R48 Derivative Markets and Instruments

R48 Derivative Markets and Instruments 2020 Level I Notes
R48 Derivative Markets and Instruments
1. Introduction ......................................................................................................................................................2
2. Derivatives: Definitions and Uses .............................................................................................................2
3. The Structure of Derivative Markets .......................................................................................................3
3.1 Exchange-Traded Derivatives Markets ...........................................................................................3
3.2 Over-the-counter Derivatives Markets ............................................................................................4
4. Types of Derivatives .......................................................................................................................................5
4.1 Forward Commitments ..........................................................................................................................6
4.2 Contingent Claims ....................................................................................................................................9
4.3 Hybrids ...................................................................................................................................................... 13
4.4 Derivatives Underlyings ..................................................................................................................... 13
5. The Purposes and Benefits of Derivatives .......................................................................................... 14
6. Criticisms and Misuses of Derivatives.................................................................................................. 15
7. Elementary Principles of Derivative Pricing ..................................................................................... 15
7.1 Storage ....................................................................................................................................................... 16
7.2 Arbitrage ................................................................................................................................................... 16
Summary .............................................................................................................................................................. 17
Practice Questions ............................................................................................................................................ 20
This document should be read in conjunction with the corresponding reading in the 2020 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2019, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
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1. Introduction
This reading covers what is a derivative, why derivatives are needed, the different types of
derivatives and how they are priced.
2. Derivatives: Definitions and Uses
A derivative is a financial instrument that derives its value from the performance of an
underlying asset. In simple terms, a derivative is a legal contract between a buyer and a
seller, entered into today, regarding a transaction that will be fulfilled at a specified time in
the future. This legal contract is based on an underlying asset.
A derivative contract defines the rights of each party involved. There are two parties
participating in the contract: a buyer and a seller.
• Long: Buyer of the derivative is said to be long on the position. He has the right to buy
the underlying according to the conditions mentioned in the contract.
• Short: Seller of the derivative is said to be short. Remember “s” is for short and seller.
Let us take an example. Assume A is planning a family vacation to Fiji after six months and is
saving money for the trip. He estimates he will need 15,000 Fijian dollars (FJD) which in
today’s terms translates to 500,000 in his local currency (LCR). But he is worried that FJD
may appreciate, and the 500,000 will buy less FJD after six months. So he enters into a
contract with B to buy 15,000 FJD at a certain exchange rate six months from now – a week
before his travel. What has A done?
In a way, he has removed any uncertainty with respect to exchange rates in the future and
limited his risk. This agreement between A and the other party is a derivative where the
underlying is the exchange rate. The value of the contract fluctuates based on the underlying
exchange rate. A is long, and the party that agrees to deliver 15,000 FJD six months later is
short on the position. This agreement is shown in the exhibit below.
Derivatives are sometimes compared to insurance as they offer protection against

something. Like insurance, they have a value based on what they are protecting (usually the
asset), a definite life span, and an expiration date.

Risk management is the process by which an organization or individual defines the level of
risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the
former. Derivatives are an important tool for companies to manage risk effectively.
3. The Structure of Derivative Markets
In this section, we look at the characteristics of exchange-traded and over-the-counter
markets. The exhibit below shows the structure of the derivatives market.
3.1. Exchange-Traded Derivatives Markets

Derivatives traded on exchanges are called exchange-traded derivatives. Examples include
stock futures, currency futures. The exchange is the intermediary between the long and
short parties. It takes an initial margin from both the parties as a guarantee.
Exchange-traded derivatives are standardized. To standardize a derivative implies that the
contract is bound by terms and conditions, and there is little ability to alter those terms. The
contract clearly specifies when it can be traded, when it will expire, what is the lot size, a
minimum amount, and settlement price. There is no room for customization. The only aspect
not defined is the price. The price is determined by the buyers and sellers. For example, a
gold contract on CME defines its quality (995 fineness), contract size (100 troy ounces), how
it will be settled (physical), and so on.
The advantages of standardization are as follows:
• Liquidity: Standardization boosts liquidity as there is no ambiguity, unlike an OTC
market. All market participants are aware when a particular currency/stock future
will trade and when it will expire.
• Clearing and settlement process: Standardization facilitates in clearing and settlement.
After the trade is executed, the clearing and settlement process kicks in. The flow of
money and securities does not happen directly between the investors, as you can see

from the diagram below. Instead, it flows through a third party called the
clearinghouse. Clearing is the process by which the clearinghouse verifies the
execution of the transaction and the identity of the participants. Settlement refers to
the process in which the exchange transfers money from one party to another, or from
a participant to the exchange or vice versa.
• More transparent: The presence of a clearinghouse makes the whole process

transparent and minimizes the impact of default between the parties. All the
information regarding prices, settlement, and daily turnover is disclosed within
exchanges and clearinghouse which means there is a lack of privacy and flexibility.
• Credit guarantee: It goes without saying that one party loses while the other wins in a
derivative contract as it is based on the performance of the underlying. Clearinghouses
guarantee that the winning party gets paid by requiring participants to post a margin
(cash deposit) called margin or performance bonds, and uses these deposits to make a
payment in the event of default.
3.2. Over-the-counter Derivatives Markets
Unlike an exchange-traded derivative, OTC contracts are negotiated directly between two
parties without an exchange. The characteristics of OTC markets are as follows:
• OTC market comprises an informal network of dealers, typically banks, linked
electronically. These are also called dealer markets.
• Contracts are customized as per the client’s needs.
• Unlike an exchange-traded system where the clearinghouse guarantees settlement,
OTC derivatives have credit risk. Each party bears the risk that the other party will
default.
The key differences between exchange-traded and OTC markets are summarized below:
Differences between exchange-traded and OTC markets
Feature Exchange-traded OTC
Rules Standardized Customized
Where are the contracts traded Exchanges Dealer network
Intermediary Yes, an exchange No intermediary
Trading, clearing, and settlement Centralized Decentralized

Liquidity More Almost the same

Transparent Yes No
Level of regulation High Low
Flexibility/privacy No Yes
Margin required Yes May or may not be
Examples Futures and options Forwards and Swaps
Market Makers
Market makers can operate in both exchange-traded and OTC markets. The market makers
make money through the bid-ask spread. For instance, if party A wants to take a long
position, the market maker will take the opposite position, i.e., a short position. The market
maker will then look for another party, suppose B, with whom the market maker will take a
long position. In other words, the market maker will sell to party A and buy from party B.
The overall effect is cancelled out, and no matter what happens to the underlying, the market
maker is covered. The bid amount will be lesser than the ask price, and the difference
between both will generate a profit for the market maker.
4. Types of Derivatives
The following exhibit shows the different types of derivatives.

4.1. Forward Commitments

A forward commitment is a contract that requires both parties to engage in a transaction at a
later point in time (the expiration) on terms agreed upon today. The parties establish the
identity and quantity of the underlying, the manner in which the contract will be executed or
settled when it expires, and the fixed price at which the underlying will be exchanged. Both
the parties – the buyer and the seller - have an obligation to engage in the transaction at a
future date in a forward commitment.
We will look at the three types of forward commitments: forward contracts, futures
contracts, and swaps.
Forward Contracts
A forward contract is an over-the-counter derivative contract in which two parties agree to
exchange a specific quantity of an underlying asset at a later date at a fixed price they agree
on when the contract is signed. It is a customized and private contract between two parties.
Terms of a forward contract
• Price.
• Where the asset will be delivered.
• Identity of the underlying.
• Number of units or quantity of the underlying. For example, if the underlying is gold
and the price is fixed per gram, the number of grams to be delivered must be specified.
• It is a customized contract between two parties and not traded over the exchange.
Risk of a forward contract
• The long hopes the underlying will increase in value while the short hopes the asset
will decrease in value. One of the two will happen and whoever owes money may
default.
• With forward contracts, no money is exchanged at the start of the contract. Further,
the value of the contract is zero at initiation.
Payoff for long and short:
The diagram below illustrates the payoff diagram for long and short in a forward contract:

Notation:
• S0 = price of the underlying at time 0; ST = price of the underlying at time T
• FT = forward price fixed at inception at time t = 0
• T = when the forward contract expires
Example
Whizz wants to sell 500 shares of beverage maker FTC to Fizz at $50 per share after 180
days. What happens if the market price of FTC at expiry is $50, $60, $70 or $40?
Solution:
Fizz is the long party and Whizz is the short party.
At expiry from Fizz’s perspective (long) when market price is:
$50: payoff is 0 and no one gains or loses
$60: long gains by $10
$70: long gains by $20
$40: long loses by $10 as he can buy the asset cheaper by $10 directly from the market
instead of paying $50 to Whizz
From Whizz’s perspective, it is exactly the opposite to that of Fizz. When the share price
increases to $70, he loses $20 as he can sell it in market for $70 but is selling for only $50 to
Fizz.
The payoff for the long is depicted diagrammatically below:

Futures
A futures contract is a standardized derivative contract created and traded on a futures
exchange such as the Chicago Mercantile Exchange (CME). In a futures contract, two parties
agree to exchange a specific quantity of the underlying asset at an agreed-upon price at a
later date. The buyer agrees to purchase the underlying asset from the other party, the seller.
The agreed-upon price is called the futures price.
There are some similarities with a forward contract: two parties agreeing on a contract, an
underlying asset, a fixed price called the futures price, a future expiry date, etc. But the
following characteristics differentiate futures from a forward:
• The contracts are standardized.
• They are traded on a futures exchange.
• The fixed price is called futures price and is denoted by f. (Forward prices are usually
represented by F.)
• The biggest difference is that gains or losses are settled on a daily basis by the
exchange through its clearinghouse. This process is called mark to market.
• Settlement price is the average of final futures trades and is determined by the
clearinghouse.
• The futures price converges to a spot price at expiration.
• At expiry: the short delivers the asset and the long pays the spot price.
Let us take an example. Assume Ann enters into a contract to buy 100 grams of gold at $55
per gram after 90 days. The futures price is $55. At the end of day 1, the futures price is $58.
There is a gain of $3. So, $300 ($3 per gram x 100 grams) is credited to Ann’s account. This is
called marking to market. The account maintained by Ann is called the margin account.
Swaps
A swap is an over-the-counter contract between two parties to exchange a series of cash
flows based on some pre-determined formula. The simplest swap is a plain vanilla interest
rate swap. Consider two companies A and B in Hong Kong that enter into a swap agreement;

Company A agrees to pay 10% interest per year to company B for three years on a notional
principal of HKD 90,000. Company B, in turn, agrees to pay HIBOR + 150 basis points per
year to company A for the same period and on the same notional principal.
4.2. Contingent Claims
We now move to the other major category of derivative instruments called contingent
claims. The holder of a contingent claim has the right, but not the obligation to make a final
payment contingent on the performance of the underlying.
In a contingent claim, two parties, A and B, sign a contract at time 0 to engage in a
transaction at time T. Unlike a forward or futures contract, A has the right, but not the
obligation to make a payment and take delivery of the asset at time T.
There are three types of contingent claims: options, credit derivatives, and asset-backed
securities.
Options
An option is a derivative contract in which one party, the buyer, pays a sum of money to the
other party, the seller or writer, and receives the right to either buy or sell an underlying
asset at a fixed price either on a specific expiration date or at any time prior to the expiration
date. Options trade on exchanges, or they can be customized in the OTC market.
The buyer/holder of an option is said to be long.
The seller/writer of an option is said to be short.
There are two types of options based on when they can be exercised:
• European option: This type of option can be exercised only on the expiration date.
• American option: This type of option can be exercised on or any time before the
option’s expiration date.
There are two types of options based on the purpose it serves:
• Call option: Gives the buyer the right to buy the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to sell the
underlying asset.
• Put option: Gives the buyer the right to sell the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to buy the
underlying asset.
Assume there are two parties: A and B. A is the seller, writer, or the short party. B is the
buyer or the long party. A and B sign a contract, according to which B has the right to buy
one share of Strong Steel Inc. for $50 after six months.
In our example, B has bought the right to buy, which is called a call option. The right to sell is
called a put option. If B has the right to buy a share (exercise the option) of Strong Steel Inc.
anytime between now and six months, then it is an American-style option. But if he can

exercise the right only at expiration, then it is a European-style option. $50, the price fixed at
which the underlying share can be purchased, was fixed at inception and is called the strike
price or exercise price.
B bought the right to buy the share at expiration from A. So B has to pay A, a sum of money
called the option premium for holding this right without an obligation to purchase the share.
The call premium B paid is $3. An investor would buy a call option if he believes the value of
the underlying would increase.
The diagram below shows the call option payoff and profit for both a buyers and sellers
perceptive.
Call option buyer and seller payoff at expiration:

cT = Max (0,ST – X)
where:
ST = stock’s price
X = exercise price
For example, suppose you buy a call option with an exercise price of 30 and an expiration of
three months for a premium of 1.00 when the stock is trading at 25. At expiration, consider
the outcomes when the stock’s price is 25, 30, or 35. The buyer’s payoffs would be:
For ST = 25, payoff = cT = Max(0,ST – X) = Max(0,25 – 30) = Max(0, –5) = 0.
For ST = 30, payoff = cT = Max(0,ST – X) = Max(0,30 – 30) = Max(0, 0) = 0.
For ST = 35, payoff = cT = Max(0,ST – X) = Max(0,35 – 30) = Max(0, 5) = 5.
To the seller, who received the premium at the start, the payoff is:
–cT = –Max(0,ST – X)

At expiration, the call seller’s payoffs are:

For ST = 35, payoff = –cT = –Max(0,ST – X) = –Max(0,35 – 30) = 0.
For ST = 30, payoff = –cT = –Max(0,ST – X) = –Max(0,30 – 30) = 0.
For ST = 35, payoff = –cT = –Max(0,ST – X) = –Max(0,35 – 30) = –5.
The call buyer’s profit would be:
Profit = Max(0,ST – X) – c0
where:
c0 = option premium
For ST = 25, profit = Max(0,ST – X) – c0 = Max(0,25 – 30) – 1.00 = – 1.
For ST = 30, profit = Max(0,ST – X) – c0 = Max(0,30 – 30) – 1.00 = – 1.00.
For ST = 35, profit = Max(0,ST – X) – c0 = Max(0,35 – 30) – 1.00 = 4.00.
The call seller’s profit is:
Π = –Max(0,ST – X) + c0
At expiration, the call seller’s profit for each underlying price at expiration are:
For ST = 35, profit = –Max(0,ST – X) + c0 = –Max(0,35 – 30) + 1.00 = 1.00.
For ST = 30, profit = –Max(0,ST – X) + c0 = –Max(0,30 – 30) + 1.00 = 1.00.
For ST = 35, profit = –Max(0,ST – X) + c0 = –Max(0,35 – 30) + 1.00 = –4.00.
Put option buyer and seller payoff at expiration:
An investor would buy a put option if he believes the value of the underlying would
decrease. If it decreases by expiration date, the investor has a right to exercise the option to
sell the underlying at the exercise price, which will be greater than the then market price.
The payoff to the put holder is:
pT = Max(0,X – ST)
The put buyer’s profit would be:
Π = Max(0,X – ST) – p0
where: p0 is option premium.
The payoff for the seller is:
–pT = –Max(0,X – ST)
The put seller’s profit would be:
Π = –Max(0,X – ST) + p0

Credit Derivatives
A credit derivative is a class of derivative contracts between two parties, a credit protection
buyer and a credit protection seller, in which the latter provides protection to the former
against a specific credit loss. The main type of credit derivative is a credit default swap.
Credit Default Swap
A credit default swap is a derivative contract between two parties, a credit protection buyer
and a credit protection seller, in which the buyer makes a series of cash payments to the seller
and receives a promise of compensation for credit losses resulting from the default of a third
party.
• A CDS is a form of insurance.

• The objective of a CDS is to buy protection to cover the loss of par value of the bond, if
a credit event occurs. A credit event is like bankruptcy, restructuring, or failure to pay
that impairs the borrower’s ability to make timely payments.
• The CDS transfers the credit risk of the borrower from one party (protection buyer) to
another (protection seller).
• If the borrower defaults, the CDS seller pays the CDS buyer.
Asset-Backed Securities
An asset-backed security is a derivative contract in which a portfolio of debt instruments is
assembled and claims are issued on the portfolio in the form of tranches, such that the
prepayments or credit losses are allocated to the most junior tranches first and the most
senior tranches last.
The following exhibit shows how asset-backed securities are created.

Listed below are the major points related to asset-backed securities:

• A pool of loans are grouped together to form a portfolio of loans.
• Financial institutions such as banks, auto companies, and credit card companies that
lend these loans, package them into marketable securities through a process called
securitization, and sell them to a special purpose vehicle. These financial institutions
are the originators of an ABS.
• These securities are called asset-backed securities because they are backed by the
receivables of an asset, such as home loan, auto loan, etc.
• Unlike investors of a bond, all the investors of an ABS do not receive the same rate of
return because it is affected by the prepayments of the underlying loans.
• ABS is typically divided into tranches or bond classes. The prepayment risk and credit
risk are typically different across the bond classes.
4.3. Hybrids
Hybrid instruments combine derivatives, fixed-income securities, currencies, equities, and
commodities. An example of a hybrid is a callable bond or a convertible bond that is created
by combining bonds and options.
4.4. Derivatives Underlyings
We have seen that derivatives are contracts that derive their value from an underlying. The
commonly used underlyings are listed below:
• Equities: Individual stocks and stock indices. Options on stocks and equity swaps are
the most commonly used derivatives.
• Fixed-Income Instruments: Bonds, notes. Options, forwards, futures, and swaps on
bonds are used.
• Interest Rates: Most widely used derivative. But the underlying is not an asset.
• Currencies: Currency is the underlying. Options, forwards, futures, and swaps on
currencies are used.

• Commodities: Any commodity such as food, oil, gold, silver, etc. Futures are the most
used commodity derivatives.
• Credit: Underlying is credit of some form. Examples of derivatives created on credit as
an underlying include CDS or CDO.
• Other: Contracts can also be based on several different types of underlying such as
weather, electricity, natural disasters, etc.
5. The Purposes and Benefits of Derivatives
The modern derivatives market finds its origin with the formation of the Chicago Board of
Trade in 1848. In the mid-1800s, Chicago was becoming a major hub of transportation and
commerce where farmers gathered to sell their agricultural produce every year from
September to November. As the city’s storage capacity was not adequate to store all the
grains during this period, some farmers found it economical to dump the grains in the
Chicago River (literally!) than cart it all the way back to their farms. The rest of the year, the
prices of the grains would rise sharply.
The Chicago Board of Trade introduced a financial instrument called a “to-arrive” contract
that a farmer could sell anytime of the year that specified the price and delivery date for the
grain. On that pre-determined date, he could deliver the grain. This ensured the farmers got
a fair price for their produce all through the year by entering into a contract ahead of time to
deliver the grains at some point in the future.
Some of the benefits of derivatives are listed below:
Risk Allocation, Transfer, and Management
Derivatives are a cost-effective way of transferring risk from one party to another. For
example, if an investor has a substantial investment in a stock that he does not want to sell
but reduce the risk, he can do so by taking a short position in a futures contract or buying a
put option.
Information Discovery
There are two primary advantages of futures markets:
• Price discovery: Futures prices reveal more information than spot prices. For
commodities that trade worldwide like gold, a futures contract expiring soon is a
better indicator of its value than gold price in India or the U.S. which may be wide
apart.
• Implied volatility: Implied volatility measures the risk of the underlying or the
uncertainty associated with options. With the models such as BSM to price an option,
it is possible to determine the implied volatility, and hence the risk.
Operational Advantages
Some of the major operational advantages associated with derivatives are given below:
• Lower transaction costs than the underlying.

• Greater liquidity than the underlying spot markets.

• Easy to take a short position.
Margin requirements and option premiums are low relative to the cost of the underlying
Market Efficiency
Any mispricing is corrected more quickly in the derivatives market than the spot market
because of operational advantages: low transaction costs, easier to take a short position, etc.
The market is more liquid as it attracts more market participants because of its low cost to
trade.
They allow investors to participate in price movements, both long and short positions are
allowed.
Some instruments may not be bought directly, but an investor can gain exposure to these
instruments through derivatives. For example, the weather.
6. Criticisms and Misuses of Derivatives
Studies researching the cause of a crash over the past 30 years always point to derivatives as
one of the primary reasons. The sub-prime crisis of 2007-08 was also caused by a derivative
– Credit Default Swap.
Speculation and Gambling
Derivatives are often compared to gambling as it involves a lot of speculation and risk taking.
An important distinction between speculation and gambling is that a very few benefit from
gambling. But speculation makes the whole financial markets more efficient.
Destabilization and Systemic Risk
Derivatives are often blamed to have destabilizing consequences on the financial markets.
This is primarily due to the high amount of leverage taken by speculators. If the position
turns against them, then they default. This triggers a ripple effect causing their creditors to
default, creditors’ creditors to default, and so on. A default by speculators impacts the whole
system. For example, the credit crisis of 2008.
Complexity
Another criticism of derivatives is their complexity. The models are highly complex and are
not easily comprehensible by everyone.
7. Elementary Principles of Derivative Pricing
Derivative pricing is based on the hedge portfolio concept: combination of a derivative and
underlying such that risk is eliminated. The hedge portfolio should earn the risk-free rate. A
derivative’s value is the price of the derivative that forces the hedge portfolio to earn the
risk-free rate. It is also important to understand the concepts of storage and arbitrage.

7.1. Storage
Certain kinds of derivatives like forward/future contracts where the underlying is a
commodity like food grain, gold, or oil require storage. Storage incurs costs and
consequently the forward/future price must be adjusted upwards.
7.2. Arbitrage
Arbitrage is the condition that if two equivalent assets or derivatives or combinations of
assets and derivatives sell for different prices, then this leads to an opportunity to buy at a
low price and sell at a high price, thereby earning a risk-free profit without committing any
capital.
Let us consider an example of a stock selling in two markets A and B. The stock is selling in
market A for $51 and in market B for $52. An arbitrage opportunity exists here as an
investor can buy the stock at a lower price in market A and sell it at a higher price in market
B.
The combined actions of arbitrageurs bring about a convergence of prices. Hence, arbitrage
leads to the law of one price: transactions that produce equivalent results must sell for
equivalent prices. If more people buy the stock in market A, and more people sell the stock in
market B, the stock’s price will converge in both the markets.

Summary
LO.a: Define a derivative, and distinguish between exchange-traded and over-the-
counter derivatives.
A derivative is a financial instrument that derives its value from the performance of an
underlying asset. It is a legal contract between a buyer and seller entered into today,
regarding a transaction that will be fulfilled at a specified time in the future.
Differences between exchange-traded and OTC markets
Feature Exchange-traded OTC
Rules Standardized Customized
Where are the contracts traded Exchanges Dealer network
Intermediary Yes, an exchange No intermediary
Trading, clearing, and settlement Centralized Decentralized
Liquidity More Almost the same
Transparent Yes No
Level of regulation High Low
Flexibility/privacy No Yes
Margin required Yes May be or not
Examples Futures and options Swaps
LO.b: Contrast forward commitments with contingent claims.
Forward commitments are contracts entered into at one point in time that require both
parties to engage in a transaction at a later point in time (the expiration), on terms agreed
upon at the start. Examples: forward contracts, futures contracts, and swaps.
The holder of a contingent claim has the right, but not the obligation, to make a final
payment, contingent on the performance of the underlying.
Example: call option and put option.
LO.c: Define forward contracts, futures contracts, options (calls and puts), swaps, and
credit derivatives, and compare their basic characteristics.
Forward contract is an over-the-counter derivative contract in which two parties agree to
exchange a specific quantity of an underlying asset on a later date, at a fixed price they agree
on when the contract is signed. It is a customized and private contract between two parties.
A futures contract is a standardized derivative contract, created and traded on a futures
exchange. In a futures contract, two parties agree to exchange a specific quantity of the
underlying asset at an agreed-upon price at a later date.
flows based on some pre-determined formula.

A call option gives the buyer the right to buy the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to sell the underlying
asset.
A put option gives the buyer the right to sell the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to buy the underlying
asset.
Credit derivative is a class of derivative contracts between two parties, a credit protection
buyer and a credit protection seller, in which the latter provides protection to the former
against a specific credit loss.
LO. d. Determine the value at expiration and profit from a long or a short position in a
call or put option.
The call option buyer’s payoffs at expiration is:
cT = Max(0,ST – X)
To the seller, who received the premium at the start, the payoff is:
–cT = –Max(0,ST – X)
The call buyer’s profit is:
Max(0,ST – X) – c0
The call seller’s profit is:
Π = –Max(0,ST – X) + c0
The payoff to the put holder is:
pT = Max(0,X – ST)
The put buyer’s profit is:
Π = Max(0,X – ST) – p0
The payoff for the seller is:
–pT = –Max(0,X – ST)
The put seller’s profit is:
Π = –Max(0,X – ST) + p0
LO.e: Describe purposes of, and controversies related to, derivative markets.
Benefits
• Risk allocation, transfer, and management protection with minimum investment.
• Information discovery.
• Price discovery.
• Implied volatility.
• Market efficiency.

Criticisms
• Speculation and gambling.
• Destabilization of financial markets.
LO.f: Explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Arbitrage
• Arbitrage is the condition under which two equivalent assets or derivatives or
combination of assets and derivatives sell for different prices.
• This allows us to buy at a low price and sell at a high price, and earn a risk-free profit
from this transaction without committing any capital.
Role
• The combined actions of arbitrageurs force the prices of similar securities to
converge.
• Hence, arbitrage leads to the law of one price: transactions that produce equivalent
results must sell for equivalent prices.

Practice Questions
1. Which of the following statements most accurately describes a derivative? A derivative:
A. passes through the returns of the underlying.
B. duplicates the performance of the underlying.
C. transforms the performance of the underlying.
2. In contrast to over-the-counter derivatives, exchange-traded derivatives would most

likely be:
A. customized.
B. less regulated.
C. more transparent.
3. An agreement to purchase a specific stock next month for $100 is:

A. a forward commitment.
B. a contingent claim.
C. both a forward commitment as well as a contingent claim.
4. Which of the following best describes an interest rate swap?

A. An agreement where two parties agree to exchange a series of cash flows.
B. An agreement where the credit seller provides protection to the credit buyer.
C. An agreement where the buyer has the right to purchase the underlying from the
seller.
5. Analyst 1: Options provide payoffs that are linearly related to the payoffs of the
underlying.
Analyst 2: Forwards provide payoffs that are linearly related to the payoffs of the
underlying.
A. Analyst 1 is correct.
B. Analyst 2 is correct.
C. Both analysts are correct.
6. Which of the following derivatives will most likely have a non-zero value at initiation of
the contract?
A. Futures
B. Forwards
C. Options
7. Consider a call option selling for $1.90 in which the exercise price is $78. If the price of
the underlying at expiration is $81, the payoff and profit for a buyer is
A. 0

B. $3.00 and $1.10, respectively.

C. $3.00 and $4.90, respectively.
8. Derivatives are least likely to:

A. provide more opportunities to go short compared with the spot market.
B. prevent arbitrage.
C. improve liquidity.
9. Which of the following statements about arbitrage is least accurate?

