CFA ®

Level II
Derivatives

Leslie Xiao F R M
 CONTENTS 1. Derivatives
• R37 Pricing and Valuation of Forward Commitments
• R38 Valuation of Contingent Claims

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Level I vs. Level II

 相较于一级而言，二级计算有较大程度的增加，主要从定量角度进行考察和学习。

 课程特征与学习建议:
 本门课程难度比较大，计算公式很多，一定要着重理解和总结；

 知识点之间的类比关系比较强，建议把第一部分学透后，再继续学后面的知识点；

 可以适当多做一些题，熟悉解题步骤，提高做题速度；

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 R37 Pricing and Valuation of
Forward Commitments

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What we are going to learn?
The candidate should be able to:

 Describe and compare how equity, interest rate, fixed-income, and currency forward
and futures contracts are priced and valued;

 Calculate and interpret the no-arbitrage value of equity, interest rate, fixed-income,
and currency forward and futures contracts;

 Describe and compare how interest rate, currency, and equity swaps are priced and
valued;

 Calculate and interpret the no-arbitrage value of interest rate, currency, and equity
swaps.

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Forward Contracts

 A forward contract is an agreement between two parties in which one party, the
buyer, agrees to buy from the other party, the seller, an underlying asset or other
derivative, at a future date at a price established at the start of the contract.
 Long position: a position in an asset or contract in which one owns the asset or has an
exercisable right under the contract.
 Short position: a position in an asset or contract in which one has sold an asset or
does not own, or in which a right under a contract can be exercised against oneself.

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Price and Value

 The price is the predetermined price in the contract that the long should pay to the
short to buy the underlying asset at the settlement date.
 The contract value is zero to both parties at initiation.
 The no-arbitrage principle: tradable securities with identical cash flow payments
must have the same price. Otherwise, traders would be able to generate risk-free
arbitrage profits.
 Two assets or portfolios with identical future cash flows, regardless of future
events, should have same price;
 The portfolio should yield the risk-free rate of return, if it generates certain
payoffs.
 General formula: FP = S0×( 1+Rf )T

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Generic Pricing: No-Arbitrage Principle

 Pricing a forward contract is the process of determining the no-arbitrage price that will
make the value of the contract be zero to both sides at the initiation of the contract.

 Forward price=price that would not permit profitable riskless arbitrage in frictionless
markets

FP=S0*(1+rf)T＋Carrying Costs－Carrying Benefits

 Valuation of a forward contract means determining the value of the contract to the long
(or the short) at some time during the life of the contract.

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Forwards Arbitrage

 Cash-and-Carry Arbitrage with forward contract market price too high

relative to carry arbitrage model.
 If FP >S0×( 1+Rf )T

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Forwards Arbitrage

 Reverse Cash-and-Carry Arbitrage with forward contract market price too

low relative to carry arbitrage model.
 If FP < S0×(1+Rf)T

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Forwards Arbitrage

 Reverse Cash-and-Carry Arbitrage with forward contract market price too

low relative to carry arbitrage model.
 If FP < S0×(1+Rf)T

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Forward contract value
 T-bill (zero-coupon bond) forwards
 buy a T-bill today at the spot price (S0) and short a T-month T-bill forward contract at
the forward price (FP);
FP  S0  (1  R f )T
 Forward value of long position at initiation(t=0), during the contract life(t=t), and at
expiration(t=T).

FP
St 
(1  R f )T t

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Equity Forward Contracts
 Forward contracts on a dividend-paying stock
 Price:

 Value:

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Forward Contracts
Case 1 Example

 Assuming a forward contract with 100 days until maturity on a stock, the
stock price is $45 and expected to pay dividend of $0.3 in 20 days, and
$0.5 in 75 days. The risk free rate is 4%. Calculate the no-arbitrage forward
price.
 Correct Answer:
S0=$45 D1=$0.3 D2=$0.5 FP?

0 20 75 100 days

$0.3 $0.5
PVD    $0.795343
1.04 20/365 1.0475/365

FP  ($45 - $0.795343)  1.04100/365  $44.68

Forward Contracts
Case 2 Example
 After 40 days, the stock price changed to $48. Calculate the valuation of the forward
contract.

 Correct Answer:
 There's only one dividend remaining (in 35 days) before the contract matures (in 60 days)
as shown below, so:

S0=$45 D1=$0.3 S40=$48 D2=$0.5 FP=$44.68

0 20 40 75 100 days
35 days

60 days
V40?
$0.5
PVD40   $0.498123
1.0435/365
$44.68
V40 (long position)  （$48 - $0.498123) -  $3.11
1.0460/365
Forward Contracts
Case 3 Example

• One month ago, Tod purchased a forward contract with three months to
expiration at a quoted price of 100.20 (quoted as a per 100 par value). The
contract notional amount is ¥100,000,000. The current forward price is
100.05. The risk free rate is 0.3%. The value of the position is closest to:
A. -¥149,925.
B. -¥150,000.
C. -¥150,075.
Forward Contracts
Case 3 Example

• Correct Answer: A.
The value of Tod’s forward position is calculated as
Vt T   PVt ,T  Ft T   F0 T  
Vt T   100.05  100.20  / 1  0.0030 
2/12

 0.149925  per 100 par value 

Therefore, the value of the Tod’s forward position is

0.149925
Vt T    ¥100, 000, 000   ¥149,925
100
Equity Index Forward Contracts

 Forward contracts on an equity index

 Continuously compounded risk-free rate: Rfc= ln (1+ Rf )

 Continuously compounded dividend yield: δc

( R cf  c )T
 Price: FP  S 0  e

 Value: Vlong   St   FP 
   R c (T t ) 
 e (T t )
c
 e f 

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Forward Contracts
Case 4 Example

 Assuming a forward contract on the Dow Jones Index with 100 days.
Currently, the value of Dow Jones Index is 21,000 and the continuous
dividend yield is 2%. The continuously compounded risk free rate is 3.2%.
Calculate the no-arbitrage price of the forward contract.

FP = 21,000  e(0.032 - 0.02)  (100/365) = 21,069.1547

 After 75 days, the value of Dow Jones Index is 20,050. Keep the risk free
rate and dividend yield same as before. Calculate the valuation of the
forward contract.

20,050 21,069.1547
V75 (long position) = 0.02(25/365)
- = -1,000.481
e e0.032  (25/365)
Forward Contracts on Coupon Bonds
 Coupon bonds
 Similar to dividend-paying stocks, but the cash flows are coupons

 Price: FP  ( S 0  PVC 0)  (1  R f )T

FP
 Value: Vlong  ( St  PVCt ) 
(1  R f )T t

Or Vlong  PVt ,T [ Ft T   F0 T ]

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Forward Contracts on Coupon Bonds
Case 5 Example
 Assuming a forward contract with 150 days on a US treasury bill. The US
treasury bill has a 5% coupon rate, the price is $1,100 and will make
coupon payment in 90 days. The risk free rate is 4%. Calculate the
forward price.

 Correct Answer:
$1000  0.05
C  $25
2
$25.00
PVC0   $24.7594
1.0490 / 365
The forward price of the contract is therefore:

FP(on a income security) = ($1,100 - $24.7594)  1.04150/365 =1,092.7122

Currency Forward Contracts
 Price: covered Interest Rate Parity (IRP)
(1  RD )T
FP  S0 
(1  RF )T
FP and S0 are quoted in currency D per unit of currency F (i.e., D/F)
 Value:
St FP
Vlong  T t

(1  RF ) (1  RD )T t
 If you are given the continuous interest rates

 RFc )T
FP  S0  e
c
( RD

 St   FP 
Vlong   R c ( T  t )    RDc (T t ) 
e F  e 

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Currency Forward Contracts
Case 6 Example

• Consider the following: The U.S. risk-free rare is 6 percent, the Swiss risk-
free rate is 4 percent, and the spot exchange rate between the United
States and Switzerland is $0.6667.

