Ch01 11HullFundamentals6thEd

Introduction
Chapter 1
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.1
The Nature of Derivatives
A derivative is an instrument whose value depends on the values of other more basic underlying variables
1.2
Examples of Derivatives
Futures Contracts Forward Contracts Swaps Options
1.3
Ways Derivatives are Used

To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another
1.4
Futures Contracts
A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)
1.5
Exchanges Trading Futures

Chicago Board of Trade Chicago Mercantile Exchange Euronext Eurex BM&F (Sao Paulo, Brazil) and many more (see list at end of book)
1.6
Futures Price
The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price
1.7
Electronic Trading
Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
1.8
Examples of Futures Contracts

Agreement to: buy 100 oz. of gold @ US$600/oz. in December (NYMEX) sell 62,500 @ 1.9800 US$/ in March (CME) sell 1,000 bbl. of oil @ US$65/bbl. in April (NYMEX)
1.9
Terminology
The party that has agreed to buy has a long position The party that has agreed to sell has a short position
1.10
Example
January: an investor enters into a long futures contract on COMEX to buy 100 oz of gold @ $600 in April April: the price of gold $615 per oz What is the investors profit?
1.11
Over-the Counter Markets

The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers
1.12
Size of OTC and Exchange Markets

(Figure 1.2, Page 4)
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
1.13
Forward Contracts
Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates
1.14
Foreign Exchange Quotes for GBP on July 14, 2006 (See page 5)
Bid 1.8360 1.8372 1.8400 1.8438 Offer 1.8364 1.8377 1.8405 1.8444
1.15
Spot 1-month forward 3-month forward 6-month forward
Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)
1.16
American vs European Options

An American option can be exercised at any time during its life A European option can be exercised only at maturity
1.17
Intel Option Prices (Sept 12, 2006; Stock Price=19.56); See page 6
Calls Jan 2007 4.950 2.775 1.175 0.375 0.125 Puts Jan 2007 0.150 0.475 1.375 3.100 5.450
Strike Price ($) $15.00 $17.50 $20.00 $22.50 $25.00
Oct 2006 4.650 2.300 0.575 0.075 0.025
Apr 2007 5.150 3.150 1.650 0.725 0.275
Oct 2006 0.025 0.125 0.875 2.950 5.450
Apr 2007 0.275 0.725 1.700 3.300 5.450
1.18
Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange International Securities Exchange Eurex (Europe) and many more (see list at end of book)
1.19
Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price
1.20
Three Reasons for Trading Derivatives: Hedging, Speculation, and Arbitrage

Hedge funds trade derivatives for all three reasons (See Business Snapshot 1.1) When a trader has a mandate to use derivatives for hedging or arbitrage, but then switches to speculation, large losses can result. (See Barings, Business Snapshot 1.2)
1.21
Hedging Examples (Example 1.1 and 1.2,

page 11)
A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
1.22
Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)
40,000 Value of Holding ($)
35,000 No Hedging 30,000 Hedging
25,000 Stock Price ($) 20,000 20 25 30 35 40
1.23
Speculation Example (pages 14)

An investor with $2,000 to invest feels that Amazon.coms stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of $22.50 is $1 What are the alternative strategies?
1.24
Arbitrage Example (pages 15-16)

A stock price is quoted as 100 in London and $182 in New York The current exchange rate is 1.8500 What is the arbitrage opportunity?
1.25
1. Gold: An Arbitrage Opportunity?

Suppose that: The spot price of gold is US$600 The quoted 1-year futures price of gold is US$650 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
1.26
2. Gold: Another Arbitrage Opportunity?

1.27
The Futures Price of Gold

If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=600, T=1, and r=0.05 so that F = 600(1+0.05) = 630
1.28
1. Oil: An Arbitrage Opportunity?

Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$80 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
1.29
2. Oil: Another Arbitrage Opportunity?

Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$65 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
1.30
Mechanics of Futures Markets

Chapter 2
2.1
Futures Contracts
Available on a wide range of underlyings Exchange traded Specifications need to be defined:
What can be delivered, Where it can be delivered, & When it can be delivered
Settled daily
2.2
Margins
A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
2.3
Example of a Futures Trade

An investor takes a long position in 2 December gold futures contracts on June 5
contract size is 100 oz. futures price is US$400 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)
2.4
A Possible Outcome
Table 2.1, Page 27
Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 (600) . . . (420) . . . (1,140) . . . 260 (600) . . . (1,340) . . . (2,600) . . . (1,540) 3,400 . . . 0 . . . Futures Price (US$) 400.00 5-Jun 397.00 . . . . . . 13-Jun 393.30 . . . . . . 19-Jun 387.00 . . . . . . 26-Jun 392.30
Day
2,660 + 1,340 = 4,000 . . . . . < 3,000 2,740 + 1,260 = 4,000 . . . . . . 5,060 0
2.5
Other Key Points About Futures

They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity
2.6
Collateralization in OTC Markets

It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)
2.7
Delivery
If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash
2.8
Some Terminology
Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of trades in 1 day
2.9
Convergence of Futures to Spot

