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Financial Engineering
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Overview of Financial Engineering

The purpose of this module is to study different mechanisms that are used to solve the problems
of finance, and new financial market developments giving rise to the use of new tools in risk
management, asset management, mortgage finance, derivatives pricing and hedging, as well as the
need to provide better tools to help financial decision making. Two of the problems that we
encounter in the financial services industry are asset allocation and valuation. The first, asset
allocation, asks how we allocate our resources in various assets to achieve our goals. These goals
are usually phrased in terms of how much risk we are willing to acquire, how much income we
want to derive from the assets and what level of return we are looking for. The second, derivative
valuation, asks to calculate an intrinsic value of a derivative security (for example, an option on a
stock).

New financial products and market designs, improved computer and telecommunications
technology and advances in the theory of finance during the past quarter-century have led to
dramatic and rapid changes in the structure of global financial markets and institutions. The
scientific breakthroughs in financial engineering in this period both shaped and were shaped by
the extraordinary flow of financial innovation, which coincided with those changes. The
cumulative impact has significantly affected all of us-as users, producers, or overseers of the
financial system. The mechanics of financial engineering hinges around the use of derivative
instruments to design new products that meet the needs of the investors as well manage risk that
is inherent in the financial markets.

What is Financial Engineering?

➢ Financial engineering is the use of mathematical techniques to solve financial problems.

Financial engineering uses tools and knowledge from the fields of computer science,
statistics, economics and applied mathematics to address current financial issues as well as
to devise new and innovative financial products.
➢ The process of researching and developing new financial products and services that would
meet customer needs and prove profitable.
➢ The process of creating new securities or processes and designing new financial
instruments, especially derivative securities.
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➢ It is mainly a process of employing mathematical finance and computer modeling skills to

make pricing, hedging, trading and portfolio management decisions. Utilizing various
derivative securities and other methods. Financial engineering aims to precisely control the
financial risk that an entity takes on. Methods can be employed to take on unlimited risks
under certain events or completely eliminate other risks by utilizing combinations of
derivative and other securities.

Reasons for Rapid Growth in Financial Engineering

➢ Since the 1950s and 1960s, and particularly in the last decade, the global and financial
environment has changed rapidly. In particular, the breakdown of the Bretton Woods
agreement in 1972 which ultimately led to floating exchange rates, has led to major
increases in volatility and competition (Smith, 1990). Technology has improved
dramatically in this period. Government debt has also increased in most countries. Marshall
(1992) has classified the causes of increasing risk into two: environmental and intra-firm.
We use this classification here to analyze the reasons why the increase in risk and major
developments in finance, taken together, created the right environment for rapid growth in
financial engineering.

Environmental factors

Increase in price volatility: The term "price" here includes the price of money, foreign exchange,
stocks, and commodities. The currency floats have meant that the stability of exchange rates is a
thing of the past. Interest rates have been very volatile too, e.g., in June 1982; AA bonds were
yielding 15.3 percent. In May 1986 the same bonds yielded 8.9 percent and in April, 1989, 10.2
percent (Brigham, 1990). Oil prices are the best example of dramatic commodity price volatility,
and the October, 1987 stock crash illustrates the volatility in stock prices. There was also a major
volatility in overall prices, i.e., inflation, over the past three decades. This all-round increase in
volatility has led to tremendous increases in the risks which companies face, and enhanced the
need for hedging the risks. The recent global financial crisis come in as another case in point
where financial markets have become very volatile and risky for the traders.

Globalization of the world economy and competition: Commerce has grown very rapidly in the
past two decades. This has increased the size of markets and greatly enhanced competition
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(Marshall, 1992). Multinational firms produce, market, and obtain financing globally. Every
multinational firm has significant risk exposures to foreign currencies, domestic and foreign
interest rates, energy and commodity prices, and global equity prices.

Deregulation and increase in competition: Initially, investment banks were the only ones which
could offer various services regarding risk management. Deregulation of the financial markets has
brought in new entrants into the financial markets, who have aggressively competed with the
traditional banking sector, by introducing new products and services. In return, banks were forced
to come out with innovative ways to compete with new entrants by taking recourse to off-balance
sheet transactions.

Advances in technology and communication: Funds can be transferred from ATMs and
telephones now. Computers have entered the field of finance in a big way. Real-time worldwide
information and data collection, analysis, decision-making, and trading are made possible.
Securities’ trading goes electronic and moves from exchange floors into cyberspace. Banks are the
biggest users of information technology.

Development of new markets and market linkages: There has been an explosive growth of
futures and options exchanges worldwide. 24-hour trading has become possible on futures and
options exchanges across the globe. The Chicago Exchange has developed a computer system on
which trade can now be carried out at any time, replacing human activity on the floor (Marshall,
1992:665).

Dramatic decline in information and transactions costs: There has been a tremendous decline
in transaction costs and spreads, e.g., the cost of transacting a share of $100 has declined from $1
in the 1970s to under 2 cents in the 1990s (Marshall,1992:). Computerized databases of financial
transactions are available to subscribers. Information asymmetry has considerably declined.

Advances in financial theory: Developments in finance theory have contributed immensely to

the development of new hedging techniques.
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Arbitrage opportunities: The globalization of the financial markets has meant that arbitrage
opportunities across different capital markets could be identified and exploited. In theory,
exploiting these differentials through arbitrage should eventually lead to their disappearance.

Completing markets: Often there have been gaps in the financial markets which have been
identified and filled up with new kinds of instruments. For example, at one time there were no
interest rate forward contracts; interest rate swaps were then designed to fill this gap. Thus, swaps
complete markets (Smith, 1986).

Standardisation: There has been an increasing standardization of financial instruments, e.g., in

futures, options and swaps. This has expanded the market. Making securities tradable across
markets increases the nature of risks to be managed.

Intrafirm factors:

Liquidity needs: Companies need liquidity of their "free cash flows". To make use of funds
temporarily not needed, money markets and swap markets have developed rapidly. The same
purpose in the longer term is served by FRNs (floating rate notes), adjustable rate preferred stock,
etc.

Risk aversion: The risk aversion of firms to the increasing risks has been an important driving
force in motivating innovations.

Quantitative sophistication of management training: The increase in the quantitative skills

possessed by managers has led to a demand for better tools of financial management.

Many forms of financial innovation, including euro-bonds, euro-dollars, electronic funds transfer,
etc., have arisen from these factors. The development of financial engineering is perhaps the most
important of the outcomes of the changes discussed above.

Basic Notions and Assumptions

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➢ Suppose there are two assets, one being a risk free security and the other being a risky
asset.
➢ Risk free asset can be a bank deposit or a government bond and the risky asset can be a
stock, commodity, foreign exchange or any asset whose future price is unknown.
➢ The price of one share at time “t” will be denoted by St
➢ The current price S0 is known to all investors but the future price St remains uncertain.
➢ The difference between (St and S0) St - S0 as a fraction of the initial value represents the
rate of return
➢ RR = (St - S0)/ S0
➢ The price of a bond at time t is denoted by At while the initial price is denoted by A0
➢ Both the future price and current price of the bond are known today by investors
➢ Hence RR is given by (At - A0)/ A0

Assumptions

Randomness

➢ The future stock St is a random variable with at least two different values while the future
price of the bond At is a known value.

Positivity of Prices

➢ All stock and bond prices are strictly positive and the total wealthy of an investor holding
X shares and Y bonds is given by Vt = xSt + yAt
➢ The pair (x,y) is called the portfolio ,Vt being the value of the portfolio
➢ The change in prices between time 0 and T give rise to change in portfolio value denoted
by Vt-V0 = x(St-S0) + y (At-A0)
➢ Portfolio return is given by Kv =(Vt- V0)/V0

Example

Let the current price and future price of the bond be $90 and $100 while the initial stock price is
$25
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St can either be $30 with probability p or 20 with probability 1-p.For a portfolio with X=10 shares
and Y=15 bonds, Calculate V0, Vt and Kv

V0 = (15)(90) + (10)(25) = 1600

Vt (p) = 15(100) + 10(30) = 1800

V t(1-p) = 15(100) + 10(20)= 1700

Kv (p) = V t(p) – V0 /V0 = (1800-1600)/1600 = 12.5%

K v(1-p) = (1700-1600)/1600= 6.25%

Divisibility, Liquidity and Short Selling

An investor can hold any number of x and y of stock shares and bonds whether integer or fraction,
positive, negative or zero. The fact that one can hold a fraction of a share or a bond is referred to
as divisibility. Any asset can be bought or sold on demand at the market price in the required
quantities. A short position is regarded as negative position in an asset.

