Derivatives 2022 Level I High Yield Notes

R46 Basics of Derivative Pricing and Valuation

Use of arbitrage, replication, and risk neutrality in pricing derivatives
Arbitrage is the condition under which two equivalent assets or derivatives or
combination of assets and derivatives sell for different prices.
 This allows an arbitrageur to buy at a low price and sell at a high price, earning a risk-
free profit without committing any capital.
 In well-functioning markets, arbitrage opportunities are quickly exploited. The
combined actions of arbitrageurs force the prices of similar securities to converge.
Hence, arbitrage leads to the law of one price: securities or derivatives that produce
equivalent results must sell for equivalent prices.
Replication is the creation of an asset or a portfolio from another asset, portfolio, and/or
derivative. Example: stock + short forward = risk-free asset.
Risk neutrality: The risk aversion of an individual does not impact derivative pricing. The
risk-free rate is used for pricing derivatives.
The overall process of pricing derivatives by arbitrage and risk neutrality is called
arbitrage-free pricing. According to this process:
 A derivative must be priced such that no arbitrage opportunities exist, and there can
only be one price for the derivative that earns the risk-free return.
 Asset + Derivative = Risk-free asset

Value v/s price of forward and futures contracts

Price: The price of a forward or futures contract is the forward price that is specified in the
contract.
Value: The value of a forward or futures contract is zero at initiation. Its value may
increase or decrease during its life according to changes in the spot price.
 At initiation, the value of a forward contract is zero.
 Value at expiration: ST - F
F
 Value during the life of the contract: Vt = St – (1 + r)T−t

Monetary and nonmonetary benefits and costs associated with holding the
underlying asset
The forward price of an asset with benefits and/or costs is the spot price compounded at
the risk-free rate over the life of the contract plus the future value of costs minus the future
value of benefits.
F = S0 (1 + r)t + FV (costs) – FV (benefits)

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Derivatives 2022 Level I High Yield Notes

F0 (T) = (S0 ) × (1 + r)T – (γ − θ) ×(1 + r)T

F0 (T) = (S0 − γ + θ) × (1 + r)T
where:
γ = present value of the benefit. It is subtracted from the spot price because if you own the
asset, you receive any benefits associated with the asset during the life of the contract.
θ = present value of costs incurred on the asset during the life of the contract. These costs
make it more expensive to hold the asset and hence increase the forward price.

The following information is provided for an asset:

 Spot price of S0 = $100
 Present value of benefits from the asset = $10
 Present value of costs associated with holding the asset = $20
Assuming a risk-free rate of 10% and a time period of 3 months, calculate the forward price
for this asset.
Solution:
3
T = 12 = 0.25
F0 (T) = (100 – 10 + 20)(1.1)0.25 = 112.65
The value of a forward contract is the spot price of the underlying asset minus the
present value of the forward price.
0 F (T)
Vt (T) = St – (1+r)T−t (without benefits and costs)

F0 (T)
Vt (T) = St – (γ - θ) (1 + r)t - (1+r)T−t
(with benefits and costs)

In the above example, let’s say 1-month later the price of the underlying is $104. Calculate
the value of the contract to the long party.
Solution:
t = 1/12 = 0.083; T-t = 2/12 = 0.167
112.65
Vt (T) = 104 – (10 - 20) 1.10.083 - (1.1)0.167
= $3.21

Forward rate agreement

A forward rate agreement (FRA) is a derivative contract that has an interest rate, rather
than an asset price, as its underlying.
Uses
 FRA allows an investor to lock in a certain interest rate for borrowing or lending at
some future date.
 One party will pay the other party the difference between the interest rate specified in
the FRA and the market interest rate at contract settlement.

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Derivatives 2022 Level I High Yield Notes

 Firms can therefore reduce or eliminate the risk of future borrowing costs using an
FRA.

Difference in forward and futures prices

Futures prices can differ from forward prices because of the effect of interest rates on the
interim cash flows from the daily settlement.
 If interest rates are constant, or have zero correlation with futures prices, then
forwards and futures prices will be the same.
 If futures prices are negatively correlated with interest rates, then it is more desirable
to buy forwards than futures.
 If future prices are positively correlated with interest rates, then it is more desirable to
buy futures than forwards.