(Figure 2.1, page 25)
Futures Price Spot Price
Spot Price Futures Price
Time
Time
(a)
(b)
2.10
Questions
When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?
2.11
Regulation of Futures
Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups
2.12
Accounting & Tax

It is logical to recognize hedging profits (losses) at the same time as the losses (profits) on the item being hedged It is logical to recognize profits and losses from speculation on a mark to market basis Roughly speaking, this is what the accounting and tax treatment of futures in the U.S.and many other countries attempts to achieve
2.13
Forward Contracts
A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement (unless a collateralization agreement requires it). At the end of the life of the contract one party buys the asset for the agreed price from the other party
2.14
Profit from a Long Forward or Futures Position

Profit
Price of Underlying at Maturity
2.15
Profit from a Short Forward or Futures Position

Profit
Price of Underlying at Maturity
2.16
Forward Contracts vs Futures Contracts (Table 2.3, page 39)

Forward Private contract between two parties Not standardized Usually one specified delivery date Settled at end of contract Delivery or final settlement usual Some credit risk Futures Traded on an exchange Standardized Range of delivery dates Settled daily Usually closed out prior to maturity Virtually no credit risk
2.17
Foreign Exchange Quotes

Futures exchange rates are quoted as the number of USD per unit of the foreign currency Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.
2.18
Hedging Strategies Using Futures

Chapter 3
3.1
Long & Short Hedges

A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price
3.2
Arguments in Favor of Hedging
Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables
3.3
Arguments against Hedging

Shareholders are usually well diversified and can make their own hedging decisions It may increase risk to hedge when competitors do not Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult
3.4
Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)
Futures Price
Spot Price
Time t1 t2 3.5
Basis Risk
Basis is the difference between spot & futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out
3.6
Long Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 (F2 F1) = F1 + Basis
3.7
Short Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 F2) = F1 + Basis
3.8
Choice of Contract
Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis
3.9
Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is S h= F where S is the standard deviation of S, the change in the spot price during the hedging period, F is the standard deviation of F, the change in the futures price during the hedging period is the coefficient of correlation between S and F.
3.10
Hedging Using Index Futures

(Page 62)
To hedge the risk in a portfolio the number of contracts that should be shorted is P
F
where P is the value of the portfolio, is its beta, and F is the current value of one futures (=futures price times contract size)
3.11
Reasons for Hedging an Equity Portfolio

Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outpeform the market.)
3.12
Example
Futures price of S&P 500 is 1,000 Size of portfolio is $5 million Beta of portfolio is 1.5 One contract is on $250 times the index What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
3.13
Changing Beta
What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?
3.14
Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk
3.15
Interest Rates
Chapter 4
4.1
Types of Rates
Treasury rates LIBOR rates Repo rates
4.2
Measuring Interest Rates

The compounding frequency used for an interest rate is the unit of measurement The difference between quarterly and annual compounding is analogous to the difference between miles and kilometers
4.3
Continuous Compounding
(Page 77)
In the limit as we compound more and more frequently we obtain continuously compounded interest rates $100 grows to $100eRT when invested at a continuously compounded rate R for time T $100 received at time T discounts to $100e-RT at time zero when the continuously compounded discount rate is R
4.4
Conversion Formulas
(Page 77)
Define Rc : continuously compounded rate Rm: same rate with compounding m times per year
Rm R c = m ln 1 + m R m = m e Rc / m 1
4.5
Zero Rates
A zero rate (or spot rate), for maturity T is the rate of interest earned on an investment that provides a payoff only at time T
4.6
Example (Table 4.2, page 79)

Maturity Zero Rate (years) (% cont. comp.) 0.5 1.0 1.5 2.0 5.0 5.8 6.4 6.8
4.7
Bond Pricing
To calculate the cash price of a bond we discount each cash flow at the appropriate zero rate In our example, the theoretical price of a twoyear bond providing a 6% coupon semiannually is
3e
0.05 0.5
+ 3e
0.058 1.0
+ 3e
0.064 1.5
+ 103e
0.068 2 .0
= 98.39
4.8
Bond Yield
The bond yield is the discount rate that makes the present value of the cash flows on the bond equal to the market price of the bond Suppose that the market price of the bond in our example equals its theoretical price of 98.39 The bond yield is given by solving 3e y 0.5 + 3e y 1.0 + 3e y 1.5 + 103e y 2 .0 = 98.39 to get y = 0.0676 or 6.76%.
4.9
Par Yield
The par yield for a certain maturity is the coupon rate that causes the bond price to equal its face value. In our example we solve
c 0.050.5 c 0.0581.0 c 0.0641.5 + e + e e 2 2 2 c 0.0682.0 + 100 + e = 100 2 to get c=6.87 (with s.a. compounding)
4.10
Par Yield continued

In general if m is the number of coupon payments per year, P is the present value of $1 received at maturity and A is the present value of an annuity of $1 on each coupon date
(100 100 P ) m c= A
4.11
Sample Data (Table 4.3, page 80)