 Calculate the continuously compounded U.S. and Swiss risk-free rates;

 Calculate the price at which you could enter into a forward contract that
expires in 90 days;

 Calculate the value of the forward position 25 days into the contract.
Assume that the spot rate is $0.65.
Currency Forward Contracts
Case 6 Example

• Correct Answer:

1. rCHF= ln(1.04)=0.0392; r$= ln(1.06)=0.0583

2. S0 = $0.6667; T = 90/365
F (0,T) = ($0.666  e-0.0392(90/365) )(e0.0583(90/365) ) = $0.6698
3. St = $0.65; T = 90/365; t = 25/365; T - t = 65/365

The value of the contract is -$0.0174 per Swiss franc

Vt (0,T) = ($0.65  e-0.0392(65/365) ) - ($0.6698  e-0.0583(65/365) ) = -$0.0174

Forward Rate Agreements (FRAs)
 A Forward Rate Agreement (FRA) is a forward contract on an interest rate (LIBOR).
 The long position can be viewed as the right and the obligation to borrow at the
forward rate in the future;
 The short position can be viewed as the right and the obligation to lend at the forward
rate in the future;
 No loan is actually made, and FRAs are always settled in cash at contract expiration.
 Let’s take a 1×4 FRA for example. A 1×4 FRA is
 a forward contract expires in 1 month,
 and the underlying loan is settled in 4 months,
 with a 3-month notional loan period.
 The underlying interest rate is 90-day LIBOR in 30 days from now.

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Forward Rate Agreements (FRAs)
 LIBOR (London Interbank Offered Rate): Collective name for multiple rates at which a
select set of banks believe they could borrow unsecured funds from other banks in the
London interbank market for different currencies and different borrowing periods ranging
from overnight to one year.
 an annualized rate based on a 360-day year
 an add-on rate
 the reference rate for many floating-rate bonds
 USD interest rate
 published daily by the British Banker’s Association
 Euribor (Europe Interbank Offered Rate): established in Frankfurt, and published by
European Central Bank.

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Forward Pricing and Valuation – FRA
 LIBOR, Euribor, and FRAs（Con’t）
Settlement: settle in cash, but no actual loan is made at the settlement date.
 Payoff qualitative analysis:
 If the reference rate at the expiration date is above the specified contract rate, the
long will receive cash payment from the short;
 If the reference rate at the expiration date is below the contract rate, the short will
receive cash payment from the long.
 Payoff quantitative analysis

  days  
  Floating rate at settlement-forward rate   360  
 Notional principal   
  days  
1+Floating rate at settlement  
  360  

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Forward Pricing and Valuation – FRA
Case 7 Example
• In 30 days, a UK company expects to make a bank deposit of £10,000,000
for a period of 90 days at 90-day Libor set 30 days from today. The
company is concerned about a possible decrease in interest rates. The
company enters into a £10,000,000 notional amount 1 × 4 receive-fixed
FRA. The appropriate discount rate for the FRA settlement cash flows is
0.40%. After 30 days, 90-day Libor in British pounds is 0.55%.

If the FRA was initially priced at 0.60%, the payment received to settle it
will be closest to:
A. –£2,448.75.
B. £1,248.75.
C. £1,250.00.
Forward Pricing and Valuation – FRA
Case 7 Example

• Correct Answer : B
The settlement amount of the 1 × 4 FRA at h for receive-fixed is

NA{[FRA(0,h,m) – Lh(m)]tm}/[1 + Dh(m)tm]

= [10,000,000(0.0060 – 0.0055)(0.25)]/[1 + 0.0040(0.25)]

= £1,248.75.

Because the FRA involves paying floating, its value benefited from a
decline in rates.
FRA Pricing
 The forward price in an FRA is the no-arbitrage forward rate (FR)
 If spot rates are known, The FR is just the unbiased estimate of the forward
interest rate

L(m) / m FR /n
L(m + n) /m+ n

(1  Lm  m / 360) (1  FR  n / 360)  (1  Lm  n  ( m  n) / 360)

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FRA Pricing
Case 8 Example

 Calculate the price of a 1×4 FRA. The current 30-day LIBOR is

3% and 120-day LIBOR is 3.9%.

 Correct Answer:
(1+3%  30/360) 1+FRA 0  (120-30)/360 = (1+3.9% 120/360)

 The annualized forward rate is FRA0= 4.2%.

FRA Pricing
Case 9 Example

 Suppose we entered a receive-floating 6 × 9 FRA at a rate of 0.86%, with

notional amount of C$10,000,000 at Time 0. The six-month spot Canadian
dollar (C$) Libor was 0.628%, and the nine-month C$ Libor was 0.712%.
After 90 days have passed, the three-month C$ Libor is 1.25% and the six-
month C$ Libor is 1.35%.
Assuming the appropriate discount rate is C$ Libor, the value of the
original receive-floating 6 × 9 FRA will be closest to:
A. C$14,539.
B. C$14,625.
C. C$14,651.
Futures Contract Value

 The value of a futures contract is zero at contract inception.

 Futures contracts are marked to market daily, the value just after marking to market is
reset to zero.
 Between the times at which the contract is marked to market, the value can be different
from zero.
V (long) = current futures price − futures price at the last mark-to-market time.
 Another view of futures: settle previous futures, and then open another new futures
with same date of maturity.

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T-bond Futures Contracts

 Underlying: Hypothetical 30 year treasury bond with 6% coupon rate.

 Bond can be deliverable: $100,000 par value T-bonds with any coupon but with a maturity
of at least 15 years.
 The quotes are in points and 32nds: A price quote of 95-18 is equal to 95.5625 and a dollar
quote of $95,562.50.
 The short has a delivery option to choose which bond to deliver. Each bond is given a
conversion factor (CF), which means a specific bond is equivalent to CF standard bond
underlying in futures contract.
1
For a specific Bond A: FP标准  FPA 
CFA

 The short designates which bond he will deliver (cheapest-to-deliver bond).

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Arbitrage from T-Bond futures
 There are methods to buy the underlying bond A
 Buy bond A through T-bond futures
 The adjusted price of the futures contract is equal to the conversion factor multiplied by the
quoted futures price:
FPA  FP标准  CFA
 Adding the accrued interest of AIT at expiration, the adjusted price of the futures contract gives
a total price of:
V1  FP标准  CFA +AIT

 Buy bond through holding the bond at the beginning of the period
 the no-arbitrage futures price at expiration is equal to the following:
V2  ( S0clean  AI 0 )  (1  R f )T  FVC

 The available arbitrage profit is the present value of this difference

Arbitrage profit =PV V2  V1

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Arbitrage from T-Bond futures
Case 9 Example-Arbitrage
• Troubadour identifies an arbitrage opportunity relating to a fixed-income futures contract and its
underlying bond. Current data on the futures contract and underlying bond are presented in
Exhibit . The current annual compounded risk-free rate is 0.30%.

Based on Exhibit and assuming annual compounding, the arbitrage profit on the bond futures
contract is closest to:
A. 0.4158.
B. 0.5356.
C. 0.6195.
Arbitrage from T-Bond futures
Case 9 Example-Arbitrage
There are methods to buy the underlying bond:
• Buy bond through T-bond futures
• The adjusted price of the futures contract is equal to the conversion factor
multiplied by the quoted futures price:
F0  T  =CF  T  QF0  T  =  0.90 125  =112.50
• Adding the accrued interest of 0.20 at expiration, the adjusted price of the
futures contract gives a total price of 112.70.
• Buy bond through holding the bond at the beginning of the period
• the no-arbitrage futures price at expiration is equal to the following:
F0 T   FV0，T T   S0  AI 0 - PVCI 0，T 
 1  0.003 112.00  0.08 - 0 
0.25

 112.1640
The available arbitrage profit is the present value of this difference:
• (112.70 – 112.1640) /(1.003)0.25 = 0.5356. This difference means that the
futures contract is overpriced by = 0.5360.
Quoted futures price and forward price

 The quoted futures price is adjusted with conversion factor

QFP clean   S0clean  AI 0   (1  R f )T - AIT - FVC  

1
CF

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Quoted futures price and forward price
Case 9 Example
• Euro-bond 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. They are traded on the
Eurex. Suppose the underlying 2% German bond is quoted at €108 and has accrued
interest of €0.083 (one-half of a month since last coupon which pays annually). The euro-
bond futures contract matures in one month. At contract expiration, the underlying bond will
have accrued interest of €0.25, there are no coupon payments due until after the futures
contract expires, and the current one-month risk-free rate is 0.1%. The conversion factor is
0.729535. The equilibrium euro-bond futures price based on the carry arbitrage model will
be closest to:

A. €147.57.

B. €147.82.

C. €148.15.
Quoted futures price and forward price
Case 9 Example

• Correct Answer: B.
In this case, we have T = 1/12, CF(T) = 0.729535, B0(T + Y) = 108, FVCI0,T = 0, AI0
= 0.5(2/12) = €0.083, AIT = 1.5(2/12) = 0.25, r = 0.1%.

