Derivatives

Derivative
Level 2 -- 2017
Instructor: Feng
Brief Introduction
Topic weight:
Study Session 1-2 Ethics & Professional Standards 10 -15%
Study Session 3 Quantitative Methods 5 -10%
Study Session 4 Economics 5 -10%
Study Session 5-6 Financial Reporting and Analysis 15 -20%
Study Session 7-8 Corporate Finance 5 -15%
Study Session 9-11 Equity Investment 15 -25%
Study Session 12-13 Fixed Income 10 -20%
Study Session 14 Derivatives 5 -15%
Study Session 15 Alternative Investments 5 -10%
Study Session 16-17 Portfolio Management 5 -10%
Weights: 100%
Brief Introduction
Content:
Ø SS 14: Derivative Investments: Valuation and Strategies
ü Reading 40: Pricing and Valuation of Forward
Commitments
ü Reading 41: Valuation of Contingent Claims
ü Reading 42: Derivatives Strategies
Brief Introduction
考纲对比:
Ø 与2016年相比，2017年的考纲几乎全部改变。
ü Reading 40 和 Reading 41的主要内容在2016年考纲中基
本也都有，但考纲的结构和表述几乎全部改变；
ü Reading 42是新增的，从2016年三级内容中调整到二级。
Brief Introduction
推荐阅读:
Ø 期权、期货及其它衍生产品
ü John C.Hull 著
ü ISBN: 978-7-1114-8437-0
ü 机械工业出版社
Brief Introduction
学习建议:
Ø 本门课程难度比较大，计算公式很多，一定要着重理解
和总结；
Ø 知识点之间的类比关系比较强，建议把第一部分学透后，
在继续学后面的知识点；
Ø 可以适当多做一些题，熟悉解题步骤，提高做题速度；
Ø 最重要的，认真、仔细的听课。
Brief Introduction
Review of Derivatives in Level 1
Tasks:
Ø Review the basics of derivative instrument;
Ø Review the fundamental of derivative pricing.
Forward commitment
Ø Contracts entered into at one point in time that require
both parties to engage in a transaction at a later point in
time (the expiration) on terms agreed upon at the start.
üForward, future, and swap
Contingent claim
Ø Derivatives in which the outcome or payoff is dependent on
the outcome or payoff of an underlying asset.
üOption
Forward
Ø An over-the-counter derivative contract in which two parties
agree that one party, the buyer, will purchase an underlying
asset from the other party, the seller, at a later date at a
fixed price (forward price) they agree on when the contract
is signed.
üIn addition to the (forward) price, the two parties also
agree on several other matters, such as the identity and
the quantity of the underlying.
Futures
Ø Futures contracts are specialized forward contracts that
have been standardized and trade on a future exchange.
üFuture contracts have specific underlying assets, times to
expiration, delivery and settlement conditions, and
quantities.
üThe exchange offers a facility in the form of a physical
location and/or an electronic system as well as liquidity
provided by authorized market makers.
Swap
Ø An over-the-counter derivative contract in which two parties
agree to exchange a series of cash flows whereby one party
pays a variable series that will be determined by an
underlying asset or rate and the other party pays either (1) a
variable series determined by a different underlying asset or
rate or (2) a fixed series.
üA swap is a series of (off-market) forwards.
Price of forward commitment
Ø The fixed price or rate at which the underlying will be
purchased at a later date.
üGenerally may not change as the (expected) price of the
underlying asset changes.
Value of forward commitment
Ø The difference of “with the position” from “without the
position”.
üMay increase or decrease as the (expected) price of the
underlying asset changes.
Option
Ø A derivative contract in which one party, the buyer, pays a
sum of money to the other party, the seller or writer, and
receives the right to either buy or sell an underlying asset at
a fixed price either on a specific expiration date or at any
time prior to the expiration date.
ü An option is a right, but not an obligation.
ü Default in options is possible only from the short to the
long.
Option (Cont.)
Ø Option premium (c0, p0): payment to seller from buyer.
Ø Call option: right to buy.

Ø Put option: right to sell.
Ø Exercise price/strike price (X): the fixed price at which the

underlying asset can be purchased.
Ø American option: exercisable at or prior to expiration.

Ø European option: exercisable only at expiration.
Arbitrage
Ø Arbitrage is a type of transaction undertaken when two
assets or portfolios produce identical results but sell for
different prices.
Ø Law of one price:
üAssets that produce identical future cash flows regardless
of future events should have the same price;
üTrader will exploit the arbitrage opportunity quickly (buy
low and sell high), then make the prices converge.
Replication
Ø Creation of an asset or portfolio from another asset,
portfolio, and/or derivative.
Ø An asset and a hedging position of derivative on the asset
can be combined to produce a position equivalent to a risk-
free asset.
ü Asset + Derivative = Risk-free asset
ü Asset - Risk-free asset = -Derivative
ü Derivative - Risk-free asset = - Asset
• A “-” sign indicates a short position, or borrowing at Rf.
No arbitrage pricing
Ø Determine the price of a derivative by assuming that there
are no arbitrage opportunities (no arbitrage pricing).
üThe derivative price can then be inferred from the
characteristics of the underlying and the derivative, and
the risk-free rate.
Ready! Go!
Pricing and Valuation of Forward Contract
Tasks:
Ø Describe how forward contracts is priced and
valued;
Ø Calculate and interpret the no-arbitrage value of
forward contract.
Pricing of forward
Ø If the underlying asset generates no periodic cash flow, the
forward price can be calculated as follows:
F0(T) = S0×(1+r)T
üS0: spot price;
ür: risk free rate.
Carry arbitrage model
Ø When the forward contract is overpriced, F0(T) > S0(1+r)T,
Cash-and-Carry Arbitrage is available:
üAt initiation, borrowing money S0 at risk-free rate, buying
(long) the spot asset, and selling (short) the forward at F0(T);
• Initial investment at initiation: $0;
üAt expiration, settling the short position on forward
contract by delivering the asset.
• Profit at expiration: F0(T) - S0(1+r)T.
Carry arbitrage model
Ø When forward contract is underpriced, F0(T) < S0(1+r)T,
Reverse Cash-and-Carry Arbitrage is available:
üAt initiation, borrowing and selling (short) the spot asset,
investing the proceed S0 at risk-free rate, and buying (long)
the forward at F0(T).
• Initial investment at initiation: $0;
üAt expiration, paying F0(T) to settle the long position on
forward contract, and delivering the spot asset to close the
short position on spot asset.
• Profit at expiration: S0(1+r)T- F0(T).
Pricing of forward
Ø If the underlying asset generates periodic cash flow, the
forward price can be calculated as:
F0(T) = (S0- γ+ θ)(1+r)T
üγ: benefit of carrying the spot asset, in present value form;
üθ: cost of carrying the spot asset, in present value form;
üγ - θ: net cost of carry.
Valuation of forward
Ø In the financial world, we generally define value as the
value to the long position.
Ø At initiation, the forward contract has zero value.
• Neither party to a forward transaction pays to enter the
contract at initiation.
V0(T) = 0
Valuation of forward (Cont.)
Ø During its life (t < T), the value of a forward contract is:
Vt(T) = (St - γt + θt) - F0(T)(1+r)-(T-t)
üϴt: present value of the cost of holding an asset (t to T);
üγt: present value of the benefit of holding an asset (t to T);
Ø At expiration, the value of a forward contract is:
VT(T) = ST - F0(T)
Example
Ø Assume that at Time 0 we entered into a one-year forward
contract with price F0(T) = 105. Nine months later, at Time t
= 0.75, the observed price of the stock is S0.75 = 110 and the
interest rate is 5%. Calculate the value of the existing
forward contract expiring in three months.
Ø Solution:
Vt(T) = St - F0(T)(1+r)-(T-t) = 110 – 105(1+5%)-0.25 = 6.273
Summary
Ø Importance: ☆☆☆
Ø Content:
ü Pricing and valuation of forward contract on underlying
with/without cash flows.
Ø Exam tips:
ü 是forward pricing and valuation的一般形式，对后面的学
习非常重要，但考试一般都是靠后面具体的forward
contract。
Pricing and Valuation of Equity and Currency
Forward
Tasks:
Ø Describe how equity and currency forward
contracts is priced and valued;
equity and currency forward contract.
Pricing and Valuation of Equity Forward
Pricing and valuation of equity forward
Ø If the underlying is a stock and has discrete dividends, then
forward price can be calculated as:
F0(T) = (S0- PVD0)×(1+r)T or: F0(T) = S0×(1+r)T - FVDT
üPVD: present value of expected dividends;
üFVD: future value of expected dividends.
Ø The value of equity forward can be calculated as:
Vt(T) = (St - PVDt) - F0(T)(1+r)-(T-t)
Example
Ø Suppose Nestlé stock is trading for CHF70 and pays a CHF2.20
dividend in one month. Further, assume the Swiss one-month
risk-free rate is 1.0%, quoted on an annual compounding
basis. Assume that the stock goes ex-dividend the same day
the single stock forward contract expires. Thus, the single
stock forward contract expires in one month. Calculate the
one-month forward price for Nestlé stock.
Ø Solution:
1
F0 (T) = S 0  1+r  - FVDT = 70  (1 + 0.01)
T
12
- 2.2 = 67.86
Example
Ø Suppose we bought a one-year forward contract at 102 and
there are now three months to expiration. The underlying is
currently trading for 110, and interest rates are 5% on an
annual compounding basis. If there are no other carry cash
flows, calculate the forward value of the existing contract.
Ø Solution:
- T - t 
Vt  T  = (S t - PVD t ) - F0  T 1 + r 
= 110 - 102  1 + 0.05 
-0.25
= 9.24
Pricing and valuation of equity index forward
Ø For equity index, the forward price is usually calculated as if
the dividends are paid continuously:
c c
F0 (T) = S 0  e(Rf - δ )T
c
üR f : continuously compounded risk-free rate;
c
ü δ : continuously compounded dividend yield.
Ø The value of equity index forward can be calculated as:
c c
Vt (T) = St  e- δ  (T - t) - F0 (T)  e- Rf  (T - t)
Example
Ø The continuously compounded dividend yield on the EURO
STOXX 50 is 3%, and the current stock index level is 3,500.
The continuously compounded annual interest rate is 0.15%.
Calculate the three month forward price.
Ø Solution:
(R cf  c )  T
F0 (T) = S 0  e  3500  e (0.15% 3%)  0.25  3475.15
Pricing and Valuation of Currency Forward
Pricing of currency forward
Ø The price of currency forward can be calculated by covered
interest rate parity (IRP):
T
 1 + RDC 
F0 (T) = S0   
 1 + RFC 
üF0(T) and S0 are quoted by direct quotation: DC/FC;

