H 17 Decoursetext

Derivatives
Peter Moles
DE-A2-engb 2/2017 (1012)

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Derivatives
Dr. Peter Moles MA, MBA, PhD
Peter Moles is Senior Lecturer at the University of Edinburgh Management School. He is an experienced
financial professional with both practical experience of financial markets and technical knowledge
developed in an academic and work environment.
Prior to taking up his post he worked in the City of London for international and money-centre banks.
During the course of his career in the international capital markets he was involved in trading, risk
management, origination, and research. He has experience of both the Eurobond and Euro money
markets. His main research interests are in financial risk management, the management of financial
distress and in how management decisions are made and the difficulties associated with managing complex
problems. He is author of the Handbook of International Financial Terms (with Nicholas Terry, published by
Oxford University Press) and is editor of the Encyclopaedia of Financial Engineering and Risk Management
(published by Routledge). He is a contributing author for The Split Capital Investment Trust Crisis (published
by Wiley Finance) and has written a number of articles on the problems of currency exposure in industri-
al and commercial firms.
First Published in Great Britain in 2004.
© Peter Moles 2004
The rights of Peter Moles to be identified as Author of this Work has been asserted in accordance with
the Copyright, Designs and Patents Act 1988.
All rights reserved; students may print and download these materials for their own private study only and
not for commercial use. Except for this permitted use, no materials may be used, copied, shared, lent,
hired or resold in any way, without the prior consent of Edinburgh Business School.
Contents
Introduction xi
Arrangement of the Course xii
Approach and Key Concepts xii
Assessment xiii
Acknowledgements xiv
PART 1 INTRODUCTION TO THE DERIVATIVES PRODUCT SET
Module 1 Introduction 1/1
1.1 Introduction 1/2

1.2 Arbitrage Relationships 1/8
1.3 Derivative Markets 1/17
1.4 Uses of Derivatives 1/19
1.5 Learning Summary 1/24
Review Questions 1/25
Case Study 1.1: Terms and Conditions of a Futures Contract 1/29
Case Study 1.2: Constructing a Derivative Security using Fundamental
Financial Instruments 1/29
Module 2 The Derivatives Building Blocks 2/1

2.2 Forward Contracts 2/4
2.3 Futures Contracts 2/6
2.4 Swap Contracts 2/7
2.5 Option Contracts 2/9
Case Study 2.1 2/16
PART 2 TERMINAL INSTRUMENTS

Module 3 The Product Set: Terminal Instruments I – Forward Contracts 3/1

3.2 The Nature of the Forward Contract 3/2
3.3 Using Forwards as a Risk-Management Instrument 3/11
3.4 Boundary Conditions for Forward Contracts 3/12
3.5 Modifying Default Risk on Forward Contracts 3/13
Derivatives Edinburgh Business School v

Contents

Case Study 3.1: Interest-Rate Risk Protection 3/34
Case Study 3.2: Exchange-Rate Protection 3/35
Module 4 The Product Set: Terminal Instruments II – Futures 4/1

4.2 Futures Contracts 4/2
4.3 Types of Futures Transactions 4/13
4.4 Convergence 4/18
4.5 The Basis and Basis Risk 4/21
4.6 Backwardation and Contango 4/35
4.7 Timing Effects 4/37
4.8 Cash–Futures Arbitrage 4/40
4.9 Special Features of Individual Contracts 4/42
4.10 Summary of the Risks of Using Futures 4/46
Case Study 4.1: The Use of Short-Term Interest-Rate Futures for Hedging 4/55
Module 5 The Product Set: Terminal Instruments III – Swaps 5/1

5.2 Interest-Rate Swaps 5/5
5.3 Cross-Currency Swaps 5/9
5.4 Asset–Liability Management with Swaps 5/11
5.5 The Basics of Swap Pricing 5/17
5.6 Complex Swaps 5/29
5.7 The Credit Risk in Swaps 5/34
Appendix 5.1: Calculating Zero-Coupon Rates or Yields 5/41
Case Study 5.1 5/49
PART 3 OPTIONS
Module 6 The Product Set II: The Basics of Options 6/1

6.2 Types of Options 6/6
6.3 Option-Pricing Boundary Conditions 6/18
6.4 Risk Modification with Options 6/21
vi Edinburgh Business School Derivatives

Contents

Case Study 6.1 6/31
Module 7 The Product Set II: Option Pricing 7/1

7.2 Pricing the Option Liability 7/2
7.3 Multiperiod Extension of the Option-Pricing Method 7/8
7.4 Put–Call Parity Theorem for Pricing Puts 7/12
Appendix 7.1: Dynamic Replication of the Option Liability 7/16
Case Study 7.1 7/24
Module 8 The Product Set II: The Black–Scholes Option-Pricing Model 8/1

8.2 The Black–Scholes Option-Pricing Formula for Calls 8/3
8.3 The Black–Scholes Option-Pricing Formula for Puts 8/4
8.4 Properties of the Black–Scholes Option-Pricing Model 8/4
8.5 Calculating the Inputs for the Black–Scholes Option-Pricing Model 8/5
8.6 Using the Black–Scholes Option-Pricing Model 8/12
Case Study 8.1: Applying the Black–Scholes Model 8/21
Case Study 8.2: The Black–Scholes and Binomial Models 8/21
Module 9 The Product Set II: ‘The Greeks of Option Pricing’ 9/1

9.2 The Effect on Option Value of a Change in the Pricing Variables 9/3
9.3 Sensitivity Variables for Option Prices 9/3
9.4 Asset Price (U0) and Strike Price (K) / Delta (δ), Lambda (λ) and Gamma (γ) 9/5
9.5 Option Gamma (γ) 9/13
9.6 Time to Expiry / Theta (θ) 9/18
9.7 Risk-Free Interest Rate (r) / Rho (ρ) 9/24
9.8 Volatility (σ) / Vega (ν) 9/26
9.9 Sensitivity Factors from the Binomial Option-Pricing Model 9/29
9.10 Option Position and Sensitivities 9/33
Derivatives Edinburgh Business School vii

Contents
Case Study 9.1: Option-Pricing Sensitivities 9/43
Module 10 The Product Set II: Extensions to the Basic Option-Pricing Model 10/1

10.2 Value Leakage 10/2
10.3 Value Leakage and Early Exercise 10/8
10.4 Interest-Rate Options (IROs) 10/17
10.5 Complex Options 10/27
Case Study 10.1: Applying the American-Style Put Adjustment 10/36
Case Study 10.2: Valuing an Interest-Rate Option 10/36
PART 4 USING DERIVATIVES AND HEDGING

Module 11 Hedging and Insurance 11/1

11.2 Setting up a Hedge 11/7
11.3 Hedging Strategies 11/16
11.4 Portfolio Insurance 11/36
11.5 The Use of Options as Insurance 11/40
Case Study 11.1: Hedging Interest-Rate Risk 11/56
Case Study 11.2: Hedging with Written Calls 11/56
Module 12 Using the Derivatives Product Set 12/1

12.2 Case 1: British Consulting Engineers 12/4
12.3 Case 2: United Copper Industries Inc. 12/12
Case Study 12.1 12/36
Appendix 1 Practice Final Examinations and Solutions A1/1

Examination One 1/2
Examination Two 1/13
viii Edinburgh Business School Derivatives

Contents
Appendix 2 Formula Sheet for Derivatives A2/1

1. Financial Basics 2/1
2. Covered Arbitrage 2/1
3. Cost of Carry Model 2/1
4. Implied Forward Rate 2/2
5. Forward Rate Agreement Settlement Terms 2/2
6. Synthetic Agreement for Forward Exchange Settlement Terms 2/2
7. Hedge Ratio 2/2
8. Fair Value of an At-Market Swap 2/2
9. Spot or Zero-coupon Rate (Zi) Derived from the Par-Yield Curve 2/3
10. Option Pricing 2/3
11. Black–Scholes Option Pricing Model 2/3
12. Option Sensitivities 2/5
13. Adjustments to the Option Pricing Model 2/6
14. Hedging 2/8
Appendix 3 Interest Rate Calculations A3/1

Time-Value-of-Money (TVM) 3/1
Simple Interest 3/2
Bank Discount 3/3
Bonds 3/5
Yield (internal rate of return (IRR)) 3/5
Computing Zero-Coupon Rates 3/7
Appendix 4 Answers to Review Questions A4/1

Module 1 4/1
Module 2 4/8
Module 3 4/11
Module 4 4/19
Module 5 4/28
Module 6 4/38
Module 7 4/43
Module 8 4/51
Module 9 4/55
Module 10 4/60
Module 11 4/67
Module 12 4/74
References R/1
Index I/1
Derivatives Edinburgh Business School ix

Introduction
This elective course covers one of the core areas of market finance, namely deriva-
tives. The major classes of derivatives – forwards, futures, options, and swaps – are
key instruments for allowing market participants to transfer and mitigate risks and to
speculate on future asset values. The growth in the size and diversity of derivatives
markets testifies to their importance within the financial system. Furthermore, the
theory of option pricing is one of the key ideas in finance for which Myron Scholes
and Robert Merton were awarded their Nobel Prize in 1997.* The Black–Scholes
option pricing model has been described as ‘the workhorse of the financial services
industry’. Understanding derivative pricing is an important element for financial
engineers when seeking to address problems in finance.
Financial futures are one of the most heavily traded markets in the world, with
futures exchanges existing in all major countries. Since the mid-1970s over seventy
futures (and options) exchanges have been established. They are organised markets
for exchanging a wide variety of financial and business risks, ranging from interest
rates across to insurance and, latterly, weather. The volume of transactions and the
types of instruments available to speculate on and manage risk continues to increase
as new uses are found for futures.
The development of a theory to price contingent securities has had major ramifi-
cations for the financial services industry. Option markets, both formal markets (as
with futures) and over-the-counter trading between principals, have expanded
dramatically following the introduction of a working model for their pricing. Option
pricing is complex with a number of factors determining their value. Many financial
transactions include option-like elements. In addition, some problems in corporate
finance can also be best understood in terms of option theory. This course provides
a conceptual understanding of how options are priced and how they can be used for
a wide range of risk management and other uses by financial practitioners.
Swaps are one of the newest developments in the derivatives product set and
have become an important component of derivatives markets. The pricing of swaps
illustrates how financial securities are valued in a competitive market. Swaps are a
key tool for asset-liability managers for all types of firms and complement the
derivative instruments available in futures and options markets.
A large part of the role of finance, the actions of the financial specialist and the
operations of the financial department within firms, are devoted to handling,
controlling, and profiting from risk. Hence this course emphasises how market
participants manage and exploit financial risks using derivatives. Of course, such
instruments can also be used for speculation or arbitrage.† But it is the ability of
* Nobel Prize in Economic Science, 1997, for ‘a new method to determine the value of derivatives’
† We only need to look at the activities of Nick Leeson of Barings Bank fame to see how an arbitrage
strategy can be easily turned into a speculative one! He fraudulently undertook highly speculative
transactions when he was supposed to be involved in low-risk arbitrage activity. As a result, Barings
Bank collapsed in 1995.
Derivatives Edinburgh Business School xi

Introduction
derivatives to modify risks that has helped place these instruments at the centre of
current activity in the global financial markets.
Before starting this course, the student is expected to have some prior knowledge
of the fundamentals of finance and, in particular, time value of money methods and
an understanding of statistical concepts. The level of knowledge required is that
which it is necessary to have in order to successfully complete a course in finance. It
is also strongly recommended that students have taken Financial Risk Management
which covers the sources of financial risk and methods of risk assessment.
Arrangement of the Course

The Modules that go to make up Derivatives fall into the following topic areas:
Topic area Modules

One Introduction to the Derivatives Product Set: 1 and 2
Introduces the fundamentals of derivatives and their
pricing, the different types, and their uses
Two Terminal Instruments 3 to 5
The different types of terminal derivatives: forwards,
futures and swaps
Three Options 6 to 10
The nature, types, pricing and uses of options
Four Using Derivatives and Hedging: 11, 12
Risk management using derivatives
The initial modules (Part One) introduce the different types of derivatives, name-
ly forwards, futures, swaps and options, how they are used, and explains the way in
which they can be valued.
The discussion then proceeds to cover in detail the mechanics and use of the
different terminal instruments, that is, forwards, futures and swaps (Part Two), and
options (Part Three) principally as risk management tools – since this is a prime
justification for the growth in derivatives markets – and shows how they can be
incorporated into the process as a means to transfer and control risk. The applica-
tion of these tools then follows (in Part Four), together with some of the inevitable
complexities that result from this process.
In presenting the text in this way, the aim is it provides a comprehensive and
logical approach to what is a complex subject.
Approach and Key Concepts

Derivative pricing is a complex subject. The text presents the different derivatives
product set elements in rising order of complexity. Whilst this is useful in develop-
ing a good understanding of how the derivatives product set works, it does have
some disadvantages in that material on one subject (for instance, the cost of carry
xii Edinburgh Business School Derivatives

Introduction
model used to price forwards and futures) is presented in different parts of the
elective. As a result, we would encourage students to look at alternative ways to
approach the text.
A basic premise of the material is that it is orientated towards the needs of a
market user, with a strong emphasis on using derivatives for risk management
purposes. Of course, as is explained at different points, these instruments can be
used for other objectives – for instance, speculating and spreading.
As a course, it concentrates on the methodological and operational issues in-
volved in using derivatives. That is, it is technique based and emphasises the
mathematical, financial, or engineering approach to these instruments. Market users
can – and do – use these instruments without such knowledge. But seasoned
practitioners will agree that gaining the understanding of derivatives that this course
provides will assist you in using these instruments wisely.
As a subject derivatives introduces ideas that are central to modern financial
theory and practice. Daily, and all over the world, practitioners are putting to use the
models described in this course to manage the ongoing financial risks in the
organisations for which they work. For instance, the ideas behind option theory and
arbitrage pricing are central to managing the risks of contingent cash flows. It is a
prerequisite for anyone wishing to pursue a career in financial services or become a
financial specialist to gain an understanding of derivatives markets and pricing.
Assessment
As is customary with this programme, you will find self-test questions and cases at
the end of each Module. The answers are given at the end of the text. Also, there are
two pro-forma exams of the type it is necessary to pass in order to gain credit from
this course. The exam assessment is based on the following criteria:
Section Number of Marks Total marks

questions obtainable for the
per question section
Multiple choice questions 30 2 60
Cases 3 40 120
180
Derivatives Edinburgh Business School xiii

Acknowledgements
I would like to thank the Financial Times Ltd and the Scotsman for permission to
reproduce items from their publications as background material to this course.
Thanks are also in order to the production team at Edinburgh Business School
and an anonymous reviewer of an early draft of some of the text who provided
valuable comment on the evolving material. As is usual in these matters, all errors
remain the author’s responsibility.
Derivatives Edinburgh Business School xiv

PART 1
Introduction to the Derivatives

Product Set
Module 1 Introduction
Module 2 The Derivatives Building Blocks
Derivatives Edinburgh Business School

Module 1
Introduction
Contents
1.1 Introduction.............................................................................................1/2
1.2 Arbitrage Relationships..........................................................................1/8
1.3 Derivative Markets .............................................................................. 1/17
1.4 Uses of Derivatives .............................................................................. 1/19
1.5 Learning Summary .............................................................................. 1/24
Review Questions ........................................................................................... 1/25
Case Study 1.1: Terms and Conditions of a Futures Contract ................. 1/29
Financial Instruments .......................................................................... 1/29
Learning Objectives
Derivatives have become an important component of financial markets. The
derivative product set consists of forward contracts, futures contracts, swaps and
options. A key issue is how prices for such derivatives are determined. The ability of
market participants to set up replicating portfolios ensures that derivative prices
conform to no-arbitrage conditions. That is, the prices cannot be exploited without
taking a risk. Replication also explains how derivative claims can be manufactured to
order.
The principal justification for the existence of derivatives is that they provide an
efficient means for market participants to manage risks. But derivatives also have
other uses such as speculation and the implementation of investment strategies.
After completing this module, you should:
 know the history of the development of derivatives, namely that:
 there is early historical evidence for forward and option contracts
 futures contracts were developed in the 19th Century and that financial fu-
tures were introduced in 1973
 swaps were first traded as recently as 1981
 new derivative products continue to be developed to meet specific needs of
market participants
 know that derivatives are designed to manage risk, usually the price or market
risk of the underlier that arises from uncertainty about the underlier’s value in
the future. In particular, that:
 market participants who need to buy in the future are exposed to the risk that
prices may rise before they can buy. This exposure to price risk is known as
buyer’s risk
Derivatives Edinburgh Business School 1/1

Module 1 / Introduction
 market participants who need to sell in the future are exposed to the risk that
prices may fall before they can sell. This exposure to price risk is known as
seller’s risk
 be able to differentiate between the different elements of the risk management
product set, namely forward contracts, futures, swaps, and options;
 understand how prices in financial markets are maintained in proper relationship
to each other through arbitrage;
 be aware that arbitrage relationships rely on the Law of One Price and how
imperfections in the way real markets operate can limit the applicability of the
law;
 understand that the payoff of derivative instruments can be replicated using
combinations of fundamental financial instruments;
 understand how in an efficient market the prices of derivatives, which can be
replicated using fundamental financial instruments, are determined through arbi-
trage-free relationships;
 know the main uses for derivatives, namely:
 risk modification
 hedging
 speculation
 spreading
 arbitrage
 lowering borrowing costs
 tax and regulatory arbitrage
 completing the market
 be aware that the main justification for derivatives is that they enable market
participants to efficiently transfer risks.
1.1 Introduction
In 1995, Nick Leeson a trader at Barings Bank made the headlines when it became
public knowledge that, unknown to his bosses, he had run up losses of US$1.3bn
through dealing in derivatives. Prior to this, many people had been unawares of the
importance of derivatives in the financial system and their capacity to generate profits
or (in Leeson’s case) disastrous losses. Derivative is the generic name for a set of
financial contracts that include, forward contracts, futures, swaps and options. The
term derivative comes from the fact that the instruments obtain their value (derive it)
from the behaviour of more basic underlying variables. Hence derivatives are also often
referred to as contingent claims. The underlying variables can be a specific asset or
security, index, commodity, or even the relationship between different assets. The main
classes of instruments are forward contracts, futures, swaps and options. Later modules
of this course will examine each of these instruments in detail.
The number, type and variety of derivative contracts has expanded greatly since
the introduction of the first exchange-traded instruments in the early 1970s. Since
then, instruments have been introduced to manage the risks in interest rates,
1/2 Edinburgh Business School Derivatives

currencies, commodities, equities and equity indices, credit and default risks, and
other financial risks. This increased variety, coupled to a wider use of derivatives by
market practitioners to address a variety of problems, has meant an explosion in the
volume of outstanding contracts.
While the current interest in the use – and abuse – of derivatives has been a
recent phenomenon, the commercial world has employed derivative contracts since
the dawn of trade. The increased use of financial derivatives, that is instruments
used to manage or speculate on financial risks, can be traced back to the introduc-
tion of financial futures in 1972 by the Chicago Mercantile Exchange (CME) and by the
Chicago Board of Trade (CBOT) and options on company shares by the Chicago Board
Options Exchange (CBOE) the following year. The CBOE is a subsidiary of the
CBOT, an exchange established in the 19th century to trade derivatives on agricul-
tural products. By introducing financial futures, the CME was responding to a
demand by financial markets for better ways to manage risks. By offering exchange-
traded options, the CBOE made available contracts that provided insurance against
future uncertainty.
Since 1973 the use of financial derivatives has snowballed and many new finan-
cial derivatives exchanges have been established. Not only has the volume of
transactions increased but the type and complexity of the instruments themselves
has increased dramatically. For instance, the original types of options traded at the
CBOE are now referred to as standard options to distinguish them from the exotic
options that have since been introduced.
Derivatives were introduced into commerce as a necessary tool for merchants to
handle risks. The principal risk that they are designed to manage is the price risk or
market risk of the underlier (the asset, security or variable that is the basis of the
derivative contract). The earliest form of derivative is the forward contract, which is
simply a purchase/sale agreement where the implementation or settlement of the
contract is deferred to some mutually agreed date in the future. In a normal contract
the purchase/sale leads to an immediate transfer of the contracted element from the
seller to the buyer, that is ‘on the spot’ and hence are called spot contracts or cash
market contracts. With the forward contract, the transfer of the underlier is deferred
to a mutually agreed date although the price (and other features such as quality and
quantity) is agreed today. The attractions for both buyer and seller are obvious: by
trading now the buyer is guaranteed the price at which he can purchase. In the same
way, the seller is guaranteed the price at which he can sell in the future. This
arrangement makes a lot of commercial sense and evidence from earliest history
suggests that fixing a price for future delivery was an important element in commer-
cial activity. Early evidence of the prevalence of such contracts comes from the
ancient Assyrian commercial code, which included laws governing the writing and
enforcement of such contracts. There is also evidence from as early as 2000BC of
forward dealing in India. Historians have uncovered evidence that ancient Rome
had a market in such forward contracts for wheat, the staple commodity food for
the city.
In the 15th century, historians have documented that Antwerp was the centre of
a sophisticated forward currency market linked to the Flanders cloth trade. Mer-

chants due to receive or make payments in one of the many different currencies that
circulated in Europe at the time were able to fix in advance the exchange rate for
conversion (for example from florins to marks) so as to eliminate the risk. In fact
Thomas Gresham, the English businessman, established a bourse (or exchange) in
London in direct imitation of those that existed in Antwerp. This later became the
Royal Exchange. Gresham’s initiative was an early example of the commercial
competition for the management of risks. In the 18th century, terminal markets at
dockyards and other transit points were the focal points for dealing in forward
contracts. Merchants with goods being shipped to the port would be concerned that
their cargoes would temporarily upset the demand and supply balance. To counter
this, they would ‘sell forward’ part or all of their products for delivery when the ship
docked.
In the mid-19th century, Chicago, Illinois, had become a centre for the mid-West.
Its proximity to the Great Lakes and the grain growing plains meant that farmers
shipped their produce to the city. The seasonal nature of production meant that
prices for grain rocketed in the spring but collapsed after the harvest. In 1848,
merchants in the city gathered together to find a better way of organising the grain
trade. As a result, the Chicago Board of Trade was created. Over the next few years, the
technology of forward contracts was refined. The result was the development of
futures contracts. While economically the same, these differed from forward
contracts by the fact that they not only managed the price risk in the underlier but
that they eliminated the credit risk that exists in forward contracts. The benefit of a
forward contract depends entirely on the willingness of both parties to honour the
agreement. If the market price changes substantially, there is a strong incentive for
the buyer (seller) to renege on the agreement and buy (sell) in the spot market. The
development of futures solved the performance risk problem by requiring each
party to collateralise their position. Futures have allowed a tremendous expansion of
the market in forward transactions since there is no longer a requirement to check
the soundness of the party with whom one is dealing.
Unlike forwards or futures contracts, options allow the buyer, known as the option
holder, the right to terminate the agreement and hence are more flexible. Like forward
contracts the first use of option contracts pre-dates written records. There is an
account by Aristotle of Thales, a philosopher in ancient Athens, about the use of
options. While the account is meant to show the benefits of an understanding of
philosophical ideas, the story itself shows that the use of options for commercial
purposes was well established. The story is that, stung by critics as to why he was poor,
Thales used the insights he had developed through philosophy to make himself a
considerable fortune. Observing that the forthcoming olive harvest was likely to be a
good one, he travelled around Attica making contracts with olive press owners to hire
their facilities in the autumn. As he had little money, the contracts involved his being
given the right of first use for the press at a given price. He paid a small amount of
money for this option. In the event as he had anticipated the harvest was abundant and
Thales was able to exercise his option and hire out the presses at a profit to growers,
making him rich in the process. While Aristotle’s account may be exceptional, there is
good historical evidence elsewhere. For instance during the Shogun era, the Japanese
silk trade made frequent use of option contracts. Options also are often written into

commercial contracts. For instance, many contracts allow the buyer to cancel delivery
in exchange for a fee.
Prior to the initiative taken by the Chicago Board of Trade in 1973, options on fi-
nancial instruments had been traded in financial markets, but were considered
esoteric and of little significance. The existence of traded options plus the happy
coincidence of the publication of the Black–Scholes option-pricing model (BSOPM)
greatly accelerated the expansion of the market in financial options. BSOPM
provided a mathematical solution to the pricing of options based on two important
premises. First, that the value of an option can be modelled by looking at a replicat-
ing portfolio which has the same payoffs as the option, and second, the importance
of arbitrage forces in an efficient market. In the 1970s, financial institutions intro-
duced options on an ever-wider range of financial assets and sectors: currency
options, options on stock and other indices, options on interest rates and debt
securities to name but a few. In the 1980s financial engineers, that is mathematically
adept modellers of such contingent claims, were able to develop a range of options
with non-standard terms and conditions. These ‘exotic’ options offered features
such as average prices (known as average rate options), or fixed payoffs (binary
options), or under certain conditions ceased to have a value (that is, they were
‘knocked out’), and many more. More recently, a second generation of exotic
options has been created with names such as perfect trader that greatly expand the
opportunities available. Today, financial market users can find options to manage all
sorts of different risk characteristics. And if they cannot, they can ask a financial
institution to create one that exactly meets their needs.
Swiss Re and Mitsui Sumitomo Insurance Swap Catastrophic
Risks ______________________________________________________
In August 2003, Swiss Re, the reinsurance company, and Mitsui Sumitomo Insur-
ance of Japan entered into one of the world’s first catastrophe risk swaps. The
US$100 million transaction between the two insurance companies allows each
company to reduce its exposure to natural disasters, known in the insurance
industry as catastrophic risk, in its core market by passing on this risk to the
other party.
Under the agreement announced by the two firms, Swiss Re swapped US$50
million of potential insurance losses from North Atlantic hurricanes with the
same amount of protection given by Mitsui Sumitomo Insurance for a Japanese
typhoon.
According to a spokesperson at Swiss Re the key attraction was to swap future
potential insurance payouts on rare but devastating events. The likelihood that
the event would occur is about 2 per cent; that is, there is an expectation that
there will be one such event every 50 to 100 years. However, if such an event
happened, both insurers would be exposed to very large losses. Such events are
known as ‘peak risks’, insurance market jargon for the natural disasters that cost
insurance companies hundreds of millions in payouts.
The rationale from both sides is to provide an element of protection against the
very large exposures that the insurers have to such infrequent but costly

catastrophes and to diversify their risk. It leaves both insurers’ core business
unaffected.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Swaps in contrast to the other derivatives are a relatively recent innovation. The
first cross-currency swap was unveiled only in 1981 although there were instruments
with similar characteristics traded prior to this. The first interest rate swap to be
publicly traded followed in 1982. The market in swaps grew very rapidly throughout
the 1980s and the instrument became established as a class of derivative. The
difference between a forward contract and a swap is that, with the swap, there is a
multiplicity of cash flows. The two parties to a swap agree to exchange a set of
predetermined cash flows rather than the single cash flow from a forward contract
(this singularity also applies to futures and options). The development of an
agreement that exchanged a series of cash flows helped financial market users to
manage the risks of a given cash stream. As a result, market users can now swap
cash flows from equities and commodities as well as manage interest rates and
currencies. Additional non-standard features have been introduced to meet special
circumstances, such as swaps which have option elements and are callable or
putable.
The Risk Management Product Set __________________________
The different derivative instruments that are traded in financial markets are
often called the risk management product set because their main function is to
transfer risks. The market for derivatives deals principally with market risk (or
the risk that the price of the underlying variables will change over time) but
other risks, such as credit risks and catastrophic risks, are also traded. The
market in derivatives can be seen as a market in risk. By appropriately trading
the instruments, market participants can exchange risks and reduce their
exposure to undesirable economic factors. Instruments exist to manage interest
rate risks, currency risks, equity risks, and commodity risks as well as some
other specialised risks. The instruments used to manage these risks are:
Forward contract: A commercial contract between two parties to buy and
sell at a price agreed today which has the delivery or settlement of the contract
deferred until some mutually agreed date in the future (when the exchange then
takes place). Quantity and quality are specified when the forward contract is
initiated. Any contract where the delivery or settlement is later in time than
that which is normal for the market in the physical commodity, known as the
spot market, is a forward contract.
Futures contract: Functionally this is the same as the forward contract.
However, it differs because the contract is traded on an exchange, the contracts
are standardised for all users to facilitate trading, the contract will be between
the buyer and the exchange’s clearing house and the seller and the exchange’s
clearinghouse. The result is that the credit risk will be intermediated. In addi-
tion, both buyer and seller will be required to post a performance bond to
ensure that the can fulfil their obligation under the contract.

Option contract: This gives the holder (or buyer) of the option the right but
not the obligation to buy or sell the underlier at a specific price at or before a
specific date. While the option buyer (or holder) has the right to complete the
contract or not, the option seller (or writer) is obliged to complete the con-
tract if the holder requests it.
Swap contract: An agreement between two parties to exchange (or in
financial parlance, to swap) two different sets of future periodic cash flows
based on a predetermined formula.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
1.1.1 Fundamental Financial Instruments

Fundamental financial instruments exist in order to allow individuals to invest for
the future, to allow individuals and firms to raise capital and to borrow. In doing so,
these instruments or securities have a number of risks. For example, investors in a
firm’s shares are hoping that the management will be able to realise a profit. The
managers may be spectacularly successful or woefully unsuccessful in this regard. In
addition, the legal and economic structure of fundamental financial instruments is
designed to allow investors to modify and transfer risks as well as to address
contractual problems. An investor who holds all his wealth in just one company is
exposed to the risk that the business might underperform – or even fail. By creating
a company where ownership is split into shares, investors can spread the risk across
a great many companies. At the same time, firms can raise money from a large
number of individuals. By spreading their investment across a wide range of firms
investors can diversify and hence reduce the impact on their wealth of one particular
business failing. As a consequence, they can take more risk in their portfolios. The
legal contract also protects shareholders so that in the event of failure the most they
can lose is the money they invested. These contractual arrangements help savers and
borrowers to contract together and undertake economic activity.
On the other hand, derivatives are securities that obtain their existence from the
value of fundamental financial instruments. They mimic the performance of the
underlier. But unlike fundamental financial instruments, which are a necessary part
of the economic system, derivatives are redundant securities. For a firm to raise
capital, it will have to issue shares or borrow money. In theory all the benefits of
derivatives can be achieved through the use of fundamental financial instruments.
The reasons derivatives exist is that they provide an efficient solution to the
problems of risk transfer. Take the situation where a merchant wants to lock-in the
price of grain. The fundamental financial instrument solution would be to buy the
grain today and store it. For most businesses this is both costly and inefficient. Far
better to be able to buy in the forward market and lock in both delivery and price
today in anticipation of future need. Similarly with a seller: a farmer may wish to
take advantage of current high prices to lock in the selling price. Without the
existence of a forward market in his produce, this is impossible. So although
derivatives are technically redundant, they exist because they allow economic agents’
needs to manage their risks in an efficient manner. They are the least-cost solution
to the risk management process.

They also exist because there is a two-way market in risks. A buyer is exposed to
potential price increases, a seller to possible price declines. We can show their
positions in terms of risk profiles, as shown in Figure 1.1. The buyer and seller are
both exposed to the risk that the market price will change. For the buyer the main
concern is that the price will rise and future purchases will cost more. For the seller,
the main concern is that the price will fall and a future sale will generate less
revenue. The solution is for buyers and sellers to exchange their risks. This is what
derivatives are largely designed to do. That said, as with fundamental financial
instruments, derivatives can also be used – and are used – for other purposes: for
investment and speculation.
Position of buyer
+ Buyer gains if market price declines
Market price
M
Current price
Buyer loses if market price rises
–
Position of seller
Seller loses if market price declines
+
Seller gains if market price rises
Market price
M
Current price
Figure 1.1 Risk profiles of buyers and sellers

Buyers will gain if market price falls, but lose if price rises. Sellers will gain if market price rises,
but will lose if price falls
In the jargon of financial markets, the buyer would be considered to be short the risk, or having a
short position in the risk (or the market for the risk); the seller would be considered to be long
the risk, or having a long position in the risk (or the market for the risk).
1.2 Arbitrage Relationships

A key issue is how to determine the value of derivative instruments. By value one
means the price at which the agreement is reached (for instance the forward price
for delivery) and/or any payment required by one party to the other (this applies to
options). Prices of such instruments are set by arbitrage conditions. As discussed in
the previous section, derivatives are functionally redundant since they can be
replicated through the use of fundamental financial instruments. Consequently, the
value relationships that apply between fundamental financial instruments have a

critical role in determining the value of derivatives. Of equal importance is the

ability of market participants to create replicating portfolios using combinations of
instruments to mimic the value of derivatives. This ability to replicate allows market
participants to arbitrage between fundamental financial instruments (that is items
traded in the spot markets) and derivatives.
In an economically efficient market, assets or combinations of assets that have
the same payoffs should trade at the same price. In economics, classic deterministic
arbitrage involves market participants buying an asset at one price in one market and
simultaneously selling it at a higher price in another market thus enabling the
arbitrageur to realise an immediate risk-free profit.* The rule of thumb is to buy low
and sell high. For instance, if the exchange rate for sterling against the US dollar in
London was $1.75/£and in New York it was $1.74/£, in the absence of any market
imperfections which prevented it, an arbitrageur could sell pounds in London and
obtain $1.75 and buy pounds in New York at $1.74 netting a profit of 1¢ per pound
with little or no risk.† In an efficient market such, as that which characterises foreign
exchange, opportunities to arbitrage should be rare to non-existent. Economists
refer to the relationship where assets, or combinations of assets, which have the
same payoffs and hence should trade at the same price as the Law of One Price.
Arbitrage ensures that prices between different assets (and combinations of assets)
remain in the correct value relationship to each other.
It may take some thought and analysis to determine whether the price of two
assets or combinations of assets are in the correct arbitrage-free relationship to each
other. To be sure that the prices offer an arbitrage opportunity we need to know
what the prices should be. Hence, we need a pricing or valuation model. In finance
most models are valuation models since we want to know whether the asset, security
or portfolio is being valued correctly. That is, we want to measure our should be (or
theoretical) price against the actual market price.
For instance, if the current or spot market gold price is $400 per ounce, the for-
ward market price with one year delivery is $450 per ounce and the one-year interest
rate in US dollars is 4 per cent is there the possibility for arbitrage or are prices in the
correct relationship to each other? Or what if the spot gold price is $400/oz, the one-
year forward price is $400/oz and the one-year US dollar interest rate is 4 per cent,
does this present an arbitrage opportunity? In order to answer this, we need to be able
to set up a replicating portfolio to take advantage of any mispricing. The arbitrageur
would need to know if any element was mispriced. In order to know whether the
forward price was correct or not he would need a pricing model with which to
compare the actual price. For forward contracts the theoretical price (as determined
by the pricing model) is called the cost of carry. This is discussed in detail in Module 3.
* Note that in practice there may be some small residual risks involved. Also, the terms arbitrage and
arbitrageur have been much abused. Many speculative activities, such as betting on the outcome of
mergers and acquisitions, are termed arbitrage. Risk arbitrage as such activities are known has little in
common with the classic definition of deterministic arbitrage.
† Moving money from London to New York and back is virtually costless. The counterparties to the
transactions might worry about the arbitrageur’s credit standing but otherwise without the presence of
government regulations there is little to stop a market participant from exploiting the opportunity.
Hence in a competitive market it is unlikely to be present for long.

Suffice at this point to explain that with the forward price of gold at $450/oz, the
arbitrageur would want to buy the gold in the spot market, finance this by borrowing
dollars at 4 per cent and simultaneously agreeing to sell gold in one year’s time. The
payoff from this strategy, which is known as a cash-and-carry arbitrage, is shown in
the upper half of Table 1.1. On the other hand, with the forward price of gold in one
year at $400/oz the arbitrageur would want to undertake the opposite strategy:
borrow gold for a year and sell it, investing the proceeds at 4 per cent and agreeing to
buy gold in the forward market. This is known as a reverse cash and carry and is
shown in the lower half of Table 1.1.
Table 1.1 Arbitrage operations in gold

Cash-and-carry in gold $
At initiation
Sell gold in forward contract @ $450/oz
Buy gold spot at $400/oz (400.00)
Finance purchase by borrowing for 1 year 400.00
Net investment 0.00
At maturity
Sale of gold through forward contract 450.00
Repayment of borrowed funds (400.00)
Interest on funds at 4% (16.00)
Net profit 34.00
Reverse cash-and-carry in gold $

At initiation
Buy gold in forward contract @ $400/oz
Sell gold spot at $400/oz 400.00
Invest by lending for 1 year (400.00)
Net position 0.00
At maturity
Purchase gold through forward contract (400.00)
Loan 400.00
Interest on loan 16.00
Net profit 16.00
Note: it is possible to configure the transaction so as to extract the profit at initiation.
Note that the cash-and-carry and reverse-cash-and-carry strategies require us to

set up replicating portfolios using fundamental financial instruments. These portfo-
lios involve buying or selling in the spot market, borrowing or lending, and taking
the opposite position in the derivative.
If the price is above this replicating price we can expect many market participants
to set up cash-and-carry transactions and seek to buy gold in the spot market and

sell it in the forward market. Supply and demand will push down the price at which
buyers are prepared to transact in the forward market. In the same way, with the
price of the forward contract at $400/oz, market participants will seek to sell gold in
the spot market and buy it back in the forward market. The only price that would
prevent arbitrage is one where the forward price exactly equalled the replicating
portfolio price, namely $416/oz.
To summarise: in order to determine whether arbitrage is possible we need a
pricing model for the derivative that explains what the price should be. Equally, we
can consider that the only appropriate price for the forward contract is the price that
prevents arbitrage. Another way to look at it is to see that that the correct (or
theoretical) price is the reproduction cost of taking the opposite side of the transac-
tion. Knowing this provides a way of valuing such contracts. Another example will
help to make this latter point clear. In Table 1.2, we have the exchange rate and
relevant interest rates between sterling and the US dollar. At what rate would a bank
agree to undertake a forward foreign exchange transaction with a customer who
wished to buy £1 million and sell US dollars in 12 months’ time?
Table 1.2 Currency and interest rates for the US dollar and sterling
Market conditions
Spot exchange rate US$1.4500 = £1
Interest rates
1 year US dollar 4.00%
1 year sterling 5.00%
The reproduction approach requires us to create a replicating portfolio that is

risk-free to the bank. The agreement involves the bank paying (a) £1 million and (b)
receiving US dollars in exchange. We can do this by the bank (1) borrowing US
dollars in the money markets for one year, (2) buying the present value of £1 million
and selling dollars at the spot exchange rate and (3) depositing the sterling in the
money market for one year. At maturity, the deposited sterling (3) is repaid and is
used to pay (a) £1 million to the customer in exchange for which the customer gives
(b) US dollars which are then used to pay off (1) the dollars borrowed by the bank.
By correctly pricing the forward foreign exchange contract and trading through the
replicating portfolio, the liability is exactly matched. The bank needs to quote a
forward exchange rate of US$1.43619 to the pound. The replicating transactions are
shown in Table 1.3.

Table 1.3 Replicating transactions required to price a forward foreign

exchange contract
At initiation
US dollars Exchange Sterling
rate
Borrow $ 1 380 952.38 $1.4500 (952 380.95) Invest £
[1] [2] [3]
At maturity
Customer (1 436 190.48) $1.4362 1 000 000 Customer
pays receives
(b) (a)
Notes:
(a) customer buys sterling and (b) sells US dollars
[1] bank borrows US dollars at 4 per cent per annum which will be offset at the maturity of the
forward contract by the customer delivering US dollars (b)
[2] bank converts US dollars into sterling at the spot exchange rate of $1.4500
[3] bank invests the sterling at the one-year sterling rate of 5 per cent. At maturity, sterling will be
used to pay the customer (a)
In practice, the bank can simply price the forward foreign exchange contract
using the interest rate parity relationship for the forward foreign exchange rate:
1+ ﴾1.1﴿
=
(1+ )
where is the forward rate at time t, and are foreign (quoted currency) and
domestic (base currency) interest rates respectively for the currency pair for the time
period t. Equation 1.1 gives the same result as the replicating portfolio calculations
in Table 1.3 and can be considered an arbitrage-free pricing model for the forward
foreign exchange rate. In fact, the interest rate parity model is a variant of the cost
of carry model discussed earlier in the context of the gold price, which is also, as we
have seen, an arbitrage-free pricing model.
1.2.1 Dynamic Arbitrage

Not all arbitrage operations can be undertaken simultaneously. Consider the
following situation. Take a contingent claim (an option to purchase a share) which
has an agreed purchase price of $90 after two years. The current share price is $100.
We don’t know what the price of the shares will be in two year’s time. We do know
that if the share price is less than $90, the holder of the contingent claim will not
exercise their right of purchase and instead will buy at the then prevailing lower
market price. Given this uncertainty, we cannot simply buy the shares now and sell
them to the contingent claim holder at maturity. Let us now assume that an investor
is willing to pay $25 for this contingent claim. Is there an arbitrage opportunity?
We need to know something about how the share price might behave between
now and two years’ time. Keeping things simple, we know that at t=1 the share

price might rise to $120 or it might fall to $80. If it rises to $120 at = 1, at = 2 it

might subsequently rise again to $140 or fall back to $100. If on the other hand it
falls to $80 at = 1, at = 2 the price might recover to $100 or continue its fall to
$60. The possible price paths for the share are given in Figure 1.2.
Value of contingent
t=0 t=1 t=2 claim (S – K)
140 50
120
100 100 10
80
60 0
Figure 1.2 Possible price paths for the share

The value of our contingent claim will therefore depend on the possible price
paths between now and year 2. Its current value is the difference between the
market price for the shares and the price at which the claim can be exercised. The
current price is $100 for the shares and the price at which the shares can be pur-
chased is $90, so the claim must be worth at least $10. That is the claim must be
worth a minimum of (S − K) where S is the share price and K is the price at which
the share can be purchased. Since the contingent claim is an option, if the share
price is below K, the investor will not exercise the right of purchase and abandon
the claim. So the payoff (S − K) is bounded on the downside at zero. The payoff
will be the maximum of (S − K), or zero. Depending on the future price behaviour
the value of the contingent claim will be:
Share price at t=2 140 100 60

Contingent claim value 50 10 0
As with the earlier examples, the arbitrageur will want to sell the overpriced ele-
ment and hold the correctly priced one. In this case it involves selling the contingent
claim and holding the arbitrage or replicating portfolio. At initiation, the arbitrageur
will have sold one contingent claim and will take a fractional investment of 0.6985
shares plus borrowing 48.32.* Interest rates are 4 per cent per annum. The position
at t=0 is given in Table 1.4.
* The fractional investment, known as delta (Δ), is determined by the ratio of price change in the
derivative if the share price rises or falls to that of the underlier, namely:
− ﴾1.1﴿
=
−
The share price range is 120 − 80 and the value of Δ is .6985 so the value ( − ) is 27.94. To
solve for Δ we need to know the value of the contingent claim at t=1 for both the up move (U) and

Table 1.4 Arbitrage position at t=0

Component Value
Buy 0.6985 of a share (69.85)
Borrow 48.32
Sell contingent claim 25.00
Net position/gain 3.47
Arbitrageur has sold one contingent claim and set up a replicating portfolio to deliver the
commitment to sell, if required, under the claim
What happens at the end of year one? The arbitrageur does not know whether
the share price will go up or down. However, the portfolio will need to be re-
balanced at t=1. After one year, if the share price has risen, the required fractional
holding needs to be increased (in this case to one, or one share). If the share price
has fallen, then the fractional holding needs to be reduced (in this case to 0.25 or a
quarter of a share). The net value of the position at t=1 when the share price has
either risen or fallen and after rebalancing is shown in Table 1.5.

Component Share price
120 80
Value of fractional holding in share from 83.82 55.88
t=0
Required fractional holding in shares 1.000 0.2500
Required additional holding .3015 (.4485)
Adjustment to share position 36.18 (35.88)
[A] Total position in shares 120.00 20.00
Original borrowing (48.32) plus interest 50.29 50.29

at 4%
Additional borrowing/(repayment) 36.18 (35.88)
[B] Net borrowed funds 86.47 14.41
[A − B] Value of position (contingent 33.53 5.58

claim)
Arbitrageur rebalances the replication portfolio established at t=1. If the value of the shares has
risen, the arbitrageur increases the fractional holding in the shares; if the share price has fallen, the
arbitrageur reduces the fractional holding in the shares.
the down move (D). We can only find this by solving first the value of the claim at t=2 and working
backwards to find the theoretical (or arbitrage free) price of the claim at t=1, knowing its value at t=2.
The value of the position in Table 1.5 in the upper node is 33.53 and the lower node is 5.58. So for
t=0, the appropriate fractional investment to take in the share is:
33.53 − 5.58
= = .6985
120 − 80

At maturity, the contingent claim’s value will depend on how the share price has
performed between the first and second year. As Figure 1.2 shows there are three
possible outcomes. The result of the replicating portfolio is given in Table 1.6.
As Table 1.6 shows by following the replicating strategy, regardless of the out-
come at maturity, the arbitrageur has exactly the required amount of money to pay
off the value of the contingent claim. With the share price at $140 and the exercise
price of $90 the contingent claim seller has to deliver a security worth $140 for $90.
Buying the security in the market at $140 but selling at $90 means a loss of $50. The
replicating strategy has delivered a profit of $50 so the arbitrageur walks away
without loss.

Component Share price
140 1001 60
[A] Portfolio from t=1 140 100
when share = $120
[B] Borrowing (86.47) 90 90
plus interest at 4%
[A − B] Net value of position 50 10(a)
[A] Portfolio from t=1 25 25

when share = $80
[B] Borrowing (14.41) 15 15
plus interest at 4%
[A − B] Net value of position 10(b) 0
Payout on contingent claim 50 10 0

Net position of arbitrageur 0 0 0
Possible outcomes depending on the share price at t=1

1 Note that either outcome (a) or (b) occurs depending on what happens at t=1
As with the earlier examples for gold and the forward foreign exchange transac-
tion, the theoretical or arbitrage free price thrown up by the model for the
contingent claim is the price that exactly compensates the contingent claim seller for
replicating the payoff of the claim. This means the correct theoretical price for the
contingent claim should have been $21.53. Market forces will lead arbitrageurs to
sell contingent claims if the market price is above the theoretical price and buy them
if it is below thus forcing convergence to the theoretical price.*
The model for valuing a contingent claim is known as a conditional arbitrage
model and requires the arbitrageur to rebalance the replicating portfolio as the value
of the underlier changes. This conditional arbitrage model is the basis of all standard
* As with the cost-of-carry example, if the price of the contingent claim is below that of the replicating
portfolio, the arbitrageur will buy the contingent claim and sell the replicating portfolio (going short
the shares and lending) and rebalancing at t=1.

option pricing models where the value of the option is determined by reference to
its replicating portfolio. For this reason such pricing models are often called
arbitrage pricing models.
An important corollary of the replicating portfolio approach is that the contin-
gent claim seller, who has the obligation to deliver under the contract, is indifferent
to the price behaviour of the underlier. Hence risk preferences do not affect the
pricing of these claims. As the position is risk-free, it will earn the risk-free rate of
interest and this means that complications about risk-adjusted discount rates can be
ignored when working out the present value of the portfolio.
Note another outcome of the modelling process: even without an arbitrage op-
portunity, the dynamic replication strategy allows the contingent claim seller to
manage the risk from selling the contract. In the example above, once the vendor
has received $21.53 for the contingent claim, by following the dynamic replication
strategy, the writer has eliminated all risk.*
1.2.2 Impediments to the Law of One Price

In an efficient market there are no impediments to prevent smart market partici-
pants exploiting the fact that if there are two assets or packages of assets that have
the same payoff and which have different prices then arbitrage can be undertaken.
In order to determine whether there is a profitable arbitrage opportunity, the market
participant may have to undertake sophisticated modelling to determine whether he
can construct a replicating portfolio synthetically via a combination of fundamental
financial instruments. Given the potential rewards from arbitrage, market partici-
pants will devote time and effort to constructing replicating portfolios in order to
exploit incorrect prices.
How realistic is it for market participants to undertake such arbitrages? The repli-
cating portfolio is almost the same as the asset or contingent claim being replicated.
To the extent that the model has non-realistic assumptions when applied in practice
then the values of the two may differ. Arbitrageurs and contingent claim vendors
are always seeking to improve the accuracy of their models. However, the real world
departs from that of the models. In particular, transaction costs affect the result and
are not a feature of most theoretical models. In the case of our dynamic replication
example, the arbitrageur does not know in advance whether at t=1 more shares will
be purchased or sold – and how many. Hence transaction costs will affect the
exactness of the result.
Other real world market imperfections or frictions can also affect the result. One
possible problem is contractual uncertainties. For instance, when a market partici-
pant sells shares he does not own, these have to be borrowed. Generally shares can
only be borrowed for a short period (days or weeks). Hence the maturity of the
* In practice of course the model is only a representation of reality and to the extent that actual market
behaviour differs from that assumed in the model the writer will have an element of residual risk.
Hence a prudent writer will charge more for the option to cover himself. But to the extent that actual
and model behaviour converge, competition for business in financial markets will drive down the
prices of contingent claims towards their theoretical values.

contingent claim being replicated may differ from the transactions that underpin the
replicating portfolio. There are other complications from stock borrowing. The
stock lender may require a haircut (or prudential deposit) so that the short seller
does not receive the totality of the value of the short sale. Also, it is the case that
borrowing and lending rates differ.
Another issue is taxes. The assumption of most models is that there are no taxes.
In practice, the tax treatment of the gains and losses from the written leg of the
position (the contingent claim sold to the investor) might be treated differently from
that of the components of the replicating portfolio. So one may not be able to offset
the other leading to unanticipated losses. Another factor is the periodic apparent
irrationality of financial markets. For instance, in periods of disturbance or stress,
pricing relationships can break down leading to unanticipated losses.* Yet another
factor that can make arbitrage hazardous are differences in information between
market participants. Prices at which transactions are made may not reflect the true
intrinsic value of the instruments being traded.
The result is that while the pricing models that are used to compute the theoreti-
cal or fair value of a derivative have been shown to be good representations of the
actual market prices of such instruments, the models are not quite the same thing as
the derivatives themselves. This always needs to be kept in mind when considering
the analysis of such models. Nevertheless, the arbitrage principle is a powerful tool
for both analysing derivatives and explaining the observed prices of such instru-
ments in financial markets.
1.3 Derivative Markets

Derivatives are traded in financial markets. We can distinguish two types of markets
and instruments: exchange-traded and over-the-counter (OTC) markets. Exchange-
traded instruments are bought and sold through an organised exchange. For
example, in the UK, the major exchange for financial derivatives is Euronext-LIFFE.
On this exchange, interest rate, equity and commodity derivatives are traded. In
order to facilitate trading products are standardised. For instance, all the options
traded on a particular underlier will have the same terms. The exchange will fix the
number of units in the underlier, the maturity dates and the exercise prices for the
options, where and when the underlier is to be delivered. These are laid out in the
contract specifications. The only factor that will vary will be the price at which the
options trade. Transactions either are executed on the trading floor or – as with
Euronext-LIFFE – through screen-based trading systems. The exchange controls
how trading is organised and regulates the activities of traders, who have to be
registered with the exchange. The way trading and other elements of the settlement
process are organised means that market participants have virtually no credit risk.
In contrast OTC markets involve bilateral transactions between market partici-
pants. Since these are negotiated directly between the parties involved, it is possible
* A good example is the collapse of Long-Term Capital Management (LTCM). See Roger Lowenstein
(2001), When Genius Failed, New York: HarperCollins Publishers.

to offer non-standard products. Unlike exchange-traded products that have to be

standardised to ensure liquidity, OTC markets can offer great flexibility to users. All
terms can be negotiated and customised to meet the needs of the parties involved.
However, since contracts are negotiated directly between the two parties, OTC
transactions are subject to credit risk. This means that only counterparties with a
good credit reputation are acceptable as counterparties although mechanisms similar
to those used for exchange-traded products can be used to alleviate this problem.
Plus since the contracts are customised, it is not easy to unwind or cancel such a
contract after it has been agreed.
Derivatives Markets Terminology ____________________________
Derivatives markets are replete with their own, sometimes esoteric, terminolo-
gy. Some of the more common terms are given below.
Cash market: The market in fundamental financial instruments or physical
goods. Also called the spot market.
Derivative or derivative instrument or security: A contract whose payoff
and hence value is determined by the price of another underlying asset. Also
referred to as a contingent claim.
Contract specifications or characteristics: The terms detailing the quality,
size, price and delivery terms of a derivatives contract. For over-the-counter
markets these might differ between transactions, for exchange-traded contracts
only some elements are negotiable.
Underlier: the fundamental financial instrument, portfolio, or physical asset,
from which the derivatives contract obtains its value.
Delivery: Procedures for settling the payment and receipt of the underlier at
maturity or upon exercise. Some contracts do not involve a transfer of the
underlier from seller to buyer and settle by paying the difference between the
contracted price and the delivery price.
Clearinghouse: The institution which, as it names suggests, organises the
settlement of transactions and, for exchange-traded derivatives, acts as the
counterparty to all transactions.
Long or long position: A situation where a market participant either currently
holds the underlier or will need to purchase the underlier in the future. Hence a
purchaser of a forward or futures contract who is contracted to receive the
underlier at the maturity of the contract is deemed to have a long position in
the contract.
Short or short position: A situation where a market participant either
currently has sold the underlier short or will need to sell the underlier in the
future. Hence a seller of a forward contract who is contracted to deliver the
underlier at the maturity of the contract is deemed to have a short position in
the contract.

Holder. The buyer of an option. The buyer has the right to exercise the option
and complete the transaction if it is advantageous to do so. That is, the buyer
‘holds’ the rights from the option.
Writer: The seller of an option. With a call option the writer has to sell at the
strike price, with a put the writer has to buy at the strike price. Hence the
seller has written the right of exercise.
Exercise: To activate the right to purchase or sell given by an option.
Exercise price or strike price: The contracted price (or rate) at which an
option holder can execute or complete the transaction.
Expiration: The point at which a derivatives contract ceases to exist, that is it
expires. Also called maturity.
Life: The length of time a derivatives contract is in force. Also called the tenor.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
1.4 Uses of Derivatives

As discussed above in Section 1.2.2, market participants need fundamental financial
instruments to borrow and lend. As we have seen, derivatives can be replicated
using combinations of fundamental financial instruments. That said, derivative
instruments provide an efficient or least-cost means of undertaking many financial
activities. Their ability to meet the many different needs of market users reinforces
their importance in the financial system. This section examines the different uses to
which market participants put derivatives.*
1.4.1 Risk Modification

The fundamental justification for the existence of derivatives is their ability to
modify risks. Consider the following situation. An investor can either buy a share
with a current value of $100 or purchase an option to buy the share for $4. With the
option the investor has the right to buy the share in six months’ time at $100. What
are the possible outcomes? Let us assume that the share can be worth either $120 or
$80 in six months’ time. With the immediate share purchase, the investor can either
gain or lose $20 depending on the outcome. With the option, however, the inves-
tor’s maximum loss is $4, the cost of the option. Only if the share price is at $120 in
six months’ time will the investor exercise his right to buy at $100. Then his gain will
be $120 − $100 − $4, or $16. By buying the option rather than the share the
investor has modified his risk. The maximum loss is now limited. In like fashion all
derivatives allow users to modify their risks. This ability to modify risk is a key
characteristic of derivatives and justifies their position within the financial pantheon.
* Of course the total market activity recorded for particular types of derivative will represent the sum of
the different uses that market participants have for the particular instruments.

Note that risk modification can involve taking more risk rather than reducing risk.*
If the investor had wanted to take more risk then he could have written the option!
1.4.2 Hedging
Hedging is a special case of risk modification that has as objective the elimination of
all risk. While risk modification changes the nature of a risk but may not eliminate it
completely, with hedging the intention is to remove the source of risk. For instance,
a company is selling its product abroad. The currency in which the buyer negotiates
is not the operating currency of the seller. Once the contract is struck, the seller is
faced with the fact that due to the time lag between agreeing terms and receiving
payment there is a risk that the exchange rate will have changed. Derivatives provide
a simple solution to this problem. In this case the seller can agree a forward foreign
exchange contract with a bank to sell the foreign currency and buy the domestic
currency. In this way the company has hedged its exchange rate risk on the sale. The
intention when entering the forward contract is to reduce the unwanted exchange
rate risk to as little as possible. This will be zero in this case as the forward foreign
exchange contract exactly matches and offsets the foreign currency position. In
other cases, the fit might not be so exact and the hedge will be imperfect. Neverthe-
less, the intention when using derivatives for hedging is to obtain the maximum
protection from the source of risk even if there is some residual risk. With an
imperfect hedge, some protection is better than none at all.
1.4.3 Speculation
Speculation is risk modification designed to benefit from exposure to a particular
risk. Take the situation where a market participant has a view that as a result of
tensions in the Gulf region, the oil price will increase. Strategy one is to buy crude
oil in the spot market. There are significant disadvantages to this strategy if the only
reason for buying oil is to profit from an anticipated increase in price. Oil is a bulky
commodity and will have to be stored, and this can be costly. It is also necessary to
find a buyer for the oil when the anticipated price increase has taken place. Far
simpler from the speculator’s perspective is to buy crude oil futures. That is,
exchange-traded contracts that fix the price at which crude oil can be bought and
sold at a specific date in the future. These have the same economic exposure to
changes in the spot price for crude oil but none of the disadvantages of physical
ownership. In fact by using futures, which are highly liquid instruments, the
speculator can immediately take a position in the crude oil market (the underlying
risk factor) and sell it again without worrying about finding a seller, storage or an
eventual buyer. The costs of setting up a position to take advantage of a rise in the
crude oil price in the futures market will be far less than the costs of setting up a
similar trade in the spot market. That means that even a relatively small increase in
the crude oil price will make money for the speculator. So while derivative markets
* The emphasis of this course will be on how derivatives can modify risk and, in particular, how they are
used for risk management. This focus builds on the principles and processes of the eMBA elective
Financial Risk Management.

are designed to manage risks, they do allow the more adventurous to benefit from
assuming risk. In this case, the speculator is taking the risk that oil prices do not rise
as anticipated! The existence of speculative activity in derivative markets acts to
increase the pool of capital available for the market and to increase the supply of
counterparties thus increasing the market size for market participants who are
natural hedgers.
1.4.4 Arbitrage
Arbitrage operations aim to exploit price anomalies. The basic mechanisms have
been described in Section 1.2. The existence of derivatives provides arbitrageurs
with more pricing relationships that can be exploited if the prices move away from
their correct relationships. For instance, if the prices at which options are traded
differ from their theoretical value, arbitrageurs will step in to exploit this fact. Take
the situation where a call option on a share with an exercise price of $100 is trading
at $4.5 and the corresponding put (with the same exercise price) is trading at $2.7.
The current share price is $102. The options have 3 months to maturity (expiration)
after which they are void. The three months interest rate is 4 per cent per annum. A
trader can arbitrage the mispricing of the call and the put. The trader buys the call
for $4.5, sells the put at $2.7 and sells the share for $102 and invests the present
value of the $100 exercise price (this is $99.02). The net gain from this is $1.18. At
maturity one of two situations arises. If the share price is above $100, the arbitrageur
exercises the call by using the invested funds and receives the share. This share is
then returned to the stock lender. If the share price is below $100, the call is
abandoned. Having written the put the arbitrageur is now contractually committed
to purchasing the share for $100 when its market price is less than this. The holder
exercises the put and the arbitrageur pays for the share he is obliged to receive using
the invested funds. Again the share is returned to the stock lender. Whatever the
outcome, the arbitrageur nets a $1.18 from the transaction without having to invest
any of his own money.
1.4.5 Spreading
Spreading involves taking advantage of – or limiting the impact of – price changes
between two assets. Hence it can be either for speculative purposes or for risk
management. Extending the oil speculator example in Section 1.4.3, now the
speculator has a view that the margin between unrefined crude oil and its refined
products (unleaded gasoline and heating oil) is likely to increase due to refining
capacity shortages. He wants to take advantage of this fact. One possibility, as with
the simple directional crude oil transaction, is for him to sell crude oil and buy
unleaded gasoline and heating oil in the spot market. But this is even more compli-
cated than the simple strategy of buying crude oil on the expectation that its price
will rise. It is far simpler for the speculator to deal in energy futures contracts.
Contracts exist for crude oil and its refined elements, unleaded gasoline and heating
oil. By buying futures in the refined products and selling the crude oil futures, the

speculator is anticipating a widening their price relationship.* If he is correct,

regardless of whether the crude oil price goes up or down, the speculator will make
money. This is an important feature of spread trading. The profit (or loss) from the
spread transaction is not dependent on absolute price levels but on changes in the
price relationship between the two assets. Using derivatives for spreading reduces
the cost and complexity of setting up transactions designed to exploit or hedge
changes in this relationship. Hence derivatives are the instruments of choice for this
type of transaction. In fact, to use the spot or physical markets to exploit these
spread relationships, speculators would have to anticipate very significant changes in
their relative prices to compensate for transaction and other costs.
1.4.6 Decreasing Financing Costs

Derivatives allow users to modify their risks. They can help firms decrease their
financing costs. Take the situation where a company can either borrow in its own
country and lend the money to its foreign subsidiary or the subsidiary can borrow in
the local currency. In the case where the subsidiary borrows locally, the local income
will service the debt. In the case where the parent supplies the funds, the local
income has to be exchanged for the currency of the parent company. The company
is likely to be able to borrow in its own country on much finer terms because it is
better known and respected than in the foreign country where it is less well known.
By borrowing locally it is paying more (but eliminating the exchange rate risk on the
borrowing). The company would benefit if it could borrow in its home country and
yet lend in the local currency of its subsidiary. This is precisely what cross-currency
swaps allow firms to do. They can raise finance in the cheapest market and currency
without having to worry about the exchange rate risk. The cross-currency swap
converts the borrowed currency into the desired currency while at the same time
eliminating the exchange rate risk. Firms can reduce their financing costs because
derivatives are available to manage undesirable financial risks.
1.4.7 Tax and Regulatory Arbitrage

Under UK laws, individuals and firms have the right to organise their affairs to
minimise the amount of taxes they pay. Derivatives allow firms to manage their tax
liabilities. For instance, a firm that borrows money from a bank may not know what
its future interest rate cost will be. Interest expense is normally tax deductible, but
only if there is sufficient profit. The firm therefore may be exposed to unanticipated
increases in borrowing costs that it cannot offset against its profits if these are not
large enough. It may therefore want to fix the total interest charge it pays so as to
ensure that it can take advantage of the interest rate tax shield. The firm can do this
using derivatives. By entering into a forward rate agreement the firm can fix the
amount of interest it will pay for a given period without having to renegotiate its
* This margin is known as the crack spread. That is, the difference in price between the unrefined and
refined products which represent the refiner’s costs and margin from ‘cracking’ the crude into its
constituents. A refiner might be interested in protecting this margin and hence would undertake a
crack spread designed to lock-in a fixed margin if it was of the view that excess refining capacity was
likely to depress margins.

borrowing from the bank. The contract converts an uncertain future interest
expense into a fixed or certain expense.
In a similar manner to the firm’s management of its tax deductibles, banks and
other regulated financial institutions can manage the amount of regulatory capital
required to support their business. One way of doing this is to use derivatives.
Banks have to allocate more capital against loans to commercial enterprises than for
loans to governments and state entities to cover against the potential default risk.
This means banks are limited in the amount of lending they can make to commercial
firms without raising more capital. Banks can use derivatives to reduce the amount
of capital required to lend to commercial enterprises. By using a credit derivative,
the bank buys insurance against default. As a result financial regulators are prepared
to allow banks which have lent to commercial enterprises and used credit derivatives
to transfer the default risk to allocate less capital to such loans.
1.4.8 Completing the Market

Finance theory suggests that it should be possible to construct unique payoffs for
every future possible state of the world. Take the simple example given in Table 1.7
that assumes there are only two possible outcomes and two available securities.
Table 1.7 Complete market

Security Price State of nature
1 2
B 9 10 10
M 13 10 20
By holding judicious combinations of security B and M, a financial engineer can

create portfolios which have a positive payoff in one state and zero payoff in the
other. The cost of setting up a security with a payoff of 1 in state two will be 0.4 and
that for state one will be 0.5.*
In that sense, the two available securities B and M ‘span the market’ and the
market can be considered complete. If, on the other hand, as given in Table 1.8,
* The replicating portfolio will be created by finding the appropriate value for Δ such that the portfolio is
risk-free with in state one a net value of zero and in state two a net value of one. This is obtained by:
1−0
= = .1
20 − 10
And setting up the replicating portfolio, such that:
20 − (1 + ) = 1
10 − (1 + ) = 0
Where B is the amount of borrowing at the risk-free rate (which is 11.11 per cent). The cost now of
setting up such a portfolio will be:
13 − /(1 + ) = .4
In like fashion, the cost of setting up a replicating portfolio with a payoff of 1 in state one and zero in
state two is 0.5.

there are three states of nature and only two securities, then the market is incom-
plete.
Table 1.8 Incomplete market

Security Price State of nature
1 2 3
B 9 10 10 10
M 13 9 11 13
The market could be completed by adding a third security, such as a derivative that
had a positive payoff in one of the states but a value of zero in the others. Then the
available securities would span the market and it would be complete and it would be
possible to construct a replicating portfolio that generated a positive value in one state
and zero in the others.
While this analysis is largely theoretical and based on a simple example, the ability
of derivatives to help complete the market provides an important justification for
their existence.
1.5 Learning Summary

Derivatives are contracts specifically designed to manage risks. Although technically
redundant securities since they can be replicated using fundamental financial
instruments, they provide an efficient means for market participants to manage and
transfer risks. Their importance in this role continues to increase and they have
become an important element in modern financial markets. While some, such as
futures and swaps, are relatively new classes of instruments others such as forward
contracts and options have always been a feature of commercial life. The great
expansion over the last 30 years or so in derivatives on fundamental financial
instruments is due to changes in the financial system and theoretical developments
in our understanding of how these instruments can be valued.
A key principle of valuation in an efficient market is the ability of replicating
portfolios made up of fundamental financial instruments to provide the same
payoffs as derivatives. Under the Law of One Price, two assets or combinations of
assets with the same payoffs should have the same price. This identity between the
derivative contract and a replicating portfolio with the same payoffs as the derivative
is enforced by arbitrage. While this theoretical understanding provides the ability to
price derivatives, frictions in real world financial markets may lead to divergences
between theoretical arbitrage-free prices and actual market prices for derivatives.
Derivatives are traded either on organised exchanges with specific rules and a
significant degree of investor protection or directly between market participants in
the over-the-counter markets. In the later case, market participants have to take into
consideration the credit risk of the counterparty to the transaction. Exchange-traded
contracts have standardised terms and conditions, OTC derivatives can be custom-
ised as required.

Derivatives provide market participants with not just the opportunity to modify
risks, but also to engage in speculation and to undertake transactions that would
otherwise be problematical when undertaken using fundamental financial instru-
ments. These include such benefits as reducing financing costs and taking advantage
of tax benefits and regulations.
Review Questions
Multiple Choice Questions
1.1 Which of the following is correct? The forward market that existed in the Netherlands
at Antwerp in the 14th century was a market for:
A. Grain and other agricultural produce.
B. Tulip bulbs.
C. Currencies.
D. Wool and cloth.
1.2 Which of the following best describes the nature of a forward contract? With a forward
contract, the two parties agree to:
A. exchange an item of a specific quality for cash at a future predetermined date.
B. exchange an item for an agreed amount of cash at a future predetermined date.
C. exchange a given amount of an item for an agreed amount of cash at a future
predetermined date.
D. exchange a given amount of an item of a specific quality for an agreed amount
of cash at a future predetermined date.
1.3 If you have a ____ sensitivity to changes in market prices, you would be said to be
____ and would benefit from an ____ in the market price. Which is correct?
A. positive long the risk increase
B. positive short the risk decrease
C. negative long the risk decrease
D. negative short the risk increase
1.4 Which of the following correctly describes a futures contract?

A. A futures is an instrument whose value depends on the values of other more
basic underlying variables.
B. An exchange-traded contract to buy or sell a specific amount of an asset or
security for a specific price or rate on a specific future date.
C. An agreement to buy or sell an asset at a certain time in the future for a certain
price (the delivery price).
D. All of A, B, and C.

1.5 What is the economic difference between forward contracts and futures?
A. There is no economic difference between forward contracts and futures.
B. Futures are only available on some underlying assets, whereas it is possible to
trade any asset with forward contracts.
C. Futures contracts are traded on an exchange and have standardised terms and
conditions whereas forward contracts are traded over-the-counter and have
negotiated terms.
D. Both B and C explain the economic difference between forward and futures
contracts.
1.6 Which of the following is correct? A swap is:

A. An agreement between two counterparties to exchange two different sets of
future periodic cash flows.
B. The spot purchase or sale of a commodity combined with the simultaneous
sale or purchase of the same commodity in the forward market.
C. The sale of one security to purchase another.
D. None of A, B, or C, correctly defines a swap.
1.7 Which of the following is correct? An exotic option is:

A. an option to exchange currencies where one of the currency pair is an
emerging market country.
B. an option which has non-standard terms and conditions.
C. an option-like feature that has been incorporated into a security.
D. an option that is not traded on a derivatives exchange.
1.8 Which of the following is correct? The major impediment to market participants using
forward contracts is:
A. The reputation and credit standing of the counterparty on the other side.
B. The lack of counterparties willing to enter the other side of the transaction.
C. There are no transactions available with the right maturity.
D. All of A, B and C.
1.9 Which of the following is correct? Fundamental financial instruments are:

A. a set of redundant securities issued by firms to investors.
B. required by firms in order to raise capital and borrow money.
C. those replicating transactions used to model the payoff of contingent claims.
D. another name for the risk management product set.
1.10 Which of the following is not deterministic arbitrage?

A. You borrow in euros and lend in dollars and buy dollars in the forward market
to exploit a mispricing opportunity in the market.
B. In a takeover situation, you buy the target company’s shares and sell the
bidder’s company shares to exploit a mispricing opportunity in the market.
C. You sell gold in London and simultaneously buy gold in Los Angeles to exploit a
mispricing opportunity in the market.
D. You sell crude oil futures and buy crude oil in the spot market to exploit a
mispricing opportunity in the market.

1.11 Which of the following is correct? Dynamic arbitrage requires that:

A. the derivative that is sold and the offsetting arbitrage transactions have the
same value at maturity.
B. the payoffs at maturity of the element that has been sold is less than that of the
purchased element.
C. the composition of the replicating portfolio be adjusted over time in response
to changes in the derivative price.
D. the replicating portfolio is rebalanced over time to maintain the correct
relationship to the derivative being arbitraged.
1.12 Which of the following is the correct definition of a replicating portfolio?

A. A package of securities and borrowing or lending designed to give the same
payoff as another financial security.
B. A portfolio of securities designed to meet a specific investment objective or
target.
C. A package of fundamental financial instruments and derivative securities
designed to meet a specific investment objective or target.
D. A portfolio of fundamental financial instruments and derivative securities
designed to eliminate risk.
1.13 Which of the following is not a fundamental financial instrument?

A. A share.
B. A call option on a share.
C. A bond.
D. A bank loan.
1.14 The spot price of a commodity is $1200 and its forward price in one year is $1255. The
one-year interest rate is 4 per cent per annum. Which of the following is correct? An
arbitrageur can create a replicating portfolio by:
A. borrowing and buying the commodity in the cash market and buying the
forward contract to give a profit of $55.
B. selling the commodity in the cash market and investing and buying the forward
contract to give a profit of $7.
C. borrowing and buying the commodity in the cash market and selling the
forward contract to give a profit of $7.
D. selling the commodity in the cash market and investing and selling the forward
contract to give a profit of $55.

1.15 The spot exchange rate between sterling and the US dollar is $1.7425/£. The six-month
interest rate is sterling is 3.75 per cent per annum and that in US dollars is 2.5 per cent
per annum. The six-month forward foreign exchange rate is $1.7385. Which of the
following is correct? An arbitrageur can create a replicating portfolio by:
A. borrowing US$1.7425 million for six months, exchanging it at the spot
exchange rate into sterling, investing the sterling, and selling sterling at the
forward exchange rate to make a net profit of $6650.
B. borrowing £1 million for six months, exchanging it at the spot exchange rate
into US dollars, investing the dollars, and selling the dollars at the forward
exchange rate to make a net profit of $6650.
C. borrowing US$1.7425 million for six months, exchanging it at the spot rate into
dollars, investing the dollars, and buying the dollars at the forward exchange
rate to make a net profit of $6650.
D. borrowing £1 million for six months, exchanging it at the spot exchange rate
into sterling, investing the sterling, and buying the sterling at the forward
exchange rate to make a net profit of $6650.
1.16 Which of the following is correct? In the context of derivatives markets, hedging can be
considered to be a special case of:
A. arbitrage that involves taking no risk on delivery.
B. risk reduction where the intention is to eliminate all risks.
C. speculation where the intention is to take on as much risk as possible.
D. financial engineering that involves taking no model risk.
1.17 The general rule for undertaking arbitrage is this: ____ and ____ which means, in terms
of derivatives, ____ a derivative instrument when its price is ____ its theoretical or fair
value price. Which of the following is correct?
A. buy low sell high selling above
B. sell low buy high buying below
C. buy low sell high buying below
D. sell low buy high selling above
1.18 Why might you not wish to undertake an arbitrage transaction despite the fact there
appeared to be a profitable opportunity available?
A. There are uncertainties surrounding the model used to evaluate the arbitrage
opportunity which might lead to a loss rather than a gain.
B. There are timing differences in the nature of the two sides of the arbitrage
opportunity which might lead to a loss rather than a gain.
C. The tax treatment of the gains and losses may differ and one may fail to offset
the other which might lead to a loss rather than a gain.
D. All of A, B and C might lead to a decision not to arbitrage an apparently
profitable opportunity.

Case Study 1.1: Terms and Conditions of a Futures Contract

1 You have been asked to research and propose a new futures contract on pepper.
Pepper is a consumption commodity and is a major additive to food both during
preparation and at the table and, by weight, is an expensive commodity. Lay out the
specifications of the contract giving all the important elements you would need to
include in the contract so that potential users would know exactly what is being traded.

Financial Instruments
There is an economy which has only two possible futures states or conditions. Either
economic conditions will be good, or they will be poor. Two fundamental financial instruments
or securities exist in this economy which are used to finance operations; we can consider
these to be debt and equity.
The current or market prices of the two securities or fundamental financial instruments
available in the market are given below and the values that they may have in one year’s time,
depending on the state of the economy:
Time t=0 t=1

Security Under good Under poor
conditions conditions
Security 1 (debt) 100 105 105
Security 2 (equity) 60 120 30
1 Create two derivative securities from these fundamental financial instruments.

1. A derivative security that will provide a positive return under good market condi-
tions, but no losses if the market at t=1 turns out to be poor.
2. A derivative security that will provide a positive return under poor market condi-
tions, but no losses if the market at t=1 turns out to be good.
Hint: you must think of a suitable combination or portfolio of the two securities which provides a
payoff in the two states, such that in the desired state it has a positive value and zero value in the
undesired state.
References
1. Chicago Board of Trade: www.cbot.com
2. Chicago Mercantile Exchange: www.cme.com
3. Roger Lowenstein (2001), When Genius Failed, New York: HarperCollins Publishers.
4. Peter Moles & Nicholas Terry (1997) The Handbook of International Financial Terms,
Oxford: Oxford University Press

Module 2
The Derivatives Building Blocks

Contents
2.1 Introduction.............................................................................................2/2
2.2 Forward Contracts .................................................................................2/4
2.3 Futures Contracts ...................................................................................2/6
2.4 Swap Contracts .......................................................................................2/7
2.5 Option Contracts ....................................................................................2/9
Case Study 2.1................................................................................................. 2/16
Learning Objectives
This module introduces the derivatives product set and shows how the individual
products are related. It discusses the two principal kinds of products used to manage
financial risk: terminal instruments and options. It follows a building-block ap-
proach to show how the different instruments, forward contracts, futures contracts,
swap contracts and options, have common fundamentals.
The key differences for terminal products relate not so much to their economic
effects, which are remarkably similar in that their gains or losses are directly related
to the underlying asset price, but to the way the different instruments handle
performance risk. With a forward and a swap contract, each party is directly taking
the counterparty risk of the other. This is not the case with futures where contracts
are collateralised and an intermediary institution, the clearing house, acts as guaran-
tor.
Options have a non-linear function in relation to the underlying asset price and
the position of the two sides to the option transaction is very different. The option
buyer has performance risk with the option seller, but the seller has no risk in regard
to the buyer since the buyer will only exercise his right to perform if it is to his
advantage to do so.
Although options appear to be radically different instruments from the terminal
products, it is shown that this is not the case and that options can be seen as being
made up of a package consisting of a forward contract and a loan.
After completing this module, you will understand:
 how terminal contracts are put together;
 how options modify the underlying risk profile of a position; and
 how to apply a building-block approach to derivatives.

Module 2 / The Derivatives Building Blocks
2.1 Introduction
Increasing awareness of uncertainty in the economic environment has changed the
way that financial markets operate. Firms operating in various product markets have
realised that successful strategies require that the risks inherent in changes in interest
rates, currencies and commodities be successfully managed. Firms have turned to a
number of different instruments to manage these risks. This module looks at the
building blocks that form the derivative product set used to manage price risk (and
other risks) in the financial markets.
As previously discussed, firms have a number of ways in which they can seek to
control the financial risks they face. The most commonly adopted approach is to
hedge; in order to hedge, firms turn to a number of different approaches. For
instance, if a firm is exposed to foreign exchange-rate risk on its exports, it might
resort to borrowing in a foreign currency. The intended effect is that the income
stream would be directly correlated with or would offset the foreign currency
exposure from the loan. That is, the firm applies the matching principle to reduce its
risk. However, such an on-balance-sheet approach is generally costly and –
perhaps more important – somewhat inflexible in the face of changing circumstanc-
es. The alternative is to use what are known as off-balance-sheet instruments, or
derivatives: that is, forwards, futures, swaps and options, or combinations thereof.
It is easy to assume that a forward lending/borrowing transaction is somehow
different to a foreign exchange forward transaction, or that an option to buy a
particular commodity differs from an option on a particular share. In fact, these
instruments, forwards and options, are the fundamental building blocks that allow
market participants to manage a variety of market-related risks. At their most basic,
these building blocks come in only two guises: terminal instruments and options.
These latter can even be considered as a special case of the former, in which the
good and bad elements of the payoffs of the terminal instrument have been snapped
apart.
2.1.1 Risks and the Building-Block Approach

The basic approach to risk management involves initially identifying the exposure
that the firm faces. For instance, a copper producer would have an exposure to the
copper price that is positively correlated to price movements: the producer gains if
prices rise, but loses if prices fall. The producer’s risk profile is illustrated in Fig-
ure 2.1.
The producer’s area of concern is the effect of a fall in the market price. In order
to protect the firm against such an eventuality, the producer wants to enter into a
hedging transaction that has the opposite price behaviour to the existing exposure,
namely that the value of the hedge will increase as the copper price falls. The risk
profile of such a position is shown in Figure 2.2.

+
Value
Risk profile
of the firm
Producer gains if
market price increases
– +
Market price
Producer loses if of copper
market price falls
Area of
concern
Figure 2.1 Risk profile for copper producer
+
Payoff of hedging Value
instrument
– +
Market price
of copper
Figure 2.2 Payoff of a hedging instrument that is inversely correlated to

the copper price
Through combining the original existing exposure with the hedging instrument,
the firm ensures that its exposure to the copper price is matched and eliminated.
This is shown in Figure 2.3.

+ Firm's risk profile

Payoff of hedging Value
instrument
(a') (b)
– +
Market price
Result is that of copper
exposure (a) (b')
to changes
in copper
price is
eliminated
Figure 2.3 The firm’s original exposure to movements in the copper

price is eliminated when combined with the appropriate
hedge
If the market price falls to the point represented by line (a), the company is com-
pensated for by the gain on the hedging instrument (a’). Since the hedging
instrument has the opposite profile to the exposed position, the gain in price at line
(b) is offset by a loss on the hedging position (b’). The net effect, however, is for the
producer to have eliminated its exposure to changes in the market price of copper
over the hedging horizon.
2.2 Forward Contracts

Of the building blocks, the forward contract is the earliest in origin and also the
simplest. The forward contract binds the buyer, or long position holder, to buy a
given asset on a set date in the future at a price agreed at the time the contract is
entered into. If at the time the contract matures, the market price is above the
contracted price, the buyer gains. If, however, the market price is below the con-
tracted price, the buyer loses. The opposite applies to the seller, or short position
holder. These are illustrated in Figure 2.4.
The position to adopt in a forward contract to hedge a given exposure depends
on the underlying risk position or sensitivity, as shown in Table 2.1.
There is a major problem with forward contracts, namely the concern by both
parties that the other party will honour its obligation on the contract at maturity.
This default risk or credit risk means that only creditworthy counterparties are
acceptable.

Long underlying position + Short hedge = Producer's hedge

+ + +
– – –
+ + +
– – –
Short underlying position + Long hedge = Buyer's hedge
+ + +
– – –
+ + +
– – –
Underlying risk profile Hedge risk profile
Figure 2.4 Underlying risk positions and forward contracts
Table 2.1 The effect of hedging long and short positions in an

underlying asset
Effect of Effect of
Underlying adverse Hedging adverse Hedging
risk change in position change in transaction
position price in to adopt price in known as
underlying underlying
Long Fall in the Short Gain in the Producer’s
position market price hedge value of the hedge, since
hedging producers are
instrument concerned
offsets loss on about the price
the long at which they
position can sell assets
Short Rise in the Long Gain in the Buyer’s
position market price hedge value of the hedge, since
hedging consumers are
instrument concerned
offsets loss on about the price
the short at which they
position can buy assets
Note: The risk positions are illustrated in Figure 2.4.

2.3 Futures Contracts

Futures contracts developed in the 1860s on agricultural commodities as a direct
result of the problems arising from actual or potential non-performance by the
counterparty that are inherent features of the forward contract. This took place in
Chicago with the founding of what has become the Chicago Board of Trade
(CBOT). Financial futures, that is, futures contracts on financial instruments, were
not introduced until 1972 when trading in currency futures contracts started. Note
that, not coincidentally, the introduction of financial futures took place at the same
time as the Bretton Woods system was collapsing.
The futures contract, whether on commodities or exchange rates, as a means of
handling risk has the same characteristics as a forward. Thus the use of futures for
risk management purposes is identical to that illustrated in Figure 2.4 and Table 2.1.
However, it differs in several major respects to the forward in that the performance
or credit risk that is inherent in entering a forward contract is virtually eliminated.
Futures were originally conceived as a means of eliminating the credit risk from
forward contracts. This is achieved in two ways, by marking to market the
contract every day and through the use of a clearing house which stands between
the buyer and seller and undertakes to honour all transactions.
The marking to market process reduces credit risk by requiring that the losses
and gains on a contract relative to the underlying cash instrument are paid for or
credited to the parties concerned. Since the time over which the contract is out-
standing is reduced to one day or trading session, the performance risk is reduced
correspondingly. One can envisage a futures contract as being a series of one-day
forward contracts where the contract is settled each day and a new contract entered
into for the next day at the new price.
The clearing house also acts to protect market participants from default risk. It
does this in two ways. First it requires each contract to be collateralised or paid for
in advance by requiring buyers and sellers to post margin (also known as a perfor-
mance bond) with the exchange. This margin is set above the maximum anticipated
daily price movement. In effect, the potential losses are paid by users in advance, the
clearing house having received the performance bond which it can use to meet any
non-payment. For administrative purposes, the margin required when setting up a
position in futures, known as the initial margin, is made up of two components. It
consists of a minimum or maintenance margin below which the account held by the
participant at the exchange is not allowed to fall, and the difference between this
maintenance margin and the initial margin required when establishing the position.
The reason for this is to avoid having to call for additional margin whenever the
futures settlement price changes slightly, as it is likely to do.
If the minimum margin point is reached and the call for more margin to top up
the account back to its original collateralised level is not met, the clearing house will
close out the position by doing the opposing transaction on the exchange. The
amount in the margin account is used to cover any losses. However, just in case a
loss is realised, the exchange will also have an insurance fund and be able to call on
its members to make good the loss. As a result of the margin mechanism and the

availability of funds from its members, there is very little credit risk for futures
users.
The other function of the clearing house is to act as the counterparty to all trans-
actions that are effected on the exchange. The forward transaction involves both
parties taking each other’s credit risk. With futures, the exchange is the counterparty
to both buyers and sellers. This is shown in Figure 2.5.
Forward contract
Party A Party B
Futures contract
Party A Party B
Clearing
House
Figure 2.5 The role of the clearing house as intermediary in the futures
contract
The clearing house’s function is to reduce transaction costs in futures contracts.
Each party enters into a transaction, not with a specific counterparty whose credit
standing needs to be evaluated, but with a single entity which, due to the collateralis-
ing mechanism and the surety of its membership, has a rock solid credit standing.
Performance risk is all but eliminated through this arrangement.
Because they standardise transactions as to amounts and delivery dates, futures
are also highly liquid instruments. Since the clearing house is the counterparty to all
transactions, it is relatively easy for a futures position to be closed. The holder of the
long position simply sells the contract; and the purchase followed by a sale, once the
difference in price has been accounted for, extinguishes the obligation with the
clearing house. Similarly, the holder of the short position buys back the contract and
the sale followed by a repurchase likewise eliminates the outstanding obligation to
the clearing house. This feature of futures makes them very attractive instruments
for setting up short-term, off-balance-sheet positions since complex negotiations
with the other party are not required. Participants need only to buy and sell the
contracts on the exchange.
2.4 Swap Contracts

Swaps are the newest form of terminal product building blocks. The introduction of
swaps into the financial markets is generally credited with the cross-currency swap
transaction between the World Bank and International Business Machines (IBM) in

1981, although there is some evidence to suggest that the approach may have been
used privately in the 1970s. Although a single contractual obligation, a swap is
merely a package of forward contracts that are bundled together. However, unlike a
series of forward contracts or futures, the swap is a single contractual obligation and
the pricing is structured so as to achieve a level series of fixed payments over the life
of the swap.
The swap, or exchange contract as it is sometimes called, obliges the two parties
to exchange or swap a series of cash flows at specified intervals over a particular
time period. The commonest type of swap relates to an exchange of payments
determined by two different interest rates, and hence called an interest-rate swap,
where one party typically agrees to pay a fixed rate of interest and the other party a
rate based on an index or reference rate. Figure 2.6 shows the cash flows from a
fixed-for-floating interest-rate swap. Financial markets were particularly volatile at
this point. Such a swap can be decomposed into a series of simple forward agree-
ments where one party agrees to pay a fixed rate and the other party agrees to make
a payment determined at the maturity of the contract based on a reference or index
rate. A forward contract based on interest rates is available and is known as a
forward-rate agreement (FRA), although the exact mechanics of the contract are
slightly different from those of forward contracts, as discussed.
Swap contract
Rfixed Rfixed Rfixed
m
1 2
Rfloating Rfloating Rfloating
equals a bundle of forward contracts

Rfixed
1
Rfixed
+ Rfloating
2
Rfixed
+ .... + Rfloating
m
Rfloating
Figure 2.6 Cash flows on a fixed-for-floating interest-rate swap

Note: The swap is equal to a package of forward contracts on interest rates where one party pays
a fixed rate and the other party pays a floating rate related to an index or reference rate.
There is nothing to prevent such an arrangement being made for other cash flows,
as long as they can be contractually defined, and swap contracts exist on currencies (as
mentioned earlier the cross-currency swap contract preceded the interest-rate swap),
commodities, equities or any other definable asset. The basic approach once under-
stood can be – and has been – used in a wide variety of applications.
At this point it should be clear that the major differences between the terminal
product building-block product set relate not to their characteristic, which in all cases

is a linear payoff (or symmetric profile) between the value of the underlying asset
and the position in the instrument, but to the amount of credit or default risk that is
being assumed by market participants. Forward and swap contracts are direct obliga-
tions between market participants whereas futures use credit-enhancement methods
to eliminate virtually all performance risk. The use of the different instruments in a
particular context will be driven by the balance between credit concerns, the degree of
tailoring required on the contract – that is, how perfectly the contract acts as a hedge –
and the ability to be able to ‘trade out’ of the position at minimal cost.
2.5 Option Contracts

The terminal product, whether forward, future or swap, creates a two-sided obliga-
tion which the parties are required to perform. Options are different: they confer on
the holder or owner the right, but not the obligation, to make a particular future
transaction. In the case of a call option, the holder has the right to buy at a set
price; with a put option, the holder has the right to sell at the agreed price. In both
cases, since the holder has a right, this right need not be exercised if it suits the
holder not to do so. The holder will only exercise the option if it leads to a gain. On
the other hand, the option seller (known as the option writer) is required to perform
under the terms of the contract if called upon to do so. As a result, the holder is
taking credit risk on the writer, but not vice versa.
With an option, the holder will only exercise if it is beneficial to do so. The pay-
off profiles for calls and puts are given in Figure 2.7 and show that there is an
asymmetric or non-linear payoff between the option and the underlying asset.
Payoff for call option holder Payoff for put option holder
+ +
– –
+ +
– –
Payoff for call option writer Payoff for put option writer
+ +
– –
+ +
– –
Figure 2.7 Payoffs from holding (taking a long position in) call options
and put options and the corresponding written (or short)
positions

The payoffs in Figure 2.7 beg the question why anyone should be willing to take
a short or written position in an option given that it appears that the only outcome
is the loss of money. A detailed explanation of how pricing on options reconciles
the advantages of being the holder with the disadvantage of being the seller is given
later. Suffice to say at this point that the option value is that which ensures that, ex
ante, the transaction is a fair one, that is, it has a zero net present value.
What is apparent from the option payoffs is that these are similar to those given
in Figure 2.4 for forward contracts, minus the undesirable bits which lead to losses.
Note that this characteristic of options in providing payoffs or protection against
only undesirable movements in the value of the underlying asset has led them to be
characterised as a form of insurance. As one of the derivatives product set, options
provide a very useful capacity to insure against undesirable consequences and these
are shown in Figure 2.8. The combination of holding a put and having a long
underlying exposure provides a hedge against price falls but allows gains to be made
if the price rises. The combination of holding a call and having a short underlying
exposure provides a hedge against price rises, but allows gains to be made if the
price falls.
Long underlying exposure + Put option = Downside hedge

+ + +
– – –
+ + +
– – –
Short underlying exposure + Call option = Upside hedge
+ + +
– – –
+ + +
– – –
Underlying risk profile Option risk profile Combined risk profile
Figure 2.8 Hedging exposures using options

Note: A long position is hedged by holding a put option which gives the right to sell if the price
change is undesirable; a short position is hedged by holding a call option which gives the right to
buy if the price change is undesirable.
In terms of the building blocks of financial risk management, the asymmetrical
profile of options would appear to make them very different from the terminal
products previously described. However, options are not as different as they would
at first appear. The originators of modern option theory, Fisher Black and Myron
Scholes, showed that an option is in fact a portfolio consisting of two elements: a
forward contract on the underlying asset and a loan. They demonstrated mathemati-

cally that a call option can be replicated dynamically by continually adjusting these
two elements. As the value of the underlying asset rises, the portfolio consists of
more of the underlying asset and less of the loan; the opposite happens as the price
falls.* Since the payoffs from this replicating portfolio and the option are the same,
under the law of one price they should have the same value.
The important point in terms of the building blocks is that options are packages
consisting of a forward contract and a loan. This is even clearer if the ways in which
options can be combined are examined. By combining a long position in a call
option with a short position in a put option with the same exercise price, or a long
position in a put with a short position in a call, we can re-create the two possible
positions available in forward contracts, as shown in Figure 2.9.
Long call + Short put = Long forward position

+ + +
– – –
+ + +
– – –
Long put + Short call = Short forward position
+ + +
– – –
+ + +
– – –
Figure 2.9 Synthetic forward positions created from long and short
positions in options (put–call parity)
The identity between combinations of calls and puts and a forward contract is
known technically as put–call parity. In terms of the building blocks, a package of
a long position and a short position in calls and puts with the same exercise price is
equivalent to a forward contract. Options can be seen as a special case of the
forward contract where the undesirable element has been cut off, leaving just the
desired payoff.
The relationships between the derivatives product set basic building blocks can
be summarised as: Terminal products, forwards, futures and swaps have the same
linear payoff profiles and differ significantly only in terms of the degree of default
* Note that the original Black–Scholes option-pricing model only derived the value for call option on
non-dividend paying shares with European-style exercise (that is, exercise may only take place at the
expiry of the option contract). The model has been significantly developed to allow the pricing of
options on a much wider range of asset types.

risk in the instrument.* Options have, however, a non-linear payoff profile and
provide a one-way bet on the future value of the underlying asset, and these in turn
are packages of forward contracts and loans.

This module introduces the basic elements of the derivatives product set and
illustrates how the building blocks relate to each other. The financial markets are
replete with different products which are baffling to an outsider. Does an ‘exchange
of differences’ differ from a forward outright transaction, or a currency option from
the call provision in a bond? These are just some of the complexities that must be
dealt with if one is to understand financial markets. Examination reveals, however,
that seemingly complicated instruments are similar if not the same in terms of what
they do.
The product set can be broken down into two parts. First, there are the terminal
products. These are made up of various kinds of forward contracts, which are
bilateral agreements between market participants and which are subject to counter-
party risks. Next are futures, which differ from forwards in that the contract is
effectively renegotiated each day at the new prevailing market rate. When this
approach is used, futures virtually eliminate credit risk or performance risk, which is
the major disadvantage of forward contracts. Finally, there are swaps, which involve
intermediate payments over the life of the contract and which are equivalent to a
bundle of forward contracts.
The other building block of the financial derivatives product set consists of op-
tions. These come in two basic kinds, an option giving the right to buy, known as a
call, and an option giving the right to sell, known as a put. Although options offer a
one-way bet on the future outcome, they can be characterised as being a package
made up of a forward contract and a loan.
* Note that this is a generalisation and that specific forward instruments differ slightly as a result of the
way in which the contract has been defined.

Review Questions
2.1 The following diagram shows a risk profile.
Gains
Underlier
Losses
This is the risk profile of:

I. a commodity consumer.
II. a commodity producer.
III. a short position in an underlier.
IV. a long position in an underlier.
V. a short hedge.
VI. a long hedge.
The correct answer is:
A. I, III and V.
B. II, IV and V.
C. V.
D. VI.
2.2 For a hedged long position holder, a fall in the market price will:
A. reduce the price of the hedge and increase the value of the asset position.
B. increase the price of the hedge and reduce the value of the asset position.
C. reduce the price of the hedge and reduce the value of the asset position.
D. increase the price of the hedge and increase the value of the asset position.
2.3 Performance risk is the risk that:

A. the asset return will be less than expected.
B. the hedge’s counteracting behaviour in relation to the asset is less than
expected.
C. a counterparty to a transaction will not honour the bargain.
D. arises from mismatches between the maturity of the assets and the liabilities.

2.4 Marking to market involves:

A. establishing the difference between the purchase price and the current market
price for reporting purposes.
B. revaluing an asset to the current price at which it can be realised in the market.
C. the calculation of the margin requirement on a position.
D. none of A, B and C.
2.5 The following diagram shows a risk profile.
Gains
Underlier
Losses
This is the payoff profile for:

A. a written call.
B. a purchased put.
C. an upside hedge.
D. none of the above.
2.6 A forward contract has the following characteristics:

I. It is a bilateral agreement between the buyer and seller to be executed in the future.
II. The contract terms are set by the exchange on which forwards are traded.
III. The contract terms are agreed between the two sides at the initiation of the
transaction.
IV. There is performance risk between the two sides.
V. The final transaction price is varied in accordance with market conditions at
maturity.
A. I, II and IV.
B. I, II and V.
C. I, III and IV.
D. II, IV and V.

2.7 In establishing an underlying ____ position, the effect of a positive movement in the
underlier is a ____ in the market price. To hedge the position requires a ____ position
in the hedging instrument. The correct set of terms is:
A. long rise short
B. long fall long
C. short fall long
D. short rise short
2.8 The role of a clearing house in futures markets is:

A. to settle all the different transactions that take place on the exchange.
B. to interpose itself between buyers and sellers.
C. to guarantee transactions.
D. all of A, B and C.
2.9 The main difference between a forward contract and a swap contract is:
A. there are no differences between these two forms of contract.
B. the forward contract is concerned with interest-rate risks whereas the swap
contract handles currency risk.
C. the forward contract has one cash flow whereas the swap has a multiple set of
cash flows.
D. the buyer of a forward contract can only make gains whereas the buyer of a
swap may make gains or losses.
2.10 The structure of forward transactions and swap transactions is such that:
A. forward transactions can be applied to all financial instruments, whereas swaps
can only be applied to currencies and interest rates.
B. forward transactions can only be applied to currencies and interest rates,
whereas swaps can be applied to all financial instruments.
C. forward transactions can only address problems of market risk whereas swaps
can be applied to different kinds of financial risks.
D. both forward transactions and swaps can be applied to the same types of
financial instruments.
2.11 The main difference between options and the other derivative products is:
A. there is no difference between options and other derivative products.
B. there is less credit risk in options that in the other derivative products.
C. there is more credit risk in options than in the other derivative products.
D. options provide a non-linear payoff profile, whereas the other derivative
products have a linear payoff profile.
2.12 A put option requires the option seller to:

A. buy the underlying asset from the option holder at a fixed price.
B. sell the underlying asset to the option holder at a fixed price.
C. pay the purchase price for the option at initiation.
D. reimburse the option holder for all losses on the put.

2.13 In establishing an underlying ____ position, the effect of a positive movement in the
underlier is a ____ in the market price. To hedge the position requires a ____ position
in the hedging instrument. The correct set of terms is:
A. long rise long
B. long fall short
C. short rise long
D. short fall short
2.14 In the case of an option:

A. both the buyer and the seller will have unlimited market risk.
B. the buyer will have unlimited market risk but the seller will have no market
risk.
C. the buyer will have no market risk but the seller will have unlimited market
risk.
D. neither the buyer nor the seller will have market risk.
2.15 In the case of an option:

A. both the buyer and the seller will have credit risk.
B. the buyer will have credit risk but the seller will have no credit risk.
C. the buyer will have no credit risk but the seller will have credit risk.
D. neither the buyer nor the seller will have credit risk.
Case Study 2.1

We have seen that an option has an asymmetrical payoff when compared to the terminal
product set. Use payoff diagrams (such as that of Figure 2.1) to show how different combina-
tions of options can be used to engineer different payoffs. In this exercise you may ignore the
cost or premium from buying and selling options.
1 How would you create a position that benefited from both a rise and a fall in the value
of the underlying asset using options?
2 How would you create a position that provided a gain over a given expected price range
if the underlying was (a) expected to increase; and (b) expected to decrease? Note that
the logic of such an approach is that options are valuable and it costs money to buy an
option. One way of reducing the cost of setting up the desired exposure to the
underlying is to sell an option against the desired position. (This is known in the market
as a ‘spread’.)

PART 2
Terminal Instruments
Module 3 The Product Set:
Terminal Instruments I – Forward Contracts
Terminal Instruments II – Futures
Terminal Instruments III – Swaps

Module 3
The Product Set:

Terminal Instruments I – Forward
Contracts
Contents
3.1 Introduction.............................................................................................3/2
3.2 The Nature of the Forward Contract ..................................................3/2
3.3 Using Forwards as a Risk-Management Instrument ........................ 3/11
3.4 Boundary Conditions for Forward Contracts................................... 3/12
3.5 Modifying Default Risk on Forward Contracts ................................. 3/13
Case Study 3.1: Interest-Rate Risk Protection ............................................ 3/34
Case Study 3.2: Exchange-Rate Protection ................................................. 3/35
Learning Objectives
Terminal contracts are of three kinds: forwards, futures and swaps. The least
complicated is the forward contract, which is a bilateral agreement between two
parties. The key determinant of the pricing of terminal instruments is through
hedging. This module and Module 4 on futures examine the nature, structure and
risks of simple terminal contracts. Module 5 looks at swaps, which can also be seen
as packages of forward contracts. The other member of the derivatives product set
consists of options (which are discussed in Modules 6–10).
This module examines the nature and use of forward contracts to hedge risks.
Forward contracts are the simplest of the terminal instruments used to manage
various kinds of risk and, because they can be tailored to specific user needs, they
provide a perfect hedge.
The forward contract form has been adapted to address the problem of credit
risk (or default) on such deferred-performance contracts and two examples are
shown: the forward-rate agreement, for interest rates, and the synthetic agreement
for forward exchange, for currencies.
After completing this module you should:
 be able to price a forward contract;
 know how specific forward contracts work in currencies and interest rates;
 understand the credit risk implications of the forward contract;
 understand how modifying the contractual cash flows reduces credit exposure.

Module 3 / The Product Set: Terminal Instruments I – Forward Contracts
3.1 Introduction
One of the risks facing any holder or potential buyer of an asset is that the market
price will change at some point in the future. Business activities are already compli-
cated enough without the added risk that the final delivery price is different from
the one expected. As most economic activity involves a number of factor costs,
land, labour and capital, uncertainty about the payoff from engaging in a given
enterprise is an added problem. One can well envisage the merchants of the ancient
world seeking to reduce this uncertainty by agreeing today a price for selling or
buying a given item at some mutually agreed date in the future. Assuring a given
outlet for a particular course of activity mitigates the risks inherent in the enterprise.
This works both for the seller, who may earn less than anticipated, and the buyer,
who may have to pay more than expected. Both have an incentive to deal today for
implementation in the future.
Thus the forward contract was developed. Its origin is probably as old as com-
merce itself. Ancient texts, such as clay tablets from the Assyrian empire, record
commercial transactions which relate to agreements that have the deferred execu-
tion characteristics of the forward contract. Today, forward contracts exist on a
wide range of financial instruments, commodities, indices and assets. The most
frequently used contracts are foreign-exchange forwards which are used by banks,
companies, investment institutions, governments and other entities, to manage their
currency exposures.
The subject of this module is the first type of terminal product, known generical-
ly as a forward contract or simply a forward. These instruments allow parties to
lock in a value for an agreed future execution or maturity date. A forward contract is
simply a bilateral commercial agreement negotiated today but with its execution or
settlement deferred to some agreed date in the future. To anticipate the later
discussion, it is worth mentioning at this point that a futures contract is essentially
an exchange-traded version of a forward contract, although as a result, there are
some important differences between the two instruments. Futures contracts are
discussed in the next module.
Underlying the development of terminal contracts has been a desire by market
participants (producers and users) to ‘lock in’ future transaction costs. This ability to
fix a price for future delivery means that terminal markets are a valuable way of
reducing or transforming price risk for both buyers and sellers. That said,
forward contracts since they involve no investment can be – and are – used for
speculation on asset values. The original development of such markets reflected the
economic requirements of the time. The earliest markets were in agricultural
produce, but more recently the needs of financial markets have led to the introduc-
tion of terminal products to trade risks in a variety of financial instruments.
3.2 The Nature of the Forward Contract

A forward contract is a very simple commercial agreement. It involves two parties, a
buyer and a seller, agreeing a price at which a quantity of a product, commodity or
other item will be exchanged for a given amount of money. The price specified in

the contract is known as the contract price or exercise price. Thus, John Doe Inc.
of the USA might have a currency exposure in relation to sterling where Jock
Distillers plc of the UK has agreed to sell a given quantity of whisky to the other
company in six months’ time and the contract is priced in sterling. In order to
protect itself, John Doe can enter into a contract with a financial intermediary (for
foreign exchange, this is likely to be a bank) where the intermediary agrees to buy
dollars from the company and sell it sterling at a price determined today for delivery
at an agreed future date. This contract is shown schematically in Figure 3.1. As a
result of this transaction, John Doe has managed to eliminate the exchange-rate
risk by entering into the forward contract with the intermediary rather than waiting
until the goods have to be paid for. Undertaking the forward contract transfers the
currency risk to the intermediary, who may be better placed to take on this risk.
Assuming that the whisky is duly delivered, then John Doe has completely eliminat-
ed currency risk from the transaction.
Sterling (£)
Intermediary John Doe
US dollars ($)
Figure 3.1 Forward transaction between John Doe Inc. and the financial
intermediary (e.g. a bank)
Note: John Doe provides US dollars to the intermediary in exchange for sterling at an agreed date
in the future.
Participants in forward markets are those entities which wish to fix their future
transaction costs. As the above example demonstrates, the ability of John Doe to
buy whisky for sale in the US market would be much reduced if it could not hedge
its currency exposure. The company would not know its costs until the moment it
came to pay for the whisky in six months’ time. This might greatly reduce the
attraction of buying and marketing the whisky.* The existence of a forward market
in currencies reduces the importer’s risks and makes the business commercially
attractive. Alternatively, it can be seen as increasing the whisky producer’s oppor-
tunity to sell abroad. The economic rationale for forward markets is that they add
value by eliminating or reducing uncertainty. The demand for forward contracts will
be determined by the number of firms facing uncertainty about future prices.
3.2.1 Pricing the Forward Contract

The above example raises the question of the price at which the financial intermedi-
ary should agree to buy the dollars and sell the customer sterling. The answer is
based on the intermediary’s ability to hedge its exposure, a theory of forward pricing
often referred to as the cost-of-carry model. The simplest explanation of the cost-
of-carry pricing model is with an illustration. Continuing our foreign exchange
forward transaction example, let us assume that at the time the contract was to be
* Of course, the dollar price of the sterling amount might have fallen, thereby providing a gain. But it is
the potential for losses which most exercises the mind!

negotiated, the market conditions described in Table 3.1 existed in the two curren-
cies.
Table 3.1 Market conditions when the forward contract in Figure 3.1
was negotiated
Sterling Market conditions US dollars
1.000 Spot exchange rate 1.5000
10% 6 months’ euro-deposit rate in the currency 6%
Let us also assume that the intermediary has no other outstanding transactions.
The pricing through hedging approach requires the intermediary to create a
situation where it is in a position to fulfil the forward contract obligation and, at the
same time, to eliminate the risk of the transaction.* This is important because the
financial intermediary, by entering into the forward transaction with John Doe, has
assumed the currency risk. In order to eliminate its risk, the intermediary will need
to undertake each of the following transactions:
(i) borrow US dollars today;
(ii) exchange these into sterling at the current spot rate;
(iii) deposit these for six months in sterling.
At the maturity of the forward contract the following will happen: the customer
will (a) pay the bank US dollars, which can be used to repay the initial dollar loan (i);
the maturing sterling deposit (iii) is used to pay the customer the contracted sterling
amount (b). The various steps of the transaction are shown schematically in
Figure 3.2.
Thus the various elements of the contract will net out at maturity. The borrowing
in dollars will be matched off against the dollars paid to the intermediary at the
forward date ((i) against (a)). The deposit in sterling will mature and is used to pay
out the sterling received against the dollars ((ii) against (b)).
Given the market information in Table 3.1 and the steps in Figure 3.2, we can
work out the price at which the bank can create the transaction in such a way that it
is fully hedged and has no market risk. For foreign exchange forward contracts, this
will be a function of the interest-rate differential between the two currencies. This is
also known as covered arbitrage. The formula used to calculate the forward price
based on the difference between the two interest rates is given by Equation 3.1:
1 + Foreign currency rate ﴾3.1﴿
Spot rate ×
1 + Domestic currency rate
* As we will see in Section 3.2.2, the financial intermediary is still left with a credit risk on the contract.

£
Lend £ (iii) (b)
Sterling
Spot Forward Customer

FX – bank: (ii) bank sells £; buys £;
sells $; buys $ sells $
buys £
US dollars
Borrow $ (i) (a)

$
t=0 t=m
Figure 3.2 Schematic representation of the pricing by hedging (cost-of-

carry) model for a foreign exchange forward contract
Substituting the market rates from Table 3.1 gives:
( . ) . ﴾3.2﴿
1.5000 × = 1.4725
( . ) .
We can see that this is the correct forward rate if we break down the calculation
as shown in Table 3.2.
Table 3.2 Calculation of the forward foreign-exchange rate from the

deposit rates of the two currencies
Sterling Exchange rate US dollars
t=0 £66.67 1.5000 $100.00
Deposited at 10% for 6 months = Borrowed at 6% for 6 months =
t=m £69.92 1.4725 $102.96
Note that $102.96 ÷ 69.92 = 1.4725
The interest-rate markets (via the eurocurrency markets) and the forward foreign-
exchange market are closely integrated. For a given maturity, the difference between
the interest rates in the two currencies is directly related to the difference between
the spot and the forward exchange rate for the currencies for the same period.
Note that we can also conceive, in the foreign exchange case, that the forward
contract can be priced as if it were a pair of zero-coupon loans (which is typically
the case for short-term borrowings and lendings). Since both sides are equal, at
inception the forward has a zero net present value. Neither party pays the other to
enter into the contract – if we ignore the bid-offer spread charged by a market
maker. It is this feature where no payments are made until maturity that sometimes
leads to the idea that forward contracts are ‘free’. Although there is no upfront
payment, they are only free in the sense that the contracted terms are ‘fair’ to each
side. The cost-of-carry model is therefore also a model that provides a fair valuation
of the contract’s worth. Of course, once the contract becomes seasoned, it will have

a positive value to one or other party depending on what has happened to the cash
or spot price of the contracted item and to interest rates in the two currencies.
The cost-of-carry approach works with other forward contracts. If a customer
has agreed to buy a given quantity of crude oil, the contract price at which the seller
will agree to enter into the agreement will be based on the funding cost of buying
crude oil and the costs associated with holding and storing the commodity (includ-
ing any anticipated wastage while in storage) until the delivery date. If the contract is
for a year and the interest rate is 8 per cent per annum and the annual storage cost 4
per cent, the forward price in one year’s time will be set 12 per cent above the
current spot, or cash market, price. The vendor, or short position in the forward
contract, can cover his position in the same way as the financial intermediary in the
foreign exchange example, by buying the crude oil in the market for current
delivery, storing it for 12 months and then delivering it to the customer. Note that
the price of the contract is independent of either party’s views on what the future
price will be. As long as the seller can hold the deliverable item and can borrow to
fund the position, the obligation is hedged out.
This model has led economists to characterise terminal markets into two catego-
ries. The first are ‘carry’ markets, where the commodity, asset or financial
instrument can be held for delivery and the second are markets, such as those for
soft commodities like wheat, maize, soy bean and so forth, where the delivery is
conditional on future events. These are called ‘discovery’ markets in that the futures
price uncovers facts about future availability.
The Cost-of-Carry Model ___________________________________
The generic cost-of-carry model for the forward price
Forward price = cash price + financing cost per unit + storage cost per unit
(Note that this model also applies to the futures price.)
The basic equation is given as:
−t ﴾3.3﴿
, = + ×R , × +G,
365
where:
t,T : forward price at time t, for a forward (futures) contract requiring de-
livery at time T
t : cash price at time t
Rt,T : riskless interest rate at which funds can be borrowed at time t, for the
period (T – t)
Gt,T : storage costs and other related costs for the physical asset per unit of
time from holding the asset for the period (T – t)
Note that different forward contracts will have different elements in their
pricing. The cost of storing financial instruments is virtually nil, so the storage
costs in this case will be zero. In addition, with most financial instruments, the
short position (the party required to make the delivery in the future) will
receive any income on the asset prior to the contract’s maturity date. This is a

loss to the buyer, so the storage cost in this case can be seen as foregone
income, that is, dividends or interest paid before the contract matures. This is
true, for instance, of forward contracts on equities or an equity index. The
buyer gains by deferring the purchase of the shares; the seller, however,
receives the dividends before maturity. In this situation, the financing cost raises
the forward price, but the value leakage from dividend (or interest payments for
debt instruments) reduces the forward price. As with the currency forward, the
price is the balance between these two effects.
Note also that the above model is an operational model in the sense that the
forward price is that which an intermediary or market maker might quote. It
therefore follows common money market usage and computes the interest cost
based on simple interest. Sometimes the cost-of-carry model is expressed in
textbooks as:
= (1 + )( )
﴾3.4﴿
or:
( )
= ·e
where the terms are as previously defined. In this case (1 + )( − ) is the
compounded rate of return for the period, or in the continuously compounded
model ( − ) is the continuously compounded rate of return. Correctly con-
verting between the various methods should give the same value to the forward
price.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
All the Colours of Cost-of-Carry Models ______________________

Standard Cost of Carry Model
The standard cost of carry model assumes the underlying asset in the contract
pays no interest and suffers no value loss. In such a condition, the only factor
influencing the forward price will be interest rates. The standard model for the
cost of carry model is therefore:
( )
= ﴾3.5﴿
where 0 is the current spot price, (T – t) is the time to expiration, r is the
interest rate, and is the current forward or futures price for delivery at time
T.
Cost of Carry with a Dividend Payment
When the asset pays a dividend or other value leakage, then the value of the
forward or futures contract becomes:
( ) ( )
− ﴾3.6﴿ =
where D is the dividend or value leakage and (k – t) is the time to the dividend
payment. Note that in this case, the forward price can be below the current
spot price.
If there is more than one dividend due, then the model becomes:

( )
− ∑ ( )
= ﴾3.7﴿
where is the ith dividend payment at time .

Cost of Carry with Continuous Dividends
When the asset pays a continuous dividend (for instance, if the underlying asset
is an index of securities which pay dividends) or the underlier is a currency with
a foreign interest rate, the model becomes:
( )( )
= ﴾3.8﴿
where q is the dividend yield or foreign currency interest rate. Note for
currencies, the cost of carry formula given above is simply a continuous time
version of the interest rate parity equation that underlies the pricing of foreign
exchange forward contracts.
Cost of Carry with Storage Costs
Storage costs can either be considered as a lump sum and as such act as a
negative dividend, that is they will raise the forward price, or as a continuous
cost, like an add-on to the interest rate. The lump sum cost of carry model with
storage costs (W) will be:
+∑ ( ) ( )
= ﴾3.9﴿
where is the ith storage cost monetary payment over the life of the forward
contract payable at time .
For the continuous cost version of the model we have:
( )( )
= ﴾3.10﴿
where w is the add-on to the interest cost to reflect the storage costs of the
underlier over the forward period (T – t).
Note that for commodities, there may be an additional element in storage costs,
namely wastage which also needs to be included.
Cost of Carry with a Convenience Yield
The convenience yield is the price (expressed as an interest yield) a consumer
of a commodity is willing to pay to ensure security of supply of the physical
product. As such it is equivalent to value leakage or a dividend yield in that it
reduces the forward price. The model is therefore:
( )( )
= ﴾3.11﴿
where y is the convenience yield.
Convenience yields are not observable in the market and can only be computed
by reference to the cost of carry valuation of the forward price without the
convenience yield. That is, they are backed out using the appropriate cost of
carry model for the underlier in question. For instance, if the underlier was
priced using the cost of carry model where the only pricing factor was the
interest rate, then we can determine the implied convenience yield as:

= ln + ( − ) /( − ) ﴾3.12﴿
For instance, if a commodity without value leakage or storage costs was trading
at 100 in the spot market ( 0 ), the six month continuously compounded interest
rate was 5 per cent per annum and the futures price ( ) was 101, then the
implied convenience yield would be 2 per cent per annum:
= ln + .05(.5) /.5 = .02 ﴾3.13﴿

To obtain the present value of the convenience yield, we use the following
formula:
( )( )
= ﴾3.14﴿ −
So if the time to expiration is 9 months and the continuously compounded
interest rate is 5 per cent, there is no wastage of storage cost (u), the futures
value is 102 and the spot value of the commodity is 100, we have:
. (. )
= 100 − 102 = 1.75 ﴾3.15﴿
while its future value at the expiration of the contract is 1.82.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
3.2.2 Forward Contracts and Default

Although forward contracts are an efficient way of transferring different price or
rate risks to another party, they have a major disadvantage from the viewpoint of
each party. There is a cost involved in entering into the transaction, namely the cost
of default. Let us return to the currency example analysed earlier. If the company,
for whatever reason, fails to honour the bargain struck with the financial intermedi-
ary, the latter may suffer a loss. This loss will be the shortfall that arises when it sells
the sterling to repay the dollar borrowing. This shortfall is the contract’s replace-
ment cost. In fact, because the company’s position is the mirror of the
intermediary’s, we can confidently say that the company will only default on its
promise if it is to its advantage to do so, that is, when the contract is a loss from the
company’s point of view. Naturally, the opposite condition pertains to the credit
risk the company is taking with the financial intermediary. Table 3.3 shows the
situation under different market scenarios.
The credit risks involved in entering forward contracts act as a deterrent to their
use. Only those counterparties who will honour their obligations with a high degree
of certainty are likely to be acceptable participants in such a market. In addition,
whereas the demand for price protection is likely to increase as the price volatility of
the contracted asset increases, the replacement costs associated with default likewise
increase. It is deviations from the expected path between the current or spot price
and the forward price that lead to this performance risk. The greater the deviation
or volatility, the greater the risk. It is, however, this same undesirable volatility in the
price that makes the contract valuable to both parties!

Table 3.3 Effect of changes in the exchange rate on the value of the
forward contract at maturity
Currency at Profit and loss from the position
maturity Contract value of the company
1.5000 1.5000 − 1.4725 = 0.0275 Gain: company can buy sterling for
1.4725, and sell in the market at
1.5000
1.4725 1.4725 − 1.4725 = 0 No effect
1.4500 1.4500 − 1.4725 = Loss: company has to buy sterling for

−0.0225 1.4725 rather than in the market at
1.4500
3.2.3 Forward Contracts, Asset Prices and Time

We have already said that the agreed price at which a forward is negotiated, ignoring
any intermediary’s bid-offer spread and other incidental transaction costs, is based
on the cost-of-carry model. By implication, the forward will have a net present value
of zero at origination. There is no gain to either the buyer or the seller at this point
(ignoring transaction costs). Note that although from a pricing point of view the
contract has no special value (and, as we have said, that is why it is sometimes
confusingly considered to be ‘free’), there may be strong economic incentives to
enter into the contract as a way of reducing risk. Another point that is also worth
repeating at this juncture is that the forward price will be largely a function of the
net cost of financing the hedging position for delivery into the contract.* The
forward rate will be determined by the shape of the term structure of interest rates.
Let us illustrate this on the basis of a commodity and the following interest rates to
one year. As you will see in Table 3.4, the short-term interest rate structure is
humped, with a maximum interest rate of 6 per cent per annum in nine months,
which then falls to 4 per cent for one year. This is somewhat unrealistic but serves
to make the point. If we use the cost-of-carry model, we see that the forward price
will be the funding cost for holding the asset to delivery.
Table 3.4 Spot, or cash, price and forward prices for a hypothetical
commodity
Period Interest rate (p.a.) (%) Commodity price
Spot (today) n/a 200.00
Three months 3 201.50
Six months 5 205.00
Nine months 6 209.00
Twelve months 4 208.00
* See Module 4 for a discussion of the implied financing rate or implied repo rate.

As the forward price is determined by interest rates, as long as the party which is
obliged to make delivery has the asset in question, it is in a position to transform the
nature of the risks being assumed into ones where it has superior expertise. Let us
use the above example to illustrate this process. A consumer of the commodity
seeks to acquire the commodity in six months’ time and approaches an intermediary
which specialises in providing forward contracts. This intermediary has a strong
view that the six-month interest rate overprices the expected change in interest rates
in the second (forward) three-month period. As a result, it enters into the contract
and decides to fund its position by borrowing for three months at 3 per cent. In
three months’ time, it so happens that it has correctly forecast the course of interest
rates and that the three-month rate is unchanged. Its total cost of funds on an
annual basis is 3 per cent, netting the firm a gain of just less than 3.00 on delivery at
the end of the second three-month period. Note that the nature of the risk being
assumed here is interest-rate risk, not price risk on the commodity.
At the time the contract is entered into, an at-market forward will have a net
present value of zero. This will not be the case as time passes. Two factors will
change over time. The time delay before the contract is executed will shorten. The
value difference between the cash price and the forward price should, therefore,
converge. This will only happen if the cash price remains unchanged. If, however,
the cash price changes, then the forward price will also change. Any forward
contract hitherto entered into will gain or lose value from this change. If the price of
the commodity in Table 3.4 has, after three months changed from 200 to 180 and
the interest rate for three months is 3.5 per cent, then the forward price for three
months will be 181.54, some way from the 205.00 on the existing forward contract.
3.3 Using Forwards as a Risk-Management Instrument

From the user’s perspective, forward contracts provide a convenient means of
hedging an exposure. As our earlier example based on the currency requirements of
John Doe showed, the use of a forward foreign exchange contract served to
eliminate that firm’s exchange-rate risk. It allows the user to separate the price risk
from the underlying position and to transfer this to another party better able to
assume the risk. Note that at the macro level, risk is not extinguished by this
process: it is merely passed on. If, however, two entities have the opposite expo-
sures (as the commodity producer and consumer do), then there is a benefit of
reduced risk to both sides from entering into such an agreement.
In using a forward as a risk-management instrument, if the underlying asset in the
forward transaction is an exact match for the exposure, and if the amount and maturity
of the contract also exactly match, the forward will provide a perfect hedge against the
risk. Such perfectly tailored solutions are generally possible with forward contracts since
they are bilateral agreements entered into in the over-the-counter (OTC) markets with
a specific counterparty, with the intention of being held to maturity. For this reason,
they are not usually unwound before maturity since there is a significant cost from doing
so. They also require that each party be willing to accept the credit risk (the performance
or default risk) of the other. The amount of credit risk that is being assumed is the
replacement cost if the counterparty should not be in a position to meet its obligation at

the maturity of the contract. Note that if the underlying asset spot or cash market price
behaves as might be expected and moves towards the forward price, there is negligible
credit risk. It is the volatility in the potential outcome that creates a credit exposure.
There is a degree of paradox here since the more volatility or uncertainty there is about
the market price in the future, the greater the demand for hedging; but the greater the
credit risk of entering into the transaction. What is happening is that the forward
contract is exchanging a high probability about changes in market prices into a low(ish)
probability of default.
Because significant transaction costs preclude trading (with the exception of the
market in currency forwards, where the breadth of the market means transaction costs
are low) and concerns over credit, futures provide an alternative method of achieving
nearly the same degree of protection without assuming significant counterparty risk.*
3.4 Boundary Conditions for Forward Contracts

The discussion so far shows that in an efficient market, the forward price must be close
to the price of the cost-of-carry model. If it is not, then riskless arbitrage can be undertak-
en, known as a cash and carry arbitrage. If the forward price is higher than the cost of
carry (that is, the contract is expensive), the arbitrageur will sell the forward and hold the
underlying cash commodity or instrument for delivery into the contract. Since the cash
instrument is pre-sold via the forward, there is no price risk. The difference between the
buying price and the selling price, less any interest and storage costs, is the net gain from
the arbitrage. The opposite is done if the forward contract is lower than the price of the
cost-of-carry model, that is, the contract is cheap. (This arbitrage transaction is known as a
reverse cash and carry.) The underlying position is sold and the proceeds are invested.
The price risk is eliminated by receiving the cash commodity or instrument at the maturity
of the contract. The two relationships are shown in Table 3.5. Because of the existence of
such a money-making machine, the market prices of both elements, forwards and cash,
rapidly adjust, with the result that the opportunity disappears. In fact, such opportunities
are generally very rare in a smoothly functioning market.
Table 3.5 Cash market forward market arbitrage opportunities (cash

and carry arbitrage)
If forward con-
tracts are: (in Action to be taken in Action to be taken in the cash
relation to their the forward market market
fair or theoretical
value)
Expensive (higher) Sell the forward contract Buy and hold cash commodity or
(agree to make delivery) instrument (deliver into forward
contract)
Cheap (lower) Buy the forward contract Sell (short) cash commodity or
(agree to accept delivery) instrument (receive from the
forward contract)
* Typically there will be some degree of basis risk left to the user of futures contracts.

The arbitrage-free channel that will exist between the forward price and the
ability of market participants to engage in riskless arbitrage will be determined by
the boundary conditions shown in Table 3.5 and given by Equation 3.16.
(1 + ) + < < (1 + ) − ﴾3.16﴿
The arbitrageur can buy the underlying cash asset and sell the forward contract
when (1 + ) + < . That is, the cost of carry, at the borrowing rate
including transaction costs ( ), is less than the value of the forward contract. The
opposite applies when (1 + ) − − > , the arbitrageur sells the forward
and invests at the lending rate less any transaction costs. The greater the uncer-
tainty about , , and transaction costs ( ), the wider the channel before arbitrage
can take place. Different markets will show variations in the boundary before
arbitrage becomes feasible. There may also be differences in the various costs for
individual market participants which may provide different boundaries to the
viability of such strategies.
There is another reason why arbitrage situations will not arise very frequently: the
bid-ask spread in the forward market is likely to be narrower than the arbitrage
range spread. This is because the credit risk inherent in the forward contract is less
than that implied in the actual borrowing and lending of funds that would be
necessary to perform the arbitrage. With a forward contract, as previously discussed,
the actual amount at risk is the difference between the original value and the current
replacement cost (the replacement transaction in the market). In most circumstanc-
es, this will usually be less than the full value of the contract. Hence the implied
price of credit will be less than that which operates in the cash markets where the
full value is ‘at risk’.
3.5 Modifying Default Risk on Forward Contracts

The default risk problem of the forward contract has led financial intermediaries to
develop instruments where the credit risk can be greatly reduced. Futures are one
solution and these are discussed in the next module. This section will look at two
credit-efficient forward instruments which address the problem of default risk, one
on interest rates, known as a forward-rate agreement (FRA) and the other on
currencies. Currency forward contracts based on the FRA model are known by the
generic name of synthetic agreements for forward exchange or SAFEs.
3.5.1 Forward-Rate Agreements

If you knew you had the opportunity to deposit some money for six months in
three months’ time and were concerned about the rate at which the deposit could be
made, you might approach a deposit-taking institution now with a view to arranging
a forward-start deposit. The question is, how might the bank determine the interest
rate at which it would be willing to borrow money? The implied forward rate is the
forward-start interest rate for period other than the present. For instance, the
interest rate for a fixed rate investment which was due to start in six months’ time

and last for six months would have an interest rate based on the interest rate that is
expected to prevail for the half year in six months’ time.*
Let us reconsider the issue in the light of our understanding of this relationship.
For a given period , the interest rate will be made up of the spot rates prevailing
for periods − 0, − 0, where < . That is:
(1 + ) = (1 + ) (1 + ) ﴾3.17﴿
Note that, for short-term maturities, interest rates are quoted as simple rates, with
the result that Equation 3.17 becomes:
− ﴾3.18﴿
1+ = 1+ 1+
12 12 12
If the bank lends for the period to a customer, and borrows for a period in
the market ( < ), the new deposit that we would make at time will replace the
maturing borrowing by the bank. The maximum rate that the bank would be
prepared to accept on our deposit will thus be the current implied forward rate .
Let us calculate this result but, in addition, also include the market’s bid-offer spread
for borrowing and lending. In fact we will calculate the rate at which the bank will
theoretically quote both to receive a deposit ( ) and to make a forward-start loan
( ) for the same period. The relevant figures are given in Table 3.6.
Table 3.6 Short-term interest rates showing the bid and offer spreads
Period Bid rate Offer rate
Three months 5.75% 5.875%
Nine months 6.125% 6.25%
Note: For currencies quoted on the London market, the bid and offer spreads (London interbank
offered rate (LIBOR) and London interbank bid rate (LIBID)) for short maturities are usually one-
eighth of a percentage point apart.
We can visualise the bank’s situation as that shown in Figure 3.3. In the case of a
forward-start deposit, the bank conceptually lends for the nine months and borrows
for the intervening three months. In the opposite case, the bank borrows for nine
months, and lends for three months.† In both cases, the bank needs to price up the
interest rate at which it will agree to lend or borrow for a forward start.
* For a discussion of how these are obtained, see Financial Risk Management, section 10.4.
† Short-term interest rates are often quoted on the basis of a notional year of 360 days (as with the US
dollar and the Deutschemark and a range of other Continental currencies) or a year of 365 days (as
with sterling).