QF0(T) = [1/CF(T)]{FV0,T[B0(T + Y) + AI0] – AIT – FVCI0,T}

Thus, we have

QF0(T) = [1/0.729535][(1 + 0.001)1/12(108 + 0.083) – 0.25 – 0]

= 147.82

In equilibrium, the euro-bond futures price should be approximately €147.82 based

on the carry arbitrage model.
Pricing a plain vanilla swap

 A plain vanilla swap is an interest rate swap in which one party pays a fixed rate and the
other pays a floating rate.
 Pricing a plain vanilla swap means calculating the fixed rate (swap rate) that makes the
contract value zero at initiation.

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Pricing a plain vanilla swap

 Since a floating-rate bond has a value equal to its par value at initiation, what we will do is to
find a fixed-rate bond with a value equal to the same par value at initiation. Denote C as the
fixed coupon amount when the par value is equal to 1(also known as fixed swap rate), we
have:
1 = C×B1 + C×B2 + C×B3 + …… + C×Bn +1×Bn
1  Bn
C
B1  B2  L  Bn
 Recall that Bn is the discount factor, which is the present value of $1 in n periods. It’s
important to note that C is a periodic rate, and you must annualize it to get the
annual swap rate.
 Swap rate=annualized periodic rate(C)

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Pricing a plain vanilla swap
Case 10 Example
• Calculate the swap rate of a 1-year quarterly-pay plain vanilla swap. The LIBOR spot
rates are: R(90-day)=2.5%; R(180-day)=3%; R(270-day)=3.5%; R(360-day)=4%.

• Correct Answer:

Step 1: Calculate the discount factors:

B1=1/(1+2.5%×90/360)= 0.9938; B2=1/(1+3%×180/360) = 0.9852

B3=1/(1+3.5%×270/360)= 0.9744; B4=1/(1+4%×360/360)= 0.9615

Step 2: Calculate the periodic swap rate, C:

C = (1−B4)/(B1+B2+B3+B4)

= (1−0.9615)/(0.9938+0.9852+0.9744+0.9615)

= 0.98%
Pricing a plain vanilla swap
Case 10 Example

• Step 3: Calculate the annualized swap rate:

swap rate = 0.98%×360/90 = 3.92%

The swap rate can be viewed as the average of the spot rates. So every
time you get a swap rate result, always check if it is within the range of the
spot rates. For example, we get the result of 3.92% and this value is within
the range of 2.5% and 4%. Another trick is that the swap rate is usually
very close to the last spot rate (4% here).
Valuing a plain vanilla swap

 The value of a receive-fixed, pay-floating interest rate swap is simply the value of buying a
fixed-rate bond and issuing a floating-rate bond.
Paying fixed rate
Company X Company Y
Paying floating rate

 Notes: the value of a floating rate bond will be equal to the notional amount at any of its
periodic settlement dates when the next payment is set to the market rate (floating).
 The valuation formula:

Vswap ( X )  B flt - B fix Vswap (Y )  B fix - B flt

Or V payer swap  PVt ,T [ Ft  swap rate   F0  swap rate ]

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Valuing a plain vanilla swap
Case 11 Example
• Q1: Suppose you are pricing a five-year Libor-based interest rate swap. The
estimated present value factors are as follows. Calculate the fixed swap rate.

Maturity(Years) Present Value Factor

1 0.990099
2 0.977876
3 0.965136
4 0.951529
5 0.937467

Correct Answer:

Because it is a 5-year annually-pay plain vanilla swap, Swap rate is equal to

1.2968%.
Valuing a plain vanilla swap
Case 11 Example

• Q2: Suppose two years ago we entered a $1,000,000 7-year receive-fixed

Libor-based interest rate swap with annual resets (30/360 day account).
The fixed rate in the swap contract entered two years ago was 2%. The
present value factors are same as Q1 as presented below. Calculate the
value for the party in the swap receiving the fixed rate.

 Correct Answer:
 Value of the swap per dollar notional
V   2%  1.2968%    0.990099  0.977876  0.965136  0.951529  0.937467   0.033909
 Thus, the value of the swap is $33,909.
Pricing a currency swap
 Consider a swap involving two currencies, the US dollar ($) and the Euro (€). The exchange rate is
now 0.80€/$. As we do in a plain vanilla swap, we can get the fixed rate that will make the fixed $
payments equal to $1, and the fixed rate that will make the fixed € payments equal to €1.

 For example,

 If the US term structure is: R(90-day)=5.2%, R(180-day)=5.4%, R(270-

day)=5.55%, R(360-day)=5.7%, we can get the fixed rate of 5.56%.

 If the Euro term structure is: R(90-day)=3.45%, R(180-day)=3.58%, R(270-

day)=3.7%, R(360-day)=3.75%, we can get the fixed rate of 3.68%.

 Our currency swap involving dollars for Euros would have a fixed rate of 5.56% in dollars and 3.68%
in Euros. The notional principal would be $1 and €0.8. There are four ways to construct the swap:

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Pricing a currency swap

 There are four ways to construct the swap

 Swap 1: pay dollar fixed at 5.56% and receive Euro fixed at 3.68%.
 Swap 2: pay dollar fixed at 5.56% and receive Euro floating.
 Swap 3: pay dollar floating and receive Euro fixed at 3.68%.
 Swap 4: pay dollar floating and receive Euro floating.
 In the swap 4 (floating for floating), there is no pricing problem because there is no
fixed rate. We should only set the notional principal to €0.8 for every 1$.

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Pricing a currency swap
Case 12 Example

• Some days later, the term structures in both countries will change, and
the exchange rate will also be different. You can calculate the fixed- and
floating-rate bond prices in both currencies, and then you will get the swap
value just as you do in a plain vanilla swap.
GBP 6%
Company A Company B
USD 5%
the value of the swap in USD to Company A is :
Vswap (USD )  BUSD - ( S0  BGBP )
where :
S0  spot rate in USD per GBP
Pricing a currency swap
Case 13 Example

• Consider a two-year currency swap with semiannual payments. The

domestic currency is the U.S. dollar, and the foreign currency is the U.K.
pound. The current exchange rate is $1.41 per pound.

