Contents

11 Interest Rate Calculations 3

11.1 Interest Rate Conventions . . . . . . . . . . . . . . . . . . . . . . . . 3
11.2 Zero Coupon (discount) Bonds . . . . . . . . . . . . . . . . . . . . . 3
Lecture Notes in Finance 2 (MiQE/F, MSc course 11.3 Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

at UNISG) 11.4 Coupon Bonds . . . . . . . . . . .

11.5 Estimating the Yield Curve . . . . .
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11.6 Conventions on Important Markets . . . . . . . . . . . . . . . . . . 25
Paul Söderlind1 11.7 Inflation-Indexed Bonds . . . . . . . . . . . . . . . . . . . . . . . . 28

A More Details on Bond Conventions 31

8 May 2010
A.1 Bond Equivalent Yields on US Bonds . . . . . . . . . . . . . . . . . 31

12 Bond Portfolios 35
12.1 Duration: Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . 35
12.2 Duration Matching . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
12.3 Yield Curve Models . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
12.4 Interest Rates and Macroeconomics . . . . . . . . . . . . . . . . . . 53
12.5 Forecasting Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . 60
12.6 Risk Premia on Fixed Income Markets . . . . . . . . . . . . . . . . . 61

13 Basic Option Pricing 65

13.1 Introduction to Options . . . . . . . . . . . . . . . . . . . . . . . . . 65
13.2 Forward and Futures . . . . . . . . . . . . . . . . . . . . . . . . . . 75
13.3 Put-Call Parity for European Options . . . . . . . . . . . . . . . . . . 78
13.4 Early Exercise of American Options . . . . . . . . . . . . . . . . . . 79
1 University of St. Gallen. Address: s/bf-HSG, Rosenbergstrasse 52, CH-9000 St. Gallen,
13.5 Put-Call Relation for American Options . . . . . . . . . . . . . . . . 83
Switzerland. E-mail: Paul.Soderlind@unisg.ch. Document name: Fin2MiQEFAll.TeX

1
 13.6 Pricing Bounds and Convexity of Pricing Functions . . . . . . . . . . 86

14 The Binomial Option Pricing Model 90

14.1 Ovierview of Option Pricing . . . . . . . . . . . . . . . . . . . . . . 90 11 Interest Rate Calculations
14.2 The Basic Binomial Model . . . . . . . . . . . . . . . . . . . . . . . 90
14.3 Interpretation of the Riskneutral Probabilities . . . . . . . . . . . . . 96 Main references: Elton, Gruber, Brown, and Goetzmann (2007) 21–22 and Hull (2006) 4
14.4 Numerical Applications of the Binomial Model . . . . . . . . . . . . 97 Additional references: McDonald (2006) 7; Fabozzi (2004); Blake (1990) 3–5; and Camp-
bell, Lo, and MacKinlay (1997) 10
15 The Black-Scholes Model and the Distribution of Asset Prices 106
15.1 The Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . 106
11.1 Interest Rate Conventions
15.2 Convergence of the BOPM to Black-Scholes . . . . . . . . . . . . . . 110
15.3 The Probabilities in the BOPM and Black-Scholes Model . . . . . . 115 Suppose we borrow one unit of currency (that is, the face value of the loan is 1) that
15.4 Hedging an Option . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 should be repaid with interest rate m periods later. The payment in period m is then the
15.5 Options on Currencies and Interest Rates . . . . . . . . . . . . . . . . 125 face value (of 1) plus the interest, so the payment is
15.6 Estimating Riskneutral Distributions . . . . . . . . . . . . . . . . . 131
payment in m D Œ1 C Y .m/m (11.1)
16 Trading Volatility 138
D exp Œmy .m/ (11.2)
16.1 VIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
D 1 C mZ.m/; (11.3)
16.2 Variance and Volatility Swaps . . . . . . . . . . . . . . . . . . . . . 140
where Y .m/ is the effective interest rate, y .m/ the continuously compounded interest rate
17 Dynamic Portfolio Choice 143
and Z.m/ is the simple interest rate.
17.1 Optimal Portfolio Choice: CRRA Utility and iid Returns . . . . . . . 143
17.2 Optimal Portfolio Choice: Logarithmic Utility and Non-iid Returns . . 144 Remark 11.1 (The transformation from one type of rate to the other) We have
17.3 Optimal Portfolio Choice: CRRA Utility and non-iid Returns . . . . . 152
17.4 Performance Measurement with Dynamic Benchmarks . . . . . . . . 159 y .m/ D ln Œ1 C Y .m/ and y .m/ D ln Œ1 C mZ.m/ =m; (11.4)
Y.m/ D exp Œy .m/ 1 and Y .m/ D Œ1 C mZ.m/ 1=m
1
A Some Proofs 164 m
Z.m/ D fŒ1 C Y.m/ 1g=m and Z.m/ D fexp Œy .m/ 1g=m:

The different interest rates are typically very similar, except for very high rates. See
Figure 11.1 for an illustration.

11.2 Zero Coupon (discount) Bonds

Suppose a bond without dividends costs B .m/ in t and gives one unit of account in t C m
(the trade date index t is suppressed to simplify notation—in case of potential confusion,

2 3
we can write B t .m/). The gross return (payoff divided by price) from investing in this Bond prices and rates Bond prices and rates
bond is 1=B.m/, since the face value is normalized to unity. 1

Bond price/face value

Eff interest rate
1 0.1
D Œ1 C Y.m/m , or (11.5) 0.9
B .m/
1=m 0.05
Y.m/ D B.m/ 1: (11.6) 1−year rate Price 1−year
0.8
2−year rate Price 2−year
0
Another way to think of this is that if we invest the amount B.m/ by buying one bond, 0.75 0.8 0.85 0.9 0.95 1 0 0.05 0.1 0.15
then after m periods we get B.m/ times the interest rate, that is, B.m/ Œ1 C Y .m/m D 1. Bond price/face value Effective interest rate

In practice, bond quotes are typically expressed in percentages (like 97) of the face value,
whereas the dicussion here effectively uses the fraction of the face value (like 0.97).
Bond prices and rates
The relation between the rate and the price is clearly non-linear—and depends on the 0.15
time to maturity (m): short rates are more sensitive to bond price movements than long

Interest rate
0.1
rates. Conversely, prices on short bonds are less sensitive to interest rate changes than
prices on long bonds. See Figure 11.1 for an illustration.
0.05 Effective rate
In terms of the continously compounded rate, we have Cont comp rate
0
1 0.85 0.9 0.95 1
D exp Œmy .m/ , or (11.7) Bond price/face value (1 year)
B .m/
y.m/ D ln B.m/=m: (11.8)
Figure 11.1: Interest rate calculations
Example 11.2 (Effective and continuously compounded rates) Let the period length be a
year (which is the most common convention for interest rates). Consider a six-month bill that is, from 0.5% to 1.5%.
so m D 0:5. Suppose B .m/ D 0:95. From (11.5) we then have that
1 Some fixed income instruments (in particular inter bank loans, LIBOR/EURIBOR)
D Œ1 C Y.0:5/0:5 , so Y.0:5/  0:108; and y.0:5/  0:103: are quoted in terms of a simple interest rate. The “price” of a deposit that gives unity at
0:95
maturity is then
Example 11.3 (Bond price changes vs interest rate changes) Suppose that, over a split
second (so the time to maturitity is virtually unchanhged), the log bond price changes by 1
B .m/ D , or (11.9)

ln B, then (11.8) says that the change in the interest rate is 1 C mZ.m/
1=B .m/ 1
Z.m/ D : (11.10)

y.m/ D
ln B.m/=m: m

For instance, if the price of a 10-year bond decreases from 0.95 to 0.86 we get that the
interest rate increases by

0:001 D ln.0:86=0:95/=10;

4 5
 1=ŒB.n/=B.m/. We define a per period effective rate of return, a forward rate, F .m; n/,
analogous with (11.5)
- 1
t t Cm t Cn D Œ1 C F .m; n/n m
: (11.12)
B.n/=B.m/
Write contract, Pay forward price get 1
agree on forward price get bond Notice that F .m; n/ here denotes a forward rate, not a forward price. This is the rate
of return over t C m to t C n that can be guaranteed in t . By using the relation between
Figure 11.2: Timing convention of forward contract bond prices and yields (11.5) this expression can be written
 1=.n m/
B.m/ Œ1 C Y .n/n=.n m/
F .m; n/ D 1D m=.n m/
1: (11.13)
B.n/ Œ1 C Y.m/
-
t t Cm t Cn See Figure 11.4 for an illustration.
Buy 1 n-bond, Pay B.n/=B.m/ get 1 Spot and forward rates
sell B.n/=B.m/ of m-bonds (the principal)
0.07 spot, 2Q
Figure 11.3: Synthetic forward contract 0.065
spot, 3Q
forward

Effective interest rate

0.06
11.3 Forward Rates
0.055
11.3.1 Implied Forward Rates 0.05

A forward contract written in t stipulates buying at t C m, a discount bond that pays one 0.045
unit of account at time t C n—see Figure 11.2 for an illustration. An arbitrage argument
0.04
(see Figure 11.3) shows that the forward price must satisfy
0.25 0.5 0.75 1
forward price D B.n/=B.m/: (11.11) Maturity, years

Proof. (of (11.11)) In period t, buy one bond maturing in t C n at the cost of B.n/
and sell B.n/=B.m/ bonds maturing in t C m at the value of B.n/: the net investment in Figure 11.4: Spot and forward rates
t is zero. In t C m, pay the principal of the maturing bonds at the cost B.n/=B.m/—this
Split up the time until n into n= h intervals of length h (see Figure 11.5). Then, the
is the net investment in t C m. The payoff in t C n is one. The forward contract has the
n-period spot rate equals the geometric average of the h-period forward rates over t to
same payoff in t C n and must therefore specify the same net investment in t C m, the
t Cn
forward price: B.n/=B.m/.
Buying a forward contract is effectively an investment from t C m to t C n, that 1 C Y.n/ D Œ1 C F .0; h/h=n  Œ1 C F .h; 2h/h=n  : : :  Œ1 C F .n h; n/h=n
is, over n m periods. The gross return (which happens to be known already in t ) is Yn=m 1
D f1 C F Œsh; .s C 1/hgh=n : (11.14)
sD0

6 7
 Multiply and simplify to get
t t+h t+2h t+3h t+n
1
D Œ1 C F .0; m/m  Œ1 C F .m; 2m/m :
B.n/
Figure 11.5: Forward contracts for several future periods
Raise to the power of 1=n to get the interest rate
This means that the forward rate can be seen as the “marginal cost” of making a loan
1 C Y.n/ D Œ1 C F .0; m/m=n  Œ1 C F .m; 2m/m=n :
longer. See Figure 11.6 for an illustration.

