Tutorial 3 – Interest Rates and Interest Rate Management - To verify that this is correct we calculate the value of a bond

To verify that this is correct we calculate the value of a bond that pays a
coupon of 7.072% per year (that is 3.5365 every six months). The value is
Problem 3.1.
¿ 0.1491
The cash prices of six-month and one-year Treasury bills are 94.0 and 89.0. A
The rate of interest is therefore 14.91% per annum. 3.536 e−0.05 ×0.5 +3.5365 e−0.06 × 1.0 +3.536 e−0.065× 1.5 +103.536
1.5-year bond that will pay coupons of $4 every six months currently sells for verifying that 7.072% is the par yield.
Problem 3.3.
$94.84. A two-year bond that will pay coupons of $5 every six months
currently sells for $97.12. Calculate the six-month, one-year, 1.5-year, and Problem 3.7
two-year zero rates. A deposit account pays 12% per annum with continuous compounding, but
interest is actually paid quarterly. How much interest will be paid each quarter Suppose that zero interest rates with continuous compounding are as follows:
on a $10,000 deposit?
6 /94=6.383 % in six
The 6-month Treasury bill provides a return of
months. This is 2 ×6.383=12.766 % per annum with semiannual The equivalent rate of interest with quarterly compounding is R where
compounding or 2 ln (¿ 1.06383)=12.38 % ¿ per annum with Maturity( years) Rate (% per annum)
4
continuous compounding. The 12-month rate is 11/89=12.360 %  R
with annual compounding or ln (¿ 1.1236)=11.65 % ¿ with e 012  1   1 2.0

continuous compounding.
 4 2 3.0
or

1 3 3.7
For the 1 year bond we must have R=4 (e 0.03−1)=0.1218
2 4 4.2

4 e−0.1238× 0.5 +4 e−0.1165 ×1 +104 e−1.5 R=94.84 The amount of interest paid each quarter is therefore: 5 4.5

1
where R is the 1 year zero rate. It follows that 0.1218
2 10,000 × =304.55
4 Calculate forward interest rates for the second, third, fourth, and fifth years.
or $304.55.
3.76+3.56+ 104 e−1.5 R =94.84e−1.5 R=0.8415 The forward rates with continuous compounding are as follows: to
Problem 3.4
R=0.115 R2 T2  R1 T1
or 11.5%. For the 2-year bond we must have T2  T1
Suppose that 6-month, 12-month, 18-month, 24-month, and 30-month zero
rates are 4%, 4.2%, 4.4%, 4.6%, and 4.8% per annum with continuous
Year 2: 4.0%
5 e−0.1238× 0.5 +5 e−0.1165 ×1 +5 e−0.115× 1.5 +105 e−2 R=97.12 compounding respectively. Estimate the cash price of a bond with a face value
of 100 that will mature in 30 months and pays a coupon of 4% per annum
where R is the 2-year zero rate. It follows that semiannually. Year 3: 5.1%

Year 4: 5.7%
e−2 R =0.7977 R=0.113
The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The
cash price is
or 11.3%. Year 5: 5.7%
−0.04 ×0.5 −0.042 ×1.0 −0.044 ×1.5 −0.046 ×2 −0.048× 2.5
2e +2 e +2 e +2 e +102 e =98.04
Problem 3.8.

Problem 3.2. Suppose that the Treasury bond futures price is 101-12. Which of the following
Problem 3.6. four bonds is cheapest to deliver?
What rate of interest with continuous compounding is equivalent to 15% per
annum with monthly compounding? Suppose that the 6-month, 12-month, 18-month, and 24-month zero rates are
5%, 6%, 6.5%, and 7% respectively. What is the two-year par yield?
The rate of interest is R where: Bond Price Conversion Factor
Using the notation in the text, m=2, d=e−0.07 ×2=0.8694 . Also
12 1 125-05 1.2131
 015  −0.05 ×0.5 −0.06 × 1.0 −0.065 ×1.5 −0.07 × 2.0
e  1 
R
 A=e +e +e +e =3.6935 2 142-15 1.3792
 12  The formula in the text gives the par yield as
i.e.,
3 115-31 1.1149
(100−100× 0.8694)×2
0.15 =7.072
R=12 ln 1+ ( 12 ) 3.6935 4 144-02 1.4026
 Problem 4.1

Suppose that the risk-free zero curve is flat at 7% per annum with continuous
4 0.8853 0.8853s 0.7558 0.6691s
The cheapest-to-deliver bond is the one for which compounding and that defaults can occur half way through each year in a new
five-year credit default swap. Suppose that the recovery rate is 30% and the
5 0.8587 0.8587s 0.7047 0.6051s
Quoted Price−Futures Price × Conversion Factor default probabilities each year conditional on no earlier default is 3% Estimate
the credit default swap spread? Assume payments are made annually.
is least. Calculating this factor for each of the 4 bonds we get Total 3.7364s
The table regarding unconditional default probabilities, is

Default probability= Corresponding Default x 1st survival

Bond 1 :125.15625−101.375 ×1.2131=2.178 The table regarding the present value of the expected payoffs (notional
Bond 2 :142.46875−101.375 ×1.3792=2.652 Survival probability=1st survival to power of years(only works for whole years) principal =$1), is