L0$(180) = 0.0585 L 0₤ (180) = 0.0493

L0$(360) = 0.0605 The comparable set of L0₤ (360) = 0.0506

L0$(540) = 0.0624 ₤ rates are L0₤ (540) = 0.0519

L0$(720) = 0.0665 L 0₤ (720) = 0.0551

Q1: Calculate the annualized fixed rates for dollars and pounds:
Pricing a currency swap
Case 13 Example
• Correct Answer for Q1:
First calculate the fixed payment in dollars and pounds. The dollar present value factors for 180,
360, 540, and 720 days are as follows

1 1
= 0.9716 ₤ (180) = 0.9759
B0$(180) = 180 B0 = 180
1+ (0.0585  ) 1+ (0.0493  )
360 360
1 1
= 0.9430 = 0.9519
$
B0 (360) = 1+ (0.0605  360 ) B0 ₤ (360) = 360
360 1+ (0.0506  )
360
1 1
= 0.9144 = 0.9278
B0$ (540) = 540 B0 ₤ (540) = 540
1+ (0.0624  ) 1+ (0.0519  )
1 360 360
= 0.8826 1
720 = 0.9007
$
B0 (720) = 1+ (0.0665  ) B0 ₤ (720) = 720
360 1+ (0.0551  )
360
The semiannual and annualized fixed payment of per $1 of notional principal is
1 - 0.8826
or 0.0632 for annualized; = 0.0316
0.9716 + 0.9430 + 0.9144 + 0.8826
Similarly The semiannual and annualized fixed payment of per £1 of notional principal is: 0.0264 or
0.0528 for annualized.
Pricing a currency swap
Case 14 Example
 Now move forward 120 days. The new exchange rate is $1.35 per pound, and the
new U.S. term structure is:

L120$(60) = 0.0613 L 120₤ (60) = 0.0517

L120$(240) = 0.0629 The comparable set of L120₤ (240) = 0.0532

L120$(420) = 0.0653 ₤ rates are L120₤ (420) = 0.0568

L120$(600) = 0.0697 L 120₤ (600) = 0.0583

Q2: Assume that the notional principal is $1 or the corresponding amount in British
pounds. Calculate the market values of the following swaps:

Pay ₤ fixed and receive $ fixed;

Pay ₤ floating and receive $ fixed

Pay ₤ floating and receive $ floating

Pricing a currency swap
Case 14 Example
 In terms of $ payments

The present value of the remaining fixed payments plus the $1 notional
principal is 0.0316(0.9899 + 0.9598 + 0.9292 + 0.8959) + 1(0.8959) =
1.0152.

The present value of the floating payments plus hypothetical $1 notional

principal discounted back 120 days is [0.0585(180/360) + 1](0.9899) =
1.0189.
Pricing a currency swap
Case 14 Example

 In terms of £ payments
 The present value of the remaining fixed payments plus the £1 notional
principal is 0.0264(0.9915 + 0.9657 + 0.9379 + 0.9114) + 1(0.9114) =
1.0119.
 Convert this amount to the equivalent of $1 notional principal and
convert to dollars at the current exchange rate: 1/1.41 * 1.35 * 1.0119
= $0.9688.
 The present value of the floating payments plus hypothetical £1 notional
principal is [0.0493(180/360) + 1](0.9915) = 1.016.
 Convert to dollars at the current exchange rate: 1/1.41 * 1.35 * 1.016
= $0.9728.
Pricing a currency swap
Case 14 Example

 The market values based on notional principal of $1 are as follows:

 Pay £ fixed and receive $ fixed = $0.0464 = 1.0152 - 0.9688
 Pay £ floating and receive $ fixed = $0.0424 = 1.0152 - 0.9728
 Pay £ floating and receive $ floating = $0.0461 = 1.0189 - 0.9728
 Pay £ fixed and receive $ floating = $0.0501 = 1.0189 - 0.9688
Pricing an equity swap
 There are three types of equity swaps: (1) pay fixed rate and receive equity return; (2) pay
floating rate and receive equity return; (3) pay one equity return and receive another equity
return. We only need to price the first type of swaps because there are no fixed rates in the
other two.
 We have the same formula as for the plain vanilla swap to get the periodic swap rate of an
equity swap:
1  Bn
C
B1  B2    Bn

 Why is this the case? We can exchange a fixed-rate bond with periodic coupon rate of C
for a stock or an index with the notional amount equal to the par value of the bond,
because the bond value at inception is equal to par.

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Valuing an equity swap
Case 15 Example

• An equity swap has the annual swap rate of 3.92% and the notional
principal of $ 1 million. The underlying is an index, currently trading
at 1000. Assume after 30 days the index becomes 1100 and the
LIBOR spot rates are:
• R(60-day)=3%;

• R(150-day)=3.5%;

• R(240-day)=4%;

• R(330-day)=4.5%.

Calculate the value of the equity swap to the fixed-rate payer.

Valuing an equity swap
Case 15 Example

Correct Answer:
Step 1: Calculate the new discount factors 30 days later:
B1 = 1/(1+3%×60/360) = 0.9950; B2 = 1/(1+3.5%×150/360) = 0.9856
B3 = 1/(1+4%×240/360) = 0.9740; B4 = 1/(1+4.5%×330/360) = 0.9604
Step 2: Calculate the value of the fixed-rate bond:
P(fixed)=0.98%×(0.9950+0.9856+0.9740+0.9604)+1×0.9604=0.998767
Step 3: Calculate the value of the index investment:
P(index) = 1×1100/1000 = 1.1
Step 4: Calculate the swap value to the fixed-rate payer:
V = [P(index) −P(fixed)]×notional principal = (1.1-0.998767)×$1 million =$101,233
Swaption contracts

 A swaption is an option to enter into a swap. We will focus on the plain vanilla interest
rate swaption. The notation for swaptions is similar to FRAs. For example, a swaption that
matures in 2 years and gives the holder the right to enter into a 3-year swap at the end of
the second year is a 2×5 swaption.
 A payer swaption is an option to enter into a swap as the fixed-rate payer.
 If interest rate increases, the payer swaption value will go up. So a payer swaption is
equivalent to a put option on a coupon bond. Another view?
 It’s also equivalent to a call option on floating rate.
 A receiver swaption is an option to enter into a swap as the fixed-rate receiver (the
floating-rate payer). If interest rate increases, the receiver swaption value will go down. So
a receiver swaption is equivalent to a call option on a coupon bond.

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Swaption contracts: Valuation at expiration
Case 16 Example

• Valuing a plain vanilla swaption at expiration is equivalent to valuing the

underlying (off-market) swap. However, if the swap value is lower than zero
at expiration, the value of a plain vanilla swaption will be zero.

• Example:

A 1-year quarterly-pay payer swaption with the swap rate of 3.84% and the notional
principal of $1 million comes to its expiration date today. The LIBOR spot rates are:
R(90-day)=2.5%; R(180-day)=3%; R(270-day)=3.5%; R(360-day)=4%. The current
rate on an interest rate swap is 3.93%. Calculate the value of the payer swaption.
Swaption contracts: Valuation at expiration
Swaption contracts: Valuation at expiration

• Correct Answer:
• Step 1: Calculate the discount factors:
B1 = 1/(1+2.5%×90/360) = 0.9938 ;

B2 = 1/(1+3%×180/360) = 0.9852;

B3 = 1/(1+3.5%×270/360) = 0.9744;

B4 = 1/(1+4%×360/360) = 0.9615;

• Step 2: Calculate the net cash savings at each payment date:

(3.93%−3.84%)×90/360×$1 million = $225

• Step 3: Calculate the present value of the savings:

$225×(0.9938+0.9852+0.9744+0.9615) = $880.85
 R37 Pricing and Valuation of
Forward Commitments

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Framework
1. Binomial Model——The Expectations Approach

 The one –period binomial stock model

 The two –period binomial stock model
 Interest rate binomial model
2. Black-Scholes-Merton Model

3. Option Greeks and Implied Volatility

4. Binomial Model——The No-arbitrage Approach

5. Black Option Valuation Model

 Option On Futures
 Interest Rate Option
 Swaptions Futures
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Put-call parity for European options
 A fiduciary call is a portfolio consisting of
 A long position in a European call option with an exercise price of X that maturities in T years on a
stock.
 A long position in a pure-discount riskless bond that pays X in T years.

 The cost a fiduciary call is the cost of the call (C0) plus the cost of the bond (the present value
of X). The payoff to a fiduciary call will be X if the call is out-of-the-money and ST if the call
is in-the-money, as shown in the following:

ST ≤X ST >X
(Call is out-of or at-the- (Call is in-the-money)
money)
Long call payoff 0 ST -X
Long bond payoff X X
Total payoff X ST

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Put-call parity for European options

 A protective put is a portfolio consisting of

 A long position in a European put option with an exercise price of X that maturities in T years on a
stock.

 A long position in the underlying stock.