Time 0 Time t Time T

(Present) (3 months) (9 months)
Bank lends for 9 months at offer rate
Forward start deposit

A
Bank borrows for
3 months at bid rate
Bank borrows for 9 months at bid rate
Bank lends for

3 months at offer rate Forward start loan
Figure 3.3 Forward-forward contracts from the bank’s perspective

Note: The bank’s customer’s cash flows would be reversed. A involves the bank agreeing to take a
deposit in three months for six months; B is the case where the bank agrees to make a loan for
six months in three months’ time.
The two rates will be (using the simple interest rates from Equation 3.18):
(1 + 0.0625 × 0.75)
(1 + )=
(1 + 0.05875 × 0.25)
(1 + 0.06125 × 0.75) ﴾3.19﴿
(1 + )=
(1 + 0.0575 × 0.25)
This comes to 6.34 per cent for the loan and 6.22 per cent for the deposit. We
can quote the above as being a three-month borrowing (lending) versus a nine-
month lending (borrowing) contract (that is, a 3 v. 9). The forward-start deposit
period is therefore six months.
Forward-Rate Agreement Terminology ______________________
The terminology of the FRA market evolved from the interbank market. The
following terms are commonly used.
the buyer has ‘buy the FRA’; ‘take the FRA’: to pay the fixed rate on the
notionally agreed to FRA; to be ‘long’ funded, that is, to agree to pay interest at
borrow: the contractual rate on the FRA (see Table A1.1);
the seller has ‘sell the FRA’; ‘place the FRA’: to receive the fixed rate on
notionally agreed to the FRA; to be ‘short’ funded; that is, to agree to pay interest
make a loan: at the floating rate on the FRA at settlement (see Table A1.1);

Table A1.1 Comparison of buying and selling the FRA

Buy the FRA, ‘Take the Sell the FRA, ‘Place the
Settlement rate FRA’ (to be long funded) FRA’ (to be short funded)
R >R Receive PV of difference: Pay PV of difference:
R −R R −R
R <R Pay PV of difference: Receive PV of difference:
R −R R −R
 contract amount: the principal sum that notionally underlies the contract
and is used for computing the payments;
 contract currency: the currency in which the contract is denominated;
 transaction, dealing or trade date: the date at which the FRA transac-
tion is agreed;
 settlement or value date: the date on which the notional loan/deposit
commences;
 maturity date: the date on which the notional loan/deposit terminates;
 fixing date: the date at which the market interest rate for reference
purposes is determined;
 reference rate: the market interest rate used to determine the settlement
amount;
 contract period: the number of days between the settlement and maturity
dates;
 settlement amount: the amount paid by one party to the other in settle-
ment of the contract; it is the present value of the difference between the
contracted rate and the settlement rate at the settlement date;
 FRABBA terms: British Bankers Association terms and conditions for
forward-rate agreement contracts. These have become the industry stand-
ard.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The difference between a forward-start deposit and the forward-rate agreement is

that there is no lending by the counterparties involved in the latter case. All that is paid
is a compensating payment for the difference between the contracted rate and the
actual settlement rate at the start of the deposit period. The settlement formula for the
FRA contract is:
− ﴾3.20﴿
| |× ×
Settlement amount = 100 Basis
1+
Basis × 100
where is the reference interest rate at settlement, is the contracted rate, is
the number of days between the settlement date and the maturity date, that is, the
period ( − ), is the notional amount of the contract, and the basis will be either
360 days or 365 days, depending on the currency.
There are two possible outcomes: one is when is higher than and the other
is the opposite. In the first, the floating rate payer (the FRA seller) makes a payment

to the fixed payer; when the settlement rate is below the contracted rate, the
opposite occurs. For example, if the rate on a US$10 million three-month US dollar
FRA had been 6 per cent and the settlement rate 4.5 per cent, with a 90-day period
for , then we would have had:
4.5 − 6 90
| |× × US$10 000 000
Settlement amount = 100 360
90
1 + 4.5
36 000
= US$37 083
If it had been the opposite situation, where the settlement rate had been, say, 9
per cent, as the customer making the deposit we would have paid the difference of 3
per cent to the bank (9 per cent − 6 per cent). In this case, we pay the bank
US$73 349.63.
You may have realised that the denominator of the above equation is a present
value formula. This is included because the settlement amount is paid at the start of
the notional deposit period, not at the end as with most interest payments. You will
further recall that forward contracts are credit instruments. Present valuing the
payment to the start is designed further to reduce the credit risk element of the FRA
contract, which is already a payment of an interest-rate difference rather than an
actual cash deposit or loan. In the above, the FRA transaction is completed with all
payments being made on the settlement date, thus eliminating a further three
months of counterparty credit exposure with the customer.
The above present value adjustment does not alter the economics of the transac-
tion. Let us assume that the customer wanted to lock in a rate of 5.875 per cent (the
bid side of the 6 per cent on the FRA). If the settlement rate is 4.5 per cent, then the
bid side will be 4.375 per cent. The deposit then pays US$109 375 at maturity.
However, at the start of the deposit period, there is an additional US$37 083 being
provided by the FRA. The total, FRA value plus the interest, now becomes
US$146 863.60. This is equal to an interest rate of 5.875 per cent for the 90-day
period. The FRA has successfully acted to ‘lock in’ the expected forward interest
rate.
Note that these results are not very sensitive to the addition of a lender’s spread
over the reference rate when actual funds are being borrowed, or a margin below
the reference rate on deposited funds (as we have shown).
British Bankers Association Formulae for Forward-Rate
Agreements _______________________________________________
The British Bankers Association uses slightly different computational formulae
to calculate the value of the payment to be made at settlement, but they provide
the same result.
When the market reference rate at settlement is above the contracted rate the
formula is (R > R ):
(R − R ) × D × A
(basis × 100) + (R × )

When the contracted rate is higher than the settlement rate, the formula is
(R < R ):
(R − R ) × D × A
(basis × 100) + (R × )
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
3.5.2 Synthetic Agreements for Forward Exchange

The preceding section has shown how an off-balance sheet instrument can be used
to replicate a forward-start deposit or loan. This section looks at a similar instru-
ment used for managing credit exposure in foreign exchange which can be thought
of as a cross-currency forward rate agreement.
The structure is known by the generic name of synthetic agreement for for-
ward exchange or SAFE. However, unlike FRAs, there are a number of different
types in use which differ in the nature of their payoffs. Within this category of
credit-risk reducing forward contract, there are, for instance, exchange-rate
agreements (ERAs) and forward-exchange agreements (FXAs), these being the
most common structures. The development of SAFEs (as an alternative to the
standard currency forward contract already discussed at the start of this module)
came in response to the capital adequacy guidelines imposed by the Bank for
International Settlements (BIS). SAFEs are notional principal contracts and are
treated as interest rate products, rather than currency products, and hence need a
lower level of regulatory capital in support.* Barclays Bank and Midland Montagu are
both credited with a role in developing the instruments for the international
financial markets.
To understand how the structure works, it is necessary to understand the idea of
the forward-forward foreign exchange swap transaction. The foreign exchange swap
is a purchase (sale) of one currency and a repurchase (resale) of the currency at a
later date.† The forward-forward element is when the initial currency exchange is
deferred into the future. This is different from the standard foreign-exchange swap
which has a spot or cash market initial cash flow. The cash flows for a spot foreign
exchange swap are shown in Figure 3.4. At the initial exchange, currency A is
received and currency B is paid away; at the re-exchange, the opposite occurs. The
effect is to have lent currency B and borrowed currency A over the period. We can
therefore either think of the swap as the interest rate differential between currencies
A and B, or the forward foreign exchange rate at time m between A and B. For a
delayed start or forward-forward swap, the rate at which the transaction will be
made will be the forward interest rates in the two currencies over the swap period.
* The weights attached to currency exposures by the capital adequacy regulations imposed significantly
higher regulatory capital requirements than for similar maturity interest rate products. Thus, given the
additional cost of capital to currency business, intermediaries have a strong incentive to convert such
exposures to interest rate equivalents.
† This transaction should not be confused with the cross-currency swap (currency swap) discussed in the
upcoming swaps module. We will use the term foreign exchange swap for the short-term exchange
discussed here and cross-currency swap for long-dated, multiple cash flow swaps discussed in Module
5.

In fact, the foreign exchange swap is the sister to that required by a bank seeking to
price the forward foreign exchange rate.
Foreign exchange swap period

t0 tm
Initial exchange Re-exchange
Currency A B
Currency B A
Figure 3.4 Schematic representation of a foreign-exchange swap
Quoting Foreign Exchange __________________________________
The quotation of currency pairs in the foreign exchange market involves one
currency being the base currency and the other the quoted currency. So, for
instance, when quoting sterling against the US dollar, sterling is the base curren-
cy and the dollar is the quoted currency. The quotation seen in the newspaper
or from an information provider will thus be one unit of sterling (that is, one
pound) against a variable amount of US dollars. A typical quote will thus be
$1.5425 to the pound. This is often written as £/$ for convenience.
This quotation applies even if the transaction is a forward contract. The only
difference will be that the rate will reflect the interest rate parity (IRP) condi-
tions between the two currencies. Taking our example above, if the one-year
interest rates are 3.25 per cent in dollars (quoted currency) and 4.125 per cent
in sterling (base currency), then the IRP values for the two currencies will be:
$1.5425 × (1.0325)
= $1.5295
(1.04125)
This rate is known as the forward outright.
In many instances, since the spot currency value changes as transactions take
place, it is easier to quote the forward rate not as an outright rate but in terms
of the interest rate differentials. In the above case, the interest rate differential
is (1.0325)/(1.04125) = 0.9916. But it is awkward to use this in practice. What
the currency markets do, is quote this differential in terms of the premium or
discount of the exchange rate relative to the spot rate. In the above case, this
differential is $1.5425 − $1.5295 = 0.0130.
The currency markets make two further adjustments. Quoting fractions can
lead to mistakes, so the differentials are expressed in terms of points by
multiplying the differential by 10 000.* So the one-year would be quoted as 130.
Actually, the fact that the points need to be subtracted from the spot quotation
* This might differ in some currencies where the quotation is a multiple of a single unit, such as the
Japanese yen.

is often ignored as market participants would know the interest rates in the two
currency pairs and since there is a bid-offer (bid-asked) spread, there will be
two quotations. Whether the swap points are added or subtracted will be
obvious from the quotation. (This information is given to you so you will
understand how quotations operate in the market. For the purposes of this
module, there will be no market maker’s spread and you will be given the
forward outright rates.)
Let’s see what happens if interest rates remain unchanged but the spot changes.
(Note short-term interest rate changes are far less frequent than changes in the
exchange rate.) Let us assume the dollar rate goes from $1.5425 to $1.5420.
The outright forward rate based on the equation will be:
$1.5420 × (1.0325)
= $1.5290
(1.04125)
The forward swap points will be $1.5420 − $1.5290 = 0.0130. There is no
change in the swap points (which represent the interest rate differentials) for
small changes in the spot rate. Hence it is much easier to quote the forward
rate in terms of swap points rather than in terms of a constantly changing spot
rate. Just remember that the swap points represent the interest rate differential
between the currency pair.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Let us look at an example. If the market conditions for sterling (£) and the euro
(€) are as given in Table 3.7. Note that sterling is the quoted currency and the euro
is the base currency. The transaction therefore relates to the number of pounds (or
fractions thereof) that are required to purchase one euro.
Table 3.7 Interest rate and currency conditions for sterling and the
euro
Time Sterling Euro Exchange Swap
rate points
Spot £0.6500 = €1
1 month 4.00% 3.25% 0.6504 4
6 months 4.125% 3.375% 0.6524 24
If €100 million is exchanged for one month at £0.6500 at the re-exchange, you
need €100 million × £0.6504 to receive back the same amount of euros.* If the
transaction had been for 6 months, then we would have had to pay back
€100 million × £0.6524. In fact, we could use the spot less the forward value,
known as the forward points, as an indication of the effect: 1 month = 4 points; 6
months = 24 points.† These swap points are effectively the interest-rate differential
* By convention, the interest rate differential is all taken in terms of changes in the quoted currency.
† These are positive, i.e. the swap points are added to the spot rate to get the forward outright exchange
rate.

expressed in terms of the exchange rate between the pair of currencies. The
differential for six months between the two currencies is:
(1.04125 × 0.5)
= 1.003688
(1.03375 × 0.5)
Multiplying by the value of the spot currency unit gives: £0.6500 × 1.003688 =
£0.6524. Subtracting the spot rate gives the interest rate differential in terms of
currency units. For convenience in quoting, the currency differential is quoted in
pips such that the swap points at one and six months are 4 and 24 respectively.
(That is, the differential is multiplied by 10 000.)
If we had wanted to create a foreign exchange swap that started in one month’s
time for five months, then we could have (1) entered into the long-dated swap to
obtain the currency of choice (e.g. the euro dollars) and (2) entered into an opposing
one month swap so as to eliminate the requirement to deliver sterling for the initial
one-month period (and actually receive the euros). This is an inconvenience since it
requires the user to borrow sterling and then invest the euros. By entering into the
short one-month reversing swap, the result is a forward-start swap for 5 months in 1
month’s time. The cash flows required to generate such a forward-start foreign
exchange swap are shown in Figure 3.5.
Foreign exchange swap period

t0 tm
t1
Initial Re-exchange Re-exchange

exchange No.1 No.2
Spot
A to B
for tm
+
Spot
B to A
for t1
=
Deferred start
A to B for t1 to tm
Figure 3.5 Schematics of the cash flows required for creating a forward-
start foreign-exchange swap
The level of demand for forward-start foreign exchange swaps is such that mar-
ket makers are willing to quote the above foreign exchange swap as a package. This
package is priced in exactly the same way as Figure 3.5 but removes the necessity for
the extra reversing transaction (and also increased credit exposure). The market
maker would quote the forward-start swap differential in terms of FX points as 20
(24 − 4) points. The two cash flows would then be as set out in Table 3.8.

Table 3.8 Cash flows from the forward-start foreign-exchange swap

Time Sterling Exchange Euro
rate
1 month (6 504 000) 0.6504 10 000 000
6 months 6 524 000 0.6524 (10 000 000)
If after the one month delay, the interest rate differential between the two cur-
rencies had decreased by one per cent, then (and for convenience assuming that the
spot rate is now 0.6504), the market would be quoting a forward rate of £0.6547 to
the euro. Closing out the swap at this new (5-month) rate would lead to a profit or
loss on the position as calculated in Table 3.9.
Table 3.9 Cash flows from closing out the forward-start foreign-exchange swap
Initial transactions Transactions taking place after one month
Time Sterling Euro FX rate Sterling Euro Net gain
Foreign-exchange swap 1 Foreign-exchange swap 2

1 m (a) (6 504 000.00) 10 000 000.00 0.6504
Spot (i) 0.6504 6 504 000.00 (10 000 000.00)
6 m (b) 6 524 000.00 (10 000 000.00) 0.6524
5 m (ii) 0.6547 (6 547 000.00) 10 000 000.00

20 000.00 0 (43 000.00) 0
£(23 000.00)
€(14 959.20)
Note: the initial transaction has a start date at 1 month and a completion date in 6 months (transactions a and b). The
reversing swaps with the opposite signs take place after 1 month and include a spot transaction and a 5-month
forward transaction (transactions i and ii). The resultant losses and gains from the four transactions indicate a net loss
of £23 000.
The cash flows computed in Table 3.9 show that the package of forward transac-
tions involve actual cash flows between the two parties, as would also be the case in
a single currency forward-forward deposit. If the requirement is to exploit or hedge
against changes in interest rate differentials between the two currencies, the logical
step is to remove these cash flows and pay only the difference at maturity (or as
with the FRA, the present value of the gain).
The SAFE is therefore an agreement between two parties which either want to
hedge against or speculate on a change in the interest rate differentials between two
currencies. Or equivalently, a change in the forward swap points of the currency
pair.

Synthetic Agreement for Forward Exchange (SAFE) Definitions

___________________________________________________________
 primary currency: the base currency for the SAFE;
 secondary currency: the foreign currency;
 settlement date: the date at which the currencies are initially exchanged;
 maturity date: the date at which the currencies are re-exchanged;
 buyer: the party which notionally obtains the primary currency at the
settlement date and repays the primary currency at the maturity date;
 seller: the party which has the opposite position to the buyer, sells the
primary currency at the settlement date and repurchases the primary cur-
rency at the maturity date.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
As we said at the start, there are two major variants of SAFEs. We will discuss
the exchange rate agreement (ERA) first, as it is the simpler instrument and similar
to an FRA. The difference is that the contract is not on an interest rate, but on the
interest-rate differential between the pair of currencies. The second type of SAFE,
the forward exchange agreement (FXA), is a contract for differences on the foreign
exchange swap we have just looked at. In practice, the actual choice of contract
(ERA or FXA) will depend on the type of exposure or protection required.
3.5.3 Exchange-Rate Agreement (ERA)

The exchange rate agreement (ERA) offers a payoff that is conditional on the
change in the forward swap points over the contract period. That is, it has a value
that depends on the change in the interest rate differential between the two con-
tracted currencies.
The payoff of an ERA is calculated as follows:
( − ) ﴾3.21﴿
Settlement amount = Notional principal ×
×( − )
(1 + )
100 × basis
where is the forward points at the settlement date, the forward points as
originally contracted, is the interest rate over the period between the settlement
date ( ) and the maturity date ( ), and the notional principal is the contracted
amount in the primary or base currency.
Take the example as per Table 3.9. If we had contracted using an ERA for €10
million against sterling with a one-month deferred swap over 6 months, with the
forward points contracted at 20, at the settlement date the points have moved to 43.
Note that in FRA terminology this would be a 1 v. 6 type contract. Given the 5-
month interest rate in sterling is now 5.00 per cent (we have assumed that all the
interest change has occurred on the sterling side), the settlement amount would be:
(0.0020 − 0.0043) ﴾3.22﴿
22 531 = €10 000 000 ×
5.00% × 150
1+
100 × 365

The payment here is the same (but present valued to the settlement date) as that
shown in Table 3.9 because all the gain (loss) arises from a change in the forward
points. However in practice in most cases, there will also been some movement in
the spot rate which can either increase or decrease the profit or loss from the
forward-start foreign exchange swap. This does not form part of the ERA calcula-
tion. It does, however, feature in the calculation for the forward exchange
agreement (FXA) contract.
Note too that, as with the FRA contract, the payment is present valued to the
settlement date. As a result, the credit exposure period is the one month between
the transaction date and the settlement date, rather the full swap period to the
maturity date of the re-exchange period. As with the FRA, the result is to further
reduce the capital requirements on the contract relative to the conventional foreign
exchange swap since all obligations by both parties are extinguished at the settle-
ment date.
British Bankers Association Settlement Terms for SAFEs ______
The British Bankers Association formula for calculating the settlement amount is as
follows:
( / / ) ( / ) ﴾3.23﴿
×
×
− × OEX / − BBASSR /
where:
C1: primary currency
C2: secondary currency
A1: first amount in the SAFE contract
A2: second amount in the SAFE contract; for ERAs, 1 = 2
BBASFSc1/c2: British Bankers Association settlement rate for the forward
spread
BBASSRc1/c2: British Bankers Association spot settlement rate (for ERAs this
is zero)
BBAIRc2: British Bankers Association interest rate for the second curren-
cy for the period T
FS: forward spread contracted in the SAFE
OEXc1/c2 outright exchange rate to the settlement date (this is nil for
ERAs)
Tsm: time from settlement to maturity (for the ERA this is the swap
period)
Basis: number of notional days in the year, either 365, for sterling, or
360, for most other currencies

An example of the settlement price on such an agreement would be a transac-

tion between sterling and the US dollar FXA for £10 million at the start date
and £12 million at the maturity date:
C1: sterling (first currency [base currency in the currency pair])

C2: US dollars (second currency [quoted currency in the currency
pair])
A1: £10 000 000 (first amount in the SAFE contract)
A2: £12 000 000 (second amount in the SAFE contract)
BBASFSc1/c2: 50
BBASSRc1/c2: $1.4650
BBAIRc2: 8.5%
FS: 75
OEXc1/c2: $1.5240
Tsm: 90 days
Basis: 360 for the US dollar
This gives:
( . . ) ( . . )
US$73 892.29 = £12 000 000 . %×
×
−(£10 000 000 × [1.5240 − 1.4650])

Note that the FXA provides the user with the flexibility of different notional
amounts at the theoretical initial and re-exchange of the two currencies.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
3.5.4 Forward-Exchange Agreements (FXA)

In the case of the exchange rate agreement (ERA) only the changes in the forward
swap points are used in the contract. In the case of the forward exchange agreement
(FXA), the contract covers both a change in the swap points and a change in the
spot rate between the transaction date and the settlement date. The FXA is there-
fore equivalent to a forward foreign exchange swap, but without the need to
exchange principal. Since the principal element is removed, the credit exposure is
significantly reduced allowing a greater variety of users to use these synthetic
forward swap agreements.
The computational formula for an FXA is:
( + )−( + ) ﴾3.24﴿
Settlement amount = × − ( − )
×( −
(1 + )
100 × basis
where is the notional amount of currency exchanged at the maturity date, the
notional amount of currency at the start date, is the outright exchange rate at the

settlement date, the contract outright exchange rate and the other terms are as per
the ERA. The equation can be divided into two parts. The elements within the
brackets relates to the changes in the maturity leg of the swap will the other compo-
nent relates to the changes in value at the settlement leg of the swap.
Note there are several terms that need to be carefully identified. The rate is the
contracted forward rate. In our example this is the one month outright rate
(£0.6504). The forward points will be the swap points for the 1 v. 6 transaction,
namely 20 points. The outright exchange rate for the maturity leg at initiation will be
£0.6504 as per the then market. The settlement values will be the value of the
spot rate at the settlement date (that is, in one month’s time from initiation) and
will be the then forward points for the 5 months to the swap’s maturity date.
Using the same example, the settlement amount on the FXA will be:
(0.6504+0.0024) − (0.6504+0.0043)
£10 000 000 × − £10 000 000
5.00% × 150
1+
100 × 365
× (0.6500−0.6504)
The payoff on the FXA is equivalent to the value obtained in Table 3.9 when we
calculated the gain from the forward-start swap, except that it has been present
valued to the start of the swap period. The equivalent future value is £(23 000), if
the discounting part of Equation 3.23 is ignored, which is the same as that obtained
in Table 3.9. Since by calculation there has been no movement in the contracted
spot rate, the term × ( − ) is zero and the payment is the same as for the
ERA.
Note that the calculation here has been slightly changed from the layout in Equa-
tion 3.23 to show where the value change has arisen. The initial forward rate on the
forward-start swap was the difference between the initial spot of £0.6500 and the
one month swap points which were 4 and the six month swap points of 24, giving a
forward differential of 20 points over the 5 months. At settlement this differential
has changed to 43 points, giving a gain of 23 points, as per the ERA. However, the
exchange rate has also changed, moving from £0.6500 at the onset to £.6504 after
one month. Because we have assumed the spot rate after one month is the same as
the one month forward, there is no value adjustment required from changes in the
spot rate (this is the right hand element of Equation 3.23: × ( − ). Typically,
the spot rate at settlement will differ from the settlement forward outright rate in
the FXA contract.
If the spot rate had moved not the contracted rate of £0.6504 but to £0.6510 and
had remained unchanged at £0.6500, then the settlement value of the FXA would
have been £(18 531) and £(28 531) respectively.
Quoting SAFEs _____________________________________________
The market will quote SAFEs in the same way as other financial instruments. As
with the FRA, the quote will be for a 1 v. 4, 2 v. 5, 3 v. 6, and so on. A market
maker will quote the offered side as the lower of the two swap points (for
instance 110/114). The trader is offering to sell the SAFE at 110 and buy at 114.

At first sight this defies the normal logic of buying low and selling high. Howev-
er, as we have demonstrated, the payoff from the SAFE depends on a change in
the swap points over the contract period in the secondary currency. Looking at
the ERA, for simplicity, we can see that the payments to be made/received will
decrease if the contracted rate is increased. The original ERA settlement
amount was £(22 531) when the swap points were 20. If the swap points had
been 15, then the payment would have been:
(0.0015 − 0.0043)
£27 429 = £10 000 000 ×
5.00% × 150
1+
100 × 365
This means that, with the points at 20, we have £(22 531) and at 15 it is
£(27 429). A positive number means a payment has to be made to the buyer;
the first term ( ) is the contracted rate, the second the settlement rate ( ).
The SAFE buyer is anticipating that swap point rates will fall, so that, at settle-
ment, the value of ( − ) is positive.
This is due to the nature of the settlement formula used. Buying a SAFE is
equivalent in swap terms to buying the primary currency (selling the secondary
currency, in this case selling dollars and buying sterling) at the settlement date
and selling the primary currency (buying the secondary currency, that is buying
dollars and selling sterling) at the maturity date. This means in order to make
money, the trader acts in a counterintuitive manner and must sell high and buy
low to make his spread. The SAFE user is equally following a buy high/sell low
approach in aiming to get the greatest difference between the contracted rate
( ) and the settlement rate ( ).
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
To summarise the attraction of the SAFE family of contracts. They provide

currency protection, but only pay the difference in the rates rather than requiring a
full transfer between the two parties as with the conventional forward-start foreign
exchange swap. As we have shown, there are significant differences between the
way the exchange rate agreement (ERA) and the forward exchange agreement
(FXA) work. The instruments are designed to achieve different objectives. The ERA
allows interest rate differentials to be covered, whereas the FXA acts like a contract
for differences on the foreign exchange swap. By reducing the credit exposure of
forward contracts, these instrument provide an opportunity for currency protection
to less creditworthy firms or require less capital to be set aside against potential
credit losses.

Forward contracts exist on a great range of different financial instruments and
commodities. They are transacted between firms in the over-the-counter markets,
are bilateral agreements and can be modified to meet both parties’ needs. This
inherent flexibility in relation to terms and conditions makes them very useful
instruments.

The basic model for valuing a forward contract is the cost-of-carry model. This
might equally be called the ‘pricing through hedging’ model since it is based on the
net cost of eliminating the price risk by the seller of the contract. For most forward
contracts this will be the net funding costs associated with holding the underlying
asset, plus some storage, and other ancillary costs. In situations where storage and
other costs are virtually zero, as with financial instruments, the cost-of-carry model
is simply the net interest-rate cost over the contract period to the future delivery.
The attraction of the forward contract as a risk-management instrument is that it
provides a simple way of eliminating future uncertainty on the price or rate at which
a transaction can be made at some point in the future. Whereas the tailored nature
of the forward is very advantageous, the fact that it is a bilateral agreement means
that both parties to the contract have counterparty risk on the other. This makes
forward contracts credit instruments with all the disadvantages that these entail.
Variations on the basic forward have been developed to reduce the credit ele-
ment on such contracts. Two examples, the forward-rate agreement (FRA) and the
synthetic agreement for forward exchange (SAFE), show how an instrument can be
developed which mitigates credit risk. The FRA is a useful instrument for eliminat-
ing interest-rate risk. The SAFE group of instruments provide an equal structure
between two currencies, the ERA being an instrument that protects against move-
ments in the forward points, or interest-rate differential; while the EXA has the
same exposure as a forward-start foreign-exchange swap. The latter instrument
makes it more useful in hedging currency risk, but without the same degree of
counterparty exposure that is inherent in a conventional swap contract.
Of course, intermediaries have other ways of controlling credit risk, for instance,
by requiring the other party to post a surety or performance bond (collateral). Such
an approach will be looked at in the context of the futures contract, which forms
the basis of the next module.
Review Questions
3.1 The interest rate in US dollars is 5 per cent per annum and that in French francs is 6.5
per cent per annum. The spot exchange rate is FFr6.50/US$.
What is the forward rate in five months’ time between the two currencies?
A. FFr6.4085
B. FFr6.4598
C. FFr6.4617
D. FFr6.5385
3.2 In a forward contract, the buyer agrees to:

A. provide delivery of the product.
B. accept delivery of the product.
C. fix the price at which the transaction will take place.

3.3 The principal purpose of a forward transaction is to allow market participants:

A. to speculate on current values.
B. to hedge the current spot value.
C. to fix transaction prices.
3.4 The cost-of-carry model is:

A. the price paid by the buyer to the seller for agreeing to enter into a forward
transaction.
B. the costs associated with holding assets for future delivery.
C. the cost of hedging a forward transaction.
3.5 A forward contract which involves no storage or wastage cost has a forward price for
three months’ delivery of 335.25. The cash commodity price is 325.75.
What is the implied interest rate?
A. 2.9 per cent.
B. 9.5 per cent.
C. 11.7 per cent.
D. 12.2 per cent.
3.6 A commodity has a dollar storage cost per month of $5 per ton. The one-month
interest rate is 9 per cent and the spot price for the commodity is $723.50/ton.
What would we expect the forward price to be?
A. $728.7
B. $733.8
C. $788.6
D. $793.6
3.7 A forward contract has been entered into to purchase an asset. It has an original
maturity of six months and a contract price of 950.25 when originated. The contract
now has three months to maturity and the spot price of the asset is 875.80, the three-
month interest rate is 6.5 per cent (there are no holding costs).
What is the replacement cost of the contract?
A. Nil.
B. 59.6
C. 60.6
D. 74.5
3.8 A financial instrument which pays no interest is trading in the market at 450.25. The
term structure of interest rates is flat at 8.5 per cent. The prices of two forward
contracts on the financial instrument (which has no storage costs), with three and six
months’ maturity, will be:
A. 459.5 and 469.0.
B. both contracts will be priced at 450.3.
C. both contracts will be priced at 464.3.
D. 469.4 and 488.52.

3.9 As a rule, forward contracts have the following features:

I. Forwards are traded between participants on an organised exchange.
II. Forwards are traded directly between participants.
III. The contract is based on mutually agreed terms.
IV. The contract is based on standardised terms and conditions.
V. A forward contract will only roughly hedge an exposure.
VI. A forward contract will perfectly hedge an exposure.
A. I, IV and V.
B. I, III and VI.
C. II, III and V.
D. II, III and VI.
3.10 The major cause of credit problems in forward contracts is:

A. the lack of suitable counterparties to take the opposite position.
B. the risk that a counterparty will not honour the agreement.
C. the lack of liquidity in such contracts.
3.11 In undertaking a forward contract to hedge a position, a participant is:

A. exchanging a liquid instrument for an illiquid one.
B. exchanging a current obligation for a future-dated one.
C. exchanging a high probability of price changes for a low probability of non-
performance.
3.12 In the forward markets an arbitrageur will ____ the cash instrument and ____ the
forward if the forward is trading ____ to the cash.
Which of the following is correct?
A. buy sell cheap
B. sell sell expensive
C. buy buy expensive
D. sell buy cheap
3.13 When comparing forward transactions with similar cash market transactions we expect
that:
A. cash and forward markets have the same bid-offer spread.
B. cash market bid-offer spreads are smaller than forward market ones.
C. cash market bid-offer spreads are larger than forward market ones.
D. some cash market bid-offer spreads are smaller and some larger than forward
market ones.

This table is used for Questions 3.14 to 3.16.
Time t=1 t=2 t=3 t=6 t=12 t=18

Rate % 8.25 8.3125 8.4375 8.625 8.75 8.9375
3.14 What is the forward-start deposit rate for three months starting in three months’ time?
A. 8.4375 per cent.
B. 8.5313 per cent.
C. 8.625 per cent.
D. 8.8128 per cent.
3.15 The market would refer to a forward-start arrangement as an ‘ versus ’ agreement.

For Question 3.14, and are:
A. 1 and 3.
B. 3 and 3.
C. 3 and 6.
D. 1 and 6.
3.16 The market in short-term interest rates uses simple interest to calculate values.
Assuming that months are one-twelfth of a year, what is the six months’ deposit rate
starting in one year?
A. 8.5632 per cent.
B. 8.75 per cent.
C. 8.8438 per cent.
D. 8.9375 per cent.
3.17 A forward-rate agreement (FRA) for £100 000 000 has a contracted rate of 8.25 per
cent and the actual rate for the six months’ deposit on the contract at settlement is
7.875 per cent.
What will be the amount paid by the buyer of the contract?
A. No money is exchanged between the parties.
B. The buyer receives £180 397.
C. The buyer pays £180 397.
D. The buyer pays £187 500.
3.18 A forward-rate agreement (FRA) for US$20 000 000 has a contracted rate of 6.15 per
cent and the actual rate for the three months’ (91 days) deposit at expiry is 6.375 per
cent.
What will be the amount paid or received by the seller of the contract?
A. The seller receives US$310 917.
B. The seller receives US$11 375.
C. The seller pays US$11 375.
D. The seller pays US$11 194.

The following information is used for Questions 3.19 to 3.23.
Initial exchange rate (US$/£)

Spot 1m 2m 3m 4m 5m 6m
1.6385 1.6377 1.6360 1.6351 1.6303 1.6238 1.6190
Exchange rate after one month (US$/£)

Spot 1m 2m 3m 4m 5m 6m
1.5450 1.5451 1.5450 1.5449 1.5447 1.5444 1.5441
3.19 You enter into a spot-start foreign-exchange swap for £5 million for three months
involving an initial sale of US dollars. At the maturity date:
A. you pay £5 million and receive US$8 175 500.
B. you receive £5 million and pay US$8 192 500.
C. you receive £5 million and pay US$7 724 500.
D. you pay £5 million and receive US$7 725 000.
3.20 In the swap entered into in Question 3.19 above, after one month you decide to
reverse the swap (that is, trade on the other side) to eliminate the position.
What transaction do you undertake?
A. You sell sterling and buy US dollars spot and buy US dollars and sell sterling
forward.
B. You buy sterling and sell US dollars spot and sell US dollars and buy sterling
forward.
C. You buy sterling and sell US dollars spot and there is no further liability at the
forward date.
D. You sell sterling and buy US dollars spot and there is no further liability at the
forward date.
3.21 In the transaction in Question 3.20, what is the net book gain or loss from entering into
the transaction (ignore discounting and the timing of the cash flows)?
A. (US$17 000).
B. (US$450 500).
C. (US$467 500).
D. US$450 500.
3.22 You enter into a forward-start foreign-exchange swap in three months’ time for three
months for £8 million in which you agree to pay sterling and receive US dollars at the
start date.
How many US dollars will you receive at the start of the swap?
A. US$12 359 200.
B. US$12 952 000.
C. US$13 080 800.
D. US$13 108 000.

3.23 In the forward-start swap given in Question 3.22 above, after one month you decide to
close out the position. What are the net payments remaining on the transaction?
A. A receipt of US$720 800 in two months and a payment of US$596 800 in five
months.
B. A receipt of US$128 800 in two months and a payment of US$4800 in two
months.
C. A receipt of £80 259 in two months with no further obligation.
D. A payment of US$720 800 in two months with no further obligation.
3.24 In a synthetic agreement for forward exchange (SAFE), the buyer of the contract will
notionally:
A. sell the base currency at the settlement date and repurchase it at maturity.
B. sell the foreign currency at the settlement date and repurchase it at maturity.
C. sell the base currency at the transaction date and repurchase it at the settle-
ment date.
D. sell the foreign currency at the transaction date and repurchase it at the
maturity date.
3.25 In the forwards markets an arbitrageur will buy the cash instrument and ____ the
forward if the forward is ____ relative to the cash.
A. sell cheap
B. sell expensive
C. buy expensive
D. buy cheap
3.26 The initial and current exchange rates after one month between the US dollar and the
Deutschemark (DM) are given as follows:
Initial conditions
Time Spot 1m 2m 3m 6m
DM/$ 1.56 1.559 1.557 1.553 1.54
Conditions after one month

DM/$ 1.57 1.568 1.564 1.561 1.553
If a US$10 million forward foreign-exchange swap for the 3 v. 6 months’ maturity had
been undertaken in which at the near date dollars had been sold, what would be the
marked-to-market value of the foreign-exchange swap after one month (ignore present
valuing and the effect of interest rates)?
A. (DM110 000).
B. DM0.
C. DM20 000.
D. DM130 000.

3.27 If the spot exchange rate between sterling and the euro is £0.6575 per euro and the
three months interest rates in sterling is 5.125 per cent and that for the euro is 3.75 per
cent, what will be the swap points for the three-months forward exchange rate? Is it?
A. 87.
B. 33.
C. 22.
D. −82.
3.28 If the spot exchange rate between the US dollar and the euro is $0.9823 and the
forward points at one-year are −124, which of the following is correct?
A. The swap points are negative because the one-year US dollar interest rate is
above the one-year interest rate in euros.
B. The swap points are negative because the one-year US dollar interest rate is
below the one-year interest rate in euros.
C. The swap points are negative because the two interest rates are the same.
D. It is not possible to tell from the information provided which interest rate is
the higher.
Case Study 3.1: Interest-Rate Risk Protection

The current date is 1 January and Dreadnought plc has a future borrowing requirement for
DM15 million in three months’ time for three months. The finance director of the company is
concerned that interest rates will rise in coming months and wants to protect the firm’s
borrowing requirement. The decision is reached that a forward-rate agreement (FRA) would
best hedge the exposure. The current yield curve, DM yield curve and FRA rates are as below:
1 Jan 1 Feb 1 Mar 1 Apr 1 May 1 June 1 July

1m 2m 3m 4m 5m 6m
No days 31 28 31 30 31 30
Offered 6.50 7.125 7.125 7.1875 7.25 7.25
Bid 6.375 7.00 7.00 7.0625 7.125 7.125
A market maker quotes the 3 v. 3 DM-LIBOR FRA rate as: 7.28 –18.
1 Which element of the FRA quote is relevant from the company’s perspective?
2 After three months, the three-month LIBOR rate has risen to 7.85 per cent. What are
the payments that have to be made or received on the FRA and what is Dreadnought’s
actual cost of funds on its borrowing? Use the exact day count. What would the cost of
funds have been had the LIBOR rate fallen to 6.50 per cent? (The year basis for DM is
360 days).

Case Study 3.2: Exchange-Rate Protection

Initial market conditions
Interest rates Exchange rate
in US dollars Interest rates (dollars per
Time Days (per cent) in Euros (per euro)
cent)
Spot 1.1500
1 month 30 4.25 3.25 1.1510
2 months 60 4.3125 3.375 1.1518
3 months 90 4.375 3.375 1.1529
The basis is 360 for both US dollars ($) and euro (€)
Conditions at settlement
Interest rates Interest rates Exchange rate
in US dollars in Euros (per (dollars per
Time Days (per cent) cent) euro)
Spot 1.1900
1 month 30 4.125 3.125 1.1910
2 months 60 4.25 3.25 1.1920
3 months 90 4.3125 3.25 1.1931
The basis is 360 for both US dollars ($) and euro (€)
1 If we enter into an exchange rate agreement (ERA) with a settlement date in one month
and a maturity date of 3 months (as of initiation) (90 days) for an amount of €100
million, what is the settlement amount that is paid on the contract? (use the exact day
count/basis)
2 If we had sold the ERA would we have made or lost the amount determined in
Question 1?
3 If, however, the contract had been a forward-exchange agreement (FXA) and the two
amounts were €100 million at the near date and €120 million at the far date, what
would have been the payment?
4 Explain the difference in the settlement values of the two contracts.

Module 4
The Product Set:

Terminal Instruments II – Futures
Contents
4.1 Introduction.............................................................................................4/2
4.2 Futures Contracts ...................................................................................4/2
4.3 Types of Futures Transactions ........................................................... 4/13
4.4 Convergence ........................................................................................ 4/18
4.5 The Basis and Basis Risk...................................................................... 4/21
4.6 Backwardation and Contango ............................................................ 4/35
4.7 Timing Effects ...................................................................................... 4/37
4.8 Cash–Futures Arbitrage ...................................................................... 4/40
4.9 Special Features of Individual Contracts .......................................... 4/42
4.10 Summary of the Risks of Using Futures ............................................ 4/46
Learning Objectives
This module continues the examination of the nature and use of terminal products
by looking at the second type of basic derivative, namely futures. Terminal contracts
are of three kinds: the simplest is the forward contract, already discussed in Module
3, which is a bilateral agreement between two parties; the futures contract is an
exchange-traded contract which has many of the features of a forward contract but
is designed to eliminate, to a large extent, the credit-risk element that exists in
forwards.
The key determinant of the pricing of all the terminal instruments is through
hedging or the cost-of-carry model.
After completing this module you should:
 be able to price a futures contract;
 understand the technical differences between a forward contract and a futures
contract;
 know how specific futures contracts work in currencies and interest rates;
 understand the effects of the basis on a futures price;
 know what is meant by backwardation and contango in futures prices;
 know what convergence means and how it affects the futures price over time;
 know the limitations involved with futures contracts for hedging purposes.

Module 4 / The Product Set: Terminal Instruments II – Futures
4.1 Introduction
In the nineteenth century, Chicago, Illinois, emerged as a market centre for farm
products in the mid-west United States. In the fall, farmers would take their produce
to Chicago in order to sell it. However, there was such a glut of grain at this period
that some farmers, for want of buyers, ended up dumping the unwanted produce in
Lake Michigan. This was in stark contrast to the situation that existed in the spring
when there was a shortage and grain prices rose significantly. Grain prices thus
followed a rollercoaster pattern, plunging in the fall when deliveries took place from
the agricultural hinterland and soaring in the spring when weather conditions meant
that transport to market was extremely difficult. Grain merchants realised that there
had to be a better way of organising the business. To ensure supply, merchants
entered into forward contracts with farmers and also with consumers. However, as
we saw in Module 3, the forward contract involved taking counterparty risk. In
periods of shortage, farmers have a strong incentive to sell elsewhere; in times of
plenty, consumers want to renege on contracts. As a result, two developments
occurred. One involved merchants developing standardised contracts in order to
minimise contractual disputes. The second was the setting up of a central organisa-
tion to trade agricultural produce – and the Chicago Board of Trade (CBOT) was
established in 1848. This formalisation of the arrangements in agricultural produce
allowed merchants to invest in silos to store grain for the periods of scarcity. Over a
number of years, the contractual arrangements used by the CBOT were refined,
contracts became largely standardised and, finally, the concept of margin or perfor-
mance bonding was introduced. These features, an organised exchange, standardised
contracts and margining (with a daily ‘marking to market’ or revaluation of the gains
and losses on contracts), are the principal distinguishing characteristics between
futures and forward contracts. These institutional arrangements largely eliminate
performance risk for both the buyer and the seller. The formula has proved an
enduring one, with the basic approach being used around the world in a variety of
futures exchanges on commodities, metals, financial instruments and currencies.
4.2 Futures Contracts

There are many different futures contracts and markets. The principal distinguishing
features between the over-the-counter (OTC) forward market and the exchange-
traded futures market in the same asset relate not to fundamental differences in their
economic effect, but to institutional arrangements for handling counterparty risk
and providing liquidity. The first problem is addressed by requiring all participants
to post a performance bond and revaluing the position each day, at which point
the losers ‘pay up’ on their losses. Equally winners have their gains credited to their
account every day. Liquidity is provided by restricting the number of maturity dates
and standardising the nature of the contracted instruments. The key differences
between forwards and futures are summarised in Table 4.1.

Table 4.1 Differences between forward and futures contracts

Forward contracts Futures contracts
All terms negotiable; private transaction Standardised terms; exchange-traded
Default risk (participants must have good credit Virtually no default risk
standing or post a deposit)
No intermediate cash flows Daily cash flows from margin changes as price
changes (to ensure performance of the con-
tract)
Creating contract often costly due to Low cost
intermediary’s profit margin
Cannot (usually) be traded before delivery; Can trade contract on an exchange which has
requires either (a) counter-trade; or (b) liquidity
cancellation by mutual agreement
Contract can be for any amount/ specification Specified contract amount or multiples thereof
Any expiry, settlement or maturity date Specific expiry date(s) (there can be as few as 4
in a year)
Terms and conditions as negotiated Standard terms as laid down by the exchange
Counterparty can be anyone Exchange clearing house
No price variability or quality risk from Risk related to differences between standard-
negotiated contract ised contract and security (position)
Cancellation by mutual consent (usually with Has to be ‘offset’; i.e. sold if owned; bought back
compensating payment) if sold short
No margin requirements Initial and variation margin required
The major types of futures contracts are listed in Table 4.2. An examination of
the table will show two things. The first is that there is a wide range of contracts to
cover different economic risks. The second is that each contract covers a major
asset class or risk type. For instance, despite the market size of corporate bonds,
there is currently no corporate bond futures contract in existence.*
Corporate bonds are very heterogeneous as far as credit quality, terms and condi-
tions are concerned, and maturity and hence standardisation is difficult. A generic
contract on such instruments would be hard to engineer. Similarly, more specific
contracts on a particular corporate type would suffer from lack of interest since any
single sub-category of corporate bond would appeal to relatively few investors. As a
result, a futures contract will be successful only if it provides a hedging mechanism
for a large number of market participants. The types of contracts in existence can be
seen as locus points in a continuum of instruments and/or exposures.† Futures
contracts require liquidity (that is, the participation of a large enough group of active
* Note that in the USA, there are municipal bond futures contracts.
† The government bond futures contract allows the hedging of interest-rate risk in corporate bonds. It
will not be a perfect hedge since there will be changes in the default spread over time. However, for
most users the attractions of a liquid contract outweigh the disadvantages of what are known as cross-
asset positions.

users) to reduce transaction costs and ensure sufficient trading volumes. Thus
futures contracts provide general cover at the expense of asset specificity. A trade-
off between transaction costs and liquidity and asset specificity is a feature of
futures. This is not a consideration with forward contracts since their bilateral nature
means that all the necessary specific features can be included in the agreement.
Table 4.2 Major categories of futures contracts

Usual deliv-
Type of futures contract Nature of underlying ery/Settlement at
expiry**
Currency futures Exchange of two currencies Give the right to buy and sell
a particular currency
Currency index futures Currency index Cash-settled exposure into a
basket of currencies
Short-term interest-rate futures Treasury bills; bank deposits Deliverable into a money
market instrument or a cash-
settled bank deposit equiva-
lent
Medium-term interest-rate Usually bonds or notes with Deliverable into an interme-
futures (a.k.a. bond futures) maturities of around 5 to 7 diate-term bond or note
years
Long-term interest rate futures Usually bonds with maturi- Deliverable into a long-term
(a.k.a. bond futures) ties around 10 years, or bond
longest available in the
market
Futures on an index of interest- Index of swap rates from Cash settled

rate swaps leading interest-rate swap
intermediaries
Spread futures Difference between two Cash settled
market reference points or
indices
Stock futures (on individual Single common stock issue Deliverable stock or cash
stocks) settled
Stock index futures (a.k.a Provide exposure to Cash settled
index futures*) performance of a stock
index
Commodity index futures Index of commodities Cash settled

Agricultural futures or softs Perishable commodities Deliverable into underlying
physical commodity
Industrial metal futures Base metals used in produc- Deliverable into underlying
tive process physical commodity
Precious metals futures Rare and precious metals Deliverable into underlying
physical commodity

Energy futures Oil and other energy Deliverable or cash settled,

products depending on contract
Freight futures Index of freight costs Cash settled
Insurance futures Index of catastrophic Cash settled

insurance losses
Weather futures Temperature index Cash settled

* This term is misleading since it is possible to have indices on other underliers than a portfolio or index of stocks
(e.g. commodities).
** ‘Deliverable’ means that the underlying cash market instrument or commodity is provided by the short position
holder; ‘cash settled’ means that the gains and losses are paid up in cash. Participants who desire the underlying
physical commodities buy them in the market directly. In some cases, with cash-settled contracts, the buyer can elect
to receive the underlier at expiry.
The structure of futures markets where there is a central, often physical, market-
place means that the trading and pricing of futures is transparent. The trading
arrangements, which involve brokers executing orders via open outcry and rapid
reporting and settlement of positions, ensure that pricing information is widely
available. Such transparency helps in providing information on the current and
future cash price based on known information. Although the value of a futures
contract is largely dictated by the term structure of interest rates, trading activity, the
demand for and the supply of futures (the ‘open interest’ and ‘volume’ of a particu-
lar contract) provide a forecast of the future price based not just on current
information but also on the consensus of market participants’ expectations.*
Another important function is the ability of futures markets to provide risk ad-
justment to cash or physical market positions. This is probably the most important
function of futures in that they provide a market for the trading of risk. Futures
markets are wholesale markets in risk management. In the futures markets risks are
transferred from the cautious to the more intrepid, the reckless or those better able
to absorb the risk. The key economic advantages and disadvantages of futures
markets are summarised in Table 4.3.
Table 4.3 Advantages and disadvantages of futures markets

Economic advantages of futures markets
Increased (economic) A central marketplace integrates the various segments of a
efficiency market; the availability of standardised contracts increases the
liquidity of the market
Increased availability of Futures markets provide price, volume and open-interest
information (outstanding contracts) information; they also act to discover the
market clearing price (price discovery/expectations of the
market)
* ‘Open interest’ is the sum of all the bought (or sold) contracts that are in existence. ‘Volume’ is the
number of contracts traded on the exchange in a given period, usually a session (day). The greater the
open interest and volume, the more hedging and speculating activity there is taking place. Market
participants monitor these variables to try to discern changes in market behaviour.

User-specific advantages of futures markets

Reduced transaction costs Commissions, bid-offered spreads and costs of effecting a short
sale are smaller than those for cash markets
Reduced credit-risk expo- The clearing house acts as counterparty to all transactions; the
sures requirement to provide margin largely eliminates performance
risk (counterparty risk)
Ability to create synthetic Allow the creation of cash and futures positions that would be
securities prohibitively expensive in the cash markets alone
Allow for hedging and Leverage or gearing on futures contracts allows hedging or
speculation speculative activity to take place with minimal (additional)
investment
Price disclosure Centralised marketplace provides transparency of pricing
Disadvantages of futures markets
Possibility of price squeezes The risk that a few individuals take control of available supply,
thus driving prices above fundamental value
Require a cash deposit to Affect the cash flow of the transaction since margin requirements
collateralise the position are unpredictable
Require the position holder Create timing mismatches between losses and gains on hedging
to pay out on losses on a transactions
daily, mark-to-market basis
Imperfect hedging Behaviour of cash and futures markets do not fully correspond
over the short term
An important function of futures markets is to provide price discovery. This

arises in those futures markets where the underlying asset has yet to come into
existence. For instance, it is April and the contract for September delivery of wheat
reflects two factors: expected demand for wheat at that period and expected supply.
Thus observers of the futures price are provided with information about the likely
market for the coming harvest. The price of the futures contract tells us something
of the market’s views on supply/demand factors in a product it is impossible to buy
in the physical markets. One can read about and observe commodities futures
markets reacting to events that change the future supply of and demand for those
products which are greatly susceptible to price discovery. Note that, on the whole,
financial futures markets are dominated by the cost-of-carry principle since the
supply of underlying financial instruments is generally infinite and any shortage is
likely to create its own supply.

Trading Futures Contracts __________________________________

Futures exchanges which have a physical floor locate futures activity in areas
known as ‘pits’.* Each pit normally trades one type of future. A large exchange
may have quite a number of different contracts, each with its own pit. The pit is
octagonal and it is sunk into the floor in a series of steps. This shape allows
traders to see each other across the pit so as to be able to carry out transactions.
These are done through a direct auction process known as ‘open outcry’ where
buy and sell orders are shouted (cried out) between all traders in the pit until a
match is made. The match is then recorded by an official of the exchange for
entry into the price dissemination and settlement system. Each broker will also
confirm the transaction with his/her own firm at the booth on the floor of the
exchange. This information is then fed into the exchange clearing house’s settle-
ment system. Confirmation is also passed back to the client. The basic sequence
of events is shown in Figure 4.1.
Futures exchanges pride themselves on both the speed at which transactions
can be carried out and the openness of the pricing involved. Open outcry
provides a visible two-sided auction process in which each trader seeks the
lowest buy (highest sell) price at which to execute the transaction. This is
immediately communicated to all traders wanting to take the opposite position.
Only the best bid and offer are allowed to appear in the marketplace. If the
trader is willing to pay the highest price, this is announced and all lesser bids are,
as a result, silenced. In this case, the best buying price will prevail at the expense
of the others. Similarly, giving the lowest selling price will ensure that the
transaction gets priority of execution. Market forces therefore determine the
result, with increased buying pushing up the price and increased selling pushing
down the price.
Behind the market, the exchange has a key role in promoting an orderly market,
ensuring that all transactions entered into are correctly recorded for settle-
ment, disseminating price and other information to all market participants, and
providing a set of rules that all members are required to follow. The exchange
may also have a regulatory role. In addition, its members act as guarantors of
the integrity of the clearing house system, ready to make good any default by
market participants.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
* Unlike many other financial markets, some futures exchanges still have a physical trading floor and
brokers working in the pits. However, new ‘electronic’ exchanges which use screen-based trading that
provides the same orderly market as traditional floor exchanges have come to dominate the industry.
Some of the new electronic exchanges have been extensions of the existing physical exchanges and the
two systems work side-by-side whereas others are new challengers.

Buying Selling
client client
Confirmation Telephoned Confirmation

of the Telephoned of the
order order
transaction transaction
Account Account
broker broker
at futures firm A at futures firm B
Confirmation Transmission Transmission Confirmation

of the of the order of the order of the
transaction to the exchange to the exchange transaction
Broker A's Broker B's

booth booth
on the exchange on the exchange
floor floor
Trading pit
Broker Broker
A B
Floor runner Buying Selling Floor runner
or hand signals or hand signals
to assistant at to assistant at
edge of the pit edge of the pit
Transactions made by 'open outcry'
between brokers in the pit
Figure 4.1 Trading procedures on a futures exchange

The key factors of futures markets are standardisation, only a limited number of
expiry dates, there not being a futures contract that exactly matches the asset to be
hedged and various institutional arrangements designed to promote liquidity and
ensure an orderly market. The nature of futures contracts is such that, although they
do address problems of liquidity and credit risk, unfortunately, they do create other
problems when in use.
4.2.1 Market Mechanisms to Increase Liquidity and Eliminate Credit Risk

Futures are readily tradeable instruments. Transaction costs are typically very low
relative to those in the cash markets or of equivalent forward contracts. These low
costs are achieved by making the contracts fungible by interposing a clearing
house as the counterparty to all transactions. The role of the clearing house is
shown in Figure 4.2. At time T, party A buys a futures contract. The (unknown)
other party is a seller, party B. This deal is carried out on the floor of the exchange
in the appropriate trading pit (see Figure 4.1). Both sides have their transaction
recorded by the exchange clearing house, which then interposes itself between A
and B. As a result, A and B have both entered into contracts with the exchange’s
clearing house. Note that from the exchange’s perspective, it is not at risk from
changes in the contract’s price since it holds offsetting positions with A and B.
Where it does have risk is in ensuring performance by both parties.

Time T
Party A Party B
Exchange clearing house
Time T+n
Party A Party C
Exchange clearing house
Party A can buy and sell futures contract, exchange

acts as counterparty to all transactions. A is initially
matched to B; when selling, a new party, C, is the buyer.
Figure 4.2 Role of the exchange clearing house in a futures market

The mechanics of the transaction are shown in Table 4.4. At time T, the clearing
house records party A as having a long outstanding position; this is offset in the
market by party B having established a short position. From the clearing house’s
perspective, the two positions cancel each other out although contractually the
clearing house is separately the counterparty to both A and B and if either defaults is
still liable to the remaining party. Thus to protect itself, the exchange will require
both A and B to post margin (a performance bond). The role of margining is
discussed in the Section 4.2.2.
Table 4.4 The role of the exchange clearing house

Exchange Total open
Time Party A clearing Party B Party C interest
house
T +1 +1
−1 −1 1
+1 0 −1 1
T+n −1 −1 / +1
−1 −1
+1 +1 1
0 0 −1 +1 1
Note that, as futures positions are created or cancelled, the open interest (last column) increases
or decreases. Open interest is therefore a measure of the demand for hedging/speculation in the
market. Volume data measure the rate of change in demand.

When A decides to close out the position, A sells its contract in the market. Be-
cause the clearing house is the other party to the future, it does not matter who the
buyer is. In this case, it is another party, C, which wishes to establish a long position.
At the same time, party B’s short or sold position remains unaffected. This would
not have been the case in a forward contract if A had approached B to cancel the
transaction. Party B would have been forced to search out C, or A would somehow
have had to pass on the position to C. This would have led to delay and additional
cost. With the futures contract, it is a quick and simple matter for A to instruct a
broker to execute the transaction.*
The Terminology of the Futures Markets _____________________
 basis: the difference between the cash asset or instrument and the futures
contract. Changes in the basis lead to basis risk;
 cash, cash asset, cash instrument, cash market: the market in the
physical or spot market value date in contrast to the futures contract or
futures market. Also called the ‘underlying’ or ‘underlier’, or alternatively the
‘spot’ or ‘physical market’;
 contracted asset or underlying instrument: the exact instrument,
commodity or other item that the futures contract can be exchanged for or
the price against which the contract is cash settled. For commodity futures,
for instance, it includes the degree of purity or type(s) that may be delivered
into the contract. For notes and bonds it will include a list of deliverable
issues;
 contract size or trading unit: number of units, value, weight and so on of
the asset or underlying instrument;
 convergence: the gradual reduction of the basis to zero as the futures
contract moves towards expiry. At expiration, the price of the cash and the
futures contract will be the same;
 delivery options: the process of settlement at the expiry of the contract
when the short position holder sends the appropriate cash instrument or
makes over the requisite physical quantity of the commodity, instrument and
so forth to the futures buyer;
 expiration and expiry: the date at which the futures contract is settled.
Typically, most financial futures contracts have only four expiry dates per
year, at three-month intervals, known as the expiry cycle. The most com-
mon cycle is March, June, September, December. Commodity futures may
have a more complex cycle reflecting seasonal variations in demand, etc.;
 last trading day: the last day it is possible to trade a particular contract
prior to expiry;
 delivery: how and where delivery will be made; what options are available
to the short position holder;
* In fact, exchanges such as the Euronext-LIFFE take pride in the fact that a typical transaction can be
executed within half a minute of the instruction being given.

 notice day: the day on which the short position holder gives notice of the
intention to deliver;
 implied repo rate: the rate of return that can be earned, before financing
costs, that is implied by selling a futures contract and buying a cash instru-
ment, such as a bond;
 margin: the cash deposit required by futures buyers and sellers and used to
collateralise their positions and maintain the creditworthiness of the futures
clearing house. Margin is made up of an initial margin deposit (which can
be in the form of high-grade income-generating securities, such as Treasury
bills) and variation margin, which is required to be added to maintain the
account above the minimum margin level;
 price quotation: how the price is quoted on the exchange. For commodity
futures, for instance, it is in units per ounce (precious metals) or tonnes
(base metals), or barrels of oil (crude oil futures). With financial futures a
variety of price quotations are used: for stock index futures, it is in index
points; for short-term interest-rate futures, it is an index equal to 100 less
the interest rate; for bond futures, it is the price of the notional bond in the
contract. The contract size is carefully designed both to provide a meaningful
tick size (typically in the region of US$10–$25) and to balance transaction
costs versus contract size;
 price limit: a maximum price change within a trading session. This is set by
the exchange. If reached, it halts trading in the contract. Limit up is the
maximum increase, limit down, the maximum price decrease allowed;
 serial months: expiry and settlement months outside the normal expiration
cycle. If the normal cycle is March, June, September and December, then
expiry months in January and February would be serial months.
 tick: the minimum price fluctuation permitted in a contract. The tick size of
the contract is determined so as to balance price sensitivity and the change
in the value of the futures contract. For instance, energy futures contracts
for crude oil are for 1000 barrels and the tick size is 1 cent. The tick value is
therefore:
Tick size × Number of barrels: 1000 × US$0.01 = US$10

1
The tick size (being 0.01 or of 1 per cent) is called an ‘oh-one’;
100th
 position limits: the maximum number of contracts it is permitted for one
account to hold on the exchange on one side of the market;
 alternative procedures: whether alternative procedures are available in
relation to the location of delivery, quality, grade and so on. Such variation is
more typical of commodities than financial futures;
 invoice amount: how the price to be paid or received is determined.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

4.2.2 Margin
We have seen in the previous section that the clearing house assumes the counter-
party risk of each futures contract. Recall that the major problem with forward
contracts is that they are credit instruments. The two parties need to be assured that
the other party will honour the obligation even though there is an incentive to
default if the cash market price has moved against the position. The same risk of
default on futures now arises between the clearing house and users of futures
contracts. It is addressed by requiring all buyers and sellers to post margin. Margin
is a form of collateral, in either cash or eligible high-grade securities such as
Treasury bills. This acts as a performance bond.
Margin is generally set so as to cover the largest daily price change that can be
anticipated, plus a safety factor. The other element of the margining system is the
daily marking to market of the contract and the crediting and debiting of gains and
losses to market participants as they occur at the end of the day.
The margining process works as follows. Every contract specifies the amount of
margin required to be deposited when initiating a transaction, known as the initial
margin and the minimum margin that has to be in the account, the maintenance
margin. This is provided by both buyers and sellers. At the end of each trading day,
the exchange will revalue each position in a process known as marking to market.
Positions that stand at a loss have their margin account debited by that day’s loss,
while positions making a profit are credited with that day’s gain, the debits and
credits being known as the variation margin. Those positions where the balance in
the account falls below the maintenance margin requirement are informed and are
required to provide additional margin to ‘top up’ the account, a process known as a
margin call.* Note that a margin call can arise even if profits have been earned,
since the exchange has the right to vary the margin requirements at will. This might
happen, for instance, if there was a significant sudden increase in the volatility in the
underlying cash market.
The margin account is under the control of the clearing house. Failure to respond
to the margin call gives the clearing house the automatic right to close out the position
by undertaking the appropriate reversing transaction. The funds in the margin account
are used to meet any resultant losses, the balance – if any – being subsequently
returned to the account holder.
The daily revaluation of gains and losses ensures that margin accounts are replen-
ished and all market participants essentially collateralise their own position by paying
for losses and being credited for any gains as they occur. Any surplus above the
initial margin can then be withdrawn as profit.
* So as to avoid the need for continual margin calls that might arise from small changes in the futures
price, the exchange normally sets the initial margin somewhat higher than the maintenance margin
level.

Effect of Margin on the Cost of a Futures Contract* ___________

Although margin is a cost, its effect, as we show below, is not very significant.
Let the interest rate be 10 per cent and the initial margin be US$750 per
contract for a short-term interest-rate futures contract. Holding one futures
contract for six months incurs US$37.50 in interest cost. This is equal to 1.5
basis points (bp) per annum on the underlying principal of US$1m for three
months; or the variation cost on one-and-a-half ticks (US$25).
Since both the buyer and the seller have this opportunity cost, this cost has the
effect of increasing the bid-offer spread on the future by 3 bp per annum. Note
that this is the highest extent of the loss. Since most exchanges allow margin to
be posted in high-grade negotiable securities such as Treasury bills (T-bills), the
actual cost is the difference between the firm’s borrowing cost and the rate
earned on the T-bills.
Note too that, first, this cost will vary directly with interest rates, rising as
interest rates rise; and second, the cost of the variation margin will depend on
the course of interest rates over the period. Let us assume a 1 per cent change
over the first three months (first rates initially fall by 1 per cent and then rise by
1 per cent; if you have a long position in the contract, you receive margin and
then reinvest it at a lower rate. Subsequently you pay when rates have risen.)
The cost will therefore be:
(US$25 × 100 × 11 × 0.25) (US$25 × 100 × 9 × 0.25) ﴾4.1﴿
− + = US$12.50
100 100
Under this scenario, the cost equals half an 01 per contract.
Note that this analysis is not to be confused with the exposition of the tailing of
the position given in Section 4.7.1.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
4.3 Types of Futures Transactions

Futures markets allow firms and individuals to take long or short positions in a
range of underlying assets. The markets themselves are markets in risk. The liquidity
of futures markets, the ability to trade on margin and the ease with which short
positions can be established mean that they are used for a range of activities in
addition to transferring risks. That the markets are used by a wide variety of
participants for different purposes leads to increased turnover and – in consequence
– liquidity. The principal uses for futures are given in Table 4.5.
* This is based on an example given by Manson, Bernard (1992) The Practitioner’s Guide to Interest Rate Risk
Management. London: Graham & Trotman Ltd.

Table 4.5 Illustrative uses for futures

User Activity or Application or transaction
strategy*
Market makers Hedging the trading Long cash market position: sell futures; short
book cash market position: buy futures
Traders Directional view on Buy or sell futures
the market
Intra-commodity Sell (buy) early expiry contract; buy (sell) later
spread expiry contract
Inter-commodity Buy (sell) contract on one underlier and sell (buy)
spread another contract on different underlier
Volatility trade Combinations using options and futures
Basis trading View on cash-futures Buy (sell) underlying and sell (buy) futures
relationship (the basis)
Long positions in the Hedging Long underlying: sell futures
underlying
Investing future cash Buy futures and close position on purchase of the
flows underlying in the cash market
Asset allocation Sell futures on one underlier; buy futures on a
different underlier
Duration adjustment** Buy (sell) futures to lengthen (shorten) duration
Short positions in the Hedging Short underlying: buy futures
underlying
Future borrowing Sell futures and close position when borrowing is
undertaken
* Not all futures will be used for all these different strategies.
** Used with interest-rate sensitive assets
Market participants are therefore often characterised as given in Table 4.6.
Table 4.6 Types of futures activity

Type Activity
Hedger Someone seeking to reduce or offset risk
Speculator A risk taker seeking (large) profits
Backing a view Pursuing a specific investment strategy or market outcome
Arbitrage Exploiting market imperfections and anomalies
Spreading Exploiting changes in the relationship between two asset
classes
In fact, some exchanges (such as the London Metal Exchange) make a distinction
in the nature of the contract being undertaken for reporting and monitoring
purposes as to whether it is speculative or for hedging purposes.

4.3.1 Outright Purchases and Sales

The following types of naked transactions are carried out using futures:
 outright purchase: the purchase of a futures contract in its own right. The
buyer has the obligation to receive the underlying at expiry. A naked purchase is
undertaken in anticipation of a rise in the price of the futures. An offsetting
transaction is designed to hedge a short position in the underlying asset, or an
asset with similar characteristics (a cross-hedge).
 outright sale: the sale of a futures contract. The seller has the obligation to
make delivery of the underlying at expiry. A naked sale is undertaken in anticipa-
tion of a fall in the price of the futures. An offsetting transaction is designed to
hedge a long position in the underlying asset, or an asset with similar characteris-
tics (cross-hedge).
4.3.2 Spread Transactions

A spread position is taken by simultaneously buying and selling futures contracts as
a package. There are two basic variants: the calendar spread and the cross-spread.
Examples of both types are given in Table 4.7.
Table 4.7 Types of spread transaction using futures

Type Activity
Calendar spread
Buy (sell) nearest to expiry future Sell (buy) back contract
Cross spread
Buy (sell) stock index future Sell (buy) government bond future
Buy (sell) FT-SE 100 future* Sell (buy) MidCap future*
* These are contracts traded on LIFFE. The FT-SE 100 contract is on the largest 100 companies
traded on the London Stock Exchange. The MidCap is the next largest group of 250 companies.
To make a profit the spreader needs to determine whether the spread between
the two contracts will increase or decrease and put on the appropriate trade. Note
that the expectation of profit does not depend on getting the direction of movement
in the assets right. The basic variants and rationale for a spread transaction are:
 intra-commodity spread (also known as a calendar or intra-market spread).
In this transaction the long and short positions are in the same contract but for
different expiry dates. It is a non-directional transaction which aims to make a
profit when the spread changes to the advantage of the position, when the price
difference either widens or narrows between the two contracts.
 inter-commodity spread (cross-asset, inter-market spread): where the long
and short positions are in contracts on different underlying assets. This can be
set up either with the same expiry date, or with different expiry dates. Thus a
long position in gold and a short position in silver could be set up to anticipate a
change in the relative value of the two metals over the transaction period.

 crush or refining spread. In some commodity markets, notably groundnuts and

crude oil, there are contracts on both the raw product and its processed product.
A spread can be established that hedges or speculates on the processing cost.
For instance, a spread between crude oil and unleaded gasoline futures is effec-
tively a play on refiners’ margins.
Note that all the transactions detailed above can be duplicated using the cash or
physical markets. However, in all cases, the cost of these strategies is significantly
greater than the equivalent result achieved by using futures. In some cases, setting
up such strategies in the physical markets would render the strategy null and void
since transaction costs would eat up all the anticipated benefits. Short selling, for
instance, is often difficult in the physical markets. The seller has to borrow the asset
to be sold and pays accordingly. In addition, short sales are often closely regulated
since they have traditionally been seen as highly speculative.
4.3.3 Leverage Effects

The final advantage of futures is the leverage provided by the instrument. In the
futures market, unlike the cash market, the buyer and seller need only provide a
fraction of the total value of the contract at the onset. A small change in the futures
price represents a large change in the value of the invested amount. The effect of
leverage (gearing) is shown in Table 4.8.
Table 4.8 Effect of futures leverage

Return on
Asset Investment Return on Future Margin investment
value in the asset investment in value on the in the
the asset future future
100 100 110 − 100 ÷ 100 100 10 20 − 10 ÷ 10
110 = 10% 110 = 100%
Taking a View on the Oil Price ______________________________

In late April, a speculator in the oil market has a view on the unfolding events in
the Gulf and thinks that these will affect the price of oil as there is a strong
potential for an outbreak of hostilities. If fighting breaks out, the threat of or
actual interruptions to oil supplies will significantly drive up its price. To back
this analysis of events, the speculator therefore buys 10 July crude oil futures
which are trading at US$20.50/barrel. At the same time the current cash or spot
delivery price is US$19.00/barrel.
Subsequently (in May), fighting does break out in the Middle East and oil prices
jump. The cash price or spot delivery price rises, in fact, to US$35.00 per barrel,
the crude oil futures contract for July delivery is now trading at US$30.00 and
the speculator closes out the transaction by selling the futures.

Speculator’s Profit
To get the profit from the speculator’s view on an increased oil price, we must
calculate the number of ticks the July oil futures contract has moved. The initial
purchase price was US$20.50; the closing-out price US$30.00, so the difference
is US$9.50 or 950 ticks (as each tick is equal to US$0.01 on the oil price). The
tick value is determined from the contract size. The crude oil futures contracts
are for 1000 barrels with a tick size of 1 cent. The tick value for the contract is
therefore US$10 (tick size × number of barrels = 1000 × US$0.01 = US$10).
As the speculator bought 10 contracts, the gain is computed as:
Ticks × Tick value × Number of contracts
950 × US$10 × 10 = US$95 000 gain
This figure ignores margin and other transaction costs.
Note that, as is expected, the cash and futures markets have both moved in the
same direction as a result of the shock to oil supplies. This is shown in Ta-
ble 4.9.
Table 4.9
Cash Futures
market price
Original (April) price US$19.00 US$20.50
Later (May) price US$35.00 US$30.00
Change in price US$16.00 US$9.50
However, the change in prices in the two markets has not been the same, as the
cash market has increased more than the futures price. The value differential
between the cash and futures markets, what is known as the basis, has changed.
There are a number of reasons for this. Although cash and futures prices are
related they form separate markets and are subject to their own particular
demand and supply factors. In the case of a key commodity like oil, the lack of
any ready substitutes leads to users being willing to accept a cost, known as a
convenience yield, to insure themselves against any shortfall. The greater the
chance of a shortage, the greater the convenience yield. A shock, like an
outbreak of hostilities in the Gulf, a key oil-producing region, is likely to drive up
considerably the market’s convenience yield in the short term and hence change
the basis.*
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
* We can say that the basis went from −$1.50 to $5 over this period. If interest rates remained largely
unchanged then the big swing in the basis was almost entirely due to changes in the convenience yield,
with users, anxious about the availability of supply, bidding up the cash market price.

4.4 Convergence
As the future moves towards expiry, the cost of carry will decline to the point
where, at expiry, the two prices should be the same. This coming together of the
cash and futures prices is known as convergence and it is the only time when the
futures price and the cash price must necessarily be the same.
Fair or Theoretical Value of a Futures Contract _______________
In conditions where there is an adequate supply of assets for delivery (that is,
where there is no market squeeze on the physical asset), it is possible to
calculate the theoretical or ‘fair value’ of a futures contract.
The difference between the cash and futures price is influenced by supply and
demand factors, but interest rates are normally the most important factor.
Calculating a Fair Value

If the cash price of gold = $355/oz, the US dollar interest rate is 5 per cent p.a.,
storage costs (warehousing and insurance, etc.) are 0.5 per cent p.a., then we
can calculate the fair value of the gold future.
Method:
 Calculate the cost of carry by working out the cost of finance and other
charges for a three-month period (90 days):
Cash × (Interest rate + Other charges) × days/360*
US$355 × 5.5% × 90/360 = US$4.88 cost of carry
 To obtain the fair value add the cost of carry to the cash price:
US$355 + US$4.88 = US$359.88
The ‘fair value’ of all futures contracts can be calculated by the above method. It
is slightly more complicated for bonds, currencies and equities; but the underly-
ing principle is the same.
Note that, when there are restrictions to the availability of supply of the
underlying asset and the market is in backwardation it is impossible to
calculate fair values. Note also that the existence of a convenience yield acts
to reduce the futures price relative to the cash price.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Recall the cost-of-carry model that we said underlies the valuation of forwards
and futures. Given that the price differential between the two was largely a function
of interest rates, the longer the time to expiry of the futures contract, the greater the
value of delay, and hence the greater the difference in value of the two. However,
we can expect the value of the futures price to change gradually as the contract
moves towards expiry, with the differential becoming smaller with time. In an
efficient market, we would anticipate that the two converged items would have the
same value on the last day the contract was extant.
Convergence is an important property of futures prices. Depending on the shape
of the term structure, we can anticipate that convergence will happen in one of two
* This is following the market convention for such valuations which use simple interest.

basic ways: either the cash and futures prices converge from above, or they con-
verge from below. Both are shown in Figure 4.3.
Convergence from above

Backwardation
Contract
expiry
Contango
Convergence from below
Time to expiry
Figure 4.3 Cash–futures convergence

Note: This shows the convergence of the cash price to the futures price as the contract moves to
expiry. The contract can either converge from above (known as backwardation), when the cash
price is above the futures price, or converge from below (known as contango), when the cash
price is below the futures price.
If we were to plot the cash price and the futures price over time, we might see a
relationship like that of Figure 4.4.
Futures price
Cash price
Time to expiry Expiry
Figure 4.4 Behaviour of the cash or spot price and the futures price as
the futures contract moves towards expiry
Note: The narrowing of the price gap or basis is due to the price convergence that occurs as the
time to expiry on the futures price diminishes. In order to prevent riskless arbitrage, at expiry the
cash and futures prices should be equal, that is, the basis goes to zero.
Understanding Convergence ________________________________
If we assume that the interest rate is flat for all maturities at 10 per cent and is
unchanged over time and the spot price of oil is US$20 per barrel, then we
would, in the absence of any market frictions, expect the oil futures prices to be
as given in Table 4.10.

Table 4.10
Time to expiry (days) Futures price Basis
0 20.00 0
30 20.17 −0.17
60 20.33 −0.33
90 20.50 −0.50
180 21.00 −1.00
365 22.00 −2.00
That is, the further away the contract is from expiry, the greater – all other
things being equal – should be the basis. The basis reflects the interest cost,
storage and other factors between the spot market price and the price for
future delivery. Obviously, as this period gets shorter, these factors become
smaller until, at expiry, to prevent arbitrage, the two converge to zero. Changes
in any of the cost-of-carry factors will change the basis, a problem known as
basis risk.
Note that in the above situation, the basis is negative (that is, the market is in
contango).
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The difference between the cash and futures price is known as the basis. The
basis is the cash market price (often referred to as the spot price) less the futures
price:
Basis = , − , ﴾4.2﴿
The basis for Figure 4.4 is shown in Figure 4.5.
Contract expiry
Time to expiry
Basis
Figure 4.5 Behaviour of the basis in Figure 4.4

4.5 The Basis and Basis Risk

Basis is the price difference between the cash market and the futures price:
Basis = Cash price − Futures price ﴾4.3﴿
If the cash price of wheat is £120/tonne and the July futures price is currently
£125/tonne, then the basis is:
Basis = £120 − £125 = −£5
In this case, the basis is negative. This is sometimes referred to as ‘£5 under
futures’. If the result had been positive, the basis would have been described as
‘over futures’.
4.5.1 Actual, Theoretical and Value Basis

Futures users often talk of basis relationships. These are the price relationships
between the actual futures price ( ) in the market, the theoretical futures price ( ∗),
and the value basis.
Given the cost-of-carry model, it is possible to calculate the theoretical basis of
a futures contract and compare this to the actual basis in the market. This theoreti-
cal price ( ∗) is computed using the cost-of-carry formula. The difference between
the cash price ( ) and the theoretical futures price is known as the ‘carry basis’, in
that the actual market basis (also known as the ‘raw’ or ‘simple’ basis) needs to be
adjusted by subtracting the carry basis to see if the futures contract is trading cheap
or dear in relation to its break-even value, known as the ‘value basis’. These
relationships are shown in Equation 4.4.
Raw basis = − ﴾4.4﴿
Carry basis = − ∗
Value basis = − ∗
In working out the implied futures break-even yield, that is, the rate at which we
are indifferent as to whether we hold cash and invest it until the futures expiry date
or buy the physical asset today, there are three distinct elements to be borne in mind
when calculating value:
 the cash or physical asset we could buy today and whether it offers any income,
its storage, insurance and depreciation;
 the rate at which we would earn interest until the delivery date;
 the price of the futures contract.
If we start with any two of the above, it is possible to calculate the third. The
resultant relationship may show that the futures contract may be trading cheap or
dear in relation to the calculated price. This is known as the value basis.
A simple example will show why the value basis is considered by market partici-
pants to be the important element. Let us consider a short-term interest rate
contract which is on three-month eurodollar deposits. We have three months to go
before the expiry of the contract. The current eurocurrency interbank yield curve
out to six months is shown in Table 4.11.

Table 4.11 Short-term interest-rates yield curve

Maturity Eurodollar Eurodollar
offered rate bid rate
3 months 5.75 5.625
6 5.875 5.75
9 5.9375 5.8125
The eurodollar futures contract is trading at 94.08, giving an implied three-month

yield of 5.92 per cent. One could suppose that one might invest now at 5.625 per
cent, the bid side of the curve, and then obtain a deposit of 5.92 per cent in three
months’ time. This looks better than placing directly for the whole six-month
period. But think again, the implied bid side yield for three months is actually 5.79
per cent, so both strategies have an equal payoff.* The value basis on the futures
contract (against the forward rate) is in fact only 0.01 per cent, in cash terms a mere
US$25 per contract, a gain likely to be eaten up in transaction costs.
There is another consideration to take into account here. Let us look at the next
contract. It would have a price of 94.11 on the current yield curve. Now we deposit
for six months and hold the future. If we then allow the yield curve to change both
in a parallel shift and via a rotation, let us look at the resultant impact on prices, as
shown in Table 4.12.
Table 4.12 Short-term-interest rates yield curve

Original Parallel
Maturity deposit shift Futures Rotational Futures
rate (+0.25%) price shift price
3 5.75 6.00 6.00
6 5.875 6.125 93.84 6.00 94.09
(6.16%) (5.91%)
9 5.9375 6.1875 93.87 5.9375 94.36
(6.13%) (5.64%)
For the three months contract, the futures price has moved from 94.08 to 93.84,
a drop of −0.24 per cent for an upward parallel shift in the curve of 0.25 per cent.
For the deferred contract with six months to go, the change has been from 94.11 to
93.87 or, again, −0.24 per cent. That is, with a parallel shift, the futures and cash
prices have moved in tandem. If the yield curve had rotated, however, the change in
the contract with the three-month expiry is to 94.09, a change of +0.01 per cent.
For the contract with six months to expiry, the price change has been to 94.36, or
+0.25 per cent. The change in the shape of the yield curve has produced unexpected
behaviour between the cash and futures prices when the yield curve twisted. That is
because the contracts are being priced off the forward interest rate. Whether the
* This is because the eurodollar contract is on the offered rate. The difference between the bid and offer
is 0.125 per cent, therefore the payoff will be: offered rate – spread, or 5.79 per cent.

result is desirable or undesirable will depend on the nature of the underlying

transaction.*
We can summarise the response of the carry basis to the three factors which will
affect the carry basis as per Figure 4.6.
Rotational
Parallel shift shift in the yield Time
in the yield curve curve
Carry Shorter period

spread for pre-delivery
Carry
basis Convergence
Yield on Yield on
cash asset futures
Futures price
Figure 4.6 Factors affecting the carry basis
4.5.2 Factors which Affect the Basis

The cost of carry provides a model for determining futures prices, but a number of
factors can affect the basis and push it away from its theoretical or carry basis. Since
futures are margined and gains and losses are credited and debited every day, futures
will be subject to interim cash flows. When this process is allied to differences in
borrowing and lending rates and other transaction costs, deviations from fair value
can occur. In addition, with some types of futures, there may be a problem in short
selling the underlying. In a number of cases, the proceeds from short selling are not
100 per cent of the market value of the asset. For instance, short-sellers of shares
have to deposit a fraction of the sales proceeds as collateral and are required to
reimburse the lender for dividends. Equally, some transactional arrangements
involving expiry and settlement can lead to uncertainty about the deliverable asset or
– as with stock index futures, where the asset is a basket of securities – the behav-
iour of the basket before expiry. Furthermore, some contracts allow the short seller
to time the exact delivery date and thus the settlement date is not known precisely.
* This problem is taken up in the discussion of hedging techniques in Module 11 on hedging.

For these reasons the basis will deviate from its theoretical value and, as we have
discussed, we need to separate the carry basis component from the actual basis to
show the value basis. We can expect the carry basis to erode at a fairly predictable
rate. If we return to the oil example discussed earlier, we can see that if the contract
has 90 days to expiry, it will have a value of 20.50. We can expect the carry basis to
decline by about 0.005 per day, giving a price of 20.49 after one or two days have
elapsed.* The behaviour of the carry basis will thus be largely predictable (in the
absence of a significant change in interest rates), whereas that for the other factors
will be unpredictable. This is shown in Figure 4.7.
Basis
Contract expiry
Time to expiry
Actual basis
Theoretical basis
Basis = Cash price – Future price
Figure 4.7 The basis over time

Consequently, as market prices change, the cash and futures prices will normally
move in the same direction, but the basis will not be constant. Sometimes the cash
price will move more than the futures price; at other times, the futures price will
move more than the cash price. This is referred to as a change in the basis. This
movement arises from the factors already discussed. It might also be partly caused
by changes in the supply and demand for hedging and/or speculating in the
underlying assets. Equally, it will arise from changes in interest rates.
We can summarise the factors that lead to basis instability as being due to:
 changes in the convergence path of the cash and the futures price;
 changes affecting the cost of carry;
 mismatches between the hedging instrument and the cash position;
 random deviations from the cost-of-carry model (‘noise’).
Whatever the cause, basis instability leads to potential problems in the use of
futures. If the basis alters then the equivalency of the cash and the futures position
will not match. This is a problem for the hedger, the effects of which are summa-
rised in Table 4.13. Remember that the problem of basis risk only applies when the
futures contract is to be sold/bought before expiry. If the contract is held to expiry,
the position pays the absolute difference between and , where is the price at
* Of course the fact that crude oil futures are quoted to two decimal places requires the price either to
stay unchanged or to jump by one cent, not move by the straight line simple average of half a cent.

expiry time and is the price when the contract was originated. Note that, as
discussed later, while the payoff of the future is assured in this later case, there is still
an uncertainty over the timing of the cash flows since profits are credited (and losses
met) on a daily basis.
Table 4.13 Basis risk and hedge performance

Hedge position and return
Type of hedge Basis weakens Basis strengthens
Short Returns < 0 Returns > 0
Long Returns > 0 Returns < 0
Weaker basis: Cash price increases less or falls more than futures price
Stronger basis: Cash price increases more or falls less than futures price
The result of a change in the basis on the performance of a hedge is given in

Table 4.14.
Table 4.14 Basis change effects and resultant hedge performance

Basis movement
Direction
= − Price Type of Type of Effect of basis Return
movements hedge basis
‘Unchanged’ changes Short − =0 nil unchanged nil
directly with
increases Long − =0 nil unchanged nil

less or falls
more than
‘Weakens’ or − >0 positive narrows negative
‘widens’
Short − <0 negative widens negative
Long − >0 positive narrows positive
− <0 negative widens negative
‘Strengthens’ or − >0 positive narrows positive
‘narrows’
Short − <0 negative widens negative
Long − >0 positive narrows positive
− <0 negative widens negative
4.5.3 Effects of a Change in the Basis

Table 4.15–Table 4.19 illustrate how a strengthening or a weakening of the basis
affects a hedging transaction. The example is based on hedging using copper futures
to hedge a copper position and a cross-asset position to bronze. A hedge is designed

to balance potential losses from a change in the market price on the underlying
position against gains in the corresponding futures position entered into as a hedge.
In Table 4.15, there is no change in the basis and the two sides match exactly.
In the next case, Table 4.16, the hedged position of Table 4.15 is subject to a
widening of the basis while prices decrease. In this case, the hedge has not worked
properly and there is a net loss of US$82 174 from the combined portfolio. Note
that if the hedge had been put on the other way round, that is, a short hedge to
hedge a future purchase, the loss shown would have been a profit.
Table 4.15 Hedging a long position with a price decrease; no change in

the basis
Market conditions
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1520
Futures price at time hedge is removed $1543
Hedging amount in tonnes 10 000
Number of tonnes per futures contract 1000
Number of futures contracts used to hedge position 10
Long hedge by copper producer: transactions
Cash Futures Basis
market
At
inception
$16 000 000 −$16 234 782 −23
At time hedge is removed
$15 200 000 −$15 434 782 −23
Cash position Futures position Overall gain/(loss)
−$800 000 $800 000 $0
Table 4.16 Price decrease; widening of the basis

Market conditions


Cash Futures Basis
market
At
inception
$16 000 000 −$16 234 782 −23
$15 200 000 −$15 516 955 −32
−$800 000 $717 826 ($82 174)
Table 4.17 shows the same basis change but with a price increase. It has the same
result as Table 4.16. As with the price decrease, if the hedge had been established
against a future purchase, the position would have turned in a profit, not a loss.
If the basis had moved the other way, that is, had narrowed instead of widened,
the outcome would have been that shown in Table 4.18 for a price decrease and in
Table 4.19 for a price increase.
Table 4.17 Price increase; widening of the basis

Market conditions
Long hedge by copper producer:
transactions
Cash Futures Basis
market
At
inception
$16 000 000 −$16 234 782 −23
$16 842 105 −$17 159 060 −32
$842 105 −$924 279 ($82 174)

Table 4.18 Price decrease; narrowing of the basis

Market conditions
Cash Futures Basis
market
At
inception
$16 000 000 −$16 234 782 −23
$15 200 000 −$15 373 912 −17
−$800 000 $860 869 $60 869
Note that in this case, the narrowing of the basis has worked in favour of the
hedger, providing a net gain of US$60 869. As with the widening of the basis, the
opposite transaction – setting up a short hedge – would have turned in the opposite
result: a loss. The general conclusion for the hedger is that a widening of the basis
disadvantages the long position but benefits the short position and a narrowing of
the basis benefits the long position but disadvantages the short.
These results should be set against the outcomes that would have resulted if no
hedging had taken place. In this case, the full cash price change would have been
either a loss – or a gain – depending on the direction of the price movements.
Although changes in the basis affect the result of the hedge, they are less than the
losses that would have occurred if the position had remained unhedged.
Table 4.19 Price increase; Narrowing of the basis

Market conditions


Cash Futures Basis
market
At inception
$16 000 000 −$16 234 782 −23
$16 842 105 −$17 016 018 −17
$842 105 −$781 236 $60 869
As there are a limited number of futures contracts in existence and a potentially

much wider range of assets to be hedged, many situations require the use of a cross-
hedge, where the asset to be hedged is not that of the underlying futures contract.
For example, as previously mentioned, there is no corporate bond contract, so
hedgers wishing to protect themselves have to resort to a cross-hedge between
government bond futures and corporate bond positions. There are other instances,
as illustrated by our example, where a bronze producer wishes to hedge and has
decided that copper futures provide the best (but by no means perfect) match for
this purpose.
In these situations, we have an additional problem, namely the behaviour or
relationship between the asset to be hedged and the asset underlying the futures
contract, as well as the basis risk between the latter two. A full discussion of
methods to address this problem is held over to Module 11 on hedging. At this
stage, we simply highlight the problem that we are dealing with two sources of risk:
(1) the price correlation behaviour between the asset to be hedged and the asset
underlying the futures contract and (2) the basis risk from using futures. Table 4.20
to Table 4.25, therefore, illustrate the potential difficulties of hedging the bronze
price which, although correlated to the copper price, has idiosyncratic factors that
dictate its price independently of copper.
Another issue is that the value of bronze is greater than the value of copper so
the hedge position has to be adjusted to take account of this fact. Such a ‘dollar
equivalency’ is a prerequisite to balancing the hedge, thus ensuring that the change
in value on both sides is the same.
In Table 4.20, when the two prices move in tandem and there is no basis shift,
the hedge is exact. However, given the nature of the hedge being used, this is
unlikely to be the case. A more likely scenario is given in Table 4.21 where the price
behaviours of copper and bronze do not move together.

Table 4.20 Cross-hedge, copper to bronze: price increase; copper and

bronze price changes move together
Market conditions
Bronze
Number of tonnes of bronze to be hedged 10 000
Price ratio of bronze to copper 1.1
Copper
Number of tonnes of copper per futures contract 1000
Long cross-hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17 600 000 −$17 858 260 −23
$18 526 316 −$18 784 575 −23
$926 316 −$926 316 −$0
Net value change for bronze position −$0
In Table 4.21, the increased price of bronze has outstripped the loss on the fu-
tures position, leading to a hedging gain of US$378 088 on the combined position.
This is a happy result for the hedger. However, if the opposite short asset/long
futures position had been set up, the hedge would have underperformed, with the
gain being a loss.
If the basis had also changed, as in Table 4.22, the unanticipated divergence
between the two sides would have been even greater, leading to an unexpected
windfall of US$624 631 on the position! Note that some of this mismatch in these
examples arises from the fact that the futures position is slightly above that actually
required due to the need to deal in a (complete) round number of contracts.*
* You may wish to re-evaluate these results using a naïve hedge ratio of 1:1 rather than the 12:10 given in
the tables. Module 11 provides an in-depth discussion of how to set the appropriate hedge ratio.

Table 4.23 shows the effect of a price increase and, at the same time, the basis
decreases. The result is a very significant hedging gain of just under US$1 million.
Table 4.24 shows another possible set of outcomes. In this case bronze prices fall
more dramatically than copper prices, while at the same time the basis increases.
The loss in this situation is US$297 884. The situation would have been worse if the
position had not been slightly ‘overhedged’ to give an 11-contract protection rather
than ten. If only ten contracts had been used, then the loss would have been
US$429 363.

bronze price changes do not correlate
Market conditions
Bronze
Copper
Long cross-hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17 600 000 −$17 858 260 −23
$18 904 404 −$18 784 575 −23
$1 304 404 −$926 316 $378 088
Net value change for bronze position $378 088

Table 4.22 Cross-hedge: copper to bronze: price increase; copper and

bronze price changes do not correlate
Market conditions
Bronze
Copper
Long cross-asset hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17 600 000 −$17 858 260 −23
$19 099 295 −$18 732 924 −19
$1 499 295 −$874 664 $624 631

bronze price changes do not correlate and the basis
decreases
Market conditions
Bronze
Copper


copper futures
Cash Futures Basis
market
At inception
$17 600 000 −$17 858 260 −23
$18 904 404 −$18 196 316 −30
$1 304 404 −$338 056 $966 348
Table 4.24 Cross-hedge, copper to bronze: price decrease; copper and

bronze price changes do not correlate and the basis increases
Market conditions
Bronze
Copper


copper futures
Cash Futures Basis
market
At inception
$17 600 000 −$17 858 260 −23
$15 855 856 −$16 412 000 −28
−$1 744 144 $1 446 260 −$297 884
Net value change for bronze position −$297 884
Finally, in Table 4.25, we show the effect of a price decrease coupled to a nar-
rowing of the basis.
As with the earlier example of the price rise, the decision to round to 11 rather
than ten contracts has meant that the loss is US$396 884, instead of $519 363, as it
would have been if only ten contracts (a naive hedge) had been used.
To summarise, the effectiveness of the hedge will depend on the degree to which
the cross-asset positions correlate and the extent of basis risk.
Table 4.25 Cross-hedge, copper to bronze: price decrease; copper and

bronze price changes do not correlate and the basis
decreases
Market conditions
Bronze
Copper


copper futures
Cash Futures Basis
market
At inception
$17 600 000 −$17 858 260 −23
$15 855 856 −$16 511 000 −19
−$1 744 144 $1 347 260 −$396 884
Net value change for bronze position −$396 884
4.6 Backwardation and Contango

The pricing model that we have presumed to be applicable so far to the futures
market is the cost of carry. This still begs the question of how the current futures
price relates to the spot price that is expected to prevail at expiry. The expectations
model states that the current futures price is equal to the market’s expected value
for the spot price at expiry ( ). That is,
= ( ) ﴾4.5﴿
where is the spot price at time .
If the expectation correctly specifies the futures pricing model, the return from
speculating in futures should be the riskless rate, as in the cost-of-carry model. This
would imply that in a ‘normal’ state, the price of futures should be higher than spot
prices. Equally, the basis should be negative ( = − ). That is, we have an
upward-sloping term structure, or a premium market (traditionally known as
‘contango’). This is illustrated in Figure 4.8.
Value
Time to delivery
or expiry
Figure 4.8 Premium market; basis will be negative (contango)

However, for certain types of futures contracts we may expect the futures price
to be lower than the spot price. That is, we have an inverted term structure or a

discount market (traditionally known as ‘backwardation’). Such a discount market

is illustrated in Figure 4.9.
Value
Time to delivery
or expiry
Figure 4.9 Discount market; basis will be positive (backwardation)

Normal backwardation, as it is called, arises because of the interrelationship between
two factors: the gain from holding the asset (that is, its ‘running yield’) as against the
cost of funding the position, the interest cost. This is best illustrated with a simple
example.
Let us assume that the term structure of interest rates is upward sloping. The
three-month rate, applicable to the expiry of the bond futures contract, is 5 per cent
p.a., while the notional bond underlying the contract is trading at par and has an
annual coupon rate of 8 per cent. (Note that the par assumption is simply for
expositional convenience.) The question is therefore: what is the ‘fair value’ of the
futures contract? Under the cost of carry model, we would expect the future value
of the contract, without value leakage to be:
( )
= ﴾4.6﴿
( )
= 100
We have already said that prices are set by the short position holder who has the
obligation to deliver the underlying. If the short borrows 100, then the cost will be
100 · over the period, or a terminal repayment of 101.26. However, over the
same period, the income earned by holding the bond will be at the rate of 8 per
cent, giving a terminal value of 102.02. If the futures contract was so priced as to
ignore the income advantage gained from the asset, there would be a strong
incentive to short the futures and hold the bonds. The equilibrium price of the
futures contract must therefore be 99.25, at a discount to the spot price, so as to
preclude such ‘cost-of-carry’ arbitrage.
This bond example enables us to observe the process by which we obtain a
backwardated market. With other types of futures this process is not so obvious.
For stock index futures, we have the dividend yield ( ) on the index constituents.
The generic pricing model in such circumstances will be:
( )( )
= ﴾4.7﴿
( )( )
= 100

where is the current futures price with expiry at time , is the riskless interest
rate and is the dividend yield. Equally, this yield could be the bond yield or the
foreign currency rate applicable to the security.* The balance between the earning
yield on the asset – for delivery – and the short-term interest rate will dictate
whether the contract is in contango or backwardation.
With commodities, we have mentioned that a number of other factors can also
affect the market:
 short-term lack of supply in the cash market. For instance, zinc available for
immediate delivery might be in short supply (a condition known as a ‘supply
squeeze’);
 seasonal influences (such as oil demand; wheat supply in the later sum-
mer/autumn etc.). It is possible to see some contract months in contango and
others in backwardation as a result. In addition, some commodities deteriorate
rapidly and cannot be stored for long (for instance, eggs);
 convenience yield. Since with commodities substitution is difficult, the value of
holding the physical commodity itself can lead to the existence of a convenience
yield, if supplies are expected to be interrupted or squeezed. In effect, it is the
value to the user of having an assured supply.
In such cases, the price of a commodity futures contract will be:
( )( )
= ﴾4.8﴿
where is the current futures price with expiry at time , is the riskless rate, is
the cost of holding the commodity and is the (unobservable) convenience yield
applicable.
When + > , we can expect commodities futures to be in contango and when
+ < , in backwardation.
4.7 Timing Effects

Since futures have only limited expiry dates, there will be more times when unwind-
ing a hedge requires the closing of a futures position than running the position to
expiry. This gives rise to the delivery basis risk problem. There is also another
problem, illustrated in Figure 4.10, when the exposure to be hedged does not match
the contract period. In the top half of the figure (A), we have the situation where
the underlying exposure period, in terms of the two start dates, and the contract
period match exactly. A more typical situation occurs in the bottom half (B) where
the exposure period and the contract period do not match.
The second case presents a problem. We could hedge with the first contract, but
this contract expires before the start of the underlying exposure period and would
require us to ‘roll over’ the expiring contract into the next contract. An alternative
approach is to use the second contract to hedge the exposure. However, as we have
* We can think of a bond as having a dividend yield. In the same way, a currency future has a foreign
currency yield. The pricing model for such forward contracts is the same as Equation 4.7.

seen earlier, there is considerable basis risk in doing so from a rotation in the term
structure of interest rates. These matters are discussed further in Module 11 on
hedging.
By using futures, the hedger has exchanged the unacceptable price risk for the
lesser problem of basis risk. In general, basis risk will be much less of a problem
than price risk and the trade-off is worth while. It is only in forward contracts that
all price risks are eliminated, but at the expense of assuming counterparty risk. By
using futures the hedger has gained liquidity, largely eliminated counterparty risk and
reduced transaction costs. The advantages derived from an exchange-traded
instrument with contract standardisation, fixed expiry dates, a central clearing
organisation and counterparty have to be counterbalanced by the residual basis risk
that results.
Perfect hedge
Contract period
Exposure period
Underlying
exposure period
Imperfect hedge
Contract period 1
Exposure period Contract period 2
Underlying
exposure period
Figure 4.10 Problem of timing with futures and underlying cash flows
4.7.1 Tailing the Hedge

Margining, where gains and losses are credited and debited each day, leads to
intermediate cash flows. Given that they occur, and as the futures price converges to
the cash price, the position holder in futures will be either paying out on losses or
receiving the gains. If these are reinvested, to assume that the notional amount on
the futures contract is equal to the underlying position is potentially to overhedge.
The timing effects that arise from the margining system require the hedger to ‘tail
the hedge’, that is, reduce the exposure on the futures contract by the expected
reinvested income from the margin position. The adjustment is shown in Equation
4.9:
( )
Tailed hedge = ﴾4.9﴿
The easiest way to explain the concept is to use an example. Global Corporation
Inc. expects to require US$100 million in 11 months’ time and anticipates raising a

three-month borrowing as a result. The Chief Financial Officer has decided to

hedge the interest-rate risk on the future borrowing and considers futures the most
appropriate instrument. Following an analysis of the alternatives, it is decided that
the three-month eurodollar futures contract is the appropriate hedge. Given that
each contract has a value of US$1 million, a simple hedge would involve the selling
of 100 contracts. However, given the daily margin cash flows into and out of the
account, the number of contracts required to hedge the position is in fact:
( )
100 ﴾4.10﴿
where, in our example, is 11 months. If the current interest rate is 10 per cent, the
appropriately tailed hedge is:
. ×
100 = 91.24
Rounded to the nearest whole number, this becomes 91 contracts to be shorted.
This tailing requirement arises from the timing of cash flows from a futures
hedge. In order for the hedge to operate effectively, the position needs to be
monitored and adjusted as required as cash flows into and out of the margin
account. The rate at which the futures and cash converge may change. In Fig-
ure 4.11 a number of alternative scenarios for convergence are shown. If the
convergence, and hence the margin flow, is different from that which is anticipated,
it may be necessary to rebalance the hedge. Futures positions therefore need to be
monitored over their life and adjusted accordingly. If the hedge had been via a
forward contract (that is, a forward rate agreement (FRA)), this would not be a
requirement.

Futures price
Ft
Panel
A
FT
Time
E
Ft
Panel
B
FT
Time
E
Ft
Panel
C
FT
Time
E
Figure 4.11 The timing of cash flows into the margin account
4.8 Cash–Futures Arbitrage

Market participants are always looking for ways to earn riskless profits. Arbitrage is
that trading activity in which traders (arbitrageurs) seek to make risk-free profits by
exploiting mispricings between instruments and markets. Generic arbitrage involves
selling the expensive asset and buying the cheap one with a view to making a profit
when the price anomaly unwinds. One such opportunity is provided by the relation-
ship between the cash market price and its concomitant futures contract. For
futures markets, the generic arbitrage strategies are given in Table 4.26.
Table 4.26 Cash–futures arbitrage

If futures are (in relation
to their fair or theoretical Futures market Cash market action
value): action
Expensive Sell futures Buy cash
Cheap Buy futures Sell cash

What Table 4.26 means is that, if the relationship derived from the cash-and-
carry model moves out of line, there is an opportunity for a riskless arbitrage. If, as
shown in Table 4.27, the futures price is expensive in relation to its fair or theoreti-
cal value, including known or estimated transaction costs, then the best course is to
short the futures contract and hold the asset for delivery into the contract or – more
typically – until the anomaly reverses itself. If the opposite condition applies and
futures are cheap, a reverse cash and carry, involving buying the futures and selling
the cash asset, is undertaken.
While the approach in Table 4.26 is certainly valid, a number of factors will mean
that there are costs associated with cash-futures arbitrage strategies:
 Transaction costs. There are two sets of transaction costs to be overcome.
 Short-selling restrictions. Many markets impose restrictions on the ability to
short-sell cash assets and there are costs associated with borrowing assets for
short-selling purposes. For instance, many stock or bond lending situations not
only involve a fee to the lender but also require a partial deposit of the asset
value and reimbursement for interest or dividend payments.
 Borrowing funds may be problematical or be subject to other restrictions.
Also the borrowing rate may not be the same as that implied by the basis.
 Unequal borrowing and lending rates are involved, the bid-offer spread
widens the range before which arbitrage becomes profitable.
 There will be intervening cash flows in the form of interest received or paid in
marking-to-market the futures contracts.
 The mechanics of the market. These include the wild card option on delivery,
expiry conditions for setting the price. These and other market mechanisms
increase the uncertainty over the ultimate gain to be made from arbitrage trans-
actions.
Table 4.27 Cash–futures arbitrage strategies

Arbitrage Futures price Cash market Futures market
Cash and carry =
Short futures + < Buy asset (long) Sell futures
Reverse cash and carry =

Long futures < − Sell asset (short) Buy futures
is the theoretical or fair value of the futures based on the cash and carry model
and is the transaction costs. is the market price of the futures contract.
4.8.1 Arbitrage Channel for Futures

Given the above we can posit an arbitrage channel for futures prices between the
opportunities provided by cash-and-carry arbitrage and its opposite, a reverse cash-
and-carry operation. This arbitrage has to take into account the market imperfec-
tions detailed above before a turn can be made. This will lead to a channel within
which the futures price can move, based on expectations and supply and demand

factors, before arbitrage can operate to bring the two markets back into line. This
will also affect the amount of value basis to be expected on a particular contract.
This channel will be:
· + < < · − ﴾4.11﴿
where is the transaction costs per unit of the cash asset. Equation 4.11 can be
expressed more simply as:
+ < < − ﴾4.12﴿
Since there is such a channel, futures prices are likely to deviate somewhat from
their theoretical value and trade cheap or dear to the theoretical price. Such ‘noise’
effects can affect the outcome of the hedge, and the width of the channel is an
influence on the degree of basis risk being assumed in any transaction.
4.9 Special Features of Individual Contracts

The discussion so far has avoided any particular reference to the specific features of
different types of contract. Although futures can be considered a generic class, there
are some special features of individual types of contract that warrant a mention.
Note that the discussion that follows is not a full analysis of individual futures
contracts but aims to highlight those special characteristics which influence their use
as a risk-management instrument.
4.9.1 Short-Term Interest-Rate Futures

The price quotation for short-term interest-rate futures based on interbank deposits
and government Treasury bills is based on an index (100 less the interest rate on the
futures contract). If interest rates were 10 per cent, the futures price would be 90
(100 − 10).
Table 4.28 Index pricing mechanism for short-term interest-rate futures

Implied interest Futures price
rate quote
7 93.00
8 92.00
9 91.00
9.50 90.50
10 90.00
10.50 89.50
11 89.00
12 88.00
13 87.00
14 86.00
15 85.00

This method of quoting the price of a futures contract means that as interest
rates rise, futures prices fall; and vice versa. This gives interest-rate futures the same
relationship as is found with bond futures (when interest rates rise, prices fall).
When investors buy or sell short-term interest-rate futures, they are trading an
index. The index measures the impact of interest-rate changes on a notional
borrowing or lending amount. For Euronext-LIFFE’s short-sterling interest-rate
contract, the notional amount is £500 000 over a specific three-month period: for
example, a June future measures the period between mid-June and mid-September.
The tick size of all short-term interest rates is an 0.01. This equals 1/100 of 1 per
cent (one basis point (1bp)); it is pronounced ‘oh-one’. As the notional amount of
money underlying the contract and the period of time on the deposit are known, it
is possible to attribute a monetary value to each tick:
For Euronext-LIFFE’s short sterling this equals:
Contract size × Time period × Tick
£500 000 × 3/12 × 0.01% = £12.50
Note that virtually all short-term interest-rate products have a tick size of 1 bp
and it is also conventional for the period of the notional investment to equal three
months.
Hedging a Borrowing Requirement __________________________
3 January: A corporate treasurer has a borrowing requirement of £1.5m for

the next three months from 3 February; the treasurer fears a rise
in rates from the current 13 per cent, so he wishes to hedge his
exposure.
Action: Sell 3 March short sterling futures at 86.75 (13.25 per cent).
Contract size = £0.5m
£1.5m
Number of contracts required = = 3 contracts
£0.5m
The position on 3 February.

Action: Borrow £1.5m at an interest rate of 13.5 per cent fixed for 3
months.
Close futures position by making a closing purchase.
Buy 3 March short sterling futures at 86.25 (13.75 per cent).
Cost of borrowing = 0.5 per cent increase

£1.5m × 0.5% × 3/12 = £1875
Profit from futures is therefore:
(86.75 − 86.25)
= 50 ticks
0.01
Ticks × Tick value × Number of contracts = Profit/(Loss)
50 × £12.50 × 3 = £1875

The profit from the futures market exactly compensated for the loss arising
from the rise in interest rates. The hedge was perfect because the basis re-
mained unchanged; in practice, such perfection is unlikely.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
4.9.2 Long-Term Interest-Rate Futures

The use of long-term interest-rate futures or bond futures is identical to other
futures hedges, if a little more complicated. The basic actions are shown in Ta-
ble 4.29.
Table 4.29 Cash-futures arbitrage

Position to be hedged Action
A current bond holding Sell future
Anticipate a purchase Buy future
Bond futures allow the holder to receive delivery of debt securities, usually gov-
ernment securities or similar. To facilitate trading a number of mechanisms are used,
both to increase the supply of eligible securities and to ensure equivalence of value.
4.9.2.1 Notional Bonds

The long-term interest-rate futures contract is based on a notional bond of a given,
constant maturity and a set coupon. For the short position holder, if the contract is
held to expiry, delivery can be made from a range of eligible bonds with the
appropriate characteristics of the notional bond. Some of these bonds will have
more or less accrued interest in their price than others.
If bond futures contracts were based on actual bond issues, it is possible that
activity in the futures markets would be so great as to cause problems of delivery of
the underlying bond at expiry. To avoid the danger of lack of supply resulting in a
squeeze, the futures exchange allows a number of eligible bonds with different
coupons and redemption dates to be delivered to satisfy the obligations of short
position holders in the contract. To equate the two, the exchange uses a conversion
factor between the notional bond and the bonds eligible for delivery.
As a result, when you look at a bond future you are looking at an index price
reflecting the prices of all deliverable bonds.
4.9.2.2 Price Factors in Bond Futures

When under the obligation to make delivery, short position holders in the bond
contract may deliver bonds with a variety of coupons and redemption dates.
Different bonds have different market prices because of coupon and maturity. As a
result, it is necessary for the exchange to introduce into the calculation of the price
(or invoice amount) a method of fairly (or equitably) treating these differences when
sellers deliver high-coupon and (as a result) high-value bonds.

The exchange, as a result, adjusts the delivery price or amount by a price factor to
reflect differences in the value of the actual deliverable bonds relative to the
notional bond.
4.9.2.3 Cheapest-to-Deliver
Price or conversion factors seek to bring all bonds to the same value for delivery.
For a number of technical reasons, they are not entirely accurate. As a result, the
short position holder (or bond seller) needs to calculate which bond is best for him
to deliver (that is, is the least-cost bond). This is known as the cheapest-to-deliver
(CTD).
Correctly identifying the CTD is obviously important for the seller (and for the
buyer!). It is important in the pricing of the future and in the creation of correct
hedges. The complexities of this process are outside the remit of this module.
4.9.2.4 Delivery Options

In addition to the above, a number of other special features are of note. These are
summarised in Table 4.30.
Table 4.30 Summary of delivery options for bond futures

Option Privilege Effect
Accrued interest The right of the short position holder This will be determined by the cost
option to decide when within the delivery of carry; a positive carry on the bond
month to make delivery of the tending to delay delivery to the last
underlying moment; negative carry tending to
ensure early delivery*
End-of-the-month The ability to make use of the delay It allows in making delivery for the
option in settlement allowed between the short holder either to substitute a
exchange’s final delivery settlement cheapest-to-deliver bond or to close
price set at the expiry of the futures out an arbitrage position at a profit
contract and the settlement date by buying more cheaply in the cash
market
Quality option The right of the short position holder The existence of a quality option
to deliver any of the cash bonds in makes a cash-and-carry arbitrage
the basket that meet the specifica- position difficult since in setting up
tions of the contract the position the arbitrageur does not
know which bond will be delivered if
the position is held to expiry
Wild card option Involves making use of the differences Differences in the two prices lead
between the cut-off time on giving either to an arbitrage that allows the
notice of the intention to deliver on substitution of an alternative cheap-
any given delivery day within the est-to-deliver bond, or to the closing
delivery month and the exchange out of an arbitrage position at a profit
delivery settlement price (EDSP) set by buying more cheaply in the cash
at the closing market
* Positive carry occurs when the yield on the bond (its internal rate of return) is higher than the short-term interest
rate involved in pricing the futures contract. With negative carry, the opposite applies.

4.9.3 Commodity Futures

Commodity futures have their own special features. Some contracts allow for an
extended delivery period so that the short position holder can elect the exact day for
delivery. They may also allow for the substitution of a lesser quality or grade of
product from that specified in the contract against a price adjustment. The contract
will also specify those locations at which delivery is allowed.
A particular arrangement allowed in commodities markets is the ability to enter
into an off-exchange transaction involving futures known variously as an exchange
for physical (EFP), against actuals (AA) or exchange of futures for physical
(EFFP).* An exchange for physical transaction allows market participants to agree a
closing-out transaction between the physical and the futures market at the same
time as they enter into a cash market transaction. The EFP is then confirmed
through the exchange at a later stage. The rationale is to allow adjustment to the
cash, or physical, position at minimum cost, by eliminating any pricing mismatches
between the position and the futures contract acting as a hedge. Thus two parties
with a buyer’s hedge and a seller’s hedge can agree to extinguish their obligations to
the exchange at the same time as they agree the price of the cash transaction.
One final aspect worth noting, although not of a contractual nature, is that, on
the whole, commodity futures suffer from greater basis risk than financial futures.
This arises from commodities being consumption assets and not investment assets.
4.10 Summary of the Risks of Using Futures

The attractive features of futures such as standardisation, liquidity, the low transac-
tion cost, open pricing and low credit risk make them useful instruments for
managing risks. There are however, as we have seen, a number of disadvantages to
using futures which stem from the mechanisms used to create the attractive
features. The key risks from using futures are summarised in Table 4.31.
Table 4.31 The risks of using futures

Source of risk Nature of the risk
Basis risk Problem of variable convergence leading to an uncertain
match between cash and futures position performance
Cross-asset positions Underlying position and futures contract are not the same,
leading to potential differences in performance
Rounding error Requirement to transact in whole contract amounts leads to
slight over- (under-) hedging
Variation margin Margin flows on futures position can cause uncertainty in hedging
Timing mismatches Gains and losses on the two sides may not match
Maturity Maturity of the underlying position does not match that of the
mismatches contracts
* This is also possible with some financial futures contracts, when it is known as a basis trade facility.
The rationale is the same as that for commodities: to minimise the price risk from the two sides of the
transaction taking place at different times.


This module has examined the institutional and market arrangements used for futures.
The great advantages of futures over forward contracts are their liquidity, low transac-
tion costs and the role of the exchange in addressing specific counterparty risk
problems. Liquidity is achieved through standardisation of contract specifications.
While the advantages of futures derive from their institutional arrangements,
these same structures also lead to their disadvantages. Futures contracts are inflexi-
ble, leading to hedge inexactness, a problem known as basis risk. The margining
systems lead to intervening cash flows which require the hedger to monitor the
position and, possibly, to make adjustments to the hedge.
Consequently, there are trade-offs between the benefits of a traded market and
contract specificity, between virtually eliminating counterparty risk and assuming
credit risk and between cost and continual monitoring of positions. Functionally,
forwards and futures achieve the same result. The judgement as to which to use is as
much part of the risk-management task as is the decision to hedge or live with the
exposure.

Review Questions
4.1 Counterparty risk is handled in futures markets by:

A. requiring all participants to post a deposit on their transactions.
B. revaluing transactions at the end of each trading day.
C. having a central clearing house act as counterparty to all transactions.
4.2 Futures markets provide liquidity for traded contracts by:

A. restricting the number of market makers in the contracts.
B. restricting the number of maturity dates for delivery.
C. increasing the number of underlying assets in a particular contract.
4.3 Marking to market is the process by which a futures exchange:

A. ensures that traded prices are correctly reported.
B. reconciles the purchase and selling prices of market participants.
C. revalues market participants’ positions at the futures clearing house.
D. ensures an orderly opening price on the exchange at the start of the trading
session.
4.4 Margin is required to be posted to the futures exchange clearing house:

A. to ensure that the buyer or seller acts in good faith.
B. to pay for losses incurred by changes in market prices during the trading
session.
C. to protect the clearing house against possible default by futures users.
4.5 Price discovery as a process observable in futures markets is the result of transactions
with forward maturity dates providing information on:
A. the likely price at maturity.
B. the likely future balance of supply and demand.
C. the price behaviour of the underlying instrument in the futures contract till the
maturity date.
4.6 The mechanism for determining transaction prices in futures markets involves:
A. an auctioneer acting for the exchange calling out bid and offered prices until a
match is made in the market.
B. a specialist offering to buy and sell at the highest and lowest prices in the
market.
C. brokers seeking the highest sell and lowest buy prices available in the market.

4.7 The exchange’s clearing house has the following outstanding positions on day 1 and day
2, as given in the table below:
Types of transactions Day 1 Day 2

Long positions at close 11 150 13 725
Short positions at close 11 150 13 725
Daily trading volume 23 750 35 550
What will be the ‘open interest’ position reported at the close of business at the end of
day 2?
A. 2 575.
B. 11 800.
C. 13 725.
D. 35 550.
4.8 Using the information from Question 4.7, an analyst’s report on the market at the end
of day 2 would indicate that there has been:
A. an increase in the demand for hedging or speculation.
B. a decrease in the demand for hedging or speculation.
C. no change in the demand for hedging or speculation.
D. Cannot answer the question from the information provided.
4.9 You purchase 20 sterling short-term interest rate (STIR) futures contracts at a price of
83.25 and the market improves so that the contracts can be sold for 86.23. The notional
value of the sterling STIR contract is £500 000 and the minimum price fluctuation is one
basis point. Each basis point price change is worth £12.50. How much profit has been
made from the transaction?
A. £3725.
B. £5580.
C. £74 500.
D. £149 000.
4.10 In setting up a futures position, the margin required to be deposited on the short-term
eurodollar contract with a notional value of US$1 million is US$500 per contract. Each
tick is worth US$25 per tick. If five contracts are entered into at 92.34 and the contract
closes at the end of the day at 92.28, how much margin will be debited from the
account at the futures clearing house?
A. US$150.
B. US$500.
C. US$750.
D. US$2500.
4.11 If we sell a futures contract we have:

A. committed to purchase the underlying asset at expiry.
B. committed to sell the underlying asset at expiry.
C. received the premium on the sale.
D. done none of A, B and C.

4.12 An inter-commodity spread involves:

A. buying a nearby date expiry futures contract and selling a later-dated futures
contract.
B. selling a nearby date expiry futures contract and buying a later-dated futures
contract.
C. buying a futures contract on one underlier and selling a futures contract on
another underlier.
Bill Wildman is a speculator who takes risks in order to have a chance of obtaining high
returns. Bill believes that gold is overpriced and will drop substantially in response to a change
in market sentiment. On 9 July, he sells five gold futures contracts at US$375.60 per troy
ounce (one futures contract is worth 100 troy ounces). On 9 September, Bill buys back the
gold contracts at US$350.20 and closes out his position. When dealing with its customers, the
brokerage house has a margin requirement of US$2500 per contract with customers on gold
futures. The tick size for gold futures is US$0.10 and its value is US$10.
4.13 What is Bill’s profit or loss in US dollars?

A. (US$12 700).
B. (US$200).
C. US$12 700.
D. US$200.
4.14 How much variation margin would have been credited to his account?
A. US$25.4
B. US$127.0
C. US$254.0
D. US$12 700
4.15 What is Bill’s return on his investment?

A. −101.6 per cent.
B. −1.6 per cent.
C. 1.6 per cent.
D. 101.6 per cent.
Arnold Schwartz is an aspiring futures trader. His first assignment by his boss is to monitor
the fair value of copper futures on the London Metal Exchange. On 21 October, the spot price
of copper is US$1346.70. The December futures price is US$1361.80. (This futures contract
expires on the twenty-first day of the expiration month, that is, in 61 days.) The financing rate
is 5 per cent (assume actual days/360). Determine the following:
4.16 What is the basis on the futures contract?

A. (US$3.69)
B. (US$15.1)
C. US$11.41
D. US$15.1

4.17 Given the current relationship of spot to the futures price, a trader would define the
basis as:
A. long the basis.
B. short the basis.
C. over futures.
D. under futures.
4.18 What is the ‘fair value’ of the futures contract?

A. US$1358.11
B. US$1361.80
C. US$11.41
D. US$0.00
4.19 You would have a short futures position if you have:

A. bought and then sold futures.
B. sold and then bought futures.
C. sold futures.
D. bought futures.
4.20 You are a hedger if you have:

A. a long position in the cash market and a short position in futures.
B. a short position in the cash market and a short position in futures.
C. a long position in the cash market and a long position in futures.
D. a long and a short position in futures.
4.21 You are a speculator if you have:

A. a long position in the cash market and a short position in futures.
B. a short position in the cash market and a short position in futures.
C. a long and a short position in futures.
D. None of A, B and C applies.
4.22 For interest-rate futures on bonds, the term cheapest-to-deliver means:

A. the bond which is in greatest supply.
B. the bond which is most easily borrowed.
C. the bond which generates either the greatest profit or least loss to the seller.
D. the bond which has the highest cost of carry.
4.23 The current price of a commodity is £245.25 and the term structure of interest rates is
flat at 6.25 per cent. Storage costs are £5 per month paid in arrears. What is the fair
value of the futures contract with three months’ expiration on the commodity?
A. £249.00
B. £260.58
C. £264.00
D. £264.07

4.24 In Question 4.23, the cash price has not changed but the three months’ interest rate has
now instantaneously changed to 7.50 per cent. In this case, the futures price will:
A. rise in value.
B. fall in value.
C. remain unchanged.
D. There is insufficient information to determine an answer.
4.25 In Question 4.23, if the interest rate and storage costs are unchanged at 6.25 per cent
and £5 per month but the cash commodity price has changed to £238.70 and the
futures contract now has two months to maturity, the new fair value of the futures will
be:
A. £241.12
B. £250.14
C. £251.15
D. £253.62
4.26 The cash market price of an asset is 718.35 and the three months’ futures price is
729.10. The three-month interest rate is 6.15 per cent and the storage, insurance and
depreciation is 2.5 per cent p.a. The value basis on the futures is:
A. (10.75)
B. (4.3)
C. 0
D. 10.75
4.27 The one-month futures price is 450.75 and the cash price is 448.60. The one-month
interest rate is 6 per cent and the storage costs are 0.5 per cent per annum. Is the value
basis:
A. nil?
B. positive?
C. negative?
D. Cannot be determined from the information.
4.28 A futures contract on a commodity is initially trading at 1118.25 versus a cash price of
1050.75. After a few days, the futures price rises to 1245.75 and the cash price is
1160.25. In this case, the basis:
A. remains unchanged.
B. has strengthened.
C. has weakened.
D. The answer cannot be determined from the information provided.
4.29 A short-term interest-rates futures position is sold at 87.53 against an implied forward
rate of 12.4375 per cent. The contract subsequently moves to 88.12 and the implied
cash position moves to 11.875 per cent. In this case, the basis:
A. remains unchanged.
B. has strengthened.
C. has weakened.
D. The answer cannot be determined from the information provided.

4.30 An equity index futures contract with a three months’ maturity is trading at 6101.25 and
there is a dividend yield on the index of 4 per cent per annum. The current short-term
interest rate is 5 per cent per annum. The current level of the index is 6080.00. What is
the carry basis?
A. (21.25)
B. (15.14)
C. 6.11
D. 15.14
4.31 A six months’ hedging transaction is to be undertaken against a future borrowing of £65
million using the sterling short-term interest-rate contract which has a notional amount
of £500 000. If the current six months’ rate is 4.5 per cent, and we want to tail the
hedge, how many contracts are required?
A. 64 contracts.
B. 65 contracts.
C. 127 contracts.
D. 130 contracts.
4.32 In the futures markets an arbitrageur wanting to take advantage of price discrepancies
will ____ the cash instrument and ____ the futures contract if the future is ____
relative to the cash. Which of the following is correct?
A. buy sell expensive
B. buy buy cheap
C. sell sell expensive
D. sell buy cheap
4.33 The current index value in mid-January is 3733 and the June futures price is at 3805
(there are 152 days left on the futures contract), the risk-free rate is 8 per cent (using a
year of 365 days), and the dividend yield is 3 per cent and transaction costs are 0.5 per
cent. (Note that stock index futures values are calculated using simple interest.) Which
of the following applies?
A. A profitable cash and carry exists between the two markets after transaction
costs.
B. A profitable reverse cash and carry exists between the two markets after
transaction costs.
C. A cash and carry exists between the two markets, but it is unprofitable after
transaction costs.
D. A reverse cash and carry exists between the two markets, but it is unprofitable
after transaction costs.
4.34 The fundamental differences between financial forward contracts and financial futures
contracts are:
I. forwards are bilateral contracts between two counterparties.
II. futures are traded on an organised exchange whereas forwards are not.
III. the cost-of-carry model applies to forward contracts only.
IV. futures contracts are standardised whereas forward contracts are not.
V. forward contracts are not tradable.
VI. for a forward, the underlying asset in the contract is restricted by law.


A. I, III and VI.
B. II, IV and V.
C. I, III and V.
D. I, II and VI.
4.35 When referring to futures contracts, the margin is:

A. the current difference between the cash or spot price and the futures price.
B. the price difference between the nearest contract to expiry and the longest-
dated contract being traded.
C. the collateral placed with the exchange’s clearing house to ensure performance.
D. the difference between the total value of the contract and the cash market
price at expiry.
4.36 ‘Cash-settled’ when applied to futures contracts on commodities means that:

A. payments are due when the contract is settled.
B. payment is made between the buyer and the commodity clearing house which
then settles with the seller.
C. the value of the contract is paid in cash and no physical commodity is ex-
changed at maturity.
D. payment is made when the contract is first negotiated.
4.37 A long-term interest-rate futures contract has three months until expiry and is based on
a notional bond rate of 9 per cent. A deliverable bond with a 9 per cent coupon is
trading at 100 in the cash market. The short-term interest rate is 12 per cent. What will
be the futures price?
A. 99.25
B. 100
C. 100.75
D. 100.95
4.38 Scotvalue Investment Managers have decided that the price relationship between the
FT-SE 100 and the FT-SE MidCap Index is due for a readjustment in that the MidCap is
undervalued compared to the FT-SE 100 index. They decide to use futures to set up a
cross-asset spread between the two indices. Which of the following transactions should
they put on to back their view?
A. A long position in the MidCap contract and a short position in the FT-SE 100
contract.
B. A short position in the MidCap nearest-to-expire contract and a short position
in the longest-to-expire FT-SE 100 contract.
C. A short position in the MidCap contract and a long position in the FT-SE 100
contract.
D. A long position in the MidCap nearest-to-expire contract and a long position in
the longest-to-expire FT-SE 100 contract.

4.39 If we bought a short-term interest-rate futures contract at 88.79 and sold it again at
89.85, what has happened to interest rates and would we have made money?
A. Interest rates have risen and we have made money.
B. Interest rates have fallen and we have lost money.
C. Interest rates have risen and we have lost money.
D. Interest rates have fallen and we have made money.
4.40 A stock index has a current value of 830.00. The risk-free interest rate is 6 per cent per
annum and the dividend yield on the index is 4 per cent per annum. (Note that stock
index futures values are calculated using simple interest.) What would you expect the
futures price of a stock index future with an expiry date in four months’ time to be?
A. 846.60
B. 835.53
C. 841.07
D. 856.95
4.41 Today is 15 October and the spot price of crude oil quoted on the New York
Mercantile Exchange (NYMEX) is US$70.40 and the price for mid-January expiration is
US$68.75, a period of 91 days. The US dollar continuously compounded interest rate
for the three months is 3.00 per cent per annum. What is the implied convenience yield
(as an annualised rate) on the contract if crude oil storage costs (continuously com-
pounded) are 1 per cent per annum?
A. 3.37 per cent.
B. 5.51 per cent.
C. 11.17 per cent.
D. 13.51 per cent.
Case Study 4.1: The Use of Short-Term Interest-Rate Futures for

Hedging
The current date is 2 April, and the treasurer of GH Inc. is expecting to receive the proceeds
of an asset sale on 15 May (that is, in 41 days). These funds will be invested for three months
(a period of 92 days). The amount due on 15 May is US$50 million.
When the treasurer looks at the situation, the cash three month rate = 9.50% − 9.625%. At
the same time, the June eurodollar futures price = 90.18 (this is the nearby contract with a
delivery (maturity) date on the contract for 20 June, that is, 77 days away).
Remember that short-term interest rates in US dollars are quoted on an Actual/360-day
basis and use simple interest.
1 What is the impact of a 50 bp adverse movement in the interest-rate position on the

return from the asset sale’s proceeds when invested?
2 How many eurodollars futures contracts should the treasurer use to hedge out his
interest-rate risk? The tick value of the short-term interest-rate future in eurodollars =
$25 per contract which has a nominal value of US$1 million. The hedge ratio (ℎ) used to
determine the appropriate number of contracts is found by:

Price sensitivity of the cash position

ℎ=
Price sensitivity of the hedge position
3 What is the interest rate on the investment as a result of the transaction in eurodollar
futures? (You will have to use straight-line interpolation between the cash and futures
rates to find this value.)
4 What are the basis effects and convergence on the futures contract between 2 April and
15 May?
5 On 15 May, the cash market rates have in fact fallen as the treasurer feared and the
three month eurodollar is trading at 9% − 9.125% and the June futures at 90.70 (scenar-
io 1). What is the treasurer’s investment rate on the US$50 million in this case?
(Express the result as an annualised rate.)
6 As in Question 5 above, cash market rates have in fact fallen and the three month
eurodollar is trading at 9 per cent − 9.125 per cent, but the June futures are now at
90.79 (scenario 2). What effect has the change in the futures price had on the return in
this case?
7 Explain why the predicted return when setting up the hedge has either performed as
expected or led to an unexpected result.

Module 5
The Product Set:

Terminal Instruments III – Swaps
Contents
5.1 Introduction.............................................................................................5/2
5.2 Interest-Rate Swaps................................................................................5/5
5.3 Cross-Currency Swaps ...........................................................................5/9
5.4 Asset–Liability Management with Swaps .......................................... 5/11
5.5 The Basics of Swap Pricing ................................................................. 5/17
5.6 Complex Swaps .................................................................................... 5/29
5.7 The Credit Risk in Swaps .................................................................... 5/34
Appendix 5.1: Calculating Zero-Coupon Rates or Yields .......................... 5/41
Case Study 5.1................................................................................................. 5/49
Learning Objectives
This module looks at the third category of derivative terminal instrument: the swap.
Such an instrument is more complex than the single-date structures of forwards and
futures. Following their invention, a large number of different swap types have been
developed in response to market needs, although the two principal kinds relate to
cross-currency and interest-rate swaps. A swap contract has many of the features of
a term instrument, such as a bond, but equally it can be unbundled into a portfolio
of simple forward contracts for pricing and risk-management purposes. The credit
risks of interest-rate swaps are far less than the equivalent risks of holding a bond.
This is not true of a cross-currency swap, where credit risk increases with the time
to maturity.
As a liability-management instrument, swaps provide an effective means for
borrowers to exploit their comparative advantage in particular markets while at the
same time maintaining their desired exposure profile to interest rates and currencies.
Swaps therefore enable borrowers to manage position risk rapidly and at minimum
cost.
As an asset-management instrument, they offer the same attractions as for liabil-
ity management, namely, exploiting anomalies and rapidly managing position risk at
minimum cost.
Swaps allow asset–liability managers to alter their overall exposure to a particular
currency or interest rate without having to undertake the early repayment of

Module 5 / The Product Set: Terminal Instruments III – Swaps
outstanding borrowings or to realise investments. Swaps also facilitate cash-flow

management.
After completing this module, you should know:
 the nature of the different types of swaps;
 how swaps are used for risk modification, asset–liability management and
arbitrage across markets;
 how to price a new, or at-market, swaps contract;
 how to value or unwind an existing, or seasoned, swaps contract;
 the credit exposure on swaps.
5.1 Introduction
Swaps are the third and newest member of the terminal instruments in the deriva-
tive product set. They only came to public knowledge in the early 1980s. Shortly
after the market became aware of these latest instruments, I can distinctly remember
my then manager saying to me that I should find out how these newfangled
transactions worked. At the time, there were only a handful in existence and
information about their structure and function was scarce. Yet by the end of the
decade, swaps were being traded by financial institutions in the same way as forward
contracts on currencies. Swaps have rapidly established themselves as an important
class within the derivative product set. This is because they are extremely useful in
managing interest-rate and currency risks and swaps now form a key part of the
various methods used by firms in managing their risks. If forwards and futures
contracts are designed to hedge a single cash flow, a swap can be seen as the
equivalent instrument for hedging a series of cash flows. Their popularity and rapid
expansion were due to two factors: they helped complete financial markets by
allowing participants to undertake new types of transactions and they acted as a
mechanism for linking the bond markets of major countries.
Swaps have the same symmetric or linear payoff profile as forwards and futures.
However, they differ from forwards and futures in that there is a multiplicity of cash
flows between the two counterparties over the life of the swap. Another reason for
the extensive use of swaps is their adaptability. Any set of cash flows which can be
contractually predetermined can form one side of a swap.
Before looking at the uses of swaps, it is worth pausing at this point to resolve
the terminological confusion that arises between what the market understands as a
swap and the – similarly named – short-term foreign exchange swap. The latter is a
short-dated exchange of one currency into another with the corresponding re-
exchange at a later date (that is, a purchase (sale) and subsequent sale (repurchase)).*
The difference between the foreign exchange swap and the capital markets swap is
that, in the second case, there is a series of periodic payments to be made by both
parties. This module looks at capital markets swaps. The foreign exchange swap is
really a specific use of foreign exchange forward contracts.
* See Module 3 for the details of such transactions.