A. Arbitrage can cause markets to be less efficient.
B. Arbitrage allows making a profit without risk.
C. Arbitrage allows making a profit without investment.

Solutions
1. C is correct. A derivative is a financial instrument that transforms the performance of the

underlying.
2. C is correct. Exchange traded derivatives are more transparent than over-the- counter
derivatives. They are also standardized and more regulated as compared to over-the-
counter derivatives.
3. A is correct. Forward commitments represent an obligation to buy/sell, whereas

contingent claims represent a right to buy/sell.
4. A is correct. Interest rate swap is an agreement between two parties to exchange a series
of cash flows. Option B describes a credit default swap. Option C describes a call option.
5. B is correct. Forwards provide payoffs that are linearly related to the payoffs of the
underlying. Whereas, the payoffs of options are non-linear, for example a call option will
provide a payoff only if the underlying crosses the strike price, otherwise it will expire
worthless and have a zero payoff.
6. C is correct. Futures and forwards have a zero value at initiation of the contract. Options
however have a non-zero value at initiation, equal to the option premium.
7. B is correct.
Payoff = cT = Max (0,ST – X) = Max (0, 81– 78) = $3
Profit = Max (0,ST – X) – c0 = Max (0, 81 – 78) – 1.90 = $1.1
8. B is correct. Derivatives facilitate arbitrage transactions not prevent them. Option A and
C are correct statements.
9. A is correct. Arbitrage makes a market more efficient. Option B and C are correct
statements.

R37 Pricing and Valuation of Forward Commitments 2021 Level II Notes
R37 Pricing and Valuation of Forward Commitments
1. Introduction ........................................................................................................................................................ 2
2. Principles of Arbitrage- Free Pricing and Valuation of Forward Commitments ...................... 2
3. Pricing and Valuing Forward and Futures Contracts ......................................................................... 3
3.1 Our Notation ................................................................................................................................................ 3
3.2 No- Arbitrage Forward Contracts ....................................................................................................... 4
3.3 Equity Forward and Futures Contracts ............................................................................................ 9
3.4 Interest Rate Forward and Futures Contracts ............................................................................ 11
3.5 Fixed- Income Forward and Futures Contracts.......................................................................... 18
3.6 Currency Forward and Futures Contracts .................................................................................... 20
3.7 Comparing Forward and Futures Contracts ................................................................................ 22
4. Pricing and Valuing Swap Contracts ...................................................................................................... 22
4.1 Interest Rate Swap Contracts ............................................................................................................ 23
4.2 Currency Swap Contracts .................................................................................................................... 26
4.3 Equity Swap Contracts ......................................................................................................................... 29
Summary................................................................................................................................................................ 33
This document should be read in conjunction with the corresponding reading in the 2021 Level II
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
reserved.
Version 1.1

1. Introduction
A forward commitment is a derivative instrument that provides the ability to lock in a price
at which one can trade the underlying instrument at some future date. Examples include
forwards, futures, and swaps.
In this reading, Section 2 discusses the principles of the no-arbitrage approach to pricing and
valuation of forward commitments. Section 3 discusses the pricing and valuation of forwards
and futures contracts based on equities, interest rate, fixed income instruments, and
currencies. The final section of this reading presents the pricing and valuation of swaps,
mainly discussing interest rate, currency, and equity swaps.
2. Principles of Arbitrage- Free Pricing and Valuation of Forward

Commitments
Forward commitment pricing involves determining the appropriate forward commitment
price at the time of the initiation of the contract. Forward commitment valuation refers to
determining the appropriate value of the forward commitment contract at different points in
time, after it has been initiated.
Both pricing and valuation follow the no-arbitrage approach which means that prices should
adjust to not allow arbitrage profits. There are two fundamental rules an arbitrageur must
follow:
• Rule #1: Do not use your own money – the arbitrageur borrows money to purchase
the underlying and invests proceeds from short selling transactions at the risk-free
rate.
• Rule #2: Do not take any price risk – the arbitrageur eliminates any market price risk
related to the underlying and the derivatives used.
The no-arbitrage approach to pricing and valuation suggests that if cash and forward
markets are priced correctly then we cannot create a portfolio with no future liabilities and a
positive cash flow today. The basic point being that one should not be able to create money
today without assuming any risk or future liability.
The law of one price states that if two investments have the same or equivalent future cash
flows, then regardless of what happens in the future, these two investments should have the
same price today. If the law of one price is violated, one could buy the cheaper asset and sell
the more expensive one which will result in a risk-free gain with no commitment of capital.
The following assumptions are made throughout this reading:
1. Replicating instruments are identifiable and investable.
2. There are no market frictions.
3. Short selling is allowed with full use of proceeds.

4. Borrowing and lending are available at a known risk-free rate.

In this reading, we will rely on the carry arbitrage model to explain forward commitment
prices. The carry arbitrage model (also known as cost-of-carry arbitrage model or cash-
and-carry arbitrage model) is a no-arbitrage approach in which the underlying instrument is
either bought or sold along with a forward position.
3. Pricing and Valuing Forward and Futures Contracts

3.1 Our Notation
Some key notations established in this section will allow us to understand the pricing and
valuation relationships. Consider a forward contract established at time 0 and expiring at
time T.
Key notations related to this contract are:

T = initial time to expiration, expressed as a fraction of years.
𝑆0 = price of the underlying at initiation of the contract.
𝑆𝑡 = price of the underlying at Time t, where t is expressed as a fraction of years.
𝑆𝑇 = price of the underlying at expiration date.
F0 (T) = forward price established at initiation for a contract expiring at date T.
V0 = value of forward contract at initiation of the contract.
Vt = value of forward contract at time t.
VT = value of forward contract at expiration date.
Most forward contracts are established at market. This means that the forward price, F0(T),
is negotiated such that the market value of the forward contract, V0, is zero at initiation.
During the life of the contract, the forward price, F0(T), is unchanged. However, the value of
the forward contract, Vt, does vary.

At expiration, the market value of a long forward contract is VT = ST − F0 (T) and the
market value of a short forward contract is VT = F0 (T) − ST . A long forward contract will
have a positive value at expiration if the underlying is above the initial forward price
whereas a short position will have a positive value at expiration if the underlying is below
the initial forward price.
With futures contracts the terminology is similar except we use lowercase letters. Hence,
futures price is depicted by “f” and futures value is depicted by “v”. The futures price is
roughly equal to the price of a similar forward contract. The futures value, however, may be
different than the value of a similar forward contract since it is influenced by the mark-to-
market process. Whenever a futures contract is marked to market, its value comes down to
zero.
3.2 No- Arbitrage Forward Contracts
Carry Arbitrage Model When There Are No Underlying Cash Flows
Carry arbitrage models are built on no-arbitrage assumptions as mentioned earlier in the
reading. To understand these models, we need to look at them from an arbitrageur’s
perspective. An arbitrageur will seek to exploit pricing discrepancies between the futures or
forward price and the underlying spot price. The basic rule of pricing is that futures or
forward price should be priced in such a way that there are no arbitrage opportunities in the
market.
Let’s consider a simple example.
An asset has a current spot price of 100. There are no cash flows associated with this asset.
You enter into a contract to sell this asset at the end of one year. What is the arbitrage-free
forward price assuming a risk-free rate of 5%?

The arbitrage free forward price is given by the following formula:

F0 (T) = Future value of underlying = FV(S0 ) = S0 (1 + r)T
F0 (1) = 100(1 + 0.05)1 = 105
To understand why this is the arbitrage free price, let us assume that a forward contract is
available at a price of 106. At this price an arbitrage profit can be made by following these
steps:
Step 1: Sell the forward contract on the underlying at 106.
Step 2: Purchase the underlying at 100.
Step 3: Borrow the funds for the underlying purchase. Since the borrowed amount is 100
and the interest rate is 5%, the amount due after 1 year is 100 x 1.05 = 105.
Step 4: Borrow the arbitrage profit. At the end of the year, the arbitrageur will get 106 by
selling the asset whereas the loan amount due is 105, which translates into an arbitrage
profit of 106 – 105 = 1. The $1 profit is available at the end of the year. If the arbitrageur
wants a cash flow at Time 0, he can simply borrow the present value of $1 which 1/1.05 =
0.9524.
This is an example of carry arbitrage, since we buy the asset at Time 0 and carry it through
time.
Now suppose that the forward price is 104 instead. This forward price is now lower than the
equilibrium price of 105 and hence, we execute the exact opposite set of transactions as
shown below:
Step 1: Buy the forward contract on the underlying at 104.
Step 2: Sell the underlying short at 100.
Step 3: Lend the short sale proceeds. Thus, 100 is invested at an interest rate of 5% and the
arbitrageur will receive 100 x 1.05 = 105 at the end of the year.
Step 4: Borrow the arbitrage profit. At the end of the year, the arbitrageur will get 105 and
purchase the asset at 104 to return it and close the short sale. This translates into a profit of
105 – 104 = 1. The PV of this cash flow is 1/1.05=0.9524.

This strategy is known as reverse carry arbitrage because we are doing the opposite of
carrying the underlying instrument. Therefore, to conclude we can say that unless F0 (T) =
FV(S0 ), there is an arbitrage opportunity.
Instructor’s Note:
To make an arbitrage profit, we sell at the higher price and buy at lower price. If the forward
contract price is higher than the equilibrium price, we will sell the forward contract and
purchase the underlying. Whereas, if the forward contract price is lower than the
equilibrium price, we purchase the forward contract and sell the underlying.
Example: Forward Contract Price

This is based on Example 1 of the curriculum.
1. A US stock paying no dividends is trading in US dollars for $55.20 and the annual US
interest rate is 1.25% with annual compounding. Based on the current stock price and
the no-arbitrage approach, what is the equilibrium three-month forward price?
2. If the interest rate immediately falls by 25 bps to 1.00%, what is the impact on the three-
month forward price?
Solution 1:
Given the information, S0 = $55.20, r = 1.25% (annual compounding), and T = 0.25.
Therefore, F0 (T) = 55.20 (1 + 0.0125)0.25 = $55.5717.
Solution 2:
The forward price will decrease because it is directly related to the interest rate. This can
also be demonstrated by calculating the forward price using r = 1.00%. F0 (T) =
55.20 (1 + 0.01)0.25 = $55.3375. As expected, the forward price lower than what we
observed in solution 1.
Valuing an existing forward contract: There are two ways of calculating the value of the
existing forward position at Time t, where t represents any time between Time 0 and Time T.
1) Since the contract was initiated at Time 0, the spot price of the underlying would have
changed and some time has passed as well, so the new forward price at Time t would be
different from the old forward price. The present value of the differences in forward
prices gives us the value of the existing forward contract.
Vt = PV(Ft (T) − F0 (T))

2) Alternatively, the value of the long forward contract is the difference between the
underlying price at Time t and the present value of the forward price as determined at
the time of initiation (at Time 0).
Vt = St − PV(F0 (T))
Note: Since this is a zero-sum game, the short position is simply the negative value of both of
the above equations.
Example: Forward Contract Value
Assume that we have entered into a one-year forward contract with price F0 (T) = 100. Nine
months later (t = 0.75), the observed price of the underlying is 105 and the interest rate is
5%. What is the value of the existing forward expiring in three months?
Solution:
F0 (T) = 100, S0.75 = 105, r = 5%, T − t = 0.25

Method 1:
The three-month forward price at t: Ft (T) = 105 (1 + 0.05)0.25 = 106.2886. The value of the
106.2886 − 100
existing forward contract is: Vt = (1+0.05)0.25
= 6.2123.
Method 2:
100
Vt = St − PV(F0 (T)) = 105 − = 6.2123
(1.05)0.25
Carry Arbitrage Model When Underlying Has Cash Flows
We now take the carry arbitrage model a step further and consider the impact of the various
costs and benefits related to the underlying instrument on forward pricing. 𝛾 denotes carry
benefits such as dividends or bond coupon payments arising from the underlying
instrument during the life of the contract. θ denotes carry costs such as storage costs during
the life of the contract.

The forward price can now be expressed as:

F0(T) = FV(S0 + θ0 – γ0)
Another formula for calculating the forward price is:
F0(T) = S(1 + r)T + FV of costs – FV of benefits
From the above equations, we can see that the forward price is the future value of the
underlying adjusted for carry cash flows. We also note that the costs are added and the
benefits are subtracted in the pricing equation. This is because costs increase the burden and
benefits decrease the burden of carrying the underlying instruments.
Consider a stock which is selling for $100. The stock will pay a dividend of 2.9277 at t = 0.5.
The risk-free rate is 5%. What is the arbitrage-free price of a one-year forward contract on
this stock?
Using the first formula,

F0(T) = FV(S0 + θ0 – γ0)
F0(T) = FV(100 + 0 – (2.9277/1.050.5)) = (100 + 0 – 2.8571) x 1.051 = 102
Using the second formula,
F0(T) = S(1 + r)T + FV of costs – FV of benefits
F0(T) = 100 x 1.051 + 0 – (2.9277 x 1.050.5) = 105 + 0 – 3 = 102
Forward Price with Continuous Compounding
If the underlying asset is a stock index such as the Russell 3000 or the S&P 500, there will be
many dividends during the year. Dealing with each dividend discretely will be too
cumbersome. Therefore, to simply our analysis, we assume that the dividend yield is
continuously compounded. This seems to be a reasonable assumption for any index with
many stocks.

The equivalence between annual compounding and continuous compounding can be

expressed as (1 + r)T = erc T or rc = ln (1 + r).
For example, if the annual compounding rate is 5%, the equivalent continuous compounding
rate is calculated as ln(1 + 0.5) = 0.0488 = 4.88%.
The forward price with continuous compounding is:
F0 (T) = S0 e(rc +θ−γ)T
Forward Value
The forward value for a long position when the underlying has cash flows is computed as:
Vt = Present value of difference in forward price = PV [Ft(T) – F0(T)]
Instructor’s Note: To discount using the continuously compounded risk free rate, use:
e-r n/360(Ft(T) – F0(T))
For example, if the annualized continuously compounded risk-free rate is 4% and you are
discounting back 30 days use: e-0.04 x 30/360(Ft(T) – F0(T))
3.3 Equity Forward and Futures Contracts
We now apply the concepts outlined above to the pricing and valuation of equity contracts.
Example: Equity Futures Contract Price with Continuously Compounded Interest
Rates
The continuously compounded dividend yield on the FTSE 100 is 2%, and the current index
level is 2,200. The continuously compounded annual interest rate is 0.25%. Based on the
carry arbitrage model, what is the price of the three-month futures contract?
Solution:
The futures price adjusted for dividend payments is f0 (T) = S0 e(r + θ− γ)T.
Therefore, the futures price adjusted is (note that θ is zero in this case):
2,200e(0.0025 + 0 − 0.02)0.25 = 2,190
Example: Equity Forward Pricing and Forward Valuation with Discrete Dividends
1. Assume that a common stock is trading for $120 and pays a $6.40 dividend in one month.
The US one-month risk-free rate is 1.0%, quoted on an annual compounding basis. A
forward contract expires in one-month on the same day when the stock goes ex-dividend.
What is the one-month forward price for this forward contract?
2. What is the impact of an increase in the risk-free interest rate on the forward price?
Solution 1:

1
Based on the given information, S0 = 120, r = 1.0%, T = 12 , and γT = 6.40.
Therefore, F0(T) = S(1 + r)T + FV of costs – FV of benefits = 120(1 + 0.01)1/12 + 0 − 6.40 =

113.6995.
Solution 2:
Increase in the risk-free rate would result in the increase in the forward price as it is directly
related to the forward price – as seen in solution 1.
Example: Equity Forward Valuation

Assume we bought a one-year forward contract at 49 and there are now three months to
expiration. The underlying stock is currently trading at 60 and the interest rate is 4% on an
annual compounding basis.
1. Given the above information, what is the forward value of the existing contract?
2. A dividend payment is announced between today and the expiration date. Assuming
there is no impact of that announcement on the stock price, what is the impact of this
announcement on the forward value?
Now assume that instead of buying a forward contract, we buy a one-year futures contract at
49 and there are now three months to expiration. Today’s futures price is 60 and there are
no other carry cash flows.
3. What is the futures value of the existing contract after marking to market?
4. Compared to the value of a forward contract, is the value of a futures contract higher or
lower?
Solution 1:
The value is equal to the present value of the difference in forward prices as observed at
Time t (now) and Time 0. F0 (T) = 49, S0.75 = 60, r = 4% and T − t = 0.25.
The forward price, now, Ft (T) = 60 (1 + 0.04)0.25 = 60.5912.
60.5912 − 49
Vt (T) = = 11.4781.
(1 + 0.04)0.25
Solution 2:

The forward value will most likely decrease as a result of the dividend announcement. The
dividend announcement would lower the new forward price and thus lower the value of the
forward contract because the forward value is the discounted difference between the new
forward price and the old forward price. The old forward price is by definition fixed
throughout the life of the contract.
Solution 3:
The futures contracts are marked to market daily and as a result the futures value is zero
each day after settlement has occurred.
Solution 4:
The futures contract value is zero after marking to market. Since we are long the futures and
forward contract and the underlying price is higher than the contracted price, the forwards
value will be more than the futures value.
3.4 Interest Rate Forward and Futures Contracts
A forward rate agreement is an over-the-counter forward contract in which the underlying
is an interest rate.
Example: After three months, a company plans to borrow $100 million for six months and
has entered into an FRA today to lock in a rate of 6%. The FRA helps the company to hedge
the risk of interest rates going up.
FRAs are expressed using two conventions:

• “X x Y” convention: ‘X’ represents the point where the underlying loan starts. This also
the point where the FRA expires. ‘Y’ represents the point where the underlying loan
ends. The FRA in the above example can be expressed as a 3 x 9 FRA.
• FRA(0, h, m) convention: ‘0’ is the point where the FRA agreement is signed. ‘h’
represents the point where the underlying loan starts i.e. the point where the FRA
expires. ‘m’ represents the duration of the underlying loan. Both ‘h’ and ‘m’ are
typically expressed in days using a 30/360 convention. The FRA in the above example
can be expressed as FRA(0, 90, 180).
An FRA contract involves two counterparties:
• The long counterparty pays a fixed rate and receives a floating rate. The long party
benefits when the floating rate rises.

• The short counterparty pays the floating rate and receives the fixed rate. The short
party benefits when the floating rate falls.
In the above example, the company is the long party and will pay a fixed rate of 6%. In return
it will receive a floating rate such as LIBOR from the counterparty.
Calculating FRA payments:
The FRA contract settles in cash and the settlement is the difference between the fixed rate
of the contract as established on the initiation date and the floating rate established on the
FRA expiration date.
In the above example, assume that the 6-month LIBOR rate after 3 months i.e. on the FRA
expiration was 8%. Since interest rates have gone up, the company (long party) will benefit.
This benefit can be calculated as:
(Floating rate − Fixed rate) × Deannualizing factor × Notional Principal
180
(8% − 6%) × × $100 million = $1 million
360
This benefit is received when the underlying loan ends. The PV of this benefit can be
calculated as:
$1million
= $0.9615 million
(1 + 0.08 × 180/360)
Discount rate
To discount we use the LIBOR rate of 8% which is the interest rate in effect. We do not use
the fixed rate of 6%, because it was calculated at time period 0 and is not the interest rate in
effect now.
PV Calculations: Exponent versus n/360
Example: Compute the present value of $1 to be received after 180 days assuming an
annualized interest rate of 8%.
The usual way of computing PV is:
1
= 0.9622
1.08180/360
However, for FRAs the convention is to use the n/360 method instead of the exponent
method. Under this method the PV is calculated as:

1
= 0.9615
(1 + 0.08 × 180/360)
Notice that both methods give almost the same answer.
There are two ways to settle the FRA at expiration date:
FRAs can be either “advanced set, settled in arrears” or “advanced set, advanced settled”.
• Advanced set, settled in arrears: ‘Advanced set’ refers to the fact that interest rate is
set at the FRA expiration date. The term settled in arrears is used when the
settlement happens at the end of the underlying loan. In the above example if the FRA
was settled in arrears, the company will receive the benefit of $1 million when the
underlying loan ends.
• Advanced set, advanced settled: ‘Advanced set’ refers to the fact that interest rate is
set at the FRA expiration date. The term advanced settled is used when the
settlement happens at the start of the underlying loan. In the above example, if the
FRA was advanced settled, the company will receive the PV of the benefit i.e. $0.9615
million when the underlying loan starts.
For this reading, we will consider all FRAs as advanced set, advanced settled.
FRA Pricing
We now look at FRA pricing by determining the appropriate fixed rate that makes the value
of the FRA equal to zero on the initiation date. The below example will help us better
understand the FRA rate calculation methodology.
Example: Three-month LIBOR is 5.60%. Nine-month LIBOR is 5.92%. What is the fixed rate
on a 3 x 9 FRA?
Let ‘x’ represent the interest rate for the 180 day period between n1 and n2. $1 invested for
270 days at 5.92%, should be equal to $1 invested for 90 days at 5.6% and the proceeds
reinvested for 180 days at x%.

(1 + 0.0592 × 270/360) = (1 + 0.056 × 90/360)(1 + x)

(1 + 0.0592 × 270/360)
i. e. (1 + x) =
(1 + 0.056 × 90/360)
(1 + 0.0592 × 270/360)
i. e. x = −1
(1 + 0.056 × 90/360)
x = 0.03
Since ‘x’ represents a 180 day rate, the annualized rate can be calculated as:
360
0.03 × = 0.06 = 6%
180
We can generalize this process in the following steps:
1. Set up the time line.
2. Compute the de-annualized fixed rate:
1 + (r2 × n2/360)
−1
1 + (r1 × n1/360)
3. Annualize by multiplying by 360/(n2 - n1)
FRA Valuation:
Let us now turn our attention towards valuing an existing FRA using the same idea as we did
with the forward contracts previously covered.
The following steps can be used:
1. Find the new FRA fixed rate at time t
2. Compute payoff at n2: (FRAt – FRA0) x (n2 – n1)/360 x NP
3. Discount back to time t.
We will continue with the FRA pricing example to understand this process.
Example: After one month, two-month LIBOR is 5.80% and eight-month LIBOR is 6.20%.
What is the value of the original FRA assuming a notional amount of $100 million?
1. We first compute the new FRA rate at time t using the three step process mentioned in
the ‘FRA pricing’ section.
Step 1: Set up the time line.

Step 2: Compute the de-annualized fixed rate:

1 + (r2 × n2/360) 1 + (0.062 × 240/360)
−1= − 1 = 0.03136
1 + (r1 × n1/360) 1 + (0.058 × 60/360)
Step 3: Annualize by multiplying by 360/(n2 - n1)
360
0.03136 × = 0.0627
240 − 60
180
(0.0627 − 0.06) × × $100million = $272,697
360
$272,697
= $261,873
1 + 0.062 × 240/360
Unless you are given an explicit discount rate, use the floating rate in effect for
discounting. In this example, we use the 8-month LIBOR rate to discount back to time t.
Example: Calculating Interest on LIBOR Spot and FRA Payments

In 30 days, a UK company expects to make a bank deposit of £5,000,000 for a period of 90
days at 90-day Libor set 30 days from today. The company is concerned about decrease in
interest rates and hence enters in a 1×4 receive-fixed FRA today that is advance set, advance
settled. The appropriate discount rate for the FRA settlement cash flows is 0.30%. After 30
days the Libor in British Pounds is 0.75%.
1. What is the interest actually paid on the UK company’s bank deposit?
2. If the FRA was initially priced at 0.80%, what is the payment received to settle it?

3. If the FRA was initially priced at 0.70%, what is the payment received to settle it?
Solution 1:
The LIBOR deposit is £5,000,000 for 90 days at 0.75%. Therefore, the interest at maturity is
90
5,000,000 × 0.0075 × (360) = £9,375.
Solution 2:
The settlement amount of the 1×4 FRA for receive-fixed is (5,000,000 × (0.0080 −
0.0075) × 90/360)/(1 + 0.0030 × 90/360) = £624.53. Because the FRA involves paying
floating, its value benefited from a decline in rates.
Solution 3:
The settlement amount of the 1×4 FRA for receive-fixed is (5,000,000 × (0.0070 −
0.0075) × 90/360)/(1 + 0.0030 × 90/360) = -£624.53. Because the FRA involves paying
floating, its value suffered from an increase in rates.
Example: FRA Fixed Rate

Based on market quotes on US dollar Libor, the six-month and nine-month rates are
currently at 1.25% and 1.50% respectively. What is the 6×9 FRA fixed rate assuming a
30/360-day count convention?
Solution:

270
1 + (r2 × n2/360) 1 + (0.0150 × 360)
−1= 180
− 1 = 0.00497
1 + (r1 × n1/360) 1 + (0.0125 × 360)

360
0.00497 × = 0.01988 = 1.988%
270 − 180
Example: FRA Valuation

Suppose we entered a receive-floating 6×9 FRA at a rate of 0.89%, with a notional amount of
$5,000,000 at T = 0. After 90 days, the three-month US dollar Libor is 1.10% and the six-
month US dollar Libor is 1.25% which will be the discount rate to determine the value. What
is the value of the original receive-floating 6×9 FRA?
Solution:
1. We first compute the new FRA rate at time t.

180
1 + (r2 × n2/360) 1 + (0.0125 × 360)
−1= 90
− 1 = 0.00349
1 + (r1 × n1/360) 1 + (0.0110 × 360)

360
0.00349 × = 0.01396 = 1.396%
180 − 90
90
(0.01396 − 0.0089) × × $5million = $6,325
360
$6325
= $6,285.71
1 + 0.0125 × 180/360

3.5 Fixed- Income Forward and Futures Contracts

To understand fixed-income forward and futures contracts, it is necessary to first
understand the unique issues associated with bond futures and their effects on derivative
pricing.
Quoted price, accrued interest and full price
The quoted price is the clean price without the interest accrued since the last coupon date.
The full price is the quoted price plus interest accrued since the last coupon date.
Full price or dirty price = Quoted price + Accrued interest
t
Accrued interest = T x PMT
where:
t = number of days since the last coupon payment
T = number of days between coupon payments
PMT = coupon payment per period
Conversion factor
Fixed-income futures contracts often have more than one bonds that can be delivered by the
seller. Because bonds trade at different prices based on their maturity and stated coupon, an
adjustment known as the conversion factor is used to make all deliverable bonds roughly
equal in price.
Cheapest to deliver bonds
However, even after applying the conversion factor there will be a bond that is the cheapest
to deliver.
The fixed-income forward or futures price can be expressed as:
F0 (T) = FV0,T (B0 + AI0 ) − AIT − FVCI0,T
The quoted price which includes the conversion factor is:
QF0 = F0 (T)/CF
where:
B0 is the quoted price observed at Time 0
AI0 is the accrued interest at Time 0
(B0 + AI0 ) = Full price at Time 0
AIT is the accrued interest at Time T
FVCI0,T is the coupons paid over the life of the futures contract
Let us now look at a numerical example for illustration purposes. Suppose T = 0.25, CF = 0.8,
B0 = 107 (quoted price), FVCI0,T = 0.0 (meaning no accrued interest over the life of the
contract), r = 0.2%, AI0 = 0.07 and AIT = 0.20.

