Intl Derivatives Market For Student

Chương 5.
Thị trường phái sinh quốc tế
PGS, TS Mai Thu Hiền

Khoa Tài chính Ngân hàng
Trường Đại học Ngoại Thương
Email: maithuhien712@yahoo.com
hien.mai.1512@gmail.com
FTU Khoa Tài chính Ngân hàng FBF
Chương 5. Thị trường phái sinh quốc tế

PPGD Số Nội dung chính Yêu cầu học viên chuẩn bị
giờ
Lý thuyết 6 5.1. Khái niệm Chance, chương 1-6, 8-12
5.2. Phân loại thị trường phái Deutsche Borse AG (2008),
sinh quốc tế The Global Derivatives
5.3. Chủ thể tham gia thị trường Market: An Introduction
phái sinh quốc tế Eiman, chương 8
5.4. Thị trường kỳ hạn Hull, 1-3, 5, 7, 10-12, 15
5.5. Thị trường tương lai Madura, chương 5
5.6. Thị trường hoán đổi Solnik, chương 10, 11
5.7. Thị trường quyền chọn
5.8. Một số thị trường giao dịch
phái sinh trên thế giới
Seminar 3 Tìm hiểu giao dịch trên một số
thị trường giao dịch phái sinh
lớn trên thế giới
Bài tập 4
Thảo luận 2 Ứng dụng hợp đồng phái sinh
nhóm nhằm phòng vệ rủi ro khi giao
dịch trên thị trường quốc tế
International derivative market

• Derivative instruments are used domestically to hedge risks.
• Around 25 years ago, the derivatives market was small and
domestic. Since then it has grown impressively – around 24
percent per year in the last decade – into a sizeable and
truly global market with about €457 trillion of notional
amount outstanding (in 2007).
• Benefits of derivatives make them indispensable to the
global financial system and the economy
– Derivatives provide risk protection with minimal upfront investment
and capital consumption.
– allow investors to trade on future price expectations.
– have very low total transaction costs compared to investing directly in
the underlying asset.
– allow fast product innovation because new contracts can be
introduced rapidly.
– can be tailored to the specific needs of any user.
1
International derivative market
• Derivatives can be differentiated along three main dimensions
– Type of derivative and market place: Derivatives can be traded
bilaterally OTC (mostly individually customized contracts) or
multilaterally on exchanges (standardized contracts).
– Type of underlying: Underlyings can be financial instruments
themselves, physical assets, or any risk factors that can be measured.
Common examples are fixed-income, foreign exchange, credit risk,
equities and equity indices or commodities. Exotic underlyings are, for
example, weather, freight rates, or economic indicators.
– Type of product: The three main types are forwards (or futures), options
and swaps. They differ in terms of their dependence on the price of the
underlying.
• The most important area of risk management in international
investment is currency risk
• A currency derivative is a contract whose price is partially
derived from the value of the underlying currency that it
presents.
2
See BIS 2008 and
WFE statistics
(www.world-
exchanges.org); the
gross market value of
a derivatives contract
refers to the positive
market value one side
of a derivatives
contract has, not See BIS 2008; the
considering negative notional amount of
market values the a derivatives
other side to the contract refers to
derivatives contract the value or
might have. In nominal amount of
contrast to notional the underlying to
amount, gross market the derivatives
value reflects more contract;
the aggregated net outstanding refers
risk position of market to open derivatives
participants and is contracts that are
therefore significantly held by market
lower participants.
Natures of international derivative market

• Global natures of the market
– The OTC segment operates with almost complete
disregard of national borders.
– Derivatives exchanges themselves provide equal
access to customers worldwide. As long as local
market regulation does not impose access barriers,
participants can connect and trade remotely and
seamlessly from around the world (e.g. from their
London trading desk to the Eurex exchange in
Frankfurt).
– The fully integrated, single derivatives market is
clearly a reality within the European Union.
3
• Europe’s leading role within the derivatives market
– Today, Europe is the most important region in the global
derivatives market, with 44 percent of the global
outstanding volume – significantly higher than its share
in equities and bonds
– The global OTC derivatives segment is mainly based in
London.
– The unrestricted pan-European provision of investment
services, in place since the introduction of the European
Union’s Investment Services Directive (ISD) in January
1996 has strengthened the competitive position of
Europe in the global market environment.
– Many European banks are currently global leaders in
derivatives.

– Historically, large derivatives exchanges were almost
exclusively located in the US
– Strong European derivatives exchanges appeared
only after deregulation and demutualization in the
1980s and 1990s.
– Over the years European players have strengthened
their position, increasing their global market share
from 24 percent in 1995 to almost 40 percent in 2007
– They are now among the largest exchanges
worldwide in a sector where the biggest players are
international exchange groups that offer trading
globally.
4
• Generally, there are two indications for competition
in a market: new market entries and customer
choice.
– New players regularly enter the market
– Customers can choose between many substitute products
across both its segments.
• The derivatives market can be characterized as
highly dynamic with plenty of market entries.
– There are no legal, regulatory or structural barriers to
entering the derivatives market.
– Almost all derivatives exchanges across the world have
been created during the last three decades only

The United States was home to the first wave of equity
options exchange foundations in the 1970s in the wake of
academic breakthroughs in options valuation and the
introduction of computer systems.
 The CBOE was founded in 1973, the American Stock Exchange,
Montreal Exchange and Philadelphia Stock Exchange started
options trading in 1975 while the Pacific Exchange commenced
options trading in 1976
A second wave of new derivatives exchanges occurred in
the 1980s and early 1990s in Europe.
 During that time a financial derivatives exchange was established in
almost every major Western European financial market – the most
important ones being London with Liffe in 1982, Paris with Matif in
1986, and Frankfurt with DTB (Deutsche Terminbörse) in 1990.

In recent years, new derivatives exchanges have started to
compete with existing derivatives marketplaces.
 For instance, ISE (The International Securities Exchange)
commenced trading in 2000 and became the market leader in US
equity options trading together with CBOE in 2003.
 In 2004, BOX (Boston Options Exchange) successfully entered
US equity options trading ICE, founded in 2000, is an example of
successful market entry into the commodity derivatives market.
Recently, two plans have been announced to establish further
derivatives trading platforms in the United States and Europe with
the ELX (Electronic Liquidity Exchange) and project “Rainbow”,
which aim to compete with established marketplaces.
 After financial crisis 1997-98 many exchanges were merged.
5
• Away from the developed markets, related
activities in emerging markets are also intensive.
– Three derivatives operations have commenced
trading in the Middle East since 2005: Dubai Gold and
Commodities Exchange, Kuwait Stock Exchange, and
IMEX Qatar.
– India saw four new derivatives exchanges set up
between 2000 and 2003: National Stock Exchange of
India, Bombay Stock Exchange, MCX India, and
NCDEX India.
– China has seen the establishment of two derivatives
exchanges since 2005: Shanghai Futures Exchange
and China Financial Futures Exchange.

• Banks are also constantly entering new product
segments:
– Goldman Sachs, for example, has invested heavily
into the commodity derivatives segment in recent
years.
– BNP Paribas has successfully developed the OTC
equity derivatives segment.
– There are numerous successful market entries into
the OTC segment such as ICAP or GFI, which
provide trading services via electronic platforms, or of
clearing service providers such as Liffe’s Bclear,
LCH.Clearnet’s SwapClear or Intercontinental
Exchange’s OTC clearing services.
6
• Newly established derivatives exchanges are
competing for energy and emission rights trading.
– Three major exchanges are providing electricity
derivatives trading and clearing in Europe: Nord Pool,
Powernext, and EEX.
– Competitive trading and clearing of European carbon
emission allowances (EU allowances or EUAs) started
on EEX and ICE in January 2005 when the European
Union Gas Emission Trading Scheme (EU ETS) was
launched.
– Bluenext, a joint venture of NYSE Euronext and Caisse
des Dépôts, has been offering comparable EUA
derivatives since April 2008, directly competing with
established EUA marketplaces
Risk mitigation
• There are wanted and unwanted risks in the derivatives
market.
• The main reason for using derivatives is to gain exposure to a
“wanted” risk. This usually is a market risk that either could
compensate for an opposite risk (hedging) or that an investor
wants to benefit from for investment purposes
• However, as with other financial instruments, there are also
“unwanted” risks associated with derivatives trading that
investors seek to avoid. These unwanted risks are
counterparty, operational, legal and liquidity risks.
• The different risks that market participants face can ultimately
lead to systemic risk, that is, the failure of one counterparty
having adverse effects on other market participants, potentially
destabilizing the entire financial market. A primary concern of
all stakeholders, including regulators, is to limit systemic risk to
the greatest extent possible.
7
Innovation
• Across the board, the derivatives market has been
highly innovative. Indeed, product and technology
innovation have driven the impressive growth of the
market.
• European players have been central to this, leading
innovation in both fields.
• Product innovation and introduction is thus
significantly more costly on-exchange. Nevertheless,
derivatives exchanges are highly innovative.
– Globally, the top three derivatives exchanges (Eurex, CME
and Euronext.Liffe) have introduced more than 800 new
products since the beginning of 2005, increasing the
number of total products available to users by more than
80 percent.
Innovation
• Product innovation is a critical driver of overall market
growth as the following examples illustrate:
– CDSs were introduced as an OTC instrument in the mid-1990s as a
way of enabling market participants to manage their exposure to
credit risk. Driven by the CDS segment the credit derivatives
segment has grown at more than 70 percent per year from €135
billion in 1996 to €37 trillion in June 2007. Today, credit derivatives
account for about 8 percent of the total derivatives volume.
– Derivatives on carbon emission allowances (for example, EUAs)
are one of the newer product innovations introduced by derivatives
exchanges. Today’s market in EUAs is still relatively small with
about €24 billion traded in 2006, which is however three times as
much as the trading volume in 2005. But already new underlyings
are added in the emissions segment of the market: besides EEX
and Eurex, which have offered derivatives on CERs since March
2008, Barclays Capital in the OTC segment, and ICE and Bluenext
recently announced plans to enter this segment.
Innovation
• Technological innovations have contributed significantly to
greater efficiency in the derivatives market.
– Through innovations in trading technology, trades at Eurex are
today executed much faster than ten years ago despite the
strong increase in trading volume and the number of quotes
(Exhibit 10).
– Trading systems that can process transactions within fractions
of a second are the latest step in the automation of exchanges
that started with the introduction of electronic trading in the mid-
1980s. European derivatives exchanges have been at the
forefront of this “revolution”. They introduced fully electronic
trading well before their US counterparts (Exhibit 11).
– In recent years, the OTC segment has also become
increasingly automated with the emergence of new electronic
OTC trading platforms. Examples include ICAP, GFI, Tradition
and Tullett Prebon.
8
INTRODUCTION TO FORWARD
9
MTH17
Forward contract
• A forward contract is an agreement between two parties in
which one party, the buyer, agrees to buy from the other
party, the seller, an underlying asset at a future date at a
price established at the start of contract.
• The parties to the transaction specify the forward
contract‘s terms and conditions. In this sense, the contract
is said to be customized. Each party is subject to the
possibility that the other party will default.
• The holder of a long forward contract (the long) is
obligated to take delivery of the underlying asset and pay
the forward price at expiration. The holder of a short
forward contract is obligated to deliver the underlying asset
and accept payment of the forward price at expiration.
28
Forward contract
• The forward contract hedge locks in a price

• Neither party pays any money at the start
29
Delivery and settlement of

a forward contract
• When a forward contract expires, two possible
arrangements that can be used to settle the obligations of
the parties:
 Delivery (the participants engage in delivery of the asset): the long
will pay the agreed-upon price to the short, who in turn will deliver
the underlying asset to the long (a deliverable forward contract).
 Cash settlement (the participants settle the cash equivalent):
permits the long and the short to pay the net cash value of the
position (F-St) on the delivery date (a cash-settled forward contract
or nondeliverable forwards NDFs).
F
Buyer (the long) Seller (the short)
30
Underlying
10
Slide 28
MTH17 CFA, Vol.6

Mai Thu Hien, 7/28/2009
Termination of a forward contract
• Until the contract expires
• Prior to expiration: Assume that the contract calls for delivery rather
than cash settlement at expiration
‒ Enter another forward contract at opposite position expiring at the same time as
the original forward contract (because of price changes in the market during the
period since the original contract was created, this new contract would likely have
a different price). The company may have credit risk if the counterparty on the
long or the short contract fails to pay.
‒ To avoid credit risk, the company contacts the same counterparty with whom
they engaged the original contract. They could agree to cancel both contracts,
the company receives $2. This termination is desirable for both parties because it
eliminates the credit risk. If the initial counterparty is a bank, the company
requests, at the start, that its initial contract be offset and the bank will charge a
fee (= F0 - F1). Note that it is possible that the company might receive a better
price from another counterparty. If that price is sufficiently attractive and the
companty does not perceive the credit risk to be too high, it may choose to deal
with the other counter party. Long 3 months (40$)
F0 F1 Short 2 months (42$) 31
Payoff of forward contract

P↑→ the buyer wins P↑→ the seller looses
Profit (Payoff) Profit
Price of Price of
underlying underlying
at maturity ST at maturity ST
Long Position Short Position

Payoff = ST - F Payoff = F - ST
FORWARD PRICING AND

VALUING
11
Measuring interest rate
m: compounding frequency
A: an amount invested for T years
V: an amount at expiration
r: interest rate per annum
T: years
• Discrete interest formula
 Annually compounded: V = A(1+r)T
 m times per annum compounded (annually m=1, semiannually m=2,
quarterly m=4, monthly m= 12, weekly m = 52, daily m = 360 if
LIBOR-style rate or m=365 if non-LIBOR-style rate): V = A(1+r/m)mT
• Continuous compounding interest formula:
m
m→∞
 V = AerT because  r
e r  lim  1  
m
 m
MTH23
Conversion Formulas
• Yield calculation
y = (cash flow from investment/amount invested)1/n – 1
Where n: number of periods until the cash flow will be received
y: the yield on investment
• Annualizing yield:
Effective annual yield = (1 + periodic interest rate)m – 1
Where m is frequency of payment per year
Periodic interest rate = (1 + Effective annual yield)1/m – 1
Generic pricing and valuation of

forward contracts
0 t T
today expiration
• S0: The price of underlying asset in the spot market at time 0
• St: The price of underlying asset in the spot market at time t
• ST: The price of underlying asset in the spot market at time T
• F0,T: The forward contract price initiated at time 0 and expiring at time T
• V0,(0,T): The value of the forward contract at time 0 when the contract is
initiated and expiring at time T.
• Vt,(0,T): The value of the forward contract at a point during the life of the
contract
• VT,(0,T): The value of the forward contract at expiration
36
12
Slide 35
MTH23 Fabozzi, Fixed income mathematics, p59-61

Generic pricing a forward contract
0 T
Buy asset at S0 Hold asset and Deliver asset
Sell forward at F0,T lose interest on Receive F0,T
Outlay S0 outlay
• This transaction is risk free and should be equivalent to investing S0

dollars in a risk-free asset that pays F0,T at time T. Thus, the amount
received at T must be the future value of the initial outlay invested at
the risk-free rate. For this equality to hold, the forward price must be
given as:
F0,T = S0(1+r)T (discrete compounding)
37
Generic valuation of a forward contract

0 T
Buy asset at S0 Hold asset and
Deliver asset
Sell forward at F0,T lose interest on
Receive F0,T
Outlay S0 outlay
• We will have to pay F0,T USD at T
• We will receive the underlying asset, which will be worth ST at T
• The present value of the payment of F0,T is F0,T/(1+r)T-t
• We have the claim on the asset’s value at T and we only know the
market value of the asset St, the current asset price. Thus we have
value of forward contract at time t during the life of the contract is the
asset price minus the present value of the exercise price:
Vt,(0,T) = St - F0,T/(1+r)T-t
• If t = 0, Vt,(0,T) = V0,(0,T) = S0 - F0,T /(1+r)T = 0 because F0,T = S0(1+r)T
• If t = T, Vt,(0,T) = VT,(0,T) = ST - F0,T /(1+r)0 = ST - F0,T
• We set the price such that the value of the contract is zero at the start.
• A zero-value contract means that the present value of the payments
promised by each party to the other is the same, a result in keeping 38
with the fact that neither party pays the other any money at the start.
Example
• An investor holds title an asset worth EUR125.72. To raise money for unrelated
purpose, the investor plans to sell the asset in nine months. The investor is
concerned about uncertainty in the price of the asset at that time and enters into
a forward contract to sell asset in nine months. The risk-free rate is 5.625%
(discrete compounding, months/12).
A. Determine the appropriate price the investor could receive in nine months by
means of the forward contract.
B. Suppose the counterparty to the forward contract is willing to engage in such a
contract at a forward price of EUR140. Explain what type of transaction the
investor could execute to take advantage of the situation. Calculate the rate of
return (annualized) and explain why the transaction is attractive.
C. Suppose the forward contract is entered into at the price you computed in Part
A. Two months later, the price of the asset is EUR118.875, the investor would
like to evaluate her position with respect to any gain or loss accrued on the
forward contract. Determine the market value of the forward contract at this
point in time from the perspective of the investor in Part A.
D. Determine the value of the forward contract at expiration assuming the contract
is entered onto at the price you computed in Part A and the price of the
underlying asset is EUR123.50 at expiration. Explain how the investor did on
the overall position of both asset and the forward contract in terms of the rate
of return.
13
Pricing and valuation of equity forward
contracts
• The present and future value of a stream of dividends over the life
of the forward contract:
PV0,T(D) = ∑i=1nDi/(1+r)ti
FV0,T(D) = ∑i=1nDi(1+r)ti
• The forward price including dividends:
F0,T = [S0 - PV0,T(D)](1+r)T or F0,T = S0(1+r)T - FV0,T(D)
or F0,T = (S0e-qT)erT
• The value of forward contract:
Vt,(0,T) = St – PVt,T(D) - F0,T/(1+r)T-t
or Vt,(0,T) = St e-q(T-t) - F0,Te-r(T-t) (continuous compounding)
• At expiration t = T and no dividends remains, VT,(0,T) = ST - F0,T
• At the contract initiation date, t = 0, V0,(0,T) = S0 – PV0,T(D) -
F0,T/(1+r)T = 0 because F0,T = [S0 - PV0,T(D)](1+r)T
40
Example
An asset manager anticipates the receipt of funds in 200 days,
which he will use to purchase a particular stock. The stock he has in
mind is currently selling for USD62.50 and will pay a USD0.75
dividend in 50 days and another USD0.75 dividend in 140 days. The
risk-free rate is 4.2% (discrete compounding, days/365). The
manager decides to commit a future purchase of the stock by going
long a forward contract on the stock.
A. At what price would the manager commit to purchase the stock in
200 days through a forward contract?
B. Suppose the manager enters into the contract at the price you
found in part A. Now, 75 days later, the stock price is USD55.75.
Determine the value of the forward contract at this point.
C. It is now the expiration day, and the stock price is USD58.50.
Determine the value of the forward contract at this time.
Pricing and valuation of fixed-income

