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You are on page 1of 16

Timing, and Quanto

Adjustments

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014 1

Forward Yields and

Forward Prices

We define the forward yield on a bond as the yield

calculated from the forward bond price

There is a non-linear relation between bond yields

and bond prices

It follows that when the forward bond price equals

the expected future bond price, the forward yield

does not necessarily equal the expected future

yield

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

2

Relationship Between Bond Yields and

Prices (Figure 30.1, page 694)

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

3

Bond

Price

Yield

Y

3

B

1

Y

1

Y

2

B

3

B

2

Convexity Adjustment for Bond Yields

(Eqn 30.1, p. 695)

Suppose a derivative provides a payoff at time T

dependent on a bond yield, y

T

observed at time T.

Define:

G(y

T

) : price of the bond as a function of its yield

y

0

: forward bond yield at time zero

o

y

: forward yield volatility

The expected bond price in a world that is FRN wrt

P(0,T) is the forward bond price

The expected bond yield in a world that is FRN wrt

P(0,T) is

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

4

) (

) (

2

1

0

0

2 2

0

y G

y G

T y

y

'

' '

o Yield Bond Forward

Convexity Adjustment for Swap

Rate

The expected value of the swap rate for the period T

to T+t in a world that is FRN wrt P(0,T) is

(approximately)

where G(y) defines the relationship between price

and yield for a bond lasting between T and T+t that

pays a coupon equal to the forward swap rate

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

5

) (

) (

2

1

0

0

2 2

0

y G

y G

T y

y

'

' '

o Rate Swap Forward

Example 30.1 (page 696)

An instrument provides a payoff in 3 years

equal to the 1-year zero-coupon rate

multiplied by $1000

Volatility is 20%

Yield curve is flat at 10% (with annual

compounding)

The convexity adjustment is 10.9 bps so that

the value of the instrument is 101.09/1.1

3

=

75.95

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

6

Example 30.2 (Page 696-697)

An instrument provides a payoff in 3 years =

to the 3-year swap rate multiplied by $100

Payments are made annually on the swap

Volatility is 22%

Yield curve is flat at 12% (with annual

compounding)

The convexity adjustment is 36 bps so that

the value of the instrument is 12.36/1.12

3

=

8.80

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

7

Timing Adjustments (Equation 30.4, page

698)

The expected value of a variable, V, in a world that is

FRN wrt P(0,T*) is the expected value of the variable in a

world that is FRN wrt P(0,T) multiplied by

where R is the forward interest rate between T and T*

expressed with a compounding frequency of m, o

R

is the

volatility of R, R

0

is the value of R today, o

V

is the volatility

of F, and is the correlation between R and V

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

8

(

+

o o

T

m R

T T R

R V VR

/ 1

) (

exp

0

*

0

Example 30.3 (page 698)

A derivative provides a payoff 6 years equal to the

value of a stock index in 5 years. The interest rate is

8% with annual compounding

1200 is the 5-year forward value of the stock index

This is the expected value in a world that is FRN wrt

P(0,5)

To get the value in a world that is FRN wrt P(0,6) we

multiply by 1.00535

The value of the derivative is 12001.00535/(1.08

6

)

or 760.26

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

9

Quantos

(Section 30.3, page 699-702)

Quantos are derivatives where the payoff is

defined using variables measured in one

currency and paid in another currency

Example: contract providing a payoff of

S

T

K dollars ($) where S is the Nikkei stock

index (a yen number)

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

10

Diff Swap

Diff swaps are a type of quanto

A floating rate is observed in one currency

and applied to a principal in another currency

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

11

Quanto Adjustment (page 700)

The expected value of a variable, V, in a

world that is FRN wrt P

X

(0,T) is its expected

value in a world that is FRN wrt P

Y

(0,T)

multiplied by exp(

VW

o

V

o

W

T)

W is the forward exchange rate (units of Y per

unit of X) and

VW

is the correlation between V

and W.

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

12

Example 30.4 (page 700)

Current value of Nikkei index is 15,000

This gives one-year forward as 15,150.75

Suppose the volatility of the Nikkei is 20%,

the volatility of the dollar-yen exchange rate is

12% and the correlation between the two is

0.3

The one-year forward value of the Nikkei for a

contract settled in dollars is

15,150.75e

0.3 0.20.121

or 15,260.23

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

13

Quantos continued

When we move from the traditional risk

neutral world in currency Y to the tradional

risk neutral world in currency X, the growth

rate of a variable V increases by

o

V

o

S

where o

V

is the volatility of V,

o

S

is the

volatility of the exchange rate (units of Y per

unit of X) and

is the correlation between

the two

o

V

o

S

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

14

Siegels Paradox

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

15

this? explain you Can

of drift a have to

for process the expect we of rate

drift a has for process the that Given

that lemma s Ito' from implies This

process neutral - risk the follows ) currency

of unit per currency of (units rate exchange An

. 1

,

) / 1 ( ) / 1 ]( [ ) / 1 (

] [

2

Y X

X Y

S S Y X

S X Y

r r S

r r

S

dz S dt S r r S d

Sdz Sdt r r dS

X

Y S

+ =

+ =

o o

o

When is a Convexity, Timing, or

Quanto Adjustment Necessary

A convexity or timing adjustment is necessary

when interest rates are used in a nonstandard

way for the purposes of defining a payoff

No adjustment is necessary for a vanilla swap,

a cap, or a swap option

Options, Futures, and Other Derivatives, 9th Edition,

Copyright John C. Hull 2014

16

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