Lesson

 1.0  
Alright,  congratulations,  you’ve  decided  to  enroll  in  a  class  to  explore  how  to  use  derivatives  to  
manage  financial  risk.  This  is  excellent  news  as  recent  events  have  proven  that  most  of  the  
bright,  ambitious  participants  in  the  financial  industry  do  not  fully  appreciate  risk.  
Unfortunately,  this  is  also  somewhat  understandable  as  the  previous  (and  current)  incentive  
structures  skew  to  taking  risks,  not  managing  (let  alone  understanding)  risks.  
 
So  that’s  where  this  class  comes  in.  In  short,  we  will  cover  the  gamut  of  financial  derivatives  –  
defining,  contextualizing,  constructing,  valuing,  and  ultimately  tying  the  instrument  to  a  hedging  
practice  to  mitigate  risks.  
 
The  derivatives  we  will  cover  include:  
• FRAs  
• Swaps  
• Futures  
• Forwards  
• European  Options  
• American  Options  
• Exotics  
• Credit  Derivatives  
• Interest  Rate  Derivatives  
• Structured  Products  
 
After  we  understand  what  each  of  these  instruments  “is”  and  “does,”  we  will  examine  the  
valuation  of  each  using  different  techniques,  moving  from  discrete  to  normal  continuous  to  non-­‐
normal  continuous.  
 
But  let’s  not  get  too  far  ahead  of  ourselves.  A  class  about  only  building  and  valuing  derivatives  
has  limited  meaning.  While  that  course  may  bestow  you  with  the  knowledge  and  ability  to  land  
a  cushy  job  with  a  hedge  fund,  without  the  resources  to  appreciate  the  dimensions  of  risk  
surrounding  the  instruments,  that  job  (or  hedge  fund  for  that  matter)  may  be  short-­‐lived.  
Instead,  this  course  will  go  a  step  further  by  providing  context  and  perspective  with  regard  to  
each  instrument,  such  that  the  risks,  practical  applications,  and  nuances  may  be  more  fully  
appreciated.  
 
So…  that’s  at  least  my  proposal.  
 
But  how  do  we  get  there?  
Well,  the  course  is  titled  “Financial  Risk  Management,”  so  let’s  start  there.  
 
Financial  risk  management  is  the  practice  of  managing  financial  risk.  This  may  seem  trivial,  but  
we  can’t  be  expected  to  manage  risk  if  we  haven’t  yet  defined  “risk.”  
 
So,  what  is  (financial)  risk?  
 
Now,  if  you’re  a  quant,  you’re  first  reaction  when  you  hear/read  the  word  risk  is  to  jump  
immediately  to  little  sigma  (σ),  volatility,  vol,  or  standard  deviation  (for  the  practitioners  way  in  
the  back).  
 
This  association  isn’t  wrong,  but  it’s  not  complete.  In  the  finance  world,  we  like  to  live  in  our  
pretty,  normal  world.  By  normal,  I’m  not  referring  to  a  house,  two  cars,  and  2.4  kids,  but  more  
normal  as  in  Normal,  Gaussian,  or  for  the  remainder  of  this  course:  
 
X~N(µ,  σ)  or  φ(x)  
 
-­‐Which  reads,  “Some  variable  X  is  normally  distributed  around  mean  µ  and  standard  deviation  
σ.”  
 
Now,  to  unpack  this  equation  a  bit,  we  can  define  ϕ(x)  as:  
 
x2
1 −2 ∞
Φ ( x) =
2π
e ;  where   ∫ −∞
Φ ( x ) = 1             [EQ  1.1]  

 
But  here’s  the  thing  -­‐  you  already  know  this.  This  is  Statistics  101,  so  moving  on…  
 
Risk  is  more  than  just  precision.  Risk  is  also  frequency,  magnitude,  and  accuracy.  
 
Risk  As  Frequency  
When  we  describe  risk  as  a  frequency,  we  are  solving  for  the  probability  of  a  loss.  So,  you  are  
asked  to  buy  one  of  ten  raffle  tickets,  you  have  a  10%  chance  to  win  and  a  90%  chance  to  lose.  If  
this  were  iterative,  you  would  expect  to  lose  nine  out  of  every  ten  times.  From  a  return  
perspective  (assuming  the  raffle  prize  is  something  we  value),  we  want  to  maximize  the  number  
of  times  we  win.  From  a  risk  perspective  (again,  assuming  the  prize  is  desirable),  we  want  to  
minimize  the  number  of  times  our  lot  is  not  drawn.  Simple  -­‐  nothing  to  it.  
 
Cue  layer  of  complexity.  
 
Still  keeping  it  simple,  we  want  to  establish  an  objective  function  that  will  allow  us  to  express  
this  thesis  more  universally.  Therefore,  we  will  define  the  probability  of  loss  as  the  number  of  
outcomes  producing  a  loss  divided  by  the  total  number  of  outcomes.  We  will  seek  to  minimize  
this  function  to  mitigate  the  frequency  risk.  
Thus,  our  objective  function  for  risk  as  frequency  is:  
 
m
1
∃(x) ∈ X : min ∑                 [EQ  1.2]  
i:yi +β xi −βi <0 m
β

 
This  says  the  same  thing  as  above,  and  yet  its  beauty  lies  in  its  simplicity.    
 
Risk  As  Magnitude  
Expanding  upon  our  previous  raffle  example,  we  are  also  concerned  about  the  size  of  the  prize,  
especially  in  relation  to  the  cost  of  the  ticket.  Let’s  assume  the  cost  of  a  single  ticket  is  $100.  If  
the  payout  is  greater  than  $1000,  then  the  expected  return  is  positive,  otherwise  this  is  a  losing  
proposition  for  you  (remember,  we’re  assuming  this  is  iterative).  So  clearly,  the  magnitude  of  
the  loss  will  affect  our  decision  to  buy  a  ticket,  and  in  an  iterative  process,  both  frequency  and  
magnitude  will  affect  our  decision  jointly.  As  above,  we  wish  to  maximize  return  and  minimize  
risk.  Therefore  our  objective  function  for  magnitude,  or  our  expected  value  of  a  loss  (average  
downside  risk)  is:  
 
m
1
∃ ( x ) ∈ X : min
β
∑ −
m
( yi + β xi [−βi ])             [EQ  1.3]  
i:yi +β xi [− βi ]<0

 
It  is  important  to  note  that  under  the  auspice  of  risk  as  magnitude,  there  are  two  types  of  
magnitude  risk  –  absolute  and  relative.  
 
From  an  absolute  perspective,  risk  is  the  value  of  the  loss  of  the  initial  investment  or  outlay.  
Absolute  risks  are  not  contingent  upon  another  variable.  Thus,  in  an  absolute  risk  case,  we  can  
ignore  the  bracketed  beta  sub  i.  
 
From  a  relative  perspective,  risk  is  the  value  of  the  loss  of  the  investment  or  outlay  as  compared  
to  its  benchmark.  Relative  risks  are  contingent  upon  a  prescribed  measurement.  Therefore,  in  a  
relative  risk  case,  we  must  use  the  bracketed  beta  sub  i.  
 
 
Risk  As  Accuracy  
What  happens  if  you’re  wrong?  What  happens  if  your  model  (read  perception  of  reality)  is  does  
not  fit  well?  Think  of  this  as  your  ability  to  interpolate  or  synthesize.  How  good  are  your  
assumptions  and/or  have  your  chosen  variables  illustrate  the  actual  outcome.  There  is  a  risk  in  
not  having  a  well-­‐fitting  model.  As  such,  this  can  be  quantified  much  in  the  same  we  would  
measure  root  mean  squared  error  in  a  least  squares  analysis.  Therefore,  we  can  express  our  
objective  function  for  root  mean  square  dollar  loss  as:  
 
m
1 2
∃(x) ∈ X : min ∑ ( yi + β xi − βi )             [EQ  1.4]  
i:yi +β xi −βi <0 m
β

 
Model  risk  is  a  type  of  Known  Unknown  risk.  In  short,  there  are  several  drivers  of  model  risk;  
these  include  ignoring  a  known  risk,  misapplied  distributions,  volatilities,  and/or  correlations  
of/among  risk  variables  in  the  model,  or  unknown  risks  not  included  in  the  model.  I  won’t  hold  a  
model  out  to  be  perfect;  as  such,  each  interpolation  of  the  universe  will  generate  residual  or  
error.  We  will  define  model  risk  as  the  expectation  of  error  caused  by  imperfect  model  fit,  
generated  by  some  factor  (or  culmination  of  factors)  residing  outside  of  the  model.  
 
Risk  As  Precision  
Alright  quants,  last  but  not  least  –  risk  is  the  chance  that  given  a  good  model,  your  results  will  
differ  from  expectations.  We  call  this  volatility  and/or  standard  deviation.  Assuming  φ(x),  then  
our  objective  function  for  standard  deviation  is:  
 

β
(
∃(x) ∈ X : min σ ( Rp )   )               [EQ  1.5]  

 
Briefly,  standard  deviation  or  variance  (STDEV2)  is  a  Known  Known  risk.  We  understand  that  
within  a  model,  there  will  be  expected  events  that  are  not  the  mean.  To  accommodate  this,  we  
build  ranges  of  expected  deviation  into  our  assumptions.  When  events  fall  outside  of  our  
ranges,  we  move  from  Known  Known  risk  back  to  Known  Unknown  risk,  i.e.  the  model  does  not  
fit  well.  
 
Let’s  consider  an  example:  
 
EX  1.1]  
While  your  current  weekend  regiment  is  anything  but  boring,  you  decide  to  high  tail  it  to  Vegas  
for  a  little  well-­‐deserved  R&R.  After  checking  into  the  your  choice  of  the  finest  hotels,  you  
forego  all  other  indulgences  and  belly  up  to  your  favorite  blackjack  table.  While  it  is  assumed  
you  have  the  ability  to  count  cards  (you  are  after  all  taking  this  class,  right?),  you  play  straight  
up.  
 
It’s  just  you  and  the  dealer,  and  she’s  got  a  clean,  fair,  full,  eight-­‐deck  inventory.  However,  you  
have  chosen  a  casino  that  (for  the  purpose  of  this  example)  will  stand  at  a  win.  But,  you’re  
feeling  lucky  as  you’ve  just  earned  the  highest  marks  in  your  financial  risk  management  class,  so  
you  wager  $500  on  the  first  hand.  
 
And  so  it  begins…  
 
The  dealer  gives  you  the  five  of  hearts  and  the  seven  of  spades,  and  she’s  showing  the  queen  of  
spades.  
 
So,  what  are  your  risks  at  T0  and  T1?  
 
(I’ll  give  you  a  hint,  a  full  credit  answer  will  probably  have  four  different  components)  
 
Frequency  >>  
• If  you  stand  
o Given  your  hand  (12)  and  dealer’s  hand  (10+x),  and  given  the  inventory  of  unknown  
cards  (8  decks  *  52  cards  –  3  known  =  413  cards)  the  chance  that  you  summarily  lose  
=  the  probability  that  the  dealer’s  unknown  card  is  >  2.  There  are  no  known  2’s  in  
play  therefore,  the  chance  that  the  dealer’s  unknown  card  is  =  2  is  (8  decks  *  4  2’s  
per  deck  =  32)  /  413  =  7.7%,  therefore  summary  loss  =  92.3%  
o If  you  survive  T=0,  then  T=1  presents  the  issue  that  the  dealer  will  hit  to  win,  there  
are  4  cards  per  suit  (4)  per  deck  (8)  that  will  cause  the  dealer  to  bust  =  128,  but  one  
is  already  known  (dealer’s  queen),  therefore  127  /  412  =  30.8%  chance  dealer  busts,  
therefore  69.2%  chance  you  lose.  
o Therefore,  the  multistage  probability  of  loss  if  you  stand  equals  0.077  x  0.308  =  2.4%  
chance  this  strategy  works.  Thus  in  an  iterative  process,  you  should  expect  to  lose  
97.6x/100  
• If  you  hit  
o You  can  affect  both  your  hand  and  the  dealer’s  hand  at  your  discretion.  
o Given  8  decks  with  52  cards  =  416  available  cards  
o Less  4  already  dealt  =  412  cards  
o Of  the  remaining  cards  we  know  there  are  4  cards  per  suit  (4)  per  deck  (8)  that  will  
cause  you  to  bust  =  128  cards  
o However,  1  or  2  are  already  known  (dealer’s  hand)  
o Therefore  126  (weighted  at  127/413  =  30.8%)  or  127  (weighted  at  1-­‐0.308  =  69.2%)  
instances  of  bust  given  available  inventory  (412)  
o Therefore  odds  of  busting  on  first  hit  are  either  30.8%  x  30.8%  +  30.6%  x  69.2%  =  
0.095  +  0.212  =  30.7%;  so  you  should  probably  hit  given  the  69.3%  chance  you  don’t  
lose  on  T=1  
Magnitude  >>  
• Your  magnitude  of  total  loss  =  $500  
• After  the  cards  are  turned,  your  probabilistic  loss  to  stand  =  97.6%  x  $500  =  $488  
• After  the  cards  are  turned,  your  probabilistic  loss  to  hit  (through  T=1)  =  30.7%  x  $500  =  
$153.50  
• Thus  to  minimize  expected  loss,  you  should  hit.  
  