The futures price is:

F0 (T) = (107 + 0.07)(1 + 0.002)0.25 − 0.20 − 0.0 = 106.9235
The quoted futures price is:
QF0 = F0 (T)/CF
106.9235
QF0 = = 133.6544.
0.8
Example: Estimating the Euro-Bund Price
Euro-bund futures have a contract value of €100,000, and the underlying consists of long-
term German debt instruments with 8.5 to 10.5 years to maturity. Suppose the underlying
2% German bund is quoted at €104 and has accrued interest of €0.17 (one month since last
coupon). The euro-bund futures contract matures in one month. At contract expiration, the
underlying bund will have accrued interest of €0.33, there are no coupon payments due until
after the futures contract expires, and the current one-month risk-free rate is 0.2%. The
conversion factor is 0.67843. What is the equilibrium euro-bund futures price based on the
carry arbitrage model?
Solution:
In this case, we have T = 1/12, CF(T) = 0.57843, B0 = 104, FVCI0,T = 0, AI0 = 0.17, AIT =
0.33, r = 0.2% therefore,
1
F0 (T) = (104 + 0.17)(1 + 0.002)12 − 0.33 − 0 = €103.86
103.86
QF0 (T) = 0.67843 = €153.09.
The euro-bund futures price should be approximately €153.09 based on the carry arbitrage
model.

The forward value observed at Time t, where t is a point in time between contact initiation
(Time 0) and contract expiration (Time T) is simply the present value of the difference in
forward prices.
Vt (T) = PV of difference in forward prices = PVt,T (Ft (T) − F0 (T))
Example: Estimating the Value of a Euro-Bund Forward Position
Suppose that one month ago, we purchased five euro-bund forward contracts with two
months to expiration and a contract notional of €100,000 each at a price of 138 (quoted as a
percentage of par). The euro-bund forward contract now has one month to expiration. Again,
assume the underlying is a 2% German bund quoted at 104 and has accrued interest of 0.17
(one month since last coupon). At the contract expiration, the underlying bund will have
accrued interest of 0.33, there are no coupon payments due until after the forward contract
expires, and the current annualized one-month risk-free rate is 0.2%.
Based on the current forward price of 143, what is the value of the euro-bund forward
position?
Solution:
Because we are given both forward prices, the value of euro-bund forward contract is:
143−138
Vt (T) = 1 = 4.9992 per €100 par value i.e. 4.9992%
(1+0.002)12
Since we have five contracts each with €100,000 par value, the value of the euro-bund
forward position is 0.04992 × 100,000 × 5 = €24,960.
3.6 Currency Forward and Futures Contracts
When trading currency derivative contracts, special care must be taken to know which is the
base currency. When quoting an exchange rate, we refer to the price of one unit of base
currency expressed in terms of the pricing currency units. The carry arbitrage model with
foreign exchange is also known as covered interest rate parity.
Based on covered interest parity, the forward rate can be expressed as:
FP/B (T) = SP/B (1 + rp )T /(1 + rb )T
where:
SP/B is the spot exchange rate
𝑟𝑝 is the interest rate in the price currency
𝑟𝑏 is the interest rate in the base currency
One way to remember this relationship is to use the interest rate of the base currency in the
denominator (base). Also, based on this relationship we can say that the higher the interest

rate in base currency, the greater the benefit of holding the base currency and hence, the
lower the forward price will be.
Example: Pricing Foreign Exchange Contracts
Suppose the current spot exchange rate, S0 (£/€), is £0.834 (what 1€ is trading for in £).
Further assume that the annual compounded annualized risk-free rates are 1.2% for British
pound and 0.5% for the euro.
1. What is the arbitrage-free one-year foreign exchange forward rate, F0 (£/€, T) (expressed
as the number of £ per 1€)?
2. Now suppose the forward rate is observed to be below the spot rate. Based on the carry
arbitrage mode, is the Eurozone interest rate higher or lower compared to British
interest rates?
Solution 1: Based on the information given, S0 (£/€), is £0.834, T = 1 year, rp = 1.2%
and rb = 0.5%
FP/B (T) = SP/B (1 + rp )T /(1 + rb )T
FP/B (T) = 0.834(1 + 0.012)1 /(1 + 0.005)1 = 0.8398, or £0.8398/€.
Solution 2:
If the interest rate of the base currency is higher relative to the interest rate of the price
currency then the forward rate will be lower than the spot rate. Since the ratio(1 +
rp )T /(1 + rb )T) will be less than 1.
Therefore, we can conclude that the Eurozone (base currency) interest rate is higher than
the British (price currency) interest rate.
The forward value for a currency contract at time t, where t lies between the contract
initiation (Time 0) and contract expiration (Time T) is simply the present value of the
difference in foreign exchange forward prices. The important point to note is that the
discount rate to be used to calculate the present value is the interest rate in the pricing
currency.
Vt (T) = PVt,T (Ft (T) − F0 (T))
In this expression, the present value is calculated using the price currency interest rate.
Example: Computing the Foreign Exchange Forward Contract Value
A corporation sold €1,000,000 against a British Pound forward at a forward rate of
£0.760/€. The current spot rate at time t is £0.742/€ and the annually compounded risk-free

rates are 0.75% for the British pound and 0.45% for the euro. Assume at Time t there are
three months until forward contract expiration.
1. What is the foreign exchange forward rate, Ft (£/€, T) (expressed as the number of £ per
1€)?
2. What is the value of the foreign exchange forward contact at Time t?
Solution 1: Based on the information given, St (£/€), is £0.742, T-t = 0.25 year, rp =
0.75% and rb = 0.45%.
Therefore,
Ft (T) = St (1 + rp )T−t /(1 + rb )T−t
Ft (T) = 0.742(1 + 0.0075)0.25 /(1 + 0.0045)0.25 = 0.7426, or £0.7426/€.

Solution 2: The value per euro to the long party of the forward contract at Time t is:
Vt (T) = PVt,T (Ft (T) − F0 (T))
Vt (T) = (0.7426 − 0.760)/(1 + 0.0075)0.25 = −£0.0174 per euro.
Since derivatives are a zero sum game, the value to the short party = - value to the long party
= £0.0174 per euro
Since the initial short position is €1,000,000, the forward contract has a positive value of
1,000,000 × 0.0174 = £17,400 for the corporation because the forward rate fell between
Time 0 to Time t.
3.7 Comparing Forward and Futures Contracts
Forward and futures prices are generally found using the same model, but futures values are
different because of the daily marking to market. Due to this daily mark-to-market feature,
futures values are zero at the end of each day because profits and losses are settled daily.
4. Pricing and Valuing Swap Contracts

flows based on some pre-determined formula. The simplest swap is a plain vanilla interest
rate swap. Consider two companies A and B that enter into a swap agreement; Company A
agrees to pay a fixed rate of 5% per year to company B for three years on a notional principal
of $100,000. Company B, in turn, agrees to pay a floating rate of LIBOR to company A for the
same period and on the same notional principal.

To price and value swaps, it is important to first understand how swap payments are
calculated. Consider a receive-fixed, pay-floating swap. The fixed rate is 5%, the floating rate
is 5.2% and the accrual period is 30 days based on a 360 day year. If the notional amount is
100 million, what is the payment of a receive-fixed, pay-floating swap?
Payment = Notional Amount x (Fixed rate – Floating rate) x Deannualizing factor
Payment = $100 million x (0.050 – 0.052) x 30/360 = -$16,666.67
Market participants often use swaps to transform one series of cash flows into another. For
example, suppose a company has issued fixed-rate bonds to the investors and is now
concerned about interest rates moving down. By entering a receive-fixed, pay floating
interest rate swap the firm can create a synthetic floating-rate bond. The two fixed rate
payments (receiving fixed as part of the swap contract and paying fixed to the bond
investors) cancel out and the firm has effectively created a synthetic variable-rate loan.
Swaps can be viewed as a combination of other instruments. For example, we can say that a
swap is a series of options or a combination of a fixed rate bond and a floating rate bond.
4.1 Interest Rate Swap Contracts
The price of a swap is the fixed rate which is calculated such that the value at initiation is
zero.
Consider a three year receive floating, pay fixed swap with annual payments. This is
equivalent to going long on a three year annual pay floating rate bond and funding this
purchase by issuing a three year annual pay fixed rate bond. Pricing the swap means to
determine the fixed rate such that the value of the swap at initiation is zero i.e. value of the
fixed bond must equal the value of the floating bond.

Let c denote the coupon payments for the fixed rate bond and d1, d2 and d3 denote the
discount factors for year 1, year 2 and year 3 respectively. Assume that both bonds have par
value of 1.
Value of floating rate bond = par value = 1
Value of fixed rate bond = cd1 + cd2 + cd3 + d3
We find the value of c such that the value of both bonds is equal. Therefore,
1 = cd1 + cd2 + cd3 + d3
1 = c(d1 + d2 + d3) + d3
1 − d3
c=
d1 + d2 + d3
This formula can be generalized as follows:
1 − dn
Swap pricing equation: rFIX = d
1 +d2 +d3+ …+dn
i.e. Swap fixed rate = (1 – final discount factor) / (sum of all discount factors)
Example: Solving for the Fixed Swap Rate Based on Present Value Factors
Suppose we are pricing a five-year Libor-based interest rate swap with annual resets using
30/360 day count and the present value factors in the below given table, what is the fixed
rate of the swap?
Maturity (years) Present Value Factors
1 0.9906
2 0.9789
3 0.9674
4 0.9556
5 0.9236

Solution:
The sum of the present values factors is 4.8161. Therefore, the fixed swap rate is:
1−0.9236
rFIX = = 1.5863%.
4.8161
Instructor’s Note: The discount factors are calculated using the 30/360 convention used in
FRA rather than the exponent convention. For example, if reset date is 6 months and the spot
rate for the first six months is 10%. Then d1 = 1 / (1 + 0.1 x 180/360)
Swap Valuation
We now turn to valuing interest rate swaps at Time t, where t is some point between the
contract initiation and expiration. We first calculate the new fixed swap rate at time t.
The value of a fixed rate swap at Time t = Stated notional amount x Sum of the present value
of the difference in fixed swap rates
V = NA(FS0 − FSt )(d1 + d2 + d3 + ⋯ + dn ) where, di is the present value factor for that
period.
The rate FS0 is a fixed rate established at contract initiation and is received by receiving-
fixed party. Thus, if the above equation gives a positive value, it is a gain to the party
receiving fixed rate. The negative of this amount is the value to the fixed rate payer.
Example: Solving for the Swap Value Based on Present Value Factors
Suppose two years ago we entered a €100,000,000 seven-year receive-fixed Libor-based
interest rate swap with annual resets using 30/360 day count. The fixed rate in the swap
contract at initiation was 3%. Using the present value factors in the below given table, what
is the value for the party receiving the fixed rate?
1 0.9906
2 0.9789
3 0.9674
4 0.9556
5 0.9236
Solution:
We first compute the new swap fixed rate. The sum of the present values is 4.8161.
Therefore, the fixed swap rate is:
1−0.9236
rFIX = = 1.59%.
4.8161
V = NA(FS0 − FSt )(d1 + d2 + d3 + ⋯ + dn )

V = (0.03 − 0.0159)4.8161 × 100,000,000 = €6,790,701.

Thus, the swap value is €6,790,701.

Note: The equivalent receive-floating swap value is simply the negative of the receive-
fixed swap value.
4.2 Currency Swap Contracts
A currency swap is a contract in which two counterparties agree to exchange future interest
payments in different currencies. There are four major types of currency swaps: fixed-for-
fixed, floating-for-fixed, fixed-for-floating, and floating-for-floating.
Key Features:
• Currency swaps often, but not always, involve an exchange of notional amounts at both
the initiation and expiration of the swap.
• The payment on each leg of the swap is in a different currency unit and the payments
are not netted.
• Each leg of the swap can be either fixed or floating.
We focus on fixed-for-fixed currency swaps to understand the currency swap pricing
concept. Currency swap pricing has three key variables: two fixed interest rates and one
notional amount. Pricing a currency swap involves solving for the appropriate notional
amount in one currency, given the notional amount in the other currency, as well as two
fixed interest rates such that the currency swap value is zero at initiation. We can consider
the two legs of the swap contract as two fixed-rate bonds in their respective currencies. One
way to find the equilibrium currency swap price (that is, the two fixed rates) is to identify
the initial coupon rates such that the two bonds trade at par.
The fixed swap rates are found in exactly the same manner as the fixed interest rate swap. As
seen in the previous section, the fixed swap rate in each currency is simply one minus the
final discount factor divided by the sum of all discount factors. It is important to ensure that
the discount factors are expressed on the basis of the appropriate currency. We illustrate
currency swap pricing with spot rates by way of an example.
Example: Currency Swap Pricing with Spot Rates
A US company needs to borrow 100 million Australian dollars (A$) for one year for its
Australian subsidiary. The company decides to issue US-denominated bonds in an amount
equivalent to A$ 100 million. The company enters into a one-year currency swap with
quarterly reset using 30/360 day count and exchanges the notional amounts at initiation
and at maturity. Based on the below interbank rates and A$/US$ spot exchange rate of
1.160:
Days to Maturity A$ interest rates US$ interest rates
90 2.35% 0.25%

180 2.45% 0.30%

270 2.60% 0.35%
360 2.75% 0.40%
1) What is the fixed swap rate for Australian and US dollars?
2) What is the notional amount in US dollars?
3) What are the fixed swap annual payments in the currency swap?
Solution to 1:
Days to A$ Calculation Present US$ Calculation Present
Maturity interest Value interest Value
rates A$ rates US$
90 2.35% 1 0.9942 0.25% 1 0.9994
90 90
1 + 0.0235 (360) 1 + 0.0025 (360)
180 2.45% 1 0.9879 0.30% 1 0.9985
180 180
1 + 0.0245 (360) 1 + 0.0030 (360)
270 2.60% 1 0.9809 0.35% 1 0.9974

270 270
1 + 0.0260 (360) 1 + 0.0035 (360)
360 2.75% 1 0.9732 0.40% 1 0.9960
360 360
1 + 0.0275 (360) 1 + 0.0040 (360)
The Australian dollar periodic rate is:
1 − 0.9732
= 0.6809%
0.9942 + 0.9879 + 0.9809 + 0.9732
The annualized rate is 0.6809% × 360/90 = 2.7236%.
The US dollar periodic rate is:
1 − 0.9960
= 0.1002%
0.9994 + 0.9985 + 0.9974 + 0.9960
The annualized rate is 0.1002% × 360/90 = 0.4009%.
Solution 2:
The US dollar notional amount is: A$ 100,000,000 / 1.16 = US$ 86,206,897.
Solution 3:
Based on the fixed rate calculated in Solution 1, the fixed swap payments for A$ is:
A$ 100,000,000 × (90/360)(0.027236) = A$ 680,900.
Based on the fixed rate calculated in Solution 1, the fixed swap payments for US$ is:
US$ 86,206,897 × (90/360)(0.004009) = US$ 86,400.86.

We now turn to currency swap valuation. The value of a fixed-for-fixed currency swap at
some point in time, Time t, is the difference in a pair of fixed-rate bonds, one expressed in
Currency ‘a’ and one expressed in Currency ‘b’. To express the bonds in the same currency
units, we convert the Currency b bond into units of Currency a using the spot foreign
exchange rate at time t.
Va = FBa − St FBb where, FB is the fixed-rate bond value in its own currency and St is the
exchange rate at Time t.
The value of the fixed rate bond is the PV of its cash flows (periodic coupon payments + par
value). Consider a 1-year bond with a par value of $1 that makes quarterly coupon payments
c. We are valuing this bond at time t as shown in the diagram below. Let d1, d2, d3 and d4
denote the discount factors for time periods 1, 2, 3 and 4 respectively.
Value of this bond = PV of cash flows = cd1 + cd2 + cd3 + cd4 + d4 = c(d1 + d2 + d3 + d4) + d4
We can generalize this formula as shown below:
FBk = NAk (rFIX,k (d1 + d2 + d3 + ⋯ dn ) + dn ) where, k represents the currency and di is the
present value factor for that period for the appropriate currency k.
Example: Currency Swap Valuation with Spot Rates
This example builds on the previous example addressing currency swap pricing. All the
other details remain the same but now 60 days have passed since the initiation of the
currency swap and we observe the following market information:
Days to maturity Present value A$ Present value US$
30 0.9954 0.9995
120 0.9932 0.9983
210 0.9876 0.9967
300 0.9841 0.9951
Sum 3.9603 3.9896
What is the current value of the currency swap entered into 60 days ago if the current spot
exchange rate is A$/US$ = 1.15?
Solution:
Based on the data given, the currency swap value is:
Va = FBa − St FBb

Va = 100,000,000(0.006809 (3.9603) + 0.9841) – 1.15(86,206,897)(0.001002(3.9896) +

0.9951) = A$ 2,058,100.85
4.3 Equity Swap Contracts
An equity swap is an OTC derivative contract in which two parties agree to exchange a
series of cash flows whereby one party pays a variable series that will be determined by an
equity index/security and the other party pays either a variable series determined by a
different equity or a fixed series.
In this reading, we consider three types of equity swaps: receive-equity return, pay-fixed;
receive-equity return, pay floating; receive-equity return, pay-another equity return.
The cash flows for the three types of equity swaps can be expressed as follows:
1. Receive-equity, pay-fixed: Notional Amount x (Equity return – Fixed rate)
2. Receive-equity, pay-floating: Notional Amount x (Equity return – Floating rate)
3. Receive-equity (a), pay-equity (b): Notional Amount x (Equity return (a) – Equity return
(b)) where a and b denote different equities.
Key points to consider for equity swaps: 1) the underlying reference instrument for the
equity leg can be an individual stock, a published stock index, or a custom portfolio 2) the
equity leg cash flow can be with or without dividends 3) all the interest rate swap nuances
exist with equity swaps that have a fixed or floating interest rate leg.
Example: Equity Swap Cash Flows
Suppose we entered into a receive-equity index and pay-fixed swap. It is quarterly reset,
30/360 day count, € 10,000,000 notional amount, pay-fixed 2.0% annualized on a quarterly
basis.
1) What is the equity swap cash flow if the equity index return for the quarter was 3%?
2) What is the equity swap cash flow if the equity index return for the quarter was -5%?
Solution 1:
The receive-equity index counterparty cash flows are:
€10,000,000(0.03 – 0.005) = €250,000 (Receive 3%, pay 0.5% for the quarter)
An important thing to note here is that the equity return is reported on a quarterly basis and
the fixed rate is on an annual basis. One must carefully interpret the different return
conventions.
Solution 2:
The receive-equity index counterparty cash flows are: (similar to Solution 1)
€10,000,000(-0.05 – 0.005) = -€550,000.
When the equity leg of the swap is negative, then the receive-equity counterparty must pay
both the equity return as well as the fixed rate.

Equity Swap Pricing and Valuation

An important point to note is that the pricing of an equity swap with equity return being one
leg and the fixed rate being the other leg is identical to the pricing of a comparable interest
rate swap even though the future cash flows are quite different. The swap price is the fixed
rate which is based on the term structure.
If the swap required a floating payment, there would be no need to price the swap, as the
floating side effectively prices itself at par automatically at the start.
If the swap involves paying one equity return against another, there would be no need to
price it either. We can effectively view this contract as paying equity ‘a’ and receiving equity
‘b’.
Valuing an equity swap after the swap is initiated is similar to valuing an interest rate swap.
The equity swap value for a receive-fixed, pay-equity is determined as follows:
Vt = FBt(C0) – (St/St–)NAE – PV(Par – NAE)
where:
FBt(C0) denotes the Time t value of a fixed-rate bond initiated with coupon C0 at Time 0
St denotes the current equity price
St– denotes the equity price observed at the last reset date
NA denotes the notional amount
PV() denotes the present value function from Time t to the swap maturity time
Example: Equity Swap Pricing
In Examples 13 and 14 related to interest rate swaps, we observed the following present
value factors.
1 0.9906
2 0.9789
3 0.9674
4 0.9556
5 0.9236
Assume an annual reset Libor floating-rate bond trading at par. The fixed rate was
previously found to be 1.59%. Given the same data, what is the fixed interest rate for a 5-
year receive-equity return, pay-fixed equity swap?
Solution:
The fixed rate on an equity swap is the same as that on an interest rate swap. The sum of the
present values factors is 4.8161. Therefore, the fixed swap rate is:

1−0.9236
rFIX = = 1.5863%.
4.8161
Example: Equity Swap Valuation

Suppose six months ago we entered a receive-fixed, pay-equity five-year annual reset swap
in which the fixed leg is based on a 30/360 day count. The swap was entered at a fixed rate
of 2.0%, the notional was 5,000,000 and the equity was trading at 100. The current spot
rates have fallen to 1.5% across maturities and the equity is trading at 108.
1. What is the fair value of the equity swap?
2. At what stock price will the value of the equity swap be equal to 0?
Solution 1:
The value of the equity swap is expressed as:
Since the par value of the bond is equal to the notional amount of equity, the third term in
the expression reduces to 0.
The value of the implied fixed-rate bond FBt(C0) is computed as:
Years Present value Factor Fixed Cash Flow PV
0.5 1 5,000,000*0.02 = 100,000 99,260

= 0.9926
1 + 0.015 × 0.5
1.5 1 5,000,000*0.02 = 100,000 97,790
= 0.9779
1 + 0.015 × 1.5
2.5 1 5,000,000*0.02 = 100,000 96,390
= 0.9639
1 + 0.015 × 2.5
3.5 1 5,000,000*0.02 = 100,000 95,010
= 0.9501
1 + 0.015 × 3.5
4.5 1 5,000,000 + (5,000,000*0.02) = 4,777,680
= 0.9368
1 + 0.015 × 4.5 5,100,000
The total of the present value of the fixed cash flows i.e. the value of the bond is 5,166,130.
Vt = FBt(C0) – (St/St–)NAE
Vt = 5,166,130 - (108/100) x 5,000,000 = -233,870.
Solution 2:
The value of the equity swap is expressed as:
Since the par value of the bond is equal to the notional amount of equity, the third term in
the expression reduces to 0.

In solution 1, we calculated the value of the fixed rate bond FBt(C0) = 5,166,130. Therefore,
we can say:
0 = 5,166,130 – (St/100) x 5,000,000.
Solving, we get St = 103.32.
The value of the equity swap will be zero if the stock price is 103.32.

Summary
LO.a: Describe and compare how equity, interest rate, fixed- income, and currency
forward and futures contracts are priced and valued.
LO.b: Calculate and interpret the no- arbitrage value of equity, interest rate, fixed-
income, and currency forward and futures contracts.
Forward commitments are valued using the no-arbitrage approach, which is built on the law
of one price.
Equity Forward and Futures Contracts
The forward price when the underlying has cash flows is expressed as:
F0(T) = FV(S0 + θ - γ)
The forward price with continuous compounding is expressed as:
F0 (T) = S0 e(rc +θ−γ)T
The forward value for a long position when the underlying has cash flows is computed as:
Vt = Present value of difference in forward price = PV [Ft(T) – F0(T)]
Interest Rate Forward and Futures Contracts
FRA fixed rate (i.e. price of an FRA):
1. Set up the time line.
n2
1+(r2× )
2. Compute the de-annualized fixed rate: 360
n1 −1
1+(r1× )
360
3. Annualize by multiplying by 360/(n2 - n1)
FRA value for pay fixed receive floating:
1. Find the new FRA fixed rate at time t
Fixed- Income Forward and Futures Contracts
The fixed-income forward or futures price can be expressed as:
The quoted price which includes the conversion factor is:
QF0 = F0 (T)/CF
Currency Forward and Futures Contracts
The forward rate for a currency futures contract can be expressed as:
FP/B (T) = SP/B (1 + rp )T /(1 + rb )T
LO.c: Describe and compare how interest rate, currency, and equity swaps are priced
and valued.

LO.d: Calculate and interpret the no- arbitrage value of interest rate, currency, and
equity swaps.
Interest Rate Swap Contracts
Swap fixed rate = (1 – final discount factor) / (sum of all discount factors)
Value of a fixed rate swap at Time T = Sum of the present value of the difference in fixed
swap rates x Stated notional amount
V = NA(FS0 − FSt )(d1 + d2 + d3 + ⋯ + dn )
Currency Swap Contracts
Pricing a currency swap involves solving for the appropriate notional amount in one
currency, given the notional amount in the other currency, as well as two fixed interest rates
such that the currency swap value is zero at initiation.
The value of a currency swap is given as:
Va = FBa − St FBb
The value of fixed rate bonds is computed as:
FBk = NAk (rFIX,k (d1 + d2 + d3 + ⋯ dn ) + dn )
Equity Swap Contracts
The equity swap value for a receive-fixed, pay-equity is determined as follows:

R38 Valuation of Contingent Claims 2020 Level II Notes
R38 Valuation of Contingent Claims

1. Introduction........................................................................................................................................................ 2
2. Principles of a No-Arbitrage Approach to Valuation .......................................................................... 2
3. Binomial Option Valuation Model .............................................................................................................. 2
3.1. One-Period Binomial Model................................................................................................................. 3
3.2. Two-period binomial model ................................................................................................................ 7
3.3. Interest Rate Options .......................................................................................................................... 11
3.4. Multiperiod Model ................................................................................................................................ 12
4. Black-Scholes-Merton Option Valuation Model................................................................................. 13
4.1. Introductory Material.......................................................................................................................... 13
4.2. Assumptions of the BSM Model ....................................................................................................... 13
4.3. BSM Model ............................................................................................................................................... 14
5. Black Option Valuation Model .................................................................................................................. 19
5.1. European Options on Futures .......................................................................................................... 19
5.2. Interest Rate Options .......................................................................................................................... 20
5.3. Swaptions................................................................................................................................................. 22
6. Option Greeks and Implied Volatility .................................................................................................... 24
6.1. Delta ........................................................................................................................................................... 24
6.2. Gamma ...................................................................................................................................................... 26
6.3. Theta .......................................................................................................................................................... 27
6.4. Vega ............................................................................................................................................................ 27
6.5. Rho .............................................................................................................................................................. 27
6.6 Implied Volatility ................................................................................................................................... 28
Summary ............................................................................................................................................................... 30
This document should be read in conjunction with the corresponding reading in the 2020 Level II
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality
of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial
Analyst® are trademarks owned by CFA Institute.

1. Introduction
A contingent claim such as a call or put option gives its owner a right but not an obligation
to a payoff determined by an underlying asset, rate, or another derivative.
The objectives of this reading are to understand:
• the principle of no arbitrage which forms the basis of option valuation models
• option valuation using the binomial model based on discrete time
• option valuation using the Black-Scholes-Merton (BSM) model based on continuous
time
• Black model applied to futures options, interest rate options, and swaptions
• Greeks and implied volatility
2. Principles of a No-Arbitrage Approach to Valuation
The principle of no arbitrage means that the correct price or value of an option is one
which ensures no arbitrage profits. The no-arbitrage approach is built on the law of one
price. According to this law, if two investments have the same future cash flows then these
should have the same price.
Option valuation is based on the following assumptions:
• Replicating instruments are identifiable and investable
• No market frictions such as transaction costs and taxes
• Short selling is allowed with full use of proceeds
• Underlying instrument follows a known statistical distribution
• Borrowing/lending at a risk-free interest rate is available
3. Binomial Option Valuation Model
This section explains how to value European and American options using the binomial
framework. The binomial option valuation model is based on the no-arbitrage approach.
The arbitrageur seeks mispricing between the option price and the underlying spot price to
make profits. In doing so, the arbitrageur follows two rules:
• Rule #1: Do not use your own money – the arbitrageur borrows money to purchase the
underlying and invests proceeds from short selling transactions at the risk-free rate.
Following are the key symbols and terms used in the valuation of options:
• 𝑆𝑡 = price of the underlying at Time t, where t is expressed as a fraction of years.
• T = initial time to expiration, expressed as a fraction of years.
• 𝑆0 = price of the underlying at initiation of the contract.
• 𝑆𝑇 = price of the underlying at expiration date.