Bond Principal (dollars) 100 100 100 100 100 Time to Maturity (years) 0.25 0.50 1.00 1.50 2.00 Annual Coupon (dollars) 0 0 0 8 12 Bond Price (dollars) 97.5 94.9 90.0 96.0 101.6
4.12
The Bootstrap Method

An amount 2.5 can be earned on 97.5 during 3 months. The 3-month rate is 4 times 2.5/97.5 or 10.256% with quarterly compounding This is 10.127% with continuous compounding Similarly the 6 month and 1 year rates are 10.469% and 10.536% with continuous compounding
4.13
The Bootstrap Method continued

To calculate the 1.5 year rate we solve
4e
0.10469 0.5
+ 4e
0.10536 1.0
+ 104 e
R 1.5
= 96
to get R = 0.10681 or 10.681% Similarly the two-year rate is 10.808%
4.14
Zero Curve Calculated from the Data (Figure 4.1, page 82)
12
Zero Rate (%)

11
10.681 10.469
10
10.808
10.536
10.127
Maturity (yrs)
9 0 0.5 1 1.5 2 2.5
4.15
Forward Rates
The forward rate is the future zero rate implied by todays term structure of interest rates
4.16
Calculation of Forward Rates

Table 4.5, page 82
Zero Rate for Year (n ) 1 2 3 4 5 (% per annum) 3.0 4.0 4.6 5.0 5.3 5.0 5.8 6.2 6.5
4.17
Forward Rate (% per annum)
an n -year Investment for n th Year
Formula for Forward Rates

Suppose that the zero rates for time periods T1 and T2 are R1 and R2 with both rates continuously compounded. The forward rate for the period between times T1 and T2 is
R2 T2 R1 T1 T2 T1
4.18
Upward vs Downward Sloping Yield Curve

For an upward sloping yield curve: Fwd Rate > Zero Rate > Par Yield For a downward sloping yield curve Par Yield > Zero Rate > Fwd Rate
4.19
Forward Rate Agreement

A forward rate agreement (FRA) is an agreement that a certain rate will apply to a certain principal during a certain future time period
4.20
Forward Rate Agreement continued

An FRA is equivalent to an agreement where interest at a predetermined rate, RK is exchanged for interest at the market rate An FRA can be valued by assuming that the forward interest rate is certain to be realized
4.21
FRA Example
A company has agreed that it will receive 4% on $100 million for 3 months starting in 3 years The forward rate for the period between 3 and 3.25 years is 3% The value of the contract to the company is +$250,000 discounted from time 3.25 years to time zero
4.22
FRA Example Continued

Suppose rate proves to be 4.5% (with quarterly compounding The payoff is $125,000 at the 3.25 year point This is equivalent to a payoff of $123,609 at the 3-year point.
4.23
Theories of the Term Structure

Page 87
Expectations Theory: forward rates equal expected future zero rates Market Segmentation: short, medium and long rates determined independently of each other Liquidity Preference Theory: forward rates higher than expected future zero rates
4.24
Management of Net Interest Income (Table 4.6, page 88)

Suppose that the markets best guess is that future short term rates will equal todays rates What would happen if a bank posted the following rates?
Maturity (yrs) 1 5 Deposit Rate 3% 3% Mortgage Rate 6% 6%
How can the bank manage its risks?
4.25
Determination of Forward and Futures Prices

Chapter 5
5.1
Consumption vs Investment Assets

Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption (Examples: copper, oil)
5.2
Short Selling (Page 97-99)

Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way
5.3
Short Selling
(continued)
At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives
5.4
Notation
S0: Spot price today F0: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T
5.5
1. Gold: An Arbitrage Opportunity?

5.6
2. Gold: Another Arbitrage Opportunity?

5.7
The Futures Price of Gold

If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=600, T=1, and r=0.05 so that F = 600(1+0.05) = 630
5.8
When Interest Rates are Measured with Continuous Compounding
F0 = S0erT
This equation relates the forward price and the spot price for any investment asset that provides no income and has no storage costs
5.9
When an Investment Asset Provides a Known Dollar Income

(page 104, equation 5.2)
F0 = (S0 I )erT where I is the present value of the income during life of forward contract
5.10
When an Investment Asset Provides a Known Yield

(Page 105, equation 5.3)
F0 = S0 e(rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding)
5.11
Valuing a Forward Contract

Page 106
Suppose that K is delivery price in a forward contract & F0 is forward price that would apply to the contract today The value of a long forward contract, , is = (F0 K )erT Similarly, the value of a short forward contract is (K F0 )erT
5.12
Forward vs Futures Prices

Forward and futures prices are usually assumed to be the same. When interest rates are uncertain they are, in theory, slightly different: A strong positive correlation between interest rates and the asset price implies the futures price is slightly higher than the forward price A strong negative correlation implies the reverse
5.13
Stock Index (Page 108)