forward contracts
• Bc: a coupon bond
• Bct,(T+Y): the bond price at time t
• T: expiration date
• Y: the remaining maturity of the bond on the forward contract
expiration
• T+Y: the time to maturity of the bond at the time the forward
contract is initiated.
• Consider a bond with n coupon to occur before its maturity date.
42
14
Pricing and valuation of fixed-income
forward contracts
• Converting the formula for a forward contract on a stock into that for a
forward contract on a bond and let CI be coupon interest over a specific
period of time, we have:
• The forward price including dividends:
F0,T = [Bc0,(T+Y) - PV0,T(CI)](1+r)T or F0,T = [Bc0,(T+Y)](1+r)T - FV0,T(CI)
where PV0,T(CI) and FV0,T(CI) is the present value and the future value of
the coupon interest over the life of the forward contract.
• The value of forward contract at time t would be:
Vt,(0,T) = Bct,(T+Y) – PVt,T(CI) - F0,T/(1+r)T-t
• At expiration, no coupons would remain, t = T and VT,(0,T) = BcT,(T+Y) - F0,T
• At time t = 0, V0,(0,T) = Bc0,(T+Y) – PV0,T(CI) - F0,T/(1+r)T = 0 because F0,T =
[Bc0,(T+Y) - PV0,T(CI)](1+r)T
43
Example
An investor purchased a bond when it was originally issued with a maturity
of five years. The bond pays semiannual coupon of USD50. It is now 150
days into the life of the bond. The investor wants to sell the bond the day
after its fourth coupon. The first coupon occurs 181 days after issue, the
second 365 days, the third 547 days, and the fourth 730 days. At this point
(150 days into the life of the bond), the price is USD1,010.25. The bond
prices quoted here include accrued interest (discrete compounding,
days/365).
A. At what price could the owner enter into a forward contract to sell the bond
on the day after its fourth coupon? Note that the owner would receive that
fourth coupon. The risk-free rate is currently 8%.
B. Now move forward 365 days. The new risk-free interest rate is 7% and the
new price of the bond is USD1,025.375. The counterparty to the forward
contract believes that it has received a gain on the position. Determine the
value of the forward contract and the gain or loss to the counterparty at this
time. Note that we have now introduced a new risk-free rate, because
interest rates can obviously change over the life of the bond and any
calculations of the forward contract value must reflect this fact. The new
risk-free rate is used instead of the old rate in the valuation formula.
INTRODUCTION TO FUTURES
15
Futures contract
• A futures contract is an alternative to a forward contract
that calls for future delivery of a standard amount of the
asset at a fixed time, place and price.
• Futures contracts exist for commodities such as cattle,
lumber, interestbearing deposits, gold, etc.
• In the US, the most important market for foreign currency
futures is the International Monetary Market (IMM), a
division of the Chicago Mercantile Exchange.
• Futures contracts are traded either in the pit (pit trading)
or on a computer screen or electronic terminal
(electronic trading).
46
Profit from futures
Profit (Payoff) Profit
Price of
underlying Price of
at maturity ST underlying
at maturity ST
Long Position Short Position
Payoff = ST – F Payoff = F – ST = (0.0037)
= $1.9800 - $1.9763 = 0.0037
or $0.0037 * 62.500 = $231.25/contract
Profit from futures
• Change by $0.0001/€ leads to a profit/loss $0,0001 * 125.000 =

$12.50 per contract
16
Offsetting (before expiration)
• A party that has opened a long or a short position collects profits or
incurs losses on a daily basis.
• At some point in the life of the futures contract prior to expiration, the
party to the contract may wish to reenter the market and close out the
position. This process is called offsetting.
– The holder of a long futures position goes back into the market and offers
the identical contract for sale
– The holder of a short futures position goes back into the market and offers
to buy the identical contract
• When a party offsets a position, it does not necessarily do so with the
same counterparty. The clearinghouse inserts itself in the middle of
each contract and becomes the counterparty to each party.
• Once the party finds a buyer (or a seller) to take the opposite position,
the party has a long and a short position in the same contract. The
clearinghouse considers that the party no longer has a position in that
contract and has no remaining exposure, nor any obligation to make or
delivery at expiration.
Prof.Dr1
Delivery and cash settlement (at expiration)

• Most futures contracts are offset before expiration. Those that
remain in place are subject to either delivery or final cash
settlement.
• When the exchange designs a futures contract, it specifies whether
the contract will terminate with delivery or cash settlement.
• If contracts are designated for delivery:
– In most case, delivery does not occur immediately after expiration but
takes place over several days
– Many contracts permit the short to choose when delivery takes place
– For many contracts, delivery can be made any business day of the month
– The delivery period usually includes the days following the last trading day
of the month, which is usually in the third week of the month
– The short can also make decision about which asset and where to deliver.
– In Exchange for physicals (EFP) transaction, if the long and the short could
arrange an alternative delivery procedures, they would report to the
exchange that they had settled their contract outside of the exchange’s
normal delivery procedures.
– Some futures contract require delivery of the actual asset (oil, wheat), and
some use only book entry (financial asset).

• If the contract terminates in delivery, the clearing house selects a
counterparty, usually the holder of the oldest long contract, to accept
delivery. The holder of the short position then delivers the underlying to
the holder of the long position, who pays the short the necessary cash for
the underlying. Suppose a party, who goes long a futures, has 2 choices:
– to close out position by selling the futures contract: The margin account
would then be marked to market at the price the trader sells. If the trader sells
close enough to the expiration, the price the trader sold at would be very
close to the final settlement price of 53
– or to leave the position open at the end of trading day and then take delivery.
Doing so would be equivalent to paying 52 and receiving 53, the trader could
then sell the asset for its price of 53, netting a USD1 gain
Closeout:
Sell contract at 53
Mark to market P/L: 53 - 52 = 1
Physical delivery:
Pay 52, receive asset worth 53
Buy futures at 50 Mark to market P/L: Cash settlement:
Pay nothing 52 - 50 = 2 Receive 53 -52 = 1
2 days before expiration 1 day before expiration Expiration

Futures price = 50 Settlement price = 52 Settlement price = 53
17
Slide 50
Prof.Dr1 cfa, lv1, p59-60

• If the contract is cash settled, the trader would not need
to close out the position close to the end of expiration day.
The trader could simply leave the position open. When the
contract expires, the margin account would be marked to
market for a gain on the final day of USD1.
Closeout:
Sell contract at 53
Mark to market P/L: 53 - 52 = 1
Physical delivery:
Pay 52, receive asset worth 53
Buy futures at 50 Mark to market P/L: Cash settlement:
Pay nothing 52 - 50 = 2 Receive 53 -52 = 1
2 days before expiration 1 day before expiration Expiration

Futures price = 50 Settlement price = 52 Settlement price = 53
Futures exchanges
• A futures exchange is a legal corporate entity whose
shareholders are its members.
• The members own memberships (seats). Exchange
members have privilege of executing transactions on the
exchange.
• The member of the exchange (clearinghouse) must post
funds with the clearinghouse
• Each member acts either a floor trader or a broker:
– Floor traders (locals) are market makers, standing ready to buy
and sell by quoting a bid and an ask price. They are the primary
providers of liquidity to the market. Locals are trading on their own
account.
– Brokers (futures commission merchants FCMs) execute
transactions for other parties off the exchange. FCMs are following
the instructions of their clients and charge a commission for doing
so.
Prof.Dr2
Futures exchanges
• Individuals taking position, whether locals on the exchange
floor or the clients of FCMs, can be categorized as hedgers,
speculators, or arbitrageurs. Speculators typically trade
according to one of several distinct styles:
– A scalper offers to buy or sell futures contracts, holding the position
for only a brief periods, perhaps just seconds. Scalpers attempt to
profit by buying at the bid price and selling at the higher ask price.
– A day trader holds a position open somewhat longer but closes all
position at the end of the day
– A position trader holds a position open overnight . Day traders and
position traders attempt to profit from the anticipated direction of the
market.
• There is also a spread trader, who simultaneously buys a
contract on an asset for one maturity month and sells a
contract on the same asset for another maturity month.
18
Slide 54
Prof.Dr2 spread trader: OF&OD, Hull 8e, ch.2

Futures exchanges
• The clearing firm are actual member of the clearing house.
• The clearinghouse deals only with the clearing firms. The
clearing firms then deal with their individual and institutional
customers.
• The clearinghouse member is required to maintain a margin
account with the clearinghouse.
• The margin account for clearinghouse member (known as
clearing margin) has an original margin and also are
adjusted for gains and losses at the end of each trading day
on the same way as are the margin accounts of investors.
Everyday the account balance for each contract must be
maintained at an amount equal to the original margin times
the number of contracts outstanding.
Futures exchanges
• Each trader is required to have an account at a clearing firm.
• Futures exchange have trading either on the floor or off the
exchange on electronic terminals, or both.
– Floor trading in the US takes place in octagonal, multi-tiered pit where
floor traders stand and conduct transactions. A trade is
consummated by two traders agreeing on a price and a number of
contracts (by using a combination of hand signals and/or eye
contact). When a transaction is agreed on, the traders fill out small
paper forms and turn them over to clerks, who then see that the
transactions are entered into system and reported.
– In electronic trading, the principles remain essentially the same but
the traders do not stand in the pits. They do not see each other at all.
They sit at computer terminals, which enable them to see the bids
and offers of other traders.
Futures exchanges
• Futures exchange:
http://dir.yahoo.com/Business_and_Economy/Finance_a
nd_Investment/Futures_and_Options/Exchanges/
– CME Group: http://www.cmegroup.com/trading/fx/
– NYSE Euronext: https://globalderivatives.nyx.com/en/fx/nyse-liffe
– NASDAG OMX│PHLX: NASDAQ OMX PHLX (PHLX): option
http://www.nasdaqomxtrader.com/Micro.aspx?id=wco
– NASDAG OMX│NFX: The NASDAQ OMX Futures Exchange
(NFX)
– http://www.nasdaqomxtrader.com/Micro.aspx?id=PBOTProducts
– Tokyo International Financial Futures Exchange:
http://www.tfx.co.jp/en/index.shtml
– Montreal Exchange: http://www.m-
x.ca/produits_options_devises_en.php
57
19
Futures exchanges
• Eurex (Germany and Switzerland)

• Chicago Mercantile Exchange
• Chicago Board of Trade
• LIFFE (London)
• BM&F (Brazil)
• New York Mercantile Exchange
• Tokyo Commodity Exchange
• and many more
58
Daily settlement
• The gains and losses on each party’s position are
credited and charged on a daily basis – this procedure is
called daily settlement or marking to market.
• This practice results in the conversion of gains and
losses on paper into actual gains and losses.
• It is equivalent to terminating a contract at the end of
each day and reopening it the next day at settlement
price.
• In some sense, a futures is like a strategy of opening up
a forward contract, closing it one day later, opening up a
forward contract, closing it one day later, and continuing
in that manner until expiration.
Margin
• Margin in the stock market is quite different from
margin in the futures market. In the stock market,
margin means that a loan is made.
• The loan enables the investor to reduce the
amount of his own money required to purchase
the securities, thereby generating leverage or
gearing: M = 100 x (V-L)/V, where M is the
margin, V is the market value of the stocks and L
is the broker's loan.
Rennes1
20
Margin
• In the futures market, a margin (now called performance
bond by CME) must be placed by every buyers and sellers
in a clearing house to ensure that both parties will honor
the futures trading contract.
• Margin is commonly used to describe the amount of
money that must put into an account by a party opening up
a futures position.
• This surety is used to guarantee the payment of the
ordered assets (by the buyer) and their delivery (by the
seller).
• The margin can be in the forms of money, treasury bonds,
bank guarantee, and fixed deposit receipts.
• Margin is set as % of the contract value, between 1% and
10%, which depends on the volatility of the contract value
(the risk). In fact, futures margins are usually less than
10% of futures price.
Rennes1
Initial margin
• Initial margin is the sum required to initiate a futures
position.
• Its amount is based on maximum estimated change in
contract value within a trading day.
• Buyers and sellers must maintain a minimum margin
(maintenance margin) in their account (approximately
75% of initial margin);
• Every day or several times a day, some margin calls can
be made in order to restore the amount of initial margin
in case of high loss.
• If the margin calls is not met during the day, the clearing
house has the right to close sufficient positions to meet
the amount called
• If the investor does not want to meet the margin call, it
can close out position on the next day as soon as
possible.
Marking to Market
Your balance
Initial
margin
Maint.
margin
margin call time
21
Example of a Futures Trade
(page 27-29)
• An investor takes a long position in 2 December

gold futures contracts on June 5
– contract size is 100 oz.
– futures price is US$1250
– initial margin requirement is
US$6,000/contract
– maintenance margin is US$4,500/contract
Options, Futures, and Other 64

Derivatives, 8th Edition,
Copyright © John C. Hull 2012
Marking to market
Day Trade Settle Daily Cumul. Margin Margin

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,250.00 12,000
1 1,241.00 −1,800 − 1,800 10,200
2 1,238.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,236.20 −780 −2,760 9,240
7 1,229.90 −1,260 −4,020 7,980 4,020
8 1,230.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,226.90 780 −4,620 15,180
Options, Futures, and Other

Derivatives, 8th Edition, 65
Example
• 5-Jun: Purchase 2 gold futures contracts at COMEX
– Delivery in Dec
– Futures price: $400
– Quantity: 100 ounces
– Initial deposit: $2000/contract
– MM: $1500/contract
– No withdrawal on the deposit
• Estimate the margin call with respect to change in gold
price
• Calculate the profit/loss from this operation
22
Futures Price Gain/loss Acc.Results Margin Margin call
400
397
396.1
398.2
397.1
396.7
395.4
393.3
393.6
391.8
392.7
387
387
388.1
388.7
391
392.4
Futures vs forward contracts

Futures contracts differ from forward contracts in a number of important
ways:
‒ Futures are standardized in terms of size while forwards can be
customized
‒ Futures have fixed/standardized maturities while forwards can have
any maturity (both typically have maturities of one year or less). Or
futures have a limited range of delivery dates while forward have a
large range of delivery dates.
‒ Trading on futures occurs on organized exchanges while forwards are
traded between individuals and banks (OTC), by bank dealers via a
network of telephones and computerized dealing system
‒ A Clearing House of the exchange guarantees the futures operation,
thus the value of the operation is marked to market rates with daily
settlement of profits or losses; whereas by forward contract, no
Clearing House is responsible for the contracting parties, thus no
guarantee of settlement until the date of maturity
68

ways:
– A futures contract is settle-up or marked to market, daily at the
settlement price whereas a forward contract states a price for the
future transaction. The settlement price is a price representative of
futures transaction prices at the close of daily trading on the
exchange. It is determined by a settlement commitee for the
commodity. At the end of daily trading, a futures contract is
analogous to a new foward contract on the underlying asset at the
new settlement price with a one-day-shorter maturuty. Because of
the daily marking-to-market , the futures price will converge through
time to the spot price on the last day of trading on the contract.
– For futures trading, customers pay a commision (brokage fee, about
USD15/currency futures contract) to their brokers to execute a round
turn and a single price quoted, whereas dealers in the interbank
market quote a bid and an offer and donot charge a explicit
commission (may have an indirect fee via compensating balance
requirement). 69
23
ways:
‒ Futures has low counterparty risk, whereas forward has high
counterparty risk
‒ Futures has good liquidity thanks to their standardization, while
forward has low liquidity.
‒ Futures have an initial margin that is marked to market on a daily
basis while only a bank relationship is needed for a forward
‒ Futures are rarely delivered upon (99% is cash-settled) while forwards
are normally delivered upon (settled)
‒ Futures cover only major currencies while forwards cover over 50
currencies.
‒ Futures have smaller contract sizes, usually around USD50,000-
100,000, while forwards‘s contract sizes are at least USD5 million.
70
Types of futures contract
• 2 types: commodity and financial futures

• Commodity futures: traditional agricultural, metal, and
petroleum products
• Financial futures: stocks, bonds, currencies futures with
focus on interest rate and bond futures, stock index
futures, and currency futures:
– Short-term interest rate futures contracts: treasury bill futures,
Eurodollar futures
– Intermediate- and Long-term interest rate futures contracts:
treasury notes (maturity of 2-10 years), treasury bonds (maturity
of more than 10 years).
– Stock-index Futures Contracts
– Currency futures contracts
Table 22.1 Sample of Futures Contracts
24
Widely Traded Financial Futures Contracts
Source: Mishkin (2006) 74
Widely Traded Financial Futures Contracts
Source: Mishkin (2006) 75
25
Stock Index Futures Contracts
• The most successful futures contract at CME is S&P’s
500 Stock index.
• The contract is quoted in terms of a price on the same
order of magnitude as the S&P 500 itself.
– Exp. If the S&P 500 Index at 1187, a two-month futures contract
might be quoted at price of 1187.
• The actual price is produced by multiplying the multiplier
for the S&P 500 futures by the quoted futures price
– Exp, if the multiplier is USD250, the futures price is 1187, the
actual futures price is 1187x250 = USD296,750.
• S&P 500 futures expirations are March, June, September,
and December and go out about two years. The contracts
expire on the Thursday preceding the third Friday of the
month.
Stock Index Futures Contracts

