EBS Derivatives

(formerly Financial Risk Management 2)

9 December 2005
 Intro to my course summary
• If you are having to learn these concepts and
techniques for the first time, and Peter Moles’ book
is your guide, you have my sympathy. You are
about to experience a great number of ‘WTF?’
moments. In addition to being poorly written and
probably never edited, as a mathematics text, it
suffers two fatal flaws:
1. It often does not fully explain what is being done or why.
2. It is full of mistakes: variables often don’t jibe with the
discussion or the described methods don’t produce the results
indicated. This is particularly maddening when you are checking
the book to see of you are doing something correctly. The book
is particularly sloppy with the precedence of mathematical
operations and with mathematical precision.
 1. Fundamentals
• Financial risk management seeks to limit the effects
of changes in financial variables (interest rates,
currencies, commodity prices) on the ability of the
firm to achieve its corporate objectives.
 There may be uncertainty about a particular outcome
without there being any particular consequence.
 The risk will be managed when a deviation from the
expected outcome may be detrimental.
• Most individuals and many firms are risk averse.
That is, they see the potential gains and losses, even
if evenly distributed, as not equal.
 Alternate Approaches
• Risk avoidance: risk is not assumed
• Risk mitigation: loss prevention or control are
used to reduce risk to acceptable levels
• Risk retention: firm has the capacity to absorb
the risk and the competency to manage its
exposures
 Assumes that the firm is not retaining by default or
out of ignorance (or both)
 Risk Management Process
1. Identify the source of the
risk exposure.
2. Quantify and / or assess
the exposure.
 Top down
 Building block: effects of
risk factors are analyzed
and aggregated
3. Conduct a cost-benefit
analysis of the impacts
and possible adjustments.
4. Assess the firm’s
capabilities to undertake
its own insurance and
hedging program.
5. Select the products and
mix.
6. Keep the risk management
process under review.
 Portfolio of Projects
• One way to characterize the firm is as a portfolio of
projects, funded by a mixture of debt and equity.
 Successful projects provide cash flows that allow the firm
to grow and to reward the providers of the firm’s capital.
 Losses hinder the execution of the firm’s business strategy.
“A successful firm makes enough money to pay for its
mistakes.” – Peter Drucker
 Removing externalities allows managers to focus on
producing shareholder value.
 Nature of Exposures
• Origin: internal, input or output
• Transaction: the commitments chosen by the
firm
• Translation: assets or obligations in a foreign
currency
• Contingent: expected but non-contracted
• Economic / Strategic: GDP growth, interest
rates, foreign exchange, suppliers, customers,
competitors
 Risk Transfer and Reduction

Insure: indemnity,
Accept guarantee, options
Assess

On Balance Sheet
(Operational)

Transfer

Off Balance
Hedge
Sheet (Financial)
 2. Building Blocks
• All of the terminal products (forwards, futures,
swaps) have linear outcomes. The differences
are in:
 How they handle performance risk
 The degree of tailoring
 The possibility of trading out of the position
• Options have non-linear outcome.
 Buyer has performance risk with the seller, but the
seller has no risk with the buyer.
 Allows choice of price level.
 Terminal Products
• In a forward, the buyer and seller agree to a price for an asset
to be delivered on a set date in the future.
• Futures were conceived as a means of eliminating credit risk
from forwards.
 Daily mark-to-market out of margin funds (collateralization).
Contract is effectively renegotiated each day at the new
prevailing market rate.
 Clearing house is the counterparty for all transactions, and
guarantees performance.
 Standardization increases liquidity at the expense of basis risks.
• A swap obliges two parties to exchange (or swap) a series of
cash flows at specified intervals over a particular time period.
 This works like a bundle of forward contracts.
 Option Contracts
• Options confer on the owner the right, but not the
obligation, to make a particular future transaction: a
call gives the right to buy, and a put the right to sell.
• The option price (without merchant markup) is one
that which ensures, ex ante, the transaction is a fair
one – that is, it has zero net present value.
• An option is in fact a portfolio consisting of a forward
contract on the underlying and a loan. The call option
can be replicated dynamically by adjusting these two
elements.
 3. Forward Contracts
• A forward contract is simply a bilateral commercial
agreement negotiated today but with its execution or
settlement deferred to some agreed date in the future.
 The economic rationale is that these add value by
eliminating or reducing uncertainty.
 The demand for forward contracts will be determined by
the number of firms facing uncertainty about future prices.
• These can be tailored to match underlying risk. They
are typically held to maturity (i.e., they are not
unwound).
 The Cost-of-Carry Model
• The model posits that forward prices will be
determined by the costs of acquiring the asset in the
cash market and holding it for delivery:
 FPt,T = CPt + [CPt x Rt,T x (T-t)/365] + Gt,T where FP is the
forward price, CP is the cash price, R is the risk-free
interest rate and G are storage and other related costs.
 This provides an upper limit for the forward price, but is
not a useful formulation for discovery markets, where
prices are greatly influenced by availability.
 Intermediate payments of interest or dividends (“leakages”)
reduce the forward price.
 Volatility and Credit Exposure
• It is volatility in the potential outcome that
creates performance risk (credit exposure).
 The greater the volatility, the greater the risk.
 It is this same undesirable volatility in the price
that makes the contract valuable to both parties.
Each is willing to acquire the benefit of price
certainty at the (perceived to be lower) cost of
performance risk.
 Boundary condition (upper)
• There is an arbitrage opportunity when the
costs of carry are less than the spread between
cash and forward prices (i.e., forward is
expensive):
 CPt(1 + iB)T-t + TC < FPt, where B is the borrowing
rate and TC are transaction costs.
 Buy the cash and sell the forward.
 Boundary condition (lower)
• There is an likewise an arbitrage opportunity when
the replacement cost of the asset is less than the cash
price minus the costs of carry (i.e., forward is cheap):
 FPt < CPt(1 + iL)T-t - TC, where L is the lending rate and
TC are transaction costs.
 Would-be transaction costs (e.g., storage) are subtracted
because they are not incurred.
 Sell the cash, invest proceeds and buy the forward. This is
sometimes called a reverse cash and carry.
 Forward Rate Agreement
• An FRA is an interest rate transaction. It is called
a forward rate agreement because, although it may
be transacted today, it has a forward start.
• It replicates a forward start deposit or loan, thus
allowing the future borrower or lender to lock in
an interest rate based on the rates quoted or
implied today for the period between the
settlement date and maturity date.

transaction date settlement date maturity date

time

loan or deposit period

 Forward Rate Agreement, 2
• There is a settlement for two reasons:
 In common with a swap, the FRA has no delivery of the
principal. It is still up to the borrower or lender to make his
transaction on the settlement date.
 Rates for the covered period may change between the
transaction date and the settlement date. An amount is paid
or received in order to restore the borrower or lender to the
position he would have had with the locked-in rate.
• The borrower or lender is restored to his position as
of the maturity date, but as the payment is actually
made/ received on the settlement date, it is discounted
according to the spot rate on the settlement date.
 Forward Rate Agreement, 3
[ Rc – Rs ] x D x A
100 basis
Settlement amount =
1 + Rs x D
basis x 100

• The settlement amount is the difference between the rates,

times the number of years in the loan/deposit period, times the
notional amount, all discounted back from the maturity date to
the settlement date.
• Annualized rates are quoted as whole numbers (e.g., 5 percent
is 5 and not 0.05, thus requiring the division by 100. D is the
number of days in the loan or deposit period. Basis is the
number of days in the interest rate year, usually 360 or 365.
 Forward Rate Agreement, 4
• If you multiply the top and bottom terms by
(basis x 100) then simplify:
(Rs – Rc) x D x A
Settlement amount
= (basis x 100) + (Rs x D)

• This is the British Bankers Association formula.

