CFA 2017 Level II

Derivatives

Study Session 14
Readings 40, 41, 42

Created and developed by Michael Cao

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About Study Session 14

• 5‐15% of level II exam = 1‐3 item sets
• Core topics
– Forward/futures/FRA pricing & valuation
– Swap pricing & valuation
– Binomial model option pricing
– Options strategies
• Exam focus
– Payoff structure in each type of derivative instrument
– Understanding of ideas behind pricing and valuation
– Proficient application of numerical procedures

Reading 40

Pricing and Valuation of Forward

Commitments

Created and developed by Michael Cao

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 Forward/Futures Pricing
• Price = FPt(T), forward price written in the contract
– Price at which to buy or sell the asset at expiration
• Forward/futures price at time 0:
1
365 days per year
– Derived based on no‐arbitrage principle
– Must have because no cash is tied up when
investing in forwards/futures
– Cash grows at , hence 1
• Price is set such that value = 0 at contract initiation
– No initial cash exchange to enter contract
LOS 40.a 3

Forward/Futures Valuation
• Value = Vt(T), value of (long position in) the contract
– How much the contract itself is worth
– Negative of Vt(T) to short position (zero‐sum game)
• Forward/futures value at time t (between 0 and T):
365 days per year

1
• Special cases:

– At initiation, 0 (no initial value)

– At expirtaion, (payoff spread)

LOS 40.a/b 4

FRA Pricing & Valuation

• Forward rate agreement (FRA)
– Price: implied forward rate for t1 to t2, annualized
– Value: (new FRA rate – fixed FRA rate) × × notional

FRA: “borrow” for t2–t1 starting at t1

0 t1 t2

LOS 40.a/b 5

Created and developed by Michael Cao

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 FRA Pricing: Problem
• Given the current LIBOR rates below, what is the price of a
2×5 forward rate agreement (FRA) closest to? Current LIBOR
A. 1.24% 60‐day 2.5%
B. 1.46%
90‐day 3.0%
C. 4.98%
150‐day 4.0%
• 2×5 FRA: 3‐month loan 2 months from today 210‐day 5.0%
.
• Implied forward rate = 1 1.2448%
.

• Annualized = 1.2448% 4.9793%

FRA: “borrow” for 90 days starting in 60 days

0 60 150
LOS 40.a/b 6

Benefits/Costs of Holding Spot

• Net cost of carry: PV cost PV benefit
– Costs: avoided when using forwards/futures – desirable
• Storage, insurance, etc.
– Benefits: forgone when using forwards/futures – devaluing
• Cash flows (dividend, coupon), convenience yield, etc.
• Forward/futures price
1
– Must pay less for futures/forwards when owning the
underlying results in (higher) benefit
– Must pay more for futures/forwards when owning the
underlying incurs (higher) cost
LOS 40.a 7

Benefits/Costs of Holding Spot

• Equity forward/futures (discretely paid dividends)
– Price: PV dividend 1

– Value: PV dividend

• Equity forward/futures (continuous dividends, e.g. an

equity index consisting of many stocks)
– Price:
– Value:

LOS 40.a/b 8

Created and developed by Michael Cao

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 Benefits/Costs of Holding Spot
• Fixed income forward/futures
– Price: PV coupon 1

– Value: PV coupon

• Currency forward/futures ( in “domestic/foreign”)

– Price:

– Value:

LOS 40.a/b 9

Forward/Futures Pricing: Problem

• Given a 8% risk‐free rate, what is the price of a forward
contract expiring in 9 months with a current spot price of $48
that requires a $4 maintenance cost 9 months from now?
A. $46.85
B. $54.85
C. $55.09
• Forward price
= 1
= $48 1 0.08 $4
= 54.85

LOS 40.a 10

Swap Pricing vs. Valuation

• “Price”: swap fixed rate (SFR) written in the contract
– Interest rate at which to borrow or lend
– Derived based on no‐arbitrage principle
– SFR is set such that value = 0 at contract initiation
• Value: value of (long position in) the contract
– How much the contract itself is worth
– Negative of Vt(T) to short position – zero‐sum game
– Value = PV(fixed payments) – PV(floating payments)
Fixed
0 Floating t1 t2 t3 t4

LOS 40.c/d 11

Created and developed by Michael Cao

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 Replicating a Swap
• A swap can be replicated by
– A series of off‐market FRAs, or
– A collection of interest rate calls and puts, or
– A long bond and a short bond

Fixed
0 Floating t1 t2 t3 t4

LOS 40.c/d 12

Interest Rate Swap Pricing

• Want to find SFR (i.e. coupon C of fixed‐rate bond)
• Need to find C such that swap value = 0, or
– PV(fixed‐rate bond) = PV(floating‐rate bond)
• Note: PV(floating‐rate bond) = 1 on any reset date

C=?