Bond 3 :115.96875−101.375× 1.1149=2.946 Expected payment=survival X S

Bond 4 :144.06250−101.375 ×1.4026=1.874
Bond 4 is therefore the cheapest to deliver. Discount factor= e to the power of –rt Time Probability Recovery Expected Discount PV of
(years) of Default Rate Payoff Factor Expected
Problem 3.9 Pv of expected payment=expected payment x discount factor Payoff

A five-year bond with a yield of 11% (continuously compounded) pays an 8% Expected payoff=1-recovery rate x default 0.5 0.0300 0.3 0.0210 0.9656 0.0203
coupon at the end of each year.
PV of expected payoff=discount factor x expected payoff 1.5 0.0291 0.3 0.0204 0.9003 0.0183

a) What is the bond’s price? Expected accrual payment=default probability/2 x S 2.5 0.0282 0.3 0.0198 0.8395 0.0166
b) What is the bond’s duration?
c) Use the duration to calculate the effect on the bond’s price of a 0.2% Pv of expected accrual payment= expected accrual payment x discount factor 3.5 0.0274 0.3 0.0192 0.7827 0.0150
decrease in its yield.
d) Recalculate the bond’s price on the basis of a 10.8% per annum yield and
verify that the result is in agreement with your answer to (c). 4.5 0.0266 0.3 0.0186 0.7298 0.0136

a) The bond’s price is Time (years) Default Probability Survival Probability Total 0.0838
−0.11 −0.11× 2 −0.11 ×3 −0.11 ×4 −0.11 ×5
8e +8e +8 e +8 e +108 e =86.80 1 0.0300 0.9700

2 0.0291 0.9409 The table regarding the present value of accrual payments, is
b) The bond’s duration is
1
[ 8 e−0.11 + 2× 8 e−0.11× 2+3 × 8 e−0.11×3 + 4 × 8 e−0.11 × 4+ 5× 108
3
e−0.11×5 ] 0.0282 0.9127
86.80
4 0.0274 0.8853 Time Probability of Expected Discount PV of Expected
(years)
5 0.0266 0.8587 Default Accrual Payment Factor Accrual Payment
¿ 4.256 years
0.5 0.0300 0.0150s 0.9656 0.0145s

c) Since, with the notation in the chapter 1.5 0.0291 0.0146s 0.9003 0.0131s
The table regarding the present value of the expected regular payments
ΔB=−BDΔy s
(payment rate is per year), is
the effect on the bond’s price of a 0.2% decrease in its yield is 2.5 0.0282 0.0141s 0.8395 0.0118s

86.80 × 4.256 ×0.002=0.74 3.5 0.0274 0.0137s 0.7827 0.0107s

The bond’s price should increase from 86.80 to 87.54. Time (years) Probability Expected Discount PV of Expected
Payment 4.5 0.0266 0.0133s 0.7298 0.0097s
of Survival Payment Factor
Total 0.0598s
d) With a 10.8% yield the bond’s price is
−0.108 −0.108 ×2 −0.108 ×3 −0.108 ×4 −0.108 ×5 1 0.9700 0.9700s 0.9324 0.9044s
8e +8 e +8 e +8 e +108 e =87.54
This is consistent with the answer in (c). 2 0.9409 0.9409s 0.8694 0.8180s

Tutorial 4 – Credit Risk Derivatives -

3 0.9127 0.9127s 0.8106 0.7398s The credit default swap spread s is given by:
3.7364 s+0.0598 s=0.0838 perfect there is in effect only one company and therefore only one event that
can lead to a payoff.
“The position of a buyer of a credit default swap is similar to the position of
someone who is long a risk-free bond and short a corporate bond.” Explain this
It is 0.0221 or 221 basis points.
statement.
Problem 4.2 When n=25 (so that the swap is a 25th to default) an increase in the
A credit default swap insures a corporate bond issued by the reference entity
default correlation increases the value of the swap. When the default
against default. Its approximate effect is to convert the corporate bond into a
What is the value of the swap in Problem 4.1 per dollar of notional principal to correlation is zero there is virtually no chance that there will be 25 defaults
risk-free bond. The buyer of a credit default swap has therefore chosen to
the protection buyer if the credit default swap spread is 150 basis points? and the value of the swap is very close to zero. As the correlation increases the
exchange a corporate bond for a risk-free bond. This means that the buyer is
probability of multiple defaults increases. In the limit when the correlation is
long a risk-free bond and short a similar corporate bond.
If the credit default swap spread is 150 basis points, the value of the swap to perfect there is in effect only one company and the value of a 25th-to-default
the buyer of protection is: credit default swap is the same as the value of a first-to-default swap.
Problem 4.11

0.0838−(3.7364+ 0.0598)× 0.0150=0.0269 Problem 4.5

Why is there a potential asymmetric information problem in credit default
per dollar of notional principal. swaps?
How is the recovery rate of a bond usually defined? What is the formula
relating the payoff on a CDS to the notional principal and the recovery rate?
Problem 4.3
The recovery rate of a bond is usually defined as the value of the bond a few Payoffs from credit default swaps depend on whether a particular company
What is the credit default swap spread in Problem 4.1 if it is a binary CDS? days after a default occurs as a percentage of the bond’s face value. The defaults. Arguably some market participants have more information about this

If the swap is a binary CDS, the present value of expected payoffs per dollar of
payoff on a CDS is L(1−R) where L is the notional principal and R is that other market participants (see Business Snapshot 23.3).

notional principal is 0.1197 (see the table below) so that the recovery rate.
Problem 4.12

