DERIVATIVES

Week 11
 “Clever derivatives broke dozens of companies. It killed them.
Bankrupt. We don’t need these kinds of innovation in finance.
It’s OK to be boring in finance. What we want is innovation in
widgets”
Charlie Munger
What does this quote tell us?
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 DISCUSSION TOPICS

• Status • Next Steps

• Roll Call & Presentation

• Questions
• Pricing Short Term Money Market
Securities

• Pricing Fixed Income Securities

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STATUS

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 STATUS

Week Topic Status Week Topic Status

Week 1 Introduction to Derivatives Complete Week 8 Mid-Semester Break Complete

Week 2 Futures and Forwards Complete Week 9 Black-Scholes-Merton Option Complete

Pricing
Week 3 Interest Rate Futures Complete Week 10 Mid-semester Test Complete

Week 4 Quiz & Margin, Trading & Complete Week 11 Debt Pricing & Yield Curves
Closing out
Week 5 Options Complete Week 12 Hedging & Basis Risk

Week 6 Put-call Parity & Arbitrage Complete Week 13 Swaps

Week 7 Binomial Tree Option Pricing Complete Week 14 Lessons from the Real World
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ROLL CALL

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7
PRESENTATION

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PRESENTATION

Who’s First?

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PRICING SHORT TERM MONEY MARKET
SECURITIES

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 PRICING SHORT TERM MONEY MARKET
SECURITIES
Bank Bill Formula
𝐹𝑉
𝑃𝑉 =
𝑦 𝑑𝑎𝑦𝑠
1+ ×
100 365
Where
𝑃𝑉 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
𝐹𝑉 = 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 (𝑜𝑟 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒)
𝑦 = 𝑦𝑖𝑒𝑙𝑑 (𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 %)
𝑑𝑎𝑦𝑠 = 𝑑𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦

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 PRICING SHORT TERM MONEY MARKET
SECURITIES
Exercise 1: Price a $1,000,000 bank bill that has Exercise 3: Price a $1.5m bank bill that has 276
90 days to maturity that is trading at a yield of days to maturity and is trading at a yield of 0.89%
1.27%

A: $1,489,972.69
A: $996,878.27 (just like a BAB futures contract)

Exercise 4: Price a $2.5m bank bill that has 1 day

Exercise 2: What price is that same bank bill 40 to maturity that is trading at a yield of 0.75%
days later when it is trading at a yield of 0.78%

A: $2,499,948.63
A: $998,932.65

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PRICING FIXED INCOME SECURITIES

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 PRICING FIXED INCOME SECURITIES

Terminology
15/8/2019 $5m

• Issuer • Coupon Commonwealth of

• Perforated interest
• The entity that issued the payment Australia
bond
• Name on the face of the bond • Coupon date
• Date coupon is paid
$100 million

• Face value or Principal

• Amount paid by borrower to • Coupon rate
lender at maturity • Annual return from 15 August 2035
coupons as a percentage
• Written on the face of the of face value
bond
15/8/2035 $5m
• Yield
• Your return
• Maturity date
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• Date the principal is repaid
 PRICING FIXED INCOME SECURITIES

Australian Bond Formula

𝑓 1 − 𝑣𝑛
𝑃= 𝑣𝑑 𝑔 1+ + 100𝑣 𝑛
𝑖
𝑃: 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 $100 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑟𝑜𝑢𝑛𝑑𝑒𝑑 𝑡𝑜 3 𝑑𝑒𝑐𝑖𝑚𝑎𝑙 𝑝𝑙𝑎𝑐𝑒𝑠
𝑖: 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑑 𝑏𝑦 200
1
𝑣=
1+𝑖
𝑓: 𝑑𝑎𝑦𝑠 𝑓𝑟𝑜𝑚 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑢𝑛𝑡𝑖𝑙 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝑑: 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
𝑔: ℎ𝑎𝑙𝑓 − 𝑦𝑒𝑎𝑟𝑙𝑦 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟 $100 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝑛: 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦

Internal calculations to 8 decimal places, price per $100 face value to 3 decimal places, price of the bond to 2 decimal places

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 FIXED INCOME

Exercise 5: On 26 February 2020, what price 𝑓 = 171

would you pay for a bond that matures on 15 𝑑 = 182
August 2030 which has a $500,000 face value that 𝑓
pays a 2.25% coupon and has a yield to maturity = 0.93956044
𝑑
of 1.07%?
1.07
𝑖= = 0.00535
200
A: 1
𝑣= = 0.99467847
1+𝑖
Next coupon date: 15/8/2020 𝑛 = 20 coupon periods
Last coupon date: 15/2/2020 0.0225 × 100
𝑔= = 1.125
2

