FIN524A Options and Futures

Options and Futures
GMSF FIN 524A Summer 2016

Prof. Thomas Maurer
WashingtonUniversityinSt.Louis
OLIN BUSINESS SCHOOL
Creating knowledgeInspiring individualsTransforming business.
Class Time: July 12, 14, 16, 19, 21 9.00am 1pm
Location: Bauer Hall 150
Credit Hours: 1.5 Units
Course office hours: July 13, 15, 18, 20: 6.30pm-7.30pm; July 12, 14, 16, 19, 21,
22: 3pm-6pm
Office Location: Simon Hall 210
Office Phone: 314 935 3318
Email: thomas.maurer@wustl.edu
Summer 2016 2
COURSE DESCRIPTION
A derivative contract is a financial instrument whose value depends on or derives from the value
of an underlying asset or variable. Derivatives are used to manage and hedge risks (similar to an
insurance contract), engineer or structure payoff schedules, exploit arbitrage opportunities
(realize risk-free profits), or speculate (apply leverage to a risky position).
Commodity derivatives have been traded over-the-counter for many centuries. However,
financial derivatives written on currencies, interest rates and stocks were not traded until the
1970s. In the 1970s Fischer Black, Myron Scholes and Robert Merton developed arguably the
most famous pricing formula in finance which allows traders to determine the fair price of a
derivative contract. Over the past few decades, derivatives markets have experienced an
enormous growth measured in trading volume and in the amount of financial innovations.
However, despite the importance of derivative contracts in economics, derivatives were often
subject to serious criticism in the public press and politics due to severe events of fraud, moral
hazard, excessive risk taking and speculation. Accordingly, there is a large interest to regulate
derivatives trading and proprietary trading activities.
The objective of this course is to obtain a profound understanding of the mechanics of derivative
contracts and their applications in finance. We discuss specifications of different kinds of
derivative contracts (forwards, futures, swaps, options, etc) written on various underlyings, their
use to manage and eliminate risks, the fundamental concept of pricing contingent claims based
on the notion of no-arbitrage and payoff replication, and various approaches to implement the
no-arbitrage valuation concept (binomial trees, Black-Scholes formula, Monte Carlo
simulations).
COURSE PREREQUISITES
Basic mathematical skills for economists are assumed (level of Blume, Lawrence and Carl P.
Simon, Mathematics for Economists, Norton & Co, 1994.)
READING
Required: 1. Lecture Notes.
2. Hull, John C. Options, Futures, and Derivatives, Prentice-Hall, 9th Edition, 2014.
Summer 2016 3
HOMEWORK ASSIGNMENTS
There are several homework assignments. I do not grade the assignments, but we will discuss
some of the problem sets in class and I expect you to actively participate the discussions. I
encourage you to solve the problem sets first on your own and then discuss your work in small
groups. Spending enough time and thinking on your own about a problem is key to get an in-
depth understanding of the concepts!
TAKE-HOME EXAM
There is one take-home exam. The take-home exam is due on Saturday July 23th 6pm
(Submission by email.) Late submissions will not be considered and your take-home exam will
be marked with zero. You are allowed to work in small groups (4 or less students).
EXAM
There is one final exam on Saturday July 23th from 10am 12pm in Bauer Hall 150. The final
exam covers the material of the entire course.
The exam time is fixed. If you have a (foreseeable) conflict with this schedule, you must inform
me by the end of the second class!
Important Exam Policy:
(1) Calculators with logarithm and exponential functions are allowed and necessary
computers, tablets, cell phones or programmable calculators are not permitted. You also
must describe in detail the exact solution path showing how you get to the solution you
provide. Providing the exact formulas needed to derive a result is key to get credit a
(correct) solution without any derivations will be marked as zero.
(2) The exam is closed book (and notes) except for 1 cheat-sheet (not to exceed A4 size or
11in x 8.5in, printed front and back).
CLASS PARTICIPATION
You are supposed to attend all classes. Thorough preparation (reading the relevant chapters in
the textbook and the lecture notes) and active participation in class are key to stay on top of the
material and to succeed. I do not grade class participation.
Summer 2016 4
GRADING
Take-home exam 40%
Final Exam 60%
TOTAL 100%
COURSE SCHEDULE [Summer Term]

# DATE TOPICS READINGS HAND IN
1 Tue, 7.12.2016 Introduction, Interest Rates Chapter 1, 4
2 Thu, 7.14.2016 Forward Contracts Chapter 2, 3, 5
3 Sat, 7.16.2016 Futures Contracts Chapter 2, 3, 5
Options, Option Pricing in Discrete Chapter 10, 11, 12,
4 Tue, 7.19.2016
Time 13
Option Pricing in Discrete Time,
5 Thu, 7.21.2016 Chapter 13
Continuous Time Limit: Black-Scholes
6 Sat, 7.23.2016 Final Exam
Before Sun,
7 Take-home exam
7.23.2016, 6pm
* The schedule may change.
Summer 2016 5
ACADEMIC INTEGRITY AND CLASSROOM ETIQUETTE
I take the matters of academic integrity seriously and expect that you do, too. Please refer to
The Olin Honor Code for specific responsibilities, guidelines and procedures regarding
academic integrity.
I expect all of you as Olin students to conduct yourselves professionally. This includes, but is
not limited to:
Punctuality: Students are expected to arrive and be seated prior to the start of each class
session. They should display their name cards in all classes at all times.
Behavior: Classroom interaction will be conducted in a spirited manner but always while
displaying professional courtesy and personal respect.
Preparation: Students are expected to complete the readings, case preparations and other
assignments prior to each class session and be prepared to actively participate in class
discussion.
Distractions:
! Exiting and Entering: Students are expected to remain in the classroom for the duration
of the class session unless an urgent need arises or prior arrangements have been made
with the professor.
! Laptop, PDA, Tablet and Other Electronic Device Usage: Students are expected to not
use laptops, PDAs, tablets, and other electronic devices in classrooms unless with the
instructors consent and for activities directly related to the class session. Accessing
email or the Internet during class is not permitted as they can be distracting for peers and
faculty.
! Cellular Phone and Pager Usage: Students are expected to keep their mobile phones
and pagers turned off or have them set on silent/vibrate during class. Answering phones
or pagers while class is in session is not permitted.
! Other distractions: Those identified by individual instructors, such as eating in the
classroom.
DISABILITIES
Reasonable accommodations will be made for students with verifiable disabilities. Students
who qualify for accommodations must register through Washington Universitys Center for
Advanced Learning Disability Resources (DR) in Cornerstone. Their staff members will assist
me in arranging appropriate accommodations.
FIN 524A: Options and Futures
Thomas Andreas Maurer
Olin Business School,

Washington University in St Louis
July 2016
Thomas Maurer (Olin Business School) FIN 524A: Options and Futures 07/2016 1 / 325
Chapter 0: Course Details Content
Content I
Chapter 1: Introduction
Chapter 2: Interest Rates
Chapter 3: Forward Contracts
Chapter 4: Futures Contracts
Chapter 5: Options
Chapter 6: Option Pricing in Discrete Time
Chapter 7: Continuous Time Limit: Black-Scholes
Chapter 0: Course Details Objectives
Objectives
Introduction to derivative markets
In-depth discussion of most common derivative contracts (forwards,

futures, swaps and options) written on various underlyings (stocks,
currencies, interest rates, commodities, etc)
Specication of contracts and organization of markets
Use of derivatives to manage risk
Pricing of derivative contracts (concept of "payo replication" and "no
arbitrage")
Practical implementation of pricing concepts (Binomial trees,
Black-Scholes formula)
=> Balance between theoretical concepts in asset pricing,

computations and real world applications
Chapter 0: Course Details Readings
Readings
Lecture notes
John C. Hull, Options,

Futures, and other
Derivatives, 9th Edition
Standard text on
derivatives
Popular among
academics, students,
and practitioners
Useful reference
Chapter 0: Course Details Lectures
Lectures
Lectures: July 12, 14, 16, 19, 21; 9am until about 1pm; Bauer Hall
150
Oce hours (Simon Hall 210):

July 11, 13, 15, 18, 20: 6.30pm-7.30pm
July 12, 14, 16, 19, 21, 22: 3pm-6pm
Chapter 0: Course Details Assessment
Assessment
Requirement Weight Schedule
Take-Home Exam 40% before July 23, 6pm

Final Exam 60% July 23, 10am-noon
Take-home Exam has to be sent to me by email anytime before 6pm

on July 23
2 hour Exam takes place on the 22th of July, 10am-noon in Bauer
Hall 150
Exam policies:
Closed book (and notes) except for 1 page "cheat-sheet" (front and
back)
Calculator (no cell phones or laptops) allowed and necessary - BUT,
you also have to show how to derive and calculate your results in detail
Chapter 0: Course Details Expectations
My Expectations of You
Prerequisites
Class attendance
Preparation for class
Participation in class
Homework
If you have questions, please ask me
Chapter 0: Course Details Expectations
What You get from Me
Lecture notes
I will answer your questions:
In class
Oce hours
Email: thomas.maurer@wustl.edu
Chapter 1: Introduction Basics of Derivatives
What is a Derivative?
Denition
A derivative is a nancial instrument whose value depends on or derives
from the value of an underlying asset or variable.
Limited time to maturity

Payo at maturity is a function of the underlying variable
Current value depends on:
Characteristics of underlying variable - current level, volatility, etc
Time to maturity
Risk free interest rate
Other special characteristics of derivative contract
Examples of Derivatives
Examples of derivatives: futures, forwards, swaps, options, warrants,

structured products, etc
The underlying variables can be almost anything:

Stocks, interest rates, foreign exchange rates
Commodities - grains, oilseeds, livestock, meat, food, ber, metals
Credit risks, energy (electricity), weather, insurance payouts
Even derivatives such as futures and swaps
Examples of Derivative Payos: Forward (I)
A forward contract is an agreement to trade the underlying asset in

future (at maturity T ) for a xed price specied today (forward price
(T )
Ft at current time t)
Party that agrees to buy the underlying (long position) makes a prot
if at maturity T the price of the underlying (ST ) is higher than the
(T )
pre-specied forward price (Ft ), and makes a loss if at maturity
(T ) (long forward ) (T )
S T < Ft > PayoT = S T ! Ft
Party that agrees to sell the underlying (short position) makes a prot
if at maturity T the price of the underlying (ST ) is lower than the
(T )
(T ) (short forward ) (T )
ST > Ft > PayoT = Ft ! ST
Typically, no money is exchanged between long and short position at
time t
Futures contracts are similar (more details later)
Examples of Derivative Payos: Forward (II)
On the 4th of June, the treasurer of a corporation enters into a long

forward contract with a bank to buy 1 million in six months at an
exchange rate of 1.55 $
Do the corporation and the bank have an obligation? If so, what is it?
Corporation: A long position obligates the corporation to pay on the
4th of December $1550000 to the bank and it receives in exchange
1 million
Bank: A short position obligates the bank to pay on the 4th of
December 1 million to the corporation and it receives in exchange
$1550000
Examples of Derivative Payos: Forward (III)

What is the payo of the forward contract if the exchange rate on the
4th of December is 1.45 $ , 1.5 $ , 1.55 $ , 1.6 $ or 1.65 $ ?
Corporation: a long position in the forward pays o
0 1
B$ % C
B current ex- C
B " 1million ! $1550000
| {z } C
@ change rate A
| {z } pay $1550000
receive 1million
or !$100000, !$50000, $0, $50000, $100000
Bank: a short position in the forward pays o
0 1
B $ % C
B current ex- C
B | {z }
$1550000 ! " 1million C
@ change rate A
receive $1550000 | {z }
pay 1million
or $100000, $50000, $0, !$50000, !$100000

Importance of Derivatives
Derivatives play a key role in transferring risks in the economy
Many nancial transactions have embedded derivatives
In corporate nance, the concept of real options is essential for the

assessment of capital investment decisions
Chapter 1: Introduction Derivatives Markets
Derivatives Markets (I)
Exchange traded Over-the-Counter (OTC) traded

Futures, Options Forwards, Swaps, Options,
Warrants, Structured Products
Standardized contracts as Tailor-made and not (necessarily)

specied by exchange standardized contracts
Trading oor Network of dealers linked

through telephones and computers
Closing-out before maturity Held until maturity;

with osetting position often cash settlement
(delivery is uncommon)
Derivatives Markets (II)

Exchange traded Over-the-Counter (OTC) traded
Marking to market, Mostly no cash ows until maturity
daily settlement
Margin requirements Collateral possible
No credit, default, Credit risk

counter-party risk
Liquidity depends on contract Potential liquidity risk
Regulated Few regulations in the past,

but strong tendency to
increase regulation (Dodd Frank
Act, Volcker Rule, etc)
Exchanges
CME Group (www.cmegroup.com)

Chicago Board of Trade (CBOT, www.cbot.com)
Chicago Mercantile Exchange (CME, www.cme.com)
Chicago Board Options Exchange (CBOE, www.cboe.com)
NYSE Euronext (www.euronext.com)
American Stock Exchange (AMEX, www.amex.com)
Philadelphia Stock Exchange (PHLX, www.phlx.com), acquired by
Nasdaq (www.nasdaqtrader.com)
Eurex, Europe (www.eurexchange.com)
Bolsa de Mercadorias y Futuros, Brazil (BM&F, www.bmf.com.br)
Tokyo Financial Exchange, Japan (TFX, www.tfx.co.jp)
Many more (see the list at the end of Hull, page 799)
Size of OTC and Exchange-Traded Markets
Figure: Source: Bank for International Settlements (www.bis.org). Total notional

principal amounts for OTC market and value of underlying assets for exchange
market.
Size of OTC Market: Notional Amount vs Market Value

principal amounts and gross market value for OTC market.
OTC Market: Notional Amount

principal amounts outstanding for diverse underlyings in OTC market.
OTC Market: Market Value
Figure: Source: Bank for International Settlements (www.bis.org). Gross market

value of diverse derivatives in OTC market.
OTC Credit Risk: Lehman Bankruptcy
Lehmans led for bankruptcy on the 15th of September 2008

Biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives markets and
got into nancial diculties because it took high risks and found it
was unable to roll over its short term funding
Hundreds of thousands of transactions outstanding with about 8,000
counterparties
Unwinding these transactions has been challenging for both the
Lehman liquidators and their counterparties
Chapter 1: Introduction Derivatives Traders
How do Investors use Derivatives?
Managing risk
"Hedgers": hedging risk
Changing the nature of a liability
Changing the nature of an investment without incurring the costs of
selling one portfolio and buying another
"Speculators": trade/ bet on a view on the future direction of the

market
"Arbitrageurs": locking in an arbitrage prot
Chapter 1: Introduction Derivatives Traders: Hedging
Hedging Risk
Hedging reduces or eliminates risk associated with potential

(unknown) future movements in a market variable - for instance, price
of an asset currently owned or potentially to be owned
Hedging may increase or reduce future payos which at rst may

seem undesirable (looks like gambling)
BUT: the uncertain payo of a derivative is strongly correlated with

the uncertain payo of the underlying, and an appropriate (long or
short) position in the derivative can oset the risk in the underlying
and thus, one can reduce risk
Forwards/Futures neutralize risk by xing the price
Options provide insurance - that is, protection against adverse price

movement but still prot from favorable price movements
Hedging Risk: Examples
A rm which does business abroad may nd it useful to trade foreign

exchange rate derivatives - hedge risk in forex market
An airline may nd it useful to trade crude oil derivatives - hedge risk

in jet fuel prices
A stock trader may nd it useful to trade derivatives on stock indices

- hedge market risk
A producer of electricity may nd it useful to trade heating degree

days (HDD) or cooling degree days (CDD) derivatives - hedge risk of
demand shocks
A farmer, a holiday resort or a theme park may nd it useful to trade

weather derivatives - hedge against unfavorable weather conditions
Hedging Risk: Illustration (I)
Suppose you produce corn

You expect to harvest 20000 bushels (500 metric tons, eld of 125
acres) of corn by December and want to sell it in December
The current price of corn per bushel is $5.63
On the Chicago Mercantile Exchange corn futures contracts are traded
One futures contract is an agreement to trade 5000 bushels of corn in
the future
The current futures price for a contract with maturity in December is
$5.24 per bushel of corn, or $26200 per contract
The price of corn is volatile
Hedging Risk: Illustration (II)
Figure: Source: Wikiposit. Historical corn price.
Hedging Risk: Illustration (III)

Why would you consider to trade in the futures market?
Your skills/ advantages lie in farming, not in the ability to forecast
market price movements
What position would you take in the futures market? Long or short?
How many contracts?
Short sell 4 contracts to oset any risk and receive for sure $5.24 per
bushel, or $104800 for your entire harvest
How much does your futures position payo in December if the price
per bushel is $3, $4.5, $5, $5.5, $6, $6.5, or $8?
You have to deliver 20000 bushels of corn which is worth $60000,
$90000, $100000, $110000, $120000, $130000, or $160000
You receive $104800
The payo of your futures position is $44800, $14800, $4800,
!$5200, !$15200, !$25200, or !$55200
Hedging Risk: Illustration (IV)
This payo schedule is risky. Is it desirable to take on this risk?

The payo is perfectly negatively correlated with the corn price > you
can eliminate the corn price risk
For how much can you sell your corn in the market conditional on the
above prices?
You can sell your 20000 bushels of corn for $60000, $90000,
$100000, $110000, $120000, $130000, or $160000
How much do you earn in December from your futures position and
selling your corn in the market?
Independent of the corn price you earn $104800
Chapter 1: Introduction Derivatives Traders: Speculation
Speculation
Taking risk by betting on a view on the future direction of a market

variable and use derivatives to get extra leverage
Speculation on the gold price:

A view: The price of gold is likely to increase in the near future
One approach is to purchase gold in the spot market and sell it later
hoping the price goes up
Another approach is to trade in the derivatives market, that is, take a
long position in a forward or futures contract to lock in a price in the
near future or to buy a call option
The second approach needs only a small amount of cash as collateral or
deposited in a margin account or to purchase a call option instead of
an entire up-front investment to buy gold to take a speculative position
Chapter 1: Introduction Derivatives Traders: Arbitrage
Arbitrage
Denition
An arbitrage is a strategy that generates (today or in future) a positive
payo with non-zero probability and a negative payo with zero probability
In other words: locking in a riskless prot by taking osetting

positions simultaneously
Arbitrage across markets:

In market A, 1 ounce of gold is traded for $1640
In market B, 1 ounce of gold is traded for $1630
> Buy gold in market B and sell it in market A
> Receive instantly $10 for every ounce of gold traded
Arbitrage: Illustration in the Forward Market (I)
The current stock price of Apple is $571.5
Apple has a market beta of 0.93 and an expected return of 7.5% -

this means that its stock price is expected to increase to $614 next
year (assuming Apple does not pay dividends)
Suppose you could enter a forward contract (long or short position)

to buy in 1 year 1000 shares of Apple for $600000 (assume no
counter-party risk)
The one year risk free interest rate oered by a bank to you (lend or
borrow) is 1%
Is there an arbitrage opportunity? What do you do?
Arbitrage: Illustration in the Forward Market (II)
Today:
Borrow $594000 from the bank for 1 year at 1% interest
Buy 1000 shares of Apple for $571500
Enter a short position in the forward contract - that is, agree to sell
1000 shares for $600000 in one year
Cash ow today: $594000 ! $571500 = $22500
In 1 year:
Deliver 1000 shares of Apple and receive $600000 in cash (short
position in forward contract)
Pay back loan of ($594000 "1.01 =) $600000 from bank
Cash ow in 1 year: $600000 ! $600000 = 0 (for sure)
Principle of Asset Pricing

Fact
In asset pricing we usually assume that there exist no arbitrage
opportunities in the economy.
If two investment strategies have the same payo schedule in every

possible state of the world, then they must have the same price/ cost,
otherwise there exists an arbitrage opportunity
If investment strategy A pays o more than strategy B in every
possible state of the world, then strategy A must have a higher price/
cost than strategy B, otherwise there exists an arbitrage opportunity
=> The payo of a derivative depends on the payo of the underlying
> Use derivative, underlying and risk free asset and build strategy
which pays o nothing and thus, must cost nothing
> Recover price of derivative from price of underlying and
risk free interest rate
Chapter 1: Introduction Dangers of Derivatives
Dangers of Derivatives Trading
Traders can switch from being hedgers to speculators or from being

arbitrageurs to speculators; it is important to set up controls to
ensure that traders are using derivatives for their intended purpose
Limits to arbitrage, nancial constraints and liquidity risks are very

important issues in reality; however, they are often ignored by
arbitrageurs!
Example of Barings Bank Disaster, 1995
Nick Leeson, a trader in the Singapore oce, was employed to exploit

arbitrage opportunities between the Nikkei 225 futures prices traded
on exchanges in Singapore and Japan
He started to move from trading as an arbitrageur to become a
speculator without letting the head oce in London know
At some point he made some losses, which he was able to hide from
the head oce for a while
Subsequently he started to take bigger speculative positions in the
hope to recover his previous losses
By the time his activity was uncovered his total loss accounted for
almost $1 billion
Barings bank (over 200 years old) was bankrupt
Nick Leeson was sentenced to 6.5 years in prison in Singapore
Other Examples (I)
Clinton (cattle futures, $100000, 1979)

Hammersmith and Fulham (interest rate swaps, $600 million, 1989)
Metallgesellschaft (oil futures, $1.3 billions, 1993)
Shell (FX forwards, $1 billion, 1993)
Kidder Peabody (bond market, $350 millions, 1994)
Gibsons Greetings (derivatives trading through Bankers Trust, $20
millions, 1994)
Procter and Gamble (derivatives trading through Bankers Trust, $90
millions, 1994)
Orange County (interest rate derivatives, $2 billions, 1994)
Barings Bank (Nikkei futures, $1 billion, 1995)
Daiwa Bank (bond market, $1 billion, 1995)
Other Examples (II)
Sumitomo (copper futures, $2 billions, 1996)

LTCM (various derivatives, $4 billions, 1998)
Enrons special purpose entities (Several over $1 billion, 2001)
Allied Irish Bank (FX derivatives, $700 millions, 2002)
Amaranth (natural gas derivatives, $6 billions, 2006)
Subprime Mortgages (credit derivatives, tens of billions, 2007)
Aracruz (FX options, $2 billions, 2008)
Socit Gnrale (Euro Stoxx 50 futures, $5 billions, 2008)
Bernard L. Mado Investment Securities (Ponzi scheme, several
billions, 2008)
UBS (Euro Stoxx, DAX, S&P 500 futures, $2 billions, 2011)
Lessons to be learnt (I)
Be diversied
Risk must be quantied and risk limits well dened
Exceeding risk limits is not acceptable even when prots result
Never ignore risk management, even when times are good
Scenario analysis and stress testing is important
Liquidity risk is important
Beware of potential liquidity problems when long-term funding
requirements are nanced with short-term liabilities (e.g. credit crisis
2007)
Models can be wrong; be conservative in recognizing inception prots
(market vs model value)
There are dangers when many are following the same strategy
Lessons to be learnt (II)
It is important to fully understand the products you trade

Do not sell clients inappropriate products
Market transparency is important (e.g. complex structured securities)
Mange incentives
Beware of hedgers becoming speculators
It can be dangerous to make the Treasurers department a prot
center
Do not assume that a trader with a good track record will always be
right
Do not give too much independence to star traders
Separate the front, middle and back oce
Chapter 2: Interest Rates Types of Interest Rates
Treasury Rates
Interest rates on securities issued by a government in its own currency

Treasury Bills: zero-coupon bonds; issued weekly; maturities of 4, 13,
26, 52 weeks
Treasury Notes: coupon bonds (semi-annual payments); maturities
between 2 and 10 years (2, 3, 5, 7, 10 years)
Treasury Bonds: coupon bonds (semi-annual payments); maturities
between 20 and 30 years
Treasury Ination-Protected Securities (TIPS): principal adjusted to
CPI; coupon bonds (semi-annual payments); maturities of 5, 10, 30
years
Considered to be risk free (in nominal terms)
But ination should be considered as risk!
Federal Funds Rate
In the USA, banks have to hold reserves in Federal Reserve Bank

To meet requirements banks trade balances held at the Federal
Reserve with each other
Federal funds eective rate is the interest rate that clears the market
Maturity: overnight
Uncollateralized contracts
Federal funds target rate is set by the Federal Open Market
Committee
Federal Reserve Bank actively trades in the treasury market to
achieve the target rate
"Discount rate": rate at which banks can borrow directly from Fed
Repurchase Agreement (Repo Rate)
Agreement to sell a security today and buy it back in the future for a
slightly higher price
The agreed price increase determines the Repo Rate
Equivalent to collateralized loan
Almost risk free
London Interbank Oered Rate (LIBOR)
Interest rate at which a banks is willing to deposit money with

another bank
Borrowing banks typically have a AA rating
Rate is set once a day by the British Bankers Association on all major
currencies for maturities up to 12 months
LIBOR is the interest rate commonly used for derivatives pricing as it
is the "risk free" opportunity cost of nancial institutions
Recently more popular (due to some defaults of large banks):
Overnight Indexed Swap (OIS) Rate
OIS: swap oating overnight LIBOR interest rate payments for a xed
interest rate payment
More secure than long term LIBOR because default risk of principal is
greatly reduced and only small interest payments are subject to default
risk of long term contract
Chapter 2: Interest Rates Compounding of Interest Rates
Compounding of Interest Rates (I)
The compounding frequency is the unit of measurement for interest

rates
The eective annual interest rate (or annual equivalent rate, AER)
depends on the compounding frequency of the stated annual interest
rate
Compounding m-times per annum- (m-times . c.p.a.) at rate r yields

r m
the eective annual interest rate 1 + m !1
Compounding of Interest Rates (II)
The eective interest rate over time period (T ! t ) is

- . m (T !t )
1 + mr !1
In the continuous time limit (continuous compounding, c.c.), the
eective interest rate over time period (T ! t ) is
- . m (T !t )
limm ! 1 + mr ! 1 = e r (T !t ) ! 1
Suppose rc is the annual interest rate with c.c. and rm is the annual
interest rate
- with .m-times c.p.a.,
- rcthen .rc and rm are equivalent i
rm
rc = m ln 1 + m or rm = m e m ! 1
Illustration for r = 10%
Compounding Frequency Eective Annual Interest Rate

Annual (m = 1) 10%
Semi-annual (m = 2) 10.25%
Quarterly (m = 4) 10.381%
Monthly (m = 12) 10.471%
Weekly (m = 52) 10.506%
Daily (m = 365) 10.516%
Continuously (m ! ) 10.517%
Chapter 2: Interest Rates Term Structure of Interest Rates/ Yield Curve
Spot Rates
The (T ! t )-year spot rate rt,T is the stated annual interest rate
promised at time t for a xed investment horizon of (T ! t ) years
Instantaneous spot rate at time t for a horizon (T ! t ) ! 0 is called
short rate rt
Illustration of the term structure of interest rates (yield curve) at time t:
Horizon T ! t Spot Rate at time t (c.c.)
T !t rt = 2.50%
0.5 rt,t +0.5 = 4.00%
1 rt,t +1 = 5.00%
2 rt,t +2 = 5.50%
3 rt,t +3 = 5.90%
4 rt,t +4 = 6.10%
5 rt,t +5 = 6.25%
10 rt,t +10 = 6.40%
30 rt,t +30 = 6.50%
Chapter 2: Interest Rates Bond Pricing
Bond
A bond is a contract which promises future cash ows Ci at time

ti 2 ft1 , t2 , ..., tN g with ti > 0
Time tN is the maturity of the bond
A bond with (risk free) cash ows Ci at time ti 2 ft1 , t2 , ..., tN g

should trade for
!r0,ti ti
P0 = N
i =1 e Ci if the spot rates are quoted as c.c.
Ci
P0 = N
i =1 / r0,t 0mt
i
if the spot rates are quoted with m-times c.p.a.
1+ m i
A zero-coupon bond is a bond which does not pay any coupons but
some face value F at maturity
Coupon Bond (I)
A coupon bond pays face value F at maturity and frequently some

coupons C until maturity
The price of a (risk free) coupon bond is equal to the discounted cash
ows using the appropriate spot rate as the discount rate
Illustration I: A coupon bond with n (risk free) coupon payments per

year of size C = nc F for T -years and face value F should trade for
!r0,(t /n ) n c t
P0 = nT
t =1 e nF + e
!r0,T T F if the spot rates are quoted as
c.c.
c
nF
P0 = nT
t =1 / r0,(t /n ) 0m nt + / r
F
0mT if the spot rates are quoted
1+ 1 + 0,T
m
m
with m-times c.p.a.
Questions
Consider the term structure as stated earlier
What are the prices of the half-year, 1-year, 2-year and 3-year (risk
free) zero-coupon bonds with face value F = $1000?
(T =0.5 )
P0 = $1000e !0.04 "0.5 = $980
(T =1 )
P0 = $1000e !0.05 = $951
(T =2 )
P0 = $1000e !0.055 "2 = $896
(T =3 )
P0 = $1000e !0.059 "3 = $838
What is the price of a (risk free) 2% (annual) coupon bond with a

maturity of 3 years and face value F = $1000? What if c = 10%?
(T =3,c =0.02 )
P0 = $20e !0.05 + $20e !0.055 "2 + $1020e !0.059 "3 = $891
(T =3,c =0.1 )
P0 = $100e !0.05 + $100e !0.055 "2 + $1100e !0.059 "3 =
$1106
Estimation of Term Structure of Interest Rates
The yield curve is not directly observable
But, many zero-coupon and coupon bonds are traded and we observe
the market prices of these bonds
Given the market prices of traded bonds and using the above pricing
formula, we can infer what the term structure looks like
=> Bootstrap Method
Bond Yield
The bond yield y is a constant discount rate that makes the present
value of the bonds cash ows equal to the bonds market price
Consider a bond with price P0 and cash ows Ci at time

ti 2 ft1 , t2 , ..., tN g
c.c. yield yc solves the equation P0 = N
i =1 e
!y c t i C
i
Ci
m-times c.p.a. yield ym solves the equation P0 = N i =1 mti
(1 + ymm )
The bond yield is a weighted average of the spot rates
The yield of a (risk free) zero-coupon bond with T -years maturity is

equal to the T -year spot rate
In general (except for some simple cases), we need a good calculator

with optimization tools or computer software like excel or matlab to
solve numerically
Questions
What is the yield of a (risk free) 2% (annual) coupon bond with a

maturity of 3 years, face value F = $1000, and current price
(T =3,c =0.02 ) (T =3,c =0.1 )
P0 = $891? What if c = 10% and P0 = $1106?
(T =3,c =0.02 ) (T =3,c =0.02 ) (T =3,c =0.02 ) "2

P0 = $20e !y + $20e !y +
(T =3,c =0.02 ) "3
$1020e !y = $891
y ( T = 3,c = 0.02 ) = 5.89%
(T =3,c =0.1 ) (T =3,c =0.1 ) (T =3,c =0.1 ) "2
P0 = $100e !y + $100e !y +
(T =3,c =0.1 ) "3
$1100e !y = $1106
y (T =3,c =0.1 ) = 5.85%
Chapter 2: Interest Rates Duration
Duration
The duration of a bond is a measure of how long on average the
bondholder has to wait for cash ows
Weighted average of times of cash ows
Duration D of a bond with price P0 , cash ows Ci at time
ti 2 ft1 , t2 , ..., tN g, and yield y is dened as
Ci e !yti
D = N
i = 1 ti P 0 , if y is the c.c. yield
Ci
y mti
(1 + m )
D = N
i = 1 ti P0 , if y is the m-times c.p.a. yield
Duration of a bond is large (small) if the bond pays out much of its
cash ows late (early) in time
The duration for a bond portfolio is the weighted average duration of
the individual bonds in the portfolio with weights proportional to
prices
Questions
What is the duration of a 2% (annual) coupon bond with a maturity

(T =3,c =0.02 )
of 3 years, face value F = $1000, current price P0 = $891,
(T =3,c =0.1 )
and c.c. yield y = 5.89%? What if c = 10%, P0 = $1106,
and y = 5.85%?
$20e !0.0589
+ 2 $20e$891
!0.0589 "2
+ 3 $1020e
!0.0589 "3
D (T =3,c =0.02 ) = $891 $891 = 2.94
$100e !0.0585
+ 2 $100e
!0.0585 "2
+ 3 $1100e
!0.0585 "3
D (T =3,c =0.1 ) = $1106 $1106 $1106 = 2.75
Bond Price Volatility
The bond volatility with respect to changes in the yield is dened as

P 0 (y )
y
P0
P 0 (y )
y y (Ni=1 e !yti C i ) N
i =1 (!t i )e
!yti C
i
c.c.: P0 = P0 = P0 = !D
$ %
Ci ( !t i )C i
P 0 (y )
y N
i =1 y mti N
i =1 y mti +1
y (1 + m ) (1 + m ) !D
m-times c.p.a.: = P0 P0 = P0 = 1 + my
(known as "modied duration")
For a small change in the yield Dy the percentage change in the bond
P 0 (y )
DP o
price is well approximated by ' Py0 Dy P0
To hedge the exposure of a portfolio against small unexpected parallel
shifts in the yield curve, one has to match the duration of assets and
liabilities
Example: Duration based Hedge
You are a bank and you have short term debt (assume zero-coupon
bonds with one year maturity; e.g. approximation of deposits) with
current value of PL = $109 on your liability side of the balance sheet
Current 1-year spot rate is r0,1 = 5% (c.c.) and the 30-year spot rate
is r0,30 = 7% (c.c.)
You want to lend some money to borrowers for 30 years; assume
zero-coupon bonds
Lending rates are spot rates + x = 1%
How much money should you lend to minimize your exposure to
interest rate risks (small parallel shifts in yield curve)?
Assume all the money you do not lend will be used for other operations
without interest rate risk exposure
Note:
yield of zero-coupon bond is equal to spot rate,
yL = r0,1 , yA = r0,30 + x
Duration of a zero-coupon bond is equal to its time left to maturity,
DL = 1, DA = 30
If there are only small parallel shifts Dy in the yield curve, then we can
use the approximation DP = !DP0 Dy for bond price changes
Denote current value of money we decide to lend for 30 years by PA
Current value of balance sheet with interest rate risk exposure:
V = PA ! PL
Change in value of balance sheet if small parallel shift Dy in yield
curve: DV = DPA ! DPL = !DA PA Dy ! (!DL PL Dy ) =
(DL PL ! DA PA ) Dy
We want DV = 0 (no exposure to small parallel shifts in yield curve),

thus: PA = DDAL PL = 30
1
$109 = $33.333 ( 106
1
Lend only 30 of your balance sheet for 30 years
In one year we have to borrow again money/ rolling over our debt
because we have lend money for 30 years What if there is a crisis
and it is dicult to borrow?
Duration based hedging does not help to manage liquidity risks
Bond Price Volatility: Convexity
If changes in the yield Dy are large, the approximation

P 0 (y )
DP o
P0' P0 Dy is not very good
y
A second order Taylor expansion delivers a better approximation

2 P 0 (y )
y 2
We dene a bonds convexity as P0
2 P 0 (y ) 2
y 2 y 2
(Ni=1 e !yti C i ) N 2 !yti C
i =1 t i e i
in case of c.c.: P 0 = P0 = P0
in case of m-times c.p.a. :
$ % 1
2 Ci (
ti ti + m ) Ci
N
i =1 y mti N
i =1 y 2 y mti
dP 0 y 2 (1 + m ) (1 + m ) (1 + m )
P0 = P0 = P0
The percentage change in the bond price in response to a change in

P 0 (y ) 2 P 0 (y )
DP o
the yield Dy is well described by P0 ' y
P0 Dy + 1
2
y 2
P0 (Dy )2
Chapter 2: Interest Rates Forward Rates
Forward Rates (I)
Denition
(T ,T )
The forward rate ft 1 2 at time t for period [T1 , T2 ] with t < T1 < T2
is the future interest rate at which buyer and seller (lender and borrower)
are willing to agree at time t to trade in the future (at time T1 ) a risk free
zero-coupon bond (or an equivalent credit contract) with maturity at time
T2 (and no money is exchanged today).
No arbitrage requires the forward rate to be:

0/ 0 T 2 !t 1
rt,T T 2 !T 1
1+ 2
(T 1 ,T 2 )
= m @/ ! 1A, for m-times c.p.a.
m
ft 0 T 1 !t
rt,T T 2 !T 1
1+ 1
m
(T 1 ,T 2 ) rt,T 2 (T 2 !t )!rt,T 1 (T 1 !t )
ft = T 2 !T 1 , for c.c.
Forward Rate Agreements (FRA)
Forward rates are traded (locked-in) through Forward Rate

Agreements (FRA)
FRAs are used by many institutions to hedge unexpected changes in

the interest rate
FRAs exist on all major currencies in the world
Market for FRA is quite liquid; bid-ask spreads are only 3 or 4 basis
points
As substitutes of FRAs there are also futures contracts traded on

short-term credit instruments
Forward Rates (II)
For the case of c.c.:
(T 1 ,T 2 ) rt,T 2 !rt,T 1 rt,T 2 !rt,T 1

ft = rt,T 1 + (T2 ! t ) T 2 !T 1 = rt,T 2 + (T1 ! t ) T 2 !T 1
(T 1 ,T 2 )
if rt,T 1 < rt,T 2 (upward sloping yield curve) then ft > rt,T 2
(T ,T )
if rt,T 1 > rt,T 2 (downward sloping yield curve) then ft 1 2 < rt,T 2
(T ,T )
if rt,T 1 = rt,T 2 (at yield curve) then ft 1 2 = rt,T 2
Instantaneous forward rate (T2 ! T1 ):/ 0