Can be viewed as an investment asset paying a dividend yield The futures price and spot price relationship is therefore
F0 = S0 e(rq )T
where q is the dividend yield on the portfolio represented by the index during life of contract
5.14
Stock Index
(continued)
For the formula to be true it is important that the index represent an investment asset In other words, changes in the index must correspond to changes in the value of a tradable portfolio The Nikkei index viewed as a dollar number does not represent an investment asset
5.15
Index Arbitrage
When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index
5.16
Index Arbitrage
(continued)
Index arbitrage involves simultaneous trades in futures and many different stocks Very often a computer is used to generate the trades Occasionally (e.g., on Black Monday) simultaneous trades are not possible and the theoretical no-arbitrage relationship between F0 and S0 does not hold
5.17
Futures and Forwards on Currencies (Page 110-113)

A foreign currency is analogous to a security providing a dividend yield The continuous dividend yield is the foreign risk-free interest rate It follows that if rf is the foreign risk-free interest rate
F0 = S 0 e
( r rf ) T
5.18
Why the Relation Must Be True

Figure 5.1, page 111
1000 units of foreign currency at time zero
1000 e
rf T
units of foreign currency at time T
1000S0 dollars at time zero
1000 F0 e
rf T
dollars at time T
1000S 0e rT
dollars at time T
5.19
Futures on Consumption Assets

(Page 115)
F0 S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset value. Alternatively,
F0 (S0+U )erT
where U is the present value of the storage costs.
5.20
The Cost of Carry (Page 117)

The cost of carry, c, is the storage cost plus the interest costs less the income earned For an investment asset F0 = S0ecT For a consumption asset F0 S0ecT The convenience yield on the consumption asset, y, is defined so that F0 = S0 e(cy )T
5.21
Futures Prices & Expected Future Spot Prices (Page 118-119)

Suppose k is the expected return required by investors on an asset We can invest F0er T now to get ST back at maturity of the futures contract This shows that
F0 = E (ST )e(rk )T
5.22
Futures Prices & Future Spot Prices (continued)

If the asset has no systematic risk, then k = r and F0 is an unbiased estimate of ST positive systematic risk, then k > r and F0 < E (ST ) negative systematic risk, then k < r and F0 > E (ST )
5.23
Interest Rate Futures

Chapter 6
6.1
Day Count Conventions in the U.S. (Page 127)
Treasury Bonds: Actual/Actual (in period) Corporate Bonds: 30/360 Money Market Instruments: Actual/360
6.2
Treasury Bond Price Quotes in the U.S
Cash price = Quoted price + Accrued Interest
6.3
Treasury Bill Quote in the U.S.

If Y is the cash price of a Treasury bill that has n days to maturity the quoted price is
360 (100 Y ) n
6.4
Treasury Bond Futures

Pages 130-134
Cash price received by party with short position = Most Recent Settlement Price Conversion factor + Accrued interest
6.5
Conversion Factor
The conversion factor for a bond is approximately equal to the value of the bond on the assumption that the yield curve is flat at 6% with semiannual compounding
6.6
CBOT T-Bonds & T-Notes

Factors that affect the futures price: Delivery can be made any time during the delivery month Any of a range of eligible bonds can be delivered The wild card play
6.7
Eurodollar Futures (Page 135-137)

If Q is the quoted price of a Eurodollar futures contract, the value of one contract is 10,000[100-0.25(100-Q)] A change of one basis point or 0.01 in a Eurodollar futures quote corresponds to a contract price change of $25
6.8
Eurodollar Futures continued

A Eurodollar futures contract is settled in cash When it expires (on the third Wednesday of the delivery month) Q is set equal to 100 minus the 90 day Eurodollar interest rate (actual/360) and all contracts are closed out
6.9
Using Eurodollar Futures (Example 6.3,

page 136)
It is Jan 8. An investor wants to lock in the interest rate for 3 months starting June 20 on $5 million The investor buys 5 June Eurodollar futures contracts at 94.79. On June 20 the final settlement price is 96 What interest rate has the investor locked in?
6.10
Eurodollar Futures vs FRAs

Eurodollar futures are setrlled daily; FRAs are not The payoff from Eurodollar futures is at the beginning of the period covered by the underlying interest rate; the payoff from FRAs is at the end of this period
6.11
Forward Rates and Eurodollar Futures (Page 136-138)

Eurodollar futures contracts last as long as 10 years For Eurodollar futures lasting beyond two years we cannot assume that the forward rate equals the futures rate
6.12
Forward Rates and Eurodollar Futures continued

A " convexity adjustment " often made is 1 2 Forward rate = Futures rate t1t 2 2 where t1 is the time to maturity of the futures contract, t 2 is the maturity of the rate underlying the futures contract (90 days later than t1 ) and is the standard deviation of the short rate changes per year (typically is about 0.012)
6.13
Duration (page 138)

Duration of a bond that provides cash flow ci at time ti is
i =1
c i e yt i ti B
where B is its price and y is its yield (continuously compounded) This leads to
B = Dy B
6.14
Duration Continued
When the yield y is expressed with compounding m times per year
BDy B = 1+ y m
The expression
D 1+ y m
is referred to as the modified duration

6.15
Duration Matching
This involves hedging against interest rate risk by matching the durations of assets and liabilities It provides protection against small parallel shifts in the zero curve
6.16
Duration-Based Hedge Ratio