Accuracy  >>  
• For  this  example,  we  will  discuss  model  fit  in  a  qualitative  sense,  but  there  are  still  risks,  
which  may  include:  
o Internal  Changes  –  rules,  ability  
o External  Changes  –  new  players,  environment  
 
Precision  >>  
• Even  if  your  model  demonstrates  a  good  fit,  you  still  run  the  chance  of  bad  luck.  Even  
though  there  is  almost  a  70%  chance  that  if  you  hit,  you  will  not  bust,  the  next  card  you  
draw  could  be  a  10,  jack,  queen,  or  king.  And  this  assumes  that  events  are:  
o Independent  
o Random  
o Normally  distributed  –  we  know  this  is  NOT  truei  
• Unfortunately,  in  this  example,  you  can’t  fairly  mitigate  this  risk,  because  the  only  aspect  of  
this  encounter  you  can  control  is  the  decision  to  hit  or  stand;  however,  by  identifying  the  
threshold  that  drawing  a  “bust”  card  is  almost  1  out  of  3,  and  based  on  the  fact  that  this  is  a  
non-­‐normal  distribution,  we  can  legitimately  conclude  that  the  cards  are  stacked  against  us.  
Let’s  take  a  look  at  Endnote  (1)  to  gauge  the  actual  distribution  data  from  this  example  
 
 
EX  1.2]  
Business  inventory  example  
 
Unknown  Unknowns  
There  is  a  final  form  of  risk  that  I  would  be  remiss  if  I  did  not  mention  –  the  Unknown  
Unknowns.  These  are  the  risks  that  are  so  far  beyond  the  scope  of  the  risk  spectrum  that  they  
are  not  quantifiable.  They  are  incredibly  remote  and  exogenous,  but  no  less  real.  Unfortunately,  
many  practitioners  like  to  lump  many  of  the  Known  Unknowns  into  this  group  (usually  because  
it  gets  them  on  television).  When  misapplied,  many  will  refer  to  the  “hundred  year  flood”  as  an  
Unknown  Unknown,  but  with  even  a  cursory  analysis  of  that  statement,  we  know  that  to  be  
false.  Given  its  name  (hundred  year  flood)  we  have  a  frequency  assumption  built-­‐in.  
 
No,  Unknown  Unknowns  are  material  but  incalculable.  Think  about  Lehman’s  collapse.  Was  that  
supposed  to  happen  even  ten  decades?  No,  of  course  not.  Even  with  20/20  hindsight,  I  
challenge  you  to  find  a  reliable  model  to  predict  Lehman’s  collapse  using  data  through  2004.  
 
These  types  of  risks  are  often  called  Knightian  risks,  and  within  the  financial  risk  paradigm,  they  
usually  take  the  form  of  regulatory  risks,  counterparty  risks,  and  liquidity  risks.  
 
Risk,  conceptually  
Two  things  jump  out  of  these  examples:  
1. Randomness  –  what  is  it  exactly?  
2. Risk  is  always  itself  a  derivative  of  a  value;  therefore  what  is  value?  
 
Randomness  
• Fooled  By  Randomness  
• Against  The  Gods  
 
<Coin  flip  example>  
 
Value  
How  do  you  define  value?  Is  it  what  something  costs?  Is  it  the  price  at  which  something  could  be  
replaced?  Does  the  market  dictate  it?  Ergo,  can  value  exist  without  a  market?  
 
What  is  the  value  of  your:  
1. Education?  
2. Future  Income?  
3. Education  (now  based  on  your  differentiated  future  income)?  
4. Right  to  vote?  
5. Happiness?  
 
What  would  it  cost  to  replicate/replace  each  of  these?  What  would  it  could  you  if  these  were  
lost?  What  can  you  do  to  mitigate  the  potential  loss  of  each?  How  much  would  you  pay  to  (A)  
guarantee,  or  (B)  reduce  the  uncertainty  concerning  the  access  to  each?  
 
These  are  all  important  questions  that  capture  the  added  dimensionality  of  value.  However  we  
choose  to  define  value,  whether  quantitative  or  qualitative,  RISK  is  the  quality  of  value  that  
exposes  that  value  to  uncertainty  or  loss.  
 
These  questions  frame  the  need  for  and  application  of  derivative  instruments.  We  will  ride  this  
wave  across  different  types  of  derivatives,  what  they  are,  how  they’re  built/valued,  and  how  
they  can  be  used  to  manage  risk.  
   
Lesson  1.5  
While  we  have  made  great  strides  in  defining  the  elements  of  risk,  we’ve  only  taken  the  first  
step  in  being  able  to  mitigate  risk.  
 
Imagine  a  zoo.  
 
We  now  explained  in  great  detail  what  makes  a  monkey  a  monkey.  But  now  armed  with  this  
understanding,  how  do  you  find  a  monkey?  Well,  before  we  take  our  trip  to  the  Amazonian  
rainforest,  perhaps  we’ll  spend  a  few  days  at  the  zoo,  studying  the  monkeys  in  the  trees  to  get  a  
better  sense  of  how  they  behave.  More  specifically,  let’s  learn  to  find  the  monkeys  in  a  limited  
set  of  trees  before  we  start  perusing  millions  of  acres  of  rainforest.  
 
SO,  risk…  how  do  we  find  it?  Just  because  we  think  there  may  be  a  risk,  how  can  we  know  for  
sure?  Are  there  other  risks  of  which  we  may  not  know,  and  if  so,  how  can  you  find  something  for  
which  you  may  not  even  know  you’re  looking?  
 
The  best  way  to  begin  this  process  is  actually  at  the  end,  rather  than  the  beginning  (and  I  don’t  
mean  using  hindsight).  
 
But  I  do,  at  least  kinda.  
 
We  defined  four  distinct  elements  of  risk  in  the  previous  lesson:  
 
1. Frequency  
2. Magnitude  
3. Accuracy  
4. Precision  
 
Let’s  start  with  the  last  half  of  these  –  accuracy  and  precision.  We  discussed  how  to  quantify  and  
measure  accuracy  and  precision,  but  without  context,  these  dimensions  are  still  pretty  
enigmatic.  
 
In  a  grander  sense,  I  like  to  think  of  accuracy  and  precision  as  knowability  and  predictability.  
Granted,  one  of  these  is  not  even  a  real  word  (yet!),  but  the  difference  between  these  elements  
is  nuanced.  
 
Think  about  the  way  you  look  at  the  world…  
 
You  perceive  everything  according  to  your  perspective,  correct?  You  hear  the  sound  a  dog  
makes,  and  you  think,  “dog;”  when  you  see  the  color  red,  you  think,  “red.”  This  is  your  frameset  
for  filtering  the  world.  Granted,  the  older  and  more  experienced  you  get,  this  framework  
becomes  more  and  more  detailed,  but  all  of  this  is  just  one  huge  model  that  you  overlay  on  the  
universe,  as  you  perceive  it.  
 
Now,  while  I  can  imagine  hours  of  incredibly  interesting  discourse  regarding  the  metaphysics  of  
human  perception,  I  will  try  my  best  to  limited  the  scope  of  this  example  to  the  matter  at  hand.  
 
You  have  a  model  for  the  way  your  universe  works  (can’t  really  get  more  grandiose  than  that).  
 
But…  
 
What  if  your  model  is  wrong?  
 
Again,  this  is  not  a  lesson  in  questioning  the  existence  of  a  higher  power  or  whether  or  not  
you’re  colorblind,  but  rather,  what  is  knowability?  
 
Knowability  is  the  goodness  of  fit  of  you  model  on  a  universe’s  empirical  data;  more  specifically,  
how  well  does  your  model  measure  the  real-­‐life  examples  of  your  world.  
 
Let’s  take  a  baby  step  forward.  
 
I  was  in  the  park  a  few  weeks  ago  doing  calisthenics  (don’t  ask)  when  the  instructor’s  four  year-­‐
old  son  (who  had  been  previously  playing  on  a  playscape)  ran  up  to  her  with  urgent  news.  He  
heard  a  fire  engine  siren,  and  moments  later  a  fire  truck  came  speeding  down  the  street  
adjacent  the  park.  Like  most  four  year-­‐old  boys,  he  was  fascinated  by  the  event  and  he  excitedly  
explained  (at  length)  to  his  mother  that  there  was  a  fire.  
 
Alright,  so,  the  question  before  you  now  is  –  was  he  right?  
 
Simple  question,  right?  
 
Boy  sees  fire  truck,  therefore  fire.  
 
Yes/No?  
 
I’ll  give  you  a  second…  
 
…  
 
…  
 
Ready?  Good.  
 
    
So,  clearly  the  answer  is…  well,  he’s  probably  right,  but  not  always.  
 
This  boy  has  a  model  of  the  world  that  simplistically  holds  that  all  fire  trucks  sound  their  sirens  
and  race  across  town  for  only  one  purpose  –  to  put  out  fires.  But  after  a  decade  of  experience  
and  a  healthy  amount  of  cynicism  is  beat  into  you,  your  model  of  the  world  changes,  and  you  
realize  that  fire  engines  exist  not  exclusively  for  the  purpose  of  extinguishing  fires.  Therefore,  
the  model  does  not  hold  in  all  points  of  data  throughout  the  universe.  The  difference  between  
the  boy’s  model  and  your  model  looks  like  this:  
 
Boy’s  model:  
∀f ∈ f : f ⊃ F ;  where  all  fire  engines  obey  “if  fire  engine,  then  fire.”  
 
Your  model:  
∃f ∈ f : f ⊃ F ;  where  at  least  one  fire  engine  obeys  “if  fire  engine,  then  fire.”  
 
You  have  managed  to  repair  the  model  a  good  deal  by  loosening  the  parameters  of  the  model.  
While  this  increases  the  accuracy  of  the  model,  it  may  reduce  its  usefulness.  
 
Why  is  this?  The  model  is  more  accurate,  how  can  it  be  less  useful?  
 
Well,  think  about  the  implied  language  in  these  statements  –  one  is  hard,  while  the  other  is  soft.  
 
Which  statement  is  more  concrete?  
You  will  get  an  A  in  FIN  377.2.  
-­‐OR-­‐  
You  may  get  an  A  in  FIN  377.2.  
 
Exactly.  Declaring  a  universal  truth  (will)  provides  an  easier  framework  with  which  to  make  
decisions  going  forward,  while  a  possibility  (may)  is  more  difficult  to  handicap.  But  alas,  we’re  no  
longer  talking  about  pure  knowability  now;  we’ve  now  moved  into  the  realm  of  precision,  or  
predictability.  
 
After  we  establish  what  our  model  looks  like  to  frame  our  world-­‐view,  we  can  measure  the  
model’s  ability  to  deliver  reasonable  predictions,  beyond  its  goodness  of  fit.  This  is  the  fourth  
dimension  of  risk,  which  we  measure  in  standard  deviation.  
 
As  you  can  see  from  our  fire  engine  example  above,  while  we  may  have  improved  our  model  fit  
to  ensure  that  our  model  is  more  correct,  our  process  of  doing  so  forces  us  to  use  a  wider  net  in  
practice.  Again,  this  wider  net  is  not  necessarily  wrong,  but  it  reduces  the  usefulness  of  our  
model.  Let’s  see  why.  
 
Let’s  say  I’m  looking  for  a  good  indicator  of  fires.  If  you  first  tell  me  that  fire  engines  are  always  
indicators  of  fires,  then  I  have  an  easily  definable  and  visible  indicator.  Granted,  as  we’ve  
already  established,  this  indicator  may  not  be  correct,  but  it’s  absolute.  On  the  other  hand,  if  
you  were  to  tell  me  that  fire  engines  may  indicate  fires,  then  while  your  statement  is  more  
accurate  than  the  first  statement,  it’s  hard  to  use.  Fire  engines  may  indicate  fires…  so  what?  
Many  factors  may  indicate  a  fire.  Our  goal  is  to  build  a  model  that  is  both  accurate  and  useful.  
So  how  to  do  this?  
 
Let’s  take  another  step  forward.  
 
Since  a  solid  understanding  of  basic  statistics  is  assumed  for  financial  risk  management,  let’s  
build  on  that  foundation.  
 
We  all  remember  ordinary  least  square  (OLS)  regression?  
 
Excellent!  Well  that’s  how  we’ll  start  measuring  one  factor’s  influence  on  another’s.  Let’s  start  
small.  
 
EX  1.51]  
 
Ferrell  McNuremstein  is  a  portfolio  manager  for  Black  Stone  Rock  Capital  Advisor  Securities  
Group  Corp,  Inc.  (BSRCASGCI).  One  of  his  clients  is  Dugard  Silverblatts,  an  elderly  gentleman  
who  has  a  concentrated  position  in  one  specific  stock  –  Pear,  Inc.  
 
Pear  is  an  incredible  innovative  firm,  but  unfortunately,  there  are  no  available  options  on  Pear.  
Silverblatts  has  told  McNuremstein  on  several  occasions  that  he  (Silverblatts)  has  no  intention  of  
selling  Pear,  but  he  is  very  concerned  about  the  economy.  As  a  result,  Silverblatt  wants  to  hedge  
his  portfolio  (which  is  exclusively  Pear)  significantly.  McNuremstein  outsourced  this  project  to  
his  top  analyst,  Gomer  Leftenrite.  At  9  PM,  McNuremstein  handed  Leftenrite  a  table  and  asked  
for  his  recommendation  in  the  morning.  
 
After  a  quick  glimpse,  Leftenrite  is  leaning  toward  selling  some  shares  of  an  S&P  500  ETF  short  
to  hedge  the  Pear  position.  
 
Is  this  a  correct  read?  
 
How  should  Leftenrite  respond?  
   