(T 1 ) (T 1 ,T 2 ) rt,T 2 !rt,T 1
ft = limT 2 !T 1 ft = limT 2 !T 1 rt,T 1 + (T2 ! t ) T 2 !T 1 =
rt,T 1
rt,T 1 + (T1 ! t ) T 1 = ! T 1 (ln [P (t, T1 )]), where
!rt,T 1 (T 1 !t )
P (t, T1 ) = e (price at time t of zero-coupon bond with
maturity at time T1 )
Derivation of Forward Rates (c.c.)
Strategy 1: at time t invest $1 in (T2 ! t )-year zero-coupon bond

(spot rate rt,T 2 ) > receive $e rt,T2 (T 2 !t ) at time T2
(spot rate rt,T 1 ), and sign contract to invest $e rt,T1 (T 1 !t ) at time T1
in zero-coupon bond with maturity at T2 and xed future interest
(T ,T )
rate ft 1 2 (forward rate agreed at time t) > receive $e rt,T1 (T 1 !t )
at time T1 from (T1 ! t )-year zero-coupon bond, but have obligation
(T ,T )
to re-invest $e rt,T1 (T 1 !t ) again at interest rate ft 1 2 , $0 cash ow
at time T1 > at time T2 receive
(T 1 ,T 2 ) (T ,T )
$e rt,T1 (T 1 !t ) e ft (T 2 !T 1 ) = $e rt,T 1 (T 1 !t )+ft 1 2 (T 2 !T 1 )
Both strategies are risk free > have to pay the same return!
(T 1 ,T 2 )
=> e rt,T2 (T 2 !t ) = e rt,T1 (T 1 !t )+ft (T 2 !T 1 )
Derivation of Forward Rates (m-times c.p.a.) (I)

/ 0
rt,T 2 m (T 2 !t )
(spot rate rt,T 2 ) > receive $ 1 + m at time T2
/ 0
rt,T 1 m (T 1 !t )
(spot rate rt,T 1 ), and sign contract to invest $ 1 + m at
time T1 in zero-coupon bond with maturity at T2 and xed future
/ 0
(T 1 ,T 2 ) rt,T 1 m (T 1 !t )
interest rate ft > receive $ 1 + m at time T1 from
(T1 ! t )-year zero-coupon bond, but have obligation to re-invest
/ 0
r 1 m (T 1 !t ) (T ,T )
$ 1 + t,Tm again at interest rate ft 1 2 , $0 cash ow at
time T1 > at time T2 receive
/ 0 $ % m (T 2 !T 1 )
rt,T 1 m (T 1 !t ) T 1 ,T 2
$ 1+ m 1 + ft m
Derivation of Forward Rates (m-times c.p.a.) (II)
Both strategies are risk free > have to pay the same return!
/ 0 / 0 $ % m (T 2 !T 1 )
rt,T 2 m (T 2 !t ) rt,T 1 m (T 1 !t ) (T ,T )
ft 1 2
=> 1 + m = 1+ m 1+ m
Arbitrage Opportunity (I)

(T ,T ) r (T !t )!rt,T 1 (T 1 !t )
Is there an arbitrage if ft 1 2 > t,T2 2 T 2 !T 1 ? How can you
make money? (consider the case of c.c.)
At time t:
Borrow $1 for (T2 ! t ) years at rt,T 2
Lend $1 for (T1 ! t ) years at rt,T 1
(T 1 ,T 2 )
Sign contract to lend $e rt,T1 (T 1 !t ) from time T1 to T2 at ft
At time T1 :
Receive $e rt,T1 (T 1 !t ) from $1 loaned at time t for (T1 ! t ) years at
rt,T 1
(T 1 ,T 2 )
Lend $e rt,T1 (T 1 !t ) as agreed at time t for (T2 ! T1 ) years at ft
Cash ow at time T1 : $0
At time T2 :
Pay back $e rt,T2 (T 2 !t ) borrowed at time t for (T2 ! t ) years at rt,T 2
(T 1 ,T 2 )
Receive $e rt,T1 (T 1 !t ) e ft (T 2 !T 1 ) from $e rt,T 1 (T 1 !t ) loaned at time
(T ,T )
T1 for (T2 ! T1 ) years at ft 1 2
(T 1 ,T 2 )
Cash ow at time T2 : $e rt,T1 (T 1 !t )+ft (T 2 !T 1 ) ! $e rt,T2 (T 2 !t ) > $0
Arbitrage Opportunity (II)

(T ,T ) r (T !t )!rt,T 1 (T 1 !t )
Is there an arbitrage if ft 1 2 < t,T2 2 T 2 !T 1 ? How can you
make money? (consider the case of c.c.)
At time t:
Lend $1 for (T2 ! t ) years at rt,T 2
Borrow $1 for (T1 ! t ) years at rt,T 1
(T 1 ,T 2 )
Sign contract to borrow $e rt,T1 (T 1 !t ) from time T1 to T2 at ft
At time T1 :
(T ,T )
Borrow $e rt,T1 (T 1 !t ) as agreed at time t for (T2 ! T1 ) years at ft 1 2
Pay back $e rt,T1 (T 1 !t ) from $1 borrowed at time t for (T1 ! t ) years at
rt,T 1
Cash ow at time T1 : $0
At time T2 :
Receive $e rt,T2 (T 2 !t ) loaned at time t for (T2 ! t ) years at rt,T 2
(T 1 ,T 2 )
Pay back $e rt,T1 (T 1 !t ) e ft (T 2 !T 1 ) from $e rt,T 1 (T 1 !t ) borrowed at
(T ,T )
time T1 for (T2 ! T1 ) years at ft 1 2
(T 1 ,T 2 )
Cash ow at time T2 : $e rt,T2 (T 2 !t ) ! $e rt,T1 (T 1 !t ) e ft (T 2 !T 1 ) > $0
Forward Rates: Final Remarks
Forward rates are determined using a no arbitrage argument
Implied by the current term structure of interest rates
Independent of expectations about future changes in the short rate or

future changes in the yield curve
Example
Horizon T ! t Spot Rate (c.c.) Forward rates (c.c.)

T !t rt = 2.50%
0.5 rt,t +0.5 = 4.00%
(t +0.5,t +1 )
1 rt,t +1 = 5.00% ft = 6.00%
(t +1,t +2 )
2 rt,t +2 = 5.50% ft = 6.00%
(t +2,t +3 )
3 rt,t +3 = 5.90% ft = 6.70%
(t +3,t +4 )
4 rt,t +4 = 6.10% ft = 6.70%
(t +4,t +5 )
5 rt,t +5 = 6.25% ft = 6.85%
(t +5,t +10 )
10 rt,t +10 = 6.40% ft = 6.55%
(t +10,t +30 )
30 rt,t +30 = 6.50% ft = 6.55%
Questions
Suppose the 1-year spot rate is r0,1 = 5% (c.c.) and it is expected to
increase to r1,2 = 10% in one year time (but there is uncertainty)
Suppose the forward rate for the period between next year and the
(1,2 )
year after is f0 = 7%
Is there an arbitrage opportunity if the yield curve is at? What do
you do?
(1,2 ) 2r !r
Flat yield curve implies f0 > 0,2
2 !1
0,1
= 5%
Borrow $1 for 2 years at r0,2 = 5%
Lend $1 for 1 year at r0,1 = 5%
(1,2 )
Sign contract to lend $e 0.05 in 1 year for 1 year at f0 = 7%
$0 cash ow today and.in 1 year
- 0.12
Receive $ e ! e 0.1 in 2 years
Is there an arbitrage opportunity if the yield curve is increasing and
the 2-year spot rate is 6%? What do you do?
(1,2 ) 2r0,2 !r0,1
f0 = 2 !1 = 7%, there is no arbitrage opportunity
Chapter 2: Interest Rates Theories of Term Structures
Theories of Term Structures
Expectations Theory: forward rates equal expected future spot rates
Market Segmentation Theory: short, medium and long rates are

traded in independent markets
Liquidity Preference Theory: forward rates are higher than expected

future spot rates
Chapter 3: Forward Contracts Preliminary Note on Short Selling
Preliminary Note on Short Selling
Short selling means selling a security you do not own

You borrow the security from another person and sell it in the market
In future you buy the security in the market and give it back to the
lender
If the price of the security declines (increases) you pay less (more)
when you have to return the security than what you have received
when you borrowed it > prot (loss), payo is opposite to holding
the security (long position)
You also have to pay dividends and other benets the owner of the
security would receive if he did not lend it to you
There may be a small fee for borrowing the security
Short selling is reasonable for investment assets (stocks, bonds, gold,
etc), but not for consumption assets (oil, copper, corn, etc)
Example (I)
You short 100 shares when the price is $100 and close out the short
position 2 days later when the price is $90 (risk free rate for 2 days is
almost 0)
During the 2 day window a dividend of $3 per share is paid
What do you earn?

You borrow 100 shares and sell them for $100 each > receive $10000
Since the company pays $3 dividends for each share, the lender wants
these dividends from you as compensation for lending the shares to you
> you have to pay $300
You buy the shares back in the market for $90 each and return them
> you have to pay $9000
In total you earn $700
Example (II)
What would you earn if you had bought 100 shares?

You buy 100 shares for $100 each > pay $10000
You get $3 dividends for each share > receive $300
You sell all shares for $90 each > you receive $9000
In total you earn -$700 (loss of $700)
Chapter 3: Forward Contracts Markets for Forwards
Market for Forwards
Over-the-counter (OTC) traded

Tailor-made and not (necessarily) standardized contracts
Network of dealers linked through telephones and computers
Held until maturity
No cash ows until maturity
Often cash settlement
Collateral possible
Credit risk
Potential liquidity risk
Few regulations
Chapter 3: Forward Contracts Pricing Forward Contracts
Specication of Forward Contracts
Denition
A forward contract is an agreement to trade the underlying asset in
(T )
future (at maturity T ) for a xed price specied today (forward price Ft
at current time t)
Typically no money is exchanged at origination (contract is

"worthless")
Payo/ Prot
Party that agrees to buy the underlying (long position) makes a prot
if at maturity T the price of the underlying (ST ) is higher than the
(T )
(T ) (long forward ) (T )
ST < Ft > PayoT = ST ! Ft
Party that agrees to sell the underlying (short position) makes a prot
if at maturity T the price of the underlying (ST ) is lower than the
(T )
(T ) (short forward ) (T )
ST > Ft > PayoT = Ft ! ST
Assumptions for Pricing
No transaction costs
Same tax rate on all (net) trading prots
Investors can lend and borrow without limits at the risk free interest
rate
Investors exploit arbitrage opportunities as soon as they appear
In the following we assume continuous compounding, but all results

also hold for discrete compounding frequencies
An Arbitrage Opportunity? (I)
Suppose the price of a stock is $100 today and it is expected to

increase to $105 until next year; the stock does not pay dividends
within the next year
Short selling of the stock is possible at no cost
You can lend and borrow at a 1 year risk free interest rate of 10%
Is there an arbitrage opportunity?

No.
An Arbitrage Opportunity? (II)
If you can enter a forward contract (long or short position) to buy in

1 year 100000 stocks for $10900000 (assume no counter-party risk),
is there an arbitrage opportunity?
Today:
Sell 100000 stocks short > receive $10000000
Lend $10000000 for 1 year at 10% (risk free)
Enter a long position in the forward contract
Cash ow today: $0
In 1 year:
Receive $11051709 from loaned money
Pay $10900000 and receive 100000 stocks (long position in forward
contract)
Return 100000 stocks (close short position of 100000 stocks)
Cash ow: $151709 (risk free)
Chapter 3: Forward Contracts Pricing Forwards: Investment Asset without Intermediate Payos
Investment Asset without Intermediate Payos
Consider a forward written on an asset (underlying) which is hold by

investors purely as an investment and does not have any payos
between origination (time t) and maturity (time T ) of the forward
Create an investment strategy which takes positions in the forward,

underlying asset and risk free asset (zero-coupon bond) but does not
generate any payo in the future
Derivation of Forward Price/ Investment Strategy
At time t:
(T ) !rt,T (T !t )
Borrow an amount of Ft e for (T ! t )-years at the risk free
(T )
interest rate rt,T (issue zero-coupon bond) > receive Ft e !rt,T (T !t )
Buy 1 unit of the asset > pay St , receive 1 unit of the asset
(T )
Take a short position in forward contract with forward price Ft
(T ) !rt,T (T !t )
Cash ow: Ft e ! St
At time T > t:
Pay back borrowed money and interest > pay
(T ) (T )
Ft e !rt,T (T !t ) e rt,T (T !t ) = Ft
Close short position in forward contract > deliver 1 unit of the asset,
(T )
receive Ft
(T ) (T )
Cash ow: Ft ! Ft =0
Forward Price
Because the strategy never pays o anything in the future (every

state of the world), its cost must be zero
(T )
Ft = St e rt,T (T !t )
Alternative way:
(T )
Ft (T !t )
= e| rt,T{z }
S
| {zt } zero-coupon bond
perfect hedge/ risk free return
risk free return
Questions
(T )
Is there an arbitrage if Ft > St e rt,T (T !t ) ? What do you do?
Yes
(T )
Buy the above strategy (borrow Ft e !rt,T (T !t ) , buy underlying, short
(T ) !rt,T (T !t )
forward) > immediate payo: Ft e ! St > 0, no future
payo
(T )
Is there an arbitrage if Ft < St e rt,T (T !t ) ? What do you do?
Yes
(T )
Sell the above strategy (lend Ft e !rt,T (T !t ) , short sell underlying,
(T ) !rt,T (T !t )
long forward) > immediate payo: St ! Ft e > 0, no
future payo
Note: if short selling the asset is not possible, then a similar (but
weaker) argument holds but only investors who already hold the
underlying can prot from the "arbitrage"
Chapter 3: Forward Contracts Pricing Forwards: Inv. Asset with Discrete Intermediate Payos
Investment Asset with Discrete Intermediate Payos

Consider a forward written on an asset (underlying) which is hold by
investors purely as an investment and pays some discrete payos Isi
for si 2 fs1 , s2 , ..., sN g between origination (time t) and maturity
(time T ) of the forward
Example: dividend paying stock (Isi > 0)
Example: commodity (gold, silver, etc) with storage cost Isi < 0)
Pricing follows the same principle as before
(T )
Ft = (St ! It ) e rt,T (T !t )
with It = N
i =1 Isi e
!rt,si (si !t )
(present value of payos), or
(T ) (si ,T )
Ft N Is e ft (T !s i )
+ i =1 i = (T !t )
e| rt,T{z }
S St
| {zt } | {z } zero-coupon bond return
perfect hedge return from payo ow
Questions
Consider a 6-month forward contract to buy 1000 stocks

The current stock price is S0 = $100
A stock pays two $2 dividends in 2 and 4 months
The yield curve is at at 5% c.c.
(T )
Is there an arbitrage if the forward price is F0 = $100000? How
can you make money?
(T )
Is there an arbitrage if the forward price is F0 = $95000? How can
you make money?
Forward price should

/ be 0
(T ) 1 1 1
Ft = $1000 100 ! 2e ! 0.05 6 ! 2e ! 0.05 3 e 0.05 2 = $98481
Questions: Forward Price $100000 (I)
At time t:
(T ) !rt,T (T !t )
Borrow Ft e +/It = 0
1 1 1
$100000e !0.05 2 + $1000 2e ! 0.05 6 + 2e ! 0.05 3 = $101481.3 for
half a year at 5% > receive $101481.3
Buy 1000 stocks > pay $100000
Take a short position in forward contract
Sign contract to lend $2000 in 2 months for 4 months at 5%
Sign contract to lend $2000 in 4 months for 2 months at 5%
Cash ow: $101481.3 - $100000 = $1481.3
At time t + 16 :
Receive $2000 dividends
Lend $2000 for 4 months at 5% (agreed at time t)
Cash ow: $0
Questions: Forward Price $100000 (II)
At time t + 13 :
Receive $2000 dividends
Lend $2000 for 2 months at 5% (agreed at time t)
Cash ow: $0
At time t + 12 :
Pay back borrowed money and interest (borrowed at time t) > pay
$104050.3
Receive $2033.6 from $2000 loaned at time t + 16
Receive $2016.7 from $2000 loaned at time t + 13
Close short position in forward contract > deliver 1000 stocks,
receive $100000
Cash ow: - $104050.3 + $2033.6 + $2016.7 + $100000 = $0
Questions: Forward Price $95000 (I)
At time t:
(T ) !rt,T (T !t )
Lend Ft e +/ It = 0
$95000e !0.05 12 1 1
+ $1000 2e !0.05 6 + 2e !0.05 3 = $96604.8 for half
a year at 5% > pay $96604.8
Short sell 1000 stocks (borrow 1000 stocks and sell them in market)
> receive $100000
Take a long position in forward contract
Sign contract to borrow $2000 in 2 months for 4 months at 5%
Sign contract to borrow $2000 in 4 months for 2 months at 5%
Cash ow: $100000 - $96604.8 = $3395.2
At time t + 16 :
Borrow $2000 for 4 months at 5% (agreed at time t)
Pay $2000 dividends to lender of stocks (short selling at time t)
Cash ow: $0
Questions: Forward Price $95000 (II)
At time t + 13 :
Borrow $2000 for 2 months at 5% (agreed at time t)
Pay $2000 dividends to lender of stocks (short selling at time t)
Cash ow: $0
At time t + 12 :
Receive $99050.3 from $96604.8 loaned at time t
Pay back borrowed money and interest (borrowed at time t + 16 ) >
pay $2033.6
Pay back borrowed money and interest (borrowed at time t + 13 ) >
pay $2016.7
Close long position in forward contract > receive 1000 stocks, pay
$95000
Return the 1000 borrowed stocks (short selling at time t)
Cash ow: $99050.3 - $2033.6 - $2016.7 - $95000 = $0
Chapter 3: Forward Contracts Pricing Forwards: Inv. Asset with Intermediate Payo "Flow"
Investment Asset with Intermediate Payo "Flow"
Consider a continuous intermediate payo ow/ yield qt,T instead of

N discrete payos Isi at time si
qt,T describes the payo stream as a percentage of the underlyings
value received at every instant in time on the interval [t, T ]
Example: stock index with dividend yield qt,T > 0
Example: commodity (gold, silver, etc) with storage cost qt,T < 0
Pricing follows the same principle as before
(T )
Ft = St e (rt,T !qt,T )(T !t )
or !
(T )
Ft
ln + qt,T (T ! t ) = rt,T (T ! t )
St | {z } | {z }
| {z } yield/ zero-coupon bond return
perfect hedge return from payo ow
Derivation of Forward Price (I)
Consider a stock with the dividend yield qt,T
At time t:
(T )
Borrow Ft e !rt,T (T !t ) for (T ! t ) years at rt,T
Buy e !qt,T (T !t ) units of the stock > pay St e !qt,T (T !t )
Take short position in forward
(T )
Cash ow: Ft e !rt,T (T !t ) ! St e !qt,T (T !t )
At time s 2 (t, T ):
Reinvest stream of dividends in new stocks > number of stocks
owned grows at rate qt,T dt
Own e !qt,T (T !s ) units of the stock
Cash ow: 0
Derivation of Forward Price (II)
At time T :
Own 1 stock "at beginning of period T "
(T )
Close short position in forward > deliver 1 stock, receive Ft
(T )
Ft e !rt,T (T !t ) e rt,T (T !t )
Cash ow: 0

state of the world), its cost must be zero,
(T )
Ft = St e (rt,T !qt,T )(T !t )
Note on Forward Contracts on Stock Indices (I)
A stock index is a (hypothetical) portfolio of stocks which is

representative for a certain region, industry or "theme"
Can be viewed as an investment asset paying a dividend yield

(T )
For Ft = St e (rt,T !qt,T )(T !t ) to hold it is important that changes in
the index correspond to changes in the value of a tradable portfolio
Non-tradable: "Quantos" are derivatives where the underlying asset is

measured in one currency while the payo is in another currency with
an "articial" xed exchange rate (e.g. Nikkei index viewed as a US
dollar number)
Note on Forward Contracts on Stock Indices (II)
Trading an index involves simultaneous trades in many dierent

stocks - Examples of large indices:
Russel 3000 Index: 3000 US stocks
MSCI World Index: 1600 stocks, 24 countries
MSCI ACWI Investable Market Index: 9000 stocks, 45 countries
MSCI ACWI All Cap Index: 14000 stocks, 45 countries
Very often a computer is used to manage the trades automatically
Occasionally simultaneous trades may not be possible and the

(T )
theoretical no-arbitrage relationship between Ft and St does not
hold
Chapter 3: Forward Contracts Pricing Forwards: Foreign Exchange
Foreign Exchange: Spot Rate
Spot foreign exchange rate Et at time t is the instant price

(immediate delivery) of one countrys currency in exchange for
anothers
Example:
Suppose you are a retailer in the USA and need CHF 1 million (Swiss
francs) to pay for imports from Switzerland
Assume today is the 12th of June 2012 and the FX spot rate is
US $
Et = 1.03 CHF
You have to pay CHF 106 Et = US $1030000 for CHF 1 million
Foreign Exchange: Forwards on Currencies
In a forward contract the foreign currency is the underlying

(T )
Agreement today (time t) to exchange Ft units of the local
countrys currency for 1 unit of another currency at time T > t
Example:
Suppose you need CHF 1 million in half a year
Assume you can enter a forward contract to lock in the future
(t +0.5 ) US $
exchange rate at Ft = 1.035 CHF
If you take a long position, then in half a year you have to pay
(t +0.5 )
CHF 106 Ft = US $1035000 for CHF 1 million
Why would you be willing to lock in a higher price?

Because the risk free interest rate in the USA rt,T is higher than the
f
rate in Switzerland rt,T
Derivation of Forward price
rt,T is the (T ! t )-year spot rate in the local currency (c.c.)

f
rt,T is the (T ! t )-year spot rate in the foreign currency (c.c.)
Forward Price
Strategy 1 and 2 are both risk free and therefore have to yield the
same payo:
f (T )
e rt,T (T !t ) Ft = Et e rt,T (T !t )
or
= Et e (rt,T !rt,T )(T !t )
(T ) f
Ft
A foreign currency is analogous to a security providing a known

dividend yield
Dividend yield is the risk free interest rate prevailing in the foreign
country
The holder of the foreign currency can earn interest by investing in a
foreign denominated bond
Questions (I)
Consider the earlier example on the FX market (CHF to US$)
What is the dierence between the current 0.5-year spot rates (c.c.)
in the USA vs Switzerland?
$ % $ %
(T ) US $
f 1 Ft 1 1.035 CHF
rt,T ! rt,T = T !t ln Et = 0.5 ln US $ = 0.97%
1.03 CHF
What would the forward rate be if the 0.5-year spot rate in

Switzerland was !.75% (quarterly compounding) and the equivalent
rate in the USA was 0.5%?
$ % m (T !t )
f
rt,T (T ) - rt,T .m (T !t ) (T )
1+ m Ft = Et 1 + m > Ft =
! m (T !t ) $ %4 "0.5
rt,T
1+ m US $ 1 + 0.005
4 US $
Et rf
= 1.03 CHF
1 + !0.0075
= 1.0365 CHF
1 + t,T
m
4
Questions (II)
During the sovereign debt crisis (in Europe) the Swiss franc has
appreciated a lot which is bad news for many Swiss rms. Therefore,
the Swiss national bank has decided to intervene in order to keep the
CHF
exchange rate constant at Et = 1.2 EURO over the near future (the
SNB is pretty credible)
Suppose the 3-month spot rate in Germany is 1% (c.c.) and the

equivalent rate in Switzerland is 0.25%
An analyst at Credit Suisse claims that the forward price (in CHF) to
buy 1 Euro in 3 months should be the same as the current spot
(t + 123 ) CHF
exchange rate, Ft = Et = 1.2 EURO because the SNB is credible
Notice: on January 15th, 2015, the SNB surprised the market and
announced they will no longer peg the CHF to the EUR ! CHF
appreciated within seconds to 1 CHF
EUR
SNB is not so credible after all...
Questions (III)
Is the analysts claim true? What do you think should the forward
price be?
(T =t + 123 ) f
No, the forward price should be Ft = Et e (rt,T !rt,T )(T !t ) =
3
CHF e (0.0025 !0.01 ) 12 CHF , otherwise there is an
1.2 EURO = 1.19775 EURO
arbitrage
(t + 3 ) CHF , we can make money as follows:
If Ft 12 = 1.2 EURO
1
At time t: borrow 1 billion Swiss francs and exchange to 1.2 billion
1
Euros, invest 1.2 billion Euros in the German debt market, sign forward
0.01 3
contract to exchange e 1.212 billion Euros to Swiss francs at the rate of
CHF
1.2 EURO > cash ow: 0
3
3 e 0.01 12
At time t + 12 : receive 1.2 billion Euros from German debt market
3
and exchange to e 0.01 12
billion Swiss francs (forward contract), pay
3
back borrowed money and interest in Swiss debt market (e 0.0025 12
billion/Swiss francs) > cash
0 ow:
3 3
CHF e 0.01 12 ! e 0.0025 12 106 = CHF 1878000 (risk free)
Digression: Currency Carry Trade
Large body of empirical research shows that borrowing in low interest

rate currencies and lending in high interest rate currencies pays large
risk adjusted returns
More protable than stock market
This strategy is know as currency carry trade
In practice, it can be a hassle to borrow and lend and we might not
be able to borrow and lend at the same rate
Is there an easier way to implement a currency carry trade?
Digression: Currency Carry Trade

Notice: borrowing x in your local currency at rate rt,T and investing
x f
E t in a foreign currency at rate rt,T from t to T , has at time T
payo (measured in local currency) x
x rt,T x rt,T / 0
f (T !t ) rt,T (T !t ) f (T !t ) (T )
e ET ! xe = e ET ! F t
Et Et
This is equivalent to taking a long position in a forward to lock

yourself in to buy the foreign currency at a xed price (is worth ET ,
(T )
pay Ft )
Implement a trade between two foreign currencies (borrow one, lend
the other): take short position in one forward exchange rate and long
position in the other
Hedge funds made a lot of money with this strategy; there are ETFs
implementing this nowadays but the strategy has performed relatively
poor since the 2008 nancial crisis...
Chapter 3: Forward Contracts Limits to Arbitrage: Consumption Asset
Consumption Asset: Arbitrage?
Consider an asset that can be used for consumption (or production)

Asset pays a stream of intermediate payos q (positive: income;
negative: storage cost)
Examples: orange juice, copper, oil, corn, etc
(T )
Consider Ft > St e (rt,T !qt,T )(T !t ) : as discussed before there is an
arbitrage (borrow money, buy underlying, short position in forward)
(T )
Consider Ft < St e (rt,T !qt,T )(T !t ) : no arbitrage opportunity as the
holder of a consumption asset may not want to sell it to lock in a
positive risk free return above rt,T because he holds the asset for
consumption
Consumption Asset: Condition on Forward Price
Therefore, we have the (weaker) inequality
(T )
Ft ) St e (rt,T !qt,T )(T !t )
Similar for discrete payos
(T )
Ft ) (St ! It ) e rt,T (T !t )
The forward price has to be determined in general equilibrium (a

concept based on demand and supply) which is weaker and more
complex than a no arbitrage argument that uses a replication strategy
Cost of Carry and Convenience Yield
The cost of carry ct,T is the interest "costs" rt,T minus intermediate
payos qt,T with qt,T = income ! storage costs (during period
[t, T ])
The convenience yield on the consumption asset yt,T for the period
[t, T ] is dened such that
(T )
Ft = St e (ct,T !yt,T )(T !t )
The convenience yield yt,T indicates how large the opportunity costs
are if one does not have the asset available during the period [t, T ]
and has to postpone consumption until time T
yt,T is determined in general equilibrium
Questions (I)
The spot price of corn per bushel on the 4th of June is $5.63
Suppose the storage cost of corn per year is u = 2% of its current
price
Suppose you can enter a forward contract to trade 10000 bushels of
(T )
corn in 18 months for Ft = $5.24 per bushel of corn
The 1.5-year spot rate is 0.5% (c.c.)
(T )
What would the forward price Ft have to be if the convenience
yield was zero?
qt,T = !u,
(T )
Ft = St e (rt,T !qt,T )(T !t ) = $5.63e (0.005 +0.02 )"1.5 = $5.85
(T ) (T )
What is the meaning of Ft > Ft ?
Questions (II)
Seasonality in corn spot price
Questions (III)
What is the convenience yield between today and December next

year?
(T )
Ft = St e (rt,T +u !yt,T )(T !t )
$ (T ) % / 0
$5.24
yt,T = rt,T + u ! T 1!t ln FSt t = 0.005 + 0.02 ! 1
1.5 ln $5.63 =
7.3%
Chapter 3: Forward Contracts Limits to Arbitrage: Non-Tradable/ -Storable Underlyings
Non-Tradable/ -Storable Underlyings
Some derivatives are written on underlyings which are not traded

and/ or not storable
Examples of underlyings: temperature, rainfall, snowfall, sunshine,
electricity
Forward price cannot be derived using a no arbitrage argument
(replication strategy) because the underlying cannot be bought and
sold or hold (stored) between time t and T
Similar to the case of a consumption asset, the forward price has to
be determined in general equilibrium
Chapter 3: Forward Contracts Limits to Arbitrage: Financial Constraints
Other Limits to Arbitrage: Financial Constraints
Other nancial constraints such as portfolio constraints or collateral

requirements can make arbitrage opportunities disappear
Forward price cannot be derived using a no arbitrage argument
(replication strategy)
Similar to the case of a consumption asset, the forward price has to
be determined in general equilibrium
A danger in reality is that an "arbitrageur" ignores (or does not
realize) that there are limits to arbitrage and takes large osetting
positions which will converge in the long run > if the "arbitrageur"
is unlucky and his osetting positions strongly diverge in the short
run, he may have to liquidate his "arbitrage" strategy and realize
large losses > this is indeed an often cause of disasterous outcomes
in reality!
Example of Limits to Arbitrage: LTCM (I)

Long Term Capital Management was a hedge fund founded in 1994
Very successfull for about 4 years, but suddenly collapsed in 1998
during the Asian nancial crisis and the default of Russia
Run by a very promising group of academics and professionals,
including 2 Nobel memorial prize laureates
Highly regarded, much trusted, very desired, and access to particularly
cheap nancing including low margin and collateral requirements >
LTCM was highly leveraged!
Investment strategy was based on various arbitrages, for instance a
combination of long and short positions in two debt contracts which
are identical except for their liquidity, or oestting positions in
dual-listed rms where one stock trades at a premium > oestting
positions are expected to converge in the long run and thus, buying
cheap and selling expensive yields a "certain" prot
Example of Limits to Arbitrage: LTCM (II)
The problem is that there were limits to arbitrage! > during the
crisis some oestting trades diverged instead of converged in the short
run, LTCM was not able to post enough collateral and had to
liquidate positions with large losses although they expected to make
money on these positions in the long run
Some argue that LTCM also started to take on larger speculative bets
over time which caused losses during the crisis
LTCM was bailed out in 1998 and the partners lost everything (just
before the crisis the fund was worth several billions of US$)
Chapter 3: Forward Contracts Pricing Forwards: A Summary
Pricing Forwards: A Summary
The forward price only depends on the current price of the underlying
(St ) and the cost of carry (ct,T )
it is independent of the expected future price of the underlying (ST )
(T )
For an investment asset: Ft = St e ct,T (T !t )
For a non dividend paying stock, ct,T = rt,T
For a dividend paying stock or stock index (dividend yield qt,T ):
ct,T = rt,T ! qt,T
f ):
For a foreign exchange (interest rate in foreign currency rt,T
f
ct,T = rt,T ! rt,T
(T )
For a consumption asset: Ft = St e (ct,T !yt,T )(T !t )
ct,T = rt,T ! qt,T , qt,T = income ! storage cost
Chapter 3: Forward Contracts Forward Prices and Expected Future Spot Prices
Forward Prices and Expected Future Spot Prices
(S )
Suppose er t,T is the expected annualized return for period [t, T ]
required by investors to hold an asset (in equilibrium)
Buying 1 unit of the asset at time t (for price St ) and reinvesting all
intermediate cash ows between time t and T , ensures that there is
no cash ow on the interval [t, T ] and we own e (rt,T !ct,T +yt,T )(T !t )
units of the asset at time T (value of ST e (rt,T !ct,T +yt,T )(T !t ) )
h i (S )
Therefore, we have Et ST e ( r t,T ! c t,T + y t,T )( T ! t ) = St e er t,T (T !t ) , or
/ 0
(S )
er t,T !rt,T +ct,T !yt,T (T !t )
Et [ S T ] = S t e
(T )
Or since Ft = St e (ct,T !yt,T )(T !t ) , we have
/ 0
(S )
(T ) er t,T !rt,T (T !t )
Et [ S T ] = Ft e
Chapter 3: Forward Contracts Value of a Forward Contract at time s 2 (t, T )
Value of a Forward Contract at time s in [t,T] (I)
At origination (time t) a forward contract has a value of 0 (that is

(T )
how we have derived the forward price Ft = St e (ct,T !yt,T )(T !t ) )
After origination at time s 2 (t, T ) a new forward contract with the
same maturity at time T has (in general) a dierent forward price
than a contract negotiated at time t,
(T ) (T )
Ft 6 = Fs = Ss e (cs ,T !ys ,T )(T !s )
Chapter 3: Forward Contracts Value of a Forward Contract at time s 2 (t, T )
Value of a Forward Contract at time s in [t,T] (II)
(T )
Because the price of a newly issued forward contract (Fs ) can be
locked in,
the value of a long forward contract is
/ 0
(long ,t,T ) (T ) (T )
fs = F s ! Ft e !rs ,T (T !s )
the value of a short forward contract is

/ 0
(short,t,T ) (T ) (T )
fs = Ft ! F s e !rs ,T (T !s )
Chapter 4: Futures Contracts Comparison to Forward Contracts: Pricing
Specication of Futures Contracts
Denition
A futures contract is an agreement to trade the underlying asset in
future (at maturity T ) for a xed price specied today (at current time t)
(T )
Futures price Ft at time t is chosen such that the contract is
"worthless" (at time t)
Similar to forward contract, but

Organization of the market: futures are exchange traded
Timing of cash ows: futures are marking-to-market or settled daily,
meaning that gains or losses from a futures are realized daily, rather
than once (at maturity) as with the forward
Futures Price and Daily Cash Flows
Futures price is adjusted daily to keep the value of the contract equal
to 0 at the end of each trading day
By no arbitrage it has to be that the futures price converges to the

(T )
spot price at maturity, FT = ST
(T ) (T )
The change in the futures price from one day to another Fsi ! Fsi !1
(i 2 f1, 2, ..., ng, s0 = t, sn = T , period [si ! si !1 ] species 1 trading
day) determines the amount of money exchanged at time si
(T ) (T )
if Fsi ! Fsi !1 > 0, short position pays long position
(T ) (T )
if Fsi ! Fsi !1 < 0, long position pays short position
Cumulate payo (without reinvestment) to long (short) position over

(T ) (T )
the lifetime of the futures contract is ST ! Ft (Ft ! ST )
Futures Price Derivation (I)
Consider an underlying with a continuous intermediate payo ow/

yield qt,T during period [t, T ], and a futures contract with maturity
T written on the underlying
Suppose there are n trading days between time t and T ; let

i 2 f1, 2, ..., ng, s0 = t, sn = T , period [si !1 , si ] species 1 trading
(T )
day, and the futures price at time si is Fsi
Suppose the short rate r (c.c.) is constant on [t, T ]
Create an investment strategy which takes positions in the futures

market, underlying asset and risk free asset (zero-coupon bond) but
does not generate any payo in the future
Futures Price Derivation (II)

At time t (s0 ):
(T )
Borrow Ft for (T ! t ) years at r
Buy e ( t,T )(T !t ) units of the underlying > pay St e (r !qt,T )(T !t )
r ! q
Enter e r (s1 !t ) short positions in the futures market
(T )
Cash ow: Ft ! St e (r !qt,T )(T !t )
At time t 2 (t, T ) (si 2 fs1 , s2 , ..., sn !1 g):