3.7364 s+0.0598 s=0.1197 Problem 4.6

Does valuing a CDS using actuarial default probabilities rather than risk-
The spread, s, is 0.0315 or 315 basis points. neutral default probabilities overstate or understate its value? Explain your
Show that the spread for a new plain vanilla CDS should be 1−R times the answer.
spread for a similar new binary CDS where R is the recovery rate. Real world default probabilities are less than risk-neutral default probabilities.
Dicoun PV of It follows that the use of real world default probabilities will tend to
Prob of Expecte t Expected The payoff from a plain vanilla CDS is1−R times the payoff from a binary understate the value of a CDS.
Time Default d Payoff Factor Payoff CDS with the same principal. The payoff always occurs at the same time on the
two instruments. It follows that the regular payments on a new plain vanilla Tutorial 5 – SWAPS -
0.5 0.03 0.03 0.9656 0.028968
CDS must be 1−R times the payments on a new binary CDS. Otherwise
1.5 0.029 0.029 0.9003 0.0261087 there would be an arbitrage opportunity. Problem 5.1
Explain why a bank is subject to credit risk when it enters into two offsetting
2.5 0.0282 0.0282 0.8395 0.0236739 swap contracts.
Problem 4.8
3.5 0.0274 0.0274 0.7827 0.02144598 At the start of the swap, both contracts have a value of approximately zero. As
A company enters into a total return swap where it receives the return on a time passes, it is likely that the swap values will change, so that one swap has a
4.5 0.0266 0.0266 0.7298 0.01941268 corporate bond paying a coupon of 5% and pays LIBOR. Explain the difference positive value to the bank and the other has a negative value to the bank. If the
Tot between this and a regular swap where 5% is exchanged for LIBOR. counterparty on the other side of the positive-value swap defaults, the bank still
al 0.11960926 has to honor its contract with the other counterparty. It is liable to lose an
In the case of a total return swap a company receives (pays) the increase amount equal to the positive value of the swap.
(decrease) in the value of the bond. In a regular swap this does not happen.
Problem 4.4 Problem 5.2
Companies X and Y have been offered the following rates per annum on a $5
million 10-year investment:
n
How does a five-year th-to-default credit default swap work. Consider a Problem 4.9
basket of 100 reference entities where each reference entity has a probability
of defaulting in each year of 1%. As the default correlation between the Explain how forward contracts and options on credit default swaps are
reference entities increases what would you expect to happen to the value of structured. Fixed Rate Floating Rate
the swap when a) n=1 and b) n=25 . Explain your answer. Company X 8.0% LIBOR
When a company enters into a long (short) forward contract it is obligated to Company Y 8.8% LIBOR
buy (sell) the protection given by a specified credit default swap with a
n
A five-year th to default credit default swap works in the same way as a
specified spread at a specified future time. When a company buys a call (put) Company X requires a fixed-rate investment; company Y requires a floating-
regular credit default swap except that there is a basket of companies. The option contract it has the option to buy (sell) the protection given by a rate investment. Design a swap that will net a bank, acting as intermediary,
n
payoff occurs when the th default from the companies in the basket occurs. specified credit default swap with a specified spread at a specified future time. 0.2% per annum and will appear equally attractive to X and Y.

n
After the th default has occurred the swap ceases to exist. When n=1 (so
that the swap is a “first to default”) an increase in the default correlation
lowers the value of the swap. When the default correlation is zero there are
100 independent events that can lead to a payoff. As the correlation increases
the probability of a payoff decreases. In the limit when the correlation is
Both contracts are normally structured so that they cease to exist if a default
occurs during the life of the contract. The spread between the interest rates offered to X and Y is 0.8% per annum on
fixed rate investments and 0.0% per annum on floating rate investments. This
means that the total apparent benefit to all parties from the swap is 0.8% per
Problem 4.10 annum. Of this 0.2% per annum will go to the bank. This leaves 0.3% per
annum for each of X and Y. In other words, company X should be able to get a
fixed-rate return of 8.3% per annum while company Y should be able to get a
floating-rate return LIBOR + 0.3% per annum. The required swap is shown in
Figure S7.1. The bank earns 0.2%, company X earns 8.3%, and company Y
r f =0.03 , the spot and forward exchange rates at the end of year 6 are financial intermediary requires 50 basis points, each of A and B can be made 25
basis points better off. Thus a swap can be designed so that it provides A with
earns LIBOR + 0.3%. U.S. dollars at LIBOR +¿ 0.25% per annum, and B with Canadian dollars at
Spot: 0.8000 6.25% per annum. The swap is shown in Figure S7.2.
1 year forward: 0.8388
2 year forward: 0.8796
3 year forward: 0.9223
4 year forward: 0.9670

The value of the swap at the time of the default can be calculated on the
assumption that forward rates are realized. The cash flows lost as a result of the
default are therefore as follows:

Problem 5.3 Year Dollar CHF Forward Dollar Equiv Cash Flow
A financial institution has entered into an interest rate swap with company X. Paid Received Rate of CHF Lost
Under the terms of the swap, it receives 10% per annum and pays six-month Received Principal payments flow in the opposite direction to the arrows at the start of
LIBOR on a principal of $10 million for five years. Payments are made every the life of the swap and in the same direction as the arrows at the end of the life
six months. Suppose that company X defaults on the sixth payment date (end of of the swap. The financial institution would be exposed to some foreign
year 3) when the LIBOR/swap interest rate (with semiannual compounding) is exchange risk which could be hedged using forward contracts.
8% per annum for all maturities. What is the loss to the financial institution? 6 560,000 300,000 0.8000 240,000 -320,000
Assume that six-month LIBOR was 9% per annum halfway through year 3. Use
LIBOR discounting 7 560,000 300,000 0.8388 251,600 -308,400 Problem 5.7
8 560,000 300,000 0.8796 263,900 -296,100 Why is the expected loss from a default on a swap less than the expected loss
At the end of year 3 the financial institution was due to receive $500,000 ( from the default on a loan with the same principal?
9 560,000 300,000 0.9223 276,700 -283,300
¿ 0.5 ×10% of $10 million) and pay $450,000 (¿ 0.5 ×9 % of $10 10 7,560,000 10,300,000 0.9670 9,960,100 2,400,100 In an interest-rate swap a financial institution’s exposure depends on the
million). The immediate loss is therefore $50,000. To value the remaining swap difference between a fixed-rate of interest and a floating-rate of interest. It has
we assume than forward rates are realized. All forward rates are 8% per annum. no exposure to the notional principal. In a loan the whole principal can be lost.
The remaining cash flows are therefore valued on the assumption that the Discounting the numbers in the final column to the end of year 6 at 8% per
annum, the cost of the default is $679,800.
floating payment is 0.5 ×0.08 × 10,000,000=$ 400,000 Note that, if this were the only contract entered into by company Y, it would
Problem 5.8
A bank finds that its assets are not matched with its liabilities. It is taking
and the net payment that would be received is make no sense for the company to default just before the exchange of payments floating-rate deposits and making fixed-rate loans. How can swaps be used to
500,000−400,000=$ 100,000 . The total cost of default is at the end of year 6 as the exchange has a positive value to company Y. In offset the risk?
therefore the cost of foregoing the following cash flows: practice, company Y is likely to be defaulting and declaring bankruptcy for
reasons unrelated to this particular transaction.
The bank is paying a floating-rate on the deposits and receiving a fixed-rate on
3 year: $50,000
the loans. It can offset its risk by entering into interest rate swaps (with other
3.5 year: $100,000 Problem 5.5 financial institutions or corporations) in which it contracts to pay fixed and
4 year: $100,000 Companies A and B face the following interest rates (adjusted for the receive floating.
4.5 year: $100,000 differential impact of taxes):
5 year: $100,000
A B Problem 5.9
Discounting these cash flows to year 3 at 4% per six months, we obtain the cost Explain how you would value a swap that is the exchange of a floating rate in
of the default as $413,000. US Dollars LIBOR+0.5% LIBOR+1.0% one currency for a fixed rate in another currency.
(floating rate)
Problem 5.4 Suppose that floating payments are made in currency A and fixed payments are
Canadian dollars 5.0% 6.5%
A financial institution has entered into a 10-year currency swap with company made in currency B. The floating payments can be valued in currency A by (i)
(fixed rate)
Y. Under the terms of the swap, the financial institution receives interest at 3% assuming that the forward rates are realized, and (ii) discounting the resulting
per annum in Swiss francs and pays interest at 8% per annum in U.S. dollars. cash flows at appropriate currency A discount rates. Suppose that the value is
Interest payments are exchanged once a year. The principal amounts are 7
million dollars and 10 million francs. Suppose that company Y declares
V A . The fixed payments can be valued in currency B by discounting them at
bankruptcy at the end of year 6, when the exchange rate is $0.80 per franc. Assume that A wants to borrow U.S. dollars at a floating rate of interest and B the appropriate currency B discount rates. Suppose that the value is V B . If Q
What is the cost to the financial institution? Assume that, at the end of year 6, wants to borrow Canadian dollars at a fixed rate of interest. A financial
the interest rate is 3% per annum in Swiss francs and 8% per annum in U.S. institution is planning to arrange a swap and requires a 50-basis-point spread. is the current exchange rate (number of units of currency A per unit of currency
dollars for all maturities. All interest rates are quoted with annual If the swap is equally attractive to A and B, what rates of interest will A and B B), the value of the swap in currency A is V A −QV B. Alternatively, it is
compounding. end up paying?
V A /Q−V B in currency B.
When interest rates are compounded annually Company A has a comparative advantage in the Canadian dollar fixed-rate
T market. Company B has a comparative advantage in the U.S. dollar floating- Problem 5.10
 1 r  rate market. (This may be because of their tax positions.) However, company A The LIBOR zero curve is flat at 5% (continuously compounded) out to 1.5
F0  S 0 
 1  r 
wants to borrow in the U.S. dollar floating-rate market and company B wants to years. Swap rates for 2- and 3-year semiannual pay swaps are 5.4% and 5.6%,
borrow in the Canadian dollar fixed-rate market. This gives rise to the swap respectively. Estimate the LIBOR zero rates for maturities of 2.0, 2.5, and 3.0
 f  opportunity. years. (Assume that the 2.5-year swap rate is the average of the 2- and 3-year
where F 0 is the T-year forward rate, S0 is the spot rate, r is the domestic The differential between the U.S. dollar floating rates is 0.5% per annum, and swap rates and use LIBOR discounting.)
the differential between the Canadian dollar fixed rates is 1.5% per annum. The
risk-free rate, and r f is the foreign risk-free rate. As r =0.08 and difference between the differentials is 1% per annum. The total potential gain to The two-year swap rate is 5.4%. This means that a two-year LIBOR bond
all parties from the swap is therefore 1% per annum, or 100 basis points. If the
paying a semiannual coupon at the rate of 5.4% per annum sells for par. If R2 What are the most important aspects of the design of a new futures contract? Does a perfect hedge always succeed in locking in the current spot price of an
asset for a future transaction? Explain your answer.
is the two-year LIBOR zero rate The most important aspects of the design of a new futures contract are the
2.7 e−0.05 ×0.5 + 2.7 e−0.05 ×1.0 +2.7 e−0.05 ×1.5 +102.7 e−R ×2.0 =100 2
specification of the underlying asset, the size of the contract, the delivery No. Consider, for example, the use of a forward contract to hedge a known
arrangements, and the delivery months. cash inflow in a foreign currency. The forward contract locks in the forward
Solving this gives R2=0.05342. The 2.5-year swap rate is assumed to
exchange rate, which is in general different from the spot exchange rate.
be 5.5%. This means that a 2.5-year LIBOR bond paying a semiannual coupon
at the rate of 5.5% per annum sells for par. If R2.5 is the 2.5-year LIBOR zero Problem 6.3
rate Problem 6.7
2.75 e−0.05 ×0.5 +2.75 e−0.05 × 1.0+ 2.75 e−0.05× 1.5 +2.75 e−0.05342×2.0 R ×2.5
Explain
+102.75 e−protect
how margin investors
=100 against the possibility of default.
2.5