It is not as intuitive as the other, but is much less
confusing to work with.
(
• The future borrower will “buy” or “take” the
FRA (i.e., pay the fixed rate); the future lender
will “sell” or “place” the FRA (i.e., receive the
fixed rate).
 Forward Exchange Rates
• Forward rates for foreign exchange are projected
using the theory of interest rate parity.
 The interest rate for the quoted currency is divided by
the interest rate for the base currency. Multiplying by
the spot exchange rate gives the forward outright.
 If the spot rate is USD 1.5425/£, the one-year USD
interest rate is 3.25% and the one-year GBP interest
rate is 4.125%, the forward outright in one year is

1.0325
$1.5425 x = $1.5295
1.0412
5
 Forward Exchange Rates, 2
• As the differentials between exchange rates are
much more stable that the rates themselves, the
custom in the foreign exchange markets is to
quote the differential as a premium or discount
to the spot rate.
 Nobody wants to risk a misplaced decimal, so the
differential is multiplied by 10,000.
 From the one-year projection on the previous slide:
$1.5425 - $1.5295 = 0.0130 x 10,000 = 130
forward points or pips)
 SAFE
• Although interest rates are required in the calculation,
a Synthetic Agreement for Forward Exchange
(SAFE) is a foreign exchange transaction.
• One is notionally borrowing or lending an amount of
the foreign currency in the future, for a known term,
and wants to lock in the exchange rate or forward
points differential at today’s rates.
• The most common structures are:
 Exchange rate agreement (ERA)
 Forward exchange agreement (FXA)
 SAFE, 2
• As with the FRA, there is no delivery of
principal, and the would-be borrower or lender
will still have to make that transaction on the
settlement date.
• Without the transfer and re-transfer of
principal amounts, this transaction has reduced
credit exposure, and thus requires smaller
reserve requirements.
 SAFE, 3
• Rates or forward points may change between the
transaction date and the settlement date. An amount is
paid or received in order to restore the borrower or
lender to the position he would have had with a
locked-in exchange rate or forward point spread.
• The “buyer” of the SAFE sells the foreign currency at
the settlement date and repurchases it at maturity (is
the lender of the foreign currency). The “seller” of
the SAFE purchases the foreign currency at the
settlement date and resells at maturity (borrower of
the foreign currency).
 Exchange Rate Agreement
• The payoff of ERA =
(fc – fd)
notional principal x
i x (Tm – Ts)
1+
100 x basis

• That is, the difference in forward points between the

contract date and the settlement date is discounted for
the time between maturity and settlement. This is then
multiplied by the notional principal.
• The borrower or lender is restored to his position as
of the maturity date, but as the payment is actually
made/ received on the settlement date, it is discounted
according to the spot rate on the settlement date.
Forward Exchange Agreement (FXA)
• An FXA covers both a change in the swap points and a change
in the spot rate between the transaction date and the settlement
date.
[(sc + fc) - (sd + fd)]
Settlement amount = Am x – As x (sc - sd)
i x (Tm – Ts)
1+
100 x basis
 Difference between contract rate + points and settlement rate + points
is discounted for basis and for time between maturity and settlement,
and multiplied by the notional maturity amount.
 Subtract from this the difference between the contract and settlement
rates, multiplied by the notional amount exchanged on the settlement
date. (These notional amounts are different because we expect the original amount to
change over time, e.g., we expect $1.00 delivered on settlement day to equal $1.02 when
“re-exchanged”.)
 Quoting an FXA
• As with an FRA, a quote will be for 1 v. 4, 2 v. 6 etc.
• A positive point spread (fc – fd) means that a
payment is made to the buyer. This makes the bid –
offer counter-intuitive. If the spread were 110 -
114:
 A larger fc makes it more likely that the term will be
positive, therefore the buyer bids the higher number (i.e.,
114).
 A smaller fc makes it more likely that the term will be
negative, therefore the seller offers the lower number
(i.e., 110).
 4. Futures
• The principal distinguishing features between the
forward market and the exchange-traded futures
market in the same asset relate not to fundamental
differences in their economic effect, but to
institutional arrangements dealing with counterparty
risk and providing liquidity.
 The former is addressed by requiring all participants to post
a performance bond and revaluing the position each day.
 The latter is provided by restricting the number of maturity
dates and standardizing the nature of the contracted
instruments.
 Advantages / Disadvantages
• Transparency • Rounding error: actual
• Price discovery exposure may not be a whole
• contract unit
Liquidity
• Daily margining creates a
• Economic efficiency: bid –
offer spread, transaction costs, mismatch of cash flows
leverage • Basis risks caused by
• Short position easily standardization: commodity,
established timing and location
• Positions are easily offset
(fungible)
• No credit exposure
 Minimizing Performance Risk
• The exchange’s clearing house acts as the
counterparty for all contracts.
• The exchange requires the posting of an initial margin
amount, intended to approximate a maximum daily
price move.
• Contracts are marked to market at the end of each
day, with the losses paid from the margin funds of the
losers into the accounts of the winners.
• If the margin funds on hand fall below the
maintenance level, the exchange requires the posting
of additional funds (“margin call”).
 Convergence
• As the future moves towards expiry, the cost
of carry will decline to the point where, at
expiry, the two prices should be the same.
 This coming together of the cash and futures prices
is known as convergence and it is the only time
when the futures price and the cash price must
necessarily be the same.
 For markets in which they are no supply issues
(convenience yields), the “fair” price of the future
will be cash price plus the costs of carry.
 Basis Relationships
• Raw or simple basis: Cash – Future, i.e., S – F
• Carry basis: Cash – theoretical Future, based on costs
of carry, i.e., S – F*
 A comparison of the simple basis and carry basis will
indicate whether the future is cheap or dear relative to cash.
 This should also consider leakages such as interim
payments of dividends or interest.
• Value basis: F – F*
• As market prices change, the cash and futures prices
will normally move in the same direction, but the
basis will not be constant. This could be problematic
for the hedger.
 Effects of a Change in Basis
• As with the underlying itself, a market participant can
be long or short the basis. This will be the same
direction as the position in the underlying (cash).
• Basis increase:
 Cash increases more quickly or decreases more slowly than
futures
 Favors the long basis holder and prejudices the short
• Basis decrease:
 Cash decreases more quickly or increases more slowly than
futures
 Favors the short basis holder and prejudices the long