Solvency

The total wealthy of an investor must be non negative at all times, Vt ≥ 0 for t =0, T.A portfolio
satisfying this condition is called admissible.

No arbitrage Principle

This refers to the fact that no investor can lock in profit without taking risk and with no initial
endowment. If a portfolio violating this principle exists, then an arbitrage opportunity exists.

What is a derivative?

➢ A derivative can be defined as a financial instrument whose value depend on the price of
another underlying security or variable.The underlying can be anything: stock,stock
index,weather,energy prices. A stock option, for example, is a derivative whose value is
dependent on the price of a stock.
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➢ Futures and options are now traded actively on many exchanges throughout the world.
Forward contracts, swaps, and many different types of options are regularly traded outside
exchanges by financial institutions, fund managers, and corporate treasurers in what is
termed the over-the-counter market. There is now active trading in credit derivatives,
electricity derivatives, weather derivatives, and insurance derivatives. Many new types of
interest rate, foreign exchange, and equity derivative products have been created. There
have been many new ideas in risk management and risk measurement. Analysts have also
become more aware of the need to analyze what are known as real options. In this opening
chapter we take a first look at forward, futures, swaps and option markets and provide an
overview of how they are used by hedgers, speculators, and arbitrageurs.

Exchange Traded Markets

➢ A derivatives exchange is a market where individuals’ trade standardized contracts that

have been defined by the exchange. Derivatives exchanges have existed for a long time.
Examples of early exchanges include The Chicago Board of Trade, the Chicago Mercantile
Exchange (1919) and the Chicago Board Options Exchange. The Chicago Board of Trade
was established in 1 848 to bring farmers and merchants together. Initially its main task
was to standardize the quantities and qualities of the grains that were traded. Within a few
years the first futures-type contract was developed. It was known as a to-arrive contract.
Speculators soon became interested in the contract and found trading the contract to be an
attractive alternative to trading the grain itself.

➢ Traders have met on the floor of an exchange using hands and shouting as a way of trading
(open outcry system).However with the coming in of technology, electronic trading has
become popular. This is a system where a computer is used to match buy and sell orders.

Over the Counter Market

➢ The over-the-counter market is an important alternative to exchanges and, measured in

terms of the total volume of trading, has become much larger than the exchange-traded
market. It is a telephone- and computer-linked network of dealers, who do not physically
meet. Trades are done over the phone and are usually between two financial institutions or
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between a financial institution and one of its corporate clients. Financial institutions often
act as market makers for the more commonly traded instruments. This means that they are
always prepared to quote both a bid price (a price at which they are prepared to buy) and
an offer price (a price at which they are prepared to sell).
➢ Telephone conversations in the over-the-counter market are usually taped. If there is a
dispute about what was agreed, the tapes are replayed to resolve the issue. Trades in the
over-the-counter market are typically much larger than trades in the exchange traded
market. A key advantage of the over-the counter market is that the terms of a contract do
not have to be those specified by an exchange (tailor made). Market participants are free
to negotiate any mutually attractive deal. A disadvantage is that there is usually some credit
risk in an over-the counter trade (i.e., there is a small risk that the contract will not be
honored). As mentioned earlier, exchanges have organized themselves to eliminate
virtually all credit risk.

Short and Long Positions

➢ A long position is easier to understand because it conforms to the instincts of a newcomer

to financial engineering. In our daily lives, we often “buy” things; we rarely “short” them.
Hence, when we buy an item for cash and hold it in inventory, or when we sign a contract
that obliges us to buy something at a future date, we will have a long position. We are long
the “underlying instrument,” and this means that we benefit when the value of the
underlying asset increases. A short position, on the other hand, is one where the market
practitioner has sold an item without really owning it. For example, a client calls a bank
and buys a particular bond. The bank may not have this particular bond on its books, but
can still sell it. In the mean time, however, the bank has a short position. A short (long)
position can be on an instrument, such as selling a “borrowed” bond, a stock, a future
commitment, a swap, or an option. But the short (long) position can also be on a particular
risk. For example, one can be short (long) volatility—a position such that if volatility goes
up, we lose (gain). Or one can be short (long) a spread—again, a position where if the
spread goes up, we lose (gain).

Forward Contracts
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➢ A forward contract is an agreement to buy or sell an asset at a certain future time for a
certain price. It is an agreement/contract between two parties that gives the right and the
obligation to one of the parties to purchase (or sell) a specified commodity (or financial
instrument) at a specified price at a specific future time. No money changes hands at the
outset of the agreement. For example, I could buy (long) a June forward contract for 50,000
litres of orange juice concentrate for $25/litre. This would obligate me to take delivery of
the frozen orange juice concentrate in June at that price. No money changes hands at the
establishment of the contract. A similar notion is that of a futures contract. The difference
between a forward and a future contract is that futures are generally traded on exchanges
and require other technical aspects, such as margin accounts. A forward can be contrasted
with a spot contract, which is an agreement to buy or sell an asset today. A forward contract
is traded in the over-the-counter market -usually between two financial institutions or
between a financial institution and one of its clients.
➢ One of the parties to a forward contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date for the same
price.
Forward contracts on foreign exchange are very popular. Most large banks have a “forward
desk” within their foreign exchange trading room that is devoted to the trading of forward
contacts.

Futures Contract

➢ A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future for a certain price. Unlike forward contracts, futures contracts are
normally traded on an exchange. To make trading possible, the exchange specifies certain
standardized features of the contract. As the two parties to the contract do not necessarily
know each other, the exchange also provides a mechanism that gives the two parties a
guarantee that the contract will be honored.

➢ The largest exchanges on which futures contracts are traded are the Chicago Board of
Trade (CBOT) and the Chicago Mercantile Exchange (CME). On these and other
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exchanges throughout the world, a very wide range of commodities and financial assets
form the underlying assets in the various contracts. The commodities include pork bellies,
live cattle, sugar, wool, lumber, copper, aluminum, gold, and tin. The financial assets
include stock indices, currencies, and Treasury bonds. One way in which a futures
contract is different from a forward contract is that an exact delivery date is usually not
specified. The contract is referred to by its delivery month, and the exchange specifies the
period during the month when delivery must be made. For commodities, the delivery
period is often the entire month. The holder of the short position has the right to choose
the time during the delivery period when it will make delivery. Usually, contracts with
several different delivery months are traded at any one time. The exchange specifies the
amount of the asset to be delivered for one contract and how the futures price is to be
quoted. In the case of a commodity, the exchange also specifies the product quality and
the delivery location. Consider, for example, the wheat futures contract currently traded
on the Chicago Board of Trade. The size of the contract is 5,000 bushels. Contracts for
five delivery months (March, May, July, September, and December) are available for up
to 1 8 months into the future. The exchange specifies the grades of wheat that can be
delivered and the places where delivery can be made.

➢ Futures prices are regularly reported in the financial press. Suppose that on September 1,
the December futures price of gold is quoted as $300. This is the price, exclusive of
commissions, at which traders can agree to buy or sell gold for December delivery. It is
determined on the floor of the exchange in the same way as other prices (i.e., by the laws
of supply and demand). If more traders want to go long than to go short, the price goes
up; if the reverse is true, the price goes down.

Options

➢ Options are traded both on exchanges and in the over the counter market. There are two
basic types of options. A call option gives the holder the right to buy the underlying asset
by a certain date for a certain price. A put option gives the holder the right to sell the
underlying asset by a certain date for a certain price. The price in the contract is known as
the exercise price or strike price; the date in the contract is known as the expiration date
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or maturity. American options can be exercised at any time up to the expiration date.
European options can be exercised only on the expiration date itself. Most of the options
that are traded on exchanges are American. In the exchange traded equity options market,
one contract is usually an agreement to buy or sell 100 shares. European options are
generally easier to analyze than American options, and some of the properties of an
American option are frequently deduced from those of its European counterpart.
It should be emphasized that an option gives the holder the right to do something. The
holder may not have to exercise this right. This is what distinguishes options from forwards
and futures, where the holder is obligated to buy or sell the underlying asset. Note that
whereas it costs nothing to enter into a forward or futures contract, there is a cost to
acquiring an option called a premium.