Explain why a short hedger’s position improves when the basis strengthens
Solving this gives R2.5 =0.05442. The 3-year swap rate is 5.6%. This unexpectedly and worsens when the basis weakens unexpectedly.
means that a 3-year LIBOR bond paying a semiannual coupon at the rate of
Margin is money deposited by an investor with his or her broker. It acts as a
R3 is the three-year LIBOR zero rate
5.6% per annum sells for par. If guarantee that the investor can cover any losses on the futures contract. The
The basis is the amount by which the spot price exceeds the futures price. A
short hedger is long the asset and short futures contracts. The value of his or
−0.05 ×0.5 −0.05 × 1.0
+2.8 e−0.05 ×1.5 +2.8 e−0.05342× 2.0
balance in the margin account is adjusted daily to reflect gains and losses on
2.8 e +2.8 e the futures contract. If losses are above a certain level, the investor is required
her position therefore improves as the basis increases. Similarly it worsens as
the basis decreases.
+2.8 e−0.05442× 2.5 +102.8 e−R × 3.0=100 3 to deposit further margin. This system makes it unlikely that the investor will
default. A similar system of margin accounts makes it unlikely that the
Solving this gives R3=0.05544. The zero rates for maturities 2.0, 2.5, investor’s broker will default on the contract it has with the clearing house
and 3.0 years are therefore 5.342%, 5.442%, and 5.544%, respectively. member and unlikely that the clearing house member will default with the Problem 6.8
clearing house.
Problem 5.11 “If the minimum-variance hedge ratio is calculated as 1.0, the hedge must be
OIS rates have been estimated as 3.4% for all maturities. The three-month perfect." Is this statement true? Explain your answer.
LIBOR rate is
3.5%. For a six-month swap where payments are exchanged every three
Problem 6.4 The statement is not true. The minimum variance hedge ratio is
months the swap
rate is 3.6%. All rates are expressed with quarterly compounding. What is the
LIBOR forward rate for the three-month to six-month period if OIS discounting A trader buys two July futures contracts on frozen orange juice. Each contract σS
is used? is for the delivery of 15,000 pounds. The current futures price is 160 cents per ρ
pound, the initial margin is $6,000 per contract, and the maintenance margin σF
Suppose that the LIBOR forward rate is F. Assume a principal of $1000. A is $4,500 per contract. What price change would lead to a margin call? Under
swap where 3.6% ($9 per quarter) is received and LIBOR is paid is worth zero. what circumstances could $2,000 be withdrawn from the margin account? It is 1.0 when ρ=0.5 and σ S=2 σ F . Since ρ<1.0 the hedge is
The exchange at the three-month point to the party receiving fixed is worth clearly not perfect.
9−8.75 There is a margin call if more than $1,500 is lost on one contract. This happens
=0.2479 if the futures price of frozen orange juice falls by more than 10 cents to below Problem 6.9
1+ 0.034/ 4 150 cents per lb. $2,000 can be withdrawn from the margin account if there is
The exchange at the six-month point to the party receiving fixed is worth a gain on one contract of $1,000. This will happen if the futures price rises by The standard deviation of monthly changes in the spot price of live cattle is (in
9−1000 × F /4 6.67 cents to 166.67 cents per lb. cents per pound) 1.2. The standard deviation of monthly changes in the futures
price of live cattle for the closest contract is 1.4. The correlation between the
¿¿ futures price changes and the spot price changes is 0.7. It is now October 15. A
Hence
beef producer is committed to purchasing 200,000 pounds of live cattle on
9−1000 × F /4 +0.2479 = 0 Problem 6.5
November 15. The producer wants to use the December live-cattle futures
¿¿ Show that, if the futures price of a commodity is greater than the spot price
contracts to hedge its risk. Each contract is for the delivery of 40,000 pounds of
so that F = 3.701%. cattle. What strategy should the beef producer follow?
during the delivery period, then there is an arbitrage opportunity. Does an
arbitrage opportunity exist if the futures price is less than the spot price?
The optimal hedge ratio is
Explain your answer.
Tutorial 6 – Forwards and Futures contract -
If the futures price is greater than the spot price during the delivery period, an 1.2
Problem 6.1
arbitrageur buys the asset, shorts a futures contract, and makes delivery for an 0.7 × =0.6
immediate profit. If the futures price is less than the spot price during the 1.4
The party with a short position in a futures contract sometimes has options as delivery period, there is no similar perfect arbitrage strategy. An arbitrageur The beef producer requires a long position in
to the precise asset that will be delivered, where delivery will take place, when
delivery will take place, and so on. Do these options increase or decrease the
can take a long futures position but cannot force immediate delivery of the 200000 ×0.6=120,000 lbs of cattle. The beef producer should
asset. The decision on when delivery will be made is made by the party with therefore take a long position in 3 December contracts closing out the position
futures price? Explain your reasoning. the short position. Nevertheless companies interested in acquiring the asset on November 15.
will find it attractive to enter into a long futures contract and wait for delivery
These options make the contract less attractive to the party with the long to be made.
position and more attractive to the party with the short position. They
therefore tend to reduce the futures price. Problem 6.10
Problem 6.6
A trader owns 55,000 units of a particular asset and decides to hedge the
Problem 6.2 value of her
 position with futures contracts on another related asset. Each futures contract
is on 5,000
¿ 2.95 The maximum profit is limited to the put premium received and is achieved
i.e., it is $2.95. The forward price is: when the price of the underlying is at or above the option’s strike price at
units. The spot price of the asset that is owned is $28 and the standard expiration. The maximum loss is unlimited for an uncovered put writer.
deviation of the 45 e0.1 × 0.5=47.31
or $47.31.
change in this price over the life of the hedge is estimated to be $0.43. The
Problem 7.2
futures price of Problem 6.12

