Study Session 17

Derivative Investments


A. Derivative Markets and Instruments

a. define a derivative.

A derivative is a Iinancial instrument that oIIers a return based on the return oI some
other underlying asset. In this sense, its return is derived Irom another instrument. A
derivative contract has a limited liIe, and its payoII is typically determined and/or made
on the expiration date.







b. differentiate between exchange-traded and over-the-counter derivatives.

Based on the markets where they are created and traded, derivatives can be classiIied into
two groups:

Exchange-traded derivatives are created, authorized, and traded on a derivatives
exchange, an organized Iacility Ior trading derivatives.
They are standardized instruments with respect to certain terms and conditions oI
the contract.
They trade in accordance with rules and speciIications prescribed by the
derivatives exchange and are usually subject to governmental regulation.
They are guaranteed by the exchange against loss resulting Irom the deIault oI
one oI the parties.

Over-the-counter derivatives are transactions created by any two parties oII a
derivatives exchange.
They don't have standardized terms and Ieatures. The parties set all oI their own
terms and conditions.
Each party assumes the credit risk oI the other party.






c. define a forward commitment and identify the types of forward commitments.

Based on the rights and obligations oI the parties that enter into the contract, derivatives
can be classiIied into two groups: Iorward commitments and contingent claims (see los e
please).

A forward commitment is an agreement between two parties in which one party agrees
to buy and the other agrees to sell an asset at a Iuture date at a price agreed on today. In
essence, a Iorward commitment represents a commitment to buy or sell.

There are three types oI Iorward commitments.

A forward contract is an agreement to buy or sell an asset at a speciIied time in the
Iuture Ior a speciIied price.
In essence, a Iorward contract is a Iorward commitment created in the over-the-
counter market. It is not conditional - both the buyer and the seller are obliged
to perIorm the contract as agreed.
It is negotiated in the present and will be settled in the Iuture. In contrast a spot
contract is settled immediately.
The parties to the transaction speciIy the Iorward contract's terms and conditions,
such as when and where delivery will take place and the precise identity oI the
underlying. In this sense the contract is said to be customized.
Each party is subject to the possibility that the other party will deIault.
In the Iinancial world the underlying asset oI a Iorward contract can be a security
(i.e, a stock or bond), a Ioreign currency, a commodity, or combinations thereoI,
or sometimes an interest rate.
The Iorward market is a private and largely unregulated market.

Futures contract: created and traded on a Iutures exchange, a Iutures contract is a
variation oI a Iorward contract that has essentially the same basic deIinition but some
additional Ieatures. Futures and Iorwards are essentially similar contracts; the
principles Ior pricing and the applications oI Iutures and Iorwards are almost identical.
They diIIer only in the institutional settings in which they trade.
Futures contracts always trade on an organized exchange.
Futures contracts are always highly standardized with speciIied underlying
goods, quantity (contract size), delivery date, trading hours and trading area
(some exchanges may speciIy that the contract can be only traded in a
designated trading area on the Iloor (called a pit)).
PerIormance on Iutures contract is guaranteed by a clearing house -- a Iinancial
institution associated with the Iutures exchange that guarantees the Iinancial
integrity oI the market to all traders.
All Iutures contracts require that traders post margin in order to trade.
Futures markets are regulated by an identiIiable government agency, while
Iorward contracts in general trade in an unregulated market. Futures contracts
are public transactions. A Iutures transaction must be reported to:
The Iutures exchanges;
The clearinghouse; and
At least one regulatory agency.
The price oI the Iutures transaction is available to the public through price
reporting services.
Forward contracts are generally designed to be held until expiration, but a
Iutures market provides suIIicient liquidity to permit parties to enter the market
and oIIset transactions previously created.

A swap is a variation oI a Iorward contract that is essentially equivalent to a series oI
Iorward contracts. SpeciIically, a swap is an agreement between two parties to
exchange a series oI Iuture cash Ilows. Swaps are custom-tailored to meet the speciIic
needs oI counterparties, so counterparties can choose the exact dollar amount and/or
maturity that they need. They are private transactions and thus are not traded on
exchanges and can avoid regulation to a considerable degree. See Section E "Swap
Markets and Contracts" Ior details.





d. describe the basic characteristics of forward contracts, futures contracts, and swaps.

See los c please.







e. define a contingent claim and identify the types of contingent claims.

A contingent claim is a derivative contract with a payoII dependent on the occurrence oI
a Iuture event. It can be either exchange-traded or over-the-counter.

The primary types oI contingent claims are options. The payoII oI an option is
contingent on the occurrence oI an event.

Other types involve variation oI options, oIten combined with other Iinancial
instruments or derivatives.

Many corporations issue convertible bonds which are bonds that can be
exchanged Ior the stock oI the issuing Iirm at a pre-agreed time and exchange
ratio. The bondholder has an option to participate in gains on the market price oI
the Iirm's stock without having to participate in losses on the stock.

Callable bonds are redeemable by the issuer beIore the maturity under speciIic
conditions and at a stated price. The issuer has an option to pay oII the bonds
beIore maturity.

Warrants are securities entitling the holder to buy a proportionate amount oI
stocks at some speciIied Iuture date at a speciIied price. They are similar to call
options.

Exotic options are options that are more complex than basic put or call options.
Exotic options trade over-the-counter.

Interest rate options are options whose underlying asset is an interest rate.

Options on futures are options whose underlying assets is a Iutures contract.
They are all exchange-traded.

Asset-backed securities are securities that are collateralized by a pool oI
securities such as mortgages, loans or bonds. Typically borrowers oI mortgages,
loans or bonds have the prepayment option to pay oII their debts early.





f. describe the basic characteristics of options and distinguish between an option to buy
(call) and an option to sell (put).

In essence, options represent the right, not commitment, to buy or sell. They are created
only by selling and buying. For every owner (buyer, option holder) oI an option (who has
all the rights), there is a seller (option writer) who has all the obligations. The seller
receives payment (the premium) Ior an option Irom the buyer, and conIers rights to the
option buyer. For details please see Section D "Option Markets and Contracts".





g. discuss the purposes and criticisms of derivative markets.

Some oI the main beneIits that Iinancial derivatives bring to the market are:

Price discovery: Iutures, Iorwards and swaps provide valuable inIormation about the
prices oI the underlying assets. Options provide inIormation on the price volatility oI
the underlying assets.

Market completeness: a complete market is a market in which any and all
identiIiable payoIIs can be obtained by trading the securities available in the market.
The Iinancial derivatives help traders to more exactly shape the risk and return
characteristics oI their portIolios, thereby increasing the welIare oI traders and the
economy as a whole.

Risk management reIers to the process oI identiIying the desired level oI risk,
measuring the actual level oI risk, and taking actions to bring the actual level oI risk
to the desired level oI risk. Financial derivatives provide a powerIul tool Ior limiting
risks that individuals and Iirms Iace in the ordinary conduct oI their business. For
speculators risks associated with Iinancial derivatives are not necessarily evil because
they provide very powerIul instruments Ior knowledgeable traders to expose
themselves to calculated and well-understood risks in pursuit oI proIit.

Market efficiency: derivatives provide an alternative Ior investing in the underlying
assets. II the prices oI the underlying assets are too high, investors will invest in
derivatives, thereby reducing the demand Ior the underlying assets. As a result, the
derivatives market will Iorce the prices oI the underlying assets back to their
appropriate levels.

Trading efficiency: as the derivative markets are highly liquid, Iinancial derivatives
can be bought or sold with less transaction costs than directly trading the underlying
assets. In addition, derivatives are designed to Iacilitate risk management, and serve
as a Iorm oI insurance. The cost oI insurance must be low relative to the value oI the
insured assets. Otherwise insurance would not exist.

The complexity oI derivatives means that sometimes the parties that use them don't
understand them well. As a result they are oIten used improperly, leading to potentially
large losses. This can explain why unknowledgeable investors tend to consider
derivatives excessively dangerous. Derivatives are also mistakenly characterized as a
Iorm oI legalized gambling. This view tends to overlook the beneIits oI derivatives (e.g.
risk management). In Iact, derivatives make Iinancial market work better, not worse.





h. explain the concept of arbitrage and the role it plays in determining prices and in
promoting market efficiency.

Arbitrage is a process through which an investor can buy an asset or combination oI
assets at one price and concurrently sell at a higher price, thereby earning a proIit without
investing any money or being exposed to any risk.

In a well-Iunctioning market, arbitrage opportunities should not exist. II they do exist,
arbitrage activities would quickly eliminate the price diIIerential. The no-arbitrage
principle states that any rational price Ior a Iinancial instrument must exclude arbitrage
opportunities. This is the minimal requirement Ior a Ieasible or rational price Ior any
Iinancial instrument. There is no Iree money.

The role oI arbitrage:

It Iacilitates the determination oI prices. The combined actions oI many investors
engaging in arbitrage result in rapid price adjustments that eliminate any arbitrage
opportunities, thereby bringing prices back.

It promotes market eIIiciency. EIIicient markets are those in which it is impossible to
earn abnormal returns, which are returns that are in excess oI the return required Ior
the risk assumed. Arbitrage activities will quickly eliminate arbitrage opportunities
available in the market, thereby promoting market eIIiciency.

Hedgers vs Speculators: two parties involved in the risk management process

Depending on their prior risk exposures, participants in the derivatives market can be
classiIied into hedgers and speculators.

A hedger trades Iutures to reduce some pre-existing risk exposure.
Prior to the transaction, the hedger does have risk exposure.
AIter the transaction, the hedger reduces risk exposure.
At the time oI entering into hedging transactions, the hedger knows the beneIit
- reduced risk.
Hedgers are oIten producers or users oI a given commodity.

A speculator takes a view oI the market, and accepts the market's risk in pursuit oI
proIit.
Prior to the transaction, the speculator has no risk exposure.
AIter the transaction, the speculator has increased risk exposure.
The proIits/losses oI a speculative transaction are not known immediately.

B. Forward Markets and Contracts


a. discuss the differences between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk.

A forward contract is an agreement to buy or sell an asset at a speciIied time in the
Iuture (called the expiration date) Ior a price established today (called forward price).
The holder oI a long Iorward contract (the "long", the buyer) is obligated to take
delivery oI the underlying asset and pay the Iorward price at expiration.
The holder oI a short Iorward contract (the "short", the seller) is obligated to deliver
the underlying asset and accept payment oI the Iorward price at expiration.
A Iorward contract locks in a price but no money changes hands at the start.

At expiration, a Iorward contract can be terminated by
having the short make delivery oI the underlying asset to the long, or
having the long and short exchange the equivalent cash value delivery (cash
settlement).