• At CME, the Mini S&P 500 has a multiplier of USD50 and
trades only electronically.
• In the US, the Down Jones Industrials, the S&P Midcap
400 and the NASDAQ 100 are also traded widely.
• Well-known stock index futures contracts around the
world include the UK’s FTSE (pronounced Footsic 100),
Japan’s Nikkei 225, France’s CAC 40, and Germany’s
DAX 30.
26
Currency Futures Contracts
• In the US, the primary currencies on which trading occurs
are EUR, CAD, CHF, JPY, GBP, MXN, and AUD.
• Each contract has a designated size and quotation unit.
– Exp. The euro contract covers EUR125,000 and is quoted in dollar
per euro. A futures price such as USD0.855 is stated in dollars and
converts to a contract price of 125,000 x 0.8555 = USD106,937.50
• The JPY futures price is structured differently. Because of
the large number of yen per dollar, the contract covers
JPY12,500,000 and is quoted without two zeroes that
ordinarily precede the price.
– Exp. A price might be stated as 0.8025, but this actually represents a
price of 0.008205, which converts to a contract price of 12,500,000 x
0.008205 = USD102,562.50
• Currency futures contracts expire in the months of March,
June, September, and December. The specific expiration is
the second business day before the third Wednesday of the
month.
Figure 23.2 Foreign Exchange Futures
Foreign currency futures
• Contract specifications are established by the exchange

on which futures are traded.
• Major features that are standardized are:
 Contract size
 Method of stating exchange rates
 Maturity date
 Last trading day
 Collateral and maintenance margins
 Settlement
 Commissions
 Use of a clearinghouse as a counterparty
81
27
Basic principles to futures hedging
• A perfect hedge is one that completely eliminates the

risk. Perfect hedges are rare.
• For the most part, therefore, a study of hedging is a
study of the way in which hedges can be constructed so
that they perform as close to perfect as possible:
– When is a short futures position appropriate?
– When is a long futures position appropriate?
– What is the optimal size of the futures position for reducing risk?
• When an individual or company chooses to use futures
markets to hedge a risk, the objective is usually to take a
position that neutralizes the risk as far as possible.
Basic principles
• Example: a company that knows it will gain USD10,000 for
each 1 cent increase in the price of commodity over the
next months and lose USD10,000 for each 1 cent decrease
in the price of a commodity during the same period.
• To hedge, the company’s treasurer should take a short
position that is designed to offset the risk. The futures
position should lead to a loss of USD10,000 for each 1 cent
increase in the price of commodity over the 3 months and a
gain of USD10,000 for each 1 cent decrease in the price
during this period.
• If the price of the commodity goes down (up), the gain
(loss) on the futures position offsets the loss(gain) on the
rest of the company’s business.
Long & Short Hedges
• A long futures hedge is appropriate when you know

you will purchase an asset in the future and want to
lock in the price
• A short futures hedge is appropriate when you know
you will sell an asset in the future and want to lock
in the price

28
Hedging with futures and forward
for managing bond portfolio risk
Managing interest rate risk
• Managing the interest rate risk of a loan using FRA (by

forward)
• Managing bond portfolio risk (for longer-term loans)
Strategies and Applications for Managing

Bond Portfolio Risk
• We dealt with the risk associated with short-term borrowing
interest rates by using the FRA.
• The risk associated with longer-term loans primarily takes
the form of bond market risk.
• We shall look at a firm managing a government bond
portfolio, that is a lending position. The firm can manage the
risk associated with interest rates by using futures on
government bonds.
• Consider a money manager who holds a bond portfolio can
trade any number of futures contract to adjust the risk. If he
can completely balance the risk of futures position against
the risk of the bond portfolio, the risk is eliminated (in
practice, we might want to adjust the risk only a little):
– Measuring the risk of a bond portfolio
– Measuring the risk of bond futures
– Balancing the risk of a bond portfolio against the risk of bond futures
29
Measuring the risk of a bond portfolio
• The sensitivity of a bond to a general change in interest rate
is usually captured by assuming that the bond price changes
in response to a change in its yield. More specifically, it is the
appropriate percentage change in prices for a 100 basis
point change in rates.
• The responsiveness of a bond price to a yield change is
captured in two ways: duration and basis point value.
• Duration is a measure of the size and timing of cash flows
paid by a bond.
– It quantifies these factors by summarizing them in the form of a single
number, which is interpreted as an average maturity of the bond.
– Or to speak in terms of an average maturity of a bond, a coupon bond
is a combination of zero-coupon bonds. Thus, the duration is the
average maturity of these component zero-coupon bonds.
– The average is not an ordinary average but a weighted average, with
the weights based on the present values of the respective cash
payments on the bonds. Hence the weights are not equal.
• So, duration is the weighted-average maturity of a bond,
where weights are the present values of the bond’s cash
flows, given as proportions of bond’s price

n
Ct  (t )
 (1  r )
t 1
t
Dy B
DURB  n DB   DURB B (1)
Ct 1  yB

t 1 (1  r )
t
DB   MDUR B BDy B ( 2)
DURB
MDURB 
1  yB
B: the bond price
yB : the yield
DURB: Macaulay duration (thời gian đáo hạn bình quân)
MDURB: modified duration (thời gian đáo hạn bình quân
điều chỉnh)
(1): the relationship between the change in the bond price
and its yield. The negative sign is consistent with the
inverse relationship between the bond price and its yield.
(2): simplified version of (1)
Example
Face value of a bond = USD1000
T= 3 years
Coupon rate = 7%
Yield = 9%
DUR?
30
Example
Face value of a bond = USD1000
T= 3 years
Coupon rate = 7%
Yield = 9%
DUR? $70 $70 x 2 $1,070 x3
 
1.09 (1.09) 2 (1.09)3
DUR   2.8 years
$70 $70 $1,070
 2
 3
1.09 (1.09) (1.09)
Bond‘s value will change by approximately 2.8% if

interest rate change by 100 basis points. It is also the
weighted average number of years to receive the
present value of the bond‘s cash flows.
Example
Consider a 5-year bond with $1,000 face value. The

bond makes annual coupon payments at a 10% coupon
rate. Assume that the continuously compounded
annualized yield of this bond equals 5% (i.e., y = ln(1+r)
= 5%)
Example
or 
Duration can be also computed by dividing the sum of the products of

Fixedincomerisk.com
the present value and the maturity of each cash flow by the bond price
31
• The duration of a bond portfolio is a weighted average of
the durations of the bonds in the portfolio, where the
weights are defined as the proportions of investments in the
bonds.
• Consider another bond B with a maturity of 10 years and a
coupon rate of 10%. Using the same yield, the price of bond
B is $1,373.96 and its duration is 7.257 years. The duration
of bond B is longer since it has a longer maturity.
• Now consider a bond portfolio including one bond A and
two bonds B. The portfolio value is thus:
1210.23 + 2(1373.96) = $3,958.15.
The portfolio duration is computed as follows:
Suppose the bond price is USD922.50, modified duration

is 5.47 years and the yield increases by 15 basis points.
• Then the price change should be
DB ≈ -5.47(922.50)(0.0015) = -USD7.57
• In response to a 15 basis point increase in yield, the bond
price should decreased by approximately USD7.57.
• So the new bond price would be predicted to be
USD922.50-7.57 = USD914.93

• Some managers use another measure of the price volatility of
a bond to quantify interest rate risk – the price value of a
basis point (PVBP). This measure is the absolute value of the
change in the price of a bond for 1 basis point change in
yield.
• Thus, the relationship between the bond price and its yield
change is sometimes stated as the change in the bond price
for a 1 basis point change in yield. This is referred to as basis
point value (BPV), present value of a basis point (PVBP), or
price value of a basis point (again PVBP):
PVBPB ≈ MDURBB(0.0001)
• The multiplication by 0.0001enables PVBP to capture how
much the bond price changes for 1 basis point change:
– Exp. PVBPB ≈ (5.47)(922.50)(0.0001) = USD0.5046
– For 1 basis point change, the bond price would change by
approximately USD0.5046. Accordingly, a 15 basis point change
produce a price change of 15(0.5046) = USD7.57
32
• Duration and PVBP are usually thought of with respect to
individual bonds, but in practice they are used at the portfolio
level.
• A given bond portfolio can be thought as a series of cash
flows that can be captured in terms of a representative bond:
– Exp. We might describe this bond as a bond portfolio with a market
value of USD922.5 million, a modified duration of 5.47 years and a
portfolio bond yield that is a complex weighted average of the yields
on the component bonds of the portfolio. The portfolio bond change is
a weighted average of yield changes on the component bonds. Given
such a yield change, the bond portfolio value will change in an
approximate manner according to the duration formula shown in the
previous slides.
Measuring the risk of bond futures

• Having measured the responsiveness of a bond portfolio to
an interest rate change, we now measure the
responsiveness of a futures contract to an interest change.
• Most bond futures contracts are based on a hypothetical
benchmark bond.
– Exp: at CBOT US Treasury bond futures contract is based on a 6%
bond with at least 15 years from the futures expiration to maturity or
the first call date.
• Even though, any bond meeting the maturity requirement
can be delivered. At any time, a single bond exists that the
holder of the short position would find optimal to deliver if
current conditions continued
• Cheapest-to-deliver bond: the bond on which the futures
contract is based. In other word, the cheapest to deliver
bond is the underlying.
Measuring the risk of bond futures

• The responsiveness of the futures contract to an interest rate
change is equivalent to the responsiveness of that bond on
futures expiration day to an interest rate change. This
responsiveness can be measured as that bond’s modified
duration on the futures expiration.
• Thus implied duration of futures contract means the
duration of the underlying bond calculated as of the futures
expiration. We use the term implied to emphasize that a
futures contract does not itself have a duration but that its
duration is implied by the underlying bond.
• We also mean that the underlying bond has been identified
as the cheapest bond to delivered and that if another bond
takes its place, the duration of that bond must be used.
• Thus, we can use the price sensitivity formula to capture the
sensitivity of the futures contract to a yield change:
Df ≈ -MDURffDyf
where –MDURf is the implied modified duration of the
futures, f is the futures price, and Dyf is the basis point
change in the implied yield on the futures.
33
Balancing the risk of a bond portfolio
against the risk of bond futures
• We have measured the responsiveness of a bond portfolio
the responsiveness of a futures contract to interest
changes, we should be able to find a way to balance the
two to offset the risk.
• Assume that a 1 basis point change in the interest rate will
cause a 1 basis point change in the yield on the bond
portfolio and a 1 basis point change in the implied yield on
the futures. Or say in other words, an interest rate change
occurs in the market (exp. the overnight Fed funds rate in
the US) and drives the yield on the bond and implied yield
on the futures one-for-one (Dyf = DyB).
• Assume that a money manager, who holds a bond portfolio
of a particular market value, will not make any transactions
in the actual bonds themselves, however can trade any
number of futures contracts to adjust the risk.

• Let Nf be the number of futures contract traded.
• To balance the risk, suppose we combine the change in the
value of the bond portfolio and the change in the value of Nf
futures contract and set equal to zero:
DB + NfDf = 0 or Nf = -DB/Df
• We obtain:
 MDUR B  B  Dy B   MDUR B  B 
N f         
 MDUR f  f  Dy f   MDUR f  f 

• However, it is not that all rates change by the same
amount. We make adjustments by supposing the yield on
the bond portfolio changes by a multiple of the implied yield
on the futures on the following manner:
DyB = byDyf
where b is the yield beta. b can be more or less than 1,
depending on whether the bond yield is more or less
sensitive than the implied yield
• We obtain Nf = - (MDURB/MDURf)(B/f)by
where Nf is the number of futures contracts needed to
change our portfolio’s modified duration to meet a target.
• We have done so far completely balances the risk of the
futures position against the risk of the bond portfolio.
34
• The risk of the overall bond portfolio reflects the duration of
the bonds and the duration of the futures.
• Suppose we consider a target overall modified duration of
the portfolio, MDURT. Because the portfolio consists of
bonds worth B and futures, which have zero value, the
overall portfolio value is B.
• We introduce the notion of a dollar duration, which is the
duration times the market value:
exp. B(MDURB) or f(MDURf)
• The target dollar duration of our portfolio is set equal to the
dollar duration of the bonds we hold and the dollar duration
of the futures contracts.
B(MDURT) = B(MDURB) + f(MDURf)Nf

 
• Solving for Nf, we obtain N f   MDUR T - MDUR B  B 
 MDUR f  f
  
– If we wish to increase the MDURB , then MDURT is greater than
MDURB and the overall sign of Nf will be positive, so we buy futures:
Buying futures would add volatility and increase duration.
– If we wish to reduce the MDURB , then MDURT will be is less than
MDURB and the overall sign of Nf will be negative, meaning that we
need to sell futures: Selling futures would reduce duration and
volatility.
– If we want to eliminate risk completely, we want MDURT to equal
Zero: Nf = - (MDURB/MDURf)(B/f)
• If the bond and futures yield do not change one-for-one, we
have
 MDUR T - MDUR B  B 
N f    β y
 MDUR f  f 
Example
(Using bond futures to manage the risk of a bond portfolio)
• A portion of the pension funds of United Energy Services (UES) is a
portfolio of US government bonds. On 7 July, UES obtained a forecast
from its economist that over the next months, interest rates are likely to
make a significant unexpected decline. Its portfolio manager would like
to take a portion of the bond portfolio and increase the duration to take
advantage of this forecasted market movement.
• Specifically, UES would like to raise the duration on USD75 million of
bonds from its current level of 6.22 to 7.5 (modified duration). UES has
identified an appropriate Treasury bond futures contract that is currently
priced at USD 82,500 and has an implied modified duration of 8.12.
UES has estimated that the yield on the bond portfolio is about 5%
more volatile than the implied yield on the futures. Thus the yield beta
is 1.05.
• On 6 August, the implied yield on the futures has increased by 35 basis
points, and the futures price has now moved to USD85,000. The yield
on the bond portfolio has decreased by 40 basis points, and the
portfolio has increased in value by USD1,933,500.
35
Example
(Using bond futures to manage the risk of a bond portfolio)
Debt Management Associates (DMA) offered fixed-income portfolio

management services to institutional investors. It would like to execute
a duration-changing strategy for a EUR 100 million bond portfolio of a
particular client. This portfolio has a modified duration of 7.2. DMA
plans to change the modified duration to 5.00 by using a futures
contract priced at EUR120,000, which has an implied modified duration
of 6.25. The yield beta is 1.15.
A. Determine how many futures contracts DMA should use and whether
it should buy or sell futures.
B. Suppose that the yield on the bond has decreased by 20 basis points
at the horizon date. The bond portfolio increases in value by 1.5
percent. The futures price increase to EUR121,200. Determine the
overall gain on the portfolio and the ex post modified duration as a
result of the futures transaction.
Hedging with futures and forward

for managing equity market risk
Hedging with futures and forward for

managing equity market risk
• Managing the risk of equities
• Managing the risk of an equity portfolio
• Creating equity out of cash
• Creating cash out of equity
36
Measuring and managing the risk of
equities
• Futures provide the best way to manage the risk of
diversified equity portfolios. The most common risk
measure of this type is the beta.
• Beta measures the relationship between a stock portfolio
and the market portfolio.
• The market portfolio is the most broadly diversified
portfolio of all. It is impossible to identify the composition
of the true market portfolio and there are no futures
contracts on the true market portfolio. Thus, we tend to
use proxies, such as S&P 500 index, and futures
contracts on proxies.
• It is appropriate to measure the beta of a portfolio
relative to index on which the futures is based.
Measuring and managing the risk of

equities
• The beta of the index we use as a benchmark is 1.0.
– Ignoring any asset-specific risk, an asset with beta of 1.10 is 10%
volatile than the index. A beta of 0.8 is 20% less volatile than the
index.
• Beta is formally measured as b = covSI/2I
where covSI is the covariance between the stock portfolio
and the index (a measure of the extent to which the
portfolio and the index move together, if covSI >0: move in
the same direction) and 2I is the variance of the index.
• Beta measures only the volatility of the portfolio to the
market/index. Thus it is a measure only of the risk that
cannot be eliminated by diversifying a portfolio, called
systematic, nondiversifiable or market risk
Measuring and managing the risk of equities

• As a risk measure, beta is similar to duration.
• Similar to the dollar duration, we have bff is dollar beta of
futures contract (for the futures contract, beta is often
assumed to be 1.0, f is futures price), bSS is dollar beta of the
stock portfolio (S is the market value of the stock portfolio).
• If we wish to change the beta, we specify the desired beta as
a target beta bT.
• Because the value of futures starts off each day as zero, the
dollar beta of the combination of stock and futures if the
target beta is achieved is bTS. Then we have
bTS = bSS + Nfbff
• We solve for Nf and obtain
 β - β  S 
N f   T S  
 β f  f 
• If we want to completely eliminate the risk, bT would be zero
and the formula would reduce to N f  βS β f (S f )
37
Managing the risk of an equity portfolio
• To adjust the beta of an equity portfolio, an investment

manager would calculate the number of futures contracts.
• The manager might increase the beta if she expects the
market to move up. The manager might decrease the beta
if she expects the market to move down.
• Be aware that increasing the beta increases the risk.
Therefore, if the beta is increased and the market falls, the
loss on the portfolio will be greater than if the beta had not
been increased.
• Decreasing the beta decreases the risk. If the market rises,
the portfolio value will rise less.
Example
A. On Sep 2, BB Holdings (BBH) is a US conglomerate. Its pension
fund generates market forecasts internally and receives forecasts
from an independent consultant. As a result of these forecasts, BBH
expects the market for large-cap stock to be stronger than it believes
everyone else is expecting over the next two months.
BBH decides to adjust the beta on USD38,500,000 of large-cap
stock from its current level of 0.90 to 1.10 for the period of the next
two months. It has selected a futures contracts deemed to have
sufficient liquidity; the futures price is currently USD275,000 and the
contract has a beta of 0.95.
B. On Dec 3, the market as a whole increases by 4.4%.The stock
portfolio increases to USD40,103,000. The stock index futures
contract rises to USD286,687.50, an increase of 4.25%.
C. Suppose that instead of being optimistic, the fund manager was very
pessimistic and wanted to decrease the beta to zero.
Example
Equity analysts Inc. (EQA) is an equity portfolio
management firm. One of its clients has decided to be
more aggressive for a short period of time. It would like
EQA to move the beta on its USD65 million portfolio from
0.85 to 1.05. EQA can use a futures contract priced at
USD188,500 which has a beta of 0,92, to implement this
change in risk.
A. Determine the number of futures contracts EQA should
use and whether it should buy or sell futures.
B. At the horizon date, the equity market is down 2%. The
stock portfolio falls 1.65%, and the futures price falls to
USD185,000. Determine the overall value of the position
and the effective beta.
38
Example
Robert Brown manages an equity portfolio with a current

market value of $125 million. The beta of the portfolio is
1.25 and Brown is forecasting a short-term market
adjustment that will significantly lower equity values and
will occur in the near future. Brown has decided to use
S&P 500 futures, currently trading at 1250, to reduce the
portfolio’s systematic risk exposure by 25 percent. The
multiplier is 250. What is the number of futures contracts,
rounded up to the nearest whole number, that will be
needed to achieve Brown’s objective?
Example
A manager of a $20,000,000 portfolio wants to increase

beta from the current value of 1.1 to 1.3. The beta on the
futures contract is 1.4 and the futures price is $255,000.
Using futures contracts, what strategy would be
appropriate?
Example
A portfolio manager knows that a $100 million inflow of
cash will be received in a month. The portfolio under
management is 80% invested in stock with an average
beta of 0.9 and 20% invested in bonds with a duration of
4. The most appropriate stock index futures contract has
a price of $250,500 and a beta of 1.2. The most
appropriate bond index futures has a duration of 5 and a
price of $98,500. How can the manager pre-invest the
$100 million in the appropriate proportions?
39
Managing the risk of a foreign-market
asset portfolio
• The increasing globalization leads to hold or consider to hold foreign
stock and bonds.
• It is tempting to believe that the asset managers should accept the
foreign market risk, using it to further diversify the portfolio, and hedge
the foreign currency risk.
• Consider a US asset management firm that owns a portfolio currently
invested in euro-denominated stock. The firm is long both the stock and
the euro.
• At the future time t, the portfolio is worth St in euro and the exchange
rate is FXt dollars per euro. So the portfolio would then be worth StFXt
in dollars.
• A forward contract on the euro would require the firm to deliver a
certain number of euros and receive forward rate F. The number of
euros to be delivered would need to be specified in the contract and it
is St euros, which is unknown at the time the forward contract is
initiated.