üRDC: interest rate of domestic currency;
üRFC: interest rate of foreign currency.
Ø For continuously compounded risk-free rate:
c c
(RDC - RFC )T
F0 (T) = S0  e
Pricing and Valuation of Equity and Currency Forward
Valuation of currency forward
Ø The value of currency forward can be calculated as:
Vt (T) = S t  (1+RFC )-(T-t) - F0 (T)  (1+RDC )-(T-t)
Ø For continuously compounded risk-free rate:
c c
-RFC (T - t) -RDC (T - t)
Vt (T) = St  e - F0 (T)  e
Example
Ø A corporation sold Euro(€) against British pound (£) forward
at a forward rate of £0.8 for €1 at Time 0. The current spot
market at Time t is such that €1 is worth £0.75, and the
annually compounded risk-free rates are 0.80% for the
British pound and 0.40% for the Euro. Assume at Time t
there are three months until the forward contract expiration.
Calculate the forward price Ft(£/€, T) at Time t and the value
of foreign exchange forward contract at Time t.
Answer:
Ø The forward price Ft(£/€, T) at Time t:
T-t 0.25
 1 + RDC   1 + 0.8% 
Ft (T) = S t     0.75     0.7507
 1 + RFC   1 + 0.4% 
Ø The value of foreign exchange forward contract at Time t:

St F0 (T)
Vt (T) = -[ - ]
(1+RFC )T-t (1+RDC )T-t
0.8 0.75
= 0.25
 0.25
= £0.0499
(1  0.4%) (1  0.8%)
Summary
Ø Content:
ü Pricing and valuation of equity forward;
ü Pricing and valuation of currency forward.
Ø Exam tips:
ü 常考点：计算题。
Pricing and Valuation of FRA
Tasks:
Ø Describe how interest rate forward contracts is
priced and valued;
interest rate forward contract.
Forward rate agreement (FRA)
Ø A FRA is an over-the-counter (OTC) forward contract in
which the underlying is an interest rate (e.g. Libor).
üLong position can be viewed as the obligation to take a
loan at the contract rate (i.e., borrow at the fixed rate,
floating receiver); gains when reference rate increase;
üShort position can be viewed as the obligation to make a
loan at the contract rate (i.e., lend at the fixed rate, fixed
receiver); gains when reference rate decrease.
The notation of FRA
Ø The notation of FRA is typically “a×b FRA”:
üa: the number of months until the contract expires;
üb: the number of months until the underlying loan is settled.
Ø Example: 3×9 FRA
3×9 FRA
Today 3 months 9 months

(a) (b)
The uses of FRA
Ø Lock the interest rate or hedge the risk of borrowing or
lending at some future date.
üOne party will pay the other party the difference (based on
notional value) between the interest rate specified in the
FRA and the market interest rate at contract settlement.
• If forward rate < spot rate, the long receives payment;
• If forward rate > spot rate, the short receives payment.
Pricing of FRA
Ø The “forward price” in FRA is actually a forward rate, it can
be calculated from the spot rates.
üFRA rate is just the unbiased estimate of the forward rate;
• Recall the forward rate model in “Fixed Income Level 2”;
• But we use simple interest for money market instrument.
• Note: Libor rates are add-on rate and quoted on a
30/360 day basis in annual terms.
Pricing of FRA (Cont.)
Ø Forward rate models show how forward rates can be
extrapolated from spot rates.
30  b  30  a   30   b  a  
1  Sb    1  Sa  
  1  FR  
360  360   360 
30  b
1  Sb 
360
0 30  a
a 30   b  a  b
1  Sa  1  FR 
360 360
Example
Ø Based on market quotes on Canadian dollar (C$) Libor, the
six-month C$ Libor and the nine-month C$ Libor are
presently at 1.5% and 1.75%, respectively. Assume a 30/360-
day count convention. Calculate the 6×9 FRA fixed rate.
Ø Solution:
[1+(1.5%×180/360)]×[1+(FRA rate×90/360)]
= [1+(1.75%×270/360)]
So, FRA rate = 2.22%
Valuation of FRA at expiration (t = a)
Ø Although the interest on the underlying loan comes at the
end of the loan, the FRA is settled at the expiration of FRA.
üFor “a×b FRA”, the “interest saving” due to the FRA
position comes at “Time b”, but is settled at “Time a”;
üSo the “interest saving” need to be discounted to “Time a”
to calculate the value of FRA.
 Days 
NP  (Underlying rate - Forward rate)   
 360 
Vt 
 Days 
1  Underlying rate   
 360 
Example: 1  4 FRA
Ø Specification of 1  4 FRA:
üTerm = 30 days
üNotional amount = $1 million
üUnderlying rate = 90-day LIBOR
üForward rate = 7%
At t = 30 days, 90-day LIBOR = 8%, clarify the payment
(value) of this FRA.
Solution: 1  4 FRA
Ø Underlying floating rate > fixed rate, so long position
receives payment.
T0 T30 T120
Forward Expiry of FRA; Interest saving:

rate: 7% 90-day Libor: 8% (8%-7%) x 90/360 x $1m
= $2,500
Payment = $2,450.98
Discount at LIBOR for 90 days