Gains and losses Irom long and short Iorward positions are determined by the diIIerence
between the spot price at expiration and the contracted Iorward price. II the asset is worth
more (less) than the Iorward price, the short (long) pays the long (short) the cash
diIIerence between the market price or rate and the price or rate agreed on the contract.
That is:
the long: gain iI spot rate at expiration ~ Iorward price, lose iI spot rate at expiration
Iorward rate.
the short....(do it yourselI please).
Note that NOT all contracts can be settled through delivery. For example, iI the
underlying asset is an index, cash settlement is more practical. For this reason, cash-
settled Iorward contracts are also called nondeliverable forwards, or simply NDFs.
One party's gain is another party's loss.

For example, two parties agree to a Iorward contract to deliver a zero-coupon bond at a
price oI $97 per $100 par. At the contract's expiration, suppose the underlying zero-
coupon bond is selling at a price oI $97.25. The long is due to receive Irom the short an
asset worth $97.25, Ior which a payment to the short oI $97 is required. In a cash-
settlement Iorward contract, the short simply pays the long $0.25.

A party can terminate a Iorward contract prior to expiration by entering into an opposite
transaction with the same or a diIIerent counterparty.
For example, iI a party goes long in the original transaction, he can terminate his long
position by going short in the new Iorward contract. The original contract and the
new contract should have the same expiration date.
It is possible to leave both the original and new transactions in place, thereby leaving
both transactions subject to credit risk, or to have the two transactions cancel each
other. In the latter case, the party owing the greater amount pays the market value to
the other party, resulting in the elimination oI the remaining credit risk. This
elimination can be achieved, however, only iI the counterparty to the second
transaction is the same counterparty as in the Iirst.

A Iorward contract is subject to default risk regardless oI whether it is settled through
delivery or cash settlement. The long may not pay the agreed-upon price to the short, or
the short may not deliver the underlying asset to the long. Generally speaking Iorward
contracts are structured so that only the party owing the greater amount can deIault.





b. describe the procedures for settling a forward contract at expiration.

See los a please.





c. discuss how a party to a forward contract can terminate a position prior to expiration
and how credit risk is affected by the way in which a position is terminated.

See los a please.





d. differentiate between a dealer and an end user of a forward contract.

A dealer is a Iinancial institution that makes a market in Iorward contracts and other
derivatives. A dealer maintains bid and ask prices in Iorward contracts and always stands
ready to take either side oI a transaction.
The bid is the price at which the dealer is willing to buy.
The ask is the price at which the dealer is willing to sell.
Dealers engage in transactions with two types oI parties: end users and other dealers.
When a dealer engages in a Iorward transaction, it takes on the risk Irom the other
party.

An end user is a party that comes to a dealer needing a transaction, usually Ior the
purpose oI managing a particular risk. It is typically a corporation, nonproIit organization,
or government. Generally there are two types oI problems:
Reducing or eliminating a risk (this is commonly known as hedging).
Taking a position in anticipation oI a market move (this is commonly known as
speculation).

For example, General Motors accounts Ior its proIit and loss in US dollars. It anticipates
to receive 1 billion British pounds in three months. ThereIore, it has a risk management
problem - how to reduce or eliminate the risk oI dollar appreciation. To manage this risk,
General Motors can approach Goldman Sachs to engage in a Iorward contract:
Under this contract, GM will sell 1 billion British pounds and buy dollars at a rate oI
0.85 pound per dollar.
For GM (the end user oI the Iorward contract), the risk is eliminated because it has
locked in the exchange rate.
Goldman Sachs, the dealer, has taken on the risk Irom GM, and may then oIIset this
risk by engaging a transaction with another party.





e. describe the characteristics of equity forward contracts.

An equity forward is a contract calling Ior the purchase oI an individual stock, a stock
portIolio, or a stock index at a later date.

II an investor wants to hedge the risk on a portIolio oI stocks, entering into a Iorward
contract on each stock is not cost eIIicient because each contract will incur administrative
costs. Entering into a Iorward contract on the overall stock portIolio is more cost eIIicient
compared with the Iirst approach because only one set oI administrative costs is incurred.
Entering into a Iorward contract on a stock index is the most cost eIIicient approach
because Iorwards on a stock index are highly liquid and will result in a better quote Irom
dealers. However, unless the portIolio is an index Iund, the hedge is not perIect.

Equity Iorward contract prices and values must take into account the Iact that the
underlying stock, portIolio, or index could pay dividends.





f. describe the characteristics of forward contracts on zero-coupon and coupon bonds.

Forward contracts on bonds can be based on zero-coupon bonds or on coupon bonds, as
well as portIolios or indices based on zero-coupon bonds or coupon bonds.
Zero-coupon bonds pay their return by discounting the Iace value, oIten using a 360-
day year assumption. For example, Treasury bills in the US are zero-coupon bonds.
Forward contracts on bonds must expire beIore the bond's maturity.
A Iorward contract on a bond can be aIIected by special Ieatures oI bonds, such as
callability and convertibility.




g. explain the characteristics of the Eurodollar time deposit market.

Eurodollars are the dollars deposited outside the US. Similarly, Euroyens are yens
deposited outside Japan.

Eurodollar time deposits are dollar loans made by one bank to another. London is the
center oI the Eurodollar time deposit market. The primary Eurodollar rate is called
LIBOR (the London Interbank Offer Rate), the rate at which London banks are willing
to lend dollars to other London banks.

Although the term "Eurodollars" reIer to dollar denominated loans, similar loans exist in
other currencies.

Eurodollar deposits accrue interest by adding it on to the principal, using a 360-day year
assumption. Such a procedure is called add-on interest:
Interest Principal x LIBOR x Number oI Days to Maturity / 360

In contrast, the interest oI a zero-coupon bond is deducted Irom the Iace value. Such a
procedure is called discount interest.

Example:

The 30-day LIBOR is 5.25. NatWest, a London bank, needs to borrow $10 million Ior
30 days. How much will NatWest owe in 30 days?
Interest $10,000,000 x 5.25 x 30/360 $43,750.
Total amount owed $10,000,000 $43,750 $10,043,750.





h. define LIBOR and Euribor.

LIBOR stands Ior London Interbank Offer Rate, the rate at which London banks are
willing to lean other London banks. Euribor is the rate on a euro time deposit, a loan
made by banks to other banks in FrankIurt in which the currency is the euro.





i. describe the characteristics of forward rate agreements (FRAs).

A forward rate agreement (FRA) is a Iorward contract in which one party, the long,
agrees to pay a Iixed interest payment at a Iuture date and receive an interest payment at a
rate to be determined at expiration.
The amount used to calculate the interest payments to be exchanged is called the
notional principal.
The Iixed rate is also called the forward contract rate.
The interest rate to be determined at expiration is also called the underlying rate. It
is typically quoted in LIBOR iI the notional principal is a Eurodollar time deposit,
and in Euribor iI the notional principal is a euro time deposit.

One somewhat conIusing Ieature oI FRAs is the Iact that they mature in a certain number
oI days and are based on a rate that applies to an instrument maturing in a certain number
oI days measured Irom the maturity oI the FRA. Thus, there are two day Iigures
associated with each contract. FRAs are described by a special notation. For example, a 3
x 6 FRA expires in three months; the underlying is a Eurodollar deposit that begins in
three months and ends three months later, or six months Irom now.

Most FRAs expire in a given number oI exact months, and are based on the most
commonly traded interest rates such as 30-day LIBOR, 60-day LIBOR, and so on. These
standard FRAs are called on-the-run FRAs. For example, a 2 x 4 FRA expires in 2
months, and the underlying rate is 60-day LIBOR. Nonstandard FRAs are called off-the-
run FRAs. For example, an FRA that expires in 59 days on 104 day LIBOR.

Example:

Shell and Barclays enters into the Iollowing FRA:
Shell, the end user, takes a long position in an FRA that expires in 30 days and is
based on 60-day LIBOR.
Barclays, a dealer, quotes a rate oI 5.65 Ior this FRA.
The notional principal oI this FRA us $1,000,000.

By convention, this FRA is also reIerred to as a 1 x 3. At the expiration oI the FRA in 30
days:
Shell pays a Iixed rate oI 5.65 immediately.
Barclays promises to pay a rate oI 60-day LIBOR determined at expiration. Suppose
that the 60-day LIBOR at expiration is 6. Barclays will pay 6 oI interest to Shell
60 days aIter the contract expiration date. In eIIect, the 6 interest is paid 90 days (30
60) Irom the contract initiation date.




j. calculate the payment at expiration of an FRA and explain each of the component
terms.

The payment oI an FRA at expiration is based on the net diIIerence between the
underlying rate and the agreed-upon rate, adjusted by the notional principal and the
number oI days in the instrument on which the underlying rate is based. The payoII is
also discounted, however, to reIlect the Iact that the underlying rate on which the
instrument is based assumes that payment will occur at a later date.


Consider an FRA expiring in 90 days Ior which the underlying is 180-day LIBOR.
Suppose the dealer quotes this instrument at a rate oI 5.5 percent. Suppose the end user
goes long and the dealer goes short. The contract covers a given notional principal, which
we shall assume is $10 million.

The contract stipulates that at expiration, the parties identiIy the rate on new 180-day
LIBOR time deposits. The rate is called 180-day LIBOR. It is, thus, the underlying rate
on which the contract is based. Suppose that at expiration in 90 days, the rate on 180-day
LIBOR is 6 percent. That 6 percent interest will be paid 180 days later. ThereIore, the
present value oI a Eurodollar time deposit at that point in time would be: $10,000,000 / |1
0.06 x (180/360)|.

At expiration the end user receives the Iollowing payment Irom the dealer: $10,000,000 x
|(0.06 - 0.055) x (180/360)|/|1 0.06(180/360)| $24,272.

It is important to note that even though the contract expires in 90 days, the rate is on a
180-day LIBOR instrument; thereIore, the rate calculation adjusts by the Iactor 180/360.
The Iact that 90 days have elapsed at expiration is not relevant to the calculation oI the
payoII.



k. describe the characteristics of currency forward contracts.

A currency Iorward contract is a commitment Ior one party, the long, to buy a currency at
a Iixed price Irom the other party, the short, at a speciIied date. The contract can be
settled by actual delivery, or the two parties can choose to settle in cash on the expiration
day.

Currency Iorwards are usually used by banks and corporations to manager Ioreign
exchange risk.
C. Futures Markets and Contracts



a. identify the institutional features that distinguish futures contracts from forward
contracts.

See Section A los c please.





b. describe the characteristics of futures contracts.

See Section A los c please.





c. differentiate between margin in the securities markets and margin in the futures
markets.