PDP FC DF
FC DF P DP
Contract Price for Interest Rate Futures Duration of Asset Underlying Futures at Maturity Value of portfolio being Hedged Duration of Portfolio at Hedge Maturity
6.17
Example (page 144-145)

Three month hedge is required for a $10 million portfolio. Duration of the portfolio in 3 months will be 6.8 years. 3-month T-bond futures price is 93-02 so that contract price is $93,062.50 Duration of cheapest to deliver bond in 3 months is 9.2 years Number of contracts for a 3-month hedge is
10,000,000 6.8 = 79.42 93,062.50 9.2

6.18
Swaps
Chapter 7
7.1
Nature of Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules
7.2
An Example of a Plain Vanilla Interest Rate Swap

An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows
7.3
Cash Flows to Microsoft

(See Table 7.1, page 155)
---------Millions of Dollars--------LIBOR FLOATING FIXED Date Mar.5, 2007 Sept. 5, 2007 Mar.5, 2008 Sept. 5, 2008 Mar.5, 2009 Sept. 5, 2009 Mar.5, 2010 Rate 4.2% 4.8% 5.3% 5.5% 5.6% 5.9% 6.4% +2.10 +2.40 +2.65 +2.75 +2.80 +2.95 2.50 2.50 2.50 2.50 2.50 2.50 0.40 0.10 +0.15 +0.25 +0.30 +0.45
7.4
Net
Cash Flow Cash Flow Cash Flow
Typical Uses of an Interest Rate Swap

Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate
7.5
Intel and Microsoft (MS) Transform a Liability

5% 5.2%
Intel
LIBOR
MS
LIBOR+0.1%
7.6
Financial Institution is Involved

4.985% 5.2%
5.015%
Intel
LIBOR
F.I.
LIBOR
MS
LIBOR+0.1%
7.7
Intel and Microsoft (MS) Transform an Asset

5% 4.7%
Intel
LIBOR-0.2% LIBOR
MS
7.8
Financial Institution is Involved

(See Figure 7.5, page 159)
4.985%
5.015% 4.7%
Intel
LIBOR-0.2% LIBOR
F.I.
LIBOR
MS
7.9
Quotes By a Swap Market Maker

(Table 7.3, page 159) Maturity 2 years 3 years 4 years 5 years 7 years 10 years Bid (%) 6.03 6.21 6.35 6.47 6.65 6.83 Offer (%) 6.06 6.24 6.39 6.51 6.68 6.87 Swap Rate (%) 6.045 6.225 6.370 6.490 6.665 6.850
7.10
The Comparative Advantage Argument (Table 7.4, page 162)

AAACorp wants to borrow floating BBBCorp wants to borrow fixed
Fixed AAACorp BBBCorp 4.00% 5.20%
Floating 6-month LIBOR + 0.30% 6-month LIBOR + 1.00%
7.11
The Swap (Figure 7.6, page 162)
3.95% 4%
AAA
LIBOR
BBB
LIBOR+1%
7.12
The Swap when a Financial Institution is Involved

3.93% 4%
3.97%
AAA
LIBOR
F.I.
LIBOR
BBB
LIBOR+1%
7.13
Criticism of the Comparative Advantage Argument

The 4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates The LIBOR+0.3% and LIBOR+1% rates available in the floating rate market are sixmonth rates BBBCorps fixed rate depends on the spread above LIBOR it borrows at in the future
7.14
The Nature of Swap Rates

Six-month LIBOR is a short-term AA borrowing rate The 5-year swap rate has a risk corresponding to the situation where 10 sixmonth loans are made to AA borrowers at LIBOR This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate
7.15
Valuation of an Interest Rate Swap

Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)
7.16
Valuation in Terms of Bonds

The fixed rate bond is valued in the usual way The floating rate bond is valued by noting that it is worth par immediately after the next payment date
7.17
Example (page 168)

Receive 8% per annum and pay floating semiannually on a principal of $100 million. 1.25 years to go and next floating payment is $5.1 million
Time 0.25 0.75 1.25 Fixed Bond 4 4 104 Floating Bond 105.1 Disc Factor 0.9753 0.9243 0.8715 PV fixed PV floating Bond Bond 3.901 102.5045 3.697 90.64 98.238 102.505
Swap value = 98.238 102.505= 4.267

7.18
Valuation in Terms of FRAs
Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that todays forward rates are realized
7.19
Example (page 169)
Time 0.25 0.75 1.25
Fixed Cash Flow 4 4 4
Floating Cash Flow -5.100 -5.522 -6.051
Net Cash Flow -1.100 -1.522 -2.051
Disc Factor 0.9753 0.9243 0.8715
PV of Net Cash Flow -1.073 -1.407 -1.787 -4.267
7.20
An Example of a Currency Swap
An agreement to pay 5% on a sterling principal of 10,000,000 & receive 6% on a US$ principal of $15,000,000 every year for 5 years
7.21
Exchange of Principal
In an interest rate swap the principal is not exchanged In a currency swap the principal is exchanged at the beginning and the end of the swap
7.22
The Cash Flows (Table 7.5, page 171)