• ct = European-style call price at Time ‘t’

• Ct = American-style call price at Time ‘t’
• c = c0 at initiation date, subscripts are removed
• pt = European-style put price at Time ‘t’
• Pt = American-style put price at Time ‘t’
• p = p0 at initiation date, subscripts are removed
• X = option exercise price (also called the strike price)
Example: On 15 November, a 90-day European-style call option with an exercise price of
$50.00 is priced at $4.60. The underlying is trading at $53.00. Hence, T = 90/365, S0 =
53.00, X = 50.00, and c0 = 4.60.
The option price has two components: 1) an exercise value component, also called intrinsic
value, and 2) a time value component. Hence, we can say: c = exercise value + time value.
• For a call option, the exercise value component is S – X if S > X. In our example the
exercise value is 53.00 – 50.00 = 3.00.
• The time value component is equal to the option price minus that exercise value:
4.60 – 3.00 = 1.60.
The time value declines as time passes and becomes equal to zero at option expiration. At
expiration call and put values are equal to their intrinsic value or exercise value. The
exercise values are given as:
• cT = Max(0, ST – X)
• pT = Max(0, X – ST)
3.1. One-Period Binomial Model
The one-period binomial model can be understood using the figure below:
At t = 0 a call option has value c and the underlying stock has value S. At t = 1, either the
stock will go up to S+ or the stock will go down to S-. The up factor, u = S+/S and the down
factor, d = S-/S. If the stock goes to S+ the call option value is c+ and if the stock goes down
to S- the call option value is c-.
If a trader buys one call option, he faces price risk because the call option could go up or
down in value. The investor can hedge this risk by shorting h units of the underlying stock.

Hence at t = 0, the trader’s portfolio is –hS + c. We have a minus sign because h units of the
stock are shorted. At t = 1, the portfolio’s value is –hS+ + c+ if the stock goes up and –hS– + c–
if the stock goes down. Equating these two values (–hS+ + c+ = –hS– + c– ) and solving for h
gives:
𝑐 + − 𝑐−
h= 𝑆+ − 𝑆−
This is called the hedge ratio. It makes the trader indifferent to the movement of the
underlying. By creating a hedged portfolio, the trader has eliminated price risk and
satisfied Rule 2: “Do not take any price risk”. However, for the transaction to be completely
arbitrage-free, the trader still needs to satisfy Rule 1: “Do not use your own money”. This
can happen if the trader borrows the present value (PV) of –hS– + c– .
For a no-arbitrage scenario we have: c – hS = PV(–hS– + c– ) where PV stands for present
value. Since –hS– + c– = –hS+ + c+, we can also say: c – hS = PV(–hS+ + c+). Solving for c, we
get the no-arbitrage single-period valuation equation for call options:
c = hS + PV(–hS– + c–)
or, c = hS + PV(–hS+ + c+)
Based on these expressions it can be said that:
• A call option is equivalent to holding h units of the underlying and financing –PV(–hS– +
c–).
• A call option can be interpreted as a leveraged position in the underlying.
Example 1: Call Option Value
A non-dividend-paying stock is currently trading at $50.00. A call option has one year to
mature, the periodically compounded risk-free interest rate is 7%, and the exercise price
is $50.00. Assume a single-period binomial option valuation model, where u = 1.25 and d
= 0.80. Estimate the option value.
Solution:
S+ = 50.00*1.25 = 62.50, c+ = 12.50, S– = 50.00*0.80 = 40.00, c– = 0.
h = (12.50 – 0)/(62.50 – 40.00) = 0.56.
c = hS + PV(–hS– + c–) = 0.56*50 + PV(-0.56*40 + 0) = 0.56*50 + (-0.56*40 + 0)/1.07
= 28.00 – 20.93 = 7.07.
Notice that buying a call option for $7.07 is equivalent to buying 0.56 units of the
underlying stock for $28.00. This purchase is partially financed (20.93) such that the
effective payment is $7.07.
For put options, the no-arbitrage single-period valuation equation is:

p = hS + PV(–hS– + p–)
or, equivalently, p = hS + PV(–hS+ + p+) where the hedge ratio h is given by the expression:
𝑝+ − 𝑝−
h= ≤0
𝑆+− 𝑆−
Note that the hedge ratio is negative because p+ is less than p–.
Now, consider the equation: p = hS + PV(–hS– + p–). The term hS is negative because h is
negative. This implies short selling the underlying stock. The term PV(–hS– + p–) is positive
because h is negative. This implies lending PV(–hS– + p–). Hence it can be said that a put
option is equivalent to shorting the underlying and lending PV(–hS+ + p+).
Example 2: Put Option Value
A non-dividend-paying stock is currently trading at $50. A put option has one year to
mature, the periodically compounded risk-free interest rate is 7%, and the exercise price
is $50. Assume a single-period binomial option valuation model, where u = 1.25 and d =
0.80. Estimate the option value.
Solution:
S+ = 50.00*1.25 = 62.50, p+ = 0, S– = 50.00*0.80 = 40.00, p– = 10.
h = (0 – 10)/(62.50 – 40.00) = - 0.44.
p = hS + PV(–hS+ + p+) = - 0.44*50 + PV(- -0.44*62.5 + 0) = -0.44*50 + (0.44*62.5 +
0)/1.07
= -22.00 + 25.70 = 3.70.
Notice that buying a put option for $3.70 is equivalent to short selling 0.44 units of the
underlying stock for $22.00 and lending $25.70.
The key points related to the no-arbitrage single-period valuation model are given below:
• A long call position can be hedged by taking a short position in h shares of the
underlying stock where h is the hedge ratio and is equal to (c+ - c-) / (S+ - S-).
• A long put position can be hedged by taking a long position in h shares of the underlying
stock where h is the hedge ratio and is equal to (p+ - p-) / (S+ - S-).
• The hedge ratio is positive for call options and negative for put options.
• c = hS + PV(–hS– + c–) or equivalently c = hS + PV(–hS+ + c+).
• A call option is equivalent to holding h units of the underlying and financing –PV(–hS– +
c–).
• A call option can be interpreted as a leveraged position in the underlying.
• p = hS + PV(–hS– + p–) or equivalently p = hS + PV(–hS+ + p+).
• A put option is equivalent to shorting h units of the underlying and lending PV(–hS+ +
p+).

• A put option can be interpreted as lending that is partially financed with a short
position in shares.
The no-arbitrage results can also be represented as the present value of a unique
expectation of the option payoffs. The expectations approach is given by the following
equations:
c = PV[πc+ + (1 – π)c–] and
p = PV[πp+ + (1 – π)p–]
π = the risk-neutral probability of an up move = (1 + r – d) / (u – d)
r is the single period risk-free rate.
The expected terminal option payoffs can be expressed as:
E(c1) = πc+ + (1 – π)c– and
E(p1) = πp+ + (1 – π)p–
where c1 and p1 = values of the options at Time 1.
The discount rate for present value and future value is the risk-free rate, ‘r’. Under the
expectations approach option values can be written as:
c = PV[E(c1)] and
p = PV[E(p1)]
The probability, π, is objectively determined and is called the risk-neutral (RN) probability.
No assumption is made regarding the arbitrageur’s risk preferences. The discount rate is
not risk-adjusted. It is simply the risk-free interest rate.
Example 3: Call Value and Put Value using the Expectations Approach
A non-dividend-paying stock is currently trading at €100. A call option has one year to
mature, the periodically compounded risk-free interest rate is 5.15%, and the exercise
price is €100. Assume a single-period binomial option valuation model, where u = 1.35
and d = 0.74.
What is the call option value and put option using the expectation approach?
Solution:
S+ = uS = 1.35(100) = 135
S– = dS = 0.74(100) = 74
c+ = Max(0,uS – X) = Max(0,135 – 100) = 35
c– = Max(0,dS – X) = Max(0,74 – 100) = 0
p+ = Max(0,100 – uS) = Max(0,100 – 135) = 0

p– = Max(0,100 – dS) = Max(0,100 – 74) = 26

π = [FV(1) – d]/(u – d) = (1 + 0.0515 – 0.74)/(1.35 – 0.74) = 0.51
c = PV[πc+ + (1 – π)c–] = [(0.51)35 + (1 – 0.51)0] / 1.0515 = €17.00
p = PV[πp+ + (1 – π)p–] = [(0.51)0 + (1 – 0.51)26] / 1.0515 = €12.11
3.2. Two-period binomial model

The two-period binomial lattice can be perceived as three one-period binomial lattices.
Shown below is two-period lattice based on an example in the curriculum.
The three possible values of the underlying at Time 2, are S++ (an up move that occurs
twice),
S– – (a down move that occurs twice), and S+– = S–+ (either an up and then a down move or a
down and then an up move occurs). We assume the up and down factors are constant such
that the lattice recombines. Hence, S+ – = S– +. For the lattice show above, we assume u =
1.25, d = 0.8, and S0 = 100. Hence: S+– = 1.25(0.8)100 = 100 and S–+ = 0.8(1.25)100 = 100.
The middle node at Time 2 is 100 and can be reached from either of two paths. S++ =
1.25x1.25x100 = 156.25. S-- = 0.8x0.8x100 = 64. If the stock goes up twice the call option is
in the money and c++ = S – X = 156.25 – 100 = 56.25.
The two-period binomial option valuation model can be used to demonstrate two
important concepts, self-financing and dynamic replication. Self-financing means that the
replicating portfolio will not require any additional funds and it is dynamically rebalanced.
Additional funds, if required, are borrowed. Dynamic replication means the option
payoffs can be replicated by following a planned trading strategy.
The option values under the two-period binomial model using the expectations approach
are:
c = PV[π2c++ + 2π(1 – π)c+– + (1 – π)2c– –]
p = PV[π2p++ + 2π(1 – π)p+– + (1 – π)2p– –]
As indicated before, π, the risk-neutral probability of an up move is (1 + r – d) / (u – d).

The value of a put option can also be determined using the put-call parity. The put-call
parity relation asserts that a long stock and long put position is equivalent to lending the
present value of the exercise price at the risk-free rate and a long call.
S + p = PV(X) + c and hence p = PV(X) + c – S
Example 4: Two Period Binomial Model Call Valuation
You observe a €50 price for a non-dividend-paying stock. The call option and a put option
on this stock have two years to mature, the periodically compounded risk-free interest rate
is 5%, the exercise price is €50, u = 1.356, and d = 0.744. Assume the options are European-
style.
1. What is risk-neutral up move probability?
2. What is the call option value?
3. What is the put option value?
Solution:
π = (1 + r – d)/(u – d) = (1 + 0.05 – 0.744)/(1.356 – 0.744) = 0.50 or 50%
c++ = Max(0,uuS – X) = Max[0,1.3562(50) – 50] = 41.9368
c–+ = c+– = Max(0,udS – X) = Max[0,1.356(0.744)(50) – 50] = 0.44320
c– – = Max(0,ddS – X) = Max[0,0.7442(50) – 50] = 0.0
With this information, we can compute the call option value:
c = PV[π2c++ + 2π(1 – π)c+– + (1 – π)2c– –]
= [1/(1 + 0.05)]2[0.52 (41.9368) + 2(0.5)(1 – 0.5)0.44320 + (1 – 0.5)20.0]
= 9.71
It is vital to remember that the present value is over two periods, hence the discount factor
is [1/(1 + 0.05)]2.
The put option value can be computed using this formula:
p = PV[π2p++ + 2π(1 – π)p+– + (1 – π)2p– –]
The put option value can also be computed simply by applying put–call parity or
p = c + PV(X) – S = 9.71 + [1/(1 + 0.05)]250 – 50 = 5.06.
Thus, the current put price is €5.06.
Valuation of American Options
American options can be exercised any time before expiration. It is important to remember
that American call options on non-dividend paying stocks will not be exercised early. If the
underlying stock is expected to decline in value it is not logical to exercise the call and

receive the stock. It is better to sell the call in this situation.

On the other hand, it might make sense to exercise deep in-the-money American put
options. This is because the sales proceeds can be invested at the risk-free rate and the
interest could be worth more than the time value of the put.
When early exercise has value, the no-arbitrage approach is the only way to value
American-style options. As shown in the example below, this approach requires that one
works backward through the binomial tree and determines whether early exercise has
value at each step.
Example 5: Valuing a European put and an American put option using the two-period
binomial model
Suppose you are given the following information: S0 = 26, X = 25, u = 1.466, d = 0.656, n = 2
(time steps), r = 2.05% (per period), and no dividends.
1. What is the value of a European put?
2. What is the value of an American put?
3. What is the early exercise premium of the American put?
Solution:
To calculate the put values we should create the binominal tree as shown below:
We need to start at the end of the tree (Time 2) and work backwards. Node 2-1 represents
two up moves of the underlying so the value is 26 x 1.466 x 1.466 = 55.88. The value of the
put option (whether European or American) is 0. Similarly:
Node 2-2: Underlying = 26 x 1.466 x 0.656 = 25. European put = American put = 0.
Node 2-3: Underlying = 26 x 0.656 x 0.656 = 11.19. European put = American put = 0.

Node 1-1: Underlying = 26 x 1.466 = 38.12. European put = American put = 0.

Node 1-2: Underlying = 26 x 0.656 = 17.06. European put = 7.44, American put = 7.94.
At Node 1-2, values of the European put and the American put are different. This is because
the American put can be exercised early but the European put cannot. The value of the
American put at Node 1-2 is X – S = 25 – 17.06 = 7.94. The value of the European option is
based on the option values at Nodes 2-2 and 2-3, the risk-neutral probability and the risk-
free discount rate.
The RN probability, π = (1 + r – d)/(u – d) = (1 + 0.0205 – 0.656)/(1.466 – 0.656) = 0.45.
p- = PV[πp+ - + (1 – π)p- -] = (0 + 0.55 x 13.81) / 1.0205 = 7.44.
We now have the information to calculate the European put and American put value at
Node 0:
1. European put option = (0 + 0.55 x 7.44) / 1.0205 = 4.01.
2. American put option = (0 + 0.55 x 7.94) / 1.0205 = 4.28.
3. The early exercise premium = 4.28 – 4.01 = 0.27.
The following segment explains dividend payments within the binomial model. This
approach is known as the escrow method. Dividends payments lower the value of the stock
which has a negative effect on the value of the call option. For dividend paying instruments,
it is assumed that dividends are known; therefore, the underlying instrument is split into
two components:
i) the underlying instrument without the known dividends and
ii) the known dividends.
For example, the current value of the underlying instrument without dividends can be
expressed as Ŝ = S – γ, where γ = the present value of dividend payments and Ŝ = the
underlying instrument without dividends. The uncertainty of the stock based on Ŝ is
modelled and not S. At expiration, ŜT = ST, because we assume any dividends have already
been paid. The value of an investment in the stock, however, would be ST + γT, assuming
the dividend payments are reinvested at the risk-free rate.
Example 6: American style call option on stock with dividends
Consider an American call on a US$100 stock with exercise price of US$95. The periodically
compounded interest rate is 1.0%, the stock will pay a US$3 dividend at Time 1, u = 1.224,
d = 0.796, and the call option expires in two years.

Here, the first thing to note is that the price of the underlying is modelled ex of dividend.
The present value of the dividend at T = 0 is 3/1.01 = 2.97 and the ex-dividend price is 100
- 2.9702 = 97.03.
The up move and down move prices subsequently are calculated using a present price of
97.03. So, S+ = 97.0297 x 1.224 = 118.7644. S++ = 97.03 x 1.224 x 1.224 = 145.37, and so on.
The RN probability of an up move is (1.01 - 0.796)/(1.224 - 0.796) = 0.5
At the up move at T = 1, the binomial model gives a discounted option value of
0.5(50.3676/1.01) + 0.5(0/1.01) = 24.93446. However, since this is an American call, the
owner has the option to exercise right before the stock goes ex. Before going ex the value of
the stock would be 118.76 + 3 = 121.76 which would give an option value of 121.76 - 95 =
26.76.
The value of the option at T = 0 is 0.5(26.76/1.01) + 0.5(0/1.01) = 13.25.
This example illustrates that early exercise option of an American call can have value if the
underlying stock pays dividends during the life of contract. Hence the value of an American
call option can be higher than the value of a European call option if the underlying pays
dividends.
3.3. Interest Rate Options
Interest rate options are options where the underlying is an interest rate. A call option on
interest rates is in the money when the current spot rate is above the exercise rate. A put
option on interest rates is in the money when the current spot rate is below the exercise
rate. The example below shows how to value interest rate options using an interest rate
tree. The generation of the interest rate tree is outside the scope of this reading. We simply
use what is given. With interest rates, we assume that the RN probability of an up move at
each node is 50%.

Example 7: Option on interest rate

Consider a two-year European-style call on the periodically compounded one-year spot
interest rate (the underlying). The spot rate is 3.0454%. Assume the notional amount of the
options is US$1,000,000 and the call exercise rate is 3.25% of par. Assume the RN
probability is 50%. The binomial interest rate tree is given below.
Rate 3.9706
Call 0.007206
Rate 3.9084
Discount
factor 0.962386
Call 0.003488
Rate 3.0454
Discount Rate 3.2542
factor 0.970446 Call 0.000042
Call 0.001702
Rate 2.6034
Discount
factor 0.974627
Call 0.000020
Rate 2.2593
Call 0
c++ = Max[0,3.9706% - 3.25%] = 0.007206. c+- = Max[0,3.2542% - 3.25%] = 0.000042

Note that the discount factor at each node depends on the interest rate at that node. Hence
when the up move occurs at T = 1, the discount factor is based on an interest rate of
3.9084%. The call value on this node is 0.5(0.007206/1.039084) +
0.5(0.000042/1.039084) = 0.003488.
The call value at T = 0 is 0.5(0.003488/1.030454) + 0.5(0.000020/1.030454) = 0.001702.
3.4. Multiperiod Model

As shown in the previous sections, the two-period model divides the expiration into two
periods. Similarly, a three-period model divides expiration into three periods and so on.
Thus, with a maturity of T, if there are n time steps, then each time step is T/n in length. As
n becomes large, the multi-period mode approaches the BSM model which is discussed in
the next section.
The no-arbitrage approach can be used to value multi-period European-style or American-
style options. The expectations approach can be applied to European-style options but not
to American-style options.

4. Black-Scholes-Merton Option Valuation Model

4.1. Introductory Material
The BSM model is equivalent to a multi-period binomial model in which the length of the
time steps approaches zero. BSM values options as the present value of the expected future
payoffs.
4.2. Assumptions of the BSM Model
An important consideration for option valuation models is how to model the random
nature of the underlying instrument. This characteristic of an asset as it evolves over time
is called a stochastic process. The stochastic process chosen by Black, Scholes, and Merton
(BSM) for their option pricing model is called geometric Brownian motion (GBM). GBM
follow a lognormal distribution and assumes:
• a constant growth rate and volatility (σ) of a stock. This volatility is the annualized
standard deviation of continuously compounded percentage change in the underlying,
or in other words, the log return. As the path drifts upward, there is more variability
than the downward drift on an absolute basis. This can be understood by a simple
example: a 10% move in a stock with a price of 100 is 10 whereas a 10% move in a
stock with a price of 10 is only 1. GBM can never be zero or go below it.
• The stock moves erratically but without large jumps—a common feature with
marketable financial instruments.
Under the BSM framework, all investors agree on the distributional characteristics of GBM
except the assumed growth rate of the underlying. The standard BSM model assumes a
constant growth rate.
The assumptions of the BSM model are:
• The underlying follows geometric Brownian motion, implying a lognormal distribution
of the return, meaning that the continuously compounded logarithmic return is
normally distributed.
• Geometric Brownian motion implies continuous prices, meaning no jumps in the price
of underlying instrument only smooth movements from value to value.
• The underlying instrument is liquid, easily traded.
• Continuous trading is available, meaning able to trade at any moment.
• Short selling of the underlying instrument with full use of the proceeds is permitted.
• There are no market frictions, such as transaction costs, regulatory constraints, or
taxes.
• No-arbitrage opportunities available.
• All options are European-style, early exercise not allowed.
• The continuously compounded risk-free interest rate is known and constant; borrowing
and lending is at the risk-free rate.

• The volatility of the underlying return is known and constant.

• In case the underlying instrument pays a yield, it is expressed as a continuous known
and constant yield at an annualized rate.
4.3. BSM Model
The BSM model is based on continuous time therefore uses a continuously compounded
interest rate rather than a discretely compounded rate. The interest rate, r = the annualized
continuously compounded rate. The volatility, σ = annualized standard deviation in
percentage terms.
The BSM model for non-dividend paying stock is:
c = SN(d1) – e–rTXN(d2)
p = e–rTXN(–d2) – SN(–d1)
where:
d1 = ln(S/X) + (r + σ2 /2)T
σ√T
d2 = d1 − σ√T
N(x) denotes the standard normal cumulative distribution function - the probability of
obtaining a value of less than x based on a standard normal distribution. Here x will have
value of either d1
d2. N(x) values can be estimated by a computer program or from a statistical table. The
standard normal distribution is a normal distribution with a mean of 0 and a standard
deviation of 1. S represents the price of the underlying. T is the time to expiration in years
and r is the continuously compounded risk-free rate. Hence, e– rT is a present value factor.
The BSM model can be interpreted in multiple ways as indicated below.
Interpretation 1:
The BSM model can be given as the present value of the expected option payoff at
expiration.
For calls c = PVr[E(cT)] and for puts p = PVr[E(pT)]
where:
E(cT) = SerTN(d1) – XN(d2) and E(pT) = XN(–d2) – SerTN(–d1).
Here e–rT is the present value term.
Interpretation 2:
The BSM model call value can be interpreted as a stock component, SN(d1), minus a bond
component, e–rTXN(d2). This is visible in the call option formula: c = SN(d1) – e–rTXN(d2).

The BSM model put value can be interpreted as a bond component, e–rTXN(–d2), minus a
stock component, SN(–d1). This is visible in the put option formula: p = e–rTXN(–d2) – SN(–
d1).
Taking this concept one step further, an option can be thought of as a dynamically managed
portfolio of the underlying stock and zero-coupon bonds. To reproduce the option payoffs
with stocks and bonds, the initial cost of this replicating strategy = nSS + nBB.
Replicating Strategy Cost = nSS + nBB
where the underlying shares nS = N(d1) > 0 for calls and nS = –N(–d1) < 0 for puts.
The number of bonds is nB = –N(d2) < 0 for calls and nB = N(–d2) > 0 for puts.
If n is positive, we are buying and if n is negative, we are selling (short selling).
The price of the zero-coupon bond price, B = e–rTX.
For calls, the stock is bought because nS = N(d1) > 0 and the bond is sold because nB = –
N(d2) < 0. Selling a bond is the same as borrowing money. Therefore, a call option can be
viewed as a leveraged position in the stock.
For put options, the bond is bought because nB = N(–d2) > 0 and shares of the underlying
stock are sold because nS = –N(–d1) < 0. Buying a bond is the same as lending money. A put
can be viewed as buying a bond where this purchase is partially financed by short selling
the underlying stock.
Example 8: BSM Model interpretation
Suppose we are given the following information on call and put options on a stock: S = 100,
X = 100, r = 5%, T = 1.0, and σ = 30%. Thus, based on the BSM model, it can be
demonstrated that PV(X) = 95.123, d1 = 0.317, d2 = 0.017, N(d1) = 0.624, N(d2) = 0.507, N(–
d1) = 0.376, N(–d2) = 0.493, c = 14.23, and p = 9.35.
1. Using the no-arbitrage approach, how can a call option be replicated?
2. Using the no-arbitrage approach, how can a put option be replicated?
Solution:
The no-arbitrage approach to replicating the call option involves purchasing nS = N(d1)
= 0.624 shares of stock partially financed with nB = –N(d2) = –0.507 shares of zero-coupon
bonds priced at B = Xe –rT = 95.123 per bond. By definition, the cost of this replicating
strategy is nSS + nBB = 0.624(100) + (–0.507)95.123 = 14.17, which is the option value.
The no-arbitrage approach to replicating the put option involves trading nS = –N(–d1) = –
0.376 shares of stock. The negative number means we need to short sell 0.376 shares. We
also need to buy nB = N(–d2) = 0.493 shares of the zero-coupon. Again, the cost of the
replicating strategy is nSS + nBB = –0.376(100) + (0.493)95.123 = 9.30 which is the value of
the put option.

