MFIN6003 Derivative Securities

Lecture Note Four

HKU Business School

University of Hong Kong

Dr. Huiyan Qiu

4-1
 Outline
Currency forward and futures
Interest rate basics
• Zero-coupon bonds and coupon bonds
• Spot rates and forward rates
• An example on forward rate
Interest rate forward (forward rate
agreements)
Appendix: Eurodollar futures

Reading: Chapter 5.6, 5.7, 7.1, 7.2

4-2
Review on Forward Contracts
Forward contract: a binding agreement
(obligation) to buy or to sell an underlying asset
in the future, at a price (forward price) set today

Forward price is future value of spot price

adjusted by dividend yield of the underlying
asset.

( r − )T
F0,T = S0e
4-3
 Currency Contracts
When the underlying asset is a foreign currency
• The price on the underlying asset: exchange rate
• The dividend yield on the underlying asset: the
foreign currency-denominated interest rate
Currency forward price is called forward
exchange rate:
( r − r f )T
x0,T = x0e
x0: the current exchange rate
r: the domestic currency-denominated interest rate
rf: the foreign currency-denominated interest rate
4-4
 Currency Contracts
Currency forwards and futures and are widely
used to hedge against changes in exchange rates
Example: A U.S. based company wants to buy
some goods from a firm in Switzerland and the
cost of the goods is 62,500 SF. The firm must pay
for the goods in 120 days
Problem: the Swiss Franc may appreciate
against the dollar.
Solution #1: long a currency forward contract to
hedge. (Enter an agreement to fix the number of
total US dollars to pay for the goods.) 4-5
Example: Currency Contracts
Currency forward: agreement to pay x0,120
dollars per Swiss Frank for 62,500SF in 120
days.
• x0,120 is the forward price of the Swiss Franc (the
underlying asset).
What should be the rate x0,120, given
• Current exchange rate x0 = 0.7032$/SF
• SF-denominated risk-free interest rate is 4.5%
• US$-denominated risk-free interest rate is 3.25%
4-6
Example: Currency Contracts
By forward pricing formula,

0 120

Sign the Pay 62,500×0.7003

currency = $43,769.75
forward
contract Get 62,500SF to
pay for the goods
4-7
Example: Currency Contracts
Alternative: using cash market to hedge!
• borrow US$ today
• exchange US$ into SF
• deposit SF for 120 days
The number of US$ to borrow today:

120-days later
• Gets: 𝑆𝐹62,500
• Pays: $43,304.57𝑒 0.0325×120/365 = $43,769.75
4-8
 Synthetic Forward
The alternative solution results in the same cash flows
as using currency forward to hedge. → Currency
forward can be replicated by borrowing in one currency
(US$) and lending in the other currency (SF)
(synthetic forward).
Cash Flows
Year 0 Year T
Transaction $ SF $ SF
+ 0.6929 --- – 0.7003 ---
Convert to SF @ 0.7032$/SF – 0.6929 + 0.9853 --- ---
Invest in SF at 4.5% --- – 0.9853 --- 1
Total – 0.7003 1
4-9
 In-Class Exercise
Suppose rates are annual and continuously
compounding,
• ¥-denominated interest rate is 2%
• $-denominated interest rate is 6%
• current exchange rate is 0.009 $/ ¥

What is the theoretical 1-year forward exchange

rate?
If the observed 1-year forward exchange rate is
0.0093, how to make arbitrage profit?
4-10
 In-Class Exercise
Solution:

4-11
 Covered Interest Arbitrage
If an arbitrager identifies that the difference in
the interest rates is different from that implied
by the forward exchange rate → Interest
arbitrage:
• borrow one currency and lend the other (synthetic
currency forward)
Covered interest arbitrage: offset the
synthetic forward position with an actual
forward contract

4-12
 Covered Interest Arbitrage
Examine the exercise question from a different
perspective, the interest rate difference
implied by the observed forward exchange rate is

instead of observed 4%.