asset portfolio
• Some companies manage this problem by estimating an expected
futures value of the portfolio. They enter into a hedge based on that
expectation and adjust the hedge to accommodate any changes in
expectations.
• Other companies hedge a minimum portfolio value. They estimate that
it is unlikely the portfolio value will fall below a certain level and then
sell a forward contract for a size based on this minimum value. This
approach leaves the companies hedged for a minimum value, but any
increase in the value of the portfolio beyond the minimum would not be
hedged.
• It is not possible to leave the local equity market exposed and hedge
the currency risk .

asset portfolio
• Thus we examine the two possibilities that can be executed: hedging
the local market risk and hedging both the local market risk and the
foreign currency risk.
• We first use futures on the foreign equity portfolio as though no
currency risk existed. This transaction attempts to lock in the futures
value of the portfolio. This lock-in return should be close to the foreign
risk-free rate.
• If we also choose to hedge the currency risk, we then know that the
futures value of the portfolio will tell us the number of units of the
foreign currency that we shall have available to convert to domestic
currency at the hedge termination date. Then we would know the
amount of notional principal to use in a forward contract to hedge the
exchange rate risk.
40
Example
• On Dec 31, AZ Asset Manager is a US firm that recently began learning
about managing currency risk and would like to begin investing in foreign
market with a small position worth EUR10 million. The proposed portfolio
has a beta of 1.10. AZ is considering either hedging the European equity
market return and leaving the currency risk unhedged, or hedging the
currency risk as well as the European equity market return. If it purchases
the EUR10 million portfolio, it will put this hedge in place on 31 December
and plans to leave the position open until 31 December of the following
year.
A. For hedging the European equity market risk, it will use a stock index
futures contract on a euro-denominated stock index. This contract is
priced at EUR120,000 and has a beta of 0.95. If it hedges the currency
risk, it will use a dollar-denominated forward contract on the euro. That’s
contract has a price of USD0.815 and can have any notional principal that
the parties agree on the start. The current spot rate is USD0.80. The
foreign risk-free rate is 4% (annually compounded). The domestic interest
rate is 6%.
B. On Dec 31 of the following year, the European stock market went down
4.55%. The exchange rate fell to USD0.785, and the futures price fell to
EUR110,600.
Example
FCA Managers (FCAM) is a US asset management firm. Among its
asset classes is a portfolio of Swiss stock worth SF10 million, which has
a beta of 1.00. The spot exchange rate is USD0.75, the Swiss interest
rate is 5%, and the US interest rate is 6%. Both of these interest rate are
compounded in the LIBOR manner: Rate x (Days/360). These rates are
consistent with a six-month forward rate of USD0.7537. FCAM is
considering hedging the local market return on the portfolio and possibly
hedging the exchange rate risk for a six-month period. A futures
contract on the Swiss market is priced at SF300,000 and has a beta of
0.90.
A. What futures position should FCAM take to hedge the Swiss market
return? What return could it expect?
B. Assuming that it hedges the Swiss market return, how could it hedge
the exchange rate risk as well, and what return could it expect?
INTRODUCTION TO SWAP
41
MTH10
Swap
• A swap is an agreement between two parties to exchange
a series of future cash flows.
• For most types of swaps, one party makes payments that
are determined by a random outcome, such as an interest
rate, a currency rate, an equity return, or a commodity
price. These payments are commonly referred to as
variable or floating. The other party either makes variable
or floating payments determined by some other random
factor or makes fixed payments. At least one type of swap
involves both parties making fixed payments, but the
values of those payments vary due to random factors.
• Other definition: Swap is an over-the-counter transaction
consisting of a series of forward contracts.
124
MTH15
Natures of swap
• Although technically a swap can have a single payment, most
swaps involve multiple payments. Thus, we refer to a swap as a
series of payments.
• In fact, we have already covered a swap with one payment, which
is just a forward contract. Hence, a swap is basically a series of
forward contracts.
• With this idea in mind, we can see that a swap is like an
agreement to buy some thing over a period of time. We might be
paying a variable price or a price that has already been fixed; we
might be paying an uncertain price, or we might already know the
price we shall pay.
• When a swap is initiated, neither party pays any amount to the
other. Therefore, a swap has zero value at the start of the
contract.
• However, each party pays the notional principal to the other, but
the amounts exchanged are equivalent, though denominated in
two different currencies.
125
MTH17
Natures of swap
• Each date on which the parties make payments is called a
settlement date, some times called a payment date.
• The time between settlement dates is called the settlement period.
• On a given settlement date when payments are due, one party
makes a payment to the other, which in turn makes a payment to
the first party. With the exception of currency swaps and a few
variations associated with other types of swaps, both sets of
payments are made in the same currency. Consequently, the
parties typically agree to exchange only the net amount owed from
one party to the other, a practice called netting.
• Note the implication that swaps are generally settled in cash. It is
quite rare for swaps to call for actual physical delivery of an
underlying asset.
• A swap always has a termination date, the date of the final
payment. We can think of this date as its expiration date, as we do
with other derivatives.
• The original time to maturity is sometimes called the tenor of a
swap. 126
42
Slide 124
MTH10 xem Madura (2007), Levi (2005), p.59

CFA Level 1
Slide 125

CFA Level 2, p.253
Slide 126

CFA Level 2, p.253
MTH18
Natures of swap
• The swap market is almost exclusively an over-the-
counter market, so swaps contracts are customized to the
parties' specific needs.
• Several of the leading futures exchanges have created
futures contracts on swaps. These contracts allow
participants to hedge and speculate on the rates that will
prevail in the swap market at future dates. Of course,
these contracts are not swaps themselves but, as
derivatives of swaps, they can in some ways serve as
substitutes for swaps. These futures contracts have been
moderately successful, but their volume is insignificant
compared with the-over-the-counter market for swaps.
127
MTH20
Natures of swap
• Default is possible whenever a payment is due. When a
series of payments is made, there is default risk potential
throughout the life of the contract, depending on the financial
condition of the two parties. But default can be somewhat
complicated in swaps.
– Exp, on a settlement date, Party A owes Party B a payment of
$50,000 and Party B owes Party A a payment of $12,000. Agreeing to
net, Party A owes Party B S38,000 for that particular payment, Party
A may be illiquid, or perhaps even bankrupt, and unable to make the
payment. But it may be the case that the market value of the swap,
which reflects the present value of the remaining payments, could be
positive from the perspective of Party A and negative from the
perspective of Party B. In that case, Party B owes Party A more for
the remaining payments.
• The handling of default in swaps can be complicated,
depending on the contract specifications and the applicable
laws under which the contract was written. In most cases,
the above situation would be resolved by having A be in
default but possessing an asset, the swap, that can be used
128
to help settle its other liabilities.
Termination of a swap
• A swap has a market value that can be calculated during
its life.
– If a party holds a swap with a market value of $125,000, it can
settle the swap with the counterparty by having the counterparty
pay it $125,000 in cash. This payment terminates the transaction
for both parties.
• From the opposite perspective, a party holding a swap
with a negative market value can terminate the swap by
paying the market value to the counterparty.
• Terminating a swap in this manner is possible only if the
counterparties specify in advance that such a transaction
can be made, or if they reach an agreement to do so
without having specified in advance. In other words, this
feature is not automatically available and must be agreed
to by both parties.
43
Slide 127

CFA Level 2, p.253
Slide 128

CFA Level 2, p.253
• Many swaps are terminated early by entering into a
separate and offsetting swap.
– For example, suppose a corporation is engaged in a swap to make
fixed payments of 5% and receive floating payments based on
LIBOR, with the payments made each 15 January and 15 July.
Three years remain on the swap.
– That corporation can offset the swap by entering into an entirely
new swap in which it makes payments based on LIBOR and
receives a fixed rate with the payments made each 15 January and
15 July for three years.
• The swap fixed rate is determined by market conditions at
the time the swap is initiated. Thus, the fixed rate on the
new swap is not likely to match the fixed rate on the old
swap, but the effect of this transaction is simply to have the
floating payments offset; the fixed payments will net out to
a known amount. Hence, the risk associated with the
floating rate is eliminated. The default risk, however, is not
eliminated because both swaps remain in effect.
• Another way to terminate a swap early is sell the swap to
another counterparty.
– Suppose a corporation holds a swap worth $75,000. If it can
obtain the counterparty's permission, it can find another party to
take over its payments. In effect, it sells the swap for $75,000 to
that party. This procedure, however, is not commonly used.
• A final way to terminate a swap early is by using a
swaption. This instrument is an option to enter into a
swap at terms that are established in advance. Thus, a
party could use a swaption to enter into an offsetting
swap, as described above.
MTH16
Types of swaps
• The underlying assets in a swap can be a currency, interest
rate, stock, or commodity:
– Currency swap: each party makes interest payments to the other in
different currencies. In a currency swap the principal is usually
exchanged at the beginning and the end of the swap’s life.
– Interest rate swap: it is a currency swap in which both currencies are
the same. Because we are paying in the same currency, there is no
need to exchange notional principal at the beginning and at the end
of an interest rate swap.
– A plain vanilla swap: it is simply an interest rate swap in which one
party pays a fixed rate and the other pays a floating rate, with both
sets of payments in the same currency.
– Commodity swaps are very commonly used. Exp, airlines enter into
swaps to hedge their future purchases of jet fuel. They agree to make
fixed payments to a swap dealer on regularly scheduled dates and
receive payments determined by the price of jet fuel. Gold mining
companies use swaps to hedge future deliveries of gold. Other
parties dealing in such commodities as natural gas and precious
metals often use swaps to lock in prices for future purchases and132
sales.
44
Slide 132

CFA Level 2, p.253
Types of swaps
• In addition, swaps can be based on non-storable
commodities, like electricity and the weather. In the case of
the weather, payments are made based on a measure of a
particular weather factor, such as amounts of rain,
snowfall, or weather related damage.
• Other types of swaps: Floating-for-floating interest rate
swaps, amortizing swaps, step up swaps, forward swaps,
constant maturity swaps, compounding swaps, LIBOR-in-
arrears swaps, accrual swaps, diff swaps, cross currency
interest rate swaps, equity swaps, extendable swaps,
puttable swaps, swaptions, commodity swaps, volatility
swaps…(Hull)
133
Interest rate swaps
Interest swap
• An interest rate swap is a currency swap in which both
currencies are the same.
• Because we are paying in the same currency, there is no
need to exchange notional principal at the beginning and
at the end of an interest rate swap.
• The interest payments can be, and nearly always are,
netted. If one party owes $X and the other owes $Y, the
party owing the greater amount pays the net difference.
which greatly reduces the credit risk.
• There is no reason to have both sides pay a fixed rate.
The two streams of payments would be identical in that
case. So in an interest rate swap, either one side always
pays fixed and the other side pays floating, or both sides
pay floating (called a basis swap), but never do both sides
pay fixed.
45
Plain vanilla swap
• Consider a swap to pay Currency A fixed and Currency B
floating. Currency A could be dollars, and B could be
euros. The first case is a dollar-denominated plain vanilla
swap; the second is a euro-denominated plain vanilla
swap.
• A plain vanilla swap is simply an interest rate swap in
which one party pays a fixed rate and the other pays a
floating rate, with both sets of payments in the same
currency.
• Both sets of payments are on the same notional principal
and occur on regularly scheduled dates.
• In fact, the plain vanilla swap is probably the most
common derivative transaction in the global financial
system.
Example
• Let us now illustrate an interest rate swap. Suppose that on 15 Dec,
General Electric Company (NYSE: GE) borrows money for one year
from Bank of America (NYSE: BAC). The loan is for $25 million and
specifies that GE will make interest payments on a quarterly basis on
15 Mar, Jun, Sep, and Dec for one year at the rate of LlBOR plus 25
basis points. At the end of the year, it will pay back the principal. On
15 Dec, Mar, Jun, and Sep, LIBOR is observed and sets the rate for
that quarter. The interest is then paid at the end of the quarter.
• GE believes that it is getting a good rate, but fearing a rise in interest
rates, it would prefer a fixed-rate loan. It can easily convert the
floating-rare loan to a fixed-rate loan by engaging in a swap. Suppose
it approaches JP Morgan Chase (NYSE:JPM), a large dealer bank,
and requests a quote on a swap to pay a fixed rate and receive
LlBOR, with payments on the dates of its loan payments. The bank
prices the swap and quotes a fixed rate of 6.2% (Typically the rate is
quoted as a spread over the rate on a U.S. Treasury security with a
comparable maturity. Suppose the yield on a two-year Treasury note
is 6%. Then the swap would be quoted as 20 basis points over the
two-year Treasury rate. By quoting the rate in this manner, GE knows
what it is paying over the Treasury rate, a differential called the swap
spread). The fixed payments will be made based on a day count of
90/365, and the floating payments will be made based on 90/360.
Current LIBOR is 5.9%.
The first fixed payment, which GE makes to JPM, is $25,000,000(0.062)(90/

365) = $382,192. This is also the amount of each remaining fixed payment.
The first floating payment, which JPM makes to GE, is $25,000,000(0.059)
(90/360) = $368,750. Of course, the remaining floating payment will not be
known until later.
46
• Note in Exhibit 4 that we did not show the notional
principal, because it was not exchanged. We could
implicitly show that GE received $25 million from JPM
and paid $25 million to JPM at the start of the swap. We
could also show that the same thing happens at the end.
If we look at it that way, it appears as if GE has issued a
$25 million fixed-rate bond, which was purchased by
JPM, which in turn issued a $25 million floating-rate
bond, which was in turn purchased by GE.
• In fact, neither party actually issued a bond, but they
have generated the cash flows that would occur if GE
had issued such a fixed-rate bond, JPM had issued such
a floating-rate bond, and each purchased the bond of the
other. In other words, we could include the principals on
both sides to make each set of cash flows look like a
bond, yet the overall cash flows would be the same as
on the swap.
Exhibit 5 shows the net effect of the swap and the loan. GE pays LIBOR plus 25 basis
points to Bank of America on its loan, pays 6.2% JPM, and receives LIBOR from
JPM. The net effect is that GE pays 6.2 + 0.25 = 6.45% fixed.
• JPM is engaged in a swap to pay LIBOR and receive 6.2%. It is

exposed to the risk of LIBOR increasing. It would, therefore, probably
engage in some other type of transaction to offset this risk. One
transaction commonly used in this situation is to sell Eurodollar
futures. Eurodollar futures prices move $25 in value for each basis
point move in LIBOR. JPM will determine how sensitive its position is
to a move in LIBOR and sell an appropriate number of futures to
offset the risk.
• Bank of America is exposed to LIBOR as well, but in the banking
industry, floating-rate loans are often made because the funding that
the bank obtained to make the loan was probably already at LIBOR
or a comparable floating rate.
• It is possible but unlikely that GE could get a fixed-rate loan at a
better rate. The swap involves some credit risk: the possibility,
however small, that JPM will default. In return for assuming that risk,
GE in all likelihood would get a better rate than it would if it borrowed
at a fixed rate.JPM is effectively a wholesaler of risk, using its
powerful position as one of the world's leading banks to facilitate the
buying and selling of risk for companies such as GE. Dealers profit
from the spread between the rates they quote to pay and the rates
they quote to receive. The swaps market is, however, extremely
competitive and the spreads have been squeezed very tight, which
makes it very challenging for dealers to make a profit. Of course, this
competition is good for end users, because it gives them more
attractive rates.
47
Example
Determine the upcoming payments in a plain vanilla
interest rate swap in which the notional principal is €70
million. The end user makes a semiannual fixed payments
at the rate of 7%, and the dealer makes semiannual
floating payments at Euribor, which was 6.25% on the last
settlement period. The floating payments are made on the
basis of 180 days in the settlement period and 360 days in
a year. The fixed payments are made on the basis of 180
days in the settlement period and 365 days in a year.
Payments are netted, so determine which party pays which
and what amount.
Example
A U.S. company has entered into an interest rate swap
with a dealer in which the notional principal is $50 million.
The company will pay a floating rate of LIBOR and
receive a fixed rate of 5.75%. Interest is paid
semiannually, and the current LIBOR is 5.15%. Calculate
the first payment and indicate which party pays which.
Assume that floating-rate payment will be made on the
basis of 180/360 and fixed-rate payments will be made
on the basis of 180/365.
Example
A German company that has issued floating-rate notes

now believes that interest rates will rise. It decides to
protect itself against this possibility by entering into an
interest rare swap with a dealer. In this swap, the
notional principal is €25 million and the company will
pay a fixed rate of 5.5% and receive Euribor. The
current Euribor is 5%. Calculate the first payment and
indicate which party pays which. Assume that floating-
rate payments will be made on the basis of 90/360 and
fixed-rate payments will be made on the basis of 90/
365.
48
An Example of a “Plain Vanilla”
Interest Rate Swap
• An agreement by Microsoft to receive 6-month
LIBOR & pay a fixed rate of 5% per annum every 6
months for 3 years on a notional principal of $100
million
• Next slide illustrates cash flows that could occur
(Day count conventions are not considered)

Derivatives, 8th Edition, Copyright 145
© John C. Hull 2012
One Possible Outcome for Cash Flows to Microsoft

(Table 7.1, page 150)
Date LIBOR Floating Cash Fixed Cash Net Cash

Flow Flow Flow
Mar 5, 2012 4.20%
Sep 5, 2012 4.80% +2.10 −2.50 −0.40
Mar 5, 2013 5.30% +2.40 −2.50 −0.10
Sep 5, 2013 5.50% +2.65 −2.50 + 0.15
Mar 5, 2014 5.60% +2.75 −2.50 +0.25
Sep 5, 2014 5.90% +2.80 −2.50 +0.30
Mar 5, 2015 +2.95 −2.50 +0.45

Typical Uses of an Interest Rate Swap
• Converting a liability from

– fixed rate to floating rate
– floating rate to fixed rate
• Converting an investment from