Upward sloping yield curve Flat yield curve

8 8
Example 11.4 (Forward rate) Let m D 0:5 (six months) and n D 0:75 (nine months),
6 6 and suppose that Y.0:5/ D 0:04 and Y.0:75/ D 0:05. Then (11.13) gives
Int rate, %

Int rate, %
4 4
.1 C 0:05/0:75
Spot Œ1 C F .0:5; 0:75/0:75 0:5
D ;
2 2 .1 C 0:04/0:5
Forward (one−period)
0 0 which gives F .0:5; 0:75/  0:07. See Figure 11.4 for an illustration.
2 4 6 8 10 2 4 6 8 10
Maturity Maturity
Example 11.5 (Forward rate) Let the period length be a year. Let m D 1 (one year) and
n D 2 (two years), and suppose that Y.1/ D 0:04 and Y.2/ D 0:05. Then (11.13) gives
Downward sloping yield curve
8 .1 C 0:05/2
F .1; 2/ D 1  0:06:
.1 C 0:04/1
6
Int rate, %

Example 11.6 (Spot as average forward rate) In the previous example, (11.14) gives,
4
using F .0; 1/ D Y .1/,
2 1:041=2 1:061=2  1:05;
0
2 4 6 8 10 which indeed equals 1 C Y .2/.
Maturity

11.3.2 Continuously Compounded and Simple Forward Rates

Figure 11.6: Spot and forward rates Taking logs of 1 C F .m; n/ in (11.13) we get the continuously compounded forward rate

Proof. (of (11.14)) Let n D 2m and use (11.12) for forward contracts between 0 to m 1 B.m/ ny.n/ my.m/
f .m; n/ D ln D : (11.15)
and m to 2m n m B.n/ n m

1 1 Conversely, the n-period (continuously compounded) spot rate equals the average (con-
D Œ1 C F .0; m/m and D Œ1 C F .m; 2m/m :
B.m/=B.0/ B.2m/=B.m/ tinuously compounded) forward rate (take logs of 11.14)

h Xn= h 1
y .m/ D f Œsh; .s C 1/h: (11.16)
n sD0

8 9
 A simple forward rate (used on interbank markets) is defined as
1 c c 1Cc
D 1 C .n m/Z f .m; n/, so (11.17) -
B.n/=B.m/
  t t C m1 t C m2 t C mK
1 B.m/ nZ.n/ mZ.m/
Z f .m; n/ D 1 D : (11.18)
n m B.n/ .n m/Œ1 C mZ.m/

11.3.3 Instantaneous Forward Rates

Figure 11.7: Timing convention of coupon bond
The instantaneous forward rate, f .m/, is defined as the limit when the maturity date of
the bond approaches the settlement date of the forward contract, n ! m. This can be The coupon bond is, in fact, a portfolio of zero coupon bonds: c maturing in t C m1 ,
thought of as a forward “overnight” rate m periods ahead in time. From (11.15) it is c in t C m2 ,..., and 1 in t C mK . The price of the coupon bond must therefore equal the
price of the portfolio
f .m/ D lim f .m; n/ (11.19)
n!m
PK
n m m Œy.m/ y.n/ B c .K; c/ D kD1 B.mk /c C B.mK / (11.22)
D lim y.n/ lim
n!m n m n!m n m PK c 1
dy.m/ D C ; (11.23)
D y.m/ C m : (11.20)
kD1
Œ1 C Y .mk /mk Œ1 C Y.mK /mK
dm
where B.m/ is defined as in (11.5). The length of the time periods is typically a year, but
Conversely, the average of the forward rates over t to t C n is the spot rate, which we see
the the expression is correct also for other conventions.
by integrating (11.20) to get
Z Example 11.7 (Coupon bond price) Suppose B.1/ D 0:95 and B.2/ D 0:90. The price
1 n
y .n/ D f .s/ds: (11.21)
n 0 of a bond with a 6% annual coupon with two years to maturity is then

Equations (11.20) and (11.21) show that the difference between the forward and spot 1:01  0:95  0:06 C 0:90  0:06 C 0:90:
rates, f .n/ y.n/, is proportional to the slope of the yield curve.
Proof. (of (11.21)) Integrating the first term on the right hand side of (11.20) over Equivalently, the bond prices imply that Y .1/  5:3% and Y.2/  5:4% so
Rn
Œ0; n gives 0 y.s/ds. Integrating (by parts) the second term on the right hand side of 0:06 0:06 C 1
Rn Rn 1:01  C :
(11.20) over Œ0; n, 0 s dy.s/
ds
ds, gives ny.n/ 0 y.s/ds. Adding the two terms gives 1:053 1:0542
ny.n/.
Example 11.8 (Coupon bond price at par) A 9% (annual coupons) Suppose B.1/ D
1=1:06 and B.2/ D 1=1:0912 . The price of a bond with a 9% annual coupon with two
11.4 Coupon Bonds years to maturity is then

11.4.1 Bond Basics 0:09 0:09 1

C C  1:
1:06 1:0912 1:0912
Consider a bond which pays coupons, c, for K periods (t C m1 , t C m2 ,.. ), and one unit
This bond is (approximately) sold “at par”, that is, the bond price equals the face (or
of account (the “face” or “par” value) in the last period t C mK —see Figure 11.7.
par) value (which is 1 in this case).

10 11
 If we knew all the spot interest rates, then it would be easy to calculate the correct
price of the coupon bond. However, the situation is typically the reverse: we know prices
on several coupon bonds (different maturities and coupons), and want to calculate the
spot interest rates that are compatible with them. This is to estimate the yield curve. The
implied zero coupon bonds prices is often called the discount function.
Note that the yield to maturity is just a convention. In particular, it does not provide a
measure of the return to an investor who buys the bond and keeps it until maturity—unless
the yield curve is flat.
11.4.3 The Return of Holding a Coupon Bond until Maturity

To calculate the buy-and-hold (until maturity) return of a coupon bond we need to specify
11.4.2 Yield to Maturity
how the coupons are reinvested. One useful assumption about the reinvestment of the
The effective yield to maturity (also called redemption yield), , on a coupon bond is the coupons is that they are done by a forward contract. This means that the investor buys
internal rate of return which solves the bond now and receives nothing until maturity—as if he/she had bought a zero-coupon
PK c 1 bond. Indeed, no-arbitrage arguments show that the return (from now to maturity) is
B c .K; c/ D C ; (11.24)
kD1
.1 C /mk .1 C /mK indeed the spot interest on a zero-coupon bond.
Proof. (Buy-and-hold return on a coupon bond, simple case) Consider a 3-period
where the bond pays coupons, c, at m1 ; m2 ; :::; mK periods ahead. This equation can be
coupon bond. From (11.23), the price of the bond is
solved (numerically) for . Quotes of bonds are typically the yield to maturity or the
price. For a par bond (the bond price equals the face value, here 1), the yield to maturity B c .K; c/ D B.1/c C B.2/c C B.3/c C B.3/:
equals the coupon rate. For a zero coupon bond, the yield to maturity equals the spot
interest rate. From (11.12), we know that the forward contract for the first coupon has the gross return
(until maturity) 1=ŒB.3/=B.1/ and that the forward contract for the second coupon has
Example 11.9 (Yield to maturity) A 4% (annual coupon) bond with 2 years to maturity.
the cross return (until maturity) 1=ŒB.3/=B.2/. The value of the reinvested coupons and
Suppose the price is 1.019. The yield to maturity is 3% since it solves
the face value at maturity is then
0:04 0:04 1
1:019  C C : B.1/ B.2/
1 C 0:03 .1 C 0:03/2 .1 C 0:03/2 cC c C c C 1:
B.3/ B.3/
Example 11.10 (Yield to maturity of a par bond) A 4% (annual coupon) par bond (price
of 1)with 2 years to maturity. The yield to maturity is 4% since Dividing by the first equation (the investment) gives 1=B.3/ so the return on buying and
holding (and reinvesting the coupons) this coupon bond is the same as the 3-period spot
0:04 0:04 1
C C D1 interest rate. (The extension to more periods is straightforward.)
1 C 0:04 .1 C 0:04/2 .1 C 0:04/2
Example 11.11 (Yield to maturity of a portfolio) A 1-year discount bond with a ytm (ef- Example 11.12 (Yield to maturity versus return) Suppose also that the spot (zero coupon)
fective interest rate) of 7% has the price 1=1:07 and a 3-year discount bond with a ytm of interest rates are 4% for one year to maturity and 9% for 2 years to maturity. Notice that
10% has the price 1=1:13 . A portfolio with one of each bond has a ytm the forward rate (between year 1 and 2) is 14.24%. A 3% coupon bond with 2 years to
1 1 1 1 maturity must have the price
C D C , with   0:091:
1:07 1:13 1C .1 C  /3 0:03 0:03 C 1
C  0:8958:
This is clearly not the average ytm of the two bonds. It would be, however, if the yield 1:04 1:092
curve is flat.