TABLE  1.51  
DATE     PEAR     S&P  500   BAR  AGG  
2003  Q4   0.0216     0.0765     0.0176  
2004  Q1   0.3285     -­‐0.0211     -­‐0.0102  
2004  Q2   0.0454     -­‐0.0050     0.0128  
2004  Q3   -­‐0.0980     0.0259     0.0303  
2004  Q4   0.3586     0.0452     0.0053  
2005  Q1   0.4534     -­‐0.0207     0.0036  
2005  Q2   0.3631     0.0668     0.0066  
2005  Q3   -­‐0.1170     -­‐0.0220     -­‐0.0077  
2005  Q4   0.1011     0.0605     0.0146  
2006  Q1   0.3115     0.0239     -­‐0.0085  
2006  Q2   0.0541     -­‐0.0259     0.0103  
2006  Q3   -­‐0.1823     0.0793     0.0331  
2006  Q4   0.0239     0.0438     0.0038  
2007  Q1   -­‐0.0110     0.0307     0.0203  
2007  Q2   -­‐0.0333     -­‐0.0183     -­‐0.0023  
2007  Q3   0.3715     0.0647     0.0295  
2007  Q4   0.0495     -­‐0.1103     0.0415  
2008  Q1   0.1021     0.0051     0.0029  
2008  Q2   0.2290     -­‐0.0853     -­‐0.0106  
2008  Q3   -­‐0.2470     -­‐0.2356     -­‐0.0329  
2008  Q4   -­‐0.1230     -­‐0.1475     0.0772  
2009  Q1   0.0840     0.0568     0.0054  
2009  Q2   0.1290     0.1314     0.0242  
2009  Q3   -­‐0.0174     0.0493     0.0266  
2009  Q4   0.3058     0.0364     0.0078  
2010  Q1   0.2597     0.1051     0.0117  
2010  Q2   -­‐0.1542     -­‐0.0717     0.0375  
2010  Q3   0.2158     0.0741     0.0145  
2010  Q4   0.1987     0.0869     -­‐0.0159  
2011  Q1   -­‐0.2409     0.0603     0.0164  
2011  Q2   -­‐0.1486     -­‐0.0523     0.0249  
2011  Q3   0.0434     -­‐0.0302     0.0243  
2011  Q4   0.2876     0.0084     0.0005  
 
   
Let’s  see  if  we  can  help  Gomer  shape  his  recommendation.  
 
First  thing’s  first,  let’s  plot  the  individual  data  steams  to  see  with  what  we’re  dealing.  
 

PEAR
S&P 500

BAR AGG
So,  what  are  some  of  the  first  things  that  we  notice?  
 
First,  Pear  appears  bimodal  (having  two  peaks).  Second,  both  Pear  peaks  demonstrate  positive  
returns,  which  would  suggest  that  Pear’s  mean  quarterly  return  would  be  positive  as  well.  
Additionally,  both  the  S&P  500  and  Barclays  Aggregate  are  relatively  normally  distributed,  
though  the  S&P  is  slightly  negatively  skewed  and  the  Agg  is  positively  skewed.  
 
So,  let’s  get  to  Leftenrite’s  inclination  to  short  the  S&P  500  to  hedge  the  Pear  position.  On  its  
face,  the  guidance  seems  logical  –  a  single  stock  will  likely  behave  like  the  stock  market,  right?  
 
To  answer  that  question,  we  need  to  determine  how  Pear  covaries  with  the  stock  market.  
 
Covariance  can  be  calculated  in  several  ways.  
 
Simply  put,  covariance  is:  
 
Cov ( X,Y ) = ( X − µ X ) (Y − µY )  
( )           [EQ  1.511]  
 
However,  since  most  issues  with  covariance  are  iterative,  we  can  expand  our  definition  of  
covariance  to  include  a  series  of  observations:  
 
N
Cov ( X,Y ) = ∑
( xi − x ) ( yi − y )             [EQ  1.512]  
i=1 N
 
And,  of  course,  if  you  already  have  some  statistical  description  of  the  factors  and  their  
correlation,  then  you  can  expand  correlation  with  the  closed  form  expression:  
 
Cov ( X,Y ) = ρ XY σ Xσ Y                 [EQ  
1.513]  
 
Now,  these  measures  of  covariance  are  all  well  and  good  (and  testable),  but  for  the  purpose  of  
this  example  (and  many  many  others),  the  most  efficient  route  to  calculate  covariance  is  
through  OLS  regression.  Again,  the  assumption  is  that  at  this  point  in  our  story,  you  are  
comfortable  fitting  one  variable  against  another,  but  we’ll  still  step  slowly  through  this  example  
as  a  refresher.  
 
Please  feel  free  to  use  whatever  software  you  prefer  for  regressions;  while  its  always  good  
practice  to  do  it  by  hand,  I  would  rather  outsource  the  brute-­‐force  calculation  to  a  terminal.  
 
So,  armed  with  a  copy  of  SAS  JMP,  Leftenrite  adheres  to  our  guidance  and  regresses  the  Pear  
returns  against  the  S&P  500  and  receives  the  following  output:  
Bivariate Fit of PEAR By S&P 500

Linear Fit
PEAR = 0.0818933 + 0.9190816*S&P 500

Summary of Fit
RSquare 0.130483
RSquare Adj 0.102434
Root Mean Square Error 0.184803
Mean of Response 0.089836
Observations (or Sum Wgts) 33

Analysis of Variance
Source DF Sum of Mean Square F Ratio
Squares
Model 1 0.1588746 0.158875 4.6520
Error 31 1.0587157 0.034152 Prob > F
C. Total 32 1.2175903 0.0389*
Parameter Estimates
Term Estimate Std Error t Ratio Prob>|t|
Intercept 0.0818933 0.03238 2.53 0.0167*
S&P 500 0.9190816 0.426124 2.16 0.0389*

From  these  results,  Letenrite  is  ecstatic.  From  this  output,  he  clearly  reads  that  the  covariance  
factor,  or  beta,  of  the  S&P  for  Pear  is  0.92.  Relieved  that  the  rest  of  his  evening  has  now  opened,  
he  starts  powering  down  his  computer  to  leave.  
 
Just  as  he’s  about  the  leave  for  the  night,  his  phone  rings.  It’s  you;  you  tell  him  to  sit  back  down  
for  three  reasons.  
 
First,  his  S&P  500  beta  is  only  marginally  statistically  significant  at  best.  With  a  t-­‐stat  of  2.53  and  
a  p-­‐value  of  0.0167,  this  hypothesis  does  not  have  enough  significance  to  overturn  a  null  at  
three  sigmas.  Second,  the  R-­‐squares  demonstrate  a  correlation  between  the  S&P  500  and  Pear  
samples  of  10-­‐13%.  Third,  the  root  mean  square  error  is  0.184.  This  means  that  the  expected  
model  error  is  greater  than  its  measure  of  fit.  All  of  these  metrics  (but  especially  RMSE)  lead  you  
to  believe  that  Leftenrite’s  model  has  little  ability  to  “know”  what  will  happen  next.  Put  another  
way,  his  model’s  pretty  crappy.  
 
Knowing  this,  you  politely  ask  Leftenrite  to  fire  up  his  terminal  and  try  a  few  more  models  
before  he  leaves  for  the  evening.  
 
At  your  request,  Leftenrite  sits  down  to  attack  this  hedging  problem  another  way.  Perhaps  the  
Barclays  Aggregate  will  offer  a  more  robust  model?  
 
Bivariate Fit of PEAR By BAR AGG
Linear Fit
PEAR = 0.1254911 - 2.8345144*BAR AGG

Summary of Fit
RSquare 0.08553
RSquare Adj 0.056031
Root Mean Square Error 0.18952
Mean of Response 0.089836
Observations (or Sum Wgts) 33

Analysis of Variance
Source DF Sum of Mean Square F Ratio
Squares
Model 1 0.1041407 0.104141 2.8994
Error 31 1.1134496 0.035918 Prob > F
C. Total 32 1.2175903 0.0986

Parameter Estimates
Term Estimate Std Error t Ratio Prob>|t|
Intercept 0.1254911 0.039075 3.21 0.0031*
BAR AGG -2.834514 1.66465 -1.70 0.0986
 
Hmmm…  Leftenrite  thinks  to  himself  –  that’s  even  worse!  The  statistical  significance  of  his  beta  
and  his  R-­‐squares  fell  and  his  RMSE  increased.  
 
Then,  in  a  Zen-­‐like  moment  of  clarity,  Leftenrite  had  an  idea  –  “What  if  I  run  the  models  
simultaneously?  Perhaps  there  are  shared  or  overlaid  characteristics  that  would  improve  the  
model.”  
Response PEAR
Whole Model
Actual by Predicted Plot

Summary of Fit
RSquare 0.21699
RSquare Adj 0.164789
Root Mean Square Error 0.178268
Mean of Response 0.089836
Observations (or Sum Wgts) 33

Analysis of Variance
Source DF Sum of Mean Square F Ratio
Squares
Model 2 0.2642044 0.132102 4.1568
Error 30 0.9533859 0.031780 Prob > F
C. Total 32 1.2175903 0.0255*

Parameter Estimates
Term Estimate Std Error t Ratio Prob>|t|
Intercept 0.1177216 0.036918 3.19 0.0033*
S&P 500 0.9225244 0.41106 2.24 0.0323*
BAR AGG -2.850681 1.565838 -1.82 0.0787
Residual by Predicted Plot

Better,  but  unfortunately,  still  not  acceptable.  

 
You  will  notice  that  R-­‐square  increased  through  the  addition  of  another  factor  in  the  model.  This  
will  be  the  case,  but  just  because  you  add  a  factor  doesn’t  mean  you’re  actually  making  the  
model  better.  Sometimes  more  is  just  more.  To  filter  out  the  effects  of  factor  accumulation,  we  
use  the  adjusted  R-­‐square  metric.  This  strips  out  the  residual  of  “model-­‐pumping.”  
 
At  this  point,  Leftenrite  is  beside  himself,  he  can’t  imagine  that  the  right  answer  would  involve  a  
lognormal  regression  –  that  just  doesn’t  seem  right.  
 
So,  ignoring  the  data  set  before  him,  Leftenrite  logs  into  Bloomberg  to  research  Pear  more  
thoroughly.  After  an  hour  of  perusing  press  releases,  Leftenrite  begins  to  recognize  a  pattern.  
Pear  seemed  to  be  mentioned  daily  in  its  chip-­‐set  vendor’s,  Quantum,  press  releases.  In  turn,  
Quantum  seemed  to  pop  up  in  most  of  Pear’s  press  releases.  Additionally,  Pear  was  often  noted  
in  its  competitor’s,  HUB,  releases  as  well.  
 
Based  on  this  recognition,  Leftenrite  pulled  the  quarterly  data  for  Quantum  (QTUM)  and  HUB  
(HUBB)  and  added  them  to  the  table.    
 
   
Table  1.52  
DATE   PEAR   S&P  500   BAR  AGG   QTUM   HUBB  
2003  Q4   0.022   0.077   0.018   0.011   0.000  
2004  Q1   0.329   -­‐0.021   -­‐0.010   0.184   0.043  
2004  Q2   0.045   -­‐0.005   0.013   0.022   0.005  
2004  Q3   -­‐0.098   0.026   0.030   -­‐0.035   0.094  
2004  Q4   0.359   0.045   0.005   0.100   0.111  
2005  Q1   0.453   -­‐0.021   0.004   0.109   -­‐0.207  
2005  Q2   0.363   0.067   0.007   0.024   -­‐0.184  
2005  Q3   -­‐0.117   -­‐0.022   -­‐0.008   -­‐0.049   -­‐0.009  
2005  Q4   0.101   0.061   0.015   0.025   0.027  
2006  Q1   0.312   0.024   -­‐0.009   0.088   -­‐0.035  
2006  Q2   0.054   -­‐0.026   0.010   0.003   -­‐0.028  
2006  Q3   -­‐0.182   0.079   0.033   -­‐0.050   0.128  
2006  Q4   0.024   0.044   0.004   0.079   0.064  
2007  Q1   -­‐0.011   0.031   0.020   0.078   0.078  
2007  Q2   -­‐0.033   -­‐0.018   -­‐0.002   -­‐0.049   -­‐0.089  
2007  Q3   0.372   0.065   0.030   0.130   0.076  
2007  Q4   0.050   -­‐0.110   0.042   0.000   -­‐0.249  
2008  Q1   0.102   0.005   0.003   0.036   0.007  
2008  Q2   0.229   -­‐0.085   -­‐0.011   0.038   -­‐0.109  
2008  Q3   -­‐0.247   -­‐0.236   -­‐0.033   -­‐0.158   -­‐0.195  
2008  Q4   -­‐0.123   -­‐0.148   0.077   -­‐0.126   -­‐0.099  
2009  Q1   0.084   0.057   0.005   0.048   -­‐0.055  
2009  Q2   0.129   0.131   0.024   0.047   0.069  
2009  Q3   -­‐0.017   0.049   0.027   0.085   0.115  
2009  Q4   0.306   0.036   0.008   0.105   -­‐0.144  
2010  Q1   0.260   0.105   0.012   0.070   0.127  
2010  Q2   -­‐0.154   -­‐0.072   0.038   -­‐0.099   -­‐0.128  
2010  Q3   0.216   0.074   0.015   0.076   0.112  
2010  Q4   0.199   0.087   -­‐0.016   0.052   0.078  
2011  Q1   -­‐0.241   0.060   0.016   0.003   0.178  
2011  Q2   -­‐0.149   -­‐0.052   0.025   -­‐0.022   -­‐0.154  
2011  Q3   0.043   -­‐0.030   0.024   0.030   -­‐0.088  
2011  Q4   0.288   0.008   0.001   0.065   -­‐0.133  
 
   
Leftenrite  started  by  charting  the  QTUM  and  HUBB  returns:  
 

QTUM

Quantiles
100.0% maximum 0.184
99.5% 0.184
97.5% 0.184
90.0% 0.10734
75.0% quartile 0.0782
50.0% median 0.0358
25.0% quartile -0.0112
10.0% -0.0792
2.5% -0.1575
0.5% -0.1575
0.0% minimum -0.1575

Moments
Mean 0.0278364
Std Dev 0.0732849
Std Err Mean 0.0127573
Upper 95% Mean 0.0538221
Lower 95% Mean 0.0018507
N 33
 

HUBB

Quantiles
100.0% maximum 0.17846
99.5% 0.17846
97.5% 0.17846
90.0% 0.12202
75.0% quartile 0.07787
50.0% median 0.0001
25.0% quartile -0.1182
10.0% -0.1906
2.5% -0.2487
0.5% -0.2487
0.0% minimum -0.2487

Moments
Mean -0.017977
Std Dev 0.1155246
Std Err Mean 0.0201102
Upper 95% Mean 0.0229864
Lower 95% Mean -0.05894
N 33
 
While  only  anecdotal,  Leftenrite  noticed  that  QTUM  exhibited  a  negative  skew  and  that  HUBB  
seemed  bimodal.  Then  Leftenrite  regressed  PEAR  against  both  QTUM  and  HUBB  individually.  
 

