QUAN Ruoyuan CP-1

L1 – Intro to Derivatives L3 – Forwards and Futures on commodities

A derivative is a security or contract whose payoff
depends on, or is derived from, the value of an Storage Cost is like a negative yield, and you do not need to suffer that
“underlying” asset before
Maturity date
Major Usage of Derivative: Transfer risks.
To be specific: hedge risks (long December Swiss
franc futures, long Variance Swap); speculate or Contango (F increases with T) if very high storage costs
make a bet (“the big short”) ; circumvent market Convenience Yield (extra value of holding it):
restrictions, lock in a profit and manage taxes(at- Demand to Inventory ratio is a good measure
the-money put option); adjust the incentive-risk
tradeoff for managers; Transform pay-off
Exchange-Traded Derivatives (futures, option on Backwardation (F decreases with T) if in very high demand, people want
stocks and futures): Specific physical locations and that now!
Clearing house which centralizes the Most often the amount of futures of any kind vastly exceeds the amount
communication of bid and offer prices to all direct of the underlying commodity
market participants; Minimal counterparty risk,
both sides of any trade post margin; Contracts are
standardized; Transparent public information on L4 – Forwards and Contracts on Currencies
prices and trades Liquid contracts XXX/YYY typically means how much of the quote currency (YYY) is
OTC (Forward): No particular places and Dealers act needed to buy one unit of the base currency (XXX). And the price is
as market makers by quoting prices and trading written as S^XXX (how many YYY (USD) to exchange 1 XXX)
with their customers; More counter-party risk; Let US interest rate be r, GBP be r*, or any foreign interest rate then
Customized and exotic contracts; Opaque
information on prices and trades and less liquid
contracts
If the above holds, then we have covered interest rate condition
Foreign Exchange Swaps:

L2 – Forward and Futures contracts

A forward contract initiated at time 0 is an agreement
between two counterparties to buy or sell certain
amount of an underlying asset on a future date T for a
unit price
Payoff to Long:
Payoff to Short:
By Non-Arbitrage Principle,
Expected future price is , with
If q is dividend yield, Forward Rate:

At time t,
If we exit the forward contract at time t, you could first
derive the final payoff at time T, then discounted back
to time t to get the value of contract at time t.
If you are at short side, it is:

Differences between futures contract and forwards contract:

1. futures are traded on an exchange
2. futures are standardized (with respect to size, maturity, underlying)
3. the profits and losses of futures are marked to market (daily
settlement)
Daily P&L = Contract Size(F_t –F_t-1)
L6 – Swaps
A swap is an OTC agreement to exchange two streams of
cash flows at pre-specified date or dates T1 < · · · < Tm
until a terminal date T. It could be used to hedge a stream of
risky payments
 L7 – Introduction to Options L13 –

A European option gives its holder the right, but not the obligation, to
buy or sell a given asset (the underlying) for a pre-specified price (the
strike price) at a pre-specified date (the maturity date)
Options are not adjusted for dividends
Payoff of Call at T: , K is the strike price, Profit of the buyer should –
Option price
Moneyness of a call at any time t:
Out of the Money (OTM): St <K
In the Money (ITM): St > K
At the Money (ATM): St = K
Payoff of Put at T: , K is the strike price, Profit of the buyer should –
Option price
Put-Call Parity:
-
, is short forward contract with forward price K
We long forward contract with forward price
Then, -
=

European Option Non-Arbitrage Boundaries: ; ; The value of a call

(put) option is not less than the value of a long (short) forward with
delivery price equal to the option’s strike price and same maturity.

L8 – Option Trading Strategies

Synthetic Forward, Long Call Short Put at Butterfly Spread
Covered Call, Long Stock Short Call the same strike

Bull Spread, Long ITM Call , Short OTM Call () Bear Spread, Long ITM Put , Short OTM
Cashflow at time0: Call(, T)- Call(, T) Put ()
Cashflow at time0: Put(, T)- Put(, T)

Bull Spread Inequality

Calendar Inequality:
Straddle: Long call and put at the same ATM Strangle, Long call and put , and put strike
price is smaller
Striking news: If if bull spreads, butterfly spreads and
calendar spreads all have positive values, then there is NO
static arbitrage in the option prices that you are quoting
L9 – Binomial Tree Models L12 – Delta Hedging
Rationale: Price the derivatives at the cost of hedge Delta: Sensitivity of the option price to a small increase in the price
, of the underlying
, where and could be calculated from 2 situation directly

The formula is the same for put option.

We account for risk aversion in 2 ways:

1. Adding risk premium for the discount rate
2. Distortion of probabilities towards bad situations
If Short Call, Long Stocks
博弈： Time Decay (+), Convexiety (Large moves, -)

Where, the latter is the expected return in Mars. Gamma: Sensitivity of Delta (∆) to a small increase in the price of
the underlying

The forward price is the risk-neutral expectation

of the underlying price at T

Θ>0 for low S and Θ<0 for high S

Simulations:

L10 – Multi-step Binomial Tree

Rebalance: From to , from to
To ensure that it is also self-financing dynamic trading
Strategy, you should make sure the following

If d, u (down-factor, up-factor) are same for each step, we could use

Same qi for every step

L11 – BSM Model

Assumptions: No friction financial markets; Interest rate for Borrowing
And lending is the same; Continuous Path of stock price; mean μ and variance
σ^2 of log returns are constant over time, normally distributed and
independent between periods
Rationale: Based upon cost of hedge, and dynamic trading strategy
European Call option price:
European Put option price:
Explanation 1:
N() is the number of shares in the replicating portfolio for the call option
today (at time t). Because N(x) < 1, the portfolio in fact holds only a
fraction of one share. Which is also the sensitivity to stock price
We could use this explanation to produce a synthetic call by dynamically
adjusting the call
Explanation 2:
is the discounted expected price of the stock that we may receive from
the call
is the discounted expected value of the strike that we may pay on the call
is the risk neutral probability to exercise the option at T