Interest earned in reference period
# of days in reference period
– Treasury bonds or notes: Actual/Actual

– Corporate and municipal bonds: 30/360
– Money market instruments: Actual/360
※Note that conventions vary from country to country and
instrument to instrument
6.5

U.S.
 Calculation of interests for a period
– Suppose we need to calculate the interest earned
between Mar. 1 and July 3 for a Treasury bond
 The reference period is from Mar. 1 (the last coupon
payment date) to Sept. 1 (the next coupon payment date)
 The interest of $4 is earned during the reference period
 For Treasury bonds or notes, based on the actual/actual
convention, the accrual interest (應計利息) is
× $4 = $2.6957,
where 124 (184) is the actual number of days between Mar.
1 and July 3 (Mar. 1 and Sept. 1)
6.6
U.S.
 For corporate or municipal bonds, based on the 30/360
convention, the accrual interest is
× $4 = $2.7111,
where 122 (=(4×30)+2) is the number of days between Mar.
1 and July 3, and 180 (=(6×30)) is the number of days
between Mar. 1 and Sept. 1
– For a 124-day Treasury bill (from Mar. 1 to July 3)
with the face value to be $100, if the rate of interest
earned is known to be 8% (per annum) of the face
value, based on the actual/360 convention, the
interest income over the 124-day life is
$100 × 8% × = $2.7556
6.7
Quotations for Treasury Bonds

in the U.S.
 Quotations of T-bonds and T-notes
– Quoted as a percentage of the face value and the
tick change (最低限度變動) is 1/128 of a dollar
 A quote of 95.2344 = 95 + 30/128, given the face value
being normalized as 100
– The quoted price is the clean price (除息價格),
which is not the same as the cash price (含息價格
或是現金價格) at which the bond is traded
– Cash price (dirty price) = Quoted price (clean price)
+ Accrued Interest since the last coupon date
6.8
Quotations for Treasury Bonds
in the U.S.
 If the quoted price is 95.2344 on July 3, and the interest of $4
is for the period between Mar. 1 and Sept. 1
Cash price (dirty price) = $95.2344 + $2.6957 = $97.9301
 Note that the theoretical value for the cash price (dirty price)
is the sum of the PVs of all future cash flows
– The theoretical cash price is calculated first, and next the
theoretical clean price is obtained by deducting the accrued
interest
 Why to distinguish clean and dirty prices?
– Clean prices are more stable over time than dirty prices–when
clean prices change, it usually reflects an economic reason, e.g.,
a change in interest rates or in the bond issuer's credit quality
– Dirty prices, in contrast, change day to day depending on where
the current date is in relation to the coupon payment dates, in
addition to any economic reasons 6.9
Quotations for Treasury Bills in

the U.S.
 The quotes of T-bills are annual discount rates of
the face value with the bank-discount method
– For a Treasury bill that has 𝑛 days to maturity,
Quoted Price (%) = (100 − Cash Price)
– If the current market price is 99.5% of the face value
for a 30-day T-bill, then
Quoted Price (%) = 100 − 99.5 = 6
– This method provides a benchmark to compare with
the performance of other fixed-income securities in
terms of rates of return (ROR)
 Higher quoted prices indicate higher RORs and thus better
investment targets if all other conditions are identical 6.10
6.2 Treasury Bond Futures
(also include Ultra Treasury Bond
Futures and 10-Year, 5-Year, 3-Year,
and 2-Year Treasury Note Futures)
6.11
Treasury Bond Futures (公債期貨)
 Treasury bond futures on CME is the most

popular long-term interest rate futures contracts
– (Ultra) T-bond futures and 10-year T-note futures
prices are quoted as a percentage of the face value
and the tick change is 1/32 of a dollar
 151-20 = 151 + 20/32 = 151.625 or 115-245 = 115 + 24.5/32
 For 2-, 3-, and 5-year T-note futures, quotes are expressed
to the nearest quarter of a 1/32 of a dollar, e.g., 124-152 =
124 + 15.25/32 and 124-157 = 124 + 15.75/32
 The quoted T-bond futures prices are clean prices
– Contract size: one contract involves the delivery of
$100,000 face value of the Treasury bond 6.12
– Deliveries can take place at any time point during the
delivery month (short-side trader’s option)
– Eligible bonds (合格的債券) for delivery: any T-bond
with remaining maturity (𝜏) of at least 15 years, but
less than 25 years from the first day of the delivery
month (short-side trader’s option)
 Ultra T-bond futures: 𝜏 longer than 25 years
 10-year T-note futures: 𝜏 between 6.5 and 10 years
 5-year T-note futures: 𝜏 between 4 and 2/12 years and 5 and
3/12 years
 3-year T-note futures: 𝜏 between 2 and 9/12 years and 3
years (initial maturity < 5 and 3/12 years)
 2-year T-note futures: 𝜏 between 1 and 9/12 years and 2
years (initial maturity < 5 and 3/12 years) 6.13
– Cash amount received by the short-side trader =

Most recent quoted futures price × Conversion factor of the
bond delivered + Accrued interest of the bond delivered
 The accrued interest is for the period between the delivery

date and its previous coupon payment date
 Quoted price of bond futures = $90.00
 Conversion factor on the bond= 1.3800
 Accrued interest on the bond = $3.00
 Price received by the short side who delivers this bond is
$90.00×1.3800 + $3.00 = $127.20 (per $100 of the face
value)
6.14
– The conversion factor for a bond is approximately

equal to the QUOTED value (clean price) of the
bond given the face value to be $1 on the
assumption that the interest rate curve is flat at
6% with semiannual compounding
 To derive the conversion factor is through pricing bonds
with a constant 6% discount rate (or 3% discount rate for
every half a year)
 For calculating the conversion factor, the bond maturity
and the dates to the coupon payments are rounded down
(無條件捨去) to the multiples of three months
– Two and the only two possible cases are discussed on
Slides 6.16-6.18
6.15
Conversion Factor (轉換因子)
 Case 1: the next payment date is after 6 months

– Consider a 10% coupon bond (paid semiannually)
with 20 years and 2 months to maturity
– The bond is assumed to have exactly 20 years to
maturity, and the first (next) coupon payment is
assumed to be made after six months
– The quoted price (equal to the cash price in this case)
of this $1-face-value bond is its conversion factor
%
∑ + = 1.4623
( %) ( %)
6.16
 Case 2: the next payment date is after 3 months

– Consider an 8% coupon bond (paid semiannually)
with 18 years and 4 months to maturity
– For calculating the conversion factor, the bond is
assumed to have exactly 18 years and 3 months to
maturity, and the first coupon payment is assumed to
be made after 3 months
– The value of the bond after 3 months (with the face
value to be $1) is
%
1 4% + ∑ ( %)
+( %)
= 1.2583
6.17

– The discount interest rate for the first three-month
period is (1 + 3%) − 1 = 1.4889%
 It is equivalent to find an interest rate to generate the identical
cumulative return for six months, i.e., (1 + 𝑟) = 1 + 3%
– The present value (cash price) of this bond is
1.2583/(1+1.4889%) = 1.2399
– The conversion factor is the quoted price of this bond:
1.2399 – 1 4% 0.5 (accrued interest) = 1.2199
※For an eligible bond with a coupon rate to be 6%, the
conversion factor of this bond is 1
※The underlying asset can be regarded as a virtual 6%-
coupon T-bond, and the conversion factor measures the
values of eligible bonds in units of this virtual T-bond 6.18
Cheapest-to-deliver (CTD) Bond
 Short-side traders choose which of the
available, eligible bonds is “cheapest” to
deliver, i.e., the CTD bond (最便宜交割債券)
– Find the CTD bond by minimizing the cost of
purchasing a bond (at Quoted bond price +
Accrued interest) minus the sales proceeds
received from the T-bond futures (at Quoted
futures price × Conversion factor + Accrued interest)
 It is equivalent to deliver a bond for which [Quoted bond
price – (Quoted futures price × Conversion factor)] is lowest
– Note that the CTD bond is defined as the bond most
favorable to short-side traders for delivery rather
than the bond with the cheapest value 6.19
Cheapest-to-deliver (CTD) Bond

 Suppose there are three bonds which are
deliverable and the most recent settlement
futures price is 93.25
Bond Quoted bond price ($) Conversion factor
A 99.50 1.0382
B 143.50 1.5188
C 119.75 1.2615
– The cost of delivering each of the bonds is as follows

 Bond A: $99.50 – ($93.25 × 1.0382) = $2.69
 Bond B: $143.50 – ($93.25 × 1.5188) = $1.87
 Bond C: $119.75 – ($93.25 × 1.2615) = $2.12
– The CTD bond is Bond B
6.20
Delivery Options (交割選擇權)
 The delivery options (belonging to short-side

traders) in T-bond futures include:
– Timing option: delivery can be made at any time
point during the delivery month
– Delivery alternatives: any of a range of eligible bonds
can be delivered (CTD bond will be delivered)
– The wild card play
 Futures market is closed at 2:00 p.m.
 Spot market is closed at 4:00 p.m.
 Short-side traders have the time until 8:00 p.m. to issue to
the clearinghouse a notice of intention to deliver
 The settlement price of the futures is calculated at the
closing price at 2:00 p.m. (If the spot price declines after
2:00 p.m., there is a benefit for the short-side traders) 6.21
Prices for Treasury Bond Futures
 Theoretical futures prices for the Treasury bond

futures contracts are difficult to determine
1. The delivery options reduce T-bond futures price
2. Inappropriate to assume a constant risk-free interest
rate since the change of prices of Treasury bonds
implies a stochastic risk-free interest rates
– Suppose the CTD bond and the delivery date are
known and the risk-free interest rate applicable to a
time to maturity 𝑇 is constant
 Since the bond is a security providing known dollar incomes,
then the futures (cash) price on T-bonds is
𝐹 = (𝑆 − 𝐼 )𝑒 ,
where 𝑆 is the spot (cash) price of the CTD bond, and 𝐼 is
the PV of all coupons during the life of the futures contracts6.22
10-Year Treasury Bond Futures on
Taiwan Futures Exchange (TAIFEX)
Item Description
Name 10-year Government Bond Futures
Ticker Symbol GBF
Underlying Asset 10-year government bonds with a face value of NTD5M and 3% coupon rate
10-year ROC government bonds that pay interests once a year and mature in not less than 8 years and 6 months and not
Deliverable Bonds
more than 10 years from the expiration of the futures contract
Delivery Months The three successive months of March, June, September, and December cycle (introduced in Ch. 9)
Price Quotation Quoted by per NTD100 face value
Minimum Price Movement NTD0.005 per NTU100 (NTD250 per contract)
Daily Settlement Price The volume-weighted average trading price based on the transactions within the last one minute
Daily Price Limit +/– NTD3 based on the settlement price on the previous trading day
Last Trading Day The second Wednesday of the delivery month
Delivery Physical delivery
Delivery Day The second business day following the last trading day (no timing option)
Determined by the volume-weighted average of trading prices in the last 15 minutes before closing on the last trading day; if
there are less than 20 transactions in the last 15-minute interval, determined by the volume-weighted average of the last 20
transaction prices of the last trading day, excluding the two highest and two lowest transaction prices; if there are less than
Final Settlement Price 20 transactions on that day, determined by the volume-weighted average of actual trading prices of the last trading day
If there are no transactions on the last trading day or if the aforesaid price is apparently unreasonable, TAIFEX will
determine the final settlement price
Any investor’s same-side positions shall not exceed 1000 contracts for any single contracts and 2000 contracts for all GBFs.
Position Limit
Institutional investors may apply for an exemption from the above limit for hedging purpose
Margin The initial and maintenance margin levels shall not be less that those regulated by TAIFEX
6.23
6.3 Eurodollar Futures
6.24
Eurodollar Futures (歐洲美元期貨)
 A Eurodollar is a dollar deposited in a bank

outside the United States
– The Eurodollar interest rate refers to the rate of
interest earned on Eurodollars lending by one AA-
rated bank with another AA-rated bank, i.e., LIBOR
– Eurodollar futures are interest rate futures (on $1
million principal) which can lock the 3-month
Eurodollar LIBOR at the maturity date of the futures




0 T T  0.25
6.25
 Quotes and prices of Eurodollar futures

– For a 3-month Eurodollar futures with the quote price Z,
its price is 10,000×[100 – 0.25×(100 – Z)]
 [100 – 0.25×(100 – Z)] can be understood as the market price
of a virtual 3-month zero coupon bond (ZCB) with $100 face
value corresponding to the (locked LIBOR) = (100 – Z)%
 On the delivery date, locking the purchasing price of this
virtual 3-month ZCB is equivalent to locking the 3-month
LIBOR
 If Z = 95.53 (95.54), the price of the 3-month Eurodollar
futures is $988,825 ($988,850)  A 0.01 change in the quote
price Z corresponds to a contract price change of $25
※ Long position, Z↑ (expected LIBOR↓)  gains for lenders
Short position, Z↓ (expected LIBOR↑)  gains for borrowers 6.26
– When Eurodollar futures expires (on the third

Wednesday of the delivery month), all contracts are
closed out at Z equal to 100 minus the actual 3-month
LIBOR (x 100) on that day, i.e., Z = 100 – LIBOR x
100 (or LIBOR = (100 – Z)%)
 Eurodollar futures price = 10,000×[100 – 0.25×(LIBOR×100)]
– A Eurodollar futures contract is settled in cash
 Suppose you take a long position of a Eurodollar futures
contract on November 1 (for locking the lending rate)
 The contract expires on December 21
 The time series of quoted prices are as shown on Slide 6.28
 Taking daily settlement into account, how much do you gain
or lose a) on the first day, b) on the second day, c) over the
whole period until expiration? 6.27

Date Quote (Z)
Nov 1 97.12
Nov 2 97.23
Nov 3 96.98
⋮ ⋮
Dec 21 (maturity day) 97.42
1. On Nov. 1, you plan to lend $1 million for three months on Dec 21,
the long position of a Eurodollar futures can lock the lending rate
to be (100 – 97.12)% = 2.88% and thus the expected interest
income should be $1,000,000 × 0.25 × 2.88% = $7,200
2. On Nov. 2, you earn a gain of (97.23 – 97.12) / 0.01 × $25 =
$275 (Note that an increase of 0.01 in Z generates a gain of $25)
※ For long-side traders, the gain or loss from futures is (𝐹 − 𝐹 )
For short-side traders, the gain or loss from futures is (𝐹 − 𝐹 ) 6.28
3. On Nov. 3, you suffer a loss of (96.98 – 97.23) / 0.01 × $25

= –$625
4. On Dec. 21, you earn (100 – 97.42)% = 2.58% on lending
$1 million for three months (= $1,000,000 × 0.25 × 2.58% =
$6,450) and make a cumulative gain on the futures contract
to be (97.42 – 97.12) / 0.01 × $25 = $750
(Note that in the above example, the actual 3-month LIBOR
rate declines to become (100 – 97.42)% = 2.58%)
(Note also that the 3-month LIBOR rate, 2.58%, is
expressed with quarterly compounding)
 The total payoff is $7,200 (= $6,450 + $750), which is the
same as the payoff if the 3-month lending rate on Dec. 21
were fixed at 2.88%
6.29
Forward Rates and Eurodollar

Futures
 Eurodollar futures contracts can last as long
as 10 years
– For Eurodollar futures lasting beyond two years,
we cannot assume that (implied) forward rates
equal futures rates (2.88% in the above example)
– For forward rates, they are implied from the
current term structure of interest rates; for futures
rates, they are implied from (100 – Z)%, where Z
is the current quote price of Eurodollar futures
 (100 – 𝑍)% implies the futures rate applicable to the
following three-month period at 𝑇
 For example, if 𝑍 = 97.12 and 𝑇 is two years, then
(100 – 97.12)% = 2.88% is the futures rate for the period
of three months after two years 6.30
Futures
– Two reasons to explain that the forward rate <
futures rate
1. Futures contracts are settled daily, whereas forward
contracts (i.e., forward rate agreements, FRA) are
settled once
– The futures price of Eurodollar futures contracts, Z, is
highly negatively correlated with other interest rates
since (100 – Z)% represents a 3-month interest rate
applicable to a future time point
– According to the argument on Slides 5.26 and 5.27,
the futures price Z should be lower than the
counterpart forward price
– So, the futures rate (= (100 – Z)%) should be higher
than the counterpart forward rate 6.31

Futures
2. A Eurodollar futures is settled at the beginning of
the reference three-month period (i.e., at T); A
forward rate agreement is settled at the end of the
reference three-month period (i.e., at T + 0.25)
– If all other conditions are the same, a futures price Z
should be the 3-month-ahead PV of the counterpart
forward price, i.e., the future price Z is lower than the
counterpart forward price
– Thus, the futures rate (= (100 – Z)%) should be
higher than the counterpart forward rate
6.32
Futures
 A “convexity adjustment” often made is
Forward rate = Futures rate – 𝜎 𝑇 𝑇 ,
where 𝑇 is the time to maturity of the futures
contract, 𝑇 is the time to maturity of the rate
underlying the futures contract (90 days later
than 𝑇 ) and 𝜎 is the standard deviation of
the short-term interest rate changes per year
(typically 𝜎 is about 1.2%)
※ Note that the above formula is for rates with continuous
compounding
6.33

Futures
 Suppose we wish to calculate the forward rate
when the 8-year Eurodollar futures price quote
is 94
– The convexity adjustment is × 0.012 × 8 × 8.25 =
0.00475
– The futures rate is 6% on an actual/360 basis (for
money market instruments on Slide 6.5) with quarterly
compounding  6.083% (=6%×365/360) on an
actual/365 basis with quarterly compounding (ignoring
the leap year (閏年) effect)  6.038% with continuously
compounding (using the formula on Slide 4.14)
– The forward rate is therefore 6.038% – 0.00475 =
5.563% per annum with continuous compounding 6.34
Futures
 Convexity adjustment for different maturities
when 𝜎 is about 1.2%
Maturity of Eurodollar Convexity Adjustment
Futures (years)
2 0.032%
4 0.122%
6 0.270%
8 0.475%
10 0.738%
※ For a longer time to maturity, the difference between the futures

and forward rates is more pronounced
6.35
6.4 Duration-Based Hedging

Strategies Using Futures
6.36
Duration (存續期間)
 Duration is defined as the weighted average of the

time points to receive each payment of a bond
– The weight of the time point of each payment =
PV of that payment / bond price
– Under the continuous compounding method:
 Duration of a bond with cash payment 𝑐 at 𝑡 is
𝐷 ≡ ∑ 𝑡 ,
where 𝐵 = ∑ 𝑐𝑒 is the bond price and 𝑦 is its yield (For
calculating the duration, all discounting is at the yield to
maturity 𝑦 and thus 𝐵 is the current market value of the bond)
/
 We thus have 𝐷 = − (always say the absolute change
𝑑𝑦 rather than the percentage change ( 𝑑𝑦/y) in interest rates)
6.37
/
 Prove that 𝐷 = − , where 𝐷 ≡ ∑ 𝑡
/
∵ 𝐵 = ∑ 𝑐 𝑒 ∴− =− = − ∑ 𝑐 𝑒 (−𝑡 )
= ∑ 𝑐 𝑒 𝑡 = ∑ 𝑡 =𝐷
/ /
※ 𝐷=− can be approximated by 𝐷 ≈ − , which
indicates that the duration can measure the interest rate
risk–the percentage change in bond price due to a small
change in yield
 The negative sign implies the inverse relationship between the
changes in bond prices and yields
6.38
/
 Rewrite 𝐷 ≈ − as Δ𝐵 ≈ −𝐵𝐷Δ𝑦, based upon which
we can estimate the change in the bond price if the
duration is known and the change in its yield is estimated
Time Cash Present Value Weight Time ×
(years) flow ($) (y = 0.12) Weight
0.5 5 4.709 0.050 0.025
1.0 5 4.435 0.047 0.047
1.5 5 4.176 0.044 0.066
2.0 5 3.933 0.042 0.083
2.5 5 3.704 0.039 0.098
3.0 105 73.256 0.778 2.333
Total 94.213 1 2.653
※ If the yield rises by 0.1%, the estimated change in the bond

price is –94.213×2.653×0.1% = –0.250 6.39
 Examination the accuracy of Δ𝐵 ≈ −𝐵𝐷Δ𝑦: when the

bond yield increases by 0.1% to become 12.1%, the
actual bond price is
5𝑒 . ⋅ . + 5𝑒 . ⋅ . + 5𝑒 . ⋅ . + 5𝑒 . ⋅ . +
5𝑒 . ⋅ . + 105𝑒 . ⋅ . = 93.963,
which is lower than the original bond price (94.213) by
0.250 (to the third decimal place)
 Note that the estimate of Δ𝐵 ≈ −𝐵𝐷Δ𝑦 is not accurate
when the absolute value of Δ𝑦 is large
– If Δ𝑦 = 2%, Δ𝐵 ≈ −𝐵𝐷Δ𝑦 = −94.213 × 2.653 × 2% = −4.999
– Applying the discount yield as 14%, the actual bond price is
5𝑒 . ⋅ . + 5𝑒 . ⋅ . + 5𝑒 . ⋅ . + 5𝑒 . ⋅ . + 5𝑒 . ⋅ . +
105𝑒 . ⋅ . = 89.354,
which is lower than the original bond price (94.213) by 4.86 6.40
– When the yield 𝑦 is expressed with compounding