5.1.1 Uses of Swaps

Swaps, like the other financial instruments of the derivative product set, have to fulfil
an economic purpose in a more efficient way than other instruments or methods in
order to have a place in the financial markets. All derivatives can be replicated using
other fundamental instruments and – in that sense – they are superfluous. However
their economic rationale is that they allow market participants to manage risks at a
lower cost than via cash instruments.
Swaps permit market participants to modify sets of connected cash flows in
attractive ways and thus have become an important tool for asset–liability manage-
ment. They allow the risk manager to modify the nature of these cash flows, either
changing their currency of denomination to a more favourable one, or altering the
nature of their interest-rate risk. They have therefore become important liability
management tools for the treasury manager. However, they also provide the asset
manager with ways to take advantage of investment opportunities. They allow
attractive assets or securities which have undesirable risk characteristics to be
modified by adding the relevant swap structure. Because they transform risk, swaps
have also been extensively used in structured finance to create new risk–reward
characteristics that address the specific needs of different categories of investor.
Finally, as with all off-balance-sheet instruments, swaps provide an opportunity for
speculation.
A New Derivative is Created ________________________________
The first publicly reported swap occurred in August 1981 between the Interna-
tional Bank for Reconstruction and Development (IBRD, or World Bank) and
International Business Machines (IBM). The World Bank wanted to raise low-
interest currencies for onlending and, in order to do so, had been issuing bonds
in the Swiss market. However, the World Bank had over-issued in this market
and was seen as an unattractive credit by investors in the Swiss Franc sector.
On the other side, IBM wanted to raise funds in US dollars at least cost. A
cross-currency swap would meet both their needs. In response to this shared
objective, IBM issued a Swiss Franc denominated bond and the IBRD a US dollar
bond and both parties swapped the proceeds. In addition to the Swiss Francs,
there was a Deutschemark tranche as well, raising a total of US$290 million.
As always in these matters, the swap did not emerge out of thin air. Prior to the
milestone 1981 transaction, which is generally given as the starting point for
swaps, a large number of what are known as ‘back-to-back’ loans had been
made to get around currency controls and other market frictions. The key
technological innovation in the World Bank–IBM swap that made it attractive
and allowed the market to develop subsequently was that it did not involve the
inconvenient ‘topping-up’ arrangements on both sides that was a feature of the
back-to-back loan. This simple change to the contractual arrangements via an
enforceable single contract on both sides made swaps far easier to negotiate
and use. The rest, as they say, is history.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

5.1.2 The Basics of Swaps

Swaps are simply a bilateral contractual agreement by two parties to exchange a
series of cash flows. Many different types of swap have been developed out of the
original swap transactions that initiated this derivative category. The basic swap
types are shown in Table 5.1, together with some of the more common variations.
Table 5.1 Basic swap characteristics and types

Interest-rate swaps Cross-currency swaps
 One currency  More than one currency
 No exchange of principal  Exchange of principal is made
 Fixed/floating interest rates  Fixed/floating interest rates
 Floating/floating interest rates (cross-currency coupon swap)
(basis-rate swap or basis swap)  Fixed/fixed interest rates
 Floating/floating interest rates
(cross-currency basis swap)
Variations
 Amortising swaps  Zero-coupon swaps
 Accreting swaps  Forward rate (start) swaps
 Rollercoaster swaps  Indexed-amortising principal swaps
A swap involves an agreement between two parties, party (A) and party (B)
(known as the ‘counterparties’), to make a series of payments. Party (A) makes
payments to party (B) in return for – and contingent upon – receipt of payments
from party (B); and vice versa. Payments may be in the same currency (known as an
‘interest-rate swap’) or in different currencies (known as a ‘cross-currency swap’), or
an index or product (known variously as a ‘commodity swap’, ‘basis swap’ or ‘index
swap’). The payments by both parties are predetermined amounts, or calculated by
applying a pre-agreed index, such as a fixed or variable interest rate, a commodity
price, an equity index value or other calculable reference rate, to an actual or
notional amount of monetary or commodity principal (known as the ‘notional
principal amount’).
For an interest-rate swap, the positions of the two parties are as follows:
 Fixed-rate payer
 pays the fixed interest rate on the swap;
 receives the floating interest rate on the swap;
 has purchased a swap;
 has a long position in the swap;
 is short the bond market;
 has the price sensitivities of a longer-dated fixed-rate liability and a floating-
rate asset.
 Floating-rate payer
 pays the floating interest rate on the swap;
 receives the fixed interest rate on the swap;

 has sold a swap;

 has a short position in the swap;
 is long the bond market;
 has the price sensitivities of a longer-dated fixed-rate asset and a floating-rate
liability.
Other swaps market terms are as follows:
 swap counterparty: the other party to the swap;
 notional amount or notional principal amount: the amount of principal that
underlies the swap and is used to determine the value of the two payment
streams;
 fixed rate: the interest rate on the fixed side of the swap;
 floating rate: the interest rate on the floating side of the swap;
 maturity date: the date the contract terminates (the date that the last set of cash
flows is exchanged by the parties);
 start date: the date from which interest is calculated and accrues;
 value date: the date at which the two sides of the swap are deemed to have the
same value after any initial upfront payments or other adjustments.
5.2 Interest-Rate Swaps

Interest-rate swaps are a ‘package’ which consists of a long (short) position in one
(notional) asset and a short (long) position in another. That is, the standard or ‘plain
vanilla’ interest-rate swap can be seen as:
 a long (short) position in a fixed-rate bond
 a short (long) position in a floating-rate note (loan)
This identity is illustrated in Table 5.2.
Table 5.2 Interest-rate swap mechanics

Bond FRN Swap
Date (Fixed rate) (Floating (Fixed rate) (Floating
rate) rate)
6/11 (i) (100) 100 – –
6/5 (a) – (3.5625) (3.5625)
6/11 8 (6m LIBOR) 8 (6m LIBOR)
6/5 – (6m LIBOR) – (6m LIBOR)
6/11 (1) 8 (6m LIBOR) 8 (6m LIBOR)
6/11 (2) 100 (100) – –
Note: (a) For the standard swap contract, the first floating payment is known since the swap is
traded for spot (cash) settlement with the first six-month floating rate being set on a spot basis in
November at (i).

We can interpret Table 5.2 as follows. The swap is equivalent to buying a fixed-
rate bond at the start date and issuing or selling a floating-rate note (FRN) to
finance the purchase. The package or swap shows the residual contractual arrange-
ments that result from such a combination. In the case presented in Table 5.2, the
payment flows represent the right to receive the fixed side of the swap and pay the
floating side, which is exactly the case if the bond had been purchased and the FRN
sold. (Obviously the counterparty to the swap will have the same cash flows but
with the opposite signs.)
An alternative way to view an interest-rate swap is as a series of forward-rate
agreements (FRAs) with end-period payments.* Such an end-period FRA involves
the counterparties agreeing to pay or receive the difference between the fixed rate of
8 per cent and the six-month floating rate for a six-month period commencing on 6
May and with payment taking place on 6 November. The exchange in November is:
Payment in November = (8% − 6 − month floating rate × 0.5)
Such an arrangement is the same as an interest-rate swap with only one payment
period. A series of end-period FRAs would look the same as a series of swap
payments. This is shown in Figure 5.1.
A swap contract …
Rfixed Rfixed Rfixed
m
1 2
Rfloating Rfloating Rfloating
… equals a bundle of forward contracts (FRAs)
Rfixed
1
Rfloating Rfixed
+
2
Rfloating Rfixed
+ .... +
m
Rfloating
Figure 5.1 Relationship of interest-rate swap to forward contracts

(forward-rate agreements)
It should be noted that in practice such a series of FRAs, known in market par-
lance as a ‘strip’, would not be identical to the swap in terms of the fixed rate. As we
* The standard FRA contract present values the interest-rate differential to the start of the protection
period. The advantage of this arrangement is that it reduces the period of credit exposure for both
sides. Such an arrangement does not alter the economics of the transaction. Present valuing to the
settlement date significantly reduces the performance period for FRAs, but hardly alters the credit
exposure on a swap. Since the underlying cash instruments that underpin the swap have end-period
payment, this feature of swaps avoids additional cash transactions that the present valuing approach
would entail.

have seen with forwards and futures, the pricing is based on the cost of carry, and
each FRA fixed rate would be determined separately from the implied forward rate
in the term structure. For swaps, the fixed side (as in Table 5.2) is a flat rate, as with
a bond. Thus the value of the fixed side is made up of a blended rate, as is the case
with a bullet fixed-rate bond. We will look at how such a package is valued a bit
later.
5.2.1 Origins of the Interest-Rate Swap

The argument for the early development of the interest-rate swap is based on the
concept of comparative advantage. We have two firms, BBB which has a low
investment grade rating and wants to raise fixed-rate funding, and AAA which has
the highest investment grade rating and which wants to raise floating rate at the
lowest cost. Their respective cost of funding in the floating-rate and fixed-rate
markets is shown in Table 5.3.
Table 5.3 Cost of funding in two markets for firms of different credit
quality
Firm Cost of finance
BBB Pays LIBOR + 0.5% for a seven-year loan from a bank
BBB Pays 12% for a seven-year bond issue
AAA Pays LIBOR + 0.125% for seven-year money from a bank
AAA Pays 11% for a seven-year bond issue
Note: LIBOR is the London interbank offered rate, the benchmark index for floating-rate funds
used for most international financial transactions.
Both sides can improve their positions (that is, lower their costs) if they swap the
payment flows. In the above transaction, AAA issues a bond and swaps the cash
flows with BBB which has raised money via a bank loan. The basic flows of the
transaction are shown in Figure 5.2.
Fixed rate
1/4
11 %
11% AAA BBB LIBOR + 0.5%
LIBOR
(floating rate index)
Interest service Interest service

to bondholders to bank loan
Figure 5.2 Origins of the interest-rate swap

Both parties are better off as a result of the swap transaction. The economic
benefits of the transaction are detailed in Table 5.4 and show the gains each can
make by swapping the interest basis of the two types of borrowing.
It should be noted that although the above explanation might have applied when
the swaps market first started, it hardly explains the continued use of swaps since –
in a reasonably efficient market – such arbitrage opportunities soon disappear.
Although the above condition is less likely to produce opportunities for the two
sides consistently to reduce costs, there are a number of other reasons for the
persistence of swaps:
 interest-rate swaps provide an economical and flexible means for firms to
manage their asset and liability positions, in particular to limit the interest-rate
mismatch between the types and maturities of assets and liabilities;
 swaps provide a link between distinct markets and/or types of firms which have
differing degrees of access to various markets;
 swaps provide a lower overall cost of funding;
 swaps can minimise the cost of regulation and taxes.
Table 5.4 Economics of interest-rate swap transaction

Net cost to AAA
Payments Receipts Net position
Fixed payments 11.00% 11.25% +0.25%
Floating payments LIBOR – −LIBOR
−LIBOR −
0.25%
Direct funding alternative − LIBOR +
0.125%
Gain to AAA via swap + 0.375%
Net cost to BBB

Payments Receipts Net position
Fixed payments 11.25% – −11.25%
Floating payments LIBOR + 0.50% LIBOR − 0.50%
−11.75%
Direct funding alternative − 12.00%
Gain to BBB via swap +0.25%

Note: AAA gains difference between floating-rate borrowing from the bank at L+0.125% and all-in
cost of funds from the swap at L−0.25%. BBB gains difference between fixed-rate bond at 12% and
swapped loan at 11.75%. Who obtains the benefits depends on the relative scarcity of high-grade
credits versus demand to pay the fixed side on a swap.

5.3 Cross-Currency Swaps

The cross-currency coupon swap is similar to the interest-rate swap discussed in
Section 5.2 except that it involves exchanges between two different currencies. The
generic model can therefore be seen as:
 a long position (fixed-rate bond or floating-rate note (FRN)) in one currency; or
 a short position (bond or FRN) in another currency.
Note that it can also be a long position in a floating-rate note in one currency and
a short position in a floating-rate note in another currency (that is, a cross-currency
basis swap) or a fixed-for-fixed (or cross-currency coupon swap) where the two sides
involve predetermined fixed payments.
An example of a generic fixed-for-floating cross-currency swap is given in Ta-
ble 5.5 for a cross-currency coupon swap between sterling and the US dollar
showing the payments for the fixed-rate receiver (the floating-rate payer) on the
swap.
Table 5.5 Cross-currency swap mechanics

Sterling (£) US dollar
bond FRN Swap
Date (Fixed rate) (Floating (Fixed in £) (Floating in US$)
rate)
6/11 (i) (100) 150 (100) 150
6/5 (a) – (3.75) – (3.75)
6/11 (1) 8 (6m LIBOR) 8 (6m LIBOR)
6/11 (2) 100 (150) 100 (150)
Note: (a) For the standard swap contract, the first floating payment is known since the swap is
traded for spot settlement with the first six-month floating rate being set on a spot basis in
November at (i).
In the case of the cross-currency swap, both sides need to exchange the underly-
ing principal at the onset and re-exchange it at maturity.* In Table 5.5, the sterling
amount is exchanged at the onset for a given US dollar amount. Interest payments
are then calculated on these two and, at maturity, the initial principal amounts are
re-exchanged (shown in Table 5.5 by the last row, 6/11 (2)).
* Although this helps explain the mechanics of the cross-currency swap, this statement is not strictly true
since it is possible to have a swap where the principal is re-exchanged only at maturity. The parties can
arrange for the initial exchange via the foreign exchange markets. This structure is useful for the party
which has already exchanged the principal.

There is an alternative way of explaining a cross-currency swap. It is also a pack-

age made up of an interest-rate swap in currency A, a cross-currency basis swap to
currency B and an interest-rate swap in currency B.
5.3.1 Simple Cross-Currency Swap Example

DuPont, the US chemicals company, needs to raise sterling for its UK operations.
At the same time ICI, the British chemicals company, needs US dollars for its North
American operations. They agree to swap (that is, exchange) sterling for dollars for,
say, five years. The terms are that ICI pays the five-year US$ rate of 5 per cent on
the US dollar amount of US$15 million and DuPont the five-year sterling rate at 6
per cent on £10 million. Payments are usually made on a net basis (that is, the
differences). The effective exchange rate is therefore US$1.50 = £1. At the end of
the transaction, the principal amounts are re-exchanged by both parties (at the
contracted rate). The three components of this cross-currency swap are shown in
Figure 5.3.
Panel A US$15 million

Initiation
Dupont ICI
Original
exchange of £10 million
principal
Panel B £0.6 million

Each party Dupont ICI
services their
respective sides US$0.75 million
of the transaction
Panel C £10 million

Maturity Dupont ICI
Re-exchange
of principal US$15 million
Figure 5.3 Components of the DuPont–ICI cross-currency swap

The three stages of the cross-currency swap that are illustrated in Figure 5.3 and
that of Table 5.6 show how the desired positions of both parties are created via the
swap mechanism. In Panel A, the two parties originally exchange the principal
amounts, giving them the desired currencies. Throughout the life of the swap (Panel
B), the two parties service each other’s interest-rate payments. DuPont pays ICI in
sterling at the agreed interest rate of 6 per cent on the initial principal and, in
exchange, ICI pays the US dollar rate of 5 per cent.

Table 5.6 Cross-currency swap cash flows from ICI’s perspective

Swap cash flows Original funding Net
position
Time US$(m) £(m) £(m) (in US
dollars)
0 15.00 (10.00) 10.00 15.00
1 (0.75) 0.60 (0.60) (0.75)
2 (0.75) 0.60 (0.60) (0.75)
3 (0.75) 0.60 (0.60) (0.75)
4 (0.75) 0.60 (0.60) (0.75)
5 (15.75) 10.60 (10.60) (15.75)
Note: DuPont’s cash flows are the same, with the opposite signs.
At maturity, the end of Year 5, both parties pay the last interest payment and re-
exchange their respective principal amounts at the original exchange rate (Panel C).
5.4 Asset–Liability Management with Swaps

The development of swaps has provided asset–liability managers with new ways of
managing their exposures. Although forwards and futures provide hedges against
various risks, they are not without their problems. Swaps, since they are over-the-
counter forward-style contracts, can be tailored to the specific needs of customers.
They provide useful ways of modifying the interest-rate risk on assets and liabilities
and converting one type of exposure to another, for instance, changing the currency
or price risk on a commodity or asset (via index or commodity swaps).
5.4.1 Arbitrage Transactions

There are four principal ways in which asset–liability managers use swaps.
1. The repackaging of liabilities to create a synthetic floating-rate note. This is
achieved by issuing a bond and (simultaneously) entering into a swap to receive
the fixed rate and pay the floating rate. The economic result is a synthetic loan or
floating-rate note since the interest payments on the liability are now at a floating
or variable rate.
Market participants will prefer this route if they seek to raise floating-rate funds
and the package of bond issue plus a swap to floating is cheaper than borrowing
floating direct (see Figure 5.4, column 1).
2. The repackaging of liabilities to create a synthetic bond. This is achieved by
reversing the set of transactions in 1 above: that is, borrowing at a floating rate
and entering into a swap to pay the fixed rate and receive the floating rate. The
economic result is a fixed-rate loan or a synthetic fixed-rate bond.
As with 1, market participants will prefer this route if they wish to raise fixed-
rate finance and issuing a bond is either inappropriate (for instance, if the
amount to be fixed is below the size that is appropriate for the market), or una-
vailable (as can happen if the market considers the credit risk of the issuer to be

too high), or if the cash flow structure does not lend itself to a security transac-
tion, or direct issuance has a higher cost.
3. The repackaging of assets to create a synthetic floating-rate note, or
synthetic loan. This is achieved by buying a bond (often in the secondary mar-
ket) and entering into a swap to pay the fixed rate and receive the floating rate.
The result is to create an asset with a floating-rate income stream, that is, a syn-
thetic floating-rate note or loan.
The attractions of such an arrangement from an investor’s point of view are that
it might provide an investment that was otherwise unavailable or it might pro-
vide an increased return. For instance, most highly rated borrowers do not raise
long-term loans, but issue bonds. However many investors, such as banks, have
access to floating-rate funding and have under-utilised credit lines to high-grade
borrowers. Buying fixed-rate bonds in such a circumstance might be unaccepta-
bly risky. However, if the asset can be transformed into a loan equivalent, then it
meets the asset manager’s interest-rate risk requirements and credit criteria. Such
investors can also take advantage of temporary anomalies in the market when,
for instance, for various reasons fixed-rate bonds might be cheap (for instance
due to temporary oversupply), without assuming unwanted interest-rate risk.
4. The repackaging of assets to create a synthetic straight bond. This is
achieved by buying the floating-rate note and entering into a swap to pay the
floating rate and receive the fixed rate. The result is to create synthetically the
cash flows of a fixed-rate security or straight bond.
The attractions of such a package are the same as with the synthetic floating-rate
note. In this case, it is fixed-interest investors who find the synthetic attractive as
it allows them to diversify their credit risk and to enhance the yield on their port-
folios by broadening the set of securities available.
Decision
Fixed Floating Arbitrage
–Bb + mb
–L
Fixed –Bb + mb + Bs + ms
(bond market)
–L + (mb – ms) –Bb + mb
Market
+ Bs + ms
–L + ml –L<
Floating
–L + ml
(loan market) +L
–Bs + ms –L + ml
–Bs + (ml + ms)
+Bb + mb
Arbitrage
–Bs + ms
+L>
+L + ml
Figure 5.4 Interest-rate swap decision matrix for asset–liability

managers

Note: Bb is the benchmark for bond issuance; mb the issuer’s margin over (possibly under) the
benchmark; Bs is the swaps rate benchmark; ms is the margin over (possibly under) the swaps
rate; L is the floating-rate reference rate; ml is the margin over the floating-rate reference rate.
Note that in most cases the swaps and issuing benchmarks will be the same (that is, Bb = Bs ).
The available arbitrage opportunities for asset–liability managers are shown in
Figure 5.4. For instance, the decision to raise fixed-rate finance will involve either
the direct issue in the bond market, where the all-in cost or yield (benchmark rate
( ) plus margin ( ) and other issuing costs) is less than the synthetic alternative
(margin on the loan ( ) and the benchmark rate ( ) plus margin on the swap
( )). An investment arbitrage opportunity exists when the synthetic alternative
provides a positive net gain over the floating-rate loan equivalent (+ + ).
The alternative floating-rate structure provides similar arbitrage opportunities
between the direct and synthetic routes. We can visualise the two conditions as in
Figure 5.5, where the swap bid rates (at which swap traders are fixed payers or
floating receivers) are such that it is possible for borrowers to issue fixed-rate bonds
and swap them into floating rate at more attractive rates than borrowing directly.
This arbitrage will continue until either bond prices fall or swap rates decline (or
both). This provides the arbitrage boundary shown as ( ).
If, on the other hand, the bond yield is greater than the swap offered rate plus
spread (A), the rate at which an investor can create a synthetic FRN rather than
holding loans or floating-rate notes directly, then bonds will be purchased until this
yield-enhancing arbitrage opportunity disappears due to an increase in the price of
bonds or a decrease in the swap offered rate.
Arbitrages
Yield Investors
+B + mb
–B + ms + L
ld
et yie > L + mFRN
Mark
–B + mb
A + B + ms – L
rate
rate p bid < –L + mFRN
Swa
ered
p off
Swa
L
yield
ing
ssu
All -in i
Maturity
Figure 5.5 Arbitrage boundaries for bonds and swaps in a single

currency

5.4.2 Cross-Currency Asset–Liability Management

As we have seen, the original swap between the World Bank and IBM involved
cross-currency positions on both sides. Such transactions provide useful ways to
manage multi-currency flows. Given that there are costs in raising funds, firms find
it advantageous at times to fund in currencies which have little or limited appeal.
For example, a purchaser of a Japanese-built ship might be offered preferential
export-financing terms in yen spread over a number of years. Given the currency
risks involved, it may be preferable for firms to source elsewhere rather than have a
naked exposure to a potential appreciation of the yen. However, the cross-currency
swap market allows the firm to enter into a competitive sourcing decision and to
eliminate the currency risk of such a transaction, while at the same time capturing
most of the benefits of the subsidised yen financing rate.
For instance, the subsidised yen financing is offered for ten years, to be repaid in
equal annual instalments. Such a repayment scheme can be hedged via an amortising
cross-currency swap (say to US dollars, which is the working currency for the
shipping industry). If the market rate of interest for such a fixed-rate loan is 6 per
cent and the export finance rate 4.5 per cent, there is a 1.5 per cent interest-rate
subsidy being offered. The buyer, however, wants to pay in US dollars to match the
income from the ship. If the swap rate for a yen–US dollar ten-year amortising swap
is 6.85 per cent, then – other things being equal – the buyer should be able to
capture about 1.5 per cent of the gain in US dollars, depending on US dollar interest
rates for the relevant period.
The arithmetic goes as follows. The contract is worth US$50 million which, at the
prevailing exchange rate of Japanese yen 120 = US$1, is worth ¥6 billion. The loan is
amortised in equal instalments over ten years, so the repayment at the market rate of 6
per cent is ¥815.21 million per annum. The same cash flow at the subsidised rate of 4.5
per cent is worth ¥6.45 billion. The present value of the subsidy element is therefore
¥450.51 million. At the current exchange rate (¥120/$) this is worth US$3.75 million.
The amortising cash flow on a US$50 million swap is US$7.07 million. The amortising
value of the subsidy in US dollars is US$0.53 million per annum. Therefore the US
dollar equivalent to the interest reduction means a payment of US$6.54 million p.a. This
is equivalent to an interest cost of 5.2 per cent, a saving of 1.65 per cent, if the reduced
interest charge on the yen side is fully reflected in the dollar payments. In practice, since
the swap counterparty has to invest the interest-rate differential for ten years and take
some additional credit risk, there may be some transaction costs involved and the actual
rate may not be as low as the 5.2 per cent calculated above.
In order to service the off-market swap, the swaps intermediary will be receiving
a lower dollar flow from the company. In order to avoid a cash flow mismatch, the
intermediary will have to ensure that the difference between the at-market rate, at
which it can deal in the market, and the rate it receives is covered by borrowing.
Figure 5.6 shows the necessary cash-matching transactions it needs to make.

Liability Asset
Yen US dollar
Principal Excess Excess
PV PV
Yen 6bn US$50m
Annuity stream
Reduction
in Invested
1.5% 1.65%
interest cash
Payment
6% Payment from 6.85%
4.5% to Shipping 5.2%
Ship Company
builder at
reduced rate
Market rate Subsidised rate Market rate
Figure 5.6 Schematics of subsidised cross-currency swap from interme-

diary’s perspective

Case Study: Swedish ExportKredit’s Treasury Management

Using Swaps _______________________________________________
Swedish ExportKredit (SEK) is the official export-financing agency for Sweden and,
in the mid-1980s, was one of the first firms to make extensive use of swaps as part
of its treasury management. The agency was a regular and highly rated borrower
on the international markets, in particular, via fixed-rate eurobond issues which
could be issued on fine terms. To eliminate any interest-rate risk before the
disbursement of funds, these were swapped to provide a floating-rate liability. The
target rate of funding (expressed in relation to the floating-rate side) was an all-in
cost of around LIBOR less 50 basis points. LIBOR is short for the London inter-
bank offered rate and is the benchmark rate for international short-term
borrowing by leading financial institutions in the international market or eurocur-
rencies. The bid rate (LIBID) at which short-term deposits can be placed is
normally 0.125 per cent below LIBOR. Thus, SEK could re-deposit or warehouse
excess funds in the market and earn a positive carry or interest-rate differential of
0.375 per cent on the principal. These liability-side funding transactions are shown
on the left side of Figure 5.7.
Fixed payments Importers of Swedish

to bondholders products pay fixed
Liability-side Export credit Asset-side

Management SEK issues ‘package’ at Management
Fixed payments bonds a fixed rate
from swaps Partial use of
service coupon gain to
payments subsidise
swap rate
Swaps SEK pays Swaps SEK pays
floating rate fixed rate
All in LIBOR –0.5% Net gain SEK

~ 3/8% receives
LIBOR
Excess funds Money Money
deposited to market market
earn LIBID deposits advance
Figure 5.7 SEK’s treasury-management process

SEK’s use of swaps did not stop with controlling interest-rate risk on its
liabilities. When quoting for export finance (which was offered in a range of
major currencies), the agency was able to offer clients fixed-rate financing. It
was able to do this by again using swaps to eliminate the mismatch that now
existed between the variable-rate liabilities (achieved by swapping bond issues
for floating) and receiving a fixed rate on the export finance. By agreeing with a
swap counterparty to pay fixed and receive the floating rate (LIBOR), SEK could
ensure that the asset could be booked at a fixed rate but without incurring any
interest-rate risk since the payment was swapped for a floating rate. The net
result of these asset-side and liability-side transactions was that SEK assumed

virtually no interest-rate or currency risk in its operations. Swaps were a

perfect solution to its requirements.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.5 The Basics of Swap Pricing

As with all financial instruments, the price is determined by supply and demand.
The willingness of a counterparty to assume the opposite side to a transaction will,
ultimately, dictate the value at which both parties will transact. Given the derivative
nature of swaps, it is obvious that either side of the swap can be hedged in other
markets and hence the ‘pricing by hedging’ approach will apply. In normal circum-
stances, it is therefore possible for a counterparty to construct a riskless position on
either side of the swap so that they assume virtually no interest-rate risk. Given this,
swap pricing is not materially affected by supply and demand factors other than
when increased demand/supply causes other asset values to adjust accordingly. We
have seen this in the previous section in our examination of liability swaps. Given a
change in swaps demand, bond prices and/or swap spreads will adjust to the
imbalance between supply and demand until equilibrium is restored.
Early swap pricing adopted the traditional approach used in bond valuation and
used the yield to maturity (the internal rate of return) to calculate the value of the
payments. This was possible since the value of the floating rate payments must be
equal to the fixed rate payments. However, the floating rate is set at each rollover
date and is not known in advance, so hence the value of future floating payments is
not known. Given this, as we shall see below, they can be largely ignored in deter-
mining the price of the swap. That is not to say that the expected floating rate
payments are irrelevant for pricing, but simply to value the swap in relation to its
known fixed payments as these must equal the unknown floating rate ones. This
allowed the swap to be treated as an annuity stream valued using the current swap
yield. Modern practitioners have turned to a term structure approach based on
spot or zero-coupon interest rates in order to price the swap.
As we have seen, a swap is a bundle of forward contracts. Therefore the value to
both sides of an at-market swap based on the current market terms is such that
neither side is required to compensate the other when entering into the transaction.
As a result, swaps, like forwards and futures, are ‘free’ in that, at inception, they do
not involve an initial cash flow. Given this fact, an at-market swap must have a zero
net present value. If that is so, the two sides of the swap, the present value of the
receipts and that of the payments, must be equal. This must be so even in an
interest-rate swap where the floating-rate side is not known. In this case, as shown
in Equation 5.1, the expected value of the future floating-rate payments must be
equal to the known contractual fixed-rate payments.
( ) ﴾5.1﴿
0 = NPV = ∑ − ∑
(1 + ) (1 + )
where is the swap’s respective fixed and floating cash flows, (. ) is the expected
value and (1 + ) is the appropriate zero-coupon discount factor for time .

We can equally visualise a swap as a series of single cash flows (in similar fashion
to an ‘unbundled’ bond). This is shown conceptually in Figure 5.8.
CF1 CF2 CF3 CF4 CFm–1 CFm
S PV of
= t1 t2 t3 t4 m–1 m
CF1
PV1 CF2
+ t1
PV2 CF3
+ t2
PV3 CF4
+ t3
PV4
+ t4
CFm–1
...
+
PVm–1 CFm
m–1
+
PVm m
Figure 5.8 The fixed-side cash flows on a swap

The identity illustrated in Figure 5.8 shows us how we can price up the swap
when using Equation 5.1. The swap will be priced on the basis of the individual cash
flows that underlie the swap. Any set of fixed cash flows can be seen as the sum of a
series of zero-coupon bonds with matching cash flows.
Given an appropriate set of term instruments (or in the case of swaps, at-market
swap rates) we can generally bootstrap a set of spot or zero-coupon rates. The
payment flows on the swap are then discounted using the term structure implied by
the spot-rate term structure. The ‘fair value’ so derived corresponds (as we shall see)
to the risk position which can be hedged by entering into appropriate (new) par (at-
market) swaps. Such a ‘pricing via hedging’ approach will be perfect if (1) the cash
flows on the instrument and hedges all occur at the same time and (2) the marginal
cost or return to the entity is the floating-rate index.
The advantages of adopting term structure methods are that:
(a) it is a generally used method for calculating the ‘fair value’ of a set of cash flows;
and
(b) it provides a robust pricing and risk-management framework within which swaps
can be valued and traded.
5.5.1 Pricing a Swap

Contrary to what one might imagine, the starting point for valuing an interest-rate
swap (ignoring bid-offer spreads) is to value the (unknown) floating-rate side. The
pricing process proceeds in three steps:

1. Establish a ‘best guess’ of the floating rate applicable to each future settlement
date on the swap. This is done by using the implied forward rates from the term
structure for the relevant floating-rate period.
2. Use the zero-coupon yield curve to calculate the present value of the expected
future payments under the swap.
3. Calculate the annuity rate that has the same present value as determined in 2 to
give the fixed-rate side.
5.5.2 The Best Guess of the Floating-Rate Payments

The starting point is to use the market’s estimate of the forward rates that will prevail at
each settlement date on the floating-rate side. The first requirement is to calculate the
zero-coupon rate ( ) that relates to the relevant period by selecting an appropriate
yield curve from which to construct the zero rate, for instance, the corporate yield
curve, government bond curve, swaps curve and so forth. (We show a quick method
for bootstrapping the zero-coupon curve from par yields in Section 5.5.4 when we look
at how to value a seasoned swap.)
The floating-rate payment for the period will be the periodic interest rate for that
part of the swap. This, under the expectations hypothesis of the yield curve, will be
equal to the implied forward rate for the period times the nominal amount. To
illustrate how this is calculated, we will calculate the rate for the second payment
(the period 0.5 to 1.0) given in Table 5.7. The two zero-coupon rates correspond to
six months and one year. Therefore, the implied six-month rate – in six months – is
the unknown rate in Equation 5.2:
(1 + . ) . (1 + . . ) .
= (1 + . ) . ﴾5.2﴿
All that is required to determine the implied six-month rate in six months is to
rearrange the terms in Equation 5.2. This gives the (annualised) floating-rate
payment as 5.33 per cent. Since the cash value of this payment is for six months
only, the actual payment is 2.66 (per 100 notional principal), as in column 4 of
Table 5.7. The other rates are calculated in similar fashion. The last step is to present
value these cash flows using the formula in Equation 5.1 for the floating-rate cash
flows.
The above analysis shows that the present value of the expected floating-rate
payments comes to 28.70. Since this is an at-market swap, the present value of the
fixed rate must also come to the same amount (as per Equation 5.3):
﴾5.3﴿
28.70 = ∑
. (1 + )

Table 5.7 Calculating the net present value of the expected floating-
rate payments on an interest-rate swap
Zero-
Time coupon Floating Floating Present
rate ( )% rate (%) payment value
0.5 5.00 4.94 2.47 2.41
1.0 5.20 5.33 2.66 2.53
1.5 5.40 5.72 2.86 2.64
2.0 5.80 6.89 3.45 3.08
2.5 6.00 6.69 3.35 2.89
3.0 6.25 7.37 3.69 3.07
3.5 6.30 6.50 3.25 2.62
4.0 6.50 7.76 3.88 3.02
4.5 6.75 8.59 4.29 3.20
5.0 7.00 9.07 4.54 3.23
Total present value: 28.70
Given the above results, all that is now left for us to calculate is the interest rate that
prevails on the fixed-rate side. Again making use of the zero-coupon rates, we can
calculate the annuity factor that pertains for the ten half-yearly periods, as the example
involves the use of the same frequency for both sides of the transaction. This is shown
in Equation 5.4. It is worth noting that this is a special form of annuity where the
discount rate is not constant across time.
1 ﴾5.4﴿
∑ = 8.4852
. (1 + )
Note also that having different payment frequencies (semi-annual on the floating-
rate side versus annual on the fixed-rate side) does not alter the basic approach. Our
last step is to value the fixed-rate payments and express these as an interest rate.
5.5.3 Valuing the Fixed-Rate Side

The last requirement is to ‘back out’ the fixed-rate payments that correspond to the
expected floating-rate payments on the swap as an interest rate. This is done using
the following approach. The present value of the cash flows is discounted by the
annuity factor to determine the payments, which are expressed as an interest rate.
This is 6.77 per cent, as shown in Equation 5.5:
28.70 × 2 ﴾5.5﴿
= = 6.7647%
8.4852 × 100
Note that for the swap to have a zero net present value, there will be periods
when the value of the fixed is above that of the floating side payments. At onset the
degree to which each side is initially subsidising the other depends on the shape of
the term structure. Figure 5.9 shows the relationship from the perspective of the
fixed-rate payer.

Forward
rate Forward rate curve
(% p.a.)
Fixed rate on swap
–ve +ve value

value of net cash
of net flow
cash flow elements
elements
Positive or upward sloping term structure

Forward
rate
(% p.a.)
Fixed rate on swap

+ve value
of net cash –ve value
flow of net cash Forward rate curve
elements flow elements
Negative or downward sloping term structure
Figure 5.9 Shape of the term structure and its effects on net payments
on a swap (from the fixed-rate payer’s standpoint)
Note: The position is reversed for the floating-rate payer.
This element of cross-subsidy is a result of the flat or packaged element of pay-
ments on the swap. This, of course, is one of the reasons swaps are useful since the
fixed payments on one side can be matched to corresponding extant liabilities (or
assets) such as the coupon payments on bond issues.
In the example above, the party paying the fixed side in period 1 will pay 3.38
and receive 2.47, a net payment of 0.91. However, according to the shape of the
term structure – at initiation – future short-term interest rates will rise and the net
payment position on the fixed side will become positive on later payment dates. For
instance, the last payment has an implied floating-rate payment of 4.54, giving a net
receipt of 1.16. In the same way, if the term structure had been downward sloping,
the fixed side would only be willing to pay a lower coupon rate than the current
short-term interest rate. In general, therefore, an upward-sloping term structure
means that the fixed payer has a net payable position in the early periods versus a
net receivable position in later ones. For a downward-sloping curve, the situation
(for the fixed payer) is the opposite.
5.5.4 The Value of a Seasoned Interest-Rate Swap

As interest rates change, the value of an interest-rate swap will change as the
discount factors used to value the swap change. The value of a seasoned interest-
rate swap is the price that is required to hedge or replace the swap with current, at-
market (or par) swaps. This section shows how the valuation process is carried out.

Creating a Zero-Coupon Yield Curve from a Par Yield Curve __

When the instruments used to create a zero-coupon yield curve trade at par, a
shorthand method for calculating the zero-coupon rates can be used. The basic
formula is:
+ 100 ﴾5.6﴿
−1 × 100
100 − ( × Annuity factor)
Equation 5.6 essentially uses an annuity to present value the intermediate
interest to ‘remove’ the intermediate cash flows in order to leave a single
present value and future value which are, consequently, linked by the zero-
coupon rate. Alternatively, we can see the equation as deriving the present
value of the zero-coupon bond that makes up the last cash flow on the par
instrument, having subtracted the coupon annuity from the par value.
This rapid bootstrapping method is shown below. The starting point is the
longest maturity zero-coupon instrument (a bank deposit or money market
instrument). The yield on this par instrument is by definition the zero-coupon
rate for that maturity. Using this rate, the reciprocal value or discount rate is
added to the next maturity period (period t + 1) in the column marked in
Table 5.8. This value is used to present value the interest rate for the two-
period par instrument. This is then subtracted from 100 (the par value) to give
the price relative for the second period . The calculation for deriving 2 in
Table 5.8 is shown in Equation 5.7:
8.98% + 100 ﴾5.7﴿
=
100 − (8.98% × 0.913690)
In Equation 5.7, the rate is 8.98 per cent, the par yield for the second maturity
in Table 5.8. The process is repeated until all the desired maturities have been
covered. In Table 5.8, is equal to ( + (1 ÷ )) and where 2 to is
[( + 100) ÷ (100 − × )] and the discount factor is [1 ÷ (1 + ) ].
Table 5.8 Calculating the zero-coupon yield and associated discount

factors for par instruments
ZC
Maturity Par yield At st ZC yield discount
factor
1 9.4469 – 1.094469 9.4469 0.913685
2 8.9800 0.913685 1.187209 8.9591 0.842312
3 8.6000 1.755997 1.279176 8.5534 0.781753
You may wish to check the accuracy of the zero-coupon rate given for period 3
using the above method.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The starting point for the valuation of the seasoned swap is to determine the
value of the swap from Equation 5.1. We can ignore the floating side since, by

replacing the seasoned and off-market swap with a new at-market swap with the
opposite payment flows, the two floating-rate payments will cancel each other out.
We start by determining the zero-coupon rates that are used to present value the
cash flows. This is shown as Step 1 in Table 5.9. The method used to create the
zero-coupon rates is shown above.*
Table 5.9 Valuation of a seasoned (off-market) interest rate swap

Step 1: Determine discount factors for PV from ZC yield curve
Maturity Par yield ZC yield Discount factor
1 9.4469 9.4469 0.913685
2 8.9800 8.9591 0.842312
3 8.6000 8.5534 0.781753
Step 2: Present value future cash flows

Maturity Cash flow Discount factor Present value
0 (100.00) 1.000000 (100.00)
1 3.00 0.913685 2.741
2 3.00 0.842312 2.527
3 103.00 0.781753 80.521
(14.211)
PV using par yield: (14.277)
The second step is to present value the cash flows on the swap using the dis-
count factors derived from the zero-coupon rates. Note that to obtain a sensible
result using this approach we have to treat the swap cash flows as if they were a
bond (that is, we include the notional principal on the swap). Note that this result
provides a net present value loss of (14.211). If we had used the par yield for the
three-year maturity to value the cash flows, we would have obtained a loss of
(14.277), that is:
∑ = (14.277)
﴾5.8﴿
(1.086)
This single rate method provides a slightly different result to the value derived
from the zero-coupon rates. That is the yield-to-maturity or internal rate of return
valuation approach overestimates the loss. As we shall see, a payment of 14.211 on
this swap is all the subsidy that is required to replace it with at-market swaps and,
hence, is the swaps’ fair value. An understanding of this outcome was one reason
why practitioners abandoned the yield-to-maturity method in favour of term-
structure methods. The attractions of the zero-coupon pricing method are summa-
rised in Table 5.10.
* The method is further discussed in Appendix 5.1 to this Module.

Table 5.10 Comparison of yield-to-maturity (YTM) and zero-coupon

pricing methodologies
Methodology
Characteristics Yield-to- Zero-
maturity coupon
Accurately prices ‘at-market’ swaps Yes Yes
Accurately prices ‘off-market’ swaps No Yes
Consistently values all cash flows regardless of the No Yes
structure of the instrument
Identifies opportunities for arbitrage between No Yes
instruments
We can now proceed to show how a series of at-market swaps can be used to
unwind the swap position using an investment of 14.211 per 100. The required
transactions are shown in Table 5.11.
Table 5.11 Zero-coupon pricing model for a swap

Notional 100 4.323 4.732 (94.843)
maturity Original 1 year 2 years 3 years Total
0 (100.00) (4.323) (4.732) 94.843 (14.211)
1 3.00 4.732 0.425 (8.157) nil
2 3.00 5.517 (8.157) nil
3 103.00 (103.00) nil
We start with the furthest maturity payment, the 103.00 in Year 3. To hedge this
position requires an at-market swap that provides for a payment of this amount to
be made at the end of Year 3. The current at-market swap rate is 8.60 per cent, so
that we need a principal amount (P) which gives P + 0.0860(P) = 103.00, which
exactly cancels our Year 3 payment, leaving no cash flow. To do this, we enter a
swap with a notional principal of 94.843 (103/1.086 = ). As we are receiving fixed
on the original swap, we want to pay on the new cancelling swap. We therefore have
two payments in Years 1 and 2 where we pay out 8.157 (94.843 × 8.6%). The three
cash flows on this swap are therefore as follows:
t=0 t=1 t=2 t=3

94.843 (8.157) (8.157) (103)
The next step is to eliminate all cash flows at Year 2. We are receiving 3.00 on the
existing swap and paying out 8.157 on the new swap to eliminate cash flows in Year
3, so we now need a further receipt of 5.157 (8.157 − 3.00) to eliminate cash flows
at this point. We proceed as before, but this time use the two-year swap rate of 8.98
per cent and we require to enter into a swap to receive fixed so that at the end of
Year 2, the notional principal amount (P) and + 0.0898( ) = 5.157. To do this
requires an initial outlay of (4.732) but since we contract to receive, we also have an
intervening interest payment in Year 1 of 0.425. The payments are therefore:

t=0 t=1 t=2 t=3

(4.732) 0.425 5.157 –
We must now eliminate the cash flow for Year 1. We have the outgoing cash
flow from the three-year reversing swap in Year 1 of 8.517, the inflow on the
original swap of 3.00 and the receipt from the two-year swap of 0.425. This means
we must hedge a net cash outflow of 4.732 (8.157 − 3 − 0.425) for one year. Again
we need to find the principal (P) for this cash flow. This is equal to × 1.094469 =
4.732. Therefore P is an outflow of 4.323. The two payments are therefore:
t=0 t=1 t=2 t=3

(4.323) 4.732 – –
The above explanations of the combination of the original swap cash flows and
the new, at-market swap, hedging cash flows are shown in tabular form in Ta-
ble 5.12 which should be studied in conjunction with Table 5.11.
Table 5.12 Summary of the swaps required to hedge the off-market

swap in Table 5.11
Year 0 Year 1 Year 2 Year 3
Step 1
Year 3 swap 8.60% P + 0.086(P) (103.00)
= =
P= 94.843
CF (3) 94.843 (8.157) (8.157) (103.00)
Step 2
Year 2 swap 8.98% P + 0.0898(P) 5.157
= =
P= (4.732)
CF (2) (4.732) (0.425) 5.157
Step 3
P× 4.732
(1.094469) =
P= (4.323)
CF (1) (4.323) 4.732
We now need to put all these receive and pay swaps together. The net result is
shown in the headings of Table 5.11. The original investment is worth a notional
100, but we need to add 4.323 for the one-year swap, 4.732 for the two-year swap,
but we notionally deposit 94.843 for the three-year swap. To make the transaction
balance, we need to receive/pay in an extra 14.211. This is the same amount as that
at which we valued the swap earlier, using term-structure methods. An alternative
way to consider the valuation arrived at earlier is to think of this sum as the payment

that the fixed payer requires to surrender his right to receive the floating-rate
payment and be no worse off as a result under the new market conditions.*
The above calculations (which incidentally assume that the floating-rate indices
cancel out) show that the term-structure approach correctly values the contractual
set of cash flows in an off-market swap (or equally, in any other set of fixed cash
flows). We now turn to a similar analysis for cross-currency swaps.
5.5.5 The Value of a Seasoned Cross-Currency Swap

The valuation of an off-market or seasoned cross-currency swap uses the same
approach as that used in Section 5.5.4, but – as an added complexity – has to factor
in the possible change in value of the currency rate as well. Again, the principle of
valuation is the cost required to replace or hedge out the swap. As with a simple
interest-rate swap, the value of the at-market swap at the outset will be zero
(ignoring transaction costs):
﴾5.9﴿
0= ∑ − ·∑
(1 + ) (1 + )
where superscript A is the cash flow in currency A at time , and superscript B

is the cash flow in currency B at time . At origination, the present value of the two
sides when converted into a common currency will be the same.
In order to illustrate the valuation process for a seasoned swap, we will use the
DuPont–ICI swap described in Section 5.3. The terms of the original swap and
current market conditions, which have changed somewhat since the transaction was
entered into, are given in Table 5.13.
Table 5.13 Original terms and market conditions for the DuPont–ICI
cross-currency swap
Terms on the swap Original swap (Time Current market
0) (Time 0 + 2)
Exchange rate $1.50/£ $1.45/£
Sterling interest rate 6% 7%
US dollar interest rate 5% 4.5%
From Table 5.13 it can be seen that the interest rate on the US dollar cash flows
has fallen from 5 per cent to 4.5 per cent (−0.50 per cent) for the remaining three
years of the swap transaction, whereas for sterling it has risen from 6 per cent to 7
per cent (+1 per cent). Also, the exchange rate has now moved from US$1.50 to
US$1.45 (that is, the US dollar has strengthened against sterling).
The first step is to revalue the cash flows at the new interest rates. This revalua-
tion is shown in the last two columns of Table 5.14.
* In this case, the fixed payer is obtaining the benefit of net receipts over the remaining life of the swap.
Alternatively, we could think of it as the value required to compensate the floating-rate payer for
entering into an ‘off-market’ swap with a below-market coupon at 3 per cent.

Table 5.14 Valuation of the DuPont–ICI cross-currency swap

Swap cash flows Remaining cash Present value
flows
Time US$(m) £(m) US$(m) £(m) $4.5% £7%
0 15.00 (10.00) – – – –
1 (0.75) 0.60 – – – –
2 (0.75) 0.60 – – 0 –
3 (0.75) 0.60 (0.75) 0.60 (0.7177) 0.5608
4 (0.75) 0.60 (0.75) 0.60 (0.6868) 0.5241
5 (15.75) 10.60 (15.75) 10.60 (13.8017) 8.6528
∑ PV: ($15.2062) £9.7376
The analysis shows that the present value of the US dollar side is now
US$15.2062 million. The valuation of the sterling side reveals it is worth £9.7376
million. The overall value of the swap will be the sum of these two parts expressed
in a common currency. We now apply our valuation model to the cash flows and, to
work out the value, convert the US dollar value into sterling. (Alternatively, we
could have converted the sterling flows value into US dollars.)
($15.2062)
− £9.7376 = (£0.74945)
1.45
From ICI’s perspective, the valuation of the swap shows it is now a liability, from
DuPont’s, an asset.
An alternative method of valuing the swap, which gives an equivalent result, is to
consider the swap as a function of par swaps and to add or subtract an annuity for
the cash-flow differences between the off-market swap and par swaps over the
remaining term. On the US dollar side, interest rates have fallen by 50 basis points.
The three-year annuity factor at the new interest rate of 4.5 per cent is 2.7490. The
present value of 50 bp per unit of nominal comes to 0.0138, which is then added to
the 1 unit nominal. We can consider this amount to be the additional payment a
holder of a 5 per cent income stream requires at the current interest rate to substi-
tute a 4.5 per cent income stream and be no worse off. The total current value is
therefore 1.0138 times the principal amount on the dollar side of the swap. The
same calculation is carried out on the sterling side, but in this case there has been a
rise in interest rates, so the annuity has a negative value of −0.0262. The value per 1
nominal is therefore 0.9738. We now convert the US dollar side to sterling by
dividing the US$15 million by the current exchange rate of $1.45/£ and multiplying
by the new market value of 1.0138 to give a sterling value of −£10 487 015. The
sterling side is now worth only 0.9738 × £10 million, or £9 737 568. The difference
between these two is the swap value of £749 447.*
* Rounding means this differs slightly from the earlier result.

Using this method, we can work out how the change in value came about. There
are three elements to consider:
1. the change in the US dollar interest rate;
2. the change in the sterling interest rate; and
3. the change in the exchange rate.
Using the above methodology, we can calculate the value change for the two
interest-rate elements separately. For the sterling side, the loss in value is simply the
value change at the new interest rate:
1 − 0.9738 × £10 million = £262 432
On the US dollar side, the same calculation needs to be converted to sterling:
1 − 1.0138 × (US$15 million) = US$206 172
US$206 172 ÷ 1.45 = £142 188
Finally, the exchange rate effect is calculated as:
US$15 million ÷ 1.45 − £10 million = £344 828
The contribution of each of the components to the overall change in value is
shown in Table 5.15.
Table 5.15 Market prices affecting the value of the DuPont–ICI cross-
currency swap
Value element of the swap Gain/(loss)
US dollar interest-rate effect (− 0.5%) (£142 188)
Sterling interest-rate effect (+1%) (£262 432)
Exchange-rate effect ($1.45/£) (£344 828)
Total value change (£749 448)
The payment of £749 448 represents the present value of the cost to ICI of re-
versing out the existing swaps with current, at-market swaps with a residual term of
three years. This value, a liability to ICI and a gain to DuPont, is the cost of hedging
out the existing position and matching all the future cash flows. Both sides should
agree on this termination or cancellation value, since they can independently achieve
the equivalent outcome by arranging swaps with back-to-back matching cash flows
that provide the same result. Cancellation, with a countervailing payment, is a
preferred option since it eliminates any credit risk on the existing swap and reduces
servicing costs. The credit risk in the swap is, as we will discuss a bit later, equivalent
to the replacement cost we have just calculated.
To conclude, we can see with a fixed-to-fixed cross-currency swap that there are
three factors which will influence its value. The first two are the changes in the interest
rates used to value the cash flows in the two currencies and the third is any change in
the exchange rate. This illustrates that the change in value to be expected in a currency
swap, unless some of the effects are offsetting, is likely to be greater than the change
in value of an interest-rate swap. Consequently, cross-currency swaps have more credit
risk than interest-rate swaps since their replacement cost is likely to be greater.

Swap Valuation Summarised ________________________________

Since a swap can be replicated via a combination of cash market instruments,
this provides a model for valuing swaps.
For an interest rate swap (IRS), the value off the swap is the difference between
a fixed rate bond (B) and a floating rate note (FRN), namely:
= − ﴾5.10﴿
The valuation of the bond element is:
= ∑ +
﴾5.11﴿
(1 + ) (1 + )
where C is the coupon value of the swap (that is the fixed interest payment),
is the zero-coupon interest rate for time period t, and P is the notional principal
of the swap.
The valuation of the floating rate note (between interest reset dates) will be:
= +
﴾5.12﴿
(1 + ) (1 + )
where 1 is the zero-coupon interest rate to the next reset date. Since the
floating interest payment will be reset at the next rollover date the floating rate
note will trade at par, so there is no requirement to value the future, unknown
floating rate payments. If the swap is at the rollover date, then obviously
= .
The valuation of the cross-currency swap (CCS) is the same as that for the
interest rate swap, except that we have to take into account the exchange rate
between the two currencies. The value of the CCS will therefore be:
= −
﴾5.13﴿ /
That is, to obtain a value, we need to convert the present value of one of the
currency elements into the other one. Note that in the case of the CCS, there
are two sets of zero coupon rates, those in currency A and those for currency
B. In addition, as discussed elsewhere in this Module, there is more variety with
currencies: we could have one leg of the CCS being fixed and the other floating,
and so forth.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.6 Complex Swaps

The swaps so far discussed are generic or standard in their construction. They are
bullet-type with uniform features. In some cases, swap users require a more compli-
cated structure to reflect the principal and interest payments on the underlying asset
or liability stream. The more common types of complex swaps are the amortising
swap, the deferred-start swap (and the more elaborate version known as the
accreting swap), and the rollercoaster swap – which combines features of the
accreting swap and the amortising swap.

5.6.1 Amortising Swaps

The amortising swap has a structure in which the amount of principal in the swap is
reduced over time. An example of a profile of a reducing principal structure is
shown graphically in Figure 5.10, Panel A. To create such a swap principal profile
requires that a number of plain vanilla swaps of different maturities be put together
as shown in Panel B of Figure 5.10.
Principal Panel A
amount Amortising swap
Time
Principal Panel B
amount Swap 1 Amortising swap
from Panel A
Swap 2 created from plain
vanilla swaps with
Swap 3 different maturities
Swap 4
Time
Figure 5.10 Principal profile and structure of an amortising swap

In most cases the swap rates on the different swaps that make up the amortising
swap will not be the same. This is acceptable if the swap user is happy to have a
different interest rate for different maturities. However, if the underlying position to
be modified using swaps has a constant interest rate, as might be the case with an
amortising bond, for example, then the swap user would want to have a flat interest
rate regardless of the maturity and underlying amount on the swap.
In this case, the swaps market maker can arrange that the swap rate is a ‘blended’
rate created from the different maturity swaps used to make up the amortising
profile. Let us assume that the profile and interest rates in Table 5.16 exist.
Table 5.16 Present value of 1 per cent of the four swaps used to create
the amortising swap
Principal Effective PV of 1% PV of 1% ×
Year amount swap rate (Annuity) Swap rate
1 100 7.50% 0.9302 6.9767
2 100 7.60% 1.7940 13.6341
3 100 7.75% 2.5933 20.0983
4 100 7.80% 3.3338 26.0039
400 ∑ 66.7130

By calculating the value of 1 per cent (that is, an annuity on the principal
amount), we obtain the results in column 4 of Table 5.16. Next, this present value of
an annuity is multiplied by the interest on each swap (columns 3 and 4) to give the
results in column 5. The total is the present value of the interest that would be paid
on the different swaps. Next, as shown in Table 5.17, we find the present value of 1
per cent on the blended swap based on the par swap rates for each of the maturities.
This is given in column 4 of the table. This comes to 8.6514.
Table 5.17 Present value of 1 per cent of the amortising swap

Discount factor PV of 1% ×
Year Swap principal used to present Blended swap
value
1 400 0.9302 3.7209
2 300 0.8637 2.5912
3 200 0.7994 1.5987
4 100 0.7405 0.7405
∑ 8.6514
We can now find the interest rate that pertains to the blended swap rate. The
effective interest rate that the swaps market maker would quote on the amortising
swap is 7.7113 per cent (66.7130 ÷ 8.6514). This is the weighted-average interest rate
on the swaps package. Note that in offering such a quote, the swaps market maker
is potentially exposed to some interest-rate risk since there is a cash flow mismatch
between the simple swaps underlying the amortising package and the four swaps
used to hedge (or create) the position.
5.6.2 Deferred-Start Swaps

A deferred-start or forward swap is any swap which has the start date of the
contract delayed beyond the normal market terms for settlement. Swaps have a
normal start date from which interest is accrued that is the same as the cash
settlement period (between one and five working days after the contract is negotiat-
ed). It is possible, however, to agree to a swap in which the start date is deferred to
some mutually agreed future date. Thus the swap is priced today but only comes
into effect at the future date. Because the swap is priced off the term structure, the
fixed rate payable has to be adjusted to reflect this delay.
Let us look at the example of a swap which is deferred for one year and has a
maturity of four years. We could create this by using two simple swaps:
 a five-year spot swap with the desired fixed payment stream (paying or receiv-
ing);
 a one-year swap with the opposite characteristics to the five-year swap.
The creation of the deferred-start structure is shown graphically in Figure 5.11.

Five-year spot swap
Less one-year swap
= Four-year deferred-start swap
Spot Maturity
Figure 5.11 Mechanics of the deferred-start swap

Pricing such a swap is equivalent to pricing the implied forward rate. We start
with the two simple swaps which are based on the five-year and one-year annuity
rates. Taking the one-year rate from the five-year rate gives the four-year forward
annuity rate, as shown in Table 5.18.
Table 5.18 Calculating the deferred-start four-year annuity rate

Year Swap rate Annuity factor
5 9.25 3.86455
1 8.50 (0.92166)
Four-year swap: 2.94289
The fixed side of the swap rate can now be determined as:
(9.25 × 3.86455) − (8.50 × 0.92166) ﴾5.14﴿
= 9.4849%
2.94289
The forward-start swap rate is higher (as we would expect from the shape of the
term structure implied by Table 5.17) than the rate on the five-year spot start swap.
5.6.3 Accreting and Rollercoaster Swaps

We now have all the elements required to price up accreting swaps. As shown in
Figure 5.12, the accreting swap is a package made up of an initial spot swap and a
series of deferred-start swaps. Flat pricing is achieved in exactly the same manner as
for the amortising swap. Again from a risk-management perspective, for the market
maker quoting such a swap, there may be some residual interest-rate risk from the
cash flow mismatches between the underlying spot swaps and the payments on the
accreting package. If this was significant, the swaps market maker would need to
hedge out these residual cash flows.

Panel A
Principal Accreting swap
amount
Maturity
Principal Panel B
amount Swap 4 The four swaps,
three of which
Swap 3 are deferred start,
which make up
Swap 2 the Accreting swap
Swap 1
Maturity
Figure 5.12 Mechanics of the deferred-start swap
The final structure is a combination of the accreting swap and the amortising
swap, generally known as a rollercoaster swap. The principal profile of an example
of such a swap is shown in Panel A of Figure 5.13. The principal profile is made up
of four swaps, three of which are deferred start, as shown in Panel B of Figure 5.13.
Principal Panel A
amount Rollercoaster swap
Maturity
Principal Panel B
amount Swap 4 The rollercoaster
swap is made up
Swap 3 of a number of
deferred start
swaps with
Swap 2 different maturity
dates
Swap 1
Maturity
Figure 5.13 Mechanics of a rollercoaster swap

Other Product Extensions of the Swaps Method ______________

The swaps mechanism, involving as it does a series of payments based on one
reference rate being exchanged against another series of payments based on
another reference rate, has allowed financial engineers to develop swaps based
on other products and instruments. The two most common swaps developed
using interest-rate and cross-currency swaps financial technology are commod-
ity swaps and equity swaps.
Commodity Swaps
There are many different types and mechanisms used for commodity swaps. The
fixed-for-floating commodity swap is a bilateral agreement in which one
party agrees to pay a fixed amount for a commodity in exchange for receiving a
variable rate. As with the interest-rate swap, the two parties do not exchange
the physical commodity at each payment period and settle the difference in cash
based on a notional amount of commodity.
Another variant is a basis commodity swap where the two pricing indices are
different. For instance, a producer might wish to exchange the price of crude oil
based on the North Sea’s Brent Oil price for that for the USA’s benchmark
grade West Texas Intermediate.
Equity Swaps
As with commodity swaps, a number of different variants of equity swaps have
been developed. The simplest type is similar to an interest-rate swap where one
side of the swap is the performance of an equity index or a basket of stocks,
normally the total return (that is, capital appreciation plus dividends) whereas
the other side is pegged to a floating rate such as LIBOR. Occasionally, both
sides are stock indices and a cross-currency variant, known as a quantity-
adjusting index-linked swap, has also been developed.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.7 The Credit Risk in Swaps

Swaps, as with other derivatives, create a counterparty exposure or credit risk on the
other party to the contract. Two methodologies have been used to estimate the
amount of credit risk in a swap:
 original exposure method. This assumes the maximum credit exposure can be
predetermined at the start. Many banks use a simple formula for calculating the
credit risk of a swap:
swap risk = 3% × (notional principal amount) × years to maturity ﴾5.15﴿
This heuristic approach was based on the view that a 3 per cent p.a. change in
interest rates is a fairly cautious guess as to how far interest rates might quickly
move in an adverse direction.
 current exposure method. This revalues the exposure in terms of the cost to
replace or hedge out the exposure at any time before the contract’s maturity.

5.7.1 How Credit Risk Arises

A bank enters into a swap with a company as counterparty. At the onset, the swap is
at-market and has (excluding the dealer’s turn) a zero net present value. It is only
after the swap has moved off-market that the counterparty’s side of the swap, if
marked to market or revalued, entails a loss if unwound. In this case we mean the
new value of the payments is greater than the corresponding receipts. At this point,
from the bank’s perspective, the swap is now an asset; equally from the counterpar-
ty’s (the company’s) perspective, the swap is a liability. Also typically, the bank may
have fully – or partially – offset the interest-rate exposure by entering into other
swaps in the opposite direction with other counterparties.
An example of the situation is shown in Figure 5.14, Panel A, where PDQ Bank
has entered into a swap with XYZ Company to receive fixed and pay the floating
rate (the floating rate is based on LIBOR – the London interbank offered rate).
After 12 months, XYZ goes bankrupt as shown in Panel B, and PDQ ceases to
receive the fixed-rate payments from XYZ. Meanwhile swaps rates have fallen and
PDQ Bank is exposed to ABC Bank, with which it had entered into an opposing
swap to hedge out its interest-rate risk on the swap with XYZ.* In order to prevent
any further losses on the now defaulted swap, PDQ Bank enters into a new at-
market swap with another swaps market maker, DEF, at the new interest rate of 5.5
per cent, locking in a loss of 2.4 per cent per annum for the remaining four-year
term of the outstanding swap with ABC Bank.
Panel A PDQ Bank enters into a swap with XYZ Co. for 5 years on US$50 million
where PDQ covers its exposure at 7.9% with ABC Bank.
8% 7.9%
XYZ Co. PDQ Bank ABC Bank
LIBOR LIBOR
Panel B After 12 months, XYZ goes bankrupt
8% 7.9%
PDQ Bank ABC Bank
LIBOR LIBOR
Panel C PDQ Bank is now exposed, so enters a new at-the-market swap with
DEF Bank at 5.5% = 2.4% p.a. loss for 4 years
5.5% 7.9%
DEF Co. PDQ Bank ABC Bank
LIBOR LIBOR
Figure 5.14 The credit risk in swaps

Note that an alternative (and probably preferable) solution would have been for
PDQ Bank to cancel the swap with ABC Bank and pay out the present value of the
swap as compensation to ABC Bank. At the new rate of 5.5 per cent, the present
* A fall in interest rates is the required condition for the swap to be an asset, from the bank’s
perspective.

value of 2.4 per cent on US$50 million would have come to US$4.2 million.* Note
that in terms of the loss suffered by PDQ Bank this represents 8.41 per cent of the
notional principal of the swap.
The loss that has occurred is a function of a directional change in interest rates.
The default only occurs in cases where the swap has a positive value to the
exposed counterparty. It is also a function of the remaining term on the swap. If
the default had occurred with only one year to maturity, the exposed value would
have been only US$1.14 million. Thus for an interest-rate swap, the amount at risk
rises from inception as the rate on the swap moves away from the current market
rate but also as the time to maturity declines the credit exposure also declines. The
at-risk profile of an interest-rate swap is shown in Figure 5.15. For comparison
purposes, the exposure on a cross-currency swap is also shown. Unlike the interest-
rate swap, the cross-currency swaps’ exposure continues to grow towards maturity
since the exchange rate is unlikely to revert towards the contracted rate.† As a result,
cross-currency swaps have more credit risk than interest-rate swaps.
Cross-currency swap
Expected exposure
Interest rate swap
Time
Figure 5.15 Exposures on swaps
5.7.2 Calculating Expected Loss Rates

Section 5.7.1 showed how credit risk arises on a swap. In order to establish a proper
estimate of the actual credit risk in swaps we need to understand that two factors
must be present simultaneously for a default to take place:
* We should perhaps distinguish the loss from the lost profit. The bank anticipated making a spread of
0.1 per cent on the swap, which is lost profit. The unanticipated loss, as calculated here, is 2.4 per cent
on the interest rate based on the replacement. We will consider, for evaluation purposes, that the loss is
on the difference between the swap and its replacement value.
† In fact, a currency is likely either to appreciate or to depreciate in a fairly predictable trend based
around purchasing power parity. The credit risk will thus grow with time as the principal to be re-
exchanged depreciates or appreciates. In fact, the party holding the appreciating currency has less risk
than the holder of the depreciating currency, since this is always likely to mean the swap is a liability.

 the counterparty (the company XYZ in our example) must experience financial
distress, or become insolvent (that is, file for protection against its creditors in
legal bankruptcy proceedings);
 the value of the swap to the company must be such that it would have to pay out
to the other party if the transaction was terminated voluntarily. For the firm in
financial difficulties or in bankruptcy proceedings, the swap must represent a
liability. Conversely, it is an asset to the other party to the transaction (PDQ
Bank, in Figure 5.14). We can safely assume that, in the case where the swap is
an asset to the company (and a liability to the bank), the company would seek to
arrange its affairs in such a way as to realise the value of the swap, before or even
during bankruptcy proceedings.*
The expected loss rate from a swap is therefore the product of two factors:
Expected loss from default = of default × expected loss if default occurs
We can also think of the expected loss if default occurs as being (1 − recovery
rate) from defaults.
To understand how much credit risk is being taken in a swap, we need to under-
stand how far, from the original market rate, interest rates can move. As we saw
with the original exposure method discussed at the start of this section, a conserva-
tive estimate was 3 per cent p.a.
In order to be able to model the value change, we need some information on the
change that can be expected over the life of the swap. A binomial tree of interest
rate changes is shown in Figure 5.16 that, for simplicity, assumes rates can either rise
or fall by a fixed amount per annum and follow a continuing diffusion pattern.
Note, however, that there is strong empirical evidence that interest rates revert to
the mean over time and we might expect interest rates to return to some central
tendency over time.
To help explain the analysis, we show the time remaining on the swap exposures
at the bottom of the lattice, with 5 being the inception date and 0 , maturity.
Therefore 1 is one year from maturity, when interest rates can have risen to 10 per
cent or fallen to 6 per cent. This inversion of time is used to show how the exposure
declines over time as the swap moves towards maturity.
The next stage is to revalue the swap at each node on the lattice to determine the
amount required to replace the swap if it is terminated. At each node, the replace-
ment value of the swap is calculated as shown in Figure 5.16. Since the swap is a
liability to the bank at rates at or above 8 per cent, the values of the nodes are zero.
For the nodes below 8 per cent, there will be a loss, which is calculated by discount-
ing the interest rate differential that is implicit at each point, times the principal for
the number of remaining interest rate periods, and present valuing this to the
appropriate nodal point; the valuation is simply an application of DCF methods.
* In fact swap intermediaries have had to find ways to protect themselves from the ‘cherry picking’
activities of liquidators who have sought to terminate (and hence realise the positive value of) swaps
which are assets to the bankrupt firm, while disputing those which are liabilities.

0.0625 10.0%
Lattice with price change of 2 0.125 9.5%
with no value leakage
9.0% 0.25
0.25 9.0%
0.5
8.5% 0.375 8.5%
8.0% 0.5 8.0% 0.375 8.0%

0.5 7.5% 7.5%
0.375
0.25
7.0% 0.25 7.0%
0.125
6.5%
0.0625 6.0%
t5 t4
t3
t2
t1
Figure 5.16 Lattice of interest rates

The swap has a notional principal of $50 million. The difference in interest rates
is 8% − 7.5% on the notional amount over 2 years that is 0.5 per cent of 100 for 2
years, that is 0.5 per 100 per year (i.e. 0.5 per cent of $50 million = US$250 000). We
need to discount this at the 7.5 per cent rate for two years. The two year annuity
factor at 7.5 per cent is 1.7956. The value per 100 = 0.89778, rounded give 0.90. For
the cash amount this is $448 891 which, with generous rounding, gives the $450 000
figure in the text.
Thus for the 7.5 per cent rate in 2 , the interest rate differential is 0.50 per cent
(8.00 − 7.5%) on 100 over two years, discounted at 7.5 per cent. This comes to 0.90
per hundred, or for the swap with XYZ, this is US$450 000. The same calculation is
carried out for the lower rate of 7 per cent applicable at time 2 , which gives a value
of 2.73. The final stage is to work out the probability-weighted average (or expected
value) at time 2 and this is shown in the lower part of Figure 5.17. The same
calculations are made for each of the nodes and time periods. The results of the
analysis are shown in Table 5.19. The final step is to present value these to the start
of the swap. Our analysis shows that the swap has a present value exposure of
2.13445 per 100. (For the XYZ swap on a notional principal of US$50 million, that
translates to US$1.067 million.)

0
If rate is above 8%,
no default takes place 0
0
0
0 0
0 0 0
1.68 0.90
2.62 0.94
If rate is below 8%,
there is a risk of default 2.73
1.89
i% swap Value r E(V)
7.4% 0.90 0.374 0.34

6.9% 2.73 0.125 0.34
0.68
Figure 5.17 Expected loss calculation for a swap

Although the expected loss is 2.13445 per hundred if the swap party defaults, as
discussed earlier, we also need to factor in the probability of default from the
counterparty. This requires us to evaluate the likelihood of a given credit’s becoming
unable to service its agreement. Default is likely to be a function of the creditwor-
thiness of the counterparty. In Table 5.20, we show the results of such an analysis
for two different credits, the best rated triple-A credit and the lowest investment
grade credit, the triple-B rated credit. These probabilities of default would be
established from examining the historical experience of default by a given credit
class. We will not discuss how this can be achieved at this point or whether the
historical record is an appropriate guide to the future. Suffice to say, the example
given here should be taken as illustrative of the required approach to establishing
the credit-risk exposure on a swap position.
Table 5.19 Establishing the expected loss on a swap

Expected loss of value
Swap period Value at time Present
t value
5 years (at inception [ ]) 0 0
4 years (+ 1 year [ ]) 0.83733 0.77531
3 years (+ 2 years [ ]) 0.65608 0.56248
2 years (+ 3 years [ ]) 0.67804 0.53825
1 year (+ 4 years [ ]) 0.35157 0.25841
0 years (+ 5 years [ ]) 0 0
∑ 2.13445

Table 5.20 Expected losses from swap default for a AAA (best investment grade) and
BBB (worst investment grade) credit*
Expected Contribution Contribution
positive ρ of default to credit ρ of default to credit
value of for losses for losses
Year swap in PV AAA/Aaa (per 100 BBB/Baa (per 100
(mid-point) terms credits nominal) credits nominal)
1 0.4029 0.01 0.0040 0.08 0.0322
2 0.6653 0.02 0.0133 0.109 0.0725
3 0.5503 0.027 0.0149 0.125 0.0688
4 0.3932 0.033 0.0130 0.137 0.0539
5 0.1243 0.04 0.0050 0.156 0.0194
0.0502 0.2468
Annual cost over 5 years 1.26 bp 6.18 bp
* Details of the credit rating criteria appear in Module 12.
Table 5.20 needs some explanation to reconcile the result with that given in Ta-
ble 5.19. The expected positive value of the swap in present value terms in each year
used in Table 5.20 differs in that the default rates represent the mid-point between
years, as we have no indication of when such an event may take place. Thus, the
value of 0.4029 arrived at in Year 1 is a linear average of the probabilistically
weighted outcome of future interest rates as shown in Table 5.21, combined with
the exposure in the previous period, which is zero for 5 , and the result then present
valued.
The final result is to allocate the expected loss across the life of the swap as a
credit premium. For the best quality credit (triple-A), this is 1.26 basis points per
annum, whereas for the lowest investment grade (triple-B credit), this is 6.18 basis
points. Based on the above, if the swap rate was 6 per cent, the swaps market maker
would quote 6.01 to the triple-A credit and 6.06 (or higher) to the triple-B credit.
We may now summarise this discussion of the credit element of a swap. The
exposure on a swap is far less than the corresponding exposure on a cash instru-
ment for the same maturity. The amount at risk will be a function of:
1. the probability that a counterparty will default over the life of the swap; and
2. whether the swap is an asset or a liability.
The degree to which the swap is off-market and the cost of replacement at any
time is a measure of the asset risk equivalence of the swap.

Table 5.21
Interest rate Expected
( ) Probability (r) Exposure positive value
8.5% 0.5 0 0
7.5% 0.5 1.67466 0.83733
8.00 1.0 0 0
Period E(V) Discount factor Present Value
0
0.83733
. 0.41867 0.96225 0.40286

Swaps are the newest instrument in the derivatives product set. Whereas forwards
and futures hedge a single cash flow, swaps hedge a series of periodic cash flows.
From an initial start in the early 1980s they have established themselves as a very
important building block in managing various kinds of market risks. The swap
mechanism provides a very flexible way of altering the nature of a set of cash flows,
either in terms of their interest-rate exposure or currency, or both. The development
of swaps has provided linkages between different markets, thus allowing participants
to exploit advantages and arbitrage opportunities.
Swaps are extensively used by asset and liability managers to control risks and to
exploit anomalies in the capital markets. By combining simple swaps, it is now
possible to create complex packages which provide tailored solutions to many risk-
management problems.
Swaps need to be carefully valued using a term-structure approach. At inception,
an at-market swap (ignoring transaction costs) will have a zero net present value,
after any adjustments. As the swap moves towards maturity it will become off-
market and may become an asset or a liability. Depending on the path of interest
rates, it may be subject to credit risk. Calculating the potential loss from a swap
default requires two things to happen simultaneously: the swap must be an asset and
the counterparty must also default.
Appendix 5.1: Calculating Zero-Coupon Rates or Yields

We can convert a par yield curve into a set of zero-coupon rates. Assume for
simplicity that a par yield curve is given and that these rates are 1 , 2 and 3 for the
first three years. We need to find the corresponding one-, two- and three-year, zero-
coupon rates 1 , 2 and 3 that underlie the par yields.
Rather than find these rates directly, it is easier to find the value of a correspond-
ing zero-coupon bond for the required maturities. To further simplify the
arithmetic, we will take 100 to be 1, a percentage such as 6 per cent to equal 0.06. So

a zero-coupon bond with a three-year maturity trading at a yield of 6 per cent will
have a price of 0.8396. You will realise that this is equivalent to the discount factor
used to present value a payment at 6 per cent for three years. Alternatively, to solve
for the zero-coupon rate, given the zero-coupon bond price, we use the price
relative (FV/PV):
﴾5.16﴿
= −1
If we can calculate the prices of zero-coupon bonds with a value of 1, we know

that:
= 1 ÷ (1 + )
= 1 ÷ (1 + )
ℎ = 1 ÷ (1 + )
and so on, until the desired maturities have been covered.
Since coupon-paying bonds are portfolios of zero-coupon bonds, we can express
their value as:
One year 1 = (1 + )×
Two years 1 = × + (1 + )
Three years 1 = × + × (1 + )
and so on. is the zero coupon discount factor for the relevant period.
We can set up a model (or computerised model) for solving the above. Let us
define:
=
= +
= +
These are simply the annuity factors for 1, 2, and 3 years respectively derived
from the three zero-coupon prices. As an alternative, we can solve directly from the
par yield curve by substituting the annuity into the bond equation:
1 = +
1 = +
and so forth.
We now have the means to calculate zero-coupon rates from the par curve. To
facilitate computation, we use the following formula:
﴾5.17﴿
1+
= −1
1
1− ∑( )
(1 + )
where is the nth period zero-coupon interest rate, is the nth year par bond (or
swap) rate. The annuity factor allows for a simple means to compute the present
value of the coupon stream from t=1 to t=n−1 periods, namely:

1
= ∑
(1 + )
The series is equivalent to an annuity factor. As Equation 5.17 shows, this
simplifies the ‘stripping’ out the coupon payments paid on the par bonds (or par
yield securities) in order to determine the zero coupon rate for the bond’s maturity.
In order to do so, we need to know the − 1 zero coupon rates. Hence it is
necessary to proceed in an iterative process from the earliest zero-coupon maturity
date to the last, a process known as bootstrapping.
The following example shows how the method works:
Table 5.22 Bootstrapping zero-coupon rates from the par yield curve
Time Par yield + −( × ) Zero
period coupon
rate (%)
1 6.00 1.06 0 0.9434 6.00
2 6.25 1.0625 0.9434 1.8291 0.94104 6.2578
3 6.375 1.06375 1.8291 2.6596 0.88340 6.3885
4 6.4375 1.064375 2.6596 3.4383 0.82879 6.4542
Review Questions
5.1 A cross-currency swap is a transaction that involves:

A. an initial exchange of one currency at one time period with the subsequent re-
exchange of the currency at a future time period.
B. an exchange of two sets of cash flows in different currencies.
C. modification of the interest rate on a set of cash flows.
D. the exchange of bonds denominated in different currencies.
5.2 Interest-rate and cross-currency swaps allow financial managers to:

A. transform assets and liabilities in one currency into another.
B. transform the nature of the interest-rate risk.
C. take advantage of funding and investment opportunities.
5.3 With a cross-currency swap it is possible to:

A. exchange cash flows in one currency for cash flows in another currency.
B. change fixed-rate cash flows into floating-rate cash flows or the opposite.
C. exchange floating-rate cash flows based on one reference rate into floating-rate
cash flows based on another reference rate.

5.4 We may regard the fixed-rate payer on a swap as:

A. having purchased a floating-rate asset.
B. being long the bond market.
C. having sold the swap.
5.5 There are two firms, X and Y, with the following cost of funds.
Transaction Firm X Firm Y

Bank loan LIBOR + 0.25% LIBOR + 0.5%
Bond issue 7.25% 8.125%
If they enter into an interest rate swap where Y pays X’s fixed rate plus a margin equal
to a quarter of the difference between X’s and Y’s cost of fixed funds and X pays Y a
floating rate (LIBOR), what will be the total interest cost to each side following the swap
transaction? (Answer to 2 decimal places)
A. For X, floating funds cost LIBOR 0.13 per cent and for Y, fixed funds are 7.69
per cent.
B. For X, floating funds cost LIBOR 0.03 per cent and for Y, fixed funds are 7.97
per cent.
C. For X, floating funds cost LIBOR 0.13 per cent and for Y, fixed funds are 7.21
per cent.
D. For X, floating funds cost LIBOR 0.03 per cent and for Y, fixed funds are 7.69
per cent.
5.6 ABC plc of the UK and DEF SA of France agree to enter into a ten-year fixed-for-fixed
cross-currency swap between the French franc and sterling where ABC plc borrows
French francs and DEF SA sterling. The current exchange rate is FFr8.75/£. The amount
involved is £10 million. The interest rate, to be paid annually in both cases, is in FFr4.55
per cent and in sterling 6.50 per cent. What will be the amount of the first payment on
the swap?
A. FFr3.98 million/£0.52 million.
B. FFr83.52 million/£9.39 million.
C. FFr87.5 million/£10 million.
D. FFr91.48 million/£10.52 million.
5.7 In the swap described in Question 5.6, what is the present value of the French franc side
of the swap?
A. Zero.
B. FFr83.52 million.
C. FFr87.50 million.
D. FFr91.48 million.

5.8 In Question 5.6, what will be the amount exchanged between the two parties in French
francs at maturity?
A. Zero.
B. FFr83.52 million.
C. FFr87.50 million.
D. FFr91.48 million.
5.9 To create a synthetic fixed-rate bond, we need to:

A. borrow at a fixed rate and enter into a swap to pay fixed and receive floating.
B. borrow at a floating rate and enter into a swap to pay fixed and receive
floating.
C. borrow at a fixed rate and enter into a swap to pay floating and receive fixed.
D. borrow at a floating rate and enter into a swap to pay floating and receive
fixed.
5.10 An investor will have a return-enhancing opportunity using the capital markets and
swaps if:
A. the rate on a fixed-rate bond less that on a swap to receive the floating rate is
positive.
B. the rate on a fixed-rate bond less that on a swap to pay the floating rate is
negative.
C. the rate on a fixed-rate bond less that on a swap to receive the floating rate is
negative.
D. the rate on a floating-rate note less that on a swap to pay the floating rate is
positive.
The following information is used for Questions 5.11 and 5.12.
Amex Shipping Lines have agreed to buy a new container ship from Kaiwo Shipyards of
South Korea. Because the Korean Export Bank is willing to assist Kaiwo win the order, the
Bank is willing to quote an attractive financing package in Swiss Francs (SFr). This involves a
ten-year fully amortising loan with a subsidised rate of 3.5 per cent. The current interest rate
in Swiss Francs for a ten-year maturity is 4.75 per cent. The total amount of the loan is SFr75
million. The exchange rate between the Swiss Franc and the US dollar is SFr1.5/$. Amex’s
operating currency is the US dollar and in order to eliminate its currency risk it wants to swap
the proceeds into US dollars. (NB: assume annual payments and round to 2 decimal places.)
5.11 What is the present value of the cash subsidy element in Swiss Francs?
A. SFr0.80 million.
B. SFr4.80 million.
C. SFr9.00 million.
D. SFr9.60 million.
5.12 If the ten-year swaps rate in US dollars is 5.50 per cent, what will be Amex’s annual
payments in dollars if the subsidy is repaid over the life of the swap?
A. US$5.79 million.
B. US$6.21 million.
C. US$6.63 million.
D. US$7.05 million.

Term 1y 2y 3y 4y
Par swaps 7.10% 7.20% 7.30% 7.35%
5.13 Based on the swaps rates given in the table above what is the three-year zero coupon
discount rate?
A. 7.2072 per cent.
B. 7.3000 per cent.
C. 7.3099 per cent.
D. 7.3633 per cent.
5.14 What will be the true value of a four-year off-market interest-rate swap which has a
coupon rate of 6.5 per cent and on which you are the fixed-rate payer?
A. (0.028608)
B. (0.028565)
C. 0.028565
D. 0.028608
5.15 How much would we have overvalued the swap per 100 nominal if we had used the
internal rate of return or yield to maturity to price the swap?
A. 0 (the two valuation methods give the same value).
B. −0.0043
C. 0.0043
D. 0.0051
5.16 What is the implied one-year floating rate in two years’ time?
A. 7.25 per cent.
B. 7.30 per cent.
C. 7.52 per cent.
D. 7.72 per cent.
Time (years) 0.5 1 1.5 2 2.5

Zero-coupon 4.50% 4.55% 4.60% 4.70% 4.75%
5.17 Given the zero-coupon rates in the table, what is the present value of the expected
floating-rate payments on a two-year swap per 100 of nominal principal? (Assume equal
values for each half-year and ignore day-count conventions.)
A. 8.67
B. 8.78
C. 9.18
D. 9.29

5.18 A two-and-a-half-year semi-annual pay swap has a present value for the floating-rate side
of 10.95 per 100 nominal. What will be the swap’s fixed rate?
A. 4.62 per cent.
B. 4.66 per cent.
C. 4.69 per cent.
D. 4.75 per cent.
5.19 What will be the fair value of an off-market swap with a two-year remaining maturity
per 100 nominal that has a semi-annual fixed rate of 6.50 per cent to the fixed-rate
payer?
A. (3.51)
B. 0
C. 3.51
D. 103.51
5.20 If, when an at-market swap is initially entered into, the term structure of interest rates
is upward sloping, the fixed-rate payer’s first payment will:
A. be higher than that paid by the floating-rate payer.
B. be lower than that paid by the floating-rate payer.
C. be the same as that paid by the floating-rate payer.
D. depend on the slope of the yield curve.
5.21 With the yield-to-maturity approach, which of the following provides an incorrect value
for the swap?
A. A swap with an off-market fixed rate.
B. An amortising swap.
C. A deferred-start swap.
5.22 On the ABC plc of the UK and DEF SA of France fixed-for-fixed cross-currency swap
between the French franc and sterling (see Question 5.6), six years have passed and the
two companies have decided that they would like to terminate the agreement. The
contractual amount was £10 million and interest was paid annually. The original market
and current conditions are given in the following table:
Condition Original terms Current market

Exchange rate FFr8.75/£ FFr7.25/£
Fixed French interest rate 4.55% 5.65%
Fixed UK interest rate 6.50% 5.75%
Tenor 10 years 4 years
Who pays whom and how much to terminate the swap?

A. ABC plc pays DEF SA FFr9.74 million.
B. ABC plc pays DEF SA £0.26 million.
C. DEF SA pays ABC plc FFr3.36 million.
D. DEF SA pays ABC plc £2.07 million.

5.23 In Question 5.22, which of the following elements that contribute to the change in value
of a cross-currency swap were positive and which were negative when looking at the
swap from the point of view of DEF SA (the French company)?
A. The change in the FFr interest rate was positive, the change in the sterling
interest rate was positive and the change in the exchange rate was positive.
B. The change in the FFr interest rate was positive, the change in the sterling
interest rate was negative and the change in the exchange rate was positive.
C. The change in the FFr interest rate was negative, the change in the sterling
interest rate was positive and the change in the exchange rate was positive.
D. The change in the FFr interest rate was negative, the change in the sterling
interest rate was negative and the change in the exchange rate was positive.
Time 1 year 2 years 3 years 4 years

Par swaps rate 8.25% 8.10% 8.00% 7.80%
5.24 A customer wants to enter into a four-year amortising swap where the notional
principal amount of 400 is reduced by 100 at the end of each year. What should be the
uniform fixed swaps rate quoted by the swaps market-maker on the swap?
A. 7.80 per cent.
B. 7.94 per cent.
C. 7.97 per cent.
D. 8.08 per cent.
5.25 What rate will the swaps market maker quote for a two-year swap with a one-year
deferred start?
A. 7.86 per cent.
B. 8.00 per cent.
C. 8.05 per cent.
D. 8.12 per cent.
5.26 For credit risk to arise on a swap, which of the following has to take place?
I. The floating rate on the swap has to change.
II. The fixed rate on the swap has to be off-market.
III. The other party to the swap must cease to honour the agreement.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.

Case Study 5.1

You observe the following zero-coupon yield curve.
Period Rate (%)

.
5.5
.
5.7
.
6.0
.
6.2
.
6.4
1 You are considering a two-and-a-half-year LIBOR interest-rate swap with semi-annual

settlement. Estimate the present value of the floating-rate side of the swap per £1
million of notional principal.
2 What is the fixed rate on the swap?
3 In the above swap, you estimate that there is a 1% chance that the counterparty to the
swap will experience financial distress/default over the next year. You also estimate that
interest rates could decline by the following amounts over the year:
1% 25% chance
2% 10% chance
3% 5% chance
What is the potential loss on the swap in such a situation per £1 million?
4 You want to enter into an amortising swap where the total payment of 1500 is
amortised in two instalments: 1000 in 1 year and the balance at the end of 2½ years.
Draw a profile of the swap for evaluation. What will be the blended rate quoted on the
swap?

PART 3
Options
Module 6 The Product Set II: The Basics of Options
Module 7 The Product Set II: Option Pricing
Module 8 The Product Set II: The Black–Scholes
Option-Pricing Model
Module 9 The Product Set II: ‘The Greeks of Option
Pricing’
Module 10 The Product Set II: Extensions to the Basic

Module 6
The Product Set II:The Basics of

Options
Contents
6.1 Introduction.............................................................................................6/1
6.2 Types of Options .....................................................................................6/6
6.3 Option-Pricing Boundary Conditions ................................................ 6/18
6.4 Risk Modification with Options .......................................................... 6/21
Case Study 6.1................................................................................................. 6/31
Learning Objectives
This module introduces options, the terminology used in describing options and
how they are used to modify the risk profile of a given position. One of the com-
plexities with options is the specialist language used to describe them. The basic
factors which affect option values are shown with a simple example and the
boundaries to the value of options are then explained. The module finishes with a
discussion of how options can be used to modify the risk profile of a given expo-
sure.
After studying this module, you should understand:
 the options terminology;
 the basic option-pricing variables;
 how options are used to modify risks;
 the boundary conditions for the values of options.
6.1 Introduction
This module begins the examination of the second category of financial risk-
management products, namely options. As we have seen in earlier modules, which
looked at those derivative products that have a linear or symmetrical payoff, price
certainty (or the elimination of the market risks) is not always desirable. In the case of
forward contracts, for instance, entering into a forward foreign exchange contract
converts the future uncertain outcome to a fixed, predetermined rate. Sometimes this
is beneficial, but if subsequently the exchange rate moved in your favour, then the
forward contract represents an opportunity loss. The problem, of course, is that we
only have a rough idea whether the currency is likely to move in our favour. What we

Module 6 / The Product Set II: The Basics of Options
really want is a situation where we can have the forward cover provided by the
derivative product and the opportunity to make the gain if the outcome is to our
advantage. That is, as the saying goes, ‘we want to have our cake and eat it’.
In this sense, options are the cake-and-eat-it product, because they allow the
holder (but not the option writer or seller) to avoid the undesirable outcomes and
retain the benefit of the favourable developments. It is this ability for gain if
developments are favourable that makes options so attractive. Options, and the
more exotic products derived from them, seem to provide the best possible risk-
management tool. Unfortunately for the option holder they, unlike terminal
products, cost money upfront and a payment is required to compensate the writer
or seller of the option for taking on the other side of the transaction. For, if the
option holder gains if the outcome is favourable, the option seller or writer must
lose. We will look at how the fair value of this transaction is established in Section
6.2.3.
Options in one form or other have been a feature of business activity since time
immemorial. However, financial options (that is, options on financial instruments)
are a relatively new phenomenon. The development of a market in stock options in
the early 1970s was followed by the widespread expansion of options into all
spheres of financial activity throughout the 1980s and 1990s as more and more
markets and increasingly exotic product areas have added options or option-like
products. This is because, in modern financial practice, options are one of the most
versatile and exciting of the fundamental derivative building blocks. Their inherent
flexibility, coupled to sophisticated methods to establish their value, has created
opportunities for intermediaries to provide tailored solutions to many, previously
insurmountable, risk-management problems and investment problems.
From the holder’s perspective, the buying of options provides a non-linear or
asymmetrical payoff which has some of the characteristics of insurance.
6.1.1 Why Options Are Special

The terminal products examined in previous modules have the virtue of eliminating
price or value uncertainty at some point in the future. The payoff on the terminal
product will depend on the market rate at the maturity of the contract as it relates to
the rate agreed in the contract. The ‘price’ at which the contract was entered into
reflected, not so much either side’s view on the future value, but the cost of
replicating the position, known as the cost-of-carry. The payoff to either side at the
maturity of the contract will depend on whether the market price is above or below
the contract price. If a future purchase is anticipated, then by entering into the
contract, the holder gains if the market price is higher at maturity than when the
original contract was negotiated, but loses if the market price is lower. This payoff
profile is shown in Figure 6.1.

Gains (+)
Value at maturity
Market price
Contracted price
Losses (–)
Figure 6.1 Payoff of a forward contract involving a future purchase

Note: The holder of the position expects to buy the product or instrument in the future, hence is
exposed to price rises. By entering into the forward contract, the holder gains if the market price
is above the contract price. Conversely, the holder loses if the market price is below the contract
price since the holder could have bought more cheaply in the market.
With respect to the seller of the forward contract, the opposite condition applies.
This is shown in Figure 6.2 where the payoffs for the two sides of the contract are
shown. The gains from the buyer are matched by losses from the seller. Under these
conditions, the buyer and seller have the same chance of gaining or losing. Thus,
when the transaction is negotiated, the expected value of the contract is zero.
Because the value of the contract is zero, there is no need for the buyer to compen-
sate the seller and in that sense such contracts are ‘free’, that is, they have a zero net
present value ex ante.
Gains (+)
Value at maturity
Market price
Contracted price
Losses (–)
Figure 6.2 Payoff at maturity for the buyer and seller of a forward
contract
This situation is different when it comes to options. The holder or buyer of the
option has the right, but not the obligation, to purchase at the expiry of the con-
tract. If the current market price is above the contracted price, the holder gains and
will therefore take advantage of the right to purchase. If, however, the market price
is below the contracted price, the holder is not obliged to purchase under the terms
of the option contract and can buy more cheaply in the market. As a result, the

buyer stands to gain from favourable price movements, but not to lose from
movements in the other direction. The symmetrical payoff between buyer and seller
no longer applies. Gains from favourable movements are losses to the writer (or
seller) but these are no longer compensated for by gains in the opposite direction.
This is shown in Figure 6.3.
Gains (+)
Holder or option buyer’s payoff
Value at maturity
Market price
Contracted price
Writer or option seller’s payoff

Losses (–)
Figure 6.3 Payoff at expiry of the positions on a call option for the buyer
or option holder and the writer or option seller
It is important to distinguish the gains and losses made by both the buyer and the
seller in Figure 6.3. The buyer (solid line) always gains from changes in the market
price. These gains are mirrored by losses made by the option writer or seller. There
is no symmetry between the opportunity for gain that is evident in Figure 6.2, where
the potential losses by the seller if prices rise are matched by gains if prices fall. With
options, the writer does not gain from this. Hence the payoff is asymmetric or non-
linear.
The question is why anyone should be willing to sell or ‘write’ options. The writer
always loses. The simple answer is that in order to be willing to enter into the
contract, the writer receives an upfront payment, known as a premium, for taking
on the risk that the option will be exercised. The adjusted payoffs for both sides,
allowing for the payment of the premium on entering the contract, are shown in
Figure 6.4.

Gains (+)
Holder or option buyer’s payoff
Value at maturity
Premium received by
option writer
Market price
Premium paid by
option buyer Contracted price
Writer or option seller’s payoff

Losses (–)
Figure 6.4 Payoff for option holder and writer at expiry, including the
premium paid and received on the contract
Figure 6.4 shows that if the option is not exercised, the writer has made a gain,
which is the premium received against the risk that a future loss might be incurred.
Similarly, the holder has suffered a cost, the premium that is not recoverable, if the
option is abandoned.
6.1.2 A Simple Illustration of the Value of Options

We have said that options are valuable, but what are they worth? The following
illustration shows the key ingredients for the value inherent in options.
Let us suppose that a shipping company has been offered the chance to purchase
a standard bulk cargo freighter for £9.4 million that is being built in a shipyard and
will be available in one year’s time. A virtually identical ship could be purchased for
£9 million today in the secondary market. The current interest rate is 10 per cent. If
the company buys the ship now, it can be leased out for a year to earn net £0.4
million in rental charges (less expenses), paid in advance.
In order to have the ownership of the bulk freighter in one year’s time, the ship-
ping company can adopt one of two alternatives:
(a) buy the second-hand vessel ( ) now* and rent it out for one year ( );
(b) pay the premium on the call option ( ) to acquire the new ship and invest the
present value of the future purchase price ( ( )) in order to be sure of having
the right amount of money in one year’s time to make the purchase, if it should
so choose.
The payoff of the second action (b) must be at least as valuable as the first action,
such that the following holds:
+ ( )≥ − ﴾6.1﴿
Thus, the package of the call plus the present value of the exercise price must be
at least equal to the direct purchase alternative since it offers the same benefits, but
probably will be more valuable. The inequality exists because the option allows the
* The notation used here is that which is commonly used for options.

shipping company to ‘walk away’ from the purchase in one year’s time if market
conditions are such as to make it unattractive to exercise the right to purchase the
ship. Rewriting the equation, we can now solve for the unknown minimum value
that the call must have:
≥ − − ( ) ﴾6.2﴿
≥ £9m − £0.400 − £8.545m
This gives a minimum value of £55 000. The option must be worth at least this
amount. In fact, the value of being able to break the contract (or walk away) will
also depend on the volatility or range of ship prices anticipated in the future. If there
is a high degree of volatility in ship prices then the option is likely to be much more
valuable since the holder will either (a) make a profit by being able to buy a ship
with a market price well above the purchase price, with the possibility of being able
to re-sell it for an immediate profit in the market; or (b) be able to walk away from
the transaction and buy a similar ship in the second-hand market in one year’s time
at a lower price.
Note that if the option had two years to run and the terms remained largely un-
changed, it would have had much more value:
≥ − − ( ) ﴾6.3﴿
≥ £9m − £0.800 − £7.769m
which gives a value of £431 000.
The above simple illustration shows why options are valuable. It also shows the
factors that go into option pricing:
1. The exercise or strike price for the option ( ).
2. The interest rate over the life of the option ( ).
3. The current asset price (less any income it might generate over the life of the
option) ( ).
4. The length of time provided by the option ( − ).
5. The potential volatility in price (σ).
We will look at these again in more detail (see Section 6.3) to explain why they are
important. Before that, we will explain the different types of options that are
available.
6.2 Types of Options

Definition
An option gives the holder the right but not the obligation to buy/sell a fixed
quantity of an underlying asset at a fixed price at or before a specific future date
(maturity).
The terms of the option contract will specify: the time over which the option is
valid, known as the life of the option, the price, or sometimes rate, at which the
underlying asset can be purchased or sold, variously known as the exercise price or
the strike price, the amount involved, and under what conditions the option may

be exercised, whether during the life of the option or only at the moment the
contract terminates, known as the expiry date, or expiry of the option (also called,
perhaps erroneously, the maturity date or maturity of the option). In exchange for
the right to exercise, the buyer pays the seller a payment, known as the premium.
The old terms ‘call money’ and ‘put money’ are sometimes still used, but premium
or price of the option are the common terms in usage today. How this premium is
determined is discussed in Section 6.2.3.
Definition
The premium is the payment made by the option buyer (or holder) to the
option seller (or writer) for acquiring the option.
There are two types of transaction that a party may wish to undertake using op-
tions: either to buy or to sell an asset or underlying instrument. The two basic types
of options which exist cater for these transactions. The call option allows the
holder the right to purchase and the put option allows the holder the right to sell at
the pre-agreed price (or rate). Conversely, the option writer or seller is obliged to
sell, in the case of the call, and to purchase, in the case of the put. The nature of the
rights and obligations is summarised in Figure 6.5. With the call, the holder has the
right to receive the asset from the writer at the predetermined price upon the
payment of a premium. With the put, the holder has the right to sell (hence put) the
asset or underlying instrument to the writer at the predetermined price.
Asset
Call
Buyer Premium Seller
Holder Writer
Put
Asset
Figure 6.5 Relationship of option holders, writers, premium and the

underlying asset
Puts and calls can generally be of two types based on when the holder has the
right to buy or to sell the underlying asset. With the American-style option, the
holder has the right to exercise throughout the life of the option up to and including
expiry, whereas the European-style option may only be exercised at the point of
expiry. In addition to these basic types, some hybrid American-style/European-style
options exist, variously known as Atlantic-style or Bermudan options, which
incorporate features from both types.
Definitions
American-style option: an option which can be exercised at any time up to,
and including, the expiry date.
European-style option: an option which can be exercised only at the expiry
date.

6.2.1 The Call Option

Call options allow the holder the right but not the obligation to purchase the
underlying, but require the option seller or writer to sell the underlying at the strike
price.
Definition
A call option gives the right, but not the obligation, to buy a given quantity of
the underlying asset or instrument at the strike price on (or before) the expiry
day.
The call option allows the holder to benefit from a rise in the market price. The
payoff of such an option has already been given in Figure 6.4. The purchase of a call
option with a strike price of 100, for a premium of 3, would have the payoffs given
in Table 6.1, depending on the value of the underlying asset at expiry.
The values in Table 6.1 show the market price in column (i), the cost of the asset
together with the premium paid on the option in column (ii) and the profit/loss in
column (iii). When the market price is below the exercise or strike price of 100, the
holder does not exercise, but buys in the market instead. When the price is above
the strike price, the holder exercises the option and caps the purchase price at the
strike price plus the premium paid for acquiring the option. The payoff diagram
from this transaction is shown in Figure 6.6.
Table 6.1 Value of a call option at different market prices at expiry

Market price of
underlying asset at Cost of asset to Value of option
expiry option holder
(i) (ii) (ii−i)
90 93 −3
…
93 96 −3
…
95 98 −3
96 99 −3
97 100 −3
98 101 −3
99 102 −3
100 (strike price) 103 −3
101 103 −2
102 103 −1
103 103 0
104 103 1
105 103 2
…

Market price of
underlying asset at Cost of asset to Value of option
expiry option holder
107 103 4
…
110 103 7
Note: The strike price equals 100, the premium paid is 3. The break-even price is 103.
+
Payoff from long position in the asset (+U)
Payoff from long

Exercise or strike price call option (+C)
(K)
Gain/Loss
Market price
Breakeven
K+ PC
K – PC
–
Figure 6.6 Payoff of a long position in the underlying and a purchased

call option
Table 6.1 and Figure 6.6 show the gain and loss from holding a call on an asset.
In Figure 6.6, a long position in the underlying (+ ) is shown for comparison
purposes. At the exercise or strike price ( ), the holder of the option would lose the
total value of the premium. As the price improves, the break-even point on the
option is the strike price ( ) plus the premium ( ), that is ( + ), given in the
table as 103 (the exercise price of 100, plus the premium of 3). The maximum gain
will be the difference between the price of the underlying and the strike price
( − ) less the cost of the option ( ).
The holder is better off if the price has fallen below the long position in the asset
(+ ), if the price falls below the strike price less the premium ( − ). The
maximum loss that can be incurred is 3, the value of the premium. Between the
break-even point and the stop-loss point on the option, the value of holding the
option or having a long position will depend on the market value at expiry.
Market parlance defines the condition of a call option in relation to the underly-
ing depending on whether the strike price is above, at or below the price of the
underlying:
If the strike price of the call is: The option is said to be:
above the market price of the underlying (K > U) out-of-the-money (OTM)
the same as the market price of the underlying (K=U) at-the-money (ATM)
below the market price of the underlying (K < U) in-the-money (ITM)

These relationships are shown in Figure 6.7 for call options.
Option
value
At-the-money
Out-of-the-money In-the-money
Strike price Intrinsic value
Asset value
Figure 6.7 In-the-money, at-the-money and out-of-the-money conditions

for call options
Note: The difference between the asset value and the option strike price ( − ), if positive, is a
call option’s intrinsic value.
Definitions
In-the-money: an option which has intrinsic value. That is, for calls, the strike
price of the option is below the underlying price; for puts, the opposite holds
and the strike price is above the underlying price.
At-the-money: an option where the underlying price and the strike price are
equal.
Out-of-the-money: an option which has no intrinsic value. That is, for calls,
the strike price of the option is above the underlying price; for puts, the
opposite holds and the strike price is below the underlying price.
6.2.2 The Put Option

The put option gives the holder the right but not the obligation to sell, or put, the
underlying to the option writer at the contracted strike (exercise) price.
Definition
A put option gives the right, but not the obligation, to sell a given quantity of
the underlying asset or instrument at the strike price on (or before) the expiry
day.
The put option allows the holder to benefit from a fall in the market price. The
purchase of a put option, with a strike price of 100 for a premium of 3, would have
the payoffs given in Table 6.2, depending on the value of the underlying asset at
expiry.

Table 6.2 Value of a put option at different market prices at expiry

Market price of under- Cost of asset to
lying asset at expiry option holder Value of option
(i) (ii) (ii−i)
90 97 7
…
93 97 4
…
95 97 2
96 97 1
97 97 0
98 97 −1
99 97 −2
100 (strike price) 97 −3
101 98 −3
102 99 −3
103 100 −3
104 101 −3
105 102 −3
…
107 104 −3
…
110 107 −3
Note: The strike price equals 100, the premium paid is 3. The break-even price on the option is 97.
The values in Table 6.2 show the market price in column (i), the selling price of
the asset together with the premium paid on the option in column (ii), and the
difference between the two in column (iii). When the market price is above the
exercise or strike price of 100, the holder does not exercise, but sells at the higher
price in the market instead. When the price is below the strike price, the holder
exercises the option and thereby is assured of a minimum selling price or floor,
which is the strike price less the premium paid for acquiring the option. The payoff
diagram from this transaction is shown in Figure 6.8.
+
Payoff from short position in the asset (–U)
Exercise or strike price

Gain/Loss
(K)
Market price
Breakeven
K – PP
K + PP Payoff from
long put option
– (+P)
Figure 6.8 Payoff of a short position in the underlying and a purchased

put option

Table 6.2 and Figure 6.8, together, show the gain and loss from owning a put
option on an asset. In Figure 6.8, a short position in the underlying (− ) is shown
for comparison purposes. At the strike price ( ), the holder of the option would
lose the total value of the premium. As the price falls, the break-even point on the
option is the strike price ( ) less the premium ( ), that is ( − ), given in the
table as 97 (the exercise price of 100, less the premium of 3). The maximum gain
will be the difference between the strike price and the price of the underlying asset
( − ) less the cost of buying the option .
The put holder is better off in the situation where the price has risen when com-
pared to the short position in the asset (− ) if the price goes above the strike price
plus the premium ( + ). For the put holder, the maximum loss that can be
incurred is 3, the value of the premium. Between the break-even point and the stop-
loss point on the option, the value of holding the option or having a short position
will depend on the market value at expiry.
Market parlance defines the condition of a put option, in relation to the underly-
ing, depending on whether the strike price is above, at or below the price of the
underlying:
If the strike price of the put is: The option is said to be:
below the market price of the underlying ( < ) out-of-the-money (OTM)
the same as the market price of the underlying ( = ) at-the-money (ATM)
above the market price of the underlying ( > ) in-the-money (ITM)
These relationships are shown in Figure 6.9 for put options. Note that the situa-
tions for calls and puts are mirror images of each other. Calls become more
valuable, the more the underlying asset price rises above the strike price; for puts,
the opposite is true. Puts become more valuable the more the asset price falls below
the strike price, and would have their highest value if the asset value falls to zero.
Option
value
At-the-money
In-the-money Out-of-the-money
Intrinsic Strike price

value
Asset value
Figure 6.9 In-the-money, at-the-money and out-of-the-money for put

options
Note: The difference between the strike price and the asset price ( − ), if positive, is a put
option’s intrinsic value.

6.2.3 The Intrinsic Value and Time Value of Options

The value at which an option is traded in the market is its premium or price.
Conventionally, this premium is made up of two elements: an intrinsic value (IV)
element and a time value (TV) element.
Definitions
Intrinsic value of an option: the positive value if an option is immediately
exercised. For calls, it is the difference between the underlying price and the
strike price when this is positive, or zero. For puts, it is the difference between
the strike price and the underlying price when this is positive, or zero.
Time value of an option: the difference between the option price and the
intrinsic value of the option, if any. The time value will depend on the remaining
life of the option, the difference between the underlying price and the strike
price and the volatility of the underlying.
The intrinsic value (IV) is simply the difference in the value between the under-
lying asset and the option strike price, as long as this is positive. For a call option,
this occurs when the strike price ( ) is below the current market price ( ). That is,
there would be an immediate gain to the holder if the option were exercised and the
underlying purchased ( − ). The opposite condition applies to puts, where the
put has intrinsic value if there is an immediate gain from selling the asset ( − ).
Thus, in our earlier example, the call at 100 would have an intrinsic value of 4, if the
underlying was trading at 104. Conversely, the put would have zero intrinsic value at
this point, since it would be better to sell in the market rather than exercise. Howev-
er, if the underlying was trading at 96, the call would have zero intrinsic value but
now the put would have an intrinsic value of 4.
For Intrinsic value will be positive if:

Calls underlying is above the strike price IV = U − K, min 0
Puts underlying is below the strike price IV = K − U, min 0
We can consider intrinsic value as a measure of the gain accruing on exercise. If

the option is out-of-the-money, there is no gain. In addition, we can calculate the
intrinsic value of an option without having to know its price as long as we have the
strike price and the market value of the underlying.
The other element in the option price (or premium) is known as time value
(TV). We can consider time value in a number of ways: as the compensation option
writers require for taking on the risk that the option will be exercised and as the
value implied by being able to defer a purchase or a sale. The combination of the
option’s intrinsic value and the option’s time value gives the option price or
premium:
Premium = + ﴾6.4﴿
Thus, returning to our earlier examples, if the price of the call option (with a
strike of 100) is 5 when the underlying is trading at 104, the price consists of 4 of
intrinsic value (104 − 100), plus 1 of time value (5 − 4).

Time value gets its name from the fact that the time to expiry, or maturity, is a
significant factor in the value of an option. First, it allows the holder to defer having
to make the transaction. The longer the period, the more valuable this must be.
Second, for options which currently are not worth exercising since they are out-of-
the-money, the longer the time to expiry, the greater the chance (and the risk to the
writer), that the underlying price may move in such a way as to make the option
worth exercising. This latter point will depend not just on time but also on the
behaviour of the underlying asset or instrument, as we will see in Section 6.3 when
we look at how options are priced. The greater the likelihood of large price move-
ments (known as volatility), the greater the chance that the underlying price will
change in a favourable direction to the holder, thus making the option worth
exercising.
Before expiry, options will be made up of a combination of time value and intrin-
sic value. Figure 6.10 shows the relationship of the option price, time value and
intrinsic value.
Option Option price

value prior to expiry
At-the-money
point of greatest
time value
In-the-money
Out-of-the-money
Intrinsic value
KS Asset value
Figure 6.10 Relationship of time value and intrinsic value of a call option
prior to expiry in relation to the price of the underlying asset
The characteristic of the option changes depending on whether it is in- or out-of-
the-money. An out-of-the-money option will be all time value. This is highest in
relation to the option value when the option is at-the-money. As the option moves
more into-the-money, the option value is increasingly made up of intrinsic value.
That is, it becomes more like a terminal contract. These sensitivities will be exam-
ined in Module 9 once a formal method for establishing the option value has been
described.
Table 6.3 shows put and call option prices on the same underlying asset with
different maturities and strike prices.

Table 6.3 Call and put prices for a range of strike prices
Calls Puts
Strike 1 2 3 1 2 3
month months months month months months
90 10.8 11.8 12.8 0.4 1.1 1.7
95 6.7 8.2 9.4 1.3 2.4 3.2
100 3.6 5.2 6.5 3.2 4.4 5.3
105 1.7 3.2 4.4 6.3 7.3 8.1
110 0.7 1.8 2.8 10.2 10.9 11.5
Table 6.3 shows that the three month calls at 95 (that is, with a 95 strike price)
are trading at 9.4. They have an intrinsic value of 5 (100 − 95), therefore the time
value element is 4.4. There are two things to note with the table. First, the calls are
more valuable than the puts. This is typical of most asset prices, which are bounded
by a price of zero on the downside, but have a potentially infinite upside gain. As a
result, puts have less time value than calls. The second point is that, as mentioned
earlier, the time value of an option increases with maturity. If we take the 110 calls
which are out of the money and therefore have no intrinsic value, we see the time
value increases with the maturity or time to expiry of the option, the one month call
having a value of 0.7, the three month call a value of 2.8. The same applies for the
puts. Note that this reduction in value to the option price as the time to expiry
approaches is known as time decay. For options of the same type and with the
same strike price, the longer the time to expiry, the greater the value. If the underly-
ing market price remains unchanged, the time value will fall to zero as the option
approaches its expiry date. In Table 6.4 we have a range of option prices for in the
money, at the money and out of the money options on the same asset.
Table 6.4 Value of an option prior to and at expiry

Asset price 6 months 3 months 1 month At expiry
K = 100
80 1.049 0.215 0.020 0
90 3.568 1.585 0.252 0
100 8.367 5.652 3.103 0
110 15.315 12.723 10.738 10
120 23.777 21.687 20.063 20
Note: The strike price is 100.
If we remove the intrinsic value from the option values given in Table 6.4, we are
left with the time value of the options as in Table 6.5.

Table 6.5 Effect of time decay on the time value of an option

Asset price 6 months 3 months 1 month At expiry
K = 100
80 1.049 0.215 0.020 0
90 3.568 1.585 0.252 0
100 8.367 5.652 3.103 0
110 5.315 2.723 0.738 0
120 3.777 1.687 0.063 0
Note: The time value is highest for the at-the-money options.
We can also show the same relationship graphically as per Figure 6.11 which
shows the value curve for options with different remaining time to expiry. As the
time shortens, the option value is pulled towards its expiry value, which will be all
intrinsic value.
To summarise, the value of an option will depend on whether it has a positive
intrinsic value (that is, whether it is in-the-money), the time to expiry and the
likelihood that the option may be worth exercising up to or upon expiry.
Option value
Option
value
6 months
3 months
Time decay
as option moves 1 month
At expiry
towards expiry
Intrinsic value
KS Asset value
Figure 6.11 The effect of time decay on the value of an option

Note: The closer the option gets to expiry, the less the time value. At expiry, the option value is
all intrinsic value.
6.2.4 Factors which Affect Option Values

We saw in our earlier simple illustration of option value that there are a number of
factors which have a bearing on the value of a call option. These are the length of
time for which the option is granted, the prevailing interest rate, the strike price, the
asset’s current price and its volatility. In addition, any value leakage from interest or
dividend payments, and so on, over the period of the option, will also affect the
option’s value.

The effect of time on option value. To have the opportunity to do something advanta-
geous for a week is not as attractive as having the same opportunity for a month or
a year or longer. Therefore the longer the life of an option or time-span over which
the option is valid, the more attractive it is. This is due to the fact that the longer the
time over which the option is extant, the greater the chance that conditions will
move in a favourable way so as to increase the value of the option to the holder.
The effect of interest rates on option value. The possibility to defer a purchase means
we do not have to provide funds today: this saves on borrowing or allows the
money to be invested and earn a return. Therefore any contract (such as a terminal
contract) which postpones a purchase has a value. Hence, the interest rate will affect
option value in a similar way. Note that this works against puts, since a put defers
the sale of the underlying asset.
The effect of the strike price on option value. If we have the right to buy an asset which
has a current market value of 100 at a price of 10, this has an immediate opportunity
to provide a gain of 90 on the transaction. Similarly, if a call option can be exercised
at 100 and the asset is trading at 120, there is a gain of 20 from exercise. However, if
the asset price is 90, there is no value to the option. Thus the underlying asset price
or asset rate (if based on interest rates) will have a bearing on the option’s value. All
things being equal, a lower strike price will raise the value of a call but lower the
value of a put.
Loss of asset value from ‘leakages’ due to dividends or interest payments also affects
option values since we can expect the asset price to decline by the amount of the
dividend or interest payment. If we have a situation where an option has a strike
price of 100 and the asset price is 105, but it pays out an interest payment of 8 just
before the option can be exercised, we would expect the asset price to fall by the
amount of interest paid, to 97, thus making the option less valuable. The opposite
applies to puts, where value leakages reduce the asset price, making the put more
valuable.
Finally, the asset’s volatility (that is, the degree of potential price movement in the
future) will have a bearing on the option’s value. If we have a situation where a call
option is out-of-the-money with a strike price of 100 when the asset price is 95,
such an option will only become valuable if the asset price should rise above the
strike price before expiry. The more volatile the asset, the greater the chance of such
an occurrence. Thus, all things being equal, a more volatile asset will have a higher
option value.
Note that the effect of the pricing variables on the value of puts is not all the
same as it is for calls. The behaviour of put and call prices in relation to an increase
in the pricing variables is given in Table 6.6.

Table 6.6 Effects of increase in option-pricing variables on value of calls

and puts
Change in value of:
Increase in Call Put
Asset (stock) price plus (+) minus (−)
Strike (or exercise) price minus (−) plus (+)
Time to expiry* plus (+) plus (+)
Risk-free interest rate plus (+) minus (−)
Volatility plus (+) plus (+)
Leakages (dividends) minus (−) plus (+)
* Strictly speaking, for European-style options, the time to expiry is indeterminate. This is true for
calls if there is the potential for a large value leakage: the earlier-expiring option might then be
more valuable. It also applies to puts since the opportunity to reinvest at a higher interest rate
might make the earlier-expiring put more attractive as a result.
6.3 Option-Pricing Boundary Conditions

An option is the right to buy (if a call) or the right to sell (if a put) an underlying
asset. This might be a share, a bond, an interest rate, a currency exchange, a stock
index or some other kind of financial or real asset. Since it has some of the character
of a deferred purchase (or sale), there will be a set of boundary conditions that
relate the value of the asset to the value of the option. For example, it will be
irrational of the purchaser of an option to pay more for the option than the value of
the underlying asset itself. Following this logic, it is possible to establish a set of
boundary conditions within which the price or value of the option should fall. These
are shown in Figure 6.12.
Option
value C
Max C
A
Min C
Out-of-the-money
o C Intrinsic value
45
PV(K) K Asset value (U)
Figure 6.12 Minimum and maximum value boundary conditions for an

option
Note: is an American-style option, is the strike price, ( ) is the present value of the
strike price, is the current market value of a call option.

The minimum value of calls: An American-style call should be either worthless or

the difference between the underlying asset price and the strike price ( − ),
whichever is the greater. It cannot have a negative value. The European-style call
should either be worthless or sell for the difference between the underlying asset
price and the present value of the strike price ( ( )), whichever is the greater. It
cannot have a negative value. If the underlying asset has value leakage, that is, it pays
one or more dividends or interest payments before the option’s expiry, the Europe-
an-style call price should be at least zero, or the difference between the underlying
asset price, adjusted for the present value of the loss of value and the present value
of the strike price, whichever is greater.
The maximum value of calls is the value of the underlying ( ).
The time to expiry. The value of a longer-dated American-style call must be at
least the same as that of a corresponding shorter-dated American-style call. The
value of a longer-dated European-style call must be at least the same as that of a
corresponding shorter-dated European-style call as long as the underlying asset has
no value leakage (that is, there is no loss of value through interest or dividend
payments). In the case of value leakage, this condition for European-style calls does
not apply, since it may be preferable to have the shorter-dated option which can be
exercised ahead of the value distribution rather than the longer-dated one.
The strike price of calls. The difference in price between two calls that differ only in
their strike or exercise price must be less than or equal to the present value of the
difference in the exercise price. For American-style calls the difference cannot
exceed the difference in their strike prices.
The value of American-style and European-style calls. An American-style call should
sell for at least the same price as a European-style call.
The minimum value of puts. An American-style put should be either worthless or
the difference between the strike price and the underlying price ( − ), whichever
is the greater. It cannot have a negative value. In the case of a zero-leakage asset, a
European-style put should be either worthless or the difference between the
present value of the exercise price and the underlying, whichever is the greater. It
cannot have a negative value. If the underlying asset has value leakage before expiry,
the European-style put price should be at least zero, or the difference between the
present value of the strike price and the underlying asset, adjusted for the present
value of the value leakage, whichever is the greater.
The maximum value of puts. The value of an American-style put should not ex-
ceed its exercise price; the value of a European-style put cannot exceed the present
value of its exercise price.
The time to expiry. The value of a longer-expiry American-style put must be at
least as great as that of a corresponding shorter-dated American-style put; for
European-style puts no such condition applies (that is, there is uncertainty as to
whether a longer-dated put is always more valuable than a shorter-dated one).
The strike price of puts. The value of a higher strike price put must be at least the
same as the value of a corresponding put but with a lower strike price. The differ-
ence in price between two European-style puts with different strike prices must

not exceed the present value of the difference in their strike prices. For American-
style puts this difference must not exceed the difference between the two strike
prices.
The value of American-style and European-style puts. An American-style put should sell
for at least the same price as a European-style put. However, with an American-style
put it may be best to exercise early. A situation when this might be the case could
arise when the gain from reinvesting the proceeds at the current interest rate
outweighs the loss of time value surrendered from the early exercise.
The put–call parity condition. This condition holds that the price of a European-
style call is equal to the price of its corresponding put plus the current price of the
underlying, less the present value of the strike price. That is:
Call - =
Put - + Underlying − Present value of strike price ﴾6.5﴿
6.3.1 Optimal Early Exercise of American-Style Options

While, in most cases, early exercise leads to the loss of time value, there are a
number of conditions for American-style options where early exercise may be the
optimal investment strategy. Because, in certain circumstances, it may be advanta-
geous to exercise an option early, American-style options are likely to trade at a
higher price than the corresponding European-style options. This price differential
reflects the increased flexibility accorded to holders of such options. The factors
which may lead to a decision to exercise early are as follows.
1. A put being deeply in-the-money. By not exercising early, the holder forgoes
the possible interest on the realisable value of the underlying ( − ). Since the
underlying’s value is not likely to recover, the loss of time value is small. (Re-
member, we have said that a deeply in-the-money option is akin to a forward
transaction.) The advantages of early exercise might apply even in cases where
there was a small intervening cash flow on the underlying (such as a dividend
due), the loss of which would have to be balanced against the gain in interest
income. The critical asset price or break-even point from early exercise can be
worked out approximately as the ratio of the underlying asset price to the strike
price, the remaining time to expiry and the prevailing interest rate available for
the released funds.
2. A call being deeply in-the-money and where (a) there may be one or more
cash flows due on the underlying asset which may or may not have been known
with certainty when the option was written or bought; or (b) the known cash
flow may be higher than was earlier predicted. An example is a call on a stock
which was going to pay a dividend before expiry or which might announce a
special dividend to holders. In this case the option’s time value is small and it
may prove best to exercise early and lose this. As is usual in such a situation, the
holder should exercise at the last possible moment that would allow him/her to
take advantage of the situation (that is, just before the stock went ex-dividend).
3. Where the risk of default by the option writer is high or rising. Holders may
exercise in such a situation if the position is near to, at- or just in-the-money, so

as to preserve value. Early exercise effectively accelerates the transaction and

pre-empts a potential default by the counterparty. If recovery of value is uncer-
tain, it may be preferable to forgo some time value than to hold on to expiry.
6.4 Risk Modification with Options

We have already said that options are useful as a way of changing the risk profile of
a given situation. This section looks at some of the ways in which this can be
achieved by combining options and the asset being optioned in different ways.
There are a great many different strategies that can be adopted. The Euronext-
LIFFE recognises 17 complex option strategies, in addition to the basic fundamen-
tal strategies. These go by exotic names such as butterfly, guts, ladder, strangle,
combo, condor, box and so forth. There is no theoretical limit to the complexity
that can be created using options, although in practice positions using more than
four options are rare.
6.4.1 Fundamental Strategies

There are six fundamental strategies for options. These are:
1. Purchased call
2. Purchased put
3. Written (sold or short) call
4. Written put
5. Written call plus a long position in the underlying asset
6. Written put position plus a short position in the underlying asset
Table 6.7 The fundamental option strategies and their effects

Strategy Payoff Effect
(1) Long call (+ ) Gain if asset price rises Loss limited to premium paid (− ) potential
( − ) infinite gain from asset price rise ( − )
(2) Long put (+ ) Gain if asset price falls Loss limited to premium paid (− ), potential
( − ) large gain from asset price fall ( − )
(3) Short call (− ) Premium received ( ) Gain limited to premium received, potential risk
of loss if asset price rises ( − )
(4) Short put (− ) Premium received ( ) Gain limited to premium received, potential risk
of loss if asset price falls ( − )
(5) Short call, plus Premium received ( ), Gain limited to premium received; potential
long position in plus any income from opportunity loss from surrendering the underly-
underlying asset asset (+i) ing asset if the asset price rises above strike
(− , + ) price
(6) Short put, plus Premium received ( ), Gain limited to premium received; potential
short position in less any income from opportunity loss from having to purchase asset
underlying asset asset (−i) at the strike price if the asset price falls below
(− , − ) the strike price
These strategies are summarised in Table 6.7. Complex strategies can be created
by combining the different fundamental strategies into more elaborate packages.

The strategies from Table 6.7 are shown as a set of payoff diagrams in Fig-
ure 6.13 to Figure 6.16.
+ Long call
Strike price Area of gain

Premium
Area of loss
+
Short call
Area of gain
Premium
Area of loss
Figure 6.13 The payoff from a long call (fundamental strategy (1)) and a
short call (fundamental strategy (3))
Note: For details, see Table 6.7.
+ Long put
Area of gain Strike price

Asset
Gain/Loss
price
Area of loss
Premium
–
+ Short put
Premium
Area of gain Asset

Gain/Loss
price
Area of loss
Figure 6.14 The payoff from a long put (fundamental strategy (2)) and a
short put (fundamental strategy (4))
Note: For details, see Table 6.7.

Gain/Loss
+
Value of long position
in the underlying asset
Combined position
Premium Asset
price
Strike price
(K) Written call
Figure 6.15 A covered call write (fundamental strategy (5))

Note: The combined position is made up of a long position in the underlying asset (+U) and a short
or written position in a call option (−C). The combined position is equivalent to a written put
(−P). For details see Table 6.7.
Gain/Loss
+ Value of short position
in the underlying asset
Written put
Premium Asset
price
Strike price Combined position
Figure 6.16 A covered put write (fundamental strategy (6))

Note: The combined position is made up of a short position in the underlying asset (−U) and a
short or written position in a put option (−P). The combined position is equivalent to a written
call (−C). For details see Table 6.7.
6.4.2 Strategies Using Options

As mentioned at the start of Section 6.4, options can be used to manipulate the risk
profile or sensitivities of the position in relation to the underlying asset, interest rate,
currency, index or other optioned instrument. It is beyond the scope of this module
to expand on all the different option strategies that can be adopted, but this section
looks at a few of the more common methods used in the markets. The two most
important relationships are spreads and straddles.
The vertical spread is designed to reduce the cost of a given exposure profile
based on a directional view of the asset being optioned. It is essentially a package
made up of two of the first four fundamental strategies, (1) and (3), a purchased call

and a written call, or (2) and (4), a purchased put and a written put, where the strike
prices between the purchased and the written options differ. Thus a degree of
protection is provided over a given range by the purchased option whereas the
written option (which provides an immediate inflow of premium) reduces the cost
of the overall position. The payoff of a vertical call spread is shown in Figure 6.17.
Gain/Loss
+ Purchased call
Premium received
Combined
position
K1 K2 Asset
price
Premium paid
Written call
Net premium
Figure 6.17 Payoff of a vertical call spread (bull spread) based on buying a
call at strike price and selling another call with strike price
Variations on the spread structure include having options with different expiry
dates (called a horizontal or time spread), using puts instead of calls (known as a
credit spread), having different quantities of options on the purchased and sold legs
(ratio spreads), adding a further purchased deeply out-of-the-money option ( ladder)
and combining two spreads to create butterflies, iron butterflies, condors and so on.
The other derived strategy is a straddle. This has no directional view on the
movement in the underlying asset. It is a combination based on fundamental
strategies (1) and (2), being a purchased call (+ ) and a purchased put (+ ).
Alternatively, in its written or sold form, it uses fundamental strategies (3) and (4),
being short positions in the call and put. The payoff of the long straddle position is
shown in Figure 6.18. The short straddle has the opposite risk profile.
Variations on the basic straddle include: splitting the strike prices between the call
and the put (known as a strangle), reducing the cost of the position by selling-out-
of the money calls and puts (iron butterfly, which is equivalent to a package of a
bull and a bear spread), having a greater number of options on one side (a strap if
more calls are added, a strip if more puts are added). These are also known as ratio
combinations.
This section has briefly covered the use of options as a way of modifying the risk
profile of a position for speculative and risk management purposes. Because of their
asymmetrical payoff, they can be used to carve up the normal risk profile of an
asset, to remove the undesirable parts and to increase the beneficial results. They
can be purchased and sold in a very great many ways, only a few of which have been
covered, so that they are inherently flexible and a very useful way of managing the
price risk of the underlying optioned instrument.

Gain/Loss
+ Long put Long call
K
Asset
price
Call premium Put premium
Combined position
–
Figure 6.18 A purchased straddle

Note: It is made up of a long call and long short position (fundamental strategies (1) and (2)). The
holder expects the asset price to move significantly away from the strike price K in either
direction. A written version with the opposite risk profile can also be created.

This module introduced the basic character of options. Options are somewhat
technical in nature, but the technical aspect relates partly to the specialised language
used to describe options and partly to the mathematical nature of the discussions
related to pricing. These are discussed in the next two modules.
There are two basic kinds of option: calls, which give the right to purchase an
asset, and puts, which give the right to sell an asset. The risk taken by the buyer or
holder is very different from that taken by the seller or writer. In both cases, the
writer is potentially exposed to a large loss if the price of the underlying asset moves
against him or her. Thus there is an asymmetrical or non-linear payoff.
Options change their character depending on whether they are in- or out-of-the-
money, the value of an out-of-the-money option being purely the probability that
the option will have some value at expiry. An in-the-money option, however, has
many of the characteristics of a deferred purchase, or sale, of a terminal instrument.
This dualism has contributed to difficulties in understanding their nature.
This module has shown that option values relate to a number of pricing factors,
namely, the asset price, the strike price, the life or time over which the option is
granted, the prevailing interest rate, whether there are any distributions from the
underlying asset over the option’s life and the asset’s volatility. These pricing
variables have a different effect on the value of calls and the value of puts.
Because options allow the holder to modify favourably the risk exposure of a
given asset, they are valuable. As a consequence buyers have to pay an upfront
premium. But they also have the unique feature of allowing the holder to walk away
from the contract. In addition, there are minimum price boundary conditions which
apply to their value.
The ability to modify risk is a very useful attribute, which makes options of par-
ticular value to the investor or risk manager.