– fixed rate to floating rate
– floating rate to fixed rate

49
Intel and Microsoft (MS) Transform a Liability
(Figure 7.2, page 151)
Swap: 5%
Intel MS
LIBOR


• For MS, the swap could be used to transform a floating-rate loan

into a fixed-rate loan. Suppose that MS borrows USD100 million at
LIBOR + 0.1%. After entering into the swap, MS has 3 cash flows:
– Pays LIBOR + 0.1% to its outside lenders
– Receives LIBOR under the swap
– Pays 5% under the swap
• Three cash flows net out to an interest payment of 5.1%  The
swap transformed borrowing at a floating LIBOR+0.1% into
borrowing at a fixed rate of 5.1%
5%
5.2%
Intel MS
LIBOR+0.1%
LIBOR

• For Intel, the swap could transform a fixed-rate loan into a floating-rate
loan. Suppose that Intel borrows USD100 million at 5.2%. After
entering into the swap, Intel has 3 cash flows:
– Pays 5.2% to its outside lenders
– Pays LIBOR under the swap
– Receives 5% under the swap
• Three cash flows net out to an interest payment of LIBOR + 0.2% 
The swap transformed borrowing at a fixed rate of 5.2% to borrowing
at a floating LIBOR+0.2%
5%
5.2%
Intel MS
LIBOR+0.1%
LIBOR
50
Financial Institution is Involved
• Financial Institution earns 3 basis point (0.03%) on two offsetting
transactions with Intel and MS.
• MS ends up borrowing at 5.1% + 0.015% = 5.115% :
– Pays LIBOR+0.1%
– Pays x%
– Receives LIBOR
We have -LIBOR - 0.1% - x% + LIBOR = -5.115%  x = 5.015%
• Intel ends up borrowing at LIBOR+0.2% + 0.015% = LIBOR + 0.215%
– Pays 5.2%
– Pays LIBOR
– Receives y%
We have -5.2% - LIBOR + y% = -LIBOR – 0.215%  y = 4.985%
y=4.985% x=5.015%
5.2%
Intel F.I. MS
LIBOR+0.1%
LIBOR LIBOR 151
Intel and Microsoft (MS) Transform an Asset

• Suppose that MS owns USD100 million in bonds that will provide
interest at 4.7%. After entering into the swap, MS has 3 cash flows:
– Receives 4.7% on the bonds
– Receive LIBOR under the swap
– Pays 5% under the swap
• Three cash flows net out to an interest inflow of LIBOR-0.3%  The
swap transformed an asset earning 4.7% into an asset earning
LIBOR - 0.3%.
5%
4.7%
Intel MS
LIBOR-0.2%
LIBOR
Intel and Microsoft (MS) Transform an Asset

• For Intel, the swap could transform an asset earning a floating interest
rate into an asset earning a fixed interest rate. Suppose that Intel has
an investment of USD100 that yields LIBOR - 0.2%. After entering into
the swap, Intel has 3 cash flows:
– Receives LIBOR - 0.2% on its investment
– Pays LIBOR under the swap
– Receives 5% under the swap
• Three cash flows net out to an interest inflow of 4.8%  The swap
transformed an asset earning LIBOR - 0.2% into an asset earning
4.8%. 5%
4.7%
Intel MS
LIBOR-0.2%
LIBOR
Options, Futures, and Other Derivatives, 153
8th Edition, Copyright © John C. Hull 2012
51
Financial Institution is Involved
(See Figure 7.5, page 153)
transactions with Intel and MS.
• MS ends up earning at LIBOR – 0.3% - 0.015% = LIBOR – 0.315%:
– Receives LIBOR
– Pays x%
– Receives 4.7%
We have LIBOR - x% + 4.7% = LIBOR – 0.315%  x = 5.015%
• Intel ends up earning at 4.8% - 0.015% = 4.785%
– Receives LIBOR – 0.2%
– Pays LIBOR
– Receives y%
We have LIBOR - 0.2% – LIBOR + y% = 4.785%  y = 4.985%
y=4.985% x=5.015%
4.7%
Intel F.I MS
LIBOR-0.2%
154
LIBOR LIBOR
Quotes By a Swap Market Maker

Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850

Market Makers
• Many large financial institutions act as market makers for swaps,
since unlikely that two companies have completely compatible
needs.
• Bid/Offer rates differ by 3 to 4 basis points. Average of bid and offer
rates is the swap rate.
• Bfix = Value of fixed-rate bond underlying the swap
• Bfl = Value of floating-rate bond underlying the swap
• Swaps have zero value, so Bfix = Bfl.
52
Day Count
• A day count convention is specified for fixed and floating

payment
• For example, LIBOR is likely to be actual/360 in the US
because LIBOR is a money market rate

Confirmations
• Confirmations specify the terms of a transaction

• The International Swaps and Derivatives has developed
Master Agreements that can be used to cover all
agreements between two counterparties
• Governments now require central clearing to be used for
most standardized derivatives

The Comparative Advantage Argument

• AAACorp wants to borrow floating
• BBBCorp wants to borrow fixed
Fixed Floating
AAACorp 4.0% 6 month LIBOR − 0.1%
BBBCorp 5.2% 6 month LIBOR + 0.6%
• At initial:
‒ AAACorp borrows fixed-rate funds at 4%
‒ BBBCorp borrows floating-rate funds at LIBOR+0.6%
• After swap:
– AAACorp ends up with floating rate
– BBBCorp ends up with fixed rate
159
53
The Swap (Figure 7.6, page 157)
• Swap:
– AAACorp agrees to pay BBBCorp at LIBOR
– BBBCorp agrees to pay AAACorp at 4.35%
• AAACorp has three cash flows:
– Pays 4% to outside lender
– Receives 4.35% from BBB Corp
– Pays LIBOR to BBBCorp
The net effect of cash flows is that AAACorp pays LIBOR - 0.35% (0.25%
less than it would pay if it went directly to floating-rate market) or Libor-
0.1% - 0.25%
• BBBCorp has three cash flows:
– Pays LIBOR +0.6% to outside lender
– Receives LIBOR from AAACorp
– Pays 4.35% to AAACorp
The net effect of cash flows is that BBBCorp pays 4.95% (0.25% less than
it would pay if it went directly to fixed-rate market) or 5.2% - 0.25%
4.35%
4%
AAACorp BBBCorp
LIBOR+0.6% 160
LIBOR
The Swap when a Financial Institution is Involved

transactions with AAACorp and BBBCorp.
• AAACorp ends up borrowing at LIBOR – 0.35% + 0.02% = LIBOR – 0.33%:
– Receives y%
– Pays 4%
– Pays LIBOR
We have -LIBOR -4% + y% = - LIBOR + 0.33%  y = 4.33%
• BBBCorp ends up borrowing at 4.95% + 0.02% = 4.97%
– Receives LIBOR – 0.2%
– Pays LIBOR+0.6%
– Receives x%
We have -LIBOR - 0.6% + LIBOR - x% = -4.97%  x = 4.37%
y = 4.33% x = 4.37%
4%
AAACorp F.I BBBCorp
LIBOR+0.6%
161
LIBOR LIBOR
Criticism of the Comparative

Advantage Argument
• The 4.0% and 5.2% rates available to AAACorp and
BBBCorp in fixed rate markets are 5-year rates
• The LIBOR − 0.1% and LIBOR + 0.6% rates available in
the floating rate market are six-month rates
• BBBCorp’s fixed rate depends on the spread above
LIBOR it borrows at in the future

54
Example
• Let’s consider 2 companies that borrow money in the

Eurocurrency market.
Fixed Floating
Firm A T% Libor
Firm B T% + 2% Libor + 1%
• If the firm B wants to finance itself at fixed rate and the

firm A wants to borrow money at floating rate, they had
better to conclude a swap.
Example
(with FI)
• Let’s consider 2 companies, Microsoft and Intel that

borrow money in the Eurocurrency market. The
remuneration of the financial institution in change of the
transaction is 0.03%
Fixed Floating
Microsoft 5.1% Libor + 0.1%
Intel 5.2% Libor + 0.3%
• Microsoft wants to borrows at fixed rate and Intel

requires floating rate loan.
• The interest rate swap plans that:
– Microsoft pays the fixed rate 4.965%
– Intel pays the floating Libor
Example
We consider the firm Arco and the firm Cooper have

been offered the following rates on a $ 20 million 5-year
loan: The firm Arco requires a floating rate loan.
Design a swap that will net a bank, acting as
intermediary, 0.1% and that will appear equally attractive
to both companies.
Fixed Floating
Arco 6% Libor + 0.1%
Cooper 6.7% Libor + 0.4%
55
Example
We consider the firm Arco and the firm Cooper have

been offered the following rates on a $ 20 million 5-year
loan: The firm Arco requires a floating rate loan.
Design a swap that will net a bank, acting as
intermediary, 0.1% and that will appear equally attractive
to both companies.
Fixed Floating
Arco 6% Libor + 0.1%
Cooper 6.7% Libor + 0.4%
The Nature of Swap Rates

• Six-month LIBOR is a short-term AA borrowing rate
• The 5-year swap rate has a risk corresponding to the
situation where 10 six-month loans are made to AA
borrowers at LIBOR
• This is because the lender can enter into a swap where
income from the LIBOR loans is exchanged for the 5-year
swap rate

The Nature of Swap Rates

• Swap rate is the average of:
– the fixed rate that a swap market maker is prepared to pay in exchange
for receiving LIBOR (bid)
– the fixed rate that it is prepared to receive in return for paying LIBOR
(offer)
• Swap rates are nearly risk free.
• A financial institute can earn the 5-year swap rate by
– Lending the principal for the first 6 months to a AA-borrower and then
relend it for successive 6-month periods to other AA-borrowers
– Enter into a swap to exchange the LIBOR income for the 5-year swap
rate.
• In other words 8-year swap rate is an interest rate with credit risk
corresponding to 16 consecutive 6-month LIBOR loans to AA
companies.
• Swap rates are less than AA borrowing rates since more attractive
to lend money for short periods of time (6-month) than for long
periods of time to retain liquidity.
56
Using Swap Rates to Bootstrap the
LIBOR/Swap Zero Curve
• Consider a new swap where the fixed rate is the swap

rate
• When principals are added to both sides on the final
payment date the swap is the exchange of a fixed rate
bond for a floating rate bond
• The floating-rate rate bond is worth par. The swap is
worth zero. The fixed-rate bond must therefore also be
worth par
• This shows that swap rates define par yield bonds that
can be used to bootstrap the LIBOR (or LIBOR/swap)
zero curve

Example of Bootstrapping the

LIBOR/Swap Curve
(Example 7.1, page 160)
• 6-month, 12-month, and 18-month LIBOR/swap

rates are 4%, 4.5%, and 4.8% with continuous
compounding.
• Two-year swap rate is 5% (semiannual)
2.5e 0.040.5  2.5e 0.0451.0  2.5e 0.0481.5  102.5e 2 R  100

• The 2-year LIBOR/swap rate, R, is 4.953%

Determining Swap/Zero Rates

• Use of LIBOR rates as risk-free rates used to price futures contracts.
• Only know LIBOR rates up to 12-month period.
• Extend LIBOR rates past 12 months via Eurodollar futures (up to 5
years, usually)
• Traders use swap rates to extend LIBOR zero curve further. Called
the LIBOR/Swap zero curve.
• How to determine the curve:
– New floating-rate bond is always equal to its principal value (par value)
when using LIBOR/Swap zero curve for discounting. (Since rate of
interest is LIBOR and LIBOR is discount rate)
– Next Bfl = Bfix for a new swap where fixed rate equals swap rate (again
at start). This implies both Bfl and Bfix equal the notional principal.
– Together imply that swap rates define a par yield bond.
– Use bootstrap argument.
57
Example of determining
Swap/Zero Rates
The 1-year LIBOR rate is 10%. A bank trades swaps where a fixed
rate of interest is exchanged for 12-month LIBOR with payments
being exchanged annually. The 2-and 3-year swap rates (expressed
with annual compounding) are 11% and 12% per annum. Estimate
the 2- and 3-year LIBOR zero rates.
Example of determining
Swap/Zero Rates
The two-year swap rate implies that a two-year LIBOR bond with a
coupon of 11% sells for par. If R2 is the two-year zero rate:
11e−0.10×1.0 + 111e−R2×2.0 = 100
so that R2 = 0.1046. The three-year swap rate implies that a three-
year LIBOR bond with coupon of 12% sells for par. If R3 is the three-
year zero rate
12e−0.10×1.0 + 12e−0.1046×2.0 + 112e−R2×3.0 = 100
so that R3 = 0.1146. The 2- and 3-year rates are 10.46% and
11.46% with continuous compounding.
Overnight Indexed Swaps
• Fixed rate for a period is exchanged for the geometric

average of the overnight rates
• Should OIS rate equal the LIBOR rate? A bank can
– Borrow $100 million in the overnight market,
rolling forward for 3 months
– Enter into an OIS swap to convert this to the 3-
month OIS rate
– Lend the funds to another bank at LIBOR for 3
months

58
Overnight Indexed Swaps
continued
• ...but it bears the credit risk of another bank in this

arrangement
• The OIS rate is now regarded as a better proxy for the
short-term risk-free rate than LIBOR
• The excess of LIBOR over the OIS rate is the LIBOR-
OIS spread. It is usually about 10 basis points but spiked
at an all time high of 364 basis points in October 2008

Swaps & Forwards

• A swap can be regarded as a convenient way of
packaging forward contracts
• Although the swap contract is usually worth zero
at the outset, each of the underlying forward
contracts are not worth zero

Derivatives 7th Edition, Copyright 176
Credit Risk
• A swap is worth zero to a company initially
• At a future time its value is liable to be either positive or
negative
• The company has credit risk exposure only when its
value is positive
• Some swaps are more likely to lead to credit risk
exposure than others
• What is the situation if early forward rates have a
positive value?
• What is the situation when the early forward rates have
a negative value?
59
Interest rate swap valuation
Valuation of an Interest Rate Swap

• Initially interest rate swaps are worth close to zero
• At later times they can be valued as the difference
between the value of a fixed-rate bond and the
value of a floating-rate bond
• Alternatively, they can be valued as a portfolio of
forward rate agreements (FRAs)

Valuation in Terms of Bonds
• The fixed rate bond is valued in the usual way

• The floating rate bond is valued by noting that it is worth
par immediately after the next payment date

60
• Principal is not exchange in swap agreements.
• In valuing swaps helpful to think of the principal as being
exchanged. Then from the perspective of the floating-rate payer, a
swap can be regarded as a long position in fixed rate bond and short
position in floating rate bond. Yields a swap value of
Vswap = Bfix − Bfl
where Bfl is the value of the floating-rate bond and Bfix is the value of
the fixed-rate bond.
• From the perspective of the fixed-rate payer, a swap can be
regarded as a short position in fixed rate bond and long position in
floating rate bond. Yields a swap value of
Vswap = Bfl − Bfix
• Note that a bond is worth the notional interest immediately after
interest payment, since LIBOR has just been rolled-over and fair
market value has been issued.


• If the notional principal is L, the next exchange of payments is at
time t*, and the floating payment will be made at time t* - determined
at the last payment date - is k*.
• Immediately after payment Bfl = L. Therefore, immediately before the
payment
Bfl = L + k*
• The floating-rate bond can be regarded as providing a single cash
flow of L + k* at time t*.
• Discounting, the value today is (L + k*)e−r*t*
where r* is the LIBOR/swap zero rate for maturity of t*.

Valuation of Floating-Rate Bond
Value = PV
of L+k* at t*
Value = Value = L
L+k*
0 t*
Valuation First Pmt Second
Date Date Pmt Date Maturity
Floating Date
Pmt =k*

61
Example
• Suppose a financial institution has agreed to pay 6-month LIBOR
and receive 8% per annum with semiannual compounding on a
notional principal of $100 million. The swap has a remaining life of
1.25 years. The LIBOR rates with continuous compounding for 3-
month, 9-month, and 15-month maturities are 10%, 10.5%, and
11%, respectively. The 6-month LIBOR rate at the last payment date
was 10.2% with semiannual compounding.
Valuation Using Bonds

(page 161)
• Computing the value of the floating-rate bond, we have k = 0.5 ×
0.102 × 100 = $5.1 million and t = 0.25. The floating-rate bond can
be valued as though it produces a cash flow of $105.1 million in 3
months.
Time Bfix cash Bfl cash Disc PV PV
flow flow factor Bfix Bfl
0.25 4.0 105.100 0.9753 3.901 102.505
0.75 4.0 0.9243 3.697
1.25 104.0 0.8715 90.640
Total 98.238 102.505
Swap value = 98.238 − 102.505 = −4.267

Derivatives, 8th Edition, Copyright
Valuation in Terms of FRAs
• Each exchange of payments in an interest rate

swap is an FRA
• The FRAs can be valued on the assumption that
today’s forward rates are realized

62
Valuation in Terms of FRAs
• A swap can be characterized as a portfolio of FRA’s.
• In the 3-year Microsoft-Intel swap, the first exchange of payments is
known at the swap negotiations.
• The next 5 exchanges can be regarded as forward rate agreements,
i.e. the exchange on Sept. 5, 2005 is an FRA of 5% for interest at the
6-month rate observed March 5, 2005, etc.
• Since FRA’s can be valued by assuming that forward interest rates
are realized, then our plain vanilla swap can be valued via FRA
valuing:
1. Use the LIBOR/swap zero curve to calculate forward rates for each
of the LIBOR rates that will determine swap cash flows
2. Calculate swap cash flows on the assumption that the LIBOR rates
will equal the forward rates
3. Discount these swap cash flows using the LIBOR/swap zero curve to
obtain the swap value
Example
Consider our 1.25 year swap example. Recall:
• Our company pays 6-month LIBOR and receives 8% per annum on
semiannual compounding on a notional principal of $100 million.
• Swap has 1.25 years remaining. LIBOR rates with continuous
compounding are 3-month, 9-month,15-month maturities at 10%,
10.5%, and 11%, respectively. 6-month LIBOR rate at last payment
was 10.2%.
Valuation of Example Using FRAs

(page 163)
Time Fixed cash Floating Net Cash Disc factor Present
flow cash flow Flow value of net
cash flow
0.25 4.0 -5.100 -1.100 0.9753 -1.073
0.75 4.0 -5.522 -1.522 0.9243 -1.407
1.25 4.0 -6.051 -2.051 0.8715 -1.787
Total -4.267
Total value of the swap is the sum of the values of the FRA’s: hence $-4.267 million.
Remarks:
1. Fixed rate in an interest rate swap is chosen so that the swap is worth zero at the
start. Therefore, the at the outset the sum of the values of the FRA’s underlying the
swap is zero.
2. Not all FRA’s have zero value, only the sum is zero.