Fixed C C C C
0 Floating t1 t2 t3 t4

• where

LOS 40.c 13

Interest Rate Swap Valuation

• Want to calculate value of swap to either party
• Swap value = difference between
– PV(fixed‐rate bond)
– PV(floating‐rate bond)
• Note: PV(floating‐rate bond) = 1 on any reset date

Fixed C PV C C C
0 Floating t1 PV t2 t3 t4

LOS 40.c/d 14

Created and developed by Michael Cao

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 Interest Rate Swap: Example
• A 2‐year semi‐annual plain vanilla interest rate swap
with notional principal of $50 million
• Quoted LIBORs Maturity Annualized
LIBOR
180‐day 4.0%
360‐day 5.0%
540‐day 6.5%
720‐day 8.0%

Fixed
0 180 360 540 720 Floating

LOS 40.c 15

Interest Rate Swap: Example

• Calculate the swap fixed rate (SFR)
• First, calculate discount factors from quoted LIBORs
Annualized Discount
– 0.9804 Maturity
. LIBOR factor
–… 180‐day 4.0% Z1 = 0.9804
360‐day 5.0% Z2 = 0.9524
• Swap fixed rate:
540‐day 6.5% Z3 = 0.9112
– 3.72% 720‐day 8.0% Z4 = 0.8621
C=?
C C C C Fixed
0 180 360 540 720 Floating

LOS 40.c 16

Interest Rate Swap: Example

• Calculate the swap fixed rate (SFR)
• 3.72% is the semi‐annual swap fixed rate
– A complicated “average” of future floating rates
• Annualized SFR = 3.72% × 2 = 7.44%
• Semi‐annual fixed‐rate payment =
$50m × 3.72% = $1.86m

3.72%
C C C C Fixed
0 180 360 540 720 Floating

LOS 40.c 17

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 Interest Rate Swap: Example
• Value the swap after 410 days, given quoted LIBORs
and 180‐day LIBOR of Annualized Discount
6.0% at last settlement Maturity LIBOR factor
date (i.e. 360‐day point) 130‐day 3.5% 0.9875

• First, calculate discount 310‐day 5.5% 0.9548

factors from current quoted LIBORs

• Value of swap (to pay‐fixed party) =
PV(floating‐rate bond) – PV(fixed‐rate bond)
Fixed
0 180 360 540 720 Floating
t

LOS 40.c/d 18

Interest Rate Swap: Example

• Value the swap after 410 days
• All calculations done for $1 notional
• PV(fixed‐rate bond) =
0.0372 × 0.9875
+ (1 + 0.0372) × 0.9548
= 1.0271
Fixed
0 180 360 540 720 Floating
t

LOS 40.c/d 19

Interest Rate Swap: Example

• Value the swap after 410 days
• Floating‐rate payment at 540‐day point =
0.06 0.03 (based on LIBOR at 360‐day point)
• Floating‐rate bond value resets to 1 at 540‐day point
• PV(floating‐rate bond) = (1 + 0.03) × 0.9875 = 1.0171
Fixed
0 180 360 540 720 Floating
t

LOS 40.c/d 20

Created and developed by Michael Cao

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 Interest Rate Swap: Example
• Value the swap after 410 days
• Value of swap (to pay‐fixed party) =
PV(floating‐rate bond) – PV(fixed‐rate bond) =
(1.0171 – 1.0271) × $50m = –$0.5m (a loss)
• Receive‐fixed/pay‐floating party gains ($0.5m)
1.0271
Fixed
0 180 360 540 720 Floating
t
1.0171

LOS 40.c/d 21

Other Types of Swaps

• Currency swap
– Notional principal exchanged at initiation and expiration
– Interest payments made in each currency, not netted
– Notional stated in either currency at exchange rate at t0
– SFR calculated in the same way as for interest rate swaps
– Potentially, two separate SFRs based on two sets of LIBORs
– Value of swap calculated in the same way as for interest
rate swaps, but netted in (either) one common currency

LOS 40.c/d 22

Other Types of Swaps

• Equity swap
– Payment structures
• Fixed interest rate for equity return
• Floating interest rate for equity return
• Equity return on index A for equity return on index B
– Periodic payments netted at each settlement date
– Notional principal not exchanged at initiation or expiration
– SFR calculated in the same way as for interest rate swaps
– Value of swap calculated in the same way as for interest
rate swaps, with equity index value as the PV of equity leg