Review Questions
6.1 The difference between options and terminal products is that:

A. options are traded on organised exchanges, whereas terminal products are not.
B. options provide insurance to the holder, whereas terminal products are
speculative instruments.
C. options provide the holder with the choice of completing the contract,
whereas terminal instruments do not.
D. options are traded on more underlying assets whereas there is only a small
range of underlying assets for terminal products.
6.2 The holder of a call will exercise the option:

A. if the asset price is below the strike price at expiry.
B. if the asset price is above the strike price at expiry.
C. if the asset price is at the strike price at expiry.
D. regardless of what the asset price is in relation to the strike price at expiry.
6.3 If you sell a call option you are:

A. required to pay a premium at the initiation of the transaction and are required
to receive the asset upon exercise.
B. paid a premium at the initiation of the transaction and are required to receive
the asset upon exercise.
C. required to pay a premium at the initiation of the transaction and are required
to surrender the asset upon exercise.
D. paid a premium at the initiation of the transaction and are required to surren-
der the asset upon exercise.
6.4 If you have the choice of either buying an asset now or acquiring an option to buy the
asset at a future date, the combination of the call, plus the present value of the purchase
price, will be:
A. equal to or greater than the asset price, plus any income distribution from the
asset before expiry.
B. equal to or greater than the asset price, less any income distribution from the
C. less than or equal to the asset price, plus any income distribution from the
D. less than or equal to the asset price, less any income distribution from the
6.5 Which of the following factors is not part of a call option contract?
A. The time-span over which the option is valid.
B. The price at which the underlying asset can be purchased.
C. The amount of the premium to be paid.
D. The interest rate applicable to the option’s expiry.

6.6 Which of the following cannot be determined from a put option contract?
A. Whether the option is American style or European style.
B. The price at which the underlying asset can be sold.
C. The amount of the premium to be paid.
D. The interest rate applicable to the option’s expiry.
6.7 The ____ of a put option will ____ the premium when the transaction is initiated and
(if exercised) will ____ the underlying asset at the agreed price. Which is correct?
A. writer pay sell
B. writer receive buy
C. holder pay sell
D. holder receive buy
6.8 A European-style option allows the holder to:

A. exercise the option at any point up to its expiry date.
B. receive the asset at a predetermined location in Europe.
C. exercise the option only at expiry.
D. exercise the option only at set dates before expiry and at expiry.
6.9 A call option has a strike price of 175 and a premium of 6.5. If the asset price at expiry
is 180.25, which of the following applies?
A. The option is in-the-money and should be exercised for a net gain of 5.25.
B. The option is in-the-money and should be exercised to cover the premium
paid, giving a net loss of 1.25.
C. The option is out-of-the-money and should not be exercised since there is a
net loss of 1.25.
D. The option is out-of-the-money but should be exercised to cover the premium
paid, giving a net loss of 6.5.
6.10 An in-the-money call option will have a strike (or exercise) price that is:
A. below the asset price and the option will have a positive intrinsic value.
B. below the asset price and the option will have no intrinsic value.
C. above the asset price and the option will have a positive intrinsic value.
D. above the asset price and the option will have no intrinsic value.
6.11 An out-of-the-money put option will have a strike (or exercise) price that is:
A. below the asset price and the option will have a positive intrinsic value.
B. above the asset price and the option will have a positive intrinsic value.
C. above the asset price and the option will have no intrinsic value.
D. below the asset price and the option will have no intrinsic value.
6.12 A put option has a strike price of 212 and the underlying asset is trading at 217. If the
time value of the option is 8, what is the option’s value?
A. 1.6
B. 5
C. 8
D. 13

6.13 A call option on a stock index has a strike price of 6825.50 and the index is at 6950.50.
If the option has time value (in index points) of 175, what is the value of the call (in
index points)?
A. 1.4
B. 50
C. 125
D. 300
6.14 For an option with different strike prices on the same underlying asset and with the
same expiry date, which of the following is true?
A. The out-of-the-money option has the greatest time value.
B. The at-the-money option has the greatest time value.
C. The in-the-money option has the greatest time value.
D. The time value for the out-of-the-money option, the at-the-money option and
the in-the-money option is the same.
6.15 An increase in the underlying price means the value of a call ____. Equally, a fall in the
risk-free interest rate means the call value ____, whereas an increase in volatility ____
the price of the call. Which is correct?
A. falls rises reduces
B. rises falls raises
C. falls rises raises
D. rises falls reduces
6.16 A decrease in the underlying price means the value of a put ____. Equally, a rise in the
risk-free interest rate means the put value ____, whereas an increase in value leakage
____ the price of the put. Which is correct?
A. falls rises reduces
B. rises falls raises
C. falls rises raises
D. rises falls reduces
6.17 Value leakage from an underlying asset has the effect of:
A. raising the price of calls and reducing the price of puts.
B. reducing the price of calls and raising the price of puts.
C. raising the price of both calls and puts.
D. reducing the price of both calls and puts.
6.18 If the price of the underlying asset falls, which of the following describes the effect on
the price of calls and puts on the asset?
A. Calls rise in value and puts fall in value.
B. Calls fall in value and puts rise in value.
C. Both calls and puts rise in value.
D. Both calls and puts fall in value.

6.19 If the risk-free interest rate falls, which of the following describes the effect on the price
of calls and puts on the asset?
6.20 If the time to expiry of an option is reduced, which of the following describes the effect
on the price of calls and puts on the asset?
6.21 If the volatility of the underlying asset falls, which of the following describes the effect on
the price of calls and puts on the asset?
6.22 Three American-style calls with the same expiry date have the strikes and market prices
given in the following table. The current market price of the asset is 120.
Strike price Option value

120 3.5
125 8.5
130 14.5
Which of the following conditions is true?

A. All the options are correctly priced in relation to each other.
B. An arbitrage opportunity exists between the 120 and the 125 strike option.
C. An arbitrage opportunity exists between the 125 and the 130 strike option.
D. There is insufficient information to determine whether an arbitrage opportunity
exists.
6.23 Which of the following statements is correct?

A. An American-style put for maturity 1 is strictly worth more than an American-
style put for maturity 2.
B. An American-style put for maturity 1 is strictly worth less than an American-
C. A European-style put for maturity 1 is strictly worth more than a European-
D. A European-style put for maturity 1 is strictly worth less than a European-style
put for maturity 2.

6.24 Which of the following is correct?

A. A put and a call (with the same exercise price as the put) are equal to the
underlying asset price less the present value of the exercise price.
B. A put plus the present value of the exercise price is equal to the underlying
asset price less a call (with the same exercise price as the put).
C. A put is equal to a call (with the same exercise price as the put) plus the
present value of the exercise price less the underlying asset price.
D. The underlying asset price less a put is equal to a call (with the same exercise
price as the put) less the present value of the exercise price.
6.25 Which of the following is not a condition for the early exercise of an American-style
option?
A. Concern about the creditworthiness of the option writer.
B. When a put is deeply in-the-money.
C. When a call is deeply in-the-money and a distribution is due on the underlying
asset.
D. Concern about the creditworthiness of the underlying asset.
6.26 Which of the following is not a fundamental option strategy?

A. Short call plus long underlying asset position.
B. Short put plus short underlying asset position.
C. Long call plus short put position.
D. Long call position.
6.27 The following payoff diagram is a:
A. long call.
B. short put.
C. short position in the underlying asset and short put.
D. A, B and C can all be represented by the payoff diagram.

6.28 A vertical spread:

I. is a non-directional strategy which requires the underlying asset either to rise or to
fall.
II. is a directional strategy which requires the underlying asset either to rise or to fall.
III. uses puts.
IV. uses calls.
V. uses both puts and calls.
A. I, III and IV.
B. II, III and IV.
C. I and V.
D. II and V.
6.29 If we were to sell a call and sell a put with the same expiry date but different strike
prices, we have:
A. a vertical spread which will make money if the underlying asset price increases.
B. a vertical spread which will make money if the underlying asset price decreases.
C. a strangle which will make money if the underlying asset price significantly
increases or decreases.
D. a strangle which will make money if the underlying asset price does not
significantly increase or decrease.
6.30 The holder of a put will exercise the option:

A. if the asset price is below the strike price at expiry.
B. if the asset price is above the strike price at expiry.
C. if the asset price is at the strike price at expiry.
D. regardless of what the asset price is in relation to the strike price at expiry.
Case Study 6.1

The following are the prices for calls and puts on cocoa. Each contract is for 10 metric tonnes
and the option contract prices are in US dollars per tonne.
Calls Puts
Price July Aug. Sept. July Aug. Sept.
($)
1300 132 162 170 3 5 13
1350 86 119 130 7 12 23
1400 49 80 96 21 26 39
1450 27 51 66 48 44 59
1500 13 35 50 84 78 93
1550 7 23 36 128 116 129
Estimated volume: 3260.
Open interest: Friday: 18 455 calls; 9728 puts.
The cash price is US$1426/metric tonne.

1 What are the intrinsic value and the time value on the $1550 September puts?
2 The report in the paper from which the table is taken showed the $1500 August puts as
having a value of $78. What is wrong with this price?
3 Draw a bullish vertical spread. What would be the possible range of outcomes from
setting up a bullish vertical spread using July calls with strikes of $1450 and $1500?
4 Set up the same bullish vertical spread for the July strikes but this time using puts
instead of calls. What is the range of possible outcomes in this situation?
5 Draw a straddle. If we set up a straddle using the $1450 September calls and puts, what
will be the break-even upward and downward movement in the cocoa price?

Module 7
The Product Set II: Option Pricing

Contents
7.1 Introduction.............................................................................................7/1
7.2 Pricing the Option Liability ...................................................................7/2
7.3 Multiperiod Extension of the Option-Pricing Method ........................7/8
7.4 Put–Call Parity Theorem for Pricing Puts ........................................ 7/12
Appendix 7.1: Dynamic Replication of the Option Liability ...................... 7/16
Case Study 7.1................................................................................................. 7/24
Learning Objectives
This module introduces methods for valuing options. The value of an option is
merely the present value of its expected payoffs. If these can be established for a
one-period case, then the value of the call is easily derived.
Option pricing is based on pricing through hedging the exposure created by the
option seller (or writer).
After completing this module, you should:
 understand how the hedging or replicating portfolio approach is used to value an
option;
 understand the role of the replicating portfolio in option pricing;
 know how to derive a ‘fair value’ for an option;
 be able to price an option using a discrete time binomial method;
 know how the option’s hedge ratio, or delta, is derived;
 be able to use the put–call parity relationship to price the corresponding put
option.
7.1 Introduction
Option pricing, since it uses five variables, seems complex. The previous module
introduced the basics of options but did not address the question of how options
are valued. This module looks at a formal model for explaining the price that the
market places on options. It starts by illustrating how a one-period case can be
priced and this method is extended to a multiperiod environment. The pricing
approach is similar to that of terminal instruments in that the price is derived from
the costs associated with hedging or replicating the payoff from the option writer’s
requirement to deliver the asset upon exercise.

Module 7 / The Product Set II: Option Pricing
7.2 Pricing the Option Liability

This section looks at how a ‘fair value’ for an option can be derived. The fair value
is the payoff to the buyer and seller or writer of the option where the expected gain
to both sides is zero. Thus the transaction has a zero expected net present value.
The premium is then the ex ante compensation from the buyer to the seller that
ensures that the transaction has an initial zero net present value (ignoring transac-
tion costs).
Let us assume that we have a call option which has a strike price of 100 and only
two possible future payoffs: the price can rise to 110 (defined as { }) or fall to 90
(defined as { }). The holder of the call option on the asset has the payoffs shown in
Table 7.1.
Table 7.1 Payoff of call option with one period and two
possible states, a rise { } to 110 and a fall { } to 90
Underlying price at Intrinsic value of option
expiry
110 10
90 0
Let us also assume that there is a risk-free rate of interest ( ) at which money can
be borrowed or lent, which we will take to be 5 per cent, for the period in question,
with the effect that < < . We will ignore real-life issues such as transaction
costs, taxes, commissions and so forth. We can envisage the payoff on the option as
in Figure 7.1.
Price in one period
Up: {u}
110
(r)
(1 – r)
90
Down: {d}
Figure 7.1 Payoff of a one-period asset with two possible states, up { }

and down { } with respective probabilities ( ) and ( − )
Note: The price change dynamics are = 1.1 and = 0.90.
The expected payoff for the asset holder in Figure 7.1 will be:
Payoff = × 110 + (1 − ) × 90 ﴾7.1﴿

However, for the option holder, the term (1 − ) × 90 is zero, since the holder is
not required to exercise in the case of adverse price changes. To solve for the value
of the option to the holder, we need only determine the probability for an upside
change in price { } and present value the result.
The writer has the opposite position. The key issue in option pricing is what
hedging transaction the writer can take that will minimise this potential loss.
Obviously, if there is 100 per cent certainty that the option will be exercised (that is,
= 1.0), the writer would wish to hold the asset and deliver it to the holder. At the
other extreme, if the probability of exercise is zero, the writer would wish to hold
none of the asset. In more usual circumstances, where 1.0 > > 0, there is some
chance that the writer will need to make delivery. A suitable value for the call can be
determined by creating a replicating portfolio consisting of borrowing or lending
at the risk-free rate together with a position in the asset or underlier.
In the case we have been discussing, this replicating portfolio will consist of:
(a) two written or sold options (short position in the option with a requirement to
deliver the underlying asset at expiry if the asset price is above the strike price);
(b) a long position in one unit of the underlying asset at an initial price of 100 each;
(c) borrowings of 85.71 at 5 per cent over the period.
The net cash flow position at time zero will thus be:
2 × call − 100 + 85.71 = 2 calls − 14.29 ﴾7.2﴿
At expiry, there are two possible outcomes, as given in Table 7.2.
Table 7.2 Payoff for replicating portfolio at expiry based on a position

made up of three short calls at 100, long two units of the
asset at 100 and borrowing 85.71 at 5 per cent for the period
Elements of the Increase in price to Decrease in price to
replicating 110 {u} 90 {d}
transaction
Proceeds from selling 1 × 110 = 110 1 × 90 = 90
asset
Payout on the short call 2 × (10) = (20) 0
positions
Repayment of (90) (90)
borrowing
Net cash flow: 0 0
The key result of Table 7.2 is that regardless of whether the price rises or falls,
the net cash flow for the writer (or option seller) is zero. Thus the combination of a
short or written position in two calls with a strike price of 100, together with a long
position in one unit of the asset at 100, plus a loan of 85.71, will provide a position
which, regardless of the outcome, involves no additional cash flows to the option
writer. Thus the position is a riskless hedge. The position in Equation 7.1 is known
as the replicating portfolio. The only other step required is to determine the price
of the calls so that the writer is compensated for the cost of setting up the initial

position (to give the transaction a zero net present value to both sides, that is, it is
‘fair’). The value of one call is thus 7.14, if we have the result that two calls minus
14.28 is zero (2 calls − 14.28 = 0; therefore 2 calls = 14.28), thus providing a fair
value for the call or, alternatively, ensuring that the net present value is zero to both
the buyer and the seller of the option.
It would have made no difference if we had priced one call only. In that case we
would have needed half a share rather than one share as above. The normal method
for pricing options is to derive the price of one option directly by allowing fractional
investments in the underlying asset, index, security or instrument. This is the
approach that will be used in all subsequent discussion. However, in real-world
trading it is obviously not possible to divide individual shares or futures contracts.
In that case a seller would simply scale up the transactions as above, selling an
appropriate number of options to get the correct round number of securities.
Therefore, the premium or price that the writer will require to sell the option will
be based on an amount that at least compensates the writer for the expected costs
of replicating the payoffs on the option. This is achieved by creating a combination
of borrowing or lending and a position in the asset that exactly matches the writer’s
obligation under the option. Alternatively, the cost of the option can be seen as the
payment required by the writer to eliminate any losses from replicating the outcome.
That is, it is the compensation paid by the buyer that makes up for the negative net
present value of the transaction to the writer.
Note that the above replicating methodology allows us to determine the fair
value or price of the option with one period to expiry. Surprisingly enough, we do
not need to know the probability of a rise or fall, only the extent to which the
underlying asset could move up or down (that is, its volatility). In practice this latter
is unknown and we need to work with the probability of an increase or decrease in
the asset value rather than potential future values.
The replicating portfolio approach given above can be applied to any situation.
The general case for pricing calls involves:
(a) selling the call ( );
(b) holding delta (δ) units of the underlying asset;
(c) borrowing an amount ( ) for the period.
At the end of the period, we want to establish values of δ and that do not
involve additional sums even if the asset price has risen or fallen. For replication to
work (as shown above), we want the transaction to be self financing once the initial
premium on the call has been paid. We get this if we set:
( )
− − =0 ﴾7.3﴿
( )
− − =0
where is the continuously compounded rate of return for the period ( − ).* We
have here two equations with two unknowns and these can be solved using a little
algebra, such that:
* How the continuous rate of return is derived from nominal rates is shown in Module 8.

− ﴾7.4﴿
=
−
where A is the asset price and and are the values of the call where the asset
price has risen ( ) and fallen ( ) respectively.* And we obtain , the amount to be
borrowed, by:
− ﴾7.5﴿
= ( )( − )
The term δ in Equation 7.4 is the ratio of the range of the possible call values to
asset values. This is often referred to in the literature on options as the hedge ratio
or the option’s delta. In our earlier example above, the hedge ratio will be:
− 10 − 0 ﴾7.6﴿
= = = 0.5
− 110 − 90
And the value of the borrowed funds ( ) will be:
− [(0)(110) − (10)(90)] ﴾7.7﴿
= ( )(
= = −42.86
− ) [(1.05)(110 − 90)]
To replicate the two possible payoffs of the one-period stock, we need to hold
0.5 of the underlying asset per unit currently worth 100 and borrow 42.86.
The two payoffs are given in Table 7.3.
Table 7.3 Payoffs for a one-period replicating portfolio for a call option
with a strike price of 100 based on Table 7.2
Asset price Payoff from replication portfolio Net position
Rises to 110 (0.5 × 110) − (42.86 × 1.05) 10
Falls to 90 (0.5 × 90) − (42.86 × 1.05) 0
Setting the initial cash flow to zero (that is, making it a zero net present value
transaction), means that:
− + =0 ﴾7.8﴿
where is the call price, δA the investment in the underlying asset and is the
amount of borrowed funds. By substituting the values for δ and from Equation
7.4 and Equation 7.5, we have:
( )
( − ) +( − ) ﴾7.9﴿
= ( )( − )
And then making the substitution:
* For put options, we would use the same formula to obtain a put’s delta:
−
=
−

( )
− ﴾7.10﴿
=
−
we obtain the value for a call with one period to expiry as:
+ (1 − ) ﴾7.11﴿
= ( )
This form of the payoff of the option is similar to the expected payoff on the
asset at any period, where the terms and (1 − ) correspond to the probabilities of
the asset’s price increasing and decreasing. The value of the option at each period is
merely the outcome of the option value-weighted by the probability of its occurring.
Therefore:
= + ﴾7.12﴿
Substituting the earlier values for δ and , we have:
0.5 × 100 − 42.86 = 7.14 ﴾7.13﴿
which is the same value as we obtained earlier in our analysis.
We may now summarise our understanding of how options are priced. The ex-
pected return on the asset will be a function of the probability of the rise ( ) times
the amount of the rise together with the probability of a fall (that is, (1 − ρ)) times
the amount of the fall:
Return on asset = ( × rise [%]) + ((1 − ) × fall [%]) ﴾7.14﴿
Return on asset = × 110 + (1 − ) × 90
This gives an expected return of 5 per cent. The value of the call on the stock will
be derived as:
(Probability of rise × 10) + [(1 − probability of rise) × 0] ﴾7.15﴿
which gives:
Value of call = 0.75 × 10 + (1 − 0.75) × 0 = 7.50 ﴾7.16﴿
However, this is the expected value at expiry. We then need to present value this
to give us the value of the call at the start of the period:
Future value of the call 7.50 ﴾7.17﴿
( )
= = 7.14
1.05
This again gives us the same value as we derived earlier.
The Risk-Neutral Valuation of Options _______________________
The replicating portfolio approach to valuing options does not lead us to having
to make assumptions about the probabilities of a price increase {u} and a price
decrease {d} in order to derive Equation 7.11. That said, given the fact the
underlier has to either increase or decrease at each step, there is a natural
tendency to interpret the variables ρ and (1 − ) as the probability of the

underlier rising and falling. Then Equation 7.11 can be considered to be the
expected value of the option discounted at the risk free rate.
What would be the expected return on the underlier, if we take the variables ρ
and (1 − ) as the probability of a rise and a fall? The expected value of the
underlier ( ) will be:
( )= ﴾7.18﴿ + (1 − )
where 0 is the stock price today and u and d are as previously defined. By
rearrangement, we can see that:
( )= ﴾7.19﴿ ( − )+
Now substituting Equation 7.10 into Equation 7.19 and simplifying, we find that:
( )
( )= ﴾7.20﴿
This shows that the expected growth rate of the underlier is at the risk-free
interest rate (r). Thus setting the probabilities of an increase or decrease in the
value of the underlier to ρ and (1 − ) is equivalent to making the assumption
that the rate of growth in the value of the underlier equals the risk-free interest
rate.
This is the basis of the risk-neutral valuation approach. In a risk-neutral
world all individuals are indifferent to risk. In the risk-neutral world, investors
do not ask for compensation for bearing risk and as a result all securities earn
the same return, the risk-free interest rate. The valuation approach used in
Equation 7.11 where the probabilities of a price increase and decrease are set to
ρ and (1 − ) is equivalent to assuming such a risk-neutral world. Hence these
are risk-neutral probabilities.
This leads to an important result in option pricing. The result in the risk-neutral
world is the same as the result from the real world. The replicating portfolio
approach gives the same value as the risk-neutral valuation approach. As a
result, we can take the valuations derived from the risk-neutral world and apply
them in the normal world where investors do care about risk. This simplifies
the valuation approach since using the risk-neutral valuation method we simply
need values for r, u, d and p.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
There are two important implications from this method of deriving the value of a
call option.
1. The writer is indifferent to the value of the asset price at expiry. If the hedge
ratio has been correctly determined, the outcome does not depend on whether
the price rises or falls.
2. The model provides a risk-neutral valuation of the outcome. The pricing of
the option does not depend on the risk preferences of individuals or institutions
since the position (and by implication the expected return on the asset) can be
hedged by borrowing and lending at the risk-free rate.

Although these two points are somewhat theoretical issues and beyond the scope
of this module, it is important to understand that the replicating portfolio approach
used by option-pricing models does not require the parties to take a view on the
outcome. As long as both parties can agree on the risk-free rate of interest, individu-
al perceptions of how the asset price might move are not relevant. This is not to say
that in practice buyers and sellers are not concerned with the outcome. The reason
that option-pricing models have been so successful in addressing the valuation of
contingent claims with an asymmetric payoff is that the valuation process has only
one area of disagreement: the volatility or potential range of prices that might be
achieved over the life of the option.
7.3 Multiperiod Extension of the Option-Pricing Method

The simple one-period valuation model for the price of a call is readily extendable to
a multiperiod context. Let us assume that instead of one period to expiry, there are
now two periods. The range of possible outcomes is shown in Figure 7.2.
To use our earlier example, the one-period set of outcomes was 110 (u) and 90
(d). The two-period range of outcomes is 120, 100 and 80. This is made up of four
possible states: + ; + ; + and + , as shown in Table 7.4.
The procedure for determining the price of the call involves a backwards iterative
process from the second period to the first period as with the one-period example
discussed earlier. Thus the value of the call with two periods to go is the value of the
call for the two one-period branches in Figure 7.2. That is, we solve for the value of
the call in the case ( + ) and ( + ), and the value of the call in the case ( + )
and ( + ) for the second period. Solving for the two branches provides the input
to the problem for the first period (that is and as shown earlier).
Price in period 2
{uu}
120
(r)
Up: {u}
(r) 110 (1 – r)
Price in {ud,du}
period 1 100
(1 – r)
90 (r)
Down: {d}
(1 – r)
{dd} 80
Figure 7.2 Payoff from option with two periods to expiry

Table 7.4 Price outcomes for asset prices over two periods
Outcome
Period Fall Rise
{d} {u}
0 100
1 90 110
{d} {u}
2 80 100 120
{d + d} {d + u; u + d} {u + u}
Table 7.5 Value of call option based on asset prices in Table 7.4 with a
strike price of 100
Outcome
Period Fall Rise
{d} {u}
1 0 10
2 0 0 20
The value of the option with one period to go is computed in exactly the same
fashion as the one-period example. The upper and lower pairs of outcomes provide
the call values with one period to go, as shown in Table 7.6.
Table 7.6 The value of the two pairs of one-period call options in Table
7.5, with one period to expiry
Pair Hedge Borrowing Value of
ratio (δ) (B) option (C)
Upper pair (u + d); u = 120; d = 100 1.000 95.24 14.76
Lower pair (u + d); u = 100; d = 80 0 0 0
The basic equation is then used to calculate back from the values in Table 7.6 to
give the single-period value. The value of is 0.75, therefore (1 − ) is 0.25.
Substituting these gives:
+ (1 − ) 0.75(14.76) + 0.25(0) ﴾7.21﴿
= ( )
= = 10.54
(1.05)
The value of the option with two periods to expiry thus becomes 10.54, as
against 7.14 for the one period alone. The reason for the increased value is that the
possible range of outcomes for the two-period model has risen from 0 to 10 to 0 to
20. Table 7.5 shows that for the two-period case, there are three outcomes.
For the two-period model, we can expand Equation 7.21 such that:
( )[ ]
= +2 (1− ) +(1 − ) ﴾7.22﴿

A Further Example of a Two-Period Option __________________

Using the same two-period example as discussed above, we now have an option
with a strike price of 90. The payoffs of this option are given in Table 7.7 as is
the intermediate values and the amount of borrowing required for the replicat-
ing portfolio.
Table 7.7 Two-period call option with a strike price of 90
t =0 Bt=0 = 67.91 18.99
t=1 Bt=1,90 = 38.10 6.90 24.29 Bt=1,110 = 85.71
0 10 30
t=2 {dd} {ud/du} {uu}
As expected, the result of lowering the strike price is to raise the value of the
call option.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The two-period example can be expanded to any number of periods as required.

The result is an expanding lattice of possible outcomes. Such a lattice is shown in
Figure 7.3 for an eight-period iteration. Each of the forks of the lattice is priced in
the recursive process shown earlier whereby the pairs of outcomes ( and ) are
priced iteratively, starting with the last period and feeding the result into the earlier
periods. Such an approach is arithmetically cumbersome when done manually, but
(relatively) easy with a computer.
Price
Time
Figure 7.3 The binomial lattice showing an eight-period expansion

The reader familiar with statistics will have recognised that the process in Ta-
ble 7.4 and shown in Figure 7.3 is in fact the behaviour of a binomial distribution.
The use of such a distribution gives this approach to option pricing its name. The
option-pricing method just described is in fact the binomial option-pricing model
developed by John Cox, Stephen Ross and Mark Rubinstein (1979). We will discuss
an alternative analytical method in the next module, but we will now turn to how we
may price put options, which have been ignored so far. Pricing puts depends on
the existence of arbitrage-free conditions between long and short positions in puts
and calls together with a long or short position in the underlying asset.
Calculating the Binomial Option-Pricing Model Inputs _________
The binomial option-pricing model requires estimates of the parameters { }, { }
and { } in order to be able to derive the value of a call. These can be derived
from statistical estimates of the behaviour of asset returns using the following
equations:
﴾7.23﴿
=
﴾7.24﴿
=
= ﴾7.25﴿
where:
σ is the annualised standard deviation
is the number of steps
( − ) is the time period for the option
is the observed interest rate for the period ( − )
= 2.71828
Thus for a six-month option (180 days) with a standard deviation of 25 per cent
where the number of steps is 25, an interest rate of 6 per cent, this gives the
following estimates:
.
.
= 2.71828 = 1.035736
.
.
= 2.71828 = 0.965496
.
.
= 2.71828 = 1.001184
These estimates are the inputs used in Equation 7.10 to derive and (1 − ):
( )
−
1.001184 − 0.965496
= = = 0.508090
− 1.035736 − 0.965496
(1 − ) = (1 − 0.508090) = 0.491910
from which a lattice of prices is then calculated (as in Figure 7.3). These esti-
mates are then used to calculate the matrix of price dispersions over time and
therefore the corresponding value of the option at each terminal state in the
binomial lattice.

Note that this calculation shows that as the variance ( ) is increased, the values
for { } and { } increase and decrease for any fixed given period and the
binomial lattice will have a wider spread of prices. This relationship is shown in
Table 7.8 for different values of and . The result is what we would expect
from raising the volatility in that the future spread of possible outcomes widens
as volatility is increased.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Table 7.8 Terminal value for asset price based on various growth rates
for up { } and down { } in the binomial option-pricing model
Initial price = 100 Maximum terminal value for price increases
{u} =1 = 10 = 20 = 50
1.01 101.00 110.46 122.02 164.46
1.02 102.00 121.90 148.60 269.16
1.05 105.00 162.89 265.33 1 146.74
1.10 110.00 259.37 672.75 11 739.09
Initial price = 100 Minimum terminal value for price decreases

{d} =1 = 10 = 20 = 50
0.9901 99.01 90.53 81.96 60.80
0.9804 98.04 82.03 67.30 37.15
0.9524 95.24 61.39 37.69 8.72
0.9091 90.91 38.55 14.87 0.85
By using the exponential for the volatility and by setting = 1/ , the lattice will
recombine at each node. Note this assumes that the distribution of asset price
returns conforms to a lognormal distribution.
7.4 Put–Call Parity Theorem for Pricing Puts

The pricing of put options depends on the pricing relationship between puts, calls
and the underlying asset.* It is based on the law of one price which states that any
two assets, or combination thereof, which have the same payoffs must trade at the
same price in an efficient market. To price puts we must know something of the
payoffs from holding different combinations of options with the underlying asset, as
briefly described in the previous module. In the following analysis we will conven-
iently forget the premium for calls and puts. (This does not alter the fundamental
result we are seeking.) The easiest way to understand how the prices of puts and
calls are interrelated is through payoff diagrams. In Figure 7.4 we have the payoff of
a put option.
* Alternatively, we can value puts directly, using the numerical methods of the binomial option-pricing
model.

We can duplicate this payoff synthetically by taking a short position in the under-
lying asset together with holding a long position in a call. This is shown in
Figure 7.5. This synthetic put position has the same payoff as a long position in a
put option. With the synthetic put, if the market price is below the strike price on
the call, the call is left unexercised and the short position shows a gain. If, however,
the market price is above the strike price, the loss that is made on the short position
(a' ) is offset by the gain from exercising the call at a profit (a), giving the combined
payoff which is shown as a heavy black line and which is the same as that shown in
Figure 7.4. Functionally, holding the put or taking a short position in the asset with
a long position in a call have the same payoffs. In an efficient market, the two
should trade at the same price (in conformity with the law of one price).
Gain
+
Payoff of long position in a put option
Market
K price
Strike price
–
Loss
Figure 7.4 Payoff from holding a long position in a put option
Gain
+
Payoff of long position in a call option
Combined payoff
of short position a
in the underlying
and long call position
Market
K price
Strike price
a’
–
Loss
Figure 7.5 Payoff from a combination of a short position in the underly-
ing asset and a long call position
Note: The combination is also known as a ‘synthetic put’.

The put–call parity theorem states that the value of a put held in conjunction
with the underlying must be the same as the corresponding call together with the
present value of the exercise price:*
Asset + Put = Call + PV(Exercise price) ﴾7.26﴿
Note that this way of putting the theorem differs slightly from the way in which
we explained put–call parity in our earlier discussion. As stated in Equation 7.26, the
left-hand side of the equation is equivalent to a synthetic call. That is, holding the
asset (long position) in conjunction with holding a put is functionally equivalent to
holding the call and investing the present value of the exercise price.
Once we have priced the call, we can derive the value of the put by applying the
put–call parity theorem to deriving the value of the put by rearranging Equation
7.26.
Thus, for our earlier example of a call where the call price was 7.14, the value of
the put can be determined as:
Put = Call + PV(Exercise price) − Asset
2.38 = 7.14 + [100 ÷ (1.05)] − 100
Using the Binomial Option-Pricing Model for Puts ____________
As an alternative to pricing a call and then using put–call parity to value the put,
we can use the binomial option-zpricing model directly to price the put.
Suppose we have a European-style put with two periods (years) to expiry, with
a strike price of 102 and a current asset price of 100. The risk-free interest rate
is 5 per cent and the proportional increase or decrease is 0.20, then the value of
the asset tree with two periods is as shown in Figure 7.6.
144
0
120
0
100 96
80 6
22
64
38
Figure 7.6 Two-period binomial tree with put values where the put has
a strike price of 102
We can compute the probability of a rise or fall as:
. ×
− 0.80
= = 0.6282
1.20 − 0.80
The two-period model therefore values the put as:
( )[ ]
= +2 (1− ) +(1 − )
Inserting the values derived from the binomial tree, we have:
× . × [0.6282 ×0+2×0.6282×0.3718×6+0.3718 ×38]
=
Therefore the put has a value of 8.06.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
* This strictly applies only to European-style options.

Note that the put–call parity theorem is the basis of much arbitrage activity be-
tween options and their underlying assets. If one of the elements of Equation 7.26 is
over- or underpriced, then a riskless profit can be made by selling the overpriced
element or buying the underpriced element and creating a synthetic hedge, so that
there is an instantaneous risk-free gain. Thus if the put was overpriced in the
market, this would be sold short (written) and the synthetic put would be created by
taking a short position in the asset and holding the long position in the call with the
same strike price.
Table 7.9 The combination of long (+) and short (−) positions in the
underlying asset, borrowing and lending used to create synthetic
positions
Combination of option
Synthetic position position and position in the
underlying asset
Long synthetic call + put − PV(exercise price) + asset
Long synthetic put + call + PV(exercise price) − asset
Short synthetic call − put + PV(exercise price) − asset
Short synthetic put − call − PV(exercise price) + asset
Short underlying asset (synthetic short + put − call
forward or future position)
Long underlying asset (synthetic long forward − put + call
or future position)
Note: Combinations of puts and calls create synthetic forward or futures positions.
The other use of the put–call relationship is to create non-existent options or

forward/future type positions in the underlying asset. For example, generally there
are more calls than puts available for exchange-traded options. This means that it
might not be possible to buy the put directly in the market. However, a synthetic
put can be created in the manner shown by holding a combination of a long call and
a short position in the asset and investing the present value of the call exercise price.
(This is the meaning of Equation 7.26.) The principal synthetic positions are
summarised in Table 7.9.

This module has looked at a formal model for pricing call options. It is based on a
discrete time method where the asset value can take only one of two states, either an
increase or a decrease. Given information about the asset’s future price behaviour, it
is possible to price the option.
The value of a call option at expiry will be the difference between the asset price
and the strike price if that is positive (that is, {max. − , 0}). The liability that the
option writer is obligated to deliver is valued through creating a portfolio of the
underlying and borrowing which exactly matches this, the residual cost of setting up
this position being the amount that the option buyer or holder has to pay for the

transaction to be ‘fair’ to both sides. The fair value of an option is thus derived from
the ability of the option writer to create a suitable replicating portfolio. A put option
can be valued by using the put–call parity theorem to price a corresponding put
from the call.
Module 8 will extend the analysis of Module 7 and will examine an analytic solu-
tion to the problem of option pricing that does not require a large number of
calculations. This involves a continuous time model first developed by Fisher Black
and Myron Scholes.
Appendix 7.1: Dynamic Replication of the Option Liability

The key factor for a dynamic replication strategy (also known as a delta hedge)
to hedge out the option liability is to find a self-financing investment strategy
that involves no new net investment of funds after the transaction is initiated. We
have an asset which has a current market value of 100 and a two-period call written
on the asset with an at-the-money strike price of 100. Let us assume that we have
the two-period set of possible outcomes given in Figure 7.7. The asset can have two
values in Period 1: either a rise to 110 or a fall to 90. In Period 2, the tree does not
recombine and the asset can take four values: 132, 108, 88 or 72, depending on the
outcome in Period 1.
Period 1 Period 2 Option

value
Strike price = 100 132 [32]
110 D = 0.7273
108 [8]
100 D = 0.7143 [0]
88
90 D = 0.2222
72 [0]
Figure 7.7 Two-period binomial tree for an asset and the resultant
option values when the strike price is 100
Note: The volatility for periods 1 and 2 are different.
What we want is a portfolio of the underlying asset and borrowings which, once
the initial investment (including the option’s price or value) has been made, requires
no further funds (other than self-liquidating borrowings). Based on the tree, the
value of the call at expiry will be: = 32, = 0, = 8 and = 0.
For convenience of exposition, we will assume the interest rate is 5 per cent
throughout. We can, at the expense of greater complexity, allow for different
interest rates for each period. The value of the call at time 0 is 14.74. (You might
like to work back through the tree yourself to check that this is the correct value.)
We therefore start with the portfolio as given in Table 7.10.

Table 7.10 Initial replicating position at time =

Portfolio Δ × Asset value Value
element
Stock 0.7143 × 100 = (71.43)
Borrowing 56.69
Written call 14.74
Total 0
Note: The delta (Δ) of the position is 0.7143. Note that in this and the subsequent tables there will
be a slight rounding error in totalling the results.
We now move forward to what has happened at the end of the first period and
we look at the situation if the asset price has risen { } or fallen { }. If the price has
risen, dynamic or delta hedging requires that we increase our asset position (borrow-
ing more at the risk-free rate, if necessary) and, if the price has fallen, we reduce our
asset position (using the proceeds to repay existing borrowings).
If the asset price has risen, we now need to increase our holding of the asset by
(0.7273 − 0.7143 × 110). The new portfolio and additional borrowing to ‘rebalance’
the position at time 1 is shown in Table 7.11.
Table 7.11 Value of the replicating portfolio when the asset has risen { }
at time = and after new investment in the asset has been
undertaken
Portfolio element Δ × Asset value Value
Existing asset 0.7142 × 110 = 78.57
New asset purchase (0.7272 − 0.7143) × 110 = 1.43
(A) Total asset position 80.00
Existing borrowing 56.69 × 1.05 = (59.52)

New borrowing (1.43)
(B) Total borrowings (60.95)
Total (A + B) 19.05
Note: The delta (Δ) of the position is now 0.7273.
If, on the other hand, the asset price has fallen at time ( = 1), we need to de-
crease our holding of the asset by (0.7143 − 0.2222 × 90) and pay off some of our
loan. The new portfolio after rebalancing, together with the reduced level of
borrowing, is shown in Table 7.12.

Table 7.12 Value of the replicating portfolio when the asset has fallen { }
at time = and after a sale of part of the asset position has
been undertaken
Portfolio element Δ × Asset value Value
Existing asset 0.7143 × 90 = 64.29
Asset sale (0.7143 − 0.2222) × 90 = (44.29)
(A) Total asset position 20
Existing borrowing 56.69 × 1.05 = (59.52)

Repayment 44.29
(B) Total borrowings (15.24)
Total (A + B) 4.76
Note: The delta (Δ) of the position is now 0.2222.
We now move forward to the next period ( = 2) when the option expires. From
our tree, we have a value for the option ( − ) of 32, 8 or zero, depending on
whether the asset price rose or fell in the first time period.
In the situation where the asset price rose (that is, ), we have the positions as
given in Table 7.13 for the portfolio in the subsequent increase and decrease stage.
Table 7.13 Resultant value of the asset and loan portfolio at time = ,
given that the asset price increased { } at time =
Portfolio Increase {u} Decrease
element {d}
Asset position 0.7273 × 132 96 0.7273 × 88 64
Borrowings 60.95 × 1.05 (64) 60.95 × 1.05 (64)
Total 32 0
In the opposite situation, where the asset price fell in Period 1 ( = 1), we have
the positions of the replicating portfolio as shown in Table 7.14.
Table 7.14 Resultant value of the asset and loan portfolio at time = ,
given that the asset price decreased { } at time =
Portfolio Increase {u} Decrease
element {d}
Asset 0.2222 × 108 24 0.2222 × 72 16
position
Borrowings 15.24 × 1.05 (16) 15.24 × 1.05 16
Total 8 0
As the results from the replicating portfolio show, we have exactly the amounts
required to meet the values of the option ( − ) for each of the four expiry values
given in Figure 7.7.
A few observations on this process are called for.

1. The replicating strategy depended on our ability to buy and sell fractions of the
asset. If we cannot do this, we cannot create a portfolio that matches our liability
and thus we are left exposed.
2. Equally, if there had been transaction costs, we would have needed to factor
these into the result. The degree to which they have an impact on the portfolio
will be a function of how frequently we seek to rebalance the portfolio.
3. The dynamic replicating strategy also assumes that we can borrow and lend as
much as we want at the risk-free rate of interest. Although for illustrative pur-
poses we set the risk-free interest rate for both periods as being the same, there
is no reason we could not have assumed different interest rates for the two peri-
ods.
4. To successfully replicate the result of the option, all we needed were the asset
values in each period for a rise { } and a fall { }. The value of the option at each
stage of the tree was computed from its maturity backwards. The asset and op-
tion values for the upper and lower pair of outcomes in Figure 7.7 were used to
derive the option value at time 0. If we have wrongly computed the future set of
asset values (that is, the asset’s volatility) at time 1 or 2, we stand to gain or lose
depending on whether we have over- or underestimated the future dispersion in
prices.
5. Note that by using this numerical approach we were able to incorporate a higher
volatility for the second step set of outcomes and allow for the fact that the tree
was non-recombining.
Review Questions
7.1 We have an asset which trades in the market today for 50 and which can take a value of
either 55 or 45 in one period. The risk-free interest rate is 4 per cent. What will be the
value of a call option written on the asset which has a strike price of 51?
A. 0.40
B. 2.69
C. 3.63
D. 4.00
7.2 A one-period call option has a high value of 250 for the asset and a low value of 200 for
the asset. If the option strike price is 230, what will be the option’s delta?
A. 0.20
B. 0.40
C. 0.60
D. 0.80

7.3 Using the information from Question 7.2, what will be the amount of borrowed funds
used in the replicating portfolio if the one-period risk-free continuously compounded
interest rate is 5 per cent?
A. 19.02
B. 47.56
C. 76.10
D. 218.78
7.4 If we have a situation where the interest rate r = 0.01 and the increase in the asset
price u = 1.04 and the decrease d = 0.96, what will be the probability of a rise in the
asset price?
A. 0.50
B. 0.54
C. 0.63
D. 0.75
7.5 A put has a value of 20 if the asset price falls one period from now. The probability of a
rise is 0.51 and the risk-free interest rate for the period is 2 per cent. What will be the
put’s current value?
A. 9.6
B. 9.8
C. 10
D. 10.2
We have an asset which can take the following prices after one and two periods where the
risk-free interest rate is 3 per cent per period.
Time 0 Time 1 Time 2

302.5
275
250 250
227.3
206.6
7.6 What will be the delta on a call option with a strike price of 260 at time 1, if the price
increases in the first period?
A. 0.31
B. 0.50
C. 0.81
D. 1.00

7.7 We have a call option on the asset with a strike price of 260. What will be the current
value of the option at time 0?
A. 14.6
B. 16.0
C. 26.8
D. 40.1
We have the following four-period set of asset prices.
Time 0 Time 1 Time 2 Time 3 Time 4

562.8
546.4
530.5 530.5
515 515
500 500 500
485.4 485.4
471.3 471.3
457.6
444.2
The risk-free rate per period is 1 per cent.
7.8 If we have a call option with a strike price at 490, what will be the delta of the option
for the topmost branch in Period 3?
A. 0.30
B. 0.50
C. 0.80
D. 1.00
7.9 If we have a put option with a strike price at 495, what will be the delta of the option
for the third pair (that is, the second pair from the bottom) in Period 4?
A. −1
B. −0.83
C. 0.83
D. 1
7.10 What will be the price difference (in value terms) if we have an in-the-money option
with a strike of 495 with two periods to expiry and the same option with one period to
expiry?
A. 4.4
B. 5.0
C. 9.5
D. 11.2

7.11 If the risk-free interest rate rises from 1 per cent per period to 2 per cent per period
what will happen to the probability of a price rise?
A. The probability of a price rise is unchanged.
B. The probability of a price rise is increased.
C. The probability of a price rise is decreased.
D. There is insufficient information to determine what happens.
7.12 If the upper and lower terminal values for the price series for the four periods are now
550 and 454.5, what has happened to the rate of increase (decrease) in the asset?
A. The rate of increase (decrease) is unchanged.
B. The rate of increase (decrease) has risen.
C. The rate of increase (decrease) has fallen.
D. There is insufficient information to answer the question.
7.13 We have an asset with an annualised standard deviation of 0.40. If we have a three-
month option and employ 50 steps, what will be the increase in the asset price per step
in the binomial model?
A. 1.0008
B. 1.0287
C. 1.0582
D. 1.1052
7.14 If we have an asset with an annualised volatility of 0.25 and we have a 40-step tree for a
37-day option and the applicable risk-free interest rate is 8 per cent, what will be the
risk-neutral probability of a price increase in the lattice?
A. 0.500
B. 0.504
C. 0.506
D. 0.508
7.15 If we have an asset price of 120 and a European-style call and a European-style put with
the same expiry date and a strike price of 100 on the asset:
A. the call will be out-of-the-money and the put in-the-money.
B. the call will be in-the-money and the put out-of-the-money.
C. both the call and the put will be in-the-money.
D. both the call and the put will be out-of-the-money.
7.16 In Question 7.15, if the call is for three months and the risk-free interest rate is 6 per
cent per annum and the call is trading at a market price of 24.50, what will be the value
of the put?
A. 0
B. 3.1
C. 4.4
D. 4.5

7.17 We have a current asset price of 500. There are European-style calls and puts on the
asset with a six-month expiry and a strike price of 490. The price of the call is 33.75 and
that of the put is 1.15. The risk-free interest rate is 10 per cent per annum. Which of
the following is true?
A. The puts and calls are correctly priced.
B. The puts and calls are incorrectly priced.
C. The call is correctly priced but the put is incorrectly priced.
D. The call is incorrectly priced but the put is correctly priced.
7.18 The current asset price is 500. There are European-style calls and puts on the asset with
a three-month expiry on the asset with a strike price of 515. The risk-free rate of
interest is 8 per cent per annum. The call is currently trading in the market at 11.30 and
the put at 17.50. Which of the following arbitrage transactions should you pursue to
take advantage of the mispricing of the puts?
A. Sell the call, borrow the required funds at the risk-free rate to buy the asset
and the put and hold the combined position to expiry to make a profit.
B. Buy the call, sell the asset, lend the proceeds at the risk-free rate and sell the
put and hold the combined position to expiry to make a profit.
C. Sell the put and buy the asset and borrow the proceeds at the risk-free rate,
and buy the call and hold the combined position to expiry to make a profit.
D. Sell the call and buy the asset and borrow the proceeds at the risk-free rate,
and sell the put and hold the combined position to expiry to make a profit.
7.19 An asset has a possible price range of 175−145 over a given period. There is a call
option on the asset with a possible payoff of 9 if the price rises, otherwise it is worth-
less. What will be the delta on the option?
A. 0.3
B. 0.4
C. 0.6
D. 1.0
7.20 We have an asset which trades in the market today for 200 and which can take a value
of either 240 or 160 in one period. The risk-free interest rate is 4 per cent. What will
be the value of a one-period call option written on the asset which has a strike price of
210?
A. 0.38
B. 14.4
C. 17.3
D. 28.9

Case Study 7.1

1 Use the binomial option-pricing model to price a six-period call option given the
following information:
σ = 0.40
(T − t) = quarter of a year
i = 8 per cent
K = 105
S = 100
e = 2.71828
2 Compute the value of the corresponding put with the same strike price. (You will need
to compute the tree of asset and put values since these are needed for Questions 3 and
4.)
3 What is the delta of the put in the fourth period for the second pair of outcomes from
the top?
4 What will the delta of the put move to if the outcome in Period 5 from Question 3 is a
price rise and what will it be if the price falls?
5 What happens to the value of the put if the strike price is reduced from 105 to 104?
References
1. Cox, J., Ross, S. and Rubinstein, M. (1979) ‘Option Pricing: A Simplified Approach’,
Journal of Financial Economics, 7 (Sept.), 229–63.

Module 8
The Product Set II:The Black–Scholes

Contents
8.1 Introduction.............................................................................................8/1
8.2 The Black–Scholes Option-Pricing Formula for Calls ........................8/3
8.3 The Black–Scholes Option-Pricing Formula for Puts .........................8/4
8.4 Properties of the Black–Scholes Option-Pricing Model .....................8/4
8.5 Calculating the Inputs for the Black–Scholes
Option-Pricing Model .............................................................................8/5
8.6 Using the Black–Scholes Option-Pricing Model ............................... 8/12
Case Study 8.1: Applying the Black–Scholes Model ................................... 8/21
Case Study 8.2: The Black–Scholes and Binomial Models ......................... 8/21
Learning Objectives
This module extends the option-pricing method to provide an analytic solution to
the value of calls and puts using the Black–Scholes option-pricing model.
After completing this module, you should know how:
 the Black–Scholes option-pricing model equation works;
 to calculate the inputs used in the model;
 to use the put version of the Black–Scholes model.
8.1 Introduction
The accuracy with which the binomial option-pricing model captures the value of an
option is questionable when there are only a small number of steps used to calculate
the price. As the number of periods to expiry is increased, that is, the period of each
step is made smaller, the number of different possible asset values at expiry increas-
es and the assumption that for each step only two possible outcomes are possible is
a more realistic description of the actual behaviour of asset prices.
As the number of iterations is increased and approaches infinity, the binomial
option-pricing model becomes the equation for the Black–Scholes option-pricing
model. In terms of development, the binomial model is a discrete time generalisa-
tion of the Black–Scholes model. Whereas the Black–Scholes model relies on
continuously adjusting prices, the binomial model assumes that the price moves in

Module 8 / The Product Set II: The Black–Scholes Option-Pricing Model
discrete steps. When the option price is calculated by means of the binomial model,
using a large number of steps (over 50), the fair value (or equilibrium price) is
virtually the same as that given by the Black–Scholes model, which indicates that the
two models are equally accurate.
There are advantages and disadvantages to both models. The attraction of the
binomial model is that it allows individual specification of the price-generation
process (that is, u and d) over time. This is helpful, for instance, in pricing exotic
options or options where the volatility is not proportional to time, as is the case with
interest rates. The disadvantage is that it is computationally cumbersome: but this is
less of a problem when using computers. By contrast, the Black–Scholes model
provides a closed-form analytic solution for the option price. Pricing can be
carried out on a calculator. Reworking the equation also allows the derivation of a
number of useful option value sensitivity or risk measures.* However, there are
disadvantages in using the Black–Scholes model in that it assumes that (a) the
variance in the returns on the asset is constant over the life of the option, (b)
interest rates are constant, (c) the asset price moves continuously (that is, there are
no ‘jumps’ in prices), and (d) asset returns follow a lognormal distribution. In
addition, the model, like other pricing models, assumes no transaction costs and no
intermediate payments such as dividends or interest (value leakages) are made by the
underlying asset.
The assumption of no transaction costs is unrealistic in a world where bid and
offer spreads exist and there will be, in practice, some cost to replicating the
behaviour of the option. The intermediate payment problem can be, as we shall see,
adjusted for quite simply if the amount of the distribution is known in advance.
More serious objections can be raised by the continuous price assumption and the
assumption that asset returns are lognormally distributed. These are complex
technical issues for theoreticians and practitioners alike. Although both assumptions
are violated in reality, empirical evidence on the validity of the Black–Scholes model
as a description of the option price-generating process has shown that the model
provides a good description of observed option prices in the market.
Assumptions Behind the Black–Scholes Option-Pricing Model __
1. The model was originally developed for pricing European-style call options
on non-dividend-paying stocks.
2. It made the following assumptions about distributions of future returns and
the cost of replicating the option using a portfolio made up of a position in
the underlying asset and borrowing:
 the variance of returns (volatility (σ)) is constant over the life of the op-
tion
 the risk-free interest rate ( ) is constant
 investors can borrow or lend at the risk-free interest rate
 a continuous price exists; there are no ‘jumps’ in prices
 stock price behaviour is characterised by a lognormal distribution
* These are discussed in the next module.

 there are no transaction costs or taxes

 all securities or assets are perfectly divisible
 there are no opportunities for risk-free arbitrage
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The Black–Scholes option-pricing model preceded the development of the bi-

nomial model. However, the Black–Scholes model determines the equilibrium price,
or fair value, based on a similar approach to that used by the binomial model using a
replicating portfolio.* The mathematics used to derive the Black–Scholes model are
complex and use stochastic calculus and a heat exchange formula borrowed from
the physical sciences. Although complex to derive, the model is easy to use and
provides an analytic solution to the option price (a ‘fair value’ price).
8.2 The Black–Scholes Option-Pricing Formula for Calls

The formula for deriving the fair price of a European-style call option ( ) on a non-
dividend paying asset or stock ( ) is:†
= ( )− ( )
﴾8.1﴿
( )
where:
ln + + ( − )
﴾8.2﴿
2
=
( − )
ln + − ( − )
2
=
( − )
or, more simply
= − ( − ) ﴾8.3﴿
and:
* Fisher Black and Myron Scholes (1973) ‘The Pricing of Options and Corporate Liabilities’, Journal of
Political Economy, 81 (May–June), 637–59.
† The present valuing of the strike price using the continuous risk-free rate is often written as
( )
. The notation of the Black–Scholes model formula in Equation 8.1 makes it plain that the
strike price is present valued and helps to make the correspondence with the put–call parity formula:
+ = + ( )

U0 current price of the underlying asset or underlier

N(d) cumulative normal probabilities, based on a normal distribution with a
mean of zero and a standard deviation of one
K exercise or strike price
(T – t) time to exercise date (expiry date), t being the transaction date and T the
expiry date
σ 2 annualised variance of the continuously compounded rate of return on
the asset
σ annualised standard deviation of the continuously compounded rate of
return on the asset
r continuously compounded risk-free rate of interest
ln natural logarithm
e 2.71828
We may explain the Black–Scholes equation in terms of our earlier discussion of

how options are priced, in that the first part of the equation 0 · ( 1 ) is the
( )
holding we have in the underlying asset. The second term, ( ) · ( ), is
the amount of borrowed funds. The value ( ) is equivalent to the hedge ratio
used in the binomial model: the hedge ratio or option’s delta is the ratio of the asset
(common stock) that keeps the combined portfolio value the same for a given small
instantaneous change in the asset price.
8.3 The Black–Scholes Option-Pricing Formula for Puts

The corresponding European-style put price on a non-dividend-paying stock ( ) is
found either by using the put–call parity theorem or from a modified Equation 8.1:
= (− )− (− )
﴾8.4﴿
( )
where 1 and 2 are found by Equation 8.3.
8.4 Properties of the Black–Scholes Option-Pricing Model

We can see that the Black–Scholes model correctly prices options when we look at
extreme values. In the case where the asset (or stock) price ( ) becomes very large
relative to the strike price ( ) then the option is almost certain to be exercised. The
call price will therefore be:
( )
= − ﴾8.5﴿
This is the same as would be derived from Equation 8.1. When becomes very
large relative to , both the sub-terms 1 and 2 become very large and the terms
( ) and ( ) approach 1.0.
Equally, for puts when the asset price is very large, the value of the put becomes
zero. This is consistent with the result of Equation 8.4.

If the volatility of the asset approaches zero then the asset is virtually riskless.
The value of the asset will grow at the interest rate to · by time . The
payoff of the option is then:
( )
max( · − , 0) ﴾8.6﴿
The present value of the payoff, discounted at the rate to time , is:
( ) ( )
max( · − , 0) ﴾8.7﴿
( )
max( − , 0)
This is consistent with Equation 8.1.
( )
In the case where > , the no-volatility case implies that for the sub-
equation ln( / ) + ( − ) > 0. As volatility moves towards zero, 1 and 2 tend
towards being positively infinite and the terms in Equation 8.1, ( ) and ( ),
tend towards 1.0. The result is that Equation 8.1 becomes simply:
( )
= −
( )
With the opposite condition, when < , the sub-equation
ln( / ) + ( − ) < 0 applies. Again, as volatility becomes zero, 1 and 2 tend
towards being negatively infinite and the terms in Equation 8.1, ( ) and ( ),
tend towards zero, which gives a zero call price.
8.5 Calculating the Inputs for the Black–Scholes Option-

Pricing Model
In order to be able to use the Black–Scholes formula, we need to calculate the
variables that are used to derive the option price. These are the current (stock) asset
price, the strike or exercise price, the time to expiry, the risk-free rate of interest and
the asset’s return volatility. The original model was for non-dividend-paying stocks.
However, the model can be readily adapted to calculating the value when there is a
dividend or other such value leakage from the underlying asset. We will discuss each
in turn.
The Five (Original) Pricing Factors __________________________
U0 Asset (stock) price

K Strike (or exercise) price
(T– t) Time to expiry
r Risk-free interest rate
σ Volatility (the standard deviation of continuously compounded return
on the asset)
Plus Dividends (or interest, or other interim payment)
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

8.5.1 Asset Price (U0)

The current value of the asset (or stock) price is required. The model assumes that
accurate and up-to-date prices are available since it presumes that the assets are
freely traded in a market. In situations where this is not applicable, for instance in
using the Black–Scholes model to price an option on a piece of real estate, there is
no generally accepted approach that is recommended. Inaccuracies in establishing
the current asset price will transfer into the option valuation.
8.5.2 Strike or Exercise Price (K)

The strike or exercise price will be determined in the option contract. For exchange-
traded options, the options exchange uses a set method for establishing the strike
price. This is usually a function of the value of the underlying, with option series
(that is, options which have a common strike price and expiry date) being intro-
duced that have strike prices set at predetermined intervals. For instance, a table of
currency options, as traded on the Philadelphia Stock Exchange, might look as given
in Table 8.1.
Table 8.1 Exchange-traded option prices for currency calls and puts on
the US dollar/Sterling exchange rate
Calls Puts
Strike Sept. Oct. Nov. Sept. Oct. Nov.
price
1.52 2.73 3.32 3.85 0.57 1.17 1.78
1.53 2.08 2.70 3.26 0.87 1.55 2.19
1.54 1.49 2.20 2.73 1.17 2.00 2.61
1.55 1.03 1.74 2.32 1.71 2.54 3.16
1.56 0.59 1.34 1.91 2.36 3.09 3.73
1.57 0.33 1.02 1.56 3.05 3.76 4.37
Note: The contract size is £31 250 and the premiums are quoted in cents per pound. Note that
the strikes for each series are set 1 cent apart (the US dollar is the quoted currency for sterling).
For the options traded in Table 8.1, there is a limited range of strike prices (at
$0.01 intervals). For over-the-counter options, there are no such limitations, the
strike price being set at whatever price or rate is agreed between the buyer and the
seller.
8.5.3 Time to Expiry (T−t)

The time to expiry will be expressed as a fraction of a year. Thus, if the option has
150 days to expiry, the value of ( − ) will be:
150 ﴾8.8﴿
( − )= = 0.41095
365

Estimates to five decimal places generally provide sufficient accuracy for the
value of the option. The value ( − ) is used twice in the formula, first in the
discounting function − ( − ) and again in adjusting the volatility of the asset ( ).
Practitioners often make the distinction between a trading day and a non-trading
day (weekends and bank holidays) since there is strong empirical evidence that
financial market prices are less volatile when markets are closed. We will return to
this point when looking at estimating the asset’s volatility. Note that, for simplicity,
in our examples we will be assuming that the variability of asset returns is constant
regardless of whether we are dealing with trading or non-trading days.
8.5.4 The Risk-Free Rate (r)

The assumption behind the risk-free rate is that it is a default-free rate. As a result,
the interest rate on Treasury bills has been proposed as being an appropriate rate.
Recall that as a money market instrument, T-bills are a pure discount instrument. In
fact, the quoted prices for T-bills are based on discount rates and the interest rate
has to be calculated from this discount method of pricing. The interest rate in turn
is then made into a continuously compounded rate.
The market price of a T-bill is found using the formula in Equation 8.9:
( − ) ﴾8.9﴿
T- bill = 100 −
Basis
where:
T-billmp is the market price of the bill

id is the quoted discount rate
(T – t) is the time to maturity
Basis is the number of days in the computational year:
for sterling instruments = 365 days
for most other currencies = 360 days
The annualised rate of interest ( ) on the T-bill is then calculated as:
﴾8.10﴿
100 ( )
= −1
T- bill
The Black–Scholes model uses the continuously compounded risk-free interest
rate ( ), so the annualised rate of interest has to be converted to the continuously
compounded rate using the following formula:
= ln(1 + ) ﴾8.11﴿
where ln is the natural logarithm and is the annualised rate of interest derived
from Equation 8.10.

For example, if we have a UK government T-bill with a maturity of 92 days where

the basis is 365 days, which is trading at a middle price (the average of the bid and
offer prices) with a discount rate of 3.4 per cent, the market price of the bill will be:
92
99.143 = 100 − 3.4%
365
The annualised interest rate on this T-bill will be calculated as:
= −1
.
= (1.008644) . −1
= 1.034741 − 1
= 3.4741%
And the continuously compounded interest rate will therefore be:
ln(1.03474) = 0.03415, or 3.415 per cent
Since the Black–Scholes model assumes that funds will be borrowed and lent at
the risk-free rate, it could be argued that the appropriate interest rate should be the
rate at which funds can be borrowed in creating the replicating portfolio. Fortunate-
ly, the option value from the model is not particularly sensitive to the risk-free rate
used and therefore mispecification of the rate is not critical. Practitioners differ in
their response to the problem, some using the T-bill rate or similar, others using a
commercial rate (such as LIBOR). Note that there is a tendency by practitioners to
use the (higher) commercial rate if the transaction is designed to lock in the types of
arbitrage discussed in the previous module, since these may critically depend on the
rate at which funds can be invested or borrowed.
8.5.5 Volatility (σ2, σ)

Volatility is the ‘unknown’ pricing factor in options. The other variables are directly
observable from market prices. In some senses, volatility is what is being traded in
options markets: the future uncertainty on asset values. Without volatility, options –
as we saw above – merely become a form of forward contract.
The Black–Scholes model uses the annualised volatility of the underlying asset
(or stock) return as an input to the valuation formula. The volatility of the asset is a
critically important variable since the value of the option is extremely sensitive to
small changes in volatility. There are three approaches to determining the appropri-
ate value for volatility: the historical volatility method, the implied volatility
method and the forecast volatility method.
The historical method involves calculating the volatility of the asset on the basis
of historical data. This might be daily, weekly or monthly data. The volatility is
defined in terms of the continuously compounded rate of return. The calculation
process takes four steps from converting prices to continuous returns.

Step 1: Calculate the Rate of Return for Each Time Period

The period return is calculated as:
− ﴾8.12﴿
=
where is the simple return for the period − 1 to , is the price at time and
is the price at time − 1.
Step 2: Convert the Simple Rate of Return to the Continuously

Compounded Rate of Return
This involves the same calculation as in Section 8.5.4 above, namely:
= ln(1 + ) ﴾8.13﴿
Step 3: Calculate the Variance of the Continuously Compounded

Rate of Return
The periodic continuously compounded rates of return are used to calculate the
variance of returns:
∑( − ) ﴾8.14﴿
=
−1
The equivalent, a computationally efficient means (here for the standard devia-
tion) of calculating the asset’s volatility, is given in Equation 8.15:
1 1 ﴾8.15﴿
= ∑ , − ∑
−1 ( − 1)
We can compute the standard error of our estimate. It follows that the more
observations we have, the more likely it is that the result is close to the true underly-
ing value. However, if the volatility is shifting over time, we do not want to use data
that are remote in time from the present. The standard error of the estimate can be
computed as:
∗
=
√2
where ∗ is the computed standard deviation from the data. How much error exists
can be seen from Table 8.2, which shows the standard error for an estimate for a
volatility of 0.25 with different values for .

Table 8.2 Effect of sample size ( ) on the standard error ( ) of a

volatility estimate ( ∗) of 0.25
n 5 10 20 50 100 150 200 400
SE 0.079 0.056 0.040 0.025 0.018 0.014 0.013 0.009
Note: The larger the sample, the lower the standard error. In practice, sample sizes for n of
between 150 and 200 observations are usually taken as sufficient for giving an accurate estimate of
the volatility of an asset.
Step 4: Annualise the Variance

The annualised variance of the continuously compounded return is required. The
measurement intervals provide a measure of the variance for the periods in ques-
tion. The annualised variance is the frequency of the observations times the periodic
variance:
= × ﴾8.16﴿
Thus, if the data are based on monthly observations, the annualised variance is
the monthly variance times 12. If the observations had been weekly, the annualised
variance is the calculated weekly variance times 52. If daily observations are made,
the annualised variance is either 252 or 365 (or 366, if a leap year). The reason for
the choice of 252 or 365 days relates to the point made earlier that the observed
volatility of financial markets differs, depending on whether the market is open for
trading. Many practitioners use the number of trading days in the year (252) rather
than the calendar days since this provides a truer reflection of the underlying
volatility.
The standard deviation of continuously compounded returns is then simply the
square root of the variance:
﴾8.17﴿
=
The second approach to deriving an estimate of volatility involves running the

Black–Scholes option-pricing model in reverse in order to back out the implied
volatility that is ‘priced’ in the market prices of traded options. The first four pricing
factors used to value options (current asset price, strike price, interest rate and
expiry date) are directly observable in the market by participants and can be readily
obtained, as can the traded option price. The implied volatility of the traded option
can be derived by a process of iteration. This is achieved by using successive
estimates of volatility until a volatility is found that provides the same price as that
observed in the market.
A quick approximation of the implied volatility in an option price can be had by
using Equation 8.18:
√2 ﴾8.18﴿
≈
( − )

If the option price is 6.5 and the underlier price 100 and there is exactly a quarter
of a year to the option’s expiry, then the implied volatility is:
6.5√2
= 0.33
100√0.25
That is, the volatility is about 33 per cent.
Forecast volatility is derived by means of an estimating technique, typically a time
series method, that aims to predict what volatility will be over the option period.
There is debate about whether a sophisticated estimate of volatility based on
extrapolating historical data or the implied volatility derived from the market prices
of options provides the best estimate for pricing options. The assumption behind
historical estimates is that the past will continue in the future. Implied volatility
provides an estimate of the market’s expectations for uncertainty over the option’s
life.
In practice, participants watch both, using trends in both estimates as a guide to
whether volatility is trading cheap or dear in the market. For option holders, who
are using the instruments as a risk-management tool, the question is perhaps
somewhat irrelevant, except in so far as the price of traded volatility has a very
major impact on the value of the options purchased.
In one respect, the availability of implied volatility estimates is useful in providing
insights into the consensus view of future uncertainty in the market. This term
structure of volatility is a useful additional forecasting tool to, say, the term structure
of interest rates. An example of the term structure of volatility for a range of currency
options is shown in Table 8.3.
Table 8.3 The term structure of implied volatility for currency options
Currency
Period US$/£ €/US$ SFr/US$ Yen/US$ Yen/€ €/£
1m 10.30 14.30 16.20 13.10 11.50 12.00
3m 10.80 13.90 15.50 13.20 11.60 10.90
6m 11.20 13.00 14.30 13.20 11.50 10.20
12m 11.55 12.70 13.80 13.35 11.40 9.80
Comment: Upward- Downward- As for Flat volatility Humped As for

sloping sloping US$/€ curve. volatility US$/€
volatility volatility Volatility curve.
curve. curve. (relatively) Uncertainty
Volatility Falling constant rises with
rises with volatility with term; time, then
term; with term; uncertainty decreases
therefore uncertainty is un-
uncertainty is decreas- changed
is increasing with with time
ing over time
time

Note that we have already stated that all the pricing factors are directly ‘observa-
ble’, except for volatility. In options markets, what is being purchased and sold is
volatility since participants can, on the whole, agree on the value of the other factors
in the option price. Consequently, attitudes to the currently observed volatility,
coupled to a forecast or view of how volatility might evolve over the time horizon,
will determine whether to buy or sell options. In the language of option traders, they
decide whether to be ‘long volatility’ (volatility is cheap) or ‘short volatility’
(volatility is expensive).
8.5.6 The Effect of Dividends

As mentioned earlier, the original Black–Scholes model was based on non-dividend-
paying common stocks or ordinary shares. While this might be considered a
restriction, it is possible to adapt the model to take into account such dividends or
other distributions (that is, value leakages) from the future value of the asset. If a
stock has a current value of 100 and we know that a distribution of 10 is to be made
in a month’s time, the current valuation is based on two elements: the present value
of the dividend to be received in one month and the share value ex-dividend (this
latter component can itself be seen as the present value of other distributions or
future dividends):
( )
= + ·
﴾8.19﴿
where 0 is the current share price, 0 is the ex-dividend share price and 1 ·
− ( −)
is the present value of dividend to be received at time ; is the continuous-
ly compounded rate of interest over the time ( − ).
If we know the distribution that will be made, we can simply adjust the current
asset price ( ) to take account of this. In effect, we take off that part of the asset’s
value, the dividend or interest payment, which does not accrue to the option holder.
This method is not infallible, as for example with the case of unknown or unex-
pected distributions. This is where the opportunity to exercise early and capture the
value distribution becomes valuable. This is possible with American-style options.
This additional benefit means that the opportunity to exercise early leads to such
options trading at a higher price (value) than European-style options, which can
only be exercised at expiry. The complications of valuing American-style options are
deferred to a later module.
8.6 Using the Black–Scholes Option-Pricing Model

The only remaining stage is to use the inputs to calculate the fair value of the call
option using the Black–Scholes formula. The required inputs are therefore going to
be those given in Table 8.4.

Table 8.4 Inputs required for the Black–Scholes option-pricing model

Input Symbol Value
Asset (stock) price 90
Strike (or exercise) price 100
Time to expiry (days) ( − ) 180
Risk-free interest rate 0.0557
Volatility 0.25
0.0625
Recall that the Black–Scholes formula is:

= ( )− ( )
( )
where:
ln + + ( − )
2
=
( − )
ln + − ( − )
2
=
( − )
or, more simply:
= − ( − )
First the values for the inputs to the formula, 1 and 2, need to be calculated:
0.0625 ﴾8.20﴿
ln(90÷100) + 0.0557+ (0.49312)
= 2
0.25√0.49312
−0.1054 + [0.08695](0.49312)
=
0.17556
= −0.35589
The variable 2 is calculated as:
= −0.35589 − (0.25)√0.49312 ﴾8.21﴿

= −0.35589 − 0.17556
= −0.53145
The values of the normal distribution corresponding to ( )are found from
Table 8.6, where the nearest corresponding numbers are as given in Table 8.5.
Table 8.5 Values for ( )

Lower corresponding
Value of value for ( ) taken
from Table 8.6
= −0.35589(−0.35) 0.36317
= −0.53145(−0.53) 0.29806

These values for ( ) from Table 8.5 are then used to find the price of the call
option:
= ( )− ( )
( )
100 ﴾8.22﴿
= (90)(0.36317) − . ( . )
(0.29806)
2.71828
= 32.6853 − 28.9984
= 3.6869
The value of the call is 3.69.
Pricing Error from not Interpolating the Normal Distribution
Table ______________________________________________________
In Equation 8.22 we used the values derived from Table 8.6, which does not
interpolate the gap between the two values in the table. In so doing, we have
slightly overestimated the value of the option. If we interpolate between the
observed points on the table, we have the following values for ( ) and ( ).
The value of 1 is 0.35589, that is, it lies 59/100 of the way between 0.35 and
0.36. The difference between the two points on the normal distribution is
0.003746, so that the linear interpolated value of ( ) should be:
59 ﴾8.23﴿
0.36317 − × 0.003746 = 0.36096
100
A similar calculation for ( ) gives a value of 0.29754. The corrected value for
the call is therefore:
100 ﴾8.24﴿
= (90)(0.36096) − . ( . )
(0.29754)
2.71828
= 32.4864 − 28.9476
= 3.5388
That is, failure to interpolate the points has overestimated the calculated option
value by 0.15 (3.69 − 3.54).
A fully accurate calculation of the point of 1 and 2 on the normal distribution
would have given an option price of 3.5375. Thus the linear interpolation
approach gives an option value that is correct to two decimal places.
It is worth pointing out that accurate estimates of ( ) and ( ) are required
and interpolation is necessary if using the table of areas under the normal curve.
The equation approach will give the correct value directly.
We can use the put–call parity relationship to price the corresponding put:
Put + stock (asset) = call + PV(exercise price) ﴾8.25﴿

Rearranging gives:
Put = call + PV(exercise price) − stock (asset) ﴾8.26﴿

so that:

10.8305 = 3.54 + 97.2905 − 90

Since the call is out-of-the-money, the corresponding put priced by the put–call
parity theorem is in-the-money.*
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Using the Black–Scholes Put Equation _______________________

As an alternative to the put–call parity method, we can calculate the put value
directly by using Equation 8.4.
= ( )
(− )− (− )
We therefore have:
100 ﴾8.27﴿
= . ( . )
(0.72045) − 90(0.63904)
2.71828
= 10.8280
The above result from Equation 8.27 was calculated using the true values for
(− ) and (− ) on the normal distribution. The model agrees with the
result computed from the put–call parity method to two decimal places.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Interpolating from a Table __________________________________

Table 8.6 provides values for dx used to derive N(dx) to two decimal places. To
ensure accurate pricing using the Black–Scholes model, values to four decimal
places are required. Reasonably accurate approximations to the true value of dx
can be obtained by interpolating between the points. Let us assume that a value
for of 0.0865 has been found. From Table 8.6, we have:
(0.08) = 0.53188
(0.09) = 0.53586
The value of 0.0865 lies 65/100 between the points N(0.08) and N(0.09). We
interpolate the difference between the two values – using a straight line method
– by:
65
(0.0865) = [ (0.09) − (0.08)] (0.08) +
100
= 0.53188 + 0.65[0.53586 − 0.53188]
= 0.53447
As shown earlier, if the value had been negative, the difference is subtracted.
To be accurate you will need to calculate dx to four decimal places and hence
the table should be used with interpolation between the values for the last two
digits. For example, if we have a value of –.3575, we:
(−0.3575) = (−0.35) − 0.75 [( (−0.35) − (−0.36)]
= 0.3632 − 0.34 [0.3632 − 0.3594]
= 0.36036
* Its value is made up of 10 of intrinsic value ( − ) and 0.8305 of time value.

Table 8.6 Normal distribution table for dx when value is less than zero (dx ≤ 0)
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.4960 0.4920 0.4880 0.4840 0.4801 0.4761 0.4721 0.4681 0.4641
–0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
–0.2 0.4207 0.4168 0.4129 0.4090 0.4052 0.4013 0.3974 0.3936 0.3897 0.3859
−0.3 0.3821 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
−0.4 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
−0.5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776
−0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
−0.7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
−0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1867
−0.9 0.1841 0.1814 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1611
−1.0 0.1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379
−1.1 0.1357 0.1335 0.1314 0.1292 0.1271 0.1251 0.1230 0.1210 0.1190 0.1170
−1.2 0.1151 0.1131 0.1112 0.1093 0.1075 0.1056 0.1038 0.1020 0.1003 0.0985
−1.3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
−1.4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
−1.5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0582 0.0571 0.0559
−1.6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
−1.7 0.0446 0.0436 0.0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
−1.8 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0.0294
−1.9 0.0287 0.0281 0.0274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
−2.0 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183
−2.1 0.0179 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
–2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.0119 0.0116 0.0113 0.0110
–2.3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0.0089 0.0087 0.0084
–2.4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
–2.5 0.0062 0.0060 0.0059 0.0057 0.0055 0.0054 0.0052 0.0051 0.0049 0.0048
–2.6 0.0047 0.0045 0.0044 0.0043 0.0041 0.0040 0.0039 0.0038 0.0037 0.0036
–2.7 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028 0.0027 0.0026
–2.8 0.0026 0.0025 0.0024 0.0023 0.0023 0.0022 0.0021 0.0021 0.0020 0.0019
–2.9 0.0019 0.0018 0.0018 0.0017 0.0016 0.0016 0.0015 0.0015 0.0014 0.0014
–3.0 0.0013 0.0013 0.0013 0.0012 0.0012 0.0011 0.0011 0.0011 0.0010 0.0010
–3.1 0.0010 0.0009 0.0009 0.0009 0.0008 0.0008 0.0008 0.0008 0.0007 0.0007
–3.2 0.0007 0.0007 0.0006 0.0006 0.0006 0.0006 0.0006 0.0005 0.0005 0.0005
–3.3 0.0005 0.0005 0.0005 0.0004 0.0004 0.0004 0.0004 0.0004 0.0004 0.0003
–3.4 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0002
–3.5 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002
–3.6 0.0002 0.0002 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
–3.7 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
–3.8 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
–3.9 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
–4.0 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Table 8.7 Normal distribution table for dx when value is greater than zero (dx ≥ 0)
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
3.5 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998
3.6 0.9998 0.9998 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.7 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.8 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.9 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
4.0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000

To be accurate you will need to calculate dx to four decimal places and hence
the table should be used with interpolation between the values for the last two
digits. For example, if we have a value of .7525, we:
(0.7525) = (0.75) + 0.25 [( (0.76) − (.75)]
= 0.7734 + 0.25 [0.7764 − 0.7734]
= 0.77413
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Polynomial Approximation to the Normal Distribution ________

An alternative approach to using the tables if one has access to a calculator with
power functions and a memory is to make use of a polynomial approximation of
the normal distribution. The following four-expansion equation is relatively easy
to use on a hand calculator:
( ) = 1 − ′( )( + + )
when ≥ 0 and
( )=1− ( )
when < 0 and where:
1
=
1+
1 /
′( ) =
√2
= 0.33267
= 0.4361836
= −0.1201676
= 0.9372980
This formula provides estimates of N(d) that are normally accurate to four
decimal places and always within 0.0002.
Using the earlier example, the value of 1 is −0.35589. The value of ′( ) is
0.374461, that for is 1.134293, and the resultant value for ( ) is 0.36041.
This is only slightly different from the interpolated value of 0.36096.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

This module has introduced an analytic method for pricing options, the well-known
Black–Scholes option-pricing model. The advantage of this analytic approach is that
it provides an exact closed-form equation for pricing the option rather than requir-
ing the iterative method of the binomial model. That said, both models – if used
correctly – provide a close result, especially if a large number of steps are used for
the binomial tree. Nevertheless, the attraction of the Black–Scholes model is that it
is easy to use, requiring a simple hand calculator and a set of tables giving the
ordinates under the normal distribution.
Because of these and other advantages, the model will be used in Module 10
which extends the approach to assets other than the non-dividend-paying stock for

which it was originally developed. The Black–Scholes model also allows the user to
calculate useful sensitivity measures, known colloquially as ‘the Greeks of option
pricing’, for measuring the effects of changes in one of the pricing variables on the
value of the option. These effects are discussed in the next module.
Review Questions
8.1 The binomial option-pricing model uses ____ time whereas the Black–Scholes model
uses ____ time and further assumes that the underlying asset’s volatility is ____ and
that ____ computational methods are used to derive the option price.
A. discrete continuous constant closed-form
B. continuous discrete variable numerical
C. discrete continuous variable closed-form
D. continuous discrete constant numerical
8.2 If there are 466 days to expiry on an option, what will be the value for time in the
Black–Scholes equation?
A. 0.78
B. 1.28
C. 2.20
D. 15.53
8.3 The current quoted rate for a three-month sterling Treasury bill is 6.55 per cent. What
is the corresponding continuously compounded risk-free rate as used in the Black–
Scholes option-pricing model?
A. 1.60 per cent.
B. 6.55 per cent.
C. 6.60 per cent.
D. 6.83 pet cent.
8.4 The price of a 150-day US Treasury bill is quoted in the market at 98.50. What is the
corresponding continuously compounded risk-free rate as used in the Black–Scholes
option-pricing model?
A. 1.51 per cent.
B. 3.68 per cent.
C. 3.71 per cent.
D. 3.75 per cent.
8.5 If we have a weekly volatility of 0.018, as measured by the standard deviation of the
continuously compounded returns on an asset, what will be the corresponding annual-
ised volatility for the asset as used in the Black–Scholes option-pricing equation?
A. 0.06
B. 0.13
C. 0.34
D. 0.94

8.6 We have an estimate of volatility of 0.36 for a particular asset using 75 observations.
What will be the standard error of the volatility estimate?
A. 0.004
B. 0.005
C. 0.029
D. 0.042
8.7 We have the following estimates for the volatility of at-the-money options with different
expiry dates:
Expiry date 0.25 year 0.50 year 0.75 year 1 year

Implied volatility 0.18 0.17 0.15 0.14
Which is correct?
A. Volatility is increasing with time and hence future value uncertainty is also
increasing.
B. Volatility is decreasing with time and hence future value uncertainty is also
decreasing.
C. Volatility is constant with time and hence future value uncertainty is also
constant.
D. There is no pattern to future volatility and hence no pattern to future value
uncertainty.
8.8 A common stock has a current market price of $125 and a dividend of $4 is expected in
two months’ time. There is a three-month European-style call option available on the
stock with a strike price of 115. The continuously compounded risk-free interest rate
for two months is 5.35 per cent and for three months 5.65 per cent. What is the stock
price for option valuation purposes (to the nearest dollar)?
A. $114.
B. $121.
C. $125.
D. $129.
8.9 An ordinary share has a value of 265 pence in the market. There is a net interim
dividend of 12.5 pence due on the share in 115 days’ time. There is a 122-day expiry
European-style call option on the share with a strike price of 255. The current continu-
ously compounded risk-free interest rate for 115 days is 6.5 per cent and for the 122-
day period 6.54 per cent. After adjusting for the value leakage, is the option currently:
A. slightly out-of-the-money?
B. at-the-money?
C. slightly in-the-money?
D. deeply in-the-money?

8.10 If we have a monthly volatility of 0.029, as measured by the standard deviation of the
continuously compounded returns on an asset, what will be the corresponding annual-
ised volatility for the asset as used in the Black–Scholes option-pricing equation?
A. 0.06
B. 0.10
C. 0.35
D. 0.41
Case Study 8.1: Applying the Black–Scholes Model

Current market conditions
Current share price 120
Strike price on the option 140
Term on the option (time to expiry) 60 days
Discount rate on a 60-day T-bill 4.3%
Stock’s volatility (σ) 20%
1 Use the information given to obtain the call price, together with its corresponding put,
on the non-dividend-paying ordinary share.
2 Is the call in-the-money, at-the-money or out-of-the-money? What is the situation as

regards the corresponding put?
3 What is the hedge ratio or delta of the two options? What does it say about the
likelihood of the option being ‘in-the-money’ at expiry in 60 days’ time?
Case Study 8.2: The Black–Scholes and Binomial Models

Calculate the price of a call option using:
1 the Black–Scholes option pricing model; and
2 a six-step binomial model and compare the price of the option.

Module 9
The Product Set II: ‘The Greeks of

Option Pricing’
Contents
9.1 Introduction.............................................................................................9/2
9.2 The Effect on Option Value of a Change in the Pricing Variables ....9/3
9.3 Sensitivity Variables for Option Prices.................................................9/3
9.4 Asset Price (U0) and Strike Price (K) / Delta (δ), Lambda (λ)
and Gamma (γ) .......................................................................................9/5
9.5 Option Gamma (γ) .............................................................................. 9/13
9.6 Time to Expiry / Theta (θ) .................................................................. 9/18
9.7 Risk-Free Interest Rate (r) / Rho (ρ) .................................................. 9/24
9.8 Volatility (σ) / Vega (ν) ........................................................................ 9/26
9.9 Sensitivity Factors from the Binomial Option-Pricing Model ........ 9/29
9.10 Option Position and Sensitivities ....................................................... 9/33
Case Study 9.1: Option-Pricing Sensitivities ............................................... 9/43
Learning Objectives
Options have complex behaviour. This is due to the multidimensionality of the
pricing variables involved. In order to understand option behaviour it is necessary to
know how they respond to changes in the value of the pricing factors. The sensitivi-
ty of the option price to changes in the pricing factors is colloquially known as ‘the
Greeks of option pricing’. This is because these value sensitivities to changes in one
of the pricing variables, derived from the option pricing model, are characterised by
Greek letters of the alphabet.
The key Greeks of option pricing are delta, gamma, rho, theta and vega. Delta
measures the sensitivity of option price to changes in the price of the underlying
asset. Gamma shows the rate of change in the option delta. Rho is the option
sensitivity to changes in interest rates; theta is the sensitivity of the option to time
decay; and vega, the sensitivity to changes in volatility.
After completing this module, you should understand:
 the multidimensional character of options;
 how sensitive option values are to changes in each of the pricing factors;
 the importance of delta, gamma, rho, theta and vega as measures of option-price
sensitivity;

Module 9 / The Product Set II: ‘The Greeks of Option Pricing’
 how values respond over the life of the option;

 the use of option sensitivities in structuring option strategies within a market
view.
9.1 Introduction
The organisation I worked for in the City often took advantage of market opportu-
nities to create securities that were attractive to investors. At one point, a significant
increase in the gold price led our organisation to issue a series of gold warrants that
allowed the holder to benefit from any further price increases. The warrants were, in
fact, securitised call options on gold and had all the characteristics of options but, in
addition, were also listed on an exchange as securities. Following the launch of these
securities and their placing with investors, our institution committed to making a
market in the warrants and I became partly responsible for trading these. What
happened just after the warrant issue was that the gold price reversed itself and the
warrants became somewhat out-of-the-money. The spurt in volatility that had
prompted the issue ceased and the gold price stabilised within a very narrow range.
Holders of the warrants who had hoped to benefit from further increases had to
decide what to do. They could either sell back the warrants to us at a loss, or hold
on. Most of the buyers decided to hold the warrants, which had an 18-month life, to
see if the gold price subsequently revived.
Since our institution had issued the warrants, it was natural that holders should
ask us to indicate their current price for portfolio valuation purposes. We were only
too happy to provide this service. Investors would phone us up regularly to ask for a
price for ‘valuation purposes’. As time passed, the gold price remained becalmed in
its narrow range and the value of the warrants began to fall. A few weeks after
launch they were quoted at US$45 each, a month later US$42, and later still US$39.
This puzzled a number of the holders since the gold price was essentially static.
What they had failed to realise was that, as time passed, the value of the option was
wasting away. They had not understood the nature of options and the sensitivity of
the option price to time decay. An understanding of ‘the Greeks’ of options would
have immediately alerted them to the fact that, for an option holder, time or theta
(the Greek alphabet letter, written as θ) had a negative sensitivity. The opposite
applied to our institution as the writer. Each passing day the option value declined,
the holders lost out (note that all the option value in the warrants was time value)
and the writer, with a short position in the option, gained since the value at which
they could be repurchased fell.
The above illustrates that understanding option sensitivities is not difficult. Any
experience with options soon shows how they behave. A simple exercise recalculat-
ing the option value for different remaining maturities would have demonstrated the
effect of time decay on their value. While such revaluation may be sufficient, there
are a number of analytic sensitivity factors, ‘the Greeks of option pricing’, which
require the basic valuation equation, Black–Scholes in this module, to be differenti-
ated in respect of the appropriate pricing factor. Each of the key pricing factors has
its own Greek letter, whereas volatility has more than one. The most important ones

are delta, gamma, rho, theta and vega. Delta refers to the option price sensitivity to
changes in the underlying asset. Gamma is the rate of change in delta (that is, it is
the second derivative of option value to price). Rho is the option sensitivity to
interest rates. Theta is the sensitivity of the option to time. Vega (or one of the
other names used) is the effect of changes in volatility on value. Another potentially
useful measure is lambda which is the leverage (or gearing) of the option with
respect to the underlying asset.
The following sections detail the nature and effects of the different sensitivity
factors. The effects are best understood visually but numerical examples are also
given when appropriate. To become familiar with option behaviour, the reader
should also calculate option prices for a range of values for each pricing factor.
Seeing how options behave as the numbers are changed is the best way to under-
stand the multidimensional behaviour of options in response to changes in the
different pricing factors.
9.2 The Effect on Option Value of a Change in the Pricing

Variables
The value of an option is sensitive to the pricing factors used to determine its value.
Table 9.1 lists the effect of an increase in the pricing variables and the correspond-
ing direction and reason for the change in the values of calls and puts. Most of the
changes are self-explanatory. It should be noted that the values of calls and puts do
not necessarily behave in the same way when the pricing variables increase.
The reason that calls and puts do not behave in exactly the same manner when all
the pricing factors are changed relates to the transaction they entitle the holder to
undertake. Recall that a call is a form of deferred purchase at a given price, a put a
deferred sale. For instance, deferring a purchase when interest rates rise increases
the value of the call since the holder can now invest the amount of the strike price
at the higher interest rate. (The equivalent result is that the present value of the
strike price required to be available to exercise the call is reduced.) With the put, the
opposite occurs. Deferring a sale reduces the opportunity for reinvestment at a
higher rate. Equally, the effect of an increase in the asset price on calls is obvious:
the difference between and increases, for the put the opposite is true, there is a
reduction in the difference between and , hence the fall in put value. The same
logic applies to the strike price ( ).
9.3 Sensitivity Variables for Option Prices

The changes in option values described in Table 9.1 can be modelled analytically by
reworking the Black–Scholes option-pricing equation to derive a series of sensitivity
measures that predict the degree of price response in the option to changes in the
pricing variable. The names and explanations for these pricing sensitivities are given
in Table 9.2.

Table 9.1 Reasons for option price changes for calls and puts when option-pricing
variables change
Increase in Call Put
Asset (stock) price plus (+) minus (−)
With a rise in the asset price, the With a rise in the asset price, the
difference between and difference between and
changes. An OTM option moves changes. An OTM option moves
nearer to ATM; an ITM option further OTM; an ITM option moves
moves to become deeper ITM. to become OTM. That is, the put
That is, the call option’s delta option’s delta decreases.
increases.
Strike (or exercise) price minus (−) plus (+)
The higher the strike price (K) The higher the strike price (K)
relative to the asset price ( − relative to the asset price ( −
), the smaller the potential gain ), the greater the potential gain
and the less likely the option will and the more likely the option will
have a positive value at expiry. have a positive value at expiry.
Time to expiry* plus (+)
The longer the time to expiry, the greater the chance that the option will
have a positive value at expiry.
Risk-free interest rate plus (+) minus (−)
Deferring a purchase means the Deferring a sale means the greater
greater the discount on the present the discount on the present value
value of the exercise price, or the of the exercise price, or the
greater the opportunity to earn greater the opportunity lost to
interest on the value of the earn interest on the cash realised
exercise price. by the exercise.
Volatility plus (+)
Increases the probability that the option will have a positive value at
expiry.
Dividends, or interest minus (−) plus (+)
payments (value ‘leak- Deferring the purchase reduces the Deferring the sale increases the
ages’) opportunity to receive the dividend opportunity to receive the dividend
or income from the asset which or income from the asset which
therefore ‘leaks’ value. The asset may be reinvested at the risk-free
price will be correspondingly rate. The asset price will be
lower, reducing the difference correspondingly lower, increasing
between and . the difference between and .
* Strictly speaking this factor is indeterminate for calls if there is potential value leakage before expiry, and for puts
there are conditions under which early exercise may be the best course of action.
Note: OTM: out-of-the-money; ATM: at-the-money; ITM: in-the-money; is the strike price; is the price at
expiry.

Table 9.2 Sensitivity variables for the Black–Scholes option-pricing

model
The Greek
name given to
Variable sensitivity Relationships
factor
Asset (stock) price Delta (δ) The change in the option price for a given
change in underlying asset price
(the ‘underlying’) (hedge ratio)
( )( )
Gamma (γ) The change in delta for a given change in the
underlying asset price
Lambda (λ) The percentage change in the option price for a
given percentage change in the asset price
(gearing/leverage)
Time to expiry Theta (θ) The change in the option price given a change in
( − ) the time to expiry
Risk-free interest Rho (ρ) The change in the option price for a given
rate ( ) change in the risk-free rate
Volatility (σ) Vega (ν) The change in the option price for a change in
the underlying asset’s volatility
Note: Vega, the sensitivity of the option price to changes in volatility, is variously known as kappa,
lambda (confusingly with lambda as the option elasticity), zeta and epsilon!
The following sections look in detail at how the option price responds to changes
in each of the pricing variables.
9.4 Asset Price (U0) and Strike Price (K) / Delta (δ), Lambda
(λ) and Gamma (γ)
The payoff of an option will be the difference between the price of the asset at
expiry and the contractual strike price. The obligation of the option writer to deliver
or receive will only occur if this difference is positive. The holder’s payoffs are
shown in Table 9.3, the writer’s position being the exact opposite (ignoring the
premium gained from selling the option).
Table 9.3 Call and put option payoffs at expiry

Option type Payoff for option holder
Call Maximum (0, − )
Put Maximum (0, − )
Note: The writer’s payoff is the opposite of those for the holder.
For a given option, other pricing variables being constant, an increase in the price
of the underlying asset will cause the call value to increase and the put value to
decrease. The change in the price of an option with respect to a given change in the

underlying instrument goes by the name of the option’s delta (δ). This is also the
variable ( ) in the Black–Scholes formula. It is also the asset ‘equivalence’ of the
option position and is also referred to as the ‘hedge ratio’ since it is the amount of
the asset that needs to be held when dynamically replicating the option’s payoff.
This is because, for option replication purposes, it provides the hedger with the
proportion of the underlying that has to be held so as to eliminate the contractual
exposure. Dynamic replication involves rebalancing the proportion of the underly-
ing over time as the delta changes. The deltas for calls and puts are:
(Call option price) ﴾9.1﴿
delta = = = ( )
(Asset price)
(Put option price) ﴾9.2﴿
delta = = = ( )−1
(Asset price)
Prior to the option’s expiry, the requirement of the short to deliver will range from
near zero (when the option is deeply out-of-the-money) to near certainty (when the
option is deeply in-the-money). In the Black–Scholes model, it is the variable that
provides an indication of how much of the asset the writer needs to hold in antici-
pation of future exercise.
But delta is not just the hedge ratio in the option-pricing model. It is also the
ratio of the change in the option price for a given change in the asset price. For
example, a delta of 0.45 means that a change in value of the underlying price by a
factor of one (say from 95.50 to 96.50) will cause an increase of 0.45 in the value of
the option. That is, an option value of 10.25 will increase to 10.70. This relationship
between option price and the underlying is, however, non-linear. The rate of change
in delta will be highest when the option is at-the-money, and lowest when the
option is deeply in-the-money or deeply out-of-the-money. A deeply out-of-the-
money option will hardly be affected by a small change in the underlying asset price.
This is because a small change in the asset is unlikely significantly to change the
chance of the option becoming in-the-money. At the other extreme, the opposite
holds and the value of a deeply in-the-money option is nearly all intrinsic value.
Delta as the Hedge Ratio for Written Options ________________
Consider a written (sold) call option position where the option’s delta is 0.55
(slightly in-the-money). This means that as the underlying asset price changes,
the option value changes by 55 per cent of the asset price. Let us suppose that
the current underlying price is £100 and the option has a value of £5, that 100
options on the asset have been written and that each option entitles the holder
to buy 100 units of the asset. The delta hedge position for the writer is to hold
5500 units of the asset (10 000 × 0.55 = 5500). For small changes in the underly-
ing value, the gain (or loss) on the written option position will tend to be offset
against the loss (gain) on the asset. If the asset price should rise by £1, this
produces a gain of £1 on the 5500 units held, or £5500. However, the option
price will also have risen by 55 pence, giving a loss of £5500 (0.55 × £1 × −100 ×
100 = (£5500)) to the writer. The opposite occurs if the price of the asset had
fallen, the written position has the gain and the asset position the loss.

The delta of the written option position is −5500 (0.55 × −10 000) and that of
the long position in the asset +5500. That is, the writer loses (5500·δ·asset
price) when the asset price increases but gains (5500·δ·asset price) on the
underlying position. Such a hedged position is also known as being delta
neutral.
It should be noted that, since the option delta is not linear the position will have
to be rebalanced over time. Changes in the asset price will change the delta, as
will time decay. As we show in the next section, even if the asset price did not
change, the delta position would need to be adjusted as the remaining life of the
option decreased.
The risk measure for an option’s delta is known as gamma. Since the real world
involves transaction costs and other costs, the frequency with which positions
need to be adjusted will have an impact on the profit and hence price at which
options will be written.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The initial step in understanding delta is to realise that the delta of the underlying
asset will always be one, if a long position, and minus one, if a short position. The
delta of long and short positions in calls and puts will be different. A long call will
have a positive delta with a range from 0 to +1; long puts will have a delta from −1
to 0. This arises from the fact that the value of a put increases as the asset price falls;
therefore put value has a negative price relationship or sensitivities to the asset price.
For short positions in calls and puts the above coefficients are reversed. Thus a
short position in a put will have a delta from 0 to +1.
The relationship of delta and option price is shown in Figure 9.1. This clearly
shows that the rate of change in delta is greatest when the option is at-the-money.
Note that the steepness of the slope, that is, the rate of change in delta, is measured
by gamma, another of the Greeks, which as we shall see below is at its highest when
the option is at-the-money and declines when the option moves into or out-of-the-
money. That is, gamma measures the steepness of the delta curve.
80
70
60 Option price
Option price
50 Delta
40
30
20
10
0
50 80 110 140 170
Asset price
Figure 9.1 How the hedge ratio (delta) changes in relation to the option
value for a call
Note: The strike price = 100, the time to expiry is six months, r = 5.57%, the standard deviation =
0.25.

The volatility of the underlying asset will also have an effect on delta. The higher
the volatility, the greater the delta ‘spread’. This is shown in Figure 9.2. There is a
simple explanation for this. If the volatility is low, the same change in asset value is
likely to have a greater impact on the option value than the same change when the
option has a higher volatility. As a result, the steepness of the delta in Figure 9.2
declines as volatility rises. That delta can change in this way demonstrates the
complex interactions that are likely to occur in option values when the pricing
factors all change in different ways!
1
0.9
0.8
0.7
0.6 Sd = 0.1
0.5 Sd = 0.2
Delta
Sd = 0.4
0.4
0.3
0.2
0.1
0
50 70 90 110 130 150 170
–0.1
Asset price
Figure 9.2 The effect of volatility on delta

Note: The strike price is 100 and the option has six months to expiry.
9.4.1 Position and Delta Sensitivity

To conclude our understanding of delta, we note that it measures how sensitive the
option is to changes in the underlying asset. However, it also provides a guide to the
position to adopt to benefit from expected changes in the price of the underlying
asset. The desired delta sensitivities to adopt to take advantage of a particular
directional view in the underlying price are given in Table 9.4.
Table 9.4 The effect of position delta and the direction of the market
Position delta Direction of movement in the asset price
(δ)
Positive (+) Bullish: an increase in value will increase the value of the
position
Neutral (0) Neutral: the position value is indifferent to changes in the asset
price
Negative (−) Bearish: a decrease in value will increase the value of the
position
Note: The writer’s payoff is the opposite of those for the holder.

Portfolio Delta _____________________________________________

The delta of a portfolio of options and other securities held is simply the
weighted sum of the individual positions in the portfolio:
= ∑ ﴾9.3﴿
where the th delta has the appropriate positive or negative sign. Thus a
portfolio of written and purchased options will be the sum of the positive and
negative deltas. A portfolio where the delta is zero is known as delta neutral.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
9.4.2 Intrinsic and Time Value

Figure 9.3 shows that the time value of an option is at its highest when the option is
at-the-money. The option is all time value when at-the-money. When it becomes
deeply in-the-money, the option is nearly all intrinsic value, reflecting the fact that it
is acting very much like a forward contract. That is, the time value for the deeply in-
the-money option (which is bound to be exercised) is virtually all made up of the
benefit to be gained from being able to defer the purchase until the option’s expiry.
80
Call at expiry
70 Call with 6 months to expiry
60
50
Call price
40
30
20
10
0
50 70 90 110 130 150 170
–10
Asset or stock price
Figure 9.3 The value of an option before expiry

Note: The shaded area represents the time value of the option and the diagonal line, the intrinsic
value. Note that the time value is greatest when the option is at-the-money.
We can also show the same relationship by expressing the time value against
delta, as in Figure 9.4. The time value increases from nothing, when the option has a
delta of zero, and gradually rises to a peak when the option is at-the-money and the
delta is 0.5. The time value then declines to a minimum value when the delta is near
one, reflecting the point at which the option is virtually bound to be exercised and,
as a result, represents a deferred purchase.
Deltas will not only change in response to changes in the asset price, but also
respond to the change in the time to expiry. As the time remaining on the option is

reduced, the delta of an in-the-money option increases and that of an out-of-the-

money option decreases. This is illustrated in Figure 9.5.
6
Time value
5
Time value
0
0.00 0.01 0.04 0.12 0.27 0.46 0.64 0.78 0.88 0.94 0.97 0.99 0.99 1.00 1.00 1.00
Delta
Figure 9.4 The relationship of the time value to the option delta
Note: The time value is highest when the option is at-the-money.
1.2 In-the-money
Out-of-the-money
1 At-the-money
0.8
0.6
Delta
0.4
0.2
0
0.5 20 40 60 80 100 120 140 160 180 200 220 240 260
–0.2
Time
Figure 9.5 The effect of the time decay on the option delta

Adjustments to Delta _______________________________________

Deltas need to be adjusted if the underlying pays a dividend or is an option on a
futures contract or a currency. The adjustments to the delta are given below.
A European-style Call Option on a Stock Index with a Dividend Yield
(d)
( )
= ( ) ﴾9.4﴿
where ( − ) is the remaining life of the option and ( ) is as previously
defined.
A European-style Put Option on a Stock Index with a Dividend Yield

(d)
( )
= ( ( ) − 1) ﴾9.5﴿
A European-style Call Option on a Futures Contract

( )
= ( ) ﴾9.6﴿
where is the risk-free rate for the period ( − ).
A European-style Put Option on a Futures Contract

( )
= ( ( ) − 1) ﴾9.7﴿
A European-style Call Option on a Currency

( )
= ( ) ﴾9.8﴿
where is the foreign risk-free rate for the period ( − ).
A European-style Put Option on a Currency

( )
= ( ( ) − 1) ﴾9.9﴿
The above adjustments to the delta are of two kinds. The first is the value
‘leakage’ from the asset due to dividends or interest payments. The second is
the requirement to present value the delta. The justification for these adjust-
ments is discussed in more detail in Module 10 on extensions to the basic
option-pricing models.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
9.4.3 The Significance of N(d2)

Although the second part of the Black–Scholes equation which uses ( ) is not a
sensitivity factor it has a useful role in analysing options. It is a measure of the
probability that the option will end up at expiry ‘in-the-money’. Thus a low ( )

indicates a low probability of the option having any value at expiry, a high value a
high probability of the option being in-the-money.
The expected payoff, given that the option will end up in-the-money, can be
found by the formula:
( )
( ) ﴾9.10﴿
( − )= − ( )
( )
If we have an option where ( ) is 0.55 and ( ) 0.52, the strike price is 100
and the asset price 110, the period six months and the risk-free rate 5 per cent, then:
. ( . )
0.55
(110 − 100) = 100 −100 0.52 = 4.5967
0.52
The present value of the above gives the option value, that is, 4.4671.
9.4.4 Option Elasticity

Option elasticity or lambda (λ) is the amount of leverage obtained from an option.
It is the percentage change in the option for a given percentage change in the asset
price.
% ﴾9.11﴿
= =
%
It is this leverage (or gearing) that is an attractive feature for speculation. If a
price change in the underlying is expected, a high sensitivity to changes in the option
price is desirable. The option has its greatest degree of leverage when it is deeply
out-of-the-money (at the limit leverage ranges from the potentially infinite down to
zero) which declines as the option moves to being at-the-money and then into-the-
money. An option’s elasticity also differs with time. The effect is shown in Table 9.5
and also in Figure 9.6.
Table 9.5 Option leverage (lambda) for different expiry months and
asset prices, volatility = 0.25
Asset price 1 month 3 months 6 months
K = 100
95 24.190 12.156 8.130
100 17.779 10.174 7.178
105 12.960 8.531 6.359
The above discussion suggests that for capitalising on changes in the underlying’s
value, out-of-the-money options provide a greater change in price than in-the-
money options.

20
Lambda
Option price
15
Option price and Lambda

10
0
85 95 105 115
Asset price
Figure 9.6 The effect of option leverage (Lambda)
9.5 Option Gamma (γ)

When discussing delta, we pointed out the risk of changes in the underlying asset
price. This is an important risk since a rapid change in delta will require frequent
(and costly) adjustments to remain delta hedged. This risk goes by the name of
gamma (γ). Gamma is also sometimes known as convexity, since it measures the
rate of change in the delta relative to changes in the underlying. This is shown in
Figure 9.7. Depending on the curvature of the option price relative to the underlying
price, the rate of change in delta will be different. This is the relationship shown in
Figure 9.1 which illustrates the behaviour of delta in respect of the underlying asset.
Option price
AC2
dC2
C2
AC1
dC1
C1
V1 V2 Underlying
Figure 9.7 Error arising from predicting price change using an option’s
delta

When the option is deeply in-the-money, the rate of change in delta for a change
in the underlying price will be relatively small. This is the case in Figure 9.7 for the
option value 2 at 2 . The error for a price change is small, as shown by the slight
difference between the actual price change ( ) from 2 and that implied by the
option’s delta ( ). However, at 1 , there is a significant difference between the
actual price change ( ) and that predicted by delta ( ). The error depends on
the curvature of the option price in relation to the underlying. Gamma is the
measure of that curvature. If the rate of change is small relative to changes in the
underlying, then the gamma will be small. If, however, gamma is large then the
option’s delta is highly sensitive to changes in the price of the underlying. Hence,
gamma measures the risk in delta, the hedge ratio required to eliminate the price risk
on the option.
An option’s gamma (γ) is the second derivative of option price to the underlying.
Formally, it is given by:
(delta) ′( ) ﴾9.12﴿
= = =
(Asset price) ( − )
where
1 ( / ) ﴾9.13﴿
′( )=
√2
Calculation Formula for Gamma ____________________________
A computational formula for deriving the option gamma given in Equation 9.12 is
given below:
⁄ ﴾9.14﴿
=√
( )
where is the exponential, 2.78218, = 3.14159, and the other variables have
already been defined.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Gamma is the risk in the option’s delta, that is, it measures the rate of change in
the hedge ratio or delta that takes place with the asset price changes. If the gamma is
small, the delta is not very sensitive to changes in the underlying asset; if it is large,
the delta is very sensitive to price changes in the underlying. We have already seen
that the slope of delta is highest when the option is at-the-money and we would
expect the option value to be most sensitive at this point. As expected, the gamma
of an option is at its greatest when the option is at-the-money. Gamma therefore
measures the degree of curvature in the call price curve before expiry (see Fig-
ure 9.8). Gamma risk is the amount by which the delta and hence the hedge
position must be adjusted for a given change in the asset price.

1
0.9
0.8
Delta and Gamma

0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
50 70 90 110 130
Asset price
Figure 9.8 Delta and gamma

Note: The option gamma is highest when the option is at-the-money (delta = 0.5). It declines when
the option moves either out-of-the-money or into-the-money. It is at its lowest when the option
is either deeply out-of-the-money or deeply in-the-money.
Gamma is important for hedging purposes. If an option is written (sold) and is
being hedged with other options with different conditions then merely matching the
two opposing deltas will not fully hedge the written exposure. This is due to the fact
that the values for the written and purchased options will not change by the same
amount. In order to hedge correctly, the gammas of the long and short positions
need to be equal. This is known as a delta/gamma hedge.
Making a Position Gamma Neutral __________________________
Delta hedging allows the hedger to neutralise the price risk in a position. A
position in the underlying, a forward, or a futures contract on the underlying has
a gamma of zero. It is only by taking an appropriate position in an option that
the gamma risk can be reduced or eliminated. If the delta-neutral position has a
gamma of and the option has a gamma equal to and the weight of these
options in the position is , the gamma of portfolio then will be:
= + ﴾9.15﴿
The position in the option required to make the portfolio gamma neutral will
be:
− ﴾9.16﴿
Adding a new element to a position will change the delta, so the position in the
underlying or its future equivalent will have to be adjusted to maintain the delta-
neutral stance.
Note that gamma neutrality will, as with delta, need to be rebalanced as time
passes and prices change. A strategy which seeks to neutralise both delta and
gamma risk is often referred to as a delta/gamma hedge.

Suppose that a position has been set up to be delta neutral, but it has a gamma
of −4500. The delta and gamma of a call are 0.57 and 1.8 respectively, and the
position can be made gamma neutral by adding a long position of 2500 options:
4500
= 2500
1.8
However, this action changes the delta of the position, from zero to: 2500 ×
0.57 = 1425. Therefore, 1425 of the underlying asset must be sold at the same
time to keep the overall portfolio delta neutral.
Adding the gamma correction to the delta neutral position can be seen as a
correction for the fact that, in practice, the underlying position in the asset or
its forward or futures equivalent cannot be continuously adjusted, as the Black–
Scholes model requires.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The gamma for calls will be positive, that for puts, as we might expect, negative.
The different types of position of gamma are summarised in Figure 9.9.
DV DV
DU DU
Slightly positive gamma Large positive gamma

DV DV
DU DU
Slightly negative gamma Large negative gamma
Figure 9.9 Alternative relationships between the change in value of a

delta-neutral position (ΔV) and the price of the underlying as-
set or stock (ΔU) and time to expiry

We can summarise the relationship between gamma and delta and the underlying
asset price as shown in Table 9.6.
Table 9.6 Relationship of gamma to changes in the asset price and delta
If Gamma (γ) is Asset price (U) Delta (δ)
Positive (+) Increases (+) Increases (+)
(> 0) Decreases (−) Decreases (−)
Negative (−) Increases (+) Decreases (−)
(< 0) Decreases (−) Increases (+)
An option’s gamma is also sensitive to the other pricing factors. For instance,
gamma increases towards expiry, but the relationship depends on whether the
option is out-of-the-money, in-the-money or at-the-money. Gamma will be highest
for an at-the-money option as it approaches expiry. This is shown graphically in
Figure 9.10. The reason that the at-the-money gamma becomes so large near expiry
is that a small change in the underlying will greatly affect the end value of an option.
The decline in gamma for options that are out-of or in-the-money is due to the fact
that a reversal of their fortunes becomes increasingly unlikely as the time to expiry
becomes shorter and shorter. It is the same effect that increases the delta of the in-
the-money and decreases the delta of out-of-the-money options.
0.45
0.4
0.35
0.3 In-the-money
Out-of-the-money
Gamma
0.25 At-the-money
0.2
0.15
0.1
0.05
0
0.5 30 60 90 120 150 180 210 240 270 300 330 360
Time
Figure 9.10 The effect of the time to expiry on the option’s gamma
Another important influence on gamma is volatility. The greater the volatility, the
‘flatter’ the gamma curve. This is shown in Figure 9.11. This is the gamma counter-
part of the effect of volatility on delta. We have seen that a higher volatility spreads
out the delta (recall Figure 9.2), and it has the same flattening effect on gamma.

Sd = 0.1
Sd = 0.2
0.06
Sd = 0.4
0.05
0.04
Gamma
0.03
0.02
0.01
0
50 70 90 110 130
Asset price
Figure 9.11 The effect of option volatility on the option’s gamma
9.5.1 Position Gamma

As with delta, a directional view on future volatility requires the appropriate gamma
positions. These are shown in Table 9.7. As with delta, a positive gamma is required
if volatility is expected to increase, a negative gamma if volatility is expected to
decline.
Table 9.7 Relationship of gamma to volatility

Position Volatility
gamma (γ)
Positive (+) Bullish: increase in volatility will increase value of position
Neutral (0) Neutral: indifferent to changes in volatility on position
Negative (−) Bearish: decrease in volatility will increase value of position
9.6 Time to Expiry / Theta (θ)

We have already discussed how time affects option value in the introduction to this
module. Theta (θ) measures the sensitivity of the option price to the time to expiry
and is often referred to as time decay. In effect, it is a measure of the loss of time
value in the option. Since the option value must converge to its intrinsic value at
expiry, theta is a measure of the rate at which the option loses time value.
(Call price) · ﴾9.17﴿
= =−
(Time to expiry) ·
For puts:
(Put price) · ﴾9.18﴿
= =−
(Time to expiry) ·

The computation of theta for European-style calls is given by Equation 9.19:*
( ) ﴾9.19﴿
=− ′( )− ( )
2 ( − )
Equation 9.20 given the computation for European-style puts:
( ) ﴾9.20﴿
=− ′( )+ (− )
2 ( − )
( / )
where ′( ) = √ is as previously defined.
Note that, following decision science practice, although theta has a negative sign,
it is shown as a positive number in the tables and figures of this section. Theta
works against the option holder (as discussed in the introduction to this module)
and for the option writer. In terms of effect it will have a negative sensitivity for
long option positions (which lose out as the time to expiry decreases) and positive
for short option positions.
Theta is seldom calculated in practice. A simpler calculation of the effect of time
decay is to revalue an option by changing the number of days to expiry while, at the
same time, keeping all other factors constant. The difference in price between the
longer- and shorter-dated valuations gives the amount of value loss from time
decay. Table 9.8 shows the effect of revaluing options at various maturities and the
daily loss of time value for out-of-the-money, at-the-money and in-the-money
options. The effect is also shown graphically in Figure 9.12.
Table 9.8 The effect of time on option prices before expiry

Days Out-of-the-money At-the-money In-the-money
0 0 0 10
1 0 0.529458 10.01485
30 0.244381 3.080128 10.72433
60 0.873222 4.483088 11.72178
90 1.556585 5.608696 12.68450
180 3.516096 8.301071 15.24927
360 6.928837 12.446190 19.46982
Days Out-of-the-money At-the-money In-the-money

0 0 0 10
1 0 0.529458 10.01485
Loss of time value – 0.529458 0.01485
29 0.226739 3.024749 10.69202

30 0.244381 3.080128 10.72433
* Note that for American-style options theta is indeterminate.

Loss of time value 0.017643 0.055379 0.032309
59 0.850705 4.441993 11.68873

60 0.873222 4.483088 11.72178
179 3.495393 8.27454 15.22297

180 3.516096 8.301071 15.24927
359 6.911293 12.42564 19.44855

360 6.928837 12.44619 19.46982
Note: The option holder loses from time decay; the option writer gains. The time decay differs
depending on whether the option is out-of-the-money, at-the-money or in-the-money and the
remaining time to expiry of the option.
Since the time value of an option is highest for an at-the-money option, its rate
of time decay is also highest as shown by the larger daily price loss, as given in the
middle column of Table 9.8. The cross-sectional relationship between out-of-the-
money and in-the-money thetas is shown graphically by Figure 9.13. For options
with no chance of exercise, there is no time value and theta is zero. As the probabil-
ity of exercise increases, theta rises to reach a peak when the option is at-the-money.
It then declines as the option moves into-the-money to the point where exercise
becomes certain. Where the option delta is now (close to or at) one, the Black–
Scholes model simplifies to Equation 9.21:
( )
= − ﴾9.21﴿
where − ( − ) is the continuous time discount factor. This shows that for deeply in-
the-money options, theta is the rate of convergence of the (continuous time) cost-
of-carry model used in pricing forward and futures contracts.

10
Time value
4
In-the-money
2 Out-of-the-money
At-the-money
0
0 20 40 60 80 100 120 140 160 180 200 220 240
–2 Time to expiry
Figure 9.12 The effect of time decay on an option

Note: The option has a standard deviation of 0.25, and a risk-free interest rate of 5.57 per cent.
Call price
Option price and Theta value
Theta
50 60 70 80 90 100 110 120 130 140 150 160 170

Asset value
Figure 9.13 Option value and theta

Adjustments to Theta ______________________________________

As with delta, we need to modify the basic formula to take account of value
‘leakages’.
Theta for a European-style Call Option Paying a Dividend Yield (d)
( )
· ′( ) ( ) ( )
﴾9.22﴿
=− + · · ( ) − ( )
2 ( − )
Theta for a European-style Put Option Paying a Dividend Yield (d)
( )
· ′( ) ( ) ( )
﴾9.23﴿
=− − · · (− ) + (− )
2 ( − )
The above adjustments also work for European-style calls and puts on curren-
cies where is replaced by in Equation 9.22 and Equation 9.23. For
European-style futures options, is set equal to , the risk-free rate for time
( − ) and , the asset price, becomes , the futures price.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
As other option-pricing factors change, so does theta. The theta curve against the
underlying price shown in Figure 9.13 takes on a different shape depending on the
remaining time to expiry. Thetas for different remaining times to expiry are shown
in Figure 9.14. The less time to expiry, the greater the curve. This is to be expected
since the time decay increases as the remaining life of the option declines.
30 days
25 90 days
180 days
20
15
Theta value
10
0
50 60 70 80 90 100 110 120 130 140 150 160 170
Asset price
Figure 9.14 Theta and the time to expiry

We may now summarise the effect of time on option value. Options will lose all
their time value by the time they expire. Theta measures the rate of time decay
which will be different depending on whether the option is out-of, at-the, or in-the-
money. Time decay behaves asymmetrically in relation to the strike price and the
remaining time to expiry on the option.

Practically, as suggested earlier, it is easier to recalculate the value of an option

with a (trading) day less to expiry as traders tend to do, rather than use the formula
for theta directly.
180
160
140
Option price and Theta value
120 Call price
100
80
60
40
Theta
0
0.5 40 80 120 160 200 240 280 320 360
Time to expiry
Figure 9.15 The effect of the option price and theta
9.6.1 Position Theta

The writer of an option gains from time decay, the holder loses. The relevant
position thetas to adopt are shown in Table 9.9.
Table 9.9 The relationship of theta to time to expiry

Position theta (θ) Volatility
Positive (+) Beneficial: decrease in time to expiry increases value of
the position
Neutral (0) Neutral: position indifferent to changes in time to expiry
Negative (−) Bearish: decrease in time to expiry decreases value of
position
9.6.2 Sign Relationships for Delta, Gamma and Theta

The combined sign relationships for the delta, gamma, and theta of calls and options
are given in Table 9.10. Note that the gamma and theta signs are always opposite.
Positive gamma comes from holding a long position in options and selling options
creates a negative gamma.

Table 9.10 Sign relationships for the three most important sensitivity
variables for options
Position Delta (δ) Gamma(γ) Theta (θ)
Long call + + −
Long put − + −
Short (written) call − − +
Short (written) put + − +
9.7 Risk-Free Interest Rate (r) / Rho (ρ)

The discussion of theta, the time decay of an option, shows the effect of interest
rates on the option value as the remaining life of the option decreases. Since the
Black–Scholes equation uses interest rates as one of the pricing factors, options are
sensitive to changes in interest rates. The sensitivity of option value to interest rates
is given by rho (ρ). Interest rates are, however, the variable that influences option
prices the least. Interest-rate sensitivity for calls is given by the change in option
price for a change in interest rate:
(Call price) ﴾9.24﴿
= =
(Interest rate)
Formally, for calls, rho is calculated as:
( )
=( − ) ( ) ﴾9.25﴿
Similarly, for puts:
(Put price) ﴾9.26﴿
= =
(Interest rate)
The rho for puts is given by:
( )
=( − ) (− ) ﴾9.27﴿
You will recall from our earlier analysis that we know that ( ) represents the
amount borrowed or lent at the risk-free rate in the replicating portfolio used to derive
the option value. Whereas the cost of borrowing (or deferring) purchase will have an
impact on the option value, options are not very sensitive to changes in interest rates.
Table 9.11 shows that a doubling of the interest rate from 5 per cent to 10 per cent for
a six-month at-the-money call increases the value from 8.23 to 9.45. It has less effect
on deeply out-of-the-money and deeply in-the-money options.
Table 9.11 The effect of interest rates on option prices

t = 0.5 year r= 0.05 0.1 0.15
Out-of-the-money 90 3.490 4.197 4.955
At-the-money 100 8.229 9.453 10.701
In-the-money 110 15.124 16.791 18.431

The relationships of option value to changes in the risk-free interest rates, given
in Table 9.11, may be presented graphically, as in Figure 9.16.
20
OTM
18 ATM
ITM
16
14
Option value 12
10
0
0.01 0.02 0.06 0.85 0.11 0.16
Interest rate
Figure 9.16 Option-price sensitivity to changes in interest rates

As with the other sensitivity factors, rho changes when other pricing variables
change. Figure 9.17 shows the different sensitivity to interest rates of options at two
different times to expiry. As one might intuitively expect, the longer-dated option
has more interest-rate sensitivity than the shorter-dated one.
10
7 180 days
30 days
6
Option price
0
0.10 1.10 2.10 3.10 4.10 5.10 6.10 7.10 8.10 9.10 10.10 11.10 12.10
Interest rates (%)
Figure 9.17 Option-price sensitivity to interest rates and time to expiry

9.8 Volatility (σ) / Vega (ν)

The volatility of the underlying asset or stock is the single most important determi-
nant of the option value. This is due to the nature of options. Since they offer a
one-way bet on the future asset price, any change in volatility and hence the
potential spread of future prices is going to increase the option’s value. Vega (ν) is
the sensitivity of option value to a change in volatility. Note that vega is also
confusingly known as kappa, lambda (unhelpfully confusing volatility with lambda
as the option’s elasticity), zeta, epsilon or simply as volatility risk (σ).
Table 9.12 shows the change in the option value for a change in volatility.
Table 9.12 The effect of volatility on the value of an option

Volatility 30 days 180 days
0.05 0.831 3.104
0.1 1.383 4.293
0.2 2.528 6.983
0.3 3.651 9.668
Note: The option is at-the-money.
Doubling the volatility of the one-month option from 0.1 to 0.2 more than dou-
bles the option price. For the six-month option, the value increases by 63 per cent.
Figure 9.18 shows the change in value from changes in volatility graphically.
35
Sd = 0.25
Sd = 0.40
30 Value at expiry
25
Option price
20
15
10
0
75 85 95 105 115 125
–5 Asset price
Figure 9.18 The effect of change in volatility on the value of an option

Note: The option has six months to expiry and the volatility is either 0.25 or 0.40.
The vega of an option is given by:
(Option price) ﴾9.28﴿
= =
(Volatility)

The computation for European-style calls and puts is the same:
= ( − ) · ′( ) ﴾9.29﴿
where ′( ) is as previously defined.
Adjustments to Vega _______________________________________
In the case of a dividend or currency option, the vega has to be adjusted as
follows. The adjusted formula for a stock or stock index paying a continuous
dividend ( ) becomes:
= ( − ) · ′( ) ( ) ﴾9.30﴿
For a currency option, becomes and for a futures option, is replaced
by ( and by , the futures price.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Table 9.13 shows that option value is most sensitive to changes in volatility when
the option is at-the-money. Vega behaves in a similar way, as shown by Table 9.14.
The shape of the vega curve is similar to that of the gamma curve discussed earlier.
As with gamma, vega is at its peak when the option is trading at-the-money and
declines when the option becomes either out-of-the-money or in-the-money.
Consequently, as with gamma, deep in-the-money or deep out-of-the-money
options have a lower price sensitivity to changes in volatility than do corresponding
near-to or at-the-money options. The distribution of vega for different volatilities is
shown graphically in Figure 9.19. As volatility increases, the vega curve is expanded.
Hence, the vega of high-volatility options declines less rapidly than that of the same
options but with a lower volatility as they move out-of or into-the-money.
Table 9.13 Option-price sensitivity to volatility

Asset price Option price
K = 100 σ = 0.1 σ = 0.2 σ = 0.4
Out-of-the- 90 0.448 2.403 7.268
money
At-the-money 100 4.321 7.000 12.483
In-the-money 110 12.798 14.236 19.061
Note: As volatility goes up, so does the option price.
Table 9.14 The effect of volatility on option vega

Asset price Vega
K = 100 σ = 0.1 σ = 0.2 σ = 0.4
Out-of-the- 90 14.464 22.654 25.166
money
At-the-money 100 25.727 27.217 27.409
In-the-money 110 6.398 19.919 26.274
Note: Vega is highest for at-the-money options.

35 Sd = 0.1
Sd = 0.2
30 Sd = 0.4
25
Vega value
20
15
10
0
50 80 110 140 170
–5
Asset price
Figure 9.19 The effect of a change in volatility on vega
9.8.1 Position and Vega Sensitivity

As with the other sensitivity factors, the sensitivity of the option value to changes in
volatility alters as other pricing factors change. Figure 9.20 shows the value for two
similar options which only differ as to their remaining life. The sensitivity of the
longer-dated option is higher and rises more rapidly as volatility increases, reflecting
the added value provided by the wider spread of future outcomes over the option’s
longer life.
12
30 days
180 days
10
8
Option price
0
0.01 0.10 0.15 0.20 0.25 0.30 0.35
–5 Volatility
Figure 9.20 Option-price sensitivity to changes in volatility and time to

expiry
Option traders often describe their positions in terms of volatility. Buying op-
tions means a positive exposure to vega (and equally a positive gamma). Selling or
writing options creates a negative vega (and gamma). The two relationships are
shown in Table 9.15. Trading strategies that are ‘long volatility’ or involve ‘buying

volatility’ entail holding options; strategies that are ‘short volatility’ or involve
‘selling volatility’ entail writing options. Since the other pricing factors for options
are generally known in the market, trading volatility can be considered the key
function for option market makers.
Table 9.15 Vega and gamma position sensitivities

Option position Vega Gamma
Long Positive (+) Positive (+)
Short (written) Negative (−) Negative (−)
To summarise, vega is the sensitivity of any position to a change in the implied

volatility of the underlying asset. Gamma, however, measures the effect of the
existing level of volatility on the option price.
9.8.2 Summary of Sensitivity Factors for Calls and Puts

Table 9.16 summarises the direction of the sensitivity factors for long and short
positions in calls and puts for the five pricing factors.
Table 9.16 Sign relationships for the Greeks of option pricing sensitivity
variables for options
Position Delta Gamma Theta Rho Vega
(δ) (γ) (θ) (ρ) (ν)
Long call + + − + +
Long put − + − − +
Short (written) call − − + − −
Short (written) put + − + + −
As we will see in Section 9.10, these sensitivities are used in designing option
strategies to fit a particular directional or volatility view when combining or spread-
ing with options.
9.9 Sensitivity Factors from the Binomial Option-Pricing

Model
So far the discussion has involved deriving sensitivity factors for the continuous-
time Black–Scholes option-pricing model. The advantage of using Black–Scholes is
that it provides a closed-form analytic solution to the option value. An option’s
sensitivity values can be calculated in like fashion by applying the equations in
sections Section 9.2 to Section 9.8. Although the binomial model involves a
backwards reiteration through the lattice to derive the current expected value of the
option, sensitivity factors can also be calculated in an analogous fashion to those in
the Black–Scholes model. Recall that with the binomial model asset price can take
only two forms: an upward change ( ) and a downward change ( ). As time passes,

we have a lattice of price changes as shown by Figure 9.21. The corresponding

option prices ( ) are shown in Figure 9.22.
A U3,uuu
U2,uu
U1,u U3,(uud)
D B
U0 U2,uddu
U1,d U3,(udd)
C
U2,dd
U3,ddd
Figure 9.21 Lattice of asset prices (Ut) in the binomial option-pricing

model
C3,uuu
C2,uu
C1,u C3,(uud)
C0 C2,uddu
C1.d C3,(udd)
C2,dd
T1 C3,ddd
T2
T3
Figure 9.22 The call option prices derived from Figure 9.21
9.9.1 Binomial Delta

Option delta is the ratio of a small change in the asset price and the corresponding
change in the option value. At a time ΔT we will have two values for the option,
when the asset (stock) price has risen ( ), and when the asset price has fallen
( ). When = − then = − . We have an estimate of the option’s
delta at time ΔT which is:

− ﴾9.31﴿
=
−
The delta of the option for the first period of the lattice in Figure 9.22 will there-
fore be:
, − , ﴾9.32﴿
( $) =
, − ,
That for the second period will be:
, − , ﴾9.33﴿
( , ) =
, − ,
For example, if the option had a value of 4.3 if the stock price was 104 and a
value of zero, if the stock price was 96, then, based on Equation 9.32 and Equation
9.33, the delta of this particular option would be:
4.3 − 0
0.54 =
104 − 96
9.9.2 Binomial Gamma

The option’s gamma is more complicated to compute. At time 2 we have two
estimates of delta. When the asset price is at (2, , ) , half-way between the first and
second nodes of the lattice, we have ( + )/2, on the upside for branches A and
B of Figure 9.21. The option delta will therefore be:
, − ,
−
When the asset price is at (2, , ) , half-way between the second and third nodes
of the lattice on the downside for branches B and C, the delta is:
, − ,
−
The difference between the two asset values (ℎ) is:
1 ﴾9.34﴿
ℎ= ( − )
2
The gamma is therefore the change in delta divided by the change in ℎ:
, − , , , , − , ﴾9.35﴿
−
− −
( ) =
ℎ
Note that this approach provides the gamma for the period between 2 and 1 .
If we had wanted the gamma at 0 , it is usual to start the tree at −2 , setting the
price such that 2, , is the appropriate current market price of the asset. The
value of the option is then that given by 2, , , rather than at 0 . If this is done,
the delta in Equation 9.31 becomes:

, − , ﴾9.36﴿
=
−
and we can estimate the option’s gamma using Equation 9.34. In most cases, since
the interval between nodes is set to be a small period of time, the delta from
Equation 9.31 and the gamma for Equation 9.35 are used for these coefficients at
time zero since there will be little difference to the result.
9.9.3 Binomial Theta

An estimate of the effect of elapsed time on the option can be calculated from the
binomial lattice. This can be found by:
, , − ﴾9.37﴿
=
2
If at 2 , assuming an unchanged price for the underlying, the option value was
4.85, and at 0 it was 5.75, and each jump was one week (0.01923 of a year), then
theta would be:
4.85 − 5.75
−11.75 =
2 × 0.03846
9.9.4 Binomial Vega

The vega of an option being priced using the binomial method can be found by
recalculating the option’s value for a small change in the volatility ( ) while
keeping all other factors constant. Vega then is:
∗
− ﴾9.38﴿
=
∗
where is the new value of the option at the changed volatility ( + ).
9.9.5 Binomial Rho

Rho, the option’s sensitivity to changes in interest rates, is calculated using the same
approach as that for the binomial estimate of vega. The original option value
estimated with the initial tree is recalculated incorporating a small change in interest
rates. The difference in value, divided by the change in interest rate, as in Equation
9.38, provides an estimate of rho.
Higher Order Greeks _______________________________________
The discussion of the Greeks has covered the five major sensitivity factors,
delta, gamma, theta, rho and vega. However, for option traders managing large
portfolios of options, additional sensitivity measures have been suggested. Some
of the more common ones are given below:
Charm. The sensitivity of delta due to time decay (that is, the decay effect on
delta as the option moves towards expiration)

Color. The sensitivity of gamma due to time decay (that is, the decay effect on
gamma as the option moves towards expiration)
Fugit. The risk-neutral expected life of an American-style option (calculated
from a binomial tree)
Phi (dividend rho). The change in option value from a small change in the
dividend or dividend yield
Speed. The sensitivity of gamma to changes in the price of the underlier
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
9.10 Option Position and Sensitivities

The above discussion shows the effect on the option price of changes in one of the
pricing variables. Depending on the requirement, these sensitivities show either the
actions required to hedge out the particular risk, or the desired sensitivity of an
option to changes in the factor. Table 9.17 summarises the appropriate sensitivity
for each pricing variable, the nature of that relationship and the effect of the
direction of the sensitivity on the option position.
Note that this section reverts to discussing sensitivities in terms of the Black–
Scholes option-pricing model.