Swap contracts v/s a series of forward contracts

A normal forward contract has a zero value at the start because of no-arbitrage pricing. In a
swap, since the fixed price is priced differently than the market price, this forward contract
has a non-zero value at the start and is called an off-market forward. A swap is a series of
off-market forward contracts where:
 Each forward contract is created at a price and maturity equal to the fixed price of the
swap with the same maturity and payment dates, respectively.
 This means that the series of FRAs built into a swap are all off-market FRAs: some with
positive values and some with negative values.
 The combined value of the off-market FRAs is zero.

Value and price of swaps

Price: The price of a swap is the fixed interest rate specified in the swap contract.
Value
 At initiation, the value of swap is zero.
 The value of a swap during the life of the swap changes according to how expected
future floating rates change over time.
 An increase in expected futures rates will result in a positive value for the fixed-rate
payer.
 A decrease in expected futures rates will result in negative value for the fixed-rate
payer.

Value of a European option at expiration

Call option
 At expiration, the value of a call option is the greater of zero or the value of the
underlying asset minus the exercise price.

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Derivatives 2022 Level I High Yield Notes

 CT = max (0, ST – X )
Put option
 At expiration, the value of a put option is the greater of zero or the exercise price minus
the value of the underlying.
 PT = max (0, X − ST )

Exercise value, time value, and moneyness of an option

Moneyness refers to whether an option is in the money or out of the money.
 If immediate exercise of the option would result in a positive payoff, then the option is
in the money.
 If immediate exercise would result in a loss, then the option is out of the money.
 If immediate exercise would result in neither a gain nor a loss, then the option is at the
money.
Call Option Put Option
In-the-money S>X S<X
At-the-money S=X S=X
Out-of-the-money S<X S>X
Exercise value of an option is the maximum of zero or the amount that the option is in-the-
money.
Time value of an option is the amount by which the option premium exceeds the exercise
value.
 Prior to expiration an option also has time value in addition to exercise value.
 When an option reaches expiration, the time value is zero.

Factors that determine the value of an option

Increase in Value of call option will Value of put option will
Value of the underlying Increase Decrease
Exercise price Decrease Increase
Risk-free rate Increase Decrease
Time to expiration Increase Increase (exception: a few
European puts)
Volatility of the underlying Increase Increase
Costs incurred while Increase Decrease
holding the underlying
Benefits received while Decrease Increase
holding the underlying

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Derivatives 2022 Level I High Yield Notes

Put–call parity for European options

European put and call prices are related through put–call parity, which specifies that the
put price plus the price of the underlying equals the call price plus the present value of the
exercise price.
According to put-call parity,
Fiduciary call = Protective put
Long call + risk free bond = Long put + stock
X
c0+ (1 = p0 + S0
+ r)T

Assume call and put options with an exercise price of $100 in which the underlying is at
$90 at time t=0. The risk-free rate is 10% and the options expire in 3 months. The call price
is $2. Calculate the put price.
Solution:
X
p0 = c0+ (1 + r)T - S0 = 2 + 100/1.10.25 – 90 = $9.64

Put–call–forward parity for European options

According to put-call parity, since a fiduciary call = protective put, a fiduciary call must be
equal to a protective put with a forward contract.
Bond + Call = Long Put + Asset
Replacing asset in the above equation with a forward contract + risk free bond, we get:
Bond + Call = Long Put + Long forward + Risk-free bond.
X F (T)
c0+ (1 + r)T = p0 + (1 0+ r)T

In the put-call parity example covered above, assume a forward contract on the underlying
expiring in 3 months. This contract will have a price of 90 x 1.10.25 = $92.17. Using this
forward contract instead of the underlying, the put price can be calculated as:
X F (T)
p0 = c0+ (1 + r)T - (1 0+ r)T = 2 + 100/1.10.25 – 92.17/1.10.25 = $9.64

Value of an option using a one-period binomial model

 The binomial model is a simple model for valuing options based on only two possible
outcomes for a stock’s movement: going up and going down.
 π and 1- π are called the synthetic probabilities; they represent the weighted average of
producing the next to possible call values.
 By discounting the future expected call values at the risk-free rate, we can get the
current call value.
1+r−d
π= u−d

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Derivatives 2022 Level I High Yield Notes

πc+ −
1 +(1−π)c1
c0 =
1+r

Assume the following data is given:

S0 = 40; u = 1.2; d= 0.75; X = 38; r = 5%; c0 =?

The value of the call option at time 0 using the 1-period binomial model is 6.35.

European v/s American options

 If the underlying asset has a cash flow such as a dividend or interest, then American call
prices will be more than European call prices. This is because the option can be
exercised early to collect this cash flow.
 American put prices will always be higher than European put prices because the right
to exercise early always has value for a put.

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