Note that "margin" in the Iutures market diIIers Irom "margin" in the securities market:

In the securities market, "margin" means a collateralized loan Irom the broker. A
margin transaction involves buying stocks with some cash and borrowing the rest
through the broker. The broker keeps the stocks as collateral. Eventually, the investor
must repay the borrowed margin loan with interest.

In the Iutures market, margin is the down payment (or good Iaith deposit, or collateral)
that traders put up with the clearinghouse. The main purpose oI margin is to ensure
that traders will IulIill their obligations. Both the buyer and the seller oI a contract
must deposit margin.

In the securities market, margin requirements are typically set by Iederal regulators.
In the Iutures market, margin requirements are set by clearinghouses. Clearinghouses
use margin requirements to control the risk oI deIault.

In the securities market, margin requirements are expressed as a percentage oI the
transaction value. In the Iutures market, margin requirements are expressed in dollar
terms.



d. describe how a futures trade takes place.

Futures trading occurs on a Iutures exchange.

In Iloor-based trading (also called pit trading) traders must make any buy or sell
oIIer to all other traders in the pit. This is called an open outcry system. In contrast,
the stock exchanges use the specialist system: only one specialist can be designated
Ior a given stock.

In electronic or screen-based trading, exchange members enter their bid and ask
prices into a computer system, through which traders will then complete their
transactions.

In either case, a party to a Iutures contract goes long, committing to buy the underlying
asset at an agreed-upon price, or short, committing to sell the underlying asset at an
agreed-upon price. Each party must deposit a good Iaith deposit (called margin) with the
clearing house oI the exchange. The contract is marked to market on a daily basis.






e. describe how a futures position may be closed out (i.e., offset) prior to expiration.

A Iutures trader who has established a position can re-enter the market and close out the
position by doing the opposite. This process is called offsetting: iI the trader goes long
(short) in the original transaction, he should go short (long) in the new contract. The party
has oIIset the position, no longer has a contract outstanding, and has no Iurther obligation.

Since counterparty credit risk is not a concern Ior Iutures transactions, it is not necessary
to oIIset a position with the same counterparty as in the original Iutures contract. In
contrast, a Iorward contract is subject to the deIault risk oI the buyer or the seller. As a
result, entering into the opposite transaction with the same counterparty as in the original
transaction helps eliminate deIault risk.






f. define initial margin, maintenance margin, variation margin, and settlement price.

BeIore trading a Iutures contract, the prospective trader must deposit Iunds with a broker.
They Iunds serve as a good-Iaith deposit by the trader and are reIerred to as margin. The
main purpose oI margin is to provide a Iinancial saIeguard to ensure that traders will
perIorm on their contract obligations. It makes the Iutures market saIer, but it restricts
trading activities so it should not be unreasonably high. The trader retains title to the
margin and receives interest on it.

Initial Margin: the amount oI trader must deposit before trading any Iutures. It
approximately equals the maximum daily price Iluctuation permitted Ior the contract
being traded. It is usually less than 10 percent oI the Iutures price, which is much
lower than the initial margin requirement in the stock market.

Maintenance Margin: this is the minimum level oI deposit a trader must keep in the
margin account. It is lower than the initial margin. When it is reached, the trader is
required to replenish the margin, bringing it back to its initial level.

Variation Margin: The additional amount a trader must deposit to bring the margin
back to its initial level: variation margin initial margin - margin account balance.

Settlement Price: The settlement price is an average oI the last Iew trades oI the day
and is used to determine the gains and losses marked to the parties' account.






g. describe the process of marking to market.

Terms:
Daily Settlement (or Marking to Market): traders are required to realize any losses
in cash on the day they occur.
Margin Call: the demand Ior more margin.

The Iutures clearinghouse engages in marking to market practice, in which gains and
losses on a Iutures position are credited and charged to the trader's margin account on a
daily basis. Thus, proIits are available Ior withdrawal and losses must be paid quickly
beIore they build up and pose a risk that the party will be unable to cover large losses.

A long position gains iI the price rises: gain/loss on a long position (the day's
settlement price - previous settlement price) x contract size.
A short position gains iI the price Ialls: gain/loss on a short position (previous
settlement price - the day's settlement price) x contract size.
The margin account balance at the end oI the day is determined by taking the
previous balance and accounting Ior any gains and losses Irom the day's activity,
based on the settlement price, as well as any money added or withdrawn: the day's
margin balance previous day's margin balance (-) the day's gain (loss) (-)
deposits (withdrawals).

h. compute the margin balance, given the previous day | || | balance and the new futures
price.

Day 0: 1 contract oI oat is priced at $100.
Jim buys 10 contract oI oats priced.
He is required to post an initial margin oI $50 ($5 per contract times 10).
Maintenance margin is set at $20 ($2 per contract times 10).

Day 1: The settlement price is $101.
Jim gains $10. That is, his position is marked to market.
Margin balance is $60 (i.e. 50 10).

Day 2: The settlement price is $96.
Jim loses $50: (96 - 101) x 10.
Jim's margin balance is $10 (i.e. 60 - 50). Since his margin balance is below the
maintenance margin oI $20, Jim receives a margin call.
Jim must deposit more Iunds to restore his balance up to the initial margin. Variation
margin initial margin - margin balance 50 - 10 40.





i. explain price limits, limit move, limit up, limit down, and locked limit.

Price limits: they are restrictions on the price oI a Iutures trade. They are based on a
range relative to the previous day's settlement price. No trade can take place outside
oI the price limits. Note that not all contracts have price limits. For example, suppose
that the price limit is $5, and the previous settlement price is $110. Today, all trades
must take place between $105 (i.e. 110 - 5) and $115 (i.e. 110 5). As a result,
today's settlement price must also Iall between $105 and $115.

Limit move: iI the price at which two parties would like to trade exceeds the upper or
lower price limit, the price must Ireeze at the limit. This is called a limit move.
Limit up: it is when the market price would be at or above the upper limit.
Limit down: it is when the market price would be at or below the lower limit.
Locked limit: it occurs when a trade cannot take place because the price
would be above the limit up or below the limit down prices.

Let's continue with the above example. Suppose Bill and Jim would like to make
a trade at $118. Since the proposed price exceeds the upper limit oI $115, the
trade cannot take place. II Bill and Jim agrees to trade at $115, a limit up occurs.
II the two parties cannot consummate the trade because oI the price limit, a locked
limit occurs.





j. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration, delivery, an equivalent cash settlement, or an exchange-for-physicals.

There are several ways to close a Iutures position:

Cash settlement: some Iutures positions can be closed through cash settlement, in
which traders make payments at the expiration date to settle any gains or losses.

Delivery: A Iutures position can be closed at expiration through the physical delivery
oI a particular good.
Contracts such as stock index Iutures do not allow actual delivery.
Only 0.5 oI all contracts traded were settled this way.

Delivery takes place at certain locations and at certain times as speciIied by a Iutures
exchange. Delivery options are Ieatures associated with a Iutures contract that
permits the short some Ilexibility in what to deliver, when to deliver it, and when in
the expiration month to make delivery. For example, US Treasury bond Iutures
typically allow delivery oI bond issues with any coupon rate as long as their maturity
is over 15 years.

Offset (also called close-out): the trader transacts in the Iutures market to bring his or
her net position in a particular Iutures contract back to zero (reversing trade). It is
crucial that the trader buys (sells) exactly the same contract that was sold (bought)
originally. This is the most popular way to close a Iutures position. Note that this is
essentially the same method used to terminate a Iutures position prior to expiration.

Exchange for Physicals (EFP): two traders agree to a simultaneous exchange oI a
cash commodity and Iutures contracts based on that cash commodity. The result is
much like an oIIset. However, the diIIerences are:
they exchange the physical good;
the Iuture contract is not closed by a transaction on the Iloor oI the exchange
but a report oI desire to the Iutures exchange;
the two parties privately negotiated the terms and price. It is sometimes called
ex-pit transaction (or against actuals or versus cash transactions) since an
EFP transaction takes place away Irom the trading Iloor oI the exchange.

For example, John bought 1 wheat Iutures, and wants to buy physical wheat.
Janice sold 1 wheat Iutures, and owns wheat and wishes to sell. John and Janice
agree on a price Ior the physical wheat, and agree to cancel their Iutures positions
against each other. John buys the wheat Irom Janice and pays the agreed price.
They report their EFP to the exchange. The exchange notes that their positions
match (1 long and 1 short) and cancels these Iutures obligations.



k. explain delivery options in futures contracts.

See los j please.





l. distinguish among scalpers, day traders, and position traders.

A Iutures exchange is a legal corporation entity whose shareholders are its members.
Members hold exchange memberships (called seats). These memberships are bought and
sold in an active market. Only members have the right to trade on the exchange.

There are two types oI members:
Floor traders (typically called locals), who make market by standing ready to buy
and sell at quoted prices. Locals are the primary provider oI liquidity to the Iutures
market.
Floor commission merchants (FCMs), who trade on behalI oI clients outside the
exchange.

According to their trading styles, there are three types oI locals:

Scalpers are Iutures traders who take positions Ior very short periods oI time and
attempt to proIit by buying at the bid price and selling at the ask price.

Day traders close out all positions by the end oI the day. They never hold a position
overnight.

Position traders leave their positions open overnight and potentially longer. Unlike
scalpers, both day traders and position traders try to proIit Iorm the anticipated market
movements. However, position traders are more aggressive than day traders since
position traders tend to hold positions open longer.





m. describe the characteristics of the following types of futures contracts: 1reasury bill,
Eurodollar, 1reasury bond, stock index, and currency.

There are two major groups oI Iutures contracts: commodity futures, which are based on
agricultural, metal, and petroleum products, and financial futures, which are based on
Iinancial instruments such as stocks, bonds, and currencies. For the level I exam, our
Iocus is on Iinancial Iutures.

Treasure bill futures are contracts in which the underlying is a 90-day $1,000,000 oI
a US Treasury bill. Recall that Treasury bills are sold at a discount Irom par value.
The price oI a Treasury bill Iutures is quoted as 100 minus the discount rate used by
the Iutures market to derive the contract price, or simply: price 100 - rate. The
value is called the IMM Index (IMM stands Ior International Monetary Market). The
actual price oI the Iutures contract is then:

T-bill Futures Price 1 - |rate/100| x |90/360|} x $1,000,000

For example, the discount rate priced into a contract is 4.65. The quoted price is
100 - 4.65 95.35. The actual Iutures price is |1 - 0.0465 x (90/360)| x 1,000,000
$988,375.


Eurodollar futures are contracts in which the underlying is $1,000,000 oI a 90-day
Eurodollar time deposit. Like the T-bill contract, the price oI a Eurodollar Iutures
100 - rate, which is also known as the IMM index. The calculation oI a Iutures price
is also similar. However, Eurodollar Iutures cannot be settled in cash. Rather, they are
settled by physical delivery oI a Eurodollar time deposit.