the related asset is $27 and the standard deviation of the change in this over
the life of the
hedge is $0.40. The coefficient of correlation between the spot price change
and futures
price change is 0.95.
(a) What is the minimum variance hedge ratio?
(b) Should the hedger take a long or short futures position?
(c) What is the optimal number of futures contracts with no tailing of the
hedge?
(d) What is the optimal number of futures contracts with tailing of the hedge?
The risk-free rate of interest is 7% per annum with continuous compounding, Suppose that a European put option to sell a share for $60 costs $8 and is
and the dividend yield on a stock index is 3.2% per annum. The current value of held until maturity. Under what circumstances will the seller of the option
the index is 150. What is the six-month futures price? (the party with the short position) make a profit? Under what circumstances
will the option be exercised? Draw a diagram illustrating how the profit
Using equation (5.3) the six month futures price is from a short position in the option depends on the stock price at maturity of
the option.
(0.07−0.032)×0.5
150 e =152.88
or $152.88. Ignoring the time value of money, the seller of the option will make a profit
if the stock price at maturity is greater than $52.00. This is because the cost
Tutorial 7 – OPTIONS Contracts - to the seller of the option is in these circumstances less than the price
received for the option. The option will be exercised if the stock price at
maturity is less than $60.00. Note that if the stock price is between $52.00
Problem 7.1
and $60.00 the seller of the option makes a profit even though the option is
exercised. The profit from the short position is as shown below.
Compare the rights and potential obligations of

(i) A buyer of a call option

(ii) A seller of a call option
(iii) A buyer of a put option
(a) The minimum variance hedge ratio is 0.95×0.43/0.40=1.02125.
(iv) A seller of a put option
(b) The hedger should take a short position.
(c) The optimal number of contracts with no tailing is
1.02125×55,000/5,000=11.23 (or 11 when rounded to the nearest whole
number) Call options provide the holder the right to purchase an underlying asset at
(d) The optimal number of contracts with tailing is a specified price (the strike price), for a certain period of time. If the stock
1.012125×(55,000×28)/(5,000×27)=11.65 (or 12 when rounded to the nearest
whole number). fails to meet the strike price before the expiration date, the option expires
Problem 6.11 and becomes worthless. Investors buy calls when they think the share price
of the underlying security will rise or sell a call if they think it will fall. Selling
A one-year long forward contract on a non-dividend-paying stock is entered
into when the stock price is $40 and the risk-free rate of interest is 10% per a call option means the writer is (legally) obligated to seller the underlying
annum with continuous compounding.
security of the option is exercised.

a) What are the forward price and the initial value of the forward contract? Put options give the holder the right to sell an underlying asset at a specified
b) Six months later, the price of the stock is $45 and the risk-free interest rate is
still 10%. What are the forward price and the value of the forward contract? price. The seller (or writer) of the put option is obligated to buy the stock at
the strike price. Put options can be exercised at any time before the option

a) The forward price, F 0, is given by equation (5.1) as: expires. Investors buy puts if they think the share price of the underlying Problem 7.3
0.1×1 stock will fall or sell one if they think it will rise. Put buyers, those who hold
F =40 e
0 =44.21 Explain why the arguments leading to put–call parity for European options
or $44.21. The initial value of the forward contract is zero. a “long” put, are either speculative buyers looking for leverage, or insurance
cannot be used to give a similar result for American options.
buyers who want to protect their long positions in a stock for the period of
time covered by the option. Put sellers hold a short, expecting the market to When early exercise is not possible, we can argue that two portfolios that
b) The delivery price K in the contract is $44.21. The value of the contract, f, move upward, or at least stay stable. are worth the same at time T must be worth the same at earlier times.
after six months is given by equation (5.5) as:
−0.1 × 0.5
When early exercise is possible, the argument falls down. Suppose that
f =45−44.21e
P  S  C  Ke  rT . This situation does not lead to an arbitrage
opportunity. If we buy the call, short the put, and short the stock, we cannot
be sure of the result because we do not know when the put will be Give an intuitive explanation of why the early exercise of an American put or $5.06.
exercised. becomes more attractive as the risk-free rate increases and volatility
decreases. Problem 7.10