63
Risk management application
of swap strategies for interest
rate risk
Swap strategies for interest rate risk

management
• Using interest rate swaps to convert a floating-rate loan
to a fixed-rate loan (and vice versa)
• Using swaps to adjust the duration of a fixed-income
portfolio
Using interest rate swaps to convert a

floating-rate loan to a fixed-rate loan
Because much of the funding banks receive is at a
floating rate, most banks prefer to make floating-rate
loans. By lending at a floating rate, banks pass on the
interest rate risk to borrowers. Borrowers can use
forwards, futures, and options to manage their exposure
to rising interest rates, but swaps are the preferred
instrument for managing this risk. A typical situation
involves a corporation agreeing to borrow at a floating
rate even though it would prefer to borrow at a fixed rate.
The corporation will use a swap to convert its floating-
rate loan to a fixed-rate loan.
64
• Internet Book Publishers (IBP) is a corporation that typically
borrows at a floating rate from a lender called Prime
Lending Bank (PLB). In this case, it takes out a one-year
$25 million loan at 90-day LIBOR plus 300 basis points. The
payments will be made at specific dates about 91 days
apart. The rate is initially set today, the day the loan is taken
out, and is reset on each payment date: On the first
payment date, the rate is reset for the second interest
period. With four loan payments, the first rate is already set,
but IBP is exposed to risk on the other three reset dates.
Interest is calculated based on the actual day count since
the last payment date, divided by 360. The loan begins on 2
March and the interest payment dates are 2 June, 2
September, 1 December, and the following 1 March.

• IBP manages this interest rate risk by using a swap. It
contacts a swap dealer, Swaps Provider Inc. (SPI), which is
the derivatives subsidiary of a major investment banking firm.
Under the terms of the swap, SPI will make payment to IBP
at a rate of LIBOR, and IBP will pay SPI a fixed rate of
6.27%, with payments to be made on the dates on which the
loan interest payments are made.
• The dealer prices the fixed rate on a swap into the swap
such that the present values of the two payment streams are
equal. The floating rates on the swap will be set today and
on the first, second, and third loan interest payment dates,
thereby corresponding to the dates on which the loan interest
rate is reset. The notional principal on the swap is $25
million, the face value of the loan. The swap interest
payments are structured so that the actual day count is used,
as is done on the loan.

• So, IBP borrows $25 million at a floating rate and arranges for
the swap, which involves no cash flows at the origination date.
The flow of money on each loan/swap payment date is
illustrated in Exhibit 1. We see that IBP makes its loan
payments at LIBOR plus 0.03. The actual calculation of the
loan interest is as follows:
($25 million)(LIBOR + 0.03)(Days/360)
• The swap payments are calculated in the same way but are
based on either LIBOR or the fixed rate of 6.27%. The interest
owed on the loan based on LIBOR is thus offset by the
interest received on the swap payment based on LIBOR.
Consequently, IBP does not appear to be exposed to the
uncertainty of changing LIBOR, but we shall see that it is
indeed exposed. The net effect is that IBP pays interest at the
swap fixed rate of 6.27% plus the 3% spread on the loan for a
total of 9.27%.
65

• IBP's swap transaction appears to remove its exposure
to LIBOR. Indeed, having done this transaction, most
corporations would consider themselves hedged against
rising interest rates, which is usually the justification
corporations give for doing swap transactions. It is
important to note, however, that IBP is also speculating
on rising interest rates. If rates fall, IBP will not be able to
take advantage, as it is locked in to a synthetic fixed-rate
loan at 9.27%. There can be a substantial opportunity
cost to taking this position and being wrong. To
understand this point, let us reintroduce the concept of
duration.

• We need to measure the sensitivity of the market value of the
overall position compared to what it would have been had the
loan been left in place as a floating rate loan. For that we turn
to duration, a measure of sensitivity to interest rates.
• If a default-free bond is a floating-rate bond, its duration is
nearly zero because interest sensitivity reflects how much the
market value of an asset changes for a given change in
interest rates.
• A floating-rate bond is designed with the idea that its market
value will not drift far from par. Because the coupon will catch
up with the market rate periodically, only during the period
between interest payment dates can the market value stray
from par value. Moreover, during this period, it would take a
substantial interest rate change to have much effect on the
market value of the floating-rate bond.
66
• Without showing the details, we shall simply state the result
that a floating-rate bond's duration is approximately the
amount of time remaining until the next coupon payment. For
a bond with quarterly payments, the maximum duration is
0.25 years and the minimum duration is zero. Consequently,
the average duration is about 0.125 years. From the
perspective of the issuer rather than the holder, the duration
of the position is -0.125.
• The duration of IBP's floating-rate loan position in this
example is an average of -0.125, which is fairly low
compared with most financial instruments. Therefore, the
market value of the loan is not very interest-rate sensitive. If
interest rates fall, the loan rate will fall in three months, and
IBP will not have much of a loss from the market value of the
loan. If interest rates rise, IBP will not have much of a gain
from the market value of the loan.

• Now let us discuss the duration of a swap. Remember that
entering a pay-fixed, receive-floating swap is similar to
issuing a fixed-rate bond and using the proceeds to buy a
floating-rate bond. The duration of a swap is thus equivalent
to the duration of a long position in a floating-rate bond and
a short position in a fixed-rate bond (or the net of the
duration of the equivalent positions in fixed- and floating
bonds). The duration of the long position in the floating-rate
bond would, again, be about 0.125.
• What would be the duration of the short position in the fixed-
rate bond? A one-year fixed-rate bond with quarterly
payments would probably have a duration of between 0.6
and 1.0. Let us assume this duration is about 0.75 (nine
months) or 75% of the maturity, an assumption we shall
make from here out. So the duration of the swap would be
roughly 0.125 - 0.75 = -0.625.

• Combining the swap with the loan means that the duration
of IBP's overall position will be -0.125 - 0.625 = -0.75.
• The swap was designed to convert the floating-rate loan to
a fixed-rate loan. Hence, the position should be equivalent
to that of taking out a fixed-rate loan. As we assumed for a
one-year fixed-rate bond with quarterly payments, the
duration would be 0.75. The duration of a borrower's
position in a fixed-rate loan would be -0.75, the same as the
duration of borrowing with the floating-rate loan and
engaging in the swap. The negative duration means that a
fixed-rate borrower will be helped by rising rates and a
falling market value
67
• Although the duration of the one-year fixed-rate loan is not
large, at least relative to that of bonds and longer-term
loans, it is nonetheless six times that of the floating-rate
loan. Consequently, the sensitivity of the market value of
the overall position is six times what it would have been
had the loan been left in place as a floating-rate loan.
From this angle, it is hard to see how such a transaction
could be called a hedge because declining rates and
increasing market values will hurt the fixed-rate borrower.
The actual risk increases sixfold with this transaction.

• So, can this transaction be viewed as a hedge? If not, why
is it so widely used?
• From a cash flow perspective, the transaction does indeed
function as a hedge. IBP knows that its interest payments
will all be $25,000,000(0.0927)(Days/360). Except for the
slight variation in days per quarter, this amount is fixed and
can be easily built into plans and budgets.
• So from a planning and accounting perspective, the
transaction serves well as a hedge. From a market value
perspective, however, it is tremendously speculative. But
does market value matter? Indeed it does.
• From the perspective of finance theory, maximizing the
market value of shareholders' equity is the objective of a
corporation. Moreover, under recently enacted accounting
rules, companies must mark derivative and asset positions
to market values, which has improved transparency.

• So, in summary, using a swap to convert a floating-rate

loan to a fixed-rate loan is a common transaction, one
ostensibly structured as a hedge. Such a transaction,
despite stabilizing a company's cash outflows, however,
increases the risk of the company's market value.
• Whether this issue is of concern to most companies is
not clear. This situation remains one of the most widely
encountered scenarios and the one for which interest
rate swaps are most commonly employed.
68
Example
Consider a bank that holds a $5 million loan at a fixed rate
of 6% for three years, with quarterly payments. The bank
had originally funded this loan at a fixed rate, but because
of changing interest rate expectations, it has now decided
to fund it at a floating rate. Although it cannot change the
terms of the loan to the borrower, it can effectively convert
the loan to a floating-rate loan by using swap. The fixed-
rate on three-year swaps with quarterly payments at LIBOR
is 7%. We assume the number of days in each quarter to
be 90 and the number of days in a year to be 360.
A. Explain how the bank could convert the fixed-rate loan to
floating-rate loan using swap.
B. Explain why the effective floating rate on the loan will be
less than LIBOR
Example
A company has issued floating-rate notes with a maturity
of one year, an interest rate of LIBOR plus 125 basis
points, and total face value of $50 million. The company
now believes that interest rates will rise and wishes to
protect itself by entering into an interest rate swap. A
dealer provides a quote on a swap in which the company
will pay a fixed rate 6.5% and receive LIBOR. Interest is
paid quarterly, and the current LIBOR is 5%. Indicate
how the company can use a swap to convert the debt to
a fixed rate. Calculate the overall net payment (including
the loan) by the company. Assume that all payments will
be made on the basis of 90/360.
An introduction to option
69
Options
• An option is a contract giving the option purchaser (the
buyer) the right, but not the obligation, to buy or sell a
given amount of the undelying asset at a fixed price per
unit for a specified time period (until the maturity date)
• There are two basic types of options, puts and calls.
 A call is an option to buy the undelying asset
 A put is an option to sell the undelying asset
• The buyer of an option is termed the holder, while the
seller of the option is referred to as the writer or grantor.
• An American option gives the buyer the right to exercise
the option at any time between the date of writing and the
expiration or maturity date.
• An European option can be exercised only on its
expiration date.
208
209
Options
• Every option has three different price elements:

 The exercise or strike price – the price at which the
undelying asset can be purchased (call) or sold (put).
 The premium – the cost, price, or value of the option
itself- usually paid in advance by the buyer to the
seller. An option‘s value at expiration is called its
payoff.
 The underlying or actual spot price in the market.
210
70
The concept of moneyness of an option
• For Put Options

 In-the-Money = Spot Price is below Option Strike
(Exercise) Price
 Out-of-the Money = Spot Price is above Option Strike
(Exercise) Price
 At-the-Money = Spot Price and Strike (Exercise) Price
are the same
• For Call Options
 In-the-Money = Spot Price is above Option Strike
(Exercise) Price
 Out-Of-the-Money = Spot Price is below Option Strike
(Exercise) Price
 At-The Money = Spot Price and Option Strike
(Exercise) Price are the same
211
Example
A contract is traded at the spot price of $1,170
Strike price Spot price Calls Puts

1,175 > 1,170 OTM ITM
1,170 = 1,170 ATM ATM
1,165 < 1,170 ITM OTM
212
Profit and Loss for the Buyer of a

Call Option
• Buyer of a call:
– Assume purchase of August call option on Swiss
francs with strike price of 58½ ($0.5850/SF), and a
premium of $0.005/SF
– At all spot rates below the strike price of 58.5, the
purchase of the option would choose not to exercise
because it would be cheaper to purchase SF on the
open market
– At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at
the strike price and sell them into the market netting a
profit (less the option premium)
Copyright © 2007 Pearson Addison-Wesley.

All rights reserved.
71
Profit and Loss for the Buyer of a Call
Option on Swiss francs
“At the money”
Profit
Strike price
(US cents/SF)
“Out of the money” “In the money”
+ 1.00
+ 0.50
Unlimited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even price
- 1.00
Loss
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less
than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Profit and Loss for the Writer of

a Call Option
• Writer of a call:
– What the holder, or buyer of an option loses, the writer
gains
– The maximum profit that the writer of the call option can
make is limited to the premium
– If the writer wrote the option naked, that is without owning
the currency, the writer would now have to buy the
currency at the spot and take the loss delivering at the
strike price
– The amount of such a loss is unlimited and increases as
the underlying currency rises
– Even if the writer already owns the currency, the writer will
experience an opportunity loss
Profit and Loss for the Writer of a Call

Option on Swiss francs
“At the money”
Profit
Strike price
(US cents/SF)
+ 1.00
+ 0.50 Break-even price

Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
- 0.50 Unlimited loss
- 1.00
Loss
The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot
rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
72
Profit and Loss for the Buyer of a
Put Option
• Buyer of a Put:
– The basic terms of this example are similar to those just
illustrated with the call
– The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price
of that currency drops (not rises as in the case of the call option)
– If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF
– At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium
– The buyer of a put (like the buyer of the call) can never lose
more than the premium paid up front

Profit and Loss for the Buyer of a Put Option

on Swiss francs
“At the money”
Profit
Strike price
(US cents/SF)
“In the money” “Out of the money”
+ 1.00
+ 0.50 Profit up
to 58.0
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even
price
- 1.00
Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates
greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the
money”) up to 58.0 cents.
Profit and Loss for the Writer of

a Put Option
• Seller (writer) of a put:
– In this case, if the spot price of francs drops below
58.5 cents per franc, the option will be exercised
– Below a price of 58.5 cents per franc, the writer will
lose more than the premium received fro writing the
option (falling below break-even)
– If the spot price is above $0.585/SF, the option will
not be exercised and the option writer will pocket the
entire premium
73
Profit and Loss for the Writer of a Put Option
on Swiss francs
“At the money”
Profit
Strike price
(US cents/SF)
+ 1.00
Break-even
+ 0.50 price
Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Unlimited loss
- 0.50 up to 58.0
- 1.00
Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates
greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
MTH13
Call Option position
ST ≤ X ST > X
Option value at expiration (payoffs) cT
Long Call cT = max (0, ST – X)
0 *(OTM) ST – X (ITM)
Short Call -cT = -max (0, ST – X)
0 X - ST
Profit 
Long Call cT – c0 = max (0, ST – X) – c0
-c0 ST - X– c0
Short Call -cT + c0
c0 X - S T + c0
Breakeven point Maximum profit Maximum loss
Long Call ST* = X + c0 ∞ c0
Short Call ST* = X + c0 c0 ∞
c0 : call option premium
*/: cT cannot sell for less than zero because that would mean that the option seller would have to pay the
option buyer. A buyer would not pay more than zero because the option will expire an instant later with no
value). Special case: ST = X  option is treated as OTM because the option is 0 at expiration.
Example
Call option: exercise price: USD2000, premium c =
USD81.75.
• Determine the value at expiration and profit for a buyer
under two outcomes: the price of underlying at expiration
is USD1900 and 2100
• Determine the maximum profit and loss to the buyer
• Determine the breakeven price of the underlying at
expiration
• Graph the value at expiration and the profit
74
Slide 221
MTH13 CFA Level 1, p95, p.149-

Example
Call option is selling for USD7, the exercise price is
USD100, and the price of the underlying is USD98.
• Determine the value at expiration and profit for a buyer
is USD102 and 94
• Determine the value at expiration and profit for a seller
is USD91 and 101
• Determine the breakeven price of the underlying at
expiration
Put Option position

ST < X ST ≥ X
Option value at expiration (payoffs) pT
Long Put pT = max (0, X – ST)
X – ST (ITM) 0 *(OTM)
Short Put -pT = -max (0, X – ST)
ST - X 0
Profit 
Long Put pT – p0 = max (0, X – ST) – p0
X – ST – p 0 -p0
Short Put -pT + p0
Breakeven point Maximum profit Maximum loss
Long Put ST* = X - p0 X - p0 p0
Short Put ST* = X - p0 p0 X - p0
p0 : put option premium
*/: pT cannot be worth less than zero because the option seller would have to pay the option buyer. It
cannot be worth more than zero because the buyer would not pay for a position that, an instant later, will
be worth nothing. Special case: ST = X  option is treated as OTM because the option is 0 at expiration.
Example
Put option: Exercise price USD2000, premium p =
USD79.25.
• Determine the value at expiration and profit for a buyer under
two outcomes: the price of underlying at expiration is
USD1900 and 2100
• Determine the breakeven price of the underlying at expiration
75
Example
Put option is selling for USD4 in which the exercise price is
USD60 and the price of the underlying is USD62.
• Determine the value at expiration and profit for a buyer under
two outcomes: the price of underlying at expiration is USD62
and 55
• Determine the value at expiration and profit for a seller under
two outcomes: the price of underlying at expiration is USD51
and 68
• Determine the breakeven price of the underlying at expiration
Principles of option pricing
Principles of option pricing
• Components of option premium

• Payoff values
• Boundary conditions
• Put-call parity
• Factors affecting the option value
76
Notation
c: European call option C: American call option
price price
p: European put option P: American put option

price price
S0: Stock price today ST: Stock price at option

maturity
K or X: Strike price
D: PV of dividends paid
T: Life of option during life of option
: Volatility of stock price
r Risk-free rate for
maturity T with cont.
comp.

American vs European Options
An American option is worth at least as much as the

corresponding European option
Cc
Pp

MTH22
Components of Option
Premium = Intrinsic value + Time value
• Intrinsic value is what the option worth to exercise it based
on current conditions. Or intrinsic value is the financial gain
if the option is exercised immediately.
• At expiration, an option will have a value equal to its
intrinsic value because the time remaining is zero or time
value is zero. Therefore, the value max(0,ST - X) for calls or
max(0,X-ST) for puts is the option‘s intrinsic value at
expiration:
– For a call option: Intrinsic value = Spot price – Strike price
 Intrinsic value = 0: if the strike price > the spot price
 Intrinsic value > 0 (ST - X): if the spot price > the strike price
– For a put option: Intrinsic value = Strike price – Spot price
 Intrinsic value = 0: if the strike price < the spot price
 Intrinsic value > 0 (X - ST): if the spot price < the strike price
• Prior to expiration, an option will normally sell for more than
its intrinsic value. 231
77
Slide 231
MTH22 CFA level 2. p.149

Eiteman, chapter 8
Components of Option
Premium = Intrinsic value + Time value
• The difference between the market price of the option and
its intrinsic value is time value.
• The time value of an option exists because the price of the
underlying currency, the spot rate, can potentially move
further and further into the money between the present
time and the option’s expiration date.
• Value of option prior to expiration relates to bounds for
options.
• On the date of maturity, an option will have a value equal
to its intrinsic value (zero time remaining means zero time
value, time value = 0).
232
Value of an Option at Expiration

E. Call
X Underlying
233
Call Value before Expiration

E. Call
X Underlying
234
78
Call Value before Expiration
E. Call
X Underlying
235
University of Rennes 1
Put Value at Expiration

E. Put
X Underlying
237
79
Put Value before Expiration
E. Put
X Underlying
238
Intrinsic Value, Time Value & Total Value for a Call Option on British
Pounds with a Strike Price of $1.70/£
Option Premium
(US cents/£)
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0
4.0 4.00
3.30
3.0
2.0 1.67
Time value Intrinsic
1.0
value
0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74
Copyright © 2007 Pearson Addison-Wesley. Spot rate ($/£)

80
Exhibit 8.8
Analysis of Call
Option on British
Pounds with a
Strike Price =
$1.70/£
241
Exhibit 8.9 The Intrinsic, Time, and Total Value Components

of the 90-Day Call Option
on British Pounds at Varying Spot Exchange Rates
242
Exhibit 8.10 Decomposing Call Option Premiums: Intrinsic

Value and Time Value
243
81
Exhibit 8.12 Foreign Exchange Implied Volatility for Foreign
Currency Options, January 30, 2008
244
Example
On the 5th September 2011, an investor purchases a

Call option on Alcatel-Lucent stocks. The option is at the
money. The delivery date is March 2012.
The Strike Price is 100€ and the premium 9€.
• Evaluate the intrinsic value and the time value of this
option.
• Appreciate the breakeven point associated with this
option.
82
Example
The Strike Price of a CALL option is 113.5 €.