Always reinvest stream of underlyings payos in underlying >
position in underlying grows at rate qt,T dt
At time t, own e r (T !t )!qt,T (T !t ) units of the underlying
"At the end of period si " increase open short positions in the futures
market to e r (si +1 !t )
e r (si !t ) open short positions in futures market
/ from "the0 end of period
(T ) (T )
si !1 " to "the end of period si " pay o Fsi !1 ! Fsi e r (s i !t )
/ 0
(T ) (T )
Invest Fsi !1 ! Fsi e r (si !t ) for (T ! si ) years at r
Cash ow: 0
Futures Price Derivation (III)
At time T (sn ):
Own e r (T !t ) units of the underlying at time T : worth ST e r (T !t )
e r (sn !t ) open short positions in futures market
/ from "the0 end of period
(T ) (T )
sn !1 " to "the end of period sn " pay o Fsn !1 ! Fsn e r (s n !t )
Close all e r (sn !t ) short positions in futures market
Receive proceeds from invested futures payos at time
si 2 f/s1 , s2 , ..., sn !1 g
0 (in risk free asset) > receive
(T ) (T )
ni=1 Fsi !1 ! Fsi e r (s i !t ) e r (T !s i ) =
/ 0 / 0
r ( T ! t ) n (T ) (T ) r ( T ! t ) (T ) (T )
e i = 1 Fs i ! 1 ! Fs i =e Fs 0 ! Fs n
(T )
Ft e r ( T ! t ) / 0
(T ) (T ) r (T !t )
Cash ow: ST e r (T !t ) + Ft ! S T e r ( T ! t ) ! Ft e =0
(T )
(note: s0 = t, sn = T , FT = ST )
Futures Price Derivation (IV)

state of the world), its cost must be zero,
(T )
Ft = St e (r !qt,T )(T !t )
The futures price coincides with the forward price if the short rate is
constant on [t, T ]
If the short rate is stochastically changing over time (in reality this is
the case), the futures price diers from the forward price
A positive correlation between interest rate and the futures price
implies the futures price is higher than the forward price
A negative correlation implies the reverse
Chapter 4: Futures Contracts Futures Contracts and Organization of Markets
Futures Markets
Traded on exchange
Standardized contracts as specied by exchange
Trading oor
Closing-out before maturity with osetting position (delivery is
uncommon)
Marking to market (daily settlement)
Margin requirements
No credit (default or counter-party) risk
Liquidity depends on contract type
Regulated
Organization of Futures Market
Standardized Contracts
The exchange develops contracts and must specify:

Underlying
Contract size
Price and position limits
Delivery arrangements: location, time
In general, the short position gets to choose from the alternatives
Delivery
It is common to close out contracts before maturity, and most futures

contracts do not lead to delivery
Closing out a futures position means entering into a trade that osets
the original contract
If a futures contract is not closed out before maturity, it is usually

settled by delivering the underlying assets
Some futures contracts are settled in cash (e.g. futures on stock

indices)
Credit Risk: Forward vs Futures
At origination forward and futures contracts are "worthless"

There is no immediate credit risk
After origination credit risk starts to grow for forward contracts

Value of a forward position changes and existing forward contract
becomes an asset for one party and a liability for the other
Collateral can help to overcome credit risk, but remember Lehman and
LTCM...
Futures have virtually no credit risk

Value of a futures contract is set to 0 every day (marking-to-market)
Clearinghouse of the exchange guarantees payments (margin
requirements)
Credit Risk: Questions
Suppose on April 4th A bought from B 100000 bbl of oil forward at a

(July 4 )
forward price of FApr 4 = $27 per bbl for delivery on July 4th
If on May 4th the forward price for delivery on July 4th is

(July 4 )
FMay 4 = $23 per bbl and the 2-month spot rate is
rMay 4, July 4 = 5% (c.c.), who has a liability and possibility to default?
Investor A (long position) has / a liability - value of0 the 2forward contract
(long , Apr 4, July 4 ) (July 4 ) (July 4 )
fMay 4 = 10 $ FMay 4 ! FApr 4
5 e ! 12 rMay 4, July 4 =
!$396681
How could rm A and B minimize credit risk?
Require collateral as value of forward contract changes
Is the same credit risk present in futures markets?
No because of daily settlements the value of the futures is set to zero
every day
Daily Settlement and Margins (I)
Margin: Cash or marketable securities deposited by an investor with

his broker
Initial margin: Amount that must be deposited at the initial time

the futures contract is entered
Marking-to-market: Balance in margin account is adjusted daily to

reect the investors gain or loss on each trading day
Maintenance margin: If balance in the margin account drops below

the maintenance margin, investor has to top up the margin account
to the initial margin level (margin call)
Variation margin: Extra funds deposited to the margin account to

reach the initial margin level
Daily Settlement and Margins (II)
Exchange sets minimum levels for initial and maintenance margins
Brokers may require greater but not lower margins
Margin requirements may depend on the objectives of the trader, e.g.

hedger is often subject to lower margin requirements than speculator
Margins minimize possibility of default
Marking-to-market results in futures contracts being settled daily

rather than at the end of its life
Futures is in eect closed out and rewritten at a new price each day
> similar to bundle of forward contracts where each contract is closed
after one day
Daily Settlement and Margins: Example (I)
Suppose an investor enters on June 16th a long position in 2 gold

futures with maturity in December
Contract size is 100 oz
Futures price is $1632.5 per oz
Initial margin requirement is $4500 per contract ($9000 in total)
Maintenance margin is $3333 per contract ($6666 in total)
Daily Settlement and Margins: Example (II)
Futures Daily Cumulative Margin Account Margin

Day Price ($) Payo ($) Payo ($) Balance ($) Call ($)
1 1632.5 9000
1 1655.0 4500 4500 13500
2 1662.0 1400 5900 14900
3 1625.0 !7400 !1500 7500
4 1623.0 !400 !1900 7100
5 1615.0 !1600 !3500 5500 3500
6 1616.0 200 !3300 9200
7 1602.0 !2800 !6100 6400 2600
8 1611.0 1800 !4300 10800
9 1614.0 600 !3700 11400
10 1619.0 1000 !2700 12400
Daily Settlement: Cash Flow when Futures Price Increases
Daily Settlement: Cash Flow when Futures Price Declines
Futures Quotes (I)
Settlement price: Price used for calculating daily payo

Price at which the contract was traded immediately before the nal
bell
Open interest: Total number of contracts outstanding

Number of long positions or short positions
Often open interest is small for maturities far in the future
Often open interest is getting small (very) close to maturity
Volume of trading: Number of trades in one day

Trading volume > open interest, indicates that there are many day
trades
Futures Quotes (II)
Regulation (I)
In the USA, the regulation of futures markets is primarily the

responsibility of the Commodity Futures and Trading Commission
(CFTC)
Other regulators/ institutions: National Futures Association (NFA),

Security and Exchange Commission (SEC), Federal Reserve Board,
US Treasury Department
Regulators try to protect the public interest and prevent questionable

trading practices (e.g. corner the market, front running)
Dodd Frank Wall Street Reform and Consumer Protection Act, in

particular Volcker Rule (severe restrictions on proprietary trading)
Regulation (II)
When do we need Regulation
In free markets Adam Smiths invisible hand allocates goods

eciently, so why do we need regulation?
Leon Walras shows that free markets are ecient but only if there are
no market failures; e.g.
market power of a goods producer can lead to an ineciently small
supply
transaction costs can lead to a reduction in trade
positive externality can lead to too little consumption of public goods
negative externalities can cause a factory to produce too much because
it does not account for the some costs they impose on society
Banks are important to help allocate capital from savers (e.g.
households) to ecient projects in the real economy. Banks only
account for their direct costs of bankruptcy when taking risks, but they
ignore costs imposed on the society, i.e. a bank failure breaks the link
between savers and the real economy. Thus, there is an externality and
banks take more risk than socially optimal!
Chapter 4: Futures Contracts Hedging using Futures
Hedging using Futures
Hedging with futures typically involves taking a position in the futures

market that is opposite of the position already held (or that will be
held) in the spot market at a future time
Purpose is to lock in a price to buy or sell an asset in the future
Hedging using Futures: Short Hedge (I)
A short hedge is a hedge that involves a short position in futures

contracts (agree to sell the underlying at maturity)
Appropriate when hedger expects to sell an asset at some time in the

future and the underlying is positively correlated with the asset
Hedger is holding a long position in the underlying at a future time
A short hedge protects against unexpected drops in the spot price
Hedging using Futures: Long Hedge (I)
A long hedge is a hedge that involves a long position in futures

contracts (agree to buy the underlying at maturity)
Appropriate when hedger expects to purchase an asset at some time

in the future and the underlying is positively correlated with the asset
Hedger is holding a short position in the underlying at a future time
A long hedge protects against unexpected increases in the spot price
Hedging using Futures: Questions
Do you need a long or a short hedge to eliminate risks in the following

scenarios?
A rm expects to produce and sell 90000 lbs of copper in 5 months

Holding a long position > short hedge
An exporter in the USA will receive Swiss francs in 3 months (futures

US $
are quoted CHF )
Holding a long position > short hedge
A copper fabricator knows it will require 100,000 pounds of copper in

6 months to meet a certain contract
Holding a short position > long hedge
Why does a rm Hedge Risk?
Firms should focus on the main business (key competence) and

minimize risks arising from interest rates, exchange rates, and other
market variables
Hedging can be optimal when an extra dollar of income received in

times of high prots is worth less than an extra dollar of income
received in times of low prots
Preference for such a rm is concave and hedging can increase

expected utility
Taxes
Bankruptcy and distress costs
Costly external nancing
Managerial risk aversion
Reasons against Hedging

Shareholders are usually well diversied and can make their own
hedging decisions, but
less costly for rm to hedge than for (small) stockholder
rm has better market information than stockholder
rm knows more about specic transactions it is going to enter than
stockholder
Transaction costs
Requirement for costly expertise
Need to monitor and control hedging process
Cash ow/ liquidity problems
Potential collateral requirements
Complications from tax and accounting considerations
It may increase risk to hedge when competitors do not (xed margin)
Explaining a situation where there is a loss on the hedge and a gain
on the underlying can be dicult
Reasons against Hedging: Example

Danger of hedging is that losses will be realized on the hedge while
the gains on the underlying exposure are unrealized
> Liquidity problems
Metallgesellschaft sold long-term xed-price contracts on heating oil

and gasoline to customers (MG has short position)
MG hedged its positions using long positions in futures contracts
Oil price fell > negative cash ow in the short run (daily
settlement), but expect in the long run osetting positive cash ows
MG exited the futures contracts due to liquidity problems > loss of
$1.3 billions
Public press and bankers blamed MG for taking speculative bets; it
was hard for MG to convince people that their futures positions were
actually hedging the rms exposure to oil price uctuations
Hedging in the Real World
A majority of non-nancial rms use derivatives
Firms that are (statistically) more likely to use derivatives are

Large rms (relative to small rms)
Firms with more investment opportunities
Firms that have a higher market value
Firms that have higher leverage
Chapter 4: Futures Contracts Hedging using Futures: Imperfect Hedges
Imperfect Hedges
So far we have talked about perfect hedges which completely

eliminate risk
In reality futures hedges are imperfect

Mismatch between underlying of futures contract and asset to be
hedged
Maturity mismatch
Basis Risk (I)
Basis at time t is dened as the dierence between the spot price of

the asset to be hedged (St ) and the futures price of the contract used
(T )
to hedge Ft (not necessarily on the same asset)
(T )
bt = St ! Ft
Let St" be the spot price of the asset underlying the futures contract
(St 6= St" implies a mismatch between underlying of futures contract
and asset to be hedged)
/ 0
(T )
bt = (St ! St" ) + St" ! Ft
Basis risk is uncertainty about the basis when the hedge is closed out
Basis Risk (II)
Consider a hedge for a future sale of an asset at time t2 by entering

into a short futures contract at time t1 (short hedge), then
/ 0
(T ) (T )
Eective Price (received) = St2 + Ft 1 ! Ft 2
(T )
= Ft 1 + bt2
Consider a hedge for a future purchase of an asset at time t2 by

entering into a long futures contract at time t1 (long hedge), then
/ 0
(T ) (T )
Eective Price (paid) = St2 ! Ft 2 ! Ft 1
(T )
= Ft 1 + bt2
Choice of Contract
Choose a delivery month that is as close as possible, but later than

the end of the life of the hedge
Futures prices can be erratic during the delivery month
Delivery risk
Use short maturity contracts (more liquid) and roll them forward, if
delivery is far in the future
When there is no futures contract on the asset being hedged, choose

the contract whose futures prices are most closely correlated with the
price of the asset being hedged (cross hedging)
Maturity Mismatch: Example

On 15th of June a company expects to purchase 20000 bbl of crude
oil at some time in October or November
Oil futures contracts are traded for delivery every month; the contract
size is 1000 bbl
The futures price (maturity in December) on 15th of June is
(Dec )
FJune 15 = $86.00 bbl ($1720000 for 20000 bbl)
The company purchase the crude oil and closes out its futures
contract on the 10th of November when the spot price is
(Dec )
SNov 10 = $88.00 bbl and the futures price is FNov 10 = $87.10 bbl
Gain on 20 long positions
/ in futures (ignore
0 daily settlement for
(Dec ) (Dec )
simplicity): 20000 FNov 10 ! FJune 15 = $22000
The basis at close-out:
/ 0
(Dec )
bNov 10 = 20000 SNov 10 ! FNov 10 = $18000
(Dec )
The eective price paid: 20000FJune 15 + bNov 10 = $1738000
Cross Hedging and Optimal Hedge Ratio (I)
Cross hedging occurs when the futures underlying is dierent from

the asset being hedged
Optimal hedge ratio h is the proportion of the exposure that should

optimally be hedged
sS ,F s
h= 2
= rS ,F S
sF sF
sS : standard deviation of DS, change in the spot price during the hedging
period [t1 , t2 ]
sF : standard deviation of DF (T ) , change in the futures price during the
hedging period [t1 , t2 ]
rS ,F : coecient of correlation between DS and DF (T )
sS ,F : covariation between DS and DF (T )
Cross Hedging and Optimal Hedge Ratio (II)

Assume linear relationship DS = k + hDF + #, E [#] = 0,
E [DF #] = 0
Cross Hedging and Optimal Hedge Ratio (III)

Proof:
DS ! E [DS ] = h (DF ! E [DF ]) + #
h i
2
s2S = E (DS ! E [DS ])
h i
= E (h (DF ! E [DF ]) + #)2
h i 5 6
2
= h E (DF ! E [DF ]) + 2hE [(DF ! E [DF ]) #] + E #2
2
= h2 s2F + s2#
= E [(DS ! E [DS ]) h (DF ! E [DF ]) + (DS ! E [DS ]) #]
= hrsS sF + E [(hDF + # ! hE [DF ]) #]
= hsS ,F + s2#
sS ,F
=> h2 s2F + s2# = hsS ,F + s2# or h = s2F
Optimal Number of Futures Contracts
Change in hedged position during period [t1 , t2 ] is

QS DS ! NQF DF = QS (k + hDF + #) ! NQF DF
Variation is var (QS DS ! NQF DF ) = (hQS ! NQF )2 s2F + (QS )2 s2#
Optimal number of futures contracts (N) minimizes

var (QS DS ! NQF DF ),
hQS
N=
QF
N : number of futures contracts

QS : size of position being hedged (units)
QF : size of 1 futures contract (units)
Tailing the Hedge
Optimal number of contracts Nt at time t 2 [t1 , t2 ] after tailing

adjustment to allow or daily settlement of futures,
(S )
hVt
Nt = (F )
Vt
Daily adjustments, but often not possible in practice
Tailing the hedge is important when the interest rate is high and time
to maturity is long
(S ) (S )
Vt : value of position being hedged, Vt = St QS
(F ) (F ) (T )
Vt : value of principal of 1 futures contract, Vt = Ft QF
Note on Unbiased Estimation
Suppose random variables x and y are i.i.d.
Observation: x1 , x2 , ..., xN , y1 , y2 , ..., yN

xi
5 6
E [x ] = N
i =1 N , E E [ x ] = E [x ]
yi 5 6
E [y ] = N
i =1 N , E E [ y ] = E [y ]
(xi !E (x ))
2
5 6
s2x = N
i =1 N !1 , E s2x = s2x
(yi !E (y ))
2
5 6
s2y = N
i =1 N !1 , E s2y = s2y
(xi !E (x ))(yi !E [y ])
sx ,y = N
i =1 N !1 , E [sx ,y ] = sx ,y
Optimal Hedge: Example

Suppose an airline will purchase QS = 2000000 gallons of jet fuel in
one month and hedges using heating oil futures (size of 1 futures
contract is QF = 42000 gallons)
From historical data sF = 0.0313, sS = 0.0263, and r = 0.928
Today the spot price is S0 = $1.94 and the futures price is
(1/12 )
F0 = $1.99 per gallon
(S )
V0 = S0 QS = $3880000
(F ) (1 /12 )
V0 = F0 QF = $83580
Optimal hedge ratio is h = rS ,F ssFS = 0.7798
Optimal number of contracts ignoring daily settlement is
N = hQ
Q F = 37.1
S
Optimal number of contracts (today) after tailing is

(S )
hV 0
N0 = V 0F
= 36.2
Chapter 4: Futures Contracts Hedging using Futures: Hedging a Stock Portfolio
Hedging a Stock Portfolio
To hedge the risk in a stock portfolio during period [t1 , t2 ] the

number of index futures contracts that should be shorted at time
t 2 [t1 , t2 ] is
(S )
Vt
Nt = b S (F )
Vt
Daily adjustments, but often not possible in practice
bS : CAPM b of portfolio
(S )
Vt : value of the portfolio
(F )
Vt : value of principal of 1 futures contract (contract size multiplied by
futures price)
Hedging a Stock Portfolio: Questions (I)
You manage a well-diversied equity portfolio (assume no

idiosyncratic risk)
(S &P )
S&P 500 index at time 0 is I0 = 1000
(0.33 )
S&P 500 futures with 4 months maturity is F0 = 990.05
S&P 500 futures contract size/ value of principal is
(F ) (0.33 )
V0 = $250F0 = 247512.46 (if the index increases by 1 index
point, a long position pays $250)
(S )
Value of the portfolio V0 = $5000000
Risk-free interest rate is constant and r = 1% (c.c.)
Dividend yield on index q = 4%
CAPM b of the portfolio bS = 1.5
Assume we hedge the value of the portfolio over the next 3 months
(until time 0.25) using a futures contract with 4 months to maturity
Hedging a Stock Portfolio: Questions (II)

What futures position do you have to take at time 0 to eliminate as
much risk as possible?
(S )
V0
Short N = bS (F ) = 1.5 $$247512.46
5000000 = 30.3 futures
V0
(S &P )
In 3 months (at time 0.25) the index drops to I0.25 = 980 and the
(0.33 )
futures to F0.25 = 977.55
What is the gain from the futures position? (for simplicity ignore
daily settlement)
/ from N = 30.3 0short positions is
Gain
(0.33 ) (0.33 )
N F0 ! F0.25 $250 = $94668
What is the annualized return on the index? (assume dividends are
reinvested in index)
$ (S &P )
%
(I ) 1 I0.25 0.25q
r0,0.25 = 0.25 ln (S &P ) e = !4.1%
I0
Hedging a Stock Portfolio: Questions (III)
What is the annualized return on the stock portfolio? (assume S&P

500 index tracks the market well and dividends are reinvested in
portfolio)
/ 0
(S ) (I )
r0,0.25 = r + bS r0,0.25 ! r = !6.6%
What is the gain from the stock portfolio?

(S )
(S ) (S )
Gain from stock portfolio is e 0.25r0,0.25 V0 ! V0 = !$82089
What is the total gain?

/ gain is $94668
Total 0 ! $82089 = $12579, or return of
$12579
ln 1 + $5000000 = 0.25%, or 1% per annum (risk free rate)
Reasons for Hedging a Stock Portfolio
May want to be out of the market for a while > hedging avoids the
costs of selling and repurchasing the portfolio while getting short-term
protection in an uncertain market situation
Uncertain about the performance of the market, but condent that

stocks in the portfolio have been chosen well and will outperform the
market in both good and bad times > hedging ensures that the
portfolio return is the risk free return plus the excess return of the
portfolio over the market
Changing the Portfolio "beta"
Before the CAPM b of the portfolio is reduced to 0
Futures contracts can be used to change the b to some value other

than 0
To change the b from bS to b" during period [t1 , t2 ], the hedger

needs to take at time t 2 [t1 , t2 ] a short position in
(S )
Vt
Nt = ( b S ! b " ) (F ) futures contract
Vt
If N > 0 (bS > b" ), it is indeed a short position in futures
If N < 0 (bS < b" ), it is a long position in futures
Changing the Portfolio "beta": Questions
Consider the data about the S&P 500 from the questions on "hedging
a stock portfolio"
What futures position do you have to take at time 0 to reduce the

portfolio bS to b" = 0.5?
(S )
V0
Take N = ( bS ! b" ) (F ) = (1.5 ! 0.5) $$247512.46
5000000 = 20.2 short
V0
positions in futures
What futures position do you have to take at time 0 to increase the

portfolio bS to b" = 2?
(S )
V0
Take N = ( bS ! b" ) (F ) = (1.5 ! 2) $$247512.46
5000000 = !10.1 short or
V0
10.1 long positions in futures
Reasons for Changing the Portfolio "beta"
Portfolio managers adjust their portfolio b as they perceive changes in

risk and returns
When they are bullish about the market, (believe that market is
strong), or when they are not very risk averse, they will increase their
stock portfolios b
When they are bearish about the market (believe that market is weak
and risk has increased), or when they are more risk averse, they will
decrease their portfolios b
Remarks on Stock Indices

A stock index is a number computed in order to measure and track
changes in the value of a (hypothetical) portfolio of stocks
When constructing a stock market index, three issues are of particular
interest:
Which stocks are included in the index?
How is each stock weighted?
How is the average computed?
Three basic weighting schemes:
Price weighting (e.g. Dow Jones Industrial Average )
Value weighting (e.g. Standard & Poors 500 Index)
Equal weighting (e.g., S&P 500 Equal Weight Index)
Investment in index:
Holding every constituent (dicult, costly)
Mutual/ tracking fund
Exchange traded fund (ETF) since 1993
derivatives written on index
Remarks on Stock Indices: DJIA (I)
When one asks, How is the market doing?, it is usually implicit that
the question refers to the DJIA
On May 26, 1896, it was ocially published with 12 stocks (USA)
Today it includes 30 blue-chip stocks (since 1928)
DJIA is computed by adding the prices of the component stocks and
dividing the sum by a divisor (arbitrarily chosen at the origination of
the index)
Divisor is printed in the Wall Street Journal every day and is also
available in the equity product information area at CME Group website
Divisor changes to adjust for corporate events (stock splits, stock
dividends, spin-os, M&A, etc), or if a stock is removed or added to the
DJIA "to ensure that the DJIA remains representative of the market"
Example: on June 8, 2009, the divisor for the DJIA was 0.132319125;
on July 2, 2010, the divisor changed to 0.132129493 due to spin-os
Remarks on Stock Indices: DJIA (II)
The DJIA is not adjusted to account for regular dividend payments

May 26, 1896, rst ocial DJIA was 40.94
June 15, 2012, DJIA was 12767.17
If dividends were considered DJIA would be over 250000 today
Average annual return (since 1928):
DJIA: 5.37%
DJIA with dividends: 9.46%
A tracking portfolio of the DJIA consists of an equal number of

shares of each of the component stocks
Reinvestment and rebalancing is necessary due to payments of cash
dividends and corporate events
No rebalancing is needed when stock prices move
Only 30 stocks each of which is very actively traded > relatively easy
to manage
Remarks on Stock Indices: Value-Weighted Indices
Supposedly best representation of the "market"
In the Capital Asset Pricing Model (CAPM), a stocks correlation

with the market portfolio is the factor that determines its price
(expected return) - the market portfolio is value-weighted
Many stock market indices are value-weighted (S&P 500, NASDAQ,

NYSE Composite, Russel Indices, FTSE 100 (UK), SMI (Switzerland),
HSI (Hong Kong), SENSEX (India), IBEX 35 (Spain), IPC (Mexico),
Kuala Lumpur Composite Index (Malaysia), CAC 40 (France), etc)
The levels of these and yet other indices are presented daily in the
Wall Street Journal
While each index is a dierent portfolio of stocks, the method of

computing each index is the same
Remarks on Stock Indices: Futures (I)
Stock index futures are settled in cash
Trading began in February 1982, when the Kansas City Board of

Trade introduced futures on the Value Line Index (>1500 north
American stocks)
In April 1982, the Chicago Mercantile Exchange introduced futures

contracts on the S&P 500
By 1986, S&P 500 futures had become the second most actively
traded futures in the world (over 19.5 million contracts traded in
1986)
In May 1982, NYSE Composite Index futures began trading on the

New York Futures Exchange
Remarks on Stock Indices: Futures (II)
In July 1984, the Chicago Board of Trade began trading futures

contracts on the Major Market Index (20 large US stocks)
Dow Jones and Company went to court to block attempts to trade

futures on the DJIA
In June 1997, Dow Jones and Company agreed to allow DJIA options,
futures, and options on futures to be traded
=>Stock Index futures have revolutionized the art and science of equity
portfolio management as practiced by mutual funds, pension plans,
endowments, insurance company, and other money managers
Chapter 5: Options
Chapter 5: Options
Chapter 5: Options Payos of Options
Options vs Forwards
Right vs obligation
Forward: agreement (right and obligation for long and short positions)
to trade the underlying in future
Option: right (but not obligation) for the long position (buyer/ holder)
of an option, and obligation for the short position (seller/ writer) of an
option
Up-front payment
Forward: nothing (except collateral) to enter into a forward contract
Option: long position has rights which are valuable, and short position
has obligations which are costly > long position has to pay a premium
to short position at origination
Call Option
A call option gives the owner (long position) the right (but not
obligation) to buy the underlying in future (at maturity T ) for a xed
price specied today (strike price K )
The owner of the call exercises the option at maturity T i the price
of the underlying (ST ) is higher than the strike price (K )
(long call)
> PayoT = max (ST ! K , 0)
The writer or seller of a call option (short position) has the obligation
to sell the underlying i the buyer of the option calls
(short call)
> PayoT = ! max (ST ! K , 0) = min (K ! ST , 0)
Put Option
A put option gives the owner (long position) the right (but not
obligation) to sell the underlying in future (at maturity T ) for a xed
price specied today (strike price K )
The owner of the put exercises the option at maturity T i the price
of the underlying (ST ) is lower than the strike price (K )
(long put )
> PayoT = max (K ! ST , 0)
The writer or seller of a put option (short position) has the obligation
to buy the underlying i the option is exercised
(short put )
> PayoT = ! max (K ! ST , 0) = min (ST ! K , 0)
European vs American
American option can be exercised at any time during its life (at or
before the expiration date)
European option can be exercised only at (but not before) maturity
Most exchange-traded options are American
European options are generally easier to analyze, so we often deduce
properties of an American option from those of its European
counterpart
Price of an American option is equal or larger than the price of a
European option
Chapter 5: Options Option Markets
Option Markets and Underlyings
OTC and exchange traded
Underlyings: stocks, indices, interest rates (bonds), FX, futures,

swaps (swaptions), real estate
(Real options)
Market Makers
Most exchanges use market makers to facilitate options trading

Market makers quote both bid and ask prices when requested
They may hold options in their own portfolio as long as they do not
nd an osetting position
They may hedge exposure of not yet oset positions using other
derivatives or the underlying asset
They earn from bid/ask spreads and compete with one another to buy
or sell options to investors
Margins
Margins are required when options are sold to prevent default if

options are exercised
Amount of margin required depends on the traders position
A naked option is an option not combined with an osetting position in
the underlying - much more risky than its covered counterpart, and
high margin requirements are necessary
Special rules for diverse trading strategies
Organization of exchange is similar to futures markets: option clearing

cooperation, clearing house members, brokers, investors
Option positions can be closed by taking osetting positions
When exercised the clearing house randomly selects an equivalent
short position
Chapter 5: Options Special Kinds of Options
Warrants
Warrants are options that are issued by an institution (OTC)

Usually long time to maturity (up to 15 years)
Often issued together with bonds as a package
Number of warrants outstanding is determined by the size of the
original issue and changes only when they are exercised or when they
expire
Warrants on institutions own stocks are dilutive
Convertible Bonds
Convertible bonds are regular bonds that can be exchanged for equity
at certain times in the future according to a predetermined exchange
ratio
Interest is lower than normal bond because of upside potential
Convertible bonds are dilutive
Employee Stock Options
American call options as compensation to executives - incentive for

employees to work hard
Usually at the money when issued
Long time to maturity (10 years or more) and vesting period of up to
5 years
Employee cannot sell the options
Employee stock options are dilutive
Value on income statement used to be equal to the intrinsic value,
but nowadays it is equal to the "market" value
Chapter 5: Options Terminology
Notation
Specications of options (notation):

Underlying (price St at time t)
Maturity/ expiration date (time T )
Strike/ exercise price (K )
Call or Put (price Ot or Ct and Pt at time t)
Option style (European, American, Exotic)
Other important variables:

(Annual) Volatility of underlying (s)
Present value of dividends paid during the life of the option (Dt,T )
(Constant) Risk free interest rate (r , c.c.)
Moneyness: Call Option
At time t a call option is

in-the-money if St > K
at-the-money if St = K
out-of-the-money if St < K
deep-in-the-money if St >> K
deep-out-of-the-money if St << K
Call is exercised only if it is in the money
Moneyness: Put Option
At time t a put option is

in-the-money if St < K
at-the-money if St = K
out-of-the-money if St > K
deep-in-the-money if St << K
deep-out-of-the-money if St >> K
Put is exercised only if it is in the money
Chapter 5: Options Intrinsic and Time Value
Intrinsic and Time Value
Intrinsic value of an option (at time t) is dened as the payo an

option had if maturity was today
Call: max f0, St ! K g
Put: max f0, K ! St g
Time value of an option (at time t) is the long positions value to

defer the decision whether to trade or not to trade the underlying
("cherry picking") - depends on time to maturity and intermediate
payos
=> Total option value (Ot ) = intrinsic value + time value
Intrinsic and Time Value: European Call Option (no

Dividends)
Time value is usually positive due to volatility and discounting of

strike price
Time value may be negative if the underlying pays dividends
Intrinsic and Time Value: European Put Option (no

Dividends)
Time value is usually positive due to volatility

Time value is negative if the option is deep-in-the-money
Holder of option can sell underlying but only gets strike price at
maturity
Determinants of Option Prices
European American European American

Variable Call Call Put Put
St + + ! !
K ! ! + +
s + + + +
Dt,T ! ! + +
r + + ! !
T !t ? + ? +
Chapter 5: Options Financial Engineering: Replication of Securities
Financial Engineering: Replication of Securities
Replicate a security using a trading strategy consisting of other

securities
Example: long forward = long underlying + borrow
Options can be replicated by dynamically trading the underlying and
the risk free assets
A European call (put) can also be replicated using a static trading
strategy consisting of positions in a European put (call) and the
underlying and risk free assets > Put-Call parity
Synthetic Securities
Long risk free asset: e !r (T !t ) K = Pt ! Ct + St ! Dt,T
Short risk free asset: !e !r (T !t ) K = !Pt + Ct ! St + Dt,T
Long underlying: St = !Pt + Ct + e !r (T !t ) K + Dt,T
Short underlying: !St = Pt ! Ct ! e !r (T !t ) K ! Dt,T
Long call: Ct = Pt + St ! Dt,T ! e !r (T !t ) K
Short call: !Ct = !Pt ! St + Dt,T + e !r (T !t ) K
Long put: Pt = Ct ! St + Dt,T + e !r (T !t ) K
Short put: !Pt = !Ct + St ! Dt,T ! e !r (T !t ) K
Synthetic Securities: Long Risk Free Asset
Long risk free asset: e !r (T !t ) K = Pt ! Ct + St ! Dt,T

Time t < T : long put, short call, long underlying, borrow Dt,T
Time T :
ST ) K ST > K
Long RF Asset: K K
Synthetic position:
long put K ! ST 0
short call 0 ! ( ST ! K )
long underlying ST + e T !t ) Dt,T
r ( ST + e r (T !t ) Dt,T
borrow !e r (T !t ) Dt,T !e r (T !t ) Dt,T
Total K K
Replicating the Risk free Asset/ Put-Call Parity
K = PT ! CT + ST <=> e !r (T !t ) K = Pt ! Ct + St ! Dt,T
Note on Put-Call Parity
Price of European call option can be deduced from price of European

put option, and vice versa
Options have to be European, and same underlying asset, strike price,
and expiration date are required for Put-Call parity to hold
Read the signs in put-call parity
positive sign (+) means a long position (to buy)
negative sign (!) means a short position (to sell)
positive (negative) sign for K is understood as a long (short) position
in a risk-free asset or depositing/ lending money (borrowing)
Put-Call parity if underlying pays a stream of dividends qt,T (dividend

yield): Pt ! Ct + St e !qt,T (T !t ) = e !r (T !t ) K
Synthetic Securities: Short Risk Free Asset
Short risk free asset: !e !r (T !t ) K = !Pt + Ct ! St + Dt,T

Time t < T : short put, long call, short underlying, lend Dt,T
Time T :
ST ) K ST > K
Short RF Asset: !K !K
Synthetic position:
short put ! ( K ! ST ) 0
long call / 0 0 / ST ! K 0
short underlying ! ST + e r ( T ! t ) Dt,T ! ST + e r (T !t ) D t,T
lend e r (T !t ) Dt,T e r (T !t ) Dt,T
Total !K !K
Synthetic Securities: Long Underlying
Long underlying: St = !Pt + Ct + e !r (T !t ) K + Dt,T

Time t < T : short put, long call, lend e !r (T !t ) K + Dt,T
Time T :
ST ) K ST > K
Long Underlying: ST + e r (T !t ) Dt,T ST + e r (T !t ) Dt,T
Synthetic position:
short put ! ( K ! ST ) 0
long call 0 ST ! K
lend K + e r (T !t ) Dt,T K + e r (T !t ) Dt,T
Total ST + e r (T !t ) Dt,T ST + e r (T !t ) Dt,T
Synthetic Securities: Short Underlying
Short underlying: !St = Pt ! Ct ! e !r (T !t ) K ! Dt,T

Time t < T : long put, short call, borrow e !r (T !t ) K + Dt,T
Time T :
/ ST ) K 0 / ST > K 0
Short Underlying: ! ST + e r (T !t ) D t,T ! ST + e r (T !t ) D t,T
Synthetic position:
long put K ! ST 0
short call / 0 0 / ! ( ST ! K ) 0
borrow ! K + e r (T !t ) Dt,T ! K +e r ( T ! t ) Dt,T
/ 0 / 0
Total ! ST + e r ( T ! t ) Dt,T ! ST + e r ( T ! t ) Dt,T
Synthetic Securities: Long Call
Long call: Ct = Pt + St ! Dt,T ! e !r (T !t ) K

Time t < T : long put, long underlying, borrow e !r (T !t ) K + Dt,T
Time T :
ST ) K ST > K
Long Call: 0 ST ! K
Synthetic position:
long put K ! ST 0
long underlying S/T + e r (T !t ) Dt,T 0 S/T + e r (T !t ) Dt,T 0
borrow ! K + e r (T !t ) Dt,T ! K + e r (T !t ) Dt,T
Total 0 ST ! K
Synthetic Securities: Short Call
Short call: !Ct = !Pt ! St + Dt,T + e !r (T !t ) K

Time t < T : short put, short underlying, lend e !r (T !t ) K + Dt,T
Time T :
ST ) K ST > K
Short Call: 0 ! ( ST ! K )
Synthetic position:
short put / ! ( K ! ST ) 0 / 0 0
short underlying ! ST + e r ( T ! t ) Dt,T ! ST + e r (T !t ) D t,T
lend K + e r (T !t ) D t,T K + e r (T !t ) D t,T
Total 0 ! ( ST ! K )
Synthetic Securities: Long Put
Long put: Pt = Ct ! St + Dt,T + e !r (T !t ) K

Time t < T : long call, short underlying, lend e !r (T !t ) K + Dt,T
Time T :
ST ) K ST > K
Long Call: K ! ST 0
Synthetic position:
long call / 0 0 / ST ! K 0
short underlying ! ST + e r (T !t ) D t,T ! ST + e r (T !t ) D t,T
lend K + e r (T !t ) Dt,T K + e r (T !t ) Dt,T
Total K ! ST 0
Synthetic Securities: Short Put
Short put: !Pt = !Ct + St ! Dt,T ! e !r (T !t ) K

Time t < T : short call, long underlying, borrow e !r (T !t ) K + Dt,T
Time T :
ST ) K ST > K
Long Call: ! ( K ! ST ) 0
Synthetic position:
short call 0 ! ( ST ! K )
long underlying S/T + e r (T !t ) Dt,T 0 S/T + e r (T !t ) Dt,T 0
borrow ! K + e r (T !t ) Dt,T ! K + e r (T !t ) Dt,T
Total ! ( K ! ST ) 0
Chapter 5: Options Option Trading Strategies
Option Trading Strategies
We use European options in the strategies - slightly dierent

outcomes if American options are used due to the possibility of early
exercise
Time value of money and margin requirements are ignored
Prot = Final Payo ! Initial Cost
A wide range of payo functions can be created using options
Types of option trading strategies:
Take position in option and underlying
Take position in two or more options of the same type
Take position in a mixture of calls and puts
Covered Call
Protective Put
Bullspread using Calls (I)
Buy a call with a low strike price (K1 ) and sell a call with same
maturity but a high strike price (K2 > K1 ) > payo at origination:
Ct (K2 ) ! Ct (K1 ) < 0
Bullspread using Calls (II)
State CT (K1 ) !CT (K2 ) PayoT

S T < K1 0 0 0
K1 < S T < K 2 S T ! K1 0 S T ! K1
K2 < S T S T ! K1 ! ( S T ! K2 ) K2 ! K1
Speculate that the price in the underlying will increase

Limit the upside prot as well as downside risk
Require an initial investment (Ct (K2 ) ! Ct (K1 ) < 0)
Bullspread using Puts (I)
Buy a put with a low strike price (K1 ) and sell a put with same
Pt (K2 ) ! Pt (K1 ) > 0
Bullspread using Puts (II)
State PT (K1 ) !PT (K2 ) PayoT