Dollars Pounds $ ------millions-----18.00 +10.00 +1.08 0.5 +1.08 0.5 +1.08 0.5 +1.08 0.5 +19.08 10.5
Year 2007 2008 2009 2010 2011 2012
7.23
Typical Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency
7.24
Comparative Advantage Arguments for Currency Swaps (Table 7.6, page 172)
General Electric wants to borrow AUD Qantas wants to borrow USD
USD General Motors Qantas 5.0% 7.0% AUD 7.6% 8.0%
7.25
Valuation of Currency Swaps

Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts (See Examples 7.6 and 7.7)
7.26
Swaps & Forwards

A swap can be regarded as a convenient way of packaging forward contracts When a swap is initiated the swap has zero value, but typically some forwards have a positive value and some have a negative value
7.27
Credit Risk
A swap is worth zero to a company initially At a future time its value is liable to be either positive or negative The company has credit risk exposure only when its value is positive
7.28
Other Types of Swaps

Amortizing/ step up Compounding swap Constant maturity swap LIBOR-in-arrears swap Accrual swap Equity swap
7.29
Other Types of Swaps continued

Cross currency interest rate swap Floating-for-floating currency swap Diff swap Commodity swap Variance swap
7.30
Mechanics of Options Markets

Chapter 8
8.1
Types of Options
A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time
8.2
Option Positions
Long call Long put Short call Short put
8.3
Long Call
(Figure 8.1, Page 186)
Profit from buying one European call option: option price = $5, strike price = $100. 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130
8.4
Short Call
Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0 -10 -20 -30
110 120 130 70 80 90 100 Terminal stock price ($)
8.5
Long Put
Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($) 20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100
8.6
Short Put
Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 -10 -20 -30
40
50
60 70 80
Terminal stock price ($) 90 100
8.7
Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity Payoff Payoff K K Payoff K ST Payoff K ST ST

8.8
ST
Assets Underlying Exchange-Traded Options

Page 190-191
Stocks Foreign Currency Stock Indices Futures
8.9
Specification of Exchange-Traded Options

Expiration date Strike price European or American Call or Put (option class)
8.10
Terminology
Moneyness : At-the-money option In-the-money option Out-of-the-money option
8.11
Terminology
(continued)
Option class Option series Intrinsic value Time value
8.12
Dividends & Stock Splits

(Page 193-194)
Suppose you own N options with a strike price of K : No adjustments are made to the option terms for cash dividends When there is an n-for-m stock split, the strike price is reduced to mK/n the no. of options is increased to nN/m Stock dividends are handled in a manner similar to stock splits
8.13
Dividends & Stock Splits

(continued)
Consider a call option to buy 100 shares for $20/share How should terms be adjusted: for a 2-for-1 stock split? for a 5% stock dividend?
8.14
Market Makers
Most exchanges use market makers to facilitate options trading A market maker quotes both bid and ask prices when requested The market maker does not know whether the individual requesting the quotes wants to buy or sell
8.15
Margins (Page 197-198)

Margins are required when options are sold For example when a naked call option is written the margin is the greater of: 1 A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2 A total of 100% of the proceeds of the sale plus 10% of the underlying share price
8.16
Warrants
Warrants are options that are issued (or written) by a corporation or a financial institution The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire
8.17
Warrants
(continued)
Warrants are traded in the same way as stocks The issuer settles up with the holder when a warrant is exercised When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued
8.18
Executive Stock Options

Option issued by a company to executives When the option is exercised the company issues more stock Usually at-the-money when issued
8.19
Executive Stock Options continued

They become vested after a period of time (usually 1 to 4 years) They cannot be sold They often last for as long as 10 or 15 years Accounting standards are changing to require the expensing of executive stock options
8.20
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
8.21
Convertible Bonds
(continued)
Very often a convertible is callable The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose
8.22
Properties of Stock Options

Chapter 9
9.1
Notation
c : European call option price p : European put option price S0 : Stock price today K : Strike price T : Life of option : Volatility of stock price C : American Call option price P : American Put option price ST :Stock price at option maturity D : Present value of dividends during options life r : Risk-free rate for maturity T with cont. comp.
9.2
Effect of Variables on Option Pricing (Table 9.1, page 210)

Variable S0 K T r D c p C P
+ ? + +
+ ? + +
+ + + +
+ + + +
9.3
American vs European Options

An American option is worth at least as much as the corresponding European option Cc Pp
9.4
Calls: An Arbitrage Opportunity?

Suppose that c=3 T=1 K = 18
S0 = 20 r = 10% D=0
Is there an arbitrage opportunity?
9.5
Lower Bound for European Call Option Prices; No Dividends (Equation

9.1, page 215)
c S0 Ke
-rT
9.6
Puts: An Arbitrage Opportunity?