LOS 40.c/d 23

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 Reading 41

Valuation of Contingent Claims

24

Binomial Option Pricing Model

• Objective: to value an option (prior to expiration)
• Steps in binomial model – intuition important:
– Simulate possible underlying asset price paths
– Compute option payoff in each scenario
– Calculate average payoff across all scenarios
– Discount average payoff back to arrive at current fair price
pU S2++ = S1+ × U  V2++
pU S1+ = S0 × U pD
S0 S2+‐ = S0  V2+‐ E[V2]
pD S1‐ = S0 × D pU
PV(E[V2]) pD S2 = S1 × D  V2‐‐
‐‐ ‐

≡ V0 est.
LOS 41.a/b/f 25

Binomial Model (Equity): Example

• A stock with S0 = $58; Rf = 4%
• U = 1.25, D = 0.8 (so U × D = 1)
• So pU = = 53.3%, pD = 1 – pU = 46.7%
• A European put with $64 strike price and 2‐year
expiration
pU S2++ = $90.63  V2++ = $0
pU S1+ = $72.50 pD
S0 = $58 S2+‐ = $58  V2+‐ = $6.00
pD S1‐ = $46.40 pU
pD S2‐‐ = $37.12  V2‐‐ = $26.88

LOS 41.a/b 26

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 Binomial Model (Equity): Example
• For upper node at S1+,
E 0.533 $0 0.467 $6.00
$2.69
1 1 0.04
• For lower node at S1‐,
E 0.533 $6.00 0.467 $26.88
$15.15
1 1 0.04

V1+ = $2.69 pU S2++ = $90.63  V2++ = $0

pU S1+ = $72.50 pD
S0 = $58 S2+‐ = $58  V2+‐ = $6.00
pD S1‐ = $46.40 pU
pD S2‐‐ = $37.12  V2‐‐ = $26.88
V1‐ = $15.15

LOS 41.a/b 27

Binomial Model (Equity): Example

• At initiation (current time) at S0,
E 0.533 $2.69 0.467 $15.15
$8.18
1 1 0.04

V1+ = $2.69 pU S2++ = $90.63  V2++ = $0

pU S1+ = $72.50 pD
S0 = $58 S +‐ = $58
2 V +‐ = $6.00
pD S1‐ = $46.40 pU 2
pD S2‐‐ = $37.12  V2‐‐ = $26.88
V1‐ = $15.15

LOS 41.a/b 28

Binomial Model (Equity): Example

• If option is American, compare projected vs. exercise
– S1+ node: exercise payoff = $0
– S1‐ node: exercise payoff = $64 – $46.40 = $17.60 > $15.15
• At initiation (current time) at S0,
E 0.533 $2.69 0.467 $17.60
$9.28
1 1 0.04

V1+ = $2.69 pU S2++ = $90.63  V2++ = $0

pU S1+ = $72.50 pD
S0 = $58 S2+‐ = $58  V2+‐ = $6.00
pD S1‐ = $46.40 pU
pD S2‐‐ = $37.12  V2‐‐ = $26.88
V1‐ = $17.60
$15.15

LOS 41.a/b 29

Created and developed by Michael Cao

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 Binomial Option Pricing Model
• Options on fixed income securities
– Underlying interest rate tree
– Probability = 50% for up and down moves
– Interest rates (discount rates) different across nodes
0.5 i2++
0.5 i1+ 0.5
i0 i2+‐
0.5 i1‐ 0.5
0.5 i2‐‐
• Applications
– Option on a bond (with an additional bond price tree)
– Cap or floor (based on interest rate tree directly)
LOS 41.a/d/e 30

Option Greeks
Call value Put value Greek
Underlying price 
Higher Lower Delta
(relative to exercise price)
Time to expiration  Higher Higher Theta
Interest rate  Higher Lower Rho
Volatility of underlying  Higher Higher Vega
Existence of cash inflows
Lower Higher N.A.
from holding underlying

LOS 41.l 31

Delta Hedging
• Delta (Δ) of an option:
– Discrete case: Δ = ; continuous case: Δ = “N(d1)”
– For calls, 0 ≤ Δ ≤ 1; for puts, –1 ≤ Δ ≤ 0
– Put Δ = call Δ – 1 (same underlying, expiration, and strike)
• To hedge a long position of n calls (puts),
– Short (long) n × Δ units of underlying asset
• General: units of underlying = number of options × Δ
• Gamma of option: rate of change in delta
– High gamma (e.g. when option at the money)  more
variable delta  more costly to maintain delta hedge
LOS 41.m/n 32