If the basis on a commodity has gone from -10 to +10, has it widened or
narrowed? This is why the text’s formulation is unhelpful. Also wrong.
 Contango
• In the cost of carry model, the fair futures
price is going to be driven by, inter alia, the
financing cost.
 If a cash asset were valued at 100 and interest rates
were 5%, with continuous compounding the
futures contract three months out:
Ft = S x er x (T – t) = 100 x e0.05 x 0.25 = 101.26
 Forward prices in these markets will be rising as
we go further out in time, a condition called
contango.
 Backwardation
• Seasonal influences or possible supply
shortages, especially when there are no
suitable substitutes, create a convenience
yield.
 If this yield could be estimated with a parameter y,
then the futures price could be projected:
Ft = S x e(r – y)(T – t)
 Forward prices in these markets will be falling as
we go further out in time, a condition called
backwardation.
 Tailing the Hedge
• The timing effects that arise from the
margining system require the hedger to reduce
the exposure on the futures contract by the
expected reinvested income from the margin
position – that is, tail the hedge.
 Tailed hedge = N x e-rt
 If a “full” hedge would be for a position of 100
contracts, interest rates are 10% and the exposure
period were 11 months,
Tailed hedge = 100 x e-0.1 x 0.9167 = 91.24
 Interest Rate Futures
• The price quotation for Treasury bills is based on an
index: 100 less the interest rate on the futures
contract.
 If interest rates were 10 per cent on a three-month T-bill,
the futures price would be 97.5, i.e., 100 – (10 x 0.25).
• Buy as protection from a lower rate.
 If interest rates fall, the price rises (a hedging gain). If
interest rates rise, the price falls (a hedging loss).
• Sell as protection from a higher rate.
 If interest rates fall, the price rises (a hedging loss). If
interest rates rise, the price falls (a hedging gain).
 5. Swaps
• A swap is a bilateral agreement to exchange a
series of cash flows.
 It has the appearance of a bundle of forwards, with
the same linear (symmetric) payoff, but with the
same fixed price term for each settlement.
 It allows market participants to modify sets of
connected cash flows by exchanging one form
of exposure for another.
 Payments are usually made on a net basis (that is,
the differences).
 Swap Basics
Fixed-Rate Payer
 Pays the fixed interest
rate
 Receives the floating
interest rate
 Has purchased (is long)
the swap
 Is short the bond market
 Has a long-dated fixed-
rate liability and a
floating-rate asset
Floating-Rate Payer
 Pays the floating interest
rate
 Receives the fixed interest
rate
 Has sold (is short) the swap
 Is long the bond market
 Has a long-dated fixed-rate
asset and a floating-rate
liability
 Interest Rate Swap
• The payoffs of an interest rate swap would
imitate, for example, buying a fixed rate bond
and financing the purchase with a floating rate
note.
 The loan proceeds are used to purchase the bond.
 The bond pays a fixed rate coupon.
 Periodic interest payments are required on the note
at the then-prevailing (floating) interest rate.
 At bond maturity, the loan is retired.
 Cross-Currency Swap
• The parties to the swap exchange the underlying
principal at the onset and return it (not re-exchange it)
at maturity.
 A obtains $15 million from counterparty B for £10 million.
 Throughout the life of the swap, the parties service each
other’s interest-rate payments. A floating-for-floating
exchange is a cross-currency basis swap; fixed-for-fixed is
a cross-currency coupon swap.
 At termination, A re-delivers the $15 million to B and
receives £10 million.
 Asset – Liability Management
• An investment arbitrage exists when the synthetic
alternative provides a positive net gain over the
market equivalent.
 Synthetic floating-rate note: issue a bond, then swap to
receive fixed and pay floating.
 Synthetic bond: borrow at a floating rate, then swap to pay
fixed and receive floating.
 Synthetic floating-rate loan: buy a bond, then swap to pay
fixed and receive floating.
 Synthetic straight bond: buy a floating-rate note, then swap
to receive fixed and pay floating.
 Swap Pricing
• In normal circumstances, it is possible for a
counterparty to construct a riskless position on the
other side of the swap.
• The value to both sides of an at-market swap is such
that neither is required to compensate the other when
entering the transaction.
 The sum of the fixed cash flows, discounted at the
appropriate zero-coupon rates, is equal to the sum of the
expected floating rates similarly discounted.
 That is, NPV = 0
 Pricing a Swap
• At the outset, the net present value of the
fixed-rate and floating rate payments are
equal.
• Any set of fixed cash flows can be seen as the
sum of a series of zero-coupon bonds with
matching cash flows.
• The first step in valuation is to estimate the
amounts of the floating rate payments for each
future settlement date.
 Pricing a Swap, 2
• The forward floating rates could be derived from the
zero coupon rates. If the zero coupon rates for 6
months and one year were 5.00 and 5.20 respectively,
then
(1 + 0z0.5)0.5(1 + 0.5f1.0)0.5 = (1 + 0z1.0)1.0
(1.05)0.5(1 + 0.5f1.0)0.5 = (1.052)1.0
1.0247 x (1 + 0.5f1.0)0.5 = 1.052
(1 + 0.5f1.0)0.5 = 1.0266 (= 1.0533, annualized)
• Use the applicable zero-coupon rate to NPV each of
the expected future payments, e.g., for the payment at
the end of t = 5, NPV = payment / (1 + 0z5)5
 Pricing a Swap, 3
• Take the sum of the NPV’s of the floating payments.
 The fixed rate side has the same total NPV.
• The swap’s fixed rate is then related to the NPV by
the annuity factor.
 NPV = rfixed x AF
• The annuity factor for the fixed payments is the sum
of the zero-coupon factors used to discount the
floating payments.
 Annuity factor = Σ 1 / (1 + 0zt)t
• Calculated rate may have to be annualized.
 Annuity Factor
• Annuity factor = [1 – (1 / (1 + i)t)] / i
• If i = 4.5% and t = 10 then
 (1.045)10 = 1.553
 1 / 1.553 = 0.6439
 1 – 0.6439 = 0.3561
 0.3561 / .045 = 7.9127
• PV = coupon x AF
• PV / AF = coupon
 Bootstrapping
• Zero-coupon rates can be “bootstrapped” from the par yield curve with
the formula st = (Yt + 100) / (100 – (Yt x At)), where Yt is the coupon at
time t and At is the annuity rate applied to interim coupon payments.
s2 = (8.98 + 100) / (100 – (8.98 x 0.913685)) = 1.187209
• The price relative st is the equivalent zero-coupon payout.
• The zero coupon yield is the nth root of st .
• The zero coupon discount factor = 1 /st
• The annuity factor is the sum of the zero-coupon discount factors for
previous periods.