Bivariate Fit of PEAR By QTUM

Linear Fit
PEAR = 0.031199 + 2.1064994*QTUM

Summary of Fit
RSquare 0.626325
RSquare Adj 0.614271
Root Mean Square Error 0.121148
Mean of Response 0.089836
Observations (or Sum Wgts) 33

Analysis of Variance
Source DF Sum of Mean Square F Ratio
Squares
Model 1 0.7626076 0.762608 51.9598
Error 31 0.4549828 0.014677 Prob > F
C. Total 32 1.2175903 <.0001*

Parameter Estimates
Term Estimate Std Error t Ratio Prob>|t|
Intercept 0.031199 0.022604 1.38 0.1774
QTUM 2.1064994 0.292232 7.21 <.0001*
 
“Finally,”  Leftenrite  thought,  “I’m  on  to  something.”  
 
PEAR  covaried  strongly  and  positively  with  QTUM.  This  made  sense  qualitatively,  as  what  would  
be  good  for  one  is  likely  good  for  the  other  (excluding  contract  negotiations  between  the  two,  of  
course).  PEAR’s  QTUM  beta  (βQTUM)  was  2.11  at  seven  sigmas  of  statistical  significance.  
Additionally,  the  two  equities  exhibited  a  reasonable  strong  correlation  with  a  small  RMSE.  
Leftenrite  was  satisfied  that  there  was  an  exploitable  relationship  here,  but  he  pushed  onward.  
 
Bivariate Fit of PEAR By HUBB

Linear Fit
PEAR = 0.0877211 - 0.1176687*HUBB

Summary of Fit
RSquare 0.004856
RSquare Adj -0.02724
Root Mean Square Error 0.197703
Mean of Response 0.089836
Observations (or Sum Wgts) 33

Analysis of Variance
Source DF Sum of Mean Square F Ratio
Squares
Model 1 0.0059132 0.005913 0.1513
Error 31 1.2116772 0.039086 Prob > F
C. Total 32 1.2175903 0.7000

Parameter Estimates
Term Estimate Std Error t Ratio Prob>|t|
Term Estimate Std Error t Ratio Prob>|t|
Intercept 0.0877211 0.034843 2.52 0.0172*
HUBB -0.117669 0.302526 -0.39 0.7000
 
“Well  that  was  easy,  there’s  no  relationship  between  PEAR  and  HUBB!”  
 
Just  as  Leftenrite  opened  up  Word  to  begin  drafting  his  recommendation,  his  phone  rang  again  
–  you  were  calling  him  to  take  one  more  step.  
 
“Why  should  I  run  them  together,  HUBB  adds  no  value,”  countered  Leftenrite.  
 
Ultimately,  you  were  able  to  convince  him  that  it  would  only  take  another  minute  to  run  the  
multiple  regression.  
 

Whole Model
Actual by Predicted Plot

Summary of Fit
RSquare 0.734863
RSquare Adj 0.717187
Root Mean Square Error 0.103735
Mean of Response 0.089836
Observations (or Sum Wgts) 33
Analysis of Variance
Source DF Sum of Mean Square F Ratio
Squares
Model 2 0.8947619 0.447381 41.5745
Error 30 0.3228284 0.010761 Prob > F
C. Total 32 1.2175903 <.0001*

Parameter Estimates
Term Estimate Std Error t Ratio Prob>|t|
Intercept 0.0127858 0.020055 0.64 0.5286
QTUM 2.3903783 0.263013 9.09 <.0001*
HUBB -0.5847 0.166847 -3.50 0.0015*

Residual by Predicted Plot

 
Leftenrite  was  blown  away,  adding  HUBB  into  a  multiple  regression  with  QTUM  increased  the  
model  betas’  (both  QTUM  and  HUBB)  level  of  significance,  while  also  improving  model  fit  
(increasing  adjusted  R-­‐square  and  lowering  RMSE).  
 
How  is  it  possible  that  a  variable  without  any  material,  independent  regressive  value  can  add  so  
much  value?  The  more  and  more  he  reviewed  the  data  table,  he  noticed  that  PEAR  and  QTUM  
moved  the  same  direction  most  of  the  time,  but  in  those  instances  when  they  appeared  to  
behave  differently,  he  noticed  that  HUBB  moved  strongly  opposite  PEAR.  Leftenrite  realized  that  
HUBB  offered  explanations  during  periods  when  QTUM  didn’t,  and  as  a  result,  the  combination  
of  both  factors  in  the  multiple  regression  created  a  stronger  model  that  allowed  Leftenrite  to  
see  the  behaviors  of  PEAR  more  accurately.  
  
Based  on  this  final  model,  Leftenrite  concluded  that  for  every  share  of  PEAR  Silverblatts  owned,  
he  should  short  2.39  shares  (equivalent)  of  QTUM  and  go  long  0.58  shares  (equivalent)  of  HUBB.  
He  ignored  that  fact  that  Silverblatts  wanted  to  protect  his  PEAR  holdings  from  a  weakening  
economy,  and  that  Leftenrite  had  just  proven  that  PEAR’s  stock  price  had  little  relationship  with  
the  stock  market  over  the  better  part  of  the  previous  decade,  including  2008,  where  correlations  
converged  at  one.  
 
He  felt  good  about  his  recommendation  as  it  was  based  on  historical  data  and  a  sound  statistical  
model,  but  he  thought  to  himself  (as  he  was  walking  out  of  the  building,  of  course)  if  there  were  
a  better  way  to  execute  the  hedge,  other  than  using  additional  shares  of  equity?  
 
Well,  the  answer  to  Leftenrite’s  last  question  is  indelibly,  yes,  or  at  least  we  hope  it  is  for  the  
duration  of  this  book,  but  let’s  put  a  pin  in  that  for  another  lesson  or  two.  
 
So  we’ve  taken  a  look  at  a  model’s  accuracy,  as  represented  by  the  model’s  measure  of  fit,  R-­‐
square,  or  adjusted  R-­‐square.  While  this  is  clearly  important,  it  lacks  context.  
 
If  you  have  $10,000,000  are  you  rich?  Well,  perhaps,  but  it  kind  of  matters  how  much  a  gallon  of  
milk  costs,  right?  If  milk  costs  $5,000,000  per  gallon,  you  suddenly  feel  a  whole  lot  poorer.  The  
same  can  be  said  for  R-­‐square,  or  correlation.  The  measure  is  all  well  and  good,  but  I  want  to  
know  the  RMSE  for  comparison.  If  I  have  a  reasonable  R-­‐square  with  a  huge  relative  RMSE,  then  
I  don’t  have  a  good  model.  So,  contextually,  we  now  know  how  to  test  a  model  for  the  third  
factor  of  risk,  namely,  do  we  have  a  good  model,  and/or  are  our  risks  knowable  given  our  frame  
of  reference?  
 
Then  next  element  of  risk,  precision,  is  something  on  which  we’ve  already  touched.  When  
examining  the  factors’  covariances,  or  betas,  we  use  a  measure  of  risk  to  contextualize  our  
certainty  with  standard  deviation.  This  is  clearly  important  to  our  decisions  to  accept  or  reject  
our  betas  as  viable,  but  note  that  the  standard  deviation  of  the  beta  has  nothing  to  do  with  our  
model’s  fit.  Thus,  both  accuracy  and  precision  are  important,  but  they  can  be  viewed  
independently.  
 
So,  using  ordinary  least  squares  we  can  detect  risks.  We  were  able  to  show  that  PEAR’s  stock  
price  risks  don’t  really  include  equity  market  of  bond  market  risks.  As  a  result,  we  can  assert  that  
PEAR’s  stock  price  risks  are  less  macro  and  more  micro  in  nature.  This  is  clearly  critical  as  using  
the  third  and  fourth  elements  of  risk  we  can  identify  risks  and  hedges.  Moving  back  to  the  top  of  
the  list,  we  can  use  the  first  two  elements  of  risk  to  help  us  quantify  the  level  of  risk  we  bear  
according  to  expected  value.  
 
But  quantifying  known  risks  is  a  simple  matter  of  arithmetic;  it’s  detecting  the  risks  that  can  be  
tricky.  
  
Lesson  2.0  
Derivatives  “derive”  their  values  from  underlying  assets.  Without  some  sort  of  underlying,  there  
is  no  derivative  value,  hence  no  derivative.  Granted,  even  with  an  underlying,  a  derivative  may  
have  no  value  (or  negative  value),  but  let’s  set  up  our  logical  statement  to  define  a  derivative.  
 
U = underlying
d = derivative  
∀d ∈ d : d ⊃ U
 
Derivatives  can  get  their  values  from  virtually  anything,  from  interest  rates  and  exchange  rates  
to  the  price  of  gold  and  oil  to  the  price  of  a  stock  at  a  specific  point  in  time  to  the  likelihood  it  
will  rain  in  June  to  the  probability  of  a  default.  Plus,  these  events  can  be  stacked  to  incorporate  
more  than  a  single  contributing  underlying,  but  we’ll  get  there  in  due  time.  First,  let’s  get  a  
better  understanding  of  each  major  type  of  derivatives.  
 
Within  the  derivative  space,  there  are  several  super-­‐classes  of  instruments.  The  first  super-­‐class  
of  derivatives  is  the  Simple  Transaction  derivatives.  This  is  where  we  will  spend  most  of  the  
course.  These  derivatives  have  a  diverse  array  of  underlyings,  but  they  have  many  features  in  
common.  These  features  include:  
 
• Time  
• Asset(s)  
• Party  
 
Time  
The  first  common  feature  of  ST  derivatives  is  that  these  derivatives  have  a  finite  life.  Unlike  fixed  
income  products,  ST  derivatives  do  not  mature;  instead  they  expire.  This  terminology  elicits  a  
different  cognitive  response.  Maturity  connotes  patience  and  growth,  while  expiration  usually  
infers  finality  and  haste.  But  alas,  these  are  the  words,  I  don’t  choose  ‘em.  
 
Anyhow,  the  timeliness  of  ST  derivatives  requires  an  expiration  date,  and  given  the  date  of  
execution  and  this  expiration  date,  each  ST  derivative  comes  with  its  own  timeline,  both  
beginning  and  end.  Again,  this  may  seem  trivial  now,  but  this  will  be  important  when  theta  (θ)  
comes  into  play.  
 
So,  given  our  date  of  transaction  (T0)  and  expiration  date  (Te),  then  logically,  our  timeline  equals:  
 
e

∑t i = Te − T0                     [EQ  2.1]  
i=0

 
Granted,  our  concern  for  time  may  be  more  granular  than  a  total  timeline,  but  tn  can  be  any  
subset  of  the  summation  of  ti.    
 
Asset(s)  
I  agree  with  you;  that  is  a  good  question.  
 
Why  is  the  final  “s”  in  “Asset(s)”  parenthetical?  
 
Well,  that’s  because  even  though  ST  derivatives  are  based  on  the  price  of  only  one  underlying  
asset,  they  are  not  actually  based  on  the  price  of  one  underlying  asset.  
 
What?  
 
Yeah,  I  know.  But  here’s  the  thing,  the  grey  area  here  is  usually  just  the  risk-­‐free  rate.  But,  to  
access  the  risk-­‐free  rate,  we  need  to  assume  the  value  of  a  zero-­‐coupon,  which,  like  it  or  not,  is  
an  asset.  
 
The  other  asset,  you  know,  the  important  one  actually  lending  definition  to  the  derivative,  can  
be  anything,  but  for  the  purpose  of  this  course,  these  assets  will  include:  
 
• Interest  rates  
• Exchange  rates  
• Commodity  prices  
• Equity  prices  
• Fixed  income  prices  
 
ST  derivatives  can  be  directly  or  inversely  related  to  the  underlying.  Therefore,  just  because  an  
underlying  exists  and  defines  a  derivative  mean  than  the  two  will  be  positively  correlated.  Also,  
be  mindful  of  the  issue  of  causation  v.  correlations;  just  because  a  derivative  is  inversely  related  
to  the  underlying  does  not  mean  that  appreciation  in  the  price  of  the  underlying  will  necessarily  
cause  depreciation  in  the  price  of  the  derivative.  This  would  be  the  case  if  the  only  variable,  
which  defined  the  price  of  the  derivative,  were  the  underlying,  but  alas,  the  pricing  of  
derivatives  is  slightly  more  complex.  
 
Party  
With  ST  derivatives,  there  are  two  parties  involved  with  the  transaction  –  the  buyer  and  the  
seller.  Again,  this  may  seem  like  another  trivial  point,  but  in  other  types  of  derivatives  (other  
than  ST),  the  conditions  for  transaction  are  not  simply  zero-­‐sum  between  two  parties;  we  will  
see  this  when  we  deconstruct  the  different  tranches  in  CDOs  and  synthetic  CDOs.  
 
In  short,  ST  derivatives  are  defined  by  a  finite  timeline,  a  single  defining  underlying  asset,  and  a  
two-­‐party  transaction.  
 
So,  let’s  chat  about  what  types  of  derivatives  comprise  the  ST  subset;  ST  derivatives  include  
swaps,  forwards,  futures,  and  options.  
2.1     Swaps  
 
At  their  most  basic  level,  swaps  are  nothing  more  than  an  agreement  to  exchange  benefits  
between  two  parties.  So  if  you  own  a  bakery  in  need  of  a  new  counter,  and  I’m  a  carpenter  with  
a  penchant  for  pastries,  then  perhaps  we  could  enter  into  a  swap  where  I  agree  to  spend  four  
hours  a  day  for  one  week  working  on  your  new  counter,  and  you  agree  to  give  me  your  unsold  
cupcakes  and  croissants  every  day  I  work.  Our  agreement  is  a  rudimentary  swap  –  two  parties,  
agreement,  and  exchange  of  benefits.  
 