$2,500/[1+(8% x 90/360)]
Example
Ø In 30 days, a UK company expects to make a bank deposit of
£10M for a period of 90 days at 90-day Libor set 30 days
from today. The company is concerned about a decrease in
interest rates. Its financial adviser suggests that it negotiate
today, at Time 0, a 1×4 FRA, an instrument that expires in
30 days and is based on 90-day Libor. The company enters
into a £10M notional amount 1×4 receive-fixed FRA that is
advanced set, advanced settled.
Example (Cont.)
Ø After 30 days, 90-day Libor in British pounds is 0.55%. If the
FRA was initially priced at 0.60%, the payment received by
the UK company to settle it will be closest to?
Solution:
Ø Because the UK company receives fixed in the FRA, it
benefits from a decline in rates.
[10M×(0.006 – 0.0055)×0.25]/[1 + 0.0055×0.25]
= £1248.28
Valuation of FRA prior to expiration (t < a)
Ø Step 1: calculate the new FRA rate (FRt):
1  Sb  t   1  Sa  t   1  FR t 
bt at ba
Ø Step 2: calculate the value of FRA as:

 Days from a to b 
NP  (FR t - FR 0 )   
 360 
Vt 
 Days from t to b 
1  Sb  t   
 360 
0 t a b
Initiation date Evaluation date FRA expires Underlying matures
Example
Ø We entered a long 6×9 FRA at a rate of 0.86%, with notional
amount of C$ 10M. The 6-month spot C$ Libor was 0.628%,
and 9-month C$ Libor was 0.712%. After 90 days have
passed, the 3-month C$ Libor is 1.25% and the 6-month C$
Libor is 1.35%. Calculate the value of the receive-floating
6×9 FRA.
Answer:
Ø Step 1:
[1 + (1.25%×90/360)]×[1 + (new FRA rate×90/360)]
= [1 + (1.35%×180/360)]
So, new FRA rate = 1.46%
Ø Step 2:
Vt = 10M×(1.46% -0.86%)×0.25/(1+1.35%×90/360)
= 14900
Summary
Ø Content:
ü Pricing and valuation of FRA.
Ø Exam tips:
ü 常考点：FRA value 的计算。
Pricing and Valuation of Fixed-Income Forward
Tasks:
Ø Describe how fixed income forward contracts is
priced and valued;
fixed income forward contract.
Pricing and Valuation of Fixed Income Forward
Pricing and valuation of fixed income forward
Ø Similar to equity forward, the forward price of fixed income
forward can be calculated as:
F0(T) = (S0- PVC0)×(1+r)T or: F0(T) = S0×(1+r)T - FVCT
üPVC: present value of expected coupon payment;
üFVC: future value of expected coupon payment.
Ø The value of fixed income forward can be calculated as:
Vt(T) = (St - PVCt) - F0(T)×(1+r)-(T-t)
Or: Vt(T) = [Ft(T) - F0(T)]×(1+r)-(T-t)
Example
Ø One month ago, we purchased five euro-bond forward
contracts with two months to expiration and a contract
notional of €100,000 each at a price of 145 (quoted as a
percentage of par). The euro-bond forward contract now has
one month to expiration and the current forward price is 148.
Assume the risk-free rate is 0.1%, calculate the value of the
euro-bond forward position.
Answer:
Ø Vt(T) = [Ft(T) - F0(T)]×(1+r)-(T-t)
= (148 - 145)×(1+0.1%)-1/12 = 2.9997
So, the value of the forward position is:
0.029997×€100,000×5 = €14998.5
Pricing of fixed income futures
Ø In terms of fixed income futures, there are several unique
issues:
üThe prices of bonds are often quoted without accrued
interest (i.e. flat price, clean price).
üBond futures contracts often have more than one bond
that can be delivered by the short (delivery option), and
conversion factor (CF) is used in an effort to make all
deliverable bonds roughly equal in price.
• Price paid = Futures price×CF
Pricing of fixed income futures (Cont.)
üWhen multiple bonds can be delivered for a futures
contract with particular maturity, a cheapest-to-deliver
(CTD) bond typically emerges after adjusting for the
conversion factor.
Ø Calculation of accrued interest (AI):
t
AI=  PMT
T
T
t PMT PMT+F
0 settlement 1 ……… n
date
Ø The quoted price of fixed income futures can be calculated as:
Quoted futures price = [(S0 - PVC)×(1+r)T - AIT]/CF
or: Quoted futures price = [S0×(1+r)T - AIT - FVC]/CF
üAIT: the accrued interest at maturity of the futures contract;
üS0: bond full price;
• S0 = Quoted price + AI0
• AI0: the accrued interest at initiation of the future contract.
üCF: the conversion factor.
Example
Ø Suppose the underlying of Euro-bond futures is a German
bond that is quoted at €108 and has accrued interest of
€0.083. The euro-bond futures contract matures in one
month. At expiration, the underlying bond will have accrued
interest of €0.25 and have no coupon payments due until the
futures contract expires. Assume the conversion factor of the
underlying bond is 0.729535 and the current one-month
risk-free rate is 0.1%, calculate the price of the Euro-bond
futures.
Answer:
Ø According to the example:
üCF = 0.729535; T = 1/12; FVC = 0; r= 0.1%;
üS0 = €108 + €0.083 = €108.083;
üAIT = €0.25;
Ø So the futures price is:
[108.083×(1 + 0.1%)1/12 - 0.25]/0.729535 = €147.82
Pricing and Valuation of Forward and Futures
A brief summary
Ø The forward or futures price is simply the value of the
underlying adjusted for any carry cash flows;
Ø The forward value is simply the present value of the
difference in forward prices at an intermediate time in the
contract;
Ø The futures value is zero after marking to market because
profits and losses are settled daily. The time value of money
makes it not equivalent to forward value, but the differences
tend to be small.
Summary
Ø Importance: ☆☆
Ø Content:
ü Pricing and valuation of fixed income forward.
ü Pricing and valuation of fixed income futures.
Ø Exam tips:
ü 常考点：fixed income forward price 和 value的计算。
Pricing and Valuation of Interest Rate Swap
Tasks:
Ø Describe how interest rate swap is priced and
valued;
interest rate swap.
Swap
Ø There are three kinds of swaps:
üInterest rate swaps
• If A loans money to B for a fixed rate of interest and B
loans the same amount to A for floating rate of interest.
üCurrency swaps
• If the loans are in two different currencies.
üEquity swaps
• If one of the returns streams is based on a stock
portfolio or index return.
Interest rate swap
Ø Plain Vanilla interest rate swap is an interest rate swap in
which one party pays a fixed rate (fixed-rate payer) and the
other pays a floating rate (floating-rate payer).
üNotional amount is not exchanged at the beginning or the
end of the swap, because both loans are in same currency
and amount;
üOn settlement dates, interest payments are netted;
üFloating rate payments are typically made in arrears.
Pricing of interest rate swap
Ø Principle: the fixed rate in swap (FS, swap rate) should
makes the contract value zero at initiation.
Ø Methodology:
üA receive-floating, pay-fixed swap is equivalent to being
long a floating-rate bond and short a fixed-rate bond;
üIf both bonds are priced at par, the initial cash flows are
zero and the par payments at the end offset each other;
üSo, the coupon rate of fixed-rate bond should equal the
swap rate.
Example of receive-floating, pay-fixed interest rate swap
S0- FS S1- FS … Sn-1- FS