S T < K1 K1 ! S T ! ( K2 ! S T ) K1 ! K2
K1 < S T < K2 0 ! ( K2 ! S T ) ! ( K2 ! S T )
K2 < S T 0 0 0
Speculate that the price in the underlying will increase

Receive a positive up-front cash ow (Pt (K2 ) ! Pt (K1 ) > 0)
Bearspread using Calls (I)
Sell a call with a low strike price (K1 ) and buy a call with same
Ct (K1 ) ! Ct (K2 ) > 0
Bearspread using Calls (II)
State !CT (K1 ) CT (K2 ) PayoT

S T < K1 0 0 0
K1 < S T < K2 ! ( S T ! K1 ) 0 ! ( S T ! K1 )
K2 < S T ! ( S T ! K1 ) S T ! K2 K1 ! K2
Speculate that the price in the underlying will decline

Receive a positive up-front cash ow (Ct (K1 ) ! Ct (K2 ) > 0)
Bearspread using Puts (I)
Sell a put with a low strike price (K1 ) and buy a put with same
Pt (K1 ) ! Pt (K2 ) < 0
Bearspread using Puts (II)
State !PT (K1 ) PT (K2 ) PayoT

S T < K1 ! ( K1 ! S T ) K2 ! S T K2 ! K1
K1 < S T < K 2 0 K2 ! S T K2 ! S T
K2 < S T 0 0 0
Speculate that the price in the underlying will decline

Require an initial investment (Pt (K1 ) ! Pt (K2 ) < 0)
Boxspread
A combination of a bull call spread and a bear put spread with the
same two strike prices
Payo from a box spread is always the dierence between the strike
prices (K2 ! K1 ) > risk free asset
Requires an initial investment
(Ct (K2 ) ! Ct (K1 ) + Pt (K1 ) ! Pt (K2 ) = e !r (T !t ) (K2 ! K1 ))
Buttery Spreads using Calls (I)
Buy calls with low and high strike price (K1 , K3 ) and sell two calls
with same maturity but an intermediary strike price (K2 2 (K1 , K3 ))
> payo at origination: 2Ct (K2 ) ! Ct (K1 ) ! Ct (K3 )
Buttery Spreads using Calls (II)
K 1 +K 3
Assume that K2 = 2
State CT (K1 ) !2CT (K2 ) CT (K3 ) PayoT

ST < K1 0 0 0 0
K1 < S T < K2 S T ! K1 0 0 S T ! K1
K2 < S T < K3 S T ! K1 ! 2 ( S T ! K2 ) 0 K3 ! S T
K3 < ST S T ! K1 ! 2 ( S T ! K2 ) S T ! K3 0
Speculate that the underlyings volatility will be low (ST is likely to

stay close to K2 ), but have no idea in what direction the underlying
will move
K 1 +K 3
Require an initial investment if K2 = 2 , i.e.
2Ct (K2 ) ! Ct (K1 ) ! Ct (K3 ) < 0
Buttery Spreads using Puts
Buy puts with low and high strike price (K1 , K3 ) and sell two puts
with same maturity but an intermediary strike price (K2 2 (K1 , K3 ))
> payo at origination: 2Pt (K2 ) ! Pt (K1 ) ! Pt (K3 )
Calendar Spreads using Calls
Sell a call with a short time to expiration (maturity T ) and buy a call
with a longer time to expiration (maturity T b > T)
Calendar Spreads using Puts
Sell a put with a short time to expiration (maturity T ) and buy a put
with a longer time to expiration (maturity Tb > T)
Buttery and Calendar Spreads
Usually choose K2 respectively K close to the current price of the

underlying
Speculate that the underlyings volatility will be low (ST is likely to
stay close to St ), but have no idea in what direction the underlying
will move
Usually require an initial investment
When strike prices are very close together (jK2 ! K1 j ! 0,
jK3 ! K2 j ! 0) a buttery spread provides a payo consisting of a
tiny spike at the strike price (K2 )
Approximation of Arrow-Debreu security
Easy to create any thinkable payo schedule (and replicate any
security)
Straddles (I)
Buy a call and a put with the same strike price and expiration date
Straddles (II)
State PT CT PayoT
ST < K K ! ST 0 K ! ST
K < ST 0 ST ! K ST ! K
Usually choose K close to the current price of the underlying

(at-the-money options)
Speculate that the underlyings volatility will be high (ST is likely to
move far away St ), but have no idea in what direction the underlying
will move
High potential upside prot and limited downside risk
Require an initial investment
Strips and Straps

Speculate on high volatility and on direction of underlyings price
movement in the future
Strips speculate on declines in the underlyings price, and straps on
increases
Strangles
Buy a call and a put with dierent strike prices but the same
expiration date - similar to straddles but cheaper
Chapter 6: Option Pricing in Discrete Time
Chapter 6: Option Pricing in

Discrete Time
Chapter 6: Option Pricing in Discrete Time Binomial Trees
Option Pricing
Before: pricing of options using Put-Call parity

Strength: model independent
Weakness: need call price to calculate put price and vice versa
Now: pricing options by replication using a dynamic trading strategy

consisting (only) of the underlying and the risk free assets
Common method for pricing options is to assume that today we know
the possible values of the underlying asset at option expiration
This knowledge of possible values changes through time
> Binomial Tree
We begin with a single period and then stitch single periods together
to form a multi-period binomial option pricing model
The multi-period binomial option pricing model is extremely exible,
and converges to the well-known Black-Scholes formula when time
periods are very close to each other
Binomial Trees (I)
Assumptions:
Given the current (at time ti ) price of the underlying Sti , the price at
(d )
time ti +1 can only take two distinct values Sti +1 = dti Sti or
(u )
Sti +1 = uti Sti (uti > dti )
(d ) (u )
Sti +1 , Sti +1 are known at time ti , but it is uncertain which of the two
prices will be realized
The price of the underlying follows a random walk
The price of the risk free bond grows at a known rate rti ,
(d ) (u )
Bti +1 = Bti +1 = Bti +1 = e rti (ti +1 !ti ) Bti
(d ) (u )
S t i +1 B t i +1 S t i +1
S ti < B ti < S ti
Binomial Trees (II)
Because the option is a function of the underlying (at maturity), the

option price behaves in a similar way as the underlying
Given the option price Oti at time ti , the price at time ti +1 can only
(d ) (u )
take the two values Oti +1 or Oti +1
At maturity (time tn = T ) we can infer the possible option prices
from the possible realizations in the price of the underlying
n o
(w ) (w )
Example of call: = max
Otn !K , 0, Stn
8w 2 f(uu...u ) , (uu...d ) , ..., (dd...d )g
In a multi-period binomial tree we always have to work backwards
Binomial Trees (III)
Chapter 6: Option Pricing in Discrete Time Pricing by Replication
Pricing by Replication
A suitable portfolio (replicating strategy) of underlying and bond

yields the payo of the option
Portfolio of Dti invested in underlying and bti in bonds constructed at
(w ) (w )
time ti is worth Dti Sti +1 + bti Bti +1 = Oti +1 in state w 2 fd, u g at
time ti +1
If there is no arbitrage, the cost to construct this portfolio must be

equal to the current option price (at time ti )
At time ti the constructed replicating portfolio costs
Dti Sti + bti Bti = Oti
Alternatively, we can create an investment strategy (hedging portfolio)

which takes a long position in the option, Dti short positions in the
underlying and bti short positions in the bond; the strategy does not
generate any payo in the future (every state of the world) > if
there is no arbitrage, the cost of the investment strategy must be zero
Single Period (I)
No arbitrage: Oti = Dti Sti + bti Bti

Oti > Dti Sti + bti Bti : sell (expensive) option and buy (cheap)
replicating portfolio - receive positive cash ow now, no CF in future
Oti < Dti Sti + bti Bti : buy (cheap) option and sell (expensive)
replicating portfolio - receive positive CF now, no CF in future
Single Period (II)

Solve system of equations
(u ) (u )
Oti +1 = Dti Sti +1 + bti Bti +1
(d ) (d )
Oti +1 = Dti Sti +1 + bti Bti +1
for Dti and bti

(u ) (d ) (u ) (d )
Oti +1 ! Oti +1 Oti +1 ! Oti +1
Dt i = (u ) (d )
=
St i + 1 ! St i + 1 Sti (uti ! dti )
1 h i
(u ) (u )
bti = Oti +1 ! Dti Sti +1
Bti +1
: ;
e ! r t i (t i +1 ! t i ) !dti (u ) uti (d )
= O + O
Bti uti ! dti ti +1 uti ! dti ti +1
Solving the Multi-Period Model
Given the possible realizations in the price of the underlying at

maturity (time tn = T ), we know the possible option prices at
maturity
As shown, given the prices of underlying and bond at time ti (Sti , Bti )
and the possible prices of underlying, bond and option at time ti +1
(d ) (u ) (d ) (u )
(Sti +1 , Sti +1 , Bti +1 , Oti +1 , Oti +1 ), we can calculate the option price at
time ti assuming there are no arbitrage opportunities
Work backward through the Binomial tree to determine the option
price at time t0
Dividends and American Style Options
If the underlying pays dividends, we have to use the price of the

underlying before (or including) dividend payment (at time ti +1 ) in
the system of equations to solve for Dti and bti , but use the
ex-dividend price (price after dividend payment) to evaluate the cost
of the replicating portfolio (and the option price) at time ti
If the option is American, we have to evaluate whether the value of
the replicating portfolio (continuation value of the option) or the
intrinsic value of the option is larger at time ti
In latter case the option is exercised at time ti and the option price
equals the intrinsic value at time ti
Final Remarks
Option price only depends on

current price of underlying
possible increases and declines in the underlyings price (volatility)
strike price
risk free rate
time to maturity
dividend payments
In particular, the option price does not depend on

probability distribution of increases and declines in the underlyings
price or the expected return of the underlying
risk aversion of investors
Example of European Call Option (I)
The current stock price is S0 = 100

Over every one month period the stock price may increase by 10%
(u = 1.1) or decrease by 5% (d = 0.95)
The stock pays no dividends
The risk free interest rate is constant and 2% (c.c.)
What is the price of a European call option with a strike price
K = 105 and 2 months to maturity?
n o
(uu ) (uu )
O0.17 = max 0, S0.17 ! K = max f0, 121 ! 105g = 16,
(ud ) (du )
O0.17 = O0.17 = max f0, 104.5 ! 105g = 0,
(dd )
O0.17 = max f0, 90.25 ! 105g = 0
Example of European Call Option (II)
Example of European Call Option (III)

(uu ) (u ) (uu ) (u )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(ud ) (u ) (ud ) (u )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(u ) (u )
for D0.08 and b0.08
(uu ) (ud )
(u ) O0.17 ! O0.17 16 ! 0
D0.08 = (uu ) (ud )
= = 0.9697
S0.17 ! S0.17 121 ! 104.5
(uu ) (u ) (uu )
(u ) O0.17 ! D0.08 S0.17 16 ! 0.9697 " 121
b0.08 = = = !101
B0.17 1.0033
(u )
=> O0.08 = 0.9697 " 110 ! 101 " 1.0017 = 5.4953
Example of European Call Option (IV)

(du ) (d ) (du ) (d )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(dd ) (d ) (dd ) (d )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(d ) (d )
for D0.08 and b0.08
(d ) 0!0
D0.08 = =0
104.5 ! 90.25
(d ) 0 ! 0 " 104.5
b0.08 = =0
1.0033
(d )
=> O0.08 = 0 " 95 + 0 " 1.0017 = 0
Example of European Call Option (V)
Example of European Call Option (VI)

(u ) (u )
O0.08 = D0 S0.08 + b0 B0.08
(d ) (d )
O0.08 = D0 S0.08 + b0 B0.08
for D0 and b0
(u ) (d )
O0.08 ! O0.08 5.4953 ! 0
D0 = (u ) (d )
= = 0.36635
S0.08 ! S0.08 110 ! 95
(u ) (u )
O0.08 ! D0 S0.08 5.4953 ! 0.36635 " 110
b0 = = = !34.744
B0.08 1.0017
=> O0 = 0.36635 " 100 ! 34.744 " 1 = 1.891
Example of American Call Option

What is the price of the call option if it is American?
It will be exercised after 1 month if the intrinsic value is larger than
the continuation n value o
(d ) (d ) (d ) (d ) (d )
O0.08 = max S0.08 ! K , D0.08 S0.08 + b0.08 B0.08
= max f95 ! 105, 0 " 95 + 0 " 1.0017g = 0
(u )
O0.08 = max f110 ! 105, 0.9697 " 110 ! 101 " 1.0017g = 5.4953
(u ) (d )
O 0.25 !O 0.25
D0 = (u ) (d ) = 5.4953 !0
110 !95 = 0.36635
S 0.25 ! !S 0.25 !
(u ) (u )
O 0.25 !D0 S 0.25 ! 5.4953 !0.36635 "110
b0 = B 0.25 = 1.0017 = !34.744
=> O0 = 0.36635 " 100 ! 34.744 " 1 = 1.891
American call option has the same price as European call option
because the time value is always positive and we never want to
exercise early
Example of European Put Option (I)

(u = 1.1) or decrease by 5% (d = 0.95)
What is the price of a European put option with a strike price
n o
(uu ) (uu )
O0.17 = max 0, K ! S0.17 = max f0, 105 ! 121g = 0,
(ud ) (du )
O0.17 = O0.17 = max f0, 105 ! 104.5g = 0.5,
(dd )
O0.17 = max f0, 105 ! 90.25g = 14.75
Example of European Put Option (II)
Example of European Put Option (III)

(uu ) (u ) (uu ) (u )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(ud ) (u ) (ud ) (u )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(u ) (u )
for D0.08 and b0.08
(uu ) (ud )
(u ) O0.17 ! O0.17 0 ! 0.5
D0.08 = (uu ) (ud )
= = !0.0303
S0.17 ! S0.17 121 ! 104.5
(uu ) (u ) (uu )
(u ) O0.17 ! D0.08 S0.17 0 ! (!0.0303) " 121
b0.08 = = = 3.6542
B0.17 1.0033
(u )
=> O0.08 = !0.0303 " 110 + 3.6542 " 1.0017 = 0.32741
Example of European Put Option (IV)

(du ) (d ) (du ) (d )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(dd ) (d ) (dd ) (d )
O0.17 = D0.08 S0.17 + b0.08 B0.17
(d ) (d )
for D0.08 and b0.08
(d ) 0.5 ! 14.75
D0.08 = = !1
104.5 ! 90.25
(d ) 0.5 ! (!1) " 104.5
b0.08 = = 104.65
1.0033
(d )
=> O0.08 = !1 " 95 + 104.65 " 1.0017 = 9.8279
Example of European Put Option (V)
Example of European Put Option (VI)

(u ) (u )
O0.08 = D0 S0.08 + b0 B0.08
(d ) (d )
O0.08 = D0 S0.08 + b0 B0.08
for D0 and b0
(u ) (d )
O0.08 ! O0.08 0.32741 ! 9.9279
D0 = (u ) (d )
= = !0.64003
S0.08 ! S0.08 110 ! 95
(u ) (u )
O0.08 ! D0 S0.08 0.32741 ! (!0.64003) " 110
b0 = = = 70.611
B0.08 1.0017
=> O0 = !0.64003 " 100 + 70.611 " 1 = 6.608
Example of American Put Option

What is the price of the put option if it is American?
It will be exercised after 1 month if the intrinsic value is larger than
(d ) (d ) (d ) (d ) (d )
O0.08 = max K ! S0.08 , D0.08 S0.08 + b0.08 B0.08
= max f105 ! 95, !1 " 95 + 104.65 " 1.0017g = 10
(u )
O0.08 = max f105 ! 110, !0.0303 " 110 + 3.6542 " 1.0017g = 0.32741
(u ) (d )
O 0.25 !O 0.25
D0 = (u ) (d ) = 0.32741 !10
110 !95 = !0.64484
S 0.25 ! !S 0.25 !
(u ) (u )
O 0.25 !D0 S 0.25 ! 0.32741 !(!0.64484 )"110
b0 = B 0.25 = 1.0017 = 71.139
=> O0 = !0.64484 " 100 + 71.139 " 1 = 6.655
American put option has a higher price than European put option
because the time value is negative in 1 month in the down state and
exercising early is valuable
Example of European Call with Dividends (I)

Over every 3 month period the stock price may increase by 15%
(u = 1.15) or decrease by 10% (d = 0.9)
The stock pays every 3 months a dividend of 10
What is the price of an at-the-money European call option with 6
months to maturity?
n o
(uu ) (uu )
O0.5 = max 0, S0.5 ! K = max f0, 120.75 ! 100g = 20.75,
(ud ) (du )
O0.5 = max f0, 94.5 ! 100g = 0, O0.5 = max f0, 92 ! 100g = 0,
(dd )
O0.5 = max f0, 72 ! 100g = 0
Example of European Call with Dividends (II)
Example of European Call with Dividends (III)

(uu ) (u ) (uu ) (u )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(ud ) (u ) (ud ) (u )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(u ) (u )
for D0.25 and b0.25
(uu ) (ud )
(u ) O0.5 ! O0.5 20.75 ! 0
D0.25 = (uu ) (ud )
= = 0.79048
S0.5 ! S0.5 120.75 ! 94.5
(uu ) (u ) (uu )
(u ) O0.5 ! D0.25 S0.5 20.75 ! 0.79048 " 120.75
b0.25 = = = !72.857
B0.5 1.0253
(u )
=> O0.25 = 0.79048 " 105 ! 72.857 " 1.0126 = 9.2254
Example of European Call with Dividends (IV)

(du ) (d ) (du ) (d )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(dd ) (d ) (dd ) (d )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(u ) (u )
for D0.25 and b0.25
(d ) 0!0
D0.25 = =0
92 ! 72
(d ) 0 + 0 " 92
b0.25 = =0
1.0253
(d )
=> O0.25 = 0 " 80 + 0 " 1.0126 = 0
Example of European Call with Dividends (V)
Example of European Call with Dividends (VI)

(u ) (u )
O0.25 = D0 S0.25 ! + b0 B0.25
(d ) (d )
O0.25 = D0 S0.25 ! + b0 B0.25
(u ) (u )
for D0 and b0
(u ) (d )
O0.25 ! O0.25 9.2254 ! 0
D0 = (u ) (d )
= = 0.36902
S0.25 ! ! S0.25 ! 115 ! 90
(u ) (u )
O0.25 ! D0 S0.25 ! 9.2254 ! 0.36902 " 115
b0 = = = !32.799
B0.25 1.0126
=> O0 = 0.36902 " 100 ! 32.799 " 1 = 4.103
Example of American Call with Dividends

It will be exercised after 3 months if the intrinsic value is larger than
(d ) (d ) (d ) (d ) (d ) (d )
O0.25 = max S0.25 ! ! K , S0.25 ! K , D0.25 S0.25 + b0.25 B0.25
= max f90 ! 100, 80 ! 100, 0g = 0
(u )
O0.25 = max f115 ! 100, 105 ! 100, 9.2254g = 15
(u ) (d )
O 0.25 !O 0.25
D0 = (u ) (d ) = 15 !0
115 !90 = 0.6
S 0.25 ! !S 0.25 !
(u ) (u )
O 0.25 !D0 S 0.25 ! 15 !0.6 "115
b0 = B 0.25 = 1.0126 = !53.328
=> O0 = 0.6 " 100 ! 53.328 " 1 = 6.672
American call option is exercised after 3 months before the dividend
payout (if we are in the u state) because the dividend is large enough
to turn the time value of the option negative
Example of European Put with Dividends (I)

(u = 1.15) or decrease by 10% (d = 0.9)
What is the price of an at-the-money European put option with 6
months to maturity?
n o
(uu ) (uu )
O0.5 = max 0, K ! S0.5 = max f0, 100 ! 120.75g = 0,
(ud ) (du )
O0.5 = max f0, 100 ! 94.5g = 5.5, O0.5 = max f0, 100 ! 92g = 8,
(dd )
O0.5 = max f0, 100 ! 72g = 28
Example of European Put with Dividends (II)
Example of European Put with Dividends (III)

(uu ) (u ) (uu ) (u )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(ud ) (u ) (ud ) (u )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(u ) (u )
for D0.25 and b0.25
(uu ) (ud )
(u ) O0.5 ! O0.5 0 ! 5.5
D0.25 = (uu ) (ud )
= = !0.2095
S0.5 ! S0.5 120.75 ! 94.5
(uu ) (u ) (uu )
(u ) O0.5 ! D0.25 S0.5 0 + 0.2095 " 120.75
b0.25 = = = 24.675
B0.5 1.0253
(u )
=> O0.25 = !0.2095 " 105 + 24.675 " 1.0126 = 2.986
Example of European Put with Dividends (IV)

(du ) (d ) (du ) (d )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(dd ) (d ) (dd ) (d )
O0.5 = D0.25 S0.5 + b0.25 B0.5
(u ) (u )
for D0.25 and b0.25
(d ) 8 ! 28
D0.25 = = !1
92 ! 72
(d ) 8 + 1 " 92
b0.25 = = 97.532
1.0253
(d )
=> O0.25 = !1 " 80 + 97.532 " 1.0126 = 18.761
Example of European Put with Dividends (V)
Example of European Put with Dividends (VI)

(u ) (u )
O0.25 = D0 S0.25 ! + b0 B0.25
(d ) (d )
O0.25 = D0 S0.25 ! + b0 B0.25
(u ) (u )
for D0 and b0
(u ) (d )
O0.25 ! O0.25 2.986 ! 18.761
D0 = (u ) (d )
= = !0.631
S0.25 ! ! S0.25 ! 115 ! 90
(u ) (u )
O0.25 ! D0 S0.25 ! 2.986 + 0.631 " 115
b0 = = = 74.611
B0.25 1.0126
=> O0 = !0.631 " 100 + 74.611 " 1 = 11.511
Example of American Put with Dividends

It will be exercised after 3 months if the intrinsic value is larger than
(d ) (d ) (d ) (d ) (d ) (d )
O0.25 = max K ! S0.25 ! , K ! S0.25 , D0.25 S0.25 + b0.25 B0.25
= max f100 ! 90, 100 ! 80, 18.758g = 20
(u )
O0.25 = max f100 ! 115, 100 ! 105, 2.986g = 2.986
(u ) (d )
O 0.25 !O 0.25
D0 = (u ) (d ) = 2.986 !20
115 !90 = !0.6806
S 0.25 ! !S 0.25 !
(u ) (u )
O 0.25 !D0 S 0.25 ! 2.986 +0.6806 "115
b0 = B 0.25 = 1.0126 = 80.242
=> O0 = !0.6806 " 100 + 80.242 " 1 = 12.185
American put option has a higher price than European put option
because the time value is negative in 1 month in the down state and
exercising early is valuable
Chapter 6: Option Pricing in Discrete Time Risk-Neutral Probabilities
Risk-Neutral Probabilities
By no arbitrage:
Oti = Dti Sti + bti Bti

2 (d ) (u ) 3
B t i +1 S t i +1 S t i +1 B t i +1
Bti 6 B ti ! Sti (u ) S ti ! B ti (d ) 7
= 4 (u ) ( )
d
O t i +1
+ ( )
u ( )d
O t i +1 5
Bti +1 Sti +1 S t i +1 S t i +1 S t i +1
S ti ! S ti S ti ! S ti
" #
r t i (t i +1 ! t i ) r t i (t i +1 ! t i )
e ! dti (u ) uti ! e (d )
= e ! r t i (t i +1 ! t i ) Oti +1 + Oti +1
uti ! dti uti ! dti
h / 0 i
! r t i (t i +1 ! t i ) (u ) (d )
= e qu,ti Oti +1 + 1 ! qu,ti Oti +1
(d )
Bt S
i +1 ! t i +1 !
i ( i +1 i ) ! d t
rt t !t
Bt St e
with qu,ti = (u )
i
(d )
i
= u t i !d t i
i
2 (0, 1)
St St
i +1 ! ! i +1 !
St St
i i
qu,ti is always between 0 and 1 ! has property of probability

Dene articial measure Q: qu,ti is probability of an increase in the
tree, 1 ! qu,ti is probability of a decrease
Thus, the pricing equation can be writen as
h / 0 i
! r t i (t i +1 ! t i ) (u ) (d )
Oti = e qu,ti Oti +1 + 1 ! qu,ti Oti +1
= e !rti (ti +1 !ti ) EtQi [Oti +1 ]
where EtQi is the expectation under the measure Q conditional on

time ti information
This equation is also known as the Fundamental Theorem of Asset
Pricing (FTAP)
Note that measure Q is not the true world probability measure (lets
call it P), i.e. it does not describe the actual probabilities of an
increase (pu,ti ) or a decrease (1 ! pu,ti ) in the tree
"Risk-neutral" because under measure Q the expected return of the
E Q [O t ]
option is equal to the risk-free return, ti O t i +1 = e rti (ti +1 !ti ) , i.e. in a
i
truly risk-neutral world investors would only care about expected
returns but not about risk and in equilibrium all assets (independent
of their risks) are expected to earn the same risk-free return
Although we use the probability measure Q to price options (never
use the true world probability P for pricing!!!), we do not assume
investors are risk-neutral because the measure Q was derived from the
replicating portfolio by no-arbitrage, which holds independent of the
true world probability measure P (i.e. investors believe/ expectations)
and risk aversion
Recombining Binomial Tree with n Time Steps (I)
n time steps f0, 1, 2, ..., ng

In general, uti , dti , rti can depend on ti and change randomly >
"risk-neutral" probability qu,ti has to be computed for each sub-tree
Simplifying assumptions:
from ti to tii +1 (8i 2 f0, 1, ..., n ! 1g) underlying either increases by
factor u or d (< u )
risk free interest rate is constant over time, Bti +1 = Bti e r (ti +1 !ti )
(8i 2 f0, 1, ..., n ! 1g)
Binomial Tree is recombining

=> underlying (and option) can take n + 1 dierent values at maturity
=> "risk-neutral" probability qu,ti = qu is the same in each sub-tree
Recombining Binomial Tree with n Time Steps (II)
Recombining Binomial Tree with n Time Steps (III)
Given the possible realizations of the underlying at maturity, we can

calculate the possible realizations of the option at maturity,
Otn = f (Stn )
r (t i +1 !t i ) r (t i +1 !t i )
qu = e u !d !d and qd = 1 ! qu = u !e u !d are not state
dependent, i.e. they are the same across all sub-trees
The FTAP tells us that for each sub-tree it holds
/ 0
(fh g) ! r (t i +1 ! t i ) (fh gu ) (fh gd )
Oti =e qu Oti +1 + qd Oti +1
where fhg denes the history of ups and downs since t0
Recombining Binomial Tree with n Time Steps (IV)
(fh gu )
Plugging in the Price of Oti +1 yields
/ / 00
(fh g) ! r (t i +1 ! t i ) ! r (t i +1 ! t i ) (fh guu ) (fh gud )
Oti = e qu e qu Oti +2 + qd Oti +2
/ 0
! r (t i +1 ! t i ) ! r (t i +1 ! t i ) (fh gdu ) (fh gdd )
+e qd e qu Oti +2 + qd Oti +2
/ 0
! r (t i +2 ! t i ) (fh guu ) (fh gud ) (fh gdd )
= e qu2 Oti +2 + 2qu qd Oti +2 + qd2 Oti +2
Recombining Binomial Tree with n Time Steps (V)
Re-iterating yields
n $ % / 0
n
Ot0 = e !r (t n !t 0 )
k
quk qdn !k f k
u d n !k
St 0
k =0
$ %
n n!
with = k ! (n !k ) !
, k denotes the number of ups since t0
k
Example of European Call Option (I)

(u = 1.1) or decrease by 5% (d = 0.95)
What is the price of a European call option with a strike price
(uu )
O0.17 = max f0, 121 ! 105g = 16,
(ud ) (du )
O0.17 = O0.17 = max f0, 104.5 ! 105g = 0,
(dd )
O0.17 = max f0, 90.25 ! 105g = 0
Example of European Call Option (II)
Example of European Call Option (III)
From the denition of the stock price

1
100 = e !0.02 " 12 [110qu + 95 (1 ! qu )], we can calculate the "risk
neutral" probability of an increase in the stock price from one month
to another 1
e 0.02 " 12 ! 0.95
qu = = 0.34445
1.1 ! 0.95
(u ) 1
O0.08 = e !0.02 " 12 [16 " 0.34445 + 0 " (1 ! 0.34445)] = 5.5021
(d ) 1
O0.08 = e !0.02 " 12 [0 " 0.34445 + 0 " (1 ! 0.34445)] = 0
1
O0 = e !0.02 " 12 [5.5021 " 0.34445 + 0 " (1 ! 0.34445)] = 1.8921
Example of European Put Option (I)

(u = 1.1) or decrease by 5% (d = 0.95)
What is the price of a European put option with a strike price
(uu )
O0.17 = max f0, 105 ! 121g = 0,
(ud ) (du )
O0.17 = O0.17 = max f0, 10.5 ! 104.5g = 0.5,
(dd )
O0.17 = max f0, 105 ! 90.25g = 14.75
Example of European Put Option (II)
Example of European Put Option (III)

1
100 = e !0.02 " 12 [110qu + 95 (1 ! qu )], we can calculate the "risk
to another 1
e 0.02 " 12 ! 0.95
qu = = 0.34445
1.1 ! 0.95
(u ) 1
O0.08 = e !0.02 " 12 [0 " 0.34445 + 0.5 " (1 ! 0.34445)] = 0.32723
(d ) 1
O0.08 = e !0.02 " 12 [0.5 " 0.34445 + 14.75 " (1 ! 0.34445)] = 9.8252
1
O0 = e !0.02 " 12 [0.32723 " 0.34445 + 9.8252 " (1 ! 0.34445)]
= 6.5427
Example of European Call with Dividends (I)

(u = 1.15) or decrease by 10% (d = 0.9)
What is the price of an at-the-money European call option with 6
months to maturity?
(uu )
O0.5 = max f0, 100 ! 120.75g = 20.75,
(ud ) (du )
O0.5 = max f0, 100 ! 94.5g = 0, O0.5 = max f0, 100 ! 92g = 0,
(dd )
O0.5 = max f0, 100 ! 72g = 0
Example of European Call with Dividends (II)
Example of European Call with Dividends (III)

100 = e !0.05 "0.25 [115qu + 90 (1 ! qu )], we can calculate the "risk
to another
e 0.05 "0.25 ! 0.9
qu = = 0.45031
1.15 ! 0.9
(u )
O0.25 = e !0.05 "0.25 [20.75 " 0.45031 + 0 " (1 ! 0.45031)] = 9.2279
(d )
O0.25 = e !0.05 "0.25 [0 " 0.45031 + 0 " (1 ! 0.45031)] = 0
O0 = e !0.05 "0.25 (9.2279 " 0.45031 + 0 " (1 ! 0.45031)) = 4.1038
Example of European Put with Dividends (I)

(u = 1.15) or decrease by 10% (d = 0.9)
What is the price of an at-the-money European put option with 6
months to maturity?
(uu )
O0.5 = max f0, 100 ! 120.75g = 0,
(ud ) (du )
O0.5 = max f0, 100 ! 94.5g = 5.5, O0.5 = max f0, 100 ! 92g = 8,
(dd )
O0.5 = max f0, 100 ! 72g = 28
Example of European Put with Dividends (II)
Example of European Put with Dividends (III)

100 = e !0.05 "0.25 [115qu + 90 (1 ! qu )], we can calculate the "risk
to another
e 0.05 "0.25 ! 0.9
qu = = 0.45031
1.15 ! 0.9
(u )
O0.25 = e !0.05 "0.25 [0 " 0.45031 + 5.5 " (1 ! 0.45031)] = 2.9857
(d )
O0.25 = e !0.05 "0.25 [8 " 0.45031 + 28 " (1 ! 0.45031)] = 18. 758
O0 = e !0.05 "0.25 [2.9857 " 0.45031 + 18. 758 " (1 ! 0.45031)]
= 11.511
Chapter 7: Continuous Time

Limit: Black-Scholes
Recombining Binomial Tree with n Time Steps
n time steps f0, 1, 2, ..., ng

From ti to tii +1 (8i 2 f0, 1, ..., n ! 1g) underlying either increases by
factor u or d (< u ) > dispersion (volatility) of underlying is
constant over time
Risk free interest rate is constant over time, Bti +1 = Bti e r (ti +1 !ti )
(8i 2 f0, 1, ..., n ! 1g); yield curve is at
Other implicit assumptions:
No short selling constraints
No transactions costs or taxes
Perfectly divisible securities
Continuous security trading
No arbitrage opportunities
No dividends during the life of the derivative (can be relaxed without
problems)
Chapter 7: Continuous Time Limit: Black-Scholes European Call Option
European Call Option: n Time Steps (I)
A call option with strike price K and maturity date T = tn has at time
t = t0 a price
n $ % n o
n
Ct = e !r (T !t )
k u d q k n !k
q max 0, u k n !k
d S t ! K
k =0
n $ % / 0
n
= e !r (T !t )
k qu qd u d St ! K
k n !k k n !k
k =k
$ %
n
with = k !(nn!!k )! ,
k
k denotes the number Dof ups since t, E
k = arg mink 2f0,1,...,n g u k d n !k St ! K - 0 ,
e r (t i +1 !t i ) ! d T !t
qu = u !d , ti +1 ! ti = n , qd = 1 ! qu
European Call Option: n Time Steps (II)
qu u qd d
Let qu" = r (t i +1 !t i )
and qd" = r (t i +1 !t i )
e e
6 5
Sti = e !r (ti +1 !ti ) E Q Sti +1 = e !r (ti +1 !ti ) (qu uSti + qd dSti ) implies
that qu" + qd" = 1
qu" 2 (0, 1), qd" 2 (0, 1)
qu" , qd" have properties of probabilities
The call option price can be written as

n $ % n $ %
n n
Ct = St (qu" )k (qd" )n !k ! e !r (T !t ) K quk qdn !k
k =k
k k =k
k
"
= St Pr Q fST - K g ! e !r (T !t ) K Pr Q fST - K g
European Call Option: n > Innity (I)
In the data we observe stock prices Sti

We usually assume that returns are log-normally distributed,
$ % $ %
ST 1 2 p
ln = ! s (T ! t ) + zs T ! t
St 2
ST p
( ! 12 s2 )(T !t )+z s T !t
= e
St
z / N (0, 1)
h i h / 0i - .
ST
P
this implies Et St = e ( T ! t ) , Et ln SSTt
P = ! 12 s2 (T ! t ),
h / 0i
Var ln SSTt = s2 (T ! t ) (under the probability measure in the
real world)
European Call Option: n > Innity (II)

De Moivre-Laplace central limit theorem states that the binomial
distribution is approximately a normal distribution if n is large
$ % ( k !E Q
"
[k ] )
2
n 1 !
(qu" )k (qd" )n !k
"
' p e 2Var Q [k ]
k for large n 2pVar Q [k ]
"
Accordingly (under probability measure Q " ),

" 2
Z ( k !E Q [k ] )
" 1 ! "
lim Pr Q fST - K g = lim p e 2Var Q [k ] dk
n ! n ! k "
2pVar Q [k ]
Z
1 z2
= lim k !E Q " [k ] p e ! 2 dz
n ! p 2p
Q" Var [k ]
"
k !E Q
Z !p [k ]
" 1 z2
= lim Var Q [k ]
p e ! 2 dz
n ! ! 2p
European Call Option: n > Innity (III)
"
k !E Q
Z !p [k ]
Q" 1 z2 "
lim Pr f ST - K g = lim p e ! 2 dz
Var Q [k ]
n ! n ! ! 2p
"
!
k ! E Q [k ]
= F !p "
Var Q [k ]
where F (.) is the cumulative distribution function of a standard normal

distribution
"
To solve this integral (or F (.)) we have to gure out what k, E Q [k ]
"
and Var Q [k ] are (latter two are expectation and variance of how
many up moves there are in our tree under the probability measure
Q ")
European Call Option: n > Innity (IV)
Consider a path the stock price could take until maturity in a

binomial tree with 5 time steps, e.g. (d, u, u, d, d )
(duudd )
Stock price at maturity
$ (duuddwould
% then be ST = u 2 d 3 St , and the
)
S
(c.c.) return is ln T St = 2 ln (u ) + 3 ln (d )
In general with n time steps and k up moves

$ %
ST
ln = k ln (u ) + (n ! k ) ln (d )
St
/u0
= k ln + n ln (d ) (1)
d
European Call Option: n > Innity (V)
The lower bound of number of up moves can be written as

n o
k = arg min u k d n ! k St ! K - 0
k 2f0,1,...,n g
H /u0 $ %I
K
= arg min k ln + n ln (d ) - ln
k 2f0,1,...,n g d St
8 / 0 9
< ln SKt ! n ln (d ) =
= arg min k- - .
k 2f0,1,...,n g : ln du ;
/ 0
ln SKt ! n ln (d )
= - . +z
ln du
where z < 1 is a number added to make k an integer (note that

limn ! z = 0)
European Call Option: n > Innity (VI)
Taking expectations of equation (1) under the probability measure Q "

gives : $ %;
ST /u0
Q" Q"
E ln = E [k ] ln + n ln (d )
St d
Taking the variance gives
: $ %; / / u 002
Q " ST Q"
Var ln = Var [k ] ln
St d
Girsanovs Theorem states that the variance of a diusion process is

unchanged as we change the probability measure,
: $ %; : $ %;
Q" ST ST
Var ln = Var ln = s 2 (T ! t )
St St for large n
European Call Option: n > Innity (VII)