 The cost of a protective put is the cost of the put (P0) plus the cost of the stock(S0). The
payoff to a protective put is X if the put is in-the-money and ST if the put is out-of-the-
money. as shown in the following:
ST ≥ X
ST < X
(put is out-of or at-the-
(put is in-the-money)
money)
Long put payoff X - ST 0

Long stock payoff ST ST

Total payoff X ST
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Create synthetic instruments
 There are four synthetic instruments
 A synthetic European call option: X
C0  P0  S0 
synthetic call = put + stock − bond (1  R f )T

 A synthetic European put option: X

synthetic put = call + bond − stock
P0  C0   S0
(1  R f ) T

 A synthetic pure-discount risk-less bond: X

synthetic bond = put + stock − call
 P0  S0  C0
(1  R f ) T

 A synthetic stock position: X

synthetic stock = call + bond − put
S0  C0   P0
(1  R f ) T

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Create synthetic instruments

 There are two reasons why investors might wants to create synthetic positions in the
securities.

 To price options by using combinations of the other instruments with known

prices.

 To earn arbitrage profits by exploiting relative mispricing among the four

securities. If put-call parity doesn’t hold, an arbitrage profit is available.

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Exploit violations of put-call parity
Case Example

• As with all arbitrage trades, you want to “buy low and sell high.” if
put-call parity doesn’t hold (if the cost of a fiduciary call does not
equal the cost of a protective put), then you buy (go long in) the
underpriced position and sell (go short) in the overpriced position.

• Example: Exploit violations of put-call parity

90-day European call and put options with a strike price of $45 is priced at $7.50
and $3.70. The underlying is priced at $48 and makes no cash payments during the
life of the options. The risk-free rate is 5%. Calculate the no-arbitrage price of the
call option, and illustrate how to earn an arbitrage profit.

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Exploit violations of put-call parity
Case Example

• Correct Answer:

C0 = P0 + S0 − X/(1+Rf)T = $3.70 +$48 − $45/1.0590/365 = $7.24<$7.5

Since the call is overpriced

we should sell the call for $7.50 and buy the synthetic call for $7.24.

To buy the synthetic call, buy the put for $3.70, buy the underlying for $48,
and issue (sell short) a 90-day zero-coupon bond with a face value of $45.

The transaction will generate an arbitrage profit of $0.26 today.

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One-period binomial model

 A binomial model: A model for pricing options in which the underlying price can move
to only one of two possible new prices.

 At time 0 node, there are only two possible future paths in the binomial process,
an up move (S+) and a down move (S−).

 We start off by having only one binomial period, which means that the underlying
price moves to two new prices at option expiration.

 Assume that u = 1/d.

● S+=Su=S0u

S0 ●

● S− = Sd=S0d

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Expectation approach

 Risk-neutral probability of an up move is πu; Risk-neutral probability of an down move

is πd=1- πu
1 Rf  d
u 
ud
 We start with a call option. If the stock goes up to S1+ , the call option will be worth
C1+. If the stock goes down to S1−, the call option will be worth C1−. We know that the
value of a call option will be its intrinsic value on expiration date. Thus we get: C1+ =
Max (0, S1+ −X) ; C1− = Max (0, S1− −X)

1
value of an option: c   u C1   d C1  
  

(1  R f )T

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Exploit violations of put-call parity
Case Example
• Calculate the value today of a 1-year call option on the stock with the strike price of
$20. The price of the stock is $20 now, and the size of an up-move is 1.25. The risk-
free rate is 7%.

• Correct Answer:
Step 1: Calculate the parameters:
u=1.25; d=1/u=0.8; Su=20×1.25=25; Sd=20×0.8=16

C+ = Max (0, 25−20) =5; C− = Max (0, 16−20) =0

Step 2: Calculate risk-neutral probabilities, πu and πd =1− πu:

πu = (1+0.07−0.8)/(1.25−0.8) =0.6

πd =1− πu =0.4

Step 3: Calculate call option price:

C0 =(5*0.6+0*0.4)/(1+7%)=2.80

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Exploit violations of put-call parity
Case Example
• Step 4: Draw the one-period binomial tree:

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Exploit violations of put-call parity
Case Example

• Pricing a put option is similar to that of a call. The only difference is that
P+ = Max (0, X−S+) and P− = Max (0, X−S−).

• Example: Use the information in the previous example to calculate the

value today of a put on the same stock with the strike price of $20.

• Correct Answer:
P+ = Max (0, 20−25) = 0

P− = Max (0, 20−16) = 4

P = (0.6×0 + 0.4×4)/1.07 = 1.6/1.07 = 1.50

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The two –period binomial model

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Example-Call option
Case Example

 Calculate the value today of a 2-year call option on the stock with
the strike price of $18. The price of the stock is $20 now, and the
size of an up-move is 1.25. The risk-free rate is 7%.

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Example-Call option
Case Example

• Correct Answer:
Step 1: Calculate the parameters:
U = 1.25; d = 1/u = 0.8; Su = 20×1.25 = 25; Sd = 20×0.8 = 16
Suu = 20×1.25×1.25 = 31.25
Sud = 20
Sdd = 20×0.8×0.8 = 12.8
C++ = Max (0, 31.25−18) = 13.25
C+− = Max (0, 20−18) = 2
C−− = Max (0, 12.8−18) = 0
Step 2: Calculate risk-neutral probabilities, π and 1−π:
πu = (1+0.07−0.8)/(1.25−0.8) = 0.6
πd = 1−π = 0.4

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A call with a two-period binomial tree
Case Example

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A call with a two-period binomial tree
Case Example

Step 4: Calculate the call option value at year 1:

C+ = (13.25×0.6 + 2×0.4)/1.07 = 8.1776

C− = (2×0.6 + 0×0.4)/1.07= 1.1215

Step 5: Calculate the call option value today:

C = (8.1776×0.6 + 1.1215×0.4)/1.07= 5.0048

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Example-Put option(exercise)
Case Example

 Consider a two-period binomial model in which a stock currently trades at

a price of $65. The stock price can go up 20 percent or down 17 percent
each period. The risk-free rate is 5 percent.

 Calculate the price of a put option expiring in two periods with exercise
price of $60.

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A call with a two-period binomial tree
Case Example
• Correct Answer:
Step 1: Calculate the parameters:
U = 1.2; d = 0.83; Su = 65×1.2 = 78; Sd = 65×0.83 = 53.95
Suu = 65×1.2×1.2 = 93.6
Sud = 65×1.2×0.83 = 64.74
Sdd = 65×0.83×0.83 = 44.78
P++ = Max (0, 60-93.6) = 0
P+− = Max (0, 60 - 64.74) = 0
P−− = Max (0, 60-44.78) = 15.22
Step 2: Calculate risk-neutral probabilities, π and 1−π:
πu = (1+0.05−0.83)/(1.2−0.83) = 0.5946
πd = 1−π = 0.4054

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A call with a two-period binomial tree
Case Example

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A call with a two-period binomial tree
Case Example

Step 4: Calculate the put option value at year 1:

P+ = (0×0.5946 + 0×0.4054)/1.05 = 0

P− = (0×0.5946 + 15.22×0.4054)/1.05= 5.88

Step 5: Calculate the put option value today:

P = (0×0.5946 + 5.88×0.4054)/1.05= 2.27

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two-period binomial tree (American Call)

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two-period binomial tree (American Call)
Case Example
• You observe a €50 price for a non-dividend-paying stock. The call option has 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 call option is European-style.
• Q1: The probability of an up move based on the risk-neutral probability is closest to:
A. 30%.
B. 40%.
C. 50%.
 Q2: The current call option value is closest to:
A. €9.53.
B. €9.71.
C. €9.87.
• Q3: The current put option value is closest to:
A. €5.06.
B. €5.33.
C. €5.94.

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A call with a two-period binomial tree
Case Example
• Correct Answer for Q1: C.

Based on the Risk Neutral probability equation, we have: π = [1+Rf – d]/(u – d) = [(1 + 0.05) – 0.744]/(1.356 – 0.744) = 0.5or50%

• Correct Answer for Q2: B.

The current call option value calculations are as follows:

c++ = Max(0,u2S – 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,d2S – 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)2×0.0] = 9.71

• Correct Answer for Q3: A.