Swap
0 t1 t2 tn
Long floating-
S0
= S1 … Sn-1+Par
rate bond
Short fixed- - FS - FS … - FS-Par
rate bond
0 t1 t2 tn
Pricing of Plain Vanilla interest rate swap
Ø At initiation, the floating-rate bond has a value equal to its
par value, what we should do is to find a fixed-rate bond
with a value equal to the same par value at initiation.
PVFixed rate bond = PVFloating rate bond = Par value
Pricing of Plain Vanilla interest rate swap (Cont.)
Ø Assume F as the periodic coupon payment of the n-period
fixed-rate bond with par value of $1.
1 = F  D1 + F  D2 + F  D3 + ...+ F  Dn + 1  Dn
wherein:
Dn = discount factor or PV factor, the price of zero-coupon
bond with par value of $1 and maturity of n periods.
Ø Then, we have:
1 - Dn
F=
D1 + D2 + D3 + ... + Dn
Example
Ø Suppose we are pricing a five-year Libor-based interest rate
swap with annual resets (30/360 day count). The estimated
present value factors are given in the following table.
Calculate the fixed rate of the swap.
Maturity (years) Present value factors
1 0.990099
2 0.977876
3 0.965136
4 0.951529
5 0.937467
Answer:
1 - Dn
F=
D1 + D2 + D3 + ... + Dn
1 - 0.937467
=
0.990099 + 0.977876 + 0.965136 + 0.951529 + 0.937467
= 1.3%
Valuation of Plain Vanilla interest rate swap
Ø The value of a swap is the difference of value between the
floating-rate bond and the fixed-rate bond at any time
during the life of the swap.
ü For fixed-rate payer (floating-rate receiver):
Vt(T) = PVFloating-rate bond – PVFixed-rate bond
ü For fixed-rate receiver (floating-rate payer):
Vt(T) = PVFixed-rate bond – PVFloating-rate bond
Valuation of Plain Vanilla interest rate swap (Cont.)
Ø Note: the value of a floating rate bond will be equal to the
par value at each settlement date.
üAt each settlement date, the coupon rate of a floating rate
will be reset to the market rate, so the bond will be price
at par.
Example
Ø Two years ago, we entered a annual-reset €100M 7-year
receive-fixed interest rate swap with fixed swap rate of 2%.
The estimated PV factors are given in the following table.
We know the current equilibrium fixed swap rate is 1.3%.
Calculate the value for the party receiving the fixed rate.
Maturity (years) PV Factors
1 0.990
2 0.978
3 0.965
4 0.952
5 0.938
Answer:
Ø Because the value of the floating rate bond is equal to the
new fixed rate bond, so the value of the swap is the
difference of value between the old fixed rate bond and the
new fixed rate bond:
(Fold -Fnew )  (D1 + D2 + D3 + D4 + D5 )  100M
=(2%-1.3%)  (0.990+0.978+0.965+0.952+0.938)  100M
=3.376M
Summary
Ø Content:
ü Pricing and valuation of interest rate swap.
Ø Exam tips:
Pricing and Valuation of Currency and Equity Swap
Tasks:
Ø Describe how currency and equity swap is priced
and valued;
currency and equity swap.
Currency swap
Ø Currency swap involves two different currencies.
üThe principle amount of currency swap is exchanged at the
beginning according to the exchange rate, and returned at
termination;
üOn settlement dates, interest payments are not netted;
üFloating rate payments are typically made in arrears.
Currency swap (Cont.)
Ø There are four possible structures for currency swap:
üReceive fixed and pay fixed;
üReceive floating and pay fixed;
üReceive fixed and pay floating;
üReceive floating and pay fixed.
Pricing and valuation of currency swap
Ø The pricing and valuation of currency swap are similar to
that of interest rate swap:
üThe fixed rate in a currency swap is simply the swap rate
calculated from the spot rates of the corresponding
currency;
1 - Dn
F=
D1 + D2 + D3 + ... + Dn
üThe value of a swap is the difference of value between the
two equivalent bonds.
Equity swap
Ø There are 3 types of equity swaps, and there are no “pricing”
problem for the last two type.
ü Equity return for fixed rate;
ü Equity return for floating rate;
ü Equity return for another equity return.
Ø The equity leg of an equity swap can be an individual stock,
a published stock index, or a custom portfolio; and the
equity leg cash flow can be with or without dividends.
Equity swap (Cont.)
Ø Notional amount is not exchanged at the beginning or the
end of the swap.
Ø On settlement dates, payments are netted.
Pricing of equity swap
Ø The pricing of equity swap is similar to that of interest rate
swap, we can use the same formula to calculate the fixed
rate:
1 - Dn
F=
D1 + D2 + D3 + ... + Dn
Valuation of equity swap
Ø Valuation of equity swap is also similar to that of interest
rate swap, and equals the difference of value between the
two legs of the equity swap.
ü For receive fixed rate, pay equity return swap:
Vt(T) = PVFixed-rate bond – (St/St-)×NP
• St: the current equity price;
• St-: the equity price observed at the last reset date.
Valuation of equity swap (Cont.)
ü For receive floating rate, pay equity return swap:
Vt(T) = PVFloating-rate bond – (St/St-)×NP
ü For receive equity (1) return, pay another equity (2) return
swap:
Vt(T) = (S1,t/S1,t-)×NP – (S2,t/S2,t-)×NP
or: Vt(T) = (R1 – R2)×NP
• R: equity return after the last reset date.
Example
Ø An investor pays the stock A return and receives stock B
return in a $1 million quarterly-pay swap. After one month,
stock A is up 2% and stock B is down 1%. Calculate the value
of the swap to the investor.
Answer:
Vt(T) = (-2% – 1%)×$1,000,000 = $30,000.
Summary
Ø Content:
ü Pricing and valuation of currency swap;
ü Pricing and valuation of equity swap.
Ø Exam tips:
Binomial Option Valuation Model (1)
Tasks:
Ø Describe and interpret the binomial option
valuation model;
Ø Identify an arbitrage opportunity involving options
and describe the related arbitrage.
Binomial Option Valuation Model
Binomial option valuation model
Ø Binomial model is based on the idea that, over the next
period, some value will change to one of two possible
values.
Ø To construct a binomial model, we need to know the
beginning asset value ( S0 ), the size of the two possible
changes( U, D ), and the probabilities of each of these
changes occurring ( πU, πD ).
One-period binomial model (Cont.)
Prob. = πU C+ = Max (0, S+ − X)
S+ = U×S0
P+ = Max (0, X − S+)
S0
C− = Max (0, S− − X)
Prob. = πD S- = D×S0
P− = Max (0, X − S−)
T=0 T=1
ü πU = (1 + Rf - D)/(U - D), risk-neutral probability of an up-
move;
ü πD = 1 - πU, risk-neutral probability of an down-move.
Ø With one-period binomial model, the value of an option on
stock can be calculated as:
ü Step 1: Calculate the payoff of the option at maturity in
both the up-move (C+, P+) and down-move states (C-, P-);
ü Step 2: Calculate the expected value of the option in one
period as the probability-weighted average of the payoffs
in each state;
ü Steps 3: Discount this expected value back to today at the
risk-free rate.
Ø Value of an call option:
C0 = ( πU×C+ + πD×C− )/( 1 + Rf )T
Ø Value of an put option:
P0 = ( πU×P+ + πD×P− )/( 1 + Rf )T
Example
Ø A non-dividend-paying stock is currently trading at €100. A
call option on the stock has one year to mature and exercise
price of €100. Assume the risk-free interest rate is 5.15%
and a single-period binomial option valuation model where
U = 1.35 and D = 0.74, calculate the call option value.
Answer:
Ø S+ = US0 = 1.35×100 = 135; S– = DS0 = 0.74×100 = 74;
Ø C+ = Max(0, S+ – X) = 35; C– = Max(0, S- – X) = 0;
Ø πU = (1 + Rf - D)/(U - D)
= (1 + 5.15% - 0.74)/(1.35 - 0.74) = 0.511;
Ø πD = 1 – πU = 0.489;
Ø Value of the call option:
C0 = ( πU×C+ + πD×C− )/( 1 + Rf )T
= (35×0.511 + 0.489×0)/1.0515 = 17.01
Arbitrage opportunity involving options
Ø If the option market price is different from the calculated
price from the binomial valuation model, an arbitrage
opportunity exist:
üIf market price > calculated price, sell the option and buy h
shares of the stock for each option we sold;
C C  - C -
• h: hedge ratio, or delta, h    -
S S - S
üIf market price < calculated price, buy the option and sell h
shares of the stock for each option we bought.
Example
Ø A non-dividend-paying stock is currently trading at €100. A
call option on the stock has one year to mature and exercise
price of €100. Assume the risk-free interest rate is 5.15%
and a single-period binomial option valuation model where
u = 1.35 and d = 0.74.
üCalculate the hedge ratio.
üDescribe the arbitrage opportunity if the market value of
the call option is €12.
Answer:
Ø S+ = US0 = 135; S- = DS0 = 74;
Ø C+ = Max(0,S+ – X) = 35; C- = Max(0,S- – X) = 0;