Maturity Par yield At st ZC yield ZC discount

(Yt) factor

1 9.4469 - 1.094469 9.4469 0.913685

2 8.9800 0.913685 1.187209 8.9591 0.842312
3 8.6000 1.755997 1.279176 8.5534 0.781753
 Cross-Subsidy Element
• For a swap to have a zero net present value,
there will be periods when the value of the
fixed is above that of the floating side
payments.
 In general, an upward-sloping term structure
means that the fixed price payer has a net payable
position in the early periods versus a net receivable
position in the later ones.
 For a downward-sloping curve, the situation (for
the fixed rate payer) is the opposite.
 Valuing a Seasoned Swap
• Once the swap rates are no longer at-market, the swap
is said to be seasoned.
• Fixed-price payments or receipts are discounted using
the appropriate zero-coupon rate.
 This accomplishes the same valuation as replacement of the
cash flows with new swaps, working from the longest dated,
until there is only a present valuation.
• The value of a fixed-to-fixed cross-currency swap will
be influenced by three factors:
 The first two are interest rates in the respective currencies.
 The third is the change in the exchange rate.
 Amortizing Swap
• … has a structure in which the principal amount is
reduced over time.
• In most cases, the rates on the different notional
elements comprising this swap will also be different,
but a flat rate is desired.
• For each element, calculate the present value of an
interest rate annuity at that rate. Take the total of the
PV’s.
 This is the present value of the interest that will be paid on
the comprising swaps.
 Amortizing Swap, 2
• Next, calculate the PV of 1% of the swap
principal in each element, and total.
• The total of the interest PV divided by the total
of the principal PV gives the blended rate.
• There is a residual risk for the market maker as
there is a cash flow mismatch between the
package and the swap elements used to create
it.
 Deferred Start Swap
• … is any swap with the start date of the contract
deferred beyond the usual market terms for settlement
(e.g., a four-year swap priced today but comes into
effect one year from today).
 This is the equivalent of a five-year spot swap less a one-
year spot swap: (swap rate for 5-year swap x annuity
factor) – (swap rate for 1-year swap x annuity factor), all
divided by the annuity factor for the 4-year swap (which is
AF5 – AF1).
 Pricing such a swap is equivalent to pricing the implied
forward rate.
Accreting & Rollercoaster Swaps
• The accreting swap is a package made up of an
initial spot swap and a series of deferred-start
swaps.
 Flat pricing is achieved in exactly the same manner
as for an amortizing swap.
• A rollercoaster swap is a combination of an
accreting and an amortizing swap.
 Swap Credit Exposure
• The expected exposure in an interest rate swap peaks
and then diminishes as:
 Interim payments are made
 Interest rates revert to their mean
• The exposure on a cross-currency swap increases
over time as:
 Rates trend away from the initial price (i.e., there is no
reversion to a mean). This means that the interim interest
payments or re-exchange of principal amounts is becoming
less valuable to one of the parties, thus creating an
exposure equal to the net change in value.
 Expected Loss
• In a lattice, we can calculate the expected loss associated
with each node. In an interest rate swap, this would be
the cost of replacing the swap at that time and interest
rate.
 If we are paying the floating rate, there is no loss associated
with rates that are equal to or higher than the swap’s fixed rate.
 Otherwise, the loss = interest rate differential from the swap’s
fixed rate x principal amount x annuity associated with the
remaining term (given the number of payments that would be
made and the interest rate associated with the node).
 Multiply the value by the probability to get the expected loss
associated with the node.
 Expected Loss, 2
• As we do not know when a loss would occur, we
assume it to be at the mid-point of each year.
 To calculate the loss at t = 1.5, we take the average of the
probability-weighted losses for t = 1 and t = 2.
 Discount by the swap’s fixed rate for 1.5 periods to obtain
the present value.
 The sum of these gives the exposure (i.e., maximum
expected loss) at t = 0.
• Expected loss from default = φ of default x expected
loss if default occurs
 6. Options Basics
• A purchased option provides a non-linear
(asymmetric) payoff with some of the characteristics
of insurance.
• In exchange for the payment of a premium, the holder
(buyer) of a call option has the right, but not the
obligation, to buy a fixed quantity of the underlying
asset at the strike price until expiry.
• In exchange for the payment of a premium, the holder
of a put option has the right, but not the obligation, to
sell a fixed quantity of the underlying asset at the
strike price until expiry.
 More basics
• In each case, the writer (seller) of the option
must take the opposite side of the transaction if
the option is exercised.
• An option may be capable of being exercised
at any time until expiry (American-style) or
only at expiry (European-style).
 In, At or Out-of-the-Money
• In-the-money: the market price is above the
strike price of a call or below the strike price
of a put.
• At-the-money: the market price is equal to the
strike price.
• Out-of-the-money: the market is price is below
the strike price of a call or above the strike
price of a put.
 Intrinsic and Time Value
• The value of an option is comprised of
intrinsic value and time value.
 The intrinsic value is the value of an option if
exercised immediately, with a minimum of zero.
 The remainder is the time value. This value
declines as expiry approaches – a phenomenon
known as time decay.
 Factors Affecting Value
• Time to expiry: more time provides more opportunity
for conditions to favor the outcome.
• Difference between the market price and the strike
price: the amount by which an option is in or out-of-
the-money.
• Price volatility: the greater the degree of potential
price movement and thus a favorable outcome.
• Interest rates: the possibility of deferring a purchase
allows interest to be earned in the interim. This works
against the deferred sale (put).
• Leakages: the underlying asset declines in value when
interest or dividends are paid.
 Put – Call Parity
• P + U = C + PV(K)
• The put price plus the underlying asset price is
equal to the call price (with the same strike)
plus the present value of the strike.
 Fundamental Strategies
• Purchased call
• Purchased put
• Written call
• Written put
• Written call with long position in underlying
(synthetic short put)
• Written put with short position in the
underlying (synthetic short call)
 Combination Strategies
• A vertical spread is a directional strategy with a
purchased call and a written call (or a purchased put
and a written put) with the same expiry but different
strikes. A horizontal or time spread uses different
expiries.
 A ratio spread uses different numbers of puts and calls (a
strap if more calls, a strip if more puts).
 A ladder purchases an additional deep out-of-the-money
option.
• A straddle is the purchase or sale of a put and call
with the same strike and expiry.
• A strangle is the purchase or sale of a put and call,
with the same expiry but different strikes.
 Combination Strategies, 2
• A butterfly spread can be comprised of all puts or all calls,
positioned at three strikes. A long butterfly may buy calls at
+1 and -1 (“the wings”) and sell two ATM (“the body”). If the
market expires at the middle strike, the participant owns an in-
the-money call, another that expires worthless and keeps the
entire premium for writing two calls that expire worthless.
• An iron butterfly uses the same three strikes, but is comprised
of puts and calls. Strikes for a long strangle bracket the strike
for the short straddle, e.g., shorts in the ATM put and call,
long -1 put and long +1 call.
• The condor/iron condor positions use four option strikes, with
the middle options spread apart, creating a price range in
which the trade can reach maximum profit potential.
 7. Option Pricing
• The value of an option is merely the present
value of its expected payoffs.
 The pricing approach for options, like that of
terminal instruments, is derived from the costs
associated with replicating the payoffs.
 The premium is the ex ante compensation from the
buyer to the seller that ensures that the transaction
has an initial zero net present value.
 The General Case
• The general case for pricing calls involves selling the
call (C), holding delta (δ) units of the underlying asset
(A), and borrowing an amount (B) for the period.
 Final asset value – options payout – borrowing cost = 0
 δuA – Cu – Ber(T-t) = 0 (payout when the asset trades up)
 δdA – Cd – Ber(T-t) = 0 (payout when the asset trades down)
• This equality, looked at another way, requires that the
premium received plus the amount borrowed be equal
to the amount required to fund the holding of the
asset.
 Binomial Pricing of a Call
• C = δA + B
• δ = (Cu – Cd) /A(u – d)
 Cu and Cd are the values of the call where the asset price
has risen (u) and fallen (d)
 A(u – d) is the range in the values of the asset
• B = (dCu – uCd) / er(T-t) (u – d)
 Borrowed amount equals the product of the lower asset
value and the call’s value when the price has risen less the
product of the higher asset value and the call’s value when
the price has fallen all divided by the range of asset prices
scaled up for the time and interest rate.
 Binomial Pricing of a Call, 2
• One-period C = [ρCu + (1 – ρ)Cd ] / er(T-t)
• Two-period C = [ρ2Cuu + 2ρ(1 – ρ)Cud + (1 –
ρ)2Cdd ] / e2r(T-t)
• Three period C = [ρ3Cuuu + 3x2ρ(1 – ρ)Cuud +
3ρx2(1 – ρ)Cudd + (1 – ρ)3Cddd ] / e3r(T-t)
 Inputs for Binomial Pricing
• u = eσ x √(T – t) / N
 The size of upward steps (a scalar, so that in two
periods, price = u2; in three steps, price = u3)
• d = e-σ x √(T – t) / N
 The size of downward steps
 By definition, d = 1 / u
• a = er x ((T – t) / N)
 Drift?
• ρ = (a – d) / (u – d)
 Probability of an up move is the ratio of the (drift –
down move) / range
 Put – Call Parity Theorem
• The Law of One Price states that any two
assets, or combination thereof, that have the
same payoffs must trade at the same price in
an efficient market.
 As a put exposure can be created synthetically
from the underlying and calls, the Law will apply
here.
 Asset + Put = Call + PV(Exercise Price)
 Put = Call + PV(Exercise Price) – Asset
 8. The Black-Scholes Model
• The Black-Scholes model provides a closed-
form analytic solution for options pricing. Its
limitations are in its assumptions:
 The variance of returns (volatility) is constant over
the life of the option.
 Interest rates are constant. Funds can be borrowed or
lent at the risk-free rate.
 The asset price moves continuously (no jumps).
 Asset returns follow a log-normal distribution.
 No transaction costs or intermediate payments.
 All assets are perfectly divisible.
 The Formula for a Call
C = U0N(d1) – Ke-r(T-t) N(d2) where
Note that the only
U0 σ2 difference between the d1
ln + [r + ] (T – t) and d2 formulae is in this
K 2 sign. Therefore,
d1 =
σ √ (T – t) d2 = d1 – σ2 (T – t)
σ √ (T – t)
U0 σ2 = d1 – σ √ (T – t)
ln + [r – ] (T – t)
K 2
d2 =
σ √ (T – t)
 Formula Components
• The first term U0 x N(d1) is the holding in the
underlying asset. The second term Ke-r(T-t) x N(d2) is
the amount of borrowed funds.
• N(d) are the cumulative normal probabilities (i.e., 0
=< ρ <= 1) based on a normal distribution with a
mean of zero and a standard deviation of one.
 N(0) = 0.5
 N(d1) + N(-d1) = 1
 If d1 = 1.5, N(d1) = 0.93319 and N(-d1) = 0.06681
 Therefore, U0N(d1) – U0 = U0N(-d1)
 Likewise, PV(K) – PV(K)N(d2) = PV(K)N(-d2)
Deriving the Formula for the Put
• If P + U0 = C + PV(K), and C = U0N(d1) –
PV(K)N(d2), then:
 Isolating the put value,
P = U0N(d1) – PV(K)N(d2) + PV(K) - U0
 Rearranging the terms,
P = PV(K) – PV(K)N(d2) + U0N(d1) - U0
 Simplifying (see previous slide),
P = PV(K)N(-d2) - U0N(-d1)
 Time and Rate Inputs
• T – t: this is expressed as fractions of a year.
 Sometimes a distinction is made between trading days
(~252/ year) and calendar days, based on evidence that
prices are much less volatile when markets are closed.
• Risk-free rate: this is usually the US Treasury bill
rate, which is always quoted in terms of its discount:
 T-bill = 100 – id x [(T – t) / basis], where id is the quoted
discount rate and basis is usually 360 days. At 3% and 90
days to go, T-bill = 0.9925. Relative is the inverse =
1.00756, to the exponent 360/90 = 1.03058
 The model uses the continuously compounding rate, where
r = ln(1 + rs) = ln(1.03058) = 0.03013
 Volatility
• Calculate periodic simple return:
rs = (Pt – Pt-1)/ Pt-1
• Convert to continuously compounding rates:
rc = ln(1 + rs)
• Calculate variance and standard deviation:
σ2 = Σ(rt – rmean)2 / (n – 1)
σ = √σ2
• Annualize by multiplying by the square root of the frequency,
e.g., by √ 52 if the data was weekly.
• The sample’s standard error diminishes as the sample size
increases: SE = σ / √ 2n
 Implied volatility
• This works the Black-Scholes model in
reverse: taking the observable market price,
strike price, interest rate and time to expiry to
derive volatility.
• An approximation:
σ ≈ C √ 2π / U √(T – t)
• With a call priced at 6.5, an underlier at 100
and three months to go:
σ ≈ (6.5 x 2.5066) / (100 x 0.5) = 0.326
 9. The Greeks
• Delta (δ) refers to the option price sensitivity to
changes in the underlying asset.
 This describes the rate of change in the option value to the
change in the asset value.
 The rate of change is not linear. It is highest when the
option is at-the-money, and lowest when it is deeply in- or
out-of-the-money. This relationship is also not symmetrical:
the time value for a deep in-the-money call is comprised
mostly of the benefit of deferring purchase until expiry.
 The delta of a portfolio is the weighted sum of the positive
and negative deltas.
 In the Black-Scholes formulation, this is represented by
N(d1) for the call and N(d1)-1 for the put.
 Gamma
• Gamma (γ) is the rate of change in delta.
 This is the second derivative of option value to price.
 This measures the steepness of the delta curve. Since delta
experiences its greatest change when at-the-money, so too
does gamma.
N’(d1)
γ=
(U0) σ √(T – t)