𝑚 times per year
 Bond price formula 𝐵 = ∑ ( / )
 Following the same definition on Slide 6.37, duration
/( / )
𝐷 ≡ ∑ 𝑡
 The above duration formula leads to
/
− = /
𝐷 = 𝐷∗,
where 𝐷 ∗ is referred to as the “modified duration” (the
proof is shown on the next slide)
 Thus, the duration relationship to estimate the change in
the bond price is Δ𝐵 ≈ −𝐵𝐷 ∗ Δ𝑦
6.41
/ /( / )
 Prove that − = 𝐷, where 𝐷 ≡ ∑ 𝑡
/
∵ 𝐵 = ∑
( / )
/
∴− = − ∑ −𝑚𝑡 ( )
/
= ∑ 𝑡 = ∑ 𝑡
/ / /
/ /
= ∑ 𝑡 = 𝐷 ≡ 𝐷∗
/ /
※ 𝐷 is known as the modified duration 𝐷 ∗, which can measure
/
the IR risk more precisely than the duration 𝐷
※ The difference between 𝐷 ∗ and 𝐷 decreases with the
compounding frequency, and under the continuous compounding,
i.e., 𝑚 → ∞, the difference disappears (see Slide 6.38) 6.42
 Two bonds with the same duration have the

identical gradients (傾斜度) for their (Δ𝐵/𝐵-Δ𝑦)
curves at the origin
P
Q
※ The above figure implies that for one small change in yield, Δ𝑦 ,
the percentage change in the bond prices of P and Q are
almost the same, which inspires the duration-based hedging 6.43
Duration Matching
 Duration matching hedge:

– To hedge the IR risk of a bond (portfolio) 𝑃 with
nonzero Δ𝑃/Δ𝑦, consider to include 𝑁 units of an
interest-rate-sensitivity asset 𝑄 such that
+ = +𝑁 =0
 IR risk elimination: for a change in yield, Δ𝑦, the changes in
the values of P and NQ offset with each other
 Duration relationship: = −𝑃𝐷 and = −𝑄𝐷
 If we can find an asset 𝑄 such that 𝑃𝐷 = −𝑁𝑄𝐷 , the
portfolio of (𝑃 + 𝑁𝑄) is immunized (免疫) to the IR risk
※ Note that the hedging concept of +𝑁 = 0 can be
applied for other risk factors, not only for the interest rate risk6.44
Duration-Based Hedge Ratio
 Notations
– 𝑉 : Contract price for an interest rate futures contract
– 𝐷 : Duration of the asset underlying futures at the maturity
of the futures contract (do not calculate the duration of a
futures contract itself)
– 𝑃: Value of the portfolio being hedged at the maturity of
the hedge (assumed to be the same as the portfolio value
today)
– 𝐷 : Duration of the portfolio at the maturity of the hedge
( )
 Duration-based hedge ratio ( + = 0)
𝑁∗ = interest rate futures should be SHORTED
(due to = −𝑃𝐷 and = −𝑉 𝐷 ) 6.45
Example for Hedging a Bond

Portfolio
 On August 2, a fund manager has $10 million (𝑃)
invested in a portfolio of government bonds with a
duration of 6.8 years (𝐷 ) after three months and
wants to hedge against interest rate moves in the
next three months
– The manager decides to use December T-bond futures.
The futures price is 93-02 or 93.0625 (per $100 face
value) and the duration of the cheapest to deliver bond is
9.2 years (𝐷 ) in December (ignoring the basis risk)
 The CTD bond in Dec. is expected to be a 20-year, 12%-coupon
bond, and the yield of this bond is 8.8%
– 79 contracts of T-bond futures should be shorted
$ , , × .
= 79.42 6.46
$ . ×( , / )× .
Example for Hedging a Bond
Portfolio
 Effectiveness test of the hedge
– Suppose the bond yield increases by 0.2%
– Δ𝑃 ≈ −𝑃𝐷 Δ𝑦 = −10mil.× 6.8 × 0.2% = −136,000
– Δ 𝑁𝑉 ≈ −𝑁𝑉 𝐷 Δ𝑦 = −(−79) × 93.0625 × 1000 ×
9.2 × 0.2% = 135,276
– For the bond fund, the net effect from Δ𝑦 = 0.2% is
approximately equal to −136,000 + 135,276 = −724
6.47
Example for Hedging a

Floating-Rate Loan
 On the last trading day in April, a company
considers to borrow $15 million for the
following three months
– The borrowing IRs for each of the following three
months will be the one-month LIBOR rate plus 1%
– For May, the one-month LIBOR rate is known to be
8% per annum and thus the interest payments for
this month is certainly to be
$15,000,000×(8%+1%)×(1/12) = $112,500
– For June
 The IR applied to this month is determined by the one-
month LIBOR rate on the last trading day before June
6.48
Floating-Rate Loan
 The IR risk can be hedged by taking a short position in the
June Eurodollar futures contracts today
– The company pays more interests if the IR rises. For the short-
side traders of Eurodollar futures, they can obtain gains when
the IR rises (see Slide 6.26)
 The duration of the asset underlying the Eurodollar futures
at maturity is three months (0.25 years), and the duration of
the liability being hedged is one month (0.0833 years)
– The underlying asset of the Eurodollar futures is the virtual 3-
month zero coupon bond (or the 3-month LIBOR rate) on the
delivery date  𝐷 = 3 months
– The floating interest rate is adjusted monthly  Decompose the
three-month borrowing into three one-month borrowings, each
of which is made at the month start and repaid at the month end
 𝐷 = 1 month 6.49

Floating-Rate Loan
 Suppose the quoted price for June Eurodollar futures is
91.88. Thus, the contract price is
10,000×[100 – 0.25×(100 – 91.88)] = $979,700
 The number of the short position of the June Eurodollar
futures is
$ , , × .
= 5.10 ≈ 5
$ , × .
– For July
 The Sept. Eurodollar futures contract is used, and its
quoted price is 91.44. Thus, the price of this futures is
10,000×[100 – 0.25×(100 – 91.44)] = $978,600
 The number of the short position of the Sept. Eurodollar
futures is
$ , , × .
= 5.11 ≈ 5
$ , × . 6.50
Floating-Rate Loan
 Effectiveness test of the hedges
– For June
 On the last trading day before June, the one-month LIBOR
rate proves to be 8.8% and the prevailing June Eurodollar
futures quotes is 91.12 and its price is $977,800
 By closing out the futures, the company gains
5×($979,700 – $977,800) = $9,500
– For the short position of Eurodollar futures, the payoff equals
𝐹 − 𝐹 , i.e., (initial futures price – final futures price)
– For the long position of Eurodollar futures, the payoff equals
𝐹 − 𝐹 , i.e., (final futures price – initial futures price)
– The interest payment for June is $15,000,000×
(8.8%+1%)×(1/12) = $122,500
– The net interest cost is $122,500 – $9,500 = $113,000
6.51

Floating-Rate Loan
– For July
 On the last trading day before July, the one-month LIBOR
rate proves to be 9.4% and the prevailing Sept. Eurodollar
futures quote is 90.16 and its price is $975,400
 By closing out the futures, the company gains
5×($978,600 – $975,400) = $16,000
 The interest payment for July is $15,000,000
×(9.4%+1%)×(1/12) = $130,000
 The net interest cost is $130,000 – $16,000 = $114,000
※ The deterioration of the hedging effect is due to the large

change in LIBOR rate. (The LIBOR in July (9.4%) vs. the
LIBOR in June (8.8%) vs. the LIBOR in May (8%). Note
that the duration-based hedging works well for a small
change in the yield) 6.52
Limitations of Duration-Based
Hedging
 Assume that only parallel shifts in a flat yield
curve take place
– That is, assume that all yields with different times
to maturity are fixed at 𝑦 and thus move by Δ𝑦
simultaneously
 Assume that the change in yield, Δ𝑦, is small
 When a T-Bond futures contract is used for
hedge, it is assumed that we already know
which bond is the CTD bond on the delivery
day
6.53
Swaps
Chapter 7
7.54
Goals of Chapter 7
 Introduce interest rate (IR) swaps (利率交換)

– Definition for swaps
– An illustrative example for IR swaps
– Discuss reasons for using IR swaps
– Quotes and valuation of IR swaps
 Introduce currency swaps (貨幣交換)
– Payoffs, reasons for using currency swaps, and
the valuation of currency swaps
 Credit risk of swaps
 Other types of swaps
7.55
7.1 Interest Rate (IR) Swaps
7.56
Definition of Swaps
 A swap is an agreement to exchange a series

of cash flows (CFs) at specified future time
points according to certain specified rules
– The first swap contracts were created in the early
1980s
 FYI, first futures contract appeared in 1864
– Swaps are traded in OTC markets
– Swaps now occupy an important position in OTC
derivatives markets
– The calculation of CFs can depend on the future
values of an interest rate, an exchange rate, or
other market variables 7.57
Interest Rate Swap
 The most common type of swap is a “plain

vanilla” IR swap
– One party agrees to pay CFs at a fixed rate on a
notional principal for several years
– The other party pay CFs at a floating rate on the
same notional principal for the same period of time
– The floating rate in most IR swaps depends on the
LIBORs with different maturities in major currencies
– An illustrative example: On Mar. 5 of 2013, Microsoft
(MS) agrees to receive 6-month LIBOR and pay a
fixed rate of 5% with Intel every 6 months for 3 years
on a notional principal of $100 million 7.58
Cash Flows of an Interest Rate Swap
---------Millions of Dollars---------
LIBOR Floating Fixed Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 5, 2013 4.2%
Sept. 5, 2013 4.8% +2.10 –2.50 –0.40
Mar.5, 2014 5.3% +2.40 –2.50 –0.10
Sept. 5, 2014 5.5% +2.65 –2.50 +0.15
Mar.5, 2015 5.6% +2.75 –2.50 +0.25
Sept. 5, 2015 5.9% +2.80 –2.50 +0.30
Mar. 5, 2016 +2.95 –2.50 +0.45
※ For each reference period, the 6-month LIBOR in the beginning of the
period determine the payment amount at the end of the period
– Therefore, there is no uncertainty about the first CF exchange
※ The principal is also known as the notional principal (名義本金或名目
本金), or just the notional
– Only net CFs change hands  not necessary to exchange the principal at
any time point 7.59
Cash Flows of an Interest Rate Swap

If the Principal was Exchanged
---------Millions of Dollars---------
LIBOR Floating Fixed Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 5, 2013 4.2%
Sept. 5, 2013 4.8% +2.10 –2.50 –0.40
Mar.5, 2014 5.3% +2.40 –2.50 –0.10
Sept. 5, 2014 5.5% +2.65 –2.50 +0.15
Mar.5, 2015 5.6% +2.75 –2.50 +0.25
Sept. 5, 2015 5.9% +2.80 –2.50 +0.30
Mar. 5, 2016 +102.95 –102.50 +0.45
※ If the principal were exchanged at the end of the life of the swap, the
nature (or said the net CFs) of the deal would not be changed in any way
※ An IR swap can be regarded as the exchange of a fixed-rate bond (with
the CFs in the 4th column) for a floating-rate bond (with the CFs in the
3rd column)
※ This characteristic helps to evaluate IR swaps (introduced later) 7.60
Interest Rate Swap
– Day count conventions for IR swaps in the U.S.

 Since the 6-month LIBOR is a U.S. money market rate, it is
quoted on an actual/360 basis
 As for the fixed rate, it is usually quoted as actual/365
 For the first CF exchange on Slide 7.6, because there are 184
days between Mar. 5, 2013 and Sep. 5, 2013, the accurate
CF amounts are
$100 mil.× 4.2% × = $2.1467 mil. (for the floating-rate CF)
$100 mil.× 5% × = $2.5205 mil. (for the fixed-rate CF)
 For clarity of exposition, this day count issue is ignored in the
rest of this chapter
7.61
Interest Rate Swap
 Reasons for using IR swaps

1. Converting a liability from
 fixed rate (originally) to floating rate
 floating rate (originally) to fixed rate
※ Intel (wants floating-rate debt) and MS (wants fixed-rate debt)
5% LIBOR + 0.1%
5.2% Intel MS
LIBOR
Original fixed- IR swap Original floating-

rate debt of Intel rate debt of MS
– The net borrowing rate for Intel’s liability is LIBOR + 0.2%

– The net borrowing rate for MS’s liability is 5.1% 7.62
Interest Rate Swap
2. Converting the investment income from

 fixed rate (originally) to floating rate
 floating rate (originally) to fixed rate
※ Intel (wants fixed-rate income) and MS (wants floating-rate income)
5% 4.7%
LIBOR – 0.2% Intel MS
LIBOR
Original floating- IR swap Original fixed-rate

rate asset of Intel asset of MS
– The net interest rate earned for Intel’s asset is 4.8%

– The net interest rate earned for MS’s asset is LIBOR – 0.3%
7.63
Interest Rate Swap
 In practice, a financial intuition (F.I.) is involved

– Usually two nonfinancial companies do not contact
directly to arrange a swap
 It is unlikely for a company to find a trading counterparty
which needs the opposite position of the IR swap, i.e.,
another firm agrees with the principal and maturity but has a
different preference for the floating or fixed IR
 Thus, a F.I. matches the deal and earns a spread
4.985% 5.015% LIBOR + 0.1%
5.2% MS
Intel F.I.
LIBOR LIBOR
Original fixed- IR swap IR swap Original floating-

rate debt of Intel rate debt of MS 7.64
Interest Rate Swap
4.985% 5.015% 4.7%
LIBOR – 0.2% MS
Intel F.I.
LIBOR LIBOR
Original floating- IR swap IR swap Original fixed-rate

rate asset of Intel asset of MS
 The F.I. has two separate IR swaps and it has to honor the
both contracts even if Intel or MS defaults
 In most cases, Intel and MS do not even know whether the
F.I. has entered into an offsetting swap with another firm
 In OTC markets for swaps, there are many F.I.’s acting as
market markers (or said dealers) and always preparing to
trade IR swaps without having an offsetting swap
– They can hedge their unoffset swap positions with Treasury
bonds, FRAs, or other IR derivatives 7.65
Quotes By a Swap Market Maker
Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
※ IR swaps are quoted as the rate for the fixed-rate side
– Bid rate: the fixed rate that the market maker pays for buying (receiving) a
series of CFs according to LIBOR
– Offer (or say ask) rate: the fixed rate the market marker earns for selling
(paying) a series of CFs according to LIBOR
– Swap Rate: the fixed rate such that the value of this swap is zero (introduced
later), and the bid-offer quotes usually center on the swap rate in practice
– Plain vanilla fixed-for-floating swaps are usually structured so that financial
institution can earn bid-ask spreads about 0.03% to 0.04% in the U.S. 7.66
Comparative Advantage Argument
 The comparative advantage argument

explains the popularity of the IR swaps
– AAA Corp. prefers to borrow at a floating rate and
BBB Corp. prefers to borrow at a fixed rate
– The fixed or floating IRs they need to pay are
Fixed Floating
AAA Corp. 4.00% 6-month LIBOR – 0.1%
BBB Corp. 5.20% 6-month LIBOR + 0.6%
 A key feature is that the difference between the two

fixed rates (1.2%) is greater than the difference between
the two floating rates (0.7%)
 AAA (BBB) Corp. has comparative advantage in
borrowing fixed-rate (floating-rate) debt 7.67
 An ideal win-win solution with a swap

– AAA Corp. borrows fixed-rate funds at 4%
– BBB Corp. borrows floating-rate funds at LIBOR + 0.6%
– Both enter into a fixed-for-floating IR swap to obtain the IRs
they prefer
4.35%
4% LIBOR + 0.6%
AAA BBB
LIBOR
Borrow at a IR swap Borrow at a

fixed rate floating rate
 The net borrowing rate for AAA Corp. is LIBOR – 0.35%, which is
by 0.25% lower than LIBOR – 0.1% if it borrows at a floating rate
directly
 The net borrowing rate for BBB Corp. is 4.95%, which is by 0.25%
lower than 5.2% if it borrows at a fixed rate directly 7.68
– Suppose AAA and BBB cannot deal directly and a F.I. is involved
4.33% 4.37% LIBOR + 0.6%

4% BBB
AAA F.I.
LIBOR LIBOR
Borrow at a IR swap IR swap Borrow at a

fixed rate floating rate
 The net interest rate for AAA Corp. is LIBOR – 0.33%, which is by
0.23% lower than LIBOR – 0.1% if it borrows at a floating rate directly
 The net interest rate for BBB Corp. is 4.97%, which is by 0.23% lower
than 5.2% if it borrows at a fixed rate directly
 The spread earned by the F.I. is 0.04%
– In the both cases, the total gains of all participants is 0.5% , which
equals (1.2% – 0.7%), where 1.2% (0.7%) is the difference
between the fixed (floating) borrowing IRs for AAA and BBB Corp. 7.69
Criticism of the Comparative

Advantage Argument
 The comparative advantage arises from the
unmatched maturities for different IR rates
– The 4% and 5.2% rates available to AAA and BBB
are, for example, 5-year rates
– The LIBOR – 0.1% and LIBOR + 0.6% rates are
available to AAA and BBB for only 6 months
(The fixed IR level or the spread above or below the LIBOR
reflects the credit risks of AAA and BBB corporations)
 Why BBB, a worse credit-rating corp., has a comparative
advantage on borrowing at a short-term IR?
– The 6-month period is relatively short (compared with 5
years), the 6-month default prob. of BBB is significantly lower
than that that for 5 years
– The above effect is weak for AAA, a better credit-rating corp. 7.70
Criticism of the Comparative
Advantage Argument
 In practice, the floating-rate loan will be reviewed (so as the
creditworthiness of the borrower) and rolled over every 6
months, so the true cost to borrow at a floating rate is
(LIBOR + spread) rather than (LIBOR + 0.6%) in the future
– spread changes with the creditworthiness of BBB
– With the IR swaps on Slide 7.16, the net borrowing rate for BBB
is NOT FIXED at (LIBOR + 0.6%) + 4.37% – LIBOR = 4.97% for
5 years, but is (LIBOR + spread) + 4.37% – LIBOR = 4.37% +
spread dependent on its future creditworthiness every 6 months
– In contrast, if BBB borrows at a fixed IR, the borrowing rate is
fixed at 5.2% for 5 years, regardless of its future creditworthiness
– As a result, BBB cannot achieve its goal perfectly with an IR
swap if its creditworthiness changes in the future
※ The above inference disproves that the comparative advantage
argument can fully explain the popularity of IR swaps 7.71
The Nature of Swap Rates
 The n-year swap rate is a constant interest rate

corresponding to a credit risk for lending 2n
consecutive 6-month LIBOR loans to AA-rated
companies
– First, the LIBOR is the lending rate for an AA-rated
borrower
– Second, a F.I. can earn the n-year swap rate by
1. Lending for the first 6-month loan to an AA-rated borrower
and relending it for successive 6-month periods to another
AA-rated borrowers, and continue this process for n years
2. Entering into a IR swap to exchange the LIBOR income in
the above step for the constant CFs at the n-year swap rate7.72
The Nature of Swap Rates
– Note that the n-year swap rates are lower than n-

year AA-rating lending rates
 For the swap rate, the credit rating of the borrowers is
always AA for the whole n-year period
 For n-year AA-rating lending rates, it is only known that
the initial credit rating of the borrower is AA at the
beginning of the n-year period
※ Credit risk comparison: n-year swap contract < n-year AA-
rating lending
※ IR level comparison: n-year swap rate < n-year AA-rating
lending rate
※ Furthermore, since the credit risks of AA-rated companies
are very minor in practice, it can be inferred that the swap
rates are even closer to risk-free 7.73
Valuation of IR Swaps
 There are two approaches to price IR swaps

1. Regard the value of an IR swap as the
difference between the values of a fixed-rate
bond and a floating-rate bond (see Slide 7.7)
2. Regard an IR swap as a portfolio of forward rate
agreements (FRAs)
 For the Intel and MS 3-year IR swap, it can be
regarded separately as 5 FRAs (excluding the first
exchange)
7.74
 Valuation in terms of bond prices