Ø Hedge ratio: h = ( C+ - C− )/( S+ - S- ) = 35/61 = 0.574;
Ø Because the market price of option (€12) is lower than the
calculated arbitrage-free price (€17.01, calculated in previous
example), an arbitrage profit can be earned by buy the call
option and sell 0.574 share of the stock for each option we
bought.
Summary
Ø Content:
ü Binomial option valuation model and its components;
ü Arbitrage opportunities involving option;
ü Hedge ratio.
Ø Exam tips:
ü 常考点：one-period option value的计算, hedge ratio 的计
算；本任务也是option定价基本方法的介绍，对后面的
学习很重要。
Binomial Option Valuation Model (2)
Tasks:
Ø Calculate the no-arbitrage values of European and
American options using a two-period binomial model;
Ø Calculate and interpret the value of an interest rate
option using a two-period binomial model.
Two-period binomial model for European option
Ø Using the two-period binomial model to value an option is
similar, but with more steps:
üStep 1: calculate the three possible values of stock at T=2;
• S++ = UUS0; S+− = S−+ = UDS0 ; S−− = DDS0
üStep 2: calculate the payoff of the option at T=2;
• C++ = Max (0, S++ − X ); P++ = Max (0, X − S++ );
• C+− = C−+ = Max (0, S+− − X); P+− = P−+ = Max (0, X − S+−);
• C−− = Max (0, S−− − X ); P−− = Max (0, X − S−− ).
Two-period binomial model for European option (Cont.)
ü Step 3: calculate the option value at T=1 (C+ or P+, C- or P-)
by discounting the expected payoff at T=2 back one
period at risk-free rate;
• C+ = ( πU×C++ + πD×C+− )/( 1 + Rf )T
• C− = ( πU×C+− + πD×C−− )/( 1 + Rf )T
• P+ = ( πU×P++ + πD×P+− )/( 1 + Rf )T
• P− = ( πU×P+− + πD×P−− )/( 1 + Rf )T
ü Steps 4: calculate the option value at T=0 (C0 or P0) by
discounting the expected option value at T=1 back one
period at risk-free rate.
• C = ( πU×C+ + πD×C− )/( 1 + Rf )T
• P = ( πU×P+ + πD×P− )/( 1 + Rf )T
S++ = UUS0
πU
C++ = Max (0, S++ − X )
P++ = Max (0, X − S++ )
πU S+ = US0
C+ , P + πD
S+- = S-+ = UDS0 = S0
S0 πU C+− = C−+ = Max (0, S0 − X)
C0 , P 0 πD P+− = P−+ = Max (0, X − S0)
S- = DS0
C− , P − πD
S-- = DDS0
C−- = Max (0, S−- − X )
P−- = Max (0, X − S−- )
T=0 T=1 T=2
Example
Ø You observe a €50 price for a non-dividend-paying stock. An
European-style call option has two years to mature and an
the exercise price of €50. Assume the risk-free rate is 5%, U =
1.356 and D = 0.744.
üCalculate the current call option value.
üCalculate the current put option value.
Answer:
Ø Step 1: S++ = 91.94; S+− = S−+ = 50.44; S−− = 27.68;
Ø Step 2:
üC++ = 41.95; P++ = 0;
üC+− = C−+ = 0.44; P+− = P−+ = 0;
üC−− = 0; P−− = 22.32.
Answer (Cont.):
Ø Step 3:
üπU= [(1 + 0.05) - 0.744]/(1.356 - 0.744) = 0.5;
üπD =1 - πU= 0.5;
üC+ = (0.5×41.94 + 0.5×0.44)/1.05 = 20.18;
üC− = (0.5×0.44 + 0.5×0)/1.05 = 0.22;
üP+ = (0.5×0 + 0.5×0)/1.05 = 0;
üP− = (0.5×0 + 0.5×22.32)/1.05 = 10.63;
Ø Step 4:
üC0 = (0.5×20.18 + 0.5×0.22)/1.05 = 9.71;
üP0 = (0.5×0 + 0.5×10.63)/1.05 = 5.06.
Answer (Cont.):
S++ = 91.94
0.5 C++ = 41.94
P++ = 0
S+=67.8
0.5
C+= 20.18
0.5
P+ = 0 S+- = S-+ = 50.44
S0 = 50 0.5 C+− = C−+ = 0.44
C0 = 9.71 P+− = P−+ = 0
P0 = 5.06 0.5 S- = 37.2
C−= 0.22
0.5
P−= 10.63 S-- = 27.68
C−- = 0
P−- = 22.32
Year 0 Year 1 Year 2
Answer (Cont.):
Ø Recall the put-call parity:
S0 + P0 = C0 + PV(X)
Ø The put option value can be computed simply by applying
put call parity:
P0 = C0 + PV(X) – S0
= 9.71 + (50/1.052) – 50
= 5.06
Two-period binomial model for American option
Ø Non dividend-paying American call options on stock will not
be exercised early because the value of a call option will be
greater than its exercise value.
üWorth more alive than dead.
Two-period binomial model for American option (Cont.)
Ø Deep in-the-money put option or call option on dividend-
paying stock may benefit from early exercise:
üFor deep in-the-money put option, the exercise value can
be invested at the risk-free rate, and earn interest that
exceed the time value of the put;
üFor call option on dividend-paying stock, the stock price
falls at ex-dividend date, and it may be valuable to exercise
the option before the price falling.
Two-period binomial model for American option (Cont.)
Ø When value the American options that may be exercised
early, we need to determine if the option will be exercised
at each node:
üIf the exercise value is greater than the calculated
arbitrage-free value, early exercise is valuable;
üUse the higher between exercise value and the calculated
price at each node.
Example
Ø A non-dividend-paying stock is currently trading at $72, a
put option on this stock has a exercise price of $75 and a
maturity of 2 years. Suppose the interest rate is 3%, U =
1.356 and D = 0.541, πU = 0.6 and πD = 0.4.
üCalculate the put option value if it is European-style.
üCalculate the put option value if it is American-style.
Answer:
Ø If it is European style:
132.39
0.6 P++ = 0
97.63
0.6
P+= 8.61
0.4
52.82
72 0.6 P+− = P−+ = 22.18
P0 = 18.17
0.4 38.95
P−= 33.86
0.4
21.07
P−- = 53.93
Answer:
Ø If it is American style:
132.39
0.6 P++ = 0
97.63
0.6
P+= 8.61
0.4
P+ = 0 52.82
72 0.6 P+− = P−+ = 22.18
P0 = 19.02
0.4 38.95
P−= 33.86
0.4
P−= 36.05 21.07
P−- = 53.93
Binomial interest rate tree
Ø A interest rate model that assumes interest rates at any
point of time (node) have an equal probability of taking one
of two possible values in the next period, an upper path (U)
and a lower path (L).
üThe interest rates at each node are one-period forward
rates corresponding to the nodal period.
Binomial interest rate tree (Cont.)
Ø E.g.: interest rate i2,LU at node 2 is the rate that will occur if
initial interest i0 at node 0 follows the lower path to node 1,
and then follows the upper path to node 2.
i2,UU
i1,U
i0 i2,LU
i1,L
i2,LL
Node 0 Node 1 Node 2
Binomial valuation model for interest rate option
Ø The valuation of interest rate option is similar to that of
stock option, except that the payoff at maturity is different:
üCall payoff = Max(0, underlying rate – exercise rate)×NP
üPut payoff = Max(0, exercise rate – underlying rate)×NP
Example
Ø A European call option on the one year interest rate (the
underlying) has an exercise rate of 3.25% with maturity of
two years and notional amount of $1,000,000. Calculate the
call option value with the following interest rate tree.
3.97%
3.91%
3.25%
3.05%
2.60%
2.26%
Answer:
Ø C++ = (3.97% – 3.25%)×1,000,000 = 7,200;
Ø C+- = C-- = 0;
Ø C+ = (0.5×7,200 + 0.5×0)/1.0391 = 3,465;
Ø C− = 0;
Ø C0 = (0.5×3,465 + 0.5×0)/1.0305 = 1,681.
Answer (Cont.):
3.97%
C++ = 7,200
3.91%
C+ = 3,465
3.25%
3.05% C+− = C−+ = 0
C0 = 1,681
2.60%
C− = 0
2.26%
C−- = 0
Summary
Ø Content:
ü Calculation of European option value;
ü Calculation of American option value;
ü Calculation of interest rate option value.
Ø Exam tips:
Black-Scholes-Merton (BSM) model
Tasks:
Ø Identify assumptions and interpret the components
of the BSM option valuation model;
Ø Describe how the BSM model is used to value
European options on equities and currencies;
Ø Describe how the Black model is used to value
European options on futures and interest rate.
Black-Scholes-Merton Model
Assumptions of the BSM model
Ø The options are European-style;
Ø The underlying asset price follows a geometric Brownian
motion, and moves smoothly from value to value;
Ø The (continuously compounded) yield of the underlying
asset is constant and known;
Ø The continuously compounded risk-free interest rate is
known and constant; borrowing and lending at the risk-free
rate is allowed;
Assumptions of the BSM model (Cont.)
Ø The volatility of the underlying asset return is constant and
known;
Ø The market is frictionless:
üNo transaction costs, no taxes, no regulatory constraints;
üNo-arbitrage opportunities in the market;
üThe underlying asset is highly liquid, and continuous
trading is available;
üShort selling of the underlying asset is permitted.
BSM model
Ø Formulas for the BSM model are:
c
C0 = S0N(d1 ) - Xe-Rf T N(d2 )
c
and P0 = Xe-Rf TN(-d2 ) - S0N(-d1 )
 S0   c σ 
2
ln  +  Rf +  T
X  2
wherein: d1 = , d2 = d1 - σ T
σ T
üS0: underlying asset price; X: strike price;
üT: time to maturity; σ: volatility of underlying asset return;
üRf: continuously compounded risk-free rate;
üN(x): the standard normal cumulative distribution function.
Interpretation of BSM model
Ø According to BSM model, the option value can be regarded
as the present value of expected payoff at expiration:
C0 = PV  S0eRf T N(d1 ) - XN(d2 ) P0 = PV  XN(-d2 ) - S0eRf TN(-d 1) 
c c
   