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 PRICING FIXED INCOME SECURITIES

𝑓 1 − 𝑣𝑛
𝑃= 𝑣𝑑 𝑔 1+ + 100𝑣 𝑛
𝑖

1 − 0.9946784720
𝑃 = 0.994678470.93956044 1.125 1 + + 100 × 0.9946784720
0.00535

𝑃 = $111.726 𝑝𝑒𝑟 $100 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃 = $558,630.00 𝑜𝑛 𝑡ℎ𝑒 $500,000 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑏𝑜𝑛𝑑

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 FIXED INCOME

Exercise 6: On 17 January 2020, what price would 𝑓 = 125

you pay for a bond that matures on 21 November 𝑑 = 182
2035 which has a $2.5m face value that pays a 𝑓
2.75% coupon and has a yield to maturity of = 0.68681319
𝑑
1.13%?
1.13
𝑖= = 0.00565
200
A: 1
𝑣= = 0.99438174
1+𝑖
Next coupon date: 21/5/2020 𝑛 = 31
Last coupon date: 21/11/2019 0.0275 × 100
𝑔= = 1.375
2

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 PRICING FIXED INCOME SECURITIES

𝑓 1 − 𝑣𝑛
𝑃= 𝑣𝑑 𝑔 1+ + 100𝑣 𝑛
𝑖

1 − 0.9943817431
𝑃 = 0.994381740.68681319 1.375 1 + + 100 × 0.9943817431
0.00565

𝑃 = $123.869 𝑝𝑒𝑟 $100 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃 = $3,096,725.00

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 FIXED INCOME

Exercise 7: On 17 May 2020, what price would 𝑓=4

you pay for a bond that matures on 21 May 2032 𝑑 = 182
which has a $25m face value that pays a 2.50% 𝑓
coupon and has a yield to maturity of 1.11%? = 0.02197802
𝑑
1.11
𝑖= = 0.00555
A: 200
1
Next coupon date: 21/5/2020 𝑣= = 0.99448063
1+𝑖
Last coupon date: 21/11/2019 𝑛 = 24
0.0250 × 100
𝑔= = 1.250
2

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 PRICING FIXED INCOME SECURITIES

𝑓 1 − 𝑣𝑛
𝑃= 𝑣𝑑 𝑔 1+ + 100𝑣 𝑛
𝑖

1 − 0.9944806324
𝑃 = 0.994480630.02197802 1.250 1 + + 100 × 0.9944806324
0.00555

𝑃 = $116.812 𝑝𝑒𝑟 $100 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃 = $29,203,000.00

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NEXT STEPS

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 NEXT STEPS

Homework 4. What price would you pay for a $2.25m

face value bank bill which has 27 days
1. What price would you pay for a 90 day
to maturity that is trading at a yield of
bank bill with $1m face value trading at
1.16%
a yield of 0.72%?
5. How much profit or loss would you
2. What price would you pay for a 14 day
experience if you purchased a
bank bill with face value $837,546.00
$1,255,640 face value bank bill with 97
trading at a yield of 1.26%?
days to maturity at a yield of 0.98% and
3. What price would you pay for a $5.467m sold it 22 days later at a yield of 1.21%?
bank bill with 186 days to maturity
trading at a yield of 2.47%

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 NEXT STEPS
6. What price would you pay for a $25m
face value bond on 13 February 2020
which matures on 22 June 2022 that has
a coupon of 2.75% and is trading at a
yield to maturity of 1.92%?
7. What price would you pay for a $2.5m
face value bond on 2 January 2020
which matures on 28 November 2028
that has a coupon of 2.75% and is
trading at a yield to maturity of 2.925%?
8. What price would you pay for a 21 May
2021 bond on 17 April 2020 when the
bond has a face value of $12.5m, a
coupon of 2.25% and is trading at a
yield to maturity of 3.87%?
9. How much profit or loss would you
make purchasing a 3% coupon
$15.475m face value bond on 16
February 2021 which matures on 2
September 2037 at a yield of 3.65% and
selling it 13 days later at a yield of
3.825%?
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 NEXT STEPS

10. What price would you pay for a $7,178,000 face value bond on 29 March 2020 that
matures on 21 September 2028, has a coupon of 2.75% and is trading at 1.83%?
11. What price would you pay for a $1,027,000 face value bond on 31 July 2020 that
matures on 21 February 2026, has a coupon of 2.50% and is trading at 2.07%?

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QUESTIONS