If  we  contextualize  this  with  a  little  financial  flavor,  we  can  more  specifically  define  a  swap  as  an  
agreement  to  exchange  benefits  derived  from  financial  or  real  assets.  So,  now  instead  of  built-­‐
ins  and  confections,  we  can  substitute  in  bonds  (interest  rates  and  credit  default),  equities,  and  
commodities  (real  and  financial).  Again,  to  provide  a  simple  example,  let’s  say  you  are  a  risk-­‐
loving  bondholder  with  a  bond  that  pays  you  3%  annually  that  matures  in  three  years  (I  know,  
awesome  bond,  right?).  I,  on  the  other  hand,  am  a  risk-­‐averse  bondholder  with  a  bond  that  pays  
me  a  2.5%  premium  over  LIBOR.  You  and  I  run  into  each  other  at  a  coffee  shop  and  discuss  our  
discontent  with  our  holdings.  Granted,  we  could  just  sell  our  holdings  to  increase  our  utility,  so  
curb  that  desire,  we  are  both  aware  that  if  we  sell  our  bonds  we  are  liable  for  significant  capital  
gains  (these  were  long  bonds  purchased  a  long  time  ago  at  significant  discounts).  So,  now  that  
we’re  tied  into  our  holdings,  we  chat  about  great  it  would  be  if  I  could  receive  your  fixed  interest  
rate,  and  you  could  receive  mine.  Though  somewhat  unofficial,  we  scrawl  the  terms  of  the  
agreement  on  the  cardboard  sleeve  from  the  coffee  cup.  What  would  this  need  to  say  to  create  
a  valid  swap?  
 
Two  parties?  Check.  
Exchange  of  benefits?  Check.  
Timeline?  Check.  
 
Clearly,  these  are  simple  examples  of  swaps,  but  the  tenets  of  even  the  most  complex  swaps  
boil  down  to  an  agreement  to  exchange  benefits.  
 
From  a  risk  management  perspective  swaps  can  be  useful  to  offset  liabilities.  Let’s  say  you  had  a  
variable  rate  mortgage  (though  I  realize  that  if  you  are  taking  this  course,  you  are  probably  not  
the  ARM  demographic).  If  you  find  yourself  in  this  position,  then  you  can  inoculate  your  variable  
rate  exposure  through  a  swap  by  agreeing  to  pay  the  fixed  rate  on  the  swap  and  receive  the  
variable  rate.  In  this  example,  you  wind  up  with  a  fixed-­‐rate  mortgage  by  netting  out  your  
variable  exposure.  
  
Pay  >>  VAR  mortgage  and  FIX  swap  
Rec  <<  VAR  swap  
Net  ==  FIX  mortgage  
 
Swaps  are  custom  designed  for  the  counterparties  involves,  meaning  they  are  not  liquid.  Swaps  
do  not  involve  money  to  change  hands  at  the  outset  –  they  have  no  initial  cost.  
 
 
2.2   Forwards  (Forward  Contracts)  
 
A  forward  contract  is  similar  to  a  swap  with  respect  to  two  parties  entering  into  an  agreement  
for  an  exchange  of  benefits,  illiquidity,  and  no  up  front  cost,  but  in  the  case  of  a  forward  
contract;  the  exchange  involves  buying/selling  an  asset  at  a  specified  time  in  the  future.  Thus,  a  
forward  contract  is  an  agreement  between  two  parties  to  exchange  at  asset  (underlying)  for  a  
price  (delivery  price)  at  a  specified  future  date.  
 
Let’s  say  you  own  a  house  and  a  condo  near  campus.  You  live  in  the  house  and  you  rent  out  the  
condo  to  students  on  a  one-­‐year  term,  August  to  August.  You’ve  owned  the  condo  for  the  past  
five  years,  and  you’ve  rented  it  out  successfully  every  year  except  for  the  first.  You’ve  also  
noticed  a  strong  prevailing  demand  for  housing  in  the  area,  as  the  market  rates  seem  to  increase  
every  year  by  2-­‐3%.  Over  this  last  summer,  when  your  current  resident  was  preparing  to  leave  
(she  got  into  a  second-­‐tier  law  school  on  the  east  coast),  a  sophomore  majoring  in  operations  
and  risk  management  inquired  whether  she  may  rent  the  condo  for  the  next  two  years.  You  had  
always  rented  from  year  to  year,  but  the  idea  of  multiyear  stability  appealed  to  you,  so  you  
agreed  to  rent  the  condo  to  this  new  student  at  the  current  market  rate  this  year  (R0)  and  for  3%  
higher  the  second  year  (R1).  You  new  tenant  agrees  to  these  terms.  
After  the  first  year,  market  rates  are  considerably  higher/lower  than  anticipated  due  to  the  
larger  freshman  class  size/ferret  problem.  
 
In  either  case,  what  defines  your  forward  contract  and  which  party  comes  out  ahead  in  each  
scenario?  
 
As  you  can  see  from  this  example,  the  forward  contract  did  not  require  a  capital  outlay  from  
either  party,  but  the  forward  contract  clearly  had  value  by  expiration.  What  drove  the  value  of  
the  forward  contract?  
 
EX  2.2  –  Using  Swaps  and  Forwards]  
 
Growing  up,  your  family  always  took  a  summer  vacation.  Sometimes  you  drove  across  the  
country  in  your  dad’s  RV  visiting  the  state  parks,  and  others  you  would  fly  to  visit  various  
relatives.  Your  favorite  of  all  of  these  trips  was  fourteen  years  ago  when  you  spent  two  weeks  
with  your  great  aunt  Helga.  Helga  was  a  lovely  woman  who  always  smelled  of  sassafras  and  new  
books,  which  was  a  result  of  the  fact  that  she  owned  both  a  children’s  book  publishing  company  
and  bottled  her  own  root  beer.  These  endeavors  were  wildly  successful,  and  Helga  enjoyed  a  
privileged  life,  but  Helga  never  had  time  for  children  of  her  own.  She  was  always  very  close  to  
her  sister  Balelga  (your  grandmother)  and  her  children  (your  mom  and  Uncle  Bert).  Bert  fancied  
himself  a  perpetual  bachelor,  but  your  mom  had  two  kids  –  you  and  your  bratty  little  sister,  
Willow.  Helga  and  Willow  never  got  along,  but  you  and  Helga  were  kindred  spirits.  
 
Sadly,  Helga  passed  away  last  month,  but  your  great  aunt  left  you  three  of  her  most  prized  
possessions:  
1. Her  dairy  farm,  Moomelga,  located  20  miles  outside  of  Bergen,  Norway;  
2. Her  horse,  Horselga,  who  is  stabled  at  a  ranch  in  South  Queensland,  Australia;  
3. Her  root  beer  manufacturing  company,  Awesomesauce  McGee  Root  Beer,  Inc.,  located  
in  Topeka,  KS.  
 
You  were  her  favorite,  and  coincidentally,  her  only  competent  relative;  she  knew  you  would  be  
the  only  one  to  make  sense  of  her  operations.  
 
Moomelga,  Bergen’s  fourth  most  productive  dairy  farm,  produces  420  litres  of  organic  milk  per  
day,  and  it  runs  every  day  of  the  year.  Each  gallon  costs  Moomelga  NOK  4.81,  but  Moomelga  can  
sell  80%  at  market  price  (assume  NOK  13.28  today)  and  the  remaining  20%  at  10%  less.  Milk  
follows  Norway’s  inflation  rate  pretty  closely,  so  assume  approximately  3.5%  per  year.  
Moomelga  distributes  profits  on  a  monthly  basis.  Helga  owned  a  70%  interest  in  Moomelga,  the  
remaining  30%  was  issued  to  the  co-­‐op  to  run  the  farm.  
 
Horselga  is  a  beautiful  Kabardin.  He  is  sure-­‐footed  and  good-­‐tempered.  But  Horselga  is  getting  a  
bit  older  (he  took  the  news  of  Helga’s  passing  hard),  and  he  spends  his  days  milling  around  and  
eating  the  finest  straw  that  Queensland  has  to  offer.  Given  his  propensity  for  the  upscale  feed  
and  his  round  the  clock  care,  Horselga  costs  about  AUD  2,300  per  week.  With  this  level  of  
pampering,  Horselga  will  probably  live  at  least  another  12-­‐15  years.  
 
Awesomesauce  McGee  Root  Beer,  Inc.  was  Helga’s  labor  of  love,  which  is  a  nice  way  of  saying  
that  it  generates  a  profit…  sometimes.  There  is  sufficient  demand  for  this  regional  pop  at  certain  
price  levels,  but  given  the  supply  of  some  of  the  exotic  roots  that  Helga  insisted  upon  for  the  
recipe,  Awesomesauce  was  not  always  priced  to  make  a  profit.  Helga  priced  the  soda  at  $1.25  
per  bottle,  $6  for  a  six-­‐pack,  and  $10  for  a  12-­‐pack,  accounting  for  6.67%,  60%,  and  33.33%  of  
sales  respectively.  If  roots  were  priced  favorably  (80%  of  the  time),  Awesomesauce  spent  $0.40  
per  bottle,  but  in  the  most  unfavorable  of  times  (20%  of  the  time),  Awesomesauce’s  costs  rose  
to  $1.45  per  bottle.  The  main  culprit  is  Devil’s  Club  root,  which  is  only  available  from  Darcy  
Schroot’s  Root  Distribution,  Inc.,  from  whom  Awesomesauce  buys  its  supply  quarterly.  
Awesomesauce  sells  1,800  bottles  per  week.  
 
Helga  left  everything  else  to  charity,  and  you  are  a  US  resident.  Current  FX  rates  are  USD/NOK  =  
5.5  and  USD/AUD  =  0.95.  
 
So…  
 
What  should  you  do?  
 
Determine  your  assets  and  liabilities  (value  and  risk)  
Assets  >>  
• 70%  interest  in  Moo;  420L/day;  Net  [80%(8.47)+20%(7.14)]  =  70%  x  420  x  8.21  =  NOK  
2,414/day  x  365  =  NOK  881,015  year  
• 60%  x  1,800  =  1.080  bottles  come  from  six-­‐packs  >>  180  six-­‐packs;  33%  x  1,800  =  600  
bottles  come  from  12-­‐packs  >>  50  12-­‐packs;  6.67%  x  1,800  =  120  bottles  as  singles.  
o REV  ==  (1.25)(120)+(6)(180)+(10)(50)  =  $1,730/week  x  52  =  $89,960  per  year  
o EXP  ==  80%(1,800)(0.40)  +  20%(1,800)(1.45)  =  576  +  522  =  1,098/week  x  52  =  
57,096  
o NET  ==  USD  32,864  per  year  
Liabilities  
• Horselga  >>  AUD  2,300/week  x  52  =  AUD  119,600  
Net  
• If  USD/NOK  =  5.5;  and  USD/AUD  =  0.95;  then  REV  =  160,184.55+32,864  =  193,048.55  
• EXP  =  125,864.74  
• NET  =  67,153.81  
 
How  can  we  maximize  the  spread  /  mitigate  the  risk  of  the  liabilities?  
• What  are  the  risks?  
o FREQ  ==  probability  that  NET  <  0  
o MAG  ==  what  is  the  avg.  value  of  NET  <  0  
o MOD  ==  how  good  is  our  model?  
o STDEV  ==  how  frequently  will  our  good  model  miss?  
• Which  risks  can  we  mitigate?  
o For  now,  1,  2,  and  4  
• How  can  we  mitigate  FREQ,  MAG,  and  STDEV  
o Use  of  swaps  and  forwards  could  help  
§ Use  swaps  to  hedge  exchange  rate  risk;  since  the  majority  of  income  
comes  from  NOK,  you  want  a  strong  kroner,  therefore  hedge  against  
falling  NOK.  
§ Since  the  majority  of  your  expenses  come  from  AUD,  you  want  a  weak  
AUD,  therefore  hedge  against  rising  AUD.  
§ You  can  either  link  each  FX  to  the  USD,  or  you  could  pair  the  NOK  with  
AUD  
 § To  set  up  a  swap  you  would  want  to  engage  another  financial  
counterparty  to  take  the  other  end  of  your  agreement.  Since  your  asset  
is  NOK,  and  your  liability  is  AUD,  you  want  to  “pay  what  you  have,  and  
receive  what  you  don’t.”  You  have  NOK,  so  you  want  to  pay  NOK,  and  
you’re  lacking  AUD,  so  you  wish  to  receive  AUD.  
§ Therefore  every  month  you  should  be  willing  to  “swap”  NOK  for  USD  
and  USD  for  AUD  (or  just  NOK  for  AUD)  at  fixed  rates.  The  counterparty  
will  take  the  floating  rate  exchange  rate  between  the  NOK  and  USD  and  
USD  and  AUD  (or  NOK  for  AUD).  Therefore,  each  month  you  have  the  
chance  to  win  or  lose  from  the  perspective  of  is  the  fixed  more  or  less  
than  the  floating  rate.  
o Use  forwards  to  hedge  costs  of  inputs,  e.g.  Devil’s  Club  root  and  various  inputs  
used  at  the  dairy  farm.  Awesomesauce  could  enter  into  longer  term  forwards  
with  Darcy  to  ensure  supply  and  price  discovery.  
2.3   Futures  (Future  Contracts)  
 
Future  contracts  are  very  similar  to  forward  contracts  except  for  five  differencesii:  
1. Futures  are  standardized  
a. All  terms  except  for  price  are  set  by  exchange  
b. Forward  contracts  are  customized  according  to  the  needs  of  parties  
2. Futures  contracts  are  guaranteed  against  default  by  clearinghouse  
a. Forward  contracts  subject  each  party  to  the  possibility  of  default  by  their  
counterparty  
3. Future  contracts  require  margin  deposits  and  daily  settlement  
a. Forward  contracts  pay  off  full  value  at  contract,  though  some  participants  in  
forwards  use  occasional  settlement  
4. Future  contracts  are  regulated  by  federal  authorities  
a. Forwards  are  unregulated  
5. Future  contracts  are  traded  on  public  exchanges  and  are  reported  to  regulatory  
authorities  
a. Forwards  are  private  and  not  reported  
 
So,  given  that  there  are  a  few  differences,  what  are  the  tradeoffs?  
• Flexibility  versus  transparency  
• Customization  versus  practicality  
 
Future  contracts  also  provide  price  discovery  for  different  markets.  Given  that  forward  contracts  
are  between  two  parties  for  a  private  transaction,  the  WSJ  doesn’t  typically  report  on  the  terms  
of  the  contract.  On  the  other  hand,  the  future  market  provides  a  great  deal  of  information  to  
the  larger  market.  The  future  market  gives  us  our  quotes  for  many  commodities,  including  oil,  
natural  gas,  precious  metals,  industrial  metals,  agricultural,  soft,  tropical,  and  financial.  Many  of  
these  contracts  are  traded  in  open  outcry  markets  –  remember  Ferris  Bueller?  
 