Ø Call option can be regarded as leveraged stock investment;
put option can be regarded as combination of long bond
and short stock;
Ø N(d2) is the risk-neutral probability that a call option will be
exercised at expiration; N(-d2) is the risk-neutral probability
that a put option will be exercised at expiration.
Implied volatility
Ø The volatility (standard deviation) of underlying asset return
“implied” in the option market price.
üFour inputs in fives for BSM model is observable (S, X, T,
Rf), and if the option market price is available, the
volatility can be calculated with the BSM model;
üImplied volatility can be used as a mechanism to quote
option price.
• Only one quotation is needed for different options.
BSM model with carrying benefits or costs
Ø Carry benefits include dividends for stock, foreign interest
rates for currency, and coupon payments for bond;
Ø Carry costs include storage cost, insurance costs, etc.
üCarry costs can be treated as negative carry benefits.
BSM model with carrying benefits or costs (Cont.)
Ø The BSM model need to be adjusted for the carry benefits
and carrying costs:
-γT -Rcf T
C0 = S0 e N(d1 ) - Xe N(d2 )
c
and P0 = Xe-Rf TN(-d2 ) - S0e-γTN(-d1 )
 S0   c σ2 
ln  +  Rf - γ +  T
X  2
Where: d1 = , d2 = d1 - σ T
σ T
γ: carry benefits or costs as a continuous yield;
for currency option, it is the continously compounded
interest rate of foreign currency.
Black model for European options on futures
Ø Ignore margin requirements and marking to market for
futures, the Black model is the BSM model after
c
-R T
substituting F0 (T)  e f for S0:
c
C0 = e-Rf T  [F0 (T)N(d1 ) - XN(d2 )]
c
and P0 = e-Rf T  [XN(-d2 ) - F0 (T)N(-d1 )]
2
 F (T)  σ
ln 0  + T
X  2
Where: d1 =  , d2 = d1 - σ T
σ T
F0 (T): futures price at Time 0 that expires at Time T.
Black model for interest rate option
Ø The underlying of interest rate option is a FRA:
üAssume a “M×N” FRA:
0 M N
Option expires Underlying matures
Ø The formula for call option is as follows:

N
-Rcf   N-M 
C0 = e 12
 [FRA  N(d1 ) - XN(d2 )] NP   
 12 
Swaption
Ø An option with underlying of interest rate swap.
üGive the option holder the right to enter into an interest
rate swap at a future data.
0 M N
Option expires Swap matures
Swaption (Cont.)
Ø Payer swaption: the right to enter into a interest rate swap
as fixed-rate payer.
üThe swaption holder expects the interest rate to increase.
Ø Receiver swaption: the right to enter into a interest rate
swap as fixed-rate receiver.
üThe swaption holder expects the interest rate to decrease.
Summary
Ø Content:
ü Assumption and interpretation of BSM model;
ü BSM models for options on futures, interest rate option;
ü Swaption.
Ø Exam tips:
ü 常考点：BSM model的interpretation和变形，概念题。
Option Greeks
Tasks:
Ø Interpret each of the option Greeks;
Ø Describe how a delta hedge is executed.
Option Greeks
Option Greeks
Ø The sensitivity factors of the European option price against
the input factors of BSM models, including:
üDelta (Δ): option price vs. underlying price (S);
üGamma (Γ): delta vs. underlying price (S);
üTheta (θ): option price vs. time passage (t);
üVega (Λ): option price vs. underlying price volatility (σ);
üRho (ρ): option price vs. risk free rate (Rf).
Option Greeks
Delta
Ø Delta (Δ): the sensitivity of the option price against the
underlying asset price.
Option Greeks
Delta (Cont.)
Ø Delta for call option and put option:
C - C
Deltacall =   = e-δTN(d1 )
S -S
P - P
Deltaput =   = -e-δTN(-d1 )
S -S
üFor non-dividend paying stock (δ = 0):
Deltacall = N(d1 )
Deltaput = -N(-d1 ) = -1- N(-d1 ) = N(d1 ) - 1 = Deltacall -1
Ø Note: delta is also the hedge ratio (h).
Option Greeks
Delta (Cont.)
Ø Deltacall increases from 0 to 1 as stock price increases.
üDeep out-of-the-money, Deltacall → 0;
üDeep in-the-money, Deltacall → 1.
Ø Deltaput increases from -1
to 0 as stock price 1
Deltacall
increases.
üDeep out-of-the-money, 0 S
Deltaput
Deltaput → 0;
üDeep in-the-money, -1
Deltaput → -1.
Option Greeks
Delta (Cont.)
Ø When the call/put option gets closer to maturity, the delta
will drift either toward 0 if it is out-of-the-money or drift
toward 1/-1 if it is in-the-money.
Option Greeks
Delta hedge
Ø Delta-neutral portfolio: combine the underlying assets with
the options so that the value of the portfolio does not
change with variation of the price of underlying assets.
ü Number of options needed to delta hedge
= - number of shares hedged / delta of option
N N
Ncall = - stock Nput = - stock
Deltacall Deltaput
• Long stocks, short call options (positive delta);
• Long stocks, long put options (negative delta).
Option Greeks
Example
Ø We have a short position in put options on 10,000 shares of
stock. Deltacall = 0.532 and Deltaput = –0.419. Assume each
stock option contract is for one share of stock.
üCalculate the numbers of stock needed to delta hedge
assuming the hedging instrument is stock.
üCalculate the numbers of call option needed to delta hedge
assuming the hedging instrument is call option.
Option Greeks
Answer:
Ø Nstock = -Nput  Deltashort put  10000  0.419  4190
üSell 4190 shares of stock.
Ø Ncall  Deltacall = Nput  Deltaput  10000  (0.419)  4190
4190
Ncall   7876
0.532
üSell 7876 call options.
Option Greeks
Gamma
Ø Gamma (Γ): the sensitivity of the option’s delta against the
underlying asset price;
Ø Gamma for a call and put option with identical features are
the same.
Delta - Delta e- δT
Gammacall = Gammaput =  
= N(d1 )
S -S Sσ T
ü Long call/put will have a positive gamma;
ü Gamma is largest when the option is at-the-money;
ü If the option is deep in- or out-of-the-money, gamma
approaches zero.
Option Greeks
Gamma (Cont.)
Ø Gamma approximates the estimation error with delta for
option price.
üOption price with respect to stock price is non-linear, but
delta only measures the linear relationship.
Ø Gamma risk: stock prices often jump rather than move
continuously and smoothly in reality, holding a delta-
neutral portfolio will have risk against stock price too.
üIf the BSM model assumptions hold, then we would have
no gamma risk.
Option Greeks
Theta
Ø Theta (θ): the sensitivity of the option price against time
passage (t).
üTheta is usually negative for both call and put option;
• With excerption to deep in-the-money put option.
üIt is also termed the “time decay” of options.
Option Greeks
Vega
Ø Vega (Λ): the sensitivity of option price against the volatility
of the underlying asset price.
üVega for call option is equal to Vega for put option with
identical features, and both are positive;
üVega is high when options are at or near the money.
Option Greeks
Rho
Ø Rho (ρ): the sensitivity of option price against the risk-free
rate.
üRho is positive for call option;
üRho is negative for put option.
Summary
Ø Content:
ü Option Greeks;
ü Delta hedge.
Ø Exam tips:
ü 常考点1：Greeks, 定性考察，概念和正负；
ü 常考点2：Delta hedge，计算题。
Changing Risk Exposure
Tasks:
Ø Describe how interest rate, currency, and equity
swaps, futures, and forwards can be used to modify
risk and return;
Ø Describe how to replicate an asset by using options
and by using cash plus forwards or futures.
Changing Risk Exposures
Interest rate swap
Ø Interest rate swap can be used to modified the duration of a
fixed-income portfolio.
üSwap value for fixed-rate receiver
= value of fixed-rate bond – value of floating-rate bond
üDuration of fixed-rate receiver swap
= Duration of fixed-rate bond – Duration of floating-rate
bond
Interest rate futures
Ø Interest rate futures are exchange-traded derivatives and
are free of default risk.
üSometimes referred to as bond futures because the
underlying asset is often a bond.
Ø Interest rate futures can be used to modify duration of fixed
income portfolio.
üLong interest rate futures will increase portfolio duration;
üShort interest rate futures will decrease portfolio duration.
Currency swap
Ø Currency swap are usually used by companies to reduce
their funding costs.
Ø A currency swap is different from an interest rate swap in
two ways:
üThe interest rates are associated with different currencies;
üThe notional value may be exchanged at the initiation and
expiration of the swap.
Currency forward/futures
Ø Currency forward/futures can be used to manage foreign
exchange rate risk.
üE.g., a Chinese company have a Euro liability due in 6
months and is exposed to foreign exchange rate risk. The
company can hedge the liability by long Euro
forward/futures contract.
Equity swap
Ø An equity swap can exchange the return of an equity asset to
the return of another asset.
üE.g., an interest rate, or another equity asset.
Ø Equity swap can be used to modify exposure to equity
market temporarily without actually disposing the equity
portfolio.
Stock index futures
Ø Stock index futures can be used to modify the exposure to
equity market.
üLong stock index futures will increase the exposure;
üShort stock index futures will decrease the exposure.
Synthetic asset with options
Ø Long asset = long call + short put (S = c – p)
Ø Short asset = short call + long put (-S = -c + p)
üAsset price = exercise price;
üThe call option and put option have identical features.
Synthetic options
Ø Long call = long asset + long put (c = S + p)
Ø Long put = Short asset + long call (p = -S + c)
Synthetic asset with forward/futures
Ø Long asset = long futures + risk-free asset (cash)
üLong risk-free asset (synthetic cash)
= long asset + short futures
Summary
Ø Importance: ☆
Ø Content:
ü Changing risk exposure with interest rate, currency, and
equity swaps, futures, and forwards;
ü Synthetic equivalencies with options, forward/futures.
Ø Exam tips:
ü 常考点：不是考试重点。
Derivative Strategies
Tasks:
Ø Describe, calculate and interpret the value at
expiration, profit, maximum profit, maximum loss,
and breakeven underlying price at expiration for
covered calls, protective puts, spread, collar, straddle.
Covered call (S - C)
Ø Structure: short call option + long the underlying stock;
Ø Investment objectives:
üIncome generation: earn the option premium if the option
expire worthless;
üImproving on the market: capture the time value by
constructing covered call with a in-the-money call option.
• Option value = intrinsic value + time value
üTarget price realization: construct covered call with a call
option that has a exercise price equal to target price.
Covered call (Cont.)
Ø Example: Buy stock at $39, sell call option with strike price
of $40 at $3.
Long
P/L stock
Covered
+$4
call ü Profit: VT - S0 + C0
+$3
ü Max. profit: X - S0 + C0
0
$36 $39 $43 ST ü Max. loss: S0 - C0
-$36 ü Breakeven: S0 - C0
Short Call
-$39
Covered call (Cont.)
Ø Risk of covered call:
üKeeps the downside risk of the stock position;
üGives up the upside potential of the stock position.
Covered call vs. (long asset + short forward)
Ø Recall: delta is the sensitivity of option price against
underlying price.
üDelta of a long stock position: 1;
üDelta of a short stock position: -1;
üDelta of a long forward position: 1.
üDelta of a short forward position: -1.
Covered call vs. (long asset + short forward)
Ø From the aspect of delta (price sensitivity against underlying
asset price), a covered call position (S – C) is equivalent to a
position of long a stock and short forward for detalcall unit.
üBoth of them have delta of (1- deltacall).
Protective put (S + P)
Ø Structure: long put option + long underlying stock;
Ø Investment objectives:
üProvide protection or insurance against a price decline.
Protective put (Cont.)
Ø Example: Buy stock at $41, buy put option with strike price
of $40 at $3.
P/L Long stock
+$3
7
ü Profit: VT - S0 - P0
ü Max. profit: Unlimited
0
$37 $41 $44 ST ü Max. loss: S0 + P0 - X
-$3 ü Breakeven: S0 + P0
-$4 Long Put
Protective put
-$41
Protective put (Cont.)
Ø Risk of protective put:
üThe put premium will reduce the portfolio return.
• Continuous purchase of protective puts may be expensive
and probably suboptimal, but occasional purchase to deal
with a bearish short-term outlook can be a reasonable
risk-reducing activity.
Protective put vs. (long asset + short forward)
Ø From the aspect of delta (price sensitivity against underlying
asset price), a protective put position (S + P) is equivalent to
a position of long a stock and short forward for detalput unit.
üBoth of them have delta of (1+ deltaput).
• Remember: detalput is negative.
Spread strategy
Ø Long an option and short another option on same
underlying asset but with different exercise price.
üBull spread: long an option and short another with a higher
exercise price;
• The underlying asset price is expected to increase.
üBear spread: long an option and short another with a lower
exercise price;
• The underlying asset price is expected to decrease.
üBoth bull spread and bear spread can be constructed with
either call or put option.
Bull call spread
Ø Long call with lower exercise price (XL) and short call with
higher exercise price (XH).
üProfit: Max (0, ST - XL) - Max (0, ST - XH) - (CL - CH)
P/L
ü Max. profit: XH - XL - (CL - CH)
Long call
ü Max. loss: CL - CH
ü Breakeven: XL + (CL - CH)
XL
0 ST
XH
Short call
Bull call spread
Bull put spread
Ø Long put with lower exercise price (XL) and short put with
higher exercise price (XH).
üProfit: Max (0, XL - ST) - Max (0, XH - ST) - (PL - PH)
P/L ü Max. profit: PH - PL
Short put ü Max. loss: XH - XL + (PL - PH)
ü Breakeven: XH - (PL - PH)
XL XH
0 ST
Long put
Bull put spread
Bear call spread
Ø Long call with higher exercise price (XH) and short call with
lower exercise price (XL).
üProfit: Max (0, ST - XH) - Max (0, ST - XL) - (CH - CL)
P/L ü Max. profit: CL - CH
Short call ü Max. loss: XH - XL + (CH - CL)
Long call
ü Breakeven: XL + CL - CH
XL XH
0 ST
Bear call spread