SWAPS

➢ A swap is an agreement between two companies to exchange cash flows in the future. The
agreement defines the dates when the cash flows are to be paid and the way in which they
are to be calculated. Usually the calculation of the cash flows involves the future values of
one or more market variables.

➢ A forward contract can be viewed as a simple example of a swap. Suppose it is March 1,

2002, and a company enters into a forward contract to buy 100 ounces of gold for $300
per ounce in one year. The company can sell the gold in one year as soon as it is received.
The forward contract is therefore equivalent to a swap where the company agrees that on
March 1, 2003, it will pay $30,000 and receive 100S, where S is the market price of one
ounce of gold on that date.

➢ Whereas a forward contract leads to the exchange of cash flows on just one future date,
swaps typically lead to cash flow exchanges taking place on several future dates. The first
swap contracts were negotiated in the early 1 980s. Since then the market has seen
phenomenal growth.

Types of Traders
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Hedgers

Hedgers in the futures market try to offset potential price changes in the spot market by buying o
r selling a futures contract.In general, they are either producers or users of the commodity or fina
ncial product underlying that contract. Their goal is to protect their profit or limit their expenses.
For example, a cereal manufacturer may want to hedge against rising wheat prices by buying a fu
tures contract thatpromises delivery of September wheat at a specified price.If, in August, the cro
p is destroyed, and the spot price increases, the manufacturer can take delivery of the wheat at

thecontract price, which will probably be lower than the market price. Or the manufacturer can tr
ade the contract for more thanthe purchase price and use the extra cash to offset the higher spot p
rice of wheat. Hedgers transfer the risk of price variability to others in exchange for the cost of the
hedge.

Speculators
We now move on to consider how futures and options markets can be used by speculators. Whereas
hedgers want to avoid an exposure to adverse movements in the price of an asset, speculators take
a position in the market by betting either the price will go down or up.

Arbitrageurs

Arbitrageurs are a third important group of participants in futures, forward, and options markets.
Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two
or more markets.
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Transactions costs would probably eliminate the profit for a small investor. However, a large
investment house faces very low transactions costs in both the stock market and the foreign
exchange market. It would find the arbitrage opportunity very attractive and would try to take as
much advantage of it as possible.

Arbitrage opportunities such as the one just described cannot last for long. As arbitrageurs buy the
stock in New York, the forces of supply and demand will cause the dollar price to rise. Similarly,
as they sell the stock in London, the sterling price will be driven down. Very quickly the two prices
will become equivalent at the current exchange rate. Indeed, the existence of profit- hungry
arbitrageurs makes it unlikely that a major disparity between the sterling price and the dollar price
could ever exist in the first place. The very existence of arbitrageurs means that in practice only
small arbitrage opportunities are found hence valuations are based on the no arbitrage principle.

CHAPTER TWO: OPTION PRICING

What is an Option?

➢ An option is a financial instrument that gives the holder the right but not obligation of
either buying or selling the underlying asset at an agreed price called the Strike price.

➢ To enter into an option contract, an investor needs to pay a premium to the seller of the
option.

➢ An option premium is made up of the intrinsic value and the time value.

➢ The intrinsic value is determined by the difference between the strike price and market
price of the security.

➢ A call option becomes more valuable, and hence its intrinsic value becomes greater, as the
market price of the underlying stock rises above the option's strike price.
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➢ A put option becomes more valuable, and hence the intrinsic value becomes greater, as the
market price of the underlying falls below the option's strike price.

➢ An option may or may not have intrinsic value, but it will almost always have time value.
Any option may become valuable in the future and hence, a liability to the seller, so the
time value exists to compensate option sellers appropriately

Factors affecting Option Prices

Option prices are affected by various factors that include time to expiration, dividends on
underlying stocks, risk free rate, volatility, strike price, and stock prices.

➢ Time to Expiration

The longer the time to expiration the higher the option price. For both put and call options,
a longer time to maturity give the holder of the option more time to exercise the option. A
longer time to expiration allows the option to price of the underlying asset to move to
varying positions, hence giving the option holder more opportunities to exercise the option
profitably. The longer the time to expiration of a call or put option, the larger the time
value. This is because, with lots of time until expiration, the option has plenty of
opportunity to acquire intrinsic value. On the flip side, as option approaches expiration, the
time value, all else constant, will erode steadily to zero.

➢ Dividends

Dividends on stocks have varying effects on the price of call and put options. Expected
higher dividends on stocks have a negative effect on call option while they impact put
options positively. This emanates from the fact that share prices have a tendency of
decreasing in value at the ex-dividend date by the magnitude of the dividend. This decrease
in price adversely affects call options while increasing the value of put options.

➢ Volatility
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As the underlying becomes more volatile, the time value of a call and a put option increase.
This is because, as volatility rises, it becomes more likely that prices will move to the point
where the option has intrinsic value.

➢ Stock Prices

If stock prices are increasing, call option value start to increase emanating from an increase
in the intrinsic value (ST –K).As prices decreases the value of call options decreases while
put options start to increase.

➢ Strike Price

A higher strike price reduces the difference between ST and K hence reducing the intrinsic
value of a call option. On the other hand a higher strike price increases the value of put
option when prices are falling since this would increase the difference between the strike
price and the spot price (K -ST).This entails that a call option with a higher strike price cost
less than a call option with a lower strike price because the one with a higher strike prices
have low probability of being in the money or its reduces the benefit derived by the
investor.

➢ Risk Free Rate

Interest rate affect put options negatively because an investor has two options either to
short sell or to buy put options. If interest rates increases, it becomes more profitable to
short the asset since income received will generate more interest income while at the same
time buying puts will become more expensive (assuming money used to buy puts is
borrowed).This will push put prices down. As interest rates increases, call options become
more valuable. There are two options for the buyer, either to buy the shares or to buy call
options which are cheaper. Buying call options will result in capital savings and the capital
can be invested at the prevailing higher interest rate resulting in more income being
generated. Alternatively, assuming all other factors remain constant, an increase in interest
rate increases the required rate of return by stock holders while at the same time reducing
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the present value of expected future cash flows (from selling the asset).This will reduce the
price of put options.

Option Boundaries

Our major assumption is that there are no arbitrage opportunities since investors will eliminate
trade away all existing opportunities.

Assumptions

1. There are no transaction cost

2. All trading profits (net losses) are subject to the same tax rate

3. Borrowing and lending at the same risk free rate

4. The nominal rate of interest r ˃ 0, otherwise holding cash would be better.

S0 =Current stock price, ST =Stock price at maturity, K = Strike price, T = Time to

Expiration, r = continuous compound risk free rate, C = value of American call option, P
= value of American put option, c = value of European call option and p = value of
European put option.

➢ Upper Bounds on non Dividend Paying Stocks

The value of a Call option can never be greater than current stock price since a call option
give the holder the right to buy the security for a certain price K.

C ≤ S0 , c ≤ S0

The above relationship entails that the price of a call option can never be above the current
value of the share otherwise the investor will make a riskless profit by selling the call option
and buying the stock.

Hypothetically if the price of the call option is $10 while the stock is trading at $7.An
arbitrager can sell the option (giving someone the right to come and buy the share at a
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certain price K) at $10 and buy the share at $7, pocketing the $3 plus the strike price to be
received in future.

Since a Put option gives the holder the right to sell the asset at an agreed price K, the value
of the put option can never the above K.

P≤K , p≤K

Since we know that the value of a European put option at expiration cannot be worth more
than K. It follows that it cannot be more than the present value of K today.

p ≤ K℮-rT

If this condition is not met, then an arbitrager would write a put option and invest the
proceeds at the risk free rate.

Lower Bounds on non Dividend Stock

The lower bound of a European Call Option is given by

c ≥ S0 - K℮-rt

Example

Suppose S0 = 20, K=18, r=10% and T=1

Hence c= 20- 18℮-0.1(1) = 3.71.

If the call price is below $3.71 then an arbitrager can make riskless profit by buying the call say at
$3.00 then short the security in the market generating a cash flow of 20-3 = $17.00.