The put option value can be computed simply by applying put–call parity or p = c + PV(X) – S = 9.71 + [1/(1 + 0.05)2] 50 – 50 = 5.06.

Thus, the current put price is €5.06.

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The binomial interest rate tree
 The binomial interest rate tree is a set of possible interest rate paths that we use to value
options on bonds or interest rates.
 Two-Period Binomial Interest Rate Tree

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The binomial interest rate tree

 You don’t need to know how to construct an interest rate tree, since it will be given
to you on the exam, we will learn that from Fixed Income.

 You should know that the interest rates given are one-year forward rates from each
node.

 You also should know that risk-neutral probabilities for The binomial interest rate
tree , π and 1−π, are always 0.5.

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Interest rate option

 Interest rate call option

 An option which has a positive payoff if the reference interest rate,

usually the market interest rate, is greater than the exercise rate.
 Payoff=max{0, reference rate-exercise rate}*notional principal
 Interest rate put option

 An option which has a positive payoff if the reference interest rate,

usually the market interest rate, is smaller than the exercise rate.
 Payoff=max{0, exercise rate-reference rate}*notional principal
 Remember: No discounting of the payoff comparing to FRA.

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two-period binomial tree (American Call)
Case Example
Example: Calculate the value today of a 2-year interest rate call option with
the exercise rate of 5%. The notional principal is 1 million. The interest rate
tree for the first two years are illustrated below.

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two-period binomial tree (American Call)
Case Example
• Correct Answer:

Step 1: Calculate the bond price and call option intrinsic value at year 2:

C++ = Max (0, 8.58%−5%) * $1,000,000= $35,800

C+− = Max (0, 5.90%−5%) * $1,000,000 = $9,000

C−− = Max (0, 3.28%−5%) * $1,000,000 = 0

Step 2: Calculate the call option value at year 1:

C+ = (35,800×0.5 + 9,000×0.5)/1.0640 = $21,053

C− = (9,000×0.5 + 0×0.5)/1.0429 = $4,315

Step 3: Calculate the call option value today:

C = (21,053×0.5 + 4,315×0.5)/1.0513 = $12,065

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Continuous-time option pricing model

 As the period covered by a binominal model is divided into arbitrarily small, discrete
time periods, the model results converge to those of continuous-time model.

 The famous Black-Scholes-Merton model (BSM model) values options in continuous-

time and is derived from the same no-arbitrage assumption used to value the
binominal model.

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Continuous-time option pricing model

 The underlying assumptions of the BSM model are

 The price of the underlying asset follows a lognormal distribution;

 The (continuous) risk-free rate is known and constant;

 The volatility of the underlying asset is known and constant;

 The markets are frictionless;

 There are no cash flows on the underlying asset;

 The options valued are European options.

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The Value of European option using the BSM

 The BSM formulas for the prices of European call and put options are:
 R cf T
C0  [ S 0  N (d1 )]  [ X  e  N (d 2 )]
Remember that
you can always

P0  C0  S0  X  e
 Rcf T
 use put-call parity
to calculate the
put value
 where:

 S0 = underlying asset price; X = strike price; T = time to maturity

 R f = continuously compounded risk-free rate

c

 σ = volatility of the underlying asset

 N( ) = cumulative normal probability

S 

ln  0   R cf  (0.5   2 )  T 
d 2  d1  (  T )
d1   
X
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The Value of European option using the BSM
Case Example

• The underlying asset price now is 68.5 with a volatility of 0.38. The
continuously compounded risk-free rate is 4%. Consider the value of
a 110-day European call and put with the exercise price of 65.

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The Value of European option using the BSM
Case Example
• Correct Answer:
We should first calculate d1 and d2: (110 days equal to 0.3014 year)
d1 = [ln (68.5/65)+(0.04+0.38²×0.5)×0.3014]/(0.38× 0.3014 ) = 0.41
d2 = 0.41−0.38× 0.3014 = 0.20
Then look up N(d1) and N(d2) in the cumulative normal probability table:
N(0.41)=0.6591 N(0.20)=0.5793
Then we can get the value of the call:
C0 = 68.5×0.6591−65e−0.04×0.3014×0.5793 = 7.95
We can use put-call parity or the BSM formula to get the put price:
P0 = C0+PV(X)−S0 = 7.95+65 e−0.04×0.3014−68.5 = 3.67
Or, P0 = 65e−0.04×0.3014×(1−0.5793)−68.5×(1−0.6591) = 3.67

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Features of BSM

 Leveraged stock investment

 Borrow money to invest in stock

 R cf T
C0  S0  N (d1 )  X  e  N (d 2 )

 Buying the bond(or lend) with the proceeds from short selling the
underlying
 Rcf T
P0  X  e  N (-d 2 )  S0  N (-d1 )

 N(d2) : The prob. of an in-the-money call

 The present value of option payoff

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C0  e
 Rcf T
[S e0
Rcf T
 N (d1 )]  [ X  N (d 2 )]
Options on dividend paying stock or currency

 Options on dividend paying stock

 T  Rcf T
C0  [ S0  e  N (d1 )]  [ X  e  N (d 2 )]

 S0  e  T 
ln   
  f R c
+(0.5   2
)   T
d1   X  d 2  d1  (  T )
 T

 Options on currencies

 r  Foreign T  r  Domestic T

C0  [ S0  e  N (d1 )]  [ X  e  N (d 2 )]

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The Value of European option using the BSM
Case Example

• 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.

• Q1: The initial trading strategy required by the no-arbitrage approach

to replicate the call option payoffs for a buyer of the option is:
A. buy 0.317 shares of stock & short sell –0.017 shares of zero-coupon bonds.

B. buy 0.624 shares of stock & short sell 0.507 shares of zero-coupon bonds.

C. short sell 0.317 shares of stock & buy 0.017 shares of zero-coupon bonds.

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The Value of European option using the BSM
Case Example

• Q2: Identify the initial trading strategy required by the no-

arbitrage approach to replicate the put option payoffs for a
buyer of the put.
A. Buy 0.317 shares of stock & short sell –0.017 shares of zero-coupon bonds.

B. Buy 0.624 shares of stock & short sell 0.507 shares of zero-coupon bonds.

C. Short sell 0.376 shares of stock & buy 0.493 shares of zero-coupon bonds.

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The Value of European option using the BSM
Case Example
• Correct Answer for Q1: B.

 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.

 Note that by definition the cost of this replicating strategy is the BSM call model value or nSS +
nBB = 0.624(100) + (–0.507)95.123 = 14.17. (Without rounding errors, the option value is 14.23)

• Correct Answer for Q2: C.

 The no-arbitrage approach to replicating the put option is similar. In this case, we trade nS = –N(–
d1) = –0.376 shares of stock—specifically, short sell 0.376 shares and buy nB = N(–d2) = 0.493
shares of zero-coupon bonds.

 Again, the cost of the replicating strategy is nSS + nBB = –0.376(100) + (0.493)95.123 = 9.30.
(Without rounding errors, the option value is 9.35.)

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The Value of European option using the BSM
Case Example

• The underlying stock price is 225 with a volatility of 0.15. The

continuously compounded risk-free rate is 5.25% and the
continuously compounded dividend yield is 2.7%. Consider the
value of a 3-year European call with the exercise price of 200.

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The Value of European option using the BSM
Case Example

• Correct Answer:
We should first calculate the adjusted S0 = S0×e-δT = 225×e−0.027×3 = 207.49

Then calculate d1 and d2:

d1 = [ln(225/200)+(0.0525-0.027+0.15²×0.5)×3]/(0.15× 3 ) = 0.88
d2 = 0.88−0.15× 3 = 0.62
Then look up N(d1) and N(d2) in the cumulative normal probability table:

N(0.488)=0.8106 N(0.62)=0.7324

Then we can get the value of the call:

C0 = 225×e−0.027×3 ×0.8106−200e−0.0525×3×0.7324 = 43.06

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The Value of European option using the BSM
Case Example
• 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).

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The Value of European option using the BSM
Case Example

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).

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The Value of European option using the BSM
Case Example

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.