The discussion above is about the initial trading strategy. As the price of the underlying
changes, the values of nS and nB also need to be adjusted. This is called dynamic hedging.
Incorporating Carry Benefits into the BSM Model
Carry benefits include dividends for stock options, foreign interest rates for currency
options, and coupon payments for bond options. Under the BSM model these carry benefits
are taken as a continuous yield, denoted as γc or simply γ. The carry benefit-adjusted BSM
model is:
c = Se–γTN(d1) – e–rTXN(d2)
and
p = e–rTXN(–d2) – Se–γTN(–d1)
𝑙𝑛(𝑆/𝑋) + (𝑟 − 𝛾 + 𝜎2 /2)𝑇
where d1 = 𝜎√𝑇
d2 = d1 – σ√T .
The carry benefit adjusted BSM model has two components, a stock component and a bond
component.
For call options: Se–γTN(d1) = stock component, and e–rTXN(d2) = bond component.
For put options: Se–γTN(–d1) = stock component, and e–rTXN(–d2) = bond component.
Both d1 and d2 are reduced by carry benefits. An increase in carry benefits lowers the call
option value and raises the put option value.
Since carry benefits lower d1 and d2 values, the probability of being in the money with call
options declines as carry benefit increases.
For stock options, γ = δ which is the continuously compounded dividend yield.
The dividend-yield BSM model can be interpreted as a dynamically managed portfolio of
the stock and zero-coupon bonds.
For calls options on a dividend paying stock:
nS = e–δTN(d1) > 0 is the equivalent number of shares
nB = –N(d2) < 0 is the equivalent number of bonds.
For puts on a dividend paying stock:
nS = –e–δTN(–d1) < 0 is the equivalent number of units of stock
nB = N(–d2) > 0 is the equivalent number of bonds.
Example 9: BSM Model Applied to Equities
Suppose we are given the following information on an underlying stock and options: S = 60,
X = 60, r = 2%, T = 0.5, δ = 2%, and σ = 45%. Assume we are examining European-style

options.
1. Which answer best describes how the BSM model is used to value a call option with the
parameters given?
A. The BSM model call value is the exercise price times N(d1) less the present value of the
stock price times N(d2).
B. The BSM model call value is the stock price times e– δTN(d1) less the exercise price times
e–rTN(d2).
C. The BSM model call value is the stock price times e–δTN(–d1) less the present value of
the exercise price times e–rTN(–d2).
2. Which answer best describes how the BSM model is used to value a put option with the
parameters given?
A. The BSM model put value is the exercise price times N(d1) less the present value of the
stock price times N(d2).
B. The BSM model put value is the exercise price times e–δTN(–d2) less the stock price
times e–rTN(–d2).
C. The BSM model put value is the exercise price times e–rTN(–d2) less the stock price
times e–δTN(–d1).
3. Suppose now that the stock does not pay a dividend—that is, δ = 0%. Identify the
correct statement.
A. The BSM model option value is the same as the previous problems because options are
not dividend adjusted.
B. The BSM model option values will be different because there is an adjustment term
applied to the exercise price, that is e–δT, which will influence the option values.
C. The BSM model option value will be different because d1, d2, and the stock component
are all adjusted for dividends.
Solution to 1:
B is correct. The BSM call model for a dividend-paying stock can be expressed as Se–δTN(d1)
– Xe–rTN(d2).
Solution to 2:
C is correct. The BSM put model for a dividend-paying stock can be expressed as Xe–rTN(–
d2) – Se–δTN(–d1).
Solution to 3:
C is correct. The BSM model option value will be different because d1, d2, and the stock
component are all adjusted for dividends.
With dividend paying stocks, the arbitrageur is able to receive the benefits of dividend
payments when long the stock and has to pay dividends when short the stock. Dividends
influence the dynamically managed portfolio by lowering the number of shares to buy for

calls and lowering the number of shares to short sell for puts. Higher dividends lead to a
lower value of d1, thus lowering N(d1). Higher dividends also lower the number of bonds to
short sell for calls and lowers the number of bonds to buy for puts.
BSM Model and Currency Options
For foreign exchange options we will use the price currency / base currency format. If the
PKR-USD exchange rate is 100 PKR to 1 USD, this be written as 100 PKR/USD. Here USD is
the base currency and PKR is the price currency. For foreign exchange options, the carry
benefit, γ = rf, which is the continuously compounded risk-free interest rate for the base
currency.
The value of a currency call option is given by:
c = Se− rf TN(d1 ) - e–rTXN(d2)
Here S is the currency exchange rate in the price currency/base currency format, rf is risk-
free rate in the base currency and r is the risk-free rate in the price currency.
The BSM call model for currencies can be interpreted as the:
foreign exchange component, Se− rf TN(d1 ), minus the bond component, e–rTXN(d2).
The value of a currency put option is given by:
p = e–rTXN(–d2) - Se−rf TN(-d1)
The BSM put model for currencies can be interpreted as the:
bond component, e–rTXN(–d2), minus the foreign exchange component, Se−rf TN(-d1).
Example 9: BSM model on currency options
A Japanese camera exporter to Europe has contracted to receive fixed euro (€) amounts
each quarter for his goods. The spot price of the currency pair is 135¥/€. The exporter is
concerned that the yen will strengthen because in this case, his forthcoming fixed euro will
buy fewer yen. Hence, the exporter is considering buying an at-the-money spot euro put
option to protect against this fall; this in essence is a call on yen. The Japanese risk-free rate
is 0.25% and the European risk-free rate is 1.00%.
1. What are the underlying and exercise prices to use in the BSM model to get the euro put
option value?
2. What are the risk-free rate and the carry rate to use in the BSM model to get the euro
put
option value?
Solution to 1: The underlying is the spot FX price of 135 ¥/€. Because the put is at-the-
money spot, the exercise price equals the spot price.

Solution to 2: Recognize that Yen is the price currency and euro is the base currency. The
risk-free rate to use is the Japanese rate i.e. 0.25% because Yen is the price economy. The
carry rate is the base currency’s risk-free rate, which is the European rate i.e. 1.00%.
With currency options, the underlying and the exercise price must be quoted in the same
currency unit. The volatility in the model is the volatility of the log return of the spot
exchange rate.
5. Black Option Valuation Model
Fischer Black introduced a modified version of the BSM model applied to options on
underlying instruments such as options on futures contracts, interest rate-based options,
and swaptions.
5.1. European Options on Futures
The underlying instrument is the futures contract – for example equity index futures – and
the assumption is that the futures price follows geometric Brownian motion. Margin
requirements and marking to market are ignored. Black’s model for European-style futures
options is as follows:
c = e–rT[F0(T)N(d1) – XN(d2)]
p = e–rT[XN(–d2) – F0(T)N(–d1)]
where:
ln[𝐹0 (T)/X]+(𝜎2 /2)T
d1 = 𝜎√𝑇
d2 = 𝑑1 − 𝜎√𝑇
F0(T) = the futures price at Time 0 that expires at Time T,
σ = volatility related to the futures price.
X = exercise price.
e–rT = present value term.
Other terms are as defined previously.
We need to be aware of two interpretations of the Black model:
Interpretation 1:
The option value obtained through the Black model can be interpreted as the present value
of the difference between the futures price and the exercise price. The futures price F0(T)
and exercise price X are adjusted by the N(d) functions.
• For call options, the futures price is adjusted by +N(d1) and the exercise price is
adjusted by –N(d2)
• For put options, the futures price is adjusted by –N(–d1) and the exercise price is
adjusted by +N(–d2)

Interpretation 2:
The option value obtained through the Black model has two components, a futures
component and a bond component.
• Call value = futures component, F0(T)e–rTN(d1), minus the bond component, e–
rTXN(d2)
• Put value = bond component, e–rTXN(–d2), minus the futures component, F0(T)e–
rTN(–d1)
Futures Put-Call Parity under the Black Model

Futures option put–call parity under the Black model is given as:
c = e–rT[F0(T) – X] + p
Example 10: The Black Model on Options on futures
The S&P 500 Index (a spot index) is presently at 1,860 and the 0.25 expiration futures
contract is trading at 1,851.65. Suppose further that the exercise price is 1,860, the
continuously compounded risk-free rate is 0.2%, time to expiration is 0.25, volatility is
15%, and the dividend yield is 2.0%. Based on this information, the following results are
obtained for options on the futures contract.
Calls Puts
N(d1) = 0.491 N(–d1) = 0.509
N(d2) = 0.461 N(–d2) = 0.539
c = US$51.41 p = US$59.76
1. To value a European call using the Black model, what values would the present value
of exercise price and present value of futures price be multiplied with?
2. To value a European put using the Black model, what values would the present value
of exercise price and present value of futures price be multiplied with?
3. What are the underlying and exercise prices to use in the Black futures option model?
Solution to 1: The present value of the futures value would be multiplied with N(d1),
0.491 and the present value of the exercise price would be multiplied with N(d2), 0.461.
Solution to 2: The present value of the futures value would be multiplied with N(-d1),
0.509 and the present value of the exercise price would be multiplied with N(-d2), 0.539.
Solution to 3: The underlying is the futures price of 1,851.65 and the exercise price was
given as 1,860.
5.2. Interest Rate Options

An interest rate call option gives the call holder the right to a certain cash payment when
the underlying interest rate is more than the exercise rate. An interest rate put option gives

the put holder the right to a certain cash payment when the underlying interest rate is less
than the exercise rate.
Consider an interest rate call option with one-year expiration. The underlying interest rate
is a forward rate agreement (FRA) that expires in one year and is based on three-month
Libor. This FRA observed today, is the underlying rate in the Black model.
Graphically:
0 1 year 1.25 year
c = call option expires in one-year

3-month FRA expires in one year
tj-1 = time to option expiration = when interest rate is set = 1 year in the above example
tm = Libor deposit maturity = 3 months = 0.25 years
Under the standard market model, the interest rate call value is given by:
c = (AP)e−r (tj−1 + tm) [FRA(0, tj−1, tm) N(d1) − RXN(d2)]
plugging in the time we get:
c = (AP)e− r (1.25) [FRA(0,1,0.25)N(d1) − RXN(d2)]
AP = Accrual period; for 90-day Libor the AP is 90/360
FRA(0,1,0.25) = FRA rate at Time 0 that expires at Time 1 and is based 0.25 year Libor
RX = Exercise rate
Under the standard market model, the interest rate put value is given by:
p = (AP) e−r(1.25)[RXN(−d2) − FRA(0,1,0.25))N(−d1)]
For both the put and call formulas:
𝐹𝑅𝐴(0,𝑡𝑗−1,𝑡𝑚) 𝜎2
𝑙𝑛[ ]+( )𝑡𝑗−1
𝑅𝑋 2
d1 = and d2 = 𝑑1 − 𝜎√𝑡𝑗−1
𝜎√𝑡𝑗−1
All interest rates are stated on an annual basis. The volatility, σ, refers to interest rate
volatility. The put and call values are based on $1 notional amount.
As before we need to be aware of two interpretations:
Interpretation 1:
The standard market model can also be given as the present value of the expected option
payoff at expiration.
• c = PV[E(c)] where E(c) = (AP)[FRA(0, tj–1 ,tm)N(d1) – RXN(d2)]
• p = PV[E(p)] where E(p) = (AP)[RXN(–d2) – FRA(0,tj–1,tm)N(–d1)]

Interpretation 2:
The option value has two components, a futures component and a bond component.
• Call value = FRA component minus the bond component
• Put value = bond component minus the FRA component
The standard market model has the same general form as Black model, but there are
important differences. The differences with the standard market model are:
1. The discount factor, does not apply to the option expiration, tj–1 as in Black model
but applies to the maturity of the underlying FRA or tj (= tj –1 + tm).
2. The underlying is an interest rate (FRA), not a futures price.
3. The exercise price is an interest rate Rx, not a price.
4. The time to option expiration, tj–1, is used in the calculation of d1 and d2.
5. Finally, both the forward rate and the exercise rate should be expressed in decimal
form and not as percent. Or if expressed as a percent, then the notional amount
adjustment could be divided by 100.
Example 11: Interest rate options
On 15 May an investor anticipates that he would need to borrow 10,000,000 Singapore
dollars on 15 June to fund the purchase of an asset, which he expects to sell after three
months on 15 September. The current three-month Sibor (that is, Singapore Libor) is
0.55%. The appropriate FRA rate over the period of 15 June to 15 September is currently
0.68%. The interest rate call option has an exercise rate of 0.60%.
1. In using the Black model to value this interest rate call option, what would the
underlying rate be?
2. The discount factor used in pricing this option would be over what period of time?
Solution to 1: In using the Black model, a forward or futures price is used as the
underlying. Therefore, the current FRA rate of 0.68% is the underlying.
Solution to 2: The discount factor would be from 15 May – 15 September. This is
because the value of the option is determined on 15 May whereas the payoff will occur
on 15 September.
5.3. Swaptions
An option on a swap is a swaption. It gives the holder the right, but not the obligation, to
enter a swap at a pre-agreed swap rate, the exercise rate. There are two types of swaptions.
1. A payer swaption is an option on a swap to pay fixed, receive floating
2. A receiver swaption is an option on a swap to receive fixed, pay floating
The payer swaption valuation model for $1 notional amount is:

PAYSWN = (AP)PVA[RFIXN(d1) – RXN(d2)]

Here AP stands for the accrual period. If a swap is settled every quarter, AP = 90/360. PVA
refers to the present value of an annuity. RFIX is the market swap fixed rate at expiration of
the option. RX is the exercise rate.
A payer swaption has positive value if the market swap fixed rate at expiration is higher
than the exercise rate. Say a company enters into a payer swaption which expires in two
years. The underlying is a three-year annual pay swap with a fixed rate of 5% (RX). When
the swaption expires in two years the fixed rate of a three-year annual pay swap is 6%
(RFIX). The company has benefited in this case because it can now enter into a three-year
swap at a 5% fixed rate even though the market rate is 6%. This benefit can be expressed
as an annuity. The PVA function allows us to calculate the present value of that annuity.
The receiver swaption valuation model for $1 notional amount is:
RECSWN = (AP)PVA[RXN(–d2) – RFIXN(–d1)]
A receiver swaption has positive value if the market swap fixed rate at expiration is less
than then the exercise rate.
The formulas for d1 and d2 are:
𝑅 2
𝜎
ln( 𝐹𝐼𝑋 )+( )𝑇
𝑅𝑋 2
d1 = and d2 = 𝑑1 − 𝜎√𝑇
𝜎√𝑇
Here σ is the volatility of the forward swap rate.

Two interpretations of swaptions model
Interpretation 1:
The swaption model is the present value of the expected option payoff at expiration.
• PAYSWN = PV[E(PAYSWN)] where E(PAYSWN) = erTPAYSWN
• RECSWN = PV[E(RECSWN)] where E(RECSWN) = erTRECSWN
Interpretation 2:
The swaption value has two components, a swap component and a bond component.
• Payer swaption value = the swap component - the bond component
• In symbols: PAYSWN = (AP)PVA(RFIX)N(d1) - (AP)PVA(RX)N(d2)
• Receiver swaption value = the bond component - the swap component
• In symbols: RECSWN = (AP)PVA(RX)N(–d2) - (AP)PVA(RFIX)N(–d1)
The swaption model looks like the Black model but there are important differences:
1. The discount factor is absent. The payoff is not a single payment but a series of
payments. PVA (present value of an annuity) embeds the discount factor.
2. The underlying is the fixed rate on a forward interest rate swap.

3. The exercise price is an interest rate.

4. Both the forward swap rate and the exercise rate should be expressed in decimal
form and not as percent.
Example 12: Swaptions
Suppose you are an Australian company and have ongoing floating-rate debt. You have
profited for some time by paying at a floating rate because rates have been falling
steadily for the last few years. Now, however, you are concerned that within three
months the Australian central bank may tighten its monetary policy and your debt costs
will thus increase. Rather than lock in your borrowing via a swap, you prefer to hedge by
buying a swaption expiring in three months, whereby you will have the choice, but not
the obligation, to enter a five-year swap locking in your borrowing costs. The current
three-month forward, five-year swap rate is 2.65%. The current five-year swap rate is
2.55%. The current three-month risk-free rate is 2.25%.
1. What is the time to expiration for valuing the swaption using the Black Model?
2. What is the risk-free rate for valuing the swaption using the Black Model?
Solution to 1: The time to expiration of the swaption is three months.
Solution to 2: The risk-free rate to use is 2.25%, the three-month risk free rate.
6. Option Greeks and Implied Volatility

The measures examined here are delta, gamma, theta, vega, and rho. European stock
options in which the underlying stock is assumed to pay a dividend yield (denoted δ) are
considered here. For non-dividend-paying stocks, δ = 0.
6.1. Delta
Delta is defined as the change in price of an instrument for a given small change in the
value of the stock, holding all else constant.
By definition, the delta of a long position in a stock is 1. The delta of short position in a
stock is –1.
An option delta is the change in an option value for a given small change in the value of the
underlying stock, holding all else constant.
The option deltas for calls: Deltac = e–δTN(d1)
The option deltas for puts: Deltap = – e–δTN(–d1)
In the above expressions δ is the dividend yield on the underlying stocks. For non-dividend
paying stocks δ is 0 and so e–δT is 1.
Deltas change with changes in stock price and time to maturity. When the stock price
increases, the call option goes deeper in the money and the value of N(d1) moves towards 1.
As the stock price decreases, the call option goes deeper out of the money and the value of

N(d1) moves toward zero. Closer to option maturity, delta drifts either towards 0 (if out of
the money) or towards 1 (if in the money).
Delta hedging an option refers to establishing a position in an option and the underlying
stock such that there is no exposure to small changes in the stock price. A related term is
‘delta neutral portfolio’. This refers to a portfolio with a delta of 0. To create a delta neutral
portfolio the first step is to identify the hedging instrument. The table identifies possible
hedging instruments:
Original Portfolio Possible Hedging
Instrument
Long stock Short call
Long call Short stock
Long put Long stock
Once a hedging instrument has been identified, that next step is to calculate the number of
hedging instruments required. If DeltaH is the delta of the hedging instrument, the optimal
number of units of the hedging instruments, NH, is given by the formula below:
− Original Portfolio delta
NH = 𝐷𝑒𝑙𝑡𝑎𝐻
if NH = negative, then short the hedging instrument

if NH = positive, then go long/buy the hedging instrument
For example:
i. Original portfolio = 100,000 shares of stock, then the original portfolio delta =
100,000. We want to hedge using the same stock. DeltaH = 1.
NH = –100,000/1 = -100,00. Hence, short 100,000 shares.
ii. Original portfolio = 5,000 shares of stock, then the original portfolio delta = 50,000.
We want to hedge using call options. DeltaH = 0.5.
NH = –5,000/0.5 = -10,000. Hence, short 10,000 call options.
iii. Original portfolio = 3,000 put options. Original portfolio delta = –1,500.
We want to hedge using the underlying stock. DeltaH = 1.
NH = – (–1,500)/1 = 1,500. Hence, buy 1,500 shares of stock.
Estimating Changes in Option Value
The delta measure can be used to estimate the change in value of an option when the price
of the underlying changes. The relevant formulas are given below:
ĉ − c ≅ Deltac (Ŝ − S)

̂p - p ≅ Deltap (Ŝ − S)
Here, ĉ, p
̂ , Ŝ represent the estimated new values of the call, put, and stock.
A simple numerical example will illustrate these formulas. Say a stock is trading at $100. A
call option with a delta of 0.5 is currently priced at $5. A put option with a delta of -0.5 is
priced at $4. If the stock price increases to $102, what is the estimated new value of the call
option and put option?
Using the call option formula: ĉ − 5 ≅ 0.5(102 – 100). ĉ = 5 + 1 = 6.
Using the put option formula: ̂p − 4 ≅ -0.5(102 – 100). ̂p = 4 - 1 = 3.
6.2. Gamma
An option gamma is the change in a given option delta for a given small change in the
stock’s value, all else constant. Option gamma is a measure of curvature in option price
versus the stock value. The gamma for a call and put option are the same: Gammac =
𝑒 −𝛿𝑇
Gammap = 𝑆𝜎√𝑇 𝑛(𝑑1 )
A few key points related to gamma are as follows:

• Gamma is always non-negative.
• Gamma has its largest value when an option is at the money.
• Gamma changes as the stock price changes and time to expiration change.
• Gamma approximates the estimation error in delta for options because the option
price with respect to the stock is non-linear.
• Gamma measures the non-linearity risk or the risk of the delta neutral portfolio.
• A gamma neutral portfolio means gamma is zero.
• When hedging an option portfolio, the option gamma has to be managed and then
the portfolio delta is neutralized.
In the previous section, we looked at formulas that the estimated the change in option
value based on delta. These formulas can be improved by also considering the option
gamma. The revised formulas are shown below:
𝐺𝑎𝑚𝑚𝑎𝑐 2
ĉ − 𝑐 ≈ 𝐷𝑒𝑙𝑡𝑎𝑐 (Ŝ − 𝑆) + (Ŝ − 𝑆)
2
𝐺𝑎𝑚𝑚𝑎𝑝 2
̂ − 𝑝 ≈ 𝐷𝑒𝑙𝑡𝑎𝑝 (Ŝ − 𝑆) +
𝑝 (Ŝ − 𝑆)
2
The discussion above was based on options. The gamma of stock, whether long or short, is
always 0. This is because the delta of a stock is always 1 for a long position and -1 for a
short position. Since the delta does not change, the gamma is 0.
In reality, stock prices tend to 'jump' suddenly rather than move continuously and
smoothly. This creates a 'Gamma Risk' i.e. a risk that stock prices would jump while

hedging a position and suddenly leave the position un-hedged.

6.3. Theta
Option theta is defined as the change in an option value for a given small change in calendar
time, all else constant. It is the rate at which the option time value declines as an option
approaches expiration. Because stocks have no expiration, the stock theta is zero.
The gain or loss of an option portfolio/position in response to the mere passage of calendar
time is known as time decay. For long options positions, as time elapses, without any
change in other variables, there can be significant losses in value. Therefore, investment
managers with considerable option positions monitor theta and time decay. Theta is
negative for options because as time passes, option expiration declines and so does option
value.
6.4. Vega
“Vega is defined as the change in a given portfolio for a given small change in volatility,
holding everything else constant.” Vega measures the sensitivity of portfolio to volatility of
the underlying instrument.
A few key points related to vega are as follows:
• The vega of an option is positive because as volatility rises, option value for both
calls and puts rises.
• The vega of a call equals the vega of a put based on put–call parity.
• Vega is based on an unobservable parameter, future volatility, which is subjective.
• Vega is high for options that are at or near the money.
• Vega is high for options that are short dated.
6.5. Rho
Rho is the change in a given portfolio for a given small change in the risk-free interest rate,
all else constant. It measures the sensitivity of the portfolio with respect to the risk-free
interest rate.
The rho of a call is positive. The buying of an option avoids the costs associated with
purchasing stock, hence a call option allows an investor to earn interest on the money that
is not used for buying the stock. The higher the interest rate, the higher the call value.
The rho of a put is negative. Because the option to sell the stock delays the opportunity to
earn interest on the sale proceeds, therefore, higher the interest rate, the lower the put
value.
When interest rates are zero, the call and put option values are the same for at-the-money
options. As interest rates rise, the difference increases between call and put options.

6.6 Implied Volatility

Volatility is not observable. It can be estimated based on historical data. For example, for a
three-month option, we can calculate the actual historical stock volatility over the last three
months and based on this value, give an estimate of volatility over the next three months.
The volatility parameter in the BSM model, however, is the future volatility. Therefore, the
option can be “mispriced” with respect to the actual future volatility.
Different investors have different views of the future volatility. The most accurate
estimation of the option value depends upon the most accurate forecast.
Volatility can be inferred from option prices, which is known as the implied volatility. Thus,
the BSM model can be inverted to estimate implied volatility. Implied volatility is important
as it gives information about the perceived uncertainty in the market and collective opinion
of investors on the volatility of the underlying and the demand for options. This kind of
information is beneficial to traders.
As implied volatility increases, market participants are communicating an increased
market price risk. For example, if the implied volatility of a put increases, cost of buying a
put increases making hedging expensive.
Implied volatility can be understood as market’s view of how to value options. Market
participants often quote options in volatility terms. For example, a call option trading for
€15.25, may be quoted as 20.00%, where 20.00% is the implied volatility based on a
€15.25 option price.
Because volatility has the same magnitude across exercise prices and expiration dates, it
can be used to compare the values of two options, with different exercise prices and
expiration dates.
Example 13: Implied Volatility
Suppose an options dealer offers to sell a three-month at-the-money call on the FTSE
index option at 19% implied volatility and a one-month in-the-money put on Vodaphone
(VOD) at 24%. An option trader believes that based on the current outlook, FTSE
volatility should be closer to 25% and VOD volatility should be closer to 20%. What
actions might the trader take to benefit from her views?
Solution: The trader should buy the FTSE Index call and sell the Vodaphone put. The
trader expects the FTSE volatility to rise and VOD volatility to fall, therefore the FTSE call
option’s value is expected to rise and the VOD put option’s value is expected to fall.
The BSM model assumes that volatility is known and constant and that all investors agree
on the value of volatility. In reality, there are can be different implied volatilities for calls
and puts with the same terms. Implied volatility can vary across exercise prices and the
relationship is known as the volatility smile or the skew depending on the particular shape.
The implied volatility with respect to time to expiration is called the term structure of

volatility. A three-dimensional plot of the implied volatility with respect to both expiration
and exercise prices may be constructed which is known as the volatility surface.

Summary
LO.a: Describe and interpret the binomial option valuation model and its component
terms.
The binomial option valuation model is based on the no-arbitrage approach. The
arbitrageur seeks mispricing between the option price and the underlying spot price to
make profits. In doing so, the arbitrageur follows two rules:
• Rule #1: Do not use your own money – the arbitrageur borrows money to purchase the
underlying and invests proceeds from short selling transactions at the risk-free rate.
LO.b: Calculate the no-arbitrage values of European and American options using a
two-period binomial model.
The no-arbitrage approach is used for option valuation and is built on the key concept of
the law of one price, which says that if two investments have the same future cash flows
regardless of what happens in the future, then these two investments should have the same
current price. The two-period binomial model can be viewed as three one-period binomial
models, one positioned at Time 0 and two positioned at Time 1.
LO.c: Identify an arbitrage opportunity involving options and describe the related
arbitrage.
An arbitrage opportunity exists when there is a difference between option value and its
underlying price. The option can be bought/(sold) when its value is higher/(lower) than its
spot price.
LO.d: Calculate and interpret the value of an interest rate option using a two-period
binomial model.
Interest rate option valuation requires the specification of an entire term structure of
interest rates. The possible interest rate scenarios are presented using a binomial tree and
the value of the option is then worked backwards, starting from the ending node to the
beginning node.
LO.e: Describe how the value of a European option can be analyzed as the present
value of the option’s expected payoff at expiration.
In general, European-style options can be valued based on the expectations approach in
which the option value is determined as the present value of the expected future option
payouts, where the discount rate is the risk-free rate and the expectation is taken based on
the risk-neutral probability measure.
LO.f: Identify assumptions of the Black–Scholes–Merton option valuation model.

The assumptions of the BSM model are:

• The underlying follows geometric Brownian motion, implying a lognormal distribution
of the return, meaning that the continuously compounded logarithmic return is
normally distributed.
• Geometric Brownian motion implies continuous prices, meaning no jumps in the price
of underlying instrument only smooth movements from value to value.
• The underlying instrument is liquid, easily traded.
• Continuous trading is available, meaning able to trade at any moment.
• Short selling of the underlying instrument with full use of the proceeds is permitted.
• There are no market frictions, such as transaction costs, regulatory constraints, or
taxes.
• No-arbitrage opportunities available.
• All options are European-style, early exercise not allowed.
• The continuously compounded risk-free interest rate is known and constant; borrowing
and lending is at the risk-free rate.
• The volatility of the underlying return is known and constant.
• In case the underlying instrument pays a yield, it is expressed as a continuous known
and constant yield at an annualized rate.
LO.g: Interpret the components of the Black–Scholes–Merton model as applied to call
options in terms of a leveraged position in the underlying.
The BSM model call value can be interpreted as a stock component, SN(d1), minus a bond
component, e–rTXN(d2). This is visible in the call option formula: c = SN(d1) – e–rTXN(d2).
An option can be thought of as a dynamically managed portfolio of the underlying stock and
zero-coupon bonds, where the bonds are sold to finance the purchase of the stock.
LO.h: Describe how the Black–Scholes–Merton model is used to value European
options on equities and currencies.
The BSM model for non-dividend paying stock call option is:
c = SN(d1) – e–rTXN(d2)
The value of a put option on a non-dividend paying stock is given by:
p = e–rTXN(–d2) – SN(–d1)
The value of a currency call option is given by:
c = Se− rf TN(d1 ) - e–rTXN(d2)
The value of a currency put option is given by:
p = e–rTXN(–d2) - Se−rf TN(-d1)
LO.i: Describe how the Black model is used to value European options on futures.