"
h / 0i p
S
ST EQ ln ST +z s2 (T !t )
Since =e
St
t (log-normal distribution; z is a
standard normal variable),
: ; Z h / 0i p
Q " St 1 ! z 2 !E Q " ln SSTt !z s2 (T !t )
E = p e 2e dz
ST ! 2p
Z p 2 h / 0i
1 ! (z + s (T !t )) !s (T !t ) !E Q " ln SSTt
2 2
= p e 2 e dz
! 2p
"
h / 0i
S
!E Q ln ST + 12 s2 (T !t )
;% = e
t
$ : : $ %;
" St " ST 1
ln E Q = !E Q ln + s 2 (T ! t )
ST St 2
: $ %; $ : ;%
" ST " St 1
E Q ln = ! ln E Q + s 2 (T ! t )
St ST 2
European Call Option: n > Innity (VIII)

On the other hand we know that
$ : ;% " #!
n
St St
= ! ln E Q i !1
" "
! ln E Q
ST i = 1 St i
n : ;!
St i ! 1
= ! ln E Q
"
i =1 St i
n $ %!
1 1
= ! ln qu" + qd"
i =1 u d
$$ % %
qu u 1 qd d 1 n
= ! ln +
e r (T !t ) n1 u 1
e r (T !t ) n d
/ 1
0
= !n ln e !r (T !t ) n = r (T ! t )
S t i !1
line 1 to line 2 holds because S ti are i.i.d.
European Call Option: n > Innity (IX)
Combining the previous equations,

"
lim Pr Q fST - K g
n !
"
!
k ! E Q [k ]
= lim F ! p
n ! "
Var Q [k ]
0 h / 0i
1
" S
K E Q ln ST !n ln (d )
B ln ( St )!un ln (d ) + z ! t C
B ln ( d ) ln ( du ) C
= lim F B
B ! r h / 0i
C
C
n ! S
@ "
Var Q ln S T
t
A
ln ( du )
0 / 0 - . 1
St
ln K + r + 12 s2 (T ! t )
= F@ p A
s 2 (T ! t )
European Call Option: n > Innity (X)
Similar as under Q " , the de Moivre-Laplace central limit theorem

holds under Q
$ % ( k !E Q [k ] )
2
n 1 !
(qu )k (qd )n !k ' p e 2Var Q [k ]
k for large n 2pVar Q [k ]
Accordingly,
!
k ! EQ [k ]
lim Pr Q fST - K g = lim F !p
n ! n ! Var Q [k ]
To solve this integral (F (.)), we need to gure out what E Q [k ] and

Var Q [k ] are (expectation and variance of how many up moves there
are in our tree under the probability measure Q)
European Call Option: n > Innity (XI)
Taking expectations of equation (1) under the probability measure Q

gives : $ %;
ST /u0
Q Q
E ln = E [k ] ln + n ln (d )
St d
Taking the variance gives
: $ %; / / u 002
Q ST Q
Var ln = Var [k ] ln
St d
again Girsanovs Theorem states that the variance of a diusion

process is unchanged as we change the probability measure,
: $ %; : $ %;
S T ST
Var Q ln = Var ln = s 2 (T ! t )
St St for large n
European Call Option: n > Innity (XII)

h / 0i p
S
ST E Q ln ST +z s2 (T !t )
Since =e
St
t (log-normal distribution; z is a
standard normal variable),
: ; Z h / 0i p
S T 1 z 2 E Q ln
ST
+z s 2 (T !t )
EQ = p e! 2 e St
dz
St ! 2p
Z p 2 h / 0i
1 ! (z ! s (T !t )) !s (T !t ) E Q ln SSTt
2 2
= p e 2 e dz
! 2p
h / 0i
S
E Q ln ST + 12 s2 (T !t )
;% = e : $ %;
t
$ :
ST ST 1 2
ln E Q = E Q ln + s (T ! t )
St St 2
: $ %; $ : ;%
Q ST Q ST 1 2
E ln = ln E ! s (T ! t )
St St 2
European Call Option: n > Innity (XIII)
On the other hand we know that

$ : ;% " #!
n
ST St
ln E Q = ln E Q i
St i = 1 St i ! 1
n : ;!
S
= ln E Q
ti
i =1 St i ! 1
!
n
e r (T !t )
1
= ln n
i =1
/ 0
r (T !t )
= ln e = r (T ! t )
S ti
line 1 to line 2 holds because S t i !1 are i.i.d.
European Call Option: n > Innity (XIV)
Combining the previous equations,

!
[k ] k ! EQ
lim Pr Q fST - K g = lim F !p
n ! n ! Var Q [k ]
0 / 0 - . 1
St 1 2
ln K + r ! 2 s (T ! t )
= F@ p A
s 2 (T ! t )
Black-Scholes Formula for European Call Option (I)
We have recovered the Black-Scholes formula
Ct = St F (d1 ) ! Ke !r (T !t ) F (d2 )
/ 0 - .
ln SKt + r + 12 s2 (T ! t )
d1 = p
s T !t
/ 0 - .
ln SKt + r ! 12 s2 (T ! t )
d2 = p
s T !t
where F (.) is the cumulative distribution function of a standard

normal distribution
Black-Scholes Formula for European Call Option (II)

Rd ! z2
2
F (d ) = p1
! 2p e dz, F (!d ) = 1 ! F (d )
Intuition of Black-Scholes Formula (I)
Intuition for Ct = St F (d1 ) ! Ke !r (T !t ) F (d2 ):
St : present value of underlying which long position will receive at

maturity if he chooses to exercise the call
Ke !r (T !t ) : present value of strike price which long position has to pay
at maturity if he chooses to exercise the call
F (d1 ) , F (d2 ): probability of call option ending up in the money at
maturity
Intuition of Black-Scholes Formula (II)

Intuition for F (d2 ), probability of call ending up in the money:
/ 0 - . p
Under Q we have ln SSTt = r ! 12 s2 (T ! t ) + zs T ! t with
z / N (0, 1), (FTAP holds, St = e !r (T !t ) EtQ [ST ]); it follows,
n p o
Q Q ( r ! 12 s2 )(T !t )+z s T !t
Pr fST > K g = Pr St e >K
( p ! )
( r ! 12 s2 )(T !t )+z s T !t
St e
= Pr Q ln >0
K
8 / 0 - . 9
< ln SKt + r ! 12 s2 (T ! t ) =
= Pr Q z>! p
: s T !t ;
8 / 0 - . 9
< ln SKt + r ! 12 s2 (T ! t ) =
= Pr Q z< p = F (d2 )
: s T !t ;
Black-Scholes Formula for European Put Option
Put-Call parity gives us the Black-Scholes formula for put option
Pt = Ct ! St + Ke !r (T !t )
= St [F (d1 ) ! 1] ! Ke !r (T !t ) [F (d2 ) ! 1]
= Ke !r (T !t ) [1 ! F (d2 )] ! St [1 ! F (d1 )]
= Ke !r (T !t ) F (!d2 ) ! St F (!d1 )
/ 0 - .
ln SKt + r + 12 s2 (T ! t )
d1 = p
s T !t
/ 0 - .
ln SKt + r ! 12 s2 (T ! t )
d2 = p
s T !t
Intuition of BS Formula for European Put Option
Intuition for Pt = Ke !r (T !t ) F (!d2 ) ! St F (!d1 ):
St : present value of underlying which long position has to deliver at

maturity if he chooses to exercise the put
Ke !r (T !t ) : present value of strike price which long position will
receive at maturity if he chooses to exercise the put
F (!d1 ) , F (!d2 ): probability of put option ending up in the money
at maturity
Example (I)
The current stock price is St = 100

- .
The annualized expected stock return (c.c.) is ! 12 s2 = 10%
The annual stock price volatility is s = 25% (and s2 = 6.25%)
The constant short rate is r = 1%
Example (II)
What is the price of a 6-month European call option with strike price
K = 102?
- 100 . / 1 2
0
ln 102 + 0.01 + 2 (0.25) " 0.5
d1 = p = 0.004652
0.25 0.5
p
d2 = d1 ! 0.25 0.5 = !0.17212
Ct = 100F (d1 ) ! 102e !0.01 "0.5 F (d2 )
Z 0.004652
1 z2
= 100 p e ! 2 dz
! 2p
Z !0.17212
1 z2
!102e !0.01 "0.5 p e ! 2 dz
! 2p
= 6.3747
Example (III)
The table tells us that the probability of a standard normally

distributed variable being smaller than 0.004652 is roughly 0.502
Similar, the probability that a standard normally distributed variable is
smaller than !0.17212 is the same as the probability of 1 minus the
probability of the variable being smaller than 0.17212 which is roughly
1 ! 0.5675 = 0.4325
Therefore, the call price is
Ct = 100 " 0.502 ! 102e !0.01 "0.5 " 0.4325

= 6.305
The dierence is due to rounding errors!
Construction of a Binomial Tree (I)
If hwe /
observe
0i the- true moments of an underlying
h / 0i
.
E ln SSTt = ! 12 s2 (T ! t ) and Var ln SSTt = s 2 (T ! t )
(under the real world probability measure), we would like to nd
appropriate values for u and d to create a binomial tree
Under the real probability measure we want to match the moments
observed in the real world with the moments in our binomial tree
: $ %; /u0 /u0
ST
E ln = E [k ] ln + n ln (d ) = np ln + n ln (d )
St d d
: $ %; / / u 002 / / u 002
ST
Var ln = Var [k ] ln = np (1 ! p ) ln
St d d
where p is the true probability of an increase in the price of the

underlying in our tree
Construction of a Binomial Tree (II)
One possibility is
1 p T !tp
s !s T n!t
u = e , d = =e n
u
r
1 2
1 1 ! 2s T !t
p = +
2 2 s n
To verify, plugging into the equations on the previous slide
: $ %; $ %
ST 1 2
E ln = ! s (T ! t )
St 2
: $ %;
ST
lim Var ln = s 2 (T ! t )
n ! St
The chosen values for u, d and p are suitable as long as the tree is
large enough (n ! )
Construction of a Binomial Tree (III)

h / 0i
It is a fact that E ln SSTt is hard to estimate from the data (large
estimation errors) > p in our tree is hard to pin down
h / 0i
We are able to estimate Var ln SSTt with reasonably small errors
from the data > we can pin down u and d
To compute an option price from a binomial tree we only need
knowledge about the factors u and d, and we do not need to know p
h / 0i
That is, we only need a good estimate of Var ln SSTt (we do not
h / 0i
need to know E ln SSTt ) to construct a binomial tree and compute
option prices and that is exactly what we have from the data!
h / 0i
Indeed, the Black-Scholes formula only depends on Var ln SSTt
h / 0i
and not on E ln SSTt
Example (I)
The current stock price is St = 100

- .
The annualized expected stock return (c.c.) is ! 12 s2 = 10%
The annual stock price volatility is s = 25% (and s2 = 6.25%)
The constant short rate is r = 1%
Example (II)
How would you construct a Binomial Tree with n time steps to

compute the price of a 6-month European call option with strike price
K = 102?
p 0.5
We choose the factors u = e 0.25 n (gross stock return over one time
step or n6 months conditional that the stock price increases) and d = u1
(gross stock return over one time step or 6 months conditional that
n
the stock price decreases)
0.01 " 0.5
The risk neutral probability of an increase in the tree is q = e u !nd !d
q
The true probability of an increase (p = 2 + 2 0.25 0.5
1 1 0.1
n ) in the tree is
irrelevant
Example (III)
What is the call price in the tree for n = 1? How about if n is 2, 5,
10, 100, 250?
For any n we solve
p 0.5 1
0.5
e 0.01 " n ! d
0.25
u = e n , d= , q=
u u!d
!
n k
n!q (1 ! q ) n !k n o
C = e !0.01 "0.5
k! (n ! k )!
max 100u k d n !k ! 102, 0
k =0
n = 1: u = 1.1934, d = 0.8380, q = 0.47002, and Ct = 8.1079

n = 2: u = 1.1331, d = 0.8825, q = 0.47878, and Ct = 6.0220
n = 5: u = 1.0823, d = 0.9240, q = 0.48657, and Ct = 6.6884
n = 10: u = 1.0575, d = 0.9456, q = 0.49050, and Ct = 6.4005
n = 100: u = 1.0178, d = 0.9825, q = 0.49699, and Ct = 6.3919
n = 250: u = 1.0112, d = 0.9889, q = 0.49810, and Ct = 6.3735
For large n the price is close to the BS price = 6.3747
5/29/2015 The rotten heart of finance | The Economist
MorefromTheEconomist MySubscription Subscribe Loginorregister
Worldpolitics Business&finance Economics Science&technology Culture Blogs Debate Multimedia Printedition
TheLIBORscandal Comment(140) Timekeeperreadinglist
The rotten heart of finance Email Reprints&permissions
Print
Ascandaloverkeyinterestratesisabouttogoglobal
Jul7th2012| Fromtheprintedition Like 4.5k Tweet 1,369 Advertisement
Follow TheEconomist
NextinBriefing
TheturmoilatBarclays
Firstmoverdisadvantage
THEmostmemorableincidentsinearthchangingeventsaresometimesthemostbanal.
BobDiamond,Barclaysandregulatorsareallbattlingtosavetheir
IntherapidlyspreadingscandalofLIBOR(theLondoninterbankofferedrate)itisthe reputations
veryeverydaynesswithwhichbanktraderssetaboutmanipulatingthemostimportant
figureinfinance.Theyjoked,orofferedsmallfavours.Coffeeswillbecomingyourway, Latest updates
promisedonetraderinexchangeforafiddlednumber.Dude.Ioweyoubigtime!I'm FromtheprinteditionJul7th2012
openingabottleofBollinger,wroteanother.Onetraderposteddiarynotestohimselfso May30thedition,2015:Pickofourweek,
thathewouldn'tforgettofiddlethenumbersthenextweek.AskforHigh6MFix,he inaudio
enteredinhiscalendar,ashemighthaveputBuymilk. International|2hours20minsago
WhatmaystillseemtomanytobeaparochialaffairinvolvingBarclays,a300yearold TheEconomistexplains:WhytheUnited
Britishbank,rigginganobscurenumber,isbeginningtoassumeglobalsignificance.The StatesandCubaarecosyingup
numberthatthetradersweretoyingwithdeterminesthepricesthatpeopleand TheEconomistexplains|May29th,18:10
corporationsaroundtheworldpayforloansorreceivefortheirsavings.Itisusedasa
benchmarktosetpaymentsonabout$800trillionworthoffinancialinstruments,ranging SylvieGuillem:Herfinalsteps
Prospero|May29th,16:45
fromcomplexinterestratederivativestosimplemortgages.Thenumberdeterminesthe
http://www.economist.com/node/21558281 1/7
globalflowofbillionsofdollarseachyear.Yetitturnsouttohavebeenflawed.
Dailychart:SilkRoadsuccessors
Overthepastweekdamningevidencehasemerged,in Inthissection Graphicdetail|May29th,16:19
documentsdetailingasettlementbetweenBarclaysand
Therottenheartoffinance
regulatorsinAmericaandBritain,thatemployeesatthe
Firstmoverdisadvantage TheAmericaneconomy:Uhoh
bankandatseveralotherunnamedbankstriedtorigthe
Freeexchange|May29th,13:04
numbertimeandagainoveraperiodofatleastfiveyears. Reprints
Andworseislikelytoemerge.Investigationsbyregulatorsin
severalcountries,includingCanada,America,Japan,the
TheAfricanDevelopmentBank:Adesina
EU,SwitzerlandandBritain,arelookingintoallegationsthatLIBORandsimilarrates getsit
wereriggedbylargenumbersofbanks.Corporationsandlawyers,too,areexamining Freeexchange|May29th,12:05
whethertheycansueBarclaysorotherbanksforharmtheyhavesuffered.Thatcould
costthebankingindustrytensofbillionsofdollars.Thisisthebankingindustry'stobacco Johnson:Polyglots:Thehumblelinguist
moment,saysthechiefexecutiveofamultinationalbank,referringtothelawsuitsand Prospero|May29th,10:27
settlementsthatcostAmerica'stobaccoindustrymorethan$200billionin1998.It'sthat
big,hesays.
Morelatestupdates
Asmanyas20bigbankshavebeennamedinvariousinvestigationsorlawsuitsalleging
thatLIBORwasrigged.Thescandalalsocorrodesfurtherwhatlittleremainsofpublic
trustinbanksandthosewhorunthem.
Most commented
LikemanyoftheCity'sways,LIBORissomethingofananachronism,athrowbacktoa
timewhenmanybankerswithintheSquareMileknewoneanotherandwhentrustwas
1
Israelsforeign
moreimportantthancontract.ForLIBOR,aborrowingrateissetdailybyapanelof relations
Contramundum
banksfortencurrenciesandfor15maturities.Themostimportantofthese,threemonth
dollarLIBOR,issupposedtoindicatewhatabankwouldpaytoborrowdollarsforthree
monthsfromotherbanksat11amonthedayitisset.Thedollarrateisfixedeachdayby
2 SouthChinaSea:Trynottoblink
takingestimatesfromapanel,currentlycomprising18banks,ofwhattheythinkthey 3 Ukraine:Theotherbattleground
wouldhavetopaytoborrowiftheyneededmoney.Thetopfourandbottomfour 4 Socialchange:Theweakersex
estimatesarethendiscarded,andLIBORistheaverageofthoseleft.Thesubmissionsof 5 Poland'spresidentialelection:Swingingright
alltheparticipantsarepublished,alongwitheachday'sLIBORfix.
Advertisement
Intheory,LIBORissupposedtobeaprettyhonestnumberbecauseitisassumed,fora
start,thatbanksplaybytherulesandgivetruthfulestimates.Themarketisalso
sufficientlysmallthatmostbanksarepresumedtoknowwhattheothersaredoing.In
reality,thesystemisrotten.First,itisbasedonbanks'estimates,ratherthantheactual
pricesatwhichbankshavelenttoorborrowedfromoneanother.Thereisnoreporting
oftransactions,noonereallyknowswhat'sgoingoninthemarket,saysaformersenior
tradercloselyinvolvedinsettingLIBORatalargebank.Youhavethisvastoverhangof
financialinstrumentsthathangtheirownfixesoffaratethatdoesn'tactuallyexist.
Asecondproblemisthatthoseinvolvedinsettingtherateshaveoftenhadevery
incentivetolie,sincetheirbanksstoodtoprofitorlosemoneydependingonthelevelat
whichLIBORwasseteachday.Worsestill,transparencyinthemechanismofsetting
ratesmaywellhaveexacerbatedthetendencytolie,ratherthansuppressedit.Banks
thatwereweakwouldnothavewantedtosignalthatfactwidelyinmarketsbysubmitting
honestestimatesofthehighpricetheywouldhavetopaytoborrow,iftheycouldborrow Products and events
atall.
HaveyoulistenedtoTheEconomistRadioon
InthecaseofBarclays,twoverydifferentsortsofratefiddlinghaveemerged.Thefirst Facebook?
sort,andtheonethathasraisedthemostire,involvedgroupsofderivativestradersat TheEconomistRadioisanondemandsocial
BarclaysandseveralotherunnamedbankstryingtoinfluencethefinalLIBORfixingto listeningplatformthatallowsyoutolisten,shareand
increaseprofits(orreducelosses)ontheirderivativeexposures.Thesumsinvolved recommendTheEconomistaudiocontent
mighthavebeenhuge.Barclayswasaleadingtraderofthesesortsofderivatives,and
TestyourEQ
evenrelativelysmallmovesinthefinalvalueofLIBORcouldhaveresultedindailyprofits
Takeourweeklynewsquiztostayontopofthe
orlossesworthmillionsofdollars.In2007,forinstance,theloss(orgain)thatBarclays
headlines
stoodtomakefromnormalmovesininterestratesoveranygivendaywas20m($40m
atthetime).InsettlementswiththeFinancialServicesAuthority(FSA)inBritainand
WantmorefromTheEconomist?
America'sDepartmentofJustice,Barclaysacceptedthatitstradershadmanipulated VisitTheEconomistestoreandyoullfindarangeof
ratesonhundredsofoccasions.Risibly,BobDiamond,itschiefexecutive,whoresigned carefullyselectedproductsforbusinessand
onJuly3rdasaresultofthescandal(seearticle),retortedinamemotostaffthatonthe pleasure,Economistbooksanddiaries,andmuch
majorityofdays,norequestsweremadeatalltomanipulatetherate.Thiswasrather more
likeanadulterersayingthathewasfaithfulonmostdays.
Barclayshastrieditsbesttopresenttheseincidentsastheactionsofafewrogue
Franchises 2.7% FIXED
traders.YetthebrazennesswithwhichemployeesonvariousBarclaystradingfloors
colluded,bothwithoneanotherandwithtradersfromotherbanks,suggeststhatthissort
under Mortgage
ofbehaviourwas,ifnotwidespread,atleastwidelytolerated.Tradershappilyputin $10,000 Rate
writingrequeststhatwereeitherillegalor,attheveryleast,morallyquestionable.Inone franchise.franchisegato mortgagerates.freerateu
instanceatraderwouldregularlyshoutouttocolleaguesthathewastryingtomanipulate
Franchises for less Low 15-Yr, 30-Yr Rates,
theratetoaparticularlevel,tocheckwhethertheyhadanyconflictingrequests. than $10K. 100's of 3.3 APR*. Calculate
low cost franchises. New Rate/Payment 30
TheFSAhasidentifiedpriceriggingdatingbackto2005,yetsomecurrentandformer Secs!
traderssaythatproblemsgobackmuchfurtherthanthat.Fifteenyearsagotheword
wasthatLIBORwasbeingrigged,saysoneindustryveterancloselyinvolvedinthe
LIBORprocess.Itwasoneofthosewellkeptsecrets,buttheregulatorwasasleep,the
BankofEnglanddidn'tcareand[thebanksparticipatingwere]happywiththereference Advertisement
prices.Saysanother:Goingbacktothelate1980s,whenIwasatrader,yousawsome
prettyoddfixingsWithtraders,ifyoudon'tactuallynailitdown,they'llstealit.
Gallingastherevelationsareoftraderstryingtomanipulateratesforpersonalgain,the
actualharmdonewouldprobablyhavepaledincomparisonwiththesubsequent
misconductofthebanks.Tradersactingatonebank,orevenwiththeclubbyco
operationofcounterpartsatrivalbanks,wouldhavebeenabletomovethefinalLIBOR
ratebyonlyoneortwohundredthsofapercentagepoint(oronetotwobasispoints).For
thedecadeorsobeforethefinancialcrisisin2007,LIBORtradedinarelativelytight
bandwithalternativemarketmeasuresoffundingcosts.Moreover,thiswasaperiodin
whichbanksandtheglobaleconomywereawashwithmoney,andborrowingcostsfor
banksandcompanieswerelow.
Cleaninprinciple
YetasecondsortofLIBORrigginghasalsoemergedintheBarclayssettlement.
Barclaysand,apparently,manyotherbankssubmitteddishonestlylowestimatesofbank
borrowingcostsoveratleasttwoyears,includingduringthedepthsofthefinancialcrisis.
Intermsofthescaleofmanipulation,thisappearstohavebeenfarmoreegregiousat
leastintermsofthenumbers.AlmostallthebanksintheLIBORpanelsweresubmitting
ratesthatmayhavebeen3040basispointstoolowonaverage.Thatcouldcreatethe
biggestliabilitiesforthebanksinvolved(althoughthereisalsoatwistinthispartofthe
storyinvolvingtheregulators).
Asthefinancialcrisisbeganinthemiddleof2007,creditmarketsforbanksstartedto
freezeup.Banksbegantosufferlossesontheirholdingsoftoxicsecuritiesrelatingto
Americansubprimemortgages.Withunexplodedbombslitteringthebankingsystem,
bankswerereluctanttolendtooneanother,leadingtoshortagesoffundingsystemwide.
Thisonlyintensifiedinlate2007whenNorthernRock,aBritishmortgagelender,
experiencedabankrunthatstartedinthemoneymarkets.Itsoonhadtobetakenover
bythestate.Inthesefebrilemarketconditions,withalmostnointerbanklendingtaking
place,therewerelittlerealdatatouseasabasiswhensubmittingLIBOR.Barclays
maintainsthatittriedtoposthonestassessmentsinitsLIBORsubmissions,butfound
thatitwasconstantlyabovethesubmissionsofrivalbanks,includingsomethatwere
unmistakablyweaker.
Atthetime,questionswereaskedaboutthefinancialhealthofBarclaysbecauseits
LIBORsubmissionswerehigher.Backthen,Barclaysinsiderssaidtheywereposting
numbersthatwerehonestwhileotherswerefiddlingtheirs,citingexamplesofbanksthat
weretryingtogetfundinginmoneymarketsatratesthatwere30basispointshigherthan
thosetheyweresubmittingforLIBOR.
Thisversionofeventshasturnedouttobeonlypartlytrue.Initssettlementwith
regulators,BarclaysowneduptomassagingdownitsownLIBORsubmissionssothat
theyweremoreorlessinlinewiththoseoftheirrivals.Itinstructeditsmoneymarkets
teamtosubmitnumbersthatwerehighenoughtobeinthetopfour,andthusdiscarded
fromthecalculation,butnotsohighastodrawattentiontothebank(seechart1).I
wouldsortofexpressusmaybeasnotclean,butcleaninprinciple,oneBarclays
managerapparentlysaidinacalltotheFSAatthetime.
ConfoundingtheissueisthequestionofwhetherBarclayshad,orthoughtithad,thetacit
supportofbothitsregulatorandtheBankofEngland(BoE).InnotestakenbyMr
Diamond,thentheheadoftheinvestmentbankingdivisionofBarclays,ofacallwithPaul
Tucker,thenaseniorofficialattheBoE,MrDiamondrecordedwhatwasinterpretedby
someinthebankasanudgeandawinkfromthecentralbanktofudgethenumbers(see
article).ThenextdaytheBarclayssubmissionstoLIBORwerelower.Thiscouldbea
crucialpartofthebank'sdefence.
TheallegationbyBarclaysthatsomebanksseemedtobefiddlingtheirdatawould
appeartobesupportedbythedatathemselves.Overtheperiodofthefinancialcrisis,the
estimatesofitsborrowingcostssubmittedbyBarclaysweregenerallyamongthetopfour
intheLIBORpanel(seechart2).Thoseconsistentlyamongthelowestfourweresomeof
thesoundestbanksintheworld,withrocksolidbalancesheets,suchasJPMorgan
ChaseandHSBC.However,amongbanksregularlysubmittingmuchlowerborrowing
coststhanBarclayswerebanksthatsubsequentlylosttheconfidenceofmarketsandhad
tobebailedout.InBritaintheseincludedRoyalBankofScotland(RBS)andHBOS.
Thetobaccomoment
Regulatorsaroundtheworldhavewokenup,howeverbelatedly,tothepossibilitythat
thesevitalmarketsmayhavebeenriggedbyalargenumberofbanks.Thelistof
institutionsthathavesaidtheyareeithercooperatingwithinvestigationsorbeing
questionedincludesmanyoftheworld's
biggestbanks.Amongthosethathave
disclosedtheirinvolvementareCitigroup,
DeutscheBank,HSBC,JPMorganChase,
RBSandUBS.
CourtdocumentsfiledbyCanada's
CompetitionBureauhavealsoaired
allegationsbytradersatoneunnamed
bank,whichhasappliedforimmunity,that
ithadtriedtoinfluencesomeLIBORrates
incooperationwithsomeemployeesof
Citigroup,DeutscheBank,HSBC,ICAP,
JPMorganChaseandRBS.Itisnotclear
whetheremployeesofthesebanksactually
cooperatedor,iftheydid,whetherthey
succeededinmanipulatingrates.
ContinentalEuropeisfocusingoncartel
effectsratherthandiggingintotheinternalcultureofbanks.Separateinvestigations,by
theEuropeanCommissionandtheSwissauthorities,focusonthepossibleeffectsof
interbankratemanipulationonendusers.LastOctoberEuropeanCommissionofficials
raidedtheofficesofbanksandothercompaniesinvolvedintradingderivativesbasedon
EURIBOR(theeurointerbankofferedrate).TheSwisscompetitioncommission
launchedaninvestigationinFebruary,promptedbyanapplicationforleniencybyUBS,
intopossibleadverseeffectsonSwissclientsandcompaniesofallegedmanipulationof
LIBORandTIBOR(theTokyointerbankofferedrate)bythetwoSwissandtenother
internationalbanksandotherfinancialintermediaries.
Theregulatorymachinerywillgrindslowly.Investigatorsareunlikelytoproducenew
evidenceagainstotherbanksforafewmonthsyet.Slowerstillwillbetheprogressofcivil
claims.Actionsrepresentingahugevarietyofplaintiffshavebeenlaunched.Amongthe
claimantsareinvestorsinsavingsratesorbondslinkedtoLIBOR,thosebuying
derivativespricedoffit,andthosewhodealtdirectlywithbanksinvolvedinsetting
LIBOR.
Decidingafigureforthepotentialliabilityfacingbanksistough,partlybecausethecases
willbetestingnewareasofthelawsuchaswhether,forinstance,anAustralianfirmthat
tookoutaninterestrateswapwithalocalbankshouldbeabletosueaBritishor
AmericanbankinvolvedinsettingLIBOR,evenifthefirmhadnodirectdealingswiththe
bank.Theextentofthebanks'liabilitymaywelldependonwhetherregulatorspressthem
topaycompensationor,conversely,offerbankssomeprotectionbecauseofworriesthat
thesumsinvolvedmaybesolargeastoneedyetmorebailouts,accordingtoonesenior
Londonlawyer.
Aparticularworryforbanksisthattheyfaceanasymmetricriskbecausetheystandin
themiddleofmanytransactions.ForeachoftheirclientswhomayhavelostoutifLIBOR
wasmanipulated,anotherwillprobablyhavegained.Yetbankswillbesuedonlybythose
whohavelost,andwillbeunabletoclaimbacktheunjustgainsmadebysomeoftheir
othercustomers.Lawyersactingforcorporationsorotherbankssaytheirclientsarealso
consideringwhethertheycanwalkawayfromcontractswithbankssuchaslongterm
derivativespricedoffLIBOR.
Therevelationsalsoraisedifficultquestionsforregulators.MrTucker'sinvolvementinthe
BarclaysaffairmayharmhisprospectsofbeingappointedgovernoroftheBankof
England,althoughhemaywellhaveabenignexplanationforhiscomments(heisdueto
appearbeforeparliamentsoon).
Anotherissueistheconflictcentralbanksface,intimesofsystemicbankingcrises,
betweenmaintainingfinancialstabilityandallowingmarketstooperatetransparently.
WhethertheBoEinstructedBarclaystoloweritssubmissionsornot,regulatorshada
prettyclearmotiveforwantinglowerLIBOR:Britishbanks,ineffect,werebeingshutout
ofthemarkets.Thetwohardesthitbanks,RBSandHBOS,werebothfartoobigtofail,
andhigherLIBORrateswouldhavemadetheregulators'jobofsupportingthemmore
difficult.
Thishighlightsadeeperquestion:whatistherightlevelofinvolvementininfluencingor
regulatingmarketinterestrates,inacrisis,bythoseresponsibleforfinancialstability?
Centralbanksgetaslewofsensitiveinformationfrombankswhichtheyrightlydonot
wanttomakepublic.Dataondepositoutflowsatbankscouldtriggerunnecessaryruns,
forexample.YetLIBORisameasureofmarketrates,notthosepickedbypolicymakers.
Reformclub
Twobigchangesareneeded.Thefirstistobasetherateonactuallendingdatawhere
possible.Somemarketsarethinlytraded,though,andsosomehypotheticalorexpected
ratesmayneedtobeusedtocreateacompletesetofbenchmarks.Soasecondbig
changeisneeded.BecausebankshaveanincentivetoinfluenceLIBOR,anewsystem
needstoexplicitlypromotetruthtellingandreducethepossibilitiesforcoordinationof
quotes.
Ideasforhowtodothisarestartingtoappear.RosaAbrantesMetzofNYU'sStern
SchoolofBusinesswasoneofagroupofacademicswho,in2009,raisedthealarmthat
somethingfishywasgoingonwithLIBOR.Onesimplechange,sheproposes,wouldbe
significantlytoraisethenumberofbanksinthepanel.Thetheoreticalchangesneededto
repairLIBORarenotdifficult,buttherearepracticalchallengestoreform.Thethousands
ofcontractsthatuseitasapointofreferencemayneedtobechanged.Moreover,the
realobstacletochangeisnotalackofgoodideas,butalackofwillbythebanks
involvedtooverturnasystemthathasservedmostofthemratherwell.Withlawsuitsand
prosecutionsgatheringpace,thoseinvolvedinsettingthekeyrateinfinanceneedtoget
moving.AddingacalendarnotetoFixLIBORjustwon'tdo.
Fromtheprintedition:Briefing
Like 4.5k Tweet 1,369 Share 412 435
Viewallcomments(140)
MorefromTheEconomist
TheMiddleEast:ThetragedyoftheArabs
Islamandalcohol:Tipsytaboo
Theageofconsent:Howyoungistooyoung?
TheMiddleEast:Thetragedyofthe
Arabs
Islamandalcohol:Tipsytaboo
3/31/2016 Libor scandal: Former City trader Tom Hayes gets 14 years for rigging rates - Telegraph
Libor scandal: Former City trader Tom Hayes gets 14 years for rigging rates
The former banker becomes first person to be convicted by a British jury of rigging Libor rates
TraderTomHayes,foreground,arriveswithhiswifeSarah,atSouthwarkCrownCourt,inLondon,Wednesday,May27,2015Photo: AP
MarionDakers,TimWallaceandagencies
3:30PMBST03Aug2015
TomHayes,a35yearoldtrader,hasbeensentencedto14yearsinprisonafterbecomingthefirstpersontobeconvictedbyaBritishjuryofriggingLiborrates
followingatrialatLondon'sSouthwarkCrownCourt.
ThejuryunanimouslyfoundHayesguiltyofeightcountsofconspiracytodefraud,afteraweekofdeliberationsattheendofatwomonthtrial.
TheSeriousFraudOfficearguedthatHayeswasatthecentreofanetworkoftradersat10firmsthatconspiredtomanipulatetheLiborbenchmarkbetween
2006and2010.Sincethescandalwasuncovered,morethanhalfadozenbankshavepaidbillionsofpoundsinfinesandseveralhavefiredtheirchief
executives.
Duringthehearings,HayesclaimedthatheonlyadmitteddishonestyduringinterviewswiththeSeriousFraudOfficein2012toavoidextraditiontotheUnited
States.HereversedhispositionandpleadednotguiltytoeightcountsofconspiracytodefraudinDecember2013.
MrJusticeCooketoldLondon'sSouthwarkCrownCourtthatthesentencewasintendedtosendamessagetotherestofthebankingworld.
"YouplayedaleadingroleinthemanipulationofLibor.Youexertedpressureonothers,essentiallytrainedthosejuniortoyouintheactivity,madecorrupt
paymentstobrokersfortheirassistance,"saidthejudge.
"Theconductinvolvedhereistobemarkedoutasdishonestandwrong,andamessagesenttotheworldofbankingaccordingly.ThereputationofLiboris
importanttotheCity,asafinancialsector,andthebankinginstitutionsofthisCity.Probityandhonestyisessential,asistrust."
"TheLiboractivity,inwhichyouplayedaleadingrole,putallthatinjeopardy,"hesaid.
Lawyersexpectthecourttomoveontoseizinganyproceedsofcrime,followingtheverdict.Inaprocesswhichtypicallytakesseveralweeks,theprosecution
anddefencewilleachpresentevidenceofanyincomeearnedthroughthefraudulentactivityandwhatithasbeenspenton.Theywillthenlookathowmuch
couldpotentiallyberecoupedbythecourt,beforethejudgerulesonhowmuchshouldbeclaimedfromHayes.
HecouldalsobeextraditedtotheUS,aneventualityHayeshadtriedtoavoidbyinitiallyadmittingtotheoffencestotheUKauthorities,beforechanginghis
argumentslaterinthecasetopleadnotguilty.
Hayes,aformerderivativesbrokeratCitigroupandUBSwhodidnotdirectlymakeLiborsubmissions,isthefirstpersontofaceacriminaltrialfollowinga
globalinvestigationintothekeybenchmark.
ThecourtwasplayedphonecallsbyHayesaskingassociatesatotherbankstopasshisrequestsontoLiborsubmitters."Mate,canyoudomeabigfavourand
askhimifhewillsetthreemonthLiboronthelowsideinthenextfewdays,"hesaid.
DuringhisfouryearsatUBS,TokyobasedHayesmadethebankalmost200mandwaspaid1.3mintotal.HejoinedCitigroupin2009,whereheearned
http://www.telegraph.co.uk/nance/nancial-crime/11767437/Libor-trial-Tom-Hayes-found-guilty-of-rigging-rates.html 1/5
3.5minninemonthsbeforehewassackedwhenhismethodswerediscovered.Thecourtheardthatheofferedcurry,tripstofootballmatchesandmoneyin
exchangeforfavourableLiborsubmissions.
Hayes,whowasdiagnosedwithmildAspergersyndromeshortlybeforethetrial,saidwhilegivingevidencethat"everythingIdidwaswithcomplete
transparency.EverythingIdidmymanagersknewabout...sometimesgoingupallthewaytotheCEO."
ProsecutorMukulChawlaQCsaid:"MrHayes'sdesirewastoearnandmakeasmuchmoneyashecould.Hewastheringmasterattheverycentre,telling
othersaroundhimwhattodoandinanumberofcasesrewardingthemfortheirdishonestassistance."
TomHayesLibortrial:thetopquotes
HisconvictioncomesafteraseniorbankerpleadedguiltyinOctobertoraterigging,thoughneitherhenorthebankheworkedforcanbenamedforlegal
reasons.
TheconvictionisamajorvictoryfortheSeriousFraudOffice,whichhadaskedtheTreasuryformorefundstopursuethelandmarkinvestigationintoLibor
manipulation.
"ThisisaverypositiveresultfortheSFO,whichputalotofworkintothecaseandstakedalotofcredibilityonbringingthistotrial,"saidMichaelRuckfrom
lawfirmPinsentMasons,addingitwillgivetheSFOmoreconfidencetopursueothercasesofsuspectedbenchmarkabuse.
TheLondoninterbankofferedrateisusedtocalculateintereston$450trillionworthoffinancialproductsandcontracts.Apanelof16bankssubmittherateof
interesttheythoughttheywouldhavetopaytoborrowfromanotherinstitution,withanaverageratecalculateddaily.
Barclaysbecamethefirstbanktobefinedforitsroleinthescandal,paying290min2012,andaltogethermorethanhalfadozeninstitutionshavenowpaid
4bninpenalties.
TheFinancialConductAuthorityrecentlywarnedthatbanksandbenchmarkoperatorscontinuetostrugglewithpolicingratesetting,runningtheriskof
anotherscandalintheLibormould.
Timeline of the Libor scandal
1986
The British Bankers Association compiles the rst London Interbank Oer Rate in three currencies at the height of the nancial Big Bang
2005
Thomson Reuters takes over as distributor of the daily rates, replacing Telerate
2006
According to the FSA, traders were trading favours in exchange for their Libor submitters declaring false rates. Dude. I owe you big time! Come over one
day after work and Im opening a bottle of Bollinger, said one, according to a transcript from October 2006.
2007
Barclays raises the alarm to US regulators that other banks are submitting articially low rates.
2008
During the nancial crisis, banks shied away from lending to one another, and Libor shot up. Barclays has claimed that during this time, the Bank of
England encouraged it to submit lower rates and avoid further strain on the nancial system.
2009
The BBA sends out guidelines to banks on how to submit the rate in future, following discussions with the US and UK authorities.
2010
Prompted by US authorities eorts, the Financial Services Authority formally starts investigating Libor.
June 2012
Barclays is the rst bank to agree a penalty, is ned 290m by US and UK regulators and a month later loses chief executive Bob Diamond and chairman
Marcus Agius.
December 2012
Tom Hayes, formerly a trader at UBS and Citigroup, is arrested along with two other brokers from dierent rms as the UK Serious Fraud Oce continues
to investigate. A week later, UBS is ned $1.5bn for its part in the scandal.
2013
More banking nes are handed down. RBS pays 390m to settle with regulators, ICAP is ned 14m, Rabobank pays 105m.
December 2013
Hayes pleads not guilty.
2014
In May, Martin Brokers is ned 630,000. Lloyds is ned 105m in July. Three months later, JP Morgan, UBS and Credit Suisse pay 61.7m to settle with
European regulators. An unnamed London banker pleads guilty to xing Libor.
April 2015
Deutsche Bank is hit with a record $2.5bn (1.6bn) ne for Libor xing, and is ordered to re seven employees.
July 2015
Former Rabobank trader Lee Stewart is banned from working in UK nancial services after admitting fraud in the US.
August 2015
Tom Hayes is sentenced to 14 years in prison for rigging rates, becoming the rst person to be convicted by a British jury of manipulating Libor.
Heartwarmingstoryofrugby'sfavelafliers
Thefavelafliersplantocapturetheheartsandinspiremindsofyoungsportsfansacrosstheglobe
CopyrightofTelegraphMediaGroupLimited2016
5/29/2015 Fixed penalty | The Economist
Ourcookiepolicyhaschanged.Reviewourcookiespolicyformoredetailsandtochangeyourcookiepreference.
Bycontinuingtobrowsethissiteyouareagreeingtoouruseofcookies.
Foreignexchangetrading Comment(19) Timekeeperreadinglist
Fixed penalty
Alllatestupdates
Email Reprints&permissions
Print
Globalbanksagreetopay$4.3billionformanipulatingcurrencymarkets
Nov13th2014|NEWYORK| Businessandfinance Like 206 Tweet 24
Advertisement
ONCEagain,ahandfuloftheworldslargestbankshaveagreedtopayvastamountsof
moneytosettleaninvestigation,thistimeconcerningthemanipulationofbenchmarks
usedinthetradingofcurrencies.American,BritishandSwissregulatorsclubbedtogether
tosqueezesixbanksfor$4.3billionbetweenthem.Yetmorefinesmaybeinthe
pipeline.
ThedealannouncedonNovember12thfollowsanowfamiliarpattern:regulatorsrelease
emailsorinstantmessagestheyhaveharvestedthatindicatesleazyactivityinan
importantmarketbanksissuestatementsthatarecontrite,emphaticabouta
commitmenttomoralvaluesyetvagueaboutwhatexactlyoccurrednoonechargesany
individualswithanycrimesandlotsofquestionsareleftunanswered,includinghowthe
regulatorscalculatedthepenalties(BritainsFCAbeinganhonourableexception).
http://www.economist.com/news/business-and-finance/21632449-global-banks-agree-pay-43-billion-manipulating-currency-markets-fixed-penalty 1/4
5/29/2015 Fixed penalty | The Economist
ThebanksUBS,RoyalBankofScotland,JPMorgan,Citigroup,HSBCandBankof
Americawerenabbedtinkeringwiththepriceofawidelyuseddailybenchmark.Known
astheWM/Reutersfix,itsetspricesformajorcurrenciesbasedontradesconcluded
Follow TheEconomist
duringthe30secondseithersideof4pminLondon.Thebankersinvolveddiddledthefix
totheirownadvantage.Theycolludedbysharinginformationaboutclientspending
ordersandadjustingtheirownpricesaccordingly.Easyprofitsandplentifulbonuses
ensued.Losersincludedthosewhoseforeignexchangecontractsweretiedtothe4pm
fix,includingmanyfirmsandmutualfunds.
Between2008and2013,tradersformedacheerycartel,immortalisedinonlinechat Latest updates