12 13
The yield to maturity is 8.91% since The Newton-Raphson algorithm is based on a first order Taylor expansion of the bond
0:03 0:03 C 1 price equation
0:8958  C : dB.0 /
1 C 0:0891 .1 C 0:0891/2 B.1 / D B.0 / C .1 0 / :
d
However, the value of the bond at maturity, if the coupon is reinvested by a forward Set the left hand side equal to the observed price, B, guess a values of  and call it 0 ;
contract, is then solve for 1 as 1 D 0 C ŒB B.0 / = dB. d
0/
. 1 is probably a better guess of 
0:03  .1 C 0:1424/ C 0:03 C 1  1:0643; than 0 . Improve by repeating this updating as 2 D 1 C ŒB B.1 / = dB. d
1/
, and so
p forth until n converges.
so the gross return is approximately 1:0643=0:8958. Annualized ( 1:0643=0:8958) this
becomes 1.09 so the return is 9%—just like the 2-year spot rate. Remark 11.17 (Bisection method for solving (11.24)) The bisection method is a very
simple (no derivatives are needed) and robust way to solve for the yield to maturity. First,
11.4.4 Calculating the Yield to Maturity start with a lower (L ) and higher (H ) guess of the yield which are known to bracket the
Remark 11.13 (Calculating  in a simple case) If mk in (11.24) is the integer k, then true value, that is, B.H /  B  B.L / where B is the observed bond price. Second,
subtracting B c from both sides of (11.24) gives a K th order polynomial in  D 1=.1C/, calculate the bond price at the average of the two guesses: BŒ.L CH /=2. Third, replace
either H or L according to: if B  BŒ.L C H /=2 (so the midpoint .L C H /=2
PK 1
0D Bc C kD1 c
k
C .c C 1/  K ; is below the true yield) then replace L by .L C H /=2 (a higher value), but if B >
BŒ.L C H /=2 then replace H by .L C H /=2. Fourth, iterate until L  H .
where all coefficients except one are positive. There is then only one positive real root,
1 . Many software packages contain routines for finding roots of polynomials. Once that Example 11.18 (Bisection method). The first couple of iterations for a 2-year bond with
is done, pick the only positive real root, 1 , and calculate the yield as  D .1 1 /=1 . a 4% coupon and a price of 1.019 are (see also Figure 11.8)

Remark 11.14 (Calculating  in the simplest case) If the bond price, B c , is unity, then Iteration L H .L C H /=2 BŒ.L C H /=2
the bond is sold “at par.” If also mk in (11.24) is the integer k (as in the previous remark), 1 0 0:05 0:0250 1:0289
then  D c. 2 0:025 0:05 0:0375 1:0047
3 0:025 0:0375 0:03125 1:0167
Example 11.15 (Par bond) A 9% (annual coupons) 2-year bond with a yield to maturity 4 0:025 0:03125 0:028125 1:0228
of 9%, and exactly two years to maturity has the price 5 0:028125 0:03125 0:029687 1:0197
0:09 0:09 1
C C D 1:
1 C 0:09 .1 C 0:09/2 .1 C 0:09/2
11.4.5 Par Yield
Remark 11.16 (Newton-Raphson algorithm for solving (11.24)) It is straightforward to
A par yield for is the coupon rate at which a bond would trade at par (that is, have a price
use a Newton-Raphson algorithm to solve (11.24). It is then useful to note that the deriva-
equal to the face value). Setting B c .K; c/ D 1 in (11.22) and solving for the implied
tive is
dB./ PK mk c mK
D :
.1 C /mk C1 .1 C /mK C1
kD1
d

14 15
 Bisection (yield bounds) Newton−Raphson (yield) Upward sloping yield curve Flat yield curve
0.06 8 8
0.04 6 6
0.04

Int rate, %

Int rate, %
yield

yield
4 4
0.02 0.02
2−year bond, 4% coupon, price 1.019 2 Spot 2
0 Convergence critierion: 1e−005 Par yield
0 0 0
0 5 10 15 0 5 10 15 2 4 6 8 10 2 4 6 8 10
iteration iteration Maturity Maturity

Figure 11.8: Bisection method to calculate yield to maturity

Downward sloping yield curve
8
coupon rate gives 6

Int rate, %
1 4
c D PK Œ1 B.mK / , or (11.25)
kD1 B.mk /
  2
1 1
D PK 1 mK : (11.26) 0
1
kD1 Œ1CY.mk /mk
Œ1 C Y.mK / 2 4 6 8 10
Maturity
Typically, this is very similar to the zero coupon rates.

Example 11.19 Suppose B.1/ D 0:95 and B.2/ D 0:90. The two-period par yield is Figure 11.9: Spot and par yield curve
then
1 The issuer can lock in the floating rate payments by a sequence of forward rate agree-
1 D .0:95 C 0:9/c C 0:9, so c D .1 0:9/  0:054:
0:95 C 0:9 ments that pay the floating rate in return for the forward rate. In this way the swap contract
becomes riskfree so its present value must be zero. This implies that the swap rate pay-
11.4.6 Swap Rate ment (the swap rate times the length of the , hR) must therefore be

A swap contract involves a sequence of payment over the life time (maturity) of the con- 1 B.n/
hR D Xn= h ; (11.28)
tract: for each tenor (that is, sub period, for instance a quarter) it pays the floating market B.sh/
sD1
rate (say, the 3-month Libor) in return for a fixed swap rate. Split up the time until ma-
turity n into n= h intervals of length h—see Figure 11.5. In period sh, the swap contract which is the same as the par yield in (11.25).
pays Proof. (of (11.28)) Notice that a simple forward rate for an investment from sh to
hŒZ.s 1/h .h/ R (11.27) .s C 1/h is  
1 B.sh/
Z f Œsh; .s C 1/h D 1 :
where Z.s 1/h .h/ is the short (floating) simple h-period interest rate in .s 1/h and R is h BŒ.s C 1/h
the (fixed) swap rate determined in t (as part of the swap contract).

16 17
We can therefore write the present value of (11.27) as principal in t C 2, with the price (see (11.22))
Xn= h   
BŒ.s 1/h B c Œ2; c.2/ D B.1/c.2/ C B.2/Œc.2/ C 1: (11.30)
PV D B.sh/ 1 hR :
sD1 B.sh/
Since it is riskfree the PV should be zero (or else there are arbitrage opportunities), which The two period discount function value, B.2/, can be calculated from this equation since
we rearrange as it is the only unknown. We can then move on to the three-period bond,

Xn= h Xn= h  
BŒ.s 1/h B c Œ3; c.3/ D B.1/c.3/ C B.2/c.3/ C B.3/Œc.3/ C 1 (11.31)
hR B.sh/ D B.sh/ 1
sD1 sD1 B.sh/
Xn= h to calculate B.3/, and so forth. Finally, we can use (11.5) to transform these zero coupon
hR B.sh/ D 1 B.n/;
sD1 bond prices to spot interest rates.
where we have used the fact that B.0/ D 1. Finally, solve for hR to get (11.28). Remark 11.20 (Numerical calculation of the bootstrap) Equations (11.29)–(11.31) can
clearly be written
11.5 Estimating the Yield Curve 2 c 3 2 32 3
B Œ1; C.1/ c.1/ C 1 0 0 B.1/
6 c 7 6 76 7
The (zero coupon) spot rate curve is of particular interest: it helps us price any bond or 4 B Œ2; c.2/ 5 D 4 c.2/ c.2/ C 1 0 5 4B.2/5 ;
portfolio of bonds—and it has a clear economic meaning (“the price of time”). B c Œ3; c.3/ c.3/ c.3/ c.3/ C 1 B.3/
In some cases, the spot rate curve is actually observable—for instance from swaps which is a recursive (triangular) system of equations.
and STRIPS. In other cases, the instruments traded on the market include some zero
coupon instruments (bills) for short maturities (up to a year or so), but only coupon bonds Example 11.21 (Bootstrapping) Suppose we know that B.1/ D 0:95 and that the price
for longer maturities. This means that the spot rate curve needs to be calculated (or of a bond with a 6% annual coupon with two years to maturity is 1.01. Since the coupon
estimated). This section describes different methods for doing that. bond must be priced as

0:95  0:06 C B.2/  0:06 C B.2/ D 1:01;

11.5.1 Direct Calculation of the Yield Curve (“Bootstrapping”)
we can solve for the price of a two-period zero coupon bond as B.2/ D 0:90. The spot
We can sometimes calculate large portions of the yield curve directly from asset prices.
interest rates are then
The idea is to calculate a short yield first (from a bill/bond with short time to maturity)
and then use this to calculate the yield for the next (longer) bond, and so on. 1
D 1 C Y.1/ or Y.1/  0:053
For instance, suppose we have a one-period coupon bond, which by (11.22) must have 0:95
1
the price D Œ1 C Y .2/2 or Y .2/  0:054:
0:90
B c Œ1; C.1/ D B.1/Œc.1/ C 1; (11.29) Unfortunately, the bootstrap approach is tricky to use. First, there are typically gaps
where we use c.1/ to indicate the coupon value of this particular bond. The equation between the available maturities. On way around that is to interpolate. Second (and
immediately gives the one-period discount function value, B.1/. Suppose we also have a quite the opposite), there may be several bonds with the same maturity but with different
two-period coupon bond, which pays the coupon c.2/ in t C 1 and t C 2 as well as the coupons/prices, so it is impossible to calculate a unique yield curve. This could be solved
by excluding some data.