Treasury bond futures are contracts in which the underlying is $100,000 oI a US
Treasury bond with a minimum 15-year maturity (Irom the delivery date). For most
other Iutures contract, the identity oI the underlying instrument is pretty clear: Ior
example, the underlying instrument oI Treasury bill Iutures is a 90-day T-bill.
However, a unique Ieature oI Treasury bond Iutures is that there are multiple
deliverable bond issues with any coupon rate, as long as their maturity is over 15
years. As a result, the short can choose among these deliverable bonds and deliver the
cheapest-to-deliver bond (this reIers to the bond in which the amount received Ior
delivering the bond is largest compared with the amount paid in the market Ior the
bond).

Stock index futures are contracts in which the underlying is a well-known stock
index, such as the S&P 500 or FTSE 100. For example, suppose the S&P 500 Index is
at 1088. A one-month Iutures contract on the index may be quoted at a price oI 1090.
The stock index Iutures contract has a multiplier. For example, the multiplier
Ior the S&P 500 Iutures is $250.
The actual Iutures price is derived by multiplying the quoted Iutures price by
the multiplier contained in the contract. For example, with a quoted price oI
1090, the actual price oI a S&P 500 Iutures contract is $272,500 (250 x 1090).
Stock index Iutures do not allow Ior actual delivery.

Currency futures are contracts in which the underlying is a Ioreign currency. The
currency Iorward market is much larger than the currency Iutures market. In the US,
most currency Iutures are based on the euro, Canadian dollar, Swiss Iranc, Japanese
yen, British pound, Mexican peso, and Australian dollar. Contract Ior each currency
have a designated size and quotation unit. For example, an euro Iutures contract
covers 12,500 euro, and is quoted in dollars per euro. Currency Iutures are settled
through actual delivery.


D. Option Markets and Contracts

a. identify the basic elements and describe the characteristics of option contracts.

Every option is either a call option or a put option. Options are created only by selling
and buying. ThereIore, Ior every owner (buyer) oI an option, there is a seller (writer).

The owner (buyer) oI a call option has the right, but not the obligation, to purchase
the underlying good at a speciIied price on a beIore a speciIic date. This right lasts
until the speciIied date. The buyer bets that the underlying good will be worth more
than the exercise price.

The owner (buyer) oI a put option has the right, but not the obligation, to sell the
underlying good at a speciIied price on or beIore the speciIic date. This right lasts
until a speciIied date. The buyer bets that the underlying good's price will drop below
the exercise price.

The Iixed price at which the option holder can buy or sell the underlying is called the
exercise price, strike price, striking price, or strike. To acquire these rights owners oI
options buy them Irom other traders by paying the price, or premium, to a seller. In these
agreements, all rights lie with the owner oI the option. The seller oI an option has all the
obligations. Options have a deIinite expiration date: when it arrives, an option that is not
exercised simply expires. Using the option to buy or sell is the action oI exercising it.

Other characteristics oI option contracts:

The premium is paid when the option contract is initiated.

Option contracts can be settled in cash.

Options contracts can be either over-the-counter or exchange-traded. See LOS c Ior
details.





b. define European option, American option, moneyness, payoff, intrinsic value, and
time value.

There are two Iundamental kinds oI options:
American Option: it permits the owner to exercise at any time beIore or at expiration.
European Option: the owner can exercise the option only at expiration.

Consider an American option and a European option that have identical Ieatures such as:
The same underlying stock.
The same strike price.
The same time remaining until expiration date.

The American option cannot be worth less than the European option, because the owner
oI the American option also has the right to exercise the option beIore expiration iI he
desires. Put it in another way, you can do with an American option anything you can do
with a European option, plus that you can exercise early. Thus, the American option
gives the owner more Ilexibility.

In practice, most options are American options. However, European option is simpler and
easier to analyze.

Note: The terms "European" and "American" are not associated with geographical
locations.

Moneyness reIers to the potential proIit or loss Irom the immediate exercise oI an option.
An option may be:
in-the-money iI its exercise would be proIitable Ior its holder. A call (put) option is
in-the-money iI the stock price exceeds (is below) the exercise price.
out-of-money iI its exercise would be unproIitable Ior its holder. A call (put) option
is out-oI-money iI the stock price is less (higher) than the exercise price.
at-the-money iI the value oI the underlying is equal to the exercise price. A call or
put option is at-the-money iI the stock price equals to the exercise price.

Puts and calls can also be deep-in-the-money or deep-out-of-money iI the cash Ilows
Irom an immediate exercise would be large in the speaker's judgment.

Since an option gives its holder the right, not the obligation, to exercise the option, the
holder will never exercise it iI it is out-oI-money.

Intrinsic value is the value oI the option iI it is exercised immediately. At expiration
there is no question oI early exercise, and the Iollowing equations apply to both
American and European options.

Time value is the component oI an option's price that reIlects the uncertainty oI what will
happen in the Iuture to the price oI the underlying. The shorter the time to expiration, the
lower the time value. At expiration, the time value is zero.




c. differentiate between exchange-traded options and over-the-counter options.

Options can be traded as standardized instrument on an options exchange or as
customized instruments on the over-the-counter market.

For over-the-counter options, the counterparties agree on the terms through private
negotiation. These options have credit risk, and the credit risk is unilateral: because
the buyer pays a price at the start and does not have to do anything else, the buyer
cannot deIault. However, the buyer Iaces credit risk because the seller may not
perIorm its obligation when the buyer exercises the option. In most countries, over-
the-counter options markets are not regulated.

Exchange-traded options are standardized -- the exchange sets all terms except Ior the
price. They are protected Irom deIault on the part oI the writer. Exchange-traded
options markets are usually highly regulated.

Just as in the Iutures market, the clearinghouse in an options market guarantees that
all traders will honor their obligations. It acts as the intermediary counterparty to the
buyer and seller oI each trade. Thus, the clearinghouse adopts the position oI buyer to
every seller and seller to every buyer. Every trader in the options market has
obligations only to the clearinghouse, and the clearinghouse guarantees IulIillment oI
the contract to each oI the trading parties.

Some noteworthy points about exchange-traded options:
Most trading takes place in options close to being at-the-money. Deep-in-the-
money and deep-out-oI-money options are generally not actively traded.
Most exchange-traded options have very short expirations (e.g. the current
month, or the next month). Some options, known as long-term equity
anticipatory securities (LEAPS), have very long expirations (e.g. several
years). They are not usually actively traded because buyers tend to hold them
Ior a long period oI time.
Like Iutures, exchange-traded options have high liquidity, and can be bought
and sold at any time prior to expirations.






d. identify the different types of options in terms of the underlying instruments.

Almost anything with a random outcome can have an option on it. The underlying
instruments Ior options are:

individual stocks: these so-called equity options are among the most popular. There
are both exchange-traded and over-the-counter stock options.

stock indices: S&P 500, Dow Jones Industrial Average (DJIA), etc. For example,
suppose that on 12 June oI a given year the S&P 500 closed at 1241.70. A call option
with an exercise price oI $1,250 expiring on 25 July was selling Ior $27. The S&P
500 index us treated as though it were a share oI stock worth $1241.70, which can be
bought, using the call option, Ior $1,250 on 25 July. At expiration, iI the option is in-
the-money, the buyer exercise it and the writer pays the buyer the $250 contract
multiplier times the diIIerence between the index value at expiration and $1,250.

bonds: bond options are Iound almost exclusively in the over-the-counter market and
are almost always options on government bonds.

interest rates: instead oI an exercise price, an interest rate option has an exercise
rate (or strike rate), which is expressed on an order oI magnitude oI an interest rate.
Using a call option as an example:
An interest rate call is an option in which the holder has the right to make a
known interest payment and receive an unknown interest payment. The
underlying is the unknown interest rate. II the unknown interest rate turns out to
be higher than the exercise rate at expiration, the option is in-the-money and is
exercised; otherwise the option simply expires.
All interest rate option contracts have a speciIied size which is called the
notional principal.
Interest rate options are settled in cash.
In general, the payoII oI an interest rate call is: (Notional Principal) x Max (0,
Underlying rate at expiration - Exercise rate) x (Days in underlying rate/360)
For example, consider options expiring in 90 days on 180-day LIBOR. The option
buyer chooses an exercise rate oI 5.5 percent and a notional principal oI $10
million. Suppose that 180-day LIBOR is 6 percent on the expiration day. The call
is then in-the-money. The payoII to the holder oI the option is ($10,000,000) x
(0.06 - 0.055) x (180/360) $25,000. By convention this money is not paid at
expiration but 180 days later.

currencies: a currency option allows the holder to buy (iI a call) or sell (iI a put) an
underlying currency at a Iixed exercise rate, expressed as an exchange rate. Most
currency options are traded over-the-counter.

futures: A call option on a Iutures gives the holder the right to enter into a long
Iutures contract at a Iixed Iutures price. A put option on a Iutures gives the holder the
right to enter into a short Iutures contract at a Iixed Iutures price. The Iixed Iutures
price is the exercise price. For example, an investor can purchase a call option that
allows the investor to enter into a long Eurodollar Iutures contract with exercise price
oI 95.

commodities: oil, wheat, soybeans, etc.

random factors: weather, Ior example. These random Iactors aIIect economic
activities. For example, corporations may use weather options to hedge against the
risk oI weather-related losses. Let's consider the case oI a ski resort. The proIit oI a
ski resort depends on the amount oI snowIall. The lower the snowIall, the lower its
proIit. To protect against the risk oI low snowIall, a ski resort can but a put option on
the amount oI snowIall, with the exercise price set to be 30 inches oI snowIall. II
there is plenty oI snowIall (say, 50 inches), all that the ski resort can lose is the
premium paid Ior the put option. However, iI actual snowIall is below 30 inches, then
the ski resort can exercise the put option and claim the money.

real option: it is an option associated with the Ilexibility in capital investment
projects. For example, companies may invest in new projects that have the option to
deIer the Iull investment, expand or contract the project at a later date, or even
terminate the project. In Iact, most investment projects have numerous elements oI
Ilexibility that can be viewed as options. OI course, these options do not trade in
markets the same was as Iinancial and commodity options, and they must be
evaluated much more careIully. They are, nonetheless, options and thus have the
potential Ior generating enormous value.





e. compare and contrast interest rate options to forward rate agreements (FRAs).

Like FRAs, which are Iorward contracts in which the underlying is an interest rate:
interest rate options are options in which the underlying is an interest rate.
interest rate options also have a notional principal, based on which the interest
payments to be changed are calculated.

However, FRAs are commitments to make one interest payment and receive another,
whereas interest rate options are rights, not commitments, to make one interest payment
and receive another.





f. explain how option payoffs are determined, and show how interest rate option
payoffs differ from the payoffs of other types of options.