So,  how  would  you  use  a  future?  Well,  let’s  say  that  you  owned  an  airline.  Since  jet  fuel  is  a  
derivative  of  crude  oil,  and  you’re  concerned  about  the  price  of  jet  fuel  spiking  over  the  summer  
(which  would  cut  into  your  bottom  line),  you  decide  to  buy  the  June  WTI  (West  Texas  
Intermediate,  a  type  of  crude  oil)  for  $100/barrel.  This  way,  if  prices  do  spike  over  $100/barrel,  
you  can  take  delivery  of  your  physical  inventory  at  the  strike  price  (1,000  barrels  per  contract).  
This  aids  in  efficiency  of  hedging  risk  over  a  forward  contract,  because  you  can  go  to  an  
exchange  to  offset  risk,  instead  of  searching  for  another  party  to  take  your  trade.  
 
If  the  price  of  oil  is  below  your  strike,  then  you  can  still  assume  delivery  at  that  price,  or  you  can  
sell  your  future  contract  pack  to  the  market  at  the  prevailing  price,  which  will  be  close  to  the  
spot  price  of  the  commodity  as  you  approach  the  expiration  date  of  the  contract.    
 
In  the  next  sections,  we  will  elaborate  on  the  three  previous  derivatives,  before  moving  onto  
options.    
Lesson  2.4  –  Translated  from  Hull  
 
Pet  Peeve  –  most  of  the  more  popular  texts  on  derivatives  will  introduce  the  menu  of  
derivatives,  then  move  directly  into  hedging  strategies,  and  then  approach  derivative  valuations.  
I  believe  that  the  hedging  strategies  are  incredibly  important,  but  without  a  proper  
understanding  of  how  the  derivative  will  change  in  value,  discussions  of  hedging  and  risk  
management  before  valuation  are  simply  paying  lip  service  the  to  topic  and  not  doing  justice  to  
the  discipline.  So,  we  will  jump  into  the  basics  of  non-­‐option  derivative  valuations.  
 
2.41   Interest  Rates  
 
While  I’m  sure  you  have  a  pretty  good  grasp  of  interest  rates  and  the  various  types,  let’s  revisit  
compounding  to  ensure  we’re  on  equal  footing.  
 
We  will  denote  the  frequency  per  year  (or  per  annum)  of  compounding  by  m.  Thus,  A  $100  bond  
with  a  10%  annual  interest  rate  will  have  the  following  values:  
 
  Frequency   Value  
m  =  1     Annual   110.00  
m  =  2   Semi-­‐annual   110.25  
m  =  4   Quarterly   110.38  
m  =  12   Monthly   110.47  
m  =  52   Weekly   110.51  
m  =  365   Daily   110.52  
 
 
Generally,  we  can  formulate  the  equation  that  provides  these  values  as:  
 
tm
! r$
P #1+ &                   [EQ  2.412]  
" m%
 
Where  P  is  the  price  of  the  asset,  r  is  the  period-­‐level  interest  rate  (usually  annual),  m  is  the  
compound  frequency  within  a  period,  and  t  is  the  number  of  time  periods.  
 
Additionally,  we  can  take  another  step  forward  and  quantify  a  continuously  compounded  value  
as:  
 
Pert                     [EQ  2.413]  
 
Lastly,  within  a  continuously  compounded  interest  rate  regime,  we  can  determine  the  
equivalent  rate  at  a  frequency  level.  Yikes,  what  does  that  mean?  
 
Well,  given  a  continuously  compounded  interest  rate  (rc),  we  can  evaluate  the  equivalent  rate  at  
any  m  (rm).  
 
Watch:  
  
tm
! r $
Perct = P #1+ m &
" m%
! r $
∴rc = m ln #1+ m &               [EQs  2.414a  and  
" m%
∴rm = m ( erc m −1)
2.414b]  
 
Moving  on  –  we  can  use  the  continuously  compounded  interest  rate  to  value  bonds  or  bond-­‐like  
instruments.  
 
EX  2.415]  
 
I  got  a  one-­‐year  bond  with  a  $100  face-­‐value  that  pays  7%  per  annum  quarterly.  Additionally,  I  
am  given  the  continuously  compounded  zero-­‐coupon  rates  at  each  maturity:  
 
TABLE  2.415  
Maturity  (t)   Zero  Coupon  Rate  (%)  
0.25   5.7  
0.50   6.1  
0.75   6.8  
1.00   7.2  
 
We  can  determine  the  price  of  my  bond  at  any  point  along  the  maturity  schedule  given  the  
equation:  
 
m
" Ci % " C % −r t
∑$# m e −riti
' + $ P + m ' e m m    
& # m&
        [EQ  2.415]  
i=1
 
In  this  case,  our  Ci  =  7  ($100  x  7%)  and  m  =  4,  thus  our  quarterly  coupon  =  7/4.  This  quarterly  
coupon  is  then  multiplied  against  the  previous  table:  
 
1.75e−0.057*0.25 +1.75e−0.061*0.50 +1.75e−0.068*0.75 +101.75e−0.072*1.00
 
= 99.767
 
As  you  can  see  from  this  example,  we  can  solve  for  any  number  of  variables  using  EQ  2.45,  
including  bond  yield  and  par  yield.  
 
Excellent,  now  let’s  briefly  chat  about  forward  rates,  or  interest  rates  at  future  time  periods.  
 
We  can  determine  an  implied  forward  rate  based  on  known  zero  rates  in  the  future.  First,  let’s  
start  with  a  revamped  version  of  the  previous  table:  
 
   
TABLE  2.416  
Maturity  (t)   Zero  Coupon  Rate  (%)  
1   4.2  
2   4.8  
3   5.3  
4   5.6  
 
Based  on  this  table,  what  can  we  conclude?  
 
Well,  if  you  have  a  1-­‐year  zero-­‐bond,  then  after  one  year,  a  $100  investment  would  be  worth  
(assume  continuous  compounding  going  forward):  
 
Pert
 
(0.042)(1)
100e = 104.289
 
Easy  enough,  but  what  would  your  $100  investment  be  worth  if  you  instead  invested  in  the  2-­‐
year  zero-­‐bond?  
 
Pert
 
100e(
0.048)( 2)
= 110.076
 
Excellent,  now  comes  the  curveball  –  what  is  the  implied  1-­‐year  forward  rate  after  the  first  year  
(t=1)?  Said  another  way,  what  rate  would  you  need  to  earn  in  the  second  year  of  an  additional  
1-­‐year  zero-­‐bond  to  provide  the  same  return  as  a  2-­‐year  zero-­‐bond?  
 
In  this  example,  we  can  logically  assert  that  after  one  year,  we  are  left  with  104.289,  and  that  
needs  to  equal  110.076  after  another  year,  therefore,  the  rate  of  return  must  equal:  
 
" 110.076 %
$1− ' = 0.0548  
# 104.289 &
 
This  works  for  a  one-­‐year  forward  rate,  but  this  assumes  only  annual  compounding.  Annual  
compounding  is  not  bad,  but  we’re  looking  for  continuous.  
 
So…  let’s  solve  for  the  continuously  compounded  answer.  Let’s  assume  we’ll  move  back  into  a  
more  general  case:  
 
( Pe ) (e ) = ( Pe )
r1t1 rF ∂t r2t2

Per2t2
erF∂t =
Per1t1
(
rF∂t = − ln ∂P(0,T ) )     ##  P(0,T)  is  defined  as  e-­‐rt;  this  is  from  where  the  (-­‐)  sign  comes.  

∂
rF = − ln P(0,T )
∂t

Therefore,  in  this  current  example,  the  forward  rate  would  be  5.4%  
 
! 110.076 $
rF = ln # &  
" 104.289 %
 
So,  now  that  we  understand  forward  rates,  let’s  examine  forward  rate  agreements  (FRAs).  
 
FRAs  are  similar  to  swaps  on  interest  rates,  usually  tied  to  LIBOR.  To  walk  through  an  FRA  
example,  let’s  define  the  variables  we’ll  need.  
 
Let     P  represent  the  principal  value  at  the  outset  of  the  agreement,  
rk  represent  the  fixed  interest  rate  in  the  FRA,    
rm  represent  the  actual  market  rate  (LIBOR),  and  
rF  represent  the  forward  rate  in  the  FRA,  calculated  on  the  date  of  agreement.  
 
So  how  would  each  of  the  two  parties  profit?  What  would  be  the  benefit  accrued  to  each  party?  
 
We’ll  use  the  capital  Greek  letter  pi  to  denote  profit.  Let’s  assume  party  (p)  pays  the  fixed  and  
party  (q)  pays  the  floating:  
 
Π p = P ( rm − rk ) (t2 − t1 )
 
Π q = P ( rk − rm ) (t2 − t1 )
 
Note,  the  defined  time  period  does  not  need  to  always  equal  a  complete  year.  For  example,  t2  –  
t1  may  equal  six  months,  one  month,  or  a  couple  of  days.  Additionally,  while  cash  settlement  
typically  occurs  at  t1,  it  can  occur  at  different  points  along  the  interval.  Just  remember  to  
discount  the  cash  flows  accordingly.  
 
From  a  valuation  perspective,  note  that  an  FRA  will  only  have  value  if   rk ≠ rF .  Why  is  this?  Well,  
if  the  fixed-­‐rate  paid  equals  the  forward  rate,  then  each  party  is  swapping  like  goods  and  the  
value  of  the  contract  is  zero,  but  if  there  is  a  difference  between  paying  and  receiving,  then  we  
can  value  an  FRA.  
 
So  here’s  the  rub  on  valuing  FRAs  –  the  feature  of  the  FRA  that  creates  the  value  for  an  FRA  
holder/seller  is  the  difference  between  the  fixed  and  forward  rates;  everything  else  is  simply  
adjusting  for  principal  amount,  timing,  and  compounding.  
  
VFRA = P ( rk − rF ) (t2 − t1 ) e−r2t2     ##  Valuation  for  forward  rate-­‐payer  
 
VFRA = P ( rF − rk ) (t2 − t1 ) e−r2t2     ##  Valuation  for  fixed  rate-­‐payer  
 
Shall  we  walk  through  one  more  example?  
 
EX  2.417]  
 
Let’s  say  you  run  a  company  that  specializes  in  financing  assets  through  floating  rates  (LIBOR  
plus  500)…  doesn’t  really  matter  what  type  of  assets,  but  the  revenues  of  your  firm  are  tied  to  
market  interest  rates.  When  rates  increase,  you  make  more  money;  when  rates  fall,  you  lose  
money.  Essentially,  you  hold  a  portfolio  of  floating  loans  (loans  at  a  variable  rate).  
 
Currently,  rates  are  treating  you  nicely,  but  you  think  that  LIBOR  will  fall  significantly  over  the  
next  two  years.  Of  course,  you  can  sell  your  portfolio,  but  your  current  portfolio  is  pretty  illiquid  
(you  should  probably  let  the  securities  mature,  otherwise  you’ll  take  a  pretty  serious  haircut);  
additionally,  you’re  not  interested  in  the  taxable  consequences  of  assuming  the  large  gains  you  
have  in  your  portfolio.  
 
So,  what  do  you  do?  
 
FRA?  
 
…  Sure.  
 
According  to  your  Bloomberg  terminal,  the  continuously  compounded  LIBOR  rate  for  a  2-­‐year  
zero  is  3.5%  and  the  implied  1-­‐year  forward  rate  next  year  is  3.2%.  After  poking  around  the  
brokerage  universe  for  a  few  days,  you  find  another  party  interested  in  paying  out  4.5%  
compounded  annually.  You  want  to  hedge  30%  of  your  portfolio,  currently  valued  at  $90MM.  
Everything  seems  copasetic;  you  decide  to  engage  today  (t0)  in  an  FRA  to  cover  you  between  t1  
and  t2.  
 
How  much  does  this  FRA  cost  you?  
 
Alright  –  what  is  the  driver  for  FRA  valuation?  Yes,  the  difference  between  the  fixed  rate  and  the  
forward  rate.  Since  our  time  period  is  one  year  (t2  –  t1),  we  want  to  compare  rates  compounded  
annually.  Our  counterparty  fixed-­‐payer  quote  is  already  in  that  form,  but  we  need  to  translate  
our  continuously  compounded  rate  into  an  annual  rate.  Therefore:  
 
rFann = erF −1  
rFann = 3.252%  
 
Now,  we  can  simply  compute  the  value  of  this  FRA  by  substitution:  
 
 VFRA = P ( rk − rF ) (t2 − t1 ) e−r2t2
 
−( 0.035)( 2)
VFRA = ( 0.3) ( 90, 000, 000 ) ( 0.045 − 0.03522 ) e
 
VFRA = 246, 207.91
 
2.42   Duration  
 
Simply  put,  duration  is  the  weighted-­‐average  amount  of  time  it  take  for  a  bondholder  to  recoup  
his/her  cash.  As  a  result,  duration  is  also  a  great  metric  for  bond  price  sensitivity  to  yield.  
 