Suppose that p =1 T = 0.5 K = 40 Is there an arbitrage opportunity?
S0 = 37 r =5% D =0
9.7
Lower Bound for European Put Prices; No Dividends

(Equation 9.2, page 217)
p Ke
-rTS
9.8
Put-Call Parity; No Dividends

(Equation 9.3, page 217)
Consider the following 2 portfolios: Portfolio A: European call on a stock + PV of the strike price in cash Portfolio C: European put on the stock + the stock Both are worth max(ST , K ) at the maturity of the options They must therefore be worth the same today. This means that
c + Ke -rT = p + S0
9.9
Arbitrage Opportunities
Suppose that c =3 S0 = 31 T = 0.25 r = 10% K =30 D=0 What are the arbitrage possibilities when p = 2.25 ? p=1?
9.10
Early Exercise
Usually there is some chance that an American option will be exercised early An exception is an American call on a non-dividend paying stock This should never be exercised early
9.11
An Extreme Situation
For an American call option: S0 = 100; T = 0.25; K = 60; D = 0 Should you exercise immediately? What should you do if
You want to hold the stock for the next 3 months? You do not feel that the stock is worth holding for the next 3 months?
9.12
Reasons For Not Exercising a Call Early (No Dividends)

No income is sacrificed We delay paying the strike price Holding the call provides insurance against stock price falling below strike price
9.13
Should Puts Be Exercised Early ?

Are there any advantages to exercising an American put when S0 = 60; T = 0.25; r=10% K = 100; D = 0
9.14
The Impact of Dividends on Lower Bounds to Option Prices

(Equations 9.5 and 9.6, pages 223-224)
c S0 D Ke
p D + Ke
rT
rT
S0
9.15
Extensions of Put-Call Parity

American options; D = 0 S0 - K < C - P < S0 - Ke -rT
Equation 9.4 p. 220
European options; D > 0 c + D + Ke -rT = p + S0

Equation 9.7 p. 224
American options; D > 0 S0 - D - K < C - P < S0 - Ke -rT

Equation 9.8 p. 224
9.16
Trading Strategies Involving Options

Chapter 10
10.1
Three Alternative Strategies

Take a position in the option and the underlying Take a position in 2 or more options of the same type (A spread) Combination: Take a position in a mixture of calls & puts (A combination)
10.2
Positions in an Option & the Underlying (Figure 10.1, page 230)

Profit Profit
K K
(a) Profit Profit
ST
(b)
ST
K ST
(c)
K
(d)
ST
10.3
Bull Spread Using Calls

Profit ST K1 K2
10.4
Bull Spread Using Puts

Profit K1 K2 ST
10.5
Bear Spread Using Puts

Profit
K1
K2
ST
10.6
Bear Spread Using Calls

Profit
K1
K2
ST
10.7
Box Spread
A combination of a bull call spread and a bear put spread If all options are European a box spread is worth the present value of the difference between the strike prices If they are American this is not necessarily so (see Business Snapshot 10.1)
10.8
Butterfly Spread Using Calls

Profit K1 K2 K3 ST
10.9
Butterfly Spread Using Puts

Profit K1 K2 K3 ST
10.10
Calendar Spread Using Calls

Profit ST K
10.11
Calendar Spread Using Puts

Profit ST K
10.12
A Straddle Combination
Profit
ST
10.13
Strip & Strap

Profit
Profit
K Strip
ST
K Strap
ST
10.14
A Strangle Combination
Profit K1 K2 ST
10.15
Introduction to Binomial Trees

Chapter 11
11.1
A Simple Binomial Model

A stock price is currently $20 In three months it will be either $22 or $18
Stock Price = $22 Stock price = $20 Stock Price = $18
11.2
A Call Option (Figure 11.1, page 248)

A 3-month call option on the stock has a strike price of 21. Stock Price = $22 Option Price = $1 Stock price = $20 Option Price=? Stock Price = $18 Option Price = $0
11.3
Setting Up a Riskless Portfolio

Consider the Portfolio: long shares short 1 call option 22 1
18
Portfolio is riskless when 22 1 = 18 or

= 0.25
11.4
Valuing the Portfolio

(Risk-Free Rate is 12%)
The riskless portfolio is: long 0.25 shares short 1 call option The value of the portfolio in 3 months is 22 0.25 1 = 4.50 The value of the portfolio today is 4.5e 0.120.25 = 4.3670
11.5
Valuing the Option

The portfolio that is long 0.25 shares short 1 option is worth 4.367 The value of the shares is 5.000 (= 0.25 20 ) The value of the option is therefore 0.633 (= 5.000 4.367 )
11.6
Generalization (Figure 11.2, page 249)

A derivative lasts for time T and is dependent on a stock
Su u Sd d
11.7
Generalization
(continued)
Consider the portfolio that is long shares and short 1 derivative Su u Sd d The portfolio is riskless when Su u = Sd d or
u f d = Su Sd
11.8
Generalization
(continued)
Value of the portfolio at time T is Su u Value of the portfolio today is (Su u )erT Another expression for the portfolio value today is S f Hence = S (Su u )erT
11.9
Generalization
(continued)
Substituting for we obtain