Option payoIIs, which are the values oI options when they expire, are determined by the
greater oI zero or the diIIerence between underlying price and exercise price and
underlying price, iI a put. For interest rate options, the exercise price is a speciIied rate
and the underlying price is a variable interest rate. For details please see los h.






g. define interest rate caps and floors.

Borrowers oIten use interest rate call options to hedge the risk oI rising rates on Iloating-
rate loans. Lenders oIten use interest rate put options to hedge the risk oI Ialling rates on
Iloating-rate loans. Floating-rate loans usually involve multiple interest payments. Each
oI these payments is set on a given date. To hedge the risk oI interest rates increasing, the
borrower would need options expiring on each rate reset date. Thus the borrower would
require a combination oI interest rate call options. Similarly a lender would need a
combination oI interest rate put options.

Interest rate options exist in the Iorm oI caps, which are call options on interest rates, and
floors, which are put options on interest rates. SpeciIically, an interest rate cap is a series
oI call options on an interest rate, with each option expiring at the date on which the
Iloating loan rate will be reset, and with each option having the same exercising rate.
Each option is independent oI the others; thus, exercise oI one option does not aIIect the
right to exercise any oI the others. Caps consist oI a series oI call options, called caplets,
on an underlying rate, with each option expiring at a diIIerent time.

An interest rate Iloor is a series oI put options on an interest rate, with each option
expiring at the date on which the Iloating loan rate will be reset, and with each option
having the same exercise rate. Floors consist oI a series oI put options, called floorlets,
on an underlying rate, with each option expiring at a diIIerent time.





h. identify the minimum and maximum values of European options and American
options.

Summary:
The minimum value oI European and American calls and puts is zero.
The maximum value oI European and American calls is the underlying price.
The maximum value oI a European put is the present value oI the exercise price: X/(1
r)
T

The maximum value oI an American put is the exercise price.

The easiest time to determine an option's value is at expiration. At that point there is no
Iuture. Only the present matters. An option's value at expiration is called its payoff.

Long call strategy

On its expiration date, the value oI an option (either call or put, either LONG or SHORT)
is equal to its intrinsic value.

Shown below is the diagram that depicts the expiration-day value oI a LONG call option.
Since, on its expiration date, the value oI a LONG call option is equal to its intrinsic
value, this diagram also illustrates the intrinsic value oI a LONG call option on the
option's expiration date. The intrinsic value oI a call option on its expiration day is C
T

MAX (0, S
T
- X).
where: C
T
is the price oI a call option at time t, and S
T
is the price oI the underlying stock
at time t, and X is the exercise price Ior the option. For a long position in call acquired at
time t T, the cost oI the call is Ct, and the proIit or loss on the long call position held
until expiration is: C
T
- Ct MAX 0, S
T
- X] - Ct



The vertical axis shows the (intrinsic) value oI the call option. The horizontal axis shows
the price oI the underlying stock. The heavy line illustrates the expiration-day value oI
the call option Ior various prices oI the underlying stock.

Note that the value diagram (heavy line) has a "corner" or "kink" at the point where the
stock price and the call option exercise price are equal. At this point, the option is "at the
money" and its (intrinsic) value is zero. Since S
T
and X are equal, S
T
- X 0 C
T
.

For any stock price less than the call option exercise price, the call option is "out oI the
money." All stock prices that lie between the origin and the call option exercise price
(that is, to the "leIt" oI the exercise price) put the call option "out oI the money" because
they are less than the exercise price. The call option value Ior this region oI the diagram
is zero. Since S
T
is less than X, then S
T
- X 0. As a result, C
T
0.

For any stock price greater than the call option exercise price, the call option is "in the
money." All stock prices that lie to the "right" oI the call option exercise price put the call
option "in the money" because they are greater than the exercise price. The call option
value Ior this region oI the diagram is greater than zero. Since S
T
is greater than X, then
S
T
- X ~ 0. Further, the larger the stock price (S
T
), the greater the call option value.

So, Ior a call buyer (long a call option):
the worst that can happen is losing the entire purchase price oI the option.
potential proIits are theoretically unlimited.


Short call strategy

Shown below is the diagram that depicts the expiration-day value oI a SHORT call option.
On its expiration date, the value oI a SHORT call option is equal to the negative oI its
intrinsic value. Note that this is not the same as saying that the intrinsic value is negative.
Intrinsic value, by deIinition, cannot be negative.



For a call seller (short a call option):
the best thing that can happen to the seller oI a call is never to hear any more about
the transaction aIter collecting the initial premium.
potential losses Irom selling a call are theoretically unlimited.

The option market is a zero-sum game: Long call proIits Short call proIits (C
T
- Ct)
(Ct - C
T
) 0. The trader who hopes to speculate successIully must be planning Ior
someone else's losses to provide his proIit.

Long put strategy

On its expiration date, the value oI an option (either call or put, either LONG or SHORT)
is equal to its intrinsic value.

Shown below is the diagram that depicts the expiration-day value oI a LONG put option.
Since, on its expiration date, the value oI a LONG put option is equal to its intrinsic value,
this diagram also illustrates the intrinsic value oI a LONG put option on the option's
expiration date. The intrinsic value oI a put option on its expiration day is P
T
MAX(0,
X - S
T
).
where: P
T
is the price oI a put option at time t.







As with the call option diagrams, the vertical axis shows the (intrinsic) value oI the put
option. The horizontal axis shows the price oI the underlying stock. The heavy line
illustrates the expiration-day value oI the put option Ior various prices oI the underlying
stock.

Note that the value diagram (heavy line) has a "corner" or "kink" at the point where the
stock price and the put option exercise price are equal. At this point, the option is "at the
money" and its (intrinsic) value is zero. Since S
T
and X are equal, X - S
T
0 P
T
.

For any stock price greater than the put option exercise price, the put option is "out oI the
money." All stock prices that lie to the "right" oI the exercise price put the call option
"out oI the money" because they are greater than the exercise price. The put option value
Ior this region oI the diagram is zero. Since ST is greater than X, then X - S
T
0. As a
result, P
T
0.

For any stock price less than the put option exercise price, the put option is "in the
money." All stock prices that lie between the exercise price and the origin (to the "leIt" oI
the put option exercise price) put the put option "in the money" because they are less than
the exercise price. The put option value Ior this region oI the diagram is greater than zero.
Since ST is less than X, then X - S
T
~ 0. Further, the smaller the stock price (S
T
), the
greater the put option value.

Short put strategy

Shown below is the diagram that depicts the expiration-day value oI a SHORT put option.
On its expiration date, the value oI a SHORT put option is equal to the negative oI its
intrinsic value. Note, again, that this is not the same as saying that the intrinsic value is
negative. Intrinsic value, by deIinition, cannot be negative.










i. illustrate how the lower bounds of European calls and puts are determined by
constructing portfolio combinations that prevent arbitrage, and calculate an option's
lower bound.

The previous discussion tells us that the price is somewhere between zero and maximum,
which is either the underlying price, the exercise price, or the present value oI the
exercise price -- a Iairly wide range oI possibilities. We will tighten the range up a little
on the low side by establishing a lower bound on the option price.

For American options, which are exercisable immediately:
C
0
~ Max (0, S
0
- X)
P
0
~ Max (0, X - S
0
)
II the option is in-the-money and is selling Ior less than its intrinsic value, it can be
bought and exercised to net an immediate risk-Iree proIit.

However, European options cannot be exercised early; thus, there is no way Ior market
participants to exercise an option selling Ior too little with respect to its intrinsic value.
We have to determine the lower bound oI a European call by constructing a portIolio
consisting oI a long call and risk-Iree bond and a short position in the underlying asset.

First we need the ability to buy and sell a risk-Iree bond with a Iace value equal to the
exercise price and current value equal to the present value oI the exercise price. We buy
the European call and the risk-Iree bond and sell short (borrow the asset and sell it) the
underlying asset. At expiration we shall buy back the asset.

\u'u ut lx`ut`ou
Tuu:ut`ou Cuut \u'u ST \ ST ` \
buy u'' 0 0 ST \
S'' :lot uud'y`u_ S0 ST ST
buy |oud \ ! )
T
\ \
Totu' 0 S0 \!)
T
\ ST ` 0 0

This combination produces a non-negative value at expiration, so its current value must
be non-negative. For this situation to occur, the call price has to be worth at least the
underlying price minus the present value oI the exercise price:
c
0
~ Max |0, S
0
- X / (1 r)
T
|

The lower bound oI a European put is established by constructing a portIolio consisting
oI a long put, a long position in the underlying, and the issuance oI a zero-coupon bond.
This combination produces a non-negative value at expiration so its current value must be
non-negative. For this situation to occur, the put price has to be at least as much as the
present value oI the exercise price minus the underlying price.
p
0
~ Max|0, X / (1 r)
T
- S
0
|

For both calls and puts, iI this lower bound is negative, we invoke the rule that an option
price can be no lower than zero.

Example:
All options expire in 60 days, have the same exercise price (X) oI $60 and the same
underlying asset.
The current price oI the underlying (S
0
) is $50.
The risk-Iree rate (r) is 5.
Find the lower bounds oI American and European calls and puts.
Solution:
Time to expiration (T) 60/365 0.1644.
European Call (c
0
): MAX|0, 50 - 60/(1 5)
0.1644
| MAX|0, -9.95| 0.
American Call (C
0
): MAX|0, 50 - 60/(1 5)
0.1644
| MAX|0, -9.95| 0.
European Put (p
0
): MAX|0, 60/(1 5)
0.1644
- 50| MAX|0, 9.95) 9.95.
American Put (P
0
): MAX|0, 60 - 50) 10.
Note that the lower bound oI the American put is above the lower bound oI the European
put.




j. determine the lowest prices of European and American calls and puts based on the
rules for minimum values and lower bounds.

See los i please.





k. illustrate how a portfolio (combination) of options establishes the relationship
between options that differ only by exercise price.

Generally, the higher the exercise price, the lower the price oI a call and the higher the
price oI a put.
To see this, let the two exercise prices be X
1
and X
2
, with X
1
be the smaller. We construct
a combination in which we buy the X
1
call and sell the X
2
call.

\u'u ut lx`ut`ou
Tuu:ut`ou Cuut \u'u ST \! \! ST \? ST ` \?
buy u'' \ \!) 0\!) 0 ST \! ST \!
S'' u'' \ \?) 0\?) 0 0 ST \?)
Totu' 0\!) 0\?) 0 ST \! ` 0 \? \! ` 0

Note that the three outcomes are all non-negative. This Iact establishes that the current
value oI the combination, c
0
(X
1
) - c
0
(X
2
) has to be non-negative. Thus:

c
0
(X
1
) ~ c
0
(X
2
)

This shows that a call option with a higher exercise price cannot have a higher value than
one with a lower exercise price. The option with the higher exercise price has a higher
hurdle to get over, thereIore the buyer is not willing to pay as much Ior it.