Table 9.17 Summary of sensitivity factors from the Black–Scholes option-pricing model and holding long or short
positions in options
Variable Name given to Formulation from Formulation from Relationships Effect of direction of sensitivity on option
sensitivity Black–Scholes Black–Scholes position
factor model for calls model for puts
Asset (stock) Delta (δ) (hedge ( ) ( )−1 Change in option price for a Positive delta: bullish, since price increases are
price (U) ratio) given change in stock price advantageous
Zero delta: neutral position
Negative delta: bearish, since price decreases are
advantageous
Gamma (γ) ( ) ( ) Change in delta for a given Positive gamma means that if the underlying price
( ) ( ) change in stock price increases (decreases), the option delta increases
(decreases)
Negative gamma means that if the underlying
price decreases (increases), the option delta
increases (decreases)
Elasticity Lambda (λ) ( ) ( )−1 Percentage change in option The leverage or gearing of an option is at its
(option leverage price for a given percentage highest when the option is deeply out-of-the
or gearing) change in stock price money; as the option moves up-to and into-the-
money, the leverage becomes less
Time to expiry Theta (θ) (effect ′( )− − ′( )+ Change in option price given Positive theta: option position profits from time
(T−t) of time decay) ( ) ( ) a change in time until decay
( ) ( )
( ) (− ) expiration
Negative theta: option position loses from time
decay
Risk-free interest Rho (ρ) ( − ) ( )
· ( ) −( − ) ( )
· (− ) Change in option price for a Positive rho: option position gains (loses) from an
rate (r) given change in risk-free rate increase (decrease) in interest rates
Negative rho: option position loses (gains) from
an increase (decrease) in interest rates
Volatility (σ) Vega; Kappa; ( − ) · ′( ) ( − ) · ′( ) Change in option price for a Positive vega: option position gains from an
Zeta; Epsilon (ν) change in volatility increase in volatility;
Negative vega: option position gains from a
decrease in volatility
where:
1 ( / )
′( )=
√2

9.10.1 Option Sensitivities and the Market View

The next stage is to set up positions that are designed to exploit the desired sensitiv-
ity to the pricing factor. Table 9.18 shows the relationship between the market view,
that is, the expected directional change in the price of the underlying asset, and
changes in volatility. There are a large number of possible strategies that can be
adopted, depending on the expected outcome. The listed strategies are mainly
option strategy trades recognised by the Chicago Mercantile Exchange (CME) and
Euronext-LIFFE and recorded accordingly by the exchanges’ settlement systems.*
For the purposes of this discussion, it is sufficient to indicate that the payoffs
from the expected changes are those predicted by the signs on the sensitivities. For
instance, a bearish view on the market which anticipates a fall in price requires a
negative delta sensitivity, as described in Table 9.17, since in this case a fall in price
increases the value of the option (strategy) position. This is also true of the signs on
the other sensitivities given in Table 9.18.
Table 9.18 Option sensitivities and market view

Market view Bullish Bearish Undecided
Volatility (σ) view
Option sensitivity
position to adopt, Market is expected to rise Market is expected to fall Undecided on market
if: direction
σ Rising Long call Long put Long straddle
Long two-by-one ratio Long two-by-one ratio Long strangle
call spread* put spread*
Long call volatility trade Long put volatility trade Long puts
Long call spread Long put spread Long ATM calendar spread
Short put spread Short call spread Short ATM call or put
condor
Short ITM call butterfly Short ITM put butterfly Short ATM iron butterfly
Short OTM put butterfly Short OTM call butterfly Long call or put volatility
trade
Short ITM call condor Short ITM put condor Long ATM straddle
calendar spread
Short OTM put condor Short OTM call condor Short ATM call or put
butterfly
Short call ladder Short put ladder
Call ratio back spread* Put ratio back spread*
Delta + − 0
Gamma + + +
Theta − − −
* For the interested reader, a detailed analysis of these strategies is provided by McGillan, Lawrence
(1993), Options as a Strategic Investment. New York: New York Institute of Finance. These strategies are
also given in Moles, Peter and Terry, Nicholas (1997) The Handbook of International Financial Terms.
Oxford: Oxford University Press.
Chicago Mercantile Exchange website: www.cme.com; Euronext-LIFFE website: www.liffe.com

Vega + + +
Volatility (σ) view
Option sensitivity
position to adopt, Market is expected to rise Market is expected to fall Undecided on market
if: direction
σ Falling Short put Short call Short straddle
Short two-by-one ratio Short two-by-one ratio Short strangle
put spread* call spread*
Long call spread Short call spread Short puts
Short put spread Long put spread Long ATM call or put
butterfly
Short put volatility trade Short call volatility trade Long ATM iron butterfly
Long OTM call butterfly Long ITM call butterfly Long ATM call or put
condor
Long ITM put butterfly Long OTM put butterfly Short ATM calendar
spread
Long OTM call condor Long ITM call condor Short ATM straddle
calendar spread
Long ITM put condor Long OTM put condor Short call or put volatility
trade
Long put ladder Long call ladder
Ratio call spread* Ratio put spread*
Delta + − 0
Gamma − − −
Theta + + +
Vega − − −
σ Undecided Long underlying or Short underlying or Box spread
futures on underlying futures on underlying
Short put Short call Conversion
Long call Long put Reversal
Short put spread Short call spread
Long OTM call butterfly Long put or bear spread
Long ITM put butterfly Long ITM call butterfly
Long OTM call condor Long OTM put butterfly
Long ITM put condor Long ITM call condor
Short combo Short OTM put condor
Long combo
Bull spread
Delta + − 0
Gamma 0 0 0
Theta 0 0 0
Vega 0 0 0
Note: This table shows the different combinations of option positions with or without the underlying asset or futures
contract that can be used to set up the desired sensitivities. ITM means in-the-money; OTM, out-of-the-money, ATM,
at-the-money.
*Ratio spreads require a more sophisticated analysis than that shown in this table.

9.10.2 Option Combinations and Payoffs

We have already said that options provide a great deal of flexibility as risk-
management instruments. This section briefly reviews some of the ways in which
options can be used in combinations or packages as a means of modifying the
payoffs of various underlying instruments or assets. The two major adjustments are
for an unknown directional view and cost. Where the direction of the underlying is
uncertain, it is necessary to hold combinations of calls and puts. These can be
bought, if bullish on volatility, or sold, to take advantage of overpriced volatility.
These are shown in Figure 9.23. The sensitivities of the two positions are given in
Table 9.19.
Gain Position gains from price

stability of the underlying
(short volatility)
Underlying
Loss (a): Written vertical straddle
Gain Position gains from

price changes in the
underlying in either
direction (long volatility)
Underlying
(b): Purchased vertical straddle

Loss
Figure 9.23 Payoffs from written and purchased straddle (volatility

strategies)
Table 9.19 Option sensitivities for the strategies illustrated in Figure

9.23
Sensitivity Written (short) vertical Purchased (long) vertical
straddle straddle
Delta (δ) 0 0
Gamma (γ) − +
Theta (θ) + −
Vega (ν) − +

Table 9.20 Option sensitivities for the directional strategies illustrated in

Figure 9.24
Bull spread Bear spread
Sensitivity Bullish Undecided Bullish Undecided
volatility volatility
Delta (δ) + + − −
Gamma (γ) + 0 + 0
Theta (θ) − 0 − 0
Vega (ν) + 0 + 0
If there is a directional view, spreads – which involve packages of purchased and

sold options of the same type – can be used to reduce the cost of setting up the
position. These are shown in Figure 9.24.
The sensitivities of the directional views using spreads are given in Table 9.20.
Different sensitivities can be established, depending on whether there is also a
directional volatility view.
Gain Price gain

given up
Net cost
after selling
option
Underlying
Gross cost K1 K2
of setting
up position
Loss (a): Bull spread
Gain Net cost after

selling option
Price
decline
given up
Underlying
K1 K2
Gross cost
of setting up
position
(b): Bear spread
Loss
Figure 9.24 The bull spread (a) has an upward directional view on the
underlying asset price, the bear spread (b) a downward
direction view on the underlying
Note: Both holding and simultaneously selling options with different strike prices ( and 2 )
reduces the cost of setting up the position, but at the cost of surrendering any additional gains
beyond the written strike.


The change in option value for a change in one of the pricing variables depends on
whether the option is a call (the right to buy) or a put (the right to sell). In order to
understand options, one must understand the effects of such changes. The five key
factors which go to make up an option’s value are the price of the underlying asset,
the strike price, the time to expiry, the risk-free interest rate and the asset’s volatility.
Using an option-pricing model, it is possible to derive one or more sensitivity
factors which measure how the option’s value changes in response to changes in
one of the pricing factors. The key sensitivities derived from such a model are delta,
gamma, theta and vega which respectively measure the option’s sensitivity to
changes in the underlying asset’s price, the risk in delta, the effect of time and the
volatility risk of the option. Of the pricing factors, option value is most sensitive to
changes in volatility.
In addition, an option’s sensitivity to the pricing factors will change in complex
ways due to interactions between the various factors. Option behaviour is asymmet-
ric and follows complex paths, depending on what is happening to the various
variables. Behaviour will depend, for instance, on whether the option is out-of-the-
money, at-the-money or in-the-money. Examining the sensitivity factors shows that,
generally speaking, options which are near-to or at-the-money are more susceptible
to value changes than options at either extreme. Equally, options which are near to
their expiry date are usually more sensitive to changes in the pricing factors than
options with a longer remaining life.
Given an understanding of how an option behaves in respect to changes in one
of the pricing variables, a position can be established which provides the right
sensitivity to expected changes in the variable. Understanding the effect of such
sensitivities also allows the undesirable effect to be hedged out by establishing the
appropriate opposing position. In some cases this involves taking the appropriate
position in the underlying asset. For some kinds of option risks, however, it is
necessary to offset these with other positions in options since only options provide
the requisite price behaviour. Managing options is, therefore, a complex operation.
This complexity is increased by the need to manage the position over time since
changes in the pricing variables will change the position’s sensitivity and frequent
rebalancing is likely to be required.
Review Questions
9.1 For a call option and a put option, with all other factors unchanged, if the asset price
increases we would expect:
A. the value of calls and puts on the asset to increase.
B. the value of calls and puts on the asset to decrease.
C. the value of calls to increase and the value of puts to decrease.
D. the value of calls to decrease and the value of puts to increase.

9.2 For a European-style call and put on a non-dividend-paying stock, with all the other
factors unchanged, if the volatility is increased we would expect:
A. the value of calls and puts on the asset to increase.
B. the value of calls and puts on the asset to decrease.
C. the value of calls to increase and the value of puts to decrease.
D. the value of calls to decrease and the value of puts to increase.
9.3 An option’s delta (or hedge ratio) is:

A. the change in the option price for a given change in underlying asset price.
B. the percentage change in the option price for a given percentage change in the
asset price.
C. the change in the option price for a given change in the risk-free rate.
D. the change in the option price given a reduction in the time until expiry.
9.4 An option’s gamma is:

A. the change in the option price for a given change in the underlying asset price.
B. the percentage change in the option price for a given percentage change in the
underlying asset price.
D. the change in the option delta for a given change in the underlying asset price.
9.5 The vega of an option is:

A. the change in the option price for a given change in the underlying asset price.
B. the change in the option price for a change in the underlying asset’s volatility.
D. the change in the option price for a given reduction in the option’s time to
expiry.
9.6 We have written 50 options with a delta of 0.45 on a share. Each option is worth 100
shares. What will be the number of shares we need to buy to delta hedge the exposure?
A. 45.
B. 2250.
C. 5000.
D. 9000.
9.7 The delta of a position in which we have written call options was 0.67 and has moved to
0.65. In dynamically hedging the position do we:
A. buy more of the underlying asset?
B. sell some of our existing position in the underlying asset?
C. buy back some of the written call-option contracts?
D. sell some more of the call-option contracts?

9.8 The current asset price is 250 and the delta on a call option is 0.60. If the asset price
moves to 245, what will be the change in the value of the call?
A. −3.
B. There is no change in the call’s value.
C. +3.
D. +5.
9.9 An asset has a price of 450 and there is a call option with a strike price of 415 and a
delta of 0.80. What would we expect to happen to the delta as the option moves
towards expiry in a non-volatile market?
A. The delta remains unchanged at 0.80.
B. The delta falls to a value which is less than 0.80.
C. The delta rises to a value which is greater than 0.80.
D. There is no definite pattern to what happens to the option’s delta.
9.10 The gearing, or lambda, of an option will be:

A. at its highest when the option is deeply out-of-the-money.
B. at its highest when the option is at-the-money.
C. at its highest when the option is deeply in-the-money.
D. constant regardless of whether the option is out-of-the-money, at-the-money
or in-the-money.
9.11 The gamma of an option will be:

A. highest when the option is deeply out-of-the-money.
B. highest when the option is at-the-money.
C. highest when the option is deeply in-the-money.
D. constant regardless of whether the option is out-of-the-money, at-the-money
or in-the-money.
9.12 A position is delta neutral but has a gamma of 2100. There is an option available which
has a delta of 0.45 and a gamma of 1.4. What will be the transaction required to make
the portfolio delta/gamma neutral?
A. Buy 1500 of the delta 0.45 options and sell 675 of the underlying asset.
B. Sell 1500 of the delta 0.45 options and sell 675 of the underlying asset.
C. Buy 1500 of the delta 0.45 options and buy 675 of the underlying asset.
D. Sell 1500 of the delta 0.45 options and buy 675 of the underlying asset.
The following table relates to calls and puts on XYZ company shares. Each option is exer-
cisable into 100 units of XYZ ordinary shares.
Sensitivity factor Call Put

Strike price 110 80
Delta 0.214 −0.108
Gamma 0.0265 0.0169
Theta −0.009 −0.004

9.13 We own a portfolio which has 10 000 shares of XYZ. If we want to set up a vertical
spread by combining a sale of the call and a purchase of the put, what will be the
remaining delta sensitivity of the portfolio if we sell 100 calls and buy 60 puts?
A. 7 212.
B. 8 508.
C. 11 492.
D. 12 788.
9.14 Given the vertical spread transaction in Question 9.13, what will be the position gamma
of the underlying portfolio and the two option positions?
A. (366).
B. (164).
C. 164.
D. 366.
9.15 What will be the position theta (that is, exposure to time decay) of the option positions
in Question 9.13?
A. (90).
B. (66).
C. 66.
D. 90.
9.16 What are the position sensitivities for the combination of the underlying shares and the
two options?
A. Delta = positive; Gamma = negative; Theta = negative.
B. Delta = negative; Gamma = positive; Theta = positive.
C. Delta = positive; Gamma = negative; Theta = positive.
D. Delta = negative; Gamma = positive; Theta = negative.
9.17 We have a portfolio of 10 000 shares in company XYZ plc and wish to use options to
hedge the position. We have decided to set up a protective put situation where the
puts are to provide an immediate complete hedge against a change in value of the
shares. If the puts have a delta of −0.58, how many puts do we need, if each put is
exercisable on 100 shares of XYZ?
A. (58 puts).
B. 58 puts.
C. 100 puts.
D. 172 puts.
9.18 Which of the following is not a function of delta?

A. Delta is a relative measure of an option’s volatility in respect of the underlying
optioned asset.
B. Delta is a measure of the asset equivalence of an option.
C. Delta is a measure of the likelihood of the option having a positive value at
expiry.
D. Delta is a measure of the option’s price spread on the underlying asset.

9.19 To achieve delta neutrality between a call with a delta of 0.44 and a put with a delta of
−0.51, what is the combination of written calls to written puts that achieves this aim?
A. Write 44 calls against 51 written puts.
B. Write 51 calls against 44 written puts.
C. Write 116 calls against 99 written puts.
D. Write one call against each written put.
9.20 We want to modify the delta of an existing position which is currently 0.60 so that the
new delta will be 0.50. Which of the following will not achieve that result?
A. Buy puts.
B. Sell calls.
C. Buy calls.
D. Sell the underlying.
9.21 We wish to set up a vertical spread using calls where we wish to eliminate the exposure
to the underlying asset price. (This is known as a neutral ratio spread.) The call with a
strike price of 120 has a delta of 0.58 and that with a strike price of 140 has a delta of
0.29. What is the correct ratio of purchased to written calls to eliminate the effect of
price changes on the underlying?
A. Buy one 120-call and sell one 140-call.
B. Buy 29 120-calls and sell 58 140-calls.
C. Buy 58 120-calls and sell 29 140-calls.
D. Buy 100 120-calls and sell 158 140-calls.
9.22 A share has a current price of 54 and the call has a price of 6.375 and a strike price of
50 with three months left to expiry. If the share price increases to 55 and the option
price rises to 7.125, what is the delta of the option?
A. 0.55
B. 0.65
C. 0.75
D. 0.95
Case Study 9.1: Option-Pricing Sensitivities

1 Calculate the value of a call – and its corresponding put – using the Black–Scholes
option-pricing model based on the following data:

Term on the option (time to expiry) 120 days
Continuously compounded risk-free rate 5%
2 Calculate the call and put option’s gamma sensitivity and vega sensitivity to the
underlying asset (share price).

3 Recalculate the value of the option after one week has elapsed (that is, with 113 days to
go), assuming that there has been no change in the other option factors and compare
the old and new prices.
4 Recalculate the value of the option after one week has elapsed and where the volatility
has risen from 25 per cent to 30 per cent and compare the price with the original value.

Module 10
The Product Set II: Extensions to the

Basic Option-Pricing Model
Contents
10.1 Introduction.......................................................................................... 10/2
10.2 Value Leakage ...................................................................................... 10/2
10.3 Value Leakage and Early Exercise ..................................................... 10/8
10.4 Interest-Rate Options (IROs) ........................................................... 10/17
10.5 Complex Options ............................................................................... 10/27
10.6 Learning Summary ............................................................................ 10/31
Review Questions ......................................................................................... 10/32
Case Study 10.1: Applying the American-Style Put Adjustment ............ 10/36
Case Study 10.2: Valuing an Interest-Rate Option ................................... 10/36
Learning Objectives
This module looks at how the basic option-pricing model can be expanded to
include options on classes of instruments with different behaviour characteristics. It
also discusses the adjustments required to value American-style options where there
is the possibility that it is more profitable to exercise the option before expiry. The
module also looks at exotic options which modify one or more of the standard
features of traditional options.
Most of the adjustments to the model are not complicated once the logic of the
change is understood and involve only minor alterations to the basic pricing
equations. That said, interest-rate options create some special problems in pricing
given the special characteristics of interest-rate-sensitive assets.
After completing this module, you should know how to price options when:
 there is a value ‘leakage’ in the form of dividends or interest payments;
 the option is on an exchange rate between two currencies;
 the option allows the holder to ‘lock in’ an interest rate;
 there is the possibility of early exercise, as is the case with American-style
options;
and you should understand:

 the complexities of pricing interest-rate options.

Module 10 / The Product Set II: Extensions to the Basic Option-Pricing Model
10.1 Introduction
Although the original Black–Scholes option-pricing model was only designed to
value calls on non-dividend-paying stocks, the model has been successfully adapted
to pricing other assets. In fact, the basic methodology of replication has enabled
financial engineers to offer option products on a very wide range of assets and to
develop many different types of options. For instance, average-rate options pay an
average of the value of the underlying asset over the option life, with the average-
rate strike option having a strike that is set at expiry at the average of the asset value
over the option life. All-or-nothing, binary or digital options have a fixed payout if
they expire in-the-money.
This module will look at how the Black–Scholes and binomial option-pricing
models can be adapted to allow for the specific characteristics of different assets. In
particular, it will look at options on currencies and interest-rate-sensitive assets.
10.2 Value Leakage

The original restrictions of the Black–Scholes model stated that the underlying asset,
a company’s ordinary share or common stock, paid no dividends. This was obvious-
ly a major restriction since, in most cases, firms pay semi-annual or even quarterly
dividends. In order to price most options on stocks correctly, we need to adjust for
dividend payments if there is a distribution during the option period. This is likely to
be the case most of the time unless the option has a very short life.
Dividends have a large impact on option values: they increase the value of puts and
decrease the value of calls since, all else being equal, a dividend distribution will
reduce the market price of the share.* This relationship is summarised in Table 10.1.
Table 10.1 Effect of dividends on the value of calls and puts

Type of option Effect on price at Effect on option value
expiry
Calls Price reduced Value reduced
Puts Price reduced Value increased
10.2.1 Simple Adjustment for Dividends

If the option is short term, the dividend can usually be predicted with a fair degree
of accuracy. We know that, for calls, the dividend will reduce the share value as the
dividend value is paid (or ‘leaks’) away. If we have a share trading at , then the
current value of the share, less the dividend ( ) paid at time , will be:
∗ ( )
= − ﴾10.1﴿
* There may well be informational aspects of the dividend announcement which have an impact on the
market value of the shares.

In order to price the option correctly, we simply substitute ∗ into the Black–
Scholes formula to determine the adjusted value of the option based on the ex-
dividend share price that will prevail at expiry.
If we have a six-month option with a strike price of 100 and the current non-
dividend-paying stock is also 100, then with a volatility of 0.25 and a risk-free rate of
5.57 per cent, we have a value for the call of 8.406 and for the put of 5.659. For the
same option which pays a dividend of 2.5 in three months, the adjusted stock price
becomes 97.534, the present value of the dividend being 2.465 (2.5 ÷ 1.014). The
dividend-paying adjusted option values using the Black–Scholes model are then
7.014 for the call and 6.710 for the put (see Table 10.2).
Table 10.2 Option-value changes when dividend adjustments are

included
Option value No dividend With dividend
Call 8.406 7.014
Put 5.659 6.710
What we have done is to factor out the (present) value of the (known) dividend
that is in the current price of the stock. Using this approach, it is possible to adjust
other assets subject to similar value leakages to get the correct option value. Note that
since the call value will fall in such an approach, the use of ∗ in the equivalent put
model or the use of the put–call parity relationship rightly increases the corresponding
put price, as required by Table 10.1.
10.2.2 Merton’s Continuous-Dividend-Adjustment Model

Where we are unsure of the exact dividend payment or where dividends are being
paid continuously, as would be the case if the option was on a basket of stocks, such
as a stock index, then another approach is to adjust the stock (index) price by the
continuous dividend yield ( ).* We therefore adjust the Black–Scholes equation by
( )
the continuous yield such that the stock price now becomes · .
The call price with continuous dividend-yield adjustment is:
( ) ( )
= · ( )− · ( ) ﴾10.2﴿
where all the terms are as previously defined.
The put price with continuous dividend-yield adjustment is:
( ) ( )
= · (− )− · (− ) ﴾10.3﴿
The sub-equations 1 and 2 now become:
* See Merton, Robert (1973) ‘Theory of rational option pricing’, Bell Journal of Economics and Management
Science, 4 (Spring), 141–83.

ln + − + ( − )
﴾10.4﴿
2
=
( − )
ln + − − ( − )
2
=
( − )
or:
= − ( − )
This dividend adjustment is similar to that in Section 10.2.1, except that, for the
sub-equation 1 , the expansion term is now the net difference between the risk-free
rate and the dividend yield. This net difference approach between the two yields is
the basis for valuing currency options, to which we turn next.
10.2.3 Currency Options

The simple and continuous dividend-adjustment models given above suggest a way of
valuing options on currencies. With a currency option, the foreign currency is
equivalent to a stock paying a known dividend yield. The holder of a foreign currency
is the recipient of payments equal to the risk-free interest rate in the foreign currency
( ). In order to calculate the option’s value, we can replace the continuous dividend
yield ( ) with ( ). The values of European-style calls and puts on currencies are
obtained by Equation 10.5 and Equation 10.6.*
For calls on currencies:
( ) ( )
= ( )− ( ) ﴾10.5﴿
For puts:
( ) ( )
= (− )− (− ) ﴾10.6﴿
where:
ln + − + ( − )
﴾10.7﴿
2
=
( − )
ln + − − ( − )
2
=
( − )
or:
* The Black–Scholes option-pricing model applied to currencies often goes by the name of the Garman–
Kohlhagen model as these authors were the first to publish a closed form model. See Garman, M. and
Kohlhagen, S. (1983) ‘Foreign currency option values’, Journal of International Money and Finance, 2, 231–
7.

= − ( − )
and where is the spot exchange rate between the two currencies. The domestic
or base currency interest rate is ( ) and the foreign interest rate ( ).
Note that calls and puts on currencies are the same. The call provides the right to
buy a given quantity of the foreign currency in exchange for the base currency and is
equivalent to the put, which gives the right to sell the base currency in exchange for
a given quantity of the foreign currency!
If we were pricing the option against the forward exchange rate, rather than the
spot, the continuous form of the cost-of-carry model would give the forward rate
( ) at time as:
( )( )
= ﴾10.8﴿
If we substitute Equation 10.8 into Equation 10.5 and Equation 10.6, we have:
= [ · ( )− · ( )] ( ) ﴾10.9﴿
( )
= [ · (− )− · (− )] ﴾10.10﴿
The Black–Scholes sub-equations then become:
ln + ( − )
﴾10.11﴿
2
=
( − )
ln − ( − )
2
=
( − )
or:
= − ( − )
That is, we lose the term − in the Black–Scholes sub-equations. This is a
happy result of using the forward rate rather than the spot rate on the asset.
Equation 10.9, Equation 10.10 and Equation 10.11 are known as Black’s model,
which was developed to price futures options.
10.2.4 Options on Futures

The previous section gives a method of pricing currency options against the forward
contract price. The approach, devised by Fisher Black (1976), was originally devel-
oped to price options on futures. As we have seen, futures and forwards are
essentially equivalent. The model works both for forward contracts and for futures.
Many futures exchanges offer options on futures contracts (often called futures
options) as an addition to investing in the futures. At exercise, they require the
delivery of an underlying futures contract, plus a sum representing the difference
between the market value of the future price and the option’s strike price ( ). If a
call is held, it provides the holder with the right to own a long futures position; if a

put is held, it provides the holder with the right to own a short futures position.
Usually, futures options are for one futures contract.
Options on futures are written on both financial futures, such as long-term inter-
est rate or bond futures, and commodities, such as gold, copper, soybeans, wheat,
crude oil and so on.
The generalised continuous cost-of-carry model in Equation 10.8 can be rewrit-
ten as:
( )
= ﴾10.12﴿
where is the net cost of carry. For financial instruments, is the risk-free interest
rate for the period ( − ). For commodities, it is the risk-free rate ( ), plus storage
costs, insurance and deterioration (expressed as a yield) (w), less the convenience
yield ( ) (for commodities: = + − ). The Black–Scholes equations for
futures options are then:
= [ · ( )− · ( )] ( ) ﴾10.13﴿
( )
= [ · (− )− · (− )] ﴾10.14﴿
The Black–Scholes sub-equations for Equation 10.13 and Equation 10.14 are:
ln + ( − )
﴾10.15﴿
2
=
( − )
ln − ( − )
2
=
( − )
or:
= − ( − )
Note that Equation 10.9, Equation 10.10 and Equation 10.11 are equivalent to
Equation 10.13, Equation 10.14 and Equation 10.15, where the forward price ( ) has
been replaced by the futures price ( ). Equation 10.15 does not include the interest
rate ( ) to derive 1 or 2 .
We can use Black’s futures version of the option-pricing model in the cost-of-
carry model of Equation 10.12 when (a) is only a function of time and (b) the
volatility of the asset underlying the futures contract is constant. Condition (b) is, of
course, equally a requirement of the original Black–Scholes model.
Black’s model provides a reasonable result when the underlying futures (forward)
contracts are on currencies, stocks or stock indices, and commodity futures. The
model is less appropriate when the underlying asset is interest-rate sensitive, as is the
case with options on short-term interest-rate futures or long-term interest-rate
(bond) futures. There is a fuller discussion of interest-rate options in Section 10.4.

10.2.5 Commodity Options

Options on commodities might, at first glance, present some pricing difficulties.
Commodities are not primarily held for investment purposes and they are subject to
special effects such as the convenience yield and storage costs. Such effects are likely
to ‘contaminate’ any option-pricing model on such assets. One way round this
problem is to use observable commodity forward or futures prices, as discussed in
the previous section. By definition, the forward or futures price at any particular
point will be a function of interest rates ( ), storage and depreciation costs ( ) and
the convenience yield ( ). The relationship between the spot price and the for-
ward/futures price will be:
( )( )
= ﴾10.16﴿
If we know the storage and depreciation costs associated with holding the com-
modity, as per Equation 3.10 (as discussed in Module 3 on pricing forward
contracts), we can solve for the unknown convenience yield by re-arranging
Equation 10.16 as follows (note this is the same as Equation 3.12) as:
= ln + ( + )( − ) /( − ) ﴾10.17﴿
In pricing a commodity option, the value for is equivalent to an implicit dividend

yield from holding the commodity, less the cost of storage. This allows the use of a
variant of Merton’s continuous-dividend model, discussed in Section 10.2.2, where
( − ) is substituted for in Equation 10.2, Equation 10.3 and Equation 10.4. The
commodity option-pricing model then becomes, for calls:
( )
= ( )− ( ) ﴾10.18﴿
For put it is:
( )
= (− )− (− ) ﴾10.19﴿
and the sub-equations become:
( )
﴾10.20﴿
ln + + ( − )
2
=
( − )
( )
ln + − ( − )
2
=
( − )
or:
= − ( − )
An alternative approach is to price the option directly on the futures price, using
Black’s Equation 10.13 and Equation 10.14 for calls and puts respectively.

10.3 Value Leakage and Early Exercise

In the preceding sections we have seen how to make simple adjustments to the
option value to take account of a predictable value leakage, such as a dividend
payment. However, if the dividend is very large, it might even be profitable to
exercise a call option in order to capture the dividend. Value leakage is not a
problem for puts, although it may make early exercise more desirable (see Ta-
ble 10.1).
Early exercise is possible if the option is American style, that is, it allows the
holder to exercise prior to the expiry date. In the absence of dividends, it will never
be optimal to exercise an American-style call option before expiry since the holder is
then surrendering time value. Under the no-dividend condition, American-style and
European-style call options are equivalent. When there is value leakage, it can only
be most advantageous to exercise just before the stock goes ex-dividend. Holders of
shares before the ‘ex-dividend’ date are entitled to receive the dividend payment.
Exercise will thus be on the last trading day before the ex-dividend date. By exercis-
ing early, the holder gets the dividend but equally surrenders any remaining time
value.
Decisions as to the desirability of early exercise in the case of value leakage re-
volve around whether it is more advantageous to keep the remaining time value of
the option or whether it is better to capture the leakage. This is not subject to an
analytic solution.
Let us assume there are a number of dividend dates ( ) before the expiry date ,
with corresponding dividends ( ), such that 1 < 2 … < < . At the final
dividend date ( ) before the option’s expiry, there are two possible values. Early
exercise gives the holder . Doing nothing provides an option value of − −
− ( − )
immediately after the stock goes ex-dividend.
Decisions on early exercise will therefore depend on the relationship between
these two values:
( )
− − ≥ − ﴾10.21﴿
Early exercise will thus be conditional on the size of the dividend ( ) at time .
This is summarised in Table 10.3.
Table 10.3 Conditions for early exercise of an option at time

Early exercise not optimal Early exercise optimal
≤ 1− ( )
> 1− ( )
In the case where the dividend is equal In the case where the dividend is
to or less than the remaining time value, greater than the remaining time value,
the surrendered time value of the the surrendered time value of the
option is greater than the value of the option is less than the value of the
dividend received. Early exercise is thus dividend received. Early exercise is thus
not optimal. optimal.

The assessment as to whether to exercise early will depend on whether the divi-
dend is greater than the loss of time value. Typically, this will only be the case when
the option is near to expiry or where the value leakage is exceptionally large.
We consider next the dividend at time −1 to determine whether it is optimal to
exercise at this point. At the penultimate dividend date ( ), there are two
possible values. Early exercise gives the holder −1
− . Doing nothing provides
− ( − )
an option value of −1
− −1 − immediately after the stock goes ex-
dividend.
As with the last dividend, the decision to exercise early will depend on:
( )
− − ≥ − ﴾10.22﴿
or, equivalently, if:
( )
≤ 1−
it will not be optimal to exercise at time −1 . We can show that for all dividends if:
( )
≤ 1− ﴾10.23﴿
it will never be optimal to exercise.
Equation 10.17 shows that unless the dividend (or dividend yield) is the same as
or higher than the risk-free rate, it is never optimal to exercise early. However, as a
general rule the attraction of early exercise increases as the option moves closer to
expiry. In usual circumstances, we may conclude from the above that the only case
that needs to be examined is the final dividend at time .
10.3.1 Pseudo-American Adjustment for Calls

Given that we can be reasonably certain that early exercise is only likely at the last
dividend payment before expiry, Fisher Black proposed an approximating solution
to the problem of early exercise for American-style calls using the Black–Scholes
model. This is frequently called the pseudo-American adjustment for dividends.*
The approach involves two valuations of the option, the original calculation for a
European-style option expiring at time , adjusted for the value leakage, and the
same option expiring at time . The value for an American-style option is the
higher of the two prices so derived. The resultant value also indicates whether early
exercise is likely to be optimal.
We have already priced a six-month option with a dividend of 2.5 in three
months in Section 10.2.1. The equivalent option expiring in three months has a
value of 5.651. The option is therefore valued at the higher value of 7.014.
If, however, the dividend had been paid in Month 5, then the five-month option
has a value of 7.570 as compared to 7.014 for the six-month one. Early exercise is
* See Black, Fisher (1975) ‘Fact and fantasy in the use of options’, Financial Analysts Journal, 32
(July/August), 36–41 and 61–72.

thus potentially optimal and the American-style option is valued at the higher five-
month price.
We can illustrate the situation graphically, as in Figure 10.1. When the value leak-
age from the dividend is a long way from the expiry date (as shown in Panel [A]),
the stock has a greater potential to rise above the strike price. When the value
leakage is close to the expiry date (as shown by Panel [B]), this is less likely, thus
increasing the likelihood that early exercise is the right decision.
Share price
[A]
t1 T
Share price
[B]
t2 T
Figure 10.1 Dividend payments and share value

To summarise, early exercise tends to be optimal if the option is trading in-the-
money and there is a short time to expiry, and hence the option has little time value
left. Note that the pseudo-American adjustment actually slightly undervalues the
American-style call since it assumes that the option holder makes the decision
upfront about whether to exercise, whereas in fact the holder has the right through-
out the option’s life and therefore retains the flexibility as to which course of action
is preferable.
10.3.2 Early Exercise for Puts

The changes required to the basic Black–Scholes model described in Section 10.3.1
work quite well for calls. However, the approach is unsatisfactory when it comes to
American-style puts. The basic problem is that it may be optimal to exercise a put
early even if there is no value leakage. There is also no single point in the life of a

put at which a pseudo-American adjustment, as just described, can be applied. The

problem is that the desirability of exercising a put depends on the degree to which it
is trading in-the-money.
Early exercise is attractive for puts since it liberates value which can then be
reinvested. For instance, if the strike price is 50, but the underlier price is at 5,
then immediate exercise ( − ) allows a gain of 45 to be realised. For European-
( )
style options, without early exercise, the value of the option will be ( − )
so if in the above case, we have to wait three months and interest rates are 6 per
cent the current put value will be 44.26. In this case we’re better off exercising
immediately and getting 45 rather than waiting for three months. In addition, the
price might subsequently recover and some of the gain is then lost. Receiving the
gain now is always better than receiving the gain later, so early exercise is desirable
when the underlier has fallen below the strike price by some margin. This is the
critical price point A shown in Figure 10.2.
Given the above, we find that early exercise of puts becomes more likely under
three conditions:
 As the underlier price falls relative to the strike price, that is, the put moves
‘deeply into-the-money’.
 As interest rates rise, increasing the attractions of liberating value now for
reinvestment.
 As volatility falls, decreasing the probability of future, advantageous price
declines.
When early exercise is the optimal strategy, the value of the option becomes the
difference between the strike price and the asset price ( − ). For American-style
puts, the value curve therefore merges into the intrinsic value line for puts when is
small relative to , as shown in Figure 10.2. At point ( ), the put value becomes
equal to the intrinsic value ( − ). However, for European-style puts without the
opportunity for early exercise under the above conditions, if the exercised value
becomes very large, there may be times when these puts are worth less than their
intrinsic value. The same relationship for American-style puts in Figure 10.2 is
shown for European-style puts in Figure 10.3, where the point of convergence is at
( ′). In this case the lower boundary condition is the present value of the strike
price ( ( − ) and not ( − ).

American-style
put price
A K Asset price
Figure 10.2 Price of an American-style put prior to expiry
European-style
put price
K
PV(K)
A' PV(K) K Asset price
Figure 10.3 Price of a European-style put prior to expiry

The difference in value between the American-style and European-style puts
relates to the region to the left of and ′ respectively. There have been problems
developing an analytical solution to pricing American-style puts and the simplest
approach is to adopt the numerical procedures available from using the binomial
option pricing model for puts while adding a check at each step for the desirability
of exercise, namely:
≥( − ) ﴾10.24﴿
We will use the put terms given in Table 10.4 to illustrate the procedure. First we
will price the put assuming it is European-style.

Table 10.4 Terms and conditions for the six-month, American-style put
Variable Value
Strike price ( ) 100
Stock price ( ) 100
Time to expiry ( − ) 6 months (0.5 year)
Δt 1 month (0.0833 year)
Risk-free rate ( ) 5.57%
Volatility ( ) 0.25
Pricing factors
u 1.0748
d .9304
PV factor .9954
p .5142
(1 – p) .4858
The tree for the underlier calculated using the binomial approach is given in
Table 10.5. The price diffuses at 1.0748 per period if it rises, so the 6 period
maximum price = 100 × 1.0748 = 154.19. If the price declines then it falls by
1/1.0748. So after six steps the lowest price will be = 100 × 1.0748 = 64.86. The
other prices are calculated in a similar manner.
Table 10.5 Underlier price tree and exercised value of put option (K – U)
at expiration
Months
0 1 2 3 4 5 6 (K – U)
154.19 0
143.45
133.47 133.47 0
124.17 124.17
115.53 [L] 115.53 115.53 0
107.48 [N] 107.48 [I] 107.48
100 100.00 [K] 100.00 [F] 100.00 0
93.04 [M] 93.04 [H] 93.04 [C]
86.56 [J] 86.56 [E] 86.56 13.44
80.53 [G] 80.53 [B]
74.93 [D] 74.93 25.07
69.71 [A]
64.86 35.14
For explanation of the significance of the letters see text.

Using the backward induction technique, we can price the European-style put
using the straightforward numeric technique where we work back from the known
expiration values ( − ) to the present. The pricing process is shown in Ta-
ble 10.5. Recall that the price at [A] will be calculated as:
= ( × + (1 − ) × )
. (. )
= 29.8281 = (. 5142 × 25.07 + .4858 × 35.14)
We work back through the tree in similar fashion using the values derived at the
different nodes [A to N] to calculate the preceding values. At time zero, the value of
the European-style put is therefore 5.3733 as shown in Table 10.6.
Table 10.6 Backward induction through tree for calculating the value of
the European-style put (terms in Table 10.4)
Months
0 1 2 3 4 5 6
0
0
0 0
0 0
0.7350 [L] 0 0
2.5439 [N] 1.5199 [I] 0
5.3733 4.4827 [K] 3.1430 [F] 0
8.4193 [M] 7.6613 [H] 6.4995 [C]
12.6662 [J] 12.5164 [E] 13.44
18.0844 [G] 19.0042 [B]
24.1504 [D] 25.07
29.8281 [A]
35.14
However, if the put had been American-style, we may find there are particular
nodes where we would prefer to exercise early. At point [A] we find that the
exercised value is 30.29, more than the ‘live’ value of 29.8281 for the European-style
option – so we would want to exercise at this point. Moving up a node, at point [B]
we find that the exercised value is 19.47, also above the live value – so once again
we would want to exercise the put, if possible. At point [C], we find ( − ) = 6.96,
so again we would want to exercise.
For valuation purposes, when calculating the value of the American-style option
where we have the contractual flexibility to exercise early, we therefore replace the
‘live’ values with exercised values in our backward induction valuation when
working out the value of the American-style put. So for node [D], we will have:
. (. )
= 24.6114 = (. 5142 × 19.47 + .4858 × 30.29)
We find that when we compare this value to the exercised value at node [D] then
the option is again worth less alive than exercised. We therefore again replace the

live value with the higher exercised value of 25.07. We repeat this process for node
[E] since exercise is also optimal at this point.
Table 10.7 Values of put at early exercise at each node

Months
0 1 2 3 4 5 6
0
0
0 0
0 0
0 [L] 0 0
0 [N] 0 [I] 0
0 0 [K] 0 [F] 0
6.96 [M] 6.96 [H] 6.96 [C]
13.44 [J] 13.44 [E] 13.44
19.47 [G] 19.47 [B]
25.07 [D] 25.07
30.29 [A]
35.14
Nodes in bold have values which exceed value of put unexercised calculated using backward
induction method for the European-style put option in Table 10.6.
So moving back towards the present at each node, we test whether the put is
worth more to us exercised (i.e. we look up ( − )) or should be held to the next
period. Note what happens, while we find that node [J] is optimal when compared
against the European-style valuation, the higher node values at [G] and [H] derived
from exercise means that holding on for another month at [J] becomes the optimal
strategy. The American-style option pricing tree is shown in Table 10.8. This shows
that the value for the American-style put using the binomial option pricing valuation
is 5.7725 when compared to the European-style valuation of 5.3733. That is, the
additional flexibility of early exercise in the American-style option means it is
worth .3992 more than its European-style counterpart; that is, it is about 7.4 per
cent more valuable.
Table 10.8 Value of American-style put using the binomial option pricing
model
Months
0 1 2 3 4 5 6
0
0
0 0
0 0
0.7874 [L] 0 0
2.7288 [N] 1.6282 [I] 0
5.7725 4.8096 [K] 3.3670 [F] 0
9.0490 [M] 8.2227 [H] 6.96 [C]

Months
0 1 2 3 4 5 6
13.6223 [J] 13.44 [E] 13.44045
19.47 [G] 19.47 [B]
25.07 [D] 25.07444
30.29 [A]
35.14477
Nodes in bold are where it is optimal to exercise the option early.
Looking at Table 10.8 you will notice that early exercise becomes desirable as the
option approaches expiration and/or moves deeper into-the-money, just the
conditions described above when the American-style option is likely to be exercised.
The reason time matters, of course, is that – as expiration nears – the time value of
the option will have declined and hence the value of waiting has fallen. Equally a
significant fall in the underlier price will lead to the put being ‘deep-in-the-money’
and hence the payout will be below the critical A’ value – as shown in Figure 10.3 –
where the European-style call is worth less than its intrinsic value. Under both these
conditions, early exercise becomes the optimal strategy. Given the additional
flexibility given to American-style put options then this means that – as a rule – they
are worth somewhat more than their European-style equivalents.*
Using the Binomial Option-Pricing Model to Price American-
Style Calls and Puts _________________________________________
As discussed in the earlier section with value leakage early exercise may be the
optimal strategy. Adjusting the binomial model for the possibility of such early
termination is relatively simple. At each of the nodes in the lattice, the value of
the option is calculated under two conditions, unexercised and exercised (that
is, for a call ( − ) and for a put ( − )). Whichever value is the higher is the
option value used to price the option at that node. This higher value is then
used when working back through the tree.
In Figure 10.4, we have the following two-period share price tree. Figure 10.5
shows the corresponding European-style put option values.
121
110
100 104.5
95
90.70
Figure 10.4 Two-period binomial lattice
* Recall that for calls there will only be a value difference if the underlier has value leakage (that is, pays
dividends, etc.) otherwise the American-style and European-style options will be worth the same.

0.94 0
2.95
9.30
Figure 10.5 European-style put with two periods to expiry

The value of the American-style put will always be the higher of the put price at
time , prior to expiration, or ( − ). In Figure 10.5,the European-style put
with one period to go has a value of 2.95. However, the corresponding exer-
cised price will be 5 ( − = 100 − 95). The current value of the American-
style put allowing for early exercise will therefore be 1.59 — considerably more
than the 0.94 value for the European-style put. This clearly shows that the right
to early exercise provides the put holder with valuable additional flexibility—
which in our pricing model is translated into additional value.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
10.4 Interest-Rate Options (IROs)

This section extends the use of option-pricing models to options on interest rates.
There are three basic kinds of interest-rate option: options on short-dated, or money
market, instruments with one simple set of cash flows; options on term debt
instruments, such as bonds, which have complex sets of cash flows and options on
interest-rate futures (futures options).
10.4.1 Problems with Valuing Interest-Rate Options

For certain problems of valuation, relatively simple adjustments can be applied to
derive an adjusted value for options. The earlier sections show that, where there is
value leakage or the possibility of early exercise, simple alterations to the basic
equation can be used. However, interest-rate options present some special prob-
lems. The first is the obvious illogicality of using the Black–Scholes option-pricing
model, with its assumption of a constant risk-free interest rate, to value an option
which is based on changes in interest rates! The second problem is that interest rates
do not follow a lognormal distribution. There is a strong ‘reversion to the mean’
effect, with the level of interest rates returning to some long-run equilibrium level.
This means that very high and very low rates are unlikely to continue for long and
this therefore affects the values of any such option.

Standard deviation
of price
Equity
Bond
Maturity of the bond Time
Figure 10.6 Price volatility for the future price of a bond and a share
The third problem is that for most kinds of term interest-rate-sensitive securities,
there will be a ‘pull to par’ over the life of the asset. This is shown in Figure 10.6.
Whereas the share price standard deviation continues to increase with time, that for
a debt instrument will initially rise but gradually price volatility will fall as the
instrument moves towards maturity. This sort of behaviour violates one of the key
assumptions used for pricing options with the Black–Scholes model.
The above problems mean that valuing interest-rate options is a more complicat-
ed problem than valuing other instruments. This is partly due to the fact that such
options are pricing assets whose value depends, either wholly or in part, on the term
structure of interest rates. The difficulty is also due to the fact that the behaviour of
interest rates over time is quite complicated and, as discussed above, subject to
mean reversion. As a result, interest-rate-option pricing rapidly becomes very
complicated and mathematically demanding. That said, for certain interest-rate
products, simpler solutions provide a reasonably accurate valuation. This section is
restricted to a discussion of the simpler adjustments and ends with a brief summary
of the more complex approaches being developed.
10.4.2 Pricing Using the Forward Rate

One approach is to use the forward rate (or price) in order to price the option. This
is the same approach as used for pricing options on futures that was discussed in
Section 10.2.1 above. Recall that Black’s model provides the following pricing
equation:
= [ · ( )− · ( )] ( ) ﴾10.25﴿
( )
= [ · (− )− · (− )]

The sub-equations are:
ln + ( − )
﴾10.26﴿
2
=
( − )
ln − ( − )
2
=
( − )
or:
= − ( − )
In this case, we look at the forward or futures price (FP) rather than the current
asset price.
10.4.3 Options on Interest-Rate Futures

Most futures exchanges also offer options on futures. Because the option is on the
futures price and not on the interest rate, the interest-rate call is a futures price put!
Because of the way that futures prices are constructed, being an index for short-
term rates and a notional bond price for long-term rates, the distribution of prices
would not be lognormal. To get round this problem, the asset is the interest rate and
calls on interest rates are used to price the put on the futures price.
There is an added factor to consider: margin. In the simple option-pricing model,
the premium is paid to the writer as part of the requirement to compensate the
writer for the initial cost of replicating the position. In the case of a futures option,
many exchanges do not transfer the value of the premium to the writer, but instead
treat the premium in the same way as margin. That is, the holder pays an initial
margin which is usually a fraction of the premium amount. This is held by the
exchange and the buyer needs only to ‘top up’ the position if the market price and
time decay erode the value of the deposit with the exchange. In such a situation, the
writer does not receive the premium upfront and will therefore charge the holder
the interest cost. In this case, Black’s equation simplifies to:
= [ · ( )− · ( )] ﴾10.27﴿
= [ · (− )− · (− )] ﴾10.28﴿
The equation 10.28 and equation 10.29 have the virtue that, in pricing options on
interest rates, there is no assumption that short-term rates are constant while, at the
same time, an option is priced on forward, stochastic rates. The option is simply
priced on a (stochastic) forward rate.

10.4.4 Applying the Black–Scholes Model to an Interest-Rate Product

This section* extends the analysis in Section 10.4.2 to the pricing of an option on a
Forward Rate Agreement (FRA), which, in typical market fashion, is known as a
fraption. FRAs are discussed in Module 3 on forwards. The key point is that the
rate on the FRA, in the absence of any transaction costs, is the implied forward rate
for the relevant maturity. As a result, with an FRA we are looking at the future value
of the asset, not its current value. A time diagram of the option cover as compared
with the interest-rate protection period on the FRA, as shown in Figure 10.7, can
help explain the situation.
Time
Option period FRA
t T Interest rate protection period (M – T)
Expiry of IRO M
strike = K
Interest rates
ZM – T
ZT – t FM – T
Figure 10.7 Relationship of variables used in interest-rate option (IRO)

pricing to the time line
Note: The option period is from time t to T, the interest cover from T to M. The risk-free interest
rate from now to T is − , the forward rate from T to M, − .
We therefore require the set of data given in Table 10.9.
Table 10.9 Data for pricing a fraption (an option on an FRA)

Variable Value
Asset rate ( % ) from yield curve 6.125%
Strike (or exercise) rate ( %) 6.00% (that is, the option is just ‘in-the-
money’)
Tenor of FRA ( − ) 92 days (= 0.2521 years)
Risk-free interest rate ( ) 5.9375%
Volatility ( ) 0.20 (20%)
Start date (T) (59/365) 0.1616 (years)

End date (M) (151/365) 0.4137 (years)
The future value of the asset (in this case the FRA) is represented by % − . The
value of the difference in interest rates (that is, ( − ) ) paid at time M is .
* This follows an approach given in Manson, Bernard (1992), The Practitioner’s Guide to Interest Rate Risk
Management. London: Graham and Trotman/Kluwer Academic Publishers.

We also need to convert the interest rate to an asset value. Recall that the Black–
Scholes model is designed to price an asset and not a rate. Let us assume that the
notional principal on the FRA is £5 million. The periodic equivalent of this is thus
the notional value times the tenor (as a fraction of a year), as given in Table 10.10.
Table 10.10 Data required to convert an interest-rate quoted asset to an

asset-value equivalent for Black’s model
Variable Value
Notional principal £5 000 000.00
Cap notional principal ( ) = notional principal × tenor of FRA £1 260 273.97
FRA value (F) = Market value of FRA rate × Cap notional princi- £77 191.78
pal ( )
Strike (K) = Strike rate (K%) × Cap notional principal ( ) £75 616.44
Zero coupon rate to FRA value date( ) 5.9375%
Zero coupon rate to option maturity date ( ) 6.125%
We now can solve the result for the Black–Scholes model, starting with the sub-
equations to derive 1 and 2 :
77 191.78 0.20 ﴾10.29﴿
ln + (0.1616)
75 616.44 2
=
0.20 (0.1616)
= 0.29666
= 0.29666 − 0.20 (0.1616)
= 0.21626
The relevant values for ( ) and ( ) are then 0.6166 and 0.5857, whereas
= £77 191.78, = £75 616.44, = 0.057679 and ( − ) = 0.1616. These
values are then used to calculate the value of the fraption as:
[77 191.78(0.6166)−75 616.44(0.5857)] . ( . )
=
= £3277.21
10.4.5 Other Short-Term Interest-Rate Options

The other major class of short-term interest-rate options comprises caps and
floors. Caps provide interest-rate cover above a given strike rate over a number of
forward periods and are a portfolio of sequential options covering the reset period.
Floors provide the opposite protection below a given strike rate, that is, they protect
against interest-rate declines and provide a minimum interest rate. The two are
illustrated in Figure 10.8; for the third reset period, the cap is in-the-money, whereas
throughout the period the floor remains out-of-the-money.

Cap period
Caplet protection periods
T1 T2 T3 T4
Cap 'in-the-money' for the sub-period T3 at the repricing date.

Interest
Note the payout is made at the end of the period.
rate
Cap rate
Interest rate
Floor rate
Time
Figure 10.8 How caps and floors provide a series of protection periods
The cap (and floor) are priced as a series of options. The first will have a payout
date at the end of period 1 , the second at the end of 2 and so on. The determina-
tion of whether the option is in-the-money is made at the start of the interest-
protection period, that is, for the first protection period, at the initiation of the
transaction.
The only difference between cap pricing and that for the FRA will be the fact
that, with the cap and floor, the payout takes place at the end of the period. The
value of the option derived using the forward price has to be discounted for the fact
that payment takes place at the end of the caplet period, rather than at the start, as
with the FRA (and conventional options). Therefore the value of the individual cap
period (or caplet) would be:
Option price ﴾10.30﴿
Caplet price =
(1 + )
The cost of the cap in Figure 10.8 would be the sum of the individual options
calculated from the sub periods, that is the options for, 1 , 2 , 3 , and 4 .

10.4.6 Bond Options

While Black’s model works reasonably well for short-term interest-rate options, it is
inadequate for options on bonds. There are several related problems that arise when
pricing bond options:
1. There is the assumption that bond rates are volatile whereas short-term interest
rates are not. This problem has already been discussed in the context of options
on short-term interest rates and the solution is, once again, to price the option
off the forward rate. Note in this context that it has also been suggested that
assuming short-term rates are constant while long-term rates are volatile does
not greatly misprice the value of short-dated options on long-term bonds.
2. The bond price will not be lognormally distributed. The ‘pull to par’ effect will
constrain the bond price towards parity as it gets closer to maturity. This effect is
illustrated in Figure 10.9.
Price
Parity
Decreasing price volatility

0
Remaining maturity
Figure 10.9 Bond price volatility and remaining term to maturity

3. If the redemption price of the bond, as shown in Figure 10.9, is parity, the
‘volatility’ of the price will decline as the remaining term to maturity decreases.
If we have a 6 per cent coupon bond, paid annually, and the bond has a five-year
maturity, then at each year to maturity, it will have the prices shown in Table 10.11
if the market’s required yield to maturity is 8 per cent and 9 per cent.

Table 10.11 Bond price behaviour as term to maturity reduces

Period to At 8% At 9% Price difference
maturity
1 98.15 97.25 0.90
2 96.43 94.72 1.71
3 94.85 92.41 2.44
4 93.38 90.28 3.09
5 92.01 88.33 3.68
In order to price an option on the bond correctly, the key requirement is to esti-
mate the bond price volatility at the forward price. This will, following Figure 10.9,
decline as the bond moves towards maturity. Schaefer and Schwartz (1987) have
provided a method of adjusting volatility that takes account of the remaining term
to maturity of the bond at the forward date.* They show that the relationship of
bond volatility to duration is constant. This means that by adjusting the volatility by
duration, one can arrive at the correct forward volatility for the bond. Their formula
for the adjusted volatility to be used in pricing the option is given by:
=( · ) ﴾10.31﴿
where and are constants, is the bond price and its duration. In applying the
model, is found by solving Equation 10.31 for , and using the observed (or
historical) bond volatility, such that:
= ﴾10.32﴿
( )
where the tildes indicate an estimated element. Schaefer and Schwartz suggest a
value for of 0.5 be used.
If we apply the model to our five year bond, then the duration of the bond at the
two different interest rates over its life will be as shown in Table 10.12.
* Duration is a measure of the interest rate sensitivity of a debt instrument or bond. The formula for
Macaulay’s duration is:
·
= ∑ /∑
(1 + ) (1 + )
and modified duration is simply /(1 + ), where y is the yield on the debt instrument. In
seeking to understand the adjustments required for pricing interest rate options, it is sufficient to
understand at this point that there is a linear relationship between a bond’s observed volatility and its
duration.

Table 10.12 Duration for a five-year 6 per cent bond at varying

maturities at 8 per cent and 9 per cent yields
Duration
Maturity at 8% at 9%
1 1 1
2 1.942390 1.941887
3 2.828615 2.826210
4 3.660322 3.653891
5 4.439323 4.426189
If the observed volatility for the bond at Year 4 is known to be 12 per cent, the
value of for an option expiring at Year 3 using Equation 10.32 will be:
0.12
=
(93.38 )3.660322
.
= 0.3168
The expected volatility of the option at Year 3 will then be:
.
= (0.3168×94.85 )2.8286
= 0.0920
Table 10.13 shows the differences in volatilities arrived at by using the Schaefer–
Schwartz adjustment as compared to the original estimate of 12 per cent. It also
gives the option price for a one-year option using Black’s model from Section 10.4.2
and the option price modified using the Schaefer–Schwartz adjusted volatility.
Table 10.13 Comparison of pricing with the unadjusted Black’s model and Black’s
equation using an adjusted volatility from the Schaefer and Schwartz
method
Schaefer– Schaefer–
Schwartz Schwartz
Unadjusted adjusted Unadjusted adjusted
Year 8% Duration κ volatility volatility Black Black
1 98.15 1 1.189
2 96.43 1.943 0.607 12% 6.12% 0.061 0.0368
3 94.85 2.829 0.413 12% 8.17% 0.061 0.0465
4 93.38 3.660 0.317 12% 9.20% 0.061 0.0507
5 92.01 4.439 0.259 12% 9.82% 0.061 0.0531
Note: Alpha (α) is 0.5 and the option is ‘at-the-money’.
Table 10.13 shows that the unadjusted Black’s pricing model overvalues the
option relative to the adjusted volatility from the Schaefer–Schwartz correction.
This is due to the fact that the price is being pulled to par as the remaining life of
the bond declines, since the observed volatility for a five-year bond at 12 per cent is
higher than the volatility that would be observed in one year’s time of 9.82 per cent.
The results show that – when pricing interest-rate options on bonds – it is neces-
sary to make allowance for the effect of the bond’s declining maturity, as shown in

Figure 10.9. The modified value for a one-year option on a bond with a remaining
life of four years is 0.0531 compared with 0.061 from simply applying Black’s model
unadjusted, an overvaluation of about 13 per cent. As the maturity declines, the
error is magnified since a one year option on a bond with one year’s life remaining is
only valued at 0.0368 once the adjustment is made, a difference of 66 per cent.
10.4.7 Term-Structure Interest-Rate-Option Models

The original Black–Scholes model and its derivatives, such as Black’s model, assume
that the interest rate is the optioned asset. This approach is not without its prob-
lems. With bonds, we have noted that the price is constrained towards par as the
remaining life declines. An alternative and more sophisticated approach to pricing
bond options is to use the term structure of interest rates. In particular, the method
makes use of the spot rates or zero-coupon rates that are implied by observable
coupon-paying bond prices.
In order to use this approach it is necessary to model the evolution over time of spot
rates and bond prices. While the Cox, Ingersoll and Ross (1985) (CIR) term structure
model provides an intellectually cogent approach to the term structure, it is intractable as
a component of an interest-rate-option model. Alternative approaches making use of
the binomial model have been developed by a number of researchers. In particular, the
Ho and Lee (1986) (HL), Heath, Jarrow and Morton (1992) (HJM) and Black, Derman
and Toy (1990) (BDT) models have addressed this problem in different ways. The key
strengths and weaknesses of the various models are summarised in Table 10.14.
Table 10.14 Strengths and weaknesses of the commonly used interest-

rate-option models
Model Strengths Weaknesses
Ho and Lee (1986) Provides analytic solution; European-style options
provides an exact fit to only; little flexibility as to
the current yield curve the choice of volatility
since all maturities have a
common volatility; not
mean reverting
Heath, Jarrow and Fits all forward volatilities Lattice is non-
Morton (1992) at all times recombining – after
steps there will be 2
nodes to the lattice
Black, Derman and Toy Avoids possibility of Analytically intractable
(1990) negative interest rates
Hull and White (1990) Like Ho and Lee, but
explicitly includes mean
reversion
Rendleman and Bartter Binomial model with Not mean reverting
(1980) adjustment for changes in
interest rates

As an approach, the models generally are specified in such a way that (a) interest
rates recombine, so as to limit the size of the resultant binomial (or in some cases,
trinomial) lattice and that (b) zero-coupon rates – and hence bond prices – should
develop over time in such a way as to preclude arbitrage between different bonds.
The major problems encountered in developing a tractable model are that: (a) the
term structure specified in the model is not consistent with the initial, observed yield
curve and (b) the rate structure is not mean reverting.
10.5 Complex Options

It is beyond the scope of this module to look at complex and exotic options.
Nevertheless, in recent years there has been an explosion in the variety of options
available in response to market requirements and the designing ability of financial
engineers. This short section only highlights the major types. As a class, exotic
options may be classified in terms of payoff, singularity, leverage, path-dependency,
multivariate features, timing and choice of exercise and their embedded nature.*
10.5.1 Payoff
Payoff modifies the gain to be had from the option. With the traditional option the
payout is ( − ), whereas exotics offer a variety of payouts, variously known as
binary (digital); asset-or-nothing; or cash-or-nothing. In these, as their name
suggests, the holder receives not a difference but an absolute value. The gain from
the generic digital option will be as given in 0.
Payoff
K Asset value
Figure 10.10 Payoff for a binary (digital) option
* A useful primer on the subject is Nelken, Israel (ed.) (1996) The Handbook of Exotic Options. Chicago:
Irwin Professional Publishing. This section draws heavily on Part I of this book.

Table 10.15 Payout from a binary (digital) option

Payout Condition
1 ≥
0 <
The payoff from a binary (digital) is illustrated in Figure 10.10.
Pricing Binary Options ______________________________________
For a European-style binary call option on a non-dividend paying stock, using the
Black–Scholes option-pricing model, the fair value of such a binary where the
payoff is either 1 or 0 depending on whether the option expires in- or out-of-
the-money is:
( )
= ( )
where ( ) is:
ln − ( − )
2
( )=
( − )
Namely, the binary’s value is simply the present value of the probability of the
option expiring in-the-money.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
10.5.2 Singularity
Another payoff structure involves a contingent premium, where the premium is
paid only if the option expires in-the-money. It has the payoffs given in 0 and
illustrated in Figure 10.11.
Payoff
+
Asset price
No premium is paid
unless U > K
–
Figure 10.11 Payoff from a contingent premium option
Table 10.16 Payoff for a contingent premium option

Payout Condition
− − premium ≥
0 <

10.5.3 Leverage
The normal payoff from an option, ( − ), can be modified in a number of ways.
These power options or polynomial options have a variety of potential payoffs. For
example, the standard option payoff can be modified in such a way that the result is
( · − ), where is a constant (1,2,3, …). Alternatively, the squared power
option has ( − ) as the payoff. The payoff of the squared power option is given
in Figure 10.12.
Payoff
+
Power option payoff
Conventional option payoff
2
U – K
U–K
ÖK K
Asset price
Figure 10.12 Payoff of squared power option (with traditional option

payoff for comparison purposes)
10.5.4 Path Dependency

Path-dependent options comprise a range of exotic options which go by various
names such as barrier, lookback, average rate and average strike, ratchet and shout.
In these options, the components making up and are modified by the path the
asset price has followed over the life of the option.
A barrier option has an activating (‘knock-in’) or deactivating (‘knock-out’) fea-
ture over the life of the option. The option is dormant, when of the knock-in type,
until a preset level (the ‘barrier’) is reached, at which point it is activated. Typical
types are the ‘down-and-in’, where the asset price has to fall to a given level before
the option becomes extant, and the ‘up-and-in’, where the asset price has to rise to a
given level. The knock-out types have the opposite characteristics. More complicat-
ed versions, known as ‘double-knock-in(out)’ options exist.
The lookback option allows the holder to buy or sell the asset at the best possible
price. That is, the payoff of a call will be: ( − min( , , , … , )) and that of
the put: (max( , , , … , ) − ).
Average-rate options, also known as Asian options, pay the difference between the
average price over the option period, , rather than the terminal value of , that is,
( − ) for calls and ( − ) for puts. The average-strike option has the opposite
averaging effect, that is ( − ) for calls and ( − ) for puts.

The ratchet option has a built-in profit feature. At particular dates, the strike rate
is reset at the underlying asset price. When the strike is reset, the holder is assured of
the option’s intrinsic value up to that point, even if the asset price subsequently does
not return the previous level. If, however, the asset price at a subsequent reset date
has intrinsic value, this is also locked in. This continues until the option expires.
The shout option allows the holder to determine the strike price at any particular
time by simply ‘shouting’ (that is, announcing to the writer) the new level.
Again considerable additional variations can exist for these options.
10.5.5 Multivariate Option Features

There are three basic types of multivariate option, the basket option, the rainbow
option (also known as ‘best/worst of’) and the cross-currency option.
The basket option is an option on a portfolio of assets, such as bond and equity
indices, currencies, and so on. The payoff will be the difference between the value
of this portfolio and the strike price.
A rainbow option comes in a variety of colours. A two-colour rainbow, the sim-
plest, has a payoff that is the best (or worst) of two assets at expiry. The number of
assets determines the colours in the rainbow. A spread option is a form of two-
colour rainbow where the gain is the difference between the two assets, that is,
(( − ) − ).
A wide range of variations exist for these options, including types such as portfo-
lio options, multi-strike options and exchange options.
The cross-currency option and the quantity-adjusted option (‘quanto’) involve an
asset that is denominated in one currency but for which payment is made in another
(the holder’s base or preferred currency). A true quanto has a fixed exchange rate
but the option is struck in the foreign currency. The payoff of such an option will
be:
× max − ﴾10.33﴿
For instance, an option on a German company’s shares might specify a strike

price of €100. At expiry the share price is €120 and the €/US$ exchange rate is
US$1.12 = €1, so that the payoff will be US$22.40.
10.5.6 Compound Options

These are options on options. A call is an option to buy a call option and a caput is
an option to buy a put option. A chooser option allows the holder to determine
whether the option will be a call or a put at some predetermined date before the
option’s expiry.
10.5.7 Timing
The American-style option allows total flexibility, within the option’s life, as to
when to exercise. A variation known as the quasi-American, mid-Atlantic or

Bermudan option offers the holder a series of option exercise dates. A chooser
option (see above) also allows flexibility as to timing in deciding whether a call or a
put is the better position to hold. The ratchet and shout options also provide timing
opportunities. A forward-start ( delayed-start) option gives the holder at the expiry
of the option a new option where the strike price is equal to the asset price at that
date.
10.5.8 Embedded Options

Embedded options or ‘embeddos’ are options that form part of a particular financial
instrument. A wide range of financial instruments incorporate some option element.
For instance, a range floating-rate note (range FRN) which has a coupon that is
capped and floored at two specific rates incorporates both a written cap (the
maximum interest rate payable, regardless of the prevailing market rate, if it is above
the cap rate) and a purchased floor (the minimum interest rate payable, again
regardless of the market rate if the market rate is below the floor rate).
10.5.9 Exotics: A Summary

The development of exotic options has been dramatic over the last few years. Such
instruments can be found in all the financial markets. They address many of the
disadvantages of traditional options. For instance, average rate options are cheaper
than simple options since the payoff is likely to be lower but sufficient for a
producer or consumer since protection is sought against an ‘average’ price or rate,
rather than an extreme.
All exotic options have some degree of path dependency or interrelation, a vary-
ing degree of singularity, leverage (or gearing) to their payoffs and more or less time
dependency in their structure. As a class, they extend the opportunities presented by
the (relatively) simple straight calls and puts.

Although the original Black–Scholes model was developed to price European-style
options on non-dividend-paying stocks, it has proved possible to adapt the model to
take account of the characteristics of different types of assets. Some of these
adjustments are relatively straightforward, such as including the effect of value
leakage – dividend or interest payments – on the option value. Other adaptations
require a more complex solution, the aim of which is to preserve the simplicity of
obtaining an analytic solution to the value of an option rather than to resort to the
iterative numerical procedures of the binomial model. Only when a relatively easy
adjustment cannot be made to the Black–Scholes equation must the user resort to
numerical procedures.
In terms of providing an extension to the original Black–Scholes model, interest-
rate options have been, and remain, an asset class where simple solutions have
proven to be most problematical. The existing models are complex to operate and,
in most cases, make somewhat unrealistic assumptions about the underlying term

structure. That said, Black’s version of the analytic model provides a generally
adequate method of valuing options on short-term interest-rate-sensitive assets with
simple cash flows. For bonds, the Schaefer–Schwartz correction to Black’s equation
is a simple way of adjusting for the declining volatility of a bond as it moves towards
maturity.
More complex interest-rate-option models have been developed to price options
on interest-rate-sensitive assets which make use of the term structure. This remains
an area of continual development and refinement.
Finally, the changes made to the nature of options themselves and the growth of
options with special features collectively known as ‘exotic options’ are briefly
outlined to show how instruments and products are continually evolving in response
to the needs of market participants and the resourcefulness of financial engineers. A
detailed analysis of these exotica is beyond the scope of this module.
Review Questions
10.1 If we have a asset which has options written on it and which will be subject to a
dividend distribution during the optioned period, the effect on calls and puts will be:
A. the call value is increased and the put value is decreased.
B. the call value is decreased and the put value is increased.
C. both the call and put values are increased.
D. both the call and put values are decreased.
10.2 We have a three-month put option on an asset with a dividend yield of 2.5 per cent and
a continuously compounded risk-free interest rate of 5 per cent. If the strike price is
240 and the asset price is 235, the variable ( ) is 0.4375 and ( ) is 0.4185, what
will be the value of the put?
A. 5.09
B. 5.19
C. 6.46
D. 11.29


We have the following market conditions:
Variable US dollars Deutschemarks

Exchange rate $1 = 1.5625
FX Volatility DM/US$ 0.30
Continuously compounded risk-free rate 5.60% 6.25%
Time 181 days
10.3 If we have a currency option with a strike price of DM1.55/$ with an expiry date of 181
days, what will be the value of the call on the Deutschemark?
A. 0.129
B. 0.131
C. 0.136
D. 0.157
10.4 If the three-month forward rate was DM1.5670/$, what will be the value of the three-
month call option on the currency with a strike price of DM1.55/$?
A. 0.100
B. 0.101
C. 0.103
D. 0.113
10.5 A stock index future with 30 days to expiry is trading at 1189 whereas a futures call has
a strike of 1175. The continuously compounded risk-free interest rate is 6 per cent and
the volatility for the futures contract is 35 per cent. What is the value of the futures
option (in index points)?
A. 54.36
B. 54.63
C. 55.25
D. 56.13
10.6 If the continuously compounded risk free interest rate is 5.5 per cent and the storage
cost, also continuously compounded, is 3.0 per cent per annum, and the spot price of
zinc is $2300 per ton and a three-month futures contract is trading at $2295 per ton,
what is the three-month convenience yield on zinc, expressed as an annualised rate?
A. 0.22 per cent.
B. 2.34 per cent.
C. 3.38 per cent.
D. 9.37 per cent.

10.7 Copper is worth $1185 per tonne in the market and there is a 9-month futures
contract with a price of $1100 per tonne. The continuously compounded risk-free
interest rate is 6 per cent per annum and the cost of wastage is 4 per cent per annum.
The volatility of the copper price is 22 per cent per annum. What is the annualised
convenience yield on copper?
A. Zero.
B. 11.92 per cent.
C. 14.94 per cent.
D. 19.92 per cent.
10.8 The spot price of copper is US$1250/ton, the risk-free interest rate is 6 per cent per
annum, the cost of storage is 6 per cent per annum and there is an implied convenience
yield on copper of 9 per cent per annum for three-month delivery. What is the price of
a copper call with a three-month expiry when the strike price is US$1325 when the
volatility is 28 per cent?
A. $39.48
B. $43.34
C. $49.81
D. $53.39
10.9 We have a six-month call option with a strike price of 145 and the underlying share is
trading at a price of 156. A dividend on the share is due in four months’ time which has
a value of 4. The risk-free interest rate is 5.5 per cent. If the option is American-style,
will early exercise be:
A. desirable to capture the dividend?
B. undesirable since the remaining time value exceeds the dividend forgone?
C. desirable to partly capture the dividend?
D. undesirable since the remaining time value is equal to the dividend forgone?
10.10 We have a six-month call option with a strike price of 270 and the underlying share is
trading at a price of 295. A dividend on the share is due in two months’ time with a
value of 6. The risk-free interest rate is 4.75 per cent. If the option is American-style,
will early exercise be:
A. desirable to capture the dividend?
B. undesirable since the remaining time value exceeds the dividend forgone?
C. desirable to partly capture the dividend?
D. undesirable since the remaining time value is equal to the dividend forgone?
10.11 What is the value of a three-month, American-style call, when priced using the pseudo-
American adjustment for calls, when the underlying share has a dividend of 4.2 at the
end of month 1, the share price is 345, the strike price is 340, the volatility is 22 per
cent and the continuously compounded risk-free rate is 4.5 per cent?
A. 13.91
B. 16.91
C. 17.19
D. 19.75

10.12 We have a three-month short-term interest rate futures contract with four months to
expiry which is trading at 93.50. There is a futures call on the option with a strike price
of 92.80. The continuously compounded risk-free rate is 6.75 per cent and the volatility
of the futures contract is 15 per cent. What will be the value of the call?
A. 1.70
B. 3.50
C. 3.58
D. 3.95
The following table provides the caplet prices for a cap which has four periods to run and
with a strike rate of 6.85 per cent.
1 2 3 4
Time 0.25 0.5 0.75 1
Futures contract 93.85 93.80 93.63 93.38
Risk-free rate % 5.9683 6.0625 6.2975 6.531
Caplet price 1.88 2.78 3.48 4.06
10.13 Which, if any, of the caplets are currently ‘in-the-money’?

A. All the caplets are out-of-the-money.
B. Caplets 2, 3 and 4 are in-the-money.
C. Caplets 3 and 4 are in-the-money.
D. Caplet 4 is in-the-money.
10.14 What is the total value of the cap?

A. 9.98
B. 11.11
C. 11.86
D. 12.20
10.15 If the fourth caplet was, in fact, sold as an interest-rate option, what would its value be?
A. 0.50
B. 2.96
C. 3.87
D. 4.13
10.16 A knock-out barrier call option will expire in-the-money, if:

A. the price of the underlying does not exceed a predetermined trigger point over
the life of the option and the option has a positive intrinsic value at expiry.
B. the price of the underlying does exceed a predetermined trigger point over the
life of the option and the option has a positive intrinsic value at expiry.
C. the price of the underlying does not exceed a predetermined trigger point over
the life of the option and the option has no intrinsic value at expiry.
D. the price of the underlying does exceed a predetermined trigger point over the
life of the option and the option has no intrinsic value at expiry.

10.17 A cacall is:

A. an exotic put option which has a barrier feature.
B. an exotic call option that is exercisable into another option.
C. an exotic put option which pays the difference between the strike price and the
average price of the underlying over the optioned period.
D. an exotic call option which pays the difference between the underlying price at
expiry and the average price of the underlying over the optioned period.
10.18 An embeddo is:

A. an option which is incorporated in another asset or security.
B. an option that is only activated when the underlying moves through a trigger
point.
C. a put option which pays the difference between the strike price and the
average price of the underlying over the optioned period.
D. a call option which pays the difference between the underlying price at expiry
and the average price of the underlying over the optioned period.
Case Study 10.1: Applying the American-Style Put Adjustment

We have the following market conditions:

Term on the option (time to expiry) 0.25 year
Continuously compounded risk-free rate 6%
1 What is the value of the European-style put on the share?

2 What is the additional value of the put if it is, in fact, American style (and can be
exercised early)? Use the binomial option pricing model with one month steps to price
the put as both European-style and American-style put options.
Case Study 10.2: Valuing an Interest-Rate Option

The following market conditions exist. The six month yield curve is:
Tenor (months) 1 2 3 4 5 6
Rate % 6.50 6.125 6.1875 6.25 6.3125 6.375
A £15 million 3 v. 6 fraption (option on a forward rate agreement (FRA)) has a strike price
of 6.38 per cent. The volatility is 15 per cent.
1 What is the value of the fraption?

References
1. Black, Fisher (1975) ‘Fact and fantasy in the use of options’, Financial Analysts Journal, 32
(July/August), 36–41 and 61–72.
2. Black, Fisher (1976) ‘The pricing of commodity contracts’, Journal of Financial Economics, 3
(March), 167–79.
3. Black, Fisher, Derman, E. and Toy, W. (1990) ‘A one factor model of interest rates and
its application to treasury bond options’, Financial Analysts Journal, 11, 33–9.
4. Cox, J., Ingersoll, J. and Ross, S. (1985) ‘A theory of the term structure of interest rates’,
Econometrica, 53, 385–467.
5. Gemmill, Gordon (1993) Options Pricing an International Perspective, London: McGraw-Hill.
6. Heath, David, Jarrow, Robert and Morton, Andrew (1992) ‘Bond pricing and the term
structure of interest rates: a new methodology’, Econometrica, 60, 77–105.
7. Ho, T. and Lee, S. (1986) ‘Term structure movements and the pricing of interest rate
claims’, Journal of Finance, 41, 1011–29.
8. Hull, John and White, Alan (1988) ‘The use of control variate technique in option
pricing’, Journal of Financial and Quantitative Analysis, 23, 237–51.
9. Hull, John and White, A. (1990) ‘Pricing interest rate derivative securities’, Review of
Financial Studies, 3, 573–92.
10. Macmillan, L. (1986) ‘An analytical approximation for the American put price’, Advances
in Futures and Options Research, 1, 119–39.
11. Nelken, Israel (ed.) (1996) The Handbook of Exotic Options. Chicago: Irwin Professional
Publishing.
12. Rendleman, R. and Bartter, B. (1980) ‘The pricing of options on debt securities’, Journal of
Financial and Quantitative Analysis, 15, 11–24.
13. Schaefer, Stephen and Schwartz, Eduardo (1987) ‘Time-dependent variance and the
pricing of bond options’, Journal of Finance, 42, 1113–28.

PART 4
Using Derivatives and Hedging

Module 11 Hedging and Insurance
Module 12 Using the Derivatives Product Set

Module 11
Hedging and Insurance

Contents
11.1 Introduction.......................................................................................... 11/2
11.2 Setting up a Hedge .............................................................................. 11/7
11.3 Hedging Strategies ............................................................................ 11/16
11.4 Portfolio Insurance ............................................................................ 11/36
11.5 The Use of Options as Insurance ..................................................... 11/40
Case Study 11.1: Hedging Interest-Rate Risk ............................................ 11/56
Case Study 11.2: Hedging with Written Calls ........................................... 11/56
Learning Objectives
This module looks at how risk is managed through hedging and insurance. The
basic principle of hedging is straightforward. It is to match two opposing sensitivi-
ties in such a way that value changes on both sides of the position cancel out. The
problem arises when the two positions do not change in value in exactly the same
way, leading to an imperfect correlation of price behaviour. The greater the diver-
gence in the two sides in terms of their underlying characteristics, the greater the
degree of hedging risk. A cross-asset hedge will be imperfect, whereas a customised
forward contract will provide a perfect hedge. Various methods for determining the
optimal hedge when the two sides differ are discussed.
Options are used to provide insurance: they protect the holder against the unde-
sirable outcomes, while leaving the user the opportunity to profit from the
favourable ones.
After completing this module, you should know how to:
 set up a hedge;
 create an optimal hedge position;
 determine a cross-hedge;
 understand the effect of basis risk on a hedged position;
 hedge against a rotational shift in the yield curve;
 manage risk via dynamic hedging;
 make use of options in a hedging strategy.

Module 11 / Hedging and Insurance
11.1 Introduction
At one time, for a variety of reasons, the trading desk at which I worked had a large
position in a particular corporate bond. Because of the risk of losses, the bonds
were hedged. Since the value of the bond position had a negative sensitivity to
interest rates, the appropriate risk reducing position was required to have a positive
value sensitivity to interest rates. To hedge the price risk and, at the same time, to
provide flexibility for trading purposes, the bond position was offset by a short
position in long-term interest-rate futures. Two problems arose in setting up the
hedge. The first was how to determine the correct number of futures contracts we
should sell in order that the value change in the bonds was compensated for by the
value change in the futures position. The second was that the bonds and the
interest-rate futures contracts differed. The futures were on government bonds
whereas our position was in a corporate bond, subject to default risk and hence
priced at a discount (interest rate spread) to the default-free government bond
underlying the futures contract. Naturally, this led to price changes between the two
positions that were not exactly offsetting. The result was that the revaluation of the
combined positions changed dramatically day by day. Over the period we held the
bonds, I was frequently called in to my manager’s office to explain why my profit
and loss account oscillated so wildly over such a short period. My explanation
pointed to the problems of exactly matching two different markets and instruments
with different characteristics. The hedge was imperfect and the swings in valuation
were a result of this inexactitude. Although the position was less than perfect, over
the period during which this hedge was in place, the combined portfolio eliminated
all but a tiny element of the price risk in holding the bonds.
The above story highlights two real problems in hedging. The first involves de-
termining the correct amount of the hedge to put on. The second is the requirement
to hedge ‘cross-assets’ since there was no corporate bond futures contract that
would have provided a better ‘fit’ between the hedge and the underlying position.
Hedging usually involves the use of one instrument to offset the price risk on
another. For most practical purposes this means the use of off-balance-sheet
instruments and, in particular, the derivatives product set. Table 11.1 summarises
the advantages and disadvantages of the alternatives. Cash instruments can provide
the same results as off-balance-sheet instruments, but usually entail significant cost
disadvantages. The discussion will therefore focus on off-balance-sheet approaches
to hedging.
When off-balance-sheet instruments are used, the decision has to be made
whether to select exchange-traded instruments or over-the-counter (OTC) instru-
ments. The advantage of OTC instruments is that they can generally be customised,
but they entail significant counterparty credit risk; exchange-traded instruments are
standardised and require margin to be provided, but have very little counterparty
risk. However, standardisation means that users generally have to accept basis risk.

Table 11.1 Advantages and disadvantages of the derivatives product set

Element of the
derivatives Advantages Disadvantages
product set
Cash instruments Loans, debt Simple; can match On balance sheet;
securities, equity liability to existing costs of issue; tax
cash flows consequences
Exchange-traded Options, futures Off balance sheet; Inflexible; basis

derivatives liquid; open risk; positions
pricing; require require monitor-
only small ing; variation
investment in margin can alter
margin timing of cash
flows; limited
product range due
to standardisation
Over-the-counter Swaps, forwards, Off balance sheet; Potential illiquidi-

(OTC) derivatives caps, collars, flexible; cash flows ty; credit
options only at predeter- instruments
mined dates
11.1.1 Risk Management, Hedging and Insurance

A key concept of risk management is to hold only those risks which are acceptable
to the organisation or individual. A speculator is willing to take risk in order to earn
a reward; more typically, market participants wish to decrease risk by hedging.
Hedging is the process of ‘laying off’ unwanted or unacceptable risks. The process
itself is straightforward in that the (unwanted) exposure is matched to the hedging
instrument in such a way that the two extinguish each other. A perfect hedge will
totally eliminate the exposure, whilst an imperfect hedge will (it is hoped) eliminate
almost all of the exposure. A partial hedge will reduce, but not seek to eliminate,
all of the exposure. Such a partial hedge is a risk-reducing measure. That is, the
hedge is designed to modify the slope of the risk profile to a more acceptable shape.
For instance, a £100 million floating-rate loan might be partially swapped into a
fixed-rate loan. The sensitivity to changes in short-term interest rates will then only
be on the unswapped portion. As a result, the overall exposure is reduced to the
acceptable level, but not eliminated.
An alternative approach is to buy ‘insurance’. In financial markets, this (usually)
involves buying options which hedge the undesirable price movements. But equally,
this allows the position to benefit from gains from favourable price movements.
Finally, it is important to remember that hedging is, in many cases, as much art as
science. Price movements between the position being hedged and the hedging
instrument are not always perfectly correlated and a risk remains, variously called
basis risk, correlation risk or spread risk.

From the Financial Times ___________________________________

Hedging in practice
In reporting its 1996 financial year results, MoDo one of Sweden’s major pulp
and paper producers announced a 44 per cent fall in pre-tax profits. For FY
1996, pre-tax profits were SKr2.9bn (US$390m) compared to SKr5.2bn in 1995
on sales of SKr20.1bn (down from SKr22.3bn in 1995). Excluding the effects of
hedging, group-operating profits fell from SKr5bn in 1995 to SKr1.8bn as
performance slipped sharply in all divisions except the newsprint unit.
The reason MoDo gave for this result was that the group was hit by the
industry wide fall in prices for pulp and in several categories of paper. The
company indicated it only avoided worse results through hedging its currency
exposure, which shielded the group against the rise in the Swedish krona against
the currencies of its main markets. Currency hedging helped lift profits by
SKr1.5bn for 1996m (as compared to a gain of SKr555m in 1995).
At the same time, the company warned that with the Swedish krona past its
peak, the hedging effect would be reversed in the first half of 1997. As a policy
matter, MoDo hedged its estimated net foreign currency flows for the first five
months of FY 1997, but when making the announcement MoDo knew the krona
had weakened since the hedges had been put on. The fall in the krona was
expected to reduce profits by SKr35m.
The chief executive of ABI Leisure resigns admitting a currency
hedging error
On 15 August 1997, David Carrick, chief executive of ABI Leisure, the caravan
company, resigned and another senior manager was suspended after the
company announced an investigation into currency hedging losses which had led
ABI into the red.
In announcing the resignation ABI, which had issued a profits warning earlier in
the month, said it would now make a small loss for the year to August 31 1997.
Expectations had been for ABI to turn in a £5.4m profit (as against £5m for the
financial year 1996). On the announcement, shares in the company dropped 28p
to 37p (a fall of over 56 per cent), having more than halved in value since the
earlier profits warning.
The company, which earned more than half its profits from overseas sales,
explained that the loss was due to a breach of its normal internal procedures
that require foreign currency exposures to be hedged and foreign balances
converted back into sterling. It put down this failure of control to incorrect
management information.
Responding to questions, the company refused to comment on how the errors
had occurred or who was responsible, but announced that Price Waterhouse,
its auditor, was conducting a full review of the problem. At the same time, ABI
had taken the appropriate steps to hedge its future currency exposures. As a
result of the losses, the firm was not expected to pay a final dividend but once
the investigation was completed would again review the position.

In reporting the hedging problem, the company added that the current strength
of sterling against European currencies was having a significant negative impact
on its competitive position abroad. As a result it was also undertaking a review
of its export pricing policy. One consequence of sterling remaining at its current
level was for ABI to suffer lower margins and volumes on future exports.
In assessing these revelations, Henry Cooke Lumsden, the Manchester-based
broker which trades ABI shares on behalf of investors, took the view that a
substantial element of the losses was because of the failure to hedge properly,
but part was also was attributed to adverse trading conditions.
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11.1.2 When to Use Terminal Instruments and When to Use Options

Derivatives are tools for managing risk. In essence, they are used to modify the risk
profile of an existing cash market position. They provide other uses such as the
potential to provide higher returns and to reduce funding costs. In addition, they
serve a variety of investment and speculative purposes, being useful in backing ‘a
view’, in providing arbitrage opportunities and in allowing various types of spread-
ing strategies.
In general, we are likely to use terminal instruments – that is, forwards, futures
and swaps – which, as discussed are ‘free’ to the user, for the following types of risk-
management activities.
 To hedge price risk at minimum cost. Since there is no cost to entering terminal
transactions, they do not involve initial cash flows (that is, of course, with the
exception of transaction costs and any margin requirements), thus making deci-
sions about their use less problematical for most organisations. Their cost is
effectively hidden in their price.
 As a substitute for direct exposures to the underlying assets and to anticipate future cash
investments and disinvestments. They are useful, for instance, for temporarily invest-
ing cash flows in ‘synthetic assets’ until underlying purchases can be made, or for
eliminating market risks until sales are carried out.
 Although their function allows the holder to eliminate market price risk, the user
is left with the specific risk of the cash instrument. Thus decisions about relative asset
valuations (say, between different classes of corporate bonds) can be separated
from market movements. (For bonds this would be the interest-rate outlook.)
This applies equally in stock-specific risk-selection strategies by removing risk of
adverse market movements. In such a case, futures are used to eliminate the market
price risk element of the stock.
 Equally, for tactical asset-allocation purposes, futures provide a quick, cheap and
effective way of changing the fraction of a portfolio allocated between different
classes of asset.
 Terminal instruments provide a leveraged (or geared) exposure to the underlying asset
since they are, in effect, contracts for differences.

Options, on the other hand, since they provide non-linear payoffs, have an insur-
ance element. These asymmetrical risk profiles have particular uses in addition to
those provided by terminal instruments.
 To hedge both price and quantity risk. Options are required in the hedging of contin-
gent income streams and cash flows. Such action might arise if a firm has
entered into an agreement and as a result has written an explicit or implicit op-
tion. For instance, in the case where a firm is bidding on a contract denominated
in a foreign currency, there is a contingent price risk inherent in the contract.
Hedging with terminal instruments will not eliminate the risk. Equally, many
loan products and financial instruments include embedded options. A puttable
bond includes the right of the holder to seek early redemption of the security. In
this case, the issuer has written a put with the bond holder.
 When there is a view on the market, especially on future volatility. If it seems that the
price or rate is likely to move more than the premium paid, an option may be an
appropriate instrument. No underlying cash transactions are required and the
total risk is limited to the premium paid.
 Making the best use of management time. An option premium can be looked upon as a
management fee paid to an intermediary to manage exposure in such a way as to
eliminate downside risk and retain upside potential. That is, the premium is the
fee for dynamic replication strategies such as portfolio insurance.
To summarise, a firm is likely to use options when the firm has (explicitly or
implicitly) written an option. This will typically occur when:
(a) it sets fixed prices in foreign currency against which unknown future revenues
will be earned;
(b) bidding on an uncertain contract;
(c) there are embedded option features in a contract;
(d) it wants to back a strategy (speculate).
The disadvantage to options is their cost in the form of an upfront premium. The
premium is a direct function of their value. It is based on the ‘fair value’, which
ultimately depends on the likelihood that the option will be exercised. At the
practical level, a number of potential solutions are available.
 In/out-of-the-money options. The lower the likelihood of exercise, the cheaper the
option. If a lower level of protection is acceptable, then out-of-the-money op-
tions reduce upfront cost. Typically such options would not fully protect all the
profits from the future cash flows.
 ‘Free’ option strategies. In consideration of firms’ dislike of upfront payments for
risk-management transactions, financial intermediaries have devised a number of
(premium) ‘free’ option strategies. Examples are: currency cylinders (that is, a
‘vertical spread’ – a mix of put and call options) and participating forwards (a
mix of put/call and a forward outright transaction).
 Compound options. Compound options are options to buy options. It is insurance
to buy insurance!

However, in the final analysis, it is true to say the option user gets what he has
paid for. Remember also the risk/reward for ‘writing’ an option is very different
from that involved in ‘buying’ an option. Option writers receive a premium and
have to take on a (potentially) unlimited risk, although as previously discussed, this
can be managed dynamically.
Table 11.2 Summary of the advantages of options as compared with

terminal instruments
Terminal Instruments
Consideration Options (forwards, futures and
swaps)
Maximum amount of loss Limited to premium paid Unlimited*
Possibility of determining Can select from a range Limited to the unique

rate at which to hedge of strike prices forward rate for each
maturity
Can be used when the Yes, since option can be No, since the contract
underlying transaction is allowed to lapse must be settled
contingent
Gives the user the benefit Yes, since if spot rate is No, since the terminal
of choosing between the better, user can let contract must be settled
actual rate at maturity option expire, but if at the original contracted
(the future spot rate) and option rate is better, user rate
the hedge rate can exercise
* Note that this is an ‘opportunity’ loss, if the asset to be hedged rises (falls) in value if a long
(short) position. It will be an actual loss if the terminal instrument has been used for speculative
purposes.
11.2 Setting up a Hedge

Setting up a hedge is the final step in the risk-management process. A hedge is a
method of manipulating risks (or their sensitivity) under a clearly laid out risk-
management objective. The risk strategy will have determined the risk/reward
objectives of the firm and the benefits and costs associated with any risk-reducing
measures.
As a rule, for a hedge to be considered benefit–cost effective, it has (a) to elimi-
nate a large part of the change in value of the underlying position and (b) to do so at
lower cost than other alternative approaches. Condition (a) requires the hedge to
match the asset as closely as possible, whereas condition (b) applies to most off-
balance-sheet instruments in the derivatives product set and works against on-
balance-sheet hedges.

11.2.1 The Principle of Hedging

The primary objective of hedging is to reduce the market or price risk of an existing
(or anticipated) position. The total value ( cash ) of the position will be given by:
= ﴾11.1﴿
where ℎ is the market price per unit and ℎ the number of units in the
position.
In the absence of hedging, the change in value of the position will change as the
market price changes:
= ( ) ﴾11.2﴿
If we have a long asset position, as in Equation 11.1, we partially or fully offset
the change in the cash position with a short (in terms of sensitivity) hedging
position:
= ( )+ (− ) ﴾11.3﴿
where the resultant cash is the net change in value of the combined positions and
is the change in the price of the hedging instrument and − hedge is the
number and/or size of a short (in terms of sensitivity) position in the hedge.
If the hedge is only partially designed to eliminate the risk, we have:
( )> (− ) ﴾11.4﴿
Note that, if the sign on the hedge position is reversed in Equation 11.4, the off-
balance-sheet position adds to the exposure, effectively increasing the position.
Increasing a position in this way may be desirable if a short-term increased
weighting in an asset class or instrument is required over and above some estab-
lished long-term strategic exposure.
If the objective of the hedging transaction is to eliminate all the price risk, then
we have the fully hedged position of Equation 11.5:
=0= ( )+ (− ) ﴾11.5﴿
A Generic Step-By-Step Approach to Hedging ________________
Hedging is costly in that users pay the bid-asked spread on transactions. Even
for futures where the turn is very small, there is still a significant cost, especially
if the requirement to post margin is included. In order to minimise these costs,
it is useful only to hedge the net exposure rather than individual positions, so as
to take advantage of any internally occurring natural matching via offsets and
portfolio effects. The generic step-by-step approach involves reducing all
positions, if at all possible, to a common structure:
1. Decompose any obligation into its zero-coupon components. That is, for
instance, decompose bonds into a set of coupon and principal cash flows
using appropriate time buckets.

2. Construct a portfolio comprising all the zero-coupon cash flows. The

different positions will be aggregated into an overall portfolio. In practice,
this is easier for a financial institution to undertake than an industrial and
commercial firm. Approximations might be required in the latter case.
3. Take advantage of all natural offsets within the aggregated portfolio. Thus
inflows and outflows occurring within the same bucket will be netted (that is,
partially matched).
4. Construct a portfolio of hedges using the derivatives product set and cash
instruments to offset unacceptable risks.
5. Dynamically adjust the hedges as new positions enter the portfolio. As assets
and/or liabilities mature and other obligations are created (and possibly antic-
ipated), the overall sensitivity of the portfolio will change and the hedges will
need to be adjusted. Equally, the hedges themselves will change in effective-
ness as they move towards expiry and maturity.
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11.2.2 A Perfect Hedge

If we have a sensitivity as given in Equation 11.1, the obvious way to eliminate the
risk is to be simultaneously long the asset position and also short it! Since this
involves a sale, the two sides extinguish each other. This condition is likely to exist
where a sale is made of the exact cash asset and quantity in the position.
With a forward contract, it is possible to specify the exact nature of the contract-
ed asset, security, instrument or commodity in such a way as to eliminate all
variability between the underlying position and the hedging instrument. Forward
contracts therefore usually provide a perfect hedge. This is not achieved without
some cost, however. Such a contract, as previously discussed in Module 3 on
Forwards, cannot be easily unwound before maturity and involves credit exposure.
In situations where flexibility is required, some inexactitude in hedging may be an
acceptable benefit–cost trade-off.
11.2.3 An Imperfect Hedge

Whereas contracting in the forward market has the advantages of providing a
perfect hedge, there are many reasons why the use of a liquid market, such as that
provided by futures, is a preferred alternative. In using an imperfect hedge, the
objective is to find the minimum-risk hedge ratio of the cash position and the
hedging instrument. Techniques to determine this ratio (ℎ) range from naive
methods of determining the right proportions between the two positions to more
sophisticated methods using portfolio theory, correlation and duration.
The ratio (ℎ) can be considered as the relative price volatility of the two sides of
Equation 11.1. That is the ratio of the change in the asset price and the hedge price.
That is:
+ℎ =0 ﴾11.6﴿

One approach is to use a one-to-one ratio between the position and the hedge.
This works well, for instance, with forward contracts. If a US$1 million future cash
inflow has to be hedged back into sterling, then selling the same amount in the
forward foreign exchange market ensures that the sensitivity of the two positions, as
given in Equation 11.6, is zero. In this case, ℎ = 1.
With futures, it is possible to use the cash price of the asset and the futures price
as the appropriate ratio. If we had a requirement to hedge unleaded gasoline and we
needed to hedge one million gallons, then the appropriate short position in the
energy futures would be:
1 000 000
× 1 = 23.8contracts
42 000
Each contract is worth 42 000 US gallons (=1000 barrels), and to balance the
hedge 23.8 contracts are required.* Since only full contracts can be traded, 24
contracts are shorted. Incidentally this shows the minor hedging discrepancy that
can arise from futures. Typically, a decision has to be made, when partial contracts
are involved, whether to round the hedge up or down.†
As a rule, the naive one-to-one approach works best when the cash position is
nearly equivalent to the characteristics of the futures. The wider the discrepancy, the
greater is the hedging error that will result. For this reason, more sophisticated
hedging procedures have been developed.
The following summarises the disadvantages of naive methods for different types
of assets. For interest-rate products:
 For short-term interest-rate futures, if the underlying position has a maturity
other than that stipulated by the contract, the value change in the position needs
to be considered rather than the change in interest rates. If interest rates were to
change by 50 basis points (half a percentage point), the value changes, shown in
Table 11.3, would occur on a US$1 million (one eurodollar contract) position.
 With long-term interest-rate futures, bonds with different maturities and
different coupons will have different price sensitivities. The naive method will
leave the combined position with more basis risk than would a more sophisticat-
ed approach.
 For cross-hedges, the relationship between the two asset positions (the cash
position and the cash asset underlying the futures contract) and the futures cre-
ates a significant basis risk due to the different nature of the two assets’ price
behaviour.
* This is the specification of the unleaded gasoline contract traded on the New York Mercantile
Exchange (NYMEX). The UK’s International Petroleum Exchange (IPE) specifies a contract for 1000
tonnes.
† Recall the discussion inModule 4, Section 4.5.3.

Table 11.3 Cash and eurodollar futures price change for a 50 basis point
change in interest rate
Maturity of the money Change in value of the Change in value of
market instrument cash instrument futures contract
1 month $416.50 $1250.00
3 months $1250.00 $1250.00
6 months $2500.00 $1250.00
12 months $5000.00 $1250.00
The advantage of the naive hedge approach is its simplicity. Since many hedging
transactions involve the nearby contract (the futures contract closest to expiry), and
the same commodity is being hedged, assuming a hedge ratio of one is a reasonable
assumption. In effect, by using the naive hedge ratio, the hedger is ignoring any
changes in the basis.
11.2.4 The Regression Approach

If the two sides of Equation 11.5 are less than perfectly correlated, we can find the
minimum-variance hedge ratio of the portfolio by Equation 11.7:
ℎ=
, ﴾11.7﴿
where ℎ,ℎ
is the correlation coefficient between the cash instrument and the
hedging instrument, and ℎ and ℎ the standard deviation of change in value
of the cash position and the hedge respectively. The minimum-variance hedge ratio
is the proportion of the hedge position that minimises the net price change of the
combined cash position. The relationship between changes in the cash and hedge
position and the derivation of ℎ are illustrated in Figure 11.1. The minimum-
variance hedge ratio is the regression line obtained by minimising the sum of the
squared deviations from the line. The statistical technique, known as ordinary least
squares, used to provide the estimate for the slope (β) and the intercept (α) uses the
following equation:
= + + ﴾11.8﴿
The technique sets the value for and such that the sum of the squared error
terms (∑ ) will be as small as possible and that no other value for provides a
better description of the linear relationship between and . The slope
of this line is the hedge ratio. The residual deviations ( ) from the regression line
are that part of the risk in the cash position that is not ‘explained away’ by changes
in the hedge. That is, these residual deviations are the basis risk between the two
positions.

D Pcash
Residual
D Phedge
–
D Pcash
=
D Phedge
b = slope = h
Fitted line
Figure 11.1 The regression hedge approach

Regression analysis on historical data provides estimates for and . If, in the
earlier example, the performance of unleaded gasoline futures and the spot price had
been regressed and the results had been:
= 0.0031 + 0.8985 ﴾11.9﴿
(0.023) (0.029)
= 0.89
in the regression, the coefficient is estimated as 0.0031 and as 0.8985. The
figures in brackets below these are the standard error of the estimates and 2 the
coefficient of determination or the ‘goodness of fit’ of the regression line. A high 2
means that most observations lie on an axis along the fitted line (as is the case with
Figure 11.1), whereas a low 2 means that they are dispersed away from the line.
Since is the hedge ratio ℎ, we can rework our earlier example of hedging un-
leaded gasoline exposure to get the minimum-variance hedge position. This is:
1 000 000
× 0.8985 = 21.4contracts
42 000
The minimum-variance hedge requirement is for 21 (possibly 22) contracts rather
than the 24 contracts derived from the naive approach. This shows that, with an
imperfect correlation between the cash and hedge positions, the naive approach is
likely to overestimate the size of the hedge required.
11.2.5 Hedging Effectiveness

Equation 11.7 shows that the hedge ratio (ℎ) depends on the correlation between
the cash and the hedge prices. With the regression approach, the minimum-variance
hedge ratio does not have to be close to one, as it would be in the naive approach.

In fact one can intuitively see that, even if the standard deviations of the cash and
hedge were similar but the correlation was less than one, the result would give a
hedge ratio that is below one. At one end of the scale, the cash asset and the
underlier of the hedging instrument may be the same, as would be the case in a
holding of government bonds and hedging with the concomitant futures contract.
In this case ℎ is likely to be close to one. At the other extreme, a cross-hedge may
only have partially the same characteristics as the position being hedged. Hedging
the same bond position in short-term interest-rate futures or hedging shares in a
French company using stock index futures on the German DAX index is likely to
result in a low value for ℎ.
In order to determine the quality of the resultant portfolio, we need to measure
its hedging effectiveness. We have already seen that ℎ is equivalent to the slope of
the regression line in Equation 11.8. This relationship conveniently leads to a
measure of the effectiveness of the hedge. Remember that hedgers are substituting
basis risk for price risk in entering the (imperfect) hedge. A way of measuring how
well the hedge operates is to compare the basis risk that is assumed by hedging with
price risk that is eliminated. The smaller the basis risk compared to the price risk,
the more effective is the hedge in fulfilling its objective. This measure of hedging
effectiveness (ℎ∗ ) can be formally stated as:
− ﴾11.10﴿
ℎ∗ =
ℎ∗ = 1−
basis risk
ℎ∗ = 1− =
cash asset risk
On the basis of Equation 11.10, hedging effectiveness (ℎ∗ ) is measured by the
coefficient of determination ( ), which is a measure of the ‘goodness of fit’ of the
regression equation. Note that, in a forward contract, there will be no basis risk, so
that the hedge will be totally effective (that is, 2 = 1.0). The problem of hedging
effectiveness really only applies in situations such as futures or in the use of cross-
hedges.
If, as above, the regression analysis has a value of 2 = 0.89, a hedge using un-
leaded gasoline futures – in the absence of instability in the relationship between the
cash and futures markets – will eliminate 89 per cent of the variability in cash
market price changes.
Note also that 2 determines hedging effectiveness when a minimum-variance
hedge has been established. In situations where the cash position and the cash
instrument that underlies the hedge are the same, hedging effectiveness is usually
high. Hedging effectiveness is likely to be low for cross-hedges for non-similar
commodities. Also for cross-hedges, the minimum-variance hedge ratio can exhibit
significant instability over time. The discussion so far has assumed that historical
estimates of and 2 are used in setting up a hedge. When the cash position and
the hedge are on the same underlying asset, these estimates are likely to remain

relatively stable over time although, as we discussed in Module 4 on Futures, the

basis may strengthen and weaken in response to changing market conditions.
It is possible to take advantage of what we know about the possible behaviour of
the basis (that is, the cause of inexactness in hedging).
 As discussed, the futures price and the cash price will converge as the expiry date
approaches.
 Equally, in most circumstances, it is unusual for futures prices to deviate
significantly from the cost of carry relationship. Arbitrage will occur to maintain
the relationship within transaction cost boundaries. So the cost-of-carry will
provide a lower boundary to the basis.
 There is no upper boundary condition to the basis. At times, futures prices might
show significant backwardation (that is, futures prices that are lower than the
cash price).
 With commodities, there may exist a strong seasonal basis effect, although this
might not be totally predictable. For instance, energy demand – and hence ener-
gy futures prices – is affected by stock building going into the autumn in
anticipation of higher consumption. In many cases such stock building can be
factored into the analysis.
The objective of basis analysis is to supplement and adjust the results of mini-
mum-variance hedge ratio analysis, both in terms of known basis behaviour and –
perhaps more crucially – in terms of accepting a higher level of risk. This latter
concept is best illustrated graphically as shown in Figure 11.2.
The minimum risk portfolio, which is given by the minimum-variance hedge
ratio, provides the maximum amount of risk reduction. The optimal risk portfolio is
that combination of asset position and hedge where the manager’s indifference
curve touches the possible range of hedge positions between maximum security
(ℎ ) and maximum return (that is, ℎ = 0).
Expected return
Indifference curves
I3
I2
I1
h=0
Optimal risk-return portfolio
min
Minimum risk portfolio = h
Risk
Figure 11.2 Choice of hedge to reflect desired risk–return trade-off

11.2.6 Considerations in Determining the Appropriate Hedge Ratio

A number of issues arise in determining the appropriate hedge ratio. The approach
requires an estimate for ℎ, the optimal hedge position given the interrelationship
between the cash position and the hedging instrument. This is usually determined by
the use of ordinary least squares. The question is whether the regression equation
should be specified using price changes, percentage changes or log of price changes
or via price levels. Each is used and there are arguments in favour of each. Another
issue is the length of time intervals; should these monthly, weekly or daily, or more
frequent? Equally, the number of observations used is important; the greater the
number the better the estimate but also, perhaps, the less immediate the relation-
ship. Then there is the question of the normality of the data set.
As with most approaches the starting point is to use historical data. In many
cases these will be sufficient. As with all such estimates, adjustments can then be
made to the data set based on forecasts or qualitative judgements, if required.
When considering the appropriate hedge ratio, we also need to take into account
two other factors. Cross-hedging requires a dependency between the asset to be
hedged and the asset underlying the contract. Although such a relationship is
required to be generally stable, it may change over time. We might thus have a
cross-hedge situation where the regression gave a of 0.69. However, over the
same period, sub-period estimates provided a hedge ratio of 0.48, 0.51, 0.74 and
0.82 against the March, June, September and December contracts. In this case, we
might be of the opinion that the relationship of the two assets is higher going into
the latter part of the year, due to seasonal effects. This might be the case if the
cross-hedge ratio above was that between, say, the price of coal and that for crude
oil. A stronger relationship in the winter months would make sense, given the ability
of some users to switch between the two sources of energy.
The other factor is the effect of timing differences on the effectiveness of the
hedge. With forward contracts, the timings of both sides are customised to match;
for exchange-traded contracts, there are likely to be timing differences between the
two sides. If a price move results in a loss on the hedging position, cash must be
provided (or at least eligible securities provided as collateral) whereas, on the other
side, the revalued asset position has no corresponding cash inflows. A gain on the
futures position will result in cash inflows which have to be invested.
Hedgers using futures markets, therefore, have to be prepared to manage the
daily cash flows associated with the hedge. Having suitable funds or instruments
available or setting up borrowing facilities in advance are wise precautions. Having
to borrow funds to meet margin requirements is another cost of hedging which will
reduce its effectiveness. Tailing the hedge to anticipate these intermediate flows is a
simple way of ensuring that hedge effectiveness is maintained.*
* See Module 4, Section 4.7.1 for a discussion on ‘tailing the hedge’.

11.3 Hedging Strategies

This section examines some issues related to hedging instruments, their maturities,
liquidity and availability. As a general principle it is desirable to match the character-
istics of the cash position with that of the hedge. Thus for a forward foreign
exchange contract, its maturity is set at the date on which the foreign currency cash
flow is due to take place. However, there may be a problem in ascertaining the exact
date when the cash flow will occur.
Equally, if there is a multiplicity of cash flows, then a series of contracts expiring
at the required futures dates are entered into. Thus a commitment to receive US
dollars in three, six, nine and 12 months’ time would be matched with forward
foreign exchange contracts which matured at those dates. Although this matching
principle is desirable, it may not always be possible to match hedge maturities to
cash flows. This may be because either the contracts are non-extant or they involve
paying a substantial premium. In the latter case, obviously a benefit–cost analysis
needs to be undertaken to see if the premium is worth while.
With futures, as a rule, the more distant contracts are less well correlated with the
cash market and also suffer from potential illiquidity. Table 11.4 shows standard
measures of liquidity for futures markets – the daily trading volume and open
interest (that is, the number of outstanding contracts) for a range of currency
futures – compiled in mid-August. The data collected are such that the contracts
have one month to expiry for the nearby September contract, four months for
December, and for March, seven months.
Table 11.4 Volume and open interest for currency futures

Expiry Euro Swiss Francs Sterling Japanese Yen
Volume Open Volume Open Volume Open Volume Open
Int. Int. Int. Int.
Sept. 16 978 65 219 10 922 36 088 4 557 47 879 17 016 68 042
Dec. 397 5 307 389 3 010 11 1 308 787 6 136
March 6 872 2 614 3 9 3 168
Note: The maturity dates for the futures contracts are: September = 1 month, December = 4
months and March = 7 months.
Table 11.4 shows that the nearby currency futures contract has the most volume
but the back contracts for December and March are very thinly traded. There are
only token trades taking place in the March-expiry contracts. The situation for
commodity futures is shown in Table 11.5. Here there is more liquidity (and there
are more expiry dates) out to February for the three energy futures shown. Even so,
the liquidity of the contracts probably does not extend much beyond the December
expiry. For wheat (using a different expiry cycle), there is liquidity in the first two
contracts, the March contract probably presents some trading problems while
thereafter the contracts are illiquid if trading in any size is required, although July is
an exception to this. (The reason for this is that July is the next year’s harvest date.)

Table 11.5 Volume and open interest in commodity futures contracts

Expiry Crude oil Natural gas Unleaded Expiry Wheat
gasoline
Int. Int. Int. Int.
Sept. 14 521 75 391 17 264 20 484 10 722 21 010 Sept. 2 876 16 253
Oct. 4 468 16 622 6 034 30 705 5 803 19 668 Dec. 6 993 37 901
Nov. 1 715 19 875 1 538 14 294 1 165 8 735 Mar. 784 8 203
Dec. 1 242 14 124 1 123 16 094 1 100 4 407 May 71 345
Jan. 402 7 276 1 454 13 118 466 4 079 July 387 3 278
Feb. 25 5 588 549 7 743 460 1 449 Sept. – 83
For interest-rate contracts, we have the results shown in Table 11.6 for short-
term interest-rate futures. Volume varies dramatically depending on the contract.
For US Treasury bills, most of the interest is in the nearby contract, but some is in
the December contract. There is much less activity in the March contract. For
eurodollars, sterling and eurolira, activity is greater in the contracts with longer to
expire, reflecting the institutional structure of the interbank market.* Note that in
these, with one month to expiry, activity is already beginning to decline in the
nearby contract as positions begin to be ‘rolled forward’ into the next contract. This
is a side effect of convergence where the futures contract begins to take on more
and more of the aspects of the cash position.
Table 11.6 Volume and open interest in short-term interest-rate futures contracts
Expiry 3-month Euro- US Treasury Bills 3-month Sterling 3-month Eurolira
dollars
Int. Int. Int. Int.
Sept. 38 791 372 036 1 043 7 125 15 242 71 042 21 912 52 840
Dec. 48 901 472 055 26 1 892 36 016 114 185 23 947 44 345
March 41 322 296 246 76 813 19 415 78 403 4 035 24 098
Because of the institutional features of different futures contracts, methods to

address hedging needs that extend beyond the normal market maturities have been
developed. These are discussed in the next section.
11.3.1 Strip and Stack Hedging

The hedging approach so far described has been designed to determine the appro-
priate size of the hedge. It has not specified the appropriate contracts to use in a
given situation. The choice depends on the period of the exposure to be covered by
the hedge and the liquidity of contracts. In some situations, as shown above, there is
* In fact, in eurodollars futures contracts are traded out to ten years to meet the hedging requirements of
financial intermediaries’ marginal cost of funds (for example, commercial banks).

little choice and it is necessary to use the nearby contract, regardless of the profile of
the underlying exposure. In situations where there is liquidity across contracts,
matching the hedge period to the underlying risk is to be preferred.
If we have an exposure that covers more than one futures contract period, the
ideal solution is to match the hedging instrument to the exposure period, a process
known as a strip hedge. This is illustrated in Panel A of Figure 11.3. The alternative
stack hedge approach is used when there is no liquidity in the contracts with longer
to expiry. With this method, the procedure is to ‘stack up’ the hedge using the
nearby contract and to roll forward the position, reducing the hedge as required
over the exposure period, as shown in Panel B of Figure 11.3. As time progresses,
we therefore have a situation as shown by Figure 11.4. With the strip hedge, the
expiring contracts match the exposure and are eliminated (as with the earlier
example of the forward foreign-exchange contracts). With the stack hedge, the
initial exposure is matched to the contracts, but the remaining exposure is hedged
by rolling forward the contracts at, or near, the expiry of the nearby contract.
Panel A: Strip hedge at inception
1 2 3 4 5
t0 T
te
Series of contracts Exposure
that cover the
exposure period
Panel B: Stack hedge at inception
1
2
Nearby contracts that equate to the
3 underlying exposure with maturity T
4
5
t0 T
te
Exposure
Figure 11.3 Strip and stack hedges at inception

The stack hedge is the simpler to undertake since it involves initial transactions in
one contract (usually the contract which expires on or after the start of the exposure
period in order to avoid an initial rollover before the start of the exposure period)
whereas the strip involves buying or selling a multitude of contracts. Altough it is
easier to set up, the stack hedge creates basis risk in the position. The assumption in
using a stack hedge is that changes in the futures contract involve parallel shifts in
the yield curve. With parallel shifts, the two types of hedge provide similar protec-
tion. If, however, the yield curve rotates, the two results will not be the same. The
stack is at risk from twists in the yield curve.

Remaining contracts
Panel A: Strip hedge for periods 3 to 5
after two contract periods have expired
1 2 3 4 5
t0 T
t+n
Remaining exposure
Panel B: Stack hedge

after two contract periods have expired
Rolled nearby contracts
for the remaining periods
of the exposure
3
4
1 2 5
t0 T
te t+n
Remaining exposure
Figure 11.4 Strip and stack hedges after inception at + and before
expiry
The problem is potentially large since a twist in the term structure will cause some
futures prices to change more than others. Let us look at the problem in more detail
using short-term interest rate futures. We have the following zero-coupon rates out to
12 months as shown in Table 11.7 and the nearby contract expires in Month 1, the
next to expire in Month 4.
Table 11.7 Zero-coupon rates to 12 months

Maturity Zero-coupon
rates
1 (nearby) 5.500%
2 6.000%
3 6.120%
4 (next) 6.250%
5 6.380%
6 6.500%
7 6.563%
8 6.750%
9 6.875%
10 6.938%
11 6.938%
12 7.000%
With a short-term interest-rate future, the value of the contract will be priced not
against the prevailing spot rate but against the implied forward rate for the

relevant three-month maturity. Thus although the current three-month rate is 6.12
per cent, this is not the rate at which a contract on the three-month rate and due to
expire in one month will trade: the contract will be valued against the three-month
rate that is expected to prevail in one month’s time, or 6.501 per cent. Hence, such a
contract will be priced at 93.50.* Similarly, the next contract will have a price
reflecting the three-month rate in four months and trade at 93.02, and so on. The
spot and implied forward rate curves derived from Table 11.7 are shown in Ta-
ble 11.8.
Table 11.8 Current spot rates and the implied forward rates pertaining
in the futures contracts
Implied forward yield curve
Maturity Spot rate 1m 2m 3m 4m
1 5.500% 6.502% 6.360% 6.641% 6.902%
2 6.000% 6.431% 6.501% 6.771% 7.002%
3 6.120% 6.501% 6.634% 6.881% 6.981%
4 6.250% 6.601% 6.751% 6.896% 7.252%
5 6.380% 6.701% 6.788% 7.130% 7.378%
6 6.500% 6.741% 7.001% 7.255% 7.398%
7 6.563% 6.930% 7.126% 7.290% 7.332%
8 6.750% 7.048% 7.173% 7.246% 7.377%
9 6.875% 7.098% 7.147% 7.295%
10 6.938% 7.082% 7.201%
11 6.938% 7.137%
12 7.000%
Note: The double underlined rates are those which pertain to the nearby (n) and deferred (d)
contracts which are trading at 93.50 and 93.02.
The spot and implied forward rates shown in Table 11.8 are presented graphically
in Figure 11.5. The upward-sloping nature of the forward yield curves shows that,
based on the spot rates, the short-term yield curve is expected to rise over the next
four months.
* Recall that the futures price is (100 − ) where is the interest rate.

7.500%
7.000%
Spot
6.500% 1m
2m
3m
6.000% 4m
5.500%
5.000%
1 2 3 4 5 6 7 8 9 10 11 12
Figure 11.5 Spot and implied forward rates, derived from Table 11.8
The basis on the contract which is currently priced at 93.02, with four months to
expiry, will converge to zero at expiry. That means the price (in the absence of any
further changes in interest rates) will move to 6.12 per cent at expiry. The basis is
currently −86 (6.12 − 6.98 per cent) at T−4 months and is therefore expected to
decline to: −76 (T−3), to be at −51 at (T−2) and −38 at (T−1).
To hedge a future borrowing requirement, we will want to sell or short the fu-
tures. If prices fall (meaning that interest rates have increased) we can buy them
back at a profit, to subsidise the higher cash market rate to be paid on the borrow-
ing. If we were anticipating lending in the future, we would want to enter into the
opposite transaction: to buy futures to protect against a possible fall in interest rates
when the time comes to lend the money.
Let us start with a simple one-period hedging requirement where we have a bor-
rowing requirement in two months’ time ( + 2) for £20 million and we wanted to
hedge the exposure against adverse changes in interest rates. The only contract
available that covers the exposure period is the one currently standing at 93.02 since
the nearby contract expires in one month’s time. Since we are intending to borrow,
we want to sell the futures contract to ‘lock in’ the current rate. The rate implied by
this hedging transaction will be 6.98 per cent, less the anticipated change in the basis
over the period of 35 (86 − 51), giving a rate to be locked in using futures of 6.63
per cent (that is, the futures would be trading at 93.37 when repurchased with no
changes in interest rates). Look at Table 11.8 and you will see this is the same as the
implied three-month forward rate in two months’ time.
Now what happens if there is a change in the yield curve over the intervening
period? There are the two basic scenarios involving a parallel shift and a rotational
shift (or yield curve twist). We will explore both these shifts as they take place after
the announcement of some price-moving news that immediately changes the shape
of the yield curve just after the trade has been carried out.

What might happen if the term structure sees a parallel shift of +0.50 per cent?
The resultant yield curve and implied forward rates from such a shift are given in
Table 11.9 and Figure 11.6.
Table 11.9 Spot and implied forward rate changes with a 50 basis points
parallel shift in the yield curve
1 6.000% 7.002% 6.860% 7.141% 7.402%
2 6.500% 6.931% 7.001% 7.271% 7.502%
3 6.620% 7.001% 7.134% 7.381% 7.481%
4 6.750% 7.101% 7.251% 7.396% 7.752%
5 6.880% 7.201% 7.288% 7.630% 7.878%
6 7.000% 7.241% 7.501% 7.755% 7.898%
7 7.063% 7.430% 7.626% 7.790% 7.832%
8 7.250% 7.548% 7.673% 7.746% 7.877%
9 7.375% 7.598% 7.647% 7.795%
10 7.438% 7.582% 7.701%
11 7.438% 7.637%
12 7.500%
Note: The double underlined rates are those which pertain to the futures contract. The single
underlined rate is the new implied forward rate on the borrowing for three months to be entered
into at ( + 2). The futures prices are now at 92.99 (nearby − ) and 92.52 (deferred − )
respectively.
8.000%
7.500%
7.000% Spot
1m
2m
6.500% 3m
4m
6.000%
5.500%
5.000%
1 2 3 4 5 6 7 8 9 10 11 12
Figure 11.6 Spot and implied forward rates derived from Table 11.9
An examination of the change in rates between Table 11.8 and Table 11.9 and
Figure 11.5 and Figure 11.6 will show that the shape of the implied forward yield
curves has not been changed when the rate was increased. The new (instantaneous)

price for the two futures contracts will now be: 92.99 (−0.51) and 92.52 (−0.50)
respectively. The convergence on the latter will be at −86 (6.62 − 7.48 per cent) at
(T−4 months) and is therefore still expected to decline to −76 at (T−3), to be at
−51 at (T−2), and −38 at (T−1). With no more changes in interest rates, the
expected price of the contract will be 92.87, or an interest rate of 7.13 per cent.
Consequently, there will have been a gain from the futures hedge that compensated
for the increased borrowing cost. The three-month market rate would be 7.13 per
cent, the futures price would have shown a gain of 47 basis points (93.37 − 92.87)
from the short position. The 47 basis points futures gain is used to compensate for
the higher cash market borrowing cost which results in an all-in cost of 6.63 per
cent. This is the same rate as originally anticipated when the hedge was set up. In
this case, with a parallel shift in interest rates, the hedge has worked.
Now let us examine the situation where the yield curve twists. Here the exact
result will depend on the nature of the shift. The example involves a situation where
the curve twists with the spot rate falling from 6 per cent to 5 per cent but in such a
way that the forward rate is largely unchanged at the deferred futures maturity and
hence the contract price is unchanged. This change is chosen simply for ease of
exposition. In reality such a large fall in rates is unlikely to leave the later maturities
unaffected. The new yield curve and implied forward rates are given in Table 11.10
and shown graphically in Figure 11.7.
Table 11.10 Interest rates and implied forward rates from a ‘twist’ in the
yield curve
1 5.000% 5.827% 5.863% 6.566% 6.753%
2 5.413% 5.845% 6.214% 6.660% 7.130%
3 5.563% 6.085% 6.393% 6.942% 6.983%
4 5.813% 6.251% 6.671% 6.878% 7.192%
5 6.000% 6.502% 6.675% 7.066% 7.506%
6 6.250% 6.533% 6.865% 7.349% 7.589%
7 6.313% 6.716% 7.135% 7.442% 7.586%
8 6.500% 6.971% 7.244% 7.458% 7.599%
9 6.750% 7.085% 7.279% 7.484%
10 6.875% 7.133% 7.320%
11 6.938% 7.184%
12 7.000%
Note: The new futures prices are 93.92 and 93.02.

8.000%
7.500%
Spot
7.000%
1m
2m
6.500% 3m
4m
6.000%
5.500%
5.000%
1 2 3 4 5 6 7 8 9 10 11 12
Figure 11.7 Spot and implied forward rates from a rotational shift in the
yield curve based on Table 11.10
As in the earlier example, we now have revised futures prices: the nearby contract
will be trading at 93.92, an increase of 42 basis points on the original price of 93.50,
whereas the next to expire will be unchanged at 93.02. However the basis has risen
to 142. Again, if we hold this latter contract to expiry, we can expect convergence
with the spot rate, which is now 5.56 per cent. Therefore – with unchanged rates –
the basis will decline by −4 at (T−3), by −59 at (T−2) and −90 by (T−1). In this
case, at (T−2) when we remove the hedge, we can expect the futures price to be
93.02 plus the 59 change from convergence, or 93.61, a rate of 6.39 per cent. The
originally anticipated futures price was 93.37 ( = 6.63 per cent), but we can now
repurchase at 93.61 ( = 6.39 per cent). This gives a gain of 24 basis points, rather
than the 50 we anticipated from convergence, giving an unintended gain of 24 basis
points on the hedge. If the spot interest rate curve also stays unchanged and we can
borrow at 5.56 per cent, adding in the futures gain gives an all-in cost of 5.32 per
cent! This is not what we expected.
The position is that we want to protect ourselves from a rise in interest rates since
we are going to have to borrow money. To do this, we sell the futures since, if interest
rates go up, the price of the futures contract will go down and we can repurchase at a
profit. (Obviously, we stand to lose if the rate falls – but that’s in the nature of the
futures contract, its symmetrical!).
The original rate we put on is 6.63 per cent. We are using the deferred contract
which we intend to repurchase at T−2. With the twist in the curve, the contract has
remained unchanged, but the convergence has increased. The following diagram
illustrates the analysis.

Position Parallel Rotation

Current price 93.02 93.02
Expected price at 93.37 [A] 93.37
T−2 (no change) [A]
Increase +0.35 +0.35
Implied borrowing cost 6.63% 6.63%
Increase + 50bp 92.52 No change to 93.02
deferred
contract
Gain (from shorting +0.50 0
futures)
Expected price at T−2 92.87 (rotational) 93.61
(parallel) [B] [B]
Borrowing cost at T−2 7.13% 6.39%
Net gain from
futures [A − B] +0.50 [A − B] +0.24
Net borrowing cost
at T−2 less futures gain 6.63% 6.15%*
Hedge and cash market With a parallel shift we With a rotational shift,
combined have an exact offset the change in the hedge
between the hedge and and the cash market
the cash market have not been offset and
there is an unpected gain
of 0.24 on the futures
* Note that, if the interest rate is unchanged, the borrowing rate for 3 months is 5.56 per cent
less the 0.24 gain, giving a borrowing cost of 5.32 per cent.
We can now summarise the two results, as set out in Table 11.11.
Table 11.11 Summary of futures prices for a parallel and rotational shift
(twist) in the yield curve
Yield curve effects Parallel shift Rotational shift
(+ 50 basis points) (at 1 year)
Original nearby price 93.50 93.50
Original basis 38 38
Original deferred price 93.02 93.02
Original basis 86 86
New nearby price 92.99 93.92

New nearby basis 38 53
New deferred price 92.52 93.02

New deferred basis 86 142
Δ Nearby price −0.51 +0.42

Δ Deferred price 0.50 0
The basis and change in the rate of convergence for the deferred contract are
given in Table 11.12.
Table 11.12 Basis convergence on the deferred contract with a parallel

and rotational shift of the yield curve
Yield curve T-1 T-2 T-3 T-4
Original curve basis 38 51 76 86
Δ Basis 38 13 25 10
Parallel shift (+50 bp) 38 51 76 86

Δ Basis 38 13 25 10
Rotational shift 53 83 138 142

Δ Basis 53 30 55 4
While the analysis above produces a happy borrowing result, if the transaction
had been on the opposite side, that is, intended to hedge a loan, the situation would
have worked against the hedger, resulting in a lower lending rate than anticipated. In
addition, if we were to include a change in the value basis (that is, if the basis had
been trading cheap or dear to the cash market), the above changes might have been
somewhat dampened or accentuated, if at the same time the actual basis had shifted
closer to or further away from the futures ‘fair value’.
What has produced this unexpected result? It is an unanticipated change in the
shape of the yield curve and its effect on the convergence of the contract toward
expiry.
If the risk of yield curve twists needs to be managed then we need to refine the hedg-
ing strategy. The solution lies in setting up a spread position to protect the basis
relationship in addition to the basic hedge position. A spread between two futures
contracts with different expiry dates is designed to benefit from a change in their relative
valuations (that is, a change in the shape of the yield curve). There are, as with a simple
long or short futures position, two trades that can be put on: to buy the basis or to sell
the basis. The effect of a spread position is to gain from a steepening or flattening of
the yield curve. Think back to the problem of the twist in the curve and its effects on the
price of the two futures contracts. If we have bought or sold the nearby and deferred
contracts, we will gain if the price on the nearby increases more rapidly than that on the
deferred (that is, there is a change in their relative valuations). If we hold the nearby and
sell the deferred, we are long the spread; if we do the opposite, sell the nearby and buy
the deferred, we are short the spread. With a long spread, we expect the pricing
relationship between the nearby and the deferred to widen. With the short spread, we
anticipate the opposite. We can summarise the situation as in Table 11.13. The single
futures position is given for comparison purposes.