• r$ might be too high (lend $)
• r¥ might be too low (borrow ¥)
Arbitrage? Borrow ¥ at 2%, exchange into $
and lend for 6%. At the same time, long forward
to buy ¥ at 0.0093$/ ¥.
4-13
 Covered Interest Arbitrage
Consider arbitrage profit per ¥1000 borrowed.
Time-0 cash flow: 0 (borrow ¥1000, lend $9,
and long forward for future value of ¥1000)
One year later:
• Exercise the forward: get ¥1000e0.02 and pay
$1000e0.02 x 0.0093
• Pay back borrowed yen: ¥1000e0.02
• Get lent dollar: $9e0.06
• On net, time-1 cash flow
$9e0.06 – $1000e0.02 x 0.0093 = $0.0687
4-14
 Discussion Question
A Germany car maker expects to receive 2 million
British pounds/sterling in one year.
Worrying about the depreciation of pounds relative to
euro, the car maker takes a short position in 1-year
currency forward, committing to sell 2 million pounds
for the forward exchange rate (forward price).
What should be the forward exchange rate specified
in the contract, given the following information?

4-15
 Discussion Question
(cont’d) Now suppose that six months later, the
market condition changes to the following:

What is the market value (in euro) of the car

marker’s short forward position?

4-16
 Currency Contracts
Figure Listings
for various
currency
futures
contracts from
the Wall Street
Journal.

4-17
USD/CNH Futures in Hong Kong
Item Contract Terms
USD/CNH Futures
Contract
(USD = US dollar/CNH = RMB traded in Hong Kong)
Trading Symbol CUS
Spot month, the next three calendar months and the next six
Contract Month
calendar quarter months
Contract Size USD100,000
Price Quotation RMB per USD (e.g. RMB 6.2486 per USD)
Minimum Fluctuation RMB 0.0001 (4 decimal places)
Tick Value RMB 10
8:30 am - 4:30 pm (Day Session)
Trading Hours 5:15 pm - 1:00 am (AHFT Session) (Expiring contract month closes
at 11:00 am on the Last Trading Day)
Final Settlement Day The third Wednesday of the Contract Month
Last Trading Day Two Hong Kong Business Days prior to the Final Settlement Day
USD/CNY(HK) Spot Rate published by the Treasury Markets
Final Settlement Price Association (TMA) of Hong Kong at or around 11:30 a.m. on the
Last Trading Day
Delivery of US dollars by the Seller and payment of the Final
Settlement Method
Settlement Value in RMB by the Buyer
4-18
Exchange Fee RMB 8.00
 Outline
Currency forward and futures
Interest rate basics
• Zero-coupon bonds and coupon bonds
• Spot rates and forward rates
• An example on forward rate
Interest rate forward (forward rate
agreements)
Appendix: Eurodollar futures

Reading: Chapter 5.6, 5.7, 7.1, 7.2

4-19
 Interest Rate Risk
An example: A borrower will have to borrow
$100m from June to September:

initiation maturity
120 days 91 days

Feb Jun Sep.

If wait until June, the borrower will pay the 3-

month borrowing rate at that time. Uncertainty!

4-20
 Interest Rate Risk
How to deal with the interest rate risk?
• Use the interest rate forward (FRA) or interest
rate futures
Same as equity or currency forward/futures,
interest rate forward/futures have the future
interest rate fixed.
• Forward rate: an interest rate that is specified
now to be used for a future period.

How to determine the forward rate?

4-21
 Interest Rate: Notation
rt0(t1,t2): interest rate from time t1 to t2
prevailing (known) at time t0
• r0(0,t): the interest rate for spot period, period
starting from now. Often called spot rate. Also
written as r(0,t).
• r0(t1,t2): the implied forward rate which applies
to period from t1 to t2

t0 t1 t2

$1
4-22
 Interest Rate and Bonds
r(0, t) is the rate to use to discount cash flows at
time t to get present value.
For zero-coupon bond that does not make coupon
payment and matures at time t, bond price is:

The spot rate, r(0, t), also called the discount

rate, is the zero-coupon bond yield.
P(0, t) is the zero-coupon bond price, also called
the discount factor.
4-23
 Interest Rate and Bonds
Coupon bonds: bonds that make coupon
payment regularly plus the maturity payment.
The price of bond is equal to the present value of
all future payments.
• If a bond has price equal to par, the bond is called
par coupon bond.
Example: the 1-year and 2-year annual effective
rates are 3% and 4%, respectively. What is the
price of a 2-year bond with annual coupon rate of
5%?
4-24
 Interest Rate and Bonds
Example (cont’d)
The given 3% is 1-year spot rate, also the 1-year
zero-coupon bond yield. It is the rate to discount
year-1 cash flows.
The given 4% is 2-year spot rate, also the 2-year
zero-coupon bond yield. It is the rate to discount
year-2 cash flows.
Thus, for 2-year coupon bond paying 0.05 in year
1 and 1.05 in year 2, the bond price is

4-25
 Interest Rate and Bonds
Further discussion:
For a 2-year coupon bond to be par coupon bond,
what should be the coupon rate?
Solution: based on the definition of par coupon
bond, if x is the coupon rate of the par coupon
bond,

Solve for x → par coupon rate is 3.98%

4-26
 Spot Rates and Forward Rates
An investor investing for 2 years. Consider two
investment alternatives.

4-27
Spot Rates and Forward Rates
Two investment alternatives should result in the
same payoff:

Example: the 1-year and 2-year annual

effective rates are 3% and 4%, respectively.
What is the implied forward rate from 1 to 2?

Solution: 𝑟0 0,1 = 3% and 𝑟0 0,2 = 4%

4-28
Spot Rates and Forward Rates
In general:

Rewriting,

4-29
 In-Class Exercise
Suppose the risk-free 1-, 2-, and 3-year zero-
coupon bond yields are 6%, 6.5%, and 7%,
respectively. All rates are annual and effective.
Calculate the zero-coupon bond prices and
forward rates. Complete the table below.

Zero-Coupon One-Year
Zero-Coupon
Maturity Bond Yield Implied
Bond Price
(%) Forward Rate
1 6.00
2 6.50
3 7.00 4-30
 In-Class Exercise (cont’d)
What is the forward price for a two-year zero-
coupon bond which will be issued in year 1?
Solution:

4-31
 Outline
Currency forward and futures
Interest rate basics
• Zero-coupon bonds and coupon bonds
• Spot rates and forward rates
• An example on forward rate
Interest rate forward (forward rate
agreements)
Appendix: Eurodollar futures

Reading: Chapter 5.6, 5.7, 7.1, 7.2

4-32
An Example on Forward Rate
The forward interest rate is the rate we can
agree on today at which to borrow or to lend
money in the future.
Example: We agree today that in 1 year you will
lend me $10,000 for 3 years at 2% effective
annual interest rate.

Today 1 year 4 years later

$0 $10,000 – $10,000×1.023

4-33
 Synthetic Replication
Why 2%? How to determine the forward interest
rate?
Can I use the bond market to achieve the same
goal: lock in the interest rate today to borrow
$10,000 in 1 year for 3 years?

Synthetic replication: buy and sell zero-

coupon bonds to duplicate the cash flows now, in
year 1, and in year 4.

4-34
Synthetic Replication (cont’d)
Suppose that the 1-year effective annual rate is 1.6%
→ Price of 1-year zero-coupon bond: P(0,1) =
1/1.016 = 0.9843
and that the 4-year rate is 1.9% → price of 4-year
zero-coupon bond: P(0,4) = 1/1.0194 = 0.9275

0 1 4

P(0,1)=0.9843 $1

P(0,4)=0.9275 $1

4-35
Synthetic Replication (cont’d)
In order to receive $10,000 in year 1, I need to
buy 10,000 zero-coupon bonds today.
• The cost today is 10,000×$0.9843 = $9,842.52
The replicating portfolio should cost $0 today, so
I sell 4-year zero-coupon bonds for $9842.52 →
sell $9,842.52/$0.9275 = 10,612 units of 4-year zero
coupon bonds.
In year 1, I receive $10,000 from the 1-year zero
coupon bonds I purchased.
In years 4, I owe $10,612 from the bonds I sold.
4-36
 Synthetic Replication (cont’d)
Security Strategy Today 1 Year 4 Years
1-Year Zero +10,000 – $9842.52 $10,000
4-Year Zero – 10,612 + $9842.52 – $10,612
Total $0 $10,000 – $10,612