The Black model for European-style futures options is as follows:

c = e–rT[F0(T)N(d1) – XN(d2)]
p = e–rT[XN(–d2) – F0(T)N(–d1)]
LO.j: Describe how the Black model is used to value European interest rate options
and European swaptions.
Under the Black model the interest rate call value is given by:
c = (AP)e−r (tj−1 + tm) [FRA(0, tj−1, tm) N(d1) − RXN(d2)]
Under the Black model the interest rate put value is given by:
p = (AP) e−r(1.25)[RXN(−d2) − FRA(0,1,0.25))N(−d1)]
Under the Blak model, the payer swaption valuation model for $1 notional amount is:
PAYSWN = (AP)PVA[RFIXN(d1) – RXN(d2)]
Under the Black model, the receiver swaption valuation model for $1 notional amount is:
RECSWN = (AP)PVA[RXN(–d2) – RFIXN(–d1)]
LO.k: Interpret each of the option Greeks.
Delta is a static risk measure defined as the change in a given portfolio for a given small
change in the value of the underlying instrument, holding everything else constant.
Gamma is a static risk measure defined as the change in a given portfolio delta for a given
small change in the value of the underlying instrument, holding everything else constant.
Theta is a static risk measure defined as the change in the value of an option given a small
change in calendar time, holding everything else constant.
Vega is a static risk measure defined as the change in a given portfolio for a given small
change in volatility, holding everything else constant.
Rho is a static risk measure defined as the change in a given portfolio for a given small
change in the risk-free interest rate, holding everything else constant.
LO.l: Describe how a delta hedge is executed.
Delta hedging refers to managing the portfolio delta by entering additional positions into
the portfolio.
LO.m: Describe the role of gamma risk in options trading.
Stock prices in reality tend to 'jump' suddenly rather than move continuously and
smoothly. This creates a 'Gamma Risk' i.e. a risk that stock prices would jump while
hedging a position and suddenly leave the position un-hedged.
LO.n: Define implied volatility and explain how it is used in options trading.

Implied volatility is the BSM model volatility that yields the market option price. Implied
volatility is a measure of future volatility, whereas historical volatility is a measure of past
volatility. Implied volatility can be used to compare the values of two options, with
different exercise prices and expiration dates.

R45 Introduction to Asset-Backed Securities 2020 Level I Notes
R45 Introduction to Asset-Backed Securities
1. Introduction ......................................................................................................................................................3
2. Benefits of Securitization for Economies and Financial Markets .................................................3
3. How Securitization Works ...........................................................................................................................4
3.1 An Example of a Securitization ...........................................................................................................4
3.2 Parties to a Securitization and Their Roles ....................................................................................5
3.3 Structure of a Securitization ................................................................................................................6
3.4 Key Role of the Special Purpose Entity ............................................................................................7
4. Residential Mortgage Loans ........................................................................................................................8
4.1 Maturity .......................................................................................................................................................9
4.2 Interest Rate Determination ................................................................................................................9
4.3 Amortization Schedule ...........................................................................................................................9
4.4 Prepayment Options and Prepayment Penalties ...................................................................... 10
4.5 Rights of the Lender in a Foreclosure ........................................................................................... 10
5. Residential Mortgage-Backed Securities............................................................................................. 11
5.1 Mortgage Pass-Through Securities ................................................................................................ 12
5.2 Collateralized Mortgage Obligation................................................................................................ 15
5.3 Non-agency Residential Mortgage-Backed Securities ............................................................ 18
6. Commercial Mortgage-Backed Securities ........................................................................................... 18
6.1 Credit Risk ................................................................................................................................................ 19
6.2 CMBS Structure ...................................................................................................................................... 19
7. Non-Mortgage Asset-Backed Securities .............................................................................................. 20
7.1 Auto Loan ABS ........................................................................................................................................ 21
7.2 Credit Card Receivable ABS............................................................................................................... 21
8. Collateralized Debt Obligations .............................................................................................................. 22
8.1 CDO Structure ......................................................................................................................................... 23
8.2 An Example of a CDO Transaction .................................................................................................. 23
Summary .............................................................................................................................................................. 25
Practice Questions ............................................................................................................................................ 30

This document should be read in conjunction with the corresponding reading in the 2020 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
reserved.

1. Introduction
Asset-backed securities (ABS) are based on a principle called securitization. The
securitization process involves pooling relatively straightforward debt obligations, such as
loans or bonds, and using the cash flows from the pool of debt obligations to pay off the
bonds created in the securitization process. The instruments which become part of the pool
are called securitized assets. A simple securitization process is illustrated in the figure
below:
In this illustration, a mortgage bank sells mortgage loans to thousands of homeowners. The
mortgage bank bundles the individual loans into a pool which is sold to a separate legal
entity generally referred to as a special purpose vehicle (SPV). The special purpose vehicle
issues bonds to investors. The collateral for the bonds is the pool of mortgage loans.
The term mortgage-backed security (MBS) is commonly used for securities which are
backed by high quality real estate mortgages. The term “asset-backed securities,” or ABS, is a
broader concept that refers to securities backed by other types of assets as well. In the
example above, we can say that the SPV issues MBS.
2. Benefits of Securitization for Economies and Financial Markets
In this section, we look at the benefits from the perspective of the three parties involved in
the securitization process: borrowers who are the homeowners, investors who want to buy
mortgages, and the intermediary connecting these two parties which is a commercial
bank/financial institution. Investors cannot lend directly to homeowners because they may
be willing to lend/invest only a small amount of money, say $10,000, whereas the
homeowner may require $100,000 as a mortgage loan. Second, the investor may not have all
the information needed to assess the risk of the property.
Benefits to investors are as follows:
• Securitization converts an illiquid asset into a liquid security.
• It gives investors direct access to the payment streams of the underlying mortgage
loans that would otherwise be unattainable.

• There are higher risk-adjusted returns to investors: pooling loans results in

diversification and lower risk for investors.
• It gives investors an opportunity to buy a small part of the home buyers’ mortgage in
the form of a security issued by the SPV.
• It gives exposure to the market, real estate in this example, without directly investing
in it.
Benefits to the bank or loan originator are as follows:
• It enables banks to increase loan origination, monitoring, and collections.
• It reduces the role of the intermediaries (known as disintermediation) like the bank.
However, note that an intermediary is still required to package and distribute
securities.
• Banks have the ability to lend more money if the demand for ABS and MBS is high
relative to if the money was self-financed (from deposits, debt, equity, etc.).
• There is greater efficiency and profitability for the banking sector: the mortgage-
backed securities, at least in the US market, trade actively in the secondary market
which improves the efficiency and liquidity of the financial market.
Benefits to the borrowers of the loan are as follows:
• It lowers the risk as the pooled loans offer a diversification benefit.
• The lower risk decreases the cost of borrowing for homeowners.
3. How Securitization Works
We look at the securitization process in detail in this section.
3.1. An Example of a Securitization
Kentara is a manufacturer of automobiles that range from $20,000 to $200,000. The majority
of sales are made through loans granted by the company to its customers, and the
automobiles serves as collateral for the loans. These loans, which represent an asset to
Kentara, have maturities of five years, carry a fixed interest rate and are fully amortizing
with monthly payments. Although the servicer of such loans need not be the originator of the
loans, the assumption is that Kentara is the servicer.
Steps in the securitization transaction:
• Now assume that Kentara has $100 million of loans, shown on its balance sheet as an
asset, and Kentara wants to raise another $100 million.
• Kentara can do this by securitizing the loans and sells them to a special purpose
entity (SPE), Automobile Trust (AT).
• The SPE is a separate legal entity and is also called a special purpose vehicle (SPV) or
a special purpose company. The legal form of the SPE varies by jurisdiction but, in
almost all cases, the ultimate owner of the loans - AT - is legally independent and
considered bankruptcy remote from the seller of the loans.

• AT gets $100 million in cash from investors by selling asset-backed securities, which
it pays to Kentara.
• The customers who bought the automobiles on loan make monthly payments. AT
uses this cash flow to pay investors of the ABS.
• Setting up a separate legal entity ensures that if Kentara files for bankruptcy, the
loans backing the ABS that are issued by AT are secure within the SPE and creditors
of Kentara have no claim on the loan.
The exhibit below illustrates the steps involved in the securitization transaction for Kentara:
Source: Adapted from CFA Program Curriculum, Introduction to Asset-Backed Securities

3.2. Parties to a Securitization and Their Roles
Let us look at the parties involved in a securitization transaction.
Party Role Party in our example
Seller of pool of Originates the loans and sells to a special Kentara
securities purpose entity (SPE).
SPV or trust or Buys the loans from the seller and issues Automobile Trust (AT)
issuer ABS.

Servicer Services loans such as collecting Kentara

payments from borrowers, notifying
borrowers who may be delinquent and, if
necessary, seizing automobiles from
borrowers who do not make payments
on time.
Note that a third party or the issuer may act as a servicer.
Other parties involved include independent accountants, underwriters, trustees, rating
agencies, and guarantors.
• Lawyers: Responsible for creating the legal documentation.
• Underwriters: Facilitate bond issuance.
• Rating agencies: Rate the securities issued.
Trustee: Safeguards the assets placed in the trust, and hold funds to be paid to bondholders.
3.3. Structure of a Securitization
In the Kentara example, assume 100,000 securities of Bond Class A were issued with a par
value of $1,000 per security to raise $100 million. All the certificate holders in this case are
treated equal because there is just one class of bondholders and there is no distinction
between bondholders with respect to payment time or credit risk.
However, in reality not all bond issues are created with a similar structure. The motivation
for the creation of different types of structures is to redistribute prepayment risk and credit
risk efficiently among different bond classes in the securitization.
Prepayment risk is the uncertainty that the actual cash flows will be different from the
scheduled cash flows, as set forth in the loan agreements, because borrowers may alter
payments to take advantage of interest rate movements.
Instructor’s Note
Prepayment risk cannot be eliminated, but can be redistributed.
In the Kentara example, assume the buyers of automobiles are scheduled to make monthly
payments towards the loan over 5 years. Instead, they prepay it in two years, perhaps
because the interest rates decline, or due to any other reason. Since the loan is prepaid
quicker than planned, the investors of ABS will also be paid quickly thereby reducing their
interest income.
Time tranching: Creation of bond classes to distribute the prepayment risk is called time
tranching. Cash flow received from customers is distributed among the tranches based on
certain parameters. For example, assume AT issued the following four bond classes, with a
total par value of $100 million, instead of one bond class:
• A1 ($30 million)

Since the motive is to distribute prepayment risk, the A1 class may have a lower prepayment
risk than A4. If customers prepay, then A4 bond-holders will get prepaid before A1.
Subordination and credit tranching: Subordination is another layering structure in
securitization. The bond classes differ in their exposure to credit risk, i.e., how they share
losses if the borrowers of the original loans default. An ABS is made up of a pool of loans. So,
any default in payment will have a cascading effect on the investors. Here, several tranches
of senior and subordinated classes are created and the credit risk is distributed to each class
in a disproportionate manner based on the investor’s choice.
Bond class Par Value ($ millions)
A (senior) 80
B (subordinated) 14
C (subordinated) 6
Total 100
In this example, all the losses are first absorbed by class C, then class B, and then class A.
However, class C can accept a loss of up to $6 million. Beyond that, it is absorbed by class B.
The risk is highest for class C and lowest for class A, in this example. Based on the high risk
high return rule, the expected return of class C bondholders will be higher than that of class
A bondholders.
3.4. Key Role of the Special Purpose Entity
The securitization of a company’s assets may include some bond classes that have better
credit ratings than the company itself or its corporate bonds. Thus, in the aggregate, the
company’s funding cost is often lower when raising funds through securitization than by
issuing corporate bonds.
To understand why the funding cost is lower, we will go back to the Kentara example and
consider two scenarios for raising $100 million: one in which Kentara issues a corporate
bond, and another in which it issues ABS by securitizing loans/receivable.
Corporate bond scenario: Kentara issues corporate bonds for $100 million with auto loans
as collateral. Assume credit-rating agencies such as Moody’s assign Kentara a credit-rating of
BB (below investment-grade). The corporate bond rating will also be based on the
company’s credit rating as it reflects the creditworthiness of debt securities. Kentara’s credit
spread depends on the following two factors:
• Primarily, credit rating (BB, in this case).
• Collateral, to a lesser extent.
The cost of funding for Kentara will be higher if it issues a corporate bond, and not an ABS,
for the following reasons:

• Higher risk: Investors perceive a higher risk given the company’s creditworthiness. In
case the company goes bankrupt or is reorganized, their claim to assets will follow
the absolute priority rule (defined in the next section). Though, in reality the absolute
priority rule has not been upheld in case of reorganizations. This means that it is not
necessary for the bondholders to be paid off before the other parties (equity holders,
other creditors). Hence, the credit spread for a corporate bond backed by a collateral
does not decrease substantially.
• Higher return: To compensate for the high risk, investors expect a high return.
• Higher credit spread: Credit spread is the difference between the interest rate the
issuer has to pay on the corporate bond and the benchmark interest rate. The riskier
the bonds, the larger the spread demanded by investors as compensation for risk.
Securitization Scenario
• Funding cost is low: The collateral (loans/receivable) is legally an asset of AT. Any
cash flow from the pool of loans will be paid to the investors of ABS. When an investor
buys a bond class, he has to evaluate the credit risk of the class he is investing in. The
credit rating of the bond class will depend on the quality of the collateral and capital
structure of the SPV, and not the credit rating of the company as in the corporate
bond.
• The lower the risk, the lower the funding cost: The assets belong to the SPV. If the
company goes bankrupt, the absolute priority rule is followed. The principle is that
senior creditors are paid in full before subordinate bondholders are paid anything. So
investors demand a lower return than a corporate bond. Lower return means lower
funding cost for the issuer.
• The SPV is a bankruptcy-remote vehicle unlike corporate bonds. It means bankruptcy
has no effect on an SPV. If the company goes bankrupt, the loans/receivable do not
belong to Kentara anymore and the investors will be paid based on the securitization
structure.
4. Residential Mortgage Loans
A mortgage loan is a loan secured by the collateral of some specified real estate property
which obliges the borrower to make a predetermined series of payments to the lender. In
simple words, it is a loan a buyer takes for buying a real estate property (land, apartment,
house, etc.); the collateral is the property being bought. If the buyer defaults on mortgage
payments, then it gives the lender the right to foreclose on the loan, take possession of the
property, and sell it to recover funds given as debt.
The cash flow of a mortgage consists of the following three components:
• Interest
• Scheduled principal payments
• Prepayments (any principal repaid in excess of the scheduled principal)

The amount lent as loan towards the purchase of the property is always less than the
purchase price. It is equal to the purchase price minus the down payment made by the buyer.
The buyer’s initial equity is equal to the down payment made.
The ratio of the mortgage loan amount to the property’s purchase price is called the loan-to-
value (LTV) ratio.
We will now look at the following characteristics of residential mortgage loans in detail:
• Maturity
• Mortgage rate
• Amortization schedule
• Prepayments and prepayment penalties
• Rights of the lender in a foreclosure
4.1. Maturity
Maturity: term of a mortgage is the number of years to maturity. It varies from one country
to the other. For example, in the United States it ranges from 15 to 30 years.
4.2. Interest Rate Determination
The interest rate on the mortgage loan is called the mortgage rate or contract rate. How the
mortgage rate is calculated varies across countries.
The four basic methods for calculating mortgage rate are:
• Fixed rate: The rate remains fixed during the life of the mortgage.
• Adjustable or variable rate: The adjustable-rate mortgage (ARM) is like a floating rate.
Here, the mortgage rate is reset periodically based on some reference rate or index.
• Initial period fixed rate: The mortgage rate is fixed for some initial period and then it
is adjusted for either a new fixed rate or variable rate. If the mortgage rate is fixed for
an initial period and then set to a new fixed rate, then it is called rollover or
renegotiable mortgage. If the mortgage rate is fixed for an initial period and then it
becomes adjustable, then it is called a hybrid mortgage.
• Convertible: The mortgage is initially either a fixed or an adjustable rate. Later, the
borrower may either convert it into a fixed or adjustable mortgage for the remainder
of the mortgage’s life.
4.3. Amortization Schedule
Residential mortgages are usually amortizing loans. The amount borrowed reduces
gradually over time as periodic mortgage payments are made. Mortgage payments consist of
interest payments and scheduled principal repayments. Let’s take the example of the Smiths
who borrow $100,000 to purchase a house, assume the terms of the loan are as follows:
Loan amount = $100,000; mortgage rate = 6%; maturity term = 30 years.
The periodic mortgage payment can be computed as:

PV = -100,000; N = 360 (=12 * 30); I = 0.5 = (6 / 12); FV = 0; CPT PMT

PMT = -599.95
Interest = 0.005 * 100,000 = $500. But, the monthly payment is $599.95. During the first
month, $99.95 goes towards reduction of principal. As time goes by, the amount of the
monthly mortgage payment towards principal reduction increases and that toward interest
decreases.
Since the outstanding mortgage balance of $100,000 reduces over time, it is called
amortization.
There are two types of amortizing loans:
• Fully amortizing loans: There is no outstanding balance at the end of the mortgage’s
life. The loan is fully repaid with the last mortgage payment.
• Partially amortizing loans: The sum of all the scheduled mortgage repayments is less
than borrowed amount. A last payment, called the balloon payment, is made equal to
the unpaid mortgage balance.
Based on interest/scheduled principal repayments, there are two types of mortgages:
• Interest-only mortgage: No scheduled principal repayment for a certain number of
years.
• Bullet mortgage: No scheduled principal repayment over the entire life of the loan.
The last payment is equal to the original loan amount.
4.4. Prepayment Options and Prepayment Penalties
Prepayment is a payment made in excess of the scheduled principal repayment. Assume 10
months after taking the loan, the interest rates fall. The Smiths choose to refinance by taking
a new loan and closing the existing one by prepaying. Another scenario is part prepayment,
where, let us say, in the first month the Smiths pay $1,000 instead of the scheduled $599.95
mortgage payment. $1,000 is broken down into three parts: $500 towards interest, $99.95
for scheduled principal payment, and $400.05 towards prepayment.
In some countries, there may be a penalty for prepayment as it hurts the lender (recall
‘prepayment risk’). The objective of imposing a penalty is to compensate the lender for the
difference in the contract rate and the prevailing mortgage rate when the borrower prepays
as rates decline.
4.5. Rights of the Lender in a Foreclosure
Recourse and non-recourse mortgage loans: If the borrower of a loan defaults on payments,
then the lender can seize the property and sell it. The proceeds from the sale may be less
than the outstanding mortgage balance, and not enough to recoup the losses. There are two
types of mortgage loans in such cases:
• Recourse loans: The lender can claim the shortfall (outstanding mortgage balance –
after the property is sold) from the borrower. For instance, if the borrower has other

properties or possessions such as an expensive car, or valuable art, then these could
be sold to fulfill the shortfall.
• Non-recourse loans: Most mortgage loans are non-recourse. The lender may sell the
property in case of a default and keep the proceeds. But, unlike a recourse loan, the
bank/lender cannot claim other assets of the borrower to fulfill the shortfall in the
outstanding mortgage balance.
5. Residential Mortgage-Backed Securities
Residential mortgage-backed securities are bonds created from the securitization of
residential mortgage loans. In the U.S., residential mortgage-backed securities are divided
into the following three sectors:
1. Those guaranteed by a federal agency (Ginnie Mae) whose securities are backed by
the full faith and credit of the U.S. government.
2. Those guaranteed by either of the two government-sponsored enterprises or GSEs
(Fannie Mae and Freddie Mac) but not by the U.S. government. They do not carry the
full faith and credit of the U.S. government.
3. Those issued by private entities that are not guaranteed by a federal agency or a GSE.
The first two sectors (guaranteed by the government or a quasi-government entity) are
called the agency RMBS. The third sector is called non-agency RMBS.
Examples of agency RMBS include:
• Mortgage pass-through securities
• Collateralized mortgage obligations
The two differences between agency RMBS issued by GSEs and non-agency RMBS are as
follows:
• Non-agency RMBS use credit enhancements to reduce credit risk, while agency RMBS
issued by the GSEs are guaranteed by the GSEs themselves.

• For a loan to be included in a pool of loans backed by an agency RMBS, it must satisfy
the underwriting standards of the government agencies.
5.1. Mortgage Pass-Through Securities
A mortgage pass-through security is created when one or more holders of mortgages form a
pool of mortgages and sell shares or participation certificates in the pool. The investors
receive a share of cash flows from the underlying pool of mortgage loans.
Cash Flow Characteristics
• Monthly mortgage payments consist of interest, scheduled principal repayment,
prepayments.
• Payments are made to security holders each month.
• The servicer collects monthly payments, sends payment notices to borrowers, sends
reminders if payments are overdue, maintains records of principal balances, etc.
• The servicing fee is part of the mortgage rate.
• The amount of cash flow from mortgage loans is not equal to that received by the
investors. Similarly, there is a delay in passing the cash flow from mortgage loans to
the security holders.
• Monthly cash flow of a mortgage pass-through security = monthly cash flow of the
underlying pool of mortgages - servicing and other fees. In other words, investors of
the mortgage pass-through security receive less than the cash flow coming in from
the mortgage loans because a servicing fee is collected by the servicer.
How is the rate and maturity of a mortgage loan calculated?
• Pass-through rate: A mortgage pass-through security’s coupon rate is called the pass-
through rate. For example, if the mortgage rate for a pool of mortgages is 8%, the
annualized servicing fee is 0.6%, then the investors receive an average return of
around 7.4%.
• Weighted average coupon (WAC): Each of the mortgage loans in the securitized pool
may not have the same mortgage rate. The WAC is found by weighting the rate of each
mortgage loan in the pool by the percentage of the mortgage outstanding relative to
the outstanding amount of all mortgages in the pool.
• Weighted average maturity (WAM): Similarly, not all the loans in the pool will have
the same maturity. WAM is found by weighting the remaining number of months to
maturity for each mortgage loan in the pool by the amount of the outstanding
mortgage balance.
Conforming and Non-conforming Loans
A mortgage loan must meet certain criteria to be included in a pool of loans backing an
RMBS. Listed below are some of the underwriting standards of an agency they must conform
to:
• Maximum loan-to-value ratio: It should be below the maximum LTV to conform.

• Maximum size of the loan

• Loan documentation
If a loan meets the underwriting standards, then it is called a conforming loan.
Non-conforming mortgages that serve as collateral for mortgage pass-through securities do
not meet the underwriting standards and are privately issued by thrift institutions,
commercial banks, etc.
Example
Assume that a pool includes four mortgages with the following characteristics:
Mortgage Outstanding Balance Coupon Rate Time to Maturity
1 $1,000 4.50% 28 months
2 $2,000 4.75% 42 months
3 $4,000 5.15% 37 months
4 $3,000 3.80% 60 months
Calculate the weighted average coupon rate and weighted average maturity.
Solution:
The total outstanding amount is $10,000 and hence, the weights are as follows: Mortgage 1 =
10%, 2 = 20%, 3 = 40% and 4 = 30%.
The weighted average coupon is:
0.10 × 4.50% + 0.20 × 4.75% + 0.40 × 5.15% + 0.30 × 3.80% = 4.60%
The weighted average maturity (WAM) is:
0.10 × 28 + 0.20 × 42 + 0.40 × 37 + 0.30 × 60 = 44 months
Prepayment risk: The risk associated with uncertainty in future cash flows because of
principal repayments is called prepayment risk. It has two components: contraction risk and
extension risk.
• Contraction risk is the risk that when interest rates decline, the security will have a
shorter maturity than was anticipated at the time of purchase because homeowners
refinance at now-available lower interest rates. For instance, assume the interest rate
is 8% when the Smiths take the loan. If two years later it falls to 6%, then they will
prepay the loan and refinance at the lower rate.
• Extension risk is the risk that when interest rates rise, fewer prepayments will occur
because homeowners are reluctant to give up the benefits of a contractual interest
rate that now looks low. From an investor’s perspective, the security becomes longer
in maturity than it was at the time of purchase.
Instructor’s Note
Contraction risk occurs when interest rates decline.
Extension risk occurs when interest rates rise.

Prepayment Rate Measures

To value a mortgage pass-through security, one must be able to forecast its cash flows. But,
the cash flows are uncertain because it is not known ahead of time when homeowners may
prepay principal during the mortgage’s life. The only way to predict future cash flows is by
making some assumptions about the prepayment speed/rate.
The two measures of prepayment rate are:
• Single month mortality rate: this is a monthly measure.
• Conditional repayment rate: this is an annual measure.
Single month mortality (SMM) measures prepayments in a month. An SMM of x% means that
x% of the outstanding mortgage balance at the start of the month minus the scheduled
principal repayment, will be repaid that month.
Prepayment for a month
SMM = Begining mortgage balance for month−Scheduled principal repayment for month
Conditional repayment rate (CPR) is an annualized version of SMM.

A CPR of 6%, for example, means that approximately 6% of the outstanding mortgage
balance at the beginning of the year is expected to be prepaid by the end of the year.
100 PSA prepayment benchmark: The 100 Public Securities Association (PSA) prepayment
benchmark is expressed as a monthly series of CPRs. The benchmark assumes that
prepayment rates are low for newer mortgages and increase as time passes. A PSA
assumption greater than 100 PSA means that prepayments are assumed to be faster than the
benchmark. In contrast, a PSA assumption lower than 100 PSA means that prepayments are
assumed to be slower than the benchmark.
Cash Flows
The cash flows associated with a mortgage pass-through security have the following
components:
• Scheduled principal repayment
• Principal pre-payment
• Interest payment
The interest payment is based on the principal outstanding at the start of the period and the
interest rate. The principal pre-payment can be estimated based on the SMM (or CPR)
number. The higher the SMM, the higher the prepayment.
Instructor’s Note
The curriculum shows the cash flow calculations for a hypothetical mortgage pass-through
security. If you have the time you can study the curriculum example. However, from a
testability perspective it is more important that you understand the concept which is
explained here.