Problem 7.4
What is a lower bound for the price of a six-month call option on a non-
dividend-paying stock when the stock price is $80, the strike price is $75,
and the risk-free interest rate is 10% per annum?
The lower bound is
The early exercise of an American put is attractive when the interest earned What is the price of a European put option on a non-dividend-paying stock
on the strike price is greater than the insurance element lost. When interest when the stock price is $69, the strike price is $70, the risk-free interest rate
rates increase, the value of the interest earned on the strike price increases is 5% per annum, the volatility is 35% per annum, and the time to maturity is
making early exercise more attractive. When volatility decreases, the six months?
insurance element is less valuable. Again, this makes early exercise more
attractive.
In this case,
S0  69 , K  70 , r  005 ,   035 , and
Problem 7.8 T  05 .

80  75e 0105  $866 The price of a European call that expires in six months and has a strike price
ln(69  70)  (005  0352  2)  05
of $30 is $2. The underlying stock price is $29, and a dividend of $0.50 is
Problem 7.5 d1   01666
expected in two months and again in five months. The term structure is flat, 035 05
What is a lower bound for the price of a two-month European put option on with all risk-free interest rates being 10%. What is the price of a European
put option that expires in six months and has a strike price of $30? d 2  d1  035 05  00809
a non-dividend-paying stock when the stock price is $58, the strike price is
The price of the European put is
$65, and the risk-free interest rate is 5% per annum?
Using the notation in the chapter, put-call parity, equation (10.10), gives
The lower bound is 70e 00505 N (00809)  69 N ( 01666)
 rT
c  Ke  D  p  S0
0052 12
65e  58  $646 or
 70e0025  05323  69  04338
 rT
Problem 7.6
p  c  Ke  D  S0
In this case
A one-month European put option on a non-dividend-paying stock is  640
01 6 12 01 2 12 01512 or $6.40.
currently selling for $2.50. The stock price is $47, the strike price is $50, and p  2  30e  (05e  05e )  29  251
the risk-free interest rate is 6% per annum. What opportunities are there for In other words the put price is $2.51. Tutorial 8 – Value At Risk (VAR) -
an arbitrageur?
Problem 7.9 Problem 8.1
In this case the present value of the strike price is

50e 006112  4975 . Because What is the price of a European call option on a non-dividend-paying stock Explain the difference between value at risk and expected shortfall.
when the stock price is $52, the strike price is $50, the risk-free interest rate
is 12% per annum, the volatility is 30% per annum, and the time to maturity Value at risk is the loss that is expected to be exceeded (100 – X)% of the time
25  4975  4700 is three months? inN days for specified parameter values, X andN . Expected shortfall is
the condition in equation (10.5) is violated. An arbitrageur should borrow the expected loss conditional that the loss is greater than the Value at Risk.

S0  52 , K  50 , r  012 ,   030 , and

$49.50 at 6% for one month, buy the stock, and buy the put option. This
generates a profit in all circumstances. Problem 8.2
In this case,

If the stock price is above $50 in one month, the option expires worthless, T  025 . Consider a position consisting of a $100,000 investment in asset A and a
$100,000 investment in asset B. Assume that the daily volatilities of both
but the stock can be sold for at least $50. A sum of $50 received in one assets are 1% and that the coefficient of correlation between their returns is
month has a present value of $49.75 today. The strategy therefore ln(52  50)  (012  032  2)025 0.3. What is the 5-day 99% value at risk for the portfolio?
generates profit with a present value of at least $0.25. d1   05365
030 025 The standard deviation of the daily change in the investment in each asset is
If the stock price is below $50 in one month the put option is exercised and d 2  d1  030 025  03865 $1,000. The variance of the portfolio’s daily change is
the stock owned is sold for exactly $50 (or $49.75 in present value terms). The price of the European call is
The trading strategy therefore generates a profit of exactly $0.25 in present 1,00 02 +1,00 02 +2 ×0.3 ×1,000 ×1,000=2,600,000
52 N (05365)  50e 012025 N (03865)
value terms. The standard deviation of the portfolio’s daily change is the square root of this
or $1,612.45. The standard deviation of the 5-day change is
Problem 7.7
 52  07042  50e 003  06504
 506 1,612.45 × √ 5=$ 3,605.55
From the tables of N ( x ) we see that N (−2.33)=0.01. This 1.49 22 × 0.000 62+ 1.46 32 × 0.0005 2−2× 0.8 ×1.492 ×0.0006
VF: contract price for interest rate future
×1.463 × 0.0005
means that 1% of a normal distribution lies more than 2.33 standard
deviations below the mean. The 5-day 99 percent value at risk is therefore
¿ 0.000000288 DF: Duration of asset underlying futures at maturity
2.33×3,605.55 = $8,400.93.
P: Value of portfolio being hedged
The standard deviation is therefore $0.000537 million. The 10-day 99% VaR is
Problem 8.3
0.000537 × √ 10 ×2.33=$ 0.00396 million. DP: Duration of portfolio at hedged maturity
The volatility of a certain market variable is 30% per annum. Calculate a 99%
confidence interval for the size of the percentage daily change in the variable. Three month hedge is required for a $10 million portfolio. Duration of the
Problem 8.7
portfolio in 3 months will be 6.8 years.