At the subscription date, the contract price is 114.3 € and
the premium 1.10 €.
• Estimate the Intrinsic Value and the Time Value?
Payoff values
• An option’s value at expiration is called its payoffs
• At expiration, a call option is worth either zero or the
difference between the underlying price and the exercise
price, which is greater:
cT = max (0, ST – X)
CT = max (0, ST – X)
• At expiration, a put option is worth either zero or the
difference between the exercise price and the underlying
price, which is greater:
pT = max (0, X – ST)
PT = max (0, X – ST)
MTH24
Maximum and minimum values of

options
Option Minimum Value Maximum Value (upper bound)
European call c0 ≥ 0 c0 ≤ S0
American call C0 ≥ 0 C0 ≤ S0
European put p0 ≥ 0 p0 ≤ X/(1+r)T or p0 ≤ Xe-rT (T=n/365)
American put P0 ≥ 0 P0 ≤ X
• The minimum value of any option is zero.

• The maximum value of a European and an American call
is the current value of underlying.
• The maximum value of a European put is the present
value of the exercise price. The maximum value of an
American put is the exercise price.
83
Slide 249
MTH24 Hull, 8e, P.218-221

CFA L1, V6, P.98-103
Lower bound for a European call on
non-dividend-paying stock
• Portfolio A: One European call on a stock + a zero coupon bond (with a
face value equal to the exercise price and the current value equal to the
present value of the exercise price) that provides a payoff of X at time T.
This involves borrowing or lending an amount of money equal to the
present value of exercise price with repayment of the full exercise price.
• Portfolio B: one share of the stock
• The investor can buy the call and the bond and sell short the stock.
Short selling involves borrowing the asset and selling it. At expiration we
shall buy back the asset to cover the short position.
Value at expiration
Current value ST ≤ X ST > X
Buy call c0 0 ST - X
Portfolio A (not exercise) (exercise)
Buy bond X/(1+r)T or Xe-rT X X
Total = max(ST,X) at T X ST
Portfolio B Sell short stock -S0 -ST (minus sign means -ST
buying back)
Total c0 - S0 + X/(1+r)T X - ST 0
Lower bound for a European call on

• This combination has a negative value in no case at
expiration. Thus, the current value of the position must be
positive  c0 - S0 + X/(1+r)T ≥ 0  c0 + X/(1+r)T ≥ S0
 c0 ≥ S0 - X/(1+r)T
• Or we can say at time T, portfolio A is worth max(ST,X).
Portfolio B is worth ST. Hence A is always worth as much
as, and can be worth more than, B at option’s maturity (A ≥
B). In the absence of arbitrage, this must also be true
today. Thus c0 + X/(1+r)T ≥ S0
• Because the worst that can happen to a call is that it
expires worthless, its value cannot be negative. This
means that c0 ≥ 0, and therefore c0 ≥ max(0, S0 - X/(1+r)T)
Calls: An Arbitrage Opportunity?

• Suppose that a European call option on a stock and a
stock
c=3 S0 = 20
T=1 r = 10% (continuous compounding)
X = 18 D=0
• Is there an arbitrage opportunity?

84
Lower bound for a European put on
• The total payoff is never less than zero. Consequently, the

initial value of the combination must not be less than zero.
Therefore p0 + S0 - X/(1+r)T ≥ 0  p0 ≥ X/(1+r)T – S0.
Suppose that X/(1+r)T - S0 is negative. Then the put price
must be greater than a negative number.
• Or we can say portfolio C is worth max(ST, K) in time T and
portfolio D is worth X in time T. Hence C is always worth as
much as, and can be worth more than, D in time T (C ≥ D).
In the absence of arbitrage, this must also be true today.
Thus p0 + S0 ≥ X/(1+r)T  p0 ≥ X/(1+r)T - S0
• Because the worst that can happen to a put is that it expires
worthless, its value cannot be negative. This means that p0
≥ 0, and therefore p0 ≥ max(0, X/(1+r)T - S0)
Puts: An Arbitrage Opportunity?

• Suppose that a European put on a stock and stock
p=1 S0 = 37
T = 0.5 r = 5% (continuous compounding)
X = 40 D =0
• Is there an arbitrage opportunity?

Lower bound for options on non-

dividend-paying stock
• For a European call: The lower bound of a European call is either zero or
the underlying price minus the present value of the exercise price, which
is greater
c0 ≥ Max[0,S0 – X/(1+r)T] or c0 ≥ Max[0,S0 – Xe-rT]
• For a European put: The lower bound of a European put is the greater of
either zero or the present value of the exercise price minus the underlying
price
p0 ≥ Max[0, X/(1+r)T - S0] or p0 ≥ Max[0, Xe-rT- S0]
• For American options: The lower bound of an American option price is its
current intrinsic value (Max(0,S0 – X) for the call and Max(0,X - S0) for the
put. Intrinsic value is what the option worth to exercise at expiration. Prior
to expiration, an option normally sell for more than its intrinsic.
C0 ≥ Max(0,S0 – X), P0 ≥ Max(0,X - S0)
This reflects the potential to immediately receive the underlying price
minus the exercise price.
However an American call should not be worth less than a European call.
Thus, the lower bound of the European call holds for American calls as
well: C0 ≥ Max[0,S0 – X/(1+r)T] or C0 ≥ Max[0,S0 – Xe-rT]
85
Lower bound for options on non-
Option Lower bound
European call c0 ≥ Max[0,S0 – X/(1+r)T] or c0 ≥ Max[0,S0 – Xe-rT]
American call C0 ≥ Max[0,S0 – X/(1+r)T] or C0 ≥ Max[0,S0 – Xe-rT]
European put p0 ≥ Max[0, X/(1+r)T - S0] or p0 ≥ Max[0, Xe-rT- S0]
American put P0 ≥ Max(0,X - S0)
Example
Consider call and put options expiring in 42 days, in

which the underlying is at 72 and the risk - free rate is
4.5%. The underlying makes no cash payments during
the life of the options.
A. Find the lower bounds for European calls and puts with
exercise prices of 70 and 75.
B. Find the lower bounds for American calls and puts with
exercise prices of 70 and 75.
Put-Call Parity: No Dividends

• Assume the stocks pays no dividends. The put and
call options have the same strike price and time to
maturity
• Consider the following 2 portfolios:
– Portfolio A: European call on a stock + zero-coupon bond that
pays X at time T (a fiduciary call consists of buying a
European call and a risk-free bond, which allows protection
against downside losses) or + an cash amount equals to Xe-rT
– Portfolio C: European put on the stock + the stock (a
protective put consists of buying a European put and the
underlying asset)

86
Values of Portfolios
Value at expiration
Portfolio A Buy call c0 0 ST − X
Buy bond X/(1+r)T or Xe-rT X X
Total c0 + X/(1+r)T X ST
Portfolio C Buy put p0 X− ST 0
Buy stock S0 ST ST
Total p0 + S0 X ST

The Put-Call Parity Result

(Equation 10.6, page 222)
• The fiduciary call and protective put are worth max(ST , K ) at

the maturity of the options
• To avoid arbitrage, their values today must be the same.
Thus,
c0 + Xe -rT = p0 + S0 or c0 + X/(1+r)T = p0 + S0 : Put-call parity
(+: buy, -: sell)

Examples
• Suppose that
c = 6.64 S0 = 33.19
T = 219/365 = 0.6 r = 4%
X = 30 D=0
p = 2.75 Bond price = 30/(1 + 0.04)0.6 = 29.30
• Illustrate the put-call parity assuming stock prices at

expiration of 20 and 40
261
87
Synthetics
• c0 + X/(1+r)T= p0 + S0  c0 = p0 + S0 - X/(1+r)T
• The right-hand side is equivalent to a call, it is referred as to a
synthetic call.
• The call and the synthetic call produce the same thing at maturity but
in different ways
Value at expiration
Call Buy call c0 0 ST − X
Synthetic Buy put p0 X− ST 0
call
Buy stock S0 ST ST
Issue bond -X/(1+r)T -X -X
Total p0 + S0 - X/(1+r)T 0 ST − X
262
Synthetics
• c0 + X/(1+r)T
= p0 + S0  p0 = c0 - S0 + X/(1+r)T
• The right-hand side is equivalent to a put, it is referred as to a
synthetic put.
Value at expiration
Put Buy put P0 X− ST 0
Synthetic put Buy call c0 0 ST − X
Short stock -S0 -ST -ST
Buy bond X/(1+r)T X X
Total c0 - S0 + X/(1+r)T X− ST 0
263
Alternative combinations of calls, puts, the

underlying (the stock), and risk-free bonds
Strategy Consisting of Worth Equat Strategy Consisting of ST > X
es to
Fiduciary Long call + c0 +X/(1+r)T = Protective Long put + p0 + S0
call long bond put long underlying
Long call Long call c0 = Synthetic Long put + p0 + S0 -
call long underlying X/(1+r)T
+ short bond
Long put Long put p0 = Synthetic Long call + c0 – S0 +
put short X/(1+r)T
underlying +
long bond
Long Long S0 = Synthetic Long call + c0 +
underlying underlying underlying long bond + X/(1+r)T –
short put p0
Long bond Long bond X/(1+r)T = Synthetic Long put + p0 + S0 - c0
bond long underlying
+ short call
264
88
Arbitrage Opportunities
• Suppose that portfolio A is a fiduciary call, and portfolio
C is a protective put
c = 7.5, p = 4.25 S0 = 99
T = 0.5 r = 10% (discrete compounding)
X = 100 D=0
• What is the arbitrage possibility?
265
• Suppose European call and put options. The underlying
makes no cash payments during the life of option.
c = 8, p = 3.75 S0 = 48
T = 115/365 r = 4.5% (discrete compounding)
X = 45 D=0
A. Identifying the mispricing by comparing the price of the
actual call with the price of the synthetic call
B. Based on your answer in Part A, demonstrate how an
arbitrage transaction is executed
266
• Suppose that a stock, a European call and a European
put
c=3 S0 = 31
T = 0.25 r = 10% (continuous compounding)
X = 30 D=0
• What are the arbitrage possibilities when:

– the price of three month European put option p = 2.25?
– the price of three month European put option p = 1?

89
Values of Portfolios
Now After 3 months
Today ST < 30 ST > 30
Borrowing for 3 months 29
Portfolio A Short call 3
Portfolio C Buy put 1
Buy stock 31
At maturity Exercise call: sell stock 30
Repay loan 29.73
Profit 0.27
Exercise put to sell stock 30
Repay loan 29.73
Profit 0.27

Put-Call Parity: No Dividends

(for American options)
Put-call parity does not hold for American options

S0 – X ≤ C0 – P0 ≤ S0 – Xe-rT or
S0 – X ≤ C0 – P0 ≤ S0 – X/(1 + r)T
• An American call option on a non-dividend-paying stock:
X = 20, T = 5 months, C0 = 1.5, S0 = 19, r = 10%
 19 – 20 ≤ C – P ≤ 19 – 20-0.1x5/12
 1 ≥ P – C ≥ 0.18
 1.68 ≤ P ≤ 2.50
Bounds for options on

Option Bound
Call Max[0,S0 – X/(1+r)T] ≤ c0, C0 ≤ S0 or
Max[0,S0 – Xe-rT] ] ≤ c0, C0 ≤ S0
European put Max[0, X/(1+r)T - S0] ≤ p0 ≤ X/(1+r)T or
Max[0, Xe-rT- S0] ] ≤ p0 ≤ Xe-rT
American put Max(0,X - S0) ≤ P0 ≤ X
• Note: An American option call on a non-dividend-paying stock should not be

exercised early (p.225-226). It can be optimal to exercise an American put option on
a non-dividend-paying stock before expiration date.
90
Lower bound for options and put-call parity on
Lower bound for a European call on dividend-paying stock
• Portfolio A: One European call on a stock + an amount of cash equal to D +
X/(1+r)T or D + Xe-rT
• Portfolio B: one share of the stock
 c0 ≥ max[0, S0 - D - X/(1+r)T]
Lower bound for a European call on dividend-paying stock
• Portfolio C: One European put on a stock + one share.
• Portfolio D: an amount of cash equal to D + X/(1+r)T or D + Xe-rT
 p0 ≥ max[0, D + X/(1+r)T - S0 ]
Early exercise
• Sometimes it is optimal to exercise an American call prior to an ex-dividend
date
• It is never optimal to exercise a call at other times (see 14.12)
Put-call parity for European option
c0 + D + Xe -rT = p0 + S0 or c0 + D + X/(1+r)T = p0 + S0
Put-call parity does not hold for American option
S0 – D - X ≤ C0 – P0 ≤ S0 – Xe-rT or S0 – D- X ≤ C0 – P0 ≤ S0 – X/(1 + r)T
Effect of Variables on Option Value

Variable c p C P
S0 + − + −
X − + − +
T ? ? + +
 + + + +
r + − + −
D − + − +

Factors influencing the option value
• The effect of a difference in exercise price

• The effect of a difference in time to expiration
• The effect of a cash flows on the underlying asset
• The effect of a interest rates and volatility
91
The effect of a difference in stock price
• For calls exercised, the payoff = ST – X

– Call options become more valuable as ST increase and less
valuable as X increases.
• For put exercised, the payoff = X – ST
‒ Put options become less valuable as ST increase and less
valuable as X increases.
The effect of a difference in exercise price

• Consider two options on the same underlying with the same
expiration day but different prices
• We construct a combination in which we buy a European
call with strike price X1 and sell a European call with strike
price X2 where X1 < X2.
Long call Short call Total
Current value
c0(X1) -c0 (X2) c0 (X1) – c0 (X2)
ST ≤ X1 0 0 0
X1 < ST < X 2 ST - X1 0 ST - X1 > 0
ST ≥ X2 ST - X1 -(ST - X2) X2 - X1 > 0
• Because the value of the combination is as least as much as
zero at expiration, thus the current value c0 (X1) - c0 (X2)
must higher than zero: c0 (X1) - c0 (X2) ≥ 0  c0 (X1) ≥ c0 (X2)
• It is also true for American calls, C0 (X1) ≥ C0 (X2)
The effect of a difference in exercise price

• We construct a similar portfolio for puts, except that we buy the
put with X2 and sell the put with X1 where X1 < X2.
Long put Short put Total
Current value
p0 (X2) -p0 (X1) p0 (X2) - p0 (X1)
ST ≤ X1 X2 - ST -(X1 - ST) X2 – X1 > 0
X1 < ST < X 2 X2 - ST 0 X2 – ST > 0
ST ≥ X2 0 0 0
• Because the value of the combination is never negative at

expiration, therefore it must be non-negative today, hence p0
(X2) - p0 (X1) ≥ 0  p0 (X2) ≥ p0 (X1)
• These results also hold for American puts, thus P0 (X2) ≥ P0 (X1)
• In conclusion, the higher the exercise price, the lower the value
of a call and the higher the price of a put
92
The effect of a difference in time to
expiration
• The owner of the longer-term option has all exercise
opportunities open to the owner of the shorter-term option
and more. The longer-term option must therefore always
be worth at least as much as the shorter-term option.
• A longer-term option has more time for the underlying to
make a favorable move. If the option is in-the-money by
the end of a given period of time, it has better chance of
moving even further in-the-money over a longer period of
time.
• If the additional time gives it a better chance of moving
out-of-the-money or further out-of-the-money, the
limitation of losses to the amount of the option premium
means that disadvantages of the longer time is no
greater.

expiration
• We consider options otherwise identical except that one has a longer
time to expiration the other. The one expiring earlier has an expiration
of T1, and the one expiring later has expiration of T2. Thus we have
the price of the options are c0 (T1), c0 (T2), p0 (T1), p0 (T2)
• When the shorter-term call expires, the European call is worth max(0,
ST1 - X), the longer-term European call is worth at least max(0,ST1 –
X/(1 + r)(T2 – T1)), thus we have c0 (T2) ≥ c0 (T1).
• These results are not altered if the call is American:
C0 (T2) ≥ C0 (T1)
• Moreover, this is not always the case that European calls become
more valuable as the time to expiration increases. Consider two
European calls on a stock, one expires in 1 month, one expires in 2
months. Suppose that a very large dividend is expected in 6 weeks.
This dividend will cause the stock price to decline, so that the shorter-
term option could be worth more than the longer-term option. This is
also true for European puts. Thus, c0 (T2) (and p0 (T2)) can be either
greater or less than c0 (T2) (and p0 (T1)).