roomswhosecontentshavenowbeenmadepublic.HowcanImakefreemoneywithno
May30thedition,2015:Pickofourweek,
fckingheadsup?oneHSBCbankerasked.Othersspokeofdoubleteamingthe
inaudio
numptysinthemarkets.Theethicswerenearlyasappallingasthespellingand
International|2hours16minsago
grammar.AseniorstafferattheBankofEnglandgavetacitblessingtosomeofthe
coordination(havingbeensuspendedinMarch,hewasfiredthisweek,apparentlyfor
TheEconomistexplains:WhytheUnited
unrelatedreasons). StatesandCubaarecosyingup
TheEconomistexplains|May29th,18:10
Regulatorsareparticularlyangeredbythecurrencyscandalbecauseitcametolight
soonafterbankswerefoundtohavetamperedwithLIBOR,abenchmarkinterestrate
SylvieGuillem:Herfinalsteps
usedtopegtrillionsincontractsglobally.Bankspaidfines(somearestillnegotiating Prospero|May29th,16:45
them)andpromisedachangeofculturetheyhavefailedtodeliver.
Parallelinvestigationsarestillunderwayattwomoreregulators:AmericasDepartmentof
JusticeandNewYorksDepartmentofFinancialServices,bothofwhichhaveprovenas Graphicdetail|May29th,16:19
eagertocollectfeesasthemostaggressivebank.HuwvanSteenisofMorganStanley,a
rivalbank,reckonsthisroundofpaymentswillendupaccountingforonlyonethirdto
onehalfofthetotalregulatorswillextract.Clientswhocanestablishtheyhavebeen TheAmericaneconomy:Uhoh
wrongedcouldpushforcompensation,too. Freeexchange|May29th,13:04
Barclays,aBritishbankunderinvestigationonsimilargrounds,didnotjointhesettlement
perhapsbecauseitisholdingoutforadealwithallthedifferentregulatorsinvolved. TheAfricanDevelopmentBank:Adesina
MeanwhileDeutscheBankhaslearnedthatitwillnotfaceanyactionfromBritish getsit
authorities.
Whilequotesfromthetradersinvolvedwereincludedinthevarioussettlement Johnson:Polyglots:Thehumblelinguist
documents,theirnameswerenot.Anumberofindividualsintheforeignexchange Prospero|May29th,10:27
divisionsofthebanksconcernedhavebeensuspendedorleft,butnonehasbeen
chargedwithanywrongdoing.Intheory,civilorcriminalchargescouldbeforthcomingas
Morelatestupdates
partoftheinvestigationunderwayattheDepartmentofJustice.
Whateverthelegalinsandouts,itseemsoddtodeterminethepriceofavastrealmof
financialproductsusingafix.Globalregulatorsearlierthisyearcontemplatedthe Most commented
introductionofaglobalexchangethatwouldhavelargelycutbanksoutofthebusiness.
Theydecidedinsteadtoexpandthewindowofthe4pmbenchmarkfromsixtysecondsto 1
fiveminutes. Israelsforeign
relations
Contramundum
Like 206 Tweet 24 Share 103 1
2 SouthChinaSea:Trynottoblink
Viewallcomments(19) Addyourcomment 3 Ukraine:Theotherbattleground

4 Socialchange:Theweakersex
5 Poland'spresidentialelection:Swingingright
MorefromTheEconomist
Advertisement
ProstitutioninGermany:AgiantTeutonicbrothel
Worldpopulation:Theworldin2100
http://www.economist.com/news/business-and-finance/21632449-global-banks-agree-pay-43-billion-manipulating-currency-markets-fixed-penalty 2/4
5/29/2015 The Economist explains: Why the Swiss unpegged the franc | The Economist
Editor'sHighlights +GlobalInsights
3Dprintingwilldisruptmanufacturing
Butwewillstillneedtoday'smodel +EXPAND
TheEconomistexplains Comment(48) Timekeeperreadinglist
Explainingtheworld,daily Email Reprints&permissions
Sponsoredby Print
Previous Next LatestTheEconomistexplains Alllatestupdates

AboutTheEconomistexplains
TheEconomistexplains Onthisblog,ourcorrespondentsexplainsubjects
Why the Swiss unpegged the franc bothtopicalandtimeless,profoundandpeculiar,

withTheEconomist'strademarkclarityand
Jan18th2015,23:50BYC.W. Like 4.8k Tweet 96 brevity
RSSfeed
May29,2015
Video:TheIndustrialInternet
EXPAND
INTHEworldofcentralbanking,slowandpredictabledecisionsaretheaim.Soon
January15th,whentheSwissNationalBank(SNB)suddenlyannouncedthatitwouldno
longerholdtheSwissfrancatafixedexchangeratewiththeeuro,therewaspanic.The
francsoared.OnWednesdayoneeurowasworth1.2Swissfrancsatonepointon
Closingandgreeningthe
Thursdayitsvaluehadfallentojust0.85francs.Anumberofhedgefundsacrossthe infrastructuregap
worldmadebiglosses.TheSwissstockmarketcollapsed.WhydidtheSNBprovokesuch EXPAND
chaos?
TheSNBintroducedtheexchangeratepegin2011,whilefinancialmarketsaroundthe ThemachineofanewsoulComputerswillhelppeople
tounderstandbrainsbetter.Andunderstandingbrains
worldwereinturmoil.InvestorsconsidertheSwissfrancasasafehavenasset,along willhelppeopletobuildbettercomputers
withAmericangovernmentbonds:buythemandyouknowyourmoneywillnotbeatrisk.
InvestorslikethefrancbecausetheythinktheSwissgovernmentisasafepairofhands:
itrunsabalancedbudget,forinstance.Butasinvestorsflockedtothefranc,they
dramaticallypushedupitsvalue.AnexpensivefranchurtsSwitzerlandbecausethe
economyisheavilyreliantonsellingthingsabroad:exportsofgoodsandservicesare
worthover70%ofGDP.Tobringdownthefrancsvalue,theSNBcreatednewfrancs Follow TheEconomist
andusedthemtobuyeuros.Increasingthesupplyoffrancsrelativetoeurosonforeign
http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13 1/11
5/29/2015 The Economist explains: Why the Swiss unpegged the franc | The Economist
exchangemarketscausedthefrancsvaluetofall(therebyensuringaeurowasworth1.2
francs).Thankstothispolicy,by2014theSNBhadamassedabout$480billionworthof
foreigncurrency,asumequaltoabout70%ofSwissGDP.
Latest updates
TheSNBsuddenlydroppedthecaplastweekforseveralreasons.First,manySwissare
angrythattheSNBhasbuiltupsuchlargeforeignexchangereserves.Printingallthose
May30thedition,2015:Pickofourweek,
francs,theysay,willeventuallyleadtohyperinflation.Thosefearsareprobably inaudio
unfounded:Swissinflationistoolow,nottoohigh.Butitisahotpoliticalissue.In International|2hours21minsago
Novembertherewasareferendumwhich,haditpassed,wouldhavemadeitdifficultfor
theSNBtoincreaseitsreserves.Second,theSNBriskedirritatingitscriticsevenmore, TheEconomistexplains:WhytheUnited
thankstosomethingthatishappeningthisThursday:manyexpecttheEuropeanCentral StatesandCubaarecosyingup
Banktointroducequantitativeeasing.Thisentailsthecreationofmoneytobuythe TheEconomistexplains|May29th,18:10
governmentdebtofeurozonecountries.Thatwillpushdownthevalueoftheeuro,which
mighthaverequiredtheSNBtoprintlotsmorefrancstomaintainthecap.Butthereis SylvieGuillem:Herfinalsteps
alsoathirdreasonbehindtheSNBsdecision.During2014theeurodepreciatedagainst
othermajorcurrencies.Asaresult,thefranc(beingpeggedtotheeuro)hasdepreciated
too:in2014itlostabout12%ofitsvalueagainstthedollarand10%againsttherupee
(thoughitappreciatedagainstbothcurrenciesfollowingtheSNB'sdecision).Acheaper Graphicdetail|May29th,16:19
francboostsexportstoAmericaandIndia,whichtogethermakeupabout20%ofSwiss
exports.IftheSwissfrancisnotsoovervalued,theSNBargues,thenithasnoreasonto
continuetryingtoweakenit. TheAmericaneconomy:Uhoh
ThebigquestionnowishowmuchtheremovalofthecapwillhurttheSwisseconomy.
ThestockmarketfellbecauseSwisscompanieswillnowfinditmoredifficulttoselltheir
warestoEuropeancustomers(highrollingEuropeansarealreadycomplainingaboutthe TheAfricanDevelopmentBank:Adesina
priceofthisyearsskiingholidays).UBS,abank,downgradeditsforecastforSwiss getsit
growthin2015from1.8%to0.5%.Switzerlandwillprobablyremainindeflation.Butthe
SNBshouldnotbelambastedforremovingthecap.Rather,itshouldbecriticisedfor
adoptingitinthefirstplace.Whencentralbankstrytomanipulateexchangerates,it Johnson:Polyglots:Thehumblelinguist
almostalwaysendsintears.
Digdeeper:
Morelatestupdates
AreferendumtoboostSwitzerland'sgoldreserves(November2014)
ThemarketreactiontotheSNB'sdecision(January2015)
TheimpactonCentralEurope(January2015)
Most commented
Previous Next
TheEconomistexplains: TheEconomistexplains: 1
Israelsforeign
Whysolarpoweris WhyIslamprohibitsimages
relations
spreadingsofastinAfrica ofMuhammad
Contramundum
Like 4.8k Tweet 96 Share 483 32 2 SouthChinaSea:Trynottoblink

3 Ukraine:Theotherbattleground
4 Socialchange:Theweakersex
Viewallcomments(48) Addyourcomment
5 Poland'spresidentialelection:Swingingright
MorefromTheEconomist MorearticlesfromGELookahead
Analgorithmadaykeepshealthcareproblemsatbay
Switzerland'smonetarypolicy:ThethreebigmisconceptionsabouttheSwissfranc
Predictiveanalyticscouldimprovebothhospital
careandhealthcarefinances
Currencies:GoingcuckoofortheSwiss
Theultimategoal
Whatiftherewerenounplanneddowntime?
CentralEuropeandtheSwissfranc:Currencyrisk
Thefinalfrontierishiring
http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13 2/11
Quiz 1

Some questions may have multiple correct answers. You have to check ALL true
statements.

1. Which of the following is an arbitrage?

[ ] a) An investment strategy pays a higher expected return than the risk

free asset
[ ] b) An investment strategy pays a very risky return (big standard
deviation) but with a probability of 1 it pays a higher return than the
risk free asset
[ ] c) A gamble that costs nothing and pays with only 1% probability $1 and
with 99% probability nothing
[ ] d) A gamble that costs $0.01 and pays with 99% probability $1 and with
1% probability nothing

2. You have entered a long position in a forward contract to buy 1000000 in
one year for 1.5 $ per . What is your payoff in one year if the appreciates to
1.6 $ per ?

[ ] a) + $100000
[ ] b) - $100000
[ ] c) + 160000
[ ] d) - 160000

3. The S&P500 ETF is currently traded at $200. Put options with a strike price
of $195 and maturity in 1 month trade at a price of $2. You buy these put
options for $1000. What is your profit if the S&P500 ETF decreases to $185?

[ ] a) - $1000
[ ] b) + $4000
[ ] c) + $5000
[ ] d) + $7500

4. Which statements are correct?

[ ] a) A risk-free asset with a 5% rate of return in continuous compounding

pays a larger effective return over a 6 month investment period than
another risk-free asset with a 5% rate of return in quarterly
compounding.
[ ] b) The current price of a zero coupon bond with face value $100 and 3
years to maturity is less than the price of 2% annual coupon bond with
face value $100 and 3 years to maturity.
[ ] c) Suppose the 1-year spot rate and the 2-year spot rate are both 10%
(continuously compounded). The current price of a zero coupon bond
with face value $100 and 1 year to maturity is equal to the price of a
zero coupon bond with face value $100 and 2 years to maturity.
[ ] d) Suppose the 1-year spot rate is 10% (annually compounded) and the
2-year spot rate is only 5% (annually compounded) (note that it is
possible to have a downward sloping yield curve). The current price of
a zero coupon bond with face value $100 and 1 year to maturity is
equal to the price of a zero coupon bond with face value $100 and 2
years to maturity.

5. Which of the following scenarios has an arbitrage opportunity?

[ ] a) The exchange rate between the Japanese Yen (JPY) and the US dollar
(USD) is 0.01 USD/JPY, the exchange rate between Swiss franc (CHF)
and USD is 0.95 CHF/USD, the exchange rate between CHF and JPY is
0.0095 CHF/JPY.
[ ] b) Google stock is $500 today. It is expected to increase to $530 in one
year. The 1-year spot rate is 10% (annual compounding).
[ ] c) The 1-year spot rate is 10% (annual compounding), the 2-year spot
rate is 12% (annual compounding).
[ ] d) Facebook stock is $100 today. The 1-year spot rate is 10% (annual
compounding). The forward price to trade one Facebook stock in 1
year is $105.

Quiz 2

statements.

1. The 1-year spot rate is 5% (continuously compounded) and the 3-year spot
rate is 7% (continuously compounded). What is the forward rate to lend or
borrow money in 1 year for another 2 years?

[ ] a) 5%
[ ] b) 6%
[ ] c) 7%
[ ] d) 8%

2. The price of Apple is $125 today. Apple does not pay any dividends over the
next 3 months. There is a forward contract with 3 months to maturity and a
forward price of $130. The 3-month spot rate is 2% (continuously
compounded). Which of the following is true?

[ ] a) There is an arbitrage and an arbitrage strategy involves taking a long

position in the forward contract.
[ ] b) There is an arbitrage and an arbitrage strategy involves buying the
underlying.
[ ] c) There is an arbitrage and an arbitrage strategy involves lending money
at the risk-free rate.
[ ] d) There is no arbitrage.

3. What is the duration of a 15-year zero coupon bond with face value $1000?

[ ] a) 10 years
[ ] b) 15 years
[ ] c) 20 years
[ ] d) not possible to tell without knowing the bond yield or the 15-year spot
rate


[ ] a) The yield of a 5-year zero coupon bond is always equal to the 5-year
spot rate.
[ ] b) Suppose the yield curve is upward sloping. A 5% annual coupon bond
with 10 years left to maturity has a yield which is lower than the 10-
year spot rate.
[ ] c) A duration based hedge is suitable to eliminate interest rate risks given
there are only small parallel shifts in the yield curve.
[ ] d) A duration based hedge does not account for liquidity risks.

5. Suppose the yield curve is upward sloping. There is a 5% semi-annual
coupon bond with 5 years to maturity and a 15% semi-annual coupon bond
with 5 years to maturity. Both bonds have a face value of $1000. Check all
true statements.

[ ] a) The 5% coupon bond has a higher yield than the 15% coupon bond.
[ ] b) The 5% coupon bond has a higher duration than the 15% coupon bond.
[ ] c) The 5% coupon bond trades at a higher price than the 15% coupon
bond.
[ ] d) The 5% coupon bond price will drop by more percentage points in
response to a small upward shift in the yield curve in comparison to
the 15% coupon bond.

Quiz 3

statements.

1. The newspaper provides you with an open, low, high, and settlement price of
traded futures contracts. Which of the four price quotes is relevant to
calculate daily cash flows between long and short positions?

[ ] a) Open price
[ ] b) Low price
[ ] c) High price
[ ] d) Settlement price

2. Suppose the 1.5-year spot rates in the USA (lend/borrow $) and in the UK
(lend/borrow ) are both 5% continuously compounded. The current
exchange rate between $ and is 1.55$/. What is the (no arbitrage) forward
exchange rate with maturity in 1.5 years?

[ ] a) 1.5$/
[ ] b) 1.55$/
[ ] c) 1.6$/
[ ] d) not enough information to tell; it depends on the central bank policy in
the US and UK

3. The price of a bushel of corn is $5. Suppose there are no storage costs to keep
corn. There is a forward contract with 6 months to maturity and a forward
price of $5 per bushel (suppose the price is fair). The 6-month spot rate is 2%
(continuously compounded). What is the convenience yield?

[ ] a) - 2%
[ ] b) 0
[ ] c) 2%
[ ] d) 4%

4. The dividend yield of the S&P 500 is 3% per year. The 1-year spot rate is 2%
and the expected return on the S&P 500 is 7% per year. Which statements
are correct?

[ ] a) The expected price of the S&P 500 in 1 year is larger than the forward
price of a forward contract written on the S&P 500 with 1 year to
maturity
[ ] b) The expected price of the S&P 500 in 1 year is lower than the forward
price of a forward contract written on the S&P 500 with 1 year to
maturity
[ ] c) There is no way to tell whether the expected price of the S&P 500 in 1
year is lower or higher than the forward price of a forward contract
written on the S&P 500 with 1 year to maturity
[ ] d) Borrowing money at 2% for 1 year to buy and hold 1 unit of the S&P
500 for 1 year yields exactly the same payoff as taking a long position
in a forward contract written on 1 unit of the S&P 500 with 1 year to
maturity

5. 6 months ago (time t=0), you have entered a long position in a forward
contract written on one Apple stock with forward price $100 and 9 months to
maturity (time T=0.75). Today (time s=0.5), the price of one Apple stock is
$120, the 3-month spot rate is 10% (continuously compounding) and Apple
does not pay any dividends within the next 3 months. What is the current
value of your long position (at time s=0.5)?

[ ] a) 20
[ ] b) 22.47
[ ] c) 23.04
[ ] d) 29.52

Quiz 4

statements.

1. In which of the following situations does a hedger want to take a long hedge?

[ ] a) A firm expects to produce and sell 100000 lbs of copper in 6 months; it

plans to use copper futures to hedge its exposure to copper price
fluctuations
[ ] b) A firm expects to receive 100000 in 3 months and then plans to
exchange it to $; it plans to use $ per exchange rate futures to hedge
its exposure to exchange rate fluctuations (foreign currency is typically
the underlying)
[ ] c) A firm has to buy 100 bushels of corn in 3 months to produce corn
bread for an outstanding order; it plans to use corn futures to hedge its
exposure to corn price fluctuations
[ ] d) An airline has sold tickets for a flight in 2 months to fly from Chicago to
Hong Kong; it plans to use crude oil futures to hedge its exposure to jet-
fuel price fluctuations

2. The volatility of monthly price changes in jet-fuel is 4%, and the volatility of
price changes in heating oil futures is 5%. The correlation between jet-fuel
price changes and heating oil futures price changes is 90%. What is the
optimal hedge ratio?

[ ] a) 0.65
[ ] b) 0.72
[ ] c) 0.80
[ ] d) 0.89

3. Suppose you own a European put option written on Apple with a strike price
of $100, which expires today. Suppose the stock price of Apple is $110 today.
What is your payoff from the put option?

[ ] a) - $10
[ ] b) $0
[ ] c) $10
[ ] d) Impossible to tell, given the provided information


[ ] a) The time value of a put option is always position if the underlying does
not pay any dividends
[ ] b) The time value of a call is always position if the underlying does not
pay any dividends
[ ] c) The intrinsic value of a call option is always larger than 0
[ ] d) The time value of a call option is typically largest if the call option is
close to at-the-money

5. What is the intrinsic value of an at-the-money put option with a current price
of $2?

[ ] a) less than $2
[ ] b) $2
[ ] c) $0
[ ] d) Impossible to tell, given the provided information

Problem Set 1 - FIN 524A
Summer Term
1
1. On September 4th, an investor takes a short position in a forward contract to sell 1000
ounces of gold in 3 months (December 4th) at a price of $1700 per ounce.
(a) What is the payo of this contract at maturity if on December 4th the actual gold
price turns out to be $1650, $1675, $1700, $1725, $1750 per ounce? Explain.
(b) Suppose the investor owns 1000 ounces of gold at the time when he enters the
forward contract. What is the payo of selling 1000 ounces of gold in the spot
market on December 4th if the gold price turns out to be $1650, $1675, $1700,
$1725, $1750 per ounce?
(c) What is the total payo of the short position in the forward contract and the sale
of 1000 ounces of gold on December 4th if the gold price turns out to be $1650,
$1675, $1700, $1725, $1750 per ounce?
(d) What is the return of physically holding 1000 ounces of gold from September 4th
until December 4th and taking the aforementioned short position in the forward
contract if the gold price on September 4th was $1690 per ounce?
(e) Is the investment strategy in question (d) a good choice if the annualized risk free
interest rate is 1% (c.c.)? Explain.
2. Suppose today the exchange rate between the Japanese Yen (Y en) and US dollar
(U SD) is 0:0128 UYSD
en
, the exchange rate between the Swiss franc (CHF ) and US dollar
U SD
is 1:0459 CHF , and the exchange rate between the Japanese Yen and Swiss franc is
Y en
85 CHF . Is there an arbitrage opportunity? If so, design an arbitrage strategy.
3. Suppose the current stock price of Company X is $100 and you can enter a forward
contract (long or short position) to buy 10000 stocks in 1 year for $101 each. The
stock price of X is expected to increase to $110 in 1 year (but there is uncertainty).
The risk free interest rate is 0% (borrowing and lending without interest payments).
(a) What is the expected prot (in 1 year) of taking a long position in the forward
contract?
2
(b) Is there an arbitrage? If so, carefully describe a possible arbitrage strategy. What
should be the forward price in a world without arbitrage?
3
Summer Term
1
1. What quarterly compounded (4-times c.p.a.) interest rate is equivalent to a continu-
ously compounded (c.c.) interest rate of 10%?
2. What continuously compounded interest rate is equivalent to a 5% interest rate with

semi-annual compounding (2-times c.p.a.)?
3. You will receive $130 in 6 months for an investment of $110 today. What is the
annualized percentage rate of return with
(a) annual compounding (1-times c.p.a.)?
(b) semi-annual compounding (2-times c.p.a.)?
(c) quarterly compounding (4-times.c.p.a.)?
(d) monthly compounding (12-times c.p.a.)?
(e) weekly compounding (52-times c.p.a.)?
(f) continuous compounding (c.c.)?
4. The following (risk free) bonds are traded in the market:
- 1-year zero coupon with $1000 face value currently trades for $964.640
- 1.5-year zero coupon bond with $1000 face value currently trades for $940.353
- 2-year 4% semi-annual coupon bond with $1000 face value currently trades for $991.878 !
!
- 2-year 14% semi-annual coupon bond with $1000 face value currently trades for $1182.172
- 3-year 4% annual coupon bond with $1000 face value currently trades for $973.042
!
x% semi-annual coupon means $1000 x%
2
coupon payments every 6 months
(a) Calculate the 6-month, 1-year, 18-month, 2-year, 3-year, 4-year, and 5-year spot
rates (c.c.). Provide numerical results and analytical solutions.
(b) Draw the yield curve (term structure). Does the liquidity preference theory con-
tradict with the shape of the term structure? Explain.
(c) Verify that the yield of a 4-year 15% annual coupon bond with $1000 face value
is y = 5:07595% (c.c.). What is the duration of this bond? By how much would
2
the bond price change if the yield increased by 0.01% (parallel shift in the yield
curve)?
(d) Verify that the yield of a 5-year 6% annual coupon bond with $1000 face value
curve)?
(e) Explain why the yield of the 4-year 15% annual coupon bond is lower than the
yield of the 5-year 6% annual coupon bond.
(f) Which of the two coupon bonds would have a higher yield if the yield curve was
decreasing? Explain.
(g) Explain why the volatility (sensitivity of the bond price with respect to changes in
the yield curve) of the 4-year 15% annual coupon bond is lower than the volatility
of the 5-year 6% annual coupon bond.
(h) Calculate the continuously compounded forward rates locking in the 1-, 2-, 3- and
4-year (risk free) interest rates starting in 1 year time. Moreover, calculate the
forward rate locking in the 2.5-year risk free interest rate starting in 6 months.
(i) Explain the relationship between forward rates and (market) expectations about
spot rates in the future.
3
Summer Term
1
1. Suppose the current stock price of the Walt Disney Company is $50 and you can enter
a forward contract (long or short position) to buy 50000 stocks in 9 months for $51
each. The Walt Disney stock is expected to increase to $53 in 9 months. The 9-month
(risk free) spot rate is 3% (c.c.).
(a) Is there an arbitrage if Walt Disney does not pay dividends? If so, carefully
describe a possible arbitrage strategy. What should the forward price be in a
world without arbitrage?
(b) Suppose the 3-month (risk free) spot rate is 2.75%. Is there an arbitrage if Walt
Disney pays a dividend of $0.75 in 3 months? If so, carefully describe a possible
arbitrage strategy. What should the forward price be in a world without arbitrage?
2. The current exchange rate between the Japanese Yen (Y en) and US dollar (U SD) is
0:0128 UYSD
en
. Suppose the 9-month spot rate in the USA (invest U SD) is 3% (monthly
compounded) and the 9-month spot rate in Japan (invest Y en) is 1% (quarterly com-
pounded).
(a) Assuming markets are arbitrage free, calculate the forward exchange rate to ex-
change U SD and Y en in 9 months.
(b) Is there an arbitrage opportunity if the forward price to buy Y en in 9 months is

the same as the current exchange rate (0:0128 UYSD
en
)? If so, describe an arbitrage
strategy. How much money can you make if you own $1000 which you can invest
(assume your trades do not have a price impact, e.g. exchanging Y en for U SD
does not aect the current exchange rate)?
(c) The real interest rate is dened as the dierence between the nominal interest rate
and the expected ination, i.e. if in Japan the nominal interest rate is 1% and the
expected ination is 0.75% then the real interest rate is 0.25%. The real interest
rate measures by how much money grows in real terms or adjusted for increases
in prices, i.e. how much more consumption a dollar buys after investing it in the
risk free asset. How does your result in question a) change, if there was ination
2
in Japan. The nominal 9-month spot rate stays at 1% (quarterly compounded)
but there is an expected ination over the next 9 months of 0.75%?
3. The current spot price of one lb of copper is $3.75, the 3.5-year spot rate is 2% (semi-
annual compounding), the (continuous ow of) storage costs of copper is 3% per year.
(a) In absence of arbitrage, what should be the forward price to trade copper in 3.5
years if copper was an investment asset?
(b) Since copper is a consumption asset, it might be impossible or undesirable to

short sell it in the spot market. Does the result/ formula in question a) still hold?
Explain carefully.
(c) Assume copper is a consumption asset. Is there an arbitrage if the forward price
to trade copper in 3.5 years is $5? If so, describe an arbitrage strategy.
(d) What is the convenience yield if the true forward price to trade copper in 3.5
years is $3.78?
4. The expected return of the Dow Jones Industrial Average index is 5.5% per year, its
dividend yield is 0%, the yield curve is at and the risk free interest rate is constant
and equals 2% (c.c.).
(a) In general, do you expect speculators to take long or short positions in DJIA
forwards and futures? Explain.
(b) There is a forward contract with 9 months to maturity written on $1000 times the
DJIA index points at maturity. Given there is no arbitrage, what is the forward
price of the contract if the DJIA is currently at a level of 13000 index points?
(c) Consider you have entered a short position in the forward contract in question
b). What is the value of your position 3 months later if the DJIA has increased
to 13001 index points? What if the DJIA has increased to 14500 index points?
5. The current spot price of one bushel of corn is $5, the 1.5-year spot rate is 3% (c.c.),
the (continuous ow of) storage costs of corn is 5% per year.
3
(a) In absence of arbitrage, what should be the forward price to trade corn in 1.5
years if corn was an investment asset?
(b) Assume corn is a consumption asset. Is there an arbitrage if the forward price to
trade corn in 1.5 years is $10? If so, describe an arbitrage strategy.
(c) What is the convenience yield if the true forward price to trade corn in 1.5 years
is $2.5?
4
Summer Term
1
1. The contract size of one futures contract on the S&P 500 is $250 times the S&P 500
futures price - an increase by 1 index point means a transfer of $250 from the short to
the long position. Suppose today the S&P 500 index has reached 1460 index points,
the S&P 500 pays a dividend yield of 4.5% per year, the term structure of interest
rates is at and the short rate is constant over time and equals 2% (c.c.).
(a) In absence of arbitrage opportunities, what is todays futures price of the S&P
500 futures with maturity in 50 days?
(b) The initial margin (per contract) is $22000 and the maintenance margin is $17500.
Suppose over the next 6 days the S&P 500 index changes as follows:
(Careful: the table reports index points of the index not the futures!) For an
Day 0 1 2 3 4 5 6
S&P 500 Index 1460 1455 1458 1470 1490 1482 1479
investor with 5 short positions in the S&P 500 futures show how his margin ac-
count changes every day. Assume that the investor earns interest of 2% (c.c.) on
his margin account.
2. The US government tries to severely restrict proprietary trading activities of big nan-
cial institutions (Volcker rule).
(a) Discuss why individual traders may have incentives to take more risks than what
is optimal for their employer (institution or shareholders). Why might the Volcker
rule help to resolve this problem?
(b) Discuss why nancial institutions may have incentives to take more risks than
what is optimal for the entire economy. Why might the Volcker rule help to
resolve this problem?
(c) What are possible downsides of the Volcker rule?
3. The standard deviation (square root of variance) of monthly changes in the spot price of
live cattle is 1.2 cents per lb. The standard deviation of monthly changes in the futures
price of live cattle is 1.4 cents per lb. The correlation between the spot and futures
2
price changes is 0.7. It is now October 15. A beef producer plans to purchase 200000
lb of live cattle on November 15 and wants to use the December futures contract to
hedge risk. Each futures contract is for delivery of 40000 pounds of cattle. How many
futures positions does the beef producer have to take to minimize his exposure to price
uctuations? Ignore tailing adjustments to account for daily settlement.
4. The following table gives data on daily changes in the spot price and futures price for
a certain commodity:
!S +2 +3 -2 +1 +8 +0 -5 -4 +3 +7
!F +4 +5 -1 +0 +6 -1 -7 -4 +5 +8
(a) Use the data to calculate a minimum variance hedge ratio for an investor who
holds the commodity and plans to sell it soon. Ignore tailing adjustments to
account for daily settlement.
(b) Evaluate how well a hedging strategy based on the minimum variance hedge ratio
would have worked for each day of the 10-day period covered by the data, i.e.
compute the value of your hedge for each of the ten days by adding losses/ gains
from both the spot and futures positions.
(c) What is the cumulative gain/ loss over the 10 days?
(d) What is the daily standard deviation in your gain/ losses?
(e) What is the daily standard deviation without your hedge?
(f) What is the daily standard deviation if you use a (not optimal) hedge of 1 short
position in the futures?
5. You own a stock portfolio with a CAPM-# of 2.25 and you know that you can eliminate
all market risk (reduce your portfolios # to zero) if you take 40 short positions in S&P
500 futures.
(a) If you want to reduce your portfolios # temporarily to 0.5, how many futures
contracts do you enter?
3
(b) If you want to increase your portfolios ! temporarily to 3, how many futures
!S +5 +6 -2 -3 +8 +0 -5 -4 +1 +7
!F +6 +6 -1 -5 +6 -1 -6 -4 +0 +8
(a) Use the data to calculate a minimum variance hedge ratio for a company that
knows it will purchase the commodity in one month. Ignore tailing adjustments
to account for daily settlement.
compute the value of the hedge for each of the ten days by adding losses/ gains
4
Summer Term
1
1. Today (time t = 0) the stock price of company Z is S0 = 50. In 6 months (time t = 0:5)
(u)
it changes (under the true probability measure P ) with probability of 60% to S0:5 = 65
(d)
and with probability 40% to S0:5 = 40. From time t = 0:5 to time t = 1 the stock price
may increase by 20% with a probability of 80% or decrease by 30% with a probability
of 20%. The risk free interest rate is constant and equal to 5% (c.c.). The yield curve
is at.
(a) Draw a tree.
(b) Use replicating portfolios to calculate the price of a European at-the-money put
option with 1 year left to maturity.
(c) Use "risk neutral" probabilities to price a European at-the-money put option with
1 year left to maturity.
(d) What is the price of an American at-the-money put option with 1 year left to
maturity?
2. At time t = 0, the price of stock Y is $100. Over the next 3 months (until time
t = 0:25), it may increase to $130 (before dividend price) or decline to $50 (before
dividend price) with equal probability. If the stock price has increased from time t = 0
to t = 0:25, then Y pays a dividend of $20 (ex-dividend price is $110). It does not
pay a dividend if the stock price has declined from time t = 0 to t = 0:25. If the
stock price has increased from time t = 0 to t = 0:25, then the stock price will increase
to $143 with a probability of 70% or decline to $55 with a probability of 30% over
the following 3 months (until time t = 0:5). If the stock price has declined from time
t = 0 to t = 0:25, then the stock price will increase to $65 with a probability of 40%
and decline to $25 with a probability of 60% over the following 3 months (until time
t = 0:5). The short rate (risk-free interest rate) is constant over time and 5% (c.c.).
(a) What is the value (at time t = 0) of an at-the-money European call option with
6 months left to maturity? Use replicating portfolios to price the option.
(b) What is the value (at time t = 0) of an at-the-money American call option with
6 months left to maturity?
2
3. The current stock price of H 2 is $65. It is certain that the stock pays $3 dividends in 1
month and 4 months. A European at-the-money put option with 5 months to maturity
is traded for $6. A European at-the-money call option with 5 months to maturity is
traded for $5. 1-month, 4-month and 5-month spot rates are 13%, 11% and 9.5% (c.c.).
(a) Is there an arbitrage opportunity? If so, describe an investment strategy that

pays o today and has for sure zero cash ows at any time in the future.
(b) What level in the interest rate ensures that markets are arbitrage free?
4. The current stock price of Apple is $650. It is certain that the stock pays a $5 dividend
in 2 months. A European at-the-money put option with 3 months to maturity is traded
for $50. A European at-the-money call option with 3 months to maturity is traded
for $45. The term structure of interest rates is at and the short rate is constant and
equals 3% (c.c.).