18 19
11.5.2 Estimating the Yield Curve with Regression Analysis Example 11.23 (Cubic discount function). With a cubic discount function

If we attach some random error to the bond prices in (11.22), then that equation looks B.m/ D a0 C a1 m C a2 m2 C a3 m3 ;
very similar to regression equation: the coupon bond price is the dependent variable;
the coupons are the regressors, and the discount function values are the coefficients to we get
estimate—perhaps with OLS. This is a way of overcoming the second problem discussed  P   P   P 
B c .K; c/ D a0 .Kc C 1/Ca1 c K
kD1 mk C mK Ca2 c
K 2 2
kD1 mk C mK Ca3 c
K 3 3
kD1 mk C mK :
above since multiple bonds with the same maturity, but different coupons, are just addi-
tional data points in the estimation.
The first problem mentioned above, gaps in the term structure of available bonds, is Spot rates from cubic discount fn Pricing errors, in %
harder to deal with. If there are more coupon dates than bonds, then we cannot estimate 0.05
all the necessary zero coupon bond prices from data (fewer data points than coefficients). 2

interest rate
The way around this is to decrease the number of parameters that need to be estimated by

%
0
postulating that B.m/ is a linear combination of some J predefined functions of maturity, 0

g1 .m/,..., gJ .m/,
P −0.05 −2
B.m/ D 1 C jJD1 aj gj .m/; (11.32) 0 10 20 30 0 10 20 30
Years to maturity Years to maturity
where gj .0/ D 0 since B.0/ D 1 (the price of a bond maturing today is one).
Once the gj .m/ functions are specified, (11.32) is substituted into (11.22) and the
j coefficients a1 ,..., aj are estimated by minimizing the squared pricing error (see, for Actual and fitted ytm German bonds on 2009−06−08
instance, Campbell, Lo, and MacKinlay (1997) 10). 0.05

One possible choice of gj .m/ functions is a polynomial, gj .m/ D mj . Another

interest rate
0
common choice is to make the discount function a spline (see McCulloch (1975)). −0.05

−0.1 Actual
Example 11.22 (Quadratic discount function) With a quadratic discount function Fitted

0 10 20 30
B.m/ D a0 C a1 m C a2 m2 ; Years to maturity

we get
PK

Figure 11.10: Estimated yield curves
B c .K; c/ D kD1a0 C a1 mk C a2 m2k c C a0 C a1 mK C a2 mK
2
 P   P 
D a0 .Kc C 1/ C a1 c K kD1 mk C mK C a2 c
K 2 2
kD1 mk C mK : 11.5.3 Estimating a Parametric Forward Rate Curve

The a0 ; a1 , and a2 can be estimated by OLS if we have data on at least three bonds. This Yet another approach to estimating the yield curve is to start by specifying a function for
method can, however, lead to large errors in the fitted yields (if not the prices). See Figure the instantaneous forward rate curve, and then calculate what this implies for the discount
11.10 for an example. function. (These will typically be complicated and not satisfy the simple linear structure
in (11.32).)

20 21
 US yield curve on 1995−01−04 (Nelson−Siegel method) US forward rates on 1994−01−05 US forward rates on 1995−01−04
8.5
8 8
8

%
6 6
7.5
4 4
%

7
0 5 10 15 0 5 10 15
6.5 Coupon rate Years to maturity Years to maturity
Yield to maturity
Estimated spot rate
6 Estimated forward rate
Estimated yield to maturity US forward rates on 1996−01−02 Estimation results from the
5.5
0 5 10 15 20 25 30 Nelson−Siegel method
Years to maturity 8

%
6
Figure 11.11: Estimated US yield curve, Nelson-Siegel method
4

Let f .m/ denote the instantaneous forward rate with time to settlement m. The ex- 0 5 10 15
tended Nelson and Siegel forward rate function (Svensson (1995)) is Years to maturity

     
m m m m m
f .mI ˇ/ D ˇ0 C ˇ1 exp C ˇ2 exp C ˇ3 exp , (11.33) Figure 11.12: Estimated US yield curve, Nelson-Siegel method
1 1 1 2 2

where ˇ D .ˇ0 ; ˇ1 ; ˇ2 ; 1 ; ˇ3 ; 2 / is a vector of parameters (ˇ0 , 1 and 2 must be pos-

The spot rate implied by (11.33) is (integrate as in (11.21) to see that)
itive, and ˇ0 C ˇ1 must also be positive—see below). The original Nelson and Siegel   
function sets ˇ3 D 0. Note that in either case 1 exp . m=1 / 1 exp . m=1 / m
y.mI b/ D ˇ0 C ˇ1 C ˇ2 exp
m=1 m=1 1
  
lim f .mI b/ D ˇ0 C ˇ1 , and 1 exp . m=2 / m
m!0 C ˇ3 exp : (11.34)
m=2 2
lim f .mI b/ D ˇ0 ;
m!1
One way of estimating the parameters in (11.33) is to substitute (11.34) for the spot rate
so ˇ0 C ˇ1 corresponds to the current very short spot interest rate (an overnight rate, say) in (11.7), and then minimize the sum of the squared price errors (differences between
p
and ˇ0 to the forward rate with settlement very far in the future (the asymptote). actual and fitted prices), perhaps with 1/ duration as the weights (a practice used by
many central banks). Alternatively, one could minimize the sum of the squared yield
errors (differences between actual and fitted yield to maturity). See Figures 11.11–11.13
for illustrations.

22 23
 Spot rates from Nelson−Siegel Pricing errors, in % 11.6 Conventions on Important Markets
0.06
11.6.1 Compounding Frequency
interest rate

2
0.04
Suppose the interest rate r is compounded 2 times per year. This means that the amount

%
0.02 0 B invested at the beginning of the year gives B.1 C r=2/ after six months—which is
reinvested and therefore gives B.1 C r=2/.1 C r=2/ after another six months (at the end
0 −2
0 10 20 30 0 10 20 30 of the year). To make this payoff equal to unity (as we have used as our convention) it
Years to maturity Years to maturity
must be the case that the bond price B D 1=.1 C r=2/2 . By comparing with the definition
of the effective interest rate (with annual compounding) in (11.5) we have
Actual and fitted ytm 1  r 2
German bonds on 2009−06−08
0.06 D 1C D 1 C Y; (11.35)
B 2
where Y is the annual effective interest rate.
interest rate

0.04

0.02 This shows how we can transform from semi-annual compounding to annual com-
Actual pounding (and vice versa).
0 Fitted
More generally, with compounding n times per year, we have
0 10 20 30 
Years to maturity 1 r n
D 1C D 1 C Y: (11.36)
B n

Figure 11.13: Estimated yield curves 11.6.2 US Treasury Notes and Bonds

The convention for US Treasury notes and bonds (issued with maturities longer than one
11.5.4 Par Yield Curve
year) is that coupons are paid semi-annually (as half the quoted coupon rate), and that
When many bonds are traded at (approximately) par, the par yield curve (11.25) can be yields are semi-annual effective yields. (This applies also to most as well as for most US
obtained by just plotting the coupon rates. In practice, the yield to maturity is used instead corporate bonds and UK Treasury bonds.)
(to partly compensate for the fact that the bonds are only approximately at par)—and the However, both are quoted on an annual basis by multiplying by two. The quoted yield
gaps (across maturities) are filled by interpolation. (Recall that for a par bond, the yield to to maturity, , solves
maturity equals the coupon rate.) This is basically the way the Constant Maturity Treasury PK c=2 1
yield curve, published by the US Treasury, is constructed. B c .K; c/ D C ; (11.37)
kD1
.1 C =2/nk .1 C =2/nK

where the bond pays coupons c=2, at n1 ; n2 ; :::; nK half-years ahead. By using (11.35),
the yield quoted, , can be expressed in terms of an annual effective interest rate.

Example 11.24 A 9% US Treasury bond (the coupon rate is 9%, paid out as 4.5% semi-

24 25
annually) with a yield to maturity of 7%, and one year to maturity has the price ously compounded interest rates can be solved as

0:09=2 0:09=2 1 Y .m/ D Œ1 mYdb .m/ 1=m

1 (11.40)
C C D 1:019:
1 C 0:07=2 .1 C 0:07=2/2 .1 C 0:07=2/2
y .m/ D lnŒ1 mYdb .m/=m: (11.41)
From (11.35), we get that the yield to maturity rate expressed as an annual effective
interest is .1 C 0:035/2 1  0:071. Example 11.25 A T-bill with 44 days to maturity and a quoted discount yield of 6.21%
has the price 1 .44=360/0:0621  0:992. The effective interest rate is Œ1 .44=360/
Accrued Interest on US Bonds 0:0621 360=44 1  6:43%.

The quotes of bond prices (as opposed to yields) are not the full price (also called the
dirty price, invoice price, or cash price) the investor actually pays. Instead, it is the “clean
price” that is quoted, which is the full price less the accrued interest:
full price = quoted price + accrued interest.
The buyer of the bond (buying in t) will typically get the next coupon (trading is
“cum-dividend”). The accrued interest is the faction of that next coupon that has been
accrued during the period the seller owned the bond. It is calculated as
accrued interest = next coupon  days since last coupon/182.5.
11.6.4 LIBOR and EURIBOR
The LIBOR (London Interbank Offer Rate) and the EURIBOR (Euro Interbank Offered
Rate) are the simple interest rate on a short term loan without coupons. It is quoted
as a simple annual interest rate, using a “actual/360” day count—with the exception of
pounds which are quoted “actual/365.” This means that borrowing one dollar for 150 days
at a 6% LIBOR requires the payment of 0:06  150=360 dollars in interest at maturity.
Rescaling to make the payment at maturity equal to unity (which is the convention used
in these lecture notes), the loan must be 1=.1 C 0:06  150=360/—which is the “price”
of a deposit that gives unity in 150 days.