If the 17 is invested for a year at 10% per annum, the value at year end will be 17℮0.1 = $18.79

If at the end of the year the stock price is above 18 then the investor exercises the option by buying
the security @ 18 , making a profit of $18.79 -$18.00 = $0.79
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If the stock price at expiration is less than 18, then the investor will not exercise the option but will
make an even greater profit from the transaction. Assuming the price is $17, the investor will buy
the asset at $17 in the market, hence making a profit of $18.79-$17.00= $1.79.

Formal Argument
Portfolio A: One European call option plus an amount of cash equal to K℮-rt
Portfolio B: One share

At the end of one year, if ST˃ K, then the option will be exercised and the portfolio will be worth
ST since K℮-rt will be worth K at year end.
However assuming that ST ˂K, then the option will not be exercised and the portfolio value will
be worth K. Hence From this argument

Portfolio A at time T is worth max (ST, K).Since portfolio B is always worth ST at time T, portfolio
A can be equal to or worth more than portfolio B at time T. This is so because the price of the
stock can be less than K at time T. In the absence of arbitrage opportunities, it must be true also
today that
c + K℮-rt ≥ S0
c ≥ S0 - K℮-rt

Lower bounds of a European Put

The lower bound of a European Put is given by

p ≥ K℮-rt - S0
Suppose S0 =$37, K =$40, r = 5% and T = 0.5 years

K℮-rt - S0 = 40℮-(0.05)(0.5) -37 = 2.01

Suppose the European put price is $1.00, which is below the theoretical price then an arbitrager
can borrow $38 dollars to buy both the stock and the put option. After 6 months, the investor will
have to repay 38℮ (0.05)(0.5) = $38.96.
If the stock price is below $40 then the investor will exercise the option of selling the stock at $40,
making a profit of $40 – $38.96 = $1.04
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If the price of the stock is above $40, say $42, the arbitrage will not exercise the option hence
make a profit of $42 – $38.96 = $3.04

Formal Argument
Portfolio C: One put option and a stock
Portfolio D: Cash equivalent to K℮-rt
At time T ST ˂ K , then the option will be exercised and portfolio C will be worth K.
If ST˃K, the option will not be exercised and the investor will dispose the asset at ST at maturity.
Hence portfolio C has a value of max (ST, K).
Assume the cash is invested at the risk free rate, portfolio D is worth K at time T.
Hence portfolio C can either be equal to or greater than portfolio D at maturity

p + S0 ≥ K℮-rt
p ≥ K℮-rt - S0

PUT CALL PARITY

This is a measure of the relationship between a European a put option and a call option with the
same exercise price and exercise date. It shows that the value of a European put can be deduced
from the value of a European call provided they have the same exercise price and date.

𝒄 + 𝑲℮−𝒓𝒕 = 𝒑 + 𝑺𝟎
Assuming that c + K℮-rt is Portfolio A and p + S0 is portfolio C, then if portfolio A and C are not
the same in value arbitrage opportunities will exist.

Portfolio A consist of a European Call Option and amount of cash equal to K℮-rt
Portfolio B consist of a Put Option and a Stock

Both are worth max (ST, K)

 20

Given that S0 = 31 ,K is 30,r =10%,price for 3 months European call option is $3 and price for a 3
months European put option is $2.25.
c + K℮-rt = 3 + 30℮ - (0.1)(3/12) = $32.26
p + S0 = 2.25 +31 =$33.25
In this case portfolio C is overvalued compared to portfolio A hence the strategy would be to
Short sale assets in portfolio C and buy assets in portfolio A.
The strategy will involve buying the call and shorting both the stock and the put.
Cash flow = -3 +2.25 + 31 = $30.25
Since this cash flow is received today, it can be invested at the risk free rate for 3 months to give
30.25℮ (0.1)(3/12) = $31.02
If at expiration the price is greater than $30, then the call will be exercised.
If the price is less than $30, then the buyer of the put option will exercise the option at $30.The
arbitrager end up buying the stock at $30 either way to close the short position.
Hence his profit will be $31.02 -30.00 = $1.02

Alternatively if the call price is $3 and put price is $1.

c + K℮-r t = 3 + 30℮ - (0.1) (3/12) = $32.26
p + S0 = 1 +31 =$31.00
In this case portfolio A is overvalued than portfolio C hence the strategy would be to buy assets in
portfolio C and short assets in portfolio A. This involves buying the put and the stock and shorting
the call option.
Cash flow = 1 + 31 -3 = $29 outflow
Repayment will be 29(0.1) (3/12) =$29.73
After 3 months, if the stock price is above 30, the investor will not exercise the put option but the
buyer of the call will exercise his option (buying the security @ 30).Profit is $30.00-$29.73=$0.27
If the stock price is below 30, the call buyer won’t exercise the option, but the investor will exercise
his put option @ 30.
Hence net profit will be $30.00-$29.73 = $0.27

Example
 21

The call had a strike price of $15; 103 days left to expiration and was valued at $1.87. The stock
was trading at $13.62 and the riskless rate was 4.63%.Determine the price of the Put Option

Put Value = C – S + K e-rt = $1.87 - $13.62 + $15 e-(0.0463) (0.2822) = $3.06

ASSIGNMENT 1 (PUT CALL PARITY RELATIONSHIP)

Black –Scholes Model

The value of a call option in the Black-Scholes model can be written as a function of the five
variables:
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ2= Variance in the ln(value) of the underlying asset

The value of a call is then: Value of call = S N (d1) - K e-rt N (d2)

C = 𝑺𝑵(𝒅𝟏 ) − 𝑲℮−𝒓𝒕 𝑵(𝒅𝟐 )

𝟐
𝒍𝒏(𝑲𝑺 )+(𝒓+𝝈𝟐 )𝒕
d1 =
𝝈√𝒕
d2 = d1 -𝝈√𝒕
Example
On March 6, 2001, Cisco Systems was trading at $13.62. We will attempt to value a July 2001 call
option with a strike price of $15, trading on the CBOT on the same day for $2.00. The following
are the other parameters of the options. The annualized standard deviation in Cisco Systems stock
price over the previous year was 81.00%. This standard deviation is estimated using weekly stock
prices over the year and the resulting number was annualized as follows:
 22

Weekly standard deviation = 1.556%

Annualized standard deviation =1.556%*52 = 81%.The option expiration date is Friday, July 20,
2001. There are 103 days to expiration. The annualized treasury bill rate corresponding to this
option life is 4.63%.
The inputs for the Black-Scholes model are as follows:

Current Stock Price (S) = $13.62

Strike Price on the option = $15.00
Option life = 103/365 = 0.2822
Standard Deviation in ln (stock prices) = 81%
Riskless rate = 4.63%

Inputting these numbers into the model, we get

2
ln (13.62 0.81
15 )+(0.0463+ 2 )(0.2822)
d1 = =0.0212
0.81√0.2822

d2 = d1 -𝜎√𝑡 = 0.0212- (0.81√0.2822) = -0.4091

Using the normal distribution we can estimate N (d1) and N (d2)

N (d1) = 0.5085
N (d2) = 0.3412

The value of the call can now be estimated:

Value of Cisco Call = S N (d1) - K e-rt N (d2)
= (13.62)(0.5085)-15 e-(0.0463)(0.2822)(0.3412)=1.87
Comment on the value

Dividend Adjustments
 23

The payment of a dividend reduces the stock price; note that on the ex-dividend day, the stock
price generally declines. Consequently, call options will become less valuable and put options
more valuable as expected dividend payments increase. There are two ways of dealing with
dividends in the Black Scholes:

Short-term Options: One approach to dealing with dividends is to estimate the present value of
expected dividends that will be paid by the underlying asset during the option life and subtract it
from the current value of the asset to use as S in the model.

Modified Stock Price = Current Stock Price – Present value of expected dividends during the life
of the option

Long Term Options: Since it becomes impractical to estimate the present value of dividends as
the option life becomes longer, we would suggest an alternate approach. If the dividend yield (y =
dividends/current value of the asset) on the underlying asset is expected to remain unchanged
during the life of the option, the Black-Scholes model can be modified to take dividends into
account.