Table 11.13 The effect of changes in the term structure on long, short
and spread futures positions
Long Short
spread spread
Yield curve Long Short (buy (sell
effects futures futures nearby; nearby
sell buy
deferred) deferred)
Interest rate increase Loss Gain – –
Interest rate decrease Gain Loss – –
Curve steepens Indeterminate Indeterminate Gain Loss
Curve flattens Indeterminate Indeterminate Loss Gain
To see how this works, let us look at the example used earlier, but now adopting
some slightly different outcomes for the rotational shift to help illustrate the issue.
(They are also slightly exaggerated in terms of what might be expected to happen in
reality, to help show the effect clearly.) The parallel shift shown in Table 11.14 is the
same as discussed earlier (nearby = 6.50 per cent and deferred = 6.98 per cent, a
difference of 48 basis points). The rotational shift examples involve:
(a) an upward parallel shift in interest rates which also steepens the yield curve. The
new nearby contract interest rate = 7.45 per cent whilst the deferred = 8.41 per
cent, giving a difference of 96 basis points;
(b) a downward parallel shift which also involves a steepened yield curve. Here the
nearby = 6.03 per cent and deferred = 7 per cent, a difference of 97 basis points;
and
(c) a pivot of the yield curve around a particular point which does not involve an
increase in rates (that is, the term structure steepens around a particular maturity
point). In this case, the nearby = 6.82 per cent, the deferred = 7.81 per cent, a
difference of 99 basis points.
With a steepening of the yield curve, the result of being long the spread (that is,
having bought the nearby and sold the deferred) is that the price movement in the
nearby, whether rates increase or decrease, is less than that on the deferred. This
arises because, with a steepening of the yield curve, the implied forward rate against
which the deferred contract is priced will rise more than the rate on the nearby.
Hence the combined spread position will show a net gain from such twists in the
curve. Of course, with a steepened yield curve the opposite spread transaction,
selling the nearby and holding the deferred, will show a loss. However, with a
flattening of the yield curve, the reverse will happen: buying the spread will show a
loss and selling the spread a gain.

Table 11.14 Profit performance on a spread position under different

interest-rate scenarios
Gains and losses from a
Futures prices long spread position (in
basis points)*
Nearby Deferred Nearby Deferred Net
Original 93.50 93.02
value
Parallel shift
Up 92.99 92.52 −51 −50 −1
Down 94.00 93.51 +50 +49 +1
Rotational shift with a steepening of the yield curve

Up (a) 92.55 91.59 −95 +143 +48
Down 93.97 93.00 +47 +2 +49
(b)
Pivot 93.18 92.19 −32 +83 +51
(c)
Rotational shift with a flattening of the yield curve

Up 92.55 93.50 −95 +48 −47
(a’)
Down 93.97 93.85 +47 −83 −36
(b’)
Pivot 93.18 93.39 −32 −37 −69
(c’)
* The position of a short spread would be the opposite of that of a long spread.
We can see that adding the appropriate spread to the basic hedge in our example
would provide protection against a steepening of the yield curve. The question
therefore is, what should the spread be to protect the basic hedge position from
twists in the yield curve?
The required spread position required for short-term interest-rate futures, in
order to minimise the rotational risk of the yield curve, can be shown to be:
− ﴾11.11﴿
= ×
−
where is the required number of spread futures contracts, is the
expiry date on the futures contract, is the maturity date on the hedge and is the
maturity date of the underlying futures contract (typically 90 days). For our example
then, using months, − is two months, − is three months. The basic hedge
is a short position in 40 contracts (the short sterling contract having a value of
£500 000 and the exposure being £20 million) and the required spread position will
thus be a short 27 spread position:
−27 = −40 × 2 ÷ 3

Note that the directional sign of the futures spread required to minimise the
rotational risk of the yield curve is the same as that of the basic hedge position. If
we buy futures, we buy the spread; if we sell futures, we sell the spread. This will be
the case based on the directional behaviour of the pricing relationships given in
Table 11.13.
The resultant hedge designed to minimise curve risk will be:
(a) short deferred 40 contracts;
(b) short 27 nearby-deferred spread (that is, sell 27 nearby contracts and buy 27
deferred contracts).
After the yield curve twist, as given in Table 11.10, we have the results given in
Table 11.15.
Table 11.15 Hedging against a rotational shift in the yield curve using a
spread
Δ Value of
hedged
Initial Change position
Futures value New in (£20
value value million)
Original hedge
−40 deferred contracts 93.02 93.02 0 0
Spread hedge
−27 nearby contracts 93.50 93.92 −0.42 −28 bp
+27 deferred contracts 93.02 93.02 0 0
Combined position
−27 nearby contracts 93.50 93.92 −0.42 −28 bp
−13 deferred contracts 93.02 93.02 0 0
The result is (1) an unexpected gain from the cash market rate of 26 basis points
(as in the earlier analysis). This is now offset by (2) a loss of 28 basis points on the
spread position. This loss is the result of the 0.42 price increase on the nearby
futures price in which, when setting up the spread, there is now a short position.
Since this short position is for 27 contracts only, the value loss, in monetary terms,
is £14 175. (This is the product of the valuation formula used for futures: the price
has moved 42 ticks; each tick is worth £12.50 and there are 27 contracts.) The
unanticipated gain on the three-month deposit is 28 basis points, which translates to
£14 000 in money terms. The difference in value between the intended and actual
result is now only £175. The result is a combined hedge position that is only two
basis points away from that intended.
Of course, in this case, the spread hedge creates a loss: the yield curve has steep-
ened with a fall in the short-dated maturity interest rate. This led to a gain when
using the simple hedge. In other conditions, the results might have left a loss. Since
the intention in setting up the hedge is to eliminate as much of the market risk as

possible, the simple hedge plus the spread hedge provides a more satisfactory
solution than the simple hedge alone. This is because, in a yield curve twist scenario,
the simple hedge can be ineffective – a potentially undesirable result.
Table 11.16 shows the price performance of the hedge for the interest rate sce-
narios for the different rotational shifts given in Table 11.14.
Table 11.16 Results of yield curve twists on the spread hedge based on Table 11.14
Δ Value
Change Change of cash Combined
in value in value position position
of of (£20 (hedge
Futures Nearby Deferred nearby deferred million) and cash)
Original conditions 93.50 93.02
Deferred 0 −40
contracts
Spread hedge
Nearby −27
contracts
Deferred +27
contracts
Combined position −27 −13
Rotational shift with a steepening of the yield curve

Up 92.55 91.59 £32 063 £23 238 (£57 000) (£1 699)
Down 93.97 93.00 (£15 863) £325 £13 833 (£1 705)
Pivot 93.18 92.19 £10 800 £13 488 (£26 000) (£1 712)
Rotational shift with a flattening of the yield curve

Up 92.55 93.50 £30 780 (£7 800) (£25 167) (£2 187)
Down 93.97 93.85 (£15 863) (£13 488) £28 000 (£1 351)
Pivot 93.18 93.39 £10 800 (£6 013) (£6 000) (£1 213)
Note: The change in value of the cash position is the implied additional cost of borrowing when the futures position
was set up due to changes in interest rates. The cash borrowing rate that is anticipated when the hedge was
established was 6.63%.
The column of values for the cash position gives the difference between the
expected borrowing cost and the actual borrowing cost for each of the scenarios.
The expected cost is 6.63% × £20 million × 0.25 (a quarter of a year), or £331 500.
For instance, in the first case, the actual interest rate is 7.77 per cent. This rate is
found as follows. If we assume a straight-line yield curve between the nearby and
deferred contracts, the 92.55 nearby and 91.59 deferred indicate a three-month rate
in one month’s time of 7.45 per cent and 8.41 per cent, a difference of 96 basis
points. Hence rates rise by 32 basis points per month. If the nearby is at 7.45 per
cent, the cash position which starts one month later implies a 7.77 per cent rate. The

other cases can be computed in a similar fashion. Thus the actual borrowing cost is
£388 500, giving the additional cost of £57 000 (£388 500 − £331 500). The
combined cash and hedge cost deviation in our scenarios is within a couple of
thousand pounds of the expected rate of 6.63 per cent. This is hardly material in the
context of a borrowing requirement of £20 million. To examine how well the spread
hedge works to protect the cash borrowing rate, you may wish to try other interest-
rate scenarios to see how the expected rate and the actual rate diverge in practice.
To conclude, the spread hedge will improve hedging efficiency against a rotation
in the yield curve under most interest-rate scenarios. In practice just how well the
spread approach hedges the risk will depend on the way the yield curve twists.
Finally, note that the effect of combining the two hedges has the same result as if
we had simply sold 13 deferred and 27 nearby contracts.
We may also consider that the spread hedge used to protect the position against a
rotational shift can be seen as what is known as an interpolated hedge. That is, the
exposure (when the hedge is established) covers more than one contract period, as
shown in Figure 11.8.
Panel A: Exposures and futures contracts at inception
1 2 3
Futures contracts
Time
te–1 T1 T2 T3
Exposure
t=0 period
Panel B: Exposures and futures contracts before maturity of hedge

and after nearby contract has expired
Futures
contracts
2 3
Time
T1 T2 T3
t=0 Exposure
period
Figure 11.8 Effect of time on interpolated hedge (basic hedge plus spread
hedge)
While the nearby contract is extant, it is possible to run the spread as a precau-
tion against a yield curve twist as shown in Panel A of Figure 11.8. However, once
the maturity of the exposure period predates the expiry of the nearby contract, as
shown in Panel B of Figure 11.8, the spread expires and yield curve risk returns,
although now only for a short period (that is the time − ). Since the maximum
period between expiry dates on short-term interest-rate futures contracts is three
months, the exposure period is likely to be less than half this. This is true because
the closer the exposure period is to the outstanding contract, the more this contract
hedges it against yield curve twists. If the exposure period shown in Figure 11.8 is

close to the second futures contract 1 , then the better is the fit with the now
remaining contract number 2.
A final point to note is that if the exposure had been hedged using the appropri-
ate forward rate agreement (FRA), the result would have been perfect since the
hedge period and the underlying exposure would exactly match. The difficulties of
matching the two sides stem from the standardisation and inflexibility of exchange-
traded instruments.
Metallgesellschaft and Hedger’s Ruin _________________________
In late 1993, Metallgesellschaft was effectively bankrupt.* Its US subsidiary, MG
Refining and Marketing (MGRM), had – it seemed – run up debts of US$1.3
billion while hedging an aggressive long-term fixed-price oil marketing pro-
gramme with its customers, effectively bankrupting the group. How did this
happen?
MGRM, it transpires, had been successfully marketing long-dated fixed-price
diesel and fuel product contracts to its customers. In order to hedge the price
risk in these fixed-price delivery contracts, it had initiated a hedging programme.
This involved mostly exchange-traded futures contracts although the company
also entered into over-the-counter forwards with suitable counterparties. By
September 1993, the company’s long-term fixed-price contracts had grown
dramatically thanks to the take-up from its marketing campaign, to the extent
that it had entered into commitments worth over 180 million barrels of oil. To
gauge the size of MGRM’s activities, these commitments were equivalent to
about a quarter of Kuwait’s annual output at the time.
In the energy futures markets, the most liquid contracts are the nearby ones
(see Table 11.5). Therefore in entering into the obligation to deliver fixed-price
oil products, MGRM had taken on a significant maturity mismatch between the
fixed-price contracts which extended, in some cases, out to ten years and the
three to six month expiry date on the energy futures.
This mismatch led to significant basis risk, a risk that at the onset MGRM was
successful in managing. At the time the synthetic storage strategy was devel-
oped, the energy futures curve was largely in backwardation. By selling long and
buying short, MGRM was able to earn the basis. The general approach is shown
in Figure 11.9, which illustrates that the fixed-rate contracts were costing
MGRM, but the company was earning the spread between the purchased futures
( ℎ ) and those sold ( ) at the rollovers. As MGRM did not want to
receive the delivery of oil from its position, it sold the contract that was due to
expire before the first deliverable date and bought the next contract (that is, it
‘rolled forward’ the hedge), reducing the hedge as required. (This is the process
shown in Figure 11.3 and Figure 11.4.)
* This section is largely based on an article by Christopher Culp and Merton Miller (1995) ‘Metallgesell-
schaft and the economics of synthetic storage’, Journal of Applied Corporate Finance, 7, 62–76.

Two factors conspired against this hedging strategy. The first was the success of
the programme with MGRM’s clients. The size of the positions that MGRM was
required to take on the New York Mercantile Exchange (NYMEX) was such
that (a) it had to be granted a ‘hedger’s exemption’ to the normal position limits
allowed on the exchange and (b) other traders began to price against the
company. Remember that the strategy required MGRM to run the programme
in a largely predictable fashion, rolling over the contracts as they neared expiry.
As a result of predatory pricing, they received less on the spread than they had
originally anticipated when setting up the strategy.*
Price of
Oil/Oil futures
Positive rollover spread earned
as contracts rolled forward
Fsold Negative spread
Fbought on long-term
fixed contracts
Vfixed
Maturity
1m 4m 10 years
Figure 11.9 Schematic representation of MGRM’s maturity mismatch

The other factor that worked against them was a fall in the oil price in the
autumn of 1993 which moved the market from being in backwardation to being
in contango. Rather than earning on the rollover, MGRM now had to pay the
loss on the spread between the expiring contract and the new contracts being
entered into. Since the hedge was largely futures based, the losses were being
paid out as variation margin each day, but since the long-term contracts were
forwards, no cash was being received from its customers at this point. Problems
at MGRM also prompted NYMEX to increase the required margin on contracts
at the exchange. Given the size of the positions, MGRM now faced a significant
cash squeeze since money was being paid out at the tune of between US$20 and
US$30 million per month in margin calls. In 1993, the company had had to pay
out over US$900 million in margin on its hedges. This was beyond the means of
MGRM to finance and it appealed to its parent company in Germany for help.
* The problem of yield curve twists can be reduced in those futures contracts that offer serial months.
Serial month expiry dates are those available that fall outside the normal expiry cycle. For short-term
interest rate futures, the normal cycle is March, June, September and December. Serial month contracts
would provide expiry dates in January, February, April, May, and so forth. Where contracts are
available on such a monthly basis, the problem of mismatch between the hedging instrument and the
exposure is greatly mitigated. However, at this juncture not all futures contracts offer serial months.

MGRM’s parent company, Metallgesellschaft AG, reacted to the deteriorating

situation by taking direct operational control, replacing the management and
rapidly unwinding the hedging position. The management then realised this left
MGRM exposed to considerable price risk. To counter this, the new manage-
ment then also released MGRM’s clients from their contractual obligations, even
agreeing to buy back some obligations at give-away prices. The total loss came
to over US$1.3 billion. Metallgesellschaft itself was now in a catastrophic
position and was only saved from bankruptcy when its main lenders agreed to
rescue the group by advancing US$2.1 billion in an emergency loan.
The story illustrates the fact that even though the price risk had been hedged, it
is still possible to lose a lot of money from basis risk. If oil prices had exhibited
only parallel shifts, the stacking hedge would have worked. However, the
rotation in the yield curve, as it moved from backwardation to contango, ended
up destroying the hedging strategy since it showed how exposed MGRM was to
rotational risk.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
11.3.2 Dynamic Hedging

One possible use of hedging techniques is to modify the hedge position dynamically
over time. In a sense, that is what dynamic replication of an option position is
designed to achieve. We will begin by describing a simple risk-modification example
where a share portfolio’s sensitivity to market risk is modified using futures as a
hedge. A portfolio’s sensitivity to market effects is known as its beta (β). A beta
hedge, for an equity portfolio, is an alternative method of establishing the mini-
mum-variance hedge ratio against the market index used in the hedge (stock index
futures). The number of futures contracts required to hedge a particular portfolio is
found by multiplying the portfolio’s beta by the relative amount of the portfolio and
the stock index contract:
Value of portfolio ﴾11.12﴿
=
Value of futures contract
Equation 11.12 provides a good means of hedging a given equity portfolio. Note
that the beta here is estimated, not as in Section 11.2.5 on determining the mini-
mum-variance hedge ratio where ℎ is based on the relationship between the cash
and futures price, but simply by regressing the portfolio return against the index
return. That is, the beta is the cash price relative sensitivity, not the relationship of
the cash to futures price. This approach provides less basis risk than the minimum-
variance hedge ratio method.
Equation 11.12 also allows for risk modification as discussed in Section 11.2.5, in
that the desired market risk or sensitivity ( ) can be used to change the relative
risk of the portfolio from the actual level to the target level, as shown in Equation
11.13:
Value of portfolio ﴾11.13﴿
= −

If ( − ) is a positive number, a long rather than a short position is

taken in futures. That is, the portfolio’s sensitivity to the market is increased rather
than decreased and a greater exposure is achieved.
Modifying Interest-Rate Sensitivity ___________________________
The method given in Section 11.3.2, with suitable modifications, can be applied
to an interest-rate-sensitive position. The key in this case is to balance the price
or value changes on the asset side with those of the hedge. The first step is to
find the price value of a basis point (PVBP) of the asset or portfolio. This is
found by using Equation 11.14 to calculate the change in portfolio value from a
one basis point (0.01 per cent) change in interest rates:
(MVP)(0.0001) ﴾11.14﴿
PVBP =
1+
where is the Macaulay duration of the portfolio, MVP is the market value of
the portfolio, is the annualised yield-to-maturity and the frequency of
payments per year (usually either one (annual payments) or two (semi-annual
payments)).
Note that for a portfolio of interest-rate-sensitive assets this can be calculated
in one of two ways:
 the composite duration of the portfolio is determined, if simplicity of
calculation is required;
 the PVBP of each asset in the portfolio is calculated and the weighted sum of
these individual PVBPs is then determined.
In the case of modifying rather than completely eliminating the risk, the interest-
rate sensitivity of the portfolio, Equation 11.14 is adjusted as with that of the
equity portfolio, namely:
PVBP − PVBP ﴾11.15﴿
- - =
PVBP
The PVBP of the long-term interest-rate futures contract (bond futures)
requires some additional explanation. The futures contract will always trade to
the cheapest-to-deliver (CTD) eligible bond that is deliverable into the contract.
The PVBP of the futures contract will therefore be:
PVBP ﴾11.16﴿
PVBP - - =
Conversion factor
where the conversion factor is the adjustment made to the CTD cash bond to
equate it to the notional bond underlying the futures contract.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Example of Adjusting the Interest-Rate Sensitivity of a Portfolio

____________________________________________________________
A decision has been reached to increase the interest-rate sensitivity of a
portfolio of Euro-denominated bonds in the anticipation of a decline in yields in
the German market. The current situation, before any adjustment is made, is as
follows:
Actual portfolio duration 5 years

Target duration 8 years
Bond futures price 97−40
Cash value of the portfolio €100 million
Portfolio yield 6.75%
PVBP of bond futures (CTD cash) €105.60
Step 1
Convert the cash portfolio to a PVBP as per Equation 11.14:
5
× €100million × 0.0001 = €46 838.41
1 + 0.0675
Step 2
Convert the target portfolio to a PVBP (using Equation 11.14 again):
8
× €100million × 0.0001 = €74 941.45
1 + 0.0675
Step 3
Determine the number of bond futures (long-term interest-rate futures)
required to achieve the target portfolio duration (interest-rate sensitivity) from
Equation 11.15:
€74 941.45 − €46 838.41
= 266
105.6
To move the duration – and hence the portfolio’s sensitivity to interest rates –
to eight years, 266 bond contracts need to be purchased. If the opposite, a
reduction in interest-rate sensitivity, had been sought, the contracts would have
been shorted (sold).
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
11.4 Portfolio Insurance

The previous section details strategies to modify the risk of a given position. A
dynamic approach to the above strategies is referred to as portfolio insurance. The
objective of portfolio insurance is to guarantee a minimum value (known as a
‘floor’) to a portfolio by protecting the portfolio against a decline in market prices.
Figure 11.10 illustrates the effect of portfolio insurance (that is, a protective put
strategy) (I), as compared with a 100 per cent invested buy-and-hold position (II),

and a reduced-risk portfolio with 60 per cent invested in the market and 40 per cent
in a risk-free asset (III).
With the portfolio insurance approach, a portion of the potential return from an
uninsured portfolio is surrendered in order to guarantee a minimum portfolio value.
Figure 11.10 shows how the different strategies perform. On the upside, a pure buy-
and-hold strategy (II) is superior. It has the potential for greater gains (but equally
also for greater losses) than the risk-reduction strategy of investing a fraction of the
portfolio value in a risk-free investment (III). However, the pure insurance ap-
proach (I) provides a guaranteed minimum portfolio price and, in the event of
significant market movements, is also superior to the risk-reduction strategy.
While the protective put or pure insurance approach has attractions it does have
a number of disadvantages:
 Buying put options has a recurring performance cost in the form of the premi-
ums even though the actual floor may be deeply out-of-the-money and never
exercised.
 Only that portion of the funds left after purchasing insurance may be invested in
the market.
 There may be insufficient liquidity and volume in suitable put contracts to
undertake pure insurance for large portfolios; equally exchange-traded options
may not be available for some types of portfolios with unique exposures. Over-
the-counter alternatives may be costly or may create regulatory problems.
 Listed options have short lives and offer only a limited range of exercise prices
(typically close-to-the-money).
Portfolio value
+
100% long asset position II I

III
60% long asset position

40% risk-free investment
Market price

4% long put (pure insurance)
Figure 11.10 Alternative investment strategies: buy and hold (II); reduced-
risk portfolio (III) and pure insurance (protective put) (I)

The alternative approach is for the floor to be replicated via a synthetic put
strategy. This involves modifying the proportion of the portfolio held between a
safe asset (with zero sensitivity to the market) and risky assets (which are exposed to
market fluctuations). The intention is to replicate the payoff of buying a put option
(as indicated by line (I) of Figure 11.10) and holding a portfolio in risky assets. It
works as follows: as prices increase, more funds are transferred from the risk-free
asset to the risky portfolio; as prices decline, more funds are placed in the risk-free
asset. The advantage is, of course, that – unlike the pure insurance approach – no
cash outlays are involved, although the portfolio will be subject to transaction costs.
Such a strategy involves buying and selling either the asset or, and here the lower
transaction costs of derivatives make them attractive, futures. Figure 11.11 shows the
effect of such a strategy, as compared with the alternative buy-and-hold approach.
Portfolio value
+
Market price
Dynamic portfolio insurance
Figure 11.11 Dynamic portfolio insurance as compared with a buy-and-

hold strategy
A simple method for implementing such a strategy has been formulated by Fisher
Black and Robert Jones (1987)* and is known as the constant proportions portfo-
lio insurance (CPPI) approach. The basic formula is:
Value in risky asset = (Value of portfolio − Value of floor) ﴾11.17﴿
where is the multiplier. If we have a fund of £1000 and we set the floor at £800
and the multiplier at 2.5 and the current FT-SE 100 index is at 1000 then the
proportion in the market will be 2.5 × (1000 − 800) = £500. If the market rises to
1200, then the amount in the market is increased to £777.19. The index (market)
* Black and Jones (1987). It should be noted that what Black and Jones are proposing is a simplified
version of dynamic replication as used by option writers. In this case, there is less need for an exact
match and the maturity is indefinite.

level and proportions in the risky asset(s) and the residual in the safe investment are
shown in Table 11.17 for different levels of the index (market).
Table 11.17 uses simple level changes to illustrate the dynamics of CPPI. In
operation, the risk manager usually rebalances the portfolio by a tolerance factor for
the benchmark (say 3 per cent on the index) or according to how far the cushion
(the portfolio value – the floor) changes by 3 per cent times the multiplier, that is,
say, a change of 7.5 per cent. If we had used the tolerance factor approach, we
would rebalance the portfolio when its value had increased from the initial £1000 to
£1030 or decreased to £971. With the cushion approach, we would rebalance when
the cushion had moved from £500 to £537.5 (that is, a portfolio value of £1037.50)
or £465.11 (a portfolio value of £965.11).
As a strategy, the CPPI method delivers the appropriate convex shape of the
dynamic hedging strategy shown in Figure 11.11.* The value chosen for κ (the
multiplier) will determine the rate at which funds are moved from the market into
the risk-free asset and vice versa. The higher the multiplier, the faster the portfolio
will be rebalanced between the market and the risk-free asset. Each rebalancing
transaction returns the exposure to the market to the same multiple of the cushion.
Key decisions, therefore, are what value to set for κ, the tolerance factor, and how
frequently to rebalance the position. Frequent rebalancing returns the portfolio to
the right proportion, but leads to higher transaction costs. There will be a definite
trade-off between protection and transaction costs. In addition, in a volatile,
directionless market, the CPPI approach is likely to incur substantial transaction
costs, which cannot be predicted at the onset – a possible disadvantage when
compared to the known cost of buying protective puts.
Table 11.17 Constant proportions portfolio insurance approach at various

index levels with a guaranteed floor of 800 and κ = 2.5
Index (market) Portfolio value Invested in the Invested in the
level market risk-free asset
1500 1335 1337.64 −3
1450 1293 1231.48 61
1400 1252 1130.54 122
1350 1214 1034.73 179
1300 1178 943.96 234
1250 1143 858.15 285
1200 1111 777.19 334
1150 1080 700.99 379
1100 1052 629.46 422
1050 1025 562.50 463
1000 1000 500.00 500
950 975 437.50 538
* You will see this if you plot the results of Table 11.17 on a graph.

Index (market) Portfolio value Invested in the Invested in the

level market risk-free asset
900 952 379.93 572
850 931 327.17 604
800 912 279.05 633
750 894 235.45 659
700 878 196.21 682
650 864 161.17 703
600 852 130.18 722
550 841 103.06 738
500 832 79.64 752
450 824 59.73 764
400 817 43.14 774
350 812 29.66 782
300 808 19.06 789
250 804 11.12 793
200 802 5.56 797
150 801 2.085 799
100 800 0.35 800
50 800 −0.09 800
0 800 800
11.5 The Use of Options as Insurance

The discussion so far has assumed that the hedging instrument involves a forward
or futures transaction even if, as with the protective put strategy, the payoff profile
is that of an option. Options, since they also modify risk profiles, can be used as
insurance or as means of modifying market risk. The advantage of options is their
asymmetric or non-linear payoff. In the words of the old saying, ‘we can have our cake
and eat it’, since the option allows us to eliminate the undesirable elements of future
price changes. At its simplest, we buy puts to eliminate the downside risk on long
positions and calls to eliminate the upside risk on short positions. The major
disadvantage of options is – of course – the fact that they are not ‘free’ instruments.
We have to buy options and this is potentially costly. Ex post, the alternative strategy
will be superior to holding options. We should have either sold the asset if the price
declined, or held on to it if the price rose. Options, however, are designed to
address uncertain future developments: they remove the risk of undesirable out-
comes.

11.5.1 Options as a Way of Modifying Risk Profiles

The intention with hedging is to adjust the risk–reward profile. In using options, the
hedger is willing to give up return in order favourably to modify the risk of a
position. The basic approach is shown in Figure 11.12 where a short (buyer’s)
position is being hedged by holding a long call. In this situation, the buyer antici-
pates a fall in price but wants to hedge out a potentially adverse upward change in
the price of the underlying asset.
Let us assume that the exposure is to interest rates. If the rate at which a forward
contract locks in the hedge is 7 per cent, and the cap costs ten basis points, the
question is whether the opportunity to benefit from a fall in rates (the break-even
rate now being 6.90 per cent) is worth the potential extra ten basis points on the
borrowing. Such a decision will depend on the degree of risk aversion of the
individual or organisation, the nature of the exposure and expectations on the likely
magnitude of the change in interest rates. The decision can be evaluated in cost–
benefit terms.
Gains
+
Underlying position
Purchased call
on the underlying asset
Resultant
position
Underlying asset price

Premium
–
Losses
Figure 11.12 Hedging an exposure with options
Note: A short exposure is being hedged with a call option.
11.5.2 Hedging a Contingent Exposure

One type of risk that is well suited to hedging using options is contingent exposure (also
known as quantity risk). Take, for example, the situation where a firm anticipates (but
is not sure) that it will receive a payment in US dollars. The firm decides to hedge this in
the forward market but when the time comes there is no underlying cash flow. Then the
forward, hedging transaction turns out to be, in fact, a naked (speculative) transaction
since it cannot be matched to an existing, underlying cash flow. If options had been

used to hedge the risk, then the maximum loss (as shown in Figure 11.12) would have
been the option premium. If it had been realised before the expiry of the option that the
anticipated transaction was not going to materialise, the loss might have been less than
this. Before expiry, the option could be sold back to recoup the remaining time value.
Equally, in some cases, the option might be worth even more. From what we know
about option price behaviour we know that – unless the price movement between the
option’s purchase and resale has been extraordinarily large – the change in price on the
option (its – the option’s – delta) will be less than in the corresponding underlying
position.
Marconi’s £200 million Hedging Error ________________________
By October 2001 Marconi, the UK telecommunications equipment firm was
reeling from a massive decline in profitability and a near total collapse in its
share price as the technology bubble fuelled by a combination of internet
frenzy and year 2000 fears burst. However, in filings with the Securities and
Exchange Commission in the US, when seeking new finance it it revealed
that a stock option plan for employees was hedged in the market by the
company buying a forward contract on its own shares. As a result Marconi,
whose share price had lost over 98 per cent of its value following the
spectacular decline in telecommunications, media and technology stocks, was
left with the prospect of major losses on its hedging strategy. This was
because the price at which it was committed to purchasing the shares for
the stock option plan bore no resemblance to the current distressed price in
the market. In its filing to raise funds in the US, the company disclosed that
the stock option scheme allowed its 38 000 employees to subscribe for 1000
shares each if the share price doubled from £8 pence to £16. At the date of
the filing Marconi’s share price was just 18 pence and the company indicated
the forward contract would cost it more than £210 million.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
11.5.3 Options as Insurance

Another way to consider options within a hedging strategy is to see them as a form
of insurance. With options, unlike terminal instruments, we have the choice of a
range of strike prices that can be purchased which may be deeply or slightly out-of-
the-money (OTM), at-the-money (ATM) or slightly or greatly in-the-money (ITM).
Figure 11.13 shows the underlying position and two options with strike prices, one
at-the-money, the other some way out-of-the-money.
Figure 11.13 shows that there is a trade-off between the exercise or strike price
( ), the break-even ( ) and the cost of setting up the hedge (the premium paid).
The combined outcome of a short asset position after buying the calls has the same
payoff profile as holding a put. Whereas the at-the-money call ( ) is initially more
expensive, it is equally an out-of-the-money put. As a result, the dashed lines
showing the modified risk profile on the exposure indicate that there is potentially
more regret from buying the out-of-the-money call at 2 rather than the at-the-
money call at 1 . This is because the combined payoff of the at-the-money call and

the underlying will be ( − ≥ 0, + − ) whereas for the out-of-the-money

call, it will be ( − ≥ 0, + − ), the payoff for an in-the-money put.
For the two options shown in Figure 11.13, the payoffs of the two alternatives, with
strikes at 100 and 105 and premiums of 5 and 3 respectively, are shown in Ta-
ble 11.18.
Gains
+ Out-of-the-money call:
more downside gain, but more regret
BE1 BE2 K2 Underlying asset price
K1
At-the-money call:
less downside gain, but less regret
–
Losses
Figure 11.13 Hedging a short exposure with call options with different
exercise prices
Table 11.18 Payoffs for an at-the-money option ( ) and an out-of-the-

money option ( ) used as a hedge for a short asset position
Asset price At-the-money Out-of-the-money
U = 100 = , = = , =
80 0 + 20 − 5 = +15 0 + 20 − 3 = +
17
90 0 + 10 − 5 = + 5 0 + 10 − 3 = + 7
100 0+0−5= −5 0 + 0 − 3 = −3
110 + 10 − 10 − 5 = − 5 +5 − 10 − 3 = − 8
120 + 20 − 20 − 5 = − 5 + 15 −20 − 3 = − 8
Note: The regret from the at-the-money option is 5 and the out-of-the-money option is 8.
The above analysis shows that there is a trade-off between the desired protection
and decision regret. The out-of-the-money call provides a better performance if the
anticipated, downward movement occurs, but at the expense of a greater regret
(−8), if the underlying asset price increases. The at-the-money call provides less
regret (−5) but lower performance on the downside. In practice, therefore, the
amount of upfront premium to be paid out might dictate the actual choice of strike

price and the amount of protection provided. In fact, there is considerable evidence
to suggest that slightly out-of-the-money options are preferred by market partici-
pants in such cases, for just this reason.
11.5.4 Removing Market Risk from a Position

A situation where the linear payoffs on a hedge may be undesirable arises in the case
of stock-specific risk. Recall that the risk in a share may be broken down into two
components: a market risk element, which is common to all stocks, and a stock-
specific element, unique to the individual share or stock. If a particular company
might be subject to a takeover attempt, then the stock might be expected to
appreciate significantly as a result, regardless of wider market price behaviour.
However, the desirability of holding the stock in anticipation of such a (stock-
specific) event occurring is offset by the potential for adverse market changes in the
investment. Note that there is an implicit assumption in this strategy that the only
significant news to affect the stock will be the announcement of the takeover.
At the transaction’s initiation, the Financial Times-Stock Exchange 100 index
(FT-SE 100 or Footsie) is at 3891. The first step is to calculate the number of index
options required to hedge the position against market risk. The investment is one
million shares in Target plc which are at 95 pence each, giving a total position value
of £950 000. We also need to know the sensitivity of the share price relative to the
market (the share’s beta (β)). The relative price sensitivity of the share to the
market, that is, the share’s beta (β), is used to adjust the number of index puts used
to hedge out the market risk, as in Equation 11.18.
= Portfolio value ÷ index value ﴾11.18﴿
For the FT-SE stock index options traded on LIFFE, each index point is worth
£10, so the index value of the puts will be £10 times the index value of 3891, or
£38 910 per index point. The beta of the company’s shares is 1.5. The required
number of puts to neutralise the position’s market risk is therefore:
36.6 = 1.5 × £950 000 ÷ £38 910
This requires us to buy 36.6 put contracts, but we have to round up to complete
contracts (we could equally well have rounded down) and 37 puts are purchased for
a cost of £11 285 (30.5 [index points] × £10 × 37 [contracts]). The initial steps of
the transaction are shown in the first part of Table 11.19.
Table 11.19 Hedging systematic risk with options

Date Shares Options
15 August Objective is to take advantage of poten- Buy protective puts as a hedge against
(initiation) tial takeover of Target plc market falls
FT-SE Index = 3891.1 Acquire October put at 3850
Current share price of Target = £0.95 Price = 30½
Required number of puts
Number of shares purchased = 1 000 000 = 1.5 × £950 000 ÷ (3891 × 10)

Date Shares Options

= 37 puts at a cost 30½ index points
Portfolio value = £950 000 = (£11 285)
Target’s systematic risk (β) = 1.5
15 September Takeover rumours prove well founded, Sell puts, now trading at 16¼
(termination) Target plc shares rise to £1.25 on
announcement
FT-SE Index = 3921.3 =£6013
Portfolio value = £1 250 000
Outcome +£300 000 (£5 272)
The possibility of a takeover of Target plc was well spotted and by mid-
September the news is in the market and the decision is made to close out the
transaction and take the profits. The termination is shown in the second part of
Table 11.19. The share price of Target plc has risen from 95 to 125 pence on the
news, giving a profit of £300 000 on the transaction. However, the market has also
risen over the period and the puts are now worth only 16¼.* The position is closed
out by selling the puts, giving a cash inflow of £6013. The overall gain from the
action, before funding and other transaction costs, is thus £300 000 − £11 284 +
£6013, or £294 729.
Of course, if the stock has traded options, an alternative approach to the above is
to buy calls on the stock directly to cover the period of speculation.
11.5.5 Hedging the Value of a Portfolio with Options

This section extends the earlier analysis of hedging a single stock and looks at the
use of puts to hedge a portfolio exposed to the equity market. The approach is
known as a protective put strategy. The strategy, like that discussed in Section
11.5.4, makes use of stock index options. It should be noted that, as a general rule
if overall market protection is required, stock index futures are possibly to be
preferred. With a protective put strategy, the hedge needs to be rebalanced over
time and the use of options exposes the hedger to changes in volatility which can
influence the value of the hedge, but not that of the portfolio, leading to inaccuracy
between the two sides. Remember that, as discussed in Module 9, as the option
moves towards expiry, the option’s delta (δ) will change. The delta will also change
as the value of the underlying changes. Both of these effects need to be actively
managed if the hedge is maintained over any length of time. Recall also that it is the
market’s estimate of future volatility over the life of the option that will drive option
prices, not past (historical) volatility.
In order to apply the protective put strategy, the portfolio manager needs to
apply a delta hedge, if using out-of-the-money options. The initial step is to
calculate the number of options required to hedge the position. To do so, we need
* Note that there will also be an element of time value loss in this fall in price.

to know the sensitivity of the portfolio relative to the market (that is, the portfolio’s
beta (β)). Once we have established the relative sensitivity of the portfolio to the
underlying asset (the market index) on the hedge, we also need to have the hedge’s
sensitivity to the underlying market. This is given by the option’s delta (δ). For a
one-unit change in the index, we have the relationship of the various factors as
given in Equation 11.19.
Position (portfolio) value 1 ﴾11.19﴿
= ×
Index value Option delta( )
This gives us the right number of put options required to balance a fall in value
of the portfolio against the gain in the option position acting as a hedge. A numeri-
cal example of the approach is given in Table 11.20.
Table 11.20 Portfolio hedging with puts (a protective put strategy)

Date Shares Options
15 August Desire to protect value of equity Buy protective puts as a hedge
(initiation) portfolio
FT-SE index = 3891.1 October put 3725 = = −0.30
Portfolio value = £10 million Price = 15½
Required number of puts
Portfolio β = 1.2 =1.2 × £10 million ÷ (3891 × £10) × (1 ÷
0.30)
= 1028 puts at 15½
cost = (£159 340)
15 September Fears about fall in the market ease, the Sell puts at 4½
(termination) index now at 3921.3
Portfolio value = £10 093 136 = £46 260
Outcome +£93 136 (£110 912)
The portfolio manager wants to hedge a £10 million equity portfolio against a fall
in the UK market. The portfolio has a market sensitivity, as measured by its beta (β)
of 1.2. The manager also wants to keep down the cost of the hedge and decides to
use out-of-the-money puts which have a delta of −0.30.* The value of each put
traded on the London market is £10 times the index level. The puts’ exercise price is
3725 against the current index level of 3891.1. Applying Equation 11.19, the number
of puts required is 1028. The cost per put is 15½ index points, each worth £10, so
the total cost of the protection is £159 340.
After a month, and before the expiry of the puts, the decision is made to remove
the hedge as the required portfolio protection is no longer needed. In the interim,
the market has improved with the index now at 3921.3. The puts are now further
* Remember that delta, for puts, is a negative number. Puts become more valuable the lower the price of
the underlying.

out-of-the-money and are worth only 4½ index points each. The sale of the puts
nets £46 260. The total cost of the hedge (ignoring interest and transaction costs) is
therefore £110 912. At the same time, the portfolio has increased in value to
£10 093 136 in line with the market (i.e. £10 million × [(3921.3 ÷ 3891.1) − 1] ×
1.2). The net cost on the hedge is the difference between these two, a £17 776 loss.
This represents a loss of 0.17 per cent of the portfolio’s value.
Note the nature of the transaction. The portfolio manager has insured the port-
folio against a fall in the market below 3891.1 to 3725, a drop of 4.5 per cent, for an
upfront outlay of 1.6 per cent. The exact gains and losses on the strategy will
depend on where the index ends up when the hedge is removed or the puts expire.
Using Call Options for Hedging Market Risk __________________
One approach to hedging involves a strategy of writing calls. This is a directional
strategy that is predicated on a modest decline in the market. The attractions of
this strategy are that it allows the writer to continue to hold the underlying
asset and earn any income from it while at the same time the hedge provides an
initial cash inflow, via the option premium. (The strategy also goes by the name
of covered call writing: it is covered in the sense that the initiator of the
strategy holds the asset and can make good delivery.)
An equity investment portfolio worth £5 million and with a beta ( ) = 1.2 is to
be hedged by selling index calls. The current market index is 500 and each index
point is worth £10, hence the index value = 5000. The call price is 28 and has a
delta (δ) of 0.65. The hedge position is:
Position (portfolio) value 1 ﴾11.20﴿
= ×
The result is to sell 1846 calls. The total income will be:
1846 × 28 × £10 = £516 880
After a short period the index declines by 2 per cent to 4900. The effect on the
equity portfolio is to reduce its value to £4 882 813 – a loss of £117 187. On the
call side, these will change by 0.65 × 10 × 1846 × £10 = £119 559. Thus the calls
can be repurchased at a gain, offsetting the decline in the portfolio’s value.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Hedging is an essential tool for risk management. It is an approach that involves
creating an appropriate portfolio where the hedge position offsets the exposure. As
an alternative, the insurance approach involves acquiring protection against undesir-
able movements in the source of risk. Derivatives provide the simplest way in which
to undertake these transactions.
Whereas terminal instruments are essentially free, options involve upfront costs
but also provide a greater element of flexibility in hedging risk. Indeed for some
kinds of exposures, they provide the only satisfactory approach to the problem.
Options are uniquely useful in providing insurance against contingent exposures and

in providing a floor to potential losses. As with all insurance decisions, the level of
cover and whether insurance is required depends on individual preferences.
The use of derivatives can crate some problems. With a perfect hedge, the value
changes of the position and the derivative exactly offset each other. When the hedge
is less than perfect, basis risk arises. What the module demonstrates is that, in
addition to understanding how the various derivative instruments are priced, it is
also necessary to understand how they can be applied as risk management tools.
An effective use of derivative instruments to manage risk requires setting up the
hedging transaction so as to neutralise a large part of the change in value of the cash
position. To find the least-risk hedge, the minimum variance hedge ratio provides
the best combination of asset and hedge that minimises the value divergence (or
basis risk) between the two.
The module also shows that the market for derivative instruments also affects
how they can be used. The need to use a stack hedge is the result of a lack of
liquidity or the non-existence of longer-dated contracts. Also it is necessary to
understand how the instruments will behave as market prices change. This makes an
understanding of these issues an integral part of understanding derivatives.
With options special factors apply. For a start when used for risk management
purposes they need rebalancing and monitoring since the insurance benefit they
provide changes as market conditions change or as the contracts move towards
expiry.
Finally, an understanding of how derivatives work allows a market user to devel-
op innovative solutions to investment and risk management problems. Portfolio
insurance makes use of key understandings about the behaviour of options and how
to manage their risk.
Review Questions
11.1 Setting up a hedge using exchange-traded instruments rather than over-the-counter

instruments allows the user:
A. to customise the transaction, but at the cost of significant counterparty risk.
B. to match the underlying position more accurately to the hedge but at the cost
of mismatch or basis risk.
C. to reduce counterparty risk but at the cost of mismatch or basis risk.
D. to customise the transaction but at the cost of mismatch or basis risk.
11.2 In which of the following conditions would it be inappropriate to use terminal

instruments for hedging purposes?
A. A forward receivable in a foreign currency.
B. A competitive tender in a foreign currency.
C. To substitute for direct investment in an asset.
D. To transfer market exposure temporarily from one sector to another.

11.3 Which of the following is not a function of terminal instruments?

A. To hedge price risk.
B. To anticipate future disinvestment.
C. To raise funds.
D. To change the allocation of funds in a portfolio temporarily.
11.4 In which of the following would standard options not act as an appropriate risk-
management instrument?
A. A bond has a call provision allowing the bond issuer to redeem the bond at
specific dates before its stated maturity.
B. A foreign currency development project is being tendered for in which five
other firms are also competing for the contract.
C. A supply contract with M-Corp which has a very low credit rating.
D. The price uncertainty for commodity purchases used by a firm is expected to
increase in the future.
11.5 Unlike a terminal instrument, an option____ allow the user to determine the rate at
which to hedge and with a contingent underlying transaction ____ the contract to lapse,
and also ____ between the contracted rate or the market rate at expiry. Which of the
following is correct?
A. does it allows to choose.
B. does not it does not allow to choose.
C. does it allows no choice.
D. does not it does not allow no choice.
11.6 If we have a ____ position in an asset, then we would want to take a ____ position in
the hedge with a ____ exposure sensitivity to the underlying.
A. short long negative.
B. long short positive.
C. long short negative.
D. short long positive.
11.7 The zinc contract traded on the London Metal Exchange is for 100 tons of zinc. We
have an exposure of 24 450 tons of zinc and have determined that the minimum-
variance hedge ratio is 0.95. What is the number of contracts we require to hedge the
exposure?
A. 23.
B. 25.
C. 232.
D. 245.

11.8 The three-month eurodollar contract has a contract value of US$1 million and a tick
size of $25. If we have a two-month exposure of US$15 million, how many futures
contracts are required to hedge the position correctly?
A. 10 contracts.
B. 15 contracts.
C. 23 contracts.
D. 25 contracts.
11.9 If the correlation between a hedge and an underlying asset is +0.92 and the standard
deviation of the hedge is 0.25 and the cash position is 0.24, what is the minimum-
variance hedge ratio?
A. 0.75
B. 0.88
C. 0.96
D. 1.00
11.10 A least-squares regression equation between Treasury bills and Treasury bill futures has
the following coefficients: = −0.0002 and = 0.9628 and the = 0.94. Each
Treasury bill contract has a face value of $1 million. There is a $45 million exposure to
be hedged with futures. How many futures contracts are needed?
A. 42.
B. 43.
C. 45.
D. 47.
11.11 In Question 11.10, how effective will the hedge be in protecting the underlying position?
A. 91 per cent effective.
B. 94 per cent effective.
C. 99 per cent effective.
D. 100 per cent effective.
11.12 A strip hedge is:

A. a series of futures contracts with sequential maturity designed to match an
underlying position.
B. a minimum-variance hedge designed to match the (coefficient of determina-
tion) of an underlying position.
C. a second or tertiary hedge designed to eliminate adverse rotational or twist
effects in the yield curve on the hedged position.
D. the ratio of the price sensitivity of the underlying position to that of the hedge
so as to equate the change in value to both sides in the combined portfolio.
Short-term interest-rate futures contracts

Date Nearby Deferred
1 August 93.75 93.62
15 August 93.66 93.58

11.13 Given the information in the table above, which of the following has happened?
A. Interest rates have fallen and the yield curve has flattened.
B. Interest rates have fallen and the yield curve has steepened.
C. Interest rates have risen and the yield curve has flattened.
D. Interest rates have risen and the yield curve has steepened.
11.14 If we set up a short spread on the above contracts on 1 August, what will be the profit
or loss on the position on 15 August?
A. (0.08)
B. (0.05)
C. 0.05
D. 0.08
11.15 We have a lending requirement which is subject to rotational shift risk (or yield curve
twist risk) and we wish to set up a spread to minimise exposure to the risk. To do so,
do we:
A. establish a long spread by buying the nearby contract and selling the deferred
contract?
B. establish a long spread by selling the nearby contract and buying the deferred
contract?
C. establish a short spread by buying the nearby contract and selling the deferred
contract?
D. establish a short spread by selling the nearby contract and buying the deferred
contract?
11.16 Short-term interest-rate futures have a notional deposit period of three months and are
settled on a quarterly cycle (in mid-March, mid-June, mid-September and mid-
December). If we have a short-term interest-rate exposure period that starts in mid-
May and ends in mid-June, what is the maximum mismatch that can occur between the
expiry date of the futures and the commencement of the short-term exposure?
A. There is no mismatch between the exposure period and the futures contracts.
B. One month.
C. Two months.
D. Four months.
11.17 We have a $25 000 000 equity portfolio with a beta (β) = 1.10. It is decided to hedge
this against future market risk. The S&P 500 futures contract is worth $250 ×
index value. The tick size is $25 and the minimum price change in the index is 0.05. The
current S&P 500 index rate is at 903.50. How many futures contracts are required to
hedge the portfolio?
A. 5.
B. 100.
C. 111.
D. 122.

11.18 We have a £75 million equity portfolio fully invested in the London market which has a
beta (β) of 0.95. The current level of the Financial Times-Stock Exchange 100 index
(Footsie) is 4825. The value of stock index futures based on the Footsie is £25 ×
index points. The minimum price movement is 0.5 index points and the tick size and
value is £12.50. A decision is reached to increase the market exposure of the portfolio
in anticipation of a short-term rise in the market with a target beta of 1.2. Which of the
following transactions will achieve the correct exposure?
A. Buy 6 contracts.
B. Buy 155 contracts.
C. Sell 621 contracts.
D. Buy 621 contracts.
11.19 A bond portfolio has a market value of £100 million invested in sterling debt securities
and has a yield of 6.75 per cent for the portfolio. The duration of the portfolio is seven
years. There is some concern about the interest-rate outlook and it is decided to
reduce the duration temporarily, to four years. The long-term interest-rate futures
contract (bond contract) has a nominal value of £50 000, a coupon rate of 7.6 per cent
and an expiry cycle of mid-March, June, September and December. The contract is
trading at 101–1/4 at a yield of 6.45 per cent and the duration of the notional bond is
18.75 years. The minimum price movement for the bond futures contract is 1/32 and
the tick size and value is £15.625. How many of the long-term interest rate futures
contracts need to be sold to reduce the portfolio’s interest-rate sensitivity to a duration
of four years?
A. 273.
B. 358.
C. 1143.
D. 3152.

11.20 The diagram below shows the payoff profile for a number of different investment
alternatives: a long position in the market, a short position in the market, a long call and
a combination of safe asset and long position in the market.
a. b. c.
d.
Market value
Which payoff profile represents a long position in the market?

A. Line a.
B. Line b.
C. Line c.
D. Line d.
11.21 If, in the diagram for Question 11.20, we combine Line a and Line c, what is the
resultant position?
A. A short or written call.
B. A short or written put.
C. A long call.
D. A long put.
11.22 A portfolio worth £5000 is to be insured using the constant proportions portfolio
insurance (CPPI). This involves switching funds between the market and a risk-free
investment, such as a bank deposit, according to a prearranged formula. The market
index is at 2850 when the insurance is put in place and the floor is set at £4000, while
the multiplier is set at 2.5. How much of the portfolio will be invested in the market at
initiation?
A. £0.
B. £1800.
C. £2500.
D. £5000.

11.23 If, in Question 11.22, we apply a rebalancing tolerance factor to the cushion of 2.5 per
cent, what will be the rise in the level of the index at which we reduce the amount held
in the risk-free asset?
A. 2853.
B. 2921.
C. 2993.
D. 3001.
11.24 If we want to protect a long asset position from unfavourable outcomes, which of the
following should we undertake?
A. Sell puts on the underlying.
B. Buy calls on the underlying.
C. Buy puts on the underlying.
D. None of A, B or C.
The table gives details of the following put options available in the market. The asset price
is currently 110.
Put option 1 2 3 4
Strike price 125 120 115 110
Premium 22 15 9 3
11.25 What is the regret for put 2 with the 120 strike?
A. 5.
B. 10.
C. 13.
D. 15.
11.26 If we buy put 3 with the 115 strike as downside protection, what is the performance
loss compared to an unhedged position if the asset price subsequently improves?
A. There is no performance loss from holding the protective put.
B. 5.
C. 9.
D. 14.
11.27 A fund manager has decided to implement a protective put strategy. The value of the
portfolio is £65 million and it has a beta (β) of 0.70. There are index puts available with
a strike price of 4800 and a delta of −0.35. The current index value is 4940 and each
index point is worth £10. How many puts are required to hedge the portfolio?
A. 322.
B. 921.
C. 1316.
D. 2632.

11.28 Investicorp has a holding of 840 000 shares in ABC plc. ABC shares are currently trading
at 68 pence each and have a systematic risk (β) of 0.85. Investicorp is concerned that
ABC may announce a special dividend which will significantly increase the price.
However, Investicorp is also concerned to eliminate any market risk from holding ABC
shares. There are no traded options on ABC plc shares. There are, however, index calls
and puts available. These are worth £10 times the index value. The current index is at
2870 and the nearest strike price is at 2875. What type and how many options are
required to provide market risk protection to the position in ABC plc? Investicorp
should:
A. buy 17 puts.
B. buy 25 calls.
C. sell 20 puts.
D. sell 14 calls.
11.29 As a rule: if we buy futures, we ____ the spread by ____ the nearby and ____ the
deferred contract; if we sell futures, we ____ the spread. Which is correct?
A. buy buying selling sell
B. buy selling buying sell
C. sell buying selling buy
D. sell selling buying buy
11.30 The diagram below shows the payoff profile for a number of different investment
alternatives: a long position in the market, a short position in the market, a short call
and a combination of safe asset and long position in the market.
a. b.
c.
Market value
d.
Which payoff profile represents a combination of safe asset and long position in the
market?
A. Line a.
B. Line b.
C. Line c.
D. Line d.

Case Study 11.1: Hedging Interest-Rate Risk

These are the prices of sterling short-term interest rate futures at the start of December.
Expiry December March June September December

Price 93.55 93.28 93.00 92.81 92.71
The contract size is £0.5 million and the tick size is 0.01 per cent (£12.50).
Note that the December contract has only two weeks to run.
Assume that a month is one-twelfth of a year and that the contract expires mid-month.
1 We have a four-month exposure period to short-term interest rates that starts in mid-
February. Show the relationship of the exposure period to the available futures con-
tracts graphically. Which contract(s) seem appropriate to act as a hedge?
2 The amount of the exposure is £6.7 million. How many and which contracts should be
used to cover the interest-rate risk on the exposure?
3 What is the hedged rate that can be expected to be obtained from using futures?
4 How great is the mismatch between the exposure and the futures hedge?
Case Study 11.2: Hedging with Written Calls

The current index close is 4061.50.
Strike 3875 3925 4025 4075

Expiry Call Put Call Put Call Put Call Put
Dec. 182 3.5 135 7 53 24 24.5 45.5
Jan. 205.5 13.5 161.5 19.5 81.5 39.5 51 59
Feb. 233 25.5 191 34 115 58 83.5 76.5
March 237.5 40.5 199 51.5 130.5 80.5 100.5 100
The price = £10 per full index point.
1 We want to decide whether to buy index puts at 3925 or 4075 with February expiry.
What will be the maximum loss that can occur in either of these situations? At what
level is the break-even?
2 An alternative approach to providing protection against a modest market decline

involves writing calls rather than buying puts. By writing, premium is received upfront
rather than being paid out. If the market declines, the intention is to repurchase the calls
at a lower price. The value of the portfolio is £1.5 million and its beta (β) is 1.2. The
delta on the 3925 December calls is 0.75. How many calls should be written (sold) to
create the hedge? Show how well the strategy works if the index falls by a small amount.

References
1. Black, Fisher and Jones, Robert(1987) ‘Simplifying portfolio insurance’, Journal of Portfolio
Management, 14, (1), 48–51.
2. Culp, Christopher and Miller, Merton (1995) ‘Metallgesellschaft and the economics of
synthetic storage’, Journal of Applied Corporate Finance, 7, 62–76.

Module 12
Using the Derivatives Product Set

Contents
12.1 Introduction.......................................................................................... 12/1
12.2 Case 1: British Consulting Engineers................................................. 12/4
12.3 Case 2: United Copper Industries Inc. ............................................ 12/12
Case Study 12.1 ............................................................................................ 12/36
Learning Objectives
This module integrates the different elements of derivatives and the use of the
derivatives product set discussed in earlier modules. In particular, it shows how the
risk manager uses the various instruments to manage exposures. The examples are
based on managing foreign-exchange-rate risk and commodity price risk, but the
process is equally applicable to the other types of market risk.
After completing this module, you should understand:
 how the initial position and the appropriate hedge are determined;
 some of the issues relating to the appropriate instruments to be used;
 the difference in payoffs between terminal instruments and options;
 how risk management can be used to modify the unacceptable features of firms’
projects.
12.1 Introduction
One of the hardest tasks facing the risk manager is to decide between the different
courses of action in a given situation. There is no escaping this since to decide not
to decide – to do nothing – is in itself a decision. This module shows how the
derivatives product set is used to hedge financial and business risks.* It is based on
two case studies which are designed to illustrate the assessment and management
processes, but not to show how effective a particular approach might be.
12.1.1 Using the Derivatives Product Set

Obviously each of the instruments in the derivatives product set is not used in
isolation. Decisions about the appropriate product to use in a given situation will
* Of course derivatives can be – and are – used for many other purposes as discussed in Module 1, to
speculate, to spread between asset classes and for arbitrage.

Module 12 / Using the Derivatives Product Set
depend on the circumstances facing the firm, its costs and the nature of the expo-
sure to be hedged. At its very simplest, the decision must take into account whether
the exposure being hedged relates to contractual cash flows or has an element of
contingency. The criterion will be to use the method that achieves the decision
maker’s objective at least cost.
In the first case study, relating to the management of foreign-exchange-rate risk,
the initial analysis focuses on the nature of the cash flows and the suitability of the
different instruments in handling the currency risk. The basic factors of such an
analysis are summarised in Table 12.1.
Table 12.1 Types of foreign exposure, hedging action required and the
appropriate instrument from the derivatives product set
Appropriate
Nature of exposure or Action required to instrument from the
cash flow hedge exposure product set
1 Receivable in a foreign Hedge receipt (long Currency forward;
currency foreign currency position) currency future;
currency option
2 Payable in a foreign Hedge payable (short Currency forward;

currency foreign currency position) currency future;
currency option
3 Tender for supplying Hedge contingent receipt Currency option (or

foreign goods and (non-contracted long compound option (an
services foreign currency position) option on an option))
4 Tender for acquiring Hedge contingent payable Currency option (or

foreign goods and (non-contracted short compound option (an
services foreign currency position) option on an option))
Table 12.2 Advantages and disadvantages of the different instruments used to hedge an
exposure
Instrument Benefit Cost
Terminal instruments: No upfront cost in setting up; Loss of opportunity to gain if market
forwards, futures; forwards will provide tailored end moves in desirable direction; only one
swaps date and amounts rate at which the transaction can be
made; futures may not provide exact
match to cash flows, thus leaving basis
risk; credit risk exists on forward
contracts and swaps
Options Provide one-way protection against Usually involve an upfront payment;

adverse changes; allow the holder compound options reduce initial
to gain if market rates move in a upfront payment at expense of greater
beneficial direction premium if option is required; credit
risk is likely to exist on option contract
if purchased

In Cases 1 and 2 in Table 12.1, the receivables and payables are both contractual;
the firm knows it will receive or will have to make a payment in foreign currency at
a particular future date. In this case, either the terminal type instruments or options
would provide the required degree of protection. Note that, unless there was a
known and contracted pattern of future receivable/payable cash flows (as with a
debt obligation), swaps would be inappropriate in this case. In deciding between
forward or futures instruments and options, the manager’s choice will be made on
the basis of the cost–benefit trade-off that is expected between the two. The
benefits of the different instruments are summarised in Table 12.2.
Table 12.3 Directional hedging with the derivatives product set
Cases Direction of the Appropriate hedging Effect of adding the

exposure position hedge to the exposure
1 and 3 The firm is due to receive A contract where the Hedging with forwards
a cash inflow denominated company agrees to pay the or futures:
in the foreign currency foreign currency and receive Unhedged exposure = +FC
and needs to convert it the base currency, i.e. Hedge position = −FC/+BC
back into the base (−FC/+BC) Net position after hedge =
currency. It therefore has +BC
a long foreign curren- Net effect: hedge converts
cy/short base currency the foreign currency
position (+FC/−BC) receivable into the base
currency
Hedging with options:
Unhedged exposure = +FC
Hedge position = (max
[− /+ ], + )
2 and 4 The firm is due to make A contract where the Hedging with forwards
payment or cash outflow company agrees to pay the or futures:
denominated in the base currency and receive Unhedged exposure = −FC
foreign currency and the foreign currency, i.e. Hedge position = +FC/−BC
needs to convert from the (+FC/−BC) Net position after hedge =
base currency to the −BC
foreign currency. It Net effect: hedge converts
therefore has a short the foreign currency payable
foreign currency/long base into the base currency
currency position Hedging with options:
(−FC/+BC) Unhedged exposure = −FC
Hedge position = (min [+
/− ], − )
Note: BC = base currency; FC = foreign currency; + = long position; − = short position at maturity; s = spot;
k = strike price or rate.

In Cases 3 and 4 of Table 12.1, the contingent nature of the exposure means that
terminal instruments are inappropriate since, once they are contracted for, the
holder is obliged to make or take delivery with the other party. Options provide the
only method for managing the risks in such circumstances.*
The directional nature of the exposure needs also to be considered so that the
hedge acts to reduce the risk and not to increase it. Although this may seem an
obvious point, a number of firms have suffered losses when they have inadvertently
traded ‘on the wrong side’, thus doubling their exposure to the risk factor rather
than reducing it! One such firm was Codalco, the state-owned Chilean copper-
producing firm, where the manager in charge of controlling the firm’s exposure to
the copper market increased the firm’s risks by undertaking transactions that added
to the firm’s exposure, resulting in significant losses being incurred.
In the case of currency exposures, Cases 1 and 3 and 2 and 4 in Table 12.1 have
the same directional exposures or sensitivities, as shown in Table 12.3.
The payoffs sought from options may need a few words of explanation. In the
case where the firm is going to receive a payment, this is an asset to the firm. In
using options to hedge the exposure, it wants to lock in a minimum exchange rate at
which it can convert the foreign currency back into the base currency. At the same
time, the company will gain if the exchange rate at which it sells the foreign currency
in the spot or cash market and receives the base currency (− /+ ) is more
favourable than the strike price ( ) on the option (+ ). The risk is that the base
currency will appreciate against the foreign currency, reducing the value of the
foreign exchange receivable in the base currency. The firm would therefore want to
have a put on the foreign currency (equivalently, a call on the base currency) at a
given strike price. If the foreign currency appreciates (base currency depreciates), the
put is abandoned and the exchange is made at the more favourable market rate
prevailing in the spot market at the time of receipt.
The alternative condition applies when the foreign currency item is a payable,
since the firm wants to minimise the amount it has to pay out in base currency
terms to meet the foreign obligation. The firm achieves this by holding a call on the
foreign currency (a put on the base currency). If the foreign currency depreciates,
the call is abandoned and, again, the exchange is made at the more favourable
market rate prevailing in the spot market at the time the payment is required to be
made.
12.2 Case 1: British Consulting Engineers

British Consulting Engineers (BCE) is a UK-based engineering project management
company specialising in turnkey power projects. Most of its activities involve foreign
contracts, denominated in a wide variety of currencies but principally either US
dollars or euros. The company has recently won the project management contract
* Technically, it would also be possible to replicate an option’s payoff via dynamic hedging but this
requires constant monitoring of the exposure, minimal transaction costs and the ability to borrow at
the risk-free rate. For most firms outside the financial sector, one or more of these conditions does not
readily apply.

for a power station to be built in Sri Lanka by a German-based consortium. The

contract is in euros and BCE will be paid in this currency by the German group.
The contract will take place over a number of years, but a progress payment will be
made after one year, to a set value of €5 million. There is a range of alternatives that
the firm can pursue in terms of its risk-management strategy to manage the currency
risk from this future receivable and these are laid out in Table 12.4.
Based on past experience and commonly accepted corporate behaviour, BCE is
concerned to manage the currency exposure from the known receivable in one year.
Given the potential swing in the value of the € against sterling, the company does
not consider it acceptable to leave the exposure unhedged. Consequently, the
company faces a decision as to which instrument from the product set it should
choose to manage the exposure. The current market conditions at the point the
company needs to make its decision are given in Table 12.5, Table 12.6 and Ta-
ble 12.7.
Table 12.4 Alternatives available to manage a currency exposure

Action Result
Do nothing (wait The €5 million is converted at the prevailing spot rate in one year. If sterling
and see) appreciates in the meantime, the company will receive less in sterling terms
than anticipated; if sterling depreciates, the company will get more sterling
Hedge with The company locks in the sterling equivalent of €5 million at the forward rate
(i) a forward (representing the interest-rate differential between euros and sterling in the
contract or one year). If the company uses futures it may have to (i) set up a cross in
(ii) futures futures due to the lack of a euro–sterling contract and (ii) roll over the
contract prior to maturity. A variant might be to hedge only a proportion of
the outstanding exposure. This has the effect of reducing the position’s
sensitivity to movements in the currency pair over the exposure period
Buy insurance with The firm ‘locks in’ a minimum euro–sterling exchange rate in one year, but may
a currency option benefit from any subsequent depreciation in sterling (the base currency). The
disadvantage is that the firm will need to pay for the option upfront. It could
consider a cost reduction in setting up the position by selling an option to
recoup part of the premium, and give up some of the potential gain. Such a
strategy is known as a vertical spread or, for currencies, a cylinder
Note that the do-nothing decision is just as much a strategy as hedging the exposure

Table 12.5 Foreign exchange and money market spot and forward rates
€/£ Spot Bid/offer 1 % 3 months % 12 months %
month p.a. p.a. p.a.
mid-
rate
2.4183 169–196 2.4167 0.8 2.4121 1.0 2.3778 1.7
Eurocurrency deposit market

£ 6 /
–6 6 /
–6 /
7 /
–7 /
€ 5 /
–5 5 /
–5 /
5 /
–5 /
Table 12.6 International Monetary Market (IMM) currency futures quotes

Date €125 000 per € Sterling £62 500 per £
+ 3 months 0.6444 1.5586
+ 6 months 0.6474 1.5580
+ 9 months 0.6500 1.5550
Table 12.7 Over-the-counter currency options for €/£, for 12 months.

Note that the premium is in €cent per £ (the quoted
currency)
Strike price £ Calls £ Puts
2.25 18.26 –
2.30 15.63 1.53
2.35 13.07 3.92
2.40 10.58 6.39
2.45 8.17 8.93
2.50 5.83 11.54
2.60 3.60 14.22
The following sections look at the costs and benefits of using the different meth-
ods to hedge the euro receivable exposure.
12.2.1 Forward Foreign-Exchange Contract

Entering a forward foreign-exchange contract is the simplest of the alternatives
facing the company. By entering into the forward with a suitable counterparty
(usually a bank) the company can transact the exact amount and maturity of the
exposure and any currency risk can be eliminated. Given the data in Table 12.5, the
company will receive sterling at the rate of 2.3778 (middle market). If the spread
given in the table is applied to this rate, the approximate 30 pips (0.0030) spread on
the spot would translate to a rate of 2.3763 − 2.3793. In fact, the foreign exchange
market maker’s quote would probably be slightly wider to reflect BCE’s credit risk.

The firm expects to sell € and buy sterling so it will pay €2.3793/£, and will there-
fore receive £2 101 458.41 from the transaction.
If the company had decided on a do-it-yourself forward, it would have borrowed
the present value of the receivable of €5 million at 5.875 per cent, which comes to
€4 718 913.34. Euro interest rates are quoted on an actual/360-day year basis, and
the calculation to determine this is:
€5 000 000 ﴾12.1﴿
€4 718 913.34 =
5.875 × 365
1+
360 × 100
The euros can then be exchanged for sterling in the spot market. The spot bid
offer rate is: 2.4169 − 2.4196, so the company exchanges the borrowed € at 2.4196
to receive sterling £1 950 286.55. Depositing this at the bid side of the market gives
a value in one year of
7.8125 × 365 ﴾12.2﴿
£1 950 286.55 × 1+ = £2102652.69
365 × 100
Because sterling deposit rates are on an actual/365-day year (unlike euros), the
company receives a slightly better rate than the forward foreign exchange contract
of €2.3780/£, or a gain of £1194.28 in sterling terms. This assumes, of course, that
the company can borrow € at the offered rate and lend out sterling at the bid rate –
which is not really likely. If the company has to pay a spread, say ⅛th per cent over
LIBOR to borrow funds in euros, then the resultant transaction leaves it with only
£2 097 657.04 – a rate of €2.3836/£ and it is £3801.37 worse off.
Other factors to consider in the DIY approach are that the company now has a
separate obligation to repay the € rather than a package in one year’s time. The loan
and deposit are likely to be legally separate transactions and thus subject to credit
risk – the loan on the company, the deposit with the bank. Regardless of what
happens on the one side, the company is still required to perform on the other. For
the forward, it will be only the contract’s replacement cost if the counterparty
should default before maturity – a far lesser sum. This is also only a cost if the
contract’s replacement value is negative: rates could change so as to leave BCE
better off if the counterparty defaults. Also, borrowing and lending will inflate the
firm’s balance sheet, which will have an impact on accounting ratios – and possibly
on the firm’s credit rating. For the above reasons, firms will tend to prefer the
forward transaction rather than operating in the money markets.
12.2.2 Currency Futures

As an alternative to a forward contract, the company could consider using currency
futures. Here the situation is much more complex. First, there is no futures contract
that covers the sterling–euro cross-exchange rate.* In order to undertake the
transaction, the company will need to set up a spread transaction with two currency
* In foreign exchange terminology a cross-rate is one that does not include the US dollar as part of the
quote. Thus sterling–euro is a cross.

futures. (In effect, this involves the company taking a detour via the US dollar.) All
currency futures (except crosses) are quoted in US terms (that is, a fixed unit of the
foreign currency against a variable number of US dollars). The sensitivities of taking
a long or short position in currency futures is given in Table 12.8.
Table 12.8 Behaviour of currency futures

Change in dollar relative to other Effect on futures quote
currencies
Dollar strengthens Decreases: fewer dollars are required to
buy a unit of currency
Dollar weakens Increases: more dollars are required to
buy a unit of currency
Note: Currency futures are quoted in US$ terms, for a variable number of dollars against a unit of
the foreign currency.
The company wants to sell euros, so it needs to set up the correct sensitivity for
the initial part of the futures spread. The required sensitivities against the US dollar
are given in Table 12.9. Since the company intends to sell €, it wants to take out a
short position in the €/$ contract.
Table 12.9 Currency cash flows and currency futures positions required
as a hedge
Change in dollar relative to other Effect on futures quote
currencies
Currency risk Effect on futures
Long US dollars/ Short currency Buy currency futures
Cost more US$ to buy currency Futures increase in value
Sell at a profit
Short US dollars/ Long currency Sell currency futures
Receive fewer US$ for currency Futures decline in value
Buy back at a profit
This initial position only gets the company to exchange its euro position into US
dollars. It now needs to put on another trade, to go long the US dollar–sterling
contract. The net result of these two positions is that the company has established a
cross (or futures spread) with the right sensitivities:
Short US dollar/€ currency futures
Long US dollar/Sterling currency futures
That is a situation where the terms in the square brackets [ ], net out:
(−€/[+US dollars) + (−US dollars]/+Sterling)
leaving the desired exposure (−€/+Sterling). If the spread has been correctly
established, the US dollar washes out and the position is equivalent to a cross on the
euro–sterling rate.

The company now has to establish the number of contracts required. Each
€/$ contract is worth €125 000, so to hedge its €5 million, it will need to short 40
contracts. The company, say, uses the six month contract. Note that it will have to
roll the hedge forward, a factor we discuss below. This makes a US dollar equivalent
of €125 000 × 0.6474 × 40 = US$3 237 000. The next stage is to convert this
position into sterling, which has a contract value of £62 500. The US dollar value of
the € exposure is US$3 237 000, so this is equivalent to £2 077 663.67 at the six-
months futures price exchange rate of 1.5580. Since each contract is worth £62 500,
the number of contracts required (£2 077 663.67 ÷ 62 500) is 33.24. This rounded
down to the nearest whole number and, ignoring any other adjustments, gives a long
position of 33 contracts. The fact that the two sides are for a differing number of
contracts reflects the different contract sizes of the two futures.
In establishing the hedge, two additional factors now have to be considered. The
company will need to roll forward the hedge at the expiry of the two contracts into
the appropriate new six-month contracts for the second half of the year. Second, the
company will have to provide margin on the two positions over the next 12 months.
An additional factor is that the hedged amount is now slightly less than that
required, due to rounding into whole contracts.
All in all, the company will be assuming some basis risk over the hedge period
from such a transaction. There is the basis risk between the euro–US dollar rate and
that between the US dollar–sterling rate. There is also basis risk arising from the
need to roll forward the contract after the initial six months.* Also, at the onset,
unlike the forward contract, the exact value of its position is unknown and will
depend both on how interest rates, in Germany, the UK and the USA evolve over
the next six months and on the evolution of the exchange rate. In the meantime, the
company will also have to monitor its margin positions.
Unless the company has a pressing need to use futures, this alternative is both
complex and subject to a degree of uncertainty, and will be rejected.
12.2.3 Currency Options

The company is, however, interested in profiting from a potential rise in the value of
the euro against sterling while, at the same time, covering itself against a fall.
Currency options provide an appropriate mechanism, allowing the company to do
just that. Here the decision is somewhat different from the use of a terminal
contract. Since the forward contract is priced off the no-arbitrage conditions of
interest-rate parity, there is only one rate at which the company can elect to hedge
its euro receivable. With options, the company also has to decide at what rate to buy
insurance, since there are any number of potential strikes available (for simplicity,
only a few are given in Table 12.7). In using options, the company needs to balance
the upfront cost of the option against the potential gain. In doing so, it can adopt a
* If this is seen as a major risk, it can be hedged via short-term interest-rate futures spreads, thus heaping
complexity on complexity! More can go wrong, with a greater chance that the hedge will not perform
as intended.

wide range of strategies, ranging from a simple purchase to a variety of complex

spreads.
The cost of an at-the-money forward sterling call/€ for €5 million at €2.45 (just
under the forward rate of 2.37) would cost 8.17 €cent/£. The contract would give
the holder the right to receive £2 040 816.33. The premium on this transaction will
be 0.0817 × £2 040 816.33 = €166 731.38 (that is, 3.33 per cent of the total value).
At the fixed exchange rate this comes to £68 053.75, which, future valued at the
sterling interbank offered rate, gives a value of £73 455.51. The all-in break-even
exchange rate thus becomes €2.5415.
The results of the above transaction are illustrated in Figure 12.1 together with
the forward contract alternative. If the company believes sterling is likely to weaken
below 2.29, then the option is the preferred solution. The firm is guaranteed a rate
of 2.5415. Between these two rates, the exact result will depend on the actual
outcome.
0.4
0.3 Forward contract

Underlying exposure
0.2
0.1
0
211 221 231 241 251 261 271
–0.1
–0.2
Sterling call at Resultant exposure
–0.3 €2.45
–0.4
Weaker £/stronger €, deal Stronger £/weaker €, exercise

in market at prevailing price option at 2.45 and lock in rate
Figure 12.1 Forward versus option strategies compared

The option strategy is not without its problems, namely the upfront premium
required. A possible solution is to modify the risk–reward structure so as to reduce
this upfront cost. A popular solution is the vertical spread, or currency cylinder,
where two options are used. The first, as in Figure 12.2, is used to set up the
strategy, the second is written (or sold) at a lower strike price. If the call remains at
2.45, another option can be written partially to offset the premium being paid. If the
firm is willing to surrender part of its future potential profit, a put can be written at,
say, €2.35 to subsidise the desired position.
In deciding how to use options to provide protection, a very large range of alter-
natives is possible. The large choice of strike rates, be they out-of-the-money, at-the-
money, or in-the-money, provides a spectrum of cost–benefit profiles, protection
and regret. The addition of further options in combinations of two or more options

in spreads permits further payoffs. The limit depends on what exposure as against
initial cost is seen as the best choice in a given situation.
0.15 Written option
0.1 Resultant position

Position offers limited gain,
but at reduced cost
0.05
0
211 221 231 251 261 271
241
–0.05
–0.1
Purchased option
–0.15
–0.2
Figure 12.2 Currency cylinder (vertical spread)
12.2.4 Conclusion to the BCE Case

This section has looked at applying risk management to a single, future cash flow.
The firm is exposed if it does nothing. Because there is a range of risk-management
products available to manage currency exposure, the company has to decide which
alternative best suits its needs. While terminal-style transactions guarantee a given
sum in the base currency, they do not allow the company to exploit its position in
any way. It can achieve this by using options rather than forward contracts. In
addition, the complexities of using futures as a choice in this situation are illustrated.
The firm would have to accept a degree of imprecision in the hedge by using these
exchange-traded instruments.
The case has illustrated some basic tenets of risk management:
 Hedging is generally designed to eliminate risk. It is also seen as costless since
there is no upfront cost (other than the market maker’s bid-offer spread) to the
forward contract.
 Insurance, or the ability to take advantage of potential gains, has a cost.
We should emphasise that the appropriate course of action in such a situation
will be driven by many factors. Part of the evaluation criteria will focus on simplici-
ty, the organisational culture and the experience and technical ability inherent in the
firm, and not just on any potential for gain. After all, as we have argued, firms
should seek to avoid risks in areas outside their core expertise or competencies – it
is these latter that add value to a firm’s activities. In as much as managing financial
risks facilitates this, it is achieving its purpose.

12.3 Case 2: United Copper Industries Inc.

Bob Woodward, Chief Financial Officer of United Copper Industries Inc. (UCI),
was staying late at the firm’s head office in Tucson, Arizona, to sort out his recom-
mendations for the Upland mining project. The problem was straightforward
enough: copper price volatility was a problem that was bedevilling the decision
whether to go forward with a major development that was likely to require an
investment of over US$100 million. It was now getting to the point where UCI had
to decide whether to go ahead regardless of the uncertainties, to abandon the
project or to change the proposal in some way so as to reduce the Board’s concern
about the risks. The main problem was that if, in the future, copper prices were to
fall significantly, UCI stood to lose a bundle on the Upland mine.
Copper was UCI’s main activity, although there were several smaller, peripheral
businesses allied to its copper business. It was copper mining that drove the
company. The problem Bob had to wrestle with concerned the potential for losses if
the project proceeded and copper prices dropped and stayed low. It was a signifi-
cant risk since copper, although the world’s most significant traded metal, was
subject to significant price swings. The crux of the problem was that, under certain
scenarios, the project was extremely risky. Under some scenarios with a low selling
price, the appraisal indicated that the project had a negative net present value.
Table 12.10 Key financial information on United Copper Industries Inc.

United Copper Industries Inc.
Summary 31/12/1997 31/12/1996 31/12/1995 31/12/1994 31/12/1993
financial
information US$ millions
Sales revenue 634.3 613.2 622.8 683.5 582.1
Profit before tax 124.3 101.0 134.7 254.5 167.3
Profit after tax 105.8 98.2 106.7 182.5 141.1
Net income 133.1 79.0 94.3 342.6 125.9
Shareholders’ 629.8 528.6 201.4 109.6 (199.6)
equity
Debt 299.0 400.8 384.0 610.9 1322.1
Creditors 94.3 143.6 112.2 146.3 133.0
Profit margin 19.6 16.5 21.6 37.2 28.7
The Board of Directors had been concerned about this issue for some time. UCI
itself was relatively confident that the project was a good investment. Nevertheless,
the Board was concerned that UCI’s shareholders would be unhappy if the company
just proceeded on the hope that the copper price stayed high. Although UCI was a
major company, as indicated by the key financial data given in Table 12.10, develop-
ing the Upland mine could possibly lead the firm into financial difficulties. Such
problems would kill off senior management’s ambitious objectives for the growth
and expansion of the business.

12.3.1 Background on UCI

United Copper Industries Inc. was formed by a merger from two smaller copper
companies: Mesa Copper Industries and Canyon Copper Corporation in 1976.
Following this merger a number of other copper mines that were in poor shape
were acquired in the USA and Canada, mostly financed via small equity issues.
However, following a proposal from the group’s lead investment bank, the company
also entered into a number of limited partnerships in the early 1980s for its more
mature mines. Limited partnerships were a tax-efficient way of passing income to
investors. Exploration and development had not been ignored either, and the
company formed a joint venture with a Vancouver-based exploration company to
develop the find it had discovered in the Yukon. To finance its share of the partner-
ship, UCI issued a 4.5 per cent copper-index note, together with a placing of
common shares and a warrant issue.
Following these developments, UCI was now in the top five copper producers in
North America. Its shares were now actively traded on the American Stock Ex-
change and it sought to realise its potential. The company had set itself a set of clear
strategic goals to be realised over the next five years:
 It aimed to become the third largest producer of copper in North America. This
probably would entail a number of significant acquisitions in mining, in the USA,
Canada, but above all in Mexico, given the high potential of that market. UCI
considered a presence in that market would facilitate sales and the negotiation of
long-term contracts with users. In this regard, the Upland project was an important
plank in the firm’s strategy.
 To be successful, the Board considered that sound financial practice and
protection from a downturn in copper prices were essential. As a rider, the com-
pany considered it was not in the business of speculating on copper prices and
hence, taking a view on short-term demand.
When deciding on how to solve the unpalatable issues raised by the project sensi-
tivity analysis, Bob realised that both these strategic objectives would have to be
incorporated into the solution.
12.3.2 Current Business Activity

The primary business of UCI was copper mining and the production of refined copper
cathodes or wirebars. The company also had an exploration division which bought
licences to seek out reserves in promising geological areas. As mentioned earlier, the
company was not against using its expertise in joining with other companies to exploit
discoveries. At the moment, the company operated five mines, the two that came from
the initial merger and three, smaller mines acquired thereafter. One of these was due to
close in the near term, having nearly exhausted the deposit. Only if copper prices rose
significantly would it pay the company to continue to exploit the poor quality ore and a
decision to close was probably imminent. As a result, UCI’s output was likely to fall in
the near term. The Canadian joint venture was not expected to start producing signifi-
cant quantities of copper in the coming financial year. The company also had yet to
decide whether to proceed with its Upland project, which would more than replace the

closure. Upland had great potential, but would require a significant investment and it
would be three to four years before the first revenues were generated from the project.
It would also only be viable if copper prices remained reasonably buoyant and above the
US$1400/ton level.
12.3.3 The Copper Market

The discovery of copper, periodic name Cu, goes back to prehistory. It is the conductor
metal but is also valued for its reddish colour and its malleability. It has a wide range of
uses, from carrying an electric current and other telecommunication uses (48 per cent of
usage), to construction, such as pipes (24 per cent of usage), general engineering (12 per
cent), transport (7 per cent) and a wide range of other applications ranging from cooking
utensils to various miscellaneous items such jewellery, car parts, sculpture, and so forth
(9 per cent). The market is global and is dominated by a number of multinational
companies. The basic source, other than via recycling, comes from mining ore deposits.
Copper historically had been mined just about anywhere a suitable seam could be
located although, until the early nineteenth century, a large part of demand was met by
Cornish mines. However this situation changed rapidly and, by the middle of the
century, Chilean production has come to dominate the trade. In more recent times,
extracting has become concentrated in those mines which could operate efficiently and
at lowest cost. Annual production of refined copper is about 11.5 million tonnes per
year. Table 12.11 and Figure 12.3 give the recent price history for traded copper. Copper
price volatility is shown in Figure 12.4.
Table 12.11 Recent copper price history

Copper price in US dollars
Year Maximum Minimum Range Volatility
(%)
1976 922.3 585.8 336.5 n/a
1977 881.0 640.5 240.5 25.36
1978 778.5 617.5 161.0 19.21
1979 1060.5 811.0 249.5 27.02
1980 1287.0 733.0 554.0 39.53
1981 963.0 733.0 230.0 26.80
1982 925.3 786.0 139.3 19.00
1983 1124.0 931.0 193.0 19.43
1984 1140.0 993.0 147.0 15.01
1985 1250.5 917.5 333.0 14.83
1986 1008.5 875.5 133.0 17.28
1987 1698.0 883.5 814.5 11.95
1988 1876.0 1141.0 735.0 40.84
1989 1904.0 1513.5 390.5 39.41
1990 1653.0 1282.5 370.5 27.40
1991 1450.0 1159.0 291.0 24.67
1992 1521.0 1215.5 305.5 26.04
1993 1514.5 1085.6 428.9 15.46

Copper price in US dollars

Year Maximum Minimum Range Volatility
(%)
1994 1946.2 1229.7 716.6 31.80
1995 1939.6 1755.7 183.8 19.62
1996 1793.1 1273.8 519.3 16.66
Note: Prices are in nominal dollars.
2000
1800
1600
1400
1200
1000
800
600
400
200
0
1976 1981 1986 1991 1996
Figure 12.3 History of the copper price since 1976
0.3
0.2
0.1
0
1976
–0.1
–0.2
–0.3
Figure 12.4 Copper price volatility since 1976

Note: The pointed line gives monthly volatility whereas the smooth line is the 12-months rolling
average.
12.3.4 UCI’s Current Approach to Hedging Price Risks

The volatility of the copper price, as shown in Figure 12.4, meant that UCI had over
the years favoured hedging some of its output. Since introducing the decision to
hedge, the firm had expanded the ways and means it had used to eliminate the
commodity price risk from its production. The company produced just over 400 000
tonnes per annum. The firm had initially just hedged the immediate production
when the outlook seemed to justify it. However, it had gradually extended its
approach to having rolling, five-year output targets and a long-term view on the
copper price. The most recent forecast that the company had prepared, based on its
internal assessment, analysts’ reports, and industry sources, is given in Table 12.13
(in Section 12.3.7) in connection with the Upland project.
Equity analysts who followed the stock considered the company’s hedging pro-
gramme to be one of the prime reasons for investing in its shares. The company was
often compared favourably with other mining companies for the relative stability of
its earnings and cash flow. The last five years’ earnings and dividends are given in
Table 12.12. Last year (to 31/12/1997), however, due to the increase in share capital
the previous year (1996) and the downturn in the industry that started in year (1995),
the company had been forced to reduce its dividend from the long-run 60 cents a
share to 48 cents – a reduction that had led to much adverse analytical comment
and a dive in the share price. Senior management was keen to avoid a repetition of
the problem in the future.
Table 12.12 United Copper Industries’ earnings per share (eps) and dividend per share
(dps) record
US$/ share 31/12/1997 31/12/1996 31/12/1995 31/12/1994 31/12/1993 31/12/1992
Reported eps 1.37 1.13 1.39 5.06 1.87 2.60
Reported dps 0.48 0.60 0.60 0.60 0.60 0.60
The current tools used by the firm to hedge its price risks mostly involved for-
ward and futures contracts. The firm had hedged a very small quantity of its output
using options and had also received a number of proposals to use commodity swaps
for a part of its production, but had not – as yet – undertaken any transactions of
this type. On the liability side, as mentioned earlier, it had issued a copper-indexed
note at a time when these were fashionable.
12.3.5 Forward Contracts

The company particularly liked forward contracts and used these as the basic means
by which its price risks were being hedged. The forward market was attractive in
two respects. First, the company could lock in buyers to their output up to two
years hence and could plan where the delivery was going to take place. Second,
although the company knew it was taking counterparty risk in entering the agree-
ment, it was in a position to modify the standard terms and conditions by mutual

agreement. Nevertheless, because of the problem of counterparty risk, less than 10

per cent of its annual production was hedged this way. However, because of the
attractions, the company was always looking at opportunities to increase its hedging
via fixed-price supply agreements.
The company also had a number of long-term contracts with users out to a max-
imum maturity of seven years, which amounted to 2 per cent of annual capacity in
1997.
12.3.6 Futures Contracts

UCI was an active hedger with copper futures traded on the London Metal Ex-
change (LME) and the New York Commodity Exchange (Comex). The firm
regularly sold futures against production. Because of the market structure where
liquidity was concentrated in the nearby months, selling contracts beyond six to nine
months was usually not feasible. To hedge a given exposure, Bob Woodward had to
resort to stack hedges and rolling hedging positions forward – with all the basis risk
problems this entailed. The firm was, as was to be expected, an active user of the
market and had large structural positions. This required the company to post
considerable amounts in margin, both involving internal cash resources and tying up
borrowing lines. To manage this activity, the central treasury unit employed two
dealers, plus three back-up staff. Positions were monitored daily and adjustments,
based on market view and the evolving production and demand outlook, were
factored into any adjustments. Currently, about 45 per cent of UCI’s output was
hedged this way.
Whereas futures were used to manage the bulk of the firm’s price risks, both
forwards and futures fulfilled the same economic function for the company. One of
the aspects Bob was keenest to examine in any changes that might be contemplated
was ways to improve the firm’s approach to hedging. The Upland project offered
just the opportunity to re-examine the hedging strategy. Furthermore, a number of
banks were keen to promote a copper-linked commodity swap as a solution. Others,
such as Phibro-Salomon, were interested in selling the company long-dated over-
the-counter puts on the copper price.
12.3.7 The Upland Mining Project

The Upland mine project was situated in Utah, in the Rockies, in a find that offered
the prospect of recovering about 10 million tons of copper over a 20-year period by
means of open-cast mining. On the basis of prior experience and knowledge of the
complexities of such a site, it was envisaged that the mine development would
operate in four phases:
 Initial phase with clearing and setting up appropriate mining and melting facilities.
This was expected to last three years.
 Build-up phase, lasting three years during which the mine would reach maximum
capacity of 100 000 tons. If operated at this maximum level, this would, in fact,
add a fifth to UCI’s current output.

 Maximum output stage. The current plans envisaged a period of 15 years at

maximum capacity output.
 End phase, lasting two years, at which time, the mine – reaching exhaustion – was
likely to see a decline in production. Following the end phase, UCI would have
to undertake decommissioning and environmental clean-up to return the land –
in so far as this could be done – to its former state.
To bring the project on line, UCI would be investing about US$100 million in
site clearing and preparation, mining equipment and copper refining. As part of the
project analysis, UCI had prepared a series of long-term forecasts on the copper
price. These are given in Table 12.13 based on three scenarios: a bullish increased
demand forecast which the company considered the most likely (assigning it a 0.6
probability in the analysis); a neutral forecast where demand remained largely
constant (given a 0.25 probability); the bearish forecast (0.15 probability), envisaging
a long-term decline in copper demand.
Table 12.13 Long-term copper market forecast

Supply/demand scenarios for copper
(000s tonnes) 1 to 5 years 6 to 10 years 11 to 15 years
Increased demand (bullish) scenario (0.60 probability)
Mined supply 12 280 14 000 15 500
Demand 15 417 15 500 16 250
Deficit of mined copper 3 137 1 500 750
Price* $2 350 $2 450 $2 600
Constant demand (neutral) scenario (0.25 probability)
Mined supply 11 300 11 300 12 000
Demand 12 900 12 000 12 000
Deficit of mined copper 1 600 700 0
Price* $1 930 $1 875 $1 830
Reduced demand (bearish) scenario (0.15 probability)
Mined supply 11 340 11 500 12 000
Demand 12 940 11 300 11 850
Surplus of mined copper 400 200 150
Price* $1 650 $1 600 $1 570
* In constant dollars at 1997 prices.
Under the different scenarios, the NPV of the Upland project was:
bullish forecast: US$39.3 million;

neutral forecast: US$21.8 million;
bearish forecast: US$10.2 million.

The project itself was analysed, using standard discounted cash flow methods,
under a wide range of copper price/demand scenarios and the results, for prices
ranging from as low as US$900/ton to US$2350/ton, are shown in Figure 12.5.
Figure 12.5 shows that for the three scenarios given in Table 12.13, the Upland
project would be profitable – as measured by its net present value (NPV). However,
at prices just below US$1400/ton, the project would be unprofitable.
The questions facing UCI’s Board were, first, whether the project’s sensitivity to
copper and the break-even price were acceptable in terms of future copper price
behaviour. The Board was also concerned to maintain the company’s standing with
investors as a mining stock with a stable profit record and a good dividend record
(particularly following the previous year’s debacle). The second issue was whether
the price volatility led to an acceptable variability in cash flow from the project.
Figure 12.3 indicates that the copper price had been quite volatile and that relying
on the spot market might lead the company to experience losses and suffer consid-
erable variations in cash flow from the project – and hence profits – making it less
attractive to the firm, and to investors. An examination of the forecasts showed that
the impact of the copper price on the annual after-tax cash flow during the maxi-
mum extraction phase was as given in Table 12.14.
50 Increased demand
bullish scenario)
40
Constant demand
30 (neutral scenario)
Reduced demand
Net present value
20 (bearish scenario)
10
0
900 1100 1300 1500 1650 1800 1930 2350
–10
Break-even point
–20
Area of negative NPV
–30
–40 Copper price (US$/ton)
Figure 12.5 Graphical representation of the profitability of the Upland

project in relation to the copper price

Table 12.14 Annual after-tax cash flow and copper price for the
Upland project during the main extraction phase
Copper price After-tax cash flow
(US$ per ton) (US$ millions p.a.)
2000 21.5
1800 19.3
1600 17.2
1400 14.6
1200 9.8
1000 5.6
Bob Woodward felt that the Board would take the view that there were definite
attractions in reducing the downside risk on the investment, especially since a fall in
the copper price would also affect other parts of the firm at the same time. Bob had
already proposed the alternatives that were available for operational or financial
hedging of the Upland project. As mentioned earlier, some of these had already
been used by UCI but Bob had also included other, as yet untried, methods which
might be more appropriate in the context of the firm’s expansion. The alternatives
under consideration were:
 enter into a long-term supply contract at a fixed price with a consumer;
 sell forward the copper for an agreed period. One investment bank’s proprietary product
that is available to UCI is known as a flat-rate forward where the contango (or
the difference between the spot and forward price) was fixed regardless of ma-
turity. Another product, known as a spot deferred, is a forward contract with a
floating copper price and no fixed delivery date. It provides more flexibility than
a conventional forward contract but without the upfront cost of using an option;
 enter into a commodity swap where UCI would receive a fixed price for a given
quantity of copper against paying a variable price. The effect would be to syn-
thetically create a fixed selling price;
 hedge the position by using copper futures. This would require the setting up of a stack
hedge since futures prices do not extend beyond about three years. However,
lack of liquidity in the longer contracts means that only the shorter-dated con-
tracts would prove practical;
 buy a series of copper puts. These would need to cover output over a given period
and – as a way of saving money – these could be Asian-style (that is, average rate
options over the exercise period).
All the above measures could be used to hedge its exposure fully or partially and
could be used in tandem. So UCI could both use a commodity swap and buy copper
puts if this provided the best alternatives.
Woodward knew that any hedging decision potentially meant giving up on the
upside potential for the copper price and was concerned that, given the firm’s long-
run bullish assessment for copper – despite its temporary weakness – hedging might
prove to be the wrong decision. A decision to hedge might then be something UCI
came to regret.

Over the coming week, Bob Woodward was going to have to finalise his pro-
posal and present to the Board of United Copper Industries his intentions for
managing the price risks in the Upland project – if any. The market uncertainty
surrounding copper, with the price see-sawing daily on the commodities exchanges,
did not help. This unsettled behaviour made any ‘no action’ recommendation to the
Board even more problematical. Bob also wanted to be cautious and not add to the
problem of the dividend that had already caused so much external and internal
comment. However, locking in the price now might leave the company, and Bob,
exposed to the charge that they had inappropriately and unwisely hedged.
As part of the hedging strategy, Bob had set himself the following points to con-
sider:
 how the new hedges should be integrated with existing positions;
 considering the use of new instruments, in particular the advantages of options;
 extending the hedging period for some, at least, of the group’s output with a
commodity hedge.
In order to resolve these issues, Bob needed to examine the advantages and
disadvantages of each of the approaches and their benefit–cost trade-offs. He also
began to muse on how he might sell the preferred alternatives to the Board. It
promised to be a busy week before he and his team had finished the task.
12.3.8 Hedging Strategy for the New Investment

Bob could see that there were advantages and disadvantages to the various instru-
ments. The terminal products, using futures and forwards either in their traditional
form or in the newer variations, were costless to implement but locked UCI into a
given price. The use of options, even with average price options (Asian-style
options), was attractive but involved a significant upfront premium. Table 12.15
summarises Bob’s assessment of the advantages and disadvantages of the various
methods for hedging UCI’s copper exposure.
Table 12.15 Alternatives available to UCI for hedging its copper price exposure and their
advantages and disadvantages
Hedging method Advantages Disadvantages
Long-term supply Guaranteed price and customised Fixed price does not allow UCI to
contract (operational delivery conditions which suit UCI’s participate in any increases (which are
hedging) operations implicit in the copper market forecast);
UCI takes significant counterparty risk
Forward contracts (or As above As above; however, the use of several

tailored products such counterparties reduces counterparty risk
as the flat-rate via portfolio effects; locked-in prices will
forward or spot be different depending on delivery dates;
deferred) flat-rate forward and spot deferred are
more expensive since they are ‘tailored’
products

Hedging method Advantages Disadvantages

Commodity swap As above; since it is a financial Creates significant counterparty risk on
contract, it does not affect existing the financial institution offering the swap;
customer relationships; term pricing could be expensive if entered into
instrument with a (relatively) long for an extended maturity (Upland project
maturity extends to over 20 years)
Copper futures Exchange-traded and counterparty Contracts have only short-term maturi-
risk is virtually nil; hedge could be ties: UCI would need to use a stacked and
operated dynamically as a form of rolling hedge; margin costs could be
insurance (i.e., portfolio insurance) significant; hedge would be imprecise; firm
has no experience of operating portfolio
insurance
Copper puts Allows UCI to benefit from any Costly since premiums have to be paid;
price increases over protection requires series (i.e., floor structure) with
period; tailored strike prices; payoff long maturity to be effective; an over-the-
could be based on average and not counter (OTC) product and hence UCI
spot price at end of exercise period would be taking counterparty risk
(i.e., Asian-style option); the firm
might sell high-priced options to
partially cover the cost of protec-
tion (a vertical spread strategy, or
cylinder)
The different methods offered a trade-off. The terminal set – in its various guises
– does not involve any initial upfront costs but does lock in UCI to whatever turns
out to be the contractual price. The option alternative gives the company the
opportunity to benefit from any future price increases, but at an upfront cost. The
key issue is what would be the more attractive alternative.
Also the Board needed to consider whether changing the sensitivity of the pro-
ject to the copper price was enough to reduce the risks. An extension of the price-
sensitivity analysis showed that if half the future output was hedged, so that the
copper price for this proportion was fixed, then the break-even point dropped from
US$1395/ton to US$1300/ton. The new price/net present value (profitability)
sensitivity of the project is given in Figure 12.6.

25 Bullish scenario
20
Neutral scenario
15
Bearish scenario
Net present value

10
0
900 1100 1300 1500 1650 1800 1930 2350
–5
Original break-even point
–10
New break-even price when 50%
–15 of the output is hedged
–20 Copper price (US$/ton)
Figure 12.6 Effect of partial hedging on the Upland project’s break-even

price for copper
The variation in the hedged amount and the degree of sensitivity to the copper
price is shown in Table 12.16. The trade-off facing UCI is whether the additional
protection given by fixing a proportion of the project’s output in terms of reduced
profitability (NPV) is worth the added downside risk protection.
Table 12.16 Effect of hedging on the break-even NPV for the Upland
project and the price at which the unhedged proportion is sold
Amount hedged Break-even NPV copper
price
1.0 n/a
0.9 450
0.8 980
0.7 1150
0.6 1238
0.5 1300
0.4 1325
0.3 1350
0.2 1369
0.1 1383
0.0 1395
Note: This calculation assumes that the copper price is fixed at US$1500/ton.
What Table 12.16 shows is that there is a trade-off between the effectiveness of
partially hedging and the break-even copper price. On the basis of the previous
analysis, it does not make much sense for UCI to hedge more than 40 per cent to 50
per cent of the output since the likelihood of such a low price seems remote, even
though the price may temporarily dip down to this point in the future. Note that the

proportion of the new output to be hedged would be about the same as the current
proportion of the current output being hedged by the company.
12.3.9 A Commodity Swap

A commodity swap is an over-the-counter agreement where one party agrees to pay
a floating price for a set amount of a commodity against receiving a fixed price. As a
producer, UCI would pay the floating rate and receive fixed. One of the attractions
for UCI of using such an arrangement is that it is a purely financial transaction. The
counterparty paying the fixed rate would be a financial institution. Under such an
arrangement, UCI was separating its commercial relationships with copper users
from its risk-management activities and would be free to take advantage of any
commercial opportunities. The stages of the operation from UCI’s perspective are
given in Figure 12.7.
Receive fixed
UCI Counterparty
Pay floating
floating payment
Copper sold at Effect of commodity swap is

floating price to provide UCI with a fixed price
in the market on the copper sold in the market
Figure 12.7 A schematic representation of a commodity swap

Note: The swap involves a cash settlement of the difference between a floating-rate copper price
based on the spot price at each payment date against a contractually fixed rate agreed when the
swap is initiated.
In the swap arrangement, the floating rate would be indexed to, for instance, the
average London Metal Exchange settlement price over the reference period. The
fixed price would then be compared with the floating price to determine which
party owed the other. The mechanics of the structure are as follows. If UCI has a
commodity swap contract for 10 000 tons of copper fixed at US$1400/ton and paid
on a six-monthly basis against the average spot copper price, then its payments
under different scenarios are as given in Table 12.17.
Table 12.17 Contractual payments under a commodity swap

Average copper
price over reference Fixed Floating Net
period payment payment payment
US$1500 US$14 million US$15 million UCI pays
US$1 million
US$1300 US$14 million US$13 million UCI receives
US$1 million
Note: In practice, only the net difference is transferred between the parties, as indicated in column 4.

12.3.10 Using Copper Puts

Buying puts or engaging in a synthetic put programme using portfolio techniques
involves a more complicated analysis. In this case, UCI has to decide not only what
proportion of the output to protect but also which of the many possible strike
prices should be adopted (and whether these should change over time).
One possibility, given the greater impact on UCI of a short-term decline in the
copper price, is to go for a step-down floor on the copper price. This would involve,
say, holding a series of different expiry copper puts, which had strikes that were
reduced (offering less protection, but also costing less) as the period covered was
further into the future. The principle of a step-down floor, as compared to a conven-
tional floor, is illustrated in Figure 12.8.
Panel A: Constant price floor structure

Copper price
Period when floor is 'in-the-money'
Option periods
Time
Panel B: Step-down price floor structure
Copper price
Period when floor is 'in-the-money'
Option periods
Time
Figure 12.8 A floor (a series of puts) on the copper price

Note: Panel A shows the effect of a constant strike price and periods when the floor is ‘in-the-
money’. Panel B shows the effect when the strike is reduced each period (that is, it ‘steps down’).
With the constant strike price, there is a higher likelihood that the floor will be in-the-money and
will cost more than the step-down floor. But a constant floor will also provide more protection.
The pricing difference on the two structures is quite marked. If we take copper
price volatility as being 22 per cent (about the average of the last three years in
Table 12.11), then the effect of reducing the strike on an option is as follows. In
order to price options we must also know the other pricing variables. Interest rates
we will assume as being a constant 6 per cent, the market price as US$1500/ton, and
the strike price as US$1450 ton and US$1400 ton. The tenor of the option is two
years. The conditions are summarised as follows:

market price: US$1500

strike price 1: US$1450
strike price 2: US$1400
interest rate: 6 per cent
tenor: two years
volatility: 22 per cent
The put option prices, based on the above data, are:*

 strike price 1 (US$1450) put price = US$81.85
 strike price 2 (US$1400) put price = US$54.69
Although the idea of a step-down makes sense in that there is a potential saving
in premium, another observed characteristic of commodity price volatility is also
useful. Generally, the long-run demand for a commodity is stable and it is short-
term shocks and other disruptions to the available supply that create uncertainty.
Thus we might expect volatility to decline with maturity as the effects of relatively
constant fundamental demand/supply factors outweigh short-term technical ones
and the effect of convenience yields dissipates. Hence, the term structure of
volatility might look something like that given in Figure 12.9.
Volatility
Time to maturity
Figure 12.9 The term structure of volatility

Note: The implication is that, for a commodity, relatively constant fundamental factors dominate
for longer maturities whereas shorter maturities may be affected by technical factors, such as
supply squeezes, interruptions and other shocks.
The implication is that the more distant options should be given lower volatili-
ties. Let us assume that UCI decided to use a five-year floor on copper prices. The
five options that would make up the floor and the total prices are given in Ta-
ble 12.18. The forward volatility is that which is derived from the term structure of
copper prices. The spot volatility used to price the five individual options is a linear
* These were computed using the standard Black–Scholes equation.

combination of the forward volatilities. (More sophisticated approaches could have

been used.) Note that the floor prices are slightly lower than those on the puts since
the payment date is deferred until the end of the period (that is, they are discounted
by the one-year rate).
Table 12.18 The effect of declining volatility on the cost of long-dated

puts and the pricing of a floor
Period Volatility
Forward Spot Put price Floor price
1 22.0 22.0 63.71 60.10
2 16.5 19.3 63.19 59.61
3 13.5 17.3 52.53 49.56
4 11.5 15.9 41.60 39.25
5 10.0 14.7 31.06 29.30
252.09 237.82
Note: The floor pays out at the end of the period and hence has a lower value than the corre-
sponding option.
Table 12.19 shows the effect of having added a step-down feature to the floor
given in Table 12.18.
Table 12.19 The effect of having a step-down strike on the floor given in
Table 12.18
Period Strike Volatility
price
Forward Spot Put price Floor
price
1 1450 22.0 22.0 63.71 60.10
2 1425 16.5 19.3 50.54 47.68
3 1400 13.5 17.3 30.44 28.72
4 1375 11.5 15.9 12.61 11.89
5 1350 10.0 14.7 2.58 2.43
159.88 150.83
What Table 12.18 and Table 12.19 show is the cost of hedging production using
options. The cost of the floor without a step-down is US$237.82, whereas the step-
down only costs US$150.83. Since each floor covers 5 tons of copper these equate
to a cost per ton of US$47.56 and US$30.17 respectively. If the total output of
100 000 tons was hedged in this way, the firm would have to provide premiums of
US$23.8 million in the first case and US$15.1 million in the second case. Given that
the total investment is expected to be US$100 million, providing protection via a
floor will add between 15 per cent and 24 per cent to the investment cost.

12.3.11 Using Portfolio Insurance

Another alternative would be for UCI to operate a portfolio insurance strategy
where the exposure to copper price fluctuations was dynamically hedged. This is
similar to the put protection but would require the firm to buy and sell a large
number of futures contracts on a continuous basis for a number of years. The
attractions of such a strategy as opposed to the puts would depend on whether UCI
considered it had the appropriate in-house skills and whether the expected cost
would be less than the known cost of purchasing puts.
The method, known as the constant proportions portfolio insurance (CPPI),
works by setting a floor to the price and hedging more when the price falls and less
when it rises (in the manner of a delta hedge).*
If the current copper price is US$1500 and the floor is set at US$1400 and the
multiplier (κ) is 2, then the unhedged proportion of the portfolio is 2(1500 −
1400) = 200/1500 = 13%. The hedged amount is therefore
100 − 13 = 87%. The results at different levels are shown in Table 12.20.
Table 12.20 Dynamic hedging in relation to the copper price

Copper price Unhedged Hedged
2000 60% 40%
1900 53% 47%
1800 44% 56%
1700 35% 65%
1600 25% 75%
1500 13% 87%
1400 0 100%
1300 0 100%
Such an approach would allow UCI to guarantee a minimum return on its in-
vestment. However, in contrast to the protective puts approach, it is difficult to
determine the exact cost of such a strategy since it would depend on the costs of
trading, the cost of margin and the run-up of losses from buying back futures at a
loss. However, it does have the virtue of flexibility, since UCI could discontinue the
programme at some point in the future (although puts can also be sold back), and
employ other hedging methods, or undertake no hedging.
12.3.12 Conclusion to the UCI Case

The UCI case has looked at the issues surrounding the hedging or insuring of a
strategic business decision and some of the concerns that managers might have
when deciding whether to hedge – or not. As with most business problems there are
no hard-and-fast rules for deciding when, what or how to hedge. The issues are
* The method is detailed in Module 11 on Hedging and Insurance.

more complex than in the first case where the benefit–cost trade-off from the
hedge/not hedge decision for a single receivable is more clear cut.
For UCI to hedge means guaranteeing a price on the new project’s output – and
hence profitability – but also means most likely giving up some or all of the oppor-
tunity to gain from future price increases. There are also questions as to the risk
appetite of the firm and its shareholders and what they would want UCI’s managers to
do. The instruments available also seem less well adapted to UCI’s needs, or are
costly. The firm really requires a very long-term hedging instrument. This is not readily
available and is likely to involve the company in paying a premium for protection.
Providers are likely to impose a significant premium if UCI seeks to trade beyond the
market’s norm for risk-management products. Do-it-yourself approaches, such as
stacking hedges in futures or dynamic replication, impose significant costs in skill and
management time and, in the final analysis, may not deliver the promised outcome.
Whatever decision is reached, Bob Woodward needs to carry out a thorough
examination of the consequences of using the instruments and their cost to UCI.
This evaluation will be embedded within the firm’s long-term strategy and its
capabilities and competencies and its ability to operate a risk-management pro-
gramme.
Financial statements for United Copper Industries Inc.
Income Statement
31/12/1997 31/12/1996 31/12/1995 31/12/1994 31/12/1993 31/12/1992
US$ millions
Net income 133.1 79.0 94.3 342.6 125.9 174.9
Profit after tax 105.8 98.2 106.7 182.5 141.1 109.4
Profit before tax 124.3 101.0 134.7 254.5 167.3 155.5
Sales revenue 634.3 613.2 622.8 683.5 582.1 500.1
Trading expenses (537.7) (509.4) (479.8) (524.3) (460.9) (357.8)
Cost of goods sold (339.2) (323.3) (302.0) (395.4) (353.3) (357.8)
Selling & general (35.8) (35.4) (36.6) (44.1) (38.3)
Other expenses (162.7) (150.8) (141.3) (84.8) (69.3)
Staff costs (3.2) (2.7)
Pension costs (3.2) (2.7)
Depreciation (110.0) (98.8) (94.0) (84.8) (69.3) (40.4)
Other by format 2 (424.5) (408.0) (385.8) (439.5) (391.6) (317.4)
Exploration (52.7) (52.0) (47.2)
expenses
Other trading exp. (537.7) (509.4) (479.8) (524.3) (460.9) (357.8)
Non-trading 5.0 (2.8) 7.5 55.6 50.6
income
Assoc. co. income 5.0 (2.8) 7.5 55.6 50.6
Finance charges (12.4) (14.6) (13.0) (42.4) (87.6) (115.6)
Interest capitalised - - - - - 7.9
Other finance (12.4) (14.6) (13.0) (42.4) (87.6) (123.5)
charges

Pre-tax adjust- 15.2 (3.9) (19.9) 113.3 57.4 60.6

ments
Other profit 20.0 18.5 24.6 16.9 20.6 17.7
before tax
Taxation (18.6) (2.8) (27.9) (72.0) (26.2) (46.1)
Current taxation (44.5) (27.4) (44.6) (68.7) (38.1) (84.8)
Deferred taxation 25.9 24.6 16.7 (3.3) 11.9 38.6
Domestic current (43.1) (27.0)
tax
Domestic 26.2 24.6
deferred tax
After tax items 27.4 (19.2) (12.5) 160.0 (15.3) 65.5
Accounting policy 38.5 (11.6)
changes
Minorities share (11.1) (7.6) (12.5) (14.0) (11.6) (17.3)
of profit
Other after tax 174.1 (3.6) 82.8
items

Balance Sheet
31/12/1997 31/12/1996 31/12/1995 31/12/1994 31/12/1993 31/12/1992

US$ millions
Total assets 1 186.4 1 236.3 818.1 950.9 1 301.7 1 321.0
Tangible fixed assets 794.5 662.2 553.9 564.0 583.0 609.3
Property 68.8 71.0
Property – cost or valuation 68.8 71.0
Other tangible FA 784.1 748.9
Capital work in progress 232.7 87.5
Other tangible FA (291.0) (245.2) 553.9 564.0 583.0 609.3
Total capital WiP 232.7 87.5
Total depreciation (522.6) (425.5)
Financial assets 12.7 59.1 487.3 467.8
Assoc. company investment 6.7 6.7 434.8 413.7
Other assoc. co. 6.0 52.5 52.5 54.1
Current assets 229.0 408.7 187.5 273.9 183.3 183.1
Stocks 122.2 85.9 101.7 70.1 89.3 114.7
Raw materials etc. 25.9 26.3
Work in progress 55.9 36.1
Finished goods & resale 38.1 23.5
Other stocks 2.4 101.7 70.1 89.3 114.7
Debtors 8.2 13.2 14.1 28.2
Current investments 18.7 18.0 16.2 18.8 14.1 22.6
Cash & near cash 69.8 291.0 18.9 130.4 4.8 9.9
Other current assets 18.3 13.7 42.5 41.5 61.0 7.6
Other total assets 162.9 165.5 64.0 53.8 48.0 60.8
Total liabilities 1,186.4 1,236.3 818.1 950.9 1,301.7 1,321.0
Shareholders’ equity 629.8 528.6 201.4 109.6 (199.6) (291.8)
Share capital 151.6 123.4 108.5 108.3 108.0 107.7
Ordinary shares 138.7 110.6 108.5 109.9 109.4 109.1
Preference shares 14.4 14.4
Own equity shares (1.4) (1.5) (1.6) (1.4) (1.3)
Reserves 478.2 405.2 93.0 1.3 (307.6) (399.5)
Share premium 293.0 295.2 16.8 13.7 6.8 0.3
Revenue reserves 185.2 110.0 76.2 (12.4) (314.4) (399.8)
Deferred liabilities 91.3 124.2 148.7 188.4 172.7 201.9
Minority interest 91.3 80.2 72.7 60.7 47.2 59.0
Provisions 44.1 76.0 127.6 125.5 142.9
Other deferred taxation 44.1 76.0 127.6 125.5 142.9
Debt 207.7 276.6 235.3 422.5 1,149.4 1,200.1
Long-term loans 192.0 177.0 112.2 302.0 964.2 818.6
Short-term loans 15.7 99.6 123.1 120.5 185.2 381.6
Current maturities 88.7 112.2 112.2 112.2 112.3
Other short-term loans 10.9 8.3 73.0 269.2
Loan capital 192.0 177.0
Mortgage loans 88.7
Other debt by type 235.3 422.5 1,149.4 1,200.1
Unsecured debt 165.7 160.9
Other debt by backing 42.0 115.7 235.3 422.5 1,149.4 1,200.1
Other long-term liabilities 163.3 163.3 120.4 84.2 46.0 26.2
Creditors 94.3 143.6 112.2 146.3 133.0 184.6
Trade creditors 17.9 27.3 17.1 31.8 35.3 42.1
Other accruals etc. 74.2 65.3 81.1 70.4 64.0 93.5
Tax due 2.1 27.5 14.1 44.1 33.7 49.0
Revenue tax 2.1 27.5 14.1 44.1 33.7 49.0

Cash Flow Statement
31/12/1997 31/12/1996 31/12/1995 31/12/1994 31/12/1993 31/12/1992

US$ millions
Cash & equivalent inflows (221.3) 272.2
Operating inflows 32.8 136.4
Profit in cash flow 133.1 79.0
statement
Net income 133.1 79.0
Non-cash adjustments etc. 2.3 49.6
Depreciation & amortisa- 110.0 98.8
tion
Other non-cash adjust- (107.7) (49.1)
ments
Working capital move- (102.7) 7.7
ments
Stock decrease (increase) (67.8) 14.1
U working capital move- (34.9) (6.4)
ments
Interest & dividends (58.0) (40.8)
Dividends paid (58.0) (40.8)
Investments (153.3) (207.6)
Financial assets 71.3 (1.4)
Tangible assets acquired (235.3) (212.7)
Property acquired (235.3) (212.7)
Other investments 10.7 6.5
Financing inflows (42.8) 384.2
Share capital issued 26.1 293.3
Debt issued (68.9) 90.9
Long-term debt raised 15.0 177.0
Long-term debt repaid (88.7) (86.2)
Short-term debt raised 4.8 0.0
CF cash & equivalent (221.3) 272.2
increase
Increase in reserves 76.2 36.5 53.7 302.0 85.4 134.5

Net income 133.1 79.0 94.3 342.6 125.9 174.9
Divs. for the year (56.9) (42.6) (40.6) (40.6) (40.4) (40.4)
Ordinary Divs. (41.0) (40.8) (40.6) (40.6) (40.4) (40.4)
Preference Divs. (15.9) (1.7)

Other data
31/12/1997 31/12/1996 31/12/1995 31/12/1994 31/12/1993 31/12/1992

US$ million
Sales (source) 634.3 613.2 622.8
Sales - North 365.0 345.7 410.4
America
Other Sales (s) 269.3 267.5 212.4
Profit before tax 124.3 101.0 134.7
Reported eps 1.37 1.13 1.39 5.06 1.87 2.60
[$/share]
Reported dps 0.48 0.60 0.60 0.60 0.60 0.60
(gross) [$/share]
Net asset value per 4.00 7.55 2.97 1.62
share [$/share]

This module has looked at two case studies of risk-management activity. The first
covers the different approaches used to manage the currency risk in a future foreign
currency receivable. The second, more complicated case looks at the issues sur-
rounding the commodity price risk associated with a major capital investment
project and different approaches that might be used to manage the risk.
Review Questions
12.1 If we have a future payable in a foreign currency, the appropriate transaction to manage
the exchange-rate risk is:
A. borrow foreign currency for the time until the payable is due.
B. sell the foreign currency forward.
C. buy the foreign currency forward.
D. none of A, B or C.
12.2 Which of the following is not an appropriate transaction to hedge a contingent foreign
currency cash flow?
A. Buy a currency option.
B. Buy a compound option.
C. Buy a currency forward.
D. All of A, B and C are appropriate instruments.

12.3 If we sell a Deutschemark currency put involving the Deutschemark and the US dollar
currency pair, at exercise we are contractually obliged to:
A. buy Deutschemarks spot.
B. sell US dollars spot.
C. buy Deutschemarks at the strike rate.
D. sell US dollars at the forward rate.
12.4 Which of the following is not a means of handling currency risk?

A. Buy a forward or futures contract on the currency.
B. Sell a forward or futures contract on the currency.
C. Buy a currency option on the currency.
D. Sell a currency option on the currency.
12.5 With a forward foreign-exchange contract we can:

A. agree any maturity date and any exchange rate we choose.
B. agree any maturity date we choose but have no choice as to the exchange rate.
C. agree any exchange rate we choose but have no choice as to the maturity.
D. agree any exchange rate but have only a limited choice of maturity dates.
This information relates to Questions 12.6 and 12.7.
Rate Sterling Deutschemarks

Exchange rate 0.3846 2.60
Three-month deposit rate 7.25% 5.70%
Six-month deposit rate 7.375% 5.90%
12.6 What will be the forward foreign exchange rate in three months’ time?
A. DM2.56
B. DM2.59
C. DM2.60
D. DM2.61
12.7 If we could somehow borrow sterling at 7.25 per cent for six months what would be
the profit per £100 we could make in arbitraging the forward foreign-exchange market?
A. There is no profit to be had.
B. £0.06
C. £3.56
D. £3.62

12.8 If we wanted to sell Deutschemarks six months forward with a do-it-yourself forward
transaction, which of the following would we undertake?
A. Borrow sterling for six months, exchange it for Deutschemarks spot and invest
the proceeds for six months at the Deutschemark rate.
B. Borrow Deutschemarks for six months, exchange for sterling spot and invest
the proceeds for six months at the sterling rate.
C. Lend Deutschemarks spot for six months, enter into a forward foreign-
exchange contract with a six-month maturity to buy Deutschemarks and sell
sterling.
D. Borrow sterling spot for six months, enter into a forward foreign-exchange
contract with a six-month maturity to sell Deutschemarks and buy sterling.
12.9 Currency futures contracts are quoted in American terms, that is, a fixed amount of
foreign currency versus a variable amount of US dollars.
If we want to protect ourselves against a fall in the dollar against the Japanese Yen, do
we:
A. buy Yen currency futures?
B. sell Yen currency futures?
C. sell Yen spot and buy Yen currency futures?
D. buy Yen spot and sell Yen currency futures?
12.10 Currency futures are quoted in US terms against the foreign currency. There are
currency futures contracts quoted for the Swiss Franc and the Australian dollar. We
have a cross-transaction involving these two currencies in which we have to sell Swiss
Francs and buy Australian dollars. We wish to hedge the transaction via futures.
Which of the following spread transactions will achieve the correct exposure?
A. Buy Swiss Franc futures and sell Australian dollar futures.
B. Sell Swiss Franc futures and buy Australian dollar futures.
C. Buy Swiss Franc futures and buy Australian dollar futures.
D. Sell Swiss Franc futures and sell Australian dollar futures
Deutschemark/US dollar options DM62 500 (premium = $ per DM)

Strike price Calls Puts
Dec. Jan. Feb. Dec. Jan. Feb.
0.650 0.018 0.045 0.074 0.081 0.100 0.118
0.655 0.009 0.030 0.055 0.122 0.136 0.151
0.660 0.004 0.020 0.043 0.167 0.175 0.186
Spot rate = 1.5627
12.11 What is the break-even rate from buying February 0.655 calls?
A. $0.60
B. $0.655
C. $0.69
D. $0.71

12.12 If we set up a currency cylinder (that is, a vertical spread, involving a purchased and a
written option) based on the above in which we wish to hedge a Deutschemark
receivable, which of the following transactions will achieve the correct exposure?
A. Buy DM call with a low strike price and sell another DM call with a higher
strike price.
B. Buy DM call with a low strike price and sell a DM put with a higher strike price.
C. Buy DM put with a high strike price and sell another DM call with a lower
strike price.
D. Buy DM put with a high strike price and sell a DM put with a lower strike
price.
12.13 For a consumer, the attractions of entering into a commodity swap and paying the fixed
rate are:
A. the swap provides a flat rate for the commodity being purchased over the life
of the contract.
B. it allows the consumer to maintain existing supply arrangements.
C. it can be customised to meet the consumer’s specific needs.
D. all of A, B and C are attractions of a commodity swap.
12.14 A floor is a risk-management transaction that consists of:

A. a dynamic replication programme designed to provide a minimum value over
time.
B. a long position with a purchased put option.
C. a package made up of a series of put options with sequential expiry dates.
Case Study 12.1

The following information relates to the sterling and Swiss Franc markets.
Currency futures
Eurocurrency and foreign exchange markets
SFr/£ Spot Bid/offer 1 month % p.a. 3 % p.a. 12 % p.a.
months months
mid-rate
2.4099 83–115 2.3973 6.2 2.3752 5.8 2.774 5.5
Eurocurrency deposit market

£ 71/2 – 77/16 711/16 – 75/8 77/8 – 713/16
SFr 15/8 – 11/2 123/32 – 15/8 129/32 – 113/16
Sterling is quoted Actual/365 and Swiss Francs Actual/360.
Eurocurrency and foreign exchange markets

Swiss Francs Sterling
SFr 125 000 per SFr £62 500 per £
+ 3 months 0.7065 1.6776

1 A company has a forward foreign exchange contract in which it will receive £5 million in
three months’ time and wishes to covert this to Swiss Francs. What will it receive in
Swiss Francs if it (a) undertakes a forward transaction and (b) creates its own forward
contract via borrowing and lending?
2 How would the transaction have fared if it had been established using currency futures
contracts? How many futures contracts do we require in each of the two contracts?
3 What are the disadvantages of the currency futures contracts approach?

Appendix 1
Practice Final Examinations and

Solutions
This appendix contains two practice final examinations with solutions. Each exam is
in two sections:
Section A: Multiple Choice Questions

30 questions each worth 2 marks
Total marks available in Section A 30 × 2 = 60
Section B: Case Studies
3 case studies worth 40 marks each
Total marks available in Section B 3 × 40 = 120
Total marks available = 180
Derivatives Edinburgh Business School A1/1

Appendix 1 / Practice Final Examinations and Solutions
Examination One

Each question is worth 2 marks. No marks are deducted for incorrect answers.
1 The spot price of a commodity is $1500/tonne. The cost of storage is 2 per cent per
annum and the risk-free interest rate is 8 per cent per annum (both continuously
compounded). The commodity is not subject to deterioration or loss in storage. The
six-month forward price is quoted in the market as $1425.25.
Which of the following is the market’s continuously compounded convenience yield on
the commodity (at an annual rate)?
A. The forward price is standing at a discount to its fair value and it is not possible
to determine whether a convenience yield exists or not.
B. 10.11 per cent.
C. 20.22 per cent.
D. 21.23 per cent.
2 The UK’s Financial Services Act 1986 describes certain financial agreements as
‘contracts for differences’. Which of the following derivative instruments fall into the
category of ‘contracts for differences’?
A. Forward contracts, futures and swaps.
B. Options.
C. Both A and B.
D. Neither A nor B.
3 A commodity is trading at $2125 in the cash market and the three-month future
contract is at $2386. After a couple of days, the cash market price falls to $1995,
whereas the futures price becomes $2248.
What has happened to the cash–futures basis? Has it:
A. remained unchanged?
B. declined due to convergence?
C. strengthened?
D. weakened?
4 Which of the following correctly describes the value basis relationship for financial
futures?
where:
= futures price as quoted in the market
= futures price as computed using the cost of carry model
= cash market price or spot price
( ) = expected spot price at expiry or maturity of the futures contract
A. −
B. −
C. − ( )
D. −
A1/2 Edinburgh Business School Derivatives

5 The original terms and conditions of a seasoned, fixed-to-fixed, cross-currency swap

with a bullet maturity and current market conditions in the swaps market are given in
the following table:
Original Current
swap market
conditions conditions
Exchange rate A 2.50/B A 2.90/B
Interest rate in currency A 6% 4.5%
Interest rate in currency B 5% 7%
From the perspective of a swap holder who is contracted to pay currency A and receive
currency B, which of the following changes in the swap value is correct?
A. There is a valuation currency gain: a gain on interest rate A and a gain on
interest rate B.
B. There is a valuation currency gain: a gain on interest rate A and a loss on
interest rate B.
C. There is a valuation currency gain: a loss on interest rate A and a loss on
interest rate B.
D. There is a valuation currency loss: a loss on interest rate A and a loss on
interest rate B.
6 We have a one-period call option with a strike price of 230 and the optioned asset can
take a value of either 250 or 210 in one period. The current asset price is 225. The one-
period interest rate is 4 per cent. What is the amount of borrowed funds in the
replicating portfolio?
A. 11.54
B. 100.96
C. 112.50
D. 125.00
7 Which of the following is the correct definition of a delta/gamma hedge?

A. An offsetting position in an option where this option’s gamma is equal to the
delta of the position being hedged.
B. An offsetting position where the deltas of the two sides are equal, but of
opposite signs, and the sum of the gammas of the two positions is positive.
C. An offsetting position where the deltas of the two sides are equal, but of
opposite signs, and the sum of the gammas of the two positions is negative.
D. An offsetting position where the deltas of the two sides are equal, but of
opposite signs, as are the gammas of the two positions.

8 For a European-style call and put on a non-dividend-paying share, with all other factors
remaining unchanged, if the volatility is decreased, which of the following would we
expect?
A. The value of calls and puts on the asset to rise.
B. The value of calls and puts on the asset to fall.
C. The value of calls to rise and the value of puts to fall.
D. The value of calls to fall and the value of puts to rise.
The following information is used for Questions 9 and 10.
Time 0.5 1 1.5 2 2.5

Zero-coupon rate 6.20% 6.15% 6.0% 5.90% 5.80%
9 Given the zero-coupon rates in the table, what is the present value of the expected
floating-rate payments on a two-year interest rate swap per 100 of nominal principal?
(Assume equal values for each half-year and ignore day-count conventions.)
A. 10.83
B. 11.28
C. 11.30
D. 11.63
10 A 2.5-year swap has a present value for the floating-rate side of 13.15 per 100 nominal.
What will be the swap’s fixed rate?
A. 5.26 per cent.
B. 6.01 per cent.
C. 5.68 per cent.
D. 5.73 per cent.
11 We want to modify the delta of an existing position which is currently 0.45 so that the
new delta will be 0.65. Which of the following will not achieve that result?
A. Buy puts.
B. Sell puts.
C. Buy calls.
D. Buy the underlying asset.
12 The initial and current exchange rates after one month between the US dollar and the
Deutschemark (DM) are given as follows:
Initial conditions
DM/$ 1.56 1.559 1.557 1.553 1.54
Conditions after one month

DM/$ 1.57 1.568 1.564 1.561 1.553

If a US$10 million forward foreign exchange swap for the 3 versus 6 months maturity
had been undertaken in which at the near date dollars had been sold, which of the
options represents the marked-to-market value of the foreign exchange swap after one
month? (Ignore present valuing and the effect of interest rates.)
A. (DM240 000).
B. DM0.
C. DM20 000.
D. DM130 000.
13 Currency futures are quoted in US terms against the foreign currency. There are
currency futures contracts quoted for the Swiss Franc and the Australian dollar. We
have a cross-transaction involving these two currencies in which we have to sell Swiss
Francs and buy Australian dollars. We wish to hedge the transaction via futures.
Which of the following spread transactions will achieve the correct exposure?
A. Buy Swiss Franc futures and sell Australian dollar futures.
B. Sell Swiss Franc futures and buy Australian dollar futures.
C. Buy Swiss Franc futures and buy Australian dollar futures.
D. Sell Swiss Franc futures and sell Australian dollar futures.
14 Which of the following is correct in relation to the pseudo-American adjustment for

dividends in the option-pricing model?
A. Including the present value of the dividend term ( . ) in the Black–Scholes
option-pricing equation.
B. Calculating the option price to the ex-dividend date and the expiry date to
determine which is the more valuable.
C. Using the binomial model and adjusting the price lattice for the change in the
share price following the payment of the dividend.
15 If a customer wanted to sell sterling forward, which of the transactions would the
foreign exchange bank need to undertake to eliminate its currency and interest-rate risk
on the transaction?
A. Borrow US dollars for the term of the transaction and exchange these for
sterling in the spot market and invest the proceeds until the maturity of the
forward.
B. Borrow US dollars for the term of the transaction and exchange sterling for US
dollars in the spot market and invest the proceeds until the maturity of the
forward.
C. Borrow sterling for the term of the transaction and exchange sterling for US
dollars in the spot market and invest the proceeds until the maturity of the
forward.
D. Borrow sterling for the term of the transaction and exchange US dollars for
sterling in the spot market and invest the proceeds until the maturity of the
forward.