– For a swap where fixed CFs are received and
floating CFs are paid, its value can be expressed as
𝑉 =𝐵 −𝐵 ,
where 𝐵 and 𝐵 denote the values of a fixed-rate
and floating-rate bonds
– The value of a fixed-rate bond (Bfix) can be derived
with the traditional discounted cash flow method
– The value of a floating-rate bond (Bfl) that pays 6-
month LIBOR is equal to its par value immediately
after each coupon payment date (if it is discounted
semiannually) 7.75
 Price Bfl (with the face value to be $100) with 1.5 years to
maturity in one possible scenario for the 6-month LIBOR
$2  $100
$100 (  )
1  4%  0.5
$4  $100 $4 $102
$100 (    )
1  8%  0.5 1  8%  0.5 (1  8%  0.5 )((1  4%  0.5)
$3  $100 $3 $4 $102
$100 (     )
1  6%  0.5 1  6%  0.5 (1  6%  0.5)(1  8%  0.5) (1  6%  0.5)(1  8%  0.5 )(1  4%  0.5)
※ Note that in any scenario for LIBOR and for different life time of
bonds, the Bfl is worth its par value on the issue date and on each
date immediately after the coupon payment date 7.76
 Generalization for pricing a Bfl (with the principal (or said

par value) L) at any time point 𝑡
Value = L = PV
of L+k* at t = 0 Value = L
Value =
L+k*
0 t t*
Last Valuation First Pmt Second Maturity

Pmt Date Date Date Pmt Date Date
(Floating
CF = k*)
∗
※ A Bfl is worth the PV of (𝐿 + 𝑘 ∗ ) at 𝑡, i.e., 𝐿 + 𝑘 ∗ 𝑒 ( ),
∗
where 𝐿 + 𝑘 is the value of the Bfl on the next payment date
and 𝑟 is the continuously compounding zero rate corresponding
to the time to maturity of (𝑡 ∗ − 𝑡) 7.77
 An example for pricing pay-floating-receive-

fixed IR swaps
– For the party to pay the six-month LIBOR and
receive fixed 8% (semi-annual compounding) on a
principal of $100 million
– Remaining life of the IR swap is 1.25 years
– LIBOR rates for 3-months, 9-months and 15-
months are 10%, 10.5%, and 11% (continuously
compounding)
– The 6-month LIBOR on the last payment date was
10.2% (semi-annual compounding)
7.78
Time 𝑩𝐟𝐢𝐱 CF 𝑩𝐟𝐥 CF Discount Factor PV of 𝑩𝐟𝐢𝐱 PV of 𝑩𝐟𝐥

(yr) CF CF
0.25 $4 $105.1 𝑒 % . = 0.9753 $3.901 $102.505
0.75 $4 𝑒 . % . = 0.9243 $3.697
1.25 $104 𝑒 % . = 0.8715 $90.640
Total $98.238 $102.505
※ For per $100 principal

– The coupon payment of 𝐵 after 3 months is 0.5 × 10.2% ×
$100 = $5.1
– The value of 𝐵 today is $100 + $5.1 𝑒 % / = $102.505
according to the formula on Slide 7.24
– 𝑉 = 𝐵 − 𝐵 = $98.238 − $102.505 = −$4.267
7.79
 Valuation in terms of FRAs

– Each exchange in an IR swap is an FRA
 Note that for a newly issued IR swap, the first exchange
of payments is known when the swap is negotiated
 For each of other exchanges, it can be regarded as a
FRA applied for a future period of 6 months
– Recall that for a FRA applied in [𝑇 , 𝑇 ], the payoff of the
lender at 𝑇 is 𝐿(𝑅 − 𝑅 ) 𝑇 − 𝑇 (see Slide 4.34), where
𝐿 is the principal, 𝑅 is the fixed IR specified in the FRA
contract, and 𝑅 is the actual LIBOR for [𝑇 , 𝑇 ]
– Considering a pay-floating-receive-fixed IR swap with the
principal 𝐿, for each 6 months, the swap holder can receive
the net payoff of 𝐿 𝑅 − 𝑅 ×0.5, where 𝑅 is the actual 6-
month LIBOR for that period and 𝑅 is the fixed IR specified
in the swap contract 7.80
– The value of any derivative equals the present

value of its expected payoff
This approach has been used to price FRAs on Slide 4.37
 To evaluate the expected payoff of an exchange in an IR
swap, the expectation of the future LIBOR is needed
𝑒 𝐸 𝐿 𝑅 −𝑅 𝑇 −𝑇
=𝑒 𝐿 𝑅 − 𝐸[𝑅 ] 𝑇 − 𝑇
=𝑒 𝐿[𝑅 𝑇 − 𝑇 − 𝐸[𝑅 ] 𝑇 − 𝑇 ]
 It is known that the expected future LIBORs equal the
forward rates (𝑅 ) based on today’s term structure of IRs:
Value of an exchange = 𝑒 𝐿[𝑅 𝑇 − 𝑇 − 𝑅 𝑇 − 𝑇 ]
=𝑒 𝐿(𝑅 − 𝑅 ) 𝑇 − 𝑇
※ The above formula is identical to the FRA pricing formula on Slide 4.37 7.81
– Consider the pay-floating-receive-fixed IR swap

example on Slide 7.25. For per $100 principal,
Time Fixed Expected Expected Discount PV of expected
(yr) CF floating CF net CF factor net CF
0.25 $4 $5.100 –$1.100 0.9753 –$1.073
0.75 $4 $5.522* –$1.522 0.9243 –$1.407
1.25 $4 $6.051** –$2.051 0.8715 –$1.787
Total –$4.267
∗ . %× . %× .
𝑅 = = 10.75% (cont. comp.) ⇒ 11.044% (semi-annual comp.)
.
Expected cash outflow at 𝑡 = 0.75 is $100 × 11.044% × 0.5 = $5.522
∗∗ %× . . %× .
𝑅 = = 11.75% (cont. comp.) ⇒ 12.102% (semi-annual comp.)
.
Expected cash outflow at 𝑡 = 1.25 is $100 × 12.102% × 0.5 = $6.051
7.82
 An IR swap is worth zero when it is first initiated

– When a swap contract is first negotiated, the swap
rate (the fixed rate 𝑅 ) is determined such that the
value of the swap is zero initially
 This feature is similar to set the delivery prices of futures
contracts to be the futures prices such that the futures
contracts are worth zero when they are initiated
– With the passage of time, the value of an IR swap
emerges and can be either positive or negative
 One party’s gains are the other party’s losses, so two
parties of a swap have opposite viewpoints on the value of
the same IR swap
7.83
– Although the swap is zero initially, it does not mean

that the value of each individual FRA is zero initially
 The initial zero value of a swap means that the sum of the
values of all FRAs underlying the swap is zero
 For a pay-fixed-receive-floating swap on the issue date,
– If the zero curve is upward sloping  forward rates ↑ with T
 The forward rates with shorter times to maturity < the swap rate
 negative values for shorter-maturity FRAs
 The forward rates with longer times to maturity > the swap rate
 positive values for longer-maturity FRAs
– If the zero curve is downward sloping  forward rates ↓ with T
 The forward rates with shorter times to maturity > the swap rate
 positive values for shorter-maturity FRAs
 The forward rates with longer times to maturity < the swap rate
 negative values for longer-maturity FRAs 7.84
Determine LIBOR Zero Curve with
Eurodollar Futures and IR Swaps
 Construct the LIBOR zero curve
(It is important since traders commonly use LIBORs as
proxies for risk-free rates when trading derivatives)
– 𝑇 < 1: the quotes of spot LIBOR (given different 𝑇)
provided by financial institutions are used
– 𝑇 in [1,2] (or in [1,5]): the quotes of Eurodollar
futures are used to derive LIBOR zero rates
 Suppose the zero rate 𝑅 for 𝑇 is known
 With the convexity adjustment, the forward rates (𝑅 ) for
[𝑇 , 𝑇 ] can be derived from the futures rates implied from
the quotes of Eurodollars futures (𝑍)
 Finally, we can deduce 𝑅 through
𝑅 = ⇒𝑅 = 7.85
Determine LIBOR Zero Curve with

Eurodollar Futures and Swaps
– For longer 𝑇: the quotes of swap rates are used to
derive the LIBOR zero rate
 Consider a pay-floating-receive-fixed IR swap with the swap
rate of 5%, principal of $100, and 2 years to maturity
 Suppose the 6-month, 12-month, and 18-month LIBOR zero
rates are 4%, 4.5%, and 4.8% with cont. compounding
 Since the initial value of a swap is zero, then 𝑉 =𝐵 −
𝐵 = 𝐵 − $100 = 0 and thus
2.5𝑒 % . + 2.5𝑒 . % + 2.5𝑒 . % . + 102.5𝑒 = 100
 Solve for the 2-year LIBOR zero rate to be 4.953%
 The above equation also demonstrates that the swap rate =
par yield (refer to Slide 4.19 for the definition of the pay yield)
※Similar to the bootstrap method, LIBOR rates for shorter 𝑇
should be solved first before solving LIBOR rates for longer 𝑇 7.86
Overnight Indexed Swaps (OISs)
 An OIS is a swap where a fixed rate (𝑟̅ ) is

exchanged for the geometric average (𝑟̃ ) of the
overnight rates during a period
–𝐿 1 + 𝑟̃ /365 − 1 ⟷ 𝐿 92/365 𝑟̅ for a 92-day period
– The fixed rate 𝑟̅ is referred to as the OIS rate,
determined such that an OIS is worth zero initially
– OISs tend to have short lives (≤ 3 months)
– Longer-term OISs are typically divided into 3-month
sub-periods
 At the end of each sub-period, the net of the actual geometric
average of the overnight rates during the sub-period and the
fixed OIS rate will be exchanged 7.87
– 3-month OIS rate ≤ 3-month LIBOR rate

1. Borrow 𝐿 from a AA-rated bank in the overnight market, and roll the
interest and principal forward every day for 3 months (92 days)  pay
the geometric average of the overnight rates at the period end
2. Convert the geometric average of the overnight rates to the 3-month
OIS rate by entering into an OIS contract
3. Lend the borrowed 𝐿 to another AA-rated financial institution for 3
months at LIBOR
※ Payoff = 𝐿 × (92/365) × (LIBOR − OIS rate) > 0 in reality
※ OIS rates correspond to continually refreshed overnight rates (always
lend or borrow daily with AA-rated financial institutions)
※ To earn 3-month LIBORs, the bank bears the default risk of its trading
counterparty, which is rated AA initially
※ Thus, OIS rates, lower than LIBOR rates, are even closer to risk-free
interest rates 7.88
– In practice, many derivatives dealers choose to use

OIS zero rates for discounting collateralized
transactions (less risky) and use LIBOR zero rates for
discounting noncollateralized transactions (more risky)
– The (LIBOR – OIS) spread
 Defined as the 3-month LIBOR rate over the 3-month OIS rate
 Can be used to measure the degree of stress in financial
markets
– In normal market condition, this spread is about 10 basis points
– In Oct. 2009, this spread spiked to an all-time high of 364 basis
points because banks are reluctant to lend to each other for three-
month periods
– In Dec. 2011, due to the concern of the crisis in Greece, this
spread rose to 50 basis points 7.89
Determine Zero Curve Using OISs
 Similar to constructing a LIBOR zero curve with

swap rates, one can derive a zero curve using
OIS quotes (a better proxy for the term structure
of the risk-free interest rate)
– 𝑇 < 3 months: the quotes of OIS rates are used
– For a longer 𝑇 (assuming there are periodic
settlements (usually every 3 months) in OIS contracts)
 The OIS rate defines a par yield bond if the daily
discounting frequency is considered
 For a 1.25-year OIS contract with the OIS rate to be 4%, it
can be regarded as a bond paying a quarterly coupon at a
rate of 4% per annum and sold at par 7.90
Determine Zero Curve Using OISs
 Suppose the 3-, 6-, 9-, and 12-month OIS zero rates are 3%,
3.5%, 4%, and 4.5% with continuous compounding
 The 1.25-year OIS zero rate 𝑅 is 3.9798% by solving
% .
1𝑒 + 1𝑒 . % . + 1𝑒 % . + 1𝑒 . % + 101𝑒 .
= 100
– For a 𝑇 being so long such that the quotes of OIS
rates are not available or unreliable, e.g., 𝑇 > 5 years
 Note that LIBOR-based IR swaps are traded for longer
maturities than OIS
 Assume the (LIBOR – OIS) spread is constant and as it is for
the longest OIS maturity for which there is reliable data, e.g.,
for the 5-year time point, the corresponding (LIBOR – OIS)
zero-rate spread is 20 basis points
 Use the LIBOR zero curve minus a constant (LIBOR – OIS)
spread to derive the OIS rate zero curve 7.91
7.2 Currency Swaps
7.92
Currency Swap
 Currency swap is another popular type of swaps

– It involves exchanging principal and interest
payments in one currency for principal and interest
payments in another currency
 Different from IR swaps, the principal amounts (in
different currencies) are exchanged at the beginning and
at the end of the life of a currency swap
 The principal amounts are chosen to be approximately
equivalent using the exchange rate at the swap’s initiation
– An example of a currency swap: IBM pays 5% on a
principal of £10,000,000 and receive 6% on a
principal of $15,000,000 from British Petroleum (BP)
every year for 5 years 7.93
Currency Swap
£10 mil. Year Dollar CF Sterling CF

IBM BP for IBM for IBM
(millions) (millions)
$15 mil.
2013 –15.00 +10.0
2014 +0.90 –0.5
Dollar 6% 2015 +0.90 –0.5
IBM BP
2016 +0.90 –0.5
Sterling 5% 2017 +0.90 –0.5
2018 +15.90 –10.5
※ A currency swap can be regarded as two parallel
$15 mil. loans denominated in different currencies
IBM BP ※ The values of $15 mil. and £10 mil. are set to be
£10 mil. equivalent initially (in this case, £1 =$1.5 initially)
⇒ Two parties lend loans with equivalent values
to each other ⇒ The net value of the currency
swap is zero initially 7.94
Currency Swap
 Typical uses of a currency swap is to

– Convert a liability in one currency to a liability in
another currency
Dollar 6% Sterling 5%
Dollar 6%
IBM BP
Sterling 5%
– Convert an investment in one currency to an

investment in another currency
Dollar 6% Dollar 6%
IBM BP
Sterling 5%
Sterling 5%
7.95
Comparative Advantage
Arguments for Currency Swaps
 The comparative advantage argument

explains the popularity of the currency swaps
– General Electric (GE) prefers to borrow AUD and
Qantas Airways (QA) prefers to borrow USD
– The USD and AUD borrowing IRs they face are
USD AUD
General Electric (GE) 5.0% 7.6%
Qantas Airways (QA) 7.0% 8.0%
※ GE has a comparative advantage in the USD market,

whereas QA has a comparative advantage in the AUD
market 7.96
 Exploit the comparative advantage with

currency swaps
– Suppose that GE intends to borrow 20 mil. AUD
and QA intends to borrow 15 mil. USD, and the
current exchange rate is 0.75USD per AUD
– GE borrows USD, QA borrows AUD, and they use
currency swaps to transform GE’s USD loan into
a AUD loan and QA’s AUD loan into a USD loan
USD 5.0% USD 6.3% AUD 8.0%
USD 5.0% QA
GE F.I.
AUD 6.9% AUD 8.0%
※ GE pays 6.9% in AUD (0.7% better off) and QA pays 6.3%
in USD (0.7% better off) 7.97
– Different ways to arrange the currency swaps
1. QA bears some foreign exchange risk
USD 5.0% USD 5.2% AUD 8.0%
USD 5.0% QA
GE F.I.
AUD 6.9% AUD 6.9%
2. GE bears some foreign exchange risk
USD 6.1% USD 6.3% AUD 8.0%

USD 5.0% QA
GE F.I.
AUD 8.0% AUD 8.0%
※ These two alternatives are unlikely to be adopted in

practice because the firms prefer to eliminate the foreign
exchange risk with currency swaps thoroughly 7.98
Valuation of Currency Swaps
 Like IR swaps, currency swaps can be valued

either as the difference between 2 bonds or as
a portfolio of forward contracts
– Valuation in terms of bond prices
 For a receive-dollar-pay-foreign-currency currency swap,
then
𝑉 =𝐵 −𝑆 𝐵 ,
where 𝐵 is the domestic bond defined by the remaining
USD CFs, 𝐵 is the bond defined by the remaining foreign-
currency CFs, and 𝑆 is the spot exchange rate (expressed
as dollars for per unit of foreign currency)
 In contrast, for a pay-dollar-receive-foreign-currency
currency swap, then 𝑉 =𝑆 𝐵 −𝐵 7.99
 An example for pricing currency swaps

– All Japanese LIBOR zero rates are 4% (foreign
IR)
– All USD LIBOR zero rates are 9% (domestic IR)
– A currency swap is to received 5% in yen and pay
8% in dollars. Payments are made annually
– Principals are $10 million and 1,200 million yen
– Swap will last for 3 more years
– Current exchange rate is 110 yen per dollar
7.10
0
Time Cash Flows of PV of 𝑩𝑫 Cash flows of PV of 𝑩𝑭

(yr) 𝑩𝑫 (million $) (million $) 𝑩𝑭 (million (million yen)
(discounted yen) (discounted at
at 9%) 4%)
1 0.8 (=10×8%) 0.7311 60 (=1,200×5%) 57.65
2 0.8 (=10×8%) 0.6682 60 (=1,200×5%) 55.39
3 0.8 (=10×8%) 0.6107 60 (=1,200×5%) 53.22
3 10 7.6338 1,200 1,064.30
Total 9.6439 1,230.55
, .
※𝑉 =𝑆 𝐵 −𝐵 = − 9.6439 = 1.543 (million $)
7.10
1
– Valuation in terms of forward contracts

 Each exchange of payments (including the first one) in a
currency swap is a foreign exchange (FX) forward contract
– FX forwards is an agreement to trade an amount of a foreign
currency at a fixed price on a predetermined future date
– FX forwards are similar to the foreign currency futures contracts
(introduced in Ch. 5) except that FX forwards are traded in OTC
markets and thus there is no daily settlement requirement
– The principal is 𝐿 foreign dollars (𝐿=￥60 or ￥1260 mil. in our
example) and the fixed trading price is 𝐾 (expressed as
domestic dollars / per foreign dollar) (𝐾 = 0.8/60 or 10.8/1260 in
our example)
– Payoff of a FX forwards to purchase the foreign currency at 𝑇 is
𝐿 𝑆 − 𝐾 = 𝐿𝑆 − 𝐿𝐾, where 𝑆 is the domestic-dollar price of
the foreign currency (or said the FX rate) at 𝑇 7.10
2
– The value of a FX forward is the PV of its expected payoff

𝑒 𝐸 𝐿𝑆 − 𝐿𝐾 = 𝑒 (𝐿𝐸 𝑆 − 𝐿𝐾)
– The forward (or futures) price of the foreign currency provide
the unbiased approximation for 𝐸 𝑆 based on the information
of IRs today
– Since the forward price of the foreign currency is 𝐹 =
𝑆 𝑒( )
(introduced on Slide 5.23), we obtain 𝐸 𝑆 = 𝐹 =
𝑆 𝑒
– Thus, the value of a FX forward is
𝑒 (𝐿𝐹 − 𝐿𝐾)
– The forward FX rates of Japanese Yen, 𝐹 , in the example on
Slide 7.47 are
Time (yr) 1 2 3
Forward FX rate 1 ( % %) 1 ( % %) 1 ( % %)
𝑒 𝑒 𝑒
($/per Yen) 110 110 110
= 0.009557 = 0.010047 = 0.010562 7.10
3
– Take the first exchange in the currency swap for example: it can
be regarded as a FX forward to purchase ￥60 million with $0.8
million
– Value of the first exchange = 𝑒 % ￥60 𝐸 𝑆 − $0.8
= 𝑒 % ￥60 0.009557 − $0.8
= −0.2071 (million $)
Time Dollar CF Yen CF Expected future Yen CF Net CF PV of net
(yr) (mil. $) (mil. Yen) FX rate = in dollar (mil. $) CF (mil. $)
forward FX rate (mil. $) (discounted
at 9%)
1 –0.8 60 0.009557 0.5734 –0.2266 –0.2071
2 –0.8 60 0.010047 0.6028 –0.1972 –0.1647
3 –0.8 60 0.010562 0.6337 –0.1663 –0.1269
3 –10 1,200 0.010562 12.6746 +2.6746 +2.0417
Total +1.5430
7.10
4
7.3 Credit Risk of Swaps
7.10
5
Credit Risk
 Contracts such as swaps or forwards that are

private arrangements between two parties
entail credit risk
– A swap is worth zero to both counterparties initially
– At a future time point, its value is possible to be
either positive or negative
– A swap trader has credit risk exposure only when
the value of its swap position is positive
 The trading counterparty has the chance not to honor his
losses, which results in the credit risk
– Potential losses from defaults on a swap are much
less than the potential losses from defaults on a
loan/bond with the same principal 7.10
6
Credit Risk
 Since the value of a swap is the difference between two

parallel bonds, the value of a swap is usually a small
fraction of its notional principal
– Potential default losses on a currency swap are
greater than those on an IR swap because the
principal amounts in different currencies are
exchanged at the end of the life of a currency swap
– Credit vs. Market risks
 Credit risk arises from the possibility of a default, but the
market risk arises from the changes of the market
variables, such as IR and FX rates
 Market risk can be hedged by entering into offsetting
contracts (e.g., duration matching hedge), but credit risk
is more difficult to hedge 7.10
7
Credit Risk
 Credit default swaps (信用違約交換) (CDSs)