C = 𝑺℮−𝒚𝒕 𝑵(𝒅𝟏 ) − 𝑲℮−𝒓𝒕 𝑵(𝒅𝟐 )

where

𝟐
𝒍𝒏(𝑲𝑺 )+(𝒓−𝒚+𝝈𝟐 )𝒕
d1 =
𝝈√𝒕
d2 = d1 -𝝈√𝒕

The adjustments have two effects. First, the value of the asset is discounted back to the present at
the dividend yield to take into account the expected drop in asset value resulting from dividend
payments.
 24

Value of a Put Option

P = K ℮−rt (1 − N(d2)) − S ℮−yt (1 − N(d1))

BINOMIAL OPTION PRICING MODEL

➢ The approach we take here is called the binomial model. The word “binomial” refers to the
fact that there are only two outcomes. In other words, we let the underlying price move to
only one of two possible new prices
➢ In addition, we refer to the structure of this model as discrete model, which means that time
moves in distinct increments e.g months, weeks, days and seconds as opposed to
continuous model that talks of the tiniest increments (BSM).
➢ The binomial model has the advantage of allowing us to price American options.

➢ In addition, the binomial model is a simple model requiring a minimum of mathematics,

thus it is worthy of study in its own right.

One Period Binomial Model

➢ We start off by having only one binomial period. This means that the underlying price
starts off at a given level, then moves forward to a new price, at which time the option
expires.
➢ We let S be the current underlying price. One period later, it can move up to S+ or down to
S −.
➢ We let X be the exercise price of the option and r be the one period risk-free rate. The
option is European style.
➢ We start with a call option. If the underlying goes up to S+ , the call option will be worth
c+ .
➢ If the underlying goes down to S−, the option will be worth c−. We know that if the option
is expiring, its value will be the intrinsic value

c+= Max (0, S+ -X)

c- = Max (0, S− - X)
 25

S+ { c+= Max (0, S+ -X)}

S (c =?)

S− { c- = Max (0, S− - X)

➢ We identify factors u and d that represent how the underlying moves

S+
u= 𝑆

𝑆−
d=𝑆

➢ So that u and d represent 1 plus the rate of return if the underlying goes up and down,
respectively. Thus, S + = Su and S− = Sd
➢ To avoid an obvious arbitrage opportunity, we require that d< 1 + r < u
➢ We start by constructing an arbitrage portfolio consisting of one short call option and
purchase an unspecified number of units of the underlying
➢ Let the number of the unspecified underlying be denoted n
➢ The portfolio with an underlying and a short position on a call is called a Hedge Portfolio
with a Hedge Ratio n
➢ Its current value is H, where H = nS – c
➢ This specification reflects the fact that we own n units of the underlying worth S and we
are short one call.
➢ One period later, this portfolio value will go to either H + or H−:

H+ = nS+ – c+

H– = nS– – c–

➢ Because we can choose the value of n, let us do so by setting H + equal to H−. This
specification means that regardless of which way the underlying moves, the portfolio
value will be the same. Thus, the portfolio will be hedged
 26

➢ We do this by setting
➢ H+ = H–, which means that nS+ – c+ = nS– – c–
➢ We then solve for n to obtain

𝑐 + −𝑐 −
n= +
𝑠 −𝑠 −
➢ Because the values on the right-hand side are known, we can easily set n according to this
formula. If we do so, the portfolio will be hedged. A hedged portfolio should grow in
value at the risk-free rate.

H+ = H(1+ r), or

H– = H(1 + r)

➢ We know that H+ = nS+ − c−, H− = nS− − c−, and H = nS − c. We know the values of n,
S+, S−, c+, and c−, as well as r. We can substitute and solve either of the above for c to
obtain

𝜋𝑐 + +(1−𝜋)𝑐 −
c=
1+𝑟

1+𝑟−𝑑
where π=
𝑢−𝑑
➢ We see that the call price today, c, is a weighted average of the next two possible call
prices, c + and c−
➢ The weights are π and 1 − π. This weighted average is then discounted one period at the
risk-free rate.
➢ It is important to note, however, that π and 1 − π are the probabilities that would exist if
investors were risk neutral
➢ Risk-neutral investors value assets by computing the expected future value and
discounting that value at the risk-free rate. Because we are discounting at the risk-free
rate, it should be apparent that π and 1 − π would indeed be the probabilities if the
investor were risk neutral.
➢ In fact, we shall refer to them as risk-neutral probabilities, and the process of valuing an
option is often called risk neutral valuation

Example
 27

Suppose the underlying is a non-dividend-paying stock currently valued at $50. It can either go
up by 25 percent or go down by 20 percent. Assume that the call option has an exercise price of
50 and the risk-free rate is 7 percent .Thus, u = 1.25 and d = 0.80.

S+ = Su = 50(1.25) = 62.50

S– = Sd = 50(0.80) = 40

. Thus, the option values one period later will be

c+ = Max(0,S+ – X) = Max(0,62.50 – 50) = 12.50

c– = Max (0, S– – X) = Max(0,40 – 50) = 0

S+ =Su = 50(1.25) =62.50

Max (0, 62.50-50) =12.50

S=50

C=? S- = Sd = 50(0.80) =40

Max (0, 40-50) =0

Π = (1 +0.07 -0.80)/ (1.25-0.80) = (1.07-0.80)/ (1.25-0.80)= 0.6

Hence 1- Π = 1-0.6=0.4

Therefore c = [0.6(12.50) + 0.4(0)]/1.07 =7.01

Thus the option value is $7.01.
Arbitrage Opportunity
Suppose the option is selling for $8. If the option should be selling for $7.01 and it is selling for
$8, it is overpriced—a clear case of price not equaling value. Investors would exploit this
opportunity by selling the option and buying the underlying. The number of units of the underlying
purchased for each option sold would be the value n:
 28

𝑐 + −𝑐 −
n= + = (12.50 -0)/ (62.50-40) =0.556
𝑠 −𝑠 −
Thus, for every option sold, we would buy 0.556 units of the underlying. Suppose we sell 1,000
calls and buy 556 units of the underlying. Doing so would require an initial outlay of H = 556($50)
− 1,000($8) = $19,800

One period later, the portfolio value will be either

H+ = nS+ – c+ = 556($62.60) – 1,000($12.50) = $22,250, or

H– = nS– – c– = 556($40) – 1,000($0) = $22,240

These two values are not exactly the same, but the difference is due only to rounding the hedge
ratio, n. We shall use the $22,250 value. If we invest $19,800 and end up with $22,250, the return
is (22 250/19 800) -1 = 0.1237
That is, a risk-free return of more than 12 percent in contrast to the actual risk-free rate of 7 percent.
Thus we could borrow $19,800 at 7 percent to finance the initial net cash outflow, capturing a risk-
free profit of (0.1237 – 0.07) × $19,800 = $1,063 (to the nearest dollar) without any net investment
of money. Other investors will recognize this opportunity and begin selling the option, which will
drive down its price. When the option sells for $7.01, the initial outlay would be H = 556($50) −
1,000($7.01) = $20,790. The payoffs at expiration would still be $22,250
This transaction would generate a return of (22 250/20 790)-1 = 0.07 approximately

Thus, when the option is trading at the price given by the model, a hedge portfolio would earn
the risk-free rate, which is appropriate because the portfolio would be risk free.

If the option sells for less than $7.01, investors would buy the option and sell short the underlying,
which would generate cash up front. At expiration, the investor would have to pay back an amount
less than 7 percent. All investors would perform this transaction, generating a demand for the
option that would push its price back up to $7.01.
Exercise

Consider a one-period binomial model in which the underlying is at 65 and can go up 30 percent
or down 22 percent. The risk-free rate is 8 percent.

A. Determine the price of a European call option with exercise price of 70.
 29

Assume that the call is selling for 9 in the market. Demonstrate how to execute an arbitrage
transaction and calculate the rate of return. Use 10,000 call options.

Two Period Binomial Model

In the first period, we let the underlying price move from S to S+ or S− in the manner we did in
the one-period model. That is, if u is the up factor and d is the down factor,

S+ = Su

S– = Sd

Then, with the underlying at S+ after one period, it can either move up to S+ + or down to S+ −.
Thus,

S + + = S +u

S+ – = S+d

If the underlying is at S− after one period, it can either move up to S− + or down to S− −.