1 1
where N’(d1) e -0.5(d1)2 = 0.398942
√ 2π
= √2π
 Gamma, 2
• If an option is being hedged with other options with
different conditions, then merely matching deltas will
not fully hedge the exposure. This is because the
values for the written and purchased options will not
change at the same rates.
• The gamma of the portfolio can be zeroed by buying
or selling options to offset, as the ratio of portfolio
gamma/ option gamma requires. This, however, will
also change the delta. Delta neutrality is then restored
by buying or selling the underlying.
 Theta, Lambda
• Theta (θ) is the sensitivity of the option to time.
 As the market price and futures price converge, time value decays –
more quickly for at-the-money options, which have the highest time
value.
U0 σ
θcall = [ N’(d1) – r K e–r (T-t) N(d2) ]
2√(T – t)
U0 σ
θput = [ N’(d1) + r K e–r (T-t) N(-d2) ]
2√(T – t)

• Lambda (λ) is the percentage change in the option price for a

given percentage change in the asset price.
 This ‘gearing’ is an attractive feature for speculators. The highest
lambda is for deep out-of-the-money options.
 (U/K)N(d1) for the call; (U/K)N(d1)-1 for the put.
 Rho, Vega
• Rho (ρ) is the option sensitivity to interest rates.
ρcall = (T – t) K e–r (T- t) N(d2)
ρput = (T – t) K e–r (T- t) N(-d2)

• Vega (not really a Greek letter) and its aliases refer to

the effect of changes in volatility on value.
 This is the single most important determinant of option
value.
 The calculation, for puts and calls:
v = U0 √(T – t) N’(d1)
 Sensitivity Summary
Position Delta Gamm Theta Rho Vega
a
Long call + + - + +
Long put - + - - +
Short call - - + - -
Short put + - + + -

Every option is a race between gamma and theta.

10. Extensions to Option Pricing
• The Black – Scholes model can be modified to
price options:
 When there is a value leakage (e.g., a dividend
payment)
 On an exchange rate between currencies
 When the holder can ‘lock in’ an interest rate
 When there is a possibility of early exercise
 Value Leakage
• The payment of a dividend on a stock reduces
the stock’s value. If this occurs during the
option period, it will increase the value of a
put and decrease the value of a call.
 The model could employ the ex-dividend price:
S* = S – de-r(k – t)
subtracting from the price the present value of the
dividend.
 Continuous Dividend
Adjustment
• When dividends are being paid continuously
(as on a stock index), Merton adjusts the price
of the stock price, U, for the continuous
dividend yield, q.
 Price U term becomes U x e–q(T – t)
 In d1 sub-equation,
r + σ2/2 term becomes r – q + σ2/2
 In d2 sub-equation,
r - σ2/2 term becomes r – q – σ2/2
 Currency Options
• The holder of a foreign currency is the recipient of
payments equal to the risk-free interest rate in the
foreign currency, rc.
 Replace the continuous dividend yield, q, in the previous
example with rc. The domestic rate will be r.
• Note that calls and puts on currencies are the same:
 The call is right to receive the foreign currency in exchange
for the base currency.
 The put is the right to receive the base currency in
exchange for the foreign currency.
 Currency Options, 2
• If we were pricing the option against the forward rate
rather than the spot rate, the continuous form of the
cost of carry model would give the forward rate F at
time T:
 F = FX e(r-rc)(T-t)
 Substituting,
C = [F x N(d1) – K x N(d2)] e-r(T-t)
P = [K x N(-d2) – F x N(-d1)] e-r(T-t)
 In the d1 and d2 sub-equations, the ln(U/K) term becomes
ln(F/K) and the r term is removed.
 Options on Futures, Commodities
• For futures, the foreign currency risk-free yield is replaced
with the continuously-compounding return a, representing the
net cost of carry.
• For commodities, a = r + w – d where
 r is the risk-free rate
 w is storage costs, insurance and deterioration expressed as a yield
 d is the convenience yield
• If the relationship between the underlying and its
corresponding future price incorporate these returns:
 that is, if [ln(F/U)/(T – t )] = r + w – d
 then d = r + w – [ln(F/U)/(T – t)]
 and we replace the U term in the model and sub-equations with Ue(w - d)t
 Early Exercise
• The fundamental question is whether the capture of the
dividend through early exercise justifies the loss of the
remaining time value.
 Optimal when d > K (1 – e–r(T – t))
 Not optimal when d <= K (1 – e–r(T – t))
 The attraction increases as the option approaches expiry.
• The pseudo-American adjustment for dividend sees the call
option is valued twice:
 Once for a European-style option expiring at time T, adjusted for the
leakage
 Once for the same option expiring at the time of the last dividend
 The higher of the two prices is deemed to be the American option.
 Early Exercise, 2
• Early exercise may be attractive for puts since
it liberates value that can then be reinvested.
 This condition arises when the put is deep in-the-
money, when interest rates rise and when volatility
falls.
 If the asset falls below some critical value relative
to the strike price, the put value is simply the
option’s intrinsic value. Above that critical value,
there is a value adjustment to the European
exercise put price.
 American Value Adjustment
• The AVA for a put is based on its strike
relative to that critical value where the put is
worth only its intrinsic value.
• For any put for which we wish to calculate the
AVA, we first calculate three constants:
 M = 2r / σ2
 W = 1 – e-r(T-t)
M
 q1 = ½ [ -(M – 1) - √ (M – 1)2 + 4 ( W )]
 American Value Adjustment, 2
• In the next step, in-the-money strike values U A
are tested iteratively until K – UA = Puteuro + a1
(that is, until the exercised price is equal to the
theoretical price for the European option plus
the a1 value).
UA
• a1 = - ( q1 ) N(d1A)
q 1

• Then* AVA = (U / UA)

* In neither the example in the text nor the Case Study can you
use these methods to come to the proffered result.
 Interest Rate Options (IROs)
• It is surely illogical to use the Black-Scholes option-
pricing model, with its assumption of a constant risk-
free interest rate, to value an option that is based on
changes in interest rates!
• Interest rates do not follow a lognormal distribution –
there is a strong reversion to the mean.
• Price volatility falls as the instrument moves toward
maturity – the pull to par. This again runs counter the
assumptions of the Black-Scholes model.
 Interest Rate Forwards &
Futures
• The methodology using a forward rate is the same as
on the slide “Currency Options, 2”, above.
 The forward rates must first be converted to prices.
• Likewise, futures are quoting prices and not rates.
 To have a call on the interest rate requires that one own the
put on the futures price.
 As the writer often does receive the premium upfront, the
formulae simplify to be based on stochastic rates, without
an imbedded interest rate assumption.
 C = FP ∙ N(d1) - K ∙ N(d2)
 P = K ∙ N(-d2) - FP ∙ N(-d1)
 Pricing a Fraption
(option on a Forward Rate Agreement)