Weighted Average Life

Recall that one of the basic characteristics of a bond is its maturity. But, in the case of a MBS
the legal maturity date does not reveal much about the characteristics of the security
because of prepayments.
The weighted average life (average life) gives investors an indicator of how long investors
can expect to hold the MBS before it is paid off. The table below shows the average life at
different prepayment rates. For instance, at a prepayment rate of 125 PSA, the average time
for principal repayment is 10.1 years. Notice that the average time drops drastically to 3.2
years as the prepayment rates go up to 600 PSA.
PSA assumption 100 125 165 250 400 600
Average life (years) 11.2 10.1 8.6 6.4 4.5 3.2
5.2. Collateralized Mortgage Obligation
The prepayment risk seen in mortgage pass-through securities can be reduced by
distributing the cash flows of these mortgage products to different classes or tranches
through a process called structuring.
Collateralized mortgage obligation (CMO) is one such security created based on this
principle of structuring where the cash flows (interest and principal) are redistributed to
different tranches based on a set of rules. The different classes of bondholders in a CMO have
different exposures to prepayment risk. The collateral for a CMO is a pool of mortgage pass-
through securities and not a pool of mortgage loans.
Advantages of a CMO
Following are the key benefits of a CMO:
• CMOs can be created to closely satisfy the asset/liability needs of institutional
investors, thereby broadening the appeal of mortgage-backed products.
• Some investors may want to increase their exposure to prepayment risk, while some
may want to reduce. Based on their individual needs and risk appetite, investors can
choose the CMO.
The most common types of CMO tranches are sequential-pay tranches, planned amortization
class (PAC) tranches, support tranches, and floating-rate tranches.
Sequential-Pay CMO Structures
Each class/tranche of bond in this CMO structure is retired sequentially. Let us consider a
CMO with four tranches. Note that this example is for simplicity. The coupon rate usually
varies by tranche.
Tranche Par amount(US $) Coupon rate (%)
A 389,000,000 5.5
B 72,000,000 5.5

C 193,000,000 5.5
D 146,000,000 5.5
Total 800,000,000
The prepayment risk is mitigated in this CMO by following these interest and principal
repayment rules:
For payment of monthly coupon interest: Disburse monthly coupon interest to each tranche
on the basis of the amount of principal outstanding for each tranche at the beginning of the
month.
For disbursement of principal payments:
Disburse principal payments to tranche A until it is completely paid off.
After tranche A is completely paid off, disburse principal payments to tranche B until it is
completely paid off.
After tranche B is completely paid off, disburse principal payments to tranche C until it is
After tranche C is completely paid off, disburse principal payments to tranche D until it is
The table below shows the average life of the collateral and different tranches at various
prepayment rates. For instance, at a prepayment rate of 165 PSA, the average life of the
collateral is 8.6 years, while it is 3.4 years and 19.8 years for tranches A and D respectively.
At higher levels of prepayment, the average life of tranche A falls to 1.6 years and to 7 years
for tranche D.
PSA Collateral Tranche A Tranche B Tranche C Tranche D
100 11.2 4.7 10.4 15.1 24.0
125 10.1 4.1 8.9 13.2 22.4
165 8.6 3.4 7.3 10.9 19.8
250 6.4 2.7 5.3 7.9 15.2
400 4.5 2.0 3.8 5.3 10.3
600 3.2 1.6 2.8 3.8 7.0
• Tranche A has the highest contraction risk while tranche D has the highest extension
risk.
• Tranches A and B provide protection against contraction risk for tranches C and D.
• Similarly, tranches C and D provide protection against extension risk for tranches A
and B respectively.

CMO Structures Including Planned Amortization Class and Support Tranches

In a CMO with a sequential pay-structure, there was a great variability in average
life/prepayment risk based on the prepayment rate. This is partly overcome with a CMO
structure called the planned amortization class (PAC) tranches. PAC tranches offer great
predictability as long as the prepayment rate is within a specified band over the collateral’s
life. PACs offer protection against both extension risk and contraction risk.
Two PSA prepayment rates must be specified to create a PAC tranche. The two prepayment
speeds used to create a PAC bond is called the PAC collar. The lower and upper PSA
prepayment assumptions are called the “initial PAC collar”, or the “initial PAC bond”.
The greater certainty of the cash flow for the PAC tranches comes at the expense of the non-
PAC tranches (called support tranches). The support tranches provide protection against
both contraction and extension risk by absorbing excess principal paid or forgoing principal
payment, if the collateral payments are slow.
The table below illustrates the life of PAC and support tranches at various prepayment rates.
As you can see, for a prepayment rate between 100 PSA and 250 PSA, the average life of the
PAC tranche is 7.7 years. Whereas, the average life of support tranche varies from 20 years
to 3.3 years. The prepayment speeds of 100 PSA and 250 PSA create the initial PAC collar.
PSA Life of PAC Life of Support
50 10.2 24.9
75 8.6 22.7
100 7.7 20.0
165 7.7 10.7
250 7.7 3.3
400 5.5 1.9
600 4.0 1.4
The support tranches defer principal payments to the PAC tranches if the collateral
prepayments are slow; support tranches do not receive any principal until the PAC tranches
receive their scheduled principal repayment.
Support tranches absorb any principal prepayments in excess of the scheduled principal
repayments that are made. This rule reduces the contraction risk of the PAC tranches. If the
support tranches are paid off quickly because of faster-than-expected prepayments, they no
longer provide any protection for the PAC tranches.
For example, a mortgage pass-through security has a greater average life variability than a
PAC tranche, but lesser than that of a support tranche. The bond classes in a CMO can either
be riskier or less risky than a mortgage pass-through security.

5.3. Non-agency Residential Mortgage-Backed Securities

Unlike agency residential mortgage-backed securities (RMBS), non-agency RMBS is not
backed by the government or a by a GSE; so, credit risk is a major concern for investors. For
agency RMBS, when the principal will be repaid (prepayment risk) was a major concern. For
non-agency RMBS, if and when (credit risk + prepayment risk) the principal will be paid is a
concern.
Based on the credit quality of the mortgage loans in the pool, the securities can be classified
into two:
• Prime loans: Borrower has high credit quality, strong credit history, sufficient income
to service the loan, and equity in the underlying property.
• Subprime loan: Borrower has low credit quality.
The two complementary mechanisms required in structuring a non-agency RMBS are:
1. The cash flows are distributed by rules, such as the waterfall, that dictate the
allocation of interest payments and principal repayments to different tranches with
various degrees of seniority/priority. Each tranche has a varying exposure to
prepayment and credit risk.
2. There are rules for the allocation of realized losses, which specify that subordinated
bond classes have lower payment priority than senior classes.
Two factors to consider when forecasting the future cash flows of a non-agency RMBS:
• Default rate for the collateral.
• Recovery rate. Since some part of the mortgage may be seized and sold, the recovery
rate is considered.
In order to obtain a favorable credit rating and to ensure some protection against losses in
the pool, non-agency RMBS and non-mortgage ABS often require one or more credit
enhancements.
• Internal credit enhancements include senior/subordinated structures, cash reserve
funds, overcollateralization, and excess spread accounts.
• External credit enhancements include third party guarantee, such as a monoline
insurance company.
6. Commercial Mortgage-Backed Securities
Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial
mortgage loans on income-producing property. Important features of a CMBS are as follows:
• The underlying are loans to purchase or refinance a commercial property such as a
warehouse, apartment building, office building, hotels, health care facilities, etc.
• Commercial mortgage loans are non-recourse loans. Lenders can only stake a claim to
the income-producing property backing the loan in case of a default and not on any
other asset of the borrower.

• It is important to study the cash flows from the underlying properties for credit
analysis.
• There are two key indicators to assess the potential credit performance of a
commercial mortgage loan: 1) debt-to-service coverage ratio and 2) the loan-to-value
ratio.
Annual net operating income
Debt-to-service coverage ratio = Debt service
where:
Debt service = annual interest payment and principal repayment
Net operating income = rental income – cash operating expenses – a non-cash
replacement reserve
If DSC > 1.0, then cash flows from property are sufficient to service debt.
How to interpret DSC and LTV ratios:
• The higher the DSC ratio, the lower the credit risk and the better is the borrower’s
ability to service debt.
• A low loan-to-value ratio implies lower credit risk.
• Note: to memorize this formula, draw a parallel with interest coverage ratio from
FRA.
6.1. Credit Risk
The role of a credit-rating agency in the CMBS market is to give an opinion on the credit-
quality of the bond and provide any enhancement to achieve a desired credit rating. For
example, if specific DSC and LTV ratios are needed and those ratios cannot be met at the loan
level, then subordination is used to achieve the desired credit rating.
6.2. CMBS Structure
Interest and principal repayments in a CMBS are structured as follows:
• Interest on principal outstanding is paid to all tranches.
• The highest-rated bonds are paid off first in the CMBS structure.
• Losses arising from loan defaults are charged against the principal balance of the
lowest priority CMBS tranche outstanding. These tranches may be unrated by credit-
rating agencies and are called the “first-loss piece”, “residual tranche”, or “equity
tranche”.
Characteristics of a CMBS Structure
In this section, we look at two important characteristics of a CMBS structure: call protection
and balloon risk.

Call Protection
RMBS investors are exposed to prepayment risk since the borrowers have a right to prepay
and are not penalized for prepayment; they have an incentive to prepay. CMBS has
considerable call protection, which is protection against early prepayment of mortgage
principal. The call protection comes in two forms: at the structure level and at the loan level.
Call protection at the structural level:
Call protection at the structural level comes by structuring CMBS into sequential-pay
tranches, by credit rating. A lower-rated tranche cannot be paid off until the higher-rated
tranches are retired. But, in the case of a default, the losses must be charged to the lowest-
rated tranche first and last to the highest-rated tranche.
Call protection at the loan level:
There are four mechanisms that offer investors call protection at the loan level:
1. Prepayment lockouts: The borrower is prohibited from any prepayments during a
specific period of time.
2. Prepayment penalty points: The borrower must pay a fixed percentage of the
outstanding loan balance as prepayment penalty if he wishes to refinance.
3. Yield maintenance charges: Also known as “make-whole charge”. The borrower must
pay a penalty to the lender that makes refinancing uneconomical if the sole objective
was to get a lower mortgage rate.
4. Defeasance: Defeasance is a protection at the loan level that requires the borrower to
provide sufficient funds that can be invested in a portfolio of government securities to
replicate the cash flows in the absence of prepayments.
Balloon Risk
Residential mortgages are fully-amortizing loans that are fully amortized over a long period
of time. Usually, there is no principal outstanding after the last mortgage payment. But, many
commercial loans backing CMBS transactions are balloon loans which require a substantial
principal payment on the final maturity date. If the borrower is not able to make the lump
sum payment, he may ask for an extension of the loan over a period of time called the
“workout period”.
Balloon risk is a type of extension risk. The risk that a borrower will not be able to make the
balloon payment either because the borrower cannot arrange for refinancing or cannot sell
the property to generate sufficient funds to pay off the balloon balance is called “balloon
risk”.
7. Non-Mortgage Asset-Backed Securities
A wide range of assets apart from mortgage loans are used as collateral for asset-backed
securities. The most popular non-mortgage ABS are auto loan receivable-backed securities

and credit card receivable-backed securities. Based on the way the collateral pays, ABS can
be categorized into two types: amortizing and non-amortizing.
Examples of amortizing loans backing an ABS: mortgage loans and automobile loans.
An example of non-amortizing loans backing an ABS: credit card receivables.
ABS must offer credit enhancement to be appealing to investors.
7.1. Auto Loan ABS
Cash flows consist of interest payment, scheduled principal repayments and any
prepayments. For securities backed by auto loan receivables, prepayments result from any
of the following:
• Sales and trade-ins requiring full payoff of the loan.
• Repossession and subsequent resale of vehicles.
• Insurance proceeds received upon loss or destruction of vehicles.
• Payoff of the loan with cash to save on the interest cost.
• Refinancing of the loan at a lower interest rate.
All auto-loan backed securities have some form of credit enhancement such as:
• A senior/subordinated structure so the senior tranches have credit enhancement.
• Reserve account, overcollateralization, and excess interest on the receivables.
o The purpose of a reserve account is to provide credit enhancement. More
specifically, the reserve account is a form of internal credit enhancement that will
protect the bondholders against losses up to x% of the par value of the entire
issue.
o Overcollateralization means that the aggregate principal balance of the
automobile loan contract exceeds the principal balance of the notes. It represents
another form of internal credit enhancement. Overcollateralization can be used to
absorb losses from the collateral.
7.2. Credit Card Receivable ABS
Credit cards such as Visa and MasterCard are used to finance the purchase of goods and
services, as well as for cash advances. When a cardholder makes a purchase using a credit
card, he is agreeing to repay the amount borrowed (purchase amount) to the issuer of the
card within a certain period, typically a month. If the outstanding amount is not repaid
within this grace period, then a finance charge (interest rate) is applied to the balance not
paid in full each month.
Credit card receivables are pooled together to act as a collateral for credit card receivable-
backed securities. Cash flow, on a pool of credit card receivables consists of:
• Finance charges: These represent the periodic interest the credit card borrower is
charged on the unpaid balance after the grace period.

• Fees and principal repayments. Fees include any late payment fees and any annual
membership fees.
Characteristics of Credit Card Receivable-backed Securities
Payment Structure
• The security holders are paid an interest periodically (e.g., monthly, quarterly, or
semiannually). The interest rate may be fixed or floating.
• The principal payments made by borrowers do not flow through to investors during a
period known as the lockout period. Instead, the repayments are reinvested to issue
new loans. As a result, credit card receivables increase during the lockout period.
During this period, the cash flow to security holders comes from finance charges and
fees.
Amortization Provision
• Credit card receivable-backed securities are non-amortizing loans. The principal is
not amortized during the lockout period.
• Certain provisions in credit card receivable-backed securities require early
amortization of the principal if certain events occur. Such provisions are referred to
as “early amortization” or “rapid amortization” provisions and are included to
safeguard the credit quality of the issue. The only way the principal cash flows can be
altered is by triggering the early amortization provision. For example, if issuers
believe there may be a default in credit card repayments, then the principal
repayments will be used to pay security holders (investors) instead of reinvesting to
issue new loans.
There are two differences between credit card receivable-backed securities and auto loan
receivable-backed securities:
• Collateral for credit card receivable-backed securities are non-amortizing loans, while
the collateral for auto loan receivable-backed securities are fully amortizing loans.
• For auto loan receivable-backed securities, outstanding principal balance declines as
principal is distributed to bond classes each month. But, for credit card receivable-
backed securities the principal is reinvested to issue new loans during the lockout
period.
8. Collateralized Debt Obligations
A collateralized debt obligation is a generic term used to describe a security backed by a
diversified pool of one or more debt obligations (e.g., corporate and emerging market bonds,
leveraged bank loans, ABS, RMBS, CMBS, or CDO).
Like an ABS, a CDO involves the creation of a SPV. But, in contrast to an ABS, where the funds
necessary to pay the bond classes come from a pool of loans that must be serviced, a CDO
requires a collateral manager to buy and sell debt obligations, for and from the CDO’s

portfolio of assets, to generate sufficient cash flows to meet the obligations of the CDO
bondholders, and to generate a fair return for the equity holders.
The structure of a CDO includes senior, mezzanine, and subordinated/equity bond classes.
The whole process is illustrated below:
8.1. CDO Structure

The key components of a CDO structure are as follows:
• The CDO raises funds by issuing debt. The debt obligations are structured as bond
classes or tranches, such as senior, mezzanine, or subordinated classes with varying
risk and return expectations. Investors invest in a particular bond class based on their
risk appetite.
• The funds raised from the issuance of bonds are used by the collateral manager to
invest in assets. He seeks to earn a higher return from these assets than what is paid
to the bondholders.
• The excess spread is used to pay the equity holders and the CDO manager.
• The sources of cash flow to bondholders include interest, principal repayments, and
sale of collateral assets.
8.2. An Example of a CDO Transaction
Consider the following $100 million CDO. The collateral consists of bonds with a par value of
$100 million paying a fixed rate of 11%.
Tranche Par value (US $) Coupon rate
Senior 80,000,000 Libor + 70 bps
Mezzanine 10,000,000 9%
Subordinated/equity 10,000,000 -

Since the senior tranche requires a floating rate payment, the CDO manager enters into an
interest rate swap with another party for a notional amount of $80 million paying a fixed
rate of 8% and receiving Libor. This removes any uncertainty with respect to interest rate
movements.
Let us now evaluate the cash flows for each party.
Party Type of cash flow Amount
Collateral Pays interest each year. Coupon rate .11 x 100,000,000 = 11,000,000
= 11%
Senior Interest paid to senior tranche: Libor (Libor + 70bps) x 80,000,000 =
tranche + 70 bps Libor x 80,000,000 + 560,000
Mezzanine Interest paid: 9% 0.09 x 10,000,000 = 900,000
tranche
Interest rate CDO to swap counterparty: 8% 0.08 x 80,000,000 = 6,400,000
swap
Interest rate From swap counterparty to CDO: 80,000,000 x Libor
swap Libor
Total interest received 11,000,000
+ Libor x 80,000,000
Total interest paid Libor x 80,000,000 + 560,000
+ 900,000 + 6,400,000
= 7,860,000 + Libor x 80,000,000
Net interest = Interest received – 3,140,000
interest paid
From the net interest available, the CDO manager’s fees must be paid. If the fees are 640,000,
then the cash flow available to the subordinated/equity tranches is 3,140,000 – 640,000 =
2,500,000. The annual return for this tranche with a par value of $10 million is
2,500,000/10,000,000 = 25%
CDOs: Risks and Motivations
In the case of defaults in the collateral, there is a risk that the manager will fail to earn a
return sufficient to pay off the investors in the senior and mezzanine tranches. Investors in
the subordinated/equity tranche risk the loss of their entire investment.

Summary
LO.a: Explain benefits of securitization for economies and financial markets.
The benefits to investors are:
• Securitization converts an illiquid asset into a liquid security.
• It gives investors direct access to the payment streams of the underlying mortgage
loans that would otherwise be unattainable.
• There are higher risk-adjusted returns to investors: pooling of loans results in
diversification and lower risk for investors.
• It gives investors anywhere an opportunity to buy a small part of homebuyers’
mortgage in the form of a security issued by the SPV.
• Exposure to the market, real estate for example, without directly investing in it.
The benefits to the bank or loan originator are:
• It enables banks to increase loan origination, monitoring, and collections.
• It reduces the role of the intermediaries like the bank.
• Banks have the ability to lend more money if the demand for ABS and MBS is high
relative to if the money was self-financed.
• There is greater efficiency and profitability for the banking sector.
The borrowers of the loan benefit from securitization in the following ways:
• It lowers the risk as the pooled loans offer a diversification benefit. The lower risk, in
turn, decreases the cost of borrowing for homeowners.
LO.b: Describe securitization, including the parties involved in the process and the
roles they play.
The parties involved in the securitization process include:
• SPV (Special Purpose Vehicle): It is also called the trust or the issuer.
• Seller of pool of securities: It is also known as the originator or depositor.
• Servicer: Servicing involves collecting payments from borrowers, notifying borrowers
who may be delinquent, and if necessary, seizing equipment from borrowers who
default.
• Other parties: Independent accountants, underwriters, trustees, rating agencies, and
guarantors.
The motivation for the creation of different types of structures is to redistribute prepayment
risk and credit risk efficiently among different bond classes in the securitization.
Prepayment risk is the uncertainty that the actual cash flows will be different from the
scheduled cash flows.
Time tranching is the creation of bond classes to distribute the prepayment risk.

Subordination is another layering structure in securitization. The bond classes differ in their
exposure to credit risk.
LO.c: Describe typical structures of securitizations, including credit tranching and
time tranching.
In credit tranching, any credit losses are first absorbed by the tranche with the lowest
priority and after that by any other subordinated tranches.
In time tranching, different classes receive the principal payments from the underlying
securities sequentially as each prior tranche is repaid in full.
LO.d: Describe types and characteristics of residential mortgage loans that are
typically securitized.
The cash flow of a mortgage consists of the following three components: interest, scheduled
principal payments, and prepayments.
Following are the important characteristics of residential mortgage loans:
Maturity: The term of a mortgage is the number of years to maturity. It varies from one
country to the other.
Interest rate determination: Interest rate on the mortgage loan is called the mortgage rate or
contract rate. The four basic methods for calculating mortgage rate are fixed rate, variable
rate, initial period fixed rate, and convertible rate.
Amortization schedule: Residential mortgages are usually amortizing loans. The amount
borrowed reduces gradually over time as periodic mortgage payments are made.
There are two types of amortizing loans:
• Fully amortizing loans: There is no outstanding balance at the end of the mortgage’s
life.
• Partially amortizing loans: The sum of all the scheduled mortgage repayments is less
than the borrowed amount. A last payment, called the balloon payment, is made equal
to the unpaid mortgage balance.
Based on interest/scheduled principal repayments, there are two types of mortgages:
• Interest-only mortgage: No scheduled principal repayment for a certain number of
years.
• Bullet mortgage: No scheduled principal repayment over the entire life of the loan.
Recourse loans: The lender can claim the shortfall (outstanding mortgage balance – after
selling the property) from the borrower.
Non-recourse loans: The lender may sell the property in case of a default and keep the
proceeds but they cannot claim other assets of the borrower to fulfill the shortfall in
outstanding mortgage balance.

LO.e: Describe types and characteristics of residential mortgage-backed securities,

including mortgage pass-through securities and collateralized mortgage obligations,
and explain the cash flows and risks for each type.
Residential mortgage-backed securities (RMBS) are bonds created from the securitization of
residential mortgage loans. Examples of agency RMBS include:
• Mortgage pass-through securities
• Collateralized mortgage obligations
• Non-agency residential mortgage-backed securities
A mortgage pass-through security is created when one or more holders of mortgages form a
pool of mortgages and sell shares or participation certificates in the pool. The cash flow of a
mortgage pass-through security depends on the cash flow of the underlying pool of
mortgages and consists of monthly mortgage payments representing interest, the scheduled
repayment of principal, and any prepayments, net of servicing and other fees.
• Market participants measure the prepayment rate using two measures: the single
monthly mortality (SMM) rate and its corresponding annualized rate, namely, the
conditional prepayment rate (CPR). For MBS, the measure widely used by market
participants to assess the sensitivity of the securitized bonds to interest rate
movements is the weighted average life (WAL) or simply average life of the MBS,
instead of duration.
• Market participants use the Public Securities Association (PSA) prepayment
benchmark to describe prepayment rates. A PSA assumption greater than 100 PSA
means that prepayments are assumed to be faster than the benchmark, whereas a
PSA assumption lower than 100 PSA means that prepayments are assumed to be
slower than the benchmark.
• Prepayment risk includes two components: contraction risk and extension risk. The
former is the risk when interest rates decline; the security will have a shorter
maturity than was anticipated at the time of purchase because homeowners refinance
at now-available lower interest rates. The latter is the risk when interest rates rise;
fewer prepayments will occur because homeowners are reluctant to give up the
benefits of a contractual interest rate that now looks low.
LO.f: Define prepayment risk and describe the prepayment risk of mortgage-backed
securities.
Prepayment risk refers to the uncertainty about the timing of the principal component of the
cash flows.
Contraction risk is the risk that the loan principal will be repaid earlier than expected.
Extension risk is the risk that the loan principal will be repaid later than expected.

LO.g: Describe the characteristics and risks of commercial mortgage-backed

securities.
Two important characteristics of a CMBS structure: call protection and balloon risk.
Call protection
CMBS have considerable call protection, which is protection against early prepayment of
mortgage principal. The call protection comes in two forms: at the structure level and at the
loan level.
• Call protection at the structural level comes by structuring CMBS into sequential-pay
tranches, by credit rating.
• The four mechanisms that offer investors call protection at the loan level are payment
knockouts, prepayment penalty points, yield maintenance charges, and defeasance.
Balloon risk
Balloon risk is a type of extension risk. The risk that a borrower will not be able to make the
balloon payment, either because the borrower cannot arrange for refinancing or cannot sell
the property to generate sufficient funds to pay off the balloon balance, is called “balloon
risk”.
LO.h: Describe types and characteristics of non-mortgage asset-backed securities,
including the cash flows and credit risk of each type.
The most popular non-mortgage ABS are auto loan receivable-backed securities and credit
card receivable-backed securities.
Auto Loan Receivable-Backed Securities
Cash flows consist of interest payment, scheduled principal repayments and any
prepayments. All auto-loan backed securities have some form of credit enhancement.
Credit Card Receivable-Backed Securities
The credit card receivables are pooled together to act as a collateral for credit card
receivable-backed securities. Cash flow, on a pool of credit card receivables consists of
finance charges and fees, and principal repayments.
There are two differences between credit card receivable-backed securities and auto loan
receivable-backed securities:
• Collateral for credit card receivable-backed securities are non-amortizing loans, while
the collateral for auto loan receivable-backed securities are fully amortizing loans.
• For auto loan receivable-backed securities, outstanding principal balance declines as
principal is distributed to bond classes each month. But for credit card receivable-
backed securities, principal is reinvested to issue new loans during the lockout
period.

LO.i: Describe collateralized debt obligations, including their cash flows and credit
risk.
A collateralized debt obligation is a generic term used to describe a security backed by a
diversified pool of one or more debt obligations (collateral). The structure of a CDO includes
senior, mezzanine, and subordinated/equity bond classes. In the case of defaults in the
collateral, there is a risk that the manager will fail to earn a return sufficient to pay off the
investors in the senior and mezzanine tranches. Investors in the subordinated/equity
tranche risk the loss of their entire investment.

Practice Questions
1. Analyst 1: Securitization is beneficial for banks because it allows banks to maintain
ownership of their securitized assets.
Analyst 2: Securitization is beneficial for banks because it increases the funds available
for banks to lend.
A. Analyst 1 is correct
B. Analyst 2 is correct
C. Both analysts are incorrect
2. In a securitization, the loan servicer is least likely responsible for the:

A. issuance of the asset-backed securities.
B. collection of payments from the borrowers.
C. recovery of underlying assets for delinquent loans.
3. A securitization structure that allows investors to choose between extension risk and
contraction risk is least likely called:
A. credit tranching.
B. time tranching.
C. prepayment tranching.
4. Edward Hall obtains a non-recourse loan for $300,000. A year later when the outstanding
balance of the mortgage is $285,000, Edward cannot make his mortgage payments and
defaults on the loan. The lender forecloses and sells the house for $250,000. What
amount is the lender entitled to claim from Edward?
A. $0.
B. $35,000.
C. $50,000.
5. A conditional prepayment rate (CPR) of 9% means that approximately 9% of the

outstanding mortgage pool balance at the beginning of this year will be prepaid:
A. in the current month.
B. by the end of the year.
C. over the life of the mortgages.
6. The balloon risk in a CMBS can be best described as a type of:

A. extension risk.
B. contraction risk.
C. interest rate risk.
7. If a credit card receivables asset-backed security (ABS) has a lock-out feature:

A. no investors may sell the ABS for a certain period of time.

B. no payments are made to the ABS investor for a certain period of time.
C. no principal payments are made to the ABS investor for a certain period of time.
8. A debt security that is collateralized by a pool of bond obligations backed by corporate

and emerging market debt is most likely a:
A. CDO.
B. CMO.
C. CMBS.

Solutions
1. B is correct. Securitization allows banks to remove assets from their balance sheet,
therefore increasing the pool of available capital that can be loaned out.
2. A is correct. In a securitization, the special purpose vehicle (SPV) is responsible for the
issuance of the asset-backed securities. The servicer is responsible for both the collection
of payments from the borrowers and the recovery of underlying assets if the borrowers
default on their loans.
3. A is correct. Time tranching or prepayment tranching allows investors to choose

between extension risk and contraction risk. Credit tranching refers to creating a multi-
layered capital structure that has senior and subordinate tranches.
4. A is correct. In a non-recourse loan the lender can only look to the underlying property to
recover the outstanding mortgage balance and has no further claim against the borrower.
5. B is correct. The CPR is an annual prepayment rate.
6. A is correct. Balloon risk refers to the risk that a borrower will not be able to make the
balloon payment when due. Since the term of the loan will be extended by the lender
during the workout period, balloon risk is a type of extension risk.
7. C is correct. If a credit card receivables asset backed security (ABS) has a lock-out feature
no principal payments are made to the investor, instead the principal repayments are
reinvested in new receivables.
8. A is correct. A CDO is backed by an underlying pool of debt securities which may include
corporate and emerging market debt. Both CMO and CMBS have mortgages as collateral.