16 Which of the following is correct? Fundamental financial instruments are:

A. another name for the derivatives product set.
B. those securities that are traded on organised exchanges.
C. required by firms in order to raise capital and borrow money.
D. those replicating transactions used to model the payoff of contingent claims.
17 Which of the following is true for over-the-counter (OTC) derivative contracts as

against exchange-traded derivative contracts?
A. OTC contracts have a limited credit risk, a narrow range of underlying assets
and limited expiry dates in comparison to exchange-traded contracts.
B. OTC contracts have an unlimited credit risk, a narrow range of underlying
assets and limited expiry dates in comparison to exchange-traded contracts.
C. OTC contracts have unlimited credit risk and a wide range of underlying assets
but limited expiry dates in comparison to exchange-traded contracts.
D. OTC contracts have unlimited credit risk and a wide range of underlying assets
and unlimited expiry dates in comparison to exchange-traded contracts.
The Global Machine Co. (GMC) of the UK has examined the alternative numerically con-
trolled machines (NCMs) on offer and is considering buying a large number of the products
produced by Algorithmic Corporation (AC) of the USA. GMC is a trendsetting firm in the
industry and its purchase of AC’s NCMs will lead to other firms buying their products. To
help with the sale, AC has negotiated a special export-financing package with the Federal
Export-Import Bank which has a special, subsidised financing rate for five years of 4.3 per cent
(as against a market financing rate of 5.2 per cent). The total amount of the loan would be
US$25 million, to be repaid in five equal annual instalments. The current spot exchange rate is
US$1.60/£ (NB: assume annual payments and round to 2 decimal places).
18 Which of the following is the present value of the interest rate subsidy in sterling
(rounded to the nearest £)?
A. £0.
B. £632 347.
C. £395 217.
D. £3 539 431.
19 If the five-year swaps rate in sterling is 6.5 per cent, what will be Global Machine Co.’s
annual payments in sterling if the subsidy is repaid over the life of the swap (to the
nearest £)?
A. £3 664 812.
B. £3 759 915.
C. £3 539 431.
D. £3 628 957.

20 Unlike ____ instrument, ____ allow the user to decide at what rate to hedge and, if
market conditions should so indicate ____ the holder to let the contract lapse, giving
the user ____ of the better of the market price or the contracted rate at expiry. Which
of the following correctly completes the sentence above?
A. a terminal an option does it allows the choice
B. an option a terminal does it does not allow the choice
C. a terminal an option does it allows no choice
D. an option a terminal does not it does not allow no choice
21 We have a US$230 million portfolio invested in the US equity market with a beta of
0.95. The current level of the S&P500 index is 980 and the futures contract is worth
$250 times the index value. The tick size is $25 and the minimum price fluctuation in
the index is 0.5 index points. We want to decrease the exposure to the market so as to
reduce the fund’s beta to 0.70.
Which of the following transactions will achieve the correct market exposure?
A. Buy 2350 contracts.
B. Buy 5850 contracts.
C. Sell 235 contracts.
D. Sell 1950 contracts.
22 Which of the following is the correct definition of a replicating portfolio?

A. A package of fundamental financial instruments and derivative securities
designed to meet a specific investment objective or target.
B. A package of securities and borrowing or lending designed to give the same
payoff as another financial security.
C. A portfolio of fundamental financial instruments and derivative securities
designed to eliminate risk.
D. A portfolio of securities designed to meet a specific investment objective or
target.
23 The spot price of copper is $1200/ton and the one-year forward price is $1300 and the
risk-free interest rate is 6 per cent per annum. There is no convenience yield.
Which of the following is the implied storage cost for copper (to the nearest percentage
point)?
A. 1 per cent.
B. 2 per cent.
C. 8 per cent.
D. 11 per cent.

24 The spot price for Deutschemarks against the US dollar is DM1.7525/$. The US dollar
interest rate is 6 per cent p.a. and that for Deutschemarks is 4 per cent p.a. The
forward exchange rate for six months is DM1.7395/$.
What is the nature of the arbitrage that can be made between the cash markets and the
forward market in Deutschemark–dollars?
A. Borrow US dollars and invest spot in Deutschemarks and contract to receive
dollars/sell Deutschemarks forward.
B. Borrow Deutschemarks and invest spot in US dollars and contract to receive
dollars/sell Deutschemarks forward.
C. Borrow US dollars and invest spot in Deutschemarks and contract to pay
dollars/receive Deutschemarks forward?
D. Borrow Deutschemarks and invest spot in US dollars and contract to pay
dollars/receive Deutschemarks forward.
25 A ‘stack’ hedge is represented by which of the following?

A. A partial hedge designed to reduce but not eliminate the sensitivity of a
position to an underlying risk.
B. The ratio of long to short bonds (or bond futures) in a duration hedge designed
to equate the change in value to both sides.
C. A long-dated hedge using futures where all the exposure is hedged with the
nearby contract.
D. A long (or short) position in the nearby contract with a short (long) position in
the deferred contract designed to counteract the effects of a rotation or twist in
the yield curve.
26 In which of the following transactions would standard options not be an appropriate

risk-management instrument?
A. A contract to supply XYZ plc, a company with a very low credit rating.
B. The price volatility for the commodity sold by the firm is expected to increase
in the future.
C. A bond with a put provision allowing the bond holder to redeem the bond at
par (that is, its full value) at a date prior to its stated maturity.
D. A competitive open tender on a development project in a foreign country.
27 Which of the following are the implications of a weakening of the basis when we are
short the asset and long the futures contract?
A. The asset price changes less than the futures price and we make money.
B. The asset price changes less than the futures price and we lose money.
C. The asset price changes more than the futures price and we make money.
D. The asset price changes more than the futures price and we lose money.

28 A fund manager has decided to put in place a protective put strategy. The value of the
portfolio is £25 million and it has a beta (β) of 1.10. There are index puts available with
a strike price of 5500 and a delta of −0.45. The current index value is 5900 and each
index point is worth £10. How many index puts are needed to hedge the portfolio?
A. 210.
B. 424.
C. 466.
D. 1036.
29 The following figure is a payoff profile.
Profit
Underlyer
Loss
What does this show?

I. A long put.
II. A short call.
III. A short underlying position with a written put.
IV. A short underlying position with a written call.
V. A bearish vertical spread.
VI. A bullish vertical spread.
Which of the following is the correct answer?
A. I, IV, V and VI.
B. II and III.
C. I and IV.
D. II, III, V and VI.
30 A forward contract has been sold with an original maturity of one year and a price of
245. The contract now has six months to run and the spot price of the asset is 236. The
six-month interest rate is 6.0 per cent and there are no holding costs on the asset.
Which of the following is the replacement cost of the contract (to the nearest whole
number)?
A. Zero
B. 2
C. 9
D. 5

Case Study 1
The SteamGas Company is due to buy a plant from the Deutsches Sturm Fabrik for DM100
million and payment is due in three years’ time. The Finance Director of SteamGas is con-
cerned about the potential currency risk. He has approached his bank with a view to buying
forward cover and the bank has indicated that its bid-offered quote for such a long-dated
forward is DM2.4750–2.4900. The current spot rate is DM2.50/£.
Current interbank deposit market conditions for the two currencies are given in the fol-
lowing table.
Currency interest rates Year 1 Year 2 Year 3

% % %
Sterling Offered 6 6.25 6.375
Bid 5.875 6 6.125
Deutschemarks Offered 5.75 5.875 6

Bid 5.625 5.625 5.75
1 Describe the nature of the currency exposure that SteamGas faces. What effect will
hedging the exposure have? (The current spot rate is DM2.50/£)
[7 marks]
2 Briefly describe the nature of a forward contract.

[5 marks]
3 Calculate the forward bid and offered rates for the three-year maturity forward
contract based on the interest rates given for sterling and Deutschemarks. How much
will SteamGas have to pay in sterling if it uses this approach?
[16 marks]
4 Why might the bank’s bid and offered quote a forward rate that is narrower than the
spread calculated using interest rates?
[8 marks]
5 What factors might lead SteamGas to favour one or other alternative?

[4 marks]

Case Study 2
There are two securities available and two future states of the world. The prices today and in
one year’s time are given in the following table:
State of the world

Security 1 2
Security A 120 20
(current price = 50)
Security B 105 105
(current price = 99.06)
1 Show, by creating portfolios if necessary, the state-specific interest rate or discount

factor that is applicable for the two possible future states of the world.
[10 marks]
2 Using the above securities from the table, create and price two derivative securities that
provide a positive payoff in the each of the two states but a zero payoff in the other.
[22 marks]
3 Create and price a guarantee security that insures that the payoff of Security A has a
minimum value of 50 in state two.
[8 marks]
Case Study 3
John Smith at Savery Investment Managers is considering selling ABC stock short since there is
strong evidence of poor management and Smith takes the view that the share price will fall
over the next three months. Although shorting the stock is attractive in view of the expected
underperformance of the shares, Smith is also concerned about a potential market rise over
the same period and has decided to buy index calls as a precaution. ABC shares have a beta of
0.90 and are currently trading at 125 pence. Assume a month is one-twelfth of a year.
1 The current index level is 4500 and the pattern of dividend distribution (expressed in
index points) for the coming three months is: 25, 70 and 48. The index’s volatility is 0.30
and the risk-free rate is 6 per cent per annum. To minimise the cost of protection,
Smith is looking to buy slightly out-of-the-money European-style calls with a strike price
of 4600. How much will this cost if each index point is worth £10?
[12 marks]
2 How many calls are required if John Smith decides to short 400 000 shares of ABC?
[6 marks]

3 How well will the contract have performed if after one month the market has fallen to
4350 and the current share price of ABC is 98 pence? Assume that interest rates and
other market conditions have remained unchanged over this period.
[16 marks]
4 Explain the basic approach of the binomial option-pricing model (BOPM) for pricing
options subject to value leakage.
[6 marks]

Examination Two

Each question is worth 2 marks. No marks are deducted for incorrect answers.
1 Which of the following correctly explains what a ‘notional bond’ is?

A. The theoretical bond used in long-term interest-rate-futures contracts.
B. The amount of notional principal underlying an interest-rate swap.
C. Another name for futures margin used when high-grade securities, such as
Treasury bills, are used as position collateral.
D. All of A, B and C are uses of the term.
The following information is used for Question 2.
Zero-coupon bond prices for different maturities

Term (years) Price
1 95.24
2 89.00
3 82.79
4 76.29
2 If a forward contract to purchase the two-year bond in one year’s time is on offer at
94.00, which of the following is the appropriate arbitrage to undertake? (Assume there
are no transaction costs on purchasing and issuing bonds.)
A. Issue the two-year bond, buy the one-year bond and buy the forward contract
and reinvest in the one-year bond in one year’s time.
B. Issue the one-year bond, buy the two-year bond and sell the forward contract.
C. Issue the one-year bond, buy the two-year bond and buy the forward contract
and reinvest in the one-year bond in one year’s time.
D. There are no arbitrage opportunities available in the market.
Bond Maturity (years) Zero-coupon bond price

A 1 944.33
B 2 873.44
C 3 804.96
All the bonds redeem for a face value of 1000.
3 What is the implied two-year rate in one year’s time (expressed as an annual rate)?
A. 7.00 per cent.
B. 8.12 per cent.
C. 8.25 per cent.
D. 8.31 per cent.

4 What is the Macaulay’s duration of a portfolio of the three zero-coupon bonds with a
current market value of 10 000, of which 2000 is invested in Bond A, 4000 is invested in
bond B and 5000 invested in bond C?
A. 2.2 years.
B. 2.5 years.
C. 2.6 years.
D. 3.0 years.
5 Which of the following ‘packages’ creates an amortising swap?

A. A series of different-maturity swaps with the same start date.
B. A series of same-maturity swaps with sequential start dates.
C. A series of different-maturity swaps with different start dates.
D. A series of same-maturity swaps with the same start date.
6 We define the following terms:

= underlying asset
= price of a call option
= price of a put option
( ) = present value of the strike price
Which of the following is correct under the put–call parity theorem?

A. ( )+ − =
B. − ( )− =
C. ( )+ − =
D. − ( )+ =
7 Why might a market participant give up the opportunity to undertake an arbitrage

transaction despite the fact the transaction appeared profitable?
A. The market participant was concerned about the uncertainties surrounding the
model used to evaluate the arbitrage opportunity which might lead to a loss
rather than a gain.
B. The market participant was aware of timing differences in the nature of the two
sides of the arbitrage opportunity which might lead to a loss rather than a gain.
C. The market participant was aware that the tax treatment of the gains and
losses may differ and one may fail to offset the other which might lead to a loss
rather than a gain.
D. All of A, B and C might lead the market participant to not undertake an
apparently profitable arbitrage opportunity.

8 Which of the following is correct? In the derivatives markets, the transaction or set of
transactions known as hedging can be considered to be a special case of:
A. risk reduction, where the intention is to eliminate all of the market risk in the
underlier.
B. speculation, where the intention is to take on as much risk as possible without
purchasing or selling the underlier.
C. financial engineering that involves taking no model risk from the complexities of
the transaction.
D. arbitrage that involves taking no risk on unwinding the transaction at its
maturity or when it is reversed.
9 A position is delta neutral but has a negative gamma of 1100. There is an option
available which has a delta of 0.55 and a gamma of 1.25. What will be the transaction
required to make the portfolio delta/gamma neutral?
A. Buy 880 of the delta 0.55 options and sell 484 of the underlying asset.
B. Sell 880 of the delta 0.55 options and sell 484 of the underlying asset.
C. Buy 880 of the delta 0.55 options and buy 484 of the underlying asset.
D. Sell 880 of the delta 0.55 options and buy 484 of the underlying asset.
10 If we want to protect a long-asset position from unfavourable outcomes, which of the

following should we undertake?
I. Buy puts on the underlying.
II. Buy calls on the underlying.
III. Sell calls on the underlying.
IV. Sell puts on the underlying.
A. I.
B. II.
C. I and III.
D. II and IV.
The following information is used for Questions 11 to 13.
The following information relates to calls and puts on ABC company shares. Each option is
exercisable into 100 units of ABC ordinary shares.
Sensitivity factor Call Put

Strike price 250 190
Delta 0.455 −0.195
Gamma 0.0396 0.0219
Theta −0.011 −0.006

11 We own a portfolio which has 20 000 shares of ABC. If we want to set up a vertical
spread by combining a sale of the call and a purchase of the put, what will the remaining
delta sensitivity of the portfolio be if we sell 120 calls and buy 80 puts?
A. 13 976.
B. 12 980.
C. 23 900.
D. 16 100.
12 Given the position in Question 11, what will be the position gamma of the overall
portfolio made up of the shares and the two options positions?
A. (300).
B. (71).
C. 71.
D. 300.
13 What will the position theta (that is, exposure to time decay) of the option positions
be?
A. (48).
B. (180).
C. 180.
D. 84.
14 Which of the following correctly describes a stack hedge?

A. A minimum-variance hedge designed to match the (coefficient of determina-
tion) of an underlying position.
B. A series of futures contracts with sequential maturity designed to match an
underlying position.
C. A second or tertiary hedge designed to eliminate adverse rotational or twist
effects in the yield curve on the hedged position.
D. The procedure of setting up and then rolling forward short-term derivatives
positions to hedge a longer-term exposure.
Strike price Calls Puts

1.670 1.53 2.45 2.96 0.47 1.63 2.41
1.680 0.91 1.92 2.51 0.86 2.10 2.86
1.690 0.51 1.48 2.07 1.46 2.63 3.44
Spot rate = US$1.6715/£.
15 Which of the following is the break-even rate from buying the February 1.680 calls?
A. $1.655
B. $1.705
C. $1.429
D. $1.680

16 If we set up a currency cylinder (that is, a vertical spread, involving a purchased and a
written option) based on the above in which we wish to hedge a sterling payable, which
of the following transactions will achieve the correct exposure?
A. Buy £ call with a low strike price and sell another £ call with a higher strike
price.
B. Buy £ call with a low strike price and sell a £ put with a higher strike price.
C. Buy £ put with a high strike price and sell another £ call with a lower strike
price.
D. Buy £ put with a high strike price and sell a £ put with a lower strike price.
17 A commodity not subject to deterioration has a storage cost of 6 per cent per annum
and is trading in the cash market at a price of 640.50. The term structure of interest
rates is flat at 12 per cent. The prices of two forward contracts on the commodity in six
and nine months will be which of the following?
A. 677.8 and 697.3
B. 695.8 and 725.2
C. 659.4 and 669.1
D. 755.8 and 755.8
18 Which investment strategy is represented by the following payoff diagram?
A. Strangle.
B. Straddle.
C. Ratio put spread.
D. Bearish vertical spread.
19 The ____ of a ____ option will ____ the premium on the option when the transaction
is initiated and (if it is exercised) will ____ the underlying asset at the agreed strike
price. Which of the following correctly completes the sentence above?
A. writer put pay sell
B. holder put pay buy
C. writer call receive sell
D. holder call receive buy

20 If the correlation between a hedge and a portfolio is +0.89 and the standard deviation of
the hedge is 0.24 and that of the cash position is 0.25, which of the following is the
minimum-variance hedge ratio?
A. 0.98
B. 0.93
C. 0.96
D. 0.91
21 You are the Chief Financial Officer at ACME International and your firm is looking to
buy a machine that costs US$10 million in six months’ time from Machines Inc. They
currently have machines available but are indicating that demand for the equipment may
be such that they may not be able to deliver in six months’ time. You are concerned
about the pricing and availability of the machines but the company will not have the
money to purchase the machines until six months from today. You estimate that the
price could rise to US$11 million or fall to US$9 million over the period and the current
cost of borrowed money is 6 per cent per annum.
What is the maximum price you would be willing to pay to Machines Inc. to guarantee
availability in six months’ time at the US$10 million price?
A. US$629 214.
B. US$485 643.
C. US$287 141.
D. US$562 922.
22 You work for Corn Supplies plc, a major distributor of cereals, and note that the spot
price of wheat is US$3.67 per bushel and that the futures price for wheat with a one-
month expiry is $3.79/bushel. Your cost of carry is US$0.15 per bushel. Which of the
following actions should you take?
A. You should buy futures.
B. You should sell futures.
C. You should buy futures and sell wheat spot.
D. You should sell futures and buy wheat spot.
23 You currently own 310 shares in ABC plc at £215. Sammy Smile, your relationship
manager at Global Investment Bank, has proposed the following transaction to you. He
will exchange the above holding for ten Treasury bills with a face value of £1000 with a
current market price of £990.10 and 300 calls on ABC plc with a strike price of £50. At
the moment, there are no calls with a £50 strike price, but puts are being traded with a
£50 strike at £22 each.
Which of the following is the gain, or loss, from undertaking this transaction?
A. £8902.
B. £1099.
C. (£1099).
D. (£499).

24 Which of the following is correct? A cap is a generic risk-management transaction that

consists of:
A. a short position with a purchased call.
B. a package made up of a series of call options with sequential expiry dates.
C. a dynamic replication programme designed to provide a maximum value over
time.
25 A fund manager is concerned that the current rally in the market will be reversed and
wants to hedge a portfolio of £50 million with a beta of 1.3 against a possible market
decline. The current level of the index is 2900 and there are index puts available with a
strike price of 2500 with a delta of −0.38. Each put is worth £10 times the index level.
Which of the following represents the number of puts required to hedge the portfolio?
A. 2241.
B. 2900.
C. 5898.
D. 6842.
The following information is used for Questions 26, 27 and 28.
Strike Calls Puts

5075 113 190 255.5 48.5 104 142.5
5125 82 158 244 67 122 159.5
5175 56 129 195 91 142 180
5225 25.5 104 168.5 120.5 167 203
5275 23 81.5 144.5 157.5 194 228.5
5325 13 61.5 122.5 197.5 224 256
26 Which of the following is the break-even price for a buyer of a January 5175 put?
A. 5175.
B. 5033.
C. 5317.
D. 5125.
27 Which of the following is the gain or loss for a writer of a 5225 February call if the
index expires at 5269?
A. (£440).
B. (£2125).
C. £1245.
D. £2125.

28 Which of the following is the maximum profit per contract that can be made by setting
up a bearish vertical spread using the February 5125 and 5225 options?
A. £435.
B. £1000.
C. £565.
D. £1019.
29 A convertible bond is a debt security which gives the holder (that is, the investor) the
right to exchange the bond for shares in the company at a fixed conversion ratio. For
instance, one bond worth $1000 could be exchanged for 100 shares. If one were to
value such a bond, we could conceptually break its value down to which of the follow-
ing?
A. A debt security issued by the firm plus a put option on the firm’s shares where
the payment of the exercise price means surrendering the debt security to the
company in payment.
B. A debt security issued by the plus a call option on the firm’s shares where the
payment of the exercise price means surrendering the debt security to the
company in payment.
C. A standard call option on the firm’s shares plus a deposit to cover the exercise
of the option.
D. A standard put option on the firm’s shares plus a deposit to cover the exercise
of the option.
30 If a market participant would want to exploit an increase in the volatility of the

underlier, which of the following transactions would achieve this objective?
A. A long position in a forward contract on the underlier.
B. A position with a negative vega.
C. A position with a positive gamma.
D. A short position in a call combined with a short position in a put.
Case Study 1
Builder Bank has been offered the opportunity to buy some triple-B rated US dollar bonds
issued by Widget Industries plc of the United Kingdom. The bonds are fixed rate with an
annual coupon of 6 per cent and have exactly five years to maturity. The bonds are being
offered at 84.837. The internal rate of return on the bonds is 10 per cent. Unfortunately,
Builder Bank, although interested in the opportunity, would like to have a floating-rate asset.
However, Fast Track Investment Bank has offered to repackage the bonds as a synthetic
floating-rate note. The deal is as follows: Builder Bank will provide $100 for each bond
purchased and will receive LIBOR, as the floating rate, plus 0.20 per cent in return for the five
years, plus $100 in principal repayment at maturity. The terms and conditions in the US dollar
interest-rate swaps market are as follows:
Maturity 1 year 2 years 3 years 4 years 5 years

Par swaps rate 9.50% 9.59% 9.62% 9.69% 9.70%

1 Explain why Builder Bank would wish to hold a floating-rate asset issued by Widget
Industries plc rather than the fixed-rate bonds.
[4 marks]
2 Analyse the synthetic floating-rate offer for value. Is the transaction a reasonable one
from Builder Bank’s perspective or is Fast Track Investment Bank using its superior
know-how to exploit the bank?
[16 marks]
3 Two years have now passed. Interest rates have dropped and the new swaps curve is as
given in the table below. Also Builder Bank has reviewed its investments and would like
to unwind the synthetic floating-rate note created by holding Widget Industries plc
dollar bonds and sell off the holding. The bonds are now trading at 93.18. The new par
swaps yield curve is as follows:
Maturity 1 year 2 years 3 years
Par swaps rate 8.25% 8.38% 8.45%
What is the new value of the package and will Builder Bank make a profit from unwind-
ing the synthetic transaction?
[20 marks]
Case Study 2
Waverley Fund Managers have a portfolio invested in the UK equity market with a current
value of £150 million. This fund has an above-average market risk with a beta (β) of 1.30. The
managers are concerned that, over the immediate term, the equity market might fall. Howev-
er, they do not wish to disinvest the portfolio since they are comfortable with the individual
characteristics of the shares. As a result, they have decided to buy protective puts.
1 Describe the elements and implications of adopting such a strategy.

[6 marks]
2 The current FT-SE index level is 4800. The index has a dividend yield of 3 per cent per
annum. The risk-free interest rate is 7 per cent. The index volatility is 25 per cent.
What is the value of a European-style exercise index put with a strike (or exercise)
price of 4400 and a three-month expiry?
[14 marks]
3 What proportion of the fund must be sold and invested in the puts so that the fund is
insured against a decline in the market? Each put is worth £10 per full index point.
[14 marks]
4 What actions – if any – do Waverley Managers need to take over the life of the puts to
maintain the effectiveness of the hedge?
[6 marks]

Case Study 3
The following are the short-term interest rates in the money markets (expressed as simple
interest rates).
Months 1 2 3 4 5 6 9 12
Interest rate 6.25 6.30 6.35 6.40 6.45 6.50 6.60 6.75
Assume each month is an equal fraction of a year.
1 At what rate would a market maker quote a 3 v. 9 forward rate agreement (FRA)?
Explain your reasoning.
[10 marks]
2 Suppose you are the bank counterparty to the customer wishing to fix the FRA rate
against a future borrowing in part one, that is the customer has bought the FRA, what
position in the cash markets should the bank adopt to hedge out its interest rate risk?
[10 marks]
3 What is the value of a call option on the forward rate agreement contract where the
FRA has a value of 1 million, if the volatility is 25 per cent and the strike price is set at-
the-money (that is at the rate determined in Part 1)?
[20 marks]

Examination Answers
Examination One
1 The correct answer is C. The calculation is:

$
= ln + (.08 + .02)(.5) /.5 = .2022
$ .
2 The correct answer is C. The legal term ‘contract for differences’ indicates that the
value of the contract is based on a fixed value against a variable market value at the
maturity of the contract. All derivatives obtain their value from setting a fixed price
at the onset of the contract against which the derivative gains or loses value until
maturity or expiry.
3 The correct answer is C. The basis is the difference between the cash price and the
futures price (cash−futures). At the start the basis = $2125 − $2386 = (261). After
a couple of days the basis = $1995 − $2248 = (253). So the basis has strengthened.
Note: if we assume convergence in three months’ time, we would expect the basis to
change (in a crude linear approximation) by 3 per day. So we might have expected
the basis to decline by 6, but it has in fact declined by 8.
4 The correct answer is D. The correct description of the value basis is D: − . It

is the difference between the actual futures price ( ) and the fair or theoretical
price ( ) computed using the cost-of-carry model.
5 The correct answer is B. From the perspective of the party which is contracted to
pay currency A and receive currency B, there has been a gain on the exchange rate, a
gain from changes in interest rate A but a loss from changes in interest rate B. Note
that the other party’s gains and losses will be reversed.
6 The correct answer is B. To find out the answer, we can solve the binomial equation
directly for the amount of borrowed funds or apply the funds equation. The two
equations representing an increase or decrease in the asset price give us:
250 + 1.04 = 20
210 + 1.04 = 0

The option’s delta = 0.50[(20 − 0)/(250 − 210)] The amount of borrowed funds B
is therefore 210(0.5)/1.04 = , which gives 100.96. We could have calculated this
using the equation:
−
= ( )
( − )
210(20) − 260(0)
=
(1.04)(250 − 210)
= 100.96
7 The correct answer is D. For a delta/gamma hedge, we require that the deltas and
the gammas of the two sides are equal and of opposite signs.
8 The correct answer is B. With all other factors remaining constant, if we decrease
the underlying asset’s volatility then the prices of calls and puts will fall.
9 The correct answer is A. To calculate the present value of the payments which are
semi-annual, we need to work out the implied rates for the three future periods.
These can be calculated as:
( ) ( )
1+ ( ) 1+ = 1+
The values of the payments are calculated as in the following table:
Floating
Zero-coupon payment per
Time rate Floating rate 100 nominal Present value
0.5 6.20% 6.107 3.0535 2.963
1 6.15% 6.010 3.0050 2.831
1.5 6.00% 5.622 2.8110 2.576
2 5.90% 5.524 2.7620 2.463
10.833
Remember that a zero-coupon rate is the annualised rate, so for the half-year
payment, we need to convert the rate to the semi-annual alternative.
10 The correct answer is D. The calculation of the fixed side of the swap requires us to
equate 13.15 = ∑PV(floating payments) = ∑PV(fixed payments). We know that
13.15 is the PV of the floating payments. We can calculate the annuity for the 2.5
years by summing the discount factors for the zero-coupon rates for the 5 interest
periods. This equals 4.589. Therefore (13.15 ÷ 4.589) × 2 = 5.73%.
11 The correct answer is A. The delta sensitivity of the alternatives is given in the
following table:
Alternative Action Delta sensitivity

A Buy puts −
B Sell puts +
C Buy calls +
D Buy the underlying asset +

Of the four possible actions, A, buying puts, decreases the delta of the position. All
the other actions have a positive delta sensitivity and hence reduce the delta of the
position. So A is the right answer in that it does not achieve the result of increasing
the delta.
12 The correct answer is C. To work out the value of the swap, we need to revalue it in
line with current market conditions. The table below shows the initial value and the
current value at the prevailing exchange rate.
Time Exch. rate US dollars Deutschemarks Time Exch. US dollars Deutschemarks
rate
Initial valuation Revaluation
3 1.553 −10 000 000 15 530 000.00 2 1.564 10 000 000 −15 640 000.00
6 1.54 10 000 000 −15 400 000.00 5 1.553 −10 000 000 15 530 000.00
130 000.00 (110 000.00)
The swap had an initial value of DM130 000 (ignoring interest, etc.). The revaluation
in which the transaction is notionally reversed shows that the swap has a negative
value of DM110 000 if closed out after one month. Summing, the result is a positive
value of DM20 000 on the swap.
13 The correct answer is B. In deciding the correct exposure to create, we have the
following initial exposure: +Swiss Francs/–Australian dollars. We want to hedge
this exposure using currency futures, so that we have a hedge giving –Swiss
Francs/+ Australian dollars. The sensitivities of the two futures contracts are:
Sensitivity Swiss Franc futures Australian dollar futures

Long position +SFr −US$ +AUD −US$
Short position −SFr +US$ −AUD +US$
We can check this quickly by a simple example. If the Swiss Franc is SFr1.75/$, the
futures contract is 0.5714. If the dollar depreciates to SFr1.65/$, the futures
contract becomes 0.6061.
To neutralise the cross-exposure, we sell Swiss Franc futures and buy Australian
dollar ones. This gives a spread relationship:
−SFr/+US$
+AUD/−US$
The dollar element washes out, to give us −SFr/+AUD, the required sensitivity for
our hedge.
14 The correct answer is B. The pseudo-American adjustment for dividends involves
calculating the option price to the ex-dividend date and to expiry to determine
which is the more valuable. The higher price is then taken to be the option price.
Note that this adjustment slightly undervalues the American-style option since the
holder does not need to decide to exercise up to the ex-dividend date.

15 The correct answer is C. If the bank wants to hedge out its currency and interest-
rate risk, it will borrow the currency it is due to receive in the forward market
(sterling), exchange this in the spot market for the currency it is due to pay away (US
dollars) and invest these to the maturity of the transaction.
16 The correct answer is C. Fundamental financial instruments are those securities issued
by firms in order to raise capital and borrow money, that is, the source of their
funding. They are necessary instruments for firms to engage in economic activity,
hence their fundamental nature.
17 The correct answer is D. The attraction of over-the-counter contracts is that they
offer a wide range of underlying assets on which contracts can be written and an
unlimited range of expiry dates in comparison to exchange-traded contracts. This is
due to the fact that they are bilateral agreements entered into directly by the two
parties. However, this leads to each side taking on unlimited credit risk with the
other.
18 The correct answer is C. The value of the subsidy in sterling will be the difference in
the interest cost at-market of 5.2 per cent and at the subsidised rate of 4.3 per cent.
This comes to US$632 347. We need the sterling amount, which is US$632 347 ÷
1.60 = £395 217.
19 The correct answer is A. The total sterling amount will be US$25 000 000 −
US$632 347, being the present value of the subsidy, divided by $1.6 = £15 229 783.
The annual payments = £15 229 783 ÷ 4.1557 = £3 664 812.
20 The correct answer is A. Unlike a terminal instrument, an option does allow the user
to decide at what rate to hedge and, if market conditions should so indicate it allows
the holder to let the contract lapse, giving the user the choice of the better of the
market price or the contracted rate at expiry.
21 The correct answer is C. To decrease (rather than increase) the portfolio’s exposure
to the market, futures will need to be sold. The formula for determining the correct
number of futures will be:
Value of portfolio
= −
Substituting, we have:
US$230 000 000
= (0.70 − 0.95)
980 × 250
This gives 234.7. So we need to sell (short) 235 contracts.
22 The correct answer is B. A replicating portfolio is a package of securities and
borrowing and lending designed to give the same payoff as another financial
security.
23 The correct answer is B. The implied cost of carry for copper is: − = $1300 −
$1200 = $100. The implied storage cost = ( − ) ÷ − = 0.08 − 0.06 = 0.02.
24 The correct answer is D. We want to set up an arbitrage to receive the higher-priced
asset, in this case the forward price in Deutschemarks (the interest-rate parity
forward price = DM1.7359). So we borrow DM and invest spot in dollars and

contract to pay dollars and receive Deutschemarks forward. The resultant benefit is
shown in the following table:
Currency Spot Forward

US$ (0.971285862) (1) + 1 = 0
DM 1.702178474 Borrowing (1.7359)
FX forward 1.7395
Net gain: 0.0036
25 The correct answer is C. A stack hedge is a futures hedge where a long-dated

exposure is hedged with the nearby contract. As time passes, the futures contracts
are ‘rolled forward’ and their number reduced to balance the remaining exposure
over time.
26 The correct answer is A. Standard options which provide insurance against adverse
price (or market changes) can be used to manage the risk of increased price volatility
for the commodity sold by the firm (B), to counteract the effect of an embedded
option, such as a put provision in a bond (C) and to provide currency protection
against the risk when making a competitive tender in a foreign country (D). So A is
not a situation where a standard option (price protection option) is an appropriate
risk-management instrument.
27 The correct answer is C. In a weakening of the basis, the cash price increases less or
falls more than the futures price and since we are short, we make money.
28 The correct answer is D. A protective put strategy requires the change in the value
of the puts to balance the change in value of the portfolio. The relationship is:
Position (portfolio) value 1
= ·
Index value Option delta ( )
Substituting the values given in the question, we have:
£25 000 000 1
= 1.10 ×
£10 × 5900 −0.45
This comes to 1035.78. We need to round up to 1036 since part-contracts cannot be
purchased.
29 The correct answer is B. A payoff profile from the diagram can be created by either
selling a call or selling short the underlying asset and selling a put.
30 The correct answer is B. The current forward price for the asset will be 236 ×
(1.06) . = 242.98. This gives a difference of 2 from the original contract value.
Case Study 1
1 SteamGas is facing transaction exposure since it has a payable (a cash outflow in
three years) in Deutschemarks whereas its operational, base or reporting currency is
sterling. As a result, if the company does not hedge the exposure:

 the company will make a gain if sterling appreciates against the Deutschemark
over the exposure period;
 the company will make a loss if sterling depreciates over the period.
The exposure can be illustrated graphically using a risk profile:
Gain
Sterling depreciation
against the DM
DM/£
2.10 2.30 2.50 2.70 2.90
Sterling appreciation
against the DM
Loss
The extent of the possible loss will be dictated by how far sterling might have
moved away from the current spot rate (DM2.50/£).
Hedging is designed to eliminate a particular sensitivity by creating a two-asset (or

instrument) portfolio where the hedge instrument has the opposite sensitivity. In
this case, the requirement to pay Deutschemarks (−DM) is offset by holding a
forward contract with (−£/+DM). The result is as given in the following table:
Before hedg- After hedging

ing
Original exposure DM payable: hedge (for- −DM −DM
ward foreign-exchange contract)
Combined result (desirable exposure) £
£
Examiners’ comments on Case Study 1, Question 1

Module 5 of Financial Risk Management is devoted to the nature of currency risk:
an example of the problem of transaction exposure is provided in section 5.3.1.
This question also combines elements from Module 1 of Financial Risk Manage-
ment, where the risk profile and concept of exposure and sensitivity are discussed,
with the common risk-management practice of hedging. Additional material is

given at the start of Module 11 and, for the assessment steps firms need to make
when identifying exposures, at the start of Module 12.
2 A forward contract is a bilateral agreement where the two parties agree the price at
which to buy or sell an asset, instrument, currency, commodity, deposit, product or
security at some mutually agreed date in the future.
The two parties, known as counterparties, will agree at the outset the price – or rate,
the amounts, delivery conditions and other elements that define their benefits and
obligations. Both parties are contractually committed to perform under the agree-
ment regardless of what happens to the market price of the elements of the
exchange. This means that there is an incentive for one or other party not to
perform if, by not doing so, they would be better off. Consequently, forward
contracts are subject to performance risk.
Forward contracts are introduced in Module 2 when the derivatives building
blocks are introduced. Module 3 covers forward contracts in detail: the use of a
currency forward is used to illustrate the nature of the forward contract in
Section 3.2.
A complete answer should make reference not just to the specific elements of
the contract, but also to its bilateral nature and the problem of counterparty
risk in such bilateral contracts.
3 The forward exchange rate for the long-term foreign exchange transaction (LTFX)
is derived using:
1+ ( )
=
1+ ( ) ( )
where and are the appropriate interest rates for the foreign and domestic
currencies. To find the appropriate currency, we need to have the zero-coupon rate
(spot interest rate) for the currency pair. Since there is a bid-offered spread on the
LTFX, this involves four calculations:
1. Sterling offered rate
Time Par yield Zero-

period + − × coupon
rate
1 6.00 1.06 0 0.9434 6.00%
2 6.25 1.0625 0.9434 1.8291 0.94104 6.2578%
3 6.375 1.06375 1.8291 2.6596 0.88340 6.3885%
The value of the zero-coupon rate (spot rate) for Year 2 is computed by:
(1.0625/.94104)0.5 .
The price relative for the three-year period = (1.063885)3 = 1.20416 (offer).

2. Sterling bid rate

rate
1 5.875 1.05875 0 0.9445 5.875%
2 6 1.06 0.9445 1.83443 0.94333 6.0037%
3 6.125 1.06125 1.83443 0.88764 6.1354%
The price relative for the three-year period = (1.061354)3 = 1.19559 (bid).
3. Deutschemark offered rate

rate
1 5.75% 1.0575 0.94563 5.75%
2 5.88% 1.05875 0.94563 1.83766 0.94444 5.8787%
3 6% 1.06 1.83766 2.67704 0.88974 6.0102%
The price relative for the three-year period = (1.060102) = 1.191359.

4. Deutschemark bid rate

rate
1 5.625 1.05625 0 0.94675 5.625%
2 5.625 1.05625 0.94675 1.84308 0.94675 5.625%
3 5.75 1.0575 1.84308 0.89402 5.7574%
The price relative for the three-year period = (1.057574)3 = 1.182855 (bid).
The two forward points for three years will therefore be:
 borrow sterling and invest in Deutschemarks:
2.50 × 1.182855/1.20416 = 2.4558
 borrow Deutschemarks and invest in sterling:
2.50 × 1.191359/1.19559 = 2.4912
This result shows that SteamGas would need 100 000 000/2.4558
= £40 719 928 to meet its payable obligation.
If, on the other hand, it uses the bank’s quote, it would need
100 000 000/2.4750 = £40 404 040
The bank’s quote allows the company to achieve its risk reduction objective at less
cost (and saving £315 888).


The pricing model for forward exchange – regardless of its maturity – is via
interest-rate parity (or pricing through hedging). To compute the price, we need
to derive the appropriate zero-coupon interest rate for the period. Forward
pricing is covered in Module 3. The interest-rate parity model is described in
Module 5 of Financial Risk Management, section 5.2.1.
The calculation of the zero-coupon rates is a numerical exercise that, once
done, can be quickly repeated for the three other cases (taking care not to
make mistakes). The methodology is given in Module 10 of Financial Risk Man-
agement in Appendix 10.1, ‘Bootstrapping Zero-Coupon Rates from the Par
Yield Curve’. Another example is given in Module 5 in the examination of zero-
coupon swap pricing.
Note that the zero-coupon rates can be derived using the less computationally
efficient method shown in Module 10 of Financial Risk Management, Section 10.3.
No marks would be deducted if this approach had been used. However, since
the deposits are ‘par bonds’ the method given in the model answer can be used.
It takes less time and is less prone to error.
Note that the bank’s quote allows you to check the reasonableness of your
answer. If, as explained in the next answer, you understand the nature of the
transaction, you would expect the results given in the model answer.
4 The bank is quoting DM2.4750 − 2.4900 versus a computed (cash) alternative of
DM2.4558 − 2.5000.
The bank is willing to offer a narrower bid-offer spread since the amount of credit
risk in the forward transaction is less than that from lending to the company. The
bank’s risk is that it will have to replace the contract if SteamGas becomes insolvent
(bankrupt) prior to the forward’s maturity. Its loss (assuming there is no recovery)
will be the difference between the original price and the new price at which the bank
can offset its now defunct forward commitment. This will be less than the full
amount of the contract. The price movement will depend on:
(a) changes in the spot rate over the intervening period; and
(b) changes in the interest rate differentials for the remaining period.
Of the two, movements in the spot rate create the most risk.
Of course, the bank is likely to ‘check out’ SteamGas as an acceptable counterparty
by assessing the company’s creditworthiness before agreeing to the LDFX transac-
tion.
The discussion of credit risk in forward contracts is covered in Module 2 in the
introduction to the risk-management building blocks. The issue is also addressed
in detail in other modules in this course: Module 3 on forwards, the case in the
answer, and also in Modules 4 and 5 on Futures and Swaps. The problems of
default and replacement cost are not specifically addressed in detail for currency
forwards. The issue is, however, covered in Module 5, Section 5.6 for swaps

(another product which is subject to significant counterparty risk), and the

issues are identical.
5 SteamGas, unless there are particular reasons for not doing so, is likely automatically
to favour the LDFX forward. One reason is that it is saving £315 888 by using the
forward. Another is that it is ‘off-balance sheet’ and does not affect borrowings or
create problems with deposits, etc. Forward contracts were invented to avoid the
problems of having to use cash instruments before their due date. They address a
fundamental economic need to ‘lock in’ prices ahead of delivery dates.
The nature of ‘off-balance-sheet’ instruments is discussed in Module 2 on
financial risk-management building blocks, as well as elsewhere. Price, although
important, is often not a paramount consideration in any arrangement. When
price and convenience merge, as they do with a forward contract, then this
solution is likely to dominate the alternatives.
Case Study 2
1 There are two states of the world and two unknowns, hence:
105 + 105 = 99.06
120 + 20 = 50
We solve for 2:
105 + 105 = 99.06
−105 + 17.5 = 43.75
87.5 = 55.31
= 0.6321
We solve for 1 knowing 2:
105 + 105 × 0.6321 = 99.06
105 + 66.37 = 99.06
105 = 99.06 − 66.37
105 = 32.69
= 0.3113
The two state specific discount factors are for state one = 0. 3113 and state two =
0.6321. The risk-free discount rate = 0.9434, that is 6 per cent {[(1/.9434) − 1] ×
100%}.
The values for the pure-state contingent securities A and B with a payoff of 1 are
therefore:
State
Security Price 1 2
State A .3113 1 0
State B .6321 0 1
.9434


We could have got the same risk-free result by dividing 105 (the payoff of the
safe security by its present value 99.06 = 1.06, i.e. a return of 6 per cent.
Knowing 2 and the risk-free interest rate would allow you to back-out by
subtraction but it is better to calculate both the state discount factors separately
and then add them up. They should come to the risk-free discount factor. If not,
then there is a mistake in the calculation of these state discount factors and the
result should be checked.
2 We need to apply the replicating portfolio approach so that:
Portfolio to provide payoff in state one of 1 unit of currency:
+ (1 + ) = 1
+ (1 + ) = 0
and portfolio to provide payoff in state two of 1 unit of currency:
+ (1 + ) = 0
+ (1 + ) = 1
The delta for the portfolio for state one contingent payoff will be:
1−0
= = .01
120 − 20
The delta for the portfolio for state two contingent payoff will be:
0−1
= = −.01
120 − 20
The amount of borrowing at t=0 for the state-one contingent security will be:
= 20 × .01 = .2 = (1 + )
= . 1887
The value of the replicating portfolio at t = 0, for the state one contingent security
will be:
. 01 × 50 = .05 − .1887 = 0.3113
[Note this is the same result as we obtained in part one for the state contingent
security.]
For the second state contingent security, we need to be able to payoff 1 at expira-
tion, so the amount of lending at t=0 will be:
= 20 × .01 + .2 = 1.2 = (1 + )
The present value of the lent amount will be: 1.1321
We can sell .01 of Security A = 0.5, so the net cost of the replicating portfolio at t=0
will be: 1.1321 − 0.5 = 0.6321
[Again this is the same result as we obtained in part one.]

3 We need to provide a top-up to the performance of security A such that:
State of the
world
State 1 2
Security A payoff 120 20
Guarantee 30
Resultant payoff 120 50
There is a simple way of pricing this:

It is simply 30 units of the state two payoff security with a present value of .6321. So
the value is:
30 × .6321 = 18.96
Alternatively, we can price the guarantee, which – as the table shows – is simply a
put option, directly using the approach in part 2 treating the guarantee as a put
option with a payoff of 30, if state two occurs.
The required payoffs are:
+ (1 + ) = 0
+ (1 + ) = 30
0 − 30
= = −0.3
120 − 20
The pricing of the security will be such that:
= 20 × .30 + 30 = 36 = (1 + )
The present value of the lent amount will be: 33.96
We can sell .3 of Security A = 15, so the net cost of the replicating portfolio at t=0
will be: 33.96 − 15 = 18.96
Understanding that the guarantee is essentially a package of single unit payoff
contingent claims (in essence a package of binary or digital options) means that
obtaining the right price for the guarantee is relatively easy. While in this
question the result is relatively straightforward, a candidate should be on the
lookout, by studying the course material carefully and fully understanding its
contents, for similar ‘shortcuts’ in other situations.
Case Study 3
1 To price the option, we can use the Black–Scholes model and adjust for the known
dividends. The asset value for the model with known value leakage must adjust the
index (asset) level for the loss in value over the option period. This is:
∗ = − 25 − 70 − 48
∗ = 4500 − 24.875 − 69.304 − 47.285
∗ = 4358.536

We can now price the option. The inputs are:
∗ 4358.536
4600
( − ) 0.25
0.06
0.30
0.09
2.71828
The option pricing model is:

= ∗ ( )− · ( )
where 1 and 2 are:
∗
ln +[ + ]( − )
= 2
( − )
= − ( − )
4358.536 0.09
ln + [0.06 + ]0.25
= 4600 2
0.3√0.25
−0.05392 + 0.02625
=
0.15
= −0.18447
= −0.18447 − 0.15
= −0.33447
We now need to find ( ) and ( ) from the table:
(−0.18) = 0.42858
(−0.19) = 0.42465
Interpolating between the two, we have ( ) = 0.42682
(−0.33) = 0.37070
(−0.34) = 0.36693
and ( ) = 0.36901
Substituting into the Black–Scholes top equation, we have:
. × .
= 4358.536(0.42682) − 4600 (0.36901)
This gives a value for the call of 188.135 in index points. The price per put is
therefore £1881.35 since each point is worth £10.
2 To hedge out the market risk, John Smith needs to solve the equation:
= Portfolio value ÷ Index value

The share portfolio = £1.25 × 400 000 = £500 000 and its beta is 0.90.
The index value, adjusted for the known loss of dividends, is 4358.536. The value is
£10 per point.
The equation is therefore:
0.90 × £500 000 ÷ £43 582.36 = 10.32
Part-contracts cannot be bought, so Smith will want to hold 10 call contracts.
3 The initial stage is to reprice the puts. Now there are only two months to go and so
we have a new, adjusted value for the index (I*):
∗= 4350 − 70 − 48
∗= 4232.827
The new option value is:
4232.827 0.09
ln + [0.06 + ]0.1667
= 4600 2
0.3√0.1667
−0.08319 + 0.0175
=
0.122474
= −0.53633
= −0.53633 − 0.122474
= −0.6588
We therefore have ( ) and ( ) as 0.29587 and 0.25501.
The call value is:
. × .
= 4232.827(0.29587) − 4600 (0.25501)
This gives a value for the call of 90.97. So each call is worth £909.70.
We can now work out the economics of the transaction. The change in value of the
portfolio and the calls is given as:
Time Value of the portfolio Value of calls (N = 10)

Initiation 400 000 × £1.25 = £500 000 Put value = £1881.35 × N = (£18 881.50)
After 1 m 400 000 × £0.98 = (£392 000) Put value = £909.70 × N = £9097.00
Result £108 000 (£7215.50)
The net gain is £108 000 − £7215.50 = £100 784.50. Therefore John Smith is ahead
on his investment!
4 The binomial option model assumes that for a given step, the price can only
increase or decrease at a given rate. The option period is sub-divided into an
appropriate number of steps to provide an accurate estimate of the option’s price.
The tree of prices is then used evaluate numerically the option at each point in the
lattice. For an option subject to value leakage, it is possible to adjust the option price
explicitly at each point for the loss of value from a dividend or other payment at the
required point in such a way that the lattice has a lower value thereafter.

If we have a four-stage lattice and the asset price is expected to change by two per
stage and we anticipate a dividend of five in Period 3, the unadjusted and adjusted
lattices look as in the following figure.
108
Lattice with price change of 2 106
with no value leakage
104
104
102 102
100 100 100

98 98
96 96
94
92
103
Lattice with price change of 2
with no value leakage of 5 at 106
period 3
104
99
102 102
100 100 95
98 98
96 91
94
87
Examination Two

1 The correct answer is A. A notional bond is the theoretical bond used in long-term
interest-rate-futures (or bond-futures) contracts.
2 The correct answer is B. An arbitrage exists when there is a replicating transaction
that either at the onset or at maturity can be executed in such a way that there is no
net investment of funds. If borrowing and lending can take place, and if one
element of the alternatives is mispriced then an opportunity exists for a riskless gain.
The arbitrage to undertake is given in the following table:
Transaction Time = 0 Time = 1
year
Issue 1-year bond in ratio 89.00/95.24 = 0.9345 89.00 (93.45)
Buy 2-year bond at (89.00)
Sell 2-year bond forward at 94.00 94.00
Net difference 0 0.55

1. Issue the one-year bond in the ratio of 89.00/95.24 = 0.9345 nominal to get
enough to buy the two-year bond.
2. Sell the forward contract and enter into the obligation to deliver the bond in one
year’s time for (0.9345 time the face amount = 94.00).
3. Hold the two-year at 89.00 to give 94.00 from selling the forward contract.
4. The net position in one year is to receive 94.00 from selling the contract and use
the proceeds to redeem the one-year bond at 93.45.
5. The net gain is 0.55 of the investment, without incurring any interest-rate risk
since all the elements of the transaction are determined at the onset.
Note that, if you understood the nature of the price relationships, calculating what
the two-year bond is worth in one year’s time at the current market rate of interest
of 6 per cent will tell you which of the transactions will make money – if any: 89.00
× 1.04 = 93.45. Hence the forward contract is trading dear to its fair value, that is,
prices for interest-rate-sensitive securities being inversely related to yields. Under
these circumstances, the arbitrage transaction involves selling the expensive element
– the forward.
3 The correct answer is C. The prices of the bonds are used to derive the price
relatives:
1000
A= = 1.0601
944.33
1000
C= = 1.2423
804.96
The implied forward interest rate for one year in one year’s time = 1.2423
÷ 1.0601 = 1.17186. The annualised rate = [(1.17186) . − 1] × 100% = 8.25%.
4 The correct answer is A. The duration of the portfolio can be found by adding the
weights of the various bonds times their maturity, since the Macaulay’s duration of a
zero-coupon bond is equal to the bond’s maturity and dividing the total by the
present value of the portfolio:
1 × 2000 + 2 × 4000 + 3 × 4000
= 2.2 years
10 000
5 The correct answer is A. An amortising swap will reduce the amount of notional
principal, in the case of an interest-rate swap, and the actual principal in the case of
a cross-currency swap over the swap’s life. To do this, we need a series of swaps
with the same start date but different maturity dates, reflecting the points at which
the principal amount is stepped down.
6 The correct answer is D. The put–call parity theorem defines the following
relationship:
( )+ = +
Rearranging the equation, we can derive D, where − ( ) + = .
7 The correct answer is D. While arbitrage of derivatives using cash market
instruments does take place, a number of real world problems arise that can lead a
market participant to forego the a possible profit opportunity. These can relate to
simplifications in the models used for pricing derivatives which mean that the price
derived from the model and what actually might occur may deviate (A), differences

in the timing between the cash flows on the derivative and the replicating portfolio
(B), and differences in the way taxation authorities treat gains and losses on the
replicating portfolio and the derivative (C).
8 The correct answer is A. Hedging, in the context of derivatives markets, can be
considered a special case of risk reduction. With risk reduction a proportion of the
risk is managed through appropriate trading in derivatives. Hedging seeks to
eliminate all of the underlying market risk.
9 The correct answer is A. A delta/gamma neutral strategy will require the existing
gamma (or rate of change in delta) to be neutralised. The position is short 1100
gamma: to neutralise this, we buy options (giving a positive gamma): 1100 ÷ 1.25 =
880. So we buy 880 of the delta 0.55 options. By doing this, we unbalance the delta
of the position, so we now need to adjust the position in the underlying. We have
bought options so need to sell (delta × underlying per option) = 880 × 0.55 = 484
of the underlying asset.
10 The correct answer is C. There are two possibilities in insuring a long-asset position
against unfavourable outcomes (that is, price declines). By buying puts, the holder
has the right to sell the assets at a guaranteed minimum price. An alternative strategy
is to sell calls. If the price declines, the call price falls and can be repurchased at a
lower price. This second strategy works best for small declines in the price.
11 The correct answer is B. The sensitivity of the portfolio will be:
Element Position delta

Shares 20 000
Written calls 120 × 100 × −0.455 = (5460)
Purchased puts 80 × 100 × −0.195 = (1560)
Net position 12 980
12 The correct answer is A. The gamma sensitivity of the portfolio will be:
Element Position gamma

Shares 0
Written calls 120 × 100 × −0.0396 = (475.2)
Purchased puts 80 × 100 × 0.0219 = 175.2
Net position (300)
13 The correct answer is D. The theta sensitivity of the portfolio will be:
Element Position theta

Shares 0
Written calls 120 ×100 × .011 = 132
Purchased puts 80 × 100 × −0.006 = (48)
Net position 84

14 The correct answer is D. A stack hedge is, as its name implies, a derivatives position,
typically in short-dated futures contracts which match as closely as possible the
economic position in the exposure position. That is, if we had a five-year exposure
to the oil price, a stack hedge would use, say, futures contracts on crude oil with a
six months’ expiry, which are then rolled forward prior to expiry into subsequent
(short-term) positions, adjusting the hedge as necessary until the expiry of the
underlying exposure.
15 The correct answer is B. The break-even from buying calls will be: + . The
premium is $0.0251 per £ so the break-even = $0.0251 + 1.680 = $1.7051. To
check that answer, we know each contract is worth £31 250, so the total cost =
$781.375. We have the right to exchange £31 250 at $1.680 = $52 500, add the
premium, $781.38 = $53 281.38 ÷ £31 250 = $1.705/£.
16 The correct answer is C. If we have a sterling payable, we want to hold a call on the
quoted currency. A call allows us to buy the base currency (sterling) and sell the
quoted currency (dollars). A written call sells the base currency (Deutschemarks)
and buy the quoted currency (dollars). By writing the call, we reverse the profit
being made on the purchased put, in such a way that above the capped rate of 0.650,
for every 1 cent made on the put, we lose 1 cent on the written call. In setting up a
vertical spread or currency cylinder to cap our costs, at the expense of some
additional gain, we also sell a call on the currency. For instance, we buy $0.660
February put for $0.186 and sell the February $0.650 call for $0.074. The net cost =
$0.074 − $0.186 = $0.112.
17 The correct answer is B. The cost-of-carry model will apply for the commodity. This
is the interest cost plus the storage cost, less any income (in this case zero) on the
asset. The prices will be therefore:
640.50 × (1.18) . = 695.8
640.51 × (1.18) . = 725.2
18 The correct answer is D. The diagram represents the payoff of a bearish vertical
spread strategy using options. The strategy involves buying a put with a high strike
price ( ) and selling a put with a lower strike price ( ) to offset the cost of setting
up the original position. The holder wins if the price falls to 2 but has any gains
capped by the loss from the written option at prices below 2 . Note that it can also
be established by selling a call with a low strike price ( ) and buying a call with a
high strike price ( ).
19 The correct answer is C. The writer of a call option will receive the premium on the
option when the transaction is initiated and (if it is exercised) will sell the underlying
asset at the agreed strike price.
20 The correct answer is B. The minimum-variance hedge ratio is found by:
,
Minimum- variance hedge ratio (ℎ) =
So +0.89 × 0.25 ÷ 0.24 = 0.93.

21 The correct answer is A. The value that ACME International should place on the
option can be found by applying the option-pricing model to the situation. The
value change on the option will be +1, if the price increases to US$11 million, or 0,
if the price decreases to US$9 million. The price range is US$2 million. The option’s
delta is therefore 0.5. The cost of ‘replicating’ the liability will be:
Elements of the replicating Increase in price to Decrease in price

transaction 11m {u} to 9m {d}
Proceeds from selling asset 0.5 × 11 = 5.5 0.5 × 9 = 4.5
Payout on the short call positions (1) 0
Repayment of borrowing (4.5) (4.5)
Net cash flow 0 0
The value of the call will be: (US$5m) − 4.370786381 = C. So each call is worth
US$629 213.62.
22 The correct answer is C. The wheat price you require from holding wheat for one
month is $3.82. You can buy wheat for one-month delivery by buying futures for
$3.79. Therefore you should sell as much of your holding of physical wheat as
possible (that is, all commitments held physically for wheat with more than one-
month delivery) and buy futures. You make $0.03 per bushel in doing so.
23 The correct answer is D. The value of the shares in the portfolio is Number of
shares × Share price = £215 × 310 = £66 650.
We need to apply put–call parity to determine the ‘correct’ price for calls that are
being offered by the investment bank since we cannot observe the call price directly.
Note that arbitrage conditions will ensure that this put–call parity price is the correct
fair value for the calls.
The put–call parity formula states that:
( )+ = +
We have values for the present value of the strike price (PB(K)), the shares (S) and
the put (P), so rearranging we have:
= + − ( )
= £215 + £22 − £50 × 0.9901
= 187.50
The total value of the package on offer from the transaction is: T-bills = £990.10 ×
10 + £187.50 × 300 = £66 151. The current portfolio is worth £66 650, so there is a
loss of £499 on the transaction.
24 The correct answer is B. A cap is a sequence of written or purchased calls on a
particular asset or interest rate. The cap will determine the maximum possible gain
or cost on an asset or rate. Hence the term, since it caps the gain or caps the cost.
25 The correct answer is C. To determine how many puts are required, we need to
work out the relationship of put price value change to portfolio change as:


= ·
Substituting gives:
£50million 1
= 1.3 ·
2900 × £10 −0.38
This comes to 5898.37. We need to round to the nearest full contract, so 5898 is
correct.
26 The correct answer is B. The break-even payoff from a put option will be the strike
price less the premium ( − ). So for the 5175 put this is 5175 − 142 = 5033.
27 The correct answer is C. If the index expires at 5269, the holder will exercise. The
loss will be 5269 − 5225, or 44 points, on the option less the premium income of
168.5. This leaves a net profit of 124.5 index points. Each point is worth £10, so the
position returns a profit of £1245 per contract.
28 The correct answer is C. The maximum payoff will be the difference between the
two strikes (100 index points × £10) less the cost of setting up the position (an
outlay of 203 points on the 5225 put less an inflow of 159.5 points on the 5125 put
= net cost of 43.5 points). The maximum gain will be 100 − 43.5 index points ×
£10 = £565.
29 The correct answer is B. A convertible includes an embedded option. It can
functionally be equated to a call option, since it gives the holder the right to buy
shares, plus a debt security issued by the firm and where, if exercise takes place, the
debt security is surrendered in payment of the exercise price.
30 The correct answer is C. To benefit from an increase in volatility, it is necessary to
be long volatility. There is no volatility benefit from being long a forward contract
on the underlier. A position with negative vega will lose money from an increase in
volatility as would a short position in a call and a put. To have a positive gamma
means also to have a positive vega, so only C provides the appropriate exposure to
benefit from an increase in volatility.
Case Study 1
1 The bank will be concerned about the overall asset–liability mismatch between its
funding sources and the asset. By holding a floating-rate asset, the bank is minimis-
ing this risk. The bank’s management might be unwilling to countenance a large
mismatch between its short-term deposit funding base and the five-year bond
investment.
The other element the bank will be concerned about is the price risk of holding the
bonds directly. Applying the bond valuation formula, we can see that a 1 per cent
change in interest rates will change the bond price by just under 4 per cent (3.9 per
cent). The valuation at 10 per cent is:
6 6
+ 100− (1.1) − 5 = 84.837
0.10 0.10

A change to 11 per cent gives 81.521 – a loss of 3.316 of the principal value.
Marking the bonds to market (revaluing) in the balance sheet could have repercus-
sions for the bank with regulators, analysts, etc. if interest rates increased.
2 Fast Track Investment Bank is creating a synthetic floating-rate note package with a
payment to the bank of LIBOR + 0.20%. Using the data provided, the first step is
to back-out the zero-coupon rates and the relevant discount factors for the five
years:
Zero-coupon Discount
Time Par yields rate Annuity factors
1 9.50% 9.5000% 0.91324 0.91324
2 9.59% 9.5943% 1.74582 0.83258
3 9.62% 9.6259% 2.50485 0.75903
4 9.69% 9.7053% 3.19523 0.69038
5 9.70% 9.7144% 3.82428 0.62905
The next step is to set out the cash flows from the bond and the swap used to
convert the fixed rate into the floating rate:
Time Sum 1 year 2 years 3 years 4 years 5 years

Bond (84.837) 6 6 6 6 106
Swap 0 9.7 9.7 9.7 9.7 109.7
Deficit (3.7) (3.7) (3.7) (3.7) (3.7)
Discount factors 0.9132 0.8326 0.7590 0.6904 0.6290
PV discount (14.1498) (3.379) (3.08053) (2.80842) (2.55441) (2.32747)
LIBOR 0.20 0.20 0.20 0.20 0.20 0.20
spread
PV spread (0.76486) 0.18265 0.16652 0.15181 0.13808 0.12581
(99.75169)
The analysis proceeds as follows. The bond costs $84.837, there is a requirement to
make up the off-market coupon on the bond by investing $14.1498, the present
value of the $3.7 coupon deficit to match the fixed rate. The bonds are being
offered with a 20 basis points margin; this costs 0.765 in present value terms. The
total value of the package is $99.75. Fast Track Investment Bank is therefore taking
out 0.25 of the principal in offering the transaction for a total cost of $100.
Whether that is acceptable to Builder Bank depends on its view of the attractions of
buying the package rather than doing it itself. There is a requirement to deposit
funds under this scheme to make up for the cash flow deficits on the swap and the
margin.

3 As in Question 2, the first step is to back out the zero-coupon discount rates that
are embedded in the par yield curve.
Zero-coupon Discount
Time Par yields rate Annuity factors
1 8.25% 8.25% 0.923788 0.923788
2 8.38% 8.3855% 1.775039 0.851252
3 8.45% 8.4598% 2.558819 0.78378
The next step is to value the swap. Since interest rates have changed, the swap will
now be off-market. We can value the swap as being the PV of the fixed rate
elements treated as a bond. Alternatively, it can be seen as the swaps required to
reverse the existing position.
Calculating the PV of the swap as a bond equivalent produces the figures in the
table:
Time Cash flow Discount factor Present value

0 (100) 1.0 (100.000)
1 9.7 0.923788 8.961
2 9.7 0.851252 8.257
3 109.7 0.783780 85.981
3.199
We can see that this is correct if we ‘reverse’ the swap using the current par swaps
for the different maturities, as in the following table:
Time Off-market 1 year 2 years 3 years Total

swap
0 (100) 0.982434 1.063 101.153 3.199
1 9.7 (1.06348) (0.0891) (8.547) 0
2 9.7 (1.1526) (8.547) 0
3 109.7 (109.700) 0

When the swap itself was originally established, it was used to swap an off-market
bond into floating rate. To do so, cash was deposited to match up with the then on-
market coupon. These cash deposits can now be realised. The present value of the
remaining cash deposits is as shown in the following table:
Time 1 year 2 years 3 years

For coupon 3.7 3.7 3.7
For spread 0.2 0.2 0.2
Discount factors 0.9238 0.8513 0.7838
PV 9.9794 3.6028 3.3199 3.0567
The last stage is to sum these various factors to see if the change in value of the
different elements has created a gain or a loss, as in the following table:
Element Value
Bond 93.129
Swap (3.199)
Deposit on swap 9.468
Deposit spread 0.512
Total 99.910
Investment (100.00)
Net position (0.090)
The analysis shows that terminating the swap at this time would result in a loss of 9
cents per bond compared to holding the bond in its synthetic floating-rate note
version to maturity. Obviously, if the bank can get a slightly better price than 93.129
on the bond with the other conditions unchanged, it would break even or make a
small profit.
Examiners’ comments on Case Study 1
This case involves elements from Module 5 on Swaps. Question 1 requires the
use of cash matching in working out how the bank might ‘replicate’ the transac-
tion for itself. Note the important element of buying the spread over LIBOR. All
assets can be priced at any required investment spread simply by buying the
appropriate annuity stream.
To understand Question 3, it is necessary to ‘unbundle’ the transaction and be
careful in working out what the seller is entitled to. So the present value of the
20 basis point spread that the bank is earning belongs to the bank if the synthet-
ic floating-rate note is unwound. (Note that we could have considered this
question in another way: what is the value of a floating-rate note in the market?
This would have shown what the seller is giving up to the buyer.)

Case Study 2
1 A protective put strategy is designed to provide insurance against a potential fall in
the market – and hence the portfolio’s value – while, at the same time, providing the
holder with the opportunity to profit from any increase.
The essence of the put strategy is to hold sufficient puts so that the increase in their
value compensates for the fall in the portfolio holding. The structure is illustrated in
the following figure with the simple buy and hold shown as an alternative:
Portfolio value Losses in this area a are

compensated for by gains
in put's value a'
Payoff of put Buy and hold

at expiry strategy
Current value Protective put

of portfolio a' payoff
Performance loss on
upside (market increases)
Premium from cost of buying the puts
Pp
a
Floor to the
portfolio value
K = put strike price Market level
The put is superior to the buy and hold strategy at prices where the market has
fallen below ( − − ), where is the strike price, the index level and the
premium on the puts. It will deliver ( − ) on the upside. In the intervening areas,
the exact performance characteristics will depend on the market level at expiry or
when the hedge is removed. Note that the effect is to guarantee a minimum
portfolio value equal to ( − ).
Another attraction of the strategy is that it allows the portfolio manager to maintain
the (selected) portfolio which may outperform the index through stock selection or
selectivity.
2 To price the option, we need apply Merton’s continuous-dividend version of the
Black–Scholes model. The top equation and sub-equations for 1 and 2 for this
model are, for calls:
( ) ( )
= ( )− ( )
(To use this version, we then apply the put–call parity theorem.)
To find puts directly, we rearrange the above to give:
( ) ( )
= (− )− (− )


ln +[ − + ]( − )
= 2
( − )
= − ( − )
The pricing variables are:
( − ): 0.25
: 4800
: 4400
: 3%
: 7%
: 0.25
2 0.0625
:
The computation for 1 is:

4800 0.0625
ln + [0.07 − 0.03 + ]0.25
= 4400 2
0.25√0.25
0.087011 + 0.017813
=
0.125
This gives a value for 1 as: 0.104824 ÷ 0.125 = 0.838592
For 2 we have: 0.838592 − 0.125 = 0.713592
We now need to find the corresponding points on the normal distribution, interpo-
lating if necessary:
(0.83) = 0.79673
(0.84) = 0.79955
Interpolating, we have ( ) = 0.799151.
We do the same for 2 to get ( ) = 0.762260.
We can now price the call option:
= 4800 (0.799151) − 4400 (0.762260)
= 511.50
We can then apply the put parity identity to price the put:
PV(cash) + Call = Stock + Put
4323.67 + 511.50 = 4764.135 + Put
The put is therefore worth 71.04.
We could alternatively have priced the put directly with the put version of the
formula:
= 4400 (0.762260 − 1) − 4800 (0.799151 − 1)


Question 2 requires the student to apply the Merton continuous-dividend
model for pricing the index put. This is discussed in Module 10. In doing so, it is
important to remember the adjustments that must be made to the basic Black–
Scholes equation. In particular, if the put–call parity model is used, the stock
must be the discounted value, reflecting the ‘value leakage’ over the optioned
period.
Note that whereas the variables are calculated to six decimal places, to show an
accurate result, in an exam situation, four decimal places is sufficient. That is, we
would use a value for ( ) of 0.7992 and ( ) of 0.7623. If we do that, we get
a slightly different result from that shown in the answer. We would get 71.10
for the put.
3 The fund will want to set up a hedge/insurance position using the puts such that the
change in value of the puts equals the change in value of the portfolio. A fraction
(1 − ) will be placed in puts and the remainder of the portfolio ( ) kept in shares.
For a given (adverse) change in the market, the portfolio’s relative change will be
measured by its beta. We need this because the fund has a higher sensitivity to the
market index and we are using index puts as the hedge.
To solve for the number of puts directly using their value, we need the equation:
= ·
£150 000 000 1
(1.3) · = 20 226.54
4800 × £10 −0.20085
We need 20 226.54 puts each at 71.04 index points, each of which is worth £10. So
the total outlay, rounding up, is:
20 227 × 71.04 × £10 = £14 369 260.80
This is 9.58 per cent of the portfolio of £150 000 000. Adjusting for the cash to be
used for the hedge, we have £14 369 260.80 ÷ (£150 000 000 + £14 369 260.80) =
0.0874 or 8.74 per cent.
To compute the proportion of the portfolio required to balance the change in put
value with that of the portfolio we use the change in value equation which, for the
portfolio, is:
− × (1.3) × £150m ×
where is the index, the beta = 1.3, and is the fraction of the portfolio retained in
shares.
For the puts, we need to compute the puts’ sensitivity to the change in the index:
Index Put 4800
· = − 0.20085 = −13.571
Put Index 71.04
The value change in the puts must therefore be:
− × £150m × (1 − ) × (−13.571)

For the hedge to be balanced we require that:

− × (1.3) × £150m × = × £150m × (1 − ) × (−13.571)
Deleting from both sides and then rearranging, we have:
−(1.3) × = (1 − ) × −13.571
−(1.3) × = −13.571 + 13.571
14.871 = −13.571
= 0.9126
That is, 91.26 per cent of the portfolio remains in shares and 0.0874 or 8.74 per cent
is invested in puts (as previously calculated).
To summarise, 8.74 per cent or £13 112 136.78 must be divested and invested in the
protective puts.
Question 3 uses material from Module 11 on Hedging and Insurance. The
important thing to remember is that there is no external source of funds for the
purchase of the puts: some of the portfolio has to be sold and placed in the
hedge. We are interested in determining what fraction of the portfolio must be
sold in order to buy the puts.
As the answer to the question is presented it shows two ways to determine the
amount of the portfolio that has to be placed in the hedge. The first method
solves this using the procedure given in the module. The second approach
provides a way of directly calculating the amount based on the option’s elasticity
of lambda as given in Module 9. Both provide the same result.
Note: in a similar question you would only be required to use one method to
derive the solution. Both are given to show the alternative ways of deriving the
answer.
4 Waverley Managers cannot ignore the hedge when using puts. The balance between
the portfolio and the puts acting as a hedge/insurance will change when the level of
the index changes and the price of the puts change. This will also change the puts’
delta (δ) and hence the ‘elasticity’ or lambda of the puts. If the index should, say, go
to 4700, then all else being equal – and ignoring the puts’ gamma – we would expect
the puts to rise in value by 20. Using linear extrapolation, the delta will be −0.25, or
thereabouts. The new values will thus be:
Index Put 4800
· = − 0.25 = −12.91
Put Index 91.04
As a result, the new ratio w will also change:
− × (1.3) × £150m × = × £150m × (1 − ) × (−12.91)
So now becomes 0.9085. We now need 0.0915 in the puts, or £13 722 730.47, in
contrast to the result derived in Question 3 of £13 112 136.78. That is, we need to
‘rebalance’ the hedge, selling more of the portfolio and placing it in puts as the price
changes since the option price responds in a non-linear fashion.
The factors that will affect the options and hence cause a rebalancing to occur,
keeping the other factors constant, are:

(a) time decay: as the option moves towards expiry, the delta will decline since the
options are out-of-the-money. Time decay most affects the option’s value when
it is nearing expiry;
(b) change in interest rates: this affects the value of 1 and the discounting of the strike
price in the valuation of the option. Option values, on the whole, are not too
sensitive to a small change in interest rates;
(c) relationship of the strike price to the index value: changes here affect 1 and the value of
the call or put as derived by the Black–Scholes/Merton equation;
(d) volatility: the option price is very sensitive to changes in volatility. An increase will
significantly change the options’ delta. If the volatility were to increase from 0.25
to 0.26, the options’ delta would change from −0.2009 to −0.2086 – a factor of
3.8 per cent.
To answer Question 4 requires an understanding of the sensitivity factors of
options. These are discussed in detail in Module 9 of Financial Risk Management
2.
Case Study 3
1 We need to compute the price relatives for the two spot periods of 3 months and 6
months, namely:
3 months 9 months
Interest rate 6.35
Time period .25
Interest rate 6.60
Time period .75
Interest rate ?
Time period .50
The price relative for the first period of three months is

1 + .0625 × .25 = 1.0159
The price relative for the second period of nine months is
1 + .0660 × .75 = 1.0495
The forward interest rate will therefore be:
1.0495
= 1.0331
1.0159
12
(1.0331 − 1) × = 6.62%
6
The forward rate agreement will be priced at 6.62 per cent.

2 The customer has bought the FRA. From the bank’s perspective then, it will need to
payout if interest rates are above 6.62 per cent. On the other hand, it will receive
money if the interest rate is below the FRA rate.
To protect itself from movements in the interest rate, it will need to enter into the
following transactions:
Borrow for 9 months at 6.60 per cent
Lend for 3 months at 6.35 per cent
Relend for 6 months after the 3 months initial period at the prevailing 6-month
interest rate in 3 months’ time
The effect of this is to eliminate the interest rate risk on the FRA. If the rate is
above 6.60 per cent at the maturity of the FRA, it will be compensated by being able
to invest the rollover of funds at the higher rate in the market. If the rate is below
the FRA rate, the opposite happens: the customer compensates the bank for the
lower interest rate it can obtain on the six month deposit in the market.
3 This is an application of Black’s options on futures contracts, where the basic
equations are:
( )
=[ · ( )− · ( )]
where the sub-equations are:
ln + ( − )
2
=
( − )
= − ( − )
The key issue here is to convert the FRA rate into a price: The variables we require
to price the fraption are:
Value for calculation

Pricing element Symbol purposes
Forward rate agreement price FP 33 100
Strike price K 33 100
Time to expiration (T − t) .25
Volatility σ .25
Interest rate r .0635
The value of the FRA, and by extension that of the strike since they are equal is
found by:
Notional principal = 1 000000
Notional principal × tenor = 1000000 × 0.5 = 500000
Notional principal × tenor × interest rate = 500000 × .0662 = 33 100

The next step is to calculate 1 and 2:

. 25
ln + ( − ) 0+ (.25)
2 2
= = = .0625
( − ) . 25√. 25
= − ( − )
= . 0625 − .125 = −.0625
The values for ( ) and ( ) are found by interpolating the normal distribution
table:
( ) = . 5249
( ) = . 4751
The value of the fraption call will be:
( )
= 33 100(.5249) − 33 100 (.4751)
This gives a value of 1897 for the call.
Examiners’ Comments on Case Study 3, Question 3
The only really difficult element in this Case Study is obtaining the value of the
fraption. The key here is to remember how to convert an interest rate into a
value in order to use Black’s options on futures model. The key to getting this
value is to remember:
Value of FRA = Notional principal amount × tenor of FRA × Market value of
FRA rate
Value of strike is as above except we need to substitute:
Value of FRA = Notional principal amount × tenor of FRA × Strike rate on
fraption
The remainder of the calculation follows the standard Black–Scholes approach,
as given in Module 8.

Appendix 2
Formula Sheet for Derivatives

1. Financial Basics
Compounding factor (future value of an interest factor r% for time t):

FVIF%, = (1 + )
Discount factor (present value of an interest factor r% for time t):

PVIF%, =
( )
Future annuity factor (future value of an annuity factor for r% for n periods):
( )
FVIFA%, =
Present annuity factor (present value of an annuity factor for r% for n

periods):
( )
PVAF%, =
2. Covered Arbitrage
Spot rate ×
3. Cost of Carry Model
Simple interest
( )
· = + ×R , × +G ,
Compound interest
= (1 + )( )
or
( )
= ·

Appendix 2 / Formula Sheet for Derivatives
Arbitrage channel
(1 + )( )
+ < < (1 + )( )
−
Convenience yield
( )( )
=
4. Implied Forward Rate
Compound interest
(1 + ) = (1 + ) (1 + )
Simple interest
1+ = 1+ 1+
5. Forward Rate Agreement Settlement Terms

× ×
Settlement amount =
×
6. Synthetic Agreement for Forward Exchange Settlement Terms
Exchange rate agreement

( )
Settlement amount = notional amount × ×( )
×
Forward exchange agreement

( ) ( )
Settlement amount = × ×( ) − ( − )
×
7. Hedge Ratio
ℎ=
8. Fair Value of an At-Market Swap

( )
0 = NPV = ∑ − ∑
( ) ( )

9. Spot or Zero-coupon Rate (Zi) Derived from the Par-Yield Curve
= −1
∑
10. Option Pricing
Option delta
=
Amount borrowed
= ( )( )
Risk-neutral probability
( )
( / )
=
Value of call with one period to expiry

( )
= ( )
Value of call with two periods to expiry

( )[ ]
= + 2 (1 − ) + (1 − )
Binomial model pricing inputs
= =
= 2.71828
=
11. Black–Scholes Option Pricing Model
Value of a call
= ( )− ( )
( )
and

ln +[ + ]( − )
= 2
( − )
ln +[ − ]( − )
= 2
( − )
or more simply:
= − ( − )
Value for a put

= ( ) (− )− (− )
Standard deviation of returns

∑ ( , )
=
=
or equivalently:
1 1
= ∑ , − ∑
−1 ( − 1)
Approximation formula for implied volatility
≈
√ = 3.14159
( )
Polynomial approximation to the normal distribution

( ) = 1 − ′( )( + + )
when ≥ 0 and ( )=1− ( )
when < 0 and where =
1 /
′( ) =
√2
= 0.33267
= 0.4361836
= −0.1201676
= 0.9372980

12. Option Sensitivities
Adjustments to delta
European-style call option on a stock index with a dividend yield (d):
( )
= ( )
European-style put option on a stock index with a dividend yield (d):
( )
= ( ( ) − 1)
European-style call option on a futures contract:
( )
= ( )
European-style put option on a futures contract:
( )
= ( ( ) − 1)
European-style call option on a currency:
( )
= ( )
European-style put option on a currency:
( )
= ( ( ) − 1)
Significance of N(d2)
( ) ( )
( − )= − ( )
( )
Lambda elasticity
=
Gamma
′( )
= =
( − )
and
1 ⁄
′( )=
√2
Computational formula:
⁄
=√
( )
Theta
European-style calls:
( )
=− ′( )− ( )
2 ( − )
European-style puts:
( )
=− ′( )+ (− )
2 ( − )

European-style call with a dividend yield:

( )
· ′( ) ( ) ( )
=− + · · ( ) − ( )
2 ( − )
European-style put with a dividend yield:
( )
· ′( ) ( )
=− − · · (− )
2 ( − )
( )
+ (− )
Rho
Rho for calls:
( )
=( − ) ( )
Rho for puts:
( )
= −( − ) (− )
Vega
= ( − ) · ′( )
Underlier paying a continuous dividend:
( )
= ( − ) · ′( )
13. Adjustments to the Option Pricing Model
Continuous dividend adjustment model (Merton)

Call option:
( ) ( )
= ( )− ( )
Put option:
( ) ( )
= (− )− (− )
ln( ) + [ − + ]( − )
= 2
( − )
and:
ln( ) + [ − − ]( − )
= 2
( − )
or:
= − ( − )
Currency options
Call option on currency:
( ) ( )
= ( )− ( )
Put option on currency:
( ) ( )
= (− )− (− )

ln( )+[ − + ]( − )
= 2
( − )
where:
ln( )+[ − − ]( − )
= 2
( − )
or:
= − ( − )
Currency options on the forward price

Call option:
( )
=[ · ( )− · ( )]
Put option:
( )
= [ · (− )− · ( )]
ln( ) + [ ]( − )
= 2
( − )
where:
ln( ) − [ ]( − )
= 2
( − )
or:
= − ( − )
Options on futures
Futures call:
( )
= [FP · ( )− · ( )]
Futures put:
( )
= [ · (− )− · (− )]
ln( )+( )( − )
= 2
( − )
where:
ln( )−( )( − )
= 2
( − )
or:
= − ( − )
Commodity options
Call on a commodity:
( )
= ( )− ( )

Convenience yield on commodities:

= ln + ( + )( − ) /( − )
Put on a commodity:
( )
= (− )− (− )
( )
ln( )+( + )( − )
= 2
( − )
where:
( )
ln( )+( − )( − )
= 2
( − )
or:
= − ( − )
American-style option adjustment
AVA =
and:
= −( − 1) − ( − 1)2 +
= − ( )
where:
2
=
( )
= 1−
14. Hedging
Minimum variance hedge ratio

,
ℎ=
Hedging effectiveness
ℎ∗ =
ℎ∗ = 1−
ℎ∗ = 1− =

Futures spread
= ×
Equity hedging
=
Constant proportions portfolio insurance

Value in risky asset = (Value of portfolio − Value of floor)
Hedge ratio for index options

( )
= ×
( )

Appendix 3
Interest Rate Calculations

Time-Value-of-Money (TVM)
The value of a sum of money is a function of the time to receipt or disbursement of
the cash.
For 1 unit of currency with a single period rate of interest r. Let FV stand for the
future value, then the termination amount after one period will be:
=1+
Repeating the process for a second period, we have:
= (1 + ) + (1 + ) = (1 + )
The future value of 1 unit of currency, for n periods:
= (1 + )
If the interest rate is 10 per cent (r = 0.10) and there are 3 periods (n = 3), then:
= (1 + ) = (1.10) = 1.33
We can do the same calculation starting with any current amount (or what is
normally termed the present value (PV) ), e.g. 80 units:
= (1 + )
= 80(1 + 0.10) = 106.40
Note that equally we could do 1.33 × 80 to get the same result.
The term: (1 + ) is called the accumulation factor.
Key time value of money equation one:
= (1 + ) (Key equation 1)
If we had wanted to know how much we would have had to invest to obtain a
given future amount, we can reverse the equation. If multiplying by (1 + ) gives
the future value, then dividing will give the present value.
If we take key equation 1 and divide both sides by (1 + ) we have:
= (Key equation 2)
(1 + )
which is key equation 2. Note that key equations 1 and 2 are linked.
Key equation 2 can be written:
= (1 + )
The term (1 + )− is called the present value factor.
However, in practice financial markets calculate interest according to a number
of different conventions and it is important to know how to convert between these

Appendix 3 / Interest Rate Calculations
different approaches. The principal ones that concern us are given in the following
table:
Alternative interest rates

Method of computing
interest Implication
Simple interest Rate of growth of an asset in a single period
Compound interest Rate of growth of an asset over many periods taking
into account compounding over time
Discount interest Interest applied to the amount of a loan to determine
the amount lent (based on value at maturity)
Coupon interest Periodic cash flow paid to a holder of a bond
Yield-to-maturity Single interest rate or internal rate of return (IRR) that
is earned if the bond is held to maturity
Zero coupon yield or Yield to maturity of a zero-coupon bond (This can
discount rate (or factor) also be backed-out of par yields)
Interest rate products are traded in two major markets, the money markets and
the bond markets, which use different conventions. Money markets use simple
interest and often discount the interest paid in order to simplify transactions. The
principal method for calculating interest is known as bank discount. Bond markets
where maturities are longer use compound interest.
Simple Interest
This simply involves multiplying the interest rate times the period involved (or if
less than a year, the fraction of the year involved). The future value using simple
interest will be:
= (1 + )
The present value will therefore be:
=
1+
This is the principal method used in money markets. However, for historical
reasons money markets use a variation on simple interest known as bank discount.
This involves a basis year rather than the actual number of days in the year.
One slight real world complication in money markets is that, typically, the year
(although 365 or 366 days) is treated as if it consists of 360 days (known as bank
basis) so the divisor is 360, not the actual number of days in the year. That is a loan
at a bank will cost the borrower 1.01389 times more than the stated amount of
interest. A 1-year loan at 4 percent for $100 000 at simple interest will have interest
of:
365
$100 000 × 0.05 × = $5069.44
360

That is the real interest rate is 5.069 per cent, the difference reflecting the day-
count convention.
Bank Discount
The value of a money market instrument using this approach is based on the
formula
= (1 − )
Where P is the price, M the monetary value of the transaction, t is the time (or
number of days) to maturity and d is the discount rate used to price the transaction.
To calculate the equivalent interest rate, given the discount rate:
=
1−
where i is the simple interest rate.
To calculate the discount rate, given the interest rate:
=
1+
Bank discount is used to price US treasury bills.
If M = 100 then the market price of a treasury bill will be:
= 100 1−
360
360 100 −
=
100
Simple interest Bank discount

Cost of money is based on present value Cost of money is based on maturity
value
= Prt = Mdt
= (1 + ) = (1 − )
= =
1+ 1−
= =
1− 1+
If we want to obtain an actual days discount factor for use in fundamental equa-
tion number 1, then we need to convert the interest calculation.
If we have a 90-day US treasury bill trading at a discount of 4.50 per cent, the
equivalent interest rate will be:
0.0450
= = = 0.045512
1− 1 − 0.0450(90/360)

This interest rate now needs to be converted to an actual basis by multiplying by

365/360 to take account of the pick-up from bank basis:
0.045512 × 365/360 = 0.046144
This is the simple interest equivalent. Let’s see if this is correct. The market price
of the bill will be:
0.045(90)
= 100 1− = 98.875
360
If we discounted 100 by (1 + 0.04614412 × 90/365) where the fraction of the
year is 90/365 = 0.2466, we have:
90
= 100 1.046144× = 98.875
365
Now we want to convert our simple interest into compound interest. The com-
pound interest equivalent to 4.6144 per cent simple interest is:
90
1.046144× − 1 = 0.046953
365
If we discount the principal value now by the compound rate we have:

100
= 98.875
(1.046953)
Of course if we had the market price of the T-bill, we could have computed the
yield simply by:
100
− 1 = 0.046953
98.875
If we need the continuously compounded rate, then we simply convert the com-
pound rate using the formula:
= ln(1 + ) = ln(1.046953) = 0.045884
Using the continuously compounded rate to value the T-bill would involve:
. × /
= 100
The interest rates can be summarised as:
Interest rate method Quoted rate

Bank discount rate 4.5000
Simple interest 4.6144
Compound interest 4.6953
Continuously compounded interest 4.5884
Correctly applying the formulas with each will give the same present value. The
ones that concern us principally are compound interest and its relation continuously
compounded interest. When faced with simple interest or bank discount rate, we

would want to convert these to one of the other methods for calculating interest (or
the present value).
Bonds
Actual/365 or Actual/Actual. This method calculates the accrued interest by
multiplying the principal amount times the interest rate times the number of days in
the period, divided by 36 500. In the case of a leap year it is the number of actual
days in the period divided by 36 600. Note that the convention is to treat the starting
day, as the appropriate day in the year hence the interest day from 31st December to
1st January is part of the earlier year.
A 6 per cent coupon US$1000 Treasury bond for the period November 30 to
March 31 (a leap year) would be 122 days, but because US Treasury issues are
calculated on an Actual/Actual basis, then we need to segregate, the interest into the
normal year and the leap year.
Normal year (to January 1) Leap year (from January 1)

$ × . × + $ × . × =
US$20.01
This method of accruing interest is used for US Treasury notes and bonds and
some US Dollar denominated interest rate swaps.
Coupon or Interest Frequency: The great majority of fixed rate bonds pay
interest (coupons) either once or twice a year (known as annual or semi-annual
basis). Note also that to ease trading, the vast majority of securities issued in a
particular market will tend to follow the market’s accepted convention for interest
frequency. Occasionally, specialised securities may use different methods, for
example: Collateralized mortgage obligations (CMOs) and floating rate notes
(FRNs) which may pay interest quarterly or even monthly).
Yield (internal rate of return (IRR))

Known as the redemption yield in the UK or the yield-to-maturity (YTM) in the
USA and the international financial markets. It is simply the constant interest rate
(yield) which relates the market price of the bond (P) to its future cash flows:
= + + +⋯+
(1 + ) (1 + ) (1 + ) (1 + )
or equivalently:
= ∑
(1 + )

For semi-annual securities, like US government notes and bonds, the coupon
payment frequency is semi-annual, hence the formula becomes:
= + + +⋯+
(1 + ) (1 + ) (1 + ) (1 + )
2 2 2 2
where y is therefore the semi-annual yield expressed as an annual rate by multiplying
by two.
Note that if we are calculating the price of a bond between coupon dates, then
we will obtain what is known as the dirty price. That is, we have the price of the
bond including the amount of accrued interest due.
The equation for calculating the dirty price is similar to the basic yield calculation
in that:
= + + + ⋯+
(1 + ) (1 + ) (1 + ) (1 + )
where:
Number of days between settlement and next coupon payment
=
Number of days in the coupon period
However, for simplicity in order that prices only change when yields change,
bond prices are quoted excluding accrued interest (AI). This is known as the clean
price. It is simply the full value of the bond less any accrued interest due, namely:
Quoted price = −
where:
Number of days from last coupon payment to settlement date
=
Number of days in coupon period
Conversion Between Bases
The frequency with which interest payments are made and the method of calcu-
lating interest is different in different markets.
To compare different instruments requires us to calculate the interest on the
same basis; we therefore need to convert between the different methods of calculat-
ing interest. For example:
A 2-year loan pays interest at 6 per cent semi-annually on an Actual/360 basis.
Assuming each period is an exact half year, what would be the equivalent interest
rate if the interest were paid annually on an actual/365 basis (i.e. bond basis).
If the annual equivalent rate is taken to be x per cent, the two cash flows are:
Difference
Year Semi-annual Annual (SA − A)
0.5 3.0417 0 3.0147
1.0 3.0417 3.0147 −
1.5 3.0417 0 3.0147
2.0 103.0417 100 + 3.0147 −

For the two loans to be equivalent the PV of the two cash flows must be equal.
Therefore, the PV of the difference column must be zero.
The PV will be zero if the PV of the first year’s cash flow = 0. This will happen if
3.0417/(1 + )0.5 + 3.0417/(1 + )1 = /(1 + ).
If we assume that the required discount rate on the semi annual (sa) payment = 5
per cent; substituting we have:
= 1.05 × (2.9684 + 2.8969)
Which is 6.1586 per cent.
The same method of equating PV will allow us to convert between any pair of
interest bases.
Note the difference in result, if we had simply converted the semi-annual pay-
ments to annual equivalent, using the following formula and adjusted for the day
count:
= +1 − 1 × 100
200
This would give:
6%
6.9% = +1 − 1 × 100
200
To convert for the basis difference, would result in6.09 × 365/360 = 6.1746%,
compared to our earlier answer of 6.1586 per cent.
For complete accuracy, one should use the discount factor defined by the zero
coupon term structure of interest rates, using an exact day count incorporating
holidays and weekends. This is especially important for short-term cash flows.
Computing Zero-Coupon Rates

Money market instruments that only have two cash flows are zero-coupon instru-
ments. This is not the case for bonds (except close to maturity when only one
payment is due). For pricing purposes, we want to extract from quoted bond prices
the underlying zero-coupon interest rates (or zero-coupon prices or yields as they
are also called).
Given a par yield (that is bonds which trade at their principal value), we can apply
a bootstrapping technique to extract the zero-coupon rates. For a given maturity m,
the zero coupon rate corresponding to that maturity ( ) can be found by:
1+
= −1
1− ∑ (1 + )
where C is the coupon rate expressed as a decimal. If we denote

∑ (1 + ) =

1+
= −1
1−
To see how it works in practice, take the following five period par yield curve.
Note that since the first period has no intervening coupon payments the par yield
equals the zero-coupon rate.
Zero- +
Period Par yield coupon + /( − ( + )−
rate × )
1 0.04 0.04 1.04 1.04 0.96154
2 0.041 0.04102 1.041 1.08372 1.88428
3 0.042 0.04206 1.042 1.13155 2.76803
4 0.043 0.04311 1.043 1.18392 3.61268
5 0.044 0.04418 1.044 1.24132 4.41828

Appendix 4
Answers to Review Questions

Contents
Module 1 .............................................................................................................4/1
Module 2 .............................................................................................................4/8
Module 3 .......................................................................................................... 4/11
Module 4 .......................................................................................................... 4/19
Module 5 .......................................................................................................... 4/28
Module 6 .......................................................................................................... 4/38
Module 7 .......................................................................................................... 4/43
Module 8 .......................................................................................................... 4/51
Module 9 .......................................................................................................... 4/55
Module 10 ........................................................................................................ 4/60
Module 11 ........................................................................................................ 4/67
Module 12 ........................................................................................................ 4/74
Module 1
Review Questions

1.1 The correct answer is C. The forward market that economic historians have
uncovered in the Netherlands and centred on Antwerp, then the principal city for
the wool and cloth trade in Flanders, was in currencies. Note that forward markets
have existed on the other elements; even tulip bulbs. During the famous tulip
bubble that occurred in the Netherlands in the 17th century, market participants
were buying and selling bulbs in an informal forward market.
1.2 The correct answer is D. In a forward contract, the amount, quality and cash
consideration and the delivery date or transaction date are all predetermined.
1.3 The correct answer is A. If you have a positive sensitivity to changes in market
prices, you would be said to be long the risk and would benefit from an increase in
the market price.

Appendix 4 / Answers to Review Questions
1.4 The correct answer is D. A futures contract is an instrument whose value depends
on the values of other more fundamental underlying variables (A). It is exchange-
traded and is a contract to buy (if long) or sell (if short) an asset or security for a
specified price or rate (as with exchange rates) on a specified future date (B). It is an
agreement to buy or sell an asset at a certain time in the future for a certain price
(C).
1.5 The correct answer is A. There are institutional differences between futures and
forward contracts in the way that they operate. Futures are exchange-traded and
have standardised terms and conditions, whereas forwards do not. These are minor
operational differences which have some impact on the way that market participants
might use the two instruments but economically, the two instruments perform the
same functions.
1.6 The correct answer is A. A swap is an agreement between two parties, known as the
counterparties, to exchange two different sets of future periodic cash flows.
1.7 The correct answer is B. An exotic option is an option that has non-standard terms
and conditions. So an average rate option (AVRO) is an exotic option.
1.8 The correct answer is A. The major issue that prevents market participants from
using forward contracts is the threat that the counterparty will default on their
obligation. Note that, given their customised characteristics, the lack of counterpar-
ties willing to act on the other side of the transaction or that there may be no
transactions available with the right maturity do not create problems for market
participants. Futures do restrict the available maturity dates.
1.9 The correct answer is B. Fundamental financial instruments are those securities
issued by firms in order to raise capital and borrow money. They are necessary
instruments, hence their fundamental nature, for firms to engage in economic
activity.
1.10 The correct answer is B. With transactions A, C and D, there is a defined exit from
the transactions being undertaken. With B the only way to make a profit is by
reversing the transactions being entered into when the profit has been realised.
Taking a view on the outcome of a takeover attempt is not deterministic arbitrage.
So this is the odd one out and hence B is the answer.
1.11 The correct answer is D. With dynamic arbitrage, the replicating portfolio is
rebalanced over time (according to some predetermined criteria) in order to
maintain the correct relationship to the derivative security being arbitraged.
1.12 The correct answer is A. A replicating portfolio is a package of securities and
borrowing and lending designed to give the same payoff as another financial
security.
1.13 The correct answer is B. Fundamental financial instruments (FFI) are those
securities or transactions that raise finance for firms (and governments) and hence B
is not a FFI. A call option on a share is a derivative instrument, which obtains its
value from the price behaviour of the share.
1.14 The correct answer is C. The replicating portfolio involves [1] buying the
commodity in the spot market at $1200, [2] borrowing the purchase price and [3]

selling the commodity into the forward contract at $1255. The interest cost of
borrowing is $48, so the arbitrageur nets a profit of $7.
1.15 The correct answer is A. The replicating transaction involves [1] borrowing
US$1.7425 million for six months (giving $1 764 146.79 to be repaid at maturity, [2]
exchanging these dollars into sterling at the spot rate = £1 million, investing this at
the sterling interest rate to give £1 018 577.44. [3] Exchanging this into US dollars
gives $1 770 796.88, giving a net profit of $6650.
1.16 The correct answer is B. Hedging, in the context of derivatives markets, can be
considered a special case of risk reduction. With risk reduction a proportion of the
risk is managed through appropriate trading in derivatives. Hedging seeks to
eliminate all of the risk.
1.17 The correct answer is A. The general rule for undertaking arbitrage is this: buy low
and sell high which means, in terms of derivatives, selling a derivative instrument
when its price is above its theoretical or fair value price.
1.18 The correct answer is D. While arbitrage of derivatives using cash market
instruments does take place, a number of real world problems arise. These can relate
to simplifications in the models used for pricing derivatives (A), timing differences
between the cash flows on the derivative and the replicating portfolio (B) and
differences in the way taxation authorities treat gains and losses on the replicating
portfolio and the derivative (C).
Case Study 1.1: Terms and Conditions of a Futures Contract

1 We need to think of all the relevant elements that determine the purchase (or sale)
of a physical item. Below is an indication of the kinds of elements that a contract
designer must consider. Some are specific to the contract; others will be more
general in that the exchange will operate a common policy across the various
different contracts that are traded.
Contract element Possible terms and conditions

Name of exchange Any suitable commodity derivative exchange
Contract size or unit of trading Number of tons (or other units) of pepper per contract
Contract grade or quality Specifies a particular type and/or quality of pepper
Delivery months Months in year in which contracts expire (with a given
delivery date or series of dates)A normal cycle would be:
March, June, September, December, but for commodities
with a distinct growing season this might also include the
harvest months (for instance, July and August and Octo-
ber)
Delivery units Nature of individual units (bags, or cases, etc.)
Minimum price movement The minimum amount allowable by the exchange for a
change in price for pepper. If in US dollars, then a 1 cent
price change per pound for a contract on 1 short or net ton
(2000 lbs) = $20 price change in the contract price

Contract element Possible terms and conditions

Last trading day The last day within the delivery month
Delivery procedures Where delivery can be made (normally a series of recog-
nised warehouses designated by the exchange)
Notice day The day following the last trading day on which the short
position holder (or commodity seller) elects which delivery
point to effect delivery
Margin (or performance bond) The amount of (i) the initial margin or performance bond
required on the contract and (ii) the amount of mainte-
nance margin required
Trading limits The maximum number of contracts permitted by one firm
or individual in the contract
Price limits The maximum price increase or decrease permitted for the
contract(s) within a given trading session
Trading hours The hours during which the exchange permits trading in
the pepper futures contract
Exchange of futures for physical A procedure allowing hedgers to enter into physical
(EFFP) contracts when they hold offsetting long (that is, buying
the physical commodity) or short (that is, selling the
physical commodity) futures positions that are simultane-
ously extinguished as a result of the physical market
transaction

Financial Instruments
1 There are a number of ways we might determine what the portfolios of securities
should be that give the required payoffs in the two possible future states. We could
simply use trial and error to determine what the portfolio weights will be. However,
we can analytically determine what the portfolio payoffs should be in the two
different states given the information in the table.
First we need to determine the characteristics of the two securities. We can think of
the value of the securities at t=1 dependent on the state of the economy. The easiest
way is to think in terms of the price relative, that is the value in the future divided by
the value today (FV/PV = price relative).
So first we need to compute the implied price relatives for the two securities. For
Security 1, the debt security this is 105/100 = 1.05
Time t=1 t=0

Under good Under poor
Security conditions conditions
Security 1 (debt) 1.05 1.05
Security 2 (equity) 2 0.5

For security 1 this is the same in both possible future states of the economy so this
debt security is risk-free. For security 2, the value of the equity can either increase or
decrease and hence this is a risky security.
We can plot the price relative of the securities on a diagram as follows together with
the possible combinations of holding fractional investments in the debt and equity
securities:
3.0
Price relative for good conditions
Security 2 (equity)
2.0 Payoffs available from combining
long positions in securities 1 and 2
1.0
Security 1 (debt)
45o
0 1.0 2.0 3.0
Price relative for poor conditions
You will see that security 1 the debt claim, which falls on the diagonal of the two
possible price relatives for the two states, is value independent of the state of the
economy. As such it is risk-free. By holding this security, there is no exposure to the
state of the economy. We can create a portfolio which is more exposed to the
economy by holding a fraction of one’s wealth (α) in the debt security (D) and
investing the remainder in the equity security (E).
= + (1 − )
This is the solid line that links the price relative of the debt and equity. If we have
= 1, all the portfolio is invested in the debt security with a payoff of 105 whatever
happens and is risk-free. If α is zero, then all the investment is in the equity security.
Our payoffs are 120 or 30 depending on the state of the economy. Given that, for a
unit investment in the risky security we are guaranteed at least 30, we can use this
fact to borrow against this certain value. That is we can leverage the portfolio by
setting α to be negative and borrowing and agreeing to pay back this borrowed
money plus interest in one year’s time. Investing this in the equity provides us with a
leveraged position in the equity security.

Given this, if we wanted to create a security which provides us with a positive

payout if the economy is good but nothing if the economy does poorly, we would
want to hold a leveraged position in the debt such that < 0, that is by borrowing
up to the point where − (1 − ) = 0. How much can we borrow? We want
the total value of the portfolio to be zero if the economy does poorly, so the payoff
of the portfolio at t=1 if it does poorly should be:
= 0 = 105 + (1 − )30
For the situation where the economy does well, we have:
= − 105 + (1 − )120
We now need to determine the value for α. This is −.40. Hence we can borrow .40
of a debt security and still be certain of paying this back and invest in 1.4 in the
equity security. If the market does well, your return is:
= −.40(105) + 1.4(120) = 126
If the market does badly, the return is:
= −.40(105) + 1.4(30) = 0
The cost of this portfolio at t=0 is:
Cost = −.40(100) + 1.4(60) = 44
This is the cost of a security with payoff of 126 at t=1 if the economy does well and
zero if it does poorly. The price relative if the economy does well = 126/44 = 2.86.
Note this is far above the return available from simply holding the equity. We have a
leveraged position in the equity with a payoff that is conditional on the performance
of the economy in the coming year. Its payoff is 126 if the economy does well and
zero if it does poorly. The cost of replicating this derivative security is 44, the
amount that has to be injected into the replicating portfolio at t=0.
We can in the same way construct the payoff of the second security. Whereas in the
case of the first derivative security, we wanted to hold more of the equity, in the
case of the second one, we want to sell it short (or lend it), as it will do badly in a
poor market and invest the proceeds of this short sale in the risk-free debt. The
desired payoffs from the two conditions thus become:
If the economy does well:
= 0 = 105 − (1 − )120
And if it does poorly:
= 105 − (1 − )30
As in the previous case, we need to solve for α. This gives us a value of 8.
The payoff if the economy does well will be:
= 8(105) − 7(120) = 0
And if the economy does badly:
= 8(105) − 7(30) = 630
The price of the derivative security at t=0 is:
8(100) − 7(60) = 380

The price relative is: 630/380 = 1.66

We can now plot the new outcomes on the price relative payoff diagram:
3.0 Payoff available from combining long and short positions

in securities 1 and 2 with a positive payoff in poor
conditions, and zero payoff in good conditions
Security 2 (equity)
Price relative for good conditions
2.0
Payoffs available from combining
long positions in securities 1 and 2
Security 1 (debt)
1.0
Risk-free
line
Payoff available from combining long
and short positions in securities 1 and 2
with a positive payoff in poor
o
conditions, and zero payoff in
45 good conditions
0 1.0 2.0 3.0
Price relative for poor conditions
This shows that by simply borrowing the debt security, which is risk-free, and
investing in the risky equity security we are able to create a derivative security which
performs well if the economy does well. In the same way, but now doing the
opposite, namely investing in the risk-free debt security and selling short the risky
security, we have created a derivative security that does well if the economy does
badly.
We can think of these two securities as a call and put option respectively.
If we have one of each type of claim with a payoff of one in each state, we have:
Good Poor
economic economic
Claim Present value conditions conditions
Derivative security 1 Price relative = 2.86; 1 0
(call security) = 1/2.86 = .349
Derivative security 2 Price relative = 1.66; 0 1
(put security) = 1/1.66 = .603
Sum .952 1 1

The return you get is 1/.952 = 1.05. This is the same as the risk-free return. This
makes sense since holding both claims is equal to holding the risk-free debt claim
which gives a guaranteed return in both good and poor economic conditions.
This suggests an alternative way of valuing the securities. We now have the condi-
tion that for the derivative security 1, we have:
+ = 1
+ = 0
Where is the fractional investment in the debt claim and delta D is the holding in
the equity claim. Delta is the ratio of the contingent claim value change to the equity
value change, namely:
1−0
= = .0111
120 − 30
Solving for gives D = .333, but this is the value at t=1. Discounting at the risk-free
rate gives a present value of the fractional investment in the debt of .317.
And derivative security 2, we have:
+ = 0
+ = 1
The delta is found by:
0−1
= = −.0111
120 − 30
Solving for the second derivative security gives a present value of .635.
So security 1 costs .317 today for every one paid in a good economic state in one
year’s time or nothing if the economy does poorly and, similarly, security 2
costs .635 for every one paid in the poor economic conditions in one year’s time, or
nothing if the economy does well.
Module 2
Review Questions

2.1 The correct answer is A. The risk profile is that of a commodity consumer. It is also
the one produced from having a short position in the underlying asset or a short
hedge.
2.2 The correct answer is B. For a hedge to work effectively, the asset position and the
hedge must have offsetting effects. If the asset price falls, then the hedge price must
rise.
2.3 The correct answer is C. Performance risk is the risk that a counterparty to a
transaction will not honour the bargain. It also goes under the name of counterparty
credit risk or, for simple transactions, settlement risk.

2.4 The correct answer is B. The marking-to-market process involves a revaluation of

an asset or a position to the current market price at which it can be realised by
selling in the market.
2.5 The correct answer is B. The diagram shows the payoff profile for a purchased put.
The owner will gain if the price of the underlier falls over the life of the option.
2.6 The correct answer is C. With a forward contract, the agreement is bilateral between
the buyer and seller for execution at a date in the future. The terms are set by the
two sides at the initiation of the transaction and, because of its bilateral feature,
there is performance or counterparty risk between the two sides.
2.7 The correct answer is A. In establishing an underlying long position, the effect of a
positive movement in the underlier is a rise in the market price. To hedge the
position requires a short position in the hedging instrument.
2.8 The correct answer is D. The futures clearing house will undertake the settlement
process for all the transactions that take place on the exchange. In doing so, it will
interpose itself between buyers and sellers and will effectively guarantee the transac-
tions and remove almost all performance risk.
2.9 The correct answer is C. The forward contract involves an exchange that will take
place at one future point in time. The swap involves a series of such exchanges.
2.10 The correct answer is D. Since a swap, conceptually, is a bundle of forward
transactions, any type of instrument that is covered by a forward can, suitably
engineered, also be created as a swap transaction.
2.11 The correct answer is D. The main difference between options and the other
members of the derivative product set is that options have a non-linear (asymmetric)
payoff profile, whereas the other derivative products have a linear (symmetric)
payoff profile.
2.12 The correct answer is A. The put option seller or writer has the obligation to
purchase the underlying asset from the option holder at a fixed price if the holder
wishes to exercise the right. The writer has taken on the risk that the price of the
asset may fall and hence the holder sells at a price above that which prevails in the
market at the time the option expires or ceases.
2.13 The correct answer is C. In establishing an underlying short position, the effect of a
positive movement in the underlier is a rise in the market price. To hedge the
position requires a long position in the hedging instrument.
2.14 The correct answer is C. In the case of an option, the buyer has no market risk since
the holder can only gain from having the option. At the same time, in theory the
seller takes on unlimited market risk.
2.15 The correct answer is B. In the case of an option, the buyer has credit risk since the
holder requires the option writer to perform under the contract if it should be
profitable to do so. At the same time, the seller takes on no credit risk.

Case Study 2.1

1 In order to create such a payoff we need to combine the call option – for the case
where the price rises – with a put option – for cases when the price falls. The
resultant combination would look as shown below:
Gain
Underlying
Loss
2 The approach involves both buying and selling an option on the same underlying
but for different strike prices. The first option establishes the position, the second
reverses the effect. The structure works as shown in the following figure.
Purchased option plus Sold or written option

+ +
Underlying
Underlying
– –
… when combined … Give a vertical (bull) spread
+ +
Gains here are

offset by losses
here
Underlying
– –
This illustrates how a position sensitive to price increases is created: the same is
done using puts to create a position sensitive to price decreases.

The initial option makes a profit up to the point at which the higher starting option
that has been sold starts to make losses. The gains and losses cancel and the
resultant payoff profile of the bottom right-hand quarter is obtained. To get the
vertical bear spread, we use puts instead of calls and the payoff is linked to a fall in
the price of the underlying.
Module 3
Review Questions

3.1 The correct answer is D. The required forward rate is derived from the relationship:
(1 + foreign currency rate)
Spot rate ×
(1 + domestic currency rate)
The required result is therefore:
1.065
FFr6.50 × = FFr6.5385
1.05
3.2 The correct answer is B. The buyer of a forward contract agrees to accept delivery
of the product.
3.3 The correct answer is C. A forward transaction is designed to fix transaction prices.
Given the way it is priced, it will not hedge the current spot value (as the forward
price is likely to be different from the current spot or cash market price). While it
can be used for speculation, this is not its main purpose.
3.4 The correct answer is D. The cost-of-carry model is a pricing model for deferred or
forward transactions. As such it is the price paid to the seller for agreeing to enter
into a forward transaction. (The components will be the current spot price plus
interest costs and other storage costs less any revenues received.) It is also the costs
associated with holding assets for future delivery and the cost of hedging a forward
transaction.
3.5 The correct answer is D. To obtain the implied interest rate, the forward price is
divided by the cash price to get the price relative, which since it is for three months
has to be raised to the fourth power to get the annualised rate:
335.25
= 1.02916
325.75
(1.02916) = 1.1219
So the implied interest rate = 12.2 per cent.
3.6 The correct answer is B. The expected forward price will be the spot price plus the
interest rate and the storage cost. Adding the $5 it costs to hold the unit for one
month and multiplying by the one-month price relative gives a value of $733.75:
/
($723.50 + $5) × (1.09) = $733.75

Note that we get $733.72 if we assume storage costs are paid at the end of the
month.
3.7 The correct answer is A. The replacement cost of a contract is the cost of replacing
the contract in the market in the event of default by the other party. We need to
value the current equivalent contract. Since the cost-of-carry model applies, a three
months’ delivery forward on the asset would sell for 875.80 × (1.065)0.25 = 889.70.
The current contract is priced at 950.25 so the replacement cost to the buyer is zero
since the value is above the replacement value. (Note that for the seller, the contract
has a positive value.)
3.8 The correct answer is A. The prices of the two contracts will be a function of the
prevailing interest rate and maturity before the contract is exercised. The first
contract will be equal to: 450.25 × (1.085) . = 459.53 and the second will be
equal to: 450.25 × (1.085) . = 469.00.
3.9 The correct answer is D. The correct answer is that forward contracts are traded
directly between participants (II), the terms and conditions are mutually agreed (III)
and the contract will perfectly hedge an exposure (VI).
3.10 The correct answer is B. The major cause of credit problems in forward contracts is
the risk that a counterparty will not honour (i.e., default on) their obligation to
perform under the contract.
3.11 The correct answer is C. Whereas a forward contract may be illiquid, some contracts
such as foreign exchange forwards are highly liquid so A may not apply. Equally, by
entering into a forward, the underlying position remains although the price risk is
removed, so answer B is incorrect. A forward contract will exchange a high proba-
bility of price changes in the asset or contract underlier in the future against the low
probability of non-performance.
3.12 The correct answer is D. In the forwards markets an arbitrageur will sell the cash
instrument and buy the forward if the forward is trading cheap to the cash.
3.13 The correct answer is C. When looking at the bid-offer spreads in cash and forward
markets for similar transactions, one might expect the bid-offer spread on the
forwards to be smaller than those for the cash markets, reflecting the fact there is
more credit risk attached to the forward.
3.14 The correct answer is D. The forward-start rate of deposit will be the implied three
months rate in three months’ time expressed as an annualised rate:
.
(1.08625)
.
= 1.02134
(1.084375)
The annualised rate = (1.02134) = 1.088128 = 8.8128%

3.15 The correct answer is C. The delay in the interest rate is three months, so is 3. The
actual interest rate period is also three months, so is also 3. The market would call
the agreement a ‘3 versus 6 agreement’.
3.16 The correct answer is A. When using simple interest, we need to apply the simple
interest formula to determine the implied forward rate. The 18-month period is
found by:
18
1 + 0.089375× = 1.1341
12
No adjustment is required for the 12-month rate, so 1.1341 / 1.0875 = 1.04282.
Subtracting 1, we multiply out the result to get the six-months rate in 12 months’
time = 8.5632%.
3.17 The correct answer is C. In an FRA transaction, the buyer contracts to pay at the
contractual rate. If the rate is below the contracted rate, the buyer pays the differ-
ence, as in the question. The FRA will require the payment of the difference
between the contracted rate and the actual rate (i.e. 8.25% − 7.875%) of 0.375% for
six months. This is equal to £100 000 000 × 0.375% × 0.5 = £187 500. This has to
be present valued to the start of the period: £187 500 ÷ [1 + (0.7875/2)] =
£180 397 .
3.18 The correct answer is D. The payment on an FRA depends on whether the
settlement rate is above or below the fixed rate on the FRA. If the settlement rate is
above the contract rate, the seller makes a payment. This is calculated as 6.375% −
6.15% = 0.225%. The cash amount at maturity = 0.225% × US$20 million ×
91/360 (US dollars use a 360 day basis) = US$11 375. This has to be present valued
at the settlement rate of 6.375% for the 91 days: US$11 194.
3.19 The correct answer is A. In a foreign exchange swap, the cash flows at the start date
are reversed at the maturity date. The initial exchange involves a sale of US dollars,
so these are received back at maturity. So we want to pay sterling and receive US
dollars. The forward value will be based on the forward outright exchange rate of
1.6351. £5 million × 1.6351 = US$8 175 500.
3.20 The correct answer is A. To reverse a foreign-exchange swap you need to undertake
offsetting transactions to eliminate your position. The initial transaction involved an
initial sale of US dollars (receipt of sterling) with a corresponding purchase of US
dollars (sale of sterling) at the forward date. The set of cash flows is as follows:
Date £ US$ FX £ US$

Initial transactions Reversing transactions
Spot + − 1.6385
+ 3 months − + 1.6351
Spot + 1m 1.5450 − +
+ 2 months 1.5450 + −

3.21 The correct answer is A. Given the information, we can construct the cash flows
from the two sets of transactions and the net position when all the contracts mature
as follows:
Date £ US$ FX £ US$ Net

Spot 5 000 000 (8 192 500) 1.6385
+ 3 months (5 000 000) 8 175 500 1.6351
Spot + 1m 1.5450 (5 000 000) 7 725 000 (467 500)
2 months 1.5450 5 000 000 (7 725 000) 450 500
0 (17 000) 0 0 (17 000)
The table shows that the net loss after all payments have been made and received is
US$17 000.
3.22 The correct answer is C. The transaction will be undertaken at the forward outright
exchange rate of US$1.6351/£. This makes a US$ amount of US$13 080 800 (£8
million × US$1.6351).
3.23 The correct answer is A. The swap has to be closed out by transacting on the
opposite side to eliminate the unwanted liabilities. Sterling is the base and the
amount is constant. The cash flows look as follows:
Date £ US$ FX £ US$ Net

3 months (a) (8 000 000) 13 080 800 1.6351
6 months (b) 8 000 000 (12 952 000) 1.6190
2 months (I) 1.5450 8 000 000 (12 360 000) 720 800
5 months (II) 1.5444 (8 000 000) 12 355 200 (596 800)
0 128 800 0 (4 800) 124 000
3.24 The correct answer is B. In a SAFE, the buyer is the party which notionally obtains
the base or primary currency of the SAFE contract at the settlement date (and hence
sells the foreign currency) and repays the primary currency at the maturity date (and
hence repurchases the foreign currency).
3.25 The correct answer is B. In the forwards markets an arbitrageur will buy the cash
instrument and sell the forward if the forward is expensive relative to the cash.
3.26 The correct answer is C. To work out the value of the swap, we need to revalue it in
line with current market conditions. The table below shows the initial value and the
current value at the prevailing exchange rate.

Time Exchange US dollars DM Time Exchange US dollars DM

rate rate
Initial valuation Revaluation
3 1.553 (10 000 000) 15 530 000 2 1.564 10 000 000 (15 640 000)
6 1.54 10 000 000 (15 400 000) 5 1.553 (10 000 000) 15 530 000
0 130 000 0 (110 000)
The swap had an initial value of DM130 000 (ignoring interest, etc.). The revaluation
in which the transaction is notionally reversed shows that the swap has a negative
value of DM110 000 if closed out after one month. Summing, the result is a positive
value of DM20 000 on the swap.
3.27 The correct answer is C. The forward swap points reflect the interest rate
differentials between the two currencies. The forward outright rate for the two
currencies for the three-month period will be:
(1.05125) .
£0.6575 × = £0.6597
(1.0375) .
The difference is 0.0022, or 22 points.
Note if you had used simple interest (which is the market convention), the result
would have been the same:
(1 + 0.05125 × 0.25)
£0.6575 × = £0.6597
(1 + 0.0375 × 0.25)
3.28 The correct answer is B. The forward swap points reflect the interest rate
differential between the two currencies. The swap points will be positive if the
quoted currency has a higher interest rate than the base currency. The swap points
will be negative if the quoted currency has a lower interest rate than the base
currency. In the question, the swap points are negative (−124) so the US dollar has a
lower interest rate than the euro. The numbers were taken from actual market data.
The one-year interest rate differential was 1.3 per cent. The one-year US dollar rate
was quoted at 1.95 per cent and the euro rate as 3.23 per cent.
Case Study 3.1: Interest-Rate Risk Protection

1 The company is seeking to fix the rate at which it can borrow future funds. In the
terminology of the FRA market, it wants to buy the FRA, that is, pay interest at the
contractual rate. By so doing, it will ‘lock in’ the required cost. So it will (notionally)
agree to pay 7.28 per cent. If it had notionally wanted to receive payment, it would
have obtained 7.18 per cent.
At the settlement date, the following will happen:
 if the settlement rate > 7.28 per cent, bank (market maker) pays the company the
difference;
 if the settlement rate < 7.28 per cent, customer pays the bank (market maker)
the difference.

2 At the settlement date, the three-month interest rate is now R whereas the fixed rate
is 7.28 per cent.
The FRA settlement formula is:
15 000 000[( − 0.0728) × 91 ÷ 360]
[1 + ( × 91 ÷ 360)]
There are 91 days from 1 April to 1 July.
The initial part requires us to calculate the value for R > 7.28 per cent when R =
7.85 per cent.
Since the company is locking in the rate, the bank pays the following:
15 000 000[(0.0785 − 0.0728) × 91 ÷ 360]
= DM21 192
[1 + (0.0785 × 91 ÷ 360)]
If the DM21 192 is invested at 7.73 per cent (the bid side of the market) for 91 days
it becomes DM21 606.07. The effective interest rate to the company on borrowing
therefore equals:
(DM15 000 000 × 0.0785 × 91 ÷ 360) − 21 606.07 360
×
15 000 000 91
which equals 7.28 per cent, the contracted rate.
If, on the other hand, the interest rate is now 6.50 per cent, the following settlement
takes place:
15 000 000[(0.0728 − ) × 91 ÷ 360]
[1 + ( × 91 ÷ 360)]
The bank (market maker) is paid:
15 000 000[(0.0728 − 0.065) × 91 ÷ 360]
= DM29 096.92
[1 + (0.065 × 91 ÷ 360)]
The total interest bill at maturity now becomes: DM29 575 + DM246 458 or a total
of DM276 033, or 7.28 per cent on an annualised basis.
Case Study 3.2: Exchange-Rate Protection

1 Using the tables we need to collect the different elements for the various
transactions in the case. It is helpful to summarise the information we require:
Initial outright: 1.1529 Spot at settlement date: 1.1900

1 v. 3 month swap points: 19 Two months’ swap points: 20
Two months’ interest rate: 4.25%
US$ basis: basis 360 Number of days: (T − T ) 60
Initial amount €100m Re-exchange amount: €120m

The exchange rate agreement (ERA) pays out on the basis of movements in the
forward points of the contract without regard to changes in the spot rate. The
formula for the ERA is:
( − )
Settlement amount = notional principal ×
× (T − T )
(1 + )
100 × basis
where is the forward points at the settlement date (0.0020), the forward points
as originally contracted (0.0019), is the interest rate (4.25 per cent) over the period
between the settlement date ( ) and the maturity date ( ) (two months, or 60
days) and the notional principal is the contracted amount in the primary or base
currency (€100 million). The solution is therefore:
0.0019 − 0.0020
× €100m = US$9930
4.25% × 60
(1 + )
100 × 360
2 Buying a SAFE is equivalent in swap terms to buying the primary currency – in this
case buying euro – and selling the secondary currency (US dollars) at the settlement
date and selling the primary currency – selling euro – and buying the secondary
currency (buying US dollars) at the maturity date. This means in order to make
money, we must act in a counterintuitive manner and sell high and buy low to make
a profit. The SAFE user is equally following a buy high/sell low approach in aiming
to get the greatest difference between the contracted rate ( ) and the settlement
rate ( ). So, having sold the SAFE or ERA, the transaction involves selling the
primary currency (euros) and buying the secondary currency (US dollars). Over the
one month of the transaction, the spread has widened from 19 to 20, so by selling,
the result is a loss.
We can consider this in terms of undertaking the foreign exchange swap in the
market. This would give the following results as shown in the table:
Initial transactions Closing transactions

Time US$ Euro FX rate US$ Euro Net positions
1(a) $(115 100 000) 100 000 000 1.1510
Spot (1m) (I) 1.1900 $119 000 000 100 000 000 $3 900 000
3(b) $115 290 000 (100 000 000) 1.1529
2 months (II) 1.1920 $(119 200 000) (100 000 000) $(3 910 000)
$(10 000)
Discounted = $(9 930)
Where 1(a) is the initial exchange (involving a sale of the base currency, if the ERA
is sold) and 3(b) is the repurchase at the forward date. The initial near date transac-
tion with the one-month maturity (1(a)) is reversed after one month at the new spot
rate (I). The net result is a loss on the near leg of $3.9 million. At the same time the
far date reversing purchase of the base currency is also closed out by selling the base

currency. This leads to a gain of $3.91 million. The difference is $10 000, which
present valued at the two-month dollar interest rate gives a net loss of $9 930 as per
the ERA.
3 The settlement terms on an FXA are as follows:
( − )−( − )
Settlement amount = × − ( − )
× (T − T )
(1 + )
100 × basis
where is the notional amount of currency exchanged at the maturity date (€120
million), the notional amount of currency at the start date (€100 million), is the
outright exchange rate at the settlement date ($1.19), the contract outright
exchange rate ($1.1529) and the other terms are as per the ERA in Question 1.
Substituting these values into the formula we have:
(1.1529 + 0.0019) − (1.1900 + 0.0020)
€120m× − €100m(1.1529 − 1.1900)
4.25 × 60
(1 + )
36 000
The value of the FXA is US$758 999.

1(a) $115 100 000 (100 000 000) 1.1510
Spot (1m) (I) 1.1900 $(119 000 000) 100 000 000 $(3 900 000)
3(b) $(138 348 000) 120 000 000 1.1529
2 months (II) 1.1920 $143 040 000 (120 000 000) $4 692 000
$792 000
Discounted = $786 430
4 The explanation lies in the different nature of the two contracts. The ERA is based
solely on changes in the forward rate, while that of the FXA includes movements in
the spot and the amounts of the contracts.
The effects can be summarised if we rework the contract to have the same notional
of €100 million for the initial and re-exchange in Question 3. With a constant
exchanged amount (of €100 million) the value of the FXA comes to US$17 501.


1(a) $115 100 000 (100 000 000) 1.1510
Spot (1m) (I) 1.1900 $(119 000 000) 100 000 000 $(3 900 000)
3(b) $(115 290 000) 100 000 000 1.1529
2 months (II) 1.1920 $119 200 000 (100 000 000) $3 910 000
$10 000
Discounted = $8 403
From Question 1 we know that the change in value from movements in the forward
points is $(9930) therefore the difference between the points movements and the
total change in value of $8 403 is due to changes in the spot rate. The gain from the
spot must be the difference between these two values, or $18 333.
We can see this by thinking about the nature of the contract. By buying the FXA we
are (1) initially buying the primary currency, i.e. euros (selling the secondary curren-
cy, i.e. dollars) at the settlement date and (2) selling the primary currency (buying the
secondary currency) at the maturity date. Since the quoted currency value has fallen
against the euro from $1.1500 to $1.1900, although the swap points have worsened
(from 20 down to 19), the contract has made a money.
Module 4
Review Questions

4.1 The correct answer is D. Futures markets require all participants to post a deposit
(known as margin or a performance bond), transactions are revalued at the end of
each trading day and a central clearing house interposes itself as the counterparty to
all transactions.
4.2 The correct answer is B. To enhance liquidity, futures markets restrict the number
of maturity dates for delivery on the contracts (sometimes to as few as four dates
per year). Restricting the number of market makers on a contract is likely to reduce
liquidity, not enhance it. Increasing the number of underlying assets in a particular
contract may – in some circumstances – help increase liquidity, but this too may also
impair liquidity in some circumstances.
4.3 The correct answer is C. Marking to market is the process by which the exchange
revalues market participants’ positions at the futures clearing house. Those positions
which have increased in value are credited with the gains, those that have fallen in
value are debited with the losses.