expiration
• For European calls, the longer term gives additional time for
favorable move in the underlying to occur. For European puts,
this is also true, but there is one advantage to waiting the
additional time. When a put is exercised, the holder receives
money. The lost interest on the money is a disadvantage of
the additional time.
• For call, there is no lost interest. In fact, a call holder earns
additional interest on the money paying out the exercise price
later.
• For American put, the additional time is beneficial to the
holder of an American put. An American put can be always
exercised. There is no penalty for waiting. Thus:
p0 (T2) can be either greater or less than p0 (T1).
P0 (T2) ≥ P0 (T1)
93
The effect of a cash flows on the
underlying asset
• We specify cash flows in the form of dividends, using the
notation PV(CF, 0,T)
• The lower bounds for European option as
c0 ≥ max{0,[S0 - PV(CF, 0,T)] - X/(1+r)T}
p0 ≥ max{0,X/(1+r)T – [S0 - PV(CF, 0,T)]}
 The value of the call option is negatively related to the
size of the dividend and the value of the put option is
positively related to the size of the dividend.
The effect of a difference in interest rates
• When interest rates are higher, call options are higher

and put option prices are lower. This effect is not obvious:
– For calls:
 When investors buy calls instead of the underlying, they are
effectively buying an indirect leveraged position in the
underlying. When interest rates are higher, buying the call
instead of a direct leveraged position is more attractive.
 Moreover, by using calls, investors save more money by not
paying for the underlying until a later date.
– For puts:
 Higher interest rate is disadvantageous because the investors
lose more interest while waiting to sell the underlying
• In practice, when interest rates increase, stock prices fall.
This combined effect can be to decrease the value of a
call and increase the value of a put, or vise versa.
The effect of a volatility
• Higher volatility increases call and put option prices

because it increases possible upside values and
increases possible downside value of the underlying.
• The upside effect helps calls and does not hurt puts. The
downside effect does not hurt calls and helps puts.
• The reason call are not hurt on the downside and puts are
not hurt on the upside is that when options are out-of-the-
money, it does not matter if they end up more out-of-the-
money. But when options are in-the-money, it does
matter if they end up more in-the-money.
94
Option Pricing Models
Option pricing Models
• The purpose of option pricing is to appreciate the spot

price of an option (t = 0) from its known future value.
• 2 methods:
– Discrete-time option pricing: the Binomial model
– Continuous-time option pricing: the Black-Scholes-Merton model
The Binomial Trees
95
The Binomial model
• Assumptions: It is assumed the underlying asset price movements
consist of a large number of small binomial movements. No arbitrage.
• Principles
– The time to maturity is divided into a large number of time intervals
(step)
– At each step, the stock price moves up or down (2 possible values)
– This produces a tree that represents all the possible paths that the
stock price could take during the life of the option
– At the expiration of the option (end of the tree), all the terminal option
prices on each branch are known. They simply equal their intrinsic
values.
– The option prices at each step of the tree are calculated working back
from expiration to the present
– The option prices at each step are used to derive the option prices at
the next step of the tree using risk neutral valuation;
– The risk neutral is evaluated from the probabilities of the stock prices
moving up or down, the risk free rate and the time interval of each
step.
A Simple Binomial Model: Example1
• A stock price is currently $20

• In 3 months it will be either $22 or $18
Stock Price = $22

Stock price = $20
Stock Price = $18

A Call Option
A 3-month call option on the stock has a strike

price of 21.
Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0

96
Setting Up a Riskless Portfolio
• For a portfolio that is long D shares and a

short 1 call option values are
22D – 1
18D
• Portfolio is riskless when 22D – 1 = 18D or D

= 0.25

Valuing the Portfolio

(Risk-Free Rate is 12%)
• The riskless portfolio is:

long 0.25 shares
short 1 call option
• The value of the portfolio in 3 months is
22 ×0.25 – 1 = 4.50
• The value of the portfolio today is
4.5e–0.12×0.25 = 4.3670

Valuing the Option
• The portfolio that is

long 0.25 shares
short 1 option
is worth 4.367
• The value of the shares is
0.25 × 20 = 5.000
• The value of the option is therefore
5.000 – 4.367 = 0.633

97
Generalization (Figure 12.2, page 255)
A derivative lasts for time T and is dependent on a

stock
S0 u
ƒu = max(0, ST - X)
S0 at expiration
ƒ
S0 d
ƒd
Generalization
• Value of a portfolio that is long D shares and short 1

derivative:
S0uD – ƒu
S0dD – ƒd
• The portfolio is riskless when S0uD – ƒu = S0dD – ƒd or
ƒu  fd
D
S 0u  S 0 d
Generalization
• Value of the portfolio at time T is S0uD – ƒu
• Value of the portfolio today is (S0uD – ƒu)e–rT
• Another expression for the portfolio value today is
S0D – f
• Hence
ƒ = S0D – (S0uD – ƒu )e–rT

98
Generalization
Substituting for D we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT
where
e rT  d
p
ud

p as a Probability
• It is natural to interpret p and 1-p as probabilities of up
and down movements
• The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd
Risk-Neutral Valuation
• When the probability of an up and down movements are
p and 1-p the expected stock price at time T is S0erT
• This shows that the stock price earns the risk-free rate
• Binomial trees illustrate the general result that to value a
derivative we can assume that the expected return on
the underlying asset is the risk-free rate and discount at
the risk-free rate
• This is known as using risk-neutral valuation

99
Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0
p is the probability that gives a return on the stock equal to the
risk-free rate:
20e 0.12 ×0.25 = 22p + 18(1 – p ) so that p = 0.6523
Alternatively:
e rT  d e 0.12  0.25  0 . 9
p   0 . 6523
ud 1 .1  0 . 9
Valuing the Option Using Risk-

Neutral Valuation
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0
The value of the option is

e–0.12×0.25 (0.6523×1 + 0.3477×0) = 0.633

One-period Binomial model: steps

• Steps to option pricing:
– Find u = S0u/S0, d = S0d/S0
or u = 1+%move up, d = 1-% move down
– Find the underlying prices in the binomial tree
– Find the price of option at expiration:
c+ = fu = max(0,S+ - X), c- = fd = max(0,S- - X)
p+ = max(0,X – S+), p- = max(0,X – S-)
rT
– Find risk-neutral probability: p  e  d
ud
– Find option price today: ƒ = [ pƒu + (1 – p)ƒd ]e–rT
• The number of units of the underlying that would be required
at each node in the binomial tree to construct a risk-free
hedge using calls: D  ƒ u  f d
S 0u  S 0 d
100
Example
• 11.1, 11.4
Irrelevance of Stock’s Expected Return
• When we are valuing an option in terms of the price of

the underlying asset, the probability of up and down
movements in the real world are irrelevant
• This is an example of a more general result stating that
the expected return on the underlying asset in the real
world is irrelevant

A Two-Step: Example2
Figure 12.3, page 260
24.2
22
20 19.8
• A 6-month option with

18 X=21, r = 12%
• Each time step is 3 months 16.2
• In each of two time steps may go up or down by 10%

101
Valuing a Call Option
D 24.2
3.2(=24.1-21)
22
B
20 2.0257 E 19.8
1.2823 A 0.0
18
Start at D, then E, F, C, B, andCA
0.0 F 16.2
Value at node B
–0.12×0.25 0.0
=e (0.6523×3.2 + 0.3477×0) = 2.0257
Value at node A
= e–0.12×0.25(0.6523×2.0257 + 0.3477×0) = 1.2823

Generalization
page 261 S 0u 2
u, p fuu
S0u D
u, p B
S0 fu d, 1-p S0ud
A
f u, p E fud
S 0d
d, 1-p C
fd S 0d 2
d, 1-p
F fdd
ƒ = [ p2ƒuu + 2p(1 - p)fud + (1 – p)2ƒdd ]e–2rD t where Dt is the interval length
Options, Futures, and Other Derivatives, 8th 305

Edition, Copyright © John C. Hull 2012
A Put Option Example

72
0
60
50 1.4147 48
4.1923 4(=52-48)
40
9.4636 32
20
X = 52, time step Dt = 1yr
r = 5%, u =1.32, d = 0.8  p = e0.05x1 - 0.8 = 0.6282
1.2 – 0.8
f = e-2x0.05x1(0.62822 x 0 + 2 x 0.6282 x 0.3718 x 4 + 0.37182 x 20) = 4.1923

102
What Happens When the Put Option is American
72
0
60
50 1.4147 48
5.0894 4
40
C
12.0(=52-40) 32
20
The American feature increases the value at node C from 9.4636 to 12.0000
(12 is the payoff from early exercise)  early exercise is optimal.
This increases the value of the option from 4.1923 to 5.0894 (at A), the payoff
from early exercise is 2 (=52-50)  early exercise is not optimal.

Delta
• Delta (D) is the ratio of the change in the price of a
stock option to the change in the price of the underlying
stock
• The value of D varies from node to node
ƒu  fd
D
S 0u  S 0 d
• It evaluates the number of the underlying stock which
should be hold for each option shorted to create a risk-
neutral portfolio
• The delta of the call (put) is positive (negative)

Example
Consider a one-period binomial model in which the

underlying is at 65 and can go up 30% or down 22%.
The risk-free is 8%.
• Determine the price of a European call option with
exercise prices of 70.
• Assume that the call is selling for 9 in the market.
Demonstrate how to execute an arbitrage transaction
and calculate the rate of return. Use 10,000 call options.
103
Example
Consider a two-period binomial model in which the

underlying is at 30 and can go up 14% or down 11%
each period. The risk-free is 3% per period.
• Find the value of a European call option expiring in two
periods with an exercise price of 30.
• Find the number of units of the underlying that would be
required at each node in the binomial tree to construct a
risk-free hedge using 10,000 calls
Matching volatility with u and d
In practice, when constructing a binomial tree to

represent the movements in a stock price, we choose u
and d to match the volatility of the stock price:
u  e Dt
d  1 u  e  Dt
where  is the volatility and Dt is the length of the time

step. This is the approach used by Cox, Ross, and
Rubinstein.

Girsanov’s Theorem
• Volatility is the same in the real world and the risk-

neutral world
• We can therefore measure volatility in the real world and
use it to build a tree for the an asset in the risk-neutral
world

104
Assets Other than Non-Dividend
Paying Stocks
• For options on stock indices, currencies and futures

the basic procedure for constructing the tree is the
same except for the calculation of p

The Probability of an Up move

u  e Dt
ad
d  1 u  e  Dt
p
ud
a  e rDt for a nondividen d paying stock
a  e ( r  q ) Dt for a stock index wher e q is the dividend

yield on the index
( r  r ) Dt
ae f for a currency w here r f is the foreign
risk - free rate
a  1 for a futures contract

Proving Black-Scholes-Merton from Binomial Trees

(Appendix to Chapter 12)
As the number of steps is increased, the binomial tree model make the same
Assumptions about stock price behavior as the Black-Scholes-Merton model.
When the binomial tree is used to price a European call, the price converges to
the Black-Scholes-Merton model, as the number of time steps is increased.
n
n!
c  e  rT  p j (1  p ) n j max(S 0 u j d n j  K , 0)
j  0 (n  j )! j!
Option is in the money when j >  where
n ln( S 0 K )
 
so that 2 2 T n
c  e  rT ( S 0U1  KU 2 )
where
n!
U1   p j (1  p) n  j u j d n  j
j  ( n  j )! j!
n!
U2   p j (1  p) n  j
j  (n  j )! j!
105
Proving Black-Scholes-Merton from Binomial Trees
• The expression for U1 can be written

n! n!
U1  [ pu  (1  p )d ]n 
(n  j )! j!
 j
p* 1  p* 
n j
 e rT   
( n  j )! j!
j
p* 1  p * 
n j
j  j 
pu
where p* 
pu  (1  p) d
• Both U1 and U2 can now be evaluated in terms of the

cumulative binomial distribution
• We now let the number of time steps tend to infinity
and use the result that a binomial distribution tends to
a normal distribution
The Black-Scholes-Merton Model
• The Black-Scholes model is used to calculate the

theoretical price of call and put options by using five
variables: the underlying price, the strike price, the
volatility, the time to expiration, the risk-free interest rate.
• Assumptions:
– The underlying price follows a lognormal probability distribution as
it evolves through time. A lognormal probability distribution is one
in which the log return is normally distributed. Exp: if a stock
moves from 100 to 110, the return is 10% but the log return is
ln(1.10)=0.0953 or 9.53%. Log returns are often called
continuously compounded returns. If the log return follows the
familiar normal or bell-shaped distribution, the return is said to be
lognormally distributed.
106
– The volatility of the underlying asset, specified in the form of
standard deviation of the log return, is assumed to be known at
all times and does not change over the life of option.
– The risk-free rate is known and constant. This assumption
becomes a problem for pricing options on bonds and interest
rates.
– No tax or transaction costs
– Dividend payments are ignored
– The options are European
• Approach:
– Solving the differential equation, or
– Using risk-neutral valuation
The Concepts Underlying Black-

Scholes-Merton
• The option price and the stock price depend on the
same underlying source of uncertainty
• We can form a portfolio consisting of the stock and
the option which eliminates this source of uncertainty
• The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
• This leads to the Black-Scholes-Merton differential
equation

The Derivation of the Black-

Scholes Differential Equation
DS  mS Dt  S Dz
 ƒ ƒ 2ƒ 2 2  ƒ
Dƒ   mS  ½  S  Dt  S Dz
 S t S2  S
We set up a portfolio consisting of

 1: derivative
ƒ
+ : shares
S
This gets rid of the dependence on Dz.

107
The Derivation of the Black-Scholes
Differential Equation
The value of the portfolio, , is given by

ƒ
  ƒ  S
S
The change in its value in time Dt is given by
ƒ
D   Dƒ  DS
S

© John C. Hull 2012 322
The Derivation of the Black-Scholes

Differential Equation
The return on the portfolio must be the risk - free

rate. Hence
D  r Dt
f  f 
- Df  DS  r   f  S  Dt
S  S 
We substitute for Dƒ and DS in this equation
to get the Black - Scholes differential equation :
ƒ ƒ  2ƒ
 rS  ½ σ 2S 2  rƒ
t S S 2

The Differential Equation

• Any security whose price is dependent on the stock
price satisfies the differential equation
• The particular security being valued is determined by
the boundary conditions of the differential equation
• In a forward contract the boundary condition is ƒ = S –
X when t =T
• The solution to the equation is
ƒ = S – X e–r (T – t )

108
The Black-Scholes-Merton Formulas
(See pages 313-315)
r: Continuously T: Time remaining until
compounded expiration
risk-free interest rate N(d2): standard normal
cumulative
c  S 0 N (d1 )  X e  rT N (d 2 ) distribution function
p  X e rT N ( d 2 )  S 0 N (d1 )
ln(S 0 / X )  (r   2 / 2)T
where d1 
 T
: The annualized ln(S 0 / X )  (r   2 / 2)T
standard deviation of d2   d1   T
continuously  T
compounded return
on the stock Derivatives, 8th Edition, Copyright 325
The normal probability distribution

• The function N(x) is the probability that a normally
distributed variable with a mean of zero and a
standard deviation of 1 is less than x
• N(-x) = 1 - N(x)
• x becomes very large, N(x) becomes close to 1 and
N(-x) is close to zero.
• See tables at the end of the book

Properties of Black-Scholes Formula
• As S0 becomes very large c tends to S0 – Xe-rT and p

tends to zero
• As S0 becomes very small c tends to zero and p tends to
Xe-rT – S0
• What happens as  becomes very large?
• What happens as T becomes very large?

109
• The variable m does not appear in the Black-
Scholes-Merton differential equation
• The equation is independent of all variables affected
by risk preference
• The solution to the differential equation is therefore
the same in a risk-free world as it is in the real world
• This leads to the principle of risk-neutral valuation

Applying Risk-Neutral Valuation
1. Assume that the expected return from the

stock price is the risk-free rate
2. Calculate the expected payoff from the option
3. Discount at the risk-free rate

Valuing a Forward Contract with

• Payoff is max(0,ST – X)
• Expected payoff (the value of the option at maturity) in a risk-neutral
world is E[max(0,ST – X)]
• Present value of expected payoff is c = e-rT E[max(0,ST – X)]
which can be rewritten as c = e-rT [S0 N(d1)erT - XN(d2)]
to provide an interpretation of the terms in c = S0 N(d1) – Xe-rTN(d2)
where:
N(d2) is the probability that the option will be exercised in a risk-neutral
world, so that XN(d2) is the strike price times the probability that the strike
price will be paid.
S0 N(d1)erT is the expected value in a risk-neutral world of a variable that is
equal to ST if ST > X and to zero or otherwise.

110
Proving Black-Scholes-Merton Using
(Appendix to Chapter 14)

c  e rT  max( ST  X , 0) g ( ST )dST
X
where g(ST) is the probability density function for the lognormal

distribution of ST in a risk-neutral world. ln ST is j(m, s2) where

m  ln S 0  r   2 2 T  s  T
We substitute ln ST  m
Q
s
so that

c  e rT  max( e Qs  m  X , 0)h(Q)dQ
(ln X  m ) / s
where h is the probability density function for a standard normal.

Evaluating the integral leads to the BSM result.
Inputs to the BSM model
• The Black-Scholes-Merton model has five inputs: the

underlying price, the strike price, the risk-free rate, the
time to expiration, and the volatility
• The BSM model provides an excellent opportunity to
examine the relationships between these inputs and
option price, which are usually call the option Greeks,
because they are often referred to with Greek names.
111

Intl Derivatives Market For Student

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Chương 5.

Thị trường phái sinh quốc tế

PGS, TS Mai Thu Hiền

FTU Khoa Tài chính Ngân hàng FBF

Chương 5. Thị trường phái sinh quốc tế

International derivative market

Natures of international derivative market

Natures of international derivative market

Natures of international derivative market

Natures of international derivative market

Natures of international derivative market

• The forward contract hedge locks in a price

Delivery and settlement of

MTH17 CFA, Vol.6

F0 F1 Short 2 months (42$) 31

Payoff of forward contract

Long Position Short Position

FORWARD PRICING AND

Generic pricing and valuation of

MTH23 Fabozzi, Fixed income mathematics, p59-61

• This transaction is risk free and should be equivalent to investing S0

Generic valuation of a forward contract

Pricing and valuation of fixed-income

Profit from futures

Profit (Payoff) Profit

Profit from futures

• Change by $0.0001/€ leads to a profit/loss $0,0001 * 125.000 =

Delivery and cash settlement (at expiration)

Delivery and cash settlement (at expiration)

2 days before expiration 1 day before expiration Expiration

Prof.Dr1 cfa, lv1, p59-60

2 days before expiration 1 day before expiration Expiration

Prof.Dr2 spread trader: OF&OD, Hull 8e, ch.2

• Eurex (Germany and Switzerland)

margin call time

• An investor takes a long position in 2 December

Options, Futures, and Other 64

Day Trade Settle Daily Cumul. Margin Margin

Options, Futures, and Other

Futures vs forward contracts

Futures vs forward contracts

Types of futures contract

• 2 types: commodity and financial futures

Table 22.1 Sample of Futures Contracts

Source: Mishkin (2006) 74

Widely Traded Financial Futures Contracts

Source: Mishkin (2006) 75

Stock Index Futures Contracts

Figure 23.2 Foreign Exchange Futures

Foreign currency futures

• Contract specifications are established by the exchange

• A perfect hedge is one that completely eliminates the

Long & Short Hedges

• A long futures hedge is appropriate when you know

Options, Futures, and Other

Managing interest rate risk

• Managing the interest rate risk of a loan using FRA (by

Strategies and Applications for Managing

Measuring the risk of a bond portfolio

Bond‘s value will change by approximately 2.8% if

Consider a 5-year bond with $1,000 face value. The

Duration can be also computed by dividing the sum of the products of

Measuring the risk of a bond portfolio