For put options we can get:
P
0
(X
2
) ~ P
0
(X
1
)






l. explain how option prices are affected by the time to expiration of the option.

A longer-term European or American call must be worth at least as much as a
corresponding shorter-term European or American call.
Let's consider options otherwise identical except that one has a longer time to expiration
than the other (T
1
T
2
). When the shorter-term call expires, the European call is worth
Max(0, S
T1
- X
1
), but the longer-term European call is worth at least Max(0, S
T1
- X / (1
r)(T
2
- T
1
)), which is at least as great as this amount. Thus, the longer-term European call
is worth at least the value oI the shorter-term European. These results are not altered iI
the call is American.

A longer-term American put must be worth at least as much as a shorter-term American
put. A longer-term European put, however, can be worth more or less than a shorter-term
European put.
For European puts, the longer time gives additional time Ior a Iavorable move in the
underlying to occur. However, when a put is exercised, the holder receives money.
The lost interest on the money is disadvantage oI the additional time.
An American put can always be exercised; there is no penalty Ior waiting.





m. illustrate how put-call parity for European options is established, explain how this
result is used to create synthetic instruments, and explain why an investor would want
to create such instruments.

First we consider an option strategy reIerred to as a fiduciary call which consists oI a
European call and a risk-Iree bond that matures on the option expiration day and has a
Iace value (X) equal to the exercise price oI the call.

II the price oI the underlying is below X at expiration, the call expires worthless and
the bond is worth X.
II the price oI the underlying is above X at expiration, the call expires and is worth S
T

(the underlying price) - X.

So at expiration, the Iiduciary call will end us with X or ST, whichever is greater. This
combination allows protection against downside losses and is thus IaithIul to the notion
oI preserving capital.

Then we consider an option strategy known as a protective put, which consists oI a
European put and the underlying asset.
II the price oI the underlying is below X at expiration, the put expires and is worth X
- S
T
, and the underlying is worth S
T
.
II the price oI the underlying is above X at expiration, the put expires with no value
and the underlying is worth S
T
.

So at expiration, the protective put is worth X or S
T
, whichever is greater.

Thus, the Iiduciary call and protective put end up with the same value. They are thereIore
identical combinations. To avoid arbitrage their values today must be the same.

c
0
+ X/(1 + r)
T
p
0
+ S
0


This equation is called put-call parity. It does not say the puts and calls ate equivalent,
but it does show an equivalence (parity) oI a call/bond portIolio and a put/underlying
portIolio. Note that the put and call must have the same underlying, exercise price and
expiration date.

By re-arranging the above equation:
c
0
p
0
S
0
- X/(1 r)
T


Because the right side oI this equation is equivalent to a call, it is oIten reIerred to as a
synthetic call. It consists oI a long put, a long position in the underlying, and a short
position in the risk-Iree bond.

There are numerous other combinations that can be constructed. For example, we can
isolate the put as:
p
0
c
0
X/(1 r)
T
- S
0


The right side is a synthetic put, which consists oI a long call, a short position in the
underlying, and a long position in the risk-Iree bond.

Another example is synthetic bond: p
0
S
0
- c
0
X/(1 r)
T
.

Synthetic positions enable us to price options, because they produce the same results as
options and have known prices. Consider the Iollowing example: A European call with an
exercise price oI $30 expires in 90 days. A European put with the same exercise price,
expiration date and underlying is selling Ior $6. The underlying is selling Ior $40, and the
risk Iree rate is 10. Based on the inIormation, we can compute the value oI the synthetic
call: c
0
p
0
S
0
- X/(1 r)
T
6 40 - 30/(1 10)
90/365
$16.7 (Note the time to
expiration T 90/365 0.2466.). Since the synthetic call and the actual call have the
same payoII, they must have the same price as well. ThereIore, the price oI the call
should be $16.70.

Synthetic positions also tell how to exploit mispricing oI options relative to their
underlying assets. Continue with the above example. II the market price oI the call is $10,
the call is then underpriced. We can make a risk-Iree proIit oI $6.70 by selling the
synthetic call Ior $16.7.

We can not only synthesize a call or a put, but we can also synthesize the underlying or
the bond.





n. illustrate how violations of put-call parity for European options can be exploited and
how those violations are eliminated.

Recall that the basic put-call parity equation is: c
0
X/(1 r)
T
(Iiduciary call ) p
0
S
0

(protective put). Violations oI put-call parity occur when one side oI the equation is not
equal to the other.
An arbitrageur can buy the lower-priced side and simultaneously sell the higher-
priced side, thereby making a proIit on the price diIIerence. Since the Iiduciary
call and protective put have the same payoII, the arbitrageur's positions will
perIectly oIIset at expiration.
As more and more arbitrageurs perIorm these transactions, the price oI the lower-
priced portIolio will increase and the price oI the higher-priced portIolio will
decrease, until put-call parity is restored.

Situation: Consider the Iollowing example involving call options with an exercise price
oI $100 expiring in halI a year (T 0.5). The risk-Iree rate is 10 percent. The call is
priced at $7.5, and the put is priced at $4.25. The underlying price is $99.

Analysis: The leIt side oI the put-call parity equation is c
0
X / (1 r)
T
7.5
100/(1.10)
0.5
102.85. The right side is p0 S
0
4.25 99 103.25. This means the
protective put is overpriced.

Our strategy: We sell the protective put. This means we sell the put and sell short the
underlying. Doing so will generate a cash inIlow oI $103.25. We buy Iiduciary call,
paying out $102,85, netting a cash inIlow oI $0.4. At expiration, iI the price oI the
underlying is above 100:
the bond matures, paying $100.
use the $100 to exercise call, receiving the underlying.
deliver the underlying to cover the short sale.
the put expires with no value.
net eIIect: no money in or out.

II the price oI the underlying is below 100 at expiration, do it yourselI please....

So we receive $0.4 up Iront and do not have to pay anything out. The position is perIectly
hedged and represents an arbitrage proIit. The combined eIIects oI other investors
perIorming this transaction will result in the value oI the protective put going down
and/or the value oI the covered call going up until the two strategies are equivalent in
value.





o. explain the relationship between American options and European options in terms
of the lower bounds on option prices and the possibility of early exercise.

American option prices must always be no less than those oI otherwise equivalent
European options. American call options, however, are never exercised early unless there
is a cash Ilow on the underlying, so they can sell Ior the same as their European
counterparts in the absence oI such a cash Ilow. American put options nearly always have
a possibility oI early exercise, so they ordinarily sell Ior more than their European
counterparts.





p. explain how cash flows on the underlying asset affect put-call parity and the lower
bounds of option prices.

II the underlying makes no cash payments, American calls should not be exercised early.
Recall that an American option must be worth at least as much as a European option. The
extra value oI an American option, iI any, comes Irom the Iact that it can be exercised
immediately. However, an American call should not be exercised early iI the underlying
makes no cash payments during the liIe oI the call.

Assume an American call in in-the-money. That is, its exercise price (X) is lower than
the underlying price (S
0
).
The lower bound oI any call, American or European, is MAX|0, S
0
- X/(1 r)
T
|.
ThereIore, the American call is worth at least S
0
- X/(1 r)
T
today.
II the holder exercises the American call today, he pays the exercise price oI X and
gets the underlying with a value oI S
0
. His net gain is S
0
- X.
Since S
0
- X/(1 r)
T
is greater than S
0
- X, the American call is worth more to the
holder iI it is not exercised early. That is, iI the holder decides to exercise early, he
will lose the time value oI the call.
In Iact, iI an American call is not exercised early, it is worth the same as a European
call.

Conclusion: II the underlying makes no cash payments, there is no reason to exercise an
American call early, and American and European calls have the same value (C
0
c
0
).

However, many underlying assets make cash payments. Stocks pay dividends, bonds pay
interest, Ioreign currencies pay interest, and commodities have carrying costs. II the
underlying makes cash payments, American calls MAY be exercised early. Whether to
exercise early depends on the tradeoII between the time value oI the call and the cash
payments Irom the underlying.
II the call holder decides not to exercise, he captures the time value but loses the cash
payments. In this case, American call is worth the same as the European call.
II he chooses to exercise early, he loses the time value but gets the cash payments. In
this case, the American call can be more valuable than the European call.

All American puts may be exercised early, regardless oI whether the underlying makes
cash payments or not. ThereIore, an American put is usually more valuable than a
European put (i.e. P
0
~ p
0
).

Cash Ilows on the underlying aIIect an option's boundary conditions and put-call parity
by lowering the underlying price by the present value oI the cash Ilows over the liIe oI
the option. The present value oI the cash Ilows over the liIe oI the options should be
removed Irom the value oI the underlying: the notion PV(CF, 0, T) is used to represent
the present value oI these cash Ilows.

The put-call parity is: c
0
X/(1 r)
T
P
0
|S
0
- PV(CF, 0, T)|
European Call (c0) ~ MAX0, |S
0
- PV(CF, 0, T)| - X/(1 r)
T
|}.
European Put (p0) ~ MAX0, X/(1 r)
T
- |S
0
- PV(CF, 0, T)|}.







q. identify the directional effect of an interest rate change on an option's price.

A higher interest rate increases a call option's price and decreases a put option's price.

When investors buy call options instead oI the underlying, they are eIIectively buying
an indirect leveraged position in the underlying. When interest rates are higher,
buying the call instead oI a direct leveraged position in the underlying is more
attractive. Moreover, by using call options, investors save more money by not paying
Ior the underlying until a later date. The higher the interest rate, the more interest
expense an investor can save by using the call.

For put options, higher interest rates are disadvantageous. When interest rates are
higher, investors lose more interest while waiting to sell the underlying when using
puts. Thus, the opportunity cost oI waiting is higher when interest rates are higher.

However, except when the underlying is a bond or interest rate, interest rates do not have
a very strong eIIect on option prices.


E. Swap Markets and Contracts


a. describe the characteristics of swap contracts.

Swaps are derivative securities in the Iorm oI agreements between two counterparties to
exchange cash Ilows over a period oI time, depending on the values oI speciIied market
variables.