S– + = S– u

S– – = S–d

We now have three unique final outcomes instead of two. Actually, we have four final outcomes,
but S+ − is the same as S− +. We can relate the three final outcomes to the starting price in the
following manner:

S+ + = S+u = Suu = Su2

S+ – (or S– +) = S+d (or S–u) = Sud (or Sdu)

S– – = S–d = Sdd = Sd2

Now we move forward to the end of the first period. Suppose we are at the point where the
underlying price is S+. Note that now we are back into the one-period model we previously derived.
There is one period to go and two outcomes. The call price is c+ and can go up to c+ + or down to
c+ −. Using what we know from the one-period model, the call price must be
 30

S ++ c++ = max (0,S++ - X)

S+ (c+)
S+- c+- = max (0,S+- -X)

S- (c-)

S-- c-- = max (0,S-- - X)

𝝅𝒄++ +(𝟏−𝝅)𝒄− +
c+ =
𝟏+𝒓
If the underlying price is at S-

𝝅𝒄+− + (𝟏−𝝅)𝒄− −
c- =
𝟏+𝒓

𝟏+𝒓−𝒅
where 𝝅=
𝒖−𝒅
therefore

𝝅𝒄+ +(𝟏−𝝅)𝒄−
𝒄=
𝟏+𝒓

the hedge ratios at each point are given by

𝑐+ − 𝑐−
𝑛= +
𝑠 − 𝑠−
 31

+ 𝑐 ++ −𝑐 +−
𝑛 =
𝑠 ++ −𝑠∓

− 𝑐 − + −𝑐 − −
𝑛 =
𝑠 − + −𝑠 − −
Example
You are given that the underlying is a non dividend paying stock currently valued at $50.Assume
that the call option has an exercise price of $50 and the risk free rate is 3.44%.Consider a two
period binomial model in which the underlying goes up 11.8% and down 10.56% each period,
find the value of the European call option.

S++ = Su2 = 50 (1.118)(1.118) =62.50

S+- = Sud = 50 (1.118)(0.8944) =50
S-- = Sd2 = 50 (0.8944)(0.8944) =40

At Expiration
c++ = max (0,S++-50) = (62.50-50) =12.50
c+- = max (0,S+- -50) = (50-50) = 0
c- - = max (0, S-- -50) = (40-50) =0
After one period
𝟏+𝒓−𝒅
𝝅= =
𝟏+𝟎.𝟎𝟑𝟒𝟒−𝟎.𝟖𝟗𝟒𝟒
= 0.6261
𝒖−𝒅 𝟏.𝟏𝟏𝟖−𝟎.𝟖𝟗𝟒𝟒

𝝅𝒄++ +(𝟏−𝝅)𝒄− +
c = +
= 𝟎.𝟔𝟐𝟔𝟏(𝟏𝟐.𝟓𝟎)+(𝟏−𝟎.𝟔𝟐𝟔𝟏)(𝟎) = 7.57
𝟏+𝒓 𝟏.𝟎𝟑𝟒𝟒

𝝅𝒄+− + (𝟏−𝝅)𝒄− −
c- = = 𝟎.𝟔𝟐𝟔𝟏(𝟎)+(𝟏−𝟎.𝟔𝟐𝟔𝟏)(𝟎) =0
𝟏+𝒓 𝟏.𝟎𝟑𝟒𝟒

So the option price today is

 32

𝝅𝒄+ +(𝟏−𝝅)𝒄−
𝒄= =
𝟎.𝟔𝟐𝟔𝟏(𝟕.𝟓𝟕)+𝟎.𝟑𝟕𝟑𝟗(𝟎)
=4.58
𝟏+𝒓 𝟏.𝟎𝟑𝟒𝟒

Question
Consider a two-period binomial model in which the underlying is at 30 and can go up 14% or 11%
each .The risk-free rate is 3% per period
A. Find the value of a European call option expiring in two periods with an exercise price of 30
B. Find the number of units of the underlying that would be required at each point in the binomial
tree to construct a risk free hedge using 10 000 calls.

Binomial Put Option Pricing

Consider a one period binomial model in which the underlying is at 65 and can go up 30% or down
22%.The risk free rate is 8%.Determine the price of the European put option with exercise price
of 70

First find the underlying prices in the binomial tree. We have u = 1.30 and d = 1 – 0.22 = 0.78.

S+ = Su = 65(1.30) = 84.50

S– = Sd = 65(0.78) = 50.70

Then find the option values at expiration:

p+ = Max(0,70 – 84.50) = 0

p– = Max (0, 70 – 50.70) = 19.30

The risk-neutral probability is

1.08−0.78
= 0.5769
1.30−0.78

1-𝜋 = 0.4231

0.5769(0)+0.423(19.30)
Hence = = 7.56
1.08
 33

Forward Contract Pricing

➢ Forward contracts have zero up-front cost.
➢ The contract is binding; delivery or settlement must take place, even if it is unprofitable for
one of the parties.
➢ Forwards are symmetric assets in that the loss of one party is the gain of the other.
➢ Time value of money is critical in pricing forwards, since contract is entered now, but paid
for in the future.
What is the fair forward price?

➢ In some cases, the forward contract can be synthesized with transaction in the current spot
market.
➢ In that case, no arbitrage will require that the contractual forward price must be the same
as the forward price that could be synthesized.

Synthetic Forward Price

➢ For example, if the underlying asset doesn’t depreciate, make any payments, or entail any
storage costs or convenience yield, the synthetic forward price of the asset is
➢ Spot Price + Interest to settlement date

How to synthesize?

➢ – Borrow the amount of the spot price, with repayment

➢ – Buy the asset now for the spot price.

➢ – You pay nothing now, and you pay the spot price plus interest at the settlement date.
 34

➢ Hence the forward price should be given by

F0 = S0℮rT

➢ Where the T year forward price is F0 for an asset S0 which provides no income while
the risk free rate is r

Arbitrage Opportunities

➢
If the forward price is higher than S0℮rT (synthetic forward), borrow money and buy
the asset now, short the forward contract, and deliver the asset then.
➢
T years from now I have F0 − S0erT > 0 at no cost.

Example

Given that the current price of a delta share is $100,risk free rate is 6% and the 9 months
forward price of the delta share is $110.Device a profitable arbitrage strategy.

Borrow $100 @ 6% from the market, buy the Delta share at its current price and short the
forward contract at $110.

At maturity, loan repayment is equal to F0= 100℮ (0.06)(0.75) = $104.60

Hence sell the asset at $110 and repay $104.60, remaining with a profit equivalent to $110 -
$104.60 = $5.40 with zero investment. If a large number of investors enter into short
positions on the forward, the price will fall.

If the forward price is less than S0℮rT , short the asset, put the money in the bank, go long
on the forward contract, and deliver it then.

Example
 35

Given that the current price of a delta share is $100,risk free rate is 6% and the 9 months
forward price of the Delta share is $100.Device a profitable arbitrage strategy
Selling the asset will give you $100 now
100℮ (0.06)(0.75) = $104.60
At expiration, buy the asset $100 and remain with a riskless profit $104.60 – $100.00=
$4.60.The process of entering a long position on the Delta share will result in the forward
price increasing.
T years from now I have S0erT− F0 > 0 at no cost.

Contracts on Interest Paying Assets

➢ Many stocks/bonds pay interest/dividends to their owners at regular intervals.
Forward pricing changes when the assets pay interest at an annual rate say q.

F0 = S0℮(r-q)T
➢ This is so because the owner of the asset receives the interest on the asset hence it
reduces the cost of borrowing.
➢ Remember the assumption is an investor borrows money equivalent to S0 that allow
him to buy the asset at the current price.
➢ If the forward price is higher than this, borrow money, buy the asset now, short the
forward contract, keep the interest, and deliver the asset then.
➢ If the forward price is less than this, short the asset, put the money in the bank, go
long on the forward contract, pay the owner the interest, and deliver the asset then.