So,  let’s  start  off  with  a  win.  What  is  the  duration  of  a  2-­‐year  zero?  
 
Drum  roll…  
 
Yes,  the  duration  equals  2.  Why?  The  duration  of  a  zero  matches  its  maturity  because  all  cash  
flows  are  deferred  until  maturity  (zero  coupon  =  no  coupon).  
 
Alright,  but  what  about  the  rest  of  the  bonds  out  there?  Ah,  for  that  we  have  a  formula.  
 
If  a  bond’s  valuation  is:  
 
n
B = ∑ ci e− yti               [EQ  2.421]  
i=1
where  c  represents  the  coupon  and  y  equals  the  yield,  then  we  can  define  duration  as:  
 
n

∑t c ei i
− yti

D= i=1
              [EQ  2.422]  
B
 
or  
 
n " c e− yti %
D = ∑ ti $ i '             [EQ  2.423]  
i=1 # B &
 
Now,  EQs  2.422  and  2.423  are  really  the  same  equation,  but  I  prefer  the  latter  as  the  breakout  
of  time  allows  for  clearer  understanding  of  the  time-­‐weighted  sense  of  duration.  However,  note,  
the  total  of  the  time  weights  still  needs  to  equal  1.0.  
 
Great,  but  like  we  mentioned  earlier,  duration  is  how  we  determine  a  bond’s  price  sensitivity  to  
yield.  Now,  we  know  that  bond  prices  and  yields  are  inversely  related  (bond  prices  rise  as  yields  
decrease  and  vice  versa),  thus  (generally):  
 
∂B
ΔB = Δy  
∂y
 
So,  if  we  include  EQ  2.421,  then:  
 
n
ΔB = −Δy∑ ci ti e− yti  
i=1
And  from  this,  we  can  define  use  our  duration  definition  to  reach  our  more  simplified  definition:  
 
ΔB = −BDΔy  
 
or  
 
ΔB
= −DΔy                 [EQ  2.424]  
B
 
So,  EQ  2.424  works  wonderfully,  but  it  assumes  continuous  compounding.  If  we  have  a  non-­‐
continuously  compounded  yield,  then  we  need  to  modify  our  duration.  Creatively  enough,  we  
call  this  modified  duration.  
 
D
D* =                 [EQ  2.425]  
1+ y m
 
Awesome.  
 
We’ve  now  defined  the  first  derivative  of  a  bond’s  price  change  with  regard  to  yield  as  duration  
(or  modified  duration  in  some  cases).  The  second  derivative  of  a  bond’s  price  change  with  
regard  to  yield  is  called  convexity.  As  you  can  conclude  from  your  knowledge  of  mathematics,  
convexity  measures  the  change  in  duration  with  regard  to  yield.  
 
So,  convexity  can  be  defined  as:  
 
n

! 1 $ ! ∂2 B $
∑c t e 2 − yti
i i
C = # &# 2 & = i=1
 
" B %" ∂y % B
 
But  for  those  of  us  with  a  soft  spot  for  Brownian  motion,  we  can  expand  our  definition  of  bond  
price  sensitivity  to  include  convexity  using  Taylor  series  expansions:  
 
2
ΔB C ( Δy)
= −DΔy +  
B 2
 
Great  job  –  armed  with  this  understanding  of  interest  rates,  FRAs,  durations  and  convexities,  we  
will  forge  ahead  into  the  realm  of  forward  and  future  valuation.  
   
Lesson  2.43   Forwards  and  Futures  
 
Before  we  leap  head  first  into  forwards  and  futures,  let’s  set  up  a  few  ground  rules.  
 
First,  going  forward,  let’s  assume  no  transaction  costs,  equal  tax  regimes,  access  to  the  risk-­‐free  
rate  (borrow  and  lend),  and  arbitrage  opportunities  are  attractive  (thus,  participants  will  pile  in  
and  rectify  the  inefficiencies).  
 
Next,  let’s  define  some  of  the  variables  that  we  will  use:  
 
Variable   Description  
T   Time  until  delivery  (in  years)  
S0   Spot  price  of  the  underlying  asset  at  t=0  
I   PV  of  income  associated  with  underlying  asset  
q   Yield  associated  with  the  underlying  asset  
F0   Forward  or  futures  price  at  t=0  
f   Value  of  the  forward  contract  at  t=0  
K   Delivery  price  
rf   Risk-­‐free  rate  (continuous  compounding)  
 
The  simplest  way  to  step  into  forwards  and  futures  is  to  begin  with  an  underlying  asset  that  
does  not  produce  income.  This  could  be  a  zero-­‐bond,  a  stock  without  dividends,  various  non-­‐
time  decaying  commodities  (financial  or  physical),  etc.  
 
So,  based  on  we  know  about  continuous  compounding,  all  things  equal,  best  guess…  what  
would  you  expect  to  pay  for  an  asset  in  nine  months,  assuming  this  asset  costs  $50  today  and  
the  ten-­‐year  treasury  is  yielding  2%?  
 
Well,  if  we  assume  that  the  asset  appreciates  at  the  risk-­‐free  rate,  then  in  one  year,  we  would  
expect  the  asset  to  grow  to  50e0.02,  or  $51.01.  But  we  want  nine  months  worth  of  growth,  not  
twelve.  Thus:  
 
50e(
0.02)( 9 12)
= 50.756  
 
So  what  does  this  imply  about  expectations  and  opportunities?  
 
Well,  what  would  you  do  in  either  of  these  two  scenarios:  
 
Scenario  1:  Forward  price  =  $52  
Scenario  2:  Forward  price  =  $48  
 
Did  someone  say  arbitrage?  Exactly  right  –  two  points.  
 
In  the  first  scenario,  you  would  borrow  $50  at  2%  for  nine  months,  buy  one  unit  of  the  asset  
($50),  and  enter  into  the  forward  contract  to  sell  the  asset  in  nine  months  at  $52.  In  nine  
months,  sell  the  asset  at  $52,  use  $50.76  to  repay  the  loan,  and  retain  a  profit  of  $1.24.  
 
In  the  second  scenario,  you  would  short  one  unit  of  the  asset  ($50),  invest  that  $50  at  2%  for  
nine  months,  and  enter  into  a  forward  contract  to  buy  the  asset  in  nine  months  for  $48.  In  nine  
months,  buy  the  asset  at  $48,  close  out  short  position,  receive  $50.76  from  investment,  and  
retain  profit  of  $2.76.  
 
So,  generally  speaking,  we  can  define  a  forward  price  of  a  non-­‐income  producing  asset  as:  
 
F0 = S0 erT                   [EQ  2.431]  
 
In  the  above  equation,  r  =  rf.  
 
So,  again,  generally  speaking,  we  can  define  the  expectations  and  opportunities  for  arbitrage  as:  
 
If   Asset  (S0erT)   Forward  (F0)  
F0    >  S0erT   Long   Short  
F0    <  S0erT   Short   Long  
 
 
If  the  underlying  asset  has  an  income  stream  associated  with  it,  then  we  can  accommodate  that  
income  through  a  modified  forward  price:  
 
F0 = ( S0 − I ) erT                 [EQ  2.432]  
 
In  this  equation,  I  is  the  present  value  of  income  (continuously  compounded)  associated  with  
the  underlying  asset.  
 
If  the  underlying  asset  has  a  non-­‐cash  yield,  then  we  can  again  amend  our  working  forward  
value  equation:  
 
F0 = S0 e(
r−q)T
                  [EQ  2.433]  
 
So,  with  all  of  these  bells  and  whistles  to  derive  forward  values,  how  do  we  determine  the  value  
of  a  forward  contract?  
 
First,  we  establish  a  firm  understanding  that  there  is  an  indelible  difference  between  the  value  
of  a  forward  price  of  an  asset  (F)  and  the  value  of  a  forward  contract  (f).  Secondly,  we  need  to  
understand  the  difference  between  the  forward  price  of  an  asset  (F)  and  the  delivery  price  in  a  
forward  contract  (K).  
 
I  think  the  former  is  pretty  clear;  conceptually,  this  is  the  difference  between  the  price  of  the  
asset  and  the  price  of  a  contract  on  the  asset.  The  latter  difference  is  slightly  subtler.  
 
At  the  beginning  of  a  forward  contract,  the  forward  price  of  the  asset  is  used  to  set  the  delivery  
price  of  the  asset;  thus  at  t=0,  F0  =  K.  This  effect  will  set  f  to  zero;  remember,  no  expectation  of  
arbitrage  at  the  outset,  otherwise,  you  wouldn’t  be  able  to  get  two  parties  to  agree  to  the  
contract  (one  side  would  clearly  agree,  but  they  wouldn’t  be  able  to  find  a  sensible  
counterparty).  
 
However,  over  the  life  of  the  forward  contract,  while  K  remains  constant  (it’s  written  into  the  
contract),  F  will  change.  This  change  will  affect  the  value  of  the  forward  contract  (f).  Therefore,  
generally  speaking,  the  equation  to  determine  the  value  of  a  forward  contract  is:  
 
f = ( F0 − K ) e−rT               [EQ  2.434]  
 
Using  this  framework,  we  can  derive  the  equation  set  necessary  to  price  forward  contracts  with  
assets  without  income  or  yield,  with  income,  and  with  yield.  
 
Without  Income  or  Yield  
 
f = S0 − Ke−rT                 [EQ  2.435]  
 
With  Income  
 
f = S0 − I − Ke−rT               [EQ  2.436]  
 
With  Yield  
 
f = S0 e−qT − Ke−rT               [EQ  2.437]  
 
Awesome.  
 
We  can  use  this  forward  framework  to  help  shape  our  valuation  toolset  for  future  contracts  as  
well.  
 
For  example,  let’s  say  you  wanted  to  value  the  futures  price  of  a  stock  index…  
 
EX  2.441]  
 
You  are  running  a  long/short  equity  fund.  Generally  speaking,  you  are  a  fund  that  specializes  in  
deep  dive  value  stocks,  and  you  usually  limit  your  portfolio  to  fifteen  long  securities  given  the  
size  of  your  team.  On  top  of  this  strategy,  you  apply  an  opportunistic  short  overlay  using  stock  
index  futures.  You  have  found  this  to  be  efficient  to  express  your  shorter-­‐term  short  views.  
However,  to  apply  this  strategy  effectively,  you  must  harvest  enough  premium  on  your  short  
position.  This  means  you  must  accurately  value  the  futures  price  of  the  stock  indices  on  which  
you  trade.  
 
So,  you’re  currently  using  the  S&P  500  as  your  stock  index  of  choice  for  hedging  purposes.  The  
index  is  currently  priced  at  1,400,  the  ten-­‐year  treasury  is  yielding  2.2%,  and  the  index  has  a  
3.4%  dividend  yield.  All  yields  are  annual,  continuously  compounded  rates.  What  is  the  1-­‐month  
(also  called  front  month)  futures  prices  of  the  index?  
 
 F0 = S0 e(
r−q)T

F0 = 1, 400e(
0.022−0.034)(1 12)
 
F0 = 1, 398.60
 
Interesting.  Why  is  the  futures  price  of  the  index  lower  one  month  from  now?  
 
Exactly,  the  dividend  yield  of  the  index  is  greater  than  the  risk-­‐free  rate;  simply  put,  the  futures  
price  foregoes  the  benefit  of  the  dividend  yield  and  reaps  the  benefit  of  the  risk-­‐free  rate.  If  the  
dividend  yield  is  greater  than  the  risk-­‐free  rate,  then  the  futures  price  will  be  lower  than  the  
spot  price  (today’s  price).  
 
Moving  forward  (yes,  pun  intended)  –  we  can  also  apply  this  construct  to  value  forward  and  
future  contracts  on  currencies.  
 
Now,  if  you  hold  a  currency,  then  you  may  have  the  right  collect  the  risk-­‐free  rate  of  that  foreign  
currency.  As  a  result,  that  return  earned  should  be  subtracted  from  the  discount  rate  to  arrive  at  
a  forward  rate:  
 
F0 = S0 e( f )    
r−r T
            [EQ  2.438]  
 
So,  now  taking  what  we’ve  learned  conceptually,  let’s  apply  this  framework  to  the  commodity  
futures  market.  At  the  outset,  let’s  define  a  physical  commodity  as  platinum;  it’s  similar  to  gold,  
but  worth  more  (for  now).  
 
So,  what  will  platinum  be  worth  at  some  future  date  T,  given  it  is  worth  S0  today?  
 
F0 = S0 erT
 
 
Great  start.  But  unlike  financial  forwards  and  futures,  you  can’t  store  platinum  digitally,  or  in  a  
filing  cabinet;  its  physical  nature  necessarily  means  you’re  going  to  have  to  find  a  place  for  it.  
Regardless  if  you  own  the  storage  space  or  if  you  have  to  pay  for  storage,  there  is  a  cost  
associated  with  the  storage  (either  opportunity  or  explicit).  
 