– Invented by JPMorgan in 1997
– A CDS is an insurance policy with payoffs depending
on the occurrence of the default event of a corporate
bond or loan
– CDSs can shift the default risk from the protection
buyer to the protection seller (see the next slide)
– CDSs allow financial institutions to hedge credit risks
in the same way that they have hedged market risks
– The total size of outstanding CDS contracts reaches
a peak of $63 trillion before the 2008-2009 credit
crisis (US GDP is about $14 trillion per year) 7.10
8
Credit Risk
※ When the default event occurs, the protection seller should compensate the
protection buyer any losses on principal in the default event
※ For the protection buyer, CDS provides insurance against the possibility that
a borrower (the reference entity (參考實體)) might not pay
※ For the protection seller, CDS provides a way to earn profits by bearing
default risk without ever holding credit instruments physically 7.10
9
7.4 Other Types of Swaps
7.11
0
Other Types of Swaps
 Variations on IR swaps
– The tenors (i.e., the payment frequency) for the
floating- and fixed-rate sides could be different
 Quarterly LIBOR vs. semiannual fixed rate payments
– Other floating rates, like the commercial paper rate,
could be used
– Amortizing (攤銷) (or step up) swaps
 The principal amount reduces (or increases) in a
predetermined way
– Deferred (延遲) swaps
 Also known as the forward-start swap, where the parties
do not begin to exchange interest payments until some
future date 7.11
1

– Constant maturity swaps (CMS)
 An agreement to exchange (LIBOR + spread) (or a constant
IR) for a fixed-maturity swap rate
 For example, exchange the 6-month LIBOR + 0.1% (or 5.5%)
for 10-year swap rates every 6 months for the next 5 years
– Constant maturity Treasury swaps
 Exchange 6-month LIBOR + 0.15% for the 2-year Treasury
par yield every 6 months for the next 3 years
– Par yield: a coupon rate that causes the bond price to equal its
face value
– Compounding swaps
 Interests on one or both sides are compounded to the end of
the life of the swap and thus there is only one payment at the
end of the life of the swap 7.11
2
– LIBOR-in-arrears (遞延) swaps
 The LIBOR observed on the payment date is used
immediately to calculate the payment on that date
 Note that for standard IR swaps, the 6-month LIBOR
prevailing six months ago determines the current floating
payment
– Accrual (累積) swaps
 The interests on one side accrue only when the floating
reference rate is in a certain range (The fixed-rate side
pays in a standard way)
 For example, only when the LIBOR rate is between
[1%,2%], the interests on that day is accumulated
– For every 6 months, the number of days where the specified
condition is met determines the floating CF 7.11
3
 Other currency swaps

– Fixed-for-floating currency swaps
 A LIBOR in one currency is exchanged for a fixed rate in
another currency
 A combination of a fixed-for-floating IR swap and a fixed-
for-fixed currency swap
 It is also known as a cross-currency interest rate swap
– Floating-for-floating currency swaps
 A LIBOR in one currency is exchanged for a LIBOR in
another currency
 A combination of two fixed-for-floating IR swaps and a
fixed-for-fixed currency swap
7.11
4
– Differential Swaps
 For example, for an amount of notional principal in USD,
exchange LIBOR in USD with LIBOR in yen
 Note that theoretically the LIBOR in yen should be applied
to the principal in yen rather than the principal in USD
 It is also known as quanto swap (匯率保障交換)
 Other types of swaps
– Equity swaps
 Exchange the total return (dividends plus capital gains)
realized on an equity index for either a fixed or a floating IR
 Used by portfolio managers to purchase a series of equity
index returns with a fixed or floating IR
 Useful to escape from the capital controls of some nations 7.11
5
– Commodity swaps
 An agreement where a floating (or market or spot) price
based on an underlying commodity is exchanged for a
fixed price for a following period
 It can be decomposed into a series of forward contracts on
a commodity with different maturity dates and identical
delivery price
– Volatility swaps
 Volatility is defined as the standard deviation of the rates of
return of the underlying asset price in a reference period
 At the end of each reference period, one side pays
principal × pre-agreed volatility (e.g., 20%), and the other
side pays principal × the actual volatilities (e.g., 23%) in
the past reference period 7.11
6
Mechanics of Options
Markets
Chapter 9
9.11
7
Goals of Chapter 9
 Introduce different types of options

– Including call and put options, European vs.
American options, and options with different
underlying assets
 The items in the contracts of stock options
 Details of trading options on exchanges
 Introduce three option-like instruments
– Warrants (權證), employee stock options
(員工股票選擇權), and convertible bonds
(可轉換公司債)
9.11
8
9.1 Different Types of
Options
9.11
9
Types of Options
 Two basic types of options

– A call (買權) (put (賣權)) option gives the option
holder the right to buy (sell) an asset at a certain
price by a certain date
– The date specified in the contract is known as the
expiration date or the maturity date (到期日)
– The price specified in the contract is known as the
exercise price or the strike price (執行價)
 European vs. American options
– A European (歐式) option can be exercised only at
the end of its life, i.e., on the maturity date
– American (美式) options can be exercised at any time9.12
0
Types of Options
 Options vs. Forward and Futures

1. An option gives holders the right to do something, but
holders do not have to exercise this right
 In forwards or futures, the two parties have committed
themselves to do some action in the future
2. Purchase of an option requires an up-front payment
 Forwards or futures costs a trader nothing (except for the
margin requirements) when they are initiated
 Special assumption in this chapter
– The time value of money is not considered to calculate
the option profit, which equals the final payoff (received
at the end of the option life) minus the cost of the
option (paid in the beginning of the option life) 9.12
1
Option Positions
 Four positions for option traders

– Long call
– Long put
– Short call
– Short put
※The term of “long” means to buy options, and the
term of “short” means to sell or issue (or write) (發
行) options
– The writer of an option receives cash up front but has
potential liabilities later
– The holder of an option pay the up front cost to acquire
the option with a right to do something in the future 9.12
2
Profit of Longing a Call
– Profit at maturity for buying one European call
option: option price = $5, strike price = $100,
option life = 4 months
30 Profit ($)
20
10 Terminal
70 80 90 100 stock price 𝑆 ($)
0
45°
–5 110 120 130
※ Note that as long as 𝑆 is higher (lower) than the strike price, the call
holder should (should not) exercise this option
※ Since the cost to acquire the call option is $5, the call holder earn a
positive profit when 𝑆 is higher than (strike price + $5) 9.12
3
Profit of Shorting a Call
– Profit from writing the same European call option:

option price = $5, strike price = $100, option life =
4 months
Profit ($)
5 110 120 130

45°
0
70 80 90 100 Terminal
–10 stock price 𝑆 ($)
–20
–30
※ When 𝑆 is lower than the strike price, the call holder gives up his right and
thus the option writer can earn the whole $5 of option price
※ If this call is exercised, the maximum losses of the call writer are unlimited
※ The call writer’s profit or loss is the negative of that for the call holder 9.12
4
Profit of Longing a Put
– Profit from buying a European put option: option

price = $7, strike price = $70, option life = 3
months
Profit ($)
30
20
10 Terminal
stock price 𝑆 ($)
0
40 50 60 70 80 90 100
45°
–7
※ Note that as long as 𝑆 is lower (higher) than the strike price, the put
holder should (should not) exercise this option
※ Since the cost to acquire the put option is $7, the put holder earn a
positive profit when 𝑆 is lower than (strike price – $7) 9.12
5
Profit of Shorting a Put

– Profit from writing the same European put option:
option price = $7, strike price = $70, option life = 3
months
Profit ($)
7 °
Terminal
40 50 60 45 stock price 𝑆 ($)
0
70 80 90 100
–10
–20
–30
※ The put writer’s profit or loss is the negative of that for the put holder
※ The put writer’s profit declines when the stock price falls below the strike price
($70), and the breakeven point for the put writer is $63 (=$70 – $7) 9.12
6
Payoff Functions of European
Options
– Payoff is the final payment at maturity. The
deduction of the option price is not necessary
Payoff of longing a call Payoff of longing a put
ST ST
K K
※ Note the opposite
max(𝑆 − 𝐾, 0) max(𝐾 − 𝑆 , 0) relationship
between the payoff
Payoff of shorting a call functions of the
Payoff of shorting a put option holder and
writer
K K
ST ST
−max(𝑆 − 𝐾, 0)
−max(𝐾 − 𝑆 , 0) 9.12
7
Types of Options
 Several exchange-traded options

– Stock options (個股選擇權)
 Most stock options are traded on exchanges
 In the U.S., one stock options gives the holder the right to
buy or sell 100 shares of stock at the specified strike price
 In the U.S., exchange-traded stock options are American-
style options
– Foreign currency options (外幣選擇權)
 Most currency options trading occurs in OTC markets, but
there is some exchange trading
 In the U.S., NASDAQ OMX offers European-style option
contracts on a variety of different currencies
 One option contract is for trading10,000 units of a foreign
currency (for 1,000,000 units of Japanese yen) 9.12
8
Types of Options
– Index options (指數選擇權)

 The most popular exchange-traded option contracts in the
U.S. are the index options on S&P 500 index, S&P100
index , NASDAQ-100 index, and Dow Jones Industrial
Average Index
 All are traded on Chicago Board Options Exchange
 Most index options are European
– An exception is the index option on S&P 100 index
 One index option contract is to buy or sell, for example
100, times the index at the specified strike price
– Consider a call option with a strike price of 980, which is
exercised when the index value is 992. The option writer
pays the option holder max(992 – 980,0) × $100 = $1,200
9.12
9
Types of Options
– Futures options (期貨選擇權)

 Notations: the strike price is 𝐾, the maturity date for the
futures option is 𝑇, the maturity date for the underlying
futures is 𝑇 (> 𝑇), and the futures price at 𝑇 is 𝐹
 Call futures option: when 𝐹 > 𝐾, the holder exercises his
right and receive a long position in the underlying futures
contract plus a cash amount equal to (𝐹 −𝐾)
 Put futures option: when 𝐹 < 𝐾, the holder exercises his
right and receive a short position in the underlying futures
contract plus a cash amount equal to (𝐾 − 𝐹 )
 Note that the futures contract received by the option holder
at 𝑇 is worth zero because the zero-value futures is always
the case when it is initiated
※ If option holders close out the futures position immediately
by entering into an offsetting position, they can finish the
transaction completely and earn the received cash amount 9.13
0
Types of Options
 When an exchange trades a futures contract on commodity

assets, it often trades options on that futures contract, e.g.,
futures and futures option on corn offered by CME Group
 Reasons to trade options on futures rather than options on
the underlying commodity asset
1. A futures contract is often more liquid than its underlying asset
2. The futures option is settled in cash (plus a futures position)
rather than settled by physical delivering
(Options on commodity assets often need physical delivering)
(Most futures contracts are closed out prior to delivery, so it is
not necessary to concern the delivery options and also delivery
costs for physical delivering can be saved)
3. To make futures options more competitive, futures options often
entail lower transaction costs than options on commodity assets
9.13
1
9.2 Trading Options on

Exchanges
9.13
2
Trading Options on Exchanges
 In this section takes stock options in the U.S. for

example to explain details of option trading
 Items in option contracts
– Expiration date (or maturity date) (到期日)
 The last trading day is the third Friday of the expiration month
 The expiration date is the Saturday immediately following the
last trading day
 Option holders can instruct their brokers to exercise the
option until 4:30 p.m. Central Time on the last trading day
 Brokers should complete the paperwork and notify the
exchange about the exercise before 10:59 p.m. on the
expiration day
9.13
3
 Stock options are issued on a January, February, or March

cycle
– The January cycle months consists of Jan., Apr., July, and Oct.
(similar for February and March cycles)
1. If the expiration date in the current month has not yet been
reached, options trade for the current month (until the expiration
date), the following month, and the next two months in the cycle
2. If the expiration date in the current month has passed, options
trade for the next month, the next-but-one month, and the next
two months in the cycle
– When one option expires, trading in another month option is
started such that the above two rules can be satisfied
※ Note that exchanges can use their own rules to decide which
options expired in different months can be traded, e.g., an
exchange may consider the next three cycle months 9.13
4
– Strike price
 For each maturity, there is a series of strike prices spaced
$2.5 (for stock prices between $5 and $25), $5 (for stock
prices between $25 and $200), or $10 (for stock prices
above $200) apart
 When options with a new expiration month debuts (首次出
現), the two or three strike prices closest to the current
stock price are selected as the strike prices for the option
contracts by the exchange
– If the stock price moves outside the range, a new strike price is
introduced to extend the range to cover the stock price
– Suppose the stock price is $82, the initial strike prices for
options may be $80, $85, $90. If the stock price rises above
$90 (declines below $80), the option with the strike price of $95
($75) is initiated 9.13
5
– European or American
 In Taiwan, index option and stock options are European-
style options, but warrants (introduced later) in Taiwan are
American-style options
※ Some terminologies
 Option class
– All options of the same type (either calls or puts) are referred to
as an option class
 Option series
– Consist of all the options of a given class with the same
expiration date and strike price
– In other words, an option series refers to a particular contract
that is traded
9.13
6
 Intrinsic value (內含價值) vs. Time value (時間價值)

– The intrinsic value of an option is defined as the maximum
between zero and the payoff of the option if it were exercised
immediately
 For calls, the intrinsic value is max 𝑆 − 𝐾, 0
 For puts, the intrinsic value is max 𝐾 − 𝑆 , 0
※ An American-style option is worth at least as much as its intrinsic
value because the option holder always can realize the intrinsic
value by exercising the option immediately
– Option value = Time value + Intrinsic value
– Example: If the current stock price 𝑆 is $110 and the strike
price 𝐾 is $100, a call is worth $12, which can be decomposed
as $2 (time value) and $(110 – 100) = $10 (intrinsic value)
9.13
7
 Moneyness (價值狀況)
– In the money (ITM) (價內): Options are referred to as in the
money if they have positive intrinsic values, i.e., 𝑆 > 𝐾 for
calls and 𝑆 < 𝐾 for puts
– Out of the money (OTM) (價外): Options are referred to as
out of the money if they have zero intrinsic value, i.e., 𝑆 <
𝐾 for calls and 𝑆 > 𝐾 for puts
– At the money (ATM) (價平): 𝑆 = 𝐾 for both calls and puts
※ An ITM option will always be exercised on the expiration
date (𝑇), i.e., if 𝑆 > 𝐾 for calls or 𝑆 < 𝐾 for puts, those
options will always be exercised
9.13
8
– Anti-dilution provisions (防稀釋條款)

 Adjustment for cash dividends
– Some OTC options are cash dividend protected
 If a company declares a cash dividend, the strike price for options
on the company’s stock is reduced on the ex-dividend day (付息
日) by the amount of the cash dividend
– Most exchange-traded options in the U.S. are not adjusted in
response to cash dividends payment (It reduces values of
exchange-traded options)
 Adjustment for 𝑛-for-𝑚 stock split or stock dividends
– An 𝑛-for-𝑚 stock split is to use 𝑛 newly-issued stock shares to
exchange for 𝑚 outstanding stock shares
– A 20% stock dividend is equivalent to a 6-for-5 stock split
because shareholders receive 0.2 additional shares for each
1 share owned 9.13
9

– Since the effect of stock split and paying stock dividends is to
issue more shares to replace existing shares, there is no
impact on the asset value or the earning ability of a company
– An 𝑛-for-𝑚 stock split or stock dividends should cause the
stock price to go downward to 𝑚/𝑛 of its previous value
– Two terms in option contracts are adjusted to offset expected
changes in a stock price arising from a stock split or a payment
of stock dividends
 The strike price is reduced to 𝑚/𝑛 of its previous value
 The number of shares covered by one options is increased to 𝑛/𝑚
of its previous value
※ In Taiwan, both warrants and stock options have provisions of both
cash- and stock-dividend protection
※ Index options in Taiwan are stock-split and stock-dividend protected
– Even there is no explicit clauses of adjustments for stock splits and stock
dividends in index option contracts in Taiwan
– This is because the index level remains the same before and after stock
splits and distributions of stock dividends in Taiwan 9.14
0
※ Consider a call option to buy 100 shares for the

strike price to be $20/share
 How should terms be adjusted:
– For a 2-for-1 stock split?
 The strike price is reduced to $10 (=$20 × (1/2))
 The number of shares covered by one options is 200 (=100 ×
2)
– For a 25% stock dividend?
 It is equivalent to a 5-for-4 stock split
 The strike price is reduced to $16 (=$20 × (4/5))
 The number of shares covered by one options is 125 (=100 ×
(5/4))
9.14
1
 Position and exercise limits

– A position (exercise) limit defines the maximum
number of option contracts that an investor can hold
(exercise) on one side of the market
 Prevent from being unduly influenced by one investor
 Long calls and short puts are treated to be on the same side
of the market (bull’s view)
 Short calls and long puts are treated to be on the same side
of the market (bear’s view)
 The exercise limit usually equals the position limit
 Determined by the number of understanding shares and
trading volume associated with each underlying stock
 For the largest and most frequently traded underlying stocks,
the position limit can be 250,000 contracts on CBOE 9.14
2
 Commissions (佣金): charged by a broker and

calculated as a fix cost plus a proportion of the
dollar amount of the trade of options
– The commission is charged both when an option
position is initiated and when it is closed out by
entering into an offsetting trade
– For retail investors, a commission schedule is
Dollar amount < $2,500 $2,500 to $10,000 > $10,000
of trade
Commission $20 + 0.02 of $45 + 0.01 of dollar $120 + 0.0025 of
dollar amount amount dollar amount
 Maximum (minimum) commission is $30 per contracts for

the first 5 contracts plus $20 ($2) for each additional contract
9.14
3
 Note that if the option is exercised, the option holders need

to pay the commission for trading the underlying shares,
which is a proportion, e.g., 1.5%, of the trade amount on
the underlying shares
 The commissions for trading options vary significantly for
different brokers and nations
9.14
4
 Market Makers (造市者)

– Most exchanges use market makers to facilitate
options trading
 The market makers are always ready to trade options with
other traders and thus enhance liquidity to the market
– A market maker quotes both bid and offer prices
when requested
 The bid (offer) is the price at which the market maker is
prepared to buy (sell) the options
 The offer is always higher than the bid, and the bid-offer
spread is the source of the profit for market makers
 Thus, the bid-offer spread is a hidden cost for option
traders 9.14
5
 Margins (保證金)
– In the U.S., when stock shares are purchased, an
investor can either pay cash or borrow using a
margin account (this is known as buying on margin)
– For options, buying on margin is not always
allowed
 When options with maturities less than 9 months, the
option price must be paid in full
 For options with maturities longer than 9 months, investors
can buy on margin, borrowing up to 25% of the option price
※ The limit of buying on margin is because options already
contain substantial leverage and it is inappropriate to
further raise this leverage with buying on margin 9.14
6
– For option writers, it is required to maintain funds in a

margin account to minimize their default risk
 The required margin amount for writing a naked option is
the greater of the following two quantities:
1. A total of 100% of the proceeds of the sale plus 20% of the
underlying share price less the amount (if any) by which the
option is out of the money
2. A total of 100% of the proceeds of the sale plus 10% of the
underlying share price for calls (10% of the strike price for puts)
※ A naked option is an option that is not combined with an
offsetting position in the underlying asset initially (an example of
a non-naked option is shown on the next slide)
※ The margin required by brokers can be higher than but no less
than the amount calculated in the above process
9.14
7
※ The above calculation are performed everyday (but with the

prevailing prices of options and the underlying asset instead) to
determine daily required margins
※ For index options, the 20% is replaced by 15% because a stock
index is usually less volatile than the price of an individual stock
※ For other trading strategies, such as covered calls, protective puts,
spreads, combinations, straddles, and strangles, the CBOE
defines special rules for determining the margin requirements (The
option trading strategies will be introduced in Ch. 11)
– For example, a covered call is a written call option when the shares that
might have to be delivered are already owned by the call writer
– Therefore, the worst scenario for the writer of a covered call is to sell
the shares he owns at the strike price when the call is exercised by the
call holder
– Since the default risk of the writer of covered calls is minor, there is no
margin requirements for writing covered calls 9.14
8
 The Options Clearing Corporation (選擇權結算

公司, OCC)
– The OCC plays the same role in option markets as
the clearing house does in futures market (see Ch. 2)
 Funds to purchase an option must be deposited with the
OCC by the morning of the business day following the trade
 The OCC records all long and short positions
 The OCC has a number of members, and all options trades
must be cleared through its members
– Hierarchy of the required margin for writing options:
 Option writers maintains a margin account with a broker
 The broker maintains a margin account with a OCC member
 The OCC member maintains a margin account with the OCC 9.14
9
– Clearing process of exercising options:

 When a trader notifies a broker to exercise an option, the
broker in turn notifies the OCC member which will place an
exercise order with the OCC
 The OCC randomly selects a member with an outstanding
short position in the same option, and that member selects a
particular trader who has written the option according to
some pre-specified rules
※ In the U.S., the Commodity Futures Trading
Commission is responsible for regulating markets for
options or futures
9.15
0
 Taxation issues for options

1. When the option position is closed out or expires
unexercised
 The gains and losses from the trading of stock options are
taxed as capital gains or losses
2. When the option is exercised
 The gain or loss from the option is rolled into the position
taken in the stock and recognized when the stock position is
closed out
– For the holder who exercises a call (For the call writer), he can
acquire a long (short) position in the underlying stock at the
strike price plus the call price
– For the holder who exercises a put (For the put writer), he can
acquire a short (long) position in the underlying stock and the
net income (cost) equals the strike price less the put price 9.15
1
Trading Options in OTC Market
 Trading options in OTC markets

– The OTC market for options has become
increasingly important since the early 1980s and is
now larger than the exchange-traded market
– OTC options on foreign exchange and interest rates
are particularly popular
– The advantage of OTC options is that they can be
custom-made to meet the precise needs of investors
– The disadvantage of OTC options is that option
writer may default
 To overcome this disadvantage, option writers are
sometimes required to post collateral 9.15
2
9.3 Warrants, Employee
Stock Options, and
Convertible Bonds
9.15
3
Warrants, ESOs, and CBs
 Warrants, employee stock options (ESOs), and

convertible bonds (CBs) are financial
instruments similar to options
– Warrant (權證):
 Warrants are options issued by financial institutions or
nonfinancial corporations
 The warrant issuer settles up with the warrant holder when
a warrant is exercised
 A financial institution might issue put warrants (認售權證) on
gold and then to proceed to create a market (by offering bid
and asked prices) for trading these warrants
 The warrants issued by financial institutions can be traded
on an exchange or in an OTC market, and the issuing
financial institution acts as the market maker for this warrant9.15
4
 A common use of warrants by a nonfinancial corporation is

to issue call warrants (認購權證) on its own stock and
attaches them to the bond issue
– To make the corporate bond more attractive to investors
– To reduce the coupon rate of the corporate bond and thus
save the funding cost
– Employee stock option (ESO) (員工股票選擇權):
 ESOs are call options issued to employees by their
company to align the interests between the employees and
the shareholders
 Usually are issued to be at the money at the time of issue
– If the performance of the company is improved and thus the
share price rises, the ESO becomes in the money and brings
profit for employees 9.15
5
 ESOs cannot be exercised within a period of time (usually

1 to 4 years)
 ESOs cannot be sold to others
 ESOs can last for as long as 10 or 15 years
 Today, they are recorded as expenses at the fair market
value of the ESO in the company’s income statement in
most nations (rather than recorded as the distribution of
the stock dividends in the balance sheet in the past)
– This accounting principle makes ESOs a less attractive form
of compensation than they used to be
 Classified as the expense: affect the income statement and thus
the net worth the of firm on the balance sheet
 Classified as the stock dividends: affect the number of outstanding
shares and the net worth per share of the firm on the balance
sheet (it does not affect the net worth of the firm) 9.15
6
– Convertible bond (CB) (可轉換公司債)

 CBs are bonds issued by a company that can be converted
into equity at certain time points using a predetermined
conversion ratio
 Note that CBs are different from bonds with an attached
call warrant on the company’s stock
– This is because you cannot separate the conversion right
clearly from a CB
 Very often a convertible is callable (可贖回)
 The call-back provision is a way in which the issuer can
force the conversion at a time point earlier than the holder
might otherwise choose
– CB holders can choose to exercise the conversion right after
receiving the call back notification 9.15
7
– Different from the options traded on exchanges, the

numbers of outstanding warrants, ESOs, and CBs are
predetermined on the issue day
 The numbers of outstanding warrants, ESOs, and CBs are
determined by the size of the original issue and decrease
when they are exercised or when they expire
 In contrast, as more people trade a particular option series
on an exchange, the number of outstanding exchanged-
traded options increases
9.15
8
– When these three instruments are exercised, the

company issues more shares of its own stock and
sells the stock shares to the option holder for the
strike (or conversion) price
 Thus, the exercise of these three instruments leads to an
increase in the number of outstanding shares of the issuing
company
 Note that the above statement is not true for warrants issued
by financial institutions
– As warrant writers, financial institutions need to buy or sell
underlying assets from markets for settlement
9.15
9
Properties of Stock
Options
Chapter 10
10.1
60
Goals of Chapter 10
 Six impacting factors of option prices

– Include the current stock price, strike price, time to
maturity, volatility of the stock price, risk-free
interest rate, and paid-out dividends
 Identify the upper and lower bounds for
European- and American-style option prices
 Introduce the put-call parity (買賣權平價公式)
 The optimal early exercise (提早履約) decision
 Consider the effect of dividend payments on
– Upper and lower bounds of option prices, the put-
call parity, and the early exercise decision 10.1
61
10.1 Factors Affecting

Option Prices
10.1
62
Notation
𝑐: European call option price 𝐶: American call option price

𝑝: European put option price 𝑃: American put option price
𝑆 : Current stock price 𝑆 : Stock price at option
maturity
𝐾: Strike price 𝐷: Dividends that are expected
to be paid during option’s
life
𝑇: Life of option 𝑟: Risk-free rate for maturity T
with continuously
compounding
𝜎: Volatility of the stock price
10.16
3
Sensitivity Analysis on Option

Prices
Factors 𝑐 𝑝 𝐶 𝑃
𝑆 + – + –
𝐾 – + – +
𝑇 ? ? + +
𝜎 + + + +
𝑟 + – + –
𝐷 – + – +
※ Note that the European call (put) value can be derived as
𝑐=𝑒 𝐸[max(𝑆 − 𝐾, 0)] (𝑝 = 𝑒 𝐸[max(𝐾 − 𝑆 , 0)])
※ The American call (put) value can be derived as
𝐶 = 𝐸[𝑒 max(𝑆 − 𝐾, 0)] (𝑃 = 𝐸[𝑒 max(𝐾 − 𝑆 , 0)]),
where 𝜏 is the time point to exercise American options 10.1
64
Effect of Factors on Option
Pricing
 Stock price 𝑆 ↑
– For both European and American calls, prob. of being
ITM ↑ and thus call values ↑
– For both European and American puts, prob. of being ITM
↓ and thus put values ↓
*𝐾 = 50, 𝑟 = 5%, 𝜎 = 30%, 𝐷 = 0, and 𝑇 = 1 10.1

65

Pricing
 Strike price 𝐾 ↑
– For both European and American calls, prob. of being
ITM ↓ and thus call values ↓
– For both European and American puts, prob. of being ITM
↑ and thus put values ↑
*𝑆 = 50, 𝑟 = 5%, 𝜎 = 30%, 𝐷 = 0, and 𝑇 = 1 10.1

66
Pricing
 Time to maturity 𝑇 ↑
– For American options, the holder of the long-life option has all
the exercise opportunities open to the holder of the short-life
option–and more  The long-life American option must be
worth as least as the short-life American option
– European calls and puts generally (not always) become more
valuable as the time to expiration increases
*𝑆 = 50, 𝐾 = 50, 𝑟 = 5%, 𝜎 = 30%, and 𝐷 = 0 10.1

67

Pricing
– For European calls,
 Suppose two European call options, 𝑐 and 𝑐 , on a stock with the
same 𝐾 and with different maturity 𝑇 and 𝑇 (> 𝑇 )
 If there is a cash dividends paid in [𝑇 , 𝑇 ], the stock price
declines on the dividend payment date so that the short-life call
𝑐 could be worth more than the long-life call 𝑐
– For deeply ITM European put options, short-life put 𝑝 (with 𝑇
time to maturity) could be worth more than the long-life put 𝑝
(with 𝑇 time to maturity)
 Note that the put value can be derived as 𝑒 𝐸[max(𝐾 − 𝑆 , 0)]
 Consider an extreme case in which the stock price is close to 0
so that 𝑆 can be almost ignored when calculating payoffs of puts
 The option values of the above two put options are 𝑝 =
𝑒 𝐸 𝐾−0 =𝑒 𝐾 and 𝑝 = 𝑒 𝐸 𝐾−0 =𝑒 𝐾⇒𝑝 >
𝑝 (an inverse relationship between put values and 𝑇) 10.1
68
Pricing
 Volatility 𝜎 ↑
– The prob. that the stock perform very well or poor increases
– For calls (puts) which have limited downside (upside) risk, call
(put) holders benefit from the more prob. of high (low) prices 
option value ↑ when 𝜎 ↑
*𝑆 = 50, 𝐾 = 50, 𝑟 = 5%, 𝐷 = 0, and 𝑇 = 1 10.1

69

Pricing
 Risk-free rate 𝑟 ↑
– The expected return of the underlying asset ↑, and the
discount rate ↑ such that the PV of future CFs ↓
– For calls, option value ↑ because the higher expected 𝑆 and
the higher prob. to be ITM dominate the effect of lower PVs
– For puts, option value ↓ due to the higher expected 𝑆 , the
lower prob. to be ITM, and the effect of lower PVs
*𝑆 = 50, 𝐾 = 50, 𝜎 = 30%, 𝐷 = 0, and 𝑇 = 1 10.1

70
Pricing
 Dividend payment ↑
– Dividends have the effect of reducing the stock price on
the ex-dividend date (除息日)
– For calls, prob. of being ITM ↓ and thus call values ↓
– For puts, prob. of being ITM ↑ and thus put values ↑
10 Call 10 Put
option option
price, c price, p
8 8
6 6
4 4
2 2
Dividends, D Dividends, D
0 0
0 2 4 6 8 10 0 2 4 6 8 10
* 𝑆 = 50, 𝐾 = 50, 𝑟 = 5%, 𝜎 = 30%, and 𝑇 = 1 10.1

71
10.2 Upper and Lower

Bounds for Option
Prices
10.1
72
Upper and Lower Bounds for
Option Prices
 Some assumptions
– There are no transactions costs
– The tax rate issue is ignored in this chapter
 However, all results in this chapter hold when all
trading profits (net of trading losses) are subject
to the same tax rate
– Borrowing and lending are always possible
at the risk-free interest rate
– There is no dividends payment during the
option life
 In the last section of this chapter, this constraint
will be released 10.1
73

Option Prices
 Upper bounds for the European and
American call and put
Upper bound for call Upper bound for put
American 𝐶≤𝑆 𝑃≤𝐾
European 𝑐 ≤ 𝑆 (𝑐 ≤ 𝐶) 𝑝 ≤ 𝐾𝑒 (𝑝 ≤ 𝑃)
※ Since both American and European calls grant the holders the right
to buy one share of a stock for a certain price, the option can never
be worth more than the value of the stock share today
※ An American put grants the holder the right to sell one share of a
stock for 𝐾 at any time point, so the option value today can never be
worth more than 𝐾
※ For a European put, since its payoff at maturity cannot be worth
more than 𝐾, it cannot be worth more than the PV of 𝐾 today
※ An American option is worth at least as much as the corresponding
European option, so 𝑐 ≤ 𝐶 and 𝑝 ≤ 𝑃 10.17
4
Option Prices
 Lower bounds for European calls and puts
Lower bound for call Lower bound for put
European 𝑐 ≥ max(𝑆 − 𝐾𝑒 , 0) 𝑝 ≥ max(𝐾𝑒 − 𝑆 , 0)
– The lower bound for European calls

 Portfolio A: one European call option plus a zero-coupon
bond that provides a payoff of 𝐾 at time 𝑇
– If 𝑆 > 𝐾 at 𝑇, the call is exercised and one stock share is
purchased with the principal of the bond  Portfolio A is worth 𝑆
– If 𝑆 ≤ 𝐾 at 𝑇, the portfolio holder receives the repayment of the
principal of the bond  Portfolio A is worth 𝐾
 Portfolio A is worth max(𝑆 , 𝐾) at 𝑇
 Portfolio B: one share of the stock  worth 𝑆 at 𝑇
※ Portfolio A is more valuable than Portfolio B  𝑐 + 𝐾𝑒 ≥
𝑆  𝑐 ≥ 𝑆 − 𝐾𝑒 10.17
5

Option Prices
– Is there any an arbitrage opportunity if 𝑐 = 3, 𝑆 = 20,
𝐾 = 18, 𝑟 = 10%, 𝐷 = 0, and 𝑇 = 1?
 Since the call price violates the lower bound constraint
($20 − $18𝑒 . = $3.71) , the following strategy can
arbitrage from this distortion
– Buy the underestimated call and short one share of stock 
Generate a cash inflow of $20 – $3 = $17
– Deposit $17 at 𝑟 = 10% for one year  Generate an income of
$17𝑒 % = $18.79 at the end of the year
– If 𝑆 > $18, exercise the call to purchase one share of stock at
$18 and close out the short position  The net income is
$18.79 – $18 = $0.79
– If 𝑆 < $18, give up the right of the call, purchase 1 share at 𝑆
in the market, and close out the short position  The net
income is $18.79 – 𝑆 , which must be higher than $0.79 10.17
6
Option Prices
– The lower bound for European puts
 Portfolio C: one European put option plus one share
– If 𝑆 ≤ 𝐾 at 𝑇, the put is exercised and sell the one share of
stock owned for 𝐾  Portfolio C is worth 𝐾
– If 𝑆 > 𝐾 at 𝑇, the put expires worthless  Portfolio C is worth
𝑆
 Portfolio C is worth max(𝑆 , 𝐾) at 𝑇
 Portfolio D: an amount of cash equal to 𝐾𝑒 (or
equivalently a zero-coupon bond with the payoff 𝐾 at time
𝑇)
※ Portfolio C is more valuable than Portfolio D  𝑝 + 𝑆 ≥
𝐾𝑒  𝑝 ≥ 𝐾𝑒 −𝑆
10.17
7

Option Prices
– Is there any arbitrage opportunity if 𝑝 = 1, 𝑆 = 37,
𝐾 = 40, 𝑟 = 5%, 𝐷 = 0, and 𝑇 = 0.5?
 Since the put price violates the lower bound constraint
($40𝑒 . . − $37 = $2.01) , the following strategy can
arbitrage from this distortion
– Borrow $38 at 𝑟 = 5% for 6 months  Need to pay off
$38𝑒 % . = $38.96 after half a year
– Use the borrowing fund to buy the underestimated put and one
share of stock
– If 𝑆 > $40, discard the put, sell the stock for 𝑆 , and repay the
loan  The net income is 𝑆 – $38.96 > 0
– If 𝑆 < $40, exercise the right of the put to sell the share of
stock at $40 and repay the loan  The net income is $40 –
$38.96 = $1.04 10.1
78
Option Prices
 Lower bounds for American calls and puts
Lower bound for call Lower bound for put
American 𝐶 ≥ max(𝑆 − 𝐾, 0) 𝑃 ≥ max(𝐾 − 𝑆 , 0)
– The lower bounds for American calls and puts are

their current exercise value
 Because the holders of them always can exercise them to
obtain the current exercise value
– American options are worth at least as much as
zero
 Because the option holder has only the right but no
obligation to exercise the option
10.17
9
10.3 Put-Call Parity

(買賣權平價公式)
10.1
80
Put-Call Parity
 Recall Portfolios A and C just mentioned:

– Portfolio A: 1 European call option plus a zero-
coupon bond that provides a payoff of 𝐾 at time 𝑇
– Portfolio C: 1 European put plus 1 share of the stock
Portfolio A 𝑺𝑻 > 𝑲 𝑺𝑻 ≤ 𝑲
Call option 𝑆 −𝐾 0
Zero-coupon bond 𝐾 𝐾
Total 𝑆 𝐾
Portfolio C 𝑺𝑻 > 𝑲 𝑺𝑻 ≤ 𝑲
Put option 0 𝐾−𝑆
1 share of stock 𝑆 𝑆
Total 𝑆 𝐾
10.1
81
Put-Call Parity
– Due to the law of one price, Portfolios A and C

must therefore be worth the same today
𝑐 + 𝐾𝑒 =𝑝+𝑆
– The above equation is known as the put-call parity
 The put-call parity defines a relationship between the
prices of a European call and put option, both of which
are with the identical 𝐾 and 𝑇
– Is there any arbitrage opportunity if 𝑝 = 1 or 𝑝 =
2.25 given 𝑐 = 3, 𝑆 = 31, 𝐾 = 30, 𝑟 = 10%, 𝐷 = 0,
and 𝑇 = 0.25?
 The theoretical price of the put option is 1.26 by solving
3 + 30𝑒 . . = 𝑝 + 31
 The arbitrage strategies for 𝑝 = 2.25 and 𝑝 = 1 are
shown in the following table 10.1
82
Put-Call Parity
※ Rewrite the put-call parity: 𝑐 + 𝐾𝑒 = 𝑝 + 𝑆 ⇒ 𝑐 + 𝐾𝑒 − 𝑆 = 𝑝,

based on which it is simpler to identify the arbitrage opportunity
Three-month put price = $2.25 Three-month put price = $1
(Long 𝑐 + 𝐾𝑒 − 𝑆 and short 𝑝) (Short 𝑐 + 𝐾𝑒 − 𝑆 and long 𝑝)
Buy the call at $3, short the stock to Short the call to realize $3, buy the
realize $31, and short the put to realize stock at $31, buy put at $1, and borrow
$2.25  Deposit the net cash flow $29 at 10% for 3 months  The net
$30.25 at 10% for 3 months cash flow is 0
If 𝑆 > 30 after 3 months: If 𝑆 > 30 after 3 months:
Receive $31.02 from the deposit, The call is exercised and thus need to
exercise the call to buy the stock at $30 sell the stock for $30, and use $29.73
 Net profit = $1.02 to repay loan  Net profit = $0.27
If 𝑆 < 30 after 3 months: If 𝑆 < 30 after 3 months:
Receive $31.02 from the deposit, the Exercise the put to sell the stock for
put is exercised and thus need to buy $30, and use $29.73 to repay loan 
the stock at $30  Net profit = $1.02 Net profit = $0.27
10.1
83
Put-Call Parity
 Extension of the put-call parity for the

American call and put
𝑆 − 𝐾 ≤ 𝐶 − 𝑃 ≤ 𝑆 − 𝐾𝑒
– Identify the upper and lower bounds of 𝑃 given
𝐶 = 1.5, 𝑆 = 19, 𝐾 = 20, 𝑟 = 10%, 𝐷 = 0, and
𝑇 = 5/12
19 − 20 ≤ 1.5 − 𝑃 ≤ 19 − 20𝑒 . /
⇒ 1.68 ≤ 𝑃 ≤ 2.50
10.1
84
10.4 Optimal Early Exercise
Decision (最佳提早履約
決策)
10.18
5
Early Exercise
 American options could be exercised early

– Early exercise occurs when (option value) < (exercise
value), where option value reflects the PV of holding
all future exercise opportunities
– Early exercise occurs only when American options
are ITM
 American calls on a non-dividend paying stock
should never be exercised early
∵ 𝑐 ≥ 𝑆 − 𝐾𝑒 and 𝐶 ≥ 𝑐
∴ 𝐶 ≥ 𝑐 ≥ 𝑆 − 𝐾𝑒 ≥ 𝑆 − 𝐾 = exercise value
 It is not optimal to exercise American call
option if there is no dividend payments 10.1
86
Early Exercise
 So, American calls are equivalent to European

calls if there is no dividend payment
max 𝑆 − 𝐾𝑒 , 0 ≤ 𝑐, 𝐶 ≤ 𝑆
(based on Slides 10.15 (upper bounds) and 10.16 (lower
bounds))
𝑆
𝐾𝑒
10.1
87
Intuitions for Not Early Exercising

American Calls without
 For a deeply ITM American call option: 𝐶 = 42,
𝑆 = 100, 𝐾 = 60, 𝑇 = 0.25, and 𝐷 = 0
– Should you exercise the call immediately if
1. You intend to hold the stock for the next 3 months?
 No, it is better to delay paying the strike price 3 months later
2. You still want to hold the stock but you do not feel that the
stock is worth holding for the next 3 months?
 No, it is possible to purchase the stock at a price lower than 𝐾 =
60 after 3 months
3. You decide to sell the stock share immediately after the
exercise?
 No, selling the American call for $42 is better than undertaking the
above strategy, which is with the payoff of $100 – $60 = $40 10.1
88
Early Exercise
 A summary of reasons for not exercising an