Assets with Constant Future Income

F0 = (S0-I) ℮rT
Where I is the present value of future cash flows

Asset with Storage Costs

 36

F0 = (S0+ U) ℮rT
Where U is the present value of the storage costs over the life of the contract

➢ Commodities that are associated with the storage cost tend to increase the value of
the asset.
➢ The PV is arrived at by discounting future storage costs by a factor ℮-rt

Look at valuation of Forward Contracts on Currencies

FUTURES CONTRACT

➢ One of the parties to a forward contract will be losing money and there is always
the risk of default by the party suffering a loss
➢ Futures contracts are designed to eliminate such risk as they are traded on
organized exchange
➢ Just like a forward contract a futures contract involves a underlying asset and a
specified time of delivery
➢ A futures contract is an agreement between two parties in which one party, the
buyer, agrees to buy from the other party, the seller, an underlying asset or other
derivates at a future date at a price agreed on today.
➢ Unlike forward contracts, futures contracts is not a private and customized
transaction but rather a public transaction that takes place on an organized futures
exchange
➢ They are standardized by the exchange, setting terms and conditions with the
exception of price
➢ As a result futures contracts have a secondary market, meaning previously created
contracts can be traded
➢ Futures contracts are regulated at Federal level
➢ Each futures exchange has a division called a clearinghouse that performs the
specific responsibilities of paying and collecting daily gains and losses as well as
guaranteeing to each party the performance of the other.
 37

➢ Buyers benefit from price increases while sellers benefit from price decreases
➢ At expiration the contact can be terminated through delivery of the underlying or
cash settlement.
➢ Homogenization of futures contacts makes them more liquid than forward contracts
➢ Daily settlement or marking to market results in paper gains and losses being
converted to cash gains and losses each day

Futures Trading

➢ A long position is an agreement to buy while a short position is an agreement to sell

at a agreed future date and price
➢ Each party deposit a fee called a margin with the clearing house at the initiation of
the contract.
➢ A future trader should deposit an initial margin with the clearing house (both buyer
and seller)
➢ traders should always maintain balances above a level called maintenance margin
requirement
➢ The maintenance margin requirement is lower than the initial margin requirement
➢ If the balance falls below the maintenance margin, the trader must deposit sufficient
funds to bring back to bring the balance back up to the initial margin requirement

Example

Assume that the futures price in $100 when the transaction opens, initial margin
requirement is $5 and the maintenance margin is $3.In panel A , the trader takes a long
position of 10 contracts on Day 0 ,depositing $50 ($5*10) as indicated in Column 3.At the
end of the day, his ending balance is $50
 38

Day(1) Beginning Funds Settlement Price Gain/Loss Ending

Bal (2) Deposited Price (4) Change (6) Balance
(3) (5) (7)
0 0 50 100 - - 50
1 50 0 99.20 -0.80 -8 42
2 42 0 96.00 -3.2 -32 10
3 10 40 101.00 5 50 100
4 100 0 103.50 2.50 25 125
5 125 0 103.00 -0.50 -5 120
6 120 0 104.00 1 10 130

Profit = Ending Balance – Deposits = 130 – (50+40) = $40

HOLDER OF A SHORT POSITION OF 10 CONTRACTS

Day(1) Beginning Funds Settlement Price Gain/Loss Ending

Bal (2) Deposited Price (4) Change (6) Balance
(5) (7)
0 0 50 100 - - 50
1 50 0 99.20 -0.80 8 58
2 58 0 96.00 -3.20 32 90
3 90 0 101.00 5 50 40
4 40 0 103.50 2.5 25 15
5 15 35 103.00 -0.50 5 50
6 55 0 104.00 1 10 45

Loss = Ending Balance – Loss = 45 – (50+35) = $40

➢ The addition margin to bring back the amount up to the initial margin is called
Variation Margin
 39

➢ Price that triggers a margin call is given by the difference between Initial Margin and
Maintenance margin = $5 -$3 =$2
➢ Hence for a long position, the price should fall by $2 while for a short position it
should rise by $2

Exercise

Consider a futures contract in which the current futures price is $82.The initial margin
requirement is $5, and maintenance margin requirement is $2.You go long 20 contracts and
meet all margin calls but do not withdraw any excess margin. Assume that on the first day,
the contract is established at the settlement price, so there is no mark to market gain or
loss on that day

Day Futures Price

0 82
1 84
2 78
3 73
4 79
5 82
6 84

Determine the price level that would trigger a margin call

ASSINGMENT 2 (VALUATION OF FUTURES AND ARBITRAGE OPPORTUNITIES)

SWAPS

➢ A SWAP is an agreement between two parties to exchange a series of future cash

flows.
 40

➢ Mostly one party makes payments that are determined by a random outcome such
as interest rate, currency, equity return or a commodity price (variable or floating
payments).
➢ In some swaps both sides are floating or variable
➢ When a swap is initiated, neither party pays any amount to the other; therefore a
swap has zero value at the start of the contract.
➢ Only currency swaps do exchange equal notional amounts at the beginning of the
contract though these will be denoted in different currencies.

INTEREST RATE SWAPS

Hedging Interest Rate Risk

Example

Fixed rate- 5%

PAYS RECIEVES

MSB FFC

RECEIVES PAYS
T-Bill + 1%

Midwest Savings Bank which tends to borrow short term and lend long term in the
mortgages market has $1 million less of rate sensitive assets than it has of rate sensitive
liabilities. As interest rates rises, the increase in cost of funds (liabilities) is greater than the
interest it receives on its assets, many of which are fixed rate. This scenario results in MSB’s
net interest margin shrinking, hence its profitability. To avoid this scenario MSB will have to
convert $1 million of its fixed assets into rate sensitive, in effect making rate sensitive assets
equal to rate sensitive liabilities, thereby eliminating the gap.
 41

A 10 year interest rate swap with $1 million notional value in which RSB pays a fixed rate of
5% to Friendly Finance Company and receives the T-Bill rate + 1% effectively converts the
1 million fixed interest asset into a variable interest asset. Now when interest rates rise, the
increase on rate sensitive income on its assets exactly matches the increase in the cost of
funds on its rate sensitive liabilities, leaving the net interest margin and profitability
unchanged.
Advantages of the RSB Interest Rate Swap
➢ Cost effective rearrangement of the balance Sheet
➢ Banks keep information advantages on its customers whom they known for a longer
period (KYC)
➢ Swaps can be arranged for a very long horizon compared to other instruments like
futures and options
Disadvantages
➢ Lack of liquidity
➢ Default risk
To avoid the problem of default risk and limited information on the counterparties, swaps
usually involve investment banks and commercial banks who match the parties willing to
trade.

CURRENCY SWAPS
➢ In a currency swap, eah party makes interest payments to the other in different
currencies
➢ This involves exchanging of the notional amount at the beginning of the currency
➢ Netting off is not practical because parties are paying each other in different
currencies
Example
A US retailer Target Corporation does not have an established presence in Europe. It has
decided to begin opening a few stores in Germany and need €9 million to fund construction
and initial operations. Target would like to issue a fixed rate euro denominated bond with a
face value €9 million but the company is not very well known in Europe. European
investment bankers have given it a quote for such a bond. Deutsche Bank however tells TGT
 42

that it should issue the bond in dollars and use a swap to convert it into euros. Suppose
Target issues a five year US$10 million bond at a rate of 6%.It then enters into a swap with
Deutsche Bank in which DB will make payments to TGT in U.S. dollars at a fixed rate of 5.5%
and TGT will make payments to DB in euros at a fixed rate of 4.9% percent each 15 March
and 15 September for five years. The payments are based on a notional principle of 10
million in dollars and 9 million in euros .Assume the swap start on 15 September of the
current year. The swap specifies that the two parties exchange the notional principle at the
start of the contract.
Cash flows
15 September
❖ DB will pay TGT €9 million
❖ TGT pays DB $10 million
Each 15 March and 15 September for five years
❖ DB pays TGT 0.055(180/360)10 000 000 = $275,000
❖ TGT pays DB pays DB 0.049 (180/360)9 000 000 = €220 500
After 5 years, 15 September
❖ DB pays TGT $10 million
❖ TGT pays DB €9 million
N/B Interest calculations have been simplified by calculating semiannual interest payments
using a fraction of 180/360.In some instances actual days can be used then divided by 365

This transaction looks like TGT issued a €9 million bond then it was bought by DB ,then TGT
converts the €9 million to $10 million and buys a dollar denominated bond issued by DB.As
such TGT will pay interest in euros to DB while DB make dollar denominated interest to TGT
 43

$10 million
DB
TGT
€9 million
10 million

Target has €9 million to start expansion

TGT Bondholders

€220.500 DB
TGT
$275 000

$300 000 Net effect: Target’s interest payments consists of €220 500 and $25 000
6%
TGT Bondholders

After 5 years
 44

$10 million
TGT DB

€9 million
$10 million

Target pays off its bond holders and terminates its swap

TGT Bondholders

Credit SWAPS and Diversification of Risks

Suppose you manage a bank in Houston called Oil Drillers’ Bank (0DB), which specializes
in lending to a particular industry in your local area, oil drilling companies and another
bank, Potato Farmers Bank (PFB), specializes in lending to potato farmers in ldalo. Both
ODB and PFB have a problem because their loan portfolios are not sufficiently diversified.
To protect ODB against a collapse in the oil market, which would result in defaults on most
of its loans made to oil drillers, you could reach an agreement to have the loan payments
on, say, $100 million worth of your loans to oil drillers paid to the PFB in exchange for
PFB paying you the loan payments on $100 million of its loans to potato farmers. Such a
transaction, in which risky payments on loans are swapped for each other, is called a credit
swap. As a result of this swap, ODB and PFB have increased their diversification and
lowered the overall risk of their loan portfolios because some of the loan payments to each
bank are now coming from a different type of loans.