11.6.3 US Treasury Bills 11.6.5 European Bond Markets

Discount Yield
US Treasury bills have no coupons and are issued in 3, 6, 9, and 12 months maturities—
but the time to maturity does of course change over time. They are quoted in terms of the
(banker’s) discount yield, Ydb .m/, which satisfies
The major continental European bond markets (in particular, France and Germany) typ-
ically have annual coupons and the accrued interest is calculated according to the “ac-
tual/actual” convention, that is, as
accrued interest = next coupon  days since last coupon/365 (or 366).

B .m/ D 1 mYdb .m/, where m D days=360, so (11.38) (The computation is slightly more complicated for the UK and the scandinavian coun-
Ydb .m/ D Œ1 B .m/=m: (11.39) tries, since they have ex-dividend periods.)

Notice the convention of m Ddays=360. 11.6.6 Some Other Instruments

From (11.5) and (11.38) it is the clear that the effective interest rate and the continu-
STRIPS (Separate Trading of Registered Interest and Principal of Securities): a coupon
bond has been split up into its embedded zero coupon bonds. STRIPS are therefore zero
coupon bonds.

26 27
 An FRA (Forward Rate Agreement) is an over-the-counter contracts that guarantees an Floating rate loan Interest rate swap
interest rate during a future period. The FRA does not involve any lending/borrowing—
only compensation for the deviation of the future interest rate from the reference (forward) 63,000
bond
rate. An FRA can be emulated by a portfolio of zero-coupon bonds, similarly to a forward (at start)
my company bank
market
contract. 7%
A Repo (Repurchase agreement) is a way of borrowing a security. The buyer of a repo Libor + 0.5%
Libor
buys the security, but there is an agreement that he/she will sell it back at some fixed point
in time (the next day, after a week, etc.)—at a price that is predetermined (or decided
63,000
according to some predetermined formula).
A Swap is a contract where one payment stream is exchanged for another payment (at maturity)
stream. For instance, it could be that a stream of floating rate (based on a LIBOR rate,
say) payments are exchanged for a fixed rate payments. A swap contract is typically less External loan possibilites for my company: 8% fixed rate or Libor + 0.5%, want a fixed rate

risky than a Libor rate (deposit) of the same maturity—since the face value (notional)
Year 0: borrow 63,000 on bond market at Libor + 0.5%, enter swap contract
never changes hands—only the interest payment is risked in case of default of one of the
Year 1−5: pay 63,000*(Libor+0.5%) to bond holders, 63,000*7% to bank, receive 63,000*Libor from bank
counter parties. Figures 11.14 and 11.15 illustrate the mechanics of swaps.
Year 5: pay back the 63,000 to bond holders
An Overnight Indexed Swap (OIS) is a swap contract where the floating rate is tied to
an index of floating rates (for instance, federal funds rates in the U.S., EONIA in Europe— (effectively, a cheaper fixed rate loan)

which is a weighted average of all overnight unsecured interbank lending transactions).

Since the OIS has very little risk (as the face value or notional never changes hands—
only the interest payment is risked in case of default), it is little affected by interbank risk
premia. The quote is in terms of the fixed rate (called the swap rate, quoted a simple
interest rate)—which typically stays close to secured lending rates like repo rates.
11.7 Inflation-Indexed Bonds
Figure 11.14: Interest rate swap
(clean price). The typical case is as follows. The next coupon payment is m1 periods
ahead. The buyer of the bond in t will get this coupon (trading is “cum-dividend”). The
full price the buyer pays to the seller in t is therefore
full price = quoted price + accrued interest,

Reference: Deacon and Derry (1998)
Consider an inflation-indexed coupon bond issued in t, which has both coupons and
principal adjusted for inflation up to the period of payment (this is called “capital in-
dexed,” which is the most common type). Let P t be the value of the relevant price index
in period t. The coupon payments are cP t Cm1 l =P t l at t Cm1 , cP t Cm2 l =P t l at t Cm2 ,
and so forth—and also the principal is paid as P t CmK l =P t l in t C mK .
The lag factor l is the indexation lag. There are two reasons for this lag. First, the
convention on many markets is that the bond price is quoted disregarding accrued interest
where the accrued interest is typically the coupon payment times the fraction of this
coupon period that has already passed. To pay this accrued interest, we have to know
the next coupon payment, that is, cP t Cm1 l =P t l ; in t we must know the price level in
t C m1 l. P This mean that l  m1 must always hold: the indexation lag must be at least
as long as the time between coupon payments (six months in the UK).
Second, it takes time to calculate and publish price indices. Suppose we learn to
know Ps in s C k. This means that the indexation lag must be an additional k periods,
l  m1 C k, so it uses a known price level. For instance, in the UK, the indexation lag is

28 29
 USD loan Currency swap US 10−year interest rates Implied 10−year US inflation expectations
4
6 nominal
USD 100 USD 100 real 3
bond (at start) my company (at start) bank 4 2
market EUR 75
1
(at start) 2
6% USD 7% Euro 0
1998 2000 2002 2004 2006 2008 2010 1998 2000 2002 2004 2006 2008 2010
6% USD Year Year

USD 100 USD 100

(at end) Figure 11.16: US nominal and real interest rates
(at end)
EUR 75
(at end) where R is the real interest rate. It splits up the gross nominal return in the bond into a
gross real return and gross inflation rate. Notice that the Fisher equation assumes that
External loan possibilites for my company: 6% in USD or 8% in euro, want euro
there is no risk premia, which is a strong assumption.
Year 0: borrow USD on bond market, pay USD to bank, get EUR 75 from bank Use (11.43) to rewrite (11.42) as
Year 1−3: pay USD 100*6% to bond holders, pay EUR 75*7% to bank, get USD 100*6% from bank PK c E t P tCmk =P t E t P t CmK =P t
B c .K; c/ D C
Year 3: get USD from bank, pay EUR to bank, pay USD 100 to bond bolders Œ1 C R.mk /mk E t P t Cmk =P t
kD1
Œ1 C R.mK /mK E t P t CmK =P t
P c 1
(effectively a cheaper EUR loan) D K C (11.44)
kD1
Œ1 C R.mk /mk Œ1 C R.mK /mK
(basically 3 contracts: borrow USD from bond market, lend USD to bank, borrow EUR from bank)
With a set of inflation-indexed bonds, we could therefore estimate a real yield curve, that
is, how R .m/ depends on m. If the Fisher equation indeed holds, then the difference
Figure 11.15: Currency swap
between a nominal interest rate and a real interest rate can be interpreted as a measure of
the market’s inflation expectations (often called the “break-even inflation rate”).
8 months.
To simplify matters in the rest of this section, suppose the indexation lag is zero. Use
(11.22), modified to allow for different coupons, to price the inflation-indexed bond. To A More Details on Bond Conventions
further simplify, suppose that bonds do not have any riskpremia (clearly a strong assump-
tion), so that the bond price equals the discounted expected payoffs A.1 Bond Equivalent Yields on US Bonds
PK c E t P t Cmk =P t E t P t CmK =P t
B c .K; c/ D C : (11.42) The financial press typically quotes a bond equivalent yield for T-bills—in an attempt
kD1
Œ1 C Y.mk /mk Œ1 C Y .mK /mK
to make the yields comparable. The bond equivalent yield is the coupon (and yield to
The Fisher equation is maturity) of a par bond that would give the same yield as the T-bill. For a T-bill with at
E t P t Cm most half a year to maturity, this gives a simple interest rate, but for longer T-bills the
Œ1 C Y.m/m D Œ1 C R.m/m ; (11.43)
Pt expression is more complicated.

30 31
 We first analyze a T-bill with more than half a year to maturity. Consider a coupon face value (which is not split). In particular, there is no reinvestment. In this case, (A.1)
bond with face value B (which equals the current price of the T-bill), semi-annual coupon simplifies to
c=2 and the same yield to maturity. Since the coupon and the yield to maturity are the 1 D B.1 C 2n  c=2/: (A.3)
same, the “clean price” of the bond (the price to pay if the seller gets to keep the accrued
Solving for c (and using the fact that n D h D .days to maturity)=365) gives
interest on the first coupon payment) equals the face value (here B): it is traded at par.
Notice that the latter means that the buyer gets the following fraction of the next coupon 1=B 1
cD or (A.4)
h
payment (which is B  c=2): the fraction of a half year until the next coupon payment (or 1
(days to next coupon)2=365). BD : (A.5)
1Chc
When the T-bill has more than half a year to maturity, then the bond has two coupon Example A.3 A T-bill with 44 days to maturity and a quoted discount yield of 6.21% has
payments left (including the maturity). At maturity, the owner will have the following: (i) the price 1 .44=360/  0:0621  0:992. The bond equivalent yield is the c such that
the principal plus final coupon, B.1 C c=2/; (ii) the part of the first coupon that belongs
1
to the current owner, d D B  2n  c=2, where n D(days to next coupon)=365; and (iii) 0:992 D 44
or c D 6:6%:
1C c
the interest on d when reinvested at the semi-annual rate c=2 for half a year, d  c=2. 360