Created and developed by Michael Cao

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 Delta Hedging: Problem
• Having sold a call, an analyst will delta‐hedge this position.
With below information about an otherwise identical put,
which of the following statements is least accurate?
A. Delta‐hedging the call requires shorting 0.02 shares per contract.
B. The call is deep in‐the‐money and thus does not require hedging.
C. Rebalancing will become more costly if the underlying price is higher.
• Call delta = –0.98 + 1 = 0.02 = shares shorted
Put option
to delta‐hedge each call option contract
Price $2.4
• Call delta = 0.02  option likely out‐of‐money
Delta –0.98
(i.e. with intrinsic value close to zero)
• Stock price higher  call less out‐of‐money  delta more
sensitive (i.e. higher gamma)  more costly rebalancing

LOS 41.m/n 33

Reading 42

Derivatives Strategies

34

Covered Call
• Long underlying, short call (S – C)
– Gain on underlying offset by loss on call
– Loss on underlying reduced by call premium received
• Giving up upside potential for option premium
• Expecting no significant volatility in underlying price

Profit
Short call Covered call

+ = 0 S
Long underlying

LOS 42.c 35

Created and developed by Michael Cao

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 Protective Put
• Long underlying, long put (S + P)
– Gain on underlying reduced by put premium paid
– Loss on underlying offset by gain on put
• Protection against large drop in underlying price

Profit
Long put Protective put
+ = 0 S
Long underlying

LOS 42.d 36

Gain/Loss Analysis
• General methodology:
– From the definitions, draw the profit diagram
– To find maximum gain, compute profit based on an
(extreme) underlying price S that produces the highest
possible payoff
– To find maximum loss, compute profit based on an
(extreme) underlying price S that produces the lowest
possible payoff
– For break‐even price, start at a “kink” (some strike price)
and figure out the distance to a/the point of zero profit
• Or trial and error

LOS 42.e/h 37

Covered Call: Example

• Purchase prices S0 = $17, C0 = $4; strike price X = $19
• Maximum gain:
– Assume a very high underlying price S (> $19), say S = $20
– Call payoff = S – X (if positive), otherwise = 0
– Final payoff of the covered call strategy (S – C)
= $20 – ($20 – $19) = $19 Profit
Covered call
– Beginning cost of the strategy
= $17 – $4 = $13 0 S
– (Maximum possible) profit $19

= $19 – $13 = $6

LOS 42.e 38

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 Covered Call: Example
• Purchase prices S0 = $17, C0 = $4; strike price X = $19
• Maximum loss:
– Locate the lowest profit at S = $0
– Call payoff = S – X (if positive), otherwise = 0
– Final payoff of the strategy (S – C)
= $0 – $0 = $0 Profit
Covered call
– Beginning cost of the strategy
= $17 – $4 = $13 0 S
– (Maximum possible) loss $19

= – (minimum possible) profit

= – ($0 – $13) = $13

LOS 42.e 39

Covered Call: Example

• Purchase prices S0 = $17, C0 = $4; strike price X = $19
• Breakeven price:
– At what underlying price will profit = $0 (i.e. loss = $0)?
– Locate the point where the profit crosses zero
– Some distance to the left of $19
– Maximum profit = $6 (before) Profit
Covered call
– Distance to the left = $6
$6
– Breakeven price = $19 – $6 = $13 0 S
$19
– To confirm, at S = $13, profit =
$6
($13 – $0) – ($17 – $4) = $0
– Alternatively, trial and error to move to the left from $19
LOS 42.e 40

Bull Spread
• Long low‐strike call, short high‐strike call (Clow – Chigh)
• Long low‐strike put, short high‐strike put (Plow – Phigh)
• No upside or downside potential (capped)
• Exposure to a upward move but with low volatility

Short call Xhigh Short put

Xhigh
Bull spread
0 S 0 S
Bull spread Long put
Xlow
Xlow
Long call

LOS 42.g 41

Created and developed by Michael Cao

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 Bear Spread
• Long high‐strike call, short low‐strike call (Chigh – Clow)
• Long high‐strike put, short low‐strike put (Phigh – Plow)
• No upside or downside potential (capped)
• Exposure to a downward move but with low volatility

Short call Long put

Xlow Long call Xlow Short put
Bear spread
0 S 0 S
Bear spread
Xhigh
Xhigh

LOS 42.g 42

Straddle
• Long call, long put (C + P) – at the same strike price
• Expecting volatility in either direction (without any
directional expectation)

Straddle
0 S
Long call
Long put

LOS 42.g 43

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