Now,  we  defined  a  forward’s  value  with  income  (EQ  2.436)  as:  
 
f = S0 − I − Ke−rT
 
 
So,  if  we  think  about  a  cost  as  a  form  of  income  (negative  income),  then  when  can  expand  our  
commodity  future  price  to  include  the  negative  income  component:  
 
F0 = ( S0 +U ) erT
              [EQ  2.439]  
 
Now,  this  equation  is  appropriate  if  the  storage  costs  are  a  fixed  value,  but  we  can  transform  our  
equation  to  accommodate  a  variable  storage  cost.  Instead  of  negative  income,  we  can  treat  
storage  costs  as  negative  yield:  
 
F0 = S0 e(
r+u)T
                [EQ  2.440]  
 
Remember,  these  equations  assume  no  arbitrage,  however,  if:  
 
F0 < ( S0 +U ) erT ∪ F0 > ( S0 +U ) erT ;
 
F0 < S0 e(
r+u)T
∪ F0 > S0 e(
r+u)T

 
then  arbitrage  opportunities  exist.  For  example,  if  you  were  to  encounter:  
 
F0 < ( S0 +U ) erT  
 
Then,  
 
0 < ( S0 +U ) erT − F0  
 
Given  this  state  of  the  world,  I  would  want  to  sell  the  commodity,  avoid  the  storage  costs,  and  
own  the  future  contract.  At  the  expiration  of  the  contract,  I  would  take  delivery  of  the  asset  and  
retain  the  difference.  In  efficient  markets,  this  arbitrage  should  disappear  as  selling  the  assets  
and  buying  the  forwards  should  bring  the  equation  back  into  parity.  
 
So,  at  this  point,  hopefully  your  intuition  has  picked  up  on  the  nuance  between  owning  the  
physical  commodity  and  a  forward  or  future  contract  on  a  commodity  is  not  the  same  thing.  
After  all,  you  can  feed  a  commodity  into  a  process  (crude  into  gasoline;  soy  into  soy  oil;  hell,  
corn  into  tortillas),  but  you  can’t  turn  a  crude  contract  into  heating  oil.  
 
Thus,  in  addition  to  the  cost  of  storage,  physical  commodities  may  come  with  implicit  benefits.  
These  benefits  are  called  the  convenience  yield.  We  can  represent  this  in  our  pricing  equation  
as:  
 
F0 e yT = ( S0 +U ) erT ;
 
F0 e yT = S0 e(
r+u)T

 
The  second  equation  can  be  rewritten  as:  
 
F0 = S0 e(
r+u−y)T
                [EQ  2.441]  
 
Alright,  one  last  twist,  we  need  a  way  to  describe  a  forward  price  based  on  an  expected  future  
spot  price,  because  using  today’s  spot  price  for  every  point  along  the  futures’  yield  curve  is  not  
very  useful.  So,  instead,  we  can  define  the  forward  asset  price  as:  
  
F0 = E [ ST ] e−kT ;  where  k  =  the  required  rate  of  return       [EQ  2.442]  
 
Now,  there  are  a  whole  host  reasons  why  a  forward  price  may  be  greater  or  less  than  the  
expected  spot  price,  but  we  use  two  different  terms  to  describe  the  regimes.  
 
In  normal  backwardation,  the  future  price  is  below  the  expected  future  spot  price.  When  the  
future  price  is  greater  than  the  expected  future  spot  price  the  relationship  is  in  contango.  Note,  
these  terms  are  also  used  to  describe  the  relationship  between  future  prices  and  current  spot  
prices  as  well.  
 
Thus  far,  we  have  discussed  forward  and  future  prices  of  the  more  tangible  assets,  including  
equities,  currencies,  and  commodities.  Let’s  briefly  transition  to  the  world  of  forward  and  future  
treatments  of  rates.  
 
Conceptually,  this  can  be  a  level  trickier  than  an  equity  forward;  after  all  there’s  only  one  rate  at  
play  with  an  equity.  However,  with  a  forward  or  future  rate,  we’re  treating  one  rate  as  the  
principal  and  another  as  the  discounting  factor.  
 
So,  the  most  common  form  of  rate  future  is  probably  the  Eurodollar  future  contract.  With  the  
Eurodollar  future  contract,  we’re  valuing  the  deposits  of  one  bank  into  another.  Eurodollar  
futures  are  settled  every  three  months,  and  a  single  basis  point  month  reflects  a  $25  gain/loss  
for  a  trader.  
 
The  purpose  of  a  Eurodollar  future  is  to  lock  in  a  rate  for  a  specified  period  of  time.  As  such,  
Eurodollar  future  contracts  and  FRAs  are  similar  in  their  purposes,  but  there  are  differences.  
 
The  major  difference  between  a  futures  contract  and  forward  contract,  with  regard  to  rates  are  
their  settlements.  Futures  contracts  are  settled  at  the  outset  (t0)  and  FRAs  are  settled  at  the  
close  (tn).  
 
This  may  seem  trivial,  but  as  the  difference  between  t0  and  tn  gets  larger,  the  difference  in  
discounting  becomes  more  significant.  This  is  intuitive  if  we  contextualize  it  with  the  benefit  of  
deferring  a  loss  by  a  long  time,  or  the  pain  of  having  to  wait  for  a  significant  inflow.  
 
So,  given  there  are  differences,  how  can  we  use  a  future  rate  contract  to  hedge  and  manage  
risk?  
 
Well,  the  first  question  to  answer  would  be  what  types  of  portfolios  or  assets  would  need  a  
futures  rate  contract  to  hedge  a  risk?  
 
Exactly,  a  portfolio  or  asset  with  interest  rate  risk  exposure.  
 
Flashing  back  to  interest  rate  risk  management,  we’ll  focus  our  efforts  on  managing  interest  rate  
risk  by  focusing  on  the  duration  of  the  portfolio  or  asset.  Remember  that  duration  is  the  interest  
rate  sensitivity  of  a  portfolio  or  asset.  
 
So,  if:  
 
ΔP = −PDp Δy  
 
Then:  
 
ΔFc = −Fc D f Δy  
 
In  short,  this  means  that  a  futures  contract  used  to  hedge  a  portfolio  of  interest-­‐sensitive  
securities  will  have  similar  interest  rate  sensitivity.  Thus,  the  number  of  future  contracts  needed  
to  hedge  the  portfolio  can  be  found  by  calculating  the  price  sensitivity  hedge  ratio:  
 
PDp
N* =  
Fc D f
 
Note,  this  ratio  is  agnostic  of  the  degree  of  yield  change;  therefore,  this  process  can  be  applied  
to  conditions  where  the  yield  change  is  uncertain.  
 
   
Lesson  2.60   Swaps  
 
As  we  discussed  earlier,  swaps  are  instrument  whereby  two  parties  exchange  benefits.  The  most  
common  form  of  a  swap,  called  the  “plain  vanilla”  swap,  is  an  exchange  of  a  fixed  rate  for  a  
floating  rate.  Swaps  where  both  parties  exchange  floating  rates  are  called  basis  swaps.  The  
differential  in  basis  swaps  is  the  underlying  and/or  the  spread.  
 
So,  let’s  look  at  an  example:  
 
EX  2.61]  –  Adapted  from  FRM  Handbook  
 
Two  parties  (A  &  B)  enter  into  a  swap.  To  determine  the  parameters  of  the  swaps,  let’s  first  
examine  each  party’s  resources:  
 
Party   Fixed   Floating  
A   5.00%   LIBOR  +  350  
B   5.50%   LIBOR  +  425  
 
First  question,  how  should  the  parties  structure  the  swap?  
 
Now,  at  first  glance,  you  may  wonder  why  Party  A  would  have  any  interest  in  engaging  Party  B  
with  a  swap,  given  that  Party  A  has  access  to  more  attractive  fixed  and  floating  costs.  Thus,  we  
can  say  that  Party  A  has  an  absolute  advantage  in  both  fixed  and  floating.  However,  what  about  
the  comparative  advantages?  
 
This  is  where  we  want  to  be  clear  about  the  difference  between  an  absolute  and  comparative  
advantage.  Absolute  advantages  are  the  most  attractive  rates  in  a  given  space,  but  comparative  
advantages  must  be  considered  compound  decisions  (multiple  spaces).  
 
Therefore,  by  examining  the  differentials  together:  
 
Party   Fixed   Floating  
A   5.00%   LIBOR  +  350  
B   5.50%   LIBOR  +  425  
Differential   0.50%   0.75%  
 
We  can  now  see  that  while  Party  A  has  double  absolute  advantages,  the  comparative  advantage  
for  floating  goes  to  Party  A  and  the  comparative  advantage  for  fixed  goes  to  Party  B.  
 
Let’s  take  this  a  step  further;  given  the  comparative  advantages,  we  can  demonstrate  that  a  
swap  can  be  mutually  beneficial  to  each  party.  
 
If  each  party  were  to  borrow  from  their  preferred  ultimate  silo,  then  Party  A  would  borrow  at  
5.00%  and  Party  B  would  borrow  at  LIBOR  +  425,  resulting  in  a  total  borrowing  cost  of  LIBOR  +  
925.  If,  however,  each  party  were  to  borrow  at  their  comparative  advantage,  then  Party  A  would  
borrow  at  LIBOR  +  350  and  Party  B  would  borrow  at  5.50%,  resulting  in  a  total  borrowing  cost  of  
LIBOR  +  900.  
  
Given  this  comparative  advantage,  we  can  construct  a  swap  to  split  the  benefit  between  the  two  
parties:  
 
Party  A  
Step   Fixed   Floating  
Borrow   [PAY]  LIBOR  +  350    
Swap   [RECEIVE]  LIBOR  +  362.5   [PAY]  5.000%  
Net     [PAY]  4.875%  
Cost     [PAY]  5.000%  
Benefit     0.125%  
 
Party  B  
Step   Fixed   Floating  
Borrow   [PAY]  5.50%    
Swap   [RECEIVE]  5.00%   [PAY]  LIBOR  +  362.5  
Net     [PAY]  LIBOR  +  412.5  
Cost     [PAY]  LIBOR  +  425  
Benefit     0.125%  
 
 
In  this  example,  both  parties  receive  equal  benefit,  however,  this  is  not  always  the  case.  
 
So,  now  that  we’ve  wrapped  our  head  around  what  swaps  are  and  how  they  work,  let’s  spend  a  
couple  of  minutes  working  through  valuations.  
 
There  are  two  ways  to  value  a  swap.  In  the  first  methodology,  we  can  assume  that  swap  
valuation  is  the  difference  between  two  bonds;  in  the  second  methodology,  we  can  treat  swaps  
like  forward  contracts.  
 
So,  how  can  we  use  bonds?  Well,  imagine  that  one  side  of  the  swap  is  receiving  the  benefit  of  a  
fixed-­‐rate  bond,  and  the  other  side  of  the  swap  is  receiving  the  benefit  of  a  floating-­‐rate  bond.  
Thus,  the  value  of  a  swap  is  the  difference  between  the  two:  
 
V[ F ] = BF − B f                   [EQ  2.62]  
 
At  the  outset,  the  difference  can  be  set  to  zero,  given  the  swap  coupon  will  be  the  par  yield,  and  
thus  both  BF  and  Bf  will  equal  100.  However,  as  time  passes  and  interest  rates  change,  the  value  
of  the  swap  will  change.  Therefore,  we  can  define  a  receive-­‐fixed  swap  as  a  long  fixed-­‐rate  bond  
with  a  short  floating-­‐rate  bond,  and  a  receive-­‐floating  swap  as  a  long  floating-­‐rate  bond  with  a  
short  fixed-­‐rate  bond.  
 
On  the  other  hand,  we  can  value  a  swap  as  a  series  of  forward  contracts.  If  you  will  remember  
back  to  EQ  2.434,  a  forward  contract  equals:  
 
 f = ( F0 − K ) e−rT
                [EQ  2.434]  
 
Therefore,  we  can  define  the  value  of  a  swap  (or  a  series  of  forward  contracts  as:  
 
n
V = ∑ Pi ( Fi − K )e−riti ;  for  continuous  compounding         [EQ  2.631]  
i=1
 
n
V = ∑ Pi
( Fi − K ) ;  for  discrete  compounding           [EQ  2.632]  
t
i=1 (1+ ri ) i

 
These  same  intuitions  and  formulation  can  be  applied  to  the  gamut  of  swaps,  including  equity,  
currency,  and  commodity  swaps.    
  

                                                                                                                       
i
 Assuming Aces as 1
Column 1

Normal(6.53846,3.18367)

Quantiles

100.0% maximum 10.000

99.5% 10.000
97.5% 10.000
90.0% 10.000
75.0% quartile 10.000
50.0% median 7.000
25.0% quartile 4.000
10.0% 2.000
2.5% 1.000
0.5% 1.000
0.0% minimum 1.000

Moments
                                                                                                                                                                                                                                                                                                                                                                  
Mean 6.5384615
Std Dev 3.1836687
Std Err Mean 0.4414954
upper 95% Mean 7.4248006
lower 95% Mean 5.6521225
N 52

Fitted Normal
Parameter Estimates
Type Parameter Estimate Lower 95% Upper 95%
Location μ 6.5384615 5.6521225 7.4248006
Dispersion σ 3.1836687 2.6680676 3.9481533

CDF Plot

One-sided Confidence Interval

Parameter Estimate Lower CI Upper CI 1-Alpha
Mean 6.538462 . 7.278092 0.950
Std Dev 3.183669 . 3.81056
 
                                                                                                                                                                                                                                                                                                                                                                  
Assuming Aces as 11
Column 1

Normal(7.30769,2.9475)

Quantiles

100.0% maximum 11.000

99.5% 11.000
97.5% 11.000
90.0% 10.000
75.0% quartile 10.000
50.0% median 8.000
25.0% quartile 5.000
10.0% 3.000
2.5% 2.000
0.5% 2.000
0.0% minimum 2.000

Moments

Mean 7.3076923
Std Dev 2.9475045
                                                                                                                                                                                                                                                                                                                                                                  
Std Err Mean 0.4087453
upper 95% Mean 8.1282828
lower 95% Mean 6.4871018
N 52

Fitted Normal
Parameter Estimates
Type Parameter Estimate Lower 95% Upper 95%
Location μ 7.3076923 6.4871018 8.1282828
Dispersion σ 2.9475045 2.4701506 3.6552796
 
ii
 CFA  Curriculum  Level  III  Volume  5,  Alternative  Investments,  Risk  Management,  and  the  
Application  of  Derivatives,  p.383