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The Value of European option using the BSM
Case Example

• Correct Answer for Q1: B.

 The BSM call model for a dividend-paying stock can be expressed as

Se–δTN(d1) – Xe–rTN(d2).

• Correct Answer for Q2: C.

 The BSM put model for a dividend-paying stock can be expressed as

Xe–rTN(–d2) – Se–δTN(–d1).

• Correct Answer for Q3: C.

 The BSM model option value will be different because d1, d2, and the
stock component are all adjusted for dividends.

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Option Greeks

 The Black-Scholes-Merton model has five inputs: underlying asset price, volatility,
risk-free rate, time to expiration, and strike price.

 Measures that capture movements in the option value for a movement in one of the
factors that affect the option value, while holding all other factors constant are
called the Greeks.

 Direction of BSM European option prices for a change in the five model inputs.

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Option Greeks

 The features of Theta is also called time decay. There is an exception when the European
put option is deep in the money, the residual time to maturity has not worthy to long
position.

Relationship
Greeks Sensitivity factor
Call option Put option
Delta Underlying price Positive (Delta>0) Negative (Delta<0)
Vega Volatility Positive (Vega>0) Positive (Vega>0)
Rho Risk-free rate Positive (Rho>0) Negative (Rho<0)
Closer to maturity Closer to maturity
Theta Passage of time value declines value declines
(Theta<0) (Theta<0*)
/ Strike price Negative Positive

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The Option Delta
 The relationship between the option price and the price of the underlying asset has a special name: the
delta. The option delta is defined as:

 delta = Change in option price / Change in underlying price

 The relationship between delta of a call and put:

 The call option’s delta is defined as:
deltacall = (C1−C0)/(S1−S0) = ΔC/ΔS

 The delta of a put option is the call option’s delta minus one:
deltaput = (P1−P0)/(S1−S0) = ΔP/ΔS = deltacall −1

 The BSM perspective:

 The call option’s delta is also equal to N(d1) from the BSM model, and the put option’s delta equals N(d1)
−1.
 If the underlying has a dividend yield of δ, the call option’s delta is also equal to e-δTN(d1) from the
BSM model, and the put option’s delta equals e-δT(N(d1) −1).

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The Option Delta

 The call delta increases from 0 to 1 as stock price increases.

 When the call option is deep out-of-the-money, the call delta is close to zero. The
option price changes a very small amount for a given change in the stock price.
 When the call option is deep in-the-money, the call delta is close to one. The
option price changes almost one dollar for a one-dollar change in the stock price.

 The put delta increases from −1 to 0 as stock price increases.

 When the put option is deep in-the-money, the put delta is close to −1.
 When the put option is deep out-of-the-money, the put delta is close to zero.

 When t approaches maturity, a in-the-money call’s delta is close to 1,while a out-of-

the-money call’s delta is close to 0.

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The Option Delta

Call Value

Prior to expiration At expiration

Tangent Line

Stock value

Strike price

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The Option Delta

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Dynamic hedging

 If we long a stock and short 1/delta calls, the value of the portfolio does not change,
when the value of the stock changes. For example, if the stock price increases by n
dollar, the call price will decrease by delta×n dollar and then 1/delta calls decrease n
dollar.

 We make money by buying the stock and lose money by selling the call options; the
value of the portfolio remains unchanged. This portfolio is referred to as a delta-
neutral portfolio.

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Dynamic hedging

 However, the delta-neutral hedging is a dynamic process, since the delta is constantly
changing. The delta will change if the underlying stock price changes. Even if the
underlying stock price does not change, the delta would still change as the option
moves toward the expiration day. As the delta changes, the number of calls that
should be sold to construct the delta-neutral portfolio changes. Delta-neutral
hedging is often referred to as dynamic hedging.

number of shares hedged

number of options needed to delta hedge 
delta of call option
 number of shares hedged  hedge ratio

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The Option Gamma

 The gamma defines the sensitivity of the option delta to a change in the price of the
underlying asset. The option gamma is defined as:

 gamma = (delta1−delta0)/(S1−S0) = Δdelta/ΔS

 Call and put options on the same stock with the same T and X have equal gammas.

 A long position in calls or puts will have a positive gamma.

 Gamma is largest when the option is at-the-money.

 If the option is deep in- or out-of-the-money, gamma approaches zero.

 Gamma is largest when the option is at the money, which means delta is very sensitive
to a change in the stock price. Then we must rebalance the delta-neutral portfolio
more frequently. This leads to higher transaction cost .
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The Option Gamma

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Vega, Theta and Rho
 Vega
 Vega is defined as the change in a given portfolio for a given small change in
volatility, holding everything else constant.
 Positive to the long, both call option and put option.
 Theta
 Theta defines the sensitivity of the option value to a change in the calendar time.
 Negative to the long, both call option and put option, usually refers to time decay.
 Rho
 Rho is defined as the change in a given portfolio for a given small change in the
riskfree interest rate, holding everything else constant.
 The rho of the call is positive while the call of a put is negative(leverage effect).
 Small impact compared to vega.
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Option Greeks
Case Example
• Klein, CFA, has owned 100,000 shares of a biotechnology company A, A is waiting for its
approving from FDA who will release its decision in six months, now the current is share price is
$38, and if the latest pharmaceutical is rejected by the FDA, it will have a great impact on the
share price of company in six month and will eventually become $26. Expected annual volatility of
return is 20%, current annual risk-free rate is 1.12%.

Klein wants to use BSM model to implement a hedging strategy in using 6-month European
option if company A’s new product rejected by the FDA and gathers the data below:

Option W X Y Z
Type of Option Call Call Put Put
Exercise Price $38 $46 $38 $36
N(d1) 0.56 0.30 0.56 0.64
N(d2) 0.45 0.21 0.45 0.53

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The Value of European option using the BSM
Case Example
• Using the data above, the number of option X contracts that Klein would have to sell to
implement the hedge strategy would be closet to:
• The required number of call options to sell = Number of shares of underlying to be
hedged / N(d1), where N(d1) is the estimated delta used for hedging a position with
call options. There are 100,000 shares to be hedged and the N(d 1) for Option X from
Exhibit 2 is 0.30. Thus, the required number of call options to sell is 100,000 / 0.30
=333,333

• Based on the data above, which of the following options is most likely to exhibit the
largest gamma measure?

• Correct Answer:
• The gamma will tend to be large when the option is at-the-money. The exercise price
of Option Y is equal to the underlying price, hence at-the-money, whereas both
Option X and Option Z are out-of-the-money.

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The Value of European option using the BSM
Case Example
If Klein using Option Z from the data above, and company A's share price subsequently
dropped to $36, Klein would most likely need to take the following action to maintain the
same hedged position:
The required number of put options = Number of shares of underlying to be hedged /
[N(d1) - 1], where N(d1) - 1 is the estimated delta used for hedging a position with put
options (otherwise known as the put delta). As the share price drops to $36, the delta of
a put position will decrease toward -1.0, requiring less put options than the original
position.
If company A pays a dividend, holding all other factors constant, what would be the
most likely effect on the price of option W?
Including the effect of cash flows lowers the underlying price. Lowering the underlying
price causes the price of the call option to decrease.

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The critical role of volatility

 Historical volatility and implied volatility

 Historical volatility is using historical data to calculate the variance and standard deviation of the
continuously compounded returns.

R 
N
c c 2
i -R i

S R2c  i 1
i
N -1
  S R2 c
i

 If we have S0, X, Rf , and T, we can set the BSM price equal to the market price and then work
backwards to get the volatility. This volatility is called the implied volatility. The most basic
method to get the implied volatility is trial and error.

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No-arbitrage approach with binomial tree

 Hedge Ratio:
C1+ -C1-
h  hedge ratio  = + - (shares per option)
S1 -S1

 If the portfolio is constructed as long 1 call and short h stock, the portfolio should
exist no delta risk.

 c0=hS0 + PV(-hS- +c- )= hS0 + PV(-hS+ +c+ ) where h>=0

 p0=hS0 + PV(-hS- +p- )= hS0 + PV(-hS+ +p+ ) where h<=0

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No-arbitrage approach with binomial tree
Case Example
• Calculate the value today of a 1-year call option on the stock with the strike
price of $20. The price of the stock is $20 now, and the size of an up-move is
1.25. The risk-free rate is 7%.