4.4 The correct answer is D. Margin or collateral is posted to the futures exchange
clearing house to ensure the buyer or seller acts in good faith and will pay for losses
incurred by changes in market prices and to protect the clearing house against
possible default.
4.5 The correct answer is B. Price discovery is that process by which the demand and
supply for assets, which are yet to come into existence (such as future agricultural
produce), are revealed by participants’ actions in the futures markets which affect
prices. Price discovery makes no claims about what the price may be at the maturity
of the contract nor about the price behaviour until its maturity date.
4.6 The correct answer is C. Transaction prices are set in the futures markets by a
process called ‘open outcry’ where futures brokers seek the highest selling prices or
the lowest buying prices available from all other brokers in the market at the time.
By doing this, only the lowest buy price and highest sell price are matched, the other
prices being extinguished by the dominant bids and offers.
4.7 The correct answer is C. The open interest position is the total number of long or
short contracts that are outstanding and recorded at the exchange at the close of
business. This is 13 725 contracts.
4.8 The correct answer is A. The volume of contracts traded and the amount of open
interest are indicators of the demand for futures and hence risk management. From
day 1 to day 2 both the open interest and volume have risen, indicating an increased
demand for hedging or speculation.
4.9 The correct answer is C. To determine the answer we need to compute the
number of ticks change: 86.23 − 83.25 − 298 ticks. Each tick is worth
£12.50 and we have 20 contracts. The formula is: Number of ticks change ×
Tick size × Number of contracts. This is: 298 × £12.50 × 20 = £74 500.
4.10 The correct answer is C. The margin account will initially receive US$2500 ($500 ×
5). The price at which the contracts was established was 92.34 and the closing price
is 92.28 so the contract has lost 6 ticks in value (92.34 − 92.28). Each tick is worth
US$25 and there are 5 contracts, so the total change in value = 6 × 5 × US$25 =
US$750.
4.11 The correct answer is B. By selling, the short position holder is committed to sell
the underlying asset at expiry.
4.12 The correct answer is C. An inter-commodity spread (also known as a cross-spread
or inter-market spread) involves buying a futures contract on one underlying asset
and selling a futures contract on another underlier. Buying (or selling) a nearby-date
expiry futures contract and selling (buying) a later-dated futures contract is known as
an intra-commodity spread (or a calendar or intra-market spread).
4.13 The correct answer is C. To determine the answer, we need to work out what Bill
did:
Action Effect
He sold 5 contracts at 375.60 375.60
He bought 5 contracts back at 350.20 350.20
Difference × 5 contracts 25.4 × 5 = $127

For gold futures each contract is worth 100 ounces = $127 × 100 = US$12 700 gain.
4.14 The correct answer is D. Note that effectively his profit would be credited every day
as the price fell to the point that when he sold, he would have the full variation
margin already credited to his account. The amount will be 254 ticks at $10 per tick
times 5 contracts, or US$12 700.
4.15 The correct answer is D. Bill had to put up US$2500 in initial margin per contract
(that is, a total of US$12 500). His return, therefore is a function of his gain and the
invested capital.
4.16 The correct answer is B. The basis is the difference between the spot price and the
futures price. The generic formula is: Spot price less futures price = basis. Therefore
the basis = US$1346.70 − US$ 1361.80 = (US$15.1).
4.17 The correct answer is D. A trader would refer to the basis as being under futures.
That is, in the absence of any change in interest rates or the cash price, the futures
price would be expected to fall towards the cash price as the contract moved
towards expiry, i.e. the convergence of the cash and futures position would take
place from below. This relationship, known as contango or a positively sloped
curve, is considered the normal condition of many futures markets.
4.18 The correct answer is A. We can think of the fair value of the futures as the price at
which the cash commodity can be held and sold into the contract. This would be
the cash price plus the cost of carrying the commodity over the time period:
61
US$1346.70 × 1+0.05 = US$1358.11
360
Note that this answer is US$3.70 different from the quoted futures price. The actual
fair value and market price of the futures can diverge to some extent due to some
technical factors (such as variations in the cost of carry, the availability of physical
commodity, etc.). It is unlikely that a participant would seek to arbitrage this
position: his gain per contract would be 1.6 per cent p.a.; hardly worth the risk or
transaction costs.
4.19 The correct answer is C. If you had bought and then sold futures, you would have
no position in the futures market. If you had sold and then bought futures you
would likewise have no position in the futures market. By selling futures you have
the obligation to make delivery (i.e. a short position). If you had bought futures, you
have the obligation to take delivery (that is, a long position).
4.20 The correct answer is A. If you have a long position on one side and a short on the
other, the two positions cancel each other out. Therefore you are hedging when
doing the above. Having a long and a short position in futures might seem to be the
same as A. But to have a long and a short position in futures, you would need to be
buying one set of contracts and selling another (either a short-dated versus a long-
dated contract or contracts in two different assets or exchanges).
4.21 The correct answer is B. By holding a short position in the cash market and a short
position in futures you are seriously anticipating a fall in the price of the underlying
asset. In this case you are definitely speculating: you are betting that the price of the
cash position and the futures position will both decline in value so that you can
repurchase them at a lower price! This is speculation per se.

4.22 The correct answer is C. To facilitate transactions a range of bonds are deliverable
into the contract at expiry. The bond which, based on the price adjustment formula
used by the futures exchange for such contracts, gives the least loss or highest profit
to the seller (a short futures position) is known as the cheapest to deliver. That is, it
is the bond which generates either the greatest profit or least loss to the seller.
4.23 The correct answer is D. The fair value of the futures contract will include
borrowing costs and storage, loss and so forth on holding the commodity. If we
hold the contract for one month, the fair price will be the spot price times the
interest rate and storage costs, so we would need to get £245.25 × (1 + 0.0625) +
£5 to break even = £251.49. We hold the commodity a further month, which gives
a value of: £251.49 × (1 + 0.0625) + £5 = £257.77, and for the final month the
fair value is £264.07.
4.24 The correct answer is A. If the interest rate used to value the future goes up, then
the cost of carry is increased and the futures price should rise. It will now be priced
at £264.82.
4.25 The correct answer is B. The futures fair price will be the spot price times the
interest rate and storage costs but now for two months: that is,
the fair value = [£238.70 × (1.0625)( / )
+ £5] × (1.0625)( / )
+ £5 = £250.14
(The figures in square brackets being the value after 1 month).
Note with simple interest, the value will be:
[£238.70 × (1 + 0.625/12) + £5] × (1 + 0.625/12) + £5 = £251.22
4.26 The correct answer is B. The fair value of the futures will be 733.40[718.35 ×
(1.0865) . ]. The actual futures price = 729.10. The value basis = actual futures
price − theoretical price = 729.10 − 733.40 = (4.3).
4.27 The correct answer is C. The value basis is negative. This can be determined by
calculating the fair value of the futures contract: 448.60 × (1.065) = 450.96. The
value basis = actual futures price less the fair value = 450.75 − 450.96 = −0.21.
4.28 The correct answer is C. The basis is the cash − futures relationship. The initial
basis = 1050.75 − 1118.25 = (67.50). After the price change, the new basis =
1160.25 − 1245.75 = (85.50). The cash price has changed by: 109.50 and the futures
price by: 127.50, so the basis has weakened.
4.29 The correct answer is B. The basis is the relationship between the cash market (in
this case, the implied forward rate) and the futures price. The initial cash − futures
relationship = 12.4375% − 12.47 (100 − 87.53) = 0.03 (rounding to 2 decimal
places). The change in price means that the new relationship = 11.875% − 11.88
(100 − 88.12) = 0, so the basis has strengthened.
4.30 The correct answer is B. The fair value of the index is found by:
.
× [1 + (0.05 − 0.04)] = 6095.14
The carry basis = spot price − fair futures price = 6080.00 − 6095.14 = (15.14).

4.31 The correct answer is C. When tailing a hedge, we need to present value for the
amount involved. Using the formula, we have £65 million −rt . This gives a present
value of £63 553 830. Each contract is worth £0.5 million, so that gives a total of
127.11 contracts that are needed. (We would have got 127.14 contracts if we had
used simple interest.) We need to round down to 127.
4.32 The correct answer is A. In the futures markets an arbitrageur will buy the cash
instrument and sell the futures if the futures contract is priced expensive relative to
the cash.
4.33 The correct answer is D. In order to determine whether a cash-and-carry
opportunity exists, we need to calculate the fair value of the futures. This is found
by 3733 × (1 + (0.08 − 0.03 × 152 ÷ 365) = 3811.81. The index is trading at 3805,
so there is a value basis of (6.81). To exploit this one should buy the cash and sell
the futures. However, the net proceeds from buying the index = 3714.43 when
transaction costs of 0.5 per cent are included. The value at expiry will therefore be:
3714.43 × 1.0211 = 3792.84, which is less than we need to pay off the contract
value of 3805.
4.34 The correct answer is B. The differences between financial forward contracts and
financial futures contracts are: futures are traded on an organised exchange whereas
forward contracts are not (II), futures contracts are standardised whereas forward
contracts are not (IV) and forward contracts are not tradable (V).
4.35 The correct answer is C. Margin is the term for the collateral in cash or securities
placed with the exchange’s clearing house to ensure performance (hence it is also
sometimes called a performance bond).
4.36 The correct answer is C. A cash-settled contract is one where the value of the
contract at expiry is paid in cash and no physical commodity is exchanged at
maturity. Buyers and sellers who wish to receive or deliver the commodity will trade
in the physical spot markets.
4.37 The correct answer is C. The futures price will equate to the difference in the
running yields between the funding rate and the yield on the bond. Over the three
months, the bond will earn 100 · = 102.28. Over the same period, the short-
term interest rate will lead to a value of 103.05. Therefore the futures price will be
103.05/102.28 = 100.75.
Note you can calculate this directly if we assume that the yield on the bond is a
dividend yield then the equation can be written as:
( - )× (. . )×.
= 100 = 100.75

In the absence of any changes in interest rates, the bond will converge from above.
The futures prices are:
Fraction of year Futures price

0.25 100.75
0.1 100.30
0.05 100.15
0.01 100.03
0.0001 100.00
The basis will be 100.00 − 100.75 (that is −0.75) at three months.

4.38 The correct answer is A. The intention is for the value relationship between the FT-
SE MidCap and the FT-SE 100 index to narrow. For the company to make a gain, it
wants the spread relationship to narrow, so buying the MidCap and selling the FT-
SE 100 future is the right strategy.
4.39 The correct answer is D. A short-term interest rate futures contract is traded on an
index where (100 − i) is the futures price. For a contract to move from 88.79 to
89.85, means that the underlying interest rate has fallen (from 11.21 per cent to
10.15 per cent). Since we have a long position in the futures, having bought the
contracts, and the price has risen, we make money.
4.40 The correct answer is B. The cost-of-carry model applies to the index. Using the
simple interest model, the calculation is: 830.00 × [1 + (0.06 − 0.04 × 4 ÷ 12)] =
835.53.
4.41 The correct answer is D. The time to expiration is 91/365 = .249. The calculation is:
$70.40
= ln + (.03 + .01)(.249) /.249 = .1351
$68.75
Case Study 4.1: The Use of Short-Term Interest-Rate Futures for Hedging
1 The treasurer’s assessment of the impact of 50 bp adverse movement in cash market
exposure is as follows:
US$50m × 50 bp × 92/360 = US$63 888.89
If the treasurer does not hedge and interest rates fall, there is a loss of interest of
US$63 888.89 on the investment.
2 A 1 bp shift in interest rates means a $25 change in the futures value. The treasurer
has determined that a 50 bp shift in his investment return for 92 days will translate
to US$63 888.89, as in the answer to Question 1. The price sensitivity of a futures
contract for 50 basis points = US$1250. That for the underlying position =
US$1277.78.

The treasurer expresses his exposure as eurodollar futures as follows to get the
number of contracts required:
US$63 889.89
= 51.1 contracts
50 × US$25
Note: we could have expressed this relationship equally as:
$1277.78 ÷ $1250 × 50
To protect against a change value, the treasurer needs to buy 51.1 contracts (since
each contract is worth US$1 million). It is not possible to buy part-contracts, so the
treasurer rounds down and buys 51 futures contracts to lock in the investment rate
on US$50m.
3 To find out what the rate is, one must interpolate between the cash rate of 9.50 per
cent (this is the bid side since the funds will be deposited) and the 20 June implied
futures rate of (100 − futures rate [90.18] − 0.125 {i.e., bid-offer spread}) = 9.70%.
We can see the calculation as follows:
April 2 May 15 June 20

41 days 36 days
Spot Forward
3 months 3 months
Euro$ rate = Euro$ bid
9.50% Interpolated rate = rate =
(9.82 – 0.12)
9.50 36 + 9.70 41 =
77 77
9.70%
= 9.61%
Using eurodollar futures, the treasurer expects to achieve 9.61 per cent on his three-
month investment on 15 May.
4 The cash price of a futures contract implied by the three-month eurodollar LIBOR
on 2 April is 9.625% = 100 − 9.625 = 90.38. The basis on the futures contract for
the contract is therefore: 90.38 − 90.18 = 20 bp. We also know that by 20 June, the
basis will be zero (due to convergence). We can calculate the expected basis for 15
May as 20 × 36/77 = 9 bp. That is, in the absence of any change in interest rates,
the contract should have converged from 90.18 to 90.29. We can illustrate the
process as in the following figure.
We can therefore deduce that the expected rate on 15 May will be:
Expected rate = [100 − 90.18 − 0.125] − 0.09 = 9.61%
This is the same as we obtained via our interpolation of the yield curve.

April 2 May 15 June 20

Cash price
(as a futures price)
90.38
20 bp 9 bp Expiry
(convergence
Convergence means means the basis
basis should fall by = 0)
–11 bp
June futures price
90.18
5 With cash market rates down, as feared by the treasurer, the rate at which funds can
be invested for 92 days is now the bid side of LIBOR, or 9 per cent. Since the
treasurer bought futures at 90.18 and they are trading at 90.70, there is a profit on
the futures position of 90.70 − 90.18 = 52 ticks. Each tick is worth US$25 and he
has 51 contracts. So the gain = 51 × US$25 × 52 = US$66 300. This can be added
to the funds to be invested for the three months. US$50 066 300 invested for 92
days at 9 per cent comes to a total of US$51 217 824.90. The return on the invest-
ment is therefore 9.53 per cent.
The calculations are summarised in the table below.
15 May Cash market Futures market

Action Invest US$50 066 300 Realise profit of:
[51 × US$25 ×
(90.70 − 90.18) × 100] =
US$66 300
15 August US$50 066 300 ×
{1 + (0.09 × 92/360)}=
US$51 217 824.90
Effective interest rate US$1 217 824.90 ÷
US$50 000 000× 360/92
× 100 = 9.53%

6 We repeat the analysis carried out to answer Question 5. However, in this case, we
get a profit of 90.79 − 90.18 = 61 ticks. This makes a gain of 51 × US$25 × 61 =
US$77 775. If we repeat the calculations done earlier with the new values we show
that the treasurer gets 9.62 per cent on his investment. The calculations are summa-
rised in the following table:
15 May Cash market Futures market

Action Invest US$50 077 775 Realise profit of
[51 × US$25 ×
(90.79 − 90.18) × 100] =
US$77 775
15 August US$50 077 775 ×
{1 + (0.09 × 92/360)}=
US$51 229 563.83
Effective interest rate US$1 229 563.83 ÷
US$50 000 000× 360/92
× 100 = 9.62%
7 The results can be explained by the behaviour of the basis on the futures contract.
Recall that we anticipate convergence of the basis to zero at expiry. However, there
is scope for the basis to change if the implied forward rate which underlies the June
futures contract changes. Twists and rotations in the yield curve will create such
non-linear changes in the basis. The changes are summarised in the following table:
Original conditions Rates Expressed as a futures price

Cash price 9.625% 90.37
Futures price 9.82% 90.18
Basis 90.37 − 90.18 00.19
Hedge Scenario 1
Cash price 9.125% 90.88
Basis 90.88 − 90.70 00.18
Hedge Scenario 2
Cash price 9.125% 90.88
Basis 90.88 − 90.79 00.09
Scenario 1 shows a basis on 15 May significantly different from the expected basis
of 9 bp (due to rotation in yield curve). This change in the forward rate means that
the treasurer fails to get the expected 9.61 per cent on the investment.

Scenario 2 shows a basis somewhat better but the basis has only fallen by 9 bp not
the 11 implied by the convergence on the contract. The result is, once again, an
inexact hedge.
Module 5
Review Questions

5.1 The correct answer is B. A cross-currency swap involves an exchange of two sets of
cash flows in different currencies. A transaction that involves an initial exchange of
one currency at one time period and the subsequent re-exchange of the currency at
a future time period is a foreign exchange swap. A transaction which modifies the
interest rate on a set of cash flows is an interest rate swap. Exchanging bonds
denominated in different currencies is a bond swap.
5.2 The correct answer is D. Swaps are derivative instruments which allow financial
managers to transform assets and liabilities in one currency into another currency, to
change the nature of the interest rate risk (fixed to floating and vice versa) and to
take advantage of funding and investment opportunities.
5.3 The correct answer is D. With a cross-currency swap, one exchanges cash flows in
one currency for a series of cash flows denominated in another currency. It is also
possible to change fixed rate to floating rate or vice versa and to exchange floating
rate based on one reference rate into floating rate based on another reference rate.
5.4 The correct answer is A. The fixed rate payer (that is, one who is contractually
required to pay the fixed rate and receive the floating rate) is functionally equivalent
to one who has borrowed at the fixed rate and hence issued a bond (that is, to be
short the bond market) and invested in a floating rate asset (floating-rate note). The
fixed-rate payer is known as the swap buyer.
5.5 The correct answer is B. The funding source for X is a bond issued at 7.25 per cent.
Firm Y agrees to pay a quarter the difference between its fixed rate and X’s fixed
rate (8.125 − 7.25 × 0.25 = 0.22). Therefore, Y pays 0.22 per cent above X’s rate,
that is, a total of 7.47 per cent, which coupled to its LIBOR + 0.50 per cent floating
cost of funds, gives an all-in cost of 7.97 per cent for Y. The gain to X = LIBOR −
7.25 + 7.47 = +0.22, less LIBOR +0.25 per cent = all-in cost of funds of LIBOR +
0.03 per cent.
5.6 The correct answer is C. At the initial exchange, the two sides will swap the
principal underlying the swap. The sterling value of £10 million equates to FFr87.5
million.
5.7 The correct answer is C. The present value of the FFr payments will be equal to the
exchanged sum since the swap is at-market. This can be checked by calculating the
present value of the payments at the interest rate of 4.55 per cent:
1 1 1 1
3.98 × − ÷ + 87.5÷
0.0455 0.0455 1.0455 1.0455
That is, FFr87.50 million.

5.8 The correct answer is D. The final payment at maturity will be composed of two
elements, the last interest payment, which is equal to FFr3.98 million, and the
principal of FFr87.50 million. This makes a total of FFr91.48 million.
5.9 The correct answer is B. To create a synthetic fixed-rate bond, we start by
borrowing at a floating rate and entering into a swap to pay fixed and receive
floating. The floating receipt matches the floating liability and the borrower is left
with a fixed rate (that is, a bond-like) liability.
Note that, on the asset side, buying a floating-rate loan or note and paying away the
floating-rate interest received on the asset and being paid (receiving) on the fixed
side also creates a synthetic fixed-rate bond.
5.10 The correct answer is A. If the yield on a bond less that on a swap to receive the
floating rate (that is, to pay the fixed rate) is positive there is a yield-enhancing
opportunity. For instance, if the bond provides a yield of 10 per cent and we can
enter into a swap to receive floating and pay the fixed rate at 9.70 per cent, then we
have a synthetic floating rate note with a return of LIBOR + (10.00 per cent − 9.70
per cent) = 0.30 per cent. Note that the attraction of such an instrument will,
naturally, depend on whether the investor can buy a similar yield directly in the
floating-rate note/loan market.
5.11 The correct answer is B. The annual amortising payments without the subsidy will
be SFr9.595 million. The present value of these periodic payments at the subsidised
rate of 3.5 per cent come to SFr79.7978 million. The subsidy element is therefore
SFr4.7978 million.
5.12 The correct answer is B. The total US dollar value is equal to SFr75 million less the
SFr4.80 million subsidy. At the exchange rate of SFr1.50/$ this is equal to a
US$46.8 million. The annual repayments on this amount will be US$6.21 million.
5.13 The correct answer is C. In order to find the three-year discount rate, we need to
back out the zero-coupon prices in the swaps yield curve. The first year zero-
coupon rate is the same as the swaps rate. The second year rate is found by:
7.20% + 100
=
7.20
100 −
1.071
This gives 1.1492610.5 . The zero-coupon rate is therefore 7.72036 per cent. We find
the third year by adding the two discount factors 0.933707+ 0.870124 = 1.803831.
The third year zero-coupon discount rate is:
7.30 + 100
= = 1.2357190.33
100 − (7.30 × 1.803831)
The zero-coupon rate is therefore 7.3099 per cent.
5.14 The correct answer is D. The true present value of a swap on which you are a fixed-
rate payer is based on its term structure pricing. To find this, we need to calculate
the fourth year’s zero-coupon rate (as in Question 5.13). The four-year rates are
given in the following table:

Time Zero-coupon rate Discount Cash flow PV cash flow

factor
0 −1
1 0.071 0.933707 0.065 0.060691
2 0.072036 0.870124 0.065 0.056558
3 0.073099 0.809245 0.065 0.052601
4 0.073633 0.752621 1.065 0.801542
−0.028608
Note that, to calculate the present value of a swap we need to treat it as a bond
equivalent. The result from this calculation is −0.028608. Since a swap is a two-way
set of payments, this can equally be a gain. When contracting to pay the fixed rate,
we are receiving more on the floating-rate side if the fixed-rate coupon is below
market rates. Therefore the sign is positive since we would need to be compensated
for the higher payments required if we were to reset the transaction with at-market
swaps.
5.15 The correct answer is C.
Time Yield Discount Cash flow PV cash flow

factor
0 −1
1 0.074 0.931532 0.065 0.06055
2 0.074 0.867753 0.065 0.056404
3 0.074 0.80834 0.065 0.052542
4 0.074 0.752995 1.065 0.801939
−0.028565
The term structure approach gives the swap the correct value of 97.1392 and the
yield-to-maturity method 97.1435. The difference is that the yield method overval-
ues the swap by 0.0043.
5.16 The correct answer is C. The one-year rate in two years’ time is found by dividing
the three-year price relative by the two-year price relative and subtracting 1 and
multiplying by 100. The three-year price relative = (1.073099) = 1.235719. The
two-year price relative = (1.072036) = 1.149261. Therefore 1.235719 ÷ 1.149261
= 1.075229. Therefore the one-year floating rate in two years = 7.52 per cent.
5.17 The correct answer is B. To calculate the present value of the payments which are
semi-annual, we need to work out the implied rates for the three future periods.
These can be calculated as:
( ) ( )
1+ ( ) 1+ = 1+

The value of the payments is calculated from the following table:
Floating
Zero-coupon payment per
Time rate Floating rate 100 nominal Present value
0.5 4.50% 4.4505% 2.2252 2.176802
1 4.55% 4.5483% 2.2742 2.175182
1.5 4.60% 4.6461% 2.3231 2.171509
2 4.70% 4.9396% 2.4698 2.253026
8.77652
Remember that a zero-coupon rate is the annualised rate, so for the half-year
payment, we need to convert the rate to the semi-annual alternative.
5.18 The correct answer is C. The calculation of the fixed side of the swap requires us to
equate 10.95 = ∑ PV(floating payments) = ∑ PV (fixed payments). We know that
10.95 is the PV of the floating payments. We can calculate the annuity for the 2.5
years by summing the discount factors for the zero-coupon rates for the five interest
periods. This equals 4.6722. Therefore (10.95 ÷ 4.6722) × 200 = 4.69 per cent.
5.19 The correct answer is A. The fair value of a swap is found by calculating the present
value of the cash flows at the appropriate zero-coupon discount rates. The calcula-
tion is shown in the following table:
Time Cash flow Discount factor Present value

0 100 1 100
0.5 −3.25 0.978232 (3.17925)
1 −3.25 0.95648 (3.10856)
1.5 −3.25 0.934765 (3.03799)
2 −103.25 0.912235 (94.1882)
(3.51404)
The fixed-rate payer, is required to make the fixed payments so the swap has a
negative present value of 3.51. If the fixed-rate payer were receiving the fixed, the
swap would have had a positive present value of the same amount.
5.20 The correct answer is A. When a term structure is upward sloping, the implied
forward rates will be rising and hence, the first fixed payment will be higher than
that paid by the floating-rate payer. The assumption is that at a later date, this
condition will reverse and the fixed-rate payer will receive more than the floating-
rate payer.
5.21 The correct answer is D. The yield-to-maturity approach will not provide accurate
pricing to off-market fixed-rate swaps, to an amortising swap or to a deferred-start
swap.

5.22 The correct answer is A. To value the seasoned cross-currency swap, we need to
revalue the remaining cash flows at the new interest rates. The calculation is done in
the table below.
FFr £ FFr £
Interest 4.55% 6.50% 5.65% 5.75%
rate
Time
1 3.981 0.650 (3.76834) 0.614657
2 3.981 0.650 (3.56681) 0.581236
3 3.981 0.650 (3.37607) 0.549632
4 91.481 10.650 (73.4267) 8.515852
(84.1379) 10.26138
£ £ net
(11.6052) (1.34385)
To ABC plc, the remaining French franc payments are a liability, the sterling
payments an asset. The present value of these at the new interest rates of FFr5.65
per cent and £5.75 per cent come to FFr(84.14m) and £10.26m. Converting the FFr
payments to sterling at the current exchange rate of FFr7.25/£ gives a net liability in
sterling terms of £11.61m. Adding these means the swap has a net negative value of
£1.34 million to ABC plc.
5.23 The correct answer is D. When analysing the swap, we know that the FFr interest
rate rose from 4.55 per cent to 5.65 per cent, so that effect was negative. The
sterling interest rate went from 6.50 per cent down to 5.75 per cent, so that effect
was negative, but the exchange rate moved from FFr8.75/£ to FFr7.25/£, so this
effect was positive.
5.24 The correct answer is C. The first step is to present value 1 per cent of the four
swaps used to create the amortising swaps, as in the following table.
Year Principal Swaps PV(1%) PV1% × swaps rate

1 100 8.25% 0.923788 7.621247
2 100 8.10% 1.779541 14.41428
3 100 8.00% 2.573373 20.58699
4 100 7.80% 3.313873 25.84821
∑ 400 68.47072

The next step is to present value 1 per cent of the outstanding notional principal
using the par swaps rates as shown in the following table:
PV1% of blended
Year Principal DF swap
1 400 0.923788 3.69515
2 300 0.855849 2.567548
3 200 0.794101 1.588202
4 100 0.741418 0.741418
8.592318
The blended or uniform swaps rate quoted by a swaps market maker will be
68.47072 ÷ 8.590574 = 7.97%.
5.25 The correct answer is A. To calculate the value of the deferred swap, we need to
find the zero-coupon annuity factor for one and three years and the deferred
annuity factor for two years, together with the appropriate swap rates, as in the
following table:
Year Swap rate Annuity factor

3 8% 2.573738
1 8.25% 0.923788
Swap 2-year deferred 1.64995
To calculate the deferred-start swap, we solve the following:

(8 × 2.573738) − (8.25 × 0.923788)
= 7.86%
1.644995
5.26 The correct answer is C. For credit risk to arise on a swap, the swap must be off-
market (such that it has a positive value to the party at risk of default) and the other
party must cease to honour the agreement.

Case Study 5.1

1 To compute the floating rate, we find the implied semi-annual forward interest rates
as per the following table:
Zero- Implied Zero-

coupon ( + ) floating Periodic Payment coupon PV
Period rate ( + ) rate payment per £1m discount payment
factor
0.5 5.50 1.0271 5.426 0.0271 27 132 0.9736 26 415
1.0 5.70 1.0291 5.816 0.0291 29 079 0.9461 27 511
1.5 6.00 1.0325 6.497 0.0325 32 485 0.9163 29 766
2.0 6.20 1.0335 6.690 0.0335 33 452 0.8866 29 660
2.5 6.40 1.0354 7.079 0.0354 35 393 0.8563 30 308
4.5790 143 661
The floating rate for the third period is found by:

1/0.600 .
−1 = 1.032485
1.0570
The implied floating rate for the six-month period expressed, as an annualised rate,
will be (1.0325 − 1) × 200 = 6.497%.
The payment per million will be 0.0325 × £1m = £32 485. These payments must be
discounted at the zero-coupon rate. The present value of these payments will be
£143 661.
2 We sum the zero-coupon discount rates to find the 2½-year annuity factor
applicable for the swap, which is 4.478953. The fixed rate will therefore be:
£143 661 × 2
× 100% = 6.2748%
4.578963 × £1m
Say 6.30% for part 3.
3 We need to calculate the replacement value of the swap at the new interest rates of
5.30%, 4.30% and 3.30% for the remaining 4 semi-annual periods. This calculation
is based on the assumption that default occurs at some time after the first semi-
annual swap payment is made but before the second payment is made.
We need to compute the replacement cost for the swap for the change in the
interest rate. If interest rates decline by 1%, then the loss of interest per period from
a new, at-market, replacement swap will be £5000 per £1 million. This is simply
calculated as the one per cent interest charge per million on a semi-annual basis, that
is: 0.01 × £1 million × 0.5. The new interest rate will be 5.30% semi-annual. The
annuity factor for this and the other rates required are given below:

% change New PV Loss of PV Probability PV

in interest interest annuity interest value of times
rate rate factor per period loss rate change probability
−1% 5.30% 3.74842 £5 000 18 742 0.25 £4 686
−2% 4.30% 3.79391 £10 000 37 939 0.1 £3 794
−3% 3.30% 3.84029 £15 000 57 604 0.05 £2 880
£11 360
ρ default 0.01 £114
The loss from default if interest rates have fallen by 1 per cent is now multiplied by
the probability of a one per cent fall in the swaps rate. For a 1% fall, the expected
loss is £4686. The total expected loss is the sum of the changes in interest rate times
their occurrence: this comes to £11 360. Finally, since there is a 1% chance that the
counterparty will default, the expected loss from changes in interest rates and from
the counterparty defaulting is £114 per million.
4 The swaps profile will be as follows:
1500 Panel A: Notional principal

Notional principal
profile for step-down swap
1000
500
1 year 2 years
Maturity
1500 Panel B: Notional principal

Notional principal
profile for step-down swap

as blended simple swaps
1000 Swap 2
500
Swap 1
1 year 2 years
Maturity
The two simple swaps required to make up the amortising swap are:
1. a 500 million swap with a maturity of 2½ years
2. a 1000 million swap with a maturity of one year
To compute the blended rate on the swap, we must first back out the one-year
swaps rate from the zero-coupon rates. We have already calculated the implied

floating rate side from part 1. All we need to do now is compute the fixed rate on a
one-year swap.
Implied
Period floating rate Payment PV factor PV
0.5 5.426 2.713193 0.973585 2.641523
1 5.816 2.90791 0.946074 2.751097
1.919659 5.392621
The 1-year swaps rate is (5.392621 × 2) ÷ 1.919659 = 5.618312%, say 5.62%. We

now have the information required to compute the blended swap. It is summarised
in the following table:
Swap Notional principal amount Simple swaps rates

1-year 1 000 5.62%
2½-year 500 6.28%
1 500
The last step is to calculate the blended rate on the swap. First we calculate the value
of 1 per cent of the plain vanilla swaps that make up the blended swap:
Notional principal PV1% × simple swap

amount Rate PV1% rate
1 000 5.62 1.919659 53.926
500 6.28 4.578953 71.890
125.816
Next we compute the same for the blended swap, this time using the discount
factors from the zero-coupon rates:
Notional principal
Time period amount PV factor PV1% × simple swap
rate
0.5 1 500 0.9736 14.60377
1 1 500 0.9461 14.19111
1.5 500 0.9163 4.581537
2 500 0.8866 4.433237
2.5 500 0.8563 4.281697
42.091350

The final step is compute what would be the appropriate blended rate such that the
present value of the two elements are the same:
125.816
= 2.9891
42.019135
The annual fixed rate is therefore 5.98 per cent (2.9891 × 2).
We can check this by calculating the PV of the cash flows from the two swaps: the
bundle of one and two-and-a-half year swaps and the blended swaps.
Coupon Coupon
payment payment 2½-
(5.62% (6.28% PV 1-year year
Period Principal s.a) Principal s.a) factor PV PV
0.5 1 000 28.09 500 15.7 0.9736 27.35 15.29
1 1 000 28.09 500 15.7 0.9461 26.58 14.85
1.5 0 500 15.7 0.9163 14.39
2 0 500 15.7 0.8866 13.92
2.5 0 500 15.7 0.8563 13.44
53.93 71.89
Total PV 125.82
And for the blended swap:

Coupon pay-
ment (5.98% PV coupon
Period Principal s.a) PV factor payments
0.5 1 500 44.84 0.9736 43.652
1 500 44.84 0.9461 42.419
1.5 500 14.95 0.9163 13.695
2 500 14.95 0.8866 13.251
2.5 500 14.95 0.8563 12.798
125.816
Note there will be some cash flow differences between the plain vanilla swaps used
to create the blended swaps and the blended swap itself:
Cash flow differ-
Period Blended swap Plain vanilla ences
0.5 44.84 43.79 1.05
1 44.84 43.79 1.05
1.5 14.95 15.70 −0.75
2 14.95 15.70 −0.75
2.5 14.95 15.70 −0.75

The par swaps rates for the different maturities are given below.
Maturity 1 1.5 2 2.5

Swap rates 5.618 5.902 6.090 6.275
Module 6
Review Questions

6.1 The correct answer is C. The difference between options is that the holder has the
ability to walk away from completing the contract whereas for terminal instruments
there is a requirement (in the absence of default) to complete the bargain at maturi-
ty.
6.2 The correct answer is B. With a call option the payoff is based on the gain between
the asset price ( ) and the strike price ( ) at expiry, namely ( − ). A call holder
will therefore exercise if the asset price is above the strike price at expiry.
6.3 The correct answer is D. When you sell – or write – a call (or a put, for that matter)
you receive the premium at the initiation of the transaction. If the call is exercised
by the holder, you are required to surrender the asset.
6.4 The correct answer is B. The value of the option plus the present value of the
purchase price will be equal to or greater than the asset price less any income
distribution from the asset before expiry. The income distribution on the asset will
only be paid to the asset holder (the option writer).
6.5 The correct answer is D. The call option contract will include the amount and price
to be paid for the underlying asset and the time span over which the option can be
exercised. At initiation, the holder will pay to the writer the agreed amount of the
option premium. The rate of interest applicable will not, however, form part of the
option contract (although it is important in pricing options). So D is not part of the
call option contract.
6.6 The correct answer is D. With a put option contract, the terms and conditions will
include whether the option can be exercised at any time up to and including expiry
(that is, whether it is American-style) or can only be exercised at expiry (that is, it is
European-style). It will include details of the price at which the underlying asset can
be sold and the amount of the premium to be paid. The rate of interest applicable
will not, however, form part of the option contract. So D cannot be determined
from the put contract.
6.7 The correct answer is B. The writer of a put option will receive the premium when
the transaction is initiated and (if exercised) will buy the underlying asset at the
agreed price.

6.8 The correct answer is C. A European-style option allows the holder to exercise the
option only at the expiry of the option. Options which allow exercise at any point
are American style or if they allow exercise at fixed dates are variously known as
Mid-Atlantic or Bermudan-style options.
6.9 The correct answer is B. The option has a strike price ( ) = 175. The underlying
asset ( ) is at 180.25. The option therefore has an intrinsic value of (180.25 − 175)
= 5.25 and so is in-the-money. The cost of the option is 6.5, so there is a net loss
from the transaction of 1.25. Note that, even though the transaction made a loss,
not exercising would have resulted in a greater loss (6.5) since all the cost of the
premium would be lost.
6.10 The correct answer is A. An in-the-money call option will have a strike price ( )
that is below the asset price ( ) and as a result will have positive intrinsic value.
6.11 The correct answer is D. An out-of-the-money put option will have a strike ( ) that
is below the asset price ( ) and as a result will have no intrinsic value.
6.12 The correct answer is C. If the asset price is 217 and the strike price is 212 then, for
a put, the option will have no intrinsic value. All the option value will be time value,
which is given in the question as 8.
6.13 The correct answer is D. For a call option, the difference between the asset price
( ) and the strike price ( ), if positive represents intrinsic value. The asset price =
6950.50 and the strike = 6825.50. The difference is 125, to which must be added the
175 of time value, giving an option value of 300.
6.14 The correct answer is B. In terms of time value, options which are at-the-money
have the greatest time value.
6.15 The correct answer is B. An increase in the underlying price means the value of a
call rises. Equally, a fall in the risk-free interest rate means the call value falls,
whereas an increase in volatility raises the price of the call.
6.16 The correct answer is B. A decrease in the underlying price means the value of a put
rises. Equally, a rise in the risk-free interest rate means the put value falls, whereas
an increase in value leakage raises the price of the put.
6.17 The correct answer is B. Value leakage has the effect of reducing the price of the
underlying asset. This means the potential gain from a call ( − ) is reduced, so
the price of calls is reduced. However, it raises the price of puts since the gain
( − ) is increased.
6.18 The correct answer is B. If the value of the underlying asset falls, the value of calls is
reduced and that of puts increased.
6.19 The correct answer is B. If the risk-free interest rate falls, this reduces the price of
calls (since there is less gain from deferring the purchase) and raises the value of
puts (since there is less loss from deferring the sale).
6.20 The correct answer is D. If the time to expiry of an option is reduced, this reduces
the value of both calls and puts on the asset.
6.21 The correct answer is D. If the volatility of the underlying asset falls, this has the
effect of reducing both the value of calls and puts.

6.22 The correct answer is C. When looking at the strike price of calls it is a boundary
condition that the difference in price between two calls that differ only in their strike
(or exercise) price must be less than or equal to the present value of the difference
in the exercise price. However, for American-style calls the difference cannot exceed
the difference in their strike prices. Therefore there is an arbitrage opportunity
between the 125 and the 130 strikes. This involves buying the 125 strike and selling
the 130 one since the price difference is 6. By definition, if the 130 option is in-the-
money, the 125 will also be in-the-money, so if the 130 is exercised, the 125 is also
exercised to enable delivery of the asset at a loss of 5, but there is a gain of (14.5 −
8.5) on the option position, giving a net gain of 1. If the 130 option is not exercised
then the 125 is not exercised and the net is 6.
6.23 The correct answer is B. It is not always true that a European-style put with a longer
maturity is strictly worth more/less than a similar one with a shorter maturity.
However, a longer-maturity American-style put (which has the option of immediate
exercise) will be strictly more valuable than a shorter-maturity one.
6.24 The correct answer is C. Put–call parity theory states that put plus underlying = call
plus present value of the exercise price. Hence, the value of a put = a call with the
same exercise price as the put plus the present value of the exercise price less the
underlying asset price.
6.25 The correct answer is D. Factors which may lead to the early exercise of an
American-style option include any concerns about the creditworthiness of the
option writer, a deeply in-the-money put and a deeply in-the-money call when a
distribution is due on the underlying asset. However, concern about the creditwor-
thiness of the underlying asset is not a condition for early exercise of American-style
options. So D is not a condition for early exercise.
6.26 The correct answer is C. There are six fundamental option strategies: long and short
calls and puts, and short call and long the underlying asset and short put plus short
the underlying asset. Holding a long call and a short put is a combination of two of
the fundamental strategies. So C is not a fundamental option strategy.
6.27 The correct answer is C. The diagram is the resultant payoff of a short call or its
synthetic variant that is created by selling a put (i.e., short the put) and taking a short
position in the underlying asset.
6.28 The correct answer is D. A vertical spread is a directional strategy which is based on
the underlying asset either rising or falling over the optioned period. The usual
spread can be set up using either two calls (a bull vertical spread) or two puts (a bear
vertical spread) with the same expiry date but different strike prices.
6.29 The correct answer is D. By selling a call and a put with the same expiry date but
with different strike prices, we are selling a strangle. The payoff of a written strangle
is shown below.

+ Maximum gain arises when the

underlying asset price does not change
Written put
Written call
Underlying
asset price
K1 K2
To make money, such a position requires the underlying asset price to stay within a
narrow range. Hence it is also known as selling volatility.
6.30 The correct answer is A. With a put option the payoff is based on the gain between
the strike price ( ) at expiry and the asset price ( ), namely ( − ). A put holder
will exercise therefore if the asset price is below the strike price at expiry.
Case Study 6.1

1 The strike price, $1550, less the current market price of $1426, gives an intrinsic
value of $124. The contract is trading at $129, so $5 is the time value.
2 If we look at the $1550 July puts, they have a value of $84, which is $9 less than the
September puts with the same strike price. If we roughly interpolate for the loss of
time value between the two as being $4, we would expect the August puts to have a
value of $89 or $88. They are trading at $78 which is significantly different from
what we might expect. It looks as if the August puts are cheap and there is an
arbitrage opportunity between the September-dated put and the August one.
However, care needs to be exercised when looking at such a table since it may
report the last trade in a given contract rather than an actual market dealing price.
This could account for the price discrepancy between the three puts with the $1550
expiry price.

3 The payoff diagram for a bullish vertical spread is as given in the figure below:
+
Payoff of
vertical spread
Written call at strike K2
K1 K2 Asset
price
Purchased call
at strike K 1
A bullish vertical spread involves buying the lower-priced option (which for the
$1450 strike involves a premium outlay of $27) and selling the $1500 strike (giving a
premium income of $13). The net cost of the position is therefore $13 − $27 =
($14). The maximum gain on the position will be the difference between the two
strikes, or $50 less the net cost of setting up the position, so the most the position
can give is $36. So the range of possible outcomes will be between a loss of $14, if
the market price of cocoa is below $1450 on expiry and a gain of $36 if the cocoa
price is at or above $1500 at expiry.
4 By using puts instead of calls we have what is known as a credit spread since we are
net recipients of the premium. To give the same payoff profile, we need to sell the
higher-priced put and purchase the lower-priced one. For the July puts we sell at $84
and purchase at $48, making a net $36. At expiry, we know that if the higher-priced
put is out-of-the-money, no exercise will take place, so our maximum gain will be $36
in that case. (Hence this is also a bullish directional strategy since we want the
underlying asset price to go up.) For every dollar the $1550 put ends up in-the-money,
we lose $1 until we can exercise the $1450 strike to cap our losses. So the maximum
loss is $36 − $50, or ($14). You will notice that the bullish spread set up with calls or
puts gives the same payoffs under the same market conditions!

5 The payoff diagram of a straddle looks like this:
Purchased put
+ Purchased call
Put and call combination

‘straddle’
–
If we set up a straddle, we are either buying or selling both the call and put. This will
cost us, for the $1450 September contracts, $66 and $59, or $125. The strike is
$1450, so we need the underlying cocoa price to move to $1450 ± $125 in order to
break even, that is, outside the band $1325–$1575, if buying, or we start to lose
money, if selling.
Module 7
Review Questions

7.1 The correct answer is B. To price the option, we need to first work out the option’s
delta. This is found by:
4−0
= = 0.40
55 − 45
We can now compute the payoff of the replicating portfolio:
Elements of the replicating Increase in price to Decrease in price to

transaction 55 {u} 45 {d}
Proceeds from selling the 4 × 55 = 220 4 × 45 = 180
asset
Payout on short call position 10 × (4) = (40) 0
Repayment of borrowing (180) (180)
PV of borrowing: 173.08 173.08
We know that for the equation to balance, we have 10 × call − 200 + 173.08 = 0,
or 10 calls − 26.92 = 0. Therefore each call is worth 2.692.
7.2 The correct answer is B. The option’s delta is the ratio of the price changes on the
option (20 − 0) to that of the asset (250 − 200) = 0.40.

7.3 The correct answer is C. Applying the formula to solve for the amount of borrowed
funds, we have:
−
= ( )( − )
Substituting the values from the question, we have:
(200)(20) − (250)(0)
=
(1.051)(250 − 200)
So the borrowed funds will be 76.10.
7.4 The correct answer is C. The rise in the asset price will be a function of:
( )
−
=
−
We know that = 0.01, = 1.04, therefore = 0.96. Given this result, we can
substitute into the equation:
1.01 − 0.96
= 0.63
1.04 − 0.96
7.5 The correct answer is A. The put’s value can be found by working out the payoff
from the put times its probability. The payoff is 20, and there is a (1 − 0.51)
likelihood of the asset falling over the period. This means the put’s expected value is
9.8. We need to present value this, so we discount by the risk-free interest rate:
9.8 ÷ 1.02 = 9.6.
7.6 The correct answer is C. We know that if the price increases, the value of the option
for the upper pair in the tree will be 302.5 − 260 if the price increases in the second
stage and 250 − 260 if it decreases, with a minimum value of zero. The option
price’s range is therefore 42.5 − 0, and for the asset 302.5 − 250. We can find the
option’s delta by applying the formula:
−
=
−
The delta is 45.5 ÷ 52.5 = 0.81.
7.7 The correct answer is B. To solve for the price of the option, we can either solve the
tree numerically, or apply the two-period binomial pricing equation. Solving
numerically, we start by drawing the tree of the asset prices and then find the option
price for the final nodes, as shown below.
Strike price = 260 302.5

275 42.5
15
250 250
0
227.3
206.6
0
We now apply the valuation model. First we find the probability of a rise ( ) by
solving for:
( )
−
=
−

The ratio of the price rise = 275 ÷ 250 = 1.1. That for a fall is 227.3 ÷ 250 = 0.91.
Substituting into the equation, we have:
1.03 − 0.91
= 0.6316
1.1 − 0.91
The value of the upper pair for Period 2 =
(0.6316)(42.5) + (0.3684)(0)
= 26.06
1.03
We now compute the first-period value:
(0.6316)(26.06) + (0.3684)(0)
= 15.98
1.03
If we had decided to use the two-period computation, we would have used the
formula:
( )[ ]
= +2 (1− ) +(1 − )
Substituting the values, we have:
0.9426[(0.6316) 42.5+2(0.6316)(0.3684)0+(0.3684) 0] = 15.98
7.8 The correct answer is D. To compute the option’s delta, we need to find the upper
and lower values for the option in Period 3 for the particular branch. The upper
price = 546.4, the lower price = 515. The option values will be: 56.4 and 25 respec-
tively. We can now compute the option’s delta as:
56.4 − 25
= 1.00
546.4 − 515
7.9 The correct answer is B. To find the delta for the third pair, that is the pair made up
of the two outcomes 500 and 471.3 in Period 4, we need to apply the delta calcula-
tion, but this time for puts:
−
=
−
We know that the value of the put for the upper pair is 495 − 500 (with puts, the
payoff = {max. − , 0} ) and 495 − 471.3, so the put will have a value of 0 and
23.7 respectively. Substituting in the equation, we have:
0 − 23.7
= −0.83
500 − 471.3
Note that the delta of a put will be negative in option pricing theory since the
actions required to hedge the put option are the opposite of those taken with a call.
7.10 The correct answer is A. To compute the option value with two periods to expiry,
we can apply the two-period computation equation:
( )[ ]
= +2 (1− ) +(1 − )
To use the equation, we must first work out the values for the call at the end of the
second period for the branches of the tree: The strike is 495, so we have the
following prices:

Branch of the Asset value Option value at

tree t=2
530.5 35.5
500 5
471.3 0
We can find the value of = 530.5 ÷ 515 = 1.03, = 500 ÷ 515 = 0.97, = 0.01
per period. The probability of a rise will be:
( )
− 1.01 − 0.97
= = = 0.6667
− 1.03 − 0.97
The two-period option will have a present value of:
0.98[(0.6667) (35.5)+2(0.6667)(0.3333)(5)+(0.3333) (0)]
So the two-period option has a value of 17.64. We can now compute the value of
the one-period option as:
(0.6667)(20) + (0.3333)(0)
1.01
which gives a value of 13.20. The difference in their prices = 17.64 − 13.20 = 4.44.
7.11 The correct answer is B. If we change the risk-free interest rate from 0.01 to 0.02,
we will modify the risk-neutral probabilities of a price rise based on the equation:
( )
−
=
−
The new risk-neutral probability of a rise will be:
1.02 − 0.97
= 0.8333
1.03 − 0.97
If we raise the interest rate, we find the probability of a rise has gone up.
7.12 The correct answer is C. If after four periods the upper terminal value of asset price
is at 550 rather than the previous 562.8, we now have a rate of increase (decrease)
which is (550 ÷ 500)0.25 = 1.10.25 , or 1.024. So the rate of increase (decrease) has
fallen.
7.13 The correct answer is B. To compute the increase or per step for the binomial
model, we use the following equation:
=
where is the upward movement, is the annualised standard deviation, ( − ) is
the time and is the number of steps. Substituting the variables from the question
we have:
.
.
=
Solving, we find that = 1.0287.

7.14 The correct answer is B. To obtain the answer, we must first compute the variables
, and . We employ the formulas:
=
We find that = 1.0127, = 0.9875, and = 1.0002. We can now substitute these
into the equation:
−
=
−
This gives:
1.0002 − 0.9875
= 0.5040
1.0127 − 0.9875
7.15 The correct answer is B. If we have a put and call with the same strike price and
expiry date then by definition one will be in-the-money and the other one will be
out-of-the-money. The asset price is 120 and the call can be exercised at 100, so the
call is in-the-money and the put – by definition – is out-of-the-money.
7.16 The correct answer is B. We can apply put–call parity to price the put given the
price of the call. The value of the put will be:
Put = Call + PV (Exercise price) − Asset price
The put value = 24.50 − 120 + 98.55 = 3.05.
7.17 The correct answer is B. The value of the put based on put–call parity is found by
solving for:
Put = Call + PV (Exercise price) − Asset price
Applying this, we find that:
.
Put = 33.75 + 490 ÷ 1.1 − 500 = 0.95.
The put is currently trading at 1.15 so is overpriced in the market. However, we
cannot determine from the information which of the two options is wrongly priced,
but we know that one – or possibly both – are mispriced.
7.18 The correct answer is B. In arbitrage, we want to sell the overpriced asset and buy
the underpriced/correctly priced one. We therefore want to execute a strategy where
we sell the overpriced puts and hold the synthetic position. With options, the
application of the put–call parity theory will indicate what the transaction to take
advantage of the mispricing of the put option should be. We know that the follow-
ing should hold:
Put + Asset = Call + PV (Exercise price)
We therefore sell (short) the asset and receive 500, we buy the call at 11.30 and
invest the present value of the exercise price, 505.19. This gives us a net cost of
(16.49). However, we can sell the put for 17.50, thus netting a gain of 1.01 from the
overall transaction. If, at expiry, the asset price is above 515, the put will not be
exercised and we exercise our call to close out the short position in the asset using

the invested value of the exercise price to pay for the purchase. If the asset price is
below 515, we receive the asset from our short put position and pay out the exercise
price. We then use the asset to close out the short asset position.
7.19 The correct answer is A. To compute the option’s delta, we calculate the ratio of the
change in the option price to that of the underlying: that is, 9 ÷ (175 − 145) = 0.30.
7.20 The correct answer is C. To price the option, we need first to work out the option’s
delta: This is found by:
30 − 0
= = 0.375
240 − 160
We can now compute the payoff of the replicating portfolio:
Elements of the replicating Increase in price to Decrease in price to

transaction 240 {u} 160 {d}
Proceeds from selling the 3 × 240 = 720 3 × 160 = 480
asset
Payout on short call position 8 × (30) = (240) 0
Repayment of borrowing (480) (480)
PV of borrowing 461.54 461.54
We know that, for the equation to balance, we have 8 × call − 600 + 461.54 = 0,
therefore: 8 calls − 138.46 = 0. Therefore each call is worth 17.3.
Case Study 7.1

1 To price the call, we need to compute the values for , and . We employ the
following equations:
We find that = 1.0851, = 0.9216 and = 1.0033.
We now need to compute the tree and the terminal values for the asset prices after
six steps. The tree in the following table shows the option value at each stage.
0 1 2 3 4 5 6
Volatility 0.4
Time 0.25
Steps 6 163.21
i 8% 150.42 .21
Call strike 105 138.62 45.77 138.62

0 1 2 3 4 5 6
127.76 34.32 127.76 33.62
117.74 24.42 117.74 23.11 117.74
108.51 16.60 108.51 14.68 108.51 12.74
100 10.87 100 8.89 100 6.35 100
6.91 92.16 5.22 92.16 3.16 92.16 0
2.99 84.93 1.58 84.93 0 84.93
0.79 78.27 0 78.27 0
1.085076 0 72.14 0 72.14
0.921595 0 66.48 0
1.003339 0 61.27
0.500023 0
(1 − ) 0.499977
Based on the pricing variables we find a call value of 6.91.

2 We can approach the put pricing via two different methods: put–call parity and
directly using the binomial tree to price up the put. The answer uses the tree method
to illustrate its use. The tree for a put is given below.
0 1 2 3 4 5 6
Volatility 0.4
Time 0.25
Steps 6 163.21
i 8% 150.42 0
Put strike 105 138.62 0 138.62
127.76 0 127.76 0
117.74 0.62 117.74 0 117.74
108.51 2.47 108.51 1.24 108.51 0
100 5.63 100 4.34 100 2.49 100
9.83 92.16 8.83 92.16 7.47 92.16 5.00
14.10 84.93 13.37 84.93 12.49 84.93
19.46 78.27 19.37 78.27 20.07
1.085076 25.68 72.14 26.38 72.14
0.921595 32.17 66.48 32.86
1.003339 38.17 61.27
0.500023 43.73
(1 − ) 0.499977
This gives a price for the put of 9.83.

We can check this calculation by using the put–call parity formula:

Put + Asset = Call + PV (Exercise price)

9.83 + 100 = 6.91 + 102.92
3 The second pair of outcomes from the top has the prices = 117.74 and = 100.
The two option prices are 1.24 and 7.47. The delta of the put at this point will be:
1.24 − 7.47
= = −0.35
117.74 − 100
4 Given the point in the lattice of asset and put prices, a rise in the price will mean we
have the asset price pair: = 127.76 and = 108.51. The put value will be =0
and = 2.49. The delta of the option will thus be:
0 − 2.49
= = −0.13
127.76 − 108.51
For the lower pair, the prices will be = 108.51 and = 92.16. The put value at
this point will be = 2.49 and = 12.49. The put’s delta will thus be on the
lower fork:
2.49 − 12.49
= = −0.61
108.51 − 92.16
5 To see the effect of a reduction in the strike price of the put from 105 to 104, we
need to recalculate the tree with the payoffs of the put changed to reflect the new
strike price. This is done in the following table.
0 1 2 3 4 5 6
Volatility 0.4
Time 0.25
Steps 6 163.21
i 8% 150.42 0
Put 105 138.62 0 138.62
strike
127.76 0 127.76 0
117.74 0.49 117.74 0 117.74
108.51 2.16 108.51 0.99 108.51 0
100 5.14 100 3.84 100 1.99 100
9.19 92.16 8.15 92.16 6.72 92.16 4.00
13.30 84.93 12.51 84.93 11.49 84.93
18.53 78.27 18.38 78.27 19.07
1.085076 24.69 72.14 25.38 72.14
0.921595 31.17 66.48 31.86
1.003339 37.17 61.27
0.500023 42.73
(1 − ) 0.499977
So the new value of the put is 9.19, a fall in price of 0.64.

Module 8
Review Questions

8.1 The correct answer is A. The binomial option-pricing model uses discrete time
whereas the Black–Scholes model uses continuous time and further assumes that
the underlying asset’s volatility is constant and that closed-form computational
methods are used to derive the option price.
8.2 The correct answer is B. The time (given as ( − ) in the module) is expressed as a
fraction of a year. Therefore the time to expiry will be 466 ÷ 365 = 1.28.
8.3 The correct answer is C. Treasury bills are quoted on a discount basis. To find the
implied interest rate, we find the discount at which the bill is trading using the
formula: 100 − % × ( − )/ basis. We know that = 6.55 per cent, therefore
the discount price at which the bill is trading = 98.3625. The price relative = 100 ÷
98.3625 = 1.0166. We now derive the annualised rate by 1.01664 which gives
1.0683. We find the natural logarithm of this: ln(1.0683) = 6.60 per cent.
8.4 The correct answer is B. We know that Treasury bills are quoted at a discount to
par. The price relative and hence the implied yield for such bills will be (100 ÷
98.50)365÷150 − 1. The annualised yield will therefore be: 3.75 per cent. The
continuously compounded rate is found by taking the natural log of 1 + 0.0375
which gives a rate of 3.68 per cent.
8.5 The correct answer is B. The annualised volatility of the asset will be found by:
periodic volatility × √time. Therefore 0.018 × √52 = 0.13.
8.6 The correct answer is C. We can estimate the standard error (SE) using the
following formula:
∗
=
√2
where ∗ is the computed estimate of volatility and is the number of observations.
Substituting, we find that = 0.36 ÷ √2 × 75 = 0.029.
8.7 The correct answer is B. The data show a pattern where the implied volatility of
option prices is reducing with time. The implication is that future uncertainty is
declining with option maturity and hence future uncertainty is also decreasing with
time.
8.8 The correct answer is B. The value of the stock for option purposes is the current
value less the present value of the dividend (which will not be received by the
option holder). So $125 − $4 ( ) = $121.
8.9 The correct answer is A. To find out the current relationship of the asset, adjusted
for the value leakage, to the strike price, we first adjust the share for the dividend in
115 days’ time: the adjusted share price = 0 − 1 · − ( − ) . Therefore the
. ×( ÷ )
adjusted price = 265 − 12.5 · = 252.75. The strike price is 255 so
the option is slightly out-of-the-money.

8.10 The correct answer is B. The annualised volatility of the asset will be found by:
periodic volatility × √time. Therefore 0.029 × √12 = 0.10.
Case Study 8.1: Applying the Black–Scholes Model

1 Before we start we must convert the discount rate on the 60-day T-bill into the
continuously compounded rate. The discount = 100 − 4.30% × (60 ÷ 365) = 99.29.
The price relative = 1.00712 and the continuously compounded rate is 4.3153 per
cent.
To compute the call price using the Black–Scholes model, we must first calculate the
two sub-equations for 1 and 2 :
ln + + ( − )
2
=
( − )
= − ( − )
For 1, therefore, we substitute the pricing factors into the sub-equation:
120 0.04
ln + 0.043153+ 0.1644
= 140 2 = −1.7729
0.2√0.1644
and
= −1.7729 − 0.2√0.1644 = −1.8540
The next stage is to find the values for ( ) and ( ) from the table. With
1 = −1.7729
Area under the table Value for ( )

−1.77 0.03836
−1.78 0.03754
Difference 0.00082
Required interpolation
−1.7729 0.00082 × 29/100 = 0.00024
Interpolated value: −1.77 + interpolation 0.03836 + 0.00024 = 0.03812
For ( ) we proceed in the same manner where 2 = −1.8540.
Area under the table Value for ( )

−1.85 0.03216
−1.86 0.03144
Difference 0.00071
Required interpolation
−1.7729 0.00071 × 40/100 = 0.00029
Interpolated value: −1.77 + interpolation 0.03216 − 0.00029 = 0.03187

Substituting the values into the Black–Scholes top equation, we have:
= 120(0.03812 − 140(0.992932)(0.03187) = 0.1445
So the call has a value of 0.1445.
To price the put, we can apply the put–call parity formula:
= + ( )−
Substituting we get:
= 0.1445 + 139.01 − 120
So the put is worth 19.15.
2 We know that, for calls, if the asset price is below the strike price, the call will be
out-of-the-money. We can check this from the prices of the two options and
knowing the relationship between a call and its corresponding put. As a conse-
quence, the put is in-the-money.
Note that the put has a value less than max. { − , 0} prior to expiry. As discussed
in Module 6 on the basics of options, the boundary value conditions on a Europe-
an-style put can be expressed mathematically as:
> max. { ( )− , 0}
Min = max. { ( )− , 0}
which is what we obtained when we used the put–call parity relationship to value
the put: 19.15 > (139.01 − 120).
3 The delta ( ) or ( ) from the Black–Scholes equation of the two options is:
call: 0.038
put: −0.962
The implication is that the call is very unlikely to be exercised whereas the put is
highly likely to be exercised (the maximum delta possible on the put being −1.0).
We might say the call is, in fact, deeply out-of-the-money and the put deeply in-the-
money.
As an aside, if the put were American style, we would want to exercise it immediate-
ly since we could get a sales price of 140 immediately by doing so, with the prospect
of reinvesting it at the risk-free rate for the remaining 60 days.

Case Study 8.2: The Black–Scholes and Binomial Models
1 The Black–Scholes sub-equations to derive 1 and 2 are:

250 0.0625
ln + 0.05+ 0.329
= 240 2
0.25√0.329
= 0.47113
= − 0.25√0.329
= 0.32778
We find ( ) and ( ) from the table (or via the polynomial approximation
method). These are 0.681226 and 0.628462 respectively. We substitute these into the
top equation to get the call price C:
= 250(0.681226) − 240(0.9837)(0.628462)
= 21.93
2 We now need to compute the equivalent call value of the binomial option pricing
model using the numerical method. The tree of asset prices and related option values
at each step is given in the table below. Reiterating the option’s value for the six steps
gives an option price of 22.34.
0 1 2 3 4 5 6
Volatility 0.25
Time 0.33
Steps 6 355.17
i 5% 334.98 115.17
Call strike 240 315.94 95.63 315.94
297.98 77.25 297.98 75.94
281.04 59.94 281.04 58.64 281.04
265.07 44.67 265.07 42.35 265.07 41.04
250 32.09 250 29.10 250 25.72 250
22.34 235.79 19.25 235.79 15.54 235.79 10
12.35 222.39 9.15 222.39 5.07 222.39
5.28 209.75 2.57 209.75 0
1.060267 1.31 197.82 0 197.82
0.943159 0 186.58 0
1.002743 0 175.97
0.508801 0
(1 − ) 0.491199
The difference in the two prices of 0.40 is not surprising given that we have used
only six steps for the binomial model. As mentioned elsewhere we would need at

least 20 or more steps for the option price to converge on that given in the Black–
Scholes model.
The value of the pricing factors is as follows:

Term on the option (time to expiry) 120
days
Discount rate on a 60-day T-bill 5%
Module 9
Review Questions

9.1 The correct answer is C. If the underlying asset price on a call increases, this
potentially increases the payoff of ( − ), so the call price will increase. At the
same time, it will decrease the payoff for a put ( − ) so the value of the put will
decline.
9.2 The correct answer is A. With all other factors remaining constant, if we increase
the underlying asset’s volatility then the prices of calls and puts will increase.
9.3 The correct answer is A. An option’s delta (δ) or hedge ratio is the change in the
option price for a given (small) change in the underlying asset price.
9.4 The correct answer is D. An option’s gamma (γ) is the rate of change in the option’s
delta when there is a change in the underlying asset price.
9.5 The correct answer is B. Vega (which is also known by other names) is the option
price’s sensitivity to a change in the underlying asset’s volatility.
9.6 The correct answer is B. To delta hedge a position, having written a call on an asset,
we need to buy ( × × ) . We have written 50 options which are on
100 shares. Our delivery obligation is therefore 5000 shares. We want to buy delta
(0.45) of that number, or 2250 shares.
9.7 The correct answer is B. If we are dynamically replicating a written option position
and if the delta falls from 0.67 to 0.65, we should sell some of our existing underly-
ing asset.
9.8 The correct answer is A. The delta of an option is the rate of change for a given
change in the underlying. For a call option this will be:
=
If the asset price changes by −5(245 − 250) and it has a delta (δ) of 0.60, then the
option price will change by (−5 × 0.60), or −3.

9.9 The correct answer is C. In a non-volatile market situation, with an option with a
high delta value of 0.80, as the time to expiry is reduced, we can anticipate that the
delta will increase (towards 1).
9.10 The correct answer is A. The gearing of an option in respect to the underlying asset
price will be at its highest when the option is deeply out-of-the-money.
9.11 The correct answer is B. Gamma (γ) measures the rate of change for delta (δ) in an
option. The rate of change of delta will be highest when the option is at-the-money.
9.12 The correct answer is D. A delta/gamma neutral strategy will require the existing
gamma (or rate of change in delta) to be neutralised. The position is long 2100
gamma: to neutralise this, we sell options (giving a negative gamma): 2100 ÷ 1.4 =
1500. So we sell 1500 of the delta 0.45 options. By doing this, we unbalance the
delta of the position, so we now need to adjust the position in the underlying. We
have sold options so need to buy (delta × underlying per option) = 1500 × 0.45 =
675 of the underlying asset.
9.13 The correct answer is A. The sensitivity of the portfolio will be:
Element Position delta

Ordinary shares: 10 000
Written calls: (2 140)
Purchased puts: (648)
Net delta position: 7 212
9.14 The correct answer is B. The gamma sensitivity of the portfolio will be:
Element Position gamma

Ordinary shares: 0
Written calls: (265)
Purchased puts: 101
Net gamma position: (164)
9.15 The correct answer is C. The theta sensitivity of the portfolio will be:
Element Position theta

Ordinary shares: 0
Written calls: 90
Purchased puts: (24)
Net theta position: 66
9.16 The correct answer is C. The signs of the three positions are δ = +, γ = −, and θ =
+.
9.17 The correct answer is D. If the price of the share changes by −1, the value of the
puts will change by +0.58 (since puts, with a negative delta, become more valuable

as the underlying asset price falls). The ratio of the price changes is thus 0.58. Each
put is exercisable into 100 shares, so for the 10 000 share portfolio we need 100 puts
to provide cover. However, we are wanting to balance the value change (hence, the
idea of a complete hedge) so we need to balance the value change sensitivity of the
two sides. We do this by buying 172 puts. They will change in value by +0.58 ×
172 × 100 = 9976 per one change in the underlying. (Note that it is not a totally
perfect match and gamma effects would come into play over a wide price change.)
9.18 The correct answer is D. Delta is a measure of the relative sensitivity of the option
price to that of the underlying asset: if the delta is 0.4, we can expect the price of the
option to change by 0.4 of that of the underlying asset for small changes in price. It
is also the measure of the asset equivalence of the option: a high delta means that it
is more asset like, a low delta less asset like. In hedging options, we need to delta
hedge by holding or selling the delta amount of the contracted amount of the
underlying asset. It is also a measure of the likelihood of the option having a
positive value at expiry: high delta options having a high probability of exercise and
the reverse for low delta options. Options which are at-the-money will have a delta
= 0.50. So D is not a function of delta.
9.19 The correct answer is B. We know that the delta movement on a written call will be
−0.44 and the written puts 0.51. We want the price ratio change for this that is
closest to zero. We have 51 calls which change by 0.44 = 22.44 and 44 puts which
change by 0.51 = 22.44.
9.20 The correct answer is C. The delta sensitivity of the alternatives is given in the
following table:
Alternative Action Delta sensitivity

A Buy puts −
B Sell calls −
C Buy calls +
D Sell the underlying −
Of the four possible actions, C, buying calls, increases the delta of the position. All
the other actions have a negative delta sensitivity and hence reduce the delta of the
position. So C does not reduce the position delta.
9.21 The correct answer is B. The correct ratio of calls is found by determining the
required sensitivity of the two positions: We need to equate:
( ) =− ( )
We want to sell the two options in the ratio 0.29/0.58 = 0.5. Hence for every call
bought we need two of the written calls to achieve delta neutrality on the position.
9.22 The correct answer is C. If the stock price increases by 1, from 54 to 55 and the
option price increases from 6.375 to 7.125, then the delta of the option = 0.75.

Case Study 9.1: Option-Pricing Sensitivities

1 To determine the call price, we apply the Black–Scholes equation. The top equation
is:
= ( )− ( )
( )
And the sub-equations for 1 and 2 are:

ln + + ( − )
2
=
( − )
= − ( − )
Substituting the given values for the option, we find the values set out in the
following table:
Variable 1 2
0.47113 0.327784
( ) ( )
0.681226 0.628462
Calculating the option price from the top equation gives a call value of 10.97 and a
put value, using put–call parity, of 4.01.
2 To calculate the gamma sensitivity and vega sensitivity, we can use the differential
equation directly. For gamma this is:
′( )
( − )
where:
1 ( / )
′( )=
√2
Substituting the values we have:
( . )( . )
(1/√2 ) 0.357035
= = = 0.019926
125(0.25) 120/365 17.91819
For the put, the same calculation gives us the put gamma but with the opposite sign
(it will be the negative of the call gamma): −0.01993.
The vega sensitivity is found by:
( − ) · ′( )
Substituting into the above, we have a vega of 25.58972.

3 If we recalculate the option price after one week has elapsed and no other factors
have changed we obtain the following results:
Option Original value New value Change in value
(T − t) = 120 (T − t) = 113
Call 10.97 10.71 (0.26)
Put 4.01 3.86 (0.15)
The value has fallen due to time decay effects. The theta (or sensitivity to time decay
of the options) is approximately 0.04 per day for the call and 0.02 for the put.
4 If we recalculate the option price after one week has elapsed and volatility has
increased from 25 per cent to 30 per cent but the other factors have not changed we
have the following results:
Option Original value New value Change in value
(T − t) = 120 (T − t) = 113
σ = 25% σ = 30%
Call 10.97 11.96 0.99
Put 4.01 5.12 1.11
The rise in volatility has increased the value of the two options (in spite of some loss
of time value from the reduction in the number of days to expiry) by 0.99 for the
call and 1.11 for the put.
If we had recalculated the option price with 120 days to expiry with the new
volatility we would have had option prices of 12.26 for the call and 5.31 for the put
(see the following table). The time decay for the one week at the new higher volatility
would have been: (0.30) and (0.19) respectively.
Option Value with σ = Value with σ= Change in value
25% 30% from change in
volatility
Call 10.97 12.26 1.29
Put 4.01 5.31 1.30
We can conclude that the change in option value in this case is made up of a gain
from increased volatility and a loss from time decay, as shown in the following table:
Gain from Loss from time
Option volatility decay Net value change
Call 1.29 −0.26 0.99
Put 1.30 −0.15 1.11
This is, depending on how we analyse the result, a gain of 1.29 for the call less a loss
from time decay of 0.26, which gives the net call option value increase of 0.99. For
the put, this is a gain of 1.30 from increased volatility, less a loss of 0.15 from time
decay.

Module 10
Review Questions

10.1 The correct answer is B. When value leakage takes place, this reduces the value of
the call (by the present value of the value leakage), since the payoff ( − ) is
reduced, and increases the value of the put, since the payoff ( − ) is increased.
10.2 The correct answer is C. To find the value of the put we can value the call and then
use the put–call parity theorem to derive the matching put, or we can value the put
directly using Merton’s continuos-dividend model in its put version and calculate the
put value directly. The model, in its put form, is:
( ) ( )
= (− )− (− )
So substituting into the equation and substituting the data (and adjusting for the fact
we are given ( ) and ( ) and not (− ) and (− ) as required by the fact
that (− ) = ( ) − 1), we have:
. × . . × .
= 240 (0.5815) − 235 (0.5625)
This gives a value for the put of 6.46.
10.3 The correct answer is B. We can price the call using the currency version of the
continuous-dividend model. The top equation and the sub-equations are:
( ) ( )
= ( )− ( )
ln + − + ( − )
2
=
( − )
= − ( − )
We compute 1 and 2 from the sub-equations as 0.128392 and −0.08287. Thus
( ) and ( ) are 0.5511 and 0.4670. The value of the call will then be:
. × . . × .
= 1.5625 (0.5511) − 1.55 (0.4670)
This gives a value of 0.131.
10.4 The correct answer is B. To price the option against the forward exchange rate, we
can use Black’s futures option version of the option-pricing model which has, for
the call, the following equations:
( )
= [ · ( )− · ( )]
ln + ( − )
2
=
( − )
= − ( − )
Substituting into the equation to obtain the values for 1 and 2 , we have 0.14772
and −0.00228, which give us ( ) and ( ) of 0.5587 and 0.4991 respectively.
We now find the option value as:

. × .
= [1.567(0.5587)−1.55(0.4991)]
This gives a value for the call of 0.101.
10.5 The correct answer is A. To calculate the value we use Black’s version of the Black–
Scholes formula for futures:
( )
= [ · ( )− · ( )]
ln + ( − )
2
=
( − )
= − ( − )
Substituting into the equation to obtain the values for 1 and 1 , we have 0.168212
and 0.06787, which give us ( ) and ( ) of 0.5668 and 0.5271 respectively. We
now find the option value as:
. × .
= [1189(0.5668)−1175(0.5271)]
This gives a value of 54.36. Note that, given the very high volatility of the index, of
the option value only 14 points are intrinsic value and the rest is time value.
10.6 The correct answer is D. The calculation is as follows:
$
= ln + (.055 + .03)(.25) /.25 = .0937
$
10.7 The correct answer is D. The calculation is as given below:

$
= ln + (.06 + .04)(.75) /.75 = .1992
$
10.8 The correct answer is B. The value of a call on a commodity with a convenience
yield can be priced using Merton’s continuous-dividend version of the option-
pricing model. We need to determine the values of ( ) and ( ) using the two
sub-equations to the Black–Scholes model
( )
ln + + ( − )
2
=
( − )
= − ( − )
We find that 1 = −0.29264 and 2 = −0.43264 and ( ) and ( ) are
0.384901 and 0.33264 respectively. The top equation now is:
. × . . × .
= 1250 (0.3890) − 1325 (0.33264)
This gives a value to the call of $43.34.
10.9 The correct answer is A. To work out whether early exercise is best, we can
compute the result based on the equation:
( )
1−
Substituting we have:
. ( . )
145 1−
⇒
4 > 1.34

So it is optimal to exercise early and capture the dividend since we give up only 1.34
of time value.
10.10 The correct answer is A. As in Question 10.9, we want to compute the value for the
equation:
( )
1−
Substituting the values, we find that the right hand side of the equation comes to
4.24. So it is still optimal to exercise early and capture the dividend.
10.11 The correct answer is C. To apply the pseudo-American adjustment, we need to
compute the option value in two ways. First we compute the full tenor option
including the loss of the dividend of 4.2 at the end of Month 1 by adjusting the
underlying value as ∗= − . This gives a value to the option of 17.19. We also
compute the value of the option if it is exercised in one month’s time before the value
leakage occurs. This gives a value of 13.91. Under the pseudo-American adjustment, it
is the higher of these two values which is correct.
10.12 The correct answer is B. To price the futures option, we can use Black’s model of
the Black–Scholes option-pricing model for forward/futures contracts:
( )
=[ · ( )− · ( )]
ln + ( − )
2
=
( − )
= − ( − )
Substituting for the values of 1 and 2 , we have 0.130075 and 0.043472 respective-
ly. We find ( ) and ( ) from the table, which are: 0.55175 and 0.51734. We
now compute the value of the top equation:
. × .
= [93.50(0.55175)−92.80(0.51734)]
This gives a value of 3.50.
10.13 The correct answer is A. If the strike price is 6.85 per cent, this represents a futures
price of 100 − 6.85 per cent or 93.15, so under current market conditions all the
caplets are out-of-the-money.
10.14 The correct answer is D. The value of a cap is simply the sum of the individual
caplets. Adding the four gives a value of 12.20.
10.15 The correct answer is D. A caplet has the value of a discounted interest rate option
since the payoff is not received by the holder to the end of the optioned period. The
value of the fourth-period caplet 4.06 gives 4.13.
10.16 The correct answer is A. For a barrier option to expire in-the-money, two
conditions have to be fulfilled. The option will have intrinsic value ( − ) for a call
or ( − ) for a put and the underlying must have traded within the trigger point
throughout the option’s life.
10.17 The correct answer is B. A cacall is an exotic type of option where the optioned
asset is another option (also known as a compound option).

10.18 The correct answer is A. An embeddo is an embedded option. That is, it forms part
of the terms and conditions of an asset or security (such as the call provision that
exists on some types of bonds) and which cannot be traded separately.
Case Study 10.1: Applying the American-Style Put Adjustment

1 We can apply the put version of the Black–Scholes option-pricing model to
determine the European-style put value. The top equation for European-style puts
is:
( )
= (− )− · (− )
ln + + ( − )
2
=
( − )
= − ( − )
Applying the pricing factors to the equation gives a put value of 4.243.
2 We first calculate the pricing parameters for the binomial option pricing model from
the variables, namely:
Variable Value
Stock price ( ) 100
Strike price ( ) 102
Time to expiry ( − ) 0.25
Step time ( ) 0.0833
Volatility ( ) 0.20
Risk-free rate ( ) 0.06
Parameters Value
= √ 1.0594
= √ ; or 1/ 0.9439
− 0.9950
0.5290
=
(1 − ) 0.4710

The price tree for the underlier is as below:
Months
0 1 2 3 K–U
118.91 0
112.24
105.94 105.94 0
100 100
94.39 94.39 7.61
89.09
84.10 17.90
Using backward induction now that we know the value of the option at expiration
( − ) we can find the value of the put using the binomial method:
Months
0 1 2 3
0
0.0000
1.6717 0
4.4829 3.5668
7.6874 7.61
12.3965
17.90
The value at the lowest node at T=2 is found by:

= 12.3965 = (. 5290 × 7.61 + (1 − .5290) × 17.90)
We find the European-style put value is 4.4829. Note that this is not a bad concord-
ance with Part 1 given the few steps we are using where – using the Black–Scholes
option pricing model – we had a value of 4.243.
We now need to work out the exercised tree for values before month 3:
Months
0 1 2 3
0
0
0 0
2.0000 2.0000
7.6100 7.61
12.9053
17.90

We can see that at month two, the lowest node the option is worth more exercised
than live. We now need to replace this value in our option value tree and recalculate
the value at month 1 in the lower node:
Months
0 1 2 3
0
0.0000
1.6717 0
4.5947 3.5668
7.9259 7.61
12.9053
17.90
We find we don’t need to adapt the lower node in month 1 after changing the
lowest node in month two for early exercise. So the value of the American-style put
is 4.5947 – that is, .1118 more than the European-style option; that is, it is about 2.5
per cent more valuable.
Case Study 10.2: Valuing an Interest-Rate Option

1 To start to analyse the value of the interest-rate option, we need to understand the
two interest rates involved. The following figure helps to explain the position:
t=0 t=E t=M
(E – 0) = 0.25 years (M – E) = 0.25 years

Cover periods
Fraption (IRO) period

FRA cover period
Interest rates
0ZE
0ZM
EfM
We can now compute the values for the variables required to price the fraption, as
in the following.
The forward interest rate implied by the market is:
(1 + 0.06375) .
− 1 = 6.5628%
(1 + 0.061875) .

Note, if we had followed money market convention and used simple interest, the
forward rate would be:
( . × . )
( )
− 1 ×4=6.4625%
. × .
The solution which follows is based on the two interest rates. If you choose to go
with market conventions you will have a slightly different value for the FRA, given
the differences in the implied forward rate from the two methods.
Variable Value
Asset rate ( ) from the spot yield curve 6.5628%
(simple 6.4625%)
Strike rate ( %) 6.38%
Tenor of FRA ( − ) 0.25 years
Risk-free interest rate 6.1875%
Volatility 0.15
Start date (E) 0.25 years
End date (M) 0.50 years
Other values in the table are correct but repeated here for completeness.
To apply Black’s model for the fraption, we need to convert the interest rate
quotation into an asset equivalence, as in the following table:
Variable Value
Notional principal £15 000 000
Cap notional principal ( ) = ( × ) £3 750 000
FRA value =
market value rate of FRA × notional principal ( ) £246 106
(simple £242 345)
Strike value =
strike rate ( %) × notional principal ( ) £239 250
Zero-coupon rate to FRA value rate 6.1875%
The continuously compounded rate of interest is simply ln(1.061875) × 100% =

6.0036%. The two sub-equations for Black’s model are:
ln + ( − )
2
=
( − )
= − ( − )

£246 106 0.15
ln + (0.25
£239 250 2
=
0.15 (0.25)
this gives a value for 1 of 0.13168. Then:
= 0.13168 − 0.15 (0.25)
which has the value 0.05668. These give values for ( ) and ( ) respectively of
0.5524 and 0.5226. If we use the simple interest value for the forward rate, we have
values for ( ) and ( )of 0.5320 and 0.5021 respectively.
We now need to substitute these into the top equation:
( )
=[ · ( )− · ( )]
. × .
= [£246 106(0.5524)−£239 250(0.5226)]
So the call is worth £10 750.
Note, using simple interest, the same calculation gives a fraption value of £8666.
Module 11
Review Questions

11.1 The correct answer is C. By using exchange-traded instruments, the user reduces
counterparty risk, but at the cost of mismatch or basis risk.
11.2 The correct answer is B. Terminal instruments, with a symmetrical payoff profile
and the requirement to effect delivery, are unsuited to situations where there is price
and quantity risk. A competitive tender in a foreign currency represents an uncertain
future cash flow and it is not appropriate to hedge this exposure via a forward or
futures contract. The right instrument for such ‘a contingent exposure’ is an option.
11.3 The correct answer is C. Terminal instruments can be used for a range of purposes.
They act to hedge price risk. They can neutralise market exposure and hence
anticipate a future sale. They can temporarily change the allocation of funds in a
portfolio. It is not a function of terminal instruments to raise funds: their function is
to transfer risks. So C is not a function of terminal instruments.
11.4 The correct answer is C. Options are suitable instruments for handling contingent
transactions. A suitable position in interest-rate options would counteract the risk
that the issuer of a bond might call a bond prior to maturity if interest rates fell, thus
leaving the bond holder with a potential loss. A competitive tender in a foreign
currency, in which a number of other firms were also involved, involves considera-
ble uncertainty in relation to whether the contract would be won – and hence
whether the future cash flows would occur. If future price uncertainty on a com-
modity was expected to increase, buying options protects the holder against
increased volatility (uncertainty). However, standard options will not protect against
credit risk. Note, for the purist, that there are some credit-default options available

which are designed to provide protection against potential credit effects and hence
the word ‘standard’ in the question. So C is not an appropriate case to which to
apply standard options as a risk-management instrument.
11.5 The correct answer is A. Unlike a terminal instrument, an option does allow the user
to determine the rate at which to hedge and with a contingent underlying transac-
tion it allows the contract to lapse, and also to choose between the contracted rate
or the market rate at expiry.
11.6 The correct answer is D. If we have a short position in an asset, then we would
want to take a long position in the hedge with a positive exposure sensitivity to the
underlying.
11.7 The correct answer is C. To determine the number of contracts required we divide
the exposure by the contract size and multiply by the hedge ratio: 24 450 ÷ 100 ×
0.95 = 232.3.
11.8 The correct answer is A. The value sensitivity of the two positions will be: for the
cash position ($25 × 2/3) since the exposure is two-thirds of that on the three-
month contract, or $16.67. The ratio of price change will be $16.67 ÷ $25 = 0.667.
The value of each contract is $1 million and we have a position of $15 million. So
we need 15 × 0.667, rounded to the nearest contract, or 10 contracts.
11.9 The correct answer is B. The minimum-variance hedge ratio is found by:
,
ℎ=
So ℎ = +0.92 × 0.24 ÷ 0.25 = 0.88.

11.10 The correct answer is B. The regression hedge ratio will be 45 × 0.9628 = 43.326.
However, we must transact in complete contracts, so we round to 43 contracts.
11.11 The correct answer is B. The regression’s coefficient of determination, or 2 , can be
seen as a measure of hedging effectiveness. So the hedge should be 94 per cent
efficient.
11.12 The correct answer is A. A strip hedge is a series of futures contracts with sequential
maturities designed to match the maturity of an underlying position. For example, if
we have a one-year exposure to short-term interest rates, then short-term interest-
rate futures which have underlying tenors of three months would be sequentially
purchased or sold so that they covered the one-year exposure period.
11.13 The correct answer is C. To find out what has happened, we need to convert the
contract prices back to interest rates. We do this by reversing the index calculation
(100 − ) = futures price. We have, therefore:
Underlying interest rates

on the futures
Date Nearby Deferred Difference
1 August 6.25 6.38 +0.13
15 August 6.34 6.42 +0.08
Difference +0.09 +0.04

The spread between the nearby and the deferred contract was +0.13 on 1 August
and +0.08 on 15 August. At the same time, interest rates have risen over the two
weeks. So the yield curve has flattened whereas interest rates have risen.
11.14 The correct answer is C. A short spread position involves selling the nearby contract
and buying the deferred contract. The change in value of the sold (nearby) positions
between the two dates is a gain of 0.09. This is offset by the loss from the purchased
deferred contracts of (0.04). The net result is a gain of 0.05.
11.15 The correct answer is B. A long spread involves buying the nearby and selling the
deferred – a short spread involves the opposite. With a lending requirement, we
want to buy the spread.
11.16 The correct answer is B. The maximum mismatch period will be the difference
between the commencement of the short-term exposure period (since the interest
rate is determined at the start of the exposure period) and the expiry date of the
nearby contract. The following diagram helps to illustrate the relationship.
mid- mid- mid- mid- mid- mid- mid-

March April May June July August September
Futures contracts
March–June contract period
Expiry of June–September contract period

March contract Expiry of
June contract
Interest rate exposure period
Start of
exposure period
Mismatch period = 1 month
In this case it will be the difference between mid-May, when the exposure period
commences, and the mid-June expiry date on the short-term interest rate futures – a
period of one month.
11.17 The correct answer is D. To hedge the portfolio, we need to find the number of
contracts that balances the change in the portfolio value against the change in the
futures price. This is found using the formula:
Value of portfolio
=
Substituting the values for the S&P 500, we have:
$25 000 000
= 1.10
903.50 × $250
This gives 121.8. Since we cannot deal in part contracts, we round to 122.

11.18 The correct answer is B. To increase (rather than decrease) exposure to the market,
futures will need to be bought to obtain the desired positive sensitivity. The formula
for determining the number is:
Value of portfolio
= −
Substituting the values into the equation, we have:
£75 000 000
= (1.2 − 0.95)
£25 × 4825
This gives 155 contracts to be purchased.
11.19 The correct answer is D. The steps to analyse the result are as follows:
1. Find the portfolio to price value of 1 basis point (PVBP):
7
× £100 million × 0.0001 = £655 738
1.0675
2. Convert the target portfolio with the new duration of 4 years to a PVBP:
4
× £100 million × 0.0001 = £374 707
1.0675
We therefore want to reduce the interest rate sensitivity of the portfolio from
£655 738 to £374 707, a reduction of £281 031 per basis point.
3. Determine the futures contract PVBP.
18.75
× 1.0125 × £50 000 × 0.0001 = £89.16
1.0646
4. Determine the number of long-term interest rate futures required to be sold to
achieve the target portfolio interest rate sensitivity (duration):
£281 031
= 3152
£89.16
Therefore to reduce the duration from seven years to four years, we need to sell
(short) 3152 long-term interest rate futures.
11.20 The correct answer is B. A long position in the market is represented by Line b.
11.21 The correct answer is D. If we combine a short position in the market with a long
call, we end up with a long put position.
11.22 The correct answer is C. The constant proportions portfolio insurance (CPPI)
approach involves a dynamic policy of switching between the risky market portfolio
and a safe investment. The basic formula is:
Value in risky asset = (Value of portfolio − Value of floor)
We therefore have:
Value in risky asset = 2.5(£5000 − £4000) = £2500
11.23 The correct answer is C. With the tolerance factor approach, we will rebalance the
portfolio when the portfolio has changed by 2.5 per cent, that is, when it reaches:
£5000 × 1.025 = £5125. The change in value of the market element will thus be
£2500 + £125 = £2625. The change in the index is therefore £2625 ÷ £2500 ×
2850 = 2993.

11.24 The correct answer is C. If we have a long asset position (+U), then we can protect the
exposure by buying puts on the underlying (+P). Such a position creates a synthetic
long call position.
11.25 The correct answer is A. For an option, the regret will be the amount paid for the
option, if it is exercised, less the degree of insurance provided. The formula is
( − ≥ 0, −Δ − ). If the asset price is below, the payoff from the put will be
( − > 0, −Δ − ). If = 105, this is (120 − 105) = 15 for the put, −5 for the
asset price change and −15 for the premium, that is, −5 in all. If is 95, this is
(120 − 95) = 25, − 15 on the asset price and −15 for the premium, that is, −5 in
all. So the regret for option 2 is 5.
11.26 The correct answer is C. The performance loss from holding an unexercised put will
be − − on the upside. That is, the cost of the protection, the option’s
premium.
11.27 The correct answer is D. A protective put strategy requires the change in the value
of the puts to balance the change in value of the portfolio. The relationship is:
= ·
Substituting the values given in the question, we have:
£65 000 000 1
= 0.70 ×
£10 × 4940 −0.35
This comes to 2631.6. We need to round up to 2632 since part-contracts cannot be
purchased.
11.28 The correct answer is A. To hedge against a possible market decline, given a long
position in the market, we need to buy puts. The number required is found by:
Portfolio value
=
Index value
= 0.85 × (840 000 × 0.68) ÷ (2870 × £10)

This gives us: 16.9. Since we cannot buy part-contracts, we need to round up to 17.
11.29 The correct answer is A. If we buy futures, we buy the spread by buying the nearby
and selling the deferred contract; if we sell futures, we sell the spread.
11.30 The correct answer is C. The combination, which has a lower sensitivity than a long
position, is represented by Line c.

Case Study 11.1: Hedging Interest-Rate Risk

1 The relationship between the exposure period and the futures contracts is given in
the following figure:
Futures expiry
December March June September
expiry expiry expiry expiry
December contract
Short-term protection period
interest rate March contract
futures contracts period protection period
June contract
protection period
Interest rate exposure period
Since the bulk of the exposure period is covered by the March contract’s protection
period, this is the appropriate contract for hedging the exposure. Note that, as
discussed in Module 11, there is an element of rotational risk (yield curve twist risk)
left in the position by using only the March contract.
The situation is that each contract is worth £0.5 million. The sensitivity of the
contract price for a 1 basis point change in the yield is £12.50. Our sensitivity per £1
million is twice that. We therefore have a situation where for £6.7 million we need
to multiply the contract sensitivity by 2 and also for the fact that the price sensitivity
is for 4 months rather than the 3 months in the underlying future. This gives us a
price sensitivity of £223.33.
We could have calculated it as follows. The value of 1 bp discounted for 4 months
on £6.7 million = £6.7m × 0.0001 × 4/12 = £226. Which, allowing for the impre-
ciseness of the calculation method is near-enough to the above result.
The details of the method are given in Section 11.2.3.
2 The interest-rate sensitivity of the exposure is:
£6.7 million × 2 × £12.50 × 4/3
that of the underlying futures contract. This gives £223.33. The futures contract
sensitivity is £12.50. We therefore need £223.33 ÷ £12.50 contracts to neutralise the
two sides. This is 17.86 or, rounded up, 18 contracts.
We can see that this works. If the interest rate on the borrowing increases by 1 per
cent, we will pay 0.01 × £6.7m × 1/3 = £22 333 more. On the futures, the change
will be: £12.50 × 18 × 100 = £22 500. The one has offset the other. Note that the
slight discrepancy on the two sides relates to the rounding up to 18 contracts. If we
had used 17.86, we would have got £23 325.

3 In the absence of any major changes in market conditions, we know that the term
structure looks as follows:
December: 6.45%
March: 6.72%
June: 7.00%
We know that the futures price will converge. The implied convergence on the
March contract is approximately 0.27 per cent between the December and March
contracts. There will be four weeks left on the contract when the position is
eliminated as the underlying exposure starts. If the contract converges at a uniform
rate, this means we are 0.09 per cent away from the current price of 6.45 per cent, or
a rate of 6.72 − 0.18 or 6.54 per cent on the contract.
4 We know that the term structure between the March and June contracts increases by
0.28 per cent. Since we have a four-month exposure, we can assume that the spot
rate for four months will be 0.09 per cent higher than that implied by the March
futures contract. If the yield curve should steepen or flatten, this may change the
effectiveness of the hedge. An increase in the steepness of the yield curve will
steepen the relationship between the implied three-month rate and the expected
four-month spot rate underlying the exposure period, thus degrading the hedge. As
mentioned in the text, one solution would be to set up a spread and use the June
contract to counteract this effect.
Case Study 11.2: Hedging with Written Calls

1 The maximum loss from the put position is given by:
Maximum loss = + −
For the two positions it is:
3925 puts: 34 + 4061.50 − 3925 = 170.5 × £10 = £1705
4075 puts: 76.5 + 4061.50 − 4075 = 63 × £10 = £630
The break-even rate is:
Break- even = Index level + Put price
For the two positions it is:
3925 puts: 4061.5 + 34 = 4095.5
4075 puts: 4061.5 + 76.5 = 4138
The maximum loss is smaller for the in-the-money protective put at 4075 (£700 v.
£1705), but the break-even rate is less for the out-of-the-money protective put with
a strike of 3925 (4095.5 v. 4138).
2 To determine how many calls should be written, we apply the equation:
options = ·

Substituting the values we have:

£1 500 000 1
= −1.2 ×
4061.50 × £10 0.75
To hedge, we should sell 59.09 calls (that is, rounding to the nearest whole number:
59 calls).
Let us now examine how well the strategy has worked if the index has fallen by a
small amount. If the index declined by 3 per cent, it would now be at 3943. The
change in value of the portfolio will be £1 447 877 since it has a beta of 1.2. This
gives a loss of £52 213.
On the hedge side, the delta of the calls is 0.75. They were worth 135 × £10 × 59 or
£79 650. The index has declined from 4061.50 to 3943, or by 118.50. We can expect
the calls to decline by the amount of their delta, 0.75 × 118.50 × 59 × £10 =
£52 436 gain, on their repurchase.
The net difference between the portfolio loss and the option gain (remember they
are written options) is a negligible £233. The one has cancelled the other.
Module 12
Review Questions

12.1 The correct answer is C. If we have a future payable in a foreign currency (that is,
−FC) (that is, a short foreign currency position), the appropriate transaction to
manage the exchange-rate risk is to buy the foreign currency forward (+FC/−BC).
12.2 The correct answer is C. When a cash flow is contingent, such as with a tender on a
contract in a foreign currency, then it is inappropriate to use a terminal instrument.
Alternative C is a currency forward, thus a terminal instrument, and hence is
inappropriate for hedging the risk.
12.3 The correct answer is C. A currency put gives the holder (buyer) the right to sell the
base currency, in this case Deutschemarks and buy the quoted currency (in this case
US dollars). Hence, the writer (or seller) is obliged to buy the Deutschemarks at the
strike (contracted) rate.
12.4 The correct answer is D. Entering into a short option position (in the absence of
mitigating factors) by selling a currency option (in which the writer receives a fixed
premium for assuming unlimited exchange rate risk) is not a means of handling
currency risk. So D is not a means of handling currency risk.
12.5 The correct answer is B. With a forward contract (of any kind) it is normal that
there is a wide choice of maturity dates but that there is only one applicable price.
So with a foreign-exchange forward contract, we can agree any maturity date but
have no choice as to the exchange rate.
12.6 The correct answer is B. Sterling is normally the base currency for quotations
against the Deutschemark. With the quoted currency having a lower interest rate

than the base currency, we can expect it to appreciate against the base currency over
the forward period. The interest-rate parity relationship is given by:
(1 + )
=
(1 + )
Substituting, we find that the Deutschemark will be quoted at DM2.59 for three
months’ delivery.
12.7 The correct answer is B. The forward foreign exchange rate is DM2.5821/£. We
can borrow sterling at 7.25 per cent. If we borrow £100, we can swap this into DM
spot at DM2.60 = DM260.00. Invested at 5.90 per cent for six months =
DM267.56. Converting this back at the forward rate gives £103.62. We need to pay
back £100 plus interest = £103.56, giving a profit of £0.06.
12.8 The correct answer is B. If we wanted to undertake a do-it-yourself forward foreign
exchange transaction, we need to borrow one of the currencies for the maturity
period, exchange it spot into the other and lend the resultant amount for the same
period. Since we want to sell Deutschemarks six months forward, we will want to
‘pay away’ these at the maturity of the replicating transaction involving the spot
foreign exchange market and borrowing and lending. To do so, we must borrow
them now, to be repaid at maturity. We next convert these at the spot rate into
sterling and invest this for the six months. At maturity, we now have a liability on
the DM side, as in the question, and an asset on the sterling side. So B is the right
transaction to undertake.
12.9 The correct answer is A. If we have a situation where we are exposed to a fall in the
US dollar against the Japanese Yen (that is, we are long dollars / short the Yen) we
would want to buy currency Yen futures as protection. Since the Yen futures are
quoted in US dollars, a fall in the dollar will mean a rise in the futures value: a long
position will return a profit in this case. For example, if the Yen is (using the
conventional quote) Y120.50/$, then the futures price = 0.8299 (reciprocal price ×
100). If the Yen appreciates, to say Y110/$, then the futures price becomes 0.9091.
12.10 The correct answer is B. In deciding the correct exposure to create, we have the
following initial exposure: +Swiss Francs/−Australian dollars. We want to hedge
this exposure using currency futures, so that we have a hedge giving −Swiss
Francs/+Australian dollars. The sensitivities of the two futures contracts are:
Sensitivity Swiss Franc futures Australian dollar futures

Long position +SFr −US$ +AUD −US$
Short position −SFr +US$ −AUD +US$
We can check this quickly by a simple example. If the Swiss Franc is SFr1.75/$, the
futures contract is 0.5714. If the dollar depreciates, to SFr1.65/$, the futures
contract becomes 0.6061. To neutralise the cross exposure, we sell Swiss Franc
futures and buy Australian dollar ones. This gives a spread relationship =
+US$/−SFr
−US$/+AUD

The dollar element washes out, to give us −SFr/+AUD, the required sensitivity for
our hedge.
12.11 The correct answer is D. The break-even from buying calls will be: + . The
premium is $0.055 per DM, so the break-even = 0.655 + 0.055 = 0.71. To check
that, we know each contract is worth DM62 500, so the total cost = $3437.50. We
have the right to exchange DM62 500 at $0.655 = $40 937.50, add the premium
$3437.50 = $44 375 ÷ 62 500 = $0.71/ .
12.12 The correct answer is C. If we have a Deutschemark receivable, we want to hold a
put on the quoted currency. A put allows us to sell the base currency (Deut-
schemarks) and buy the quoted currency (dollars). A written call sells the base
currency (Deutschemarks) and buys the quoted currency (dollars). By writing the
call, we reverse the profit being made on the purchased put, in such a way that
above the capped rate of 0.650, for every 1 cent made on the put, we lose 1 cent on
the written call. In setting up a vertical spread or currency cylinder to cap our costs,
at the expense of some additional gain, we also sell a call on the currency. For
instance, we buy $0.660 February put for $0.186 and sell the February $0.650 call for
$0.074. The net cost = $0.074 − $0.186 = $0.112.
12.13 The correct answer is D. For a consumer (who has the mirror-image risk of a
producer), the attractions of entering into a commodity swap and paying the fixed
rate are that it provides a flat rate for the commodity being purchased over the life
of the swap, it allows the customer to maintain existing commercial supply arrange-
ments (that is, it separates the risk-management decision from the commercial one)
and it can be customised to meet the consumer’s specific needs.
12.14 The correct answer is D. A floor is a generic name for any risk-management
transaction designed to guarantee a minimum value or price. A long position in an
asset together with a long put provides a floor price in case of a fall in the asset’s
price. A dynamic replication programme which emulates the behaviour of a call is
designed to provide a minimum value or floor to an investment strategy. Equally, a
floor is a series of sequential expiry date put options designed to protect a position
over time.
Case Study 12.1

1 The three-month mid-rate is SFr2.3752 which must be adjusted for the bid-offer on
the currency. The bid-offer spread is 83 − 115 = 32. Adding and subtracting half of
this to the forward outright transaction of 2.3752 gives: 2.3736 − 2.3768. As we are
receiving Francs on the foreign exchange transaction, we will get SFr2.3736 for each
£. The total is therefore £5 million × 2.3736 = SFr11 868 000. (We can check that
this is right by calculating with the other price which gives a higher amount,
SFr11 884 000: a customer will always receive the lesser quantity (bid price)).
If the company undertakes a DIY forward transaction, it must borrow sterling and
lend Swiss Francs. It borrows sterling at 711 % for three months. It wants to borrow
the present value of £5 million. This is:
£5 000 000
= £4 905 718.23
(1 + 0.25 × 0.076875)

This is swapped into Swiss Francs at the bid side: SFr2.4083 × £4 905 718.23 =
SFr11 814 441.21. This is then invested at the bid side of 1⅝% for three months:
365
SFr11 814 441.21 × 1+0.25× ×0.01625 = SFr11 863 103.99
360
From the data provided, we therefore have the values set out in the following table:
Transaction Value in Swiss Francs
Currency forward 11 868 000
DIY forward 11 863 104
Difference: 4 896
The company is marginally better off, by an amount of SFr4896, by undertaking the
forward foreign exchange contract.
2 To undertake the same transaction with futures, we need to work out the right
spread transaction given that there is no Swiss Franc–sterling futures contract. The
first step is to establish the correct sensitivity for the US dollar/sterling leg and then
the appropriate sensitivity for the US dollar/Swiss Franc leg. This is a negative
sensitivity to (−£) and a positive sensitivity to the Swiss Franc (+SFr).
For the initial transaction, we want to sell sterling and buy US dollars. Therefore, we
want:
Short dollar / Sterling currency futures
Long US dollar / SFr currency futures
Each sterling contract is worth £62 500. We therefore need to sell £5 million ÷
£62 500 = 80 contracts. This gives us $1.6776 × 80 × £62 500 in US dollars:
$8 388 000.
The next stage is to convert this amount into Swiss Francs. The contract is currently
trading at $0.7065 = SFr1. The dollar amount in Swiss francs = $8 388 000 ÷ 0.7065
= SFr11 872 612. Each contract is worth SFr125 000. So we need 95 contracts:
SFr11 872 612 ÷ 125 000 = 94.98. We can only deal in round numbers of contracts,
so we use 95.
We have now established the position. We exchange US$8 389 688 via the futures
contract and have to find the balance of $1688 by other means. Our exchange rate
on the ‘fixed’ amount is SFr11 872 612 ÷ £5 million = SFr2.3745/£.
3 The obvious disadvantage is that there is a residual error in this approach. The
company can exchange all its asset into US dollars, but has to ‘round up’ the amount
on the Swiss Franc leg to make it into the nearest complete contract. All else being
equal, the company will have to find a small amount of dollars to ‘top up’ the dollar
payment if the contract is held to expiry.
In addition, as stated elsewhere, the company will have to provide margin on the
position. Since the transaction is set up as a spread, the margin amount will not be
the total of both the contracts: an offsetting allowance will be permitted by the
exchange. Nevertheless, the company will have to monitor funds going into and out
of its margin account.

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Index
ABI leisure 11/4 average rate options 10/2, 10/30, 10/32
accreting swaps 5/4, 5/34–5/35 average strike options 10/30, 10/31
actual basis 4/22–4/24, 11/27 backing out 5/22
adjustment, risk 4/5 back-to-back loan 5/4
against actuals (AA) transactions 4/47 backwardation 4/19, 4/36–4/39
ALM (asset-liability management) 5/3, Bank for International Settlements (BIS)
5/12–5/18 3/19
American-style bankruptcy 5/39
calls and puts 6/7, 6/21–6/20, 10/11, Barclays Bank 3/19
10/17 barrier option 10/30
American-style call option basic swap 5/4
early exercise 10/8 basis 4/18, 4/21, 4/22–4/36, 11/14,
American-style option 10/32 11/27
calls and puts 10/12 price 4/21, 4/36
case studies 10/42 risk 4/21, 4/22–4/36, 4/39, 4/49,
early exercise 6/21, 8/13 11/3, 11/14
amortisation 5/4, 5/15, 5/32–5/33 swap 5/9, 5/36
annualised variance 8/8, 8/10 basket option 10/31
annualised volatility 8/9, 8/10 bear and bull spreads 6/25, 9/40, 9/41
annuity factor 5/21 Bermudan option 6/8, 10/32
approximation formula 8/16–8/19 beta 11/36, 11/47, 11/49
arbitrage 3/5, 5/8, 5/12–5/14, 7/16 bid-offer spread 5/20
cash and carry 3/12 binary options 10/2, 10/28
arbitrageurs 4/42 binomial option pricing model 7/11,
Asian options 10/30, 12/22 7/12, 7/29, 8/1, 8/2
assessing risk 2/2–2/4 case studies 8/26
asset price 6/6, 6/18, 8/5, 9/5–9/14, delta 9/33, 9/42
9/33 for American-style calls and puts
in Black–Scholes model 8/5, 8/6, 9/4 10/16–10/17
asset-liability management 6/7 for puts 7/15–7/16
asset-liability management (ALM) 5/18 gamma 9/34, 9/42
asset-or-nothing payout 10/28 rho 9/35
assets 5/12, 5/13 sensitivity factors 9/32–9/35
prices 3/10–3/11 theta 9/35, 9/42
underlying 6/18, 9/7, 9/9 vega 9/35, 9/42
underlying 4/14 binomial tree 5/40, 7/17
underlying 9/6 BIS (Bank for International Settlements)
asymmetric payoff 2/9, 5/25–5/27, 6/2, 3/19
7/8, 11/43 Black, Fisher 2/11, 7/17, 10/6, 10/27,
Atlantic-style option 6/8 11/41
at-the-money 9/6, 9/8, 11/45 Black's (futures) model 10/5–10/7,
and gamma 9/16, 9/18 10/19, 10/26, 10/33
and interest rate 9/26 Black–Scholes option pricing model 8/1–
and volatility 9/29 8/20, 9/3, 9/32, 10/2, 10/26
call option value 6/10 asset price 8/6
put option value 6/12 case studies 8/25
at-the-money and lambda 9/13 problems in use of 10/2, 10/18
Derivatives Edinburgh Business School I/1

Index
puts formula 8/4, 8/15 cash flow 5/18, 5/19

blended swap rate 5/7, 5/33 free 5/18
bond future 4/46, 4/47 revaluing 5/28
bond seller 4/46 cash markets 4/10, 4/18
bonds 5/6, 5/7 cash–futures arbitrage 4/42–4/43, 4/44
corporate 4/3, 4/30 cash-or-nothing payout 10/28
notional 4/46 CBOT (Chicago Board of Trade) 2/6,
performance 4/3 4/2
synthetic 5/12, 5/13 cheapest to deliver (CTD) 4/46
bootstrapping 5/19, 5/20, 5/23 Chicago Board of Trade (CBOT) 2/6,
borrowing 4/42, 4/45, 11/16, 11/22 4/2
boundary conditions 3/12–3/14, 5/14, Chicago Mercantile Exchange (CME)
6/18–6/19 9/38
break-even value 4/22 chooser option 10/32
break-even yield 4/22, 11/45 CIR (Cox, Ingersoll and Ross) model
Bretton Woods 2/6 10/26
British Bankers Association 3/18, 3/25 clearing houses 2/6–2/7, 4/8–4/10,
British Bankers Association formulae, 4/13
terminology 3/16 closing out 4/10, 4/13
building block theory 2/1–2/13 CME (Chicago Mercantile Exchange)
bullet type swaps 5/31 9/38
buy the basis 11/27 Codalco, Chile 12/5
buy-and-hold strategy 11/39, 11/42 collateral 4/12, 4/25
buyers 3/3, 6/3, 6/4 combined hedge 11/32
buying volatility 9/31 commodity markets 4/38
calendar spread 4/15 commodity price risk 4/48, 12/1
call option 10/32 commodity swap 5/4, 5/36
call options 2/9, 2/10, 6/7, 6/8, 6/10, complex options 10/27–10/32
6/15 compound options 10/32
written calls 6/22, 6/23, 11/50 constant proportions portfolio insurance
calls and puts 6/40, 9/3, 9/7, 9/40, (CPPI) 11/41, 11/43, 12/29
11/43, 12/5 contango 4/20, 4/36–4/39
American-style 6/7 contingent exposure 11/44
and dividends 10/2 contingent premium payoff 10/29
case studies 6/40 contracts, standardised 4/2
pricing variables 6/18 convenience yields 4/18, 4/19, 4/38,
sensitivity factors 9/32 10/7
calls formula 8/3–8/4 convergence 4/11, 4/41
calls options convexity 9/14
Black–Scholes pricing formula 8/4 corporate
pricing variables 6/18 bonds 4/3, 4/30
capital market swap 5/3 correlation 4/30, 11/10, 11/13
caplet period 10/23 cost of carry 3/4–3/9, 4/7, 4/18–4/19,
caps 10/22 4/24, 4/36
caput option 10/32 continous equation 10/6
carry basis 4/22, 4/24 costs 3/2, 3/7, 10/7
'carry' markets 3/6 risk management 12/12
case studies transaction 4/16, 4/42
American-style put adjustment 10/42 counterparties 2/5, 2/13, 4/2, 11/2
calls and puts 11/66 in swaps 5/4, 5/6, 5/39
cash and carry arbitrage 3/12 covered arbitrage 3/5
I/2 Edinburgh Business School Derivatives

Index
covered call 6/21, 6/24, 11/50 duration 11/10

covered put 6/22, 6/24 Macaulay's 11/37
Cox, John 7/11, 10/26 dynamic hedging 11/36, 12/29
CPPI (constant proportions portfolio dynamic replication strategy 7/17, 9/6
insurance) 11/41, 11/43, 12/29 early exercise 6/20–6/21, 10/11
credit 5/43, 6/25 EFFP (exchange of futures for physical)
exposure 3/24, 3/28 transactions 4/47
credit risk 3/10, 5/30 embedded options 10/32
and forward contracts 2/6 embeddos 10/32
and futures 4/8 equity swaps 5/36
default risk 5/39 ERAs (exchange rate agreements) 3/18
eliminating 4/8–4/10 Euroepean-style
cross-currency option 10/31 calls and puts 10/11
cross-currency swaps 5/4 Euronext LIFFE 11/47
and credit risk 5/30, 5/38 Euronext-LIFFE 6/22, 9/38
example 5/12–5/11 European-style 10/4
cross-hedge 4/30, 4/36, 11/14, 11/15 European-style options 6/8, 8/13, 10/12
cross-spread 4/16 and leakage 10/8
cross-subsidy 5/22 and theta 9/21, 9/23
crush spread 4/16 call value 6/21
CTD (cheapest to deliver) 4/46 pricing formula 8/3
currency cylinder 6/24, 12/11 exchange of futures for physical (EFFP)
currency exposure 12/5 4/47
current asset price 6/6 exchange options 10/31
current assets 6/18 exchange rate agreements (ERAs) 3/18
current exposure valuation 5/37 case studies 3/43
cushion approach 11/41 exchange rate protection 3/43
default risk 2/6, 5/39 exchange rate risk 3/3, 3/10
delayed-start options 10/32 exchange-traded transactions 11/2
delivery 4/11, 4/25, 4/39, 4/47 exercise price 3/3
delta 9/1, 9/33, 11/49 exotic options 10/27
sign relationships 9/14, 9/16, 9/18 expectations theory 4/36, 5/20
delta hedge 7/5, 7/17–7/19, 8/4, 9/16, expiry 4/11
11/49 ex-post strategy 11/43
for written options 9/7–9/9 exposure 5/37, 11/44, 12/2
demand and supply 4/5, 4/18, 4/26, credit 3/24, 3/28
4/38 currency 12/5
derivatives 5/2, 5/3, 11/5 directional 12/4, 12/5
derivatives building blocks 2/1 naked 4/15, 5/15
derivatives product set 2/1, 12/1–12/5 fair value 5/19, 7/2–7/8, 8/13–8/14,
terminal instruments 11/51 11/6, 11/27
Derman, E. 10/27 of futures 4/18–4/19, 4/24
deviation 8/5, 11/13 financial distress 5/39
directional exposure 12/4, 12/5 financial instruments 3/7, 6/2, 10/7
discount market 4/37 financial markets 3/3
'discovery' markets 3/6, 4/6 financial risk management building
distress, financial 5/39 blocks
dividends 4/25, 8/12–8/13, 10/3, 10/9 forward conracts 2/4
do nothing decision 12/6 option contracts 6/2
do-it-yourself forward 12/7, 12/8 Financial Times-Stock Exchange 100
DuPont 5/10, 5/27–5/30 index (FT-SE100) 11/47

Index
fixed cash flow 5/19 FRN (floating rate note) 5/6, 5/12–5/14,
fixed rate bond 5/5, 5/7, 5/12 10/32
fixed rate swaps 5/5 FT-SE 100 index 11/47
fixed-for-floating commodity swap 5/36 fungible contracts 4/8
fixed-rate payer 5/5, 5/22 futures contracts 3/2, 11/9, 12/18
fixed-to-fixed cross-currency swaps 5/30 and hedging 11/14, 11/36
flat pricing 5/34 categories 4/5
floating cash flow 5/19 risks of using 4/30, 4/48
floating rate 5/5, 5/12, 5/22 futures markets 4/5, 4/6, 4/10–4/12,
floating rate note (FRN) 5/6, 5/9, 5/12– 4/18
5/14, 10/32 FXAs (forward exchange agreements)
floating-rate payer 5/5 3/18, 3/24
floors 10/32, 11/51, 12/25, 12/27, gamma 9/1, 9/3, 9/5
12/29 and volatility 9/19
interest rate option 10/22 gamma and vega 9/31
Footsie 11/47 generic approach to hedging 11/9
forecast volatility calculation 8/9, 8/11 generic arbitrage 4/42
foreign exchange 12/1 'Greeks, The' 9/1–9/43
case studies 12/2, 12/41 heat exchange formula 8/3
forwards 3/2, 3/18, 6/2, 12/7–12/8 Heath, David 10/27
swaps 3/19–3/23, 5/3 hedge ratio 7/5, 9/7, 11/10–11/12,
foreign exchange agreements (FXAs) 11/15
3/18 minimum-variance 11/11, 11/14,
foreign exchange forward contracts 3/5 11/36
foreign exchange markets 12/41 hedge ratio, minimum-variance 11/14
foreign exchange rate risk 12/2 hedge, riskless 7/4
foreign exchange, forwards 3/5 hedger's exemption 11/34
foreign exposure, types of 12/2 hedging 3/4, 4/27–4/36
forward contracts 2/4, 2/9, 6/1, 12/7, imperfect 11/3
12/17 objectives 11/8
and hedging 11/9 of borrowing requirement 4/45,
defined 3/3, 5/18 11/16, 11/22
payoff of 6/3 problems 11/2
forward exchange agreements (FXAs) tailing 4/40–4/41, 11/16
3/24 hedging interest rate risk 11/66
forward foreign exchange contract 3/2, hedging with written calls 11/67
3/19, 6/1, 12/7–12/8 hedging, tailing 4/14
forward interest rates 4/24 historical data 11/15
forward rate agreement historical volatility 8/9–8/11
British Bankers Association formulae Ho, T 10/27
3/18 horizontal spread 6/25
forward rate agreement (FRA) 2/8, ICI 5/10, 5/27–5/30
3/14–3/18, 4/41, 5/6, 10/20 imperfect hedge 11/3
forward rate pricing 10/19 implied forward rate 11/20
forward rate swaps 5/4 implied repo rate 4/11
forward-start 3/14, 3/15, 10/32 implied volatility 8/9, 8/10, 8/11
FRA (forward rate agreement) 2/8, 4/41, index pricing mechanism 4/44
5/6, 10/20 index swap 5/4
terminology 3/16, 3/18 Ingersoll, Jonathan 10/26
fraption 10/20, 10/21 initial margin 4/11, 4/12
free cash flow 5/18 insolvency 5/39

Index
insurance 2/10, 6/2, 11/1, 11/3 liquidity 4/3, 4/4, 4/8–4/10, 11/10
portfolio 11/39–11/43 loans 5/4, 5/6, 5/9, 5/12
inter-commodity spread 4/16 'lock-in' transactions 3/2, 12/5, 12/17
interest rate markets 3/5 lognormal distribution 10/18, 10/23
interest rate option, valuing 10/42 London interbank bid rate (LIBID) 5/17
interest rate options (IROs) 10/43 London interbank offer rate (LIBOR)
interest rate rise 10/11 5/17, 5/36, 12/8
interest rate risk 5/33, 5/34, 5/38, 11/66 London Metal Exchange 4/15
case studies 3/41 long call strategy 6/22, 6/23
interest rate risk protection 3/41 long spread 11/28
interest rate sensitivity 11/37 long volatility 8/12, 9/31
interest rate swaps 5/4, 5/20 long/short positions 4/14, 5/6
interest rates 4/18, 4/24, 5/21, 6/17 lookback option 10/30
lognormal distribution 10/18 maintenance margin 4/13
mean return 5/40 margin call 4/13
intermediaries 2/6–2/8, 3/3, 4/8–4/10, margining 2/6, 4/2, 4/9, 4/12–4/13,
4/12 10/19
International Bank for Reconstruction margining
and Development (IBRD) 5/3 and hedging 4/40
International Business Machines (IBM) market mechanisms 4/8–4/10, 4/43
2/8, 5/3–5/4, 5/14 market participants 4/42
interpolation 8/14–8/15, 8/16, 11/32 market risk 11/50
in-the-money 6/12, 9/6, 9/8, 9/13, market view 9/38–9/40
11/45 markets 3/3, 3/5, 3/6, 4/5
call option value 6/10 mark-to-market 2/6, 4/2, 4/3, 4/13
delta 9/11, 9/12, 9/14 maturity 5/5, 5/25, 6/7
interest rates 9/27 mean return 5/40
theta 9/22 Merton, Robert 10/3
volatility (vega) 9/30 Merton's adjustment model 10/3
intra-commodity spread 4/16 Metallgesellschaft 11/33–11/36
intrinsic value 6/13, 6/15 MG Refining and Marketing (MGRM)
investors 5/12 11/33–11/36
iron butterfly strategy 6/25 mid-Atlantic option 10/32
IROs (interest rate options) 10/43 Midland Montagu 3/19
Jarrow, Robert 10/27 minimum margin 4/12
Jones, Robert 11/41 minimum risk hedge ratio 11/10–11/11
key pricing factors 9/3 minimum risk portfolio 11/14
knock-in/out options 10/30 minimum-variance hedge ratio 11/11,
ladder spread 6/25 11/14, 11/36
lamda 9/3, 9/28 mismatch 4/32, 11/35
law of one price 7/13 MoDo paper group, Sweden 11/4
leakage 6/18, 6/19, 8/2, 9/23 Morton, Andrew 10/27
delta adjustment 9/12 multi-currency flows 5/14
theta adjustment 9/23 multiperiod pricing 7/2, 7/17–7/18
Lee, S. 10/27 multi-strike options 10/31
leverage 9/3, 9/13–9/14, 10/29 multivariate options 10/31
liabilities, repackaging 5/12–5/14 naive methodology 11/10, 11/11, 11/13
LIBID (London interbank bid rate) 5/17 naked transactions 4/15, 5/15
LIBOR (London interbank offer rate) net present value, calculating 5/22
5/17, 5/36, 12/8 neutral delta 9/7
linear payoff 2/9, 11/47 neutral gamma 9/16

Index
New York Mercantile Exchange volatility (vega) 9/29

(NYMEX) 11/10, 11/34 outright purchase 4/15
non-linear payoff 2/9, 6/26, 11/43 outright sale 4/15
normal backwardation 4/37 over-the-counter (OTC) 3/12, 4/2, 11/2,
normal distribution table 8/14, 8/17– 12/24
8/19 par yield curve 5/23
North Sea Oil (Brent) 5/36 parallel shift curve 4/23, 11/22, 11/26
notice day 4/11 parallel yield curve 4/23, 11/22, 11/27
notional bonds 4/46 parity, put-call 2/12, 10/3
notional principal contracts 3/19, 5/5 partial hedge 11/3
NYMEX (New York Mercantile path-dependant options 10/32
Exchange) 11/10, 11/34 payables and receivables 12/2, 12/3
off-balance sheet 2/2, 5/3, 11/2 payoff 6/2, 7/9, 9/5, 10/29, 12/5
off-market swaps 5/27 case study 2/21
on-balance sheet 2/2 formula 9/13
one-to-one ratio 11/10, 11/11, 11/13 modified 9/40–9/42
open interest 4/5, 4/10 payoff, linear 2/9
open outcry 4/5, 4/7 payoff, non-linear 2/9, 2/12, 6/2
optimal risk portfolio 11/14 perfect hedge 3/12, 4/40, 11/3, 11/9
option instruments 2/2 performance bond 2/6, 4/3, 4/12, 4/20
option payoffs 2/21 performance risk 2/6, 4/2
option pricing 7/1, 9/1 'pits' 4/7
sensitivity variables 9/4, 9/26 polynomial approximation 8/19
option pricing models 7/1–7/16, 8/1– polynomial options 10/29
8/19 portfolio 11/10, 11/50
option pricing sensitivities 9/52 delta 9/10
option sensitivity 9/2, 9/9 options 10/31
option strategies, fundamental 6/22– replicating 7/3, 7/5
6/24 risk 11/14
option value 6/6, 9/42 position
out-of-the money 6/10, 6/11, 6/13, delta 9/9
9/6, 9/8 gamma 9/16, 9/20
time value 6/13, 6/14–6/16 theta 9/25
options 2/2, 6/1–6/27, 12/3 vega 9/31
disadvantages 11/6 position limits 4/10
futures 10/6 positive value 5/38, 5/42
gamma 9/7 power options 10/30
ordinary least squares technique predatory pricing 11/34
11/12, 11/15 premium 6/5, 6/7
original exposure methodology 5/36, premium market 4/19, 4/37
5/40 present value 5/21, 5/22
OTC (over-the-counter) 4/2, 11/2, price discovery 4/6
12/24 price limit 4/12
out-of-the-money 6/10, 6/11, 6/12, price performance 11/31, 11/32
11/45 price quotation 4/11
OTC (over-the-counter) 3/12 price risk 3/2, 4/39
out-of-the-money 9/26 price value of basis point (PVBP) 11/37
delta 9/6, 9/11, 9/12 Price Waterhouse 11/5
gamma 9/7 pricing 3/4–3/9, 5/19, 8/5, 9/3, 10/19
lambda 9/13 models 8/1–8/19
theta 9/22 variables 9/36

Index
profits, riskless 4/42, 7/16 rotational shift 4/23, 11/22, 11/24–

protective put strategy 11/39, 11/48, 11/26, 11/30
11/49 Rubenstein, Mark 7/11
pseudo-American 10/11 SAFE (synthetic agreement for forward
pseudo-American adjustment 10/9– exchange) 3/14, 3/27–3/28
10/11 defined 3/23
purchased call strategy 6/22, 6/23 settlement calculation 3/25–3/26
purchased put strategy 6/22, 6/23 Schaefer, Stephen 10/24
pure insurance strategy 11/39 Scholes, Myron 2/11, 7/17
put equation, Black–Scholes 8/4, 8/15 Schwarz, Eduardo 10/24
put option value 6/13 seasoned swap 5/24, 5/27
put options 2/9, 2/10, 6/7, 6/11–6/13, self-financing investment strategy 7/17
6/16 sell the basis 11/27
pricing 7/12, 7/13 sellers 3/3, 4/46, 6/3, 6/4
put-call parity 4/53 selling volatility 9/31
PVBP (price value of basis point) 11/37 sensitivity 8/20, 9/31
quantity risk 11/44 option 9/9
quantity-adjusted option (quanto) 10/31 variables 9/4, 9/26, 9/32, 9/42
quasi-American option 10/32 vega and gamma 9/31
rainbow option 10/31 sensitivity factors 9/42
ratchet option 10/30, 10/31, 10/32 sensitivity gap
rate sensitivity gap 11/37–11/38 interest rate 11/37–11/38
ratio combinations 6/26 sensitivity, option 9/3
ratio spreads, option strategy 6/25 settlement risk 4/25
raw basis 4/22 short call 6/22, 6/23, 9/6
receivables and payables 12/2, 12/3 short selling 4/16, 4/25, 4/42
refining spread 4/16 short spread 11/28
regression analysis 11/12 short volatility 8/12, 9/31
replacement cost 3/9 short/long positions 4/14, 5/6
replicating methodology 7/3, 7/5, 10/2 short-term interest rate futures 4/44–
reverse cash and carry arbitrage 3/13 4/45
rho 9/1, 9/3, 9/35 shout option 10/30, 10/31, 10/32
risk adjustment 4/5 simple basis 4/22
risk assessment 2/2–2/4 simple hedge 11/31
risk management 1/1–1/34, 12/12 simple options 10/32
risk management product set 11/3 single rate method 5/25
option instruments 2/2, 6/2 spot price 4/20–4/21, 4/36
terminal instruments 2/2, 3/1–3/44, spot rates 10/26
4/1–4/69, 5/1–5/44, 6/2, 6/3, spread/s 4/15
11/5, 12/2 bears and bulls 6/25, 9/38, 9/41
risk profile 2/2–2/4, 5/38, 5/39 hedging 11/30, 11/32
risk reduction 3/2, 3/10, 11/15 long 11/28
risk reward 11/43 position 11/27, 11/29
risk transfer 2/2 short 11/28
risk-free investment 11/39 stacking hedge 11/18–11/33
risk-free rate 8/5, 8/7 standard deviation 8/5, 11/13
riskless arbitrage 3/12 standardised contracts 4/2, 4/8
riskless hedge 7/4 start date 5/5
risk-neutral valuation 7/8 step-down floor 12/25
rollercoaster swaps 5/4, 5/31 stochastic models 8/3
Ross, Stephen 7/11, 10/26 stock index futures 4/25, 4/38, 11/48

Index
stock index options 11/48 time-to-expiry 8/5

stock specific risk 11/47 tolerance factor 11/41
straddle strategy 6/25–6/26, 9/41 Toy, W. 10/27
strangle strategy 6/25 trade out 2/9
strap strategy 6/25 trade-off 4/4, 4/39, 11/45
strike price 6/6, 6/12, 6/17 risk return 11/15
and trade-off 11/46, 11/47 trading procedures 4/7–4/8, 4/11, 8/7,
in M-S model 8/5, 8/6 9/24
in option conract 6/12 trading unit 4/11
in option contract 6/6, 6/8, 6/10 transaction costs 4/16, 4/42
strike rates 12/11 transfer, risk 2/2
strip hedging 11/18–11/33 transparent markets 4/5
strip option strategy 6/26 triple-A credit 5/43
strips 5/7 triple-B credit 5/43
supply and demand 4/5, 4/18, 4/26, twist, yield curve 11/19, 11/22, 11/24–
4/38, 5/18 11/28
supply squeeze 4/38 uncertainty 4/25
swaps 3/4–3/23, 5/17–5/18, 5/1–5/44, underlying factors 4/10, 9/14, 9/16,
5/57, 11/5 9/40, 11/49
use of short term interest rate futures assets 4/14, 6/18, 9/6, 9/7, 9/9
for hedging 4/67–4/69 USA 4/2
symmetric profile 2/9 value basis 4/22–4/24, 11/27
synthetic agreement for forward value date 5/5
exchange (SAFE) 3/14, 3/27–3/28 variance 8/9
defined 3/23 variation margin 4/13
settlement calculation 3/25–3/26 vega 9/1, 9/3
synthetic call 7/15, 7/16 vertical spread 6/25, 12/11
synthetic fixed rate bond 5/12 volatility 6/6, 6/18, 8/4
synthetic floating rate note 5/9, 5/12 and delta 9/8
synthetic put 7/14, 7/16, 11/40, 12/25 bond price 10/23–10/25, 10/33
synthetic straight bond 5/13 key pricing factors 9/3
systematic risk 11/48 term structure 8/11, 12/27, 12/28
tailing 4/14, 11/16 trading strategies 9/31
term structure 3/10, 4/5, 4/19, 5/20, walk away value 6/6
11/20 West Texas Intermediate 5/36
for pricing swaps 5/18, 5/27 World Bank 2/8, 5/3–5/4, 5/14
of volatility 8/11, 12/27, 12/28 written calls 6/22, 6/23, 6/24, 9/7,
terminal instruments 2/2, 6/2, 11/51 11/50, 11/67
advantages and disadvantages 12/3 written cap 10/32
forward contracts 3/1–3/44, 6/3, written options, delta 9/6–9/9
11/5 written put strategy 6/22, 6/24, 7/16
futures 4/1–4/69, 11/5 yield curve 4/23–4/24, 5/20, 11/27
swaps 5/1–5/44, 11/5 par 5/23
terminal markets 3/2, 3/6 parallel 4/23–4/24, 11/22, 11/27
theoretical basis 4/22 rotational 4/23–4/24, 11/22, 11/27,
theta 9/1, 9/3, 9/20–9/26 11/30
tick size/value 4/12, 11/31 twist 11/19, 11/22, 11/24–11/28
time decay 6/16, 9/2, 9/20 zero coupon 5/23–5/27
time intervals 11/15 yield, convenience 4/18, 4/19, 4/38,
time value 6/6, 6/13, 6/14–6/17, 9/22 10/7
and forward contracts 3/11 yield-to-maturity calculation 5/25

Index
zero-coupon 3/6, 10/26 pricing method 5/25

interest rates 5/18, 5/20 swaps 5/4

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Derivatives

DE-A2-engb 2/2017 (1012)

Edinburgh Business School

Tel + 44 (0) 131 451 3090

1.1 Introduction 1/2

Module 2 The Derivatives Building Blocks 2/1

2.1 Introduction 2/2

PART 2 TERMINAL INSTRUMENTS

3.1 Introduction 3/2

Derivatives Edinburgh Business School v

3.6 Learning Summary 3/27

Module 4 The Product Set: Terminal Instruments II – Futures 4/1

4.1 Introduction 4/2

Module 5 The Product Set: Terminal Instruments III – Swaps 5/1

5.1 Introduction 5/2

6.1 Introduction 6/1

vi Edinburgh Business School Derivatives

6.5 Learning Summary 6/25

Module 7 The Product Set II: Option Pricing 7/1

7.1 Introduction 7/1

8.1 Introduction 8/1

9.1 Introduction 9/2

Derivatives Edinburgh Business School vii

Case Study 9.1: Option-Pricing Sensitivities 9/43

10.1 Introduction 10/2

PART 4 USING DERIVATIVES AND HEDGING

11.1 Introduction 11/2

Module 12 Using the Derivatives Product Set 12/1

12.1 Introduction 12/1

Appendix 1 Practice Final Examinations and Solutions A1/1

viii Edinburgh Business School Derivatives

Appendix 2 Formula Sheet for Derivatives A2/1

Appendix 3 Interest Rate Calculations A3/1

Appendix 4 Answers to Review Questions A4/1

Derivatives Edinburgh Business School ix

Derivatives Edinburgh Business School xi

Arrangement of the Course

Topic area Modules

Approach and Key Concepts

xii Edinburgh Business School Derivatives

Section Number of Marks Total marks

Derivatives Edinburgh Business School xiii

Derivatives Edinburgh Business School xiv

Introduction to the Derivatives

Derivatives Edinburgh Business School

Derivatives Edinburgh Business School 1/1

1/2 Edinburgh Business School Derivatives

Derivatives Edinburgh Business School 1/3

1/4 Edinburgh Business School Derivatives

Derivatives Edinburgh Business School 1/5

1/6 Edinburgh Business School Derivatives

1.1.1 Fundamental Financial Instruments

Derivatives Edinburgh Business School 1/7

+ Buyer gains if market price declines

Figure 1.1 Risk profiles of buyers and sellers

1.2 Arbitrage Relationships

1/8 Edinburgh Business School Derivatives

critical role in determining the value of derivatives. Of equal importance is the

Derivatives Edinburgh Business School 1/9

Table 1.1 Arbitrage operations in gold

Reverse cash-and-carry in gold $

Note: it is possible to configure the transaction so as to extract the profit at initiation.

Note that the cash-and-carry and reverse-cash-and-carry strategies require us to