The volatility per day is 30/ √ 252=1.89 %. There is a 99% chance Consider a position consisting of a $300,000 investment in gold and a
$500,000 investment in silver. Suppose that the daily volatilities of these two
3-month T-bond futures price is 93-02 so that contract price is $93,062.50
that a normally distributed variable will be within 2.57 standard deviations. (take 02/32 x 1000 + 93000)
We are therefore 99% confident that the daily change will be less than assets are 1.8% and 1.2%, respectively, and that the coefficient of correlation
between their returns is 0.6. What is the 10-day 97.5% value at risk for the
2.57 ×1.89=4.86 % . portfolio? By how much does diversification reduce the VaR? Duration of cheapest to deliver bond in 3 months is 9.2 years

Problem 8.4 The variance of the portfolio (in thousands of dollars) is 10,000,000  6.8
 79.42
Number of contracts for a 3-month hedge is 93,062.50  9.2
Explain how an interest rate swap is mapped into a portfolio of zero-coupon
bonds with standard maturities for the purposes of a VaR calculation. 0.01 82 ×30 02 +0.01 22 ×50 0 2+2 ×300 ×500 × 0.6 ×0.018 ×0.012=104.04

When a final exchange of principal is added in, the floating side is equivalent a
The standard deviation is √ 104.04=10.2. Since
zero-coupon bond with a maturity date equal to the date of the next payment. N (−1.96)=0.025, the 1-day 97.5% VaR is
The fixed side is a coupon-bearing bond, which is equivalent to a portfolio of 10.2 ×1.96=19.99 and the 10-day 97.5% VaR is
zero-coupon bonds. The swap can therefore be mapped into long and short
positions in zero-coupon bonds with maturity dates corresponding to the √ 10 ×19.99=63.22. The 10-day 97.5% VaR is therefore $63,220.
payment dates. A cash flow mapping procedure can then be used to map each The 10-day 97.5% value at risk for the gold investment is
S
of the zero-coupon bonds to positions in the adjacent standard-maturity zero-
coupon bonds.
5,400 × √ 10 ×1.96=33,470. The 10-day 97.5% value at risk for h
F
Optimal hedge ratio:
the silver investment is 6,000 × √ 10 ×1.96=37,188. The
Problem 8.5 diversification benefit is Optimal number of contracts:

Explain why the linear model can provide only approximate estimates of VaR
for a portfolio containing options.
33,470+37,188−63,220=$ 7,438 
h *Q A
QF no tailing

The change in the value of an option is not linearly related to the percentage h *V A
change in the value of the underlying variable. The linear model assumes that 
Formulas V F tailing
the change in the value of a portfolio is linearly related to percentage changes
in the underlying variables. It is therefore only an approximation for a portfolio
containing options. PMT
PV 
Perpetuity: r
Problem 8.6
 R 
Some time ago a company entered into a forward contract to buy £1 million Rc  m ln 1  m  Forward price: F0 = S0(1+r)T
for $1.5 million. The contract now has six months to maturity. The daily  m 
volatility of a six-month zero-coupon sterling bond (when its price is translated
Conversion formulas:
 
R m  m e Rc / m  1 R: T-year risk-free rate of interest
to dollars) is 0.06% and the daily volatility of a six-month zero-coupon dollar
bond is 0.05%. The correlation between returns from the two bonds is 0.8. The With known dollar income: F0 = (S0 – I )erT
current exchange rate is 1.53. Calculate the standard deviation of the change (100  100 d ) m
c
in the dollar value of the forward contract in one day. What is the 10-day 99% Par Yield: A I =the present value of the income during life of forward contract
VaR? Assume that the six-month interest rate in both sterling and dollars is 5%
per annum with continuous compounding.
n
 ci e  yti  B With known yield: F0 = S0 e(r–q )T
t  i    Dy
The contract is a long position in a sterling bond combined with a short Duration: i 1  B , B q: average yield during the life of the contract (expressed with continuous
−0.05 ×0.5
position in a dollar bond. The value of the sterling bond is1.53 e compounding)
PD P
or $1.492 million. The value of the dollar bond is 1.5 e−0.05 ×0.5 or $1.463 value, f, of a long forward contract: (F0 − K)e−rT
million. The variance of the change in the value of the contract in one day is V D
Duration based hedge ratio: F F
value of a short forward contract: (K – F0 )e–rT
consumption assest (storage F0 e  rT e kT  E ( ST )
F0 £ S0 e(r+u )T or
F0  E ( ST )e ( r  k )T
u: the storage cost per unit time as a percent of the asset value.

F0 £ (S0+U )erT Lower bound call option: S0 – Ke –rT

U: the present value of the storage costs. Lower bound put option: Ke –rT – S0

Futures price and expected futures spot price Put-call parity: c + Ke -rT = p + S0

 year
 day 
Daily volatilities: 252