Counterparties: the parties that agree to the swap. Because the swaps market has
virtually no governmental regulation, participation in the swaps market is eIIectively
limited to Iirms and institutions that either engage in Irequent swap transactions or
have access to major swap Iacilitators.
Notional principal: an amount used as a base Ior computations, but not an amount
that is actually transIerred Irom one party to another.
Pay fixed: in a plain vanilla interest rate swap, one counterparty agrees to pay a
sequence oI Iixed-rate interest payments and to receive a sequence oI Iloating-rate
interest payments. This counterparty is said to have the pay-Iixed side oI the deal.
Receive fixed: the counterparty with the receive-Iixed side oI the deal agrees to
receive a sequence oI Iixed-rate interest rate payments and to pay a sequence oI
Iloating-rate payments.
The tenor oI a swap transaction reIers to the speciIied time period over which
periodic net interest payments will be made between the counterparties.

Example: Party A agrees to pay a Iixed rate oI interest on $10 million each year Ior 3
years to Party B. In return, Party B agrees to pay a Iloating rate oI interest on $10 million
each year Ior 3 years to Party A.
The agreement between A and B is a swap.
Party A and Party B are counterparties oI the swap.
The nominal principal oI the swap is $10 million.
The tenor oI the swap is 3 years.

Characteristics oI swap contracts:

A swap involves a series oI payments over its tenor, and can be considered a series oI
Iorward contracts. In contrast, Iorwards, Iutures and options only involve a single or
two payment(s) (i.e. when the option is purchased and when it is exercised).

In general, neither party pays any money to the other at the initiation oI a swap. Thus,
a swap has zero value at the start. As we will see later, each party oI a currency swap
pays the notional principal to the other, but the amounts exchanged are equivalent.

Swaps are usually settled in cash.
Each date on which the parties make payments is called a settlement date (or
a payment date), and the time between two settlement dates is called the
settlement period.
In a currency swap, since periodical payments are made in diIIerent currencies,
these payments are made in Iull without netting.
That is, one party makes payment to the other, who in turn makes a payment
to the Iirst party.
In interest rate swaps, the obligations oI the parties are oIIset against each
other, and net payment is made by the party who owes it.

A swap contract has a termination date, which is the date oI the Iinal payment.

Swaps are created and traded over-the-counter, and thereIore can be customized to
suit the speciIic needs oI the counterparties. It has no guarantor such as the exchanges
oIIer Ior Iutures and exchange traded options. In Iact, all over-the-counter instruments
(e.g. Iorward contracts) have deIault risk.

There are two basic motivations Ior entering into a swap agreement:

Commercial needs:
The normal commercial operations oI some Iirms naturally lead to interest rate and
currency risk positions oI a certain type. For example, a typical savings and loan
association accepts deposits and lends those Iunds Ior long-term mortgages. Since
depositors can withdraw their Iunds on short notice but most mortgagors wish to
borrow at a Iixed rate Ior a long time, the savings and loan association can be leIt
with Iloating rate liabilities and Iixed rate assets. II interest rates rise, it will be Iorced
to increase the rate it pays on deposits but it cannot increase the interest rates on the
mortgages that have already been issued. To escape this interest rate risk, it might
use the swaps market to transIorm its Iixed rate assets into Iloating rate assets or
transIorm its Iloating rate liabilities into Iixed rate liabilities.

Comparative advantage:
In many situations, one Iirm may have better access to the capital market than
another Iirm. For example, Party A may be able to borrow in U.S. dollars cheaper
while Party B may be able to borrow cheaper in German marks. This raises the
possibility that each Iirm can exploit its comparative advantage and share the gains
by reducing overall borrowing costs.

Consider the Iollowing example. The borrowing rates Ior Iirms A and B in diIIerent
currencies are as Iollows:
U.S. Dollar Netherlands Guilders
A 5.1 6.3
B 4.9 6.6


In this case, B has an advantage in the U.S. market over A while A has an
advantage over B in the Netherlands.


Since swaps are speciIically tailored to individual counterparties, the secondary market
Ior them is quite illiquid and any changes to the contract require negotiation between the
two counterparties.


Limitations oI the swaps market are:
It can be diIIicult to locate a counterparty to take the opposite side oI the transaction.
It has no guarantor such as the exchanges oIIer Ior Iutures and exchange traded
options.
Swaps cannot be altered or terminated early without the agreement oI both parties.

However, the Iact that the swaps market provides privacy not available in exchange
trading is considered a beneIit by many participants.





b. explain how swaps are terminated.

There are Iour ways to terminate a swap beIore expiration:

Pay the market value in cash. A swap has a market value at any point in time during
its liIe. II agreed by both parties, the swap can be terminated by having one party pay
the market value oI the swap to the other party. II a party holds a swap with a positive
(negative) market value, it should receive (pay) a cash payment oI the market value
Irom (to) the counterparty. For example, iI MicrosoIt holds a swap with a market
value oI $1 million, and its counterparty is Citibank, MicrosoIt can terminate this
swap by receiving a cash payment oI $1 million Irom Citibank.

Sell the swap to another party. With the permission oI its counterparty, a party can
Iind another party to take over its payment obligations in a swap. Example
(Continued): MicrosoIt can terminate this swap by selling it to Intel Ior $1 million,
and Intel will take over MicrosoIt's payment obligations.

Enter into an oIIsetting swap. For example, GE holds a 3-year swap in which it makes
fixed pavments oI 6 and receives Iloating payments based on LIBOR. The payments
are made semiannually on June 30 and December 31. GE can terminate this swap by
entering into a new 3-year swap in which it makes floating pavments based on
LIBOR and receives Iixed payments oI, say, 7 on June 30 and December 31. The
Iloating payments in the two swaps Iully oIIset each other, and the Iixed payments net
out to be a deIinite amount, thereby eliminating the risk associated with the Iloating
rate.

Use a swaption. A swaption is simply an option to enter into a swap. A party can
exercise a swaption to enter into an oIIsetting swap.
c. define and give examples of currency swaps.

Arbitrage opportunities are unlikely to exist in the swaps markets today. Currency swaps
can, however, be used to shape and adjust exposure to exchange rate risk.

Consider the case oI Intercontinental, Inc. Intercontinental has subsidiaries in both the
United States and in Germany. As a result, the Iirm Iinds itselI Irequently exchanging
dollars Ior marks, and vice versa. As the exchange rate between dollars and marks
changes, so does the amount oI dollars and marks necessary Ior each exchange. For
instance, Intercontinental has signed a contract with a German supplier. The contract
requires a series oI payments oI DM50,000 each. Intercontinental plans to use revenues
Irom its U.S. subsidiary to make these contracted payments. As a result, each time a
payment is to be made, dollars must be exchanged Ior marks. As the exchange rate
between dollars and marks changes, so does the number oI dollars necessary to purchase
DM50,000. Intercontinental could extinguish this exchange rate risk by entering into a
plain vanilla currency swap in which it makes U.S. dollar payments to the other swap
counterparty and receives German mark payments Irom the other swap counterparty. As
a result, Intercontinental will have mark income (Irom the swap) to be used Ior the mark
payments (Ior the contract). Intercontinental will also be able to use dollar income (Irom
the U.S. subsidiary) to make dollar payments (to the other swap counterparty).

The entire motivation Ior a plain vanilla currency swap is the actual need Ior Iunds
denominated in a diIIerent currency. It involves three sets oI cash Ilows:

At the initiation oI the swap the two parties DO exchange cash denominated in
diIIerent currencies. The two notional principals are determined at the spot exchange
rate, and must be equivalent to each other.

The parties make periodic interest payments to each other during the liIe oI the swap
agreement.
The interest payment can be made at either a Iixed or a Iloating rate.
For each payment, the interest rate is multiplied by a Iraction representing the
number oI days in the settlement period over the number oI days in a year. In
some cases it is assumed that there are 30 days in each month, and 360 days in
a year. Others use exact day count in each month and 365 days in a year.
Since periodical interest payments are made in diIIerent currencies, these
payments are made in Iull without netting.

At the termination oI the swap the parties again exchange principal denominated in
diIIerent currencies.

Note that all these Ieatures are opposite to those oI a plain vanilla interest rate swap.

Example: A enters into a Iixed-Ior-Iloating annual swap with B to exchange Japanese
Yen Ior U.S. Dollars Ior a period oI 3 years. A pays the Iixed U.S. rate oI 4.8 while
receiving a Iloating Japanese annual LIBOR rate, currently at 1.2. In the Iorex market,
the exchange rate stands at 125 yen per dollar. The notional on the swap is speciIied at 1
billion yen.
At initiation, A pays B a billion yen, and B pays A 8 million dollars.
In one year, A pays B an amount oI $384,000, and B pays A an amount oI 12 million
yen.
....
At maturity, A pays back B $8,000,000 and receives a billion yen.

In a currency swap, principals are exchanged at the swap initiation and maturity. In this
case, since A pays the U.S. rate, it borrows U.S. dollars Ior Japanese Yen. It pays 1
billion yen to B and receives 1 billion/125 $8 million at swap initiation. In one year, B
pays A 1.2 x 1 billion yen 12 million yen. At the same time, A pays B $8,000,000 x
4.8 $384,000. At maturity, A pays back B $8,000,000 and receives a billion yen.





d. calculate the payments on a currency swap.

Example:
Amazon Motors currently holds 100 million French Irancs it received Irom a customer. It
enters into a Iixed-Ior-Iixed annual swap with Basin Corp. to exchange the French Irancs
Ior U.S. Dollars Ior a period oI 5 years. Amazon pays the Iixed U.S. rate oI 6 while
receiving a Iixed French rate oI 8. In the Iorex market, the exchange rate is at 5.2
Francs per U.S. dollar. Which oI the Iollowing is/are true?

I. No money exchanges hands today.
II. In one year, Amazon pays Basin an amount oI 6 million FF.
III. In one year, Basin pays Amazon an amount oI 8 million FF.

Answer: Only III is true.

In a currency swap, principals are exchanged at the swap initiation and maturity. In this
case, Amazon pays 100 million French Francs to Basin and receives 100/5.2 19.23
million U.S. dollars at swap initiation. In one year, Amazon pays Basin 6 x19.23
million 1.154 million U.S. dollars. At the same time, Basin pays Amazon 100 x 8 8
million French Francs.

Note that
Counterparties have mirror-image cash Ilows. ThereIore, a currency swap is a zero-
sum game - one party's gain is the other's loss.
Currency swaps can be used to lower borrowing cost: iI company A has a
comparative advantage in borrowing in dollars (A can borrow at 6 while B would
pay 10), and company B has a comparative advantage in borrowing in pounds,
these two Iirms can use a currency swap to reduce their borrowing costs.
e. define and give an example of a plain vanilla interest rate swap.

The swaps market is a very large, eIIicient market. In the early days oI this market, swaps
were used to exploit arbitrage opportunities and realize arbitrage proIits. Today, such
arbitrage opportunities are unlikely to exist.