To get the same return as on the T-bill, the owner of the coupon bond must get a value Remark A.4 There are two other, but equivalent, expressions for the bond equivalent
of one at maturity (the return is then 1=B), or yield for maturities of at most half a year (see, for instance, McDonald (2006) Appendix
7.A). The first is
1 D BŒ1 C c=2 C 2n  c=2  .1 C c=2/: (A.1) 1 B 1
c1 D :
B m
Solving for c gives the bond equivalent yield Substituting for B using (A.5) shows that c1 D c. The second is
p 365  Ydb
2n=B C 1=4 n C n2 n 1=2 c2 D :
cD : (A.2) 360 Ydb  days
n
Example A.1 A T-bill with 212 days to maturity and a quoted discount yield of 5.9% has Substituting for Ydb using (11.39) shows that c2 D c1 D c.
the price 1 .212=360/  0:059  0:965. There must be 212 182 D 30 days to the
next coupon payment, so n D 30=365. The bond equivalent yield is the c such that
q Bibliography
2 .30=365/ =0:965 C 1=4 .30=365/ C .30=365/2 .30=365/ 1=2
cD  6:2% Blake, D., 1990, Financial market analysis, McGraw-Hill, London.
.30=365/
Remark A.2 If we define h D .days to maturity)=365, then n D h 1=2 and we can Campbell, J. Y., A. W. Lo, and A. C. MacKinlay, 1997, The econometrics of financial
rearrange (A.2) as p markets, Princeton University Press, Princeton, New Jersey.
2 h2 C .2h 1/ .1=B 1/ 2h
cD : Deacon, M., and A. Derry, 1998, Inflation-indexed securities, Prentice Hall Europe,
2h 1
This is the expression in McDonald (2006) Appendix 7.A and Blake (1990) 4.2. Hemel Hempstead.

We now apply the same logic to a T-bill with at most half a year to maturity. The Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann, 2007, Modern portfolio
bond then only has the final coupon left (which is split with the previous owner), and the theory and investment analysis, John Wiley and Sons, 7th edn.

32 33
Fabozzi, F. J., 2004, Bond markets, analysis, and strategies, Pearson Prentice Hall, 5th
edn.

Hull, J. C., 2006, Options, futures, and other derivatives, Prentice-Hall, Upper Saddle 12 Bond Portfolios
River, NJ, 6th edn.
Main references: Elton, Gruber, Brown, and Goetzmann (2007) 21–22 and Hull (2006) 4
McCulloch, J., 1975, “The tax-adjusted yield curve,” Journal of Finance, 30, 811–830.
Additional references: McDonald (2006) 7
McDonald, R. L., 2006, Derivatives markets, Addison-Wesley, 2nd edn.

Svensson, L., 1995, “Estimating forward interest rates with the extended Nelson&Siegel
12.1 Duration: Definitions
method,” Quarterly Review, Sveriges Riksbank, 1995:3, 13–26. The “duration” of a coupon bond is used to analyse how the bond price will change in
response to changes in the yield curve. This section gives the definitions of the most
commonly used duration measures.
Recall that the yield to maturity, , of a coupon bond satisfies
c1 c2 cK
B c .K; c/ D C C ::: C
.1 C /m1 .1 C /m2 .1 C /mK
P ck
D K ; (12.1)
kD1
.1 C /mk
where the bond pays ck at mk periods from now. The principal is included in the last
“coupon” payment. We allow the payments to differ between periods—to simplify the
notation and to be able to treat a bond portfolio in the same way as an ordinary bond.
The derivative of a coupon bond price with respect to its yield to maturity is

dB c .K; c/ 1 PK ck
D mk : (12.2)
d 1 C  kD1 .1 C /mk
This measures the sensitivity of the bond price to a small change in the yield to maturity.
The dollar duration, D$ , is typically defined as this derivative times minus one

dB c .K; c/
D$ D (12.3)
d
1 PK ck
D mk : (12.4)
1 C  kD1 .1 C /mk

The change of the bond price,
B c .K; c/, due to a small change in the yield,
 , is
approximately

B c .K; c/  D$ 
 (12.5)

34 35
 It is common to divide the duration by the bond price, B c .K; c/, to get the adjusted Macaulay’s duration, ytm = 0% Macaulay’s duration, ytm = 5%
(or modified) duration, Da , 15 15
1 c=0%
Da D D$ c : (12.6) 10
c=5%
10
B .K; c/ c=10%
By dividing both sides of (12.5) by the bond price and using the definition of the adjusted
5 5
duration we see that the relative (percentage) change of the bond price due to a small
change in the yield is approximately 0 0
0 5 10 15 0 5 10 15
c Years to maturity Years to maturity

B .K; c/
 Da 
 (12.7)
B c .K; c/

It is also common to multiply the duration by .1 C  /=B c .K; c/ to get Macaulay’s Macaulay’s duration, ytm = 10%
duration, Dmac , 15

1C 10
Dmac D D$ (12.8)
B c .K; c/
PK ck 5
D kD1 mk : (12.9)
.1 C /mk B c .K; c/
0
By multiplying both sides of (12.5) by .1 C /=B c .K; c/ and using the definition of 0 5 10 15
Years to maturity
Macaulay’s duration we see that the relative (percentage) change of the bond price due to
a small relative (percentage) change in the yield is approximately
Figure 12.1: Macaulay’s duration

B c .K; c/

 Dmac  : (12.10)
B c .K; c/ 1C
maturity. The duration measures are
The term last term,
=.1 C /, is the relative change in the gross yield—since
 D
K

.1 C  /. D$ D B
1Cy
Notice that Macaulay’s duration is a weighted average of the time to the coupon (and
K
face) payments (m1 ; m2 ; :::; mK ). The weight of mk is ck =Œ.1 C /mk B c .K; c/, so the Da D , and
1Cy
weights sum to unity and they are clearly the percentage of the bond price accounted for
Dmac D K:
by the respective coupon (or principal) payments. Macaulay’s duration is therefore an
average “time to payment” of the bond. For instance, for a zero coupon bond, Macaulay’s Example 12.2 (Duration) Consider a 4% (annual) coupon bond with 2 years to maturity.
duration is the time to maturity (set c D 0 in (12.9)). For bonds with coupons, Macaulay’s Suppose the price is 1.019. The the yield to maturity is 3% since it solves
duration is less than the time to maturity—and this effect is more pronounced at high
0:04 1:04
coupon rates and at high yields to maturity. This is illustrated in Figure 12.1. 1:019  C :
1 C 0:03 .1 C 0:03/2
Remark 12.1 (Duration of a zero coupon bond) For a zero-coupon bond with a face
value of unity and maturity of K, the price is B D 1=.1 C y/K , where y is the yield to

36 37
The dollar duration is of 10% has the price 1=1:13 .The dollar duration and Macauly’s durations are
 
1 0:04 1:04 1
D$ D C2  1:94; 1-year bond: D$ D  0:83 and Dmac D 1
1:03 1:03 1:032 1:12
3
so the adjusted duration and Macaulay’s duration are 3-year bond: D$ D  2:05 and Dmac D 3:
1:14
1
Da D 1:94  1:90 A portfolio with one of each bond has a price equal Bp D 1=1:1 C 1=1:13 and a ytm
1:019
1:03 1 1
Dmac D 1:94  1:96: Bp D C , with  D 0:1:
1:019 1C .1 C  /3
Example 12.3 (Duration of a zero coupon bond) A two-period zero coupon bond with The duration and Macaulay’s duration of the portfolio are then
price 0.94 has a ytm equal to 0.03, since  
1 1 1
1 D$ D C 3 3  2:88;
0:94  : 1:1 1:1 1:1
1:032 1:1
Dmac D D$  1:90:
The duration is Bp
1 1
2  1:83; Compare with
1:03 1:032
and Macaulay’s duration is
0:83 C 2:05  2:88 and
1:03 1 1 1=1:1 1=1:13
 2 D 2: C 3  1:90;
1=1:032 1:03 1:032 Bp Bp
Proposition 12.4 (Duration of a portfolio) A portfolio with bonds A and B has the dollar which are the same.
duration D$1 C D$2 if the ytm of bond 1 and 2 are the same, otherwise it is just an
approximation. If the dollar duration is additive, then Macauly’s duration of the portfolio Example 12.6 (Duration of a portfolio, different ytm) A 1-year discount bond with a ytm
is B1 =.B1 C B2 /Dmac1 C B2 =.B1 C B2 /Dmac2 , that is, the value weighted average of (effective interest rate) of 7% has the price 1=1:07 and a 3-year discount bond with a ytm
the different Macauly’s durations. of 10% has the price 1=1:13 .The dollar duration and Macauly’s durations are
1
Proof. (Duration of a portfolio ) Thew first part is intuitive since the dollar duration 1-year bond: D$ D  0:87 and Dmac D 1
1:072
of a coupon bond is considered “correct”—and it uses the same ytm for all the coupons.). 3
3-year bond: D$ D  2:05 and Dmac D 3:
For the second part, multiply the dollar duration D$1 C D$2 by the ytm and divide by the 1:14
portfolio value .B1 C B2 /. This is Macaulay’s duration of the portfolio. Now, rewrite by A portfolio with one of each bond has a price Bp D 1=1:07 C 1=1:13 and a ytm
using D$ D BDmac =.1 C / to get the result in the proposition.
1 1
Bp D C , with   0:091:
Example 12.5 (Duration of a portfolio, same ytm) A 1-year discount bond with a ytm 1C .1 C  /3
(effective interest rate) of 10% has the price 1=1:1 and a 3-year discount bond with a ytm