Bear put spread
Ø Long put with higher exercise price (XH) and short put with
lower exercise price (XL).
üProfit: Max (0, XH - ST) - Max (0, XL - ST) - (PH - PL)
P/L ü Max. profit: XH - XL - (PH - PL)
Long put
ü Max. loss: PH - PL
Short put ü Breakeven: XH – (PH - PL)
XH ST
0 XL
Bear put spread

Collar
Ø Structure: long put + short call + underlying asset
üThe exercise price (XL) of put option is typically below the
asset price (S0);
üThe exercise price (XH) of call option is typically above the
asset price (S0).
Ø Investment objective: buy a protective put and sell a call to
offset the premium.
üZero-cost collar: the premiums for call and put are equal.
Collar (Cont.)
Ø Example: buy a stock at $40 (S0), buy a put option with strike
price of $35 (XL) at $3 (p0), and short a call option with strike
price of $44 (XH) at $3 (c0).
üProfit = (ST - S0) + Max(0, XL - ST) - Max(0, ST - XH) - (p0 - c0)
P/L ü Max. profit:
+$4 XH - S0 - (p0 - c0)
ü Max. loss:
0
$35 $40 $44 ST S0 - XL + (p0 - c0)
-$5 ü Breakeven: S0 + (p0- c0)
Collar
Straddle
Ø Long straddle: Long call + long put, with the same exercise
price, on the same underlying asset.
üProfit: Max(0, ST - X) + Max(0, X - ST) - (C0 + P0)
P/L ü Max. profit: unlimited
ü Max. loss: C0 + P0
ü Breakeven: X + (C0 + P0)
0 X
ST or: X - (C0 + P0)
Calendar spread
Ø Long calendar spread: short a near-dated call and long a
longer-dated call on the same underlying asset and with the
same exercise price.
üThe initial cash flow is negative;
üThe underlying asset is expected to be flat in the short
term but jump in the longer term.
Choice of derivative strategies
Ø The choice of derivative strategies can base on expectation
of both market direction and volatility, and need to consider
if the expectation is priced-in.
üFor expectation of market direction, typically:
• Long call/put for strong bullish/bearish expectation;
• Long call and short put for average bullish expectation;
• Short call and long put for average bearish expectation;
• Writing call/put for weak bearish/bullish expectation.
Choice of derivative strategies (Cont.)
üFor expectation of volatility, typically:
• Long straddle for high volatility expectation;
• Short straddle for low volatility expectation.
Summary
Ø Importance: ☆
Ø Content:
ü Covered call and protective put;
ü Bull call spread, bull put spread, bear call spread, bear put
spread;
ü Collar and straddle.
Ø Exam tips:
ü 常考点：不是考试重点。

Derivatives

Uploaded by

Copyright:

Available Formats

You might also like

Derivatives

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Derivatives

Uploaded by

Copyright:

Available Formats

Derivative

Ø Call option: right to buy.

Ø Exercise price/strike price (X): the fixed price at which the

Ø American option: exercisable at or prior to expiration.

üF0(T) and S0 are quoted by direct quotation: DC/FC;

Ø The value of foreign exchange forward contract at Time t:

Today 3 months 9 months

Forward Expiry of FRA; Interest saving:

Discount at LIBOR for 90 days

Ø Step 2: calculate the value of FRA as:

S0- FS S1- FS … Sn-1- FS

Ø The formula for call option is as follows:

Bear call spread

Bear put spread

You might also like