• There are two time periods to consider: the life of the

option and the interest rate protection period.
• The rates are converted to values:
 The notional principal is multiplied by the protection
period to get the cap notional principal
 the underlying (U) is the interest payable on the cap
notional principal at the market rate
 the strike (K) is the interest payable on the cap notional
principal at the FRA forward rate.
• These values are then inserted into the Black-Scholes
model as modified to price an option on a forward.
 Adjusting Bond Volatility
• We expect price volatility on a bond to decrease as it
approaches maturity.
 Schaefer and Schwartz show that the relationship of bond
duration to volatility is constant.
 Therefore, if observed volatility is adjusted by duration,
one can arrive at the correct forward volatility.
 κ (kappa) = ~σ /(Uα-1)∙D , where ~σ is the observed
volatility , U is the underlying, D is duration and α is
estimated at 0.5
 The corrected forward volatility is then σ = (κ ∙ Uα-1) D
 Complex Options
• Payoff: digital (also called Boolean, asset-or-nothing,
and cash-or-nothing)
• Singularity: premium is paid only if the option
expires in-the-money
• Path dependency: barrier (knock outs, knock ins);
lookback (buy or sell at best price in period); Asian
(average in period); ratchet (strike is periodically set
at prevailing price, thus capturing intrinsic value);
shout (holder announces to the writer what the strike
price will be)
• Compound: include cacall – a call on a call, a caput –
a call on a put; and chooser – whether the option in a
future period will be a call or a put.
 Complex Options, 2
• Multivariate: basket (portfolio v. strike); rainbow
(best of or worst of assets listed, or a spread between
assets); quantity-adjusted or ‘quanto’ (e.g., struck in
one currency but paid in another)
• Timing: forward start (strike to be set versus asset
value at a future date); Bermuda (series of option
exercise dates)
• Embedded or ‘embeddoes’: as part of another
financial instrument, e.g., a range floating-rate note
comprised of a written cap and purchased floor
 11. Hedging and Insurance
• The basic principle of hedging is to match two
opposing sensitivities in such a way that their
value changes cancel out.
 Terminal instruments are typically used to hedge
price risk or to make tactical allocations among
assets.
 Options, with their asymmetric payoff, have an
element of insurance. They can be used to hedge a
contingent income stream or liability, or to take a
view, especially on future volatility.
 Hedging Costs
• For hedging to be cost-effective:
 it has to eliminate a large part of the change in value of the
underlying position, and
 it must do so at a lower cost than alternative approaches.
• Hedging is costly in that the user usually pays the bid
– ask spread on transactions. In order to minimize
these costs, the user should take advantage of natural
offsets and portfolio effects, and hedge only the net
position.
 Hedge Ratio
• A forward contract may provide a “perfect hedge”,
albeit with a loss of flexibility and by taking on credit
exposure.
• In using an imperfect hedge, the objective is to find
the minimum-risk hedge ratio (h).
 ΔPcash + hΔPhedge = 0
 As a rule, the naïve one-to-one approach (i.e., h = 1) works
best when the cash position is nearly equivalent to the
characteristics of the futures. The wider the discrepancy,
the greater is the hedging error that will result.
 Hedge Ratio, 2
• If the two sides are less than perfectly
correlated, we can find the minimum-variance
hedge ratio of the portfolio by:
 h = ρcash,hedge x (σcash / σhedge)
where ρcash,hedge is the correlation coefficient
between the cash instrument and the hedging
instrument and σcash and σhedge are the standard
deviations of the cash and hedge instruments. This
defines the regression line.
 Strip and Stack Hedging
• If an exposure covers more than one futures contract
period, the ideal solution is to match the hedging
instrument to the exposure period, a process known
as a strip hedge.
• The alternative stack hedge approach is used when
there is no liquidity in the contracts with longer time
to expiry. The procedure is to ‘stack up’ the hedge
using the nearby contracts and roll forward the
position, reducing the hedge as required over the
exposure period.
 This makes an implicit assumption that all changes in the
yield curve are parallel shifts.
 Convergence in Interest Rates
• An interest rate future is of obligations to buy or sell
the three-month rate prevailing at contract expiry.
 The obligation is priced at 100 – id x [(T – t) / basis], where
id is the quoted discount rate and basis is usually 360 days.
If the applicable was 6.0%, a the contract would be priced
at 98.50.
 The difference between the contract rate and the spot rate is
the current basis. As the contract rate must converge with
the spot rate at expiry, this basis must shrink to zero.
 If the forward curve were upward sloping, then even in the
absence of a change in rates, we expect the futures price to
increase with the passage of time.
 Parallel Shifts and Twists
• If a futures contract had been used to hedge an
interest rate exposure, a parallel shift in the
forward curve would not affect the outcome.
• A twist changes the shape of the yield curve,
and thus the basis relationship. The effect of
convergence may create a basis gain or loss.
The solution lies in setting up a spread position
to mitigate the risk.
 Interest Rate Spreads
• Buy the basis: • Sell the basis:
 Go “long” the spread:
buy nearby contract and
sell the deferred
 Gain if the nearby
increases more quickly /
decreases more slowly
than the deferred (curve
steepens)
 Go “short” the spread:
sell the nearby contract
and buy the deferred.
 Gain if the deferred
increases more quickly /
decreases more slowly
than the nearby (curve
flattens)
 Interest Rate Spreads, 2
• The portion of the original position to spread
is: (time to expiry of deferred contract – time
to maturity of hedge) / time between contracts,
e.g. (4 – 2) / 3.
• If the original hedge was a short, then the
spread will short the nearby and vice versa.
 For a 40 contract short position in the deferred, the
spread would be 2/3 x 40 = ~27, which is -27 in
the nearby and +27 in the deferred (net -27 nearby
and -13 deferred)
 Dynamic Hedging
• A share portfolio’s market risk is modified
using stock index futures as a hedge.
 A portfolio’s sensitivity to market effects is known
as its beta (β).
 The beta is found by regressing the portfolio return
against the index return.

Value of portfolio
 Nstock index futures = β
Value of futures contract
Modifying Interest-Rate Sensitivity
• Calculate the price value of a basis point
(PVBP) for the asset or portfolio:
(D x MVP x .0001) / (1 + y/f), where:
 D is Macaulay duration
 MVP is the market value of the portfolio
 y is the annualized yield to maturity
 f is the frequency of payments per year