Islamic Finance
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Prohibition of interest or Riba
• Riba is earning money from money
• Riba is fixed and positive, depending on the amount and time of the loan
• Originally prohibited in all three Abrahamic religions (see Appendix)
Mr and Mrs Smith are a low-income couple. They want to buy a house worth 100,000. They manage to save 25,000 and
take out a 75,000 mortgage. In a happy scenario house prices go up… they keep making mortgage payments and slowly
their equity position increases. But what happens if the economy does poorly, and house prices go down. Say house
prices go down by 20%. What is the percentage loss?
Islamic Contract
Terminologies
1. Wa’da (Promise)
2. Aqd (Contract)
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WA’DA
• Unilateral undertaking or promise extended by one
person to another in which he offers to act or omit to
do something in future.
• Example: I promise to sell you a particular machine
within the next 3 months for Rs. 500,000.
• The consensus of present Ulama is that Wa’da is
enforceable by law unless the promisor is not in a
position to fulfill his or her promise. If the promise is not
fulfilled due to the negligence of the promissor, then he
has to make good the loss to the promisee.
• Somewhat like an ‘option’.
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The Four Elements of an AQD
• Muta’qidin (Contractors)
▪ The contractors must not be mahjoor (unable to make a contract)
▪ Three types of people are mahjoor: 1) insane 2) child 3) slave
• Alfaz e Aqd’ (Wording of Contract)
▪ Wording should be instant and immediate; not contingent on a future event
▪ Wording can have certain types of conditions
➢ Conditions consistent with market practice but which do not violate the Quran and Sunnah are okay
➢ Conditions which go against one or more contractors are not okay
• Ma’qood Alaih (Subject Matter)
▪ Existing, valuable, usable; capable of being owned and delivered & possessed.
▪ Should be specified & quantified
▪ At the time of sale the seller must (i) have title to it and (ii) be liable for all risks associated with its ownership
• Ma’qood Bi’hi (Consideration)
▪ Should be quantified and specified & certain. For example, a price of Rs. 5 million.
▪ Ma’qood Bi’hi (Consideration) is not necessary for Uqood Ghair Muawadha.
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Four Elements of a Valid Sale
1. Contract or Transaction (Aqd)
2. Good for sale or subject matter (Mabee)

3. Price (Thaman)
4. Delivery/possession (Qabza)
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1. Contract or Transaction (Aqd)
• Offer and acceptance (ijab o qabool)
▪ Can be verbal. Statements should be in past tense: I have sold/I have purchased
▪ Can be implied. Ex: bill settlement at month end, exchange of money with goods
• Buyer and seller must be sane and mature
• Conditions of contract
▪ Delivery of sold commodity must be certain and should not depend on contingency or chance
➢ I can’t sell you a stolen good in the hope that I’ll recover it
▪ Sale must not have unreasonable conditions
➢ I can’t buy something from you on the condition that you’ll hire my son
▪ Conditions that both parties feel are reasonable are fine as long as they don’t conflict with the
Quran and Sunnah
▪ Seemingly unreasonable conditions are fine as long as they are consistent with common market
practice and are not in conflict with the Quran and Sunnah
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2. Goods for Sale (Subject Matter)
1. Existence
2. Valuable
3. Usable
4. Capable of ownership
5. Capable of delivery/possession
6. Specific or quantified
7. Seller must have title and risk
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3. Price
• Quantified
• Specified and Certain
4. Delivery or Possession
• Physical possession
• Constructive possession: possessor/owner does not have
actual physical possession but has all the rights/liabilities
associated with the asset
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Valid Sale
(Bai Sahi’h)
Contract or Sale good or Delivery or possession

Price (Qabza)
Transaction Subject matter
(Thaman)
(Aqd) (Mube’e) only in respect of
Moveable goods
Offer & Acceptance Buyer & Seller Condition of Contract Existable
(Ijab-o-Qubool) (Muta’aquadeen) (Sharae-e-Aqd)
Quantified
(Maloom) Physical
Valuable
Sale must be Sale must be (Haqiqi)
Oral Implied (e.g. not
Sane Mature Non- immediate not
(Qauli) (Isharaa)
Contingent Deferred to
a stone or Specific &
future Leaf) Certain Constructive
Credit Sale (Muta’aiyan) (Hukmi)
(Istijrar)
Cash Sale
Unconditional Under unreasonable Usable (e.g. Currency) (e.g. possession of
(Taati) condition but in market (e.g. not
(e.g.settlement Contract documents or keys of a
(e.g. as in Practice (e.g.warranty)
at the end of
Supermarket) Alcohol) Car)
the month)
Under reasonable Capable of
conditions
ownership/title
(e.g. not sea/sky)
Capable of delivery / possession
Specific & quantified
Seller must have Title & Risk

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Valid Versus Void Sale (Bai)
• A sale is valid (Bai Sahih) if has the following elements with the necessary conditions
▪ Contract (Aqd)
▪ Subject Matter (Mabee’)
▪ Price (Thaman)
▪ Possession (Qabza)
• Void sale / non-existing sale (Bai Baatil)

▪ Offer and acceptance is not properly done
▪ Conditions related to contractors are not met
▪ Conditions related to subject matter are not met
In a void sale the buyer does not get title to the subject matter and seller does not get the price
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Valid Versus Void Sale (Bai)
• Existing sale but void due to defect (Bai Fasid)
▪ This happens if a sale took place but then conditions related to contract and/or subject matter and/or
price are not complied with.
▪ If defects are rectified the sale becomes valid
▪ If defects are not rectified the sale transaction should be reversed
• Valid but disliked sale (Bai Maqrooh)

▪ Sale is considered complete but is disliked
▪ Examples: sale after juma azaan; sale to party C while negotiation is happening between A and B.
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Types of Sale
Type Description
Bai Musawamah Cost price is not known to the buyer
Bai Murabaha Cost and profit is known to the buyer
Bai Muqayada Barter sale excluding currency sale
Bai Surf Sale of gold, silver, currency
Bai Salam Full payment is the spot market and delivery of goods is deferred
Bai Istisna Product is sold before it is fully manufactured; order to assemble/manufacture
Bai Muajjal Delivery is at spot but payment is deferred
Bai Taulia Sale price is equal to cost of goods
Bai Waddiya Sale price is less than cost of goods
Note: I do NOT expect you to learn these Arabic names.
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Prohibited Sale Transactions
• Short Selling
• Sale of Debt (Bai al Dain)
• Bai Al Kali Bil Kali: delivery and

payment are both deferred
A wants a loan of Rs 1 million from B

• Bai Al Innah (Buy Back) B sells a commodity to A for Rs 1.1 million on credit.
B buys back commodity from A for Rs 1 million.
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Khiyars
Option or right of buyer and seller to rescind a contract
Five khiyars in a sale contract
• Khiyar e Shart (optional condition): Buyer or seller can put a condition that either party has an option to rescind the
sale within a specific number days; not transferable to heirs
• Khiyar e Roiyyat (option of inspecting goods): Goods can be returned after inspection
• Khiyar e Aib (option of defect): Goods can be returned if found defective
• Khiyar e Wasf (option of quality): Goods can be returned if they lack a quality which the buyer explicitly demanded
• Khiyar e Ghaban (option of price): Goods can be returned if seller excessively overcharged and buyer was not aware
of this at the time
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Introduction to Salam
Shariah compliant valid sales contract needs to meet certain conditions - the asset, which is the subject
of the contract, has to exist at the time of contract, should be owned by the seller and be in physical or
constructive possession of the seller.
Shariah has some practical flexibility and two Islamic finance products are the exception to this rule
Salam
Istisna
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Salam contract is where full payment for the asset is made in advance at the time of the contract.
Delivery is deferred to a specific future date. Salam is similar to the conventional forward sale contract.
Muslam - buyer of the asset
Muslam Ileihi - seller of the asset
Ras al Maal - payment for the asset
Muslam Fihi – the purchased asset
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Salam contracts are mostly short term but can be for medium or long term
Mostly used for production finance
More of a trade contract rather than a loan
Salam contracts used to finance agriculture, trade, construction,

manufacturing, project finance and working capital
Salam is where payment is made in spot in advance and delivery in the

future while in Murabaha the asset is delivered in spot while the payment
is deferred in the future
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Important Characteristics of the Salam Contract
Goods Suitable for Salam:
Homogeneous goods like commodities - oil, wheat, sugar etc. which are traded
by counting, measuring, or weighing are suitable and should normally be
available at the time of delivery.
Goods with unique characteristics whose quality or quantity cannot be specified

like farm animals, precious stones etc., are not suitable.
Clear specifications of the description, quantity, quality of the goods are

provided to avoid any uncertainty or Gharar.
Salam cannot be used for Ribawi items, that is money like items, such as gold
and silver.
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Price of the Salam Contract: Full price
is paid in advance at contract, and
often is set below price of the
commodity delivered at spot, the
difference between the two price is
the benefit for the buyer.
Delivery Date and Place: Exact date

and place of the delivery needs to be
mutually agreed between the seller
and buyer and can be changed only by
mutual consent.
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Buy-back Condition: Shariah does not allow buyer to
demand a buy-back condition from seller.
Security and Guarantee: It is permitted for buyer to ask the

seller to provide security against timely delivery of the
commodity.
Penalty: A penalty can be liable on the seller if there is delay

in delivery, which can be calculated as a percentage per day
of delay but needs to be donated to charity.
Termination: Salam contract cannot be revoked unilaterally,

but only with mutual consent.
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Assignment
• Using what you’ve studied related to forward contracts how
would you priced a salam contract.
▪ What are the factors you’ll consider
▪ What is the pricing model you’ll use
• To make this more tangible you can come up with scenario.

For example you can have a salam contract which calls for the
delivery of 100 kgs of a cotton in six months.
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Benefits of the Salam Contract
Salam contract benefits the sellers since they receive the price in advance and can
utilize it as a Shariah compliant financing for producing or acquiring the items of the
contract.
Salam also benefits the purchasers by providing assets or goods at a discounted price
since the advance price is lower than the spot price.
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Role of Islamic Banks in Salam and Parallel Salam
Contract
Salam contracts are gaining in popularity amongst the global Islamic banks.
Islamic banks provide Salam financing by entering into two separate Salam contracts -
the Salam and Parallel Salam contract, which together must involve three parties,
bank being common party in both contracts.
Salam contract - bank buys certain quantity and quality of the asset or commodity
from the supplier or manufacturer to be delivered at a future date at a specific place
and pays full in advance, price usually less than the spot price at the time of contract.
Parallel Salam contract - bank as seller of the exact same quantity and quality of the
asset or commodity purchased in the Salam contract; sells to the client who is the
buyer in this contract and pays the full price in advance to the bank, delivery at the
date and place, exactly same as in the Salam contract.
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Salam and Parallel Salam Diagram
• Client approaches bank to finance purchase of specific quantity and quality of commodity or asset.
• Bank agrees and client completes application.
• Bank signs Salam contract with relevant supplier or manufacturer of the commodity or asset for a specific delivery date and
place, bank as buyer, supplier as seller.
• Then Parallel Salam contract is signed with client as buyer, bank as seller; quantity, quality and specifications same as in the
Salam contract.
• Duration of the Salam contract is much longer than the Parallel Salam contract.
• Bank orders the supplier and pays in advance for the asset or commodity required by client.
• Client makes the advance payment for the Parallel Salam much later while the delivery date and place are the same, thus
technically the client is receiving purchase finance from the bank.
• Often the bank only receives the ownership title and then passes it on to the client, while the physical delivery of the asset
is made directly to the client.
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Murabaha (Trust Sale)
Bank purchases a specified item at the request of the customer.
Bank sells the asset to the customer at an agreed marked-up price.
Deferred payments in lump sum or instalments.
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Introduction to Musharaka
• Musharaka - derived from the Arabic word Shirkah - meaning
partnership.
• It is a partnership of two or more, who put together their capital
and labor based on mutual trust; share in the profit and loss of
the joint venture and have similar rights and liabilities.
• Purest form of Islamic finance - where risks and profit or loss are
distributed equitably between the investors, proportionate to
their investment contribution
• Islamic banks enter Musharaka contracts with their clients, each
contributing capital and skills and expertise, in equal or varying
quantities, to start a new joint venture or be part of an existing
one.
• A partner might not be involved in the day to day operations, but
be a silent partner.
• Profits shared at a pre-agreed ratio, while losses, borne in
proportion to the capital contribution.
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Diminishing Musharaka
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Example of Diminishing Musharaka:
Purchase of a House
Year Rent Payment to Bank Client Pays 10% Purchase Total Ownership Ownership
by Client in $ Price of the House to Bank Payment to of Bank of Client
in $ Bank in $
Start of none none none 80% 20%
Contract
End of Year 1 80,000 100,000 180,000 70% 30%
End of Year 2 70,000 100,000 170,000 60% 40%
End of Year 3 60,000 100,000 160,000 50% 50%
End of Year 4 50,000 100,000 150,000 40% 60%
End of Year 5 40,000 100,000 140,000 30% 70%
End of Year 6 30,000 100,000 130,000 20% 80%
End of Year 7 20,000 100,000 120,000 10% 90%
End of Year 8 10,000 100,000 110,000 0% 100%
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Introduction to Istisna
Similar to Salam, Istisna also is an exception to the Shariah rulings of a valid sales contract
– asset to be sold must exist at the time of the contract, should be the owned and
physically or constructively in possessed by the seller.
Istisna word derived from the Arabic word Sina’a - meaning to manufacture a specific
commodity.
Istisna is a sales contract. Buyer contracts with the seller to manufacture, produce,
construct, fabricate, assemble or process any asset in accordance with given
specifications, descriptions, quality and quantity within a specified period and at an
agreed price.
Raw material and/or effort or labor are provided by seller and if possible, a sample or
model provided to reduce ambiguity.
Parties in the Istisna are:
Buyer – al Mustasni
Seller – al Musania
Specific asset to be manufactured - al Masnu
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Introduction to Istisna
• In Istisna, delivery of the asset is in the future, payment is spot at delivery or deferred
in the future.
• The payment options available to the buyer are:
1. Pay lumpsum or in instalments during construction
2. Pay lumpsum at delivery
3. Pay lumpsum or instalments, deferred in the future
4. Pay linked to progress in the construction or manufacture of the asset
• Unilateral cancellation not possible once work on the asset has started.
• Suitable for long term projects including – construction, project financing, building or
manufacturing a capital item.
• Unless buyer restricts it, seller has the right to contract with a third party to
manufacture, produce, construct, fabricate, assemble or process the asset, by entering
a second Istisna - Parallel Istisna.
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Role of Islamic banks in Istisna and Parallel Istisna
In modern Islamic banking, Istisna has three parties, consisting of two Istisna agreements.
First Istisna - between bank and customer, bank as seller, customer as buyer. Customer provides full specifications,
description, quality and quantity of the item, design details, material to be used, possible raw material supplier and
manufacturer, performance standards, completion time and appropriate costing. Repayment usually is long term, options to
pay lumpsum at delivery or deferred to future lumpsum at assigned period or in regular instalments over an agreed period.
Second Istisna - between bank and the assigned manufacturer, bank is the buyer and manufacturer the seller. Bank
approaches the manufacturer with exact same order and specifications provided by the customer in the first Istisna. After
receiving the quote from the manufacturer, bank adds its profit and quotes to the customer in the first Istisna.
If customer agrees, first Istisna is contracted. Bank then goes to manufacturer, concludes the second Istisna - Parallel Istisna.
Bank pays the manufacturer either in full when signing the contract or in instalments during the manufacture or sometimes
in full at delivery.
Shariah compliance requires the two Istisna contracts to be independent of each other with respect to rights and obligations.
Period of Parallel Istisna is much shorter than the first Istisna - manufacturer wants to be paid in advance or during
construction or at delivery or soon after delivery. While customer requires longer period to make the payments to bank as
needs financing for purchase of the asset. Options available to the customer are lumpsum payment on spot at delivery or
deferred lumpsum or instalments.
Price difference between the two Istisna contracts is the profit made by the bank.
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Istisna and Parallel Istisna Contracts
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Description of the Istisna Process
1. Istisna process starts when the customer approaches bank to finance, any asset to be produced, manufactured, constructed,
fabricated or assembled.
2. Customer provides bank with detailed description, specifications, quality, quantity, time to develop and expected cost
estimate.
3. Islamic bank then approach the manufacturer, builder, producer with the specifications provided by the customer for a quote.
4. When bank receives the quote from the manufacturer, valid for a few months, adds its own profit to the price and quotes to
the customer.
5. If customer accepts the quoted price and delivery time, then enters Istisna contract with the bank, customer is buyer and bank
is the seller.
6. After Istisna contract is completed, bank enters Parallel Istisna with the manufacturer, bank is buyer and manufacturer is the
seller.
7. Delivery time for both contracts usually are the same, bank takes title only from manufacturer, delivery directly to the
customer.
8. Istisna allows a variety of payment options:
a. Parallel Istisna - bank may pay the manufacturer full price at the time of contract, or pay in instalments during the period
of production, these payments could be tied with progressive completion of the production, or pay full on delivery or pay
deferred in full or in instalments after delivery. Deferred payments are less common and repayment period is short.
b. Istisna contract - buyer has the options to pay in full at delivery, or pay deferred in full or in instalments. Deferred
payments more common and repayment period is much longer.
9. Mechanism of Istisna and Parallel Istisna contracts for the same asset and delivery period, allows customer to acquire the asset
without paying immediately, thus the customer is being financed by the Islamic bank.
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Ijara Contracts
43
Ijara Sukuk
• Lessor owns the asset; hence can sell the asset, in
whole or in part
• If the lessor, after entering into ijarah, wishes to
recover his investment he can sell the leased
asset to either one party or a number of
individuals
• In the latter case as proof of each individual’s
ownership in the asset the seller can issue
certificates, representing ownership in the asset
• The holder of the certificate will be a joint owner
of the leased asset and will be entitled to his
portion of the total rent
• He will also be liable for his ownership in the
asset and will suffer a loss if the asset gets
destroyed
• These certificates can be traded at any value since
they represent ownership in an asset
44
Istisna Sukuk
This Sukuk is based on Istisna.
Used to fund manufacturing, real estate development, large industrial
projects, construction of major items like power plants, ships, aircrafts etc.
Issuer or bank issue Sukuk certificates providing the holders with the
proportionate ownership in the asset to be manufactured or constructed
Once the asset is completed its ownership is passed to the ultimate client
and the deferred payments made by the client are passed on to the Sukuk
holders.
If instead of ownership transfer the asset is leased to the client, Istisna

Sukuk converts into an Ijara Sukuk.
45
Istisna Sukuk
Steps of the Sukuk process with Istisna:
• SPV raises funds by issuing Sukuk
certificates to Sukuk-holders.
• Funds used to finance Istisna project by
paying the constructor, manufacturer,
producer, fabricator or assembler as per
Parallel Istisna contract.
• Contracted asset sold to original
customer as per first Istisna contract.
• Delivery of Istisna and Parallel Istisna
contracts at the same time, title to SPV,
asset to customer.
• Customer makes regular installment Once the asset is completed, its ownership may be passed on immediately to
payments. the ultimate client and the deferred payments made by the client are passed on
• Funds from payments distributed to to the Sukuk holders. Sometimes, instead of ownership transfer, the asset is
Sukuk-holders. leased to the client and the Istisna Sukuk converts into an Ijara Sukuk.
46
Murabaha Sukuk
Murabaha Sukuk - based on a Murabaha contract.
Seller wants to acquire asset to resell using Murabaha.
Raises the funds by issuing Sukuks.
Sukuk holders own the assets till resold
Entitled to the marked-up sales price in proportion to the shares
in the Sukuk issue.
47
Murabaha Sukuk
Seller wants to acquire asset to

resell using Murabaha.
Raises the funds by issuing
Sukuks.
Sukuk holders own the assets
till resold
Entitled to the marked-up sales
price in proportion to the
shares in the Sukuk issue.
48
Appendix
Prohibition of Interest in the Bible
Exodus 22:25 New International Version (NIV)
If you lend money to one of my people among you who is needy, do not treat it like a business deal;
charge no interest.
Leviticus 25 New International Version (NIV)

If any of your fellow Israelites become poor and are unable to support themselves among you,
help them as you would a foreigner and stranger, so they can continue to live among you.
Do not take interest or any profit from them, but fear your God, so that they may continue to live
among you. You must not lend them money at interest or sell them food at a profit.
www.ift.world 50
Factors Conventional Economics Islamic Economics
Ownership In capitalism individuals can be the absolute owners, Absolute ownership is with God, Man is only the trustee.
Conventional Economics Versus Islamic Economics
Wants and
while in socialism society collectively is the owner.
Wants are unlimited while resources are limited Wants should be limited, and sufficient resources have been provided by the
resources creating the scarcity problem. Creator. Scarcity is created by improper distribution of resources,
overconsumption, luxury and wastage.
Accumulation Any amount of wealth can be accumulated, and the Individuals can accumulate wealth, if this is done in a Shariah compliant manner.
of wealth owner can use or waste it as they please. Though owner needs to share this wealth with the less privileged in society
through the compulsory Zakat and voluntary Sadaqah. Islam says produce more
than needed and consume only what is needed.
Market Market economy is the main determinant in Market economy applies, demand and supply determine prices, though all this
economy capitalism, while in socialism demand and supply are needs to be done within a framework of social wellbeing.
not linked to prices since supply is decided centrally.
Role of the In capitalism, markets play a more dominant role than State ensures ethical activities, protects individual’s and society’s interest and
state the state, while in socialism, state plays a dominant ensures efficient allocation of resources.
role.
Law of Individuals can pass on their wealth and property to Islam has specific inheritance law and does not allow giving away more than one
inheritance anyone they please. third of one’s assets to anyone besides the legitimate heirs. Thus, ensuring fairness
in the process of transfer of wealth and property.
Economic Economic cycles show significant ups and downs. These ups and downs are reduced in Islamic economics through the moderation in
cycles consumption, avoidance of luxury, wastage and unnecessary debts.
Reward for Interest is accepted as the reward for capital. Interest is completely forbidden, and an alternative profit and loss sharing
capital mechanism is applied as reward for capital.
Social welfare In capitalism, this is achieved by free market and self- Islam encourages productivity at the individual level but through the moral
interest drive; while in socialism state achieves this by requirements of sharing of ones’ wealth aims to create social welfare.
centralized production and distribution.
Prohibition of Gharar or uncertain dealings
• Involves taking excessive risks or unnecessary uncertainty
• Two types – Gharar Fahish - substantial amount and not allowed;
Gharar Yasir - trivial amount and is tolerated
Prohibition of Maysir
• Involves all kinds of games chance or dealings where one can gain significantly or lose all depending
on the way the deal moves
Other Principles
• Encouragement to Use Profit & Loss
• Requirement for Sharia Compliant Contracts
• Avoid Hoarding
• Avoid Taking Advantage of the Seller
• Freedom of Contract
• Original Permissibility
• Interest of Society
• Relieving of Hardship versus Providing of Benefits
• Small versus Bigger
• Remove Extreme Hardship
Types of Ijara
Two main types of Ijara in the current times. :
1. Ijara or Regular Ijara or Operating Lease
• Similar to conventional Operating Lease, also called true lease.
• Contracts of rent only, rent either fixed for entire period lease or adjusted periodically
• No transfer of ownership of leased asset, asset returned to lessor at the end of the Ijara period or Ijara renewed.
• Ujrah or rentals charged over the Ijara period not sufficient to recover full value of the asset.
• Lessor can recover the remaining value of the asset by re-leasing the asset or by selling it.
• Ijara contract can be terminated by either lessee or lessor with due notice.
• Ijara commonly used for renting an apartment or a vehicle by retail customers or by corporate customers to lease
expensive assets instead of buying them like ships, aircrafts, large scale machinery or equipment.
• Lessor holds the risks and responsibilities related to ownership
• Lessee liable for proper use and care of the asset, any damage due to misuse or negligence, not regular wear and
tear, needs to be compensated by lessee.
• Depreciation and impairment loss and regular repairs are borne by the lessor.
• Islamic banks may use an index like LIBOR to determine a competitive profit rate to decide the Ujrah.
56
Types of Ijara
2. Ijara wa Iqtina or Ijara Muntahia Bittamleek or Financial Lease
Similar to conventional financial lease or hire purchase.
Ownership of the leased asset passes to the lessee at the end of the lease period. Arabic word Tamleek means ownership.
Ownership transfer may be with or without additional payment at the end of the lease period.
Ijara Muntahia Bittamleek can be of different types based on way ownership is transferred as per AAOIFI rulings: (options a and b
more common in the industry)
a. Full value of asset amortized during the lease period in the rental payments. No additional payment at the end of the lease
period.
b. Fixed amount, decided at the onset of lease contract, paid by lessee at the end of the contract.
c. Legal sale before the end of the lease period at a price equivalent to the remaining ijara instalments.
d. Market value of the asset is paid by lessee at the end of the lease period.
e. Gradual transfer of the ownership to lessee made during lease period and rental payments included payments for purchase.
In Ijara wa Iqtina, bank buys the asset based on the purchase promise from lessee, and once asset provided to lessee it is not be
returned to the bank. This kind of lease is completed when the ownership of the asset is transferred to the lessee.
The rentals can be fixed or floating, LIBOR can serve as a benchmark.
Ijara Thumma al Bay – is a third name for Islamic financial lease or Islamic hire purchase, common in Malaysia. Consists of two
separate contracts - one of operating lease second for sale with an agreed price at the end of the lease period.
57
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R48 Derivative Markets and Instruments 2020 Level I Notes

R48 Derivative Markets and Instruments

© IFT. All rights reserved 1

Derivatives are sometimes compared to insurance as they offer protection against

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3.1. Exchange-Traded Derivatives Markets

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• More transparent: The presence of a clearinghouse makes the whole process

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Liquidity More Almost the same

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4.1. Forward Commitments

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Call option buyer and seller payoff at expiration:

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At expiration, the call seller’s payoffs are:

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• A CDS is a form of insurance.

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Listed below are the major points related to asset-backed securities:

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• Greater liquidity than the underlying spot markets.

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2. In contrast to over-the-counter derivatives, exchange-traded derivatives would most

3. An agreement to purchase a specific stock next month for $100 is:

4. Which of the following best describes an interest rate swap?

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B. $3.00 and $1.10, respectively.

8. Derivatives are least likely to:

9. Which of the following statements about arbitrage is least accurate?

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1. C is correct. A derivative is a financial instrument that transforms the performance of the

3. A is correct. Forward commitments represent an obligation to buy/sell, whereas

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R37 Pricing and Valuation of Forward Commitments

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2. Principles of Arbitrage- Free Pricing and Valuation of Forward

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4. Borrowing and lending are available at a known risk-free rate.

3. Pricing and Valuing Forward and Futures Contracts

Key notations related to this contract are:

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The arbitrage free forward price is given by the following formula:

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Example: Forward Contract Price

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F0 (T) = 100, S0.75 = 105, r = 5%, T − t = 0.25

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The forward price can now be expressed as:

Using the first formula,

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The equivalence between annual compounding and continuous compounding can be

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Therefore, F0(T) = S(1 + r)T + FV of costs – FV of benefits = 120(1 + 0.01)1/12 + 0 − 6.40 =