American call early if there are no dividends
– Due to no dividends, no income is sacrificed if
you hold the American call instead of holding the
underlying stock shares
– Payment of the strike price can be delayed (Q1
on Slide 10.29)
– Holding the call provides the possibility that the
purchasing price could be lower than but never
higher than the strike price (Q2 on Slide 10.29)
– The payoff from exercising the American call is
lower than the payoff from selling the American
call directly (Q3 on Slide 10.29) 10.1
89
Early Exercise
 It can be optimal to exercise an American put

option on a non-dividend-paying stock early
∵ 𝑝 ≥ 𝐾𝑒 − 𝑆 and 𝑃 ≥ 𝑝
∴ 𝑃 ≥ 𝑝 ≥ 𝐾𝑒 −𝑆 ,
which is lower than the exercise price 𝐾 − 𝑆
 The relationship between the American put price, 𝑃,
and its exercise value, 𝐾 − 𝑆 , is uncertain
 For American puts, as long as their values 𝑃 are
lower than 𝐾 − 𝑆 , they are early exercised and the
option value rises to become 𝐾 − 𝑆
10.1
90
Early Exercise
 Geometric representation of the upper and

lower bounds for European and American puts
For European puts: For American puts
𝐾𝑒 ≥ 𝑝 ≥ max(𝐾𝑒 − 𝑆 , 0) 𝐾 ≥ 𝑃 ≥ max(𝐾 − 𝑆 , 0)
(based on Slides 10.15 and 10.16) (based on Slides 10.15 and 10.20)
𝑝
𝑆 𝑆
𝐾𝑒 𝐾𝑒 𝐾
※ Both the upper and lower bounds of American puts are higher than those
of European puts 10.19
1
Geometric Meaning of Early Exercise
max(𝐾 − 𝑆 , 0)
※ Since the lower bound for European
puts is max(𝐾𝑒 − 𝑆 , 0), it is
possible that 𝑝 < max(𝐾 − 𝑆 , 0)
max(𝐾𝑒 − 𝑆 , 0)
※ Whenever the value of an ITM

max(𝐾 − 𝑆 , 0) American put is lower than 𝐾 − 𝑆 ,
e.g., entering the region to the left of
points B and A, the put holder should
exercise the American put
※ Therefore, for these regions, the
option value curve should be replaced
by the curve of 𝐾 − 𝑆
※ Note that this replacement occurs at
any time point (not only time 0) during
the life of an American put 10.1
92
10.5 Effects of Dividend
Payments
10.19
3
Effects of Dividend Payments
 The no dividends assumption is unrealistic

– The underlying stocks of most exchange-traded
stock options are issued by large firms
– Large firms usually pay dividends periodically
(quarterly or annually)
– Denote 𝐷 to be the amount of dividend payment at
time 𝑡 (𝑡 < 𝑇) and 𝐷 = 𝐷𝑒 to be the PV of the
dividend payment
 If there are multiple dividend payments during the life of
the option, 𝐷 is the sum of the PV of these dividend
payments
10.1
94
 Similar to determining the forward (or future)

price, 𝐷 should be deducted from the current
stock price to derive the lower bounds and the
put-call parity of options
– The lower bounds for European calls and puts
𝑐 ≥ 𝑆 − 𝐷 − 𝐾𝑒 = 𝑆 − 𝐷 − 𝐾𝑒
𝑝 ≥ 𝐾𝑒 − 𝑆 −𝐷 = 𝐷 + 𝐾𝑒 −𝑆
– The put-call parity for European options
𝑐 + 𝐾𝑒 =𝑝+ 𝑆 −𝐷 ⇒ 𝑐 + 𝐷 + 𝐾𝑒 =𝑝+𝑆
– The put-call parity for American options
(𝑆 − 𝐷 ) − 𝐾 ≤ 𝐶 − 𝑃 ≤ 𝑆 − 𝐾𝑒
(The only exception for the rule of replacing 𝑆 with 𝑆 − 𝐷 is
the upper bounds of the put-call parity for American options) 10.1
95
 When dividends are expected, we can no

longer assert that an American call option will
not be exercised early
∵ 𝑐 ≥ 𝑆 − 𝐷 − 𝐾𝑒 and 𝐶 ≥ 𝑐
∴ 𝐶 ≥ 𝑐 ≥ 𝑆 − 𝐷 − 𝐾𝑒 ,
which is not necessarily larger than the exercise
value, 𝑆 − 𝐾
 It is inclined to exercise an American call
immediately prior to an ex-dividend date (美式
買權除息日前可能被提早履約)
– In fact, it is never optimal to exercise a call at any
other time points (discussed in Appendix of Ch. 13) 10.1
96
Trading Strategies
Involving Options
Chapter 11
11.1
97
Goals of Chapter 11
 Principal-protected notes (保本債券): a bond

plus options
 Three categories of trading strategies based on
options:
– Strategies involving a single European option and a
stock share
– Spread strategies: involving two or more European
options of the same type, i.e., using either European
calls or puts
– Combination strategies: involving both European
calls and puts
11.1
98
11.1 Principal-Protected
Notes (保本債券)
11.1
99
Principal-Protected Notes
 Principal-protected notes allow investors to take

a risky position without risking any principal
– The initial principal amount invested is not at risk
– The return earned by the investor depends on the
performance of the underlying asset of the option
involved
– For example, a $1000 investment consisting of
 A 3-year zero-coupon bond with a principal of $1000, which
is worth, for example, $1000𝑒 %× = $835.27 today
 A 3-year European call (or put) option on a stock portfolio
(assumed to be worth $164.73)
※ Principal guaranteed: the payoff is at least $1000 after 3
years 11.2
00
Principal-Protected Notes
– For issuing banks, in order to make profit, the actual

value of the involved option is lower than $164.73
 For example, the banks can choose a more OTM strike price
to reduce the cost for buying the option
– Is it better off if investors buy the considered options
and invest the remaining principal at the risk-free rate?
 Individual investors face wider bid-ask spreads on options
 The bank provides the service of bookkeeping and helping
settle the option
– Variations of principal-protected notes
 Investors’ maximal return could be capped (設定報酬上界)
 Use the average price instead of the final price to determine
the option payoff 11.2
01
11.2 Strategies Involving a

Single Option and a
Stock Share
11.2
02
Positions in a Call and The
Underlying Asset
(a) (b)
Profit Profit
K ST ST
※ Short a call and long a stock ※ Buy a call and short a stock
※ This strategy is known as writing a ※ The inverse of writing a covered
“covered call” (掩護性買權) call
※ This strategy can cover (or protect) the ※ Similar to the profit of longing a
risk of a sharp rise in the stock price for put (compared with Slide 9.9)
the call writer
※ This is because the call writer can sell
the stock to the call holder for 𝐾 if the
call is exercised at maturity
※ Similar to the profit of shorting a put
(compared with Slide 9.10) 11.2
03
Positions in a Put and The

Underlying Asset
(c) (d)
Profit Profit
K
ST K ST
※ Long a put and long a stock ※ Sell a put and short a stock
※ This strategy is known as a “protective ※ The inverse of a protective put
put” (保護性賣權) ※ Similar to the profit of shorting a
※ This strategy can cover (or protect) the call (compared with Slide 9.8)
stock position from the risk of the
decline in the stock price
※ The put holder can eliminate the
downside risk of the stock position by
exercising the put to sell the stock at 𝐾
※ Similar to the profit of longing a call
(compared with Slide 9.7) 11.2
04
Positions in a Option and The
Underlying Asset
 The reason for the similarity between these

strategies and longing or shorting a call or put
– The put-call parity: 𝑐 + 𝐷 + 𝐾𝑒 =𝑝+𝑆
 Since 𝐷 and 𝐾𝑒 are the present values of the dividend
payment and strike price, the sum of them is a known CF
 Thus, the put-call parity can be interpreted as that a
European call plus a constant CF adjustment equals the
combination of a European put (with the same 𝐾 and 𝑇)
and the underlying asset, i.e., 𝑐 + 𝐶𝐹 = 𝑝 + 𝑆
 For (a), −𝑐 + 𝑆 = −𝑝 + 𝐶𝐹; for (b), 𝑐 − 𝑆 = 𝑝 − 𝐶𝐹; for
(c), 𝑝 + 𝑆 = 𝑐 + 𝐶𝐹; for (d), −𝑝 − 𝑆 = −𝑐 − 𝐶𝐹
(The CF adjustment shifts the profit function upward or downward by an
amount of money but does not change the shape of the profit function) 11.2
05
11.3 Strategies Involving a

Position in Two or More
Options of The Same
Type
11.2
06
Bull Spread (牛市價差) Using
Calls withProfitThe Same T
ST
K1 K2
𝜋 = 𝑐 𝐾 − 𝑐(𝐾 ) 𝑐 𝐾 −𝑐(𝐾 ) Total Total profit = Total

incurs an up-front payoff payoff – cost of 𝜋
cost since 𝐾 < 𝐾
𝑆 ≤𝐾 0 0 0 0 – cost of 𝜋
𝐾 <𝑆 ≤𝐾 𝑆 −𝐾 0 𝑆 −𝐾 𝑆 − 𝐾 – cost of 𝜋
𝐾 <𝑆 𝑆 −𝐾 −(𝑆 − 𝐾 ) 𝐾 −𝐾 𝐾 − 𝐾 – cost of 𝜋
※ A bull call spread consists of an up-front cost and a non-negative payoff at
maturity
※ A bull spread generates a limited gain when 𝑆 is high and a limited loss when
𝑆 is low (the reason for the name)
※ Thus, a bull spread can limit the investor’s upside gain as well as downside risk 11.2
07

Calls with The Same T
 Comparison among a bull spread using calls,

holding a call option, and longing a stock share
Bull spread Call One stock share
𝜋 = 𝑐 𝐾 − 𝑐(𝐾 ) 𝑐 𝐾 𝑆
Initial cost cost of 𝜋 (minimal) cost of 𝑐 𝐾 𝑆 (maximal)
Maximum loss cost of 𝜋 (minimal) cost of 𝑐 𝐾 𝑆 (maximal)
Profit when
𝑆 − 𝐾 – cost of 𝜋 𝑆 − 𝐾 −cost of 𝑐 𝐾 𝑆 −𝑆
𝐾 <𝑆 ≤𝐾
𝐾 − 𝐾 – cost of 𝜋
Maximum gain Unlimited Unlimited
(limited)
※ Advantages of the bull spread: lowest initial cost, smallest maximum loss, and
comparable profit when 𝐾 < 𝑆 ≤ 𝐾
※ Disadvantage of the bull spread: the maximum gain is limited
※ If 𝑆 is predicted to rise to a level which is not higher than 𝐾 , the disadvantage
of the bull spread can be ignored and the bull spread is the most preferable
trading strategy 11.2
08
Puts with The Same T
Profit
K1 K2
ST
𝜋 = 𝑝 𝐾 − 𝑝(𝐾 ) 𝑝 𝐾 −𝑝(𝐾 ) Total Total profit = Total payoff

generates an up-front payoff + income of 𝜋
income since 𝐾 < 𝐾
𝑆 ≤𝐾 𝐾 −𝑆 −(𝐾 − 𝑆 ) 𝐾 −𝐾 𝐾 − 𝐾 + income of 𝜋
𝐾 <𝑆 ≤𝐾 0 −(𝐾 − 𝑆 ) 𝑆 −𝐾 𝑆 − 𝐾 + income of 𝜋
𝐾 <𝑆 0 0 0 0 + income of 𝜋
※ A bull put spread consists of an up-front income and a non-positive payoff at
maturity
※ A bull spread generates a limited gain when 𝑆 is high and a limited loss when
𝑆 is low (the reason for the name) 11.2
09
Bear Spread (熊市價差) Using

Profit
K1 K2
ST
𝜋 = −𝑐 𝐾 + 𝑐(𝐾 ) −𝑐 𝐾 𝑐(𝐾 ) Total Total profit = Total payoff

generates an up-front payoff + income of 𝜋
income since 𝐾 < 𝐾
𝑆 ≤𝐾 0 0 0 0 + income of 𝜋
𝐾 <𝑆 ≤𝐾 −(𝑆 − 𝐾 ) 0 𝐾 −𝑆 𝐾 − 𝑆 + income of 𝜋
𝐾 <𝑆 −(𝑆 − 𝐾 ) 𝑆 −𝐾 𝐾 −𝐾 𝐾 − 𝐾 + income of 𝜋
※ A bear call spread consists of an up-front income and a non-positive payoff at
maturity
※ A bear spread generates a limited gain when 𝑆 is low and a limited loss when
𝑆 is high (the reason for the name) 11.2
10
Profit
ST
K1 K2
𝜋 = −𝑝 𝐾 + 𝑝(𝐾 ) −𝑝 𝐾 𝑝(𝐾 ) Total Total profit = Total

incurs an up-front cost payoff payoff – cost of 𝜋
since 𝐾 < 𝐾
𝑆 ≤𝐾 −(𝐾 − 𝑆 ) 𝐾 −𝑆 𝐾 −𝐾 𝐾 − 𝐾 – cost of 𝜋
𝐾 <𝑆 ≤𝐾 0 𝐾 −𝑆 𝐾 −𝑆 𝐾 − 𝑆 – cost of 𝜋
𝐾 <𝑆 0 0 0 0 – cost of 𝜋
※ A bear put spread consists of a up-front cost and a non-negative payoff at
maturity
※ A bear spread generates a limited gain when 𝑆 is low and a limited loss when
𝑆 is high (the reason for the name) 11.2
11

 Comparison among a bear spread using puts,

holding a put option, and shorting a stock share
Short one
Bear spread Put
stock share
𝜋 = −𝑝 𝐾 + 𝑝(𝐾 ) 𝑃 𝐾
−𝑆
Initial cost cost of 𝜋 cost of 𝑝 𝐾 (maximal) 0 (minimal)
Maximum loss cost of 𝜋 (minimal) cost of 𝑝 𝐾 Unlimited
Profit when
𝐾 − 𝑆 – cost of 𝜋 𝐾 − 𝑆 – cost of 𝑝 𝐾 𝑆 −𝑆
𝐾 <𝑆 ≤𝐾
Maximum gain 𝐾 − 𝐾 – cost of 𝜋 (limited) 𝐾 − cost of 𝑝 𝐾 (limited) 𝑆 (limited)
※ Advantages of the bear spread: smallest maximum loss and comparable profit
when 𝐾 < 𝑆 ≤ 𝐾
※ Disadvantage of the bear spread: the maximum gain is the smallest
※ If 𝑆 is predicted to decline to a level which is not lower than 𝐾 , the
disadvantage of the bear spread can be ignored and the bear spread is the
most preferable trading strategy 11.2
12
Box Spread (盒型價差)
 A box spread is a combination of a bull call

spread (𝑐 𝐾 − 𝑐(𝐾 )) and a bear put spread
(−𝑝 𝐾 + 𝑝(𝐾 )) (with the same 𝑇)
– The payoff of the a box spread is always 𝐾 − 𝐾
𝜋 =𝑐 𝐾 −𝑐 𝐾 𝑐 𝐾 −𝑐 𝐾 −𝑝 𝐾 + 𝑝(𝐾 ) Total payoff
−𝑝 𝐾 + 𝑝(𝐾 ) on Slide 11.11 on Slide 11.15
𝑆 ≤𝐾 0 𝐾 −𝐾 𝐾 −𝐾
𝐾 <𝑆 ≤𝐾 𝑆 −𝐾 𝐾 −𝑆 𝐾 −𝐾
𝐾 <𝑆 𝐾 −𝐾 0 𝐾 −𝐾
– Since all options are European and thus the payoff

is received at maturity, a box spread is worth the
present value of its payoff, i.e., 𝑒 (𝐾 − 𝐾 ) 11.2
13
Box Spread (盒型價差)

– If the cost to construct a box spread does not equal
𝑒 (𝐾 − 𝐾 ), there is an arbitrage opportunity
 If the cost to construct a box spread 𝑀 < 𝑒 𝐾 −𝐾 :
– Use the borrowing fund, 𝑀, to construct a box spread (𝑐 𝐾 −
𝑐(𝐾 ) − 𝑝 𝐾 + 𝑝(𝐾 ))
– At maturity, the payoff from the box spread, i.e., 𝐾 − 𝐾 , is
higher than the repayment amount, 𝑀𝑒
 If the cost to construct a box spread 𝑀 > 𝑒 𝐾 −𝐾 :
– Short a box spread, i.e., −𝑐 𝐾 + 𝑐 𝐾 + 𝑝 𝐾 − 𝑝(𝐾 ), for
𝑀 and deposit the proceeds at 𝑟 for maturity 𝑇
– At maturity, the payoff of the deposit, 𝑀𝑒 , is higher than the
cash out flow from shorting the box spread, i.e., − 𝐾 − 𝐾 =
𝐾 −𝐾
※ Note that the above arbitrage strategy works only for
European options 11.2
14
Butterfly Spread (蝶式價差)
 A butterfly spread involves positions in options

with three different-strike-price calls or puts
– With calls, 𝑐 𝐾 − 2𝑐 𝐾 + 𝑐 𝐾 , where 𝐾 =
(see Slide 11.20)
– With puts, 𝑝 𝐾 − 2𝑝 𝐾 + 𝑝 𝐾 , where 𝐾 =
(see Slide 11.22)
– A common trading strategy with butterfly spreads:
 𝐾 is close to the current price
 It leads to a profit if the stock price stays close to 𝐾 , but
gives a small loss if there is a significant stock price
movement in either direction
 It is appropriate for an investor who predicts that large
stock price movements are unlikely to happen 11.2
15
Butterfly Spread (蝶式價差) Using

Profit
K1 K2 K3
ST
𝜋 = 𝑐 𝐾 − 2𝑐 𝐾 𝑐 𝐾 −2𝑐 𝐾 𝑐 𝐾 Total payoff

+𝑐 𝐾
𝑆 ≤𝐾 0 0 0 0
𝐾 <𝑆 ≤𝐾 𝑆 −𝐾 0 0 𝑆 −𝐾
𝐾 <𝑆 ≤𝐾 𝑆 −𝐾 −2(𝑆 − 𝐾 ) 0 2𝐾 − 𝐾 − 𝑆 = 𝐾 − 𝑆
𝐾 <𝑆 𝑆 −𝐾 −2(𝑆 − 𝐾 ) 𝑆 −𝐾 2𝐾 − 𝐾 − 𝐾 = 0
※ Since the payoff is non-negative, there should be an initial cost to construct the
butterfly spread (see the next slide)
※ After deducting the initial cost from the payoff function, we can derive the profit
function, which is shown above 11.2
16
 A butterfly spread requires an initial investment
– Consider the following numerical example
Strike price ($) Call price ($)
55 10
60 7
65 5
– The cost of the butterfly spread (𝑐 55 − 2𝑐 60 + 𝑐 65 )
is $1, which is the maximum loss for the investor
– The maximum payoff of the above butterfly spread is
𝐾 − 𝐾 = $5 (or 𝐾 − 𝐾 )
It owns the features of high leverage and limited loss
※If the market price of 𝑐 60 is above 7.5, it is possible to
construct the butterfly spread with zero cost or even to
generate some incomes  an arbitrage opportunity occurs 11.2
17

Profit
K1 K2 K3
ST
𝜋 = 𝑝 𝐾 − 2𝑝 𝐾 𝑝 𝐾 −2𝑝 𝐾 𝑝 𝐾 Total payoff

+𝑝 𝐾
𝑆 ≤𝐾 𝐾 −𝑆 −2(𝐾 − 𝑆 ) 𝐾 −𝑆 𝐾 − 2𝐾 + 𝐾 = 0
𝐾 <𝑆 ≤𝐾 0 −2(𝐾 − 𝑆 ) 𝐾 −𝑆 𝐾 − 2𝐾 + 𝑆 = 𝑆 − 𝐾
𝐾 <𝑆 ≤𝐾 0 0 𝐾 −𝑆 𝐾 −𝑆
𝐾 <𝑆 0 0 0 0
※ The payoff of the butterfly put spread is identical to the payoff of the butterfly call
spread
11.2
18
Calendar Spread (日曆價差) Using
Calls
Profit
𝑆
K
※ A calendar spread can be created by selling a call option with a certain strike
price and buying a longer-maturity call option with the same 𝐾, i.e., 𝑐 𝐾, 𝑇 −
𝑐(𝐾, 𝑇 ) for 𝑇 > 𝑇
※ Since 𝑇 > 𝑇 , it is general that 𝑐 𝐾, 𝑇 > 𝑐(𝐾, 𝑇 ) and thus there is a initial cost
to construct a calendar spread
※ The above figure shows the profit function at 𝑇 (explained on the next slide),
which is similar to the payoff of a butterfly spread
– The investors makes a profit if the stock price at 𝑇 is close to 𝐾, but a loss is incurred
when the stock price is significantly higher or lower than the strike price
– The advantage of the calendar spread over the butterfly spread is its lower transaction
costs 11.2
19