= [ p u + (1 p )d ]erT
where
p =
d u d
rT
11.10
Risk-Neutral Valuation
= [ p u + (1 p )d ]e-rT The variables p and (1 p ) can be interpreted as the risk-neutral probabilities of up and down movements The value of a derivative is its expected payoff in a risk-neutral world discounted at the risk-free rate
Su u Sd d
11.11
(1
p)
Irrelevance of Stocks Expected Return

When we are valuing an option in terms of the underlying stock the expected return on the stock is irrelevant
11.12
Original Example Revisited

p
Su = 22 u = 1 Sd = 18 d = 0
S
(1 p)
Since p is a risk-neutral probability 20e0.12 0.25 = 22p + 18(1 p ); p = 0.6523 Alternatively, we can use the formula
e rT d e 0.12 0.25 0 .9 = 0 . 6523 p= = ud 1 .1 0 .9
11.13
Valuing the Option

Su = 22 u = 1 Sd = 18 d = 0
52 3 0.6
0.34 77
The value of the option is e0.120.25 [0.65231 + 0.34770] = 0.633

11.14
A Two-Step Example
24.2 22 20 18 16.2 Each time step is 3 months K=21, r=12%

19.8
11.15
Valuing a Call Option

D
22 20 1.2823
A
24.2 3.2 19.8 0.0 16.2 0.0
B E C F
2.0257 18 0.0
Value at node B = e0.120.25(0.65233.2 + 0.34770) = 2.0257 Value at node A = e0.120.25(0.65232.0257 + 0.34770) = 1.2823
11.16
A Put Option Example; K=52

K = 52, t = 1yr r = 5%
60 50 4.1923
A B E
72 0 48 4 32 20
1.4147 40
C
9.4636
F
11.17
What Happens When an Option is American (Figure 11.8, page 257)

D
60 50 5.0894
A
72 0 48 4 32 20
B E
1.4147 40
C
12.0
F
11.18
Delta
Delta () is the ratio of the change in the price of a stock option to the change in the price of the underlying stock The value of varies from node to node
11.19
Choosing u and d
One way of matching the volatility is to set
u = e
t t
d = 1 u = e
where is the volatility and t is the length of the time step. This is the approach used by Cox, Ross, and Rubinstein
11.20
The Probability of an Up Move

ad ud a = e rt for a nondividend paying stock p= a = e( r q ) t for a stock index where q is the dividend yield on the index a=e
( r r f ) t
for a currency where rf is the foreign
risk - free rate a = 1 for a futures contract
11.21

Ch01 11HullFundamentals6thEd

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Ch01 11HullFundamentals6thEd

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Introduction

The Nature of Derivatives

Futures Contracts Forward Contracts Swaps Options

Ways Derivatives are Used

Exchanges Trading Futures

Examples of Futures Contracts

Over-the Counter Markets

Size of OTC and Exchange Markets

Spot 1-month forward 3-month forward 6-month forward

American vs European Options

Strike Price ($) $15.00 $17.50 $20.00 $22.50 $25.00

Oct 2006 4.650 2.300 0.575 0.075 0.025

Apr 2007 5.150 3.150 1.650 0.725 0.275

Oct 2006 0.025 0.125 0.875 2.950 5.450

Apr 2007 0.275 0.725 1.700 3.300 5.450

Exchanges Trading Options

Three Reasons for Trading Derivatives: Hedging, Speculation, and Arbitrage

Hedging Examples (Example 1.1 and 1.2,

35,000 No Hedging 30,000 Hedging

25,000 Stock Price ($) 20,000 20 25 30 35 40

Speculation Example (pages 14)

Arbitrage Example (pages 15-16)

1. Gold: An Arbitrage Opportunity?

2. Gold: Another Arbitrage Opportunity?

The Futures Price of Gold

1. Oil: An Arbitrage Opportunity?

2. Oil: Another Arbitrage Opportunity?

Mechanics of Futures Markets

Example of a Futures Trade

2,660 + 1,340 = 4,000 . . . . . < 3,000 2,740 + 1,260 = 4,000 . . . . . . 5,060 0

Other Key Points About Futures

Collateralization in OTC Markets

Convergence of Futures to Spot

Futures Price Spot Price

Spot Price Futures Price

Accounting & Tax

Profit from a Long Forward or Futures Position

Price of Underlying at Maturity

Profit from a Short Forward or Futures Position

Price of Underlying at Maturity

Forward Contracts vs Futures Contracts (Table 2.3, page 39)

Foreign Exchange Quotes

Hedging Strategies Using Futures

Long & Short Hedges

Arguments in Favor of Hedging

Arguments against Hedging

Convergence of Futures to Spot

Optimal Hedge Ratio

Hedging Using Index Futures

Reasons for Hedging an Equity Portfolio

Rolling The Hedge Forward

Measuring Interest Rates

Example (Table 4.2, page 79)

Par Yield continued

Sample Data (Table 4.3, page 80)

The Bootstrap Method

The Bootstrap Method continued

to get R = 0.10681 or 10.681% Similarly the two-year rate is 10.808%

Zero Rate (%)

Calculation of Forward Rates

Forward Rate (% per annum)

an n -year Investment for n th Year