Level 2 2016 SS 16 (Derivatives)
Level 2 2016 SS 16 (Derivatives)
Level 2 2016 SS 16 (Derivatives)
Derivatives
Reading Assignments
Forward Markets and Contracts
Futures Markets and Contracts
Example: long could hold the first contract at $20 and short
the second one at $25, and pocket $5
t=t
t=T
6
This means that the spot price grows at the risk free rate
into the forward price = No-arbitrage principle
This enables us to set the initial = 0 so that:
No upfront payment is required by any party
No opportunity for arbitrage
Means
So
St
ST
Value Notation
Means
Forward Price at t=0 (Always at
Expiration)
Means
Vo
Vt
VT
In Words
0,
0 = 0
=0
1+
(0, )
=
(1 + )
= (0, )
10
11
()
Value of Forward
0,
0 = 0 ()
=0
1+
(0, )
=
1 +
= (0, )
12
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Solution (1)
F(0,T) = (Equity Spot Price Today PV of Discrete Dividends) * (FV
Factor)
PV of D1
= 0.75/1.025(50/365)
AED 0.7475
PV of D2
= 0.75/1.025(140/365)
AED 0.7429
Total PV(Div)
= 0.7457 + 0.7429
AED 1.4904
Hence, F(0,T)
AED 54.3988
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0.75/1.025(85/365)
AED 0.7457
PV of Forward
54.3988/1.025(95/365)
AED 54.0503
Value at t = 55
-AED 9.4760
Solution (3)
VT = ST F(0,T)
VT = 44.50 54.40 = - AED 9.9 to long
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0, = 0
= 1 +
FV factor
PV factor
16
0, = 0
-0.0075*2
)x e
0.0482*2
= 2,495.05
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0,
PV of remaining
dividends
PV of Forward price
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1+
0 1 +
()
Value of Forward
0 = 0 ()
(0,)
=
1+
(0, )
=
1 +
= (0, )
20
22
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1+ 360
1+ 360
360
Valuing FRA
1. Price the new FRA
2. Compare the payoff on the original FRA to the fixed rate on a new
FRA
3. Discount the payoff back to today
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FRA: Example
FAM is trading in interest rate futures in the Eurodollar market.
Aisha Al Abri is looking at hedging interest rate risk by going long
on a 1 x 7 FRA. She has the following interest rates: 30-day LIBOR
is 4.75% and 210-day LIBOR is 5.50%
1. Compute the price of the FRA
2. Assume it is now 20 days later and the new term structure is:
10-day LIBOR is 4.85% and 190-day LIBOR is 5.90%. Aisha is
hedging a principal amount of AED 2 million. What is the
value of the FRA at this point?
3. What is the value of the FRA at expiration if the 180-day
LIBOR then is 6%?
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FRA: Example
Solution (1)
=
1+ 360
1+ 360
360
Solution (2)
1.
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FRA: Example
Compare payoff of the old FRA to the new FRA & discount it until today
Compare pay-off = (0.05950 - 0.05602) x 180/360 = 0.00169 or AED 3,370.95
1 + (0.0590 x 190/360)
Solution (3)
Compare payoff of the original FRA to the new market LIBOR & discount it
until forward maturity (expiration)
Pay-off at Maturity = (0.06 - 0.05602) x 180/360 0.00193 or AED 3,860
1 + (0.06 x 180/360)
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28
0, =
0
1 +
0, = (0
1+
Notes
Value of Forward
0, =
1 +
0, =
()
(0, )
(1 + )()
(0, )
()
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30
Forwards
Credit Risk
None
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34
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Explanation
Effect on
Futures Price
Storage Cost
Increases the
Monetary Cost + FV(SC)
Future Price;
Cash Inflows
Convenience
Yield
Net Costs
f = S0 (1 + r)T
- FV(CF)
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38
39
40
41
42
1+
In Words
46
0 1 +
0 =
Price of Futures
0 =
0 1 +
In Words
47
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Solution (2)
Futures price = (FV of Bond FV Coupons)/ CF
f0(T) = [(1205.32 x (1.025)) - 100.63] / 1.05
= AED 1,080.79
49
0 = [0 ] 1 +
0 = 0 1 +
0 = 0
()
50
(1 + )
0 = 0
Notes
Future Value Factor Using Domestic Int. Rate
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