pays o today and has for sure zero cash ows at any time in future.
(b) What level in the short rate ensures that markets are arbitrage free?
5. The current stock price of 3M Co. is $100 and in each 3 month period it will either
increase by 25% or fall by 15%. The yield curve is at and the short rate is constant
(a) Consider a 6 month time period. Calculate the risk neutral probabilities in the
model.
(b) What is the price of a 6-month European at-the-money call option? How many
call option positions do you hold to optimally hedge 1 long position in the stock
at every point in time (i.e. what is the optimal hedge today, and what is the
optimal hedge in 3 months)? Explain why the optimal hedge diers at dierent
points in time.
(c) What is the price of a 6-month European put option with a strike price of $90.
3
(d) How does your result in (c) change if 3M pays a dividend of $15 in 3 months?
6. The current stock price of XYZ is $100 and in each 1 month period it will either
model.
(b) Use replicating portfolios to calculate the price of a European call option with a
strike price of $110 and 2 months to maturity.
(c) Compute the price of a European at-the-money call option with 4 months to
maturity?
(d) Compute the price of a European put option with a strike price of $90 and a 4
months to maturity.
(e) How does your result in (c) change if XYZ pays a dividend of $30 in 3 months
and the option is American? What is the value of being able to exercise early?
7. At time t = 0, the current exchange rate between US-dollar (USD) and Euro (EUR) is
1.1 USD per EUR. Suppose the risk-free interest rates are 5% (per year) in USD and
1% (per year) in EUR (continuously compounded). Assume that the risk-free interest
rates in both currencies are constant over time. Suppose the exchange rate volatility
is 19.0621% per year and the USD is expected to appreciate against the EUR by 1.5%
(continuously compounded) per year.
(a) What is the forward exchange rate (forward price) you can lock in today (at t = 0)
to exchange 1 EUR to USD in 2.5 years?
(b) Use a Binomial tree with 2 time steps to nd the price at t = 0 of a European put
option with a strike exchange rate of 1.3 USD per EUR and 6 months to maturity
(that is, in your tree each time step equals a time interval of 3 months). Note that
the underlying is 1 EUR, that is, the put option gives the long position the right
4
p T !t
1
to sell 1 EUR at the xed strike price of 1.3 USD. [Hint: set d
= u = e" n ,
q
#! 1 " 2
p = 12 + 12 "2 T !t
n
; with % = 19:0621%; ' " 12 % 2 = "1:5%]
(c) Use again the Binomial tree in (b). What is the value at time t = 0 of an
American put option with a strike exchange rate of 1.3 USD per EUR and 6
months to maturity?
5

Quiz Solutions

Quiz 1:
1. B, c
2. a
3. b
4. a, b
5. d

Quiz 2:
1. d
2. b
3. b
4. a, b, c, d
5. a, b, d

Quiz 3:
1. d
2. b
3. c
4. a, d
5. b

Quiz 4:
1. c, d
2. b
3. b
4. b, d
5. c

Solutions - Problem Set 1 - FIN 524A
Summer Term
1
1. On September 4th, an investor takes a short position in a forward contract to sell 1000
ounces of gold in 3 months (December 4th) at a price of $1700 per ounce.
(a) What is the payo of this contract at maturity if on December 4th the actual gold
price turns out to be $1650, $1675, $1700, $1725, $1750 per ounce? Explain.
! On the 4th of December the investor has to deliver 1000 ounces of gold and
receives the predetermined amount of $1700000 (agreement on September
4th). If the investor does not own the 1000 ounces gold (prior to December
4th), he has to buy it in the spot market at the current market price on
December 4th. Therefore, the payo of the short position is:
Gold price (Dec 4th) Payo of short position in forward contract

$1650 $1700000 - $1650000 = $50000
$1675 $1700000 - $1675000 = $25000
$1700 $1700000 - $1700000 = $0
$1725 $1700000 - $1725000 = -$25000
$1750 $1700000 - $1750000 = -$50000
(b) Suppose the investor owns 1000 ounces of gold at the time when he enters the
forward contract. What is the payo of selling 1000 ounces of gold in the spot
market on December 4th if the gold price turns out to be $1650, $1675, $1700,
$1725, $1750 per ounce?
Gold price (Dec 4th) Payo of selling 1000 ounces of gold

in spot market on December 4th
$1650 $1650000
$1675 $1675000
$1700 $1700000
$1725 $1725000
$1750 $1750000
(c) What is the total payo of the short position in the forward contract and the sale
of 1000 ounces of gold on December 4th if the gold price turns out to be $1650,
$1675, $1700, $1725, $1750 per ounce?
2
! Selling 1000 ounces of gold in the spot market and taking a short position in
the forward contract pays o $1700000 for sure (independent of the price of
gold in the spot market).
Gold price (Dec 4th) Payo of short position Payo of selling 1000 Total
in forward contract ounces of gold in spot
market on December 4th
$1650 $50000 $1650000 $1700000
$1675 $25000 $1675000 $1700000
$1700 $0 $1700000 $1700000
$1725 -$25000 $1725000 $1700000
$1750 -$50000 $1750000 $1700000
(d) What is the return of physically holding 1000 ounces of gold from September 4th
until December 4th and taking the aforementioned short position in the forward
contract if the gold price on September 4th was $1690 per ounce?
! On September 4th, taking a short position does not cost anything but holding
1000 ounces of gold costs $1690000 (this can be understood as an oppor-
tunity cost if the investor already owns the gold prior to September 4th or
as the actual cost to purchase the gold in the spot market on September
4th). As established in questions (a) - (c), the investor locks in a price of
$1700000 to sell the 1000 ounces of gold on December 4th. Therefore, the
investor earns a risk free eective return over the 3 month investment period
! $1700000 "
of $1700000
$1690000
" 1 = 0:59%, or an annualized return of 4 ln $1690000
= 2:36%
(c.c.)
(e) Is the investment strategy in question (d) a good choice if the annualized risk free
interest rate is 1% (c.c.)? Explain.
! Assuming that there is no storage cost for holding gold, the investment strat-
egy in question (d) is risk free and generates a higher return than an equivalent
investment in the risk free asset. There is an arbitrage opportunity. We can
borrow money at 1% interest (issue 3-month zero-coupon bonds with 1% in-
terest rate) and invest the borrowed money in gold and take short positions
in the forward contract.
3
2. Suppose today the exchange rate between the Japanese Yen (Y en) and US dollar
(U SD) is 0:0128 UYSD
en
, the exchange rate between the Swiss franc (CHF ) and US dollar
U SD
is 1:0459 CHF , and the exchange rate between the Japanese Yen and Swiss franc is
Y en
85 CHF . Is there an arbitrage opportunity? If so, design an arbitrage strategy.
! Yes, there is an arbitrage opportunity. We can borrow 1 CHF and instantly buy
85 Y en, then exchange the 85 Y en for 1:088 U SD, and nally exchange the 1:088
U SD for 1:04 CHF . If we do the exchanges instantly, we do not have to pay any
interest on the 1 CHF borrowed and therefore, make a risk free prot of 0:04
CHF . We can repeat the same strategy until demand and supply causes the Y en
to appreciate against the CHF , the Y en to depreciate against the U SD, and the
CHF to appreciate against the U SD.
3. Suppose the current stock price of Company X is $100 and you can enter a forward
contract (long or short position) to buy 10000 stocks in 1 year for $101 each. The
stock price of X is expected to increase to $110 in 1 year (but there is uncertainty).
The risk free interest rate is 0% (borrowing and lending without interest payments).
(a) What is the expected prot (in 1 year) of taking a long position in the forward
contract?
! Taking a long position means that we have to pay $1010000 in 1 year and will
receive 10000 stocks which we expect to be worth $1100000. The expected
prot is $90000. Notice, however, that this is an expected and not a certain
prot. The stock price might fall far below $101 in 1 year and we might end
up with large losses. Since the prot might be negative with some positive
probability, this strategy is not an arbitrage.
(b) Is there an arbitrage? If so, carefully describe a possible arbitrage strategy. What
should be the forward price in a world without arbitrage?
! A possible arbitrage strategy:
Today: 1) take a short position in the forward contract, 2) borrow $1000000

at 0% interest rate, 3) buy 10000 stocks for $1000000. The cash ow
4
today is $0.
In 1 year: 1) we still hold 10000 stocks, 2) according to the short position

in the forward contract we have to deliver 10000 stocks and in return
receive $1010000, 3) we have to return $1000000 to the lender. We do
not hold any stocks anymore in 1 year. The cash ow in 1 year is $10000.
This cash ow is a risk free prot and therefore, we have an arbitrage.
Notice that the prot is much lower than the expected prot in a), but it
is risk free.
5
Summer Term
1
1. What quarterly compounded (4-times c.p.a.) interest rate is equivalent to a continu-
ously compounded (c.c.) interest rate of 10%?
! Suppose rc is the annual interest rate with c.c. and rm is the annual interest rate
with m-times c.p.a., then rc and rm are equivalent i
! r m "m
1+ = erc
m
Solving for rm and setting m = 4 and rc = 0:1, we get
! 0:1
"
rm = 4 e 4 " 1 = 10:126%
2. What continuously compounded interest rate is equivalent to a 5% interest rate with

semi-annual compounding (2-times c.p.a.)?
# $
rm m
! Solving 1 + m
= erc for rc and setting m = 2 and rm = 0:05, we get
% &
0:05
rc = 2 ln 1 + = 4:9385%
2
3. You will receive $130 in 6 months for an investment of $110 today. What is the
annualized percentage rate of return with
(a) annual compounding (1-times c.p.a.)?
! The eective (not annualized) return over 6 months is $130$110

" 1 = 18:18%.
# $ m(T !t)
We have to solve 1 + mr = $130
$110
for r, where (T " t) = 12 and m = 1.
Therefore,
% &2
$130
r= " 1 = 39:669%
$110
(b) semi-annual compounding (2-times c.p.a.)?

!# $ "
$130 2"0:5
! r = 2 $110 " 1 = 36:364%
(c) quarterly compounding (4-times.c.p.a.)?
2
!" # $
$130 2!0:25
! r=4 $110
" 1 = 34:846%
(d) monthly compounding (12-times c.p.a.)?

!" # 1 $
$130 2! 12
! r = 12 $110 " 1 = 33:88%
(e) weekly compounding (52-times c.p.a.)?

!" # 1 $
$130 2! 52
! r = 52 $110 " 1 = 33:518%
(f) continuous compounding (c.c.)?

" $130 #
! r = 2 ln $110
= 33:411%
4. The following (risk free) bonds are traded in the market:
- 1-year zero coupon with $1000 face value currently trades for $964.640
- 1.5-year zero coupon bond with $1000 face value currently trades for $940.353
- 2-year 4% semi-annual coupon bond with $1000 face value currently trades for $991.878 !
!
- 2-year 14% semi-annual coupon bond with $1000 face value currently trades for $1182.172
!
x% semi-annual coupon means $1000 x%
2
coupon payments every 6 months
(a) Calculate the 6-month, 1-year, 18-month, 2-year, 3-year, 4-year, and 5-year spot
rates (c.c.). Provide numerical results and analytical solutions.
! We denote the t-year spot rates by r0;t . The following table summarizes the
values and cash ows of the 7 bonds:
Time: 0 0:5 1 1:5 2 3 4 5

Value of bonds Cash ows of bonds
964:640 1000
940:353 1000
991:878 20 20 20 1020
1182:172 70 70 70 1070
973:042 40 40 1040
892:958 30 30 30 30 1030
1195:308 100 100 100 100 1100
3
First, we use the two zero-coupon bonds to calculate r0;1 and r0;1:5 :
! "
1000
r0;1 = ln = 3:6%
964:64
and
! "
1 1000
r0;1:5 = ln = 4:1%
1:5 940:353
We, then, use the two 2-year coupon bonds to replicate a 2-year zero-coupon
bond, i.e. buy one 2-year 4% semi-annual coupon bond with $1000 face value
2
and short sell (or issue) 7
numbers of 2-year 14% semi-annual coupon bonds
with $1000 face value. This investment strategy costs 991:878! 27 "1182:172 =
2
654:11, pays nothing (20 ! 7
" 70 = 0) after 6, 12 and 18 months, and pays
2
1020 ! 7
" 1070 = 714:29 after 2 years. Therefore, the strategy replicates a
2-year zero-coupon bond and we can calculate the 2-year spot rate:
! "
1 714:29
r0;2 = ln = 4:4%
2 654:11
Given r0;1 , r0;1:5 and r0;2 , we can use either of the 2-year coupon bonds to
calculate the 6-month spot rate:
! "
20
r0;0:5 = 2 ln !0:036
= 3%
991:878 ! 20e ! 20e!1:5"0:041 ! 1020e!2"0:044
Given r0;1 and r0;2 , we can use the 3-year coupon bond to calculate the 3-year
spot rate:
! "
1 1040
r0;3 = ln = 4:9%
3 973:042 ! 40e!0:036 ! 40e!2"0:044
Using the two 5-year coupon bonds we can replicate a 5-year zero-coupon
bond, i.e. buy one 5-year 3% annual coupon bond with $1000 face value
3
and short sell (or issue) 10
numbers of 5-year 10% annual coupon bond with
3
$1000 face value. This investment strategy costs 892:958 ! 10
" 1195:308 =
4
3
534:37, pays nothing (30 ! 10
" 100 = 0) after 1, 2, 3 and 4 years, and pays
3
1030! 10 "1100 = 700 after 5years. Therefore, the strategy replicates a 5-year
zero-coupon bond and we can calculate the 5-year spot rate:
! "
1 700
r0;5 = ln = 5:4%
5 534:37
Finally, given r0;1 , r0;2 , r0;3 and r0;5 , we can use either of the 5-year coupon
bonds to calculate the 4-year spot rate:
! "
1 30
r0;4 = ln
4 892:958 ! 30e!0:036 ! 30e!2"0:044 ! 30e!3"0:049 ! 1030e!5"0:054
= 5:2%
(b) Draw the yield curve (term structure). Does the liquidity preference theory con-
tradict with the shape of the term structure? Explain.
# The liquidity preference theory claims that investors demand a compensation

(higher interest rate) for holding long-term bonds in comparison to short-
term bonds because an investment in long-term bonds (relative to short-term
investments) implies that funds are tied up and there are stronger constraints
(less exibility) on future changes in the investors initial investment strategy.
(c) Verify that the yield of a 4-year 15% annual coupon bond with $1000 face value
curve)?
5
! Using the spot rates we can calculate the price of the bond,
150e!0:036 + 150e!2"0:044 + 150e!3"0:049 + 1150e!4"0:052 = 1345:6
Alternatively, we can calculate the price of the bond using the yield,
150e!0:0507595 +150e!2"0:0507595 +150e!3"0:0507595 +1150e!4"0:0507595 = 1345:6
The two results coincide and thus, 5:07595% is the correct yield. The duration
of the bond is
150e!0:0507595 150e!2"0:0507595
D = " 1year + " 2years
1345:6 1345:6
150e!3"0:0507595 1150e!4"0:0507595
+ " 3years + " 4years
1345:6 1345:6
= 3:385years
@P
Since the volatility of a bond ( @y
P
) equals #D, we can approximate the per-
centage change in the bond price by
#D " .y = #3:385 " 0:01% = #0:03385%
or the price drops from 1345:6 to
1345:6 " (1 # 0:0003385) = 1345:1
Indeed, we get the same result if we calculate the new bond price for the
higher yield of 5:07595% + 0:01% = 5:08595%, that is
150e!0:0508595 +150e!2"0:0508595 +150e!3"0:0508595 +1150e!4"0:0508595 = 1345:1
Therefore, the approximation works well for a small increase in the yield by
0.01%.
(d) Verify that the yield of a 5-year 6% annual coupon bond with $1000 face value
6
curve)?
! Using the spot rates we can calculate the price of the bond,
60e!0:036 + 60e!2"0:044 + 60e!3"0:049 + 60e!4"0:052 + 1060e!5"0:054 = 1022:5
Alternatively, we can calculate the price of the bond using the yield,
60e!0:0532815 +60e!2"0:0532815 +60e!3"0:0532815 +60e!4"0:0532815 +1060e!5"0:0532815 = 1022:5
The two results coincide and thus, 5:32815% is the correct yield. The duration
of the bond is
60e!0:0532815 60e!2"0:0532815 60e!3"0:0532815
D = " 1year + " 2years + " 3years
1022:5 1022:5 1022:5
60e!4"0:0532815 1060e!5"0:0532815
+ " 4years + " 5years
1022:5 1022:5
= 4:472 years
@P
Since the volatility of a bond ( @y
P
) equals #D, we can approximate the per-
centage change in the bond price by
#D " -y = #4:472 " 0:01% = #0:04472%
or the price drops from 1022:5 to
1022:5 " (1 # 0:0004472) = 1022
Indeed, we get the same result if we calculate the new bond price for the
higher yield of 5:32815% + 0:01% = 5:33815%, that is
60e!0:0533815 +60e!2"0:0533815 +60e!3"0:0533815 +60e!4"0:0533815 +1060e!5"0:0533815 = 1022
Therefore, the approximation works well for a small increase in the yield by
0.01%.
7
(e) Explain why the yield of the 4-year 15% annual coupon bond is lower than the
yield of the 5-year 6% annual coupon bond.
! The 4-year bond pays its cash ows relatively earlier in time than the 5-year
bond - indeed, the duration of the 4-year bond is lower then the duration of
the 5-year bond. Accordingly, in case of the 4-year bond for the calculation
of the yield, which is a weighted average of spot rates, we have to weight
the shorter spot rates more heavily than in the computation of the yield of
the 5-year bond. Given the yield curve has a positive slope, the yield of the
4-year bond with a relatively short duration is lower than the yield of the
5-year bond with a relatively long durations.
(f) Which of the two coupon bonds would have a higher yield if the yield curve was
decreasing? Explain.
! If the yield curve has a negative slope, then the 4-year bond has a higher
yield than the 5-year bond. In case of the 4-year bond there lies more weight
on the shorter (and now higher) spot rates in the calculation of the yield as
a weighted average of the spot rates, than in case of the calculation of the
5-year bonds yield.
(g) Explain why the volatility (sensitivity of the bond price with respect to changes in
the yield curve) of the 4-year 15% annual coupon bond is lower than the volatility
of the 5-year 6% annual coupon bond.
! An increase (decrease) in the yield has a stronger negative (positive) impact

on discounting and the present value of cash ows lying farther in the future.
Accordingly, a bond which pays its cash ows rather early in time (short
duration) is less aected by changes in the yield than a bond which pays its
cash ows rather late in time (long duration).
(h) Calculate the continuously compounded forward rates locking in the 1-, 2-, 3- and
4-year (risk free) interest rates starting in 1 year time. Moreover, calculate the
forward rate locking in the 2.5-year risk free interest rate starting in 6 months.
8
! We denote the continuously compounded forward rate locking in the (T2 " T1 )-
(T1 ;T1 )
year interest rate starting in (T1 " t) years by ft . By no arbitrage we
have
(T1 ;T2 )
e(T2 !t)rt;T2 = e(T1 !t)rt;T1 e(T2 !T1 )ft
or
(T1 ;T2 ) (T2 " t) rt;T2 " (T1 " t) rt;T1

ft =
T2 " T1
Therefore,
(1;2)
f0 = 2 # 0:044 " 0:036 = 5:2%
(1;3) 3 # 0:049 " 0:036
f0 = = 5:55%
2
(1;4) 4 # 0:052 " 0:036
f0 = = 5:733 3%
3
(1;5) 5 # 0:054 " 0:036
f0 = = 5:85%
4
(0:5;3) 3 # 0:049 " 0:5 # 0:03
f0 = = 5:28%
2:5
(i) Explain the relationship between forward rates and (market) expectations about
spot rates in the future.
! Forward rates are calculated solely from current spot rates using a no ar-
bitrage or payo replication argument - they are independent of investors
expectations about future changes in the yield curve. However, the expecta-
tion hypothesis says that the yield curve is upwards sloping if investors expect
the spot rates to be higher in the future and eectively forward rates equal
expected future spot rates.
9
Summer Term
1
1. Suppose the current stock price of the Walt Disney Company is $50 and you can enter
a forward contract (long or short position) to buy 50000 stocks in 9 months for $51
each. The Walt Disney stock is expected to increase to $53 in 9 months. The 9-month
(risk free) spot rate is 3% (c.c.).
(a) Is there an arbitrage if Walt Disney does not pay dividends? If so, carefully
describe a possible arbitrage strategy. What should be the forward price in a
world without arbitrage?
! To do not permit arbitrage the forward price should be
(0:75)
F0 = $50e0:75!0:03 = $51:138
The price of the forward contract ($51) is too cheap. We can lock in a risk free
prot by short selling 50000 stocks for $2500000, lend $2550000e"0:75!0:03 =
$2493265:655 for 9 months at the risk free interest rate of 3% (c.c.), and
taking a long position in the forward contract. This strategy pays today
$2500000 " $2493265:655 = $6734:345 and has for sure no cash ows in
future. In fact, at maturity we receive $2550000 from our investment in the
risk free asset, we buy 50000 stocks for the agreed price of $2550000 and
close out our short positions (in the spot market).
(b) Suppose the 3-month (risk free) spot rate is 2.75% (c.c.). Is there an arbitrage
if Walt Disney pays a dividend of $0.75 in 3 months? If so, carefully describe a
possible arbitrage strategy. What should be the forward price in a world without
arbitrage?
! To do not permit arbitrage the forward price should be
(0:75) ! "
F0 = $50 " $0:75e"0:25!0:0275 e0:75!0:03 = $50:376
The forward price ($51) is too expensive. We can lock in a risk free prot
by buying 50000 stocks for $2500000, borrow 50000 # $0:75e"0:25!0:0275 =
$37243 for 3 months at the risk free rate of 2.75% (c.c.), borrow 50000 #
2
$51e!0:75"0:03 = $2493265:665 for 9 months at the risk free rate of 3% (c.c.)
and take a short position in the forward contract. This strategy pays today
$37243 + $2493300 ! $2500000 = $30543. After 3 months we receive
50000 " $0:75 = $37500 dividends from holding 50000 stocks and have to
pay back $37243e0:25"0:0275 = $37500 because we have borrowed $37243 3
months earlier. Hence, there is $0 cash ow. At maturity, we have to deliver
50000 stocks (which we were holding for the past 9 months) and receive
50000 " $51 = $2550000 (short position in forward). Moreover, we have
to pay back $2493265:665e0:75"0:03 = $2550000 because we have borrowed
$2493265:665 9 months ago. Therefore, there is a $0 cash ow.
2. The current exchange rate between the Japanese Yen (Y en) and US dollar (U SD) is
0:0128 UYSD
en
. Suppose the 9-month spot rate in the USA (invest U SD) is 3% (monthly
compounded) and the 9-month spot rate in Japan (invest Y en) is 1% (quarterly com-
pounded).
(a) Assuming markets are arbitrage free, calculate the forward exchange rate to ex-
change U SD and Y en in 9 months.
12!0:75
(0:75) (1+ 0:03
12 )
# F0 = 0:0128 UYSD
en0:01 4!0:75
= 0:012993 UYSD
en
,
(1+ 4 )
or convert spot rate to c.c. spot rates
! "
0:03
r0;0:75 = 12 ln 1 + = 2:9963%
12
! "
f 0:01
r0;0:75 = 4 ln 1 + = 0:99875%
4
and then use formula derived in the lecture
(0:75) U SD
F0 = 0:0128e(0:029963!0:0099875)0:75 = 0:012993
Y en
(b) Is there an arbitrage opportunity if the forward price to buy Y en in 9 months is

the same as the current exchange rate (0:0128 UYSD
en
)? If so, describe an arbitrage
strategy. How much money can you make if you own $1000 which you can invest
(assume your trades do not have a price impact, e.g. exchanging Y en for U SD
3
does not aect the current exchange rate)?
! There is an arbitrage opportunity. We can borrow one Y en at 1% inter-

est for 9 months, exchange it immediately to U SD 0:0128, invest U SD
0:0128e(0:01!0:03)0:75 at 3% interest for 9 months, and take a long position
in the forward contract to exchange U SD 0:0128e0:01"0:75 to Y en e0:01"0:75 .
! "
This strategy pays today U SD 0:0128 1 " e(0:01!0:03)0:75 = U SD 0:00019.
In 9 months we receive U SD 0:0128e0:01"0:75 from our investment in the risk
free asset and have previously agreed to exchange it to Y en e0:01"0:75 . We have
to pay back Y en e0:01"0:75 for the one Y en borrowed 9 months ago. Hence, we
have a zero cash ow. We can scale up this strategy by any factor and thus,
generate an unlimited amount of money at the initial point in time without
having any liability in future. The strategy does not require any initial in-
vestment and our arbitrage prot does not depend on how much money we
have initially.
(c) The real interest rate is dened as the dierence between the nominal interest rate
and the expected ination, i.e. if in Japan the nominal interest rate is 1% and the
expected ination is 0.75% then the real interest rate is 0.25%. The real interest
rate measures by how much money grows in real terms or adjusted for increases
in prices, i.e. how much more consumption a dollar buys after investing it in the
risk free asset. How does your result in question a) change, if there was ination
in Japan. The nominal 9-month spot rate stays at 1% (quarterly compounded)
but there is an expected ination over the next 9 months of 0.75%?
! The result in question a) is unchanged because we do not care about real

interest rates and ination but only about nominal rates. The reason is that
we compare the nal (nominal) payo in U SD of two risk free strategies in
order to derive the forward exchange rate. That is, we compare the U SD
payo of investing one U SD in the USA to the payo of exchanging one
U SD today, investing it in Japan and exchanging the proceeds back to U SD
at a xed (nominal) forward exchange rate. Both strategies yield a U SD
4
amount and the payo depends only on nominal rates.
3. The current spot price of one lb of copper is $3.75, the 3.5-year spot rate is 2% (semi-
annual compounding), the (continuous ow of) storage costs of copper is 3% per year.
(a) In absence of arbitrage, what should be the forward price to trade copper in 3.5
years if copper was an investment asset?
! 0:02
"
! 2% twice c.p.a. is equivalent to 2 ln 1 + 2
= 1:9901% (c.c.).
(3:5)
F^0 = $3:75e3:5(0:019901+0:03) = $4:4656
(b) Since copper is a consumption asset, it might be impossible or undesirable to

short sell it in the spot market. Does the result/ formula in question a) still hold?
Explain carefully.
! For a consumption asset we have the (weaker) inequality

(3:5)
F0 " $3:75e3:5(0:019901+0:03) = $4:4656
If the forward price is below $4:4656 and the underlying is an investment
asset, then there exists an arbitrage strategy which involves a short position
in the underlying. In the case of a consumption asset we may not be able to
short sell and thus, an arbitrage strategy (which requires short selling) may
not be feasible.
(c) Assume copper is a consumption asset. Is there an arbitrage if the forward price
to trade copper in 3.5 years is $5? If so, describe an arbitrage strategy.
! We can borrow $5e!3:5"0:019901 = $4:6636, buy e3:5"0:03 lb of copper (cost:

$3:75e3:5"0:03 = $4:1652), and enter one short position in the forward. Cash
ow today: $4:7102# $4:1652 = $0:545. Over the following 3.5 years we
have a continuous negative cash ow according to the storage cost, that is
#0:03dtS" per lb of copper we are holding, where ' 2 (0; 3:5), S" is the price
of 1 lb of copper at time ' and dt is a very small time interval. To pay for
storage costs we sell at every time ' 2 (0; 3:5) a fraction of 0:03dt of our
commodity position, that is, at time ' we end up holding e(3:5!" )"0:03 lb of
copper and at maturity of the forward contract we hold exactly 1 lb of copper.
5
Since we nance storage costs by selling copper in the spot market we have a
zero net cash ow at every time ! 2 (0; 3:5). In 3.5 years, we deliver 1 lb of
copper which we were holding over the past 3.5 years and receive $5 (short
position in forward contract). In addition, we have to pay back our loan of
$4:6636e3:5!0:019901 = $5. Therefore, our arbitrage strategy (borrow $4:7102,
buy e3:5!0:03 lb of copper, enter 1 short position in the forward) pays an initial
cash ow of $0:545 and nothing thereafter.
(d) What is the convenience yield if the true forward price to trade copper in 3.5
years is $3.78?
" By denition of the convenience yield,

y0;3:5 : $3:78 = $3:75e3:5(0:019901+0:03"y0;3:5 ) and thus,
1
! "
y0;3:5 = 0:019901 + 0:03 # 3:5 ln $3:78
$3:75
= 4:7624%
4. The expected return of the Dow Jones Industrial Average index is 5.5% per year, its
dividend yield is 0%, the yield curve is at and the risk free interest rate is constant
(a) In general, do you expect speculators to take long or short positions in DJIA
forwards and futures? Explain.
(T )
" The expected index level in the DJIA in T years is E [ST ] = F0 e(0:055"0:02)T
(T )
> F0 . A speculator wants to take a long position to make money on average
(T )
(lock in the purchase price of F0 and expect to sell the DJIA again for E [ST ]
in the market).
(b) There is a forward contract with 9 months to maturity written on $1000 times the
DJIA index points at maturity. Given there is no arbitrage, what is the forward
price of the contract if the DJIA is currently at a level of 13000 index points?
" At time 0, the quoted DJIA forward price (denoted in index points) is
(0:75)
F0 = 13000e0:02!0:75 = 13196. The size of the forward contract is
(0:75)
$1000F0 = $13196000.
6
(c) Consider you have entered a short position in the forward contract in question
b). What is the value of your position 3 months later if the DJIA has increased
to 13001 index points? What if the DJIA has increased to 14500 index points?
! If the DJIA is 13001 index points:

(short)
V0:25 = ($13196000 " $1000 # 13001e0:02!0:5 ) e"0:02!0:5 = $63698
If the DJIA is 14500 index points:
(short)
V0:25 = ($13196000 " $1000 # 14500e0:02!0:5 ) e"0:02!0:5 = "$1435300
5. The current spot price of one bushel of corn is $5, the 1.5-year spot rate is 3% (c.c.),
the (continuous ow of) storage costs of corn is 5% per year.
(a) In absence of arbitrage, what should be the forward price to trade corn in 1.5
years if corn was an investment asset?
(1:5)
! F^0 = 5e1:5!(0:03+0:05) = 5:64
(b) Assume corn is a consumption asset. Is there an arbitrage if the forward price to
trade corn in 1.5 years is $10? If so, describe an arbitrage strategy.
! For a consumption asset we have the (weaker) inequality
(1:5)
F0 $ 5e1:5!(0:03+0:05) = 5:64
We can borrow 10e"1:5!0:03 = 9:56, buy e1:5!0:05 bushels of corn (cost: 5e1:5!0:05 =
5:39), and enter 1 short position in the forward. Cash ow today: 10e"1:5!0:03 "
5e1:5!0:05 = 4:17. Over the following 1.5 years we have a continuous negative
cash ow according to the storage cost, that is "0:05dtS' per bushel of corn
we are holding, where ( 2 (0; 1:5), S' is the price of 1 bushel of corn at time
( and dt is a very small time interval. To pay for storage costs we sell at
every time ( 2 (0; 1:5) a fraction of 0:05dt of our commodity position, that
is, at time ( we end up holding e(1:5"' )!0:05 bushels of corn and at maturity
of the forward contract we hold exactly 1 bushel. Since we nance storage
costs by selling corn we have a zero net cash ow at every time ( 2 (0; 1:5).
7
In 1.5 years, we deliver the 1 bushel of corn which we are holding and receive
10 (short position in forward contract). In addition, we have to pay back our
loan of 9:56e1:5!0:03 = 10. Therefore, our arbitrage strategy (borrow 9:56, buy
e1:5!0:05 bushels of corn, enter 1 short position in the forward) pays an initial
cash ow of 4:17 and nothing thereafter (for sure).
(c) What is the convenience yield if the true forward price to trade corn in 1.5 years
is $2.5?
! By denition of the convenience yield,

y0;1:5 : 2:5 = 5e1:5!(0:03+0:05"y0;1:5 ) and thus,
1
! "
y0;1:5 = 0:03 + 0:05 " 1:5 ln 2:5
5
= 54:21%
8
Summer Term
1
1. The contract size of one futures contract on the S&P 500 is $250 times the S&P 500
futures price - an increase by 1 index point means a transfer of $250 from the short to
the long position. Suppose today the S&P 500 index has reached 1460 index points,
the S&P 500 pays a dividend yield of 4.5% per year, the term structure of interest
rates is at and the short rate is constant over time and equals 2% (c.c.).
(a) In absence of arbitrage opportunities, what is todays futures price of the S&P
500 futures with maturity in 50 days?
! At time 0, the quoted S&P 500 futures price (denoted in index points) is
( 50 ) 50
F0 365 = 1460e(0:02!0:045) 365 = 1455. The size of one futures contract is there-
( 50 )
fore $250F0 365 = $363750.
(b) The initial margin (per contract) is $22000 and the maintenance margin is $17500.
Suppose over the next 6 days the S&P 500 index changes as follows:
(Careful: the table reports index points of the index not the futures!) For an
Day 0 1 2 3 4 5 6
S&P 500 Index 1460 1455 1458 1470 1490 1482 1479
investor with 5 short positions in the S&P 500 futures show how his margin ac-
count changes every day. Assume that the investor earns interest of 2% (c.c.) on
his margin account.
! 5 short positions in the futures means that the investor has to pay 5"$22000 =
$110000 into his margin account. The maintenance margin for 5 short posi-
tions is 5 " $17500 = $87500. The balance in the margin account grows from
1
one day to the next by a gross return of e0:02" 365 . To determine daily settle-
ment cash ows we rst have to calculate the futures prices on day 1 to 6.
( 50!i ) 50!i
The futures price on day i 2 f1; 2; 3; 4; 5; 6g is F i 365 = S i e(0:02!0:045) 365 ,
365 365
that is
Day 0 1 2 3 4 5 6
S&P 500 futures price 1455 1450.1 1453.2 1465.3 1485.3 1477.4 1474.5
2
On each day
! i2 f1; 2; 3; 4; 5; 6g, " 5 short positions pay
50!(i!1) 50!i
( ) ( )
5 $ $250 $ F i!1 365 % F i 365 ,
365 365
Day 0 1 2 3 4 5 6
Daily settlement $6125 %$3875 %$15125 %$25000 $9875 $3625
Accordingly, the margin account is
S&P 500 S&P 500 Daily Interest Margin Account Margin