38 39
The duration and Macaulay’s duration of the portfolio are then Duration matching means that we set h such that the change in the value is (approxi-
  mately) zero
1 1 1 DA 
A
D$ D C3  2:96; hD : (12.13)
1:091 1:091 1:0913 DH 
H
1:091
Dmac D D$  1:91: The most straightforward way of hedging is perhaps to let bond 2 be a zero-coupon bond
Bp
with the same time to maturity (and therefore duration) as the duration of bond A. In this
Compare with case, if both yields to maturity move equally much (
A D
H ) then the hedge ratio h
is 1. In general, if seems reasonable to use a similar duration, since then it is reasonable to
0:87 C 2:05  2:92 and
assume that the yields to maturity change in a similar way, so assuming
A =
H makes
1=1:07 1=1:13
C 3  1:89; sense.
Bp Bp
If
A D
H we see that the hedge ratio is positive and that it is above one if bond
which are slightly different. A has a longer duration than bond H , et vice versa. The intuition is that a the price of a
long bond is more sensitive to a yield curve shift than the price of a short bond. Therefore,
12.2 Duration Matching to hedge a long bond we need to buy more of the short bond.
In practice, the hedging portfolio also includes a small position in a short-term money
12.2.1 Basic Idea market account—to the overall portfolio have a zero value (at least initially).
Suppose we want to hedge against price movements of a bond portfolio. (This is also See Figures 12.2–12.3 for illustrations.
called immunisation.) The portfolio can be thought of as a coupon bond (with a possibly Bond prices and rates
complicated set of coupons), so the previous formulas apply. One was of doing that would 0.95
be to use a (potentially large) set of futures—to match every cash flow of the bond, but 0.9
that may well be both difficult and costly (transaction costs). Duration matching is the 0.85

Bond price/face value

other extreme: finding a single instrument to use in the hedging. 0.8
Suppose we are short one unit of a bond (portfolio) with price BAc and dollar duration 0.75
DA . We will hedge this portfolio by buying h units of a bond portfolio (the hedging 0.7
portfolio) with price BH
c
and dollar duration DH . The value of the overall position is then 0.65

c 0.6
V D hBH BAc : (12.11) Price 5−year
0.55 Price 10−year
Using the approximate relation of the bond price change (12.5) we have that the 0.01 0.02 0.03 0.04 0.05 0.06 0.07
change of value of the overall position is Effective interest rate

V  hDH 
H C DA 
A ; (12.12)

Figure 12.2: Interest rate vs bond prices
where the duations are dollar durations.
Remark 12.7 (Effect yield curve shift with imperfect duration hedge) If the duration of

40 41
 (Dollar) Duration Hedge ratio nously compounded interest y t . In t C 1 (say, after a day), this portfolio is worth

0.98 c
V t C1 D h t .BH;t c
C cA;tC1 / C B t e yt h ;
C1 C cH;t C1 /
Annuity .BA;tC1
2.8 Bond H
0.97
2.6 where cH;tC1 and cA;tC1 are coupon payments (or any other cash flows), the bond prices
0.96
2.4 are measured after coupons and y t h is the interest rate factor per day. After rebalancing
2.2 0.95 in t C 1, we need h t C1 units of bond H and we are still short one bond A—and the balance
Jan Apr Jul Oct Jan Jan Apr Jul Oct Jan is invested in the short term bill
2009 2009
c c
German bonds 2009−02−02 to 2009−11−20
B t C1 D V t C1 h t C1 BH;tC1 C BA;tC1 :
Bond A: annuity paying 0.2 each 20 March until 2014
Value after paying liabilities This is indeed very similar to the expression for B t in the first equation. Clearly, the
Bond H: government bond maturing in 2012
Annuity value of the portfolio in t C 2 is computed as in the second equation, but with subscripts
Hedge ratio is duration bond A/duration bond H
1.1 Hedging portfolio advanced one period.
Hedging portfolio = hedge ratio × bond H + short−term bills
On 20 March, 0.2 is sold off to pay liability
1 12.2.2 Problem 1: Approximation Error

0.9 The formula for the price change (12.5) is only exact for infinitesimal yield changes—and
Jan Apr Jul Oct Jan
2009 the approximation error is likely to be large when the yield changes are.
The formula is really a first-order Taylor approximation of the form

Figure 12.3: Duration hedging dB c .K; c/

B c .K; c/  
: (12.14)
d
the hedge portfolio is too long, then the overall portfolio in (12.11) is likely to loose value Obviously, a second-order Taylor approximation is more precise. It would be
when interest rates go up (since long bond prices go down more)—and vice versa. An-
dB c .K; c/ 1 d 2 B c .K; c/
other way of thinking about this is that the overall portfolio then has a positive duration:
B c .K; c/  
 C  .
 /2 : (12.15)
d 2 d 2
that is we have lent at a fixed interest rate, so we loose if the floating rates (our refinance
where the last term includes the second derivative of the bond price with respect to the
cost, say) go up.
yield to maturity. The second derivative is easily calculated to be
Remark 12.8 (Overall portfolio value over several subperiods ) Start by creating a port- d 2 B c .K; c/ PK ck
folio with a zero initial value D kD1 mk .mk C 1/ : (12.16)
d 2 .1 C /mk C2
c
0 D h t BH;t c
BA;t C B t , so B t D 0 c
h t BH;t c
C BA;t ; Dividing (12.15) by the bond price and using (12.7) gives

B c .K; c/ 1
where B t is the amount held in a short-term (almost zero duration) bill which a conti-  Da 
 C C  .
 /2 ; (12.17)
B c .K; c/ 2
where C (often called “convexity”) is the second derivative in (12.15) divided by the bond

42 43
price. It can be shown that the convexity is positive, but decreasing in the coupon rate —
for a given ytm and maturity. (The convexity is actually increasing in the coupon rate for
a given ytm and modified duration.) See Figure 12.2 for an illustration of the non-linear
effect.
By choosing the hedging bond (portfolio) so that it has a similar convexity to the bond
to be hedged may make the hedge more precise.
This suggests that the ability of duration matching (assuming
A =
H D 1) to provide
a hedge is different in different time periods and different markets.
Explicit models of how the entire yield curve moves in response to a small num-
ber of factors have implications for
A =
H —which may vary across instruments and
time. It is still an open issue of these models provide a better hedge than just assuming

A =
H D 1.

Example 12.9 (Convexity) The convexity of the bond in Example 12.2 is

  12.3 Yield Curve Models
1 0:04 1:04
C D 1.1 C 1/ C 2.2 C 1/  5:51:
1:019 1:033 1:034 12.3.1 Some Basic Facts

For a zero coupon bond in Example 12.3 (which has the same ytm and maturity), the Yield curves (in the US and most other developed countries) tend to have the following
convexity is   features (see Figure 12.4 for some examples).
1 1 6
C D 2.2 C 1/ D  5:66: First, most of the time, the yield curve is upward sloping. This is only consistent
1=1:032 1:034 1:032
expectations hypothesis if short rates are expected to be higher in the future. This means
12.2.3 Problem 2: Changing Cash Flows that short rates should (most of the time) be increasing over time—which contradicts
empirical evidence. It is more likely that long rates tend to be high because of risk premia.
The duration measures assume that the times when the coupons and the face value are
Second, the yield curve changes over time. It is common to describe the movements in
paid are unaffected by the yield change. That is true for many instruments (like most
terms of three “factors”: level, slope, and hump. To formalise this, consider the following
government bonds), but not for callable bonds—and effectively not for bonds whose risk
simple model for the effective sport interest rate in period t
premium depends on the interest rate level as most corporate bonds do (as the interest rate
level affects the default risk). y t .n/ D 0t C 1t n C 2t n2 C "nt : (12.18)

12.2.4 Problem 3: Yield Curve Changes vs. Changes in Yields to Maturity (Alternatively, the forward rate is used as the dependent variable.) Clearly, the 0 coef-
ficient represents the general level of the yield curve, 1 the slope (as a function of time
The probably most important problem with using duration for hedging is that the hedge to maturity), and 2 the curvature (capturing humps). Repeating the cross-sectional re-
ratio in (12.13) depends on the changes in the yields—and these are unknown when we gression for each trading date gives time series of coefficients. If the movements in the 0
construct the hedging portfolio. coefficient dominate then parallel movements of the yield curve dominate, etc.
The ideal case for duration matching is when
A =
H is always one, that is, when It is often more instructive to run a slightly different regression where the regressors
the yields (to maturity) move in parallel. This will be the case, for instance, if the yield are uncorrelated. Let n1 be the residual from regressing n on a constant, and n2 the
curve is flat (across maturities)—and the only movements are parallel shifts up and down. residual from regressing n2 on a constant and n1 . The regression is then
In reality, most movements in the yield curve are parallel, but changes in slope and cur-
vature are not uncommon either. Often the short interest rates move more (in response y t .n/ D ı0t C ı1t n1 C ı2t n2 C "nt : (12.19)
to news) than long rates. However, the relative frequencies of these movements seem to
The advantage of this approach is that the regressors are uncorrelated so it is straight-
change over time (according to business cycle conditions and monetary policy regime).