This effectively measures cost using the modified

duration (sensitivity measure) for a 1 bp move.
Modifying Interest-Rate Sensitivity,
2
• Divide the difference between the starting and target
positions by the PVBP for the futures contract, which
should include an adjustment for the cheapest-to-
deliver (CTD) eligible bond versus the notional
underlying bond.
• The result indicates the number of futures contracts
required to effect the modification.
 If increased exposure was desired, the sign is positive; if a
hedge, then negative.
 A futures contract protects the nominal value for a fixed
period of three months. Since time is a factor in the value, if
the underlying is more or less than that three months, the
position must be scaled accordingly.
Modifying Interest-Rate Sensitivity,
2
• Divide the difference between the starting and
target positions by the PVBP for the futures
contract.
• The result indicates the number of futures
contracts required to effect the modification.
 If increased exposure was desired, the sign is
positive; if a hedge, then negative.
 A futures contract protects the nominal value for a
fixed period of three months. As time is a factor in
the cost/ revenue of an interest rate, an underlying of
more or less than that three months will require that
the position be scaled accordingly.
 Portfolio Insurance
• With portfolio insurance, a portion of the potential
return from an uninsured portfolio is surrendered in
order to guarantee a minimum portfolio value.
• Rather than purchase puts, a floor can be replicated
with a synthetic put strategy. This involves modifying
the proportion of the portfolio held between a safe
asset (with zero sensitivity to the market) and risky
assets (those exposed to market fluctuations).
• No cash outlays are required, although there are
transaction costs.
 Portfolio Insurance, 2
• As prices increase, more assets are transferred from
the risk-free asset to the risky asset. As prices decline,
more funds are placed in the risk-free asset.
• In constant proportions portfolio insurance (CPPI),
Value in the risky asset = κ (Value of portfolio –
Value of floor)
where κ is a multiplier that determines how quickly
assets are transferred (higher being faster)
• The strategy requires the resetting of the proportion at
a fixed percentage change in the portfolio or in the
cushion (difference between portfolio and floor),
e.g.., at intervals of 5%.
 Removing Market Risk
• A stock may be the target of a takeover bid. This development
would increase its market price without affecting the broader
market.
• While holding the shares, there is a generalized risk of loss.
• A possible market loss could be hedged for the beta times the
value of the holding in the target. If one million shares were
trading at 95 p, and the beta was 1.5, an offsetting market
exposure = £ 950,000 x 1.5 = £1,425,000.
• With the FTSE index at 3891, and each point for a futures
contract worth £ 10, this is a value of £ 38,910 / contract.
Dividing into the exposure gives the contract size of an
offsetting position: £1.425m / 38,910 = 36.6 contracts (~37).
• Buy 37 out-of-the-money puts.
 Removing Market Risk, 2
• A delta hedge takes the strategy further by
selling calls or buying puts with an equivalent
underlying value.
• The product of the beta and portfolio value is
divided by the notional value of the futures
contract, as before. This number is then divided
by the delta corresponding to the option’s
strike.
 £10 million portfolio with a beta of 1.2; FTSE index
at 3891.1 (each point worth £10) and an October
3725 put with a delta of -0.30 and priced at 15.5 =
12 000 000 / (38 911 x 0.30) = 1028 puts x £10 x
15.5 = £ 159 430 outlay
 12. Using the Product Set
Terminal Instruments Costs
(Forwards, Futures, • Lost opportunity to
Swaps) participate in favorable
price move.
• Transaction can be at
Benefits only one price.
• No upfront cost. • Futures may not provide
• Forward will provide exact offset and have
tailored end date and basis risk.
amounts. • Credit risk on forwards
and swaps.
 The Product Set, 2
Options Costs
• Upfront premium
Benefits payment (although
• Provide one-way compound options or a
protection against vertical spread may
adverse changes. reduce cost). In
currency markets, this
• Allow participation in spread is called a
favorable price move. ‘cylinder’.
• Can be priced at one or • Credit risk upon
more strike prices. exercise.
 Do-It-Yourself Forward
• The key is to the transaction is to have the price
determined today, even if components have not run
their course until the future period.
• Company has separate obligation to repay the loan;
both loan and deposit are subject to credit risk
• These transactions can affect the firm’s balance sheet
and accounting ratios, and thus their credit rating
 Do-It-Yourself Forward, 2
• e.g., British company is owed USD 5.0 million
in six months, and wishes to hedge.
 Discount USD receivable to PV using six-month
USD offer rate. (Don’t forget that the rate quoted
is annualized, so use r x ½ )
 Take USD loan for PV amount at USD offer rate.
This rate has to be “corrected” from a 360 to a 365
day year – which factor operates only on the rate r
and not the “1 +” part.
 Convert to £ using bid side of spot rate
 Deposit £ at £ bid rate
 13. Asset-Liability Management
• Against a one-year loan that is repriced
quarterly, a bank could borrow funds:
 on a one-year term that is repriced quarterly: match
funded
 on a three-month term, and then seek new funding
at the end of that term: funding gap
 on a one-year term at a fixed rate: long funded
 on a one-year term that is repriced monthly: short
funded
 Rate Sensitivity Gap
• The exposure to interest rates – the rate sensitivity
gap – is the difference in the repricing characteristics
of the assets to the liabilities.
 Positive gap: assets are repricing before liabilities
 Negative gap: liabilities are repricing before assets
• While the bank may seek to increase / decrease its
rate-sensitive assets (RSA) or liabilities (RSL), their
customers, based on their own expectations, are
trying to shift their interest rate risk to the bank.
 Maturity-Gap Approach
• The bank’s assets and liabilities are bucketed
by time period. Within each bucket:
 Balance sheet assets
 Balance sheet liabilities
 Off balance-sheet instruments
 Net
• This would show the size and periods in which
the bank is exposed to interest rate changes.
 While it shows the volume of assets exposed, it
does not show the volume of that exposure.
 Cash-Gaps Method
• This is a refinement of the maturity gap approach.
 The net cash flows (positive or negative) are accumulated
in each bucket.
 These are present-valued using the zero-coupon rate.
 The present value is recalculated for a level (usually 1 bp)
shift or rotational shift.
• This requires sophisticated and accurate capture of
the cash flows from the underlying assets and
liabilities, but has superior accuracy because it is
modeling these directly.
 The Funding-Gap Method
• Within each time bucket, we calculate the net
of assets less liabilities.
 The PV of the net is calculated assuming a zero-
coupon interest rate.
 The PV is recalculated for parallel shift (1 bp
higher) and rotational shift (1 bp higher at, say, 5
years).
 The sum across buckets indicates the level risk of a
1 bp change.
 Level and Rotational Shift
• If we have a level shift risk of £120,000 and a
rotational shift risk of £145,000:
 If the risks are perfectly correlated, the total risk is
£120,000 + £145,000 = £265,000
 If the risks are perfectly uncorrelated, the total risk
is
√(120,000)2 + (145,000)2 = £188,215
 ALM for Real Assets
• Foreign currency cash flows are projected
• The sensitivity of cash flows and factor costs are
estimated versus the base currency
 If a commodity was repriced immediately in the foreign
currency due to changes in the base currency, it was given
a zero rating (e.g., oil or refined products “shadow priced”
in USD)
 If a commodity was insensitive to such changes, it was
given a 100 rating (e.g., local labor costs)
 This analysis would also attempt to estimate indirect
exposures due to responses from competitors, suppliers and
customers
 ALM for Real Assets, 2
• Future cash flows in the foreign currency were
adjusted for their currency sensitivity by multiplying
them by their sensitivity factor.
 This created a division of exposures to the local currency
and the base currency (unexposed)
 A foreign currency exposure of $150 million and a
sensitivity of 60 produces a foreign currency exposure of
$90 million and a base currency exposure of $60 million.
• A hedging decision is made on the net foreign
exposure only.
 14. Duration Measures
• Macaulay’s duration is the weighted average
maturity (the book calls it the discounted mean term)
of the cash flows in an asset or liability, with the
weights given by the present value of the cash flows.
 A zero coupon bond would have a duration equal to its term,
since all of the value in the bond is paid at maturity.
 A bond with intermediate cash flows will have a shorter
duration. How much shorter depends on the rates used to
discount the flows: higher interest rates imply shorter
duration and lower rates imply higher duration.
 Likewise, the larger the periodic flows relative to the total,
the shorter the duration and vice versa: the coupon effect.
 Loan Types
• Bullet: repays all the principal at maturity
• Amortizing (annuity): level payments are
made in each period consisting of both interest
and principal
• Balloon: initial periods are interest only and
later periods include both interest and principal
• Zero-coupon (“zero”): principal and all of the
interest is repaid at maturity
 Calculating Duration
• A three year 10% coupon bond has cash flows of 10,
10, and 110. If the discount rate is 8%, the PV of
these cash flows = (10/1.08) + (10/1.082) +
(110/1.083) = 9.2593 + 8.5734 + 87.3215 = 105.1542
• Duration = [(9.2593 x 1) + (8.5734 x 2) + (87.3215 x
3)] / 105.1542 = 2.7424 years
• If the cash flows were uneven, each can be
discounted as if it were a zero of that maturity.
 Calculating Duration, 2
coupons principal

C [
(1 + rt)n+1 – (1 + rt) – (rt x n)
rt2(1 + rt)n ] 100 x n
+ (1 + r )n
t
Duration =
PV

PVi = C [ 1 - (1 + ri)n
ri
] +(1100+ r )
i
n
 Calculating Duration, 3
• If the frequency of the (same) payments was
doubled, the duration would be halved. A
quarterly payment would have 0.25 x duration
of an instrument with the same payments
annually.
 Modified Duration
• Macaulay’s duration assumes continuous
compounding. Modified duration is an adjustment to
reflect discrete compounding intervals.
• Modified duration =
Macaulay’s duration /(1 + (ri / f ))
 If the Macaulay’s duration is 4.46 for an instrument with
annual payments when discounted at 6 percent, the
modified duration is: 4.21 = 4.46 / (1.06)
 As the frequency of the payments gets larger, the smaller
the adjustment due to discrete intervals. If payments were
monthly, modified duration is: 4.438 = 4.46 / (1.005)
 Modified Duration, 2
• Modified duration is a measure of the value sensitivity of the
present value of cash flows to a change in interest rates. The
higher the modified duration, the greater the volatility of the
PV.
 Percentage change in price = - Modified duration x Change in yield
 One percent change in PV = 1 / Modified duration
 If modified duration is 4.21, a 10 bp change in rates impacts prices:
0.421% = -4.21 x 0.10
 If the PV is 1000 for an instrument with a modified duration of
4.21, then a 10 bp change would increase / decrease the value by:
$1,000 x 0.421% = +/- $4.21
 Modified Duration, 3
CF
m.d. =
CF
ri2 [ 1
1 - (1 + ri)n ] n(100 - ri
+ (1 + ri)n+1
)