Calls
※ The reason for the profit function of the calendar spread (𝑐 𝐾, 𝑇 − 𝑐(𝐾, 𝑇 )) at 𝑇 :
– If 𝑆 ≪ 𝐾, −𝑐(𝐾, 𝑇 ) is worthless and 𝑐(𝐾, 𝑇 ) is positive but close to zero (so the net
payoff at 𝑇 is slightly higher than zero), and the investors incurs a loss that is close to
the cost of constructing the calendar spread
– If 𝑆 ≫ 𝐾, the payoff of −𝑐(𝐾, 𝑇 ) is −(𝑆 − 𝐾) and the payoff of 𝑐(𝐾, 𝑇 ) is worth a little
more than 𝑆 − 𝐾 (so the net payoff at 𝑇 is slightly higher than zero), and the investors
makes a loss that is close to the cost of constructing the calendar spread
– If 𝑆 ≈ 𝐾, the payoff of −𝑐 𝐾, 𝑇 is equal to −max(𝑆 − 𝐾, 0), but the payoff of 𝑐 𝐾, 𝑇
is still higher than its intrinsic value, which is max(𝑆 − 𝐾, 0). Therefore, the net payoff at
𝑇 is positive. If the positive payoff at 𝑇 is higher than the cost to construct the calendar
spread, the profit at 𝑇 is positive when 𝑆 ≈ 𝐾
※ Three types of calendar spreads:
– Neutral (中立) calendar spread (𝐾 ≈ 𝑆 ): make profit when 𝑆 ≈𝑆
– Bullish (牛市的) calendar spread (𝐾 > 𝑆 ): make profit when the stock price rises such
that 𝑆 ≈ 𝐾
– Bearish (熊市的) calendar spread (𝐾 < 𝑆 ): make profit when the stock price declines
such that 𝑆 ≈ 𝐾
11.2
20
Puts
Profit
𝑆
K
※ A calendar spread can also be created by selling a put option with a certain
strike price and buying a longer-maturity put option with the same 𝐾, i.e.,
𝑝 𝐾, 𝑇 − 𝑝(𝐾, 𝑇 )
※ Since 𝑇 > 𝑇 , it is general that 𝑝 𝐾, 𝑇 > 𝑝(𝐾, 𝑇 ) and thus there is a initial cost
to construct a calendar spread
11.2
21
Diagonal Spread (對角線價差)
 A diagonal spread involves a long and a short

position in calls or puts with different 𝐾 and 𝑇,
e.g., 𝑐 𝐾 , 𝑇 − 𝑐(𝐾 , 𝑇 )
– A diagonal spread is the combination of a bull (or bear)
spread and a calendar spread
 A diagonal spread 𝑐 𝐾 , 𝑇 − 𝑐(𝐾 , 𝑇 ) can be decomposed as
a calendar spread 𝑐 𝐾 , 𝑇 − 𝑐(𝐾 , 𝑇 ) (with up-front cost) (see
Slide 11.23) and a spread 𝑐 𝐾 , 𝑇 − 𝑐 𝐾 , 𝑇
 If 𝐾 > 𝐾 , 𝑐 𝐾 , 𝑇 − 𝑐(𝐾 , 𝑇 ) is a bear spread with a up-front
income (see Slide 11.14)
 If 𝐾 < 𝐾 , 𝑐 𝐾 , 𝑇 − 𝑐(𝐾 , 𝑇 ) is a bull spread with a up-front
cost (see Slide 11.11)
11.2
22
11.4 Combination Strategies
11.2
23
Straddle Combination (跨式組合)

Profit
ST
K
𝜋 = 𝑐 𝐾 + 𝑝(𝐾) 𝑐 𝐾 𝑝(𝐾) Total Total profit = Total

incurs an up-front cost payoff payoff – cost of 𝜋
𝑆 ≤𝐾 0 𝐾−𝑆 𝐾−𝑆 𝐾 − 𝑆 – cost of 𝜋
𝐾<𝑆 𝑆 −𝐾 0 𝑆 −𝐾 𝑆 − 𝐾 – cost of 𝜋
※ If the 𝑆 is close to 𝐾, the straddle leads to a loss; if there is a sufficiently large
movement in either direction, a significant profit will result
※ A straddle is appropriate when an investor is expecting a large movement in a
stock price but does not know in which direction the movement will be
※ The above profit function is also known as a bottom straddle (下跨式)
※ A top straddle (上跨式) is −𝑐 𝐾 − 𝑝(𝐾), which is the inverse of a bottom straddle
※ A top straddle is a highly risky strategy: If the 𝑆 is close to 𝐾, the straddle leads to
a profit; otherwise, the loss arising from a large movement is unlimited 11.2
24
Strip and Strap
Profit Profit
K K ST
ST
Strip Strap
※ A strip consists of a long position ※ A strap consists of a long position

in one call and two puts with the in two calls and one put with the
same strike price and maturity same strike price and maturity
date, i.e., 𝑐 𝐾 + 2𝑝(𝐾) date, i.e., 2𝑐 𝐾 + 𝑝(𝐾)
※ In a strip, the investor is betting ※ In a strap, the investor is betting
that there will be a large stock that there will be a large stock
price move and considers a price move and an increase in the
decrease in the stock price to be stock price is considered to be
more likely than an increase more likely than a decrease
11.2
25
Strangle Combination (勒式組合)

Profit
K1 K2
ST
𝜋 = 𝑐 𝐾 + 𝑝(𝐾 ), 𝑐 𝐾 𝑝(𝐾 ) Total Total profit = Total

where 𝐾 < 𝐾 payoff payoff – cost of 𝜋
𝑆 ≤𝐾 0 𝐾 −𝑆 𝐾 −𝑆 𝐾 − 𝑆 – cost of 𝜋
𝐾 <𝑆 ≤𝐾 0 0 0 0 – cost of 𝜋
𝐾 <𝑆 𝑆 −𝐾 0 𝑆 −𝐾 𝑆 − 𝐾 – cost of 𝜋
※ A strangle is similar to a straddle:
– The investor is betting that there will be a large price movement but is uncertain whether it
will be an increase or a decrease
– Comparing to straddle, the stock price has to move farther for an investor to make profit
in a strangle
11.2
26
Strangle Combination (勒式組合)
※ A strangle is also called a bottom strangle (下勒式) or a bottom vertical

combination
※ The sale of a strangle is sometimes referred to as a top strangle (上勒式) or a
top vertical combination
– It can be appropriate for an investor who feels that large stock price movement are
unlikely
– However, similar to the top straddle, it is a risky strategy involving unlimited potential
loss to the investor
11.2
27
Introduction to
Binomial Trees
Chapter 12
12.2
28
Goals of Chapter 12
 Introduce the binomial tree model (二元樹) in

the one-period case
 Discuss the risk-neutral valuation relationship
(風險中立評價關係)
 Introduce the binomial tree model in the two-
period case and the CRR binomial tree model
 Consider the continuously compounding
dividend yield in the binomial tree model
12.2
29
12.1 One-Period Binomial

Tree Model
12.2
30
One-Period Binomial Tree Model
 The binomial tree model represents possible

stock price at any time point based on a
discrete-time and discrete-price framework
– For a stock price at a time point, a binomial
distribution (二項分配) models the stock price
movement at the subsequent time point
 That is, there are two possible stock prices with assigned
probabilities at the next time point
– The binomial tree model is a general numerical
method for pricing derivatives with various payoffs
– The binomial tree model is particularly useful for
valuing American options, which do not have
analytic option pricing formulas 12.2
31
 One-period case for the binomial tree

model
– The stock price 𝑆 is currently $20
– After three months, it will be either $22 or $18 for
the upper and lower branches
𝑆 = 22
𝑆 = 20
𝑆 = 18
12.2
32
– Consider a 3-month call option on the stock with a

strike price of 21
 Corresponding to the upper and lower movements in the
stock price, the payoffs of this call option are 𝑐 = $1 and
𝑐 = $1
𝑆 = 22
𝑐 =1
𝑆 = 20
𝑐=?
𝑆 = 18
𝑐 =0
– What is the theoretical value of this call today?
12.2
33
– Consider a portfolio P: long Δ shares

short 1 call option
22D – 1
18D
– Portfolio P is riskless when 22Δ – 1 = 18Δ, which

implies Δ = 0.25
– The value of Portfolio P after 3 months is 22 x
0.25 – 1 = 18 x 0.25 = 4.5
12.2
34
– Since Portfolio P is riskless, it should earn the

risk-free interest rate according to the no-
arbitrage argument
 If the return of Portfolio P is higher (lower) than the
risk-free interest rate  Portfolio P is more (less)
attractive than other riskless assets  Buy (Short)
Portfolio P and short (buy) the riskless asset can
arbitrage  Purchasing (selling) pressure bid up
(drive down) the price of Portfolio P, which causes the
decline (rise) of the return of Portfolio P
– The value of the portfolio today is 4.5𝑒 % . =
4.367, where 12% is the risk-free interest rate
 The amount of 4.367 should be the cost (or the initial
investment) to construct Portfolio P 12.2
35
– The riskless Portfolio P consists of long 0.25

shares and short 1 call option
 The cost to construct Portfolio P equals 0.25 x 20 – 𝑐
– Solve for the theoretical value of this call today
to be 𝑐 = 0.633 by equalizing 0.25 x 20 – 𝑐 with
4.367
12.2
36
Generalization of One-Period
Binomial Tree Model
 Consider any derivative 𝑓 lasting for time T
and its payoff is dependent on a stock
𝑆 =𝑆 𝑢
𝑓
𝑆
𝑓 𝑆 =𝑆 𝑑
𝑓
– Assume that the possible stock price at 𝑇 are
𝑆 = 𝑆𝑢 and 𝑆 = 𝑆𝑑, where 𝑢 and 𝑑 are
constant multiplication factors for the upper and
lower branches
– 𝑓 and 𝑓 are payoffs of the derivative 𝑓
corresponding to the upper and lower branches 12.2
37
Binomial Tree Model
– Construct Portfolio P that longs D shares and
shorts 1 derivative. The payoffs of Portfolio P are
𝑆𝑢Δ − 𝑓
𝑆𝑑Δ − 𝑓
– Portfolio P is riskless if 𝑆𝑢Δ − 𝑓 = 𝑆𝑑Δ − 𝑓 and
thus
𝑓 −𝑓
Δ=
𝑆𝑢 − 𝑆𝑑
※Recall that in the prior numerical example, 𝑆 = 20, 𝑢 =
1.1, 𝑑 = 0.9, 𝑓 = 1, and 𝑓 = 0, so the solution of Δ for
generating a riskless portfolio is 0.25 12.2
38
Binomial Tree Model
– Value of Portfolio P at time T is 𝑆𝑢Δ − 𝑓 (or
equivalently 𝑆𝑑Δ − 𝑓 )
– Value of Portfolio P today is thus (𝑆𝑢Δ − 𝑓 )𝑒
– The initial investment (or the cost) for Portfolio P is
𝑆Δ − 𝑓
– Hence 𝑓 = 𝑆Δ − (𝑆𝑢Δ − 𝑓 )𝑒
– Substituting Δ for in the above equation,
we obtain
𝑓=𝑒 [𝑝 𝑓 + 1 − 𝑝 𝑓 ],
where 𝑝 =
12.2
39
12.2 Risk-Neutral Valuation

Relationship (風險中立
評價關係)
12.2
40
Risk-Neutral Valuation
Relationship (風險中立評價關係)
 Risk-averse (風險趨避), risk-neutral (風險中立),
and risk-loving (風險愛好) behaviors
– A game of flipping a coin
 For risk-averse investors, they accept a risky game if its
expected payoff is higher than the payoff of the riskless
game by a required amount which can compensate
investors for the risk they bear
– That is, risk-averse investors requires compensation for risk
– For different investors, they have different tolerance for risk,
i.e., they require different expected payoff to accept the same
risky game
12.2
41
 For risk-neutral investors, they accept a risky game even if
its expected payoff equals the payoff of the riskless game
– That is, they care about only the levels of the (expected)
payoffs
– In other words, they require no compensation for risk
 For risk-loving investors, they accept a risky game (enjoy
the feeling of gamble) even if its expected payoff is lower
than the payoff of the riskless game
– That is, they would like to sacrifice some benefit for entering a
risky game
– We do not discuss risk-loving behavior in this chapter
12.2
42
– In a risk-averse financial market, securities with
higher degree of risk need to offer higher expected
returns
 So, our real world is a risk averse world, i.e., most
investors are risk averse and require compensation for
the risk they tolerate
– In a risk-neutral financial market (every trader is
risk neutral), the expected returns of all securities
equal the risk free rate regardless of their degrees
of risk
 That is, even for high-risk-level derivatives, their expected
returns equal the risk free rate in the risk-neutral world
 The risk-neutral market only exists in our imagination
12.2
43
 Interpret 𝑝 in 𝑓 = 𝑒 [𝑝𝑓 + 1 − 𝑝 𝑓 ] as a
probability in the risk-neutral world
– If the expected return of the stock price is 𝜇 in the
real world (a risk averse world), the expected stock
price at the end of the period is 𝐸 𝑆 = 𝑆𝑒
𝑆𝑢
𝑆𝑑
𝑒 −𝑑
𝑝∗ 𝑆𝑢 + 1 − 𝑝∗ 𝑆𝑑 = 𝑆𝑒 ⇒ 𝑝∗ =
𝑢−𝑑 12.2
44
– Comparing with 𝑝 = , it is natural to interpret 𝑝
and 1 − 𝑝 as probabilities of upward and downward
movements in the risk-neutral world
 This is because that the expected return of any security in
the risk-neutral world is the risk free rate
– The formula 𝑓 = 𝑒 [𝑝𝑓 + 1 − 𝑝 𝑓 ] is consistent
with the general rule to price derivatives
 Note that in the risk-neutral world, [𝑝𝑓 + 1 − 𝑝 𝑓 ] is the
expected payoff of a derivative and 𝑒 is the correct
discount factor to derive the PV today
 The complete version of the general derivative pricing
method is that any derivative can be priced as the PV of its
expected payoff in the risk-neutral world 12.2
45
 Risk-neutral valuation relationship (RNVR)
– It states that any derivative can be priced with the
general derivative pricing rule as if it and its
underlying asset were in the risk-neutral world
– Since the expected returns of both the derivative
and its underlying asset are the risk free rate
 The probability of the upward movement in the prices of
the underlying asset is 𝑝 =
 The discount rate for the expected payoff of the
derivative is also 𝑟
※When we are evaluating an option on a stock, the
expected return on the underlying stock, 𝜇, is irrelevant
12.2
46
 Revisit the original numerical example in the
risk-neutral world
𝑆𝑢 = 22
𝑓 =1
𝑆 = 20
𝑓=?
𝑆𝑑 = 18
𝑓 =0
% . .
– Calculate 𝑝 = = = 0.6523
. .
– Calculate the option value according to the RNVR
𝑒 % . 0.6523 1 + 1 − 0.6523 0 = 0.633
12.2
47
12.3 Multi-Period Binomial

Tree Model
12.2
48
Two-Period Binomial Tree Model
24.2
22 ※ Note the recombined
feature can limit the
growth of the number of
20 19.8
nodes on the binomial
tree in a acceptable
18 manner
16.2
 Values of the parameters of the binomial tree
– 𝑆 = 20, 𝑟 = 12%, 𝑢 = 1.1, 𝑑 = 0.9, 𝑇 = 0.5, the
number of time steps is 𝑛 = 2, and thus the length
of each time step is Δ𝑡 = 𝑇/𝑛 = 0.25
– Hence, the risk-neutral probability 𝑝 = =
% . .
. .
= 0.6523 12.2
49

node B node D
22 24.2
2.0257 3.2
node A node E
20 19.8
1.2823 0
node C
18 node F
16.2
0
0
– For a European call option with the strike price to be
21, perform the backward induction method (逆向歸
納法) recursively on the binomial tree
 Option value at node B: 𝑒 % . 0.6523 3.2 + 0.3477 0 =
2.0257
 Option value at node C: 𝑒 % . 0.6523 0 + 0.3477 0 = 0
 Option value at node A (the initial or root node):
𝑒 % . 0.6523 2.0257 + 0.3477 0 = 1.2823 12.2
50
node D
node B
60 72
1.4147 0
node A node E
50 48
4.1923 4
node C node F
40 32
9.4636 20
 For a European put with 𝐾 = 52 and 𝑇 = 2

– 𝑆 = 50, 𝑟 = 5%, 𝑢 = 1.2, 𝑑 = 0.8, 𝑛 = 2, Δ𝑡 = 1, and 𝑝 = 0.6282
– Option value at node B: 𝑒 % 0.6282 0 + 0.3718 4 = 1.4147
– Option value at node C: 𝑒 % 0.6282 4 + 0.3718 20 =
9.4636
– Option value at node A: 𝑒 % (0.6282 1.4147 + 0.3718
9.4636) = 4.1923 12.2
51
Binomial Tree Model for American

Options node D
node B
60 72
1.4147 0
node A node E
50 48
5.0894 4
node C node F
40 32
12 20
 For an American put with 𝐾 = 52 and 𝑇 = 2
– Option value at node B: 𝑒 % 0.6282 0 + 0.3718 4 =
1.4147
– Option value at node C: 𝑒 % 0.6282 4 + 0.3718 20 =
9.4636, which is smaller than the exercise value max(𝐾 −
𝑆 , 0) = 12  it is optimal to early exercise
– Option value at node A: 𝑒 % 0.6282 1.4147 + 0.3718 12
= 5.0894 12.2
52
Delta
 Delta (Δ)
– The formula to calculate Δ in the binomial tree
model is on Slide 12.11
 In the binomial tree model, Δ is the number of shares of
the stock we should hold for each option shorted in order
to create a riskless portfolio
 For the one-period example on Slide 12.6, the delta of the
call option is = 0.25
– Theoretically speaking, Δ is defined as the ratio of
the change in the price of a stock option with
respect to the change in the price of the underlying
stock, i.e., Δ = 12.2
53
Delta
– The delta hedging strategy (delta 避險策略)

eliminates the price risk by constructing a riskless
portfolio for a period of time (details in Ch. 17)
 The method to decide the value of the delta in the
binomial tree model is in effect to perform the delta
hedging strategy
– Short 1 derivative and long Δ shares form a portfolio to be
− 𝑓 + Δ𝑆
– Since we determine Δ such that the portfolio (−𝑓 + Δ𝑆) is
riskless, it implies that the value of this portfolio is immunized
to the change in stock prices, i.e.,
𝜕𝑓 𝜕𝑆
− +Δ =0
𝜕𝑆 𝜕𝑆
– Thus, we can solve Δ = since = 1 by definition 12.2
54
Delta
– The value of Δ varies from node to node (revisit the

call option on Slide 12.23)
node B node D
22 24.2
2.0257 3.2
node A node E
20 19.8
1.2823 0
node C
18 node F
16.2
0
0
.
 Δ at node A: = 0.5064
.
 Δ at node B: = 0.7273
. .
 Δ at node C: =0 12.2
. .
55
Delta
 Since the value of Δ changes over time, the delta hedging

strategy needs rebalances over time
– For node A, Δ is decided to be 0.5024 such that the portfolio
is riskless during the first period of time
– If the stock price rises (falls) to reach node B (C), Δ changes
to 0.7273 (0), which means that we need to increase (reduce)
the number of shares held to make the portfolio risk free in
the second period
12.2
56
CRR Binomial Tree Model
 How to determine 𝑢 and 𝑑

– In practice, given any stock price at the time point
𝑡, 𝑢 and 𝑑 are determined to match the variance of
the stock price at the next time point 𝑡 + Δ𝑡
𝑆𝑢
𝑆𝑑
𝑡 𝑡 + Δ𝑡
∵ var 𝑆 =𝐸 𝑆 − 𝐸[𝑆 ]
∴ 𝑆 𝜎 Δ𝑡 = 𝑝𝑆 𝑢 + 1 − 𝑝 𝑆 𝑑 − (𝑆 𝑒 )
⇒ 𝜎 Δ𝑡 = 𝑝𝑢 + 1 − 𝑝 𝑑 − 𝑒 12.2
57
CRR Binomial Tree Model
With 𝑝 = and the assumption of 𝑢𝑑 = 1

⇒𝑢=𝑒 and 𝑑 = 𝑒
– This method is first proposed by Cox, Ross, and
Rubinstein (1979), so this method is also known
as the CRR binomial tree model
 The validity of the CRR binomial tree model depends on
the risk-neutral probability 𝑝 being in [0,1]
 In practice, the life of the option is typically partitioned
into hundreds time steps
– First, ensure the validity of the risk-neutral probability, 𝑝,
which approaches 0.5 if Δ𝑡 approaches 0
– Second, ensure the convergence to the Black–Scholes
model (introduced in Ch. 13) 12.2
58
12.4 Dividend Yield in the
Binomial Tree Model
12.2
59
The Effect of Dividend Yield on

Risk-Neutral Probabilities
𝑆𝑢
𝑆 𝐸𝑆 =𝑆𝑒
𝑆𝑑
𝑡 𝑡 + Δ𝑡
※ In the risk-neutral world, the total return from dividends and
capital gains is 𝑟
※ If the dividend yield is 𝑞, the return of capital gains in the stock
price should be 𝑟 − 𝑞
※ Hence, 𝑝𝑆 𝑢 + 1 − 𝑝 𝑆 𝑑 = 𝑆 𝑒 ⇒𝑝=
※ The dividend yield does NOT affect the volatility of the stock
price and thus does NOT affect the multiplying factors 𝑢 =