Interest rate swaps can, however, be used to shape and adjust exposure to interest rate
risk. The swap market is largely an interbank market. Financial institutions Iind swaps
useIul Ior shaping interest rate risk exposure because swaps can be customized to
individual situations.

In a plain vanilla interest rate swap:

One counterparty agrees to pav fixed interest payments and receive floating interest
payments. This counterparty is known as the pay-fixed side oI the swap.

The opposing counterparty agrees to receive fixed interest payments and pav floating
interest payments. This counterparty is known as the receive-fixed side oI the swap.

For each payment, the interest rates are multiplied by a Iraction representing the
number oI days in the settlement period over the number oI days in a year. In some
cases, it is assumed that there are 30 days in each month, and 360 days in a year.
Others use exact day count in each month and 365 days in a year.

Typically, the Iloating rate is set in advance and paid in arrears. That is, the Iloating
rate is set at one settlement date, and the cash interest is paid at the next settlement
date.

Notional principal is generally not exchanged. The notional principal is the same Ior
both parties oI the swap, so it is not necessary to transIer Iunds Irom one party to
another. Notional principal is only used to calculate the amount oI interest payments.

The obligations oI the counterparties are oIIset against each other, and net payment is
made by the party who owes it. Since both parties deal in a single currency, netting oI
payments avoids unnecessary payments.

For example, Party A might agree to pay a Iixed rate oI interest on $1 million each year
Ior Iive years to Party B. In return, Party B might pay a Iloating rate oI interest on $1
million each year Ior Iive years.

Floating rates in the international swaps market are most oIten set as equaling the London
Interbank OIIer Rate (LIBOR). This is commonly reIerred to as "LIBOR flat", and is a
very common benchmark Ior interest-rate swap transactions.

Interest rate swaps can be used to hedge against interest rate risk.

II interest rates are expected to rise, a Iirm with floating rate debt can enter into an
interest rate swap to receive floating and pav fixed. The Iloating interest payments
received will be used to cover the Iirm's original Iloating debt. Thus, the Iirm's
Iloating rate debt is converted into a Iixed rate debt, which has lower cost iI rates rise.

II interest rates are expected to fall, a Iirm with fixed rate debt can enter into an
interest rate swap to receive fixed and pav floating.





f. calculate the payments on an interest rate swap.

In a plain vanilla interest rate swap, remember the Iollowing points:

The principal value in an interest rate swap is "notional." This indicates that there is
no actual exchange oI principal amount at the initiation or termination oI the swap. It
only acts as a base amount Ior calculation oI interest payments.

The interest payment on any settlement date is made on a net basis i.e. the party that
has a higher liability pays the diIIerence between the two amounts.

The rate that the Iloating side must pay on any reset date is determined by the value
oI the Iloating rate prevailing on the previous reset date.
Obligation oI the pay-Iixed side: Iixed-rate obligation Iixed rate / number oI
payments per year x notional principal.
Obligation oI the receive-Iixed side (set in advance and paid in arrears):
(Iloating rate obligation)
t
(Iloating rate)
t - 1
/ number oI payments per year x
notional principal.
ThereIore, the value oI the payment on the Iirst reset date is known at the swap
initiation.

The counterparties have mirror-image cash Ilows. ThereIore, a currency swap is a
zero-sum game - one party's gain is the other's loss.

Example:
Consider the Iollowing interest rate swap agreement:

Party A pay Iixed
Party B receive Iixed
Tenor 5 years
Notional amount $1,000,000
Fixed rate 8
Floating rate 1 Year LIBOR 1

The swap is "determined in advance and paid in arrears." The 1 Year LIBOR rate is:
6.50 when the swap is initiated
6.75 at the oI end oI year 1
7.00 at the oI end oI year 2
7.25 at the oI end oI year 3
7.50 at the oI end oI year 4
7.75 at the oI end oI year 5

Which are the net payments oI Party B?

In this swap agreement, party A has agreed to pay party B 8 Iixed interest on a
$1,000,000 notional amount ($80,000) Ior the next Iive years. In return, party B has
agreed to pay party A an interest rate tied to the 1 year LIBOR rate plus 1 on a notional
amount oI $1,000,000 Ior the next Iive years. Due to the Iact that the swap is "determined
in advance," the Iloating rate is determined at the beginning oI the period. Thus Ior year
one as an example, party B is obligated to pay 6.50 1 or 7.50 on $1,000,000
($75,000).

The net payment is simply the diIIerence between the obligations oI the two counter
parties. With a plain vanilla swap, net payments are typically the only transactions
involving cash that actually occur.





g. define and give examples of equity swaps.

An equity swap is a swap in which at least one party pays the return on a stock or stock
index. It has the Iollowing characteristics:
An equity swap has an underlying notional principal, which is never exchanged.
The obligations oI the counterparties are oIIset against each other, and net payment is
made by the party who owes it.

The three types oI equity swaps involve one party paying a Iixed rate, a Iloating rate, or
the return on another equity, while the other party pays an equity return. For level 1 exam,
we will consider two types oI equity swaps:

One party pays Iixed rate, the other pays equity return: one counterparty agrees to pay
Iixed interest payments, while the other counterparty agrees to pay Iloating payments
based on an equity return. The Iixed rate is the same as the Iixed rate on a plain
vanilla interest rate swap.

Both parties make equity payments: that is, two counterparties exchange the return on
one equity Ior the return on another equity.


In an equity swap, the rate is the return on a stock or stock index. Several unique Ieatures
are:

The party making the Iixed-rate payment could also have to make a variable payment
based on the equity return. Suppose the end user pays the equity payment and
receives the Iixed payment, i.e. it pays the dealer the return on the S&P 500 index,
and the dealer pays the end user a Iixed rate. II the S&P 500 increases, the return is
positive and the end user pays that return to the dealer. II the S&P 500 goes down,
however, its return is obvious negative. In that case, the end user would pay the dealer
the negative return on the S&P 500, which means it would receive that return Irom
the dealer. So the dealer, or in general the party receiving the equity return, could end
up making both a Iixed-rate payment and an equity payment.

The payment is not known until the end oI the settlement period, at which time the
return on the stock is known. In an interest rate or currency swap, the Iloating interest
rate is set at the beginning oI the period.

The rate oI return is oIten structured to include both dividends and capital gains.

Example:

A mutual Iund has arranged an equity swap with a dealer. The swap's notional principal
is $100 million, and payments will be made semiannually. The mutual Iund agrees to pay
the dealer the return on a small-cap stock index, and the dealer agrees to pay the mutual
Iund based on one oI the two speciIications given below. The small-cap index starts oII at
1,805.20; six months later it is at 1,796.15.

The dealer pays a Iixed rate oI 6.75 percent to the mutual Iund, with payments made
on the basis oI 182 days in the period and 365 days in a year.
The Iixed payment is $100,000,000 x 0.0675 x 182/365 $3,365,753. The equity
payment is (1796.15/1805.20 - 1) x $100,000,000 -$501,329. The dealer makes
both payments, which add up to $3,867,082.

The dealer pays the return on a large-cap index. The index starts oII at 1,155.14 and
six months later is at 1,148.91.
The large-cap equity payment is: (1148.91/1155.14 - 1) x $100,000,000 -$539,329.
The Iund pays the dealer the net amount oI $38,000.

h. calculate the payments on an equity swap.

See los g please.
F. Risk Management Applications of Option Strategies



a. determine the value at expiration, profit, max profit, max loss, breakeven underlying
price at expiration, and general shape of the graph of the strategies of buying and
selling calls and buying and selling puts, and explain each strategy's characteristics.

See Section D los h please.





b. determine the value at expiration, profit, max profit, max loss, breakeven underlying
price at expiration, and general shape of the graph of the covered call strategy and the
protective put strategy, and explain each strategy's characteristics.

So Iar we have discussed the payoIIs oI individual options. Options can be combined
with the underlying to shape the risk and return characteristics oI the underlying.

Covered Call: Stock plus a Short Call

In a covered call transactions, a trader is generally assumed to already own a stock and
writes a call option on the underlying stock. The term "covered" means that the potential
obligation in selling the call (that is, to deliver the underlying) is covered by the
underlying. When the call is exercised, the underlying is immediately available to be
delivered to the buyer oI the call.

The value at expiration oI the covered call equals the value oI the underlying plus the
value oI the short call:

Value oI covered call value oI underlying value oI short call
S
T
- MAX(0, S
T
- X)
S
T
iI S
T
X, or X iI S
T
~ X.

This strategy is generally undertaken as an income enhancement technique, and the
intention is to keep the premium without surrendering the stock through exercise.
However, the writer oI the covered call is actually exchanging the change oI large gains
on the stock position in Iavor oI income Irom selling the option.

Example:
Tom buys a share oI stock Ior $20, and simultaneously sells a call option on that
stock Ior $5. ThereIore he pays a total oI $15 Ior the portIolio.
The exercise price oI the call (X) is $30, and the call will expire in 3 months.
Determine the expiration-day proIits/loss oI Tom's covered call position iI the stock
price Iinishes at $18, $32, or $40 respectively.

Solution: iI the stock price Iinishes at
$18: the value oI his position will be $18 (the value oI the stock) $5 (the option
premium) $23.
$32: the value oI his position will be $35 (the call option will be exercised by the
buyer).
$40: the value oI this position will be also $35.

Protective Put: Stock plus a Long Put

PortIolio insurance (protective put) is an investment management technique designed to
protect a stock portIolio Irom severe drops in value. Options, Iutures or combinations oI
other instruments can be used to implement this strategy.

In essence, portIolio insurance with options involves holding a stock portIolio and buying
a put option on the portIolio. Because the price oI a put is always positive, it is clear that
an insured portIolio costs more than the uninsured stock portIolio alone. At expiration,
the value oI the insured portIolio is: S
T
P
T
S
T
MAX 0, X - S
T
}. As you can see the
strategy oIIers protection against large drops in value.

This strategy is like a long position in a call. A trader can buy a call and invest the extra
proceed in a bond in order to replicate a position in an insured portIolio.

A portIolio oI stock has a potentially wide range oI gains and losses. II all the stocks in
the portIolio lost all oI their value, the value oI the portIolio would also lose all oI its
value. In other words, it would be possible to lose everything that had been invested. On
the other hand, as the stocks in the portIolio increase in value, the value oI the portIolio
increases. Since the value oI a share oI stock has (theoretically) no upper limit, the value
oI a portIolio has no upper limit.

PortIolio insurance limits the amount oI loss on a portIolio by balancing that loss with the
gain Irom a LONG put option. It also reduces the potential gain on a portIolio as a result
oI the premium paid Ior the put option. The "insurance" part oI portIolio insurance, then,
is the limitation oI potential loss. The insurance is not Iree, however. "The cost oI the
insurance" is the put option premium.