Day Index Futures Payo ($) ($) Balance ($) Call ($)
0 1460 1455:0 110000:0
1 1455 1450:1 6125 6:0 116131:0
2 1458 1453:2 %3875 6:4 112262:4
3 1470 1465:3 %15125 6:2 97143:6
4 1490 1485:3 %25000 5:3 72148:9 37851:1
5 1482 1477:4 9875 6:0 119881:0
6 1479 1474:5 3625 6:6 123512:6
2. The US government tries to severely restrict proprietary trading activities of big nan-
cial institutions (Volcker rule).
(a) Discuss why individual traders may have incentives to take more risks than what
is optimal for their employer (institution or shareholders). Why might the Volcker
rule help to resolve this problem?
& For traders incentives to gamble may arise due to bonus schemes which pay
a lot to traders who perform very well but do not punish traders who loose
a lot of the employers money. The Volcker rule will ensure that nancial
institutions get rid of trading desks which are particularly exposed to the
aforementioned problem. Given institutions and traders are legally restricted
to enter derivative positions which are not used for the purpose of hedging
and institutions remove proprietary trading desks, it will be harder for traders
to speculate.
3
(b) Discuss why nancial institutions may have incentives to take more risks than
what is optimal for the entire economy. Why might the Volcker rule help to
resolve this problem?
! An investors investment decision depends on the trade o between the ex-

pected return and potential upside he can earn and the potential losses he may
suer. In general, an investor is willing to undertake a risky investment and
face a certain probability of losses and even bankruptcy given the expected
payo is large enough. The problem with a nancial institution is that it is
not a normal investor. A nancial institution is a cornerstone in our economy
in the sense that it serves as an intermediary between savers and the real
economy, which needs funding to produce real consumption goods. If nan-
cial institutions disappear (go bankrupt), the real economy suers because
many entrepreneurs may not receive funding to undertake valuable projects
(systemic risk). Accordingly, risk taking of a nancial institution does not
only imply a cost for the institution itself (which it trades o for some ex-
pected prot) but also imposes a cost on the entire (real) economy (negative
externality). A standard result in economics is that free trade (Adam Smiths
invisible hand) leads to an ecient goods allocation if there are no external-
ities or market power (Walrasian equilibrium). Since risk taking of nancial
institutions imposes negative externalities on the real economy, we know that
investment and risk taking decisions of nancial institutions do not lead to
an ecient outcome. To reduce costs of a nancial institutions bankruptcy
imposed on the entire economy governments have repeatedly bailed-out -
nancially distressed banks. However, bail-outs of nancial institutions by
governments reinforces the incentives of nancial institutions to take more
risk than what is ecient for the entire economy. Markets should be regu-
lated and nancial institutions should be restricted with respect to their risk
exposure. The Volcker rule may achieve this goal by restricting proprietary
trading activities.
(c) What are possible downsides of the Volcker rule?
4
! Restricting a nancial institution in its investment decision and eectively
forcing it to deviate from an optimal investment decision (from the nan-
cial institutions point of view) may lower its protability. It is hard to say
whether the Volcker rule imposes smaller or bigger costs on nancial institu-
tions than what the entire economy gains by reducing nancial institutions
risk exposures.
3. The standard deviation (square root of variance) of monthly changes in the spot price of
live cattle is 1.2 cents per lb. The standard deviation of monthly changes in the futures
price of live cattle is 1.4 cents per lb. The correlation between the spot and futures
price changes is 0.7. It is now October 15. A beef producer plans to purchase 200000
lb of live cattle on November 15 and wants to use the December futures contract to
hedge risk. Each futures contract is for delivery of 40000 pounds of cattle. How many
futures positions does the beef producer have to take to minimize his exposure to price
uctuations? Ignore tailing adjustments to account for daily settlement.
! The optimal hedge ratio is h = 0:7 1:2

1:4
= 0:6. Since the producer plans to purchase
live cattle in the future, he has a short position in the underlying and has to take
a long position in the futures to hedge his exposure to uncertainty the price of live
cattle (long hedge). The producer has to enter N = 0:6 200000
40000
= 3 long positions
in the futures.
&S +2 +3 -2 +1 +8 +0 -5 -4 +3 +7
&F +4 +5 -1 +0 +6 -1 -7 -4 +5 +8
(a) Use the data to calculate a minimum variance hedge ratio for an investor who
holds the commodity and plans to sell it soon. Ignore tailing adjustments to
account for daily settlement.
5
! E^ [#S] = 2+3!2+1+8+0!5!4+3+7 10
= 1310
, E^ [#F ] = 4+5!1+0+6!1!7!4+5+810
= 32 ,
2 2 2 2 2
(4! 32 ) +(5! 32 ) +(!1! 32 ) +(0! 32 ) +(6! 32 )
$ 2F = 10!1
2 2 2 2 2
(!1! 32 ) +(!7! 32 ) +(!4! 32 ) +(5! 32 ) +(8! 3:2 )
+ 10!1
= 23:389,
(2! 13
10 )( 4! 3
2 ) + ( 3! 13
10 )( 5! 3
2 ) + ( !2! 13
10 )( !1! 3
+ 1! 13
2) ( 10 )(
0! 32 )+(8! 13
10 )(
6! 32 )
$ SF = 10!1
(0! 13
10 )(
!1! 32 )+(!5! 13 10 )(
!7! 32 )+(!4! 13 10 )(
!4! 32 )+(3! 13
10 )(
5! 32 )+(7! 13
10 )(
8! 32 )
+ 10!1
19:5
= 19:5. The optimal hedge ratio is h = 23:389
= 0:83373. The company has a
long position in the underlying and wants to enter 0:83373 short positions in
the futures.
compute the value of your hedge for each of the ten days by adding losses/ gains
! The daily changes of holding the commodity and 0:83373 short positions in
the futures are:
#Si +2 +3 -2 +1 +8 +0 -5 -4 +3 +7
#Fi +4 +5 -1 +0 +6 -1 -7 -4 +5 +8
# (total position)i -1.33 -1.17 -1.17 +1 +3 +0.83 +0.84 -0.67 -1.17 +0.33
(c) What is the cumulative gain/ loss over the 10 days?

P
! i # (total position)i = 0:49
(d) What is the daily standard deviation in your gain/ losses?

s " # 2
P P %(total position)j
i ,(total position)i ! j 10
! 9
= 1:41
(e) What is the daily standard deviation without your hedge?

r $ %
P P %Sj 2
i ,Si ! j 10
! 9
= 4:27 > 1:41
(f) What is the daily standard deviation if you use a (not optimal) hedge of 1 short
position in the futures?
s !2
P P (%Sj !%Fj )
,S !,F !
i i i j 10
! 9
= 1:62 > 1:41
6
5. You own a stock portfolio with a CAPM-! of 2.25 and you know that you can eliminate
all market risk (reduce your portfolios ! to zero) if you take 40 short positions in S&P
500 futures.
(a) If you want to reduce your portfolios ! temporarily to 0.5, how many futures
(S)
V0
(2:25!0:5) (F )
V0
! We have to enter N = 40 V0
(S) = 31:1 short positions in the S&P 500
(2:25!0) (F )
V0
futures.
(b) If you want to increase your portfolios ! temporarily to 3, how many futures
(S)
V0
(2:25!3) (F )
V0
! We have to enter N = 40 V
(S) = "13:3 short positions or in other
(2:25!0) 0(F )
V0
words 13.3 long positions in the S&P 500 futures.
&S +5 +6 -2 -3 +8 +0 -5 -4 +1 +7
&F +6 +6 -1 -5 +6 -1 -6 -4 +0 +8
(a) Use the data to calculate a minimum variance hedge ratio for a company that
knows it will purchase the commodity in one month. Ignore tailing adjustments
to account for daily settlement.
! E^ [&S] = 5+6!2!3+8+0!5!4+1+710
= 13
10
, E^ [&F ] = 6+6!1!5+6!1!6!4+0+8
10
= 10 9
,
9 2 9 2 9 2 9 2 9 2
(6! 10 ) +(6! 10 ) +(!1! 10 ) +(!5! 10 ) +(6! 10 )
' 2F = 10!1
2 2 2 2 2
(!1! 109 ) +(!6! 109 ) +(!4! 109 ) +(0! 109 ) +(8! 109 )
+ 10!1
= 26:989,
(5! 10 )(6! 10 )+(6! 10 )(6! 10 )+(!2! 10 )(!1! 10 )+(!3 13
13 9 13 9 13 9
10 )(
9
!5! 10 )+(8! 13
10 )(
9
6! 10 )
' SF = 10!1
(0! 13 )(!1! 109 )+(!5! 13 10 )(
9
!6! 10 )+(!4! 1310 )(
9
!4! 10 )+(1! 13
10 )(
9
0! 10 )+(7! 13
10 )(
9
8! 10 )
+ 10 10!1
24:589
= 24:589. The optimal hedge ratio is h = 26:989
= 0:91107. The company has
a short position in the underlying and wants to enter 0:91107 long positions
in the futures.
7
compute the value of the hedge for each of the ten days by adding losses/ gains
! If the underlying price increases then the company has to pay more to pur-
chase the underlying in one month in the spot market. On the other side, if
the futures price increases the company earns money from its 0:91107 long
position in the futures. The daily changes in the cost to buy the underlying in
one month are: (the company will only pay the price to purchase the under-
%S +5 +6 -2 -3 +8 +0 -5 -4 +1 +7
%F +6 +6 -1 -5 +6 -1 -6 -4 +0 +8
% (total cost) -0.47 +0.53 -1.09 +2.56 +2.53 +0.91 +0.47 -0.36 +1 -0.29
lying in one month but we pretend for now that an increase is an immediate
cost). The total change in costs over the ten day period is +5.8, and the
standard deviation of daily changes is 1.226.
8
Solution - Problem Set 5 - FIN 524A
Summer Term
1
1. Today (time t = 0) the stock price of company Z is S0 = 50. In 6 months (time t = 0:5)
(u)
it changes (under the true probability measure P ) with probability of 60% to S0:5 = 65
(d)
and with probability 40% to S0:5 = 40. From time t = 0:5 to time t = 1 the stock price
may increase by 20% with a probability of 80% or decrease by 30% with a probability
of 20%. The risk free interest rate is constant and equal to 5% (c.c.). The yield curve
is at.
(a) Draw a tree.
! The stock and bond prices are as follows:

(uu)
S1 = 65 " 1:2 = 78
(ud)
S1 = 65 " 0:7 = 45:5
(du)
S1 = 40 " 1:2 = 48
(dd)
S1 = 65 " 0:7 = 28
(u) (d)
B0:5 = B0:5 = e0:05!0:5 = 1:0253
(uu) (ud) (du) (dd)
B0:5 = B0:5 = B0:5 = B0:5 = e0:05 = 1:0513
The nal payos of the put are:

(uu)
P1 = max f0; 50 $ 78g = 0
(ud)
P1 = max f0; 50 $ 45:5g = 4:5
(du)
P1 = max f0; 50 $ 48g = 2
(dd)
P1 = max f0; 50 $ 28g = 22
(b) Use replicating portfolios to calculate the price of a European at-the-money put
option with 1 year left to maturity.
! We start with the u state:

(u) (u)
78/0:5 + e0:05 b0:5 = 0
(u) (u)
45:5/0:5 + e0:05 b0:5 = 4:5
2
or
(u) 4:5
!0:5 = = !0:138
45:5 ! 78
(u) 4:5
b0:5 = !78 e!0:05 = 10:273
45:5 ! 78
and
! "
(u) 4:5 0:05"0:5 4:5 !0:05
P0:5 = 65 +e !78 e
45:5 ! 78 45:5 ! 78
= 1:5333
For state d we have:

(d) (d)
48!0:5 + e0:05 b0:5 = 2
(d) (d)
28!0:5 + e0:05 b0:5 = 22
or
(d) 22 ! 2
!0:5 = = !1
28 ! 48
(d)
b0:5 = (2 ! 48 (!1)) e!0:05 = 47:561
and
(d) # $
P0:5 = 40 (!1) + e0:05"0:5 (2 ! 48 (!1)) e!0:05
= 8:7655
3
At time t = 0 we have:
65%0 + e0:05!0:5 b0 = 1:5333
40%0 + e0:05!0:5 b0 = 8:7655
or
8:7655 ! 1:5333
%0 = = !0:289
! 40 ! 65 "
8:7655 ! 1:5333 "0:05!0:5
b0 = 1:5333 ! 65 e = 19:835
40 ! 65
and
! "
(u) 8:7655 ! 1:5333 8:7655 ! 1:5333 "0:05!0:5
P0:5 = 50 + 1:5333 ! 65 e
40 ! 65 40 ! 65
= 5:3705
(c) Use "risk neutral" probabilities to price a European at-the-money put option with
1 year left to maturity.
" We start with the u state:
h $ %i
(u) (u)
78q0:5 + 45:5 1 ! q0:5 e"0:05!0:5 = 65
or
(u) 65e0:05!0:5 ! 45:5

q0:5 = = 0:65063
78 ! 45:5
and
' ! "(
(u) 65e0:05!0:5 ! 45:5 65e0:05!0:5 ! 45:5
P0:5 = 0 + 4:5 1 ! e"0:05!0:5
78 ! 45:5 78 ! 45:5
= 1:5333
For the d state we have:
h $ %i
(d) (d)
48q0:5 + 28 1 ! q0:5 e"0:05!0:5 = 40
or
(d) 40e0:05!0:5 ! 28
q0:5 = = 0:65063
48 ! 28
4
and
! " #$
(d) 40e0:05!0:5 ! 28 40e0:05!0:5 ! 28
P0:5 = 2 + 22 1 ! e"0:05!0:5
48 ! 28 48 ! 28
= 8:7655
At time t = 0 we have:
[65q0 + 40 (1 ! q0 )] e"0:05!0:5 = 50
or
50e0:05!0:5 ! 40
q0 = = 0:45063
65 ! 40
and
! " #$
50e0:05!0:5 ! 40 50e0:05!0:5 ! 40
P0:5 = 1:5333 + 8:7655 1 ! e"0:05!0:5
65 ! 40 65 ! 40
= 5:3705
(d) What is the price of an American at-the-money put option with 1 year left to
maturity?
" We have to check in every state whether we should exercise early. In state u
(u)
exercising does not makes sense since S0:5 > K. In state d exercising early
pays 50 ! 40 = 10 > 8:7655; we want to exercise early at tiem t = 0:5 in state
d because the intrinsic value of the put is larger than the value of a European
put (negative time value). The time value is negative for a put option if we
know for sure that the option will be exercised in future. At time t = 0 we
have:
" " ##
50e0:05!0:5 ! 40 50e0:05!0:5 ! 40
P0:5 = 1:5333 + 10 1 ! e"0:05!0:5
65 ! 40 65 ! 40
= 6:0319
2. At time t = 0, the price of stock Y is $100. Over the next 3 months (until time
t = 0:25), it may increase to $130 (before dividend price) or decline to $50 (before
dividend price) with equal probability. If the stock price has increased from time t = 0
to t = 0:25, then Y pays a dividend of $20 (ex-dividend price is $110). It does not
5
pay a dividend if the stock price has declined from time t = 0 to t = 0:25. If the
stock price has increased from time t = 0 to t = 0:25, then the stock price will increase
to $143 with a probability of 70% or decline to $55 with a probability of 30% over
the following 3 months (until time t = 0:5). If the stock price has declined from time
t = 0 to t = 0:25, then the stock price will increase to $65 with a probability of 40%
and decline to $25 with a probability of 60% over the following 3 months (until time
t = 0:5). The short rate (risk-free interest rate) is constant over time and 5% (c.c.).
(a) What is the value (at time t = 0) of an at-the-money European call option with
6 months left to maturity? Use replicating portfolios to price the option.
! The possible values of the call option at maturity are
(uu)
C0:5 = 43
(ud)
C0:5 = 0
(du)
C0:5 = 0
(dd)
C0:5 = 0
(u)
The replicating portfolio in the up state at time t = 0:25 is (0:25 number of
(u)
stocks and b0:25 number of bonds such that
(u) (u)
43 = 143(0:25 + b0:25 e0:05!0:5
(u) (u)
0 = 55(0:25 + b0:25 e0:05!0:5
or
(u) 43
(0:25 = = 0:489
143 " 55
(u) 43
b0:25 = "55 e"0:05!0:5 = "26:211
143 " 55
The value of the call option in the up state at time t = 0:25 is
(u)
C0:25 = 0:489 # 110 " 26:211e0:05!0:25 = 27:249
6
(d)
The replicating portfolio in the down state at time t = 0:25 is %0:25 number
(d)
of stocks and b0:25 number of bonds such that
(u) (u)
0 = 65%0:25 + b0:25 e0:05!0:5
(u) (u)
0 = 25%0:25 + b0:25 e0:05!0:5
or
(u)
%0:25 = 0
(u)
b0:25 = 0
The value of the call option in the up state at time t = 0:25 is
(u)
C0:25 = 0 ! 50 + 0e0:05!0:5 = 0
The replicating portfolio at time t = 0 is %0 number of stocks and b0 number

of bonds such that
(u)
27:249 = 130%0 + b0:25 e0:05!0:25
(u) (u)
0 = 50%0:25 + b0:25 e0:05!0:25
or
(u) 27:249
%0:25 = = 0:340
130 " 50
(u) 27:249 "0:05!0:25
b0:25 = "50 e = "16:819
130 " 50
The value of the call option at time t = 0 is
(u)
C0:25 = 0:340 ! 100 " 16:819 = 17:181
(b) What is the value (at time t = 0) of an at-the-money American call option with
7
6 months left to maturity?
! Check whether it is optimal to exercise early. Indeed, it is optimal to exercise

early in the up state at time t = 0:25 just before the dividend is paid and
receive 130"100 = 30 (if we do not exercise early the option is worth 27:249).
It is not optimal to exercise the option early in the down state at time t = 0:25.
Therefore, the replicating portfolio at time t = 0 is *0 number of stocks and
b0 number of bonds such that
(u)
30 = 130*0 + b0:25 e0:05!0:25
(u) (u)
0 = 50*0:25 + b0:25 e0:05!0:25
or
(u) 30
*0:25 = = 0:375
130 " 50
(u) 30
b0:25 = "50 e"0:05!0:25 = "18:517
130 " 50
The value of the call option at time t = 0 is
(u)
C0:25 = 0:375 # 100 " 18:517 = 18:983
3. The current stock price of H 2 is $65. It is certain that the stock pays $3 dividends in 1
month and 4 months. A European at-the-money put option with 5 months to maturity
is traded for $6. A European at-the-money call option with 5 months to maturity is
traded for $5. 1-month, 4-month and 5-month spot rates are 13%, 11% and 9.5% (c.c.).

pays o today and has for sure zero cash ows at any time in the future.
! Use put-call parity to check whether there is an arbitrage:
5 1 4
65 # e"0:095! 12 = 62:5 6= 6 " 5 + 65 " 3 # e"0:13! 12 " 3 # e"0:11! 12 = 60:1
8
A possible arbitrage strategy is:
Strategy Cash Flows

time 0 1 month 4 months 5 months
buy 1 stock H 2 !65 +3 +3 +S 5
n 12 o
buy 1 put !6 + max 65 ! S 5 ; 0
n 12
o
sell 1 call +5 ! max S 5 ! 65; 0
12
1
!0:13" 12
borrow 3 " e for 1 month +2:97 !3
4
borrow 3 " e!0:11" 12 for 4 months +2:89 !3
5
!0:095" 12
borrow 65 " e for 5 months +62:5 !65
Total +2:34 0 0 0
(b) What level in the interest rate ensures that markets are arbitrage free?
# To ensure that there is no arbitrage r0; 5 must be a root to

12
5
!r0; 5 " 12 1 4
65 " e 12 = 6 ! 5 + 65 ! 3 " e!0:13" 12 ! 3 " e!0:11" 12
# $
12 65
r= 5
" ln 1 4 = 18:65% is a solution.
6!5+65!3"e!0:13" 12 !3"e!0:11" 12
4. The current stock price of Apple is $650. It is certain that the stock pays a $5 dividend
in 2 months. A European at-the-money put option with 3 months to maturity is traded
for $50. A European at-the-money call option with 3 months to maturity is traded
for $45. The term structure of interest rates is at and the short rate is constant and
equals 3% (c.c.).

pays o today and has for sure zero cash ows at any time in future.
# According to the put-call parity a 3-month zero-coupon bond with face value
2
of $650 should trade for X = $50 ! $45 + $650 ! $5e!0:03" 12 = $650:02
% &
(negative (annualized) interest rate of r = ! 12
3
" ln 650:02
650
= !0:0123%
(c.c.)). However, since the interest rate is 3% (c.c.) a zero-coupon bond is
9
3
traded for $650e!0:03" 12 = $645:14. An arbitrage strategy is to buy a zero-
coupon bond for $645.14, write 1 put option, buy 1 call option, short sell 1
2
stock and lend $5e!0:03" 12 for 2 months at 3% interest. The cash ow today
2
is: !$645:14 + $50 ! $45 + 650 ! $5e!0:03" 12 = $4:88. In 2 months we receive
2
$5 from the $5e!0:03" 12 invested at 3%, and we have to pay $5 due to our
short position in the stock and the $5 dividend payment - there is a zero cash
ow. At maturity of the options we receive $650 from our zero-coupon bond,
the put option pays ! max f$650 ! S; 0g, the call pays max fS ! $650; 0g,
and closing the short position in the stock means we have to pay S, where
S is the stock price at maturity of the options. Independent of whether S is
larger or smaller than $650, there is a zero cash ow. Hence, we have found
an arbitrage strategy.
(b) What level in the short rate ensures that markets are arbitrage free?
$ To ensure that there is no arbitrage r must be a root to
3 2
$650e!r" 12 = $50 ! $45 + $650 ! $5e!r" 12
r = 0 is a solution.
5. The current stock price of 3M Co. is $100 and in each 3 month period it will either
model.
10
! Stock prices are
(u)
S0:25 = 125
(d)
S0:25 = 85
(uu)
S0:5 = 156:25
(ud)
S0:5 = 106:25
(du)
S0:5 = 106:25
(dd)
S0:5 = 72:25
The risk neutral probabilities are

e0:05!0:25 " 0:85
qu = = 0:40645
1:25 " 0:85
1 " qu = 0:59355
where qu denotes the risk neutral probability of a 25% increase in the stock
price over a 3 month time period and 1 " qu denotes the risk neutral proba-
bility of a 15% decline in the stock price over a 3 month time period (these
probabilities are constant within the entire tree since u, d and r are constant)
(b) What is the price of a 6-month European at-the-money call option? How many
call option positions do you hold to optimally hedge 1 long position in the stock
at every point in time (i.e. what is the optimal hedge today, and what is the
optimal hedge in 3 months)? Explain why the optimal hedge diers at dierent
points in time.
! A call option with a strike price 100 has the nal payos of
(uu)
C0:5 = max f156:25 " 100; 0g = 56:25
(ud)
C0:5 = max f106:25 " 100; 0g = 6:25
(du)
C0:5 = max f106:25 " 100; 0g = 6:25
(dd)
C0:5 = max f72:25 " 100; 0g = 0
11
The price of the call option is
! "
C0 = e!r"2"0:25 56:25qu2 + 6:25 ! 2qu (1 " qu )
! "
= e!0:05"2"0:25 56:25 ! 0:406452 + 6:25 ! 2 ! 0:40645 ! 0:59355
= 12:004
In the up state we hold 1 short position in the call to hedge 1 long position
in the stock - since we are sure the option is exercised 3 months later the
option payo depends linearly on the stock price. In the down state we hold
106:25!72:25
6:25!0
= 5:44 short positions in the call to hedge 1 long position in the
stock - 5.44 is the inverse of the number of stocks (-) needed in a replicating
portfolio to compute a call option price. The call prices in the up and down
states are
(u)
C0:25 = e!0:05"0:25 ! (0:40645 ! 56:25 + 0:59355 ! 6:25)
= 26:242
(d)
C0:25 = e!0:05"0:25 ! 0:40645 ! 6:25 = 2:5088
125!85
At origination, we hold 26:242!2:5088
= 1:6854 short positions in the call option
to hedge 1 long position is the stock - 1.6854 is the inverse of the number of
stocks (-) needed in a replicating portfolio to compute a call option price.
(c) What is the price of a 6-month European put option with a strike price of $90.
# The European put option has nal payos

(uu)
P0:5 = max f90 " 156:25; 0g = 0
(ud)
P0:5 = max f90 " 106:25; 0g = 0
(du)
P0:5 = max f90 " 106:25; 0g = 0
(dd)
P0:5 = max f90 " 72:25; 0g = 17:75
The price of the put is
P0 = e!r"2"0:25 17:75 ! (1 " qu )2
= e!0:05"2"0:25 17:75 ! 0:593552
= 6:0991
12
(d) How does your result in (c) change if 3M pays a dividend of $15 in 3 months?
! The European put option has a nal payos

(uu)
P0:5 = max f90 # 137:5; 0g = 0
(ud)
P0:5 = max f90 # 93:5; 0g = 0
(du)
P0:5 = max f90 # 87:5; 0g = 2:5
(dd)
P0:5 = max f90 # 59:5; 0g = 30:5
The price of the put is

! "
P0 = e!r"2"0:25 2:5qu (1 # qu ) + 30:5 (1 # qu )2
! "
= e!0:05"2"0:25 2:5 % 0:40645 % 0:59355 + 30:5 % 0:593552
= 11:068
6. The current stock price of XYZ is $100 and in each 1 month period it will either
model.
! Stock prices are

(u)
S0:25 = 115
(d)
S0:25 = 90
(uu)
S0:5 = 132:25
(ud)
S0:5 = 103:5
(du)
S0:5 = 103:5
(dd)
S0:5 = 81
The risk neutral probabilities are

1 # 0:9
qu = = 0:4
1:15 # 0:9
1 # qu = 0:6
where qu denotes the risk neutral probability of a 15% increase in the stock
13
price over a 1 month time period and qd denotes the risk neutral probability of
a 10% decline in the stock price over a 1 month time period (these probabilities
are constant within the entire tree since u, d and r are constant)
(b) Use replicating portfolios to calculate the price of a European call option with a
strike price of $110 and 2 months to maturity.
! In 2 months the call can take the prices:

(uu)
C0:17 = max f132:25 # 110; 0g = 22:25
(ud) (du)
C0:17 = C0:17 = max f103:5 # 110; 0g = 0
(dd)
C0:17 = max f81 # 110; 0g = 0
(u) (u)
In 1 month in the up state we buy a portfolio of +0:08 stocks and b0:08 bonds
to replicate the option, i.e.
(u) (u)
22:25 = 132:25+0:08 + b0:08
(u) (u)
0 = 103:5+0:08 + b0:08
that is
(u) 22:25 # 0
+0:08 = = 0:7739
132:25 # 103:5
(u) 22:25 # 0
b0:08 = #103:5 % = #80:1
132:25 # 103:5
The option is worth
(u)
C0:08 = 115 % 0:7739 # 80:1 = 8:9
(d)
In 1 month in the down state we buy a portfolio of +0:08 = 0 stocks and
(d) (d)
b0:08 = 0 bonds to replicate the option, which is worthless, C0:08 = 0, since
we know that it will not be exercised for sure. Today we buy a portfolio of
+0 stocks and b0 bonds to replicate the option, i.e.
8:9 = 115+0 + b0
0 = 90+0 + b0
14
that is
8:9 ! 0
!0 = = 0:356
115 ! 90
8:9 ! 0
b0 = !90 " = !32:04
115 ! 90
The option is worth
C0 = 100 " 0:356 ! 32:04 = 3:56
(c) Compute the price of a European at-the-money call option with 4 months to
maturity?
# We can use the binomial tree model

X4 " %
4! k 4!k
# k 4!k
$
C0 = " 0:4 " 0:6 " max 1:15 " 0:9 " 100 ! 100; 0
k=0
k! (4 ! k)!
= 10:04
(d) Compute the price of a European put option with a strike price of $90 and a 4
months to maturity.
# We can use the binomial tree model

X4 " %
4! k 4!k
# k 4!k
$
C0 = " 0:4 " 0:6 " max 90 ! 1:15 " 0:9 " 100; 0
k=0
k! (4 ! k)!
= 5:29
(e) How does your result in (c) change if XYZ pays a dividend of $30 in 3 months
and the option is American? What is the value of being able to exercise early?
# The possible call prices if hold until maturity are

(uuuu)
C4 = 40:4
12
(uuud)
C4 = 9:8
12
(uudu) (uduu) (duuu)
C4 = C4 =C4 = 2:4
12 12 12
(uudd) (udud) (duud)
C4 = C4 =C4 =0
12 12 12
(fhgu) (fhgd)
C4 = C4 =0
12 12
where fhg indicates any possible history except for fuuug, fuudg, fudug and
15
fduug. The price of the European option is
(European)
C0 = 0:44 # 40:4 + 0:43 # 0:6 # 9:8 + 3 # 0:43 # 0:6 # 2:4 = 1:687
For the American option with have to check whether it is worth to exercise
the option early after 3 months,
(uuu) state: max f152:1 $ 100; 122:1 $ 100; 0:4 # 40:4 + 0:6 # 9:8g
8 9 = 52:1
>
> (uud) state >
>
>
< >
=
(udu) state : max f119 $ 100; 89 $ 100; 0:4 # 2:4 + 0:6 # 0g = 19
>
> >
>
>
: (duu) state >
;
The American option will be exercised early in 3 months if and only if we are
in the (uuu), (uud), (udu) and (duu) states. Next, we have to check whether
it is worth to exercise the option early after 2 months,
(uu) state: max f132:25 $ 100; 0:4 # 52:1 + 0:6 # 19g = 32:25
8 9
< (ud) state =
: max f103:5 $ 100; 0:4 # 19 + 0:6 # 0g = 7:6
: (du) state ;
The American option will never be exercised early in 2 months (actually, we

are indierent whether to exercise early or not if we are in the (uu) state).
Finally, we have to check whether it is worth to exercise early after 1 month
(u) state: max f115 $ 100; 0:4 # 32:25 + 0:6 # 7:6g = 17:46
(d) state: max f90 $ 100; 0:4 # 7:6 + 0:6 # 0g = 3:04
The American option will never be exercised early in 1 month. The American
option price today is
(American)
C0 = 0:4 # 17:46 + 0:6 # 3:04 = 8:81
The value of being able to exercise early is
(American) (European)
C0 $ C0 = 7:12
16
7. At time t = 0, the current exchange rate between US-dollar (USD) and Euro (EUR) is
1.1 USD per EUR. Suppose the risk-free interest rates are 5% (per year) in USD and
1% (per year) in EUR (continuously compounded). Assume that the risk-free interest
rates in both currencies are constant over time. Suppose the exchange rate volatility
is 19.0621% per year and the USD is expected to appreciate against the EUR by 1.5%
(continuously compounded) per year.
(a) What is the forward exchange rate (forward price) you can lock in today (at t = 0)
to exchange 1 EUR to USD in 2.5 years?
(1:5) U SD U SD
! F0 = 1:1e(0:05!0:01)"2:5 EU R
= 1:2157 EU R
(b) Use a Binomial tree with 2 time steps to nd the price at t = 0 of a European put
option with a strike exchange rate of 1.3 USD per EUR and 6 months to maturity
(that is, in your tree each time step equals a time interval of 3 months). Note that
the underlying is 1 EUR, that is, the put option gives the long position the right
p T !t
to sell 1 EUR at the xed strike price of 1.3 USD. [Hint: set d1 = u = e( n ,
1 2
q
1 1 )! 2 ( T !t
p= 2+2 ( n
; with ( = 19:0621%; ) # 12 ( 2 = #1:5%]
! We choose the parameters

p 0:5
u = e0:190621 2 = 1:1
p 0:5
d = e!0:190621 2 = 0:9091
The exchange rate takes the possible values

(u)
E0:25 = 1:1 $ 1:1 = 1:21
(d)
E0:25 = 1:1 $ 0:9091 = 1
(uu)
E0:5 = 1:21 $ 1:1 = 1:331
(ud)
E0:5 = 1:21 $ 0:9091 = 1:1
(du)
E0:5 = 1 $ 1:1 = 1:1
(dd)
E0:5 = 1 $ 0:9091 = 0:9091
17
The possible nal payos of the European put option are
(uu)
P0:5 = max f0; 1:3 " 1:331g = 0
(ud) (du)
P0:5 = P0:5 = max f0; 1:3 " 1:1g = 0:2
(dd)
P0:5 = max f0; 1:3 " 0:9091g = 0:3909
Note that holding 1 EUR for 0.25 years returns EUR e0:01!0:25 . The risk
neutral probability of an appreciation in the EUR is determined by
! "
1:1 = e"0:05!0:25 q $ 1:21 $ e0:01!0:25 + (1 " q) $ 1 $ e0:01!0:25
or
1:1e(0:05"0:01)!0:25 " 1
q= = 0:529
1:21 " 1
The price of the European put option is

(u)
P0:25 = e"0:05!0:25 (0:529 $ 0 + (1 " 0:529) $ 0:2) = 0:093
(d)
P0:25 = e"0:05!0:25 (0:529 $ 0:2 + (1 " 0:529) $ 0:3909) = 0:286
P0 = e"0:05!0:25 (0:529 $ 0:093 + (1 " 0:529) $ 0:286)

! "
= e"0:05!0:5 2 $ 0:529 $ (1 " 0:529) $ 0:2 + (1 " 0:529)2 $ 0:3909 = 0:182
The price at time t = 0 of the European put option is USD 0:182.
(c) Use again the Binomial tree in (b). What is the value at time t = 0 of an
American put option with a strike exchange rate of 1.3 USD per EUR and 6
months to maturity?
% Check for early exercising at t = 0:25: in up state do not exercise early as

(u)
it would yield 1:3 " 1:21 = 0:09 < 0:093 = P0:25 ; in the down state exercise
(d)
early since it yields 1:3 " 1 = 0:3 > 0:286 = P0:25 . If it is not exercised at
t = 0, the value of the American put is
P0 = e"0:05!0:25 (0:529 $ 0:093 + (1 " 0:529) $ 0:3) = 0:188
18
At time t = 0: exercise early since it yields 1:3 ! 1:1 = 0:2 > 0:188 = P0 .
Therefore, the American put option will be exercised at time t = 0 and its
value is USD 0:2.
19

FIN524A Options and Futures

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FIN524A Options and Futures

Uploaded by

Copyright:

Available Formats

Options and Futures

GMSF FIN 524A Summer 2016

Class Time: July 12, 14, 16, 19, 21 9.00am 1pm

Location: Bauer Hall 150

Credit Hours: 1.5 Units

Office Location: Simon Hall 210

Office Phone: 314 935 3318

Take-home exam 40%

Final Exam 60%

COURSE SCHEDULE [Summer Term]

Thomas Andreas Maurer

Olin Business School,

Chapter 0: Course Details Content

Introduction to derivative markets

In-depth discussion of most common derivative contracts (forwards,

=> Balance between theoretical concepts in asset pricing,

Chapter 0: Course Details Readings

John C. Hull, Options,

Oce hours (Simon Hall 210):

Chapter 0: Course Details Assessment

Requirement Weight Schedule

Take-Home Exam 40% before July 23, 6pm

Take-home Exam has to be sent to me by email anytime before 6pm

Chapter 0: Course Details Expectations

What You get from Me

Chapter 1: Introduction Basics of Derivatives

Limited time to maturity

Examples of derivatives: futures, forwards, swaps, options, warrants,

The underlying variables can be almost anything:

Chapter 1: Introduction Basics of Derivatives

Examples of Derivative Payos: Forward (I)

A forward contract is an agreement to trade the underlying asset in

Examples of Derivative Payos: Forward (II)

On the 4th of June, the treasurer of a corporation enters into a long

Chapter 1: Introduction Basics of Derivatives

Examples of Derivative Payos: Forward (III)

or $100000, $50000, $0, !$50000, !$100000

Derivatives play a key role in transferring risks in the economy

Many nancial transactions have embedded derivatives

In corporate nance, the concept of real options is essential for the

Chapter 1: Introduction Derivatives Markets

Derivatives Markets (I)

Exchange traded Over-the-Counter (OTC) traded

Standardized contracts as Tailor-made and not (necessarily)

Trading oor Network of dealers linked

Closing-out before maturity Held until maturity;

Derivatives Markets (II)

Margin requirements Collateral possible

No credit, default, Credit risk

Liquidity depends on contract Potential liquidity risk

Regulated Few regulations in the past,

Chapter 1: Introduction Derivatives Markets

CME Group (www.cmegroup.com)

Size of OTC and Exchange-Traded Markets

Figure: Source: Bank for International Settlements (www.bis.org). Total notional

Chapter 1: Introduction Derivatives Markets

Size of OTC Market: Notional Amount vs Market Value

Figure: Source: Bank for International Settlements (www.bis.org). Total notional

OTC Market: Notional Amount

Figure: Source: Bank for International Settlements (www.bis.org). Total notional

Chapter 1: Introduction Derivatives Markets

OTC Market: Market Value

Figure: Source: Bank for International Settlements (www.bis.org). Gross market

OTC Credit Risk: Lehman Bankruptcy