PV
 Error in Modified Duration
Estimate
• Modified duration underestimates price
increases and overestimates price decreases.
When the asset is owned, this is when the rates
go down and up, respectively.
 Although the value impact up or down is predicted
to be the same size, a move of that size represents a
larger proportional decrease than it does a
proportional increase.
 This arises because of an attempt to approximate a
curved price / yield relationship with a tangent line.
 Convexity
• Duration measures the rate of change in value
for a rate in change in interest rates.
 It is the first derivative of the curve, taken at the
present value of the instrument.
 Convexity is the second derivative, and therefore
measures the rate of change in duration for a
change in the underlying rate (like gamma).
 A value change is going to be more precisely
estimated when we consider that, not only has the
underlying changed, but so has the rate of change
in the duration.
 Convexity, 2
This term = 0 when trading at par
Convexity =
CF
2 x CF
(ri)3
[ 1 - (1 +1 r ) ]
i
n
­ 22 x CF xn+1
ri (1 + ri)
n + n(n + 1)(100 – [ ri ])
(1 + ri)n+2

2 x PV
 Convexity, 3
• Convexity percentage value change = Convexity x
(change in r)2 x 100%
 If modified duration predicts a change in value of =/-
4.21% for a 100 bp change, and convexity is 11.4594, to
each we add 0.114594 %
 Increase in rates: -4.21 + 0.114594 = -4.095406
 Decrease in rates: 4.21 + 0.114594 = 4.324594
• As the discount rate increases and duration decreases,
so too does the correction provided by convexity
decrease. As with duration, convexity is greatest for a
zero-coupon asset or liability.
 Uses for Duration
• An anticipated interest rate increase would
decrease the PV of assets, therefore an investor
would attempt to reduce duration.
• An anticipated interest rate decrease would
increase the PV of assets, therefore an investor
would attempt to increase duration.
• The opposite cases apply for liabilities.
 Hedging Interest-Rate Risk
• The asset manager will have a target for the
mean term of liabilities that have to be
matched in terms of the fund’s assets, process
known as immunization.
 If interest rates are expected to rise, making asset
duration < liability duration results in asset out-
performance.
 If interest rates are expected to fall, making asset
duration > liability duration results in asset out-
performance.
 Hedging Interest-Rate Risk, 2
• An attempt to hedge a loan (an asset) would
require a short position (a liability) whose
interest rate sensitivity (modified duration)
would be equal in size, and opposite in sign.
 -MDL / MDH = -ΔL / ΔH = -1
 This term is known as the duration hedge ratio.
The ratio of the modified durations indicates the
ratio of the present value of the loan to the
corresponding hedge.
 Duration-Gap Analysis
• Duration-gap analysis is used to measure risk
in terms of a financial institution’s equity
value.
 This is the difference between the weighted
average duration of the assets and that of the fixed
liabilities, divided by the equity.
 With assets of 2200 at a duration of 2.72, and
liabilities of 2000 at a duration of 1.14, [(2200 x
2.72) – (2000 x 1.14)] / 200 = 18.52
 The sign indicates whether shareholders gain or
lose from an increase in interest rates.
 Limitations of Methodology
• Assumes that there is a constant discount rate
across all maturities.
• Assumes that changes to the term structure of
interest rates are parallel (no twisting).
• Methodology assumes that there are no options
in the portfolio, or that they are so far out of
the money that they can be ignored.
 Approximation Methods
• Duration: Subtract the PV associated with a
small increase in rates from the PV associated
with a similar decrease in rates, all divided by
the product of two times the original price
times the rate increment.
 (P- - P+)/ (2 x P0 x δi)
 For a 6 percent par loan, with a ten basis point
change: (100.4224 – 99.5799) / (2 x 100 x 0.001)
= 4.21245
 Approximation Methods, 2
• Convexity: Subtract two times the original
price from the sum of the PVs associated with
a small decrease / increase in rates, all divided
by the product of two times the original price
times the rate increment squared.
 (P- + P+ - 2 P0) / (2 x P0 x δi2)
 For a 6 percent par loan, with a ten basis point
change: (100.4224 + 99.5799 - 200) / (2 x 100 x
0.0012) = 11.45944
15. Immunization / Liability Funding
• In asset-liability management (ALM), the
central risk is that there may be insufficient
assets available in the future to meet maturing
liabilities.
 Insolvency (bankruptcy): the PV of assets is less
than the PV of liabilities.
 Illiquidity: The PV of assets is equal to or greater
than liabilities, but these cannot readily be realized
(although, presumably, one could borrow against
this asset value).
 Immunization
• Immunization seeks to match known cash flows from
an investment portfolio to expected liabilities.
 Adjustments are made to make the portfolio behave like a
zero coupon bond with a maturity equal to the decision
maker’s investment horizon. This is achieved when the
Macaulay’s duration is equal to the investment horizon.
• The Macaulay duration of a portfolio changes:
 With the passage of time
 Due to the fluctuation of interest rates
Rebalancing the Immunized Portfolio
• Balance requires that two related but opposing
interest rate risks should be fully offsetting:
 Price (market) risk arises when a bond is sold
before maturity.
 Reinvestment risk arises upon the receipt of the
coupons or income stream.
 An increase in rates would aid reinvestment at the
cost of market risk. A decrease in rates aids market
risk at the cost of reinvestment risk.
 Rebalancing, 2
• Immunization risk: Unless the portfolio is actually
comprised of zero-coupon bonds of the same maturity
as the investment horizon, any twisting in the curve
may upset the market / reinvestment balance.
 Like Macaulay duration itself, there is an assumption that
all changes to the interest rates are parallel shifts.
• The rebalancing decision considers:
 The degree of divergence
 Transaction costs
 Rebalancing, 3
• A portfolio with interim cash flows requires a smaller
initial outlay, traded off against the burden of
managing additional cash flows.
 The greater dispersion of cash flows increases the
immunization risk.
 A non-parallel shift (a twist) that lowered short-term rates
and raised longer term rates would produce less income
from interim cash flows and a capital loss on the security.
Convexity measures the portfolio risk to non-parallel shifts.
See next slide for formula for M2.
 As we narrow the dispersion around the target (a barbell),
the immunization risk declines.
 Immunization Risk
(Fong and Vasicek)

M =
2
1
I0
( CF1(1 – H)2
(1 + y)
+
CF2(2 – H)2
(1 + y) 2
+…+
CFn(n – H)2
(1 + y)n
)
I0 = initial investment • Where there is only one
cash flow at time H, 1 – H =
CFt = cash flow at time t
0 therefore M2 = 0
H = investment horizon • M2 ≈ Convexity –
y = yield on portfolio Duration, therefore a larger
convexity has a greater
n = time to last cash flow exposure to twists in rates
Credit Risk and Embedded Options
• Default risk is equivalent to underperforming the
asset value at the investment horizon. Different
responses:
 Invest only in assets with the highest credit quality.
 Select only instruments with an acceptable trade-off
between risk and return.
 Over-collateralize the portfolio to take account of potential
losses.
• There are also trade-offs in owning a callable
security, with a higher return compensating for the
potential re-investment risk.
 Response is to monitor assets and replace those subject to
significant call risk.
 Liability Funding
• Liability funding uses the matching approach to
equate a known liability stream with a set of assets in
such a way that, at each maturing liability, there is a
corresponding cash flow from the assets (multi-period
immunization).
 The matching of asset duration and liability duration is
necessary but not sufficient – assets must be decomposed
into segments so that each liability part is immunized.
 PV of assets must be => PV of liability.
 The asset durations must dominate (i.e., must have a greater
dispersion) those of the liabilities or the assets will be subject
to price risk – as when an asset must be realized at market
values without a corresponding gain in reinvested income.
 Cash Flow Matching
• …(also known as dedication) is a bootstrapping
approach to hedging a set of liabilities by finding
assets that match exactly the future cash outflows.
 This process is like the replacement of cash flows in a
swap, starting with the longest-dated cash flow, and
working to t = 0.
• Symmetric cash matching allows short-term
borrowing to satisfy a liability.
• A hybrid approach, variously known as combination
matching or horizon matching, uses cash flow
matching for earlier liabilities and immunization for
the more distant.