𝑒 and 𝑑 = 𝑒
※ Note that the discount rate for the expected payoff is still 𝑟 12.33
Valuing Stock Options:
The Black–Scholes–
Merton Model
Chapter 13
13.2
61
Goals of Chapter 13
 The stock price distribution in Black–Scholes–

Merton (BSM) model and the estimation of its
parameters
 The risk-neutral valuation relationship (RNVR)
and BSM option pricing formulae
 Extension of RNVR on pricing forward
contracts
 Implied volatilities (隱含波動度) of options
 Effects of cash dividend payments on option
prices 13.2
62
13.1 Distribution of the
Stock Price in Black–
Scholes–Merton Model
13.2
63
Distribution of The Stock Price
 In 1973, Fischer Black, Myron Scholes, and

Robert Merton achieved a major breakthrough
in pricing European options
– They developed pricing formulae for European
options, which are known as the Black–Scholes–
Merton (or simply Black–Scholes) model
– Merton and Scholes won Nobel Prize in 1997 with
this achievement
– This chapter presents the Black–Scholes–Merton
model for valuing European calls and puts on a
non-dividend-paying stock first
13.2
64
 Based on the RNVR introduced in Ch. 12, any

derivative can be priced as the PV of its
expected payoff in the risk-neutral world
– Consider a European call option, its value today is
𝑐 = 𝑒 𝐸[max(𝑆 − 𝐾, 0)|in the risk−neutral world]
=𝑒 ∫ max 𝑆 − 𝐾, 0 𝑓 𝑆 𝑑𝑆 ,
where 𝑓 𝑆 is the probability density function (PDF)
of 𝑆 in the risk-neutral world
– Therefore, to identify the distribution and thus the
PDF of 𝑆 in the risk-neutral world is the critical step
to derive the option pricing formula 13.2
65
 The distribution of 𝑆 of the BSM model in the

real world
– The BSM model considers a non-dividend-paying
stock and assumes the return on the stock in a
short period of time is normally distributed, i.e.,
~𝑁𝐷(𝜇Δ𝑡, 𝜎 Δ𝑡),
where Δ𝑆 is the change in the stock price in a short
period of time Δ𝑡, the mean of the return is 𝜇Δ𝑡, and

the standard deviation of the return is 𝜎 Δ𝑡
(Note that it is the variance of the return, not its
standard deviation, that is proportional to Δ𝑡) 13.2
66
– The assumption of the normal distribution of the

stock return implies that 𝑆 is lognormally
distributed as follows
ln 𝑆 ~𝑁𝐷(ln 𝑆 + 𝜇 − 𝑇, 𝜎 𝑇)
 𝐸[𝑆 ] = 𝑆 𝑒 (consistent with what we learned before)
– For ln 𝑋 ~𝑁𝐷(𝜇, 𝜎 ), 𝐸[𝑋] = 𝑒 /
 Rewriting the above distribution leads to the distribution of

the log return (or said log difference) in the stock price
ln 𝑆 − ln 𝑆 ~𝑁𝐷((𝜇 − )𝑇, 𝜎 𝑇)
ln ~𝑁𝐷((𝜇 − )𝑇, 𝜎 𝑇)
13.2
67
 How to interpret 𝜇 − and 𝜎?
– For simplicity, ln ~𝑁𝐷(𝜇 − , 𝜎 ) given 𝑇 = 1 year

– Suppose 𝑟 to be the annual continuously compounding return
provided by the stock asset, so 𝑆 = 𝑆 𝑒
– We can derive ln = 𝑟 and thus 𝑟 ~𝑁𝐷(𝜇 − , 𝜎 ), so 𝜇 −
and 𝜎 can be interpreted as the annual mean and standard
deviation of 𝑟 (also known as the log return of the stock price),
respectively
13.2
68
– Estimate 𝜇 − and 𝜎 using a series of historical

stock prices
 Suppose the length of the time interval between the
observations of stock prices is 𝜏, i.e., we have the series of
𝑆 ,𝑆 ,𝑆 ,…,𝑆
 Therefore, there are 𝑛 observations of the log returns of the
stock prices
𝑢 = ln , 𝑢 = ln , 𝑢 = ln , … , 𝑢 = ln
( )
 The lognormally distributed result on the bottom of Slide

13.7 can be extended to any two time points 𝑡 and 𝑡 + 𝜏, i.e.,
ln ~𝑁𝐷((𝜇 − )𝜏, 𝜎 𝜏)
13.2
69

 The arithmetic average and variance of the series of 𝑢 =
ln = ln𝑅 can estimate (𝜇 − )𝜏 and 𝜎 𝜏,
respectively
– (𝜇 − )𝜏 = 𝑢 = (ln + ln + ⋯ + ln )
1
= (ln 𝑅 + ln 𝑅 + ⋯ + ln 𝑅 )
𝑛
= ln((𝑅 𝑅 … 𝑅 ) ) = ln( 𝑅 𝑅 … 𝑅 )
⇒𝜇− =
(Note that (𝜇 − ) is the annualized geometric average of the
stock returns) (in continuous compounding)
– 𝜎 𝜏=𝑠 = ∑ (𝑢 − 𝑢)
⇒𝜎 = ⇒𝜎=
13.2
70
※ Estimate 𝜇 using a series of historical stock prices
– Given 𝐸[𝑆 ] = 𝑆 𝑒 on Slide 13.7, 𝜇 can be interpreted as
the expected continuous compounding return
– Extend 𝐸[𝑆 ] = 𝑆 𝑒 to consider any time points 𝑡 and 𝑡 + 𝜏
𝐸[𝑆 ] =𝑆𝑒 ⇒𝐸 =𝑒 ⇒ ln 𝐸 = 𝜇𝜏
– The natural logarithm of the arithmetic average of the series of
the gross returns 𝑅 = can estimate 𝜇𝜏:
𝜇𝜏 = ln + + ⋯+
( )
= ln 𝑅 + 𝑅 + ⋯+ 𝑅 = ln 𝑅
⇒𝜇= (which is the annualized arithmetic average

of the stock returns) (in continuous compounding) 13.2
71
 Suppose that returns in successive 5 years are

15%, 20%, 30%, –20% and 25%
– The arithmetic average of the annual returns is 14%
(= 𝜇 in annual compounding)
 Based on the formula on Slide 13.11, 𝜇 = = =
13.10% in continuously compounding
– The geometric average of the annual returns is
12.40% (= 𝜇 − in annual compounding)
 Based on the formula on Slide 13.10, 𝜇 − = = =
11.69% in continuously compounding
※The transformation to continuous compounding results can
be derived from 𝑅 = 𝑚 ln 1 + with 𝑚 = 1 13.2
72
– Trading days vs. Calendar days

 Usually the daily observations of stock prices are used to
estimate 𝜇 − and 𝜎
 Since the variation (or the volatility) of stock prices occurs
only on trading days, so only trading days are counted to
estimate 𝜇 − and 𝜎
– When the market is closed, the variation of stock prices is zero
 As a result, 𝜏 is set to and the number
#
of trading days in a year is assumed to be 252 in the U.S.

 Finally, 𝜇 − = = 𝑢 252 and 𝜎 = =𝑠 252
※ Note that if the number of calendar days is used, then 𝜇 −

= 𝑢 365 and 𝜎 = 𝑠 365 are overestimated 13.2
73
13.2 Risk-Neutral Valuation

Relationship and
Black–Scholes–Merton
option pricing formulae
13.2
74
RNVR and BSM model
 Assumptions underlying the BSM model

– Stock price behavior follows the lognormal model
mentioned on Slides 13.6 and 13.7
– There are no transaction costs or taxes
– All securities are perfectly divisible
– There are no dividends on the stock in [0, 𝑇]
– There are no riskless arbitrage opportunities
– Security trading is continuous
– The risk-free interest rate, 𝑟, is constant in [0, 𝑇]
– Investors can borrow or lend at 𝑟 unlimitedly
13.2
75
RNVR and BSM model
 RNVR states that any derivative can be priced

with the PV of its expected payoff if it and its
underlying asset were in the risk-neutral world
– The return of the stock price in the risk-neutral world
is 𝑟, i.e.,
~𝑁𝐷(𝑟Δ𝑡, 𝜎 Δ𝑡),
(Note that measures the total return on stock,
including the capital gains and dividend yield)
– The lognormal distribution of 𝑆 becomes
ln 𝑆 ~𝑁𝐷(ln 𝑆 + (𝑟 − )𝑇, 𝜎 𝑇)
13.2
76
RNVR and BSM model
– The probability density function for the lognormally

distributed 𝑆 is
( )

𝑓 𝑆 = 𝑒
– Based on RNVR, the risk-free interest rate should
be employed to discount the expected payoff of
any derivative
– As a result, European calls can be valued as
𝑐 = 𝑒 𝐸[max(𝑆 − 𝐾, 0)|in the risk−neutral world]
=𝑒 ∫ max 𝑆 − 𝐾, 0 𝑓 𝑆 𝑑𝑆 ,
=𝑒 ∫ (𝑆 − 𝐾)𝑓 𝑆 𝑑𝑆 13.2
77
RNVR and BSM model
– European puts can be valued as

𝑝=𝑒 ∫ (𝐾 − 𝑆 )𝑓 𝑆 𝑑𝑆
– The BSM option price formulae can be derived by
evaluating the above two integrals
𝑐 = 𝑆 𝑁 𝑑 − 𝐾𝑒 𝑁(𝑑 ),
𝑝 = 𝐾𝑒 𝑁 −𝑑 − 𝑆 𝑁 −𝑑 ,
/ /
where 𝑑 =
/ /
𝑑 = = 𝑑 −𝜎 𝑇
13.2
78
RNVR and BSM model
– 𝑁(𝑑) is the cumulative distribution function for a

standardized normally distributed variable
 It returns the probability for which a variable following a
standard normal distribution is less than a constant number 𝑑
 By definition, 𝑁 𝑑 = ∫ 𝑛 𝑥 𝑑𝑥 = ∫ 𝑒 𝑑𝑥
𝑛(𝑥) 𝑁(𝑑)
𝑑
 𝑁 𝑑 needs to be solved with numerical techniques
 In Excel 2016, “NORM.S.DIST(𝑑,1)” returns 𝑁 𝑑 and
“NORM.S.DIST(𝑑,0)” returns 𝑛 𝑑
 In exams, a table for finding the value of 𝑁 𝑑 is offered 13.2
79
RNVR and BSM model
 Properties of the BSM formulae

– As 𝑆 becomes very large, calls (puts) are extremely
ITM (OTM)
 𝑑 → ∞ ⇒ 𝑁(𝑑 ) → 1 ⇒ 𝑁(−𝑑 ) → 0
 𝑑 → ∞ ⇒ 𝑁(𝑑 ) → 1 ⇒ 𝑁(−𝑑 ) → 0
 The call value 𝑐 = 𝑆 𝑁 𝑑 − 𝐾𝑒 𝑁 𝑑 → 𝑆 − 𝐾𝑒
 The put value 𝑝 = 𝐾𝑒 𝑁 −𝑑 − 𝑆 𝑁 −𝑑 → 0
– As 𝑆 becomes very small, calls (puts) are
extremely OTM (ITM)
 𝑑 → −∞ ⇒ 𝑁(𝑑 ) → 0 ⇒ 𝑁(−𝑑 ) → 1
 𝑑 → −∞ ⇒ 𝑁(𝑑 ) → 0 ⇒ 𝑁(−𝑑 ) → 1
 The call value 𝑐 = 𝑆 𝑁 𝑑 − 𝐾𝑒 𝑁 𝑑 → 0
 The put value 𝑝 = 𝐾𝑒 𝑁 −𝑑 − 𝑆 𝑁 −𝑑 → 𝐾𝑒 −𝑆
13.2
80
RNVR and BSM model
 A full proof of the BSM formulae is beyond the

scope of this course
– In fact, Black and Scholes derived the option pricing
formulae in another way which is similar to what the
binomial tree model does
 The basic idea is to construct a riskless portfolio by
determining proper weights for the option and its underlying
asset
 This is because the option price and the underlying asset
price share the same source of uncertainty
 The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
 Thus, a partial differential equation (偏微分方程式) is derived,
and the solution of it is the BSM option pricing formula 13.2
81
RNVR and BSM model
– Similar to the binomial tree model, the procedure

to derive the BSM model also leads to the RNVR
 The no arbitrage argument implies the return of the
riskless portfolio should be the risk free interest rate
 Therefore, we can obtain that the expected growth rates
for both the underlying asset price and the option price
are the same to be the risk-free interest rate
 As a result, an option can be priced as if it and its
underlying asset were in the risk neutral world
– In fact, the general rule to price an option as the PV of its
expected payoff in the risk neutral world, i.e.,
𝑒 𝐸[payoff(𝑆 )|in the risk−neutral world],
is the unique solution of the partial differential equation
considered in the BSM model 13.2
82
13.3 Apply Risk-Neutral
Valuation Relationship
to Pricing Forward
Contracts
13.2
83
RNVR for Forward Contracts
 The RNVR is valid for pricing all derivatives,

including futures, forwards, swaps, and
options
– Three steps to evaluate any derivative with the
general rule of the RNVR:
𝑒 𝐸 payoff 𝑆 in the risk−neutral world
1. Identify the payoff function of the derivative
2. When calculating the expected payoff, assume that the
expected growth rate of the underlying asset price is
the risk-free rate
3. Discount the expected payoff at the risk-free rate
13.2
84
RNVR for Forward Contracts
 Apply the RNVR to deriving the theoretical

value of the forward contracts today
– Consider a long forward contract that matures at
time 𝑇 with the delivery price 𝐾
Step 1: The payoff of the contract at maturity is 𝑆 − 𝐾
Step 2: The expected payoff in the risk-neutral world is
𝐸[𝑆 − 𝐾|in the risk−neutral world]
= 𝐸[𝑆 |in the risk−neutral world] − 𝐾 = 𝑆 𝑒 − 𝐾
Step 3: The theoretical value of the forward contract today is
𝑓=𝑒 𝑆 𝑒 − 𝐾 = 𝑆 − 𝐾𝑒
※ The above formula is identical to the formula of the
forward value (for the underlying asset without any
income) on Slide 5.30 13.2
85
13.4 Implied Volatility
13.2
86
Implied Volatility
 The only unobservable parameter in the BSM

pricing formula is the volatility of the stock
price
– The parameters in the BSM model include 𝑆 , 𝐾, 𝑟,
𝜎, and 𝑇
– The implied volatility of an option is the volatility for
which the BSM option price equals the market price
– The is a one-to-one correspondence between
prices and implied volatilities
– The bisection method (二分逼近法) to find the
implied volatility given 𝑆 = 21, 𝐾 = 20, 𝑟 = 0.1, 𝑇 =
0.25, and 𝑐 = 1.9 ⇒ The implied 𝜎 = 24.2% 13.2
87
Implied Volatility
– The implied volatility reflects the consensus of

traders in the option market on the volatility of the
underlying asset price for a future period
 The implied volatility is a forward-looking estimation,
which is the expected volatility about a future period over
which the option will exist
 The historical volatility works well only if the price behavior
of the underlying asset in the immediate future is the
same as that in the recent past
– The implied volatility of an option DOES depend on
its strike price and time to maturity
– Traders and brokers often quote implied volatilities
rather than dollar prices (to facilitate identifying
overvalued or undervalued options) 13.2
88
Implied Volatility
 VIX (volatility index)

– The CBOE publishes indices of implied volatilities
– The most popular index, the S&P VIX, is an index of
the implied volatility of 30-day S&P 500 index options
calculated from a wide range of calls and puts
– The S&P VIX, with a normal range between 15% and
25%, can be interpreted as the expectation of the
volatility of the S&P 500 index in the future one
month
– Trading in futures on the VIX started in 2004 and
trading in options on the VIX started in 2006
 Note that the underlying asset of those derivatives is the
VIX index, which is not a tradable asset 13.2
89
13.5 Effects of Cash

Dividend Payments on
Option Prices
13.2
90
Effects of Cash Dividend
Payments on Option Prices
 European options on dividend-paying stocks
are valued by substituting 𝑆 for 𝑆 − 𝐷 in
the BSM or the binomial tree models
– 𝐷 is the sum of the PV (discounted at 𝑟) of the
dividend payments during the life of the option
– Note that this technique is used to determine the
forward price in Ch. 5 and to modify the lower
bounds and the put-call parity of options in Ch. 10
– Reasons for this replacement method:
 Note that that on the ex-dividend dates, the stock prices
are expected to reduce by the amounts of the dividend
payments 13.2
91

 Therefore, the distributions of 𝑆 are identical under the
following two situations
1. The initial stock price is 𝑆 and there are dividend payments
𝐷 ’s during the life of the option
2. The initial stock price is 𝑆 − 𝐷 and there is no dividend
payment during the life of the option
※ Since the value of a European option is

𝑒 𝐸[payoff(𝑆 )|in the risk−neutral world]
=𝑒 ∫ payoff(𝑆 )𝑓 𝑆 𝑑𝑆 ,
it can be expected that the option value should be the same
under the above two situations due to the identical
probability density function 𝑓 𝑆
13.2
92
 For American options, it can be priced with
only some numerical methods like the
binomial tree model
– To take the dividend payments into account, the
technique of replacing 𝑆 with 𝑆 − 𝐷 is no more
valid
– This is because in order to make the optimal early
exercise decision, we need the correct probability
distribution of the stock price at all time point 𝑡,
which cannot be achieved by the replacement of 𝑆
with 𝑆 − 𝐷
13.2
93

 Fischer Black proposed an approximation for
the value of an American call based on the
BSM model if there are dividend payments
during the life of the option
– The well-known early exercise behavior of
American calls
 An American call on a non-dividend-paying stock should
never be exercised early
 An American call on a dividend-paying stock should only
be exercised immediately prior to an ex-dividend date
13.2
94
– Approximate the American call equal to the
maximum of two European option prices:
1. The 1st European option price is for an option maturing
at the same time as the American option
2. The 2nd European option price is for an option
maturing just before the final ex-dividend date
(The strike price, initial stock price, risk-free interest rate,
and the volatility are the same for the options under
consideration)
※ Note that the binomial tree model can evaluate
American calls or puts accurately with proper
modifications for dealing with the cash dividend
payments (beyond the scope of this course) 13.2
95

CH 6 13

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CH 6 13

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Interest Rate Futures

 Introduce the day count and quotation

Day Count Conventions in the

– Treasury bonds or notes: Actual/Actual

Day Count Conventions in the

Quotations for Treasury Bonds

Quotations for Treasury Bills in

Treasury Bond Futures (公債期貨)

 Treasury bond futures on CME is the most

Treasury Bond Futures (公債期貨)

– Cash amount received by the short-side trader =

 The accrued interest is for the period between the delivery

– The conversion factor for a bond is approximately

Conversion Factor (轉換因子)

 Case 1: the next payment date is after 6 months

 Case 2: the next payment date is after 3 months

Conversion Factor (轉換因子)

Cheapest-to-deliver (CTD) Bond

– The cost of delivering each of the bonds is as follows

 The delivery options (belonging to short-side

Prices for Treasury Bond Futures

 Theoretical futures prices for the Treasury bond

6.3 Eurodollar Futures

 A Eurodollar is a dollar deposited in a bank

Eurodollar Futures (歐洲美元期貨)

 Quotes and prices of Eurodollar futures

– When Eurodollar futures expires (on the third

Eurodollar Futures (歐洲美元期貨)

3. On Nov. 3, you suffer a loss of (96.98 – 97.23) / 0.01 × $25

Forward Rates and Eurodollar

Forward Rates and Eurodollar

Forward Rates and Eurodollar

※ For a longer time to maturity, the difference between the futures

6.4 Duration-Based Hedging

 Duration is defined as the weighted average of the

※ If the yield rises by 0.1%, the estimated change in the bond

 Examination the accuracy of Δ𝐵 ≈ −𝐵𝐷Δ𝑦: when the

– When the yield 𝑦 is expressed with compounding

 Two bonds with the same duration have the

 Duration matching hedge:

Example for Hedging a Bond

Example for Hedging a

Example for Hedging a

Example for Hedging a

※ The deterioration of the hedging effect is due to the large

 Introduce interest rate (IR) swaps (利率交換)

7.1 Interest Rate (IR) Swaps

 A swap is an agreement to exchange a series

Interest Rate Swap

 The most common type of swap is a “plain

Cash Flows of an Interest Rate Swap

– Day count conventions for IR swaps in the U.S.

Interest Rate Swap

 Reasons for using IR swaps

Original fixed- IR swap Original floating-

– The net borrowing rate for Intel’s liability is LIBOR + 0.2%

2. Converting the investment income from

Original floating- IR swap Original fixed-rate

– The net interest rate earned for Intel’s asset is 4.8%

Interest Rate Swap

 In practice, a financial intuition (F.I.) is involved

Original fixed- IR swap IR swap Original floating-

Original floating- IR swap IR swap Original fixed-rate