• Correct Answer:
Step 1: Calculate the parameters:
u=1.25 ; d=1/u=0.8 ; Su=20×1.25=25; Sd=20×0.8=16
C+ = Max (0, 25−20) = 5 ; C− = Max (0, 16−20) = 0
Step 2: Calculate hedge ratio,:
h=(5-0)/(25-16)=5/9
Step 3: Calculate call option: c0=hS0 + PV(-hS1- +c1- )= hS0 + PV(-hS1+ +c1+ )
C0 =5/9*20+(-5/9*25+5)/(1+7%)=2.80
Or: C0 =5/9*20+(-5/9*16+0)/(1+7%)=2.80

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No-arbitrage approach with binomial tree

 Memory Tips——Similar to BSM:

 Call option: Borrow money to invest in stock

 c0=hS0 + PV(-hS- +c- )= hS0 - PV(hS- -c- ) where h>=0
 R cf T
C0  S0  N (d1 )  X  e  N (d 2 )

 Put option: Buying the bond(or lend) with the proceeds from short
selling the underlying
 p0=hS0 + PV(-hS- +p- )= -(-hS0) + PV(-hS- +p- ) where h<=0

 Rcf T
P0  X  e  N (-d 2 )  S0  N (-d1 )

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No-arbitrage approach with binomial tree
Case Example
• For the Alpha Company option, if the call option is overpriced relative to the model.
The positions to take advantage of the arbitrage opportunity are to write the call and:

A. short shares of Alpha stock and lend.

B. buy shares of Alpha stock and borrow.

C. short shares of Alpha stock and borrow.

• Correct Answer: B.
You should sell (write) the overpriced call option and then go long (buy) the
replicating portfolio for a call option. The replicating portfolio for a call option is to buy
h shares of the stock and borrow the present value of (hS- - c-).
c = hS + PV(-hS- + c-).

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Black Model: Options on Futures
 We assume that the futures price also follows geometric Brownian motion. We ignore issues like
margin requirements and marking to market. Black proposed the following model for European-style
futures options:

C0  e
 Rcf T
 FP  N (d1 )  X  N (d 2 ) P0  e
 R cf T
 X  N (d 2 )  FP  N (d1 )
 FPe  rf T 
   rf  0.5     T ln 
ln  2 FP 
  0.5   2  T
d1   X 
= 
X  d 2  d1  (  T )
 T  T

 Interpretation

 Call option is the present value of the difference between part of futures price
and part of exercise price;
 Leverage
 Call option can be thought as long futures financed by bond.

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Black Model: Options on Futures
Case Example
• The S&P 500 Index (a spot index) is presently at 1,860 and the 0.25 year 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.

We ignore the effect of the multiplier. As of this writing, the S&P 500 futures option contract has a
multiplier of 250. The prices reported here have not been scaled up by this amount. In practice,
the option cost would by 250 times the option value.

Options on Futures
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
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Black Model: Options on Futures
Case Example

1. Identify the statement that best describes how the Black model is used to
value a European call option on the futures contract just described.

A. The call value is the present value of the difference between the
exercise price times 0.461 and the current futures price times 0.539.

B. The call value is the present value of the difference between the current
futures price times 0.491 and the exercise price times 0.461.

C. The call value is the present value of the difference between the current
spot price times 0.491 and the exercise price times 0.461.

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Black Model: Options on Futures
Case Example
2.Which statement best describes how the Black model is used to value
a European put options on the futures contract just described?
A. The put value is the present value of the difference between the exercise price times
0.539 and the current futures price times 0.509.
B. The put value is the present value of the difference between the current futures price
times 0.491 and the exercise price times 0.461.
C. The put value is the present value of the difference between the current spot price
times 0.491 and the exercise price times 0.461.

3.What are the underlying and exercise prices to use in the Black futures
option model?
A. 1,851.65; 1,860
B. 1,860; 1,860
C. 1,860; 1,851.65

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Black Model: Options on Futures
Case Example
• Correct Answer for Q1: B.

 Recall Black’s model for call options can be expressed as:

 c = e–rT[F0(T)N(d1) – XN(d2)].

• Correct Answer for Q2: A.

 A is correct. Recall Black’s model for put options can be expressed as:

 p = e–rT[XN(–d2) – F0(T)N(–d1)].

• Correct Answer for Q3: A.

 The underlying is the futures price of 1,851.65 and the exercise price
was given as 1,860.

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Black Model: Interest Rate Options

 Interest rate Option

 Option Underlying: Forward rate or FRA rate;

 Strike interest rate are determined initially;

 Interest rate call option gains when rates rise and put option gains when rate fall.
30
 r N 
C0  NP   accrual period  e 360
 FRM N  N (d1 )  X  N (d 2 )
( N  M )  30
accrual period 
360

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Black Model: Interest Rate Options
Case Example
• Suppose you are a speculative investor in Singapore. On 15 May, you anticipate that some
regulatory changes will be enacted, and you want to profit from this forecast. On 15 June, you
intend to borrow 10,000,000 Singapore dollars to fund the purchase of an asset, which you expect
to resell at a profit three months after purchase, say 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%. You are concerned that rates will rise, so you want to hedge
your borrowing risk by purchasing an interest rate call option with 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?

A. 0.55%

B. 0.68%

C. 0.60%

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Black Model: Interest Rate Options
Case Example

2. The discount factor used in pricing this option would be over what
period of time?

A. 15 May–15 June

B. 15 June–15 September

C. 15 May–15 September

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Black Model: Interest Rate Options
Case Example

• Correct Answer for Q1: B.

 In using the Black model, a forward or futures price is used as the

underlying. This approach is unlike the BSM model in which a spot price is
used as the underlying.

• Correct Answer for Q2: C.

 You are pricing the option on 15 May. An option expiring 15 June when the
underlying is three-month Sibor will have its payoff determined on 15 June,
but the payment will be made on 15 September. Thus, the expected
payment must be discounted back from 15 September to 15 May.

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Black Model: Interest Rate Options
Case Example
• Solomon forecasts the three-month Libor will exceed 0.85% in six months and is considering using
options to reduce the risk of rising rates. He asks Lee to value an interest rate call with a strike price of
0.85%. The current three-month Libor is 0.60%, and an FRA for a three-month Libor loan beginning in
six months is currently 0.75%.

The valuation inputs used by Lee to price a call reflecting Solomon’s interest rate views should include
an underlying FRA rate of:

A. 0.60% with six months to expiration.

B. 0.75% with nine months to expiration.

C. 0.75% with six months to expiration.

• Correct Answer: C.

Solomon’s forecast is for the three-month Libor to exceed 0.85% in six months. The correct option
valuation inputs use the six-month FRA rate as the underlying, which currently has a rate of 0.75%.

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Black Model: Swaption
 Option on Swap

 Gives the holder the right, but not the obligation, to enter a swap at the pre-
agreed swap rate—the exercise rate.
 Option Underlying: Forward swap rate
 Payer swaption
V payer  NP   AP   PVA  RFIX  N (d1 )  RX  N (d 2 ) 
 Receiver swaption
Vreceiver  NP   AP   PVA  RX  N (d 2 ) - RFIX  N (d1 ) 
 RFIX = Fixed swap rate starting when the swaption expires;

 RX = Exercise swap rate;

 AP = the accrual period;

 PVA = a complicated average of discount factors.

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Black Model: Swaption
Case Example
• 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 payer swaption expiring in three months. 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%.

With reference to the Black model to value the swaption, which statement is correct?
A. The underlying is the three-month forward, five-year swap rate.
B. The discount rate to use is 2.55%.
C. The swaption time to expiration, T, is five years.

• Correct Answer: A.

 The current five-year swap rate is not used as a discount rate with swaptions. The swaption time
to expiration is 0.25.

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