Credit Linked Notes

 45

Another type of credit derivative, the credit-linked note, is a combination of a bond and a credit
option. Just like any corporate bond, the credit-linked note makes periodic coupon (interest)
payments and a final payment of the face value of the bond at maturity. If a key financial variable
specified in the note changes, however, the issuer of the note has the right (option) to lower the
payments on the note. For example, General Motors could issue a credit-linked note. that pays a
5% coupon rate, with the specification that if a national index of SUV sales falls by 10%, then GM
has the right to lower the coupon rate by 2 percentage points to 3%. In this way, GM can lower its
risk because when it is losing money as SUV sales fall, it can offset some of these losses by making
smaller payments on its credit-linked notes.

Termination of a SWAP
➢ By entering into a directly opposite swap
➢ Selling to another counterparty
➢ Use a swaption to enter into an offsetting swap
 46

Option Trading Strategies

Long Call
This is utilized when the investor is bullish about the market. It mainly involves buying a call
option on a particular security. The investor benefits when security prices are going up in the
market

Risk limited to the Premium. (Maximum loss if market expires at or below the option strike price).

Reward is unlimited

Breakeven Point = Strike Price + Premium

Example

Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191.10. He buys a call option with
a strike price of Rs. 4600 at a premium of Rs. 36.35, expiring on 31st July. If the Nifty goes above
4636.35, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option.
In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless)
with a maximum loss of the premium.

On expiry, Nifty closes at Net payoff

4100.00 -36.35
4300.00 -36.35
4500.00 -36.35
4636.35 0
4700.00 63.65
4900.00 263.65
5100.00 463.65
 47

5300.00 663.65

The option increases in value as the price of the underlying increase. As long as the price is below
the strike price plus the premium, the investor will not exercise the option hence loosing the
premium paid. Payoff is equal to ST –(K+P) = 4700 – (4600 +36.35) = 63.65.

Long Put

When an investor is bearish, he can buy a Put option. A put option gives the buyer of the put the
right to sell the stock at a pre specified price there by limiting his risk.

Risk is limited to the premium paid

Reward is limited

Breaking-even: K –Premium

A trader is bearish about on ZSE when it is trading at 2694.He buys a put option with strike price
$2600 at premium of $52.If the ZSE goes below 2548, the trader will make a profit on exercising
the option. If it rises above 2600, he can forgo the option.

On expiry Net Payoff

2300 248

2400 148

2500 48

2548 0

2600 -52

2700 -52

Short Call (Naked Call)

 48

This strategy involves selling a call option with the view that security prices will fall in the future.
Selling a call gives the buyer the right to come and buy a security from you the seller of the call
option. If prices go down, the buyer of the call option will not exercise the option since it will be
profitable to buy in the market at low prices hence you pocket the premium.

Risk: Unlimited
Reward: Limited to the amount of premium
Break-even Point: Strike Price+ Premium (From the buyer’s point of view)

Example

Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of
Rs. 2600 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or
below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ can retain the
entire premium of Rs.154.
Nifty closes at Net Payoff
2400 154
2500 154
2600 154
2700 54
2754 0
2800 -46
2900 -146
3000 -246

This strategy is executed by an investor who is bearish about the market. If prices continue to fall,
the buyer will not exercise the option but rather will buy the asset in the market at low price hence
the seller pockets the premium. Pay off is (K + premium -ST) = (2600+154) -2700= 54.This
strategy is very risky since the investor is selling a call option on an asset that he does not hold. If
prices continue to rise, the option buyer will exercise the option hence the option seller will be
forced to buy the asset in the market at higher prices.
 49

Short Put

This is executed when the investor is bullish about the market. The investor is hoping to earn a
premium from the transaction if the option expires unexercised. When prices are rising the option
buyer will not exercise the option hence the seller of the option will pocket the premium.

Long Straddle

This is a volatility strategy that is used when the stock price /index is expected to show large
movement in either direction. This strategy involves buying a call as well as put on the same
stock or index for the same maturity and strike price. If the price of the stock or index
increases, the call is exercised while the put expires worthless and if the price decreases, the
put is exercised and the call expires worthless. The investor is direction neutral.

Risk: Limited to the initial premium

Reward: Unlimited

Breakeven

Upper Breakeven Point is Strike Price of Long Call +net premium paid

Lower breakeven Point is Strike Price of Long Put –Net Premium paid

Assume the JSE is now 4450.An investor enters a long straddle buy buying a May R4500 JSE
put for R85 and a May R4500 JSE call for 122.The net debit taken to enter the trade is
R207,which is also the maximum possible loss.

On expiry Net Payoff for Put Net Payoff for Call Net Payoff

3800 615 -122 493

3900 515 -122 393

 50

4000 415 -122 293

4100 315 -122 193

4200 215 -122 93

4234 181 -122 59

4293 122 -122 0

4300 115 -122 -7

4400 15 -122 -107

4500 -85 -122 -207

4600 -85 -22 -107

4700 -85 78 -7

4707 -85 85 0

4766 -85 144 59

4800 -85 178

Covered Call

This is when an investor sells a call on an asset he owns. The investor can also buy the asset and
sell the option simultaneously. This leads to a inflow of premium to the investor. This is often
employed when an investor has short term neutral and to moderately bullish. The profit increases
as the underlying rises but gets caped when it reaches the strike price.

Risk is limited to the entire price of the underlying if it falls to zero but retains the premium
since prices the option will not be exercised against him.

Rewards are capped at the strike price plus premium received i.e (Call Strike Price-Stock
price paid) + premium received.

Breakeven point Stock price paid –premium received

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Example

John bought Delta for $3850 and simultaneously sells a call option at a strike price of
$4000.John does not expect the price to go beyond $4000.John’s net outflow becomes $3850-
$80 =3770 hence reducing the cost of buying the asset. If the stock stays at or below $4000,
the call option will not get exercised and John pockets $80.

Delta closing price Net payoff

3600 -170

3700 -70

3740 -30

3770 0

3800 30

3900 130

4000 230

4100 230

4200 230

4300 230

Synthetic Long Call (Buy Stock and Buy Put)

This strategy is used by an investor who is conservatively bullish about the market. The
investor purchases a stock anticipating that the price of the stock will rise in the future.
However the investor is also worried about the downside risk of the stock hence he buy a put
option on the stock. In case the price of the stock rises you get the full benefit of the price
rise. In case the price of the stock falls, exercise the Put Option (remember Put is a right to
 52

sell). You have capped your loss in this manner because the Put option stops your further
losses. The strategy has limited losses (put premium when prices go up) and unlimited profits
(after subtracting put premium). It’s called a synthetic call because the result looks like a Call
Buy Strategy although they are not similar.

This is used when ownership of the stock is desired while at the same time the investor about
near term downside risk.

Risk: Losses are limited to the stock price +put premium – put strike price

Breakeven point: Put Strike price +put premium +stock price –put strike price (The investor
will have to recover the cost of the put option purchase price + the stock price to break even)

Mr K is bullish about the Econet share .He buys Econet at the current price of $4000.To protect
against fall in the price of Econet he bought a put option with strike price $3900 at a premium
of $143

Hint: Net pay off = Payoff from the stock and net payoff from the put option