44 45
forward to decompose the variance of ynt into the sum of the variances: VarŒy t .n/ D component in the column vector Œw1i ; w2i ; w3i 0 , we have
Var.ı0t / C Var.ı1t n1 / C Var.ı2t n2 / C Var."nt /. See Figure 12.6 for an example. 2 3 2 30 2 3
pc1 t w11 w12 w13 Y t .1/ YNt .1/
An alternative is to use principal component analysis. See Figure 12.5 for an example. 6 7 6 7 6 7
Most evidence on US data suggest (see, for instance, Cochrane (2001) 19) that changes 4pc2 t 5 D 4w21 w22 w23 5 4Y t .3/ YNt .3/5 and
pc3 t w31 w32 w33 Y t .5/ YNt .5/
in the level dominate—perhaps accounting for 80–90% of the total variation in yields. The 2 3 2 3 2 32 3
slope comes second (perhaps accounting for 10%), and hump third (accounting for a few Y t .1/ YNt .1/ w11 w12 w13 pc1 t
6 7 6N 7 6 76 7
percent). Similar results are found by principal component analysis. 4Y t .3/5 D 4Y t .3/5 C 4w21 w22 w23 5 4pc2 t 5 :
Y t .5/ YNt .5/ w31 w32 w33 pc3 t
Remark 12.10 (Principal component analysis) The first (sample) principal component
For instance, the second column of the W matrix shows how each of the yields “react to”
of the zero mean N  1 vector z t D Y t YN is w10 z t where w1 is the eigenvector as-
the second principal component.
sociated with the largest eigenvalue of ˙ D Cov.z t /. This value of w1 solves the
problem maxw w 0 ˙w subject to the normalization w 0 w D 1. This eigenvalue equals
Var.w10 z t / D w10 ˙w1 . The j th principal component solves the same problem, but under US spot rates on 1994−01−05 US spot rates on 1995−01−04
the additional restriction that wi0 wj D 0 for all i < j . The solution is the eigenvector
8 8
associated with the j th largest eigenvalue (which equals Var.wj0 z t / D wj0 ˙wj ). This
means that the first K principal components are those (normalized) linear combinations

%
6 6
that account for as much of the variability as possible—and that the principal compo-
nents are uncorrelated (Cov.wi0 z t ; wj0 z t / D 0/). Dividing an eigenvalue with the sum of 4 4

eigenvalues gives a measure of the relative importance of that principal component (in 0 5 10 15 0 5 10 15
Years to maturity Years to maturity
terms of variance). If the rank of ˙ is K, then only K eigenvalues are non-zero.

Remark 12.11 (Principal component analysis 2) Let W be N xN matrix with wi as col-

US spot rates on 1996−01−02
umn i . We can the calculate the N x1 vector of principal components as pc t D W 0 z t . Estimation results from the
Nelson−Siegel method
Since W 1 D W 0 (the eigenvectors are orthogonal), we can invert as z t D Wpc t , that 8
is, Y t D YN C Wpc t . The wi vector (column i of W ) therefore shows how the different

%
6
elements in Y t change as the i th principal component changes.

4
Example 12.12 (Principal component analysis) With three yields, and the i th principal
0 5 10 15
Years to maturity

Figure 12.4: Estimated yield curve, Nelson-Siegel method

46 47
 US interest rates, Fed funds to 10 years US interest rates Regression coefficients Regressors
20 20 20 δ n0
0
10−year δ1 10 n1
15 15 3−year 15 n2
δ2
3−month 10
10 10 0
5
5 5
−10
0
0 0
1970 1980 1990 2000 2010 1970 1980 1990 2000 2010 1970 1980 1990 2000 2010 1d 3m 6m 1y 3y 5y 7y 10y
Maturity

Decomposition of y:
y = δ0 + δ1n1 + δ2n2
US interest rates, principal components US interest rates, eigenvectors
1 where (1,n1,n2) are rotated (uncorrelated)
20 1st
10 2nd 0.5 versions of a constant, maturity, maturity2
3rd
0 0
−10 −0.5 1st (96.2)
2nd (3.4)
Figure 12.6: US yield curves and regression components
−20 3rd (0.3)
−1
1970 1980 1990 2000 2010 1d 3m 6m 1y 3y 5y 7y 10y average short interest rate. Split up the time until n into n=m intervals of length m. Then,
Maturity
the expectations hypothesis says that the n-period spot rate equals the geometric average
of the m-period short rates over t to t C n
Figure 12.5: US yield curves and principal components
m
y t .n/ D a.n/ C Œy t .m/ C E t y t Cm .m/ C E t y tC2m .m/ C : : : : (12.21)
n
12.3.2 The Expectations Hypothesis of Interest Rates
If a.n/ D 0, then the pure expectations are said to hold. Hence, the expectations hypoth-
The expectations hypothesis of interest rates says that long bonds have no, or possibly esis (although not in its pure form) allows for constant risk premia.
constant, risk premia. In that case, forward interest rates can be interpreted as expected
future short interest rates. The evidence on the expectations hypothesis is mixed (see Sec- 12.3.3 Risk Premia
tion 12.5.4), so it can only be thought of as a rough (although convenient) approximation.
There are several reasons for why bonds should have risk premia. First, the real return of
To illustrate how the expectations hypothesis works, it is easiest to work with contin-
a long bond is very sensitive to inflation changes—probably more than equity. Bonds are
uously compounded interest rates. Recall that a continuously compounded interest rate,
therefore likely to have inflation risk premia. Second, long bonds are risky for investors
y t .n/, satisfies
who don’t intend to keep them until maturity—and will therefore have term premia. Third,
1 some bonds are not traded much (for instance, off-the-run bonds and many index-linked
D exp Œny t .n/ , or y t .n/ D ln B t .n/=n; (12.20)
B t .n/ bonds)—so they are likely to have liquidity premia.
where B t .n/ is the price (in t) of a zero-coupon bond which matures in t C n.
The expectations hypothesis says that the current long rate equals the expected future

48 49
 Federal funds rate which is of the same form as before. With 0 < a < 1 (that is, with 0 <  < 1) the process
20 is mean reverting.
Coefficients in yt=a+ρyt−1+εt:

15 a, ρ, σ 0.07 0.99 0.54 The forecast for t C s is

Sample: 1954:7−2009:5
E t r t Cs D .1 s /  C s r t : (12.23)
%

10
We now assume that the expectations hypothesis of interest rates holds. Using y t .1/ D r t
this in (12.21) gives the long interest rate. For instance, the n D 2 rate is
5
1
y t .2/ D a.2/ C Œr t C .1 /  C r t 
2
0
1950 1960 1970 1980 1990 2000 2010 D a.2/ C  .1 / =2 C r t .1 C / =2: (12.24)
Year
The general expression for a maturity of n D s is

Figure 12.7: Federal funds rate, monthly data y t .s/ D a.s/ C  Œs C.s/ =s C r t C.s/=s, where C.s/ D 1 C  C : : : C s 1 : (12.25)

12.3.4 A Simple One-Factor Model: The Vasicek Model In this model, all movements of the yield curve are driven by one variable (here the short
rate), so it is a one-factor model. However, the shifts of the yield are parallell only if
The Vasicek model assumes that the short interest rate is an AR(1). The specification
 D 1 (the random walk model) since then C.s/ D s in (12.25), so we get
typically involves shifting the mean of the process to allow for a risk (term) premia. To
simplify, I will crudely assume that there are some unspecified constant premia (the ex- y t .s/ D a.s/ C r t , if  D 1: (12.26)
pectations hypothesis). (The more general formulation derives the risk premia in terms of
the mean reversion and volatility of the short rate.) See Figure 12.8 for an illustration.
To simplify the notation, let r t be the short rate. It follows an AR(1)
Example 12.14 (Vasicek model) For  D 0:9 and  D 0:05, (12.25) gives (assuming no
r t C1  D  .r t / C " t C1 ; (12.22) risk premia) 2 3 2 3 2 3
y t .1/ 0 1
6 7 6 7 6 7
where  is the mean. 6y t .2/7 6 0:0025 7 6 0:95 7
6 76 7C6 7
6y .3/7 6 0:0048 7 6 0:90 7 r t :
4 t 5 4 5 4 5
Remark 12.13 (Alternative formulation of (12.22)) The process is sometimes specified in
y t .4/ 0:007 0:86
terms of changes as
r t C1 r t D a . r t / C " t C1 : This model allows us to calculate (or rather estimate) the proper way of hedging a
bond. In particular, it can be used to calculate the ratio of the yield changes (
A =
H )
Clearly, this can be written
in (12.13).
r t C1  D .1 a/ .r t / C " t C1 ; To illustrate that, consider zero coupon bonds. Then (12.25) can be used directly: the

50 51
 Vasicek model, spot rate using the 2-period bond in Example 12.14, then we have the ratio of yields
8
Short rate = 7%
y t .4/ 0:86
ρ=0.9 (quarterly), µ=0.05
Short rate = 5%
D  0:91:
7
y t .2/ 0:95
Short rate = 3%
The hedge ratio is therefore
6 4  0:86
Interest rate, %

hD  1:82;
2  0:95
5
which is slightly lower than 2 (the ratio of durations), since longer yields are less sensitive
4
to the short rate changes in the Vasicek model (as long as  < 1).

All one-factor models (not least the Vasicek model) imply that all yields are perfectly
3
correlated (there is a common single driving force) and only fairly limited yield curve
2 movements are possible. Multi-factor models overcome most of those limitations. For
0 1 2 3 4 5 6 7 8 9 10
Years to maturity instance, the model in Nelson and Siegel (1987) is a two-factor model.

Figure 12.8: Vasicek model, spot rates for different intial short rates 12.4 Interest Rates and Macroeconomics

This section outlines three (not mutually exclusive) macroeconomic approaches to mod-
spot rate coincides with the yield to maturity (which enters the hedging formula).
elling the yield curve.

y t .s/ D
r t C.s/=s: (12.27)
12.4.1 The Fisher Equation and Index-Linked Bonds
The ratio of yield changes (corresponding to
A =
H in (12.13)) for two bonds with
Let  t Cn be the one period inflation rate over t to t C n, that is,
maturities of s and q periods is

y t .s/ C.s/=s  tCn D ln.P t Cn =P t /: (12.30)

D : (12.28)

y t .q/ C.q/=q
Also, let y tr .n/ be the one period continuously compounded real interest rate (an interest
For bonds with coupons (or other portfolios of zero coupon bonds), the ratio of yield rate measured in goods).
changes typically has to been calculated numerically