From the calculation,

= 10,000 × 1.0612 = 10,000 × 1.023

4-37
 Forward Interest Rate
The forward interest rate from year 1 to year 4,
𝑟0(1,4), satisfies

This is equivalent to

Compound for a year and committed to then

compound for three years is equivalent to
compound for four years.
4-38
 Outline
Currency forward and futures
Interest rate basics
• Zero-coupon bonds and coupon bonds
• Spot rates and forward rates
• An example on forward rate
Interest rate forward (forward rate
agreements)
Appendix: Eurodollar futures

Reading: Chapter 5.6, 5.7, 7.1, 7.2

4-39
 Forward Rate Agreements
Forward Rate Agreements (FRAs) are over-the-
counter contracts that guarantee a borrowing or
lending rate on a given notional principal amount
• Forward contracts is based on the interest rate
• Do not entail the actual borrowing or lending of
money. Borrowers who enters an FRA
• get paid if a reference rate is above the FRA rate
• pay if the reference rate is below the FRA rate
• and borrow from the market at the reference rate
4-40
 FRA: Settlement
FRA can settle either at the initiation or
maturity (settle in arrears) of the borrowing or
lending transaction.
Settle at maturity, the payment to the borrower
is
Notional principal × (rreference − rFRA )
Settle at initiation, the payment to the borrower
is

4-41
 Borrower Using FRA
Borrower to borrow $100m for 91 days at
effective forward rate of 1.8%, beginning 120
days from today, in June
• Suppose the effective quarterly interest rate in
June can be either 1.5% or 2%
initiation maturity
120 days 91 days

Feb Jun Sep.

P(0, 211) = 0.95836 and P(0, 120) = 0.97561

4-42
 FRA Rate
P(0, 120) = 0.97561
• The price of zero-coupon bond maturing in June
(120-day zero-coupon bond)
• The present value of $1 at 120-days
P(0, 211) = 0.95836
• The price of zero-coupon bond maturing in
September (211-day zero-coupon bond)
• The present value of $1 at 211-days

⇒ 𝒓𝟎 (𝟏𝟐𝟎, 𝟐𝟏𝟏) = 𝟏. 𝟖% 4-43

 Borrower Using FRA
Settle at maturity (September):
• If the borrowing rate in June is 1.5%, the borrower
shall pay 100m×(1.8% – 1.5%) = $300,000 to the
contract’s counterparty
• If the borrowing rate in June is 2.0%, the borrower
will receive 100m ×(2.0% – 1.8%) = $200,000
Settle at the initiation (June):
• If the borrowing rate in June is 1.5%, the borrower
shall pay $300,000/(1+1.5%) = $295,566.50
• If the borrowing rate in June is 2.0%, the borrower
will receive $200,000/(1+2%) = $196,078.43 4-44
 Cash Flow Table
The FRA settlement is tailed by the reference rate prevailing
on the borrowing date

Cash Flows
June September
Borrowing
1.5% 2% 1.5% 2%
Rate
Borrow $100m +100m +100m -101.5m -102m
Proceeds from
- 0.3m +0.2m
FRA
Net +100m +100m -101.8m -101.8m
4-45
 Replication of FRAs
FRAs together with actual borrowing or lending can be
synthetically replicated using zero-coupon bonds. (For
simplicity, r(t,t+s) is non-annualized here.)
Table Investment strategy undertaken at time 0, resulting in net cash
flows of −$1 on day t, and receiving the implied forward rate, 1 + r(t, t +
s) at t + s.

4-46
 Summarization: FRAs
FRA can be used to lock in a borrowing or lending
rate from time t to time t + s
• To replicate the FRA (together with the actual
lending/borrowing )
• Long/short 1 + 𝑟0 𝑡, 𝑡 + 𝑠 of the zero-coupon
bond maturing at t + s
• Short/long 1 zero-coupon bond maturing at t
The forward rate we can obtain is the implied
𝑷(𝟎,𝒕)
forward rate 𝒓𝟎 𝒕, 𝒕 + 𝒔 = −𝟏
𝑷(𝟎,𝒕+𝒔)
4-47
 In-Class Exercise
Following table provides the information on zero-
coupon bonds maturing at different days.

Days to Maturity 90 180 270 360

Zero-Coupon Bond Price 0.99009 0.97943 0.96525 0.95238

What is the rate on an FRA for a 180-day loan

commencing on day 180?
Suppose Bob will have $10 million to lend from
day 90 to day 360. Describe the risk Bob’s
position is exposed to. Find two ways to help Bob
hedge the risk. 4-48
 In-Class Exercise
Solution:

4-49
 Interest Rate Futures
Short-term interest rate futures
• Eurodollar futures (Appendix)
• LIBOR – London Interbank Offered Rate
• Ceased to exist!
• SOFR futures
• SOFR - Secured Overnight Financing Rate
• Fed funds futures
• Fed funds rate – overnight US federal funds rate
Bond futures: futures contract on government
bonds
4-50
Interest Rate Futures in Hong Kong
Hong Kong Interbank Offered Rate (HIBOR): the
rate on which Hong Kong dollar-denominated
instruments are traded between banks in Hong
Kong.
One-Month HIBOR futures: 20 Oct. 1998,
based on the One-Month HIBOR.
Three-Month HIBOR futures: 26 Sept. 1998,
based on Three-Month HIBOR
The two rates are benchmarks for short-term
interest rates in the Hong Kong dollar money
market. 4-51
End of the Notes!

4-52
 Appendix:

Eurodollar Futures

4-53
 Eurodollar Futures
Eurodollar Futures are future contracts that can be
used to speculate on and hedge interest rate risk.

Figure
Specifications
for the
Eurodollar
futures
contract.

4-54
 Eurodollar Futures
What are Eurodollar futures contracts?
Based on a $1 million 3-month time deposit
earning LIBOR. Cash settlement.
Quoted futures price = 100 – 4×3-month LIBOR
• Example: quoted price of March Eurodollar
futures is 94.4 → implied LIBOR rate from March
to June is 1.4%. Settle in March!
Price change by 1 → 3-month rate change by
0.25% → borrowing or lending interest change by
$2,500.
4-55
 Eurodollar Futures
The payoff of Eurodollar Futures at expiration:
price change x $2500
Long futures + interest rate goes up → lose;
Short futures + interest rate goes up → gain.
Eurodollar Futures can be used to hedge interest
rate risk.
• To hedge future borrowing: short futures
• To hedge future lending: long futures
4-56
 Eurodollar Futures: Example
• Example: Hedging $100 million borrowing with
Eurodollar futures: to guarantee a borrowing rate
for the loan from Jun. to Sep.
• The June Eurodollar futures price is 92.8
• The implied 3-month LIBOR = (100 – 92.8)/4 = 1.8%
• We short Eurodollar futures to hedge: how many
futures contracts to short?
• $100 million borrowing vs. $1 million principal per
contract → shorting 100 contract (?)
• Concern: June Eurodollar futures settles in June!
4-57
 Eurodollar Futures: Example
• The Eurodollar futures contract settles in June.
Suppose 100 futures contract is short,
• if in June, the actual rate is 1.5% → the futures
price is 100 – 4×1.5 = 94 → payoff: 100×(92.8 – 94)
×$2500 = – $300,000
• Equivalent Sept. payoff: –$300,000×1.015=–$304,500
• if in June, the actual rate is 2% → the futures price
is 100 – 4×2 = 92 → payoff: 100×(92.8 – 92)
×$2500 = $200,000
• Equivalent Sept. payoff: $200,000×1.02 = $204,000
4-58
 Resulted Cash Flows
The resulted cash flow table if 100 Eurodollar
futures contracts are shorted to hedge:

Cash Flows
June September
Borrowing Rate 1.5% 2% 1.5% 2%
Borrow $100m +100m +100m – 101.5m – 102m
Proceeds from
– 0.3045m 0.204m
futures
Net +100m +100m -101.8045m -101.7960m
4-59
 Interest Rate Futures: WSJ Listing

Figure Listing for

interest rate
futures contracts,
including the 1-
month LIBOR and
3-month Eurodollar
contracts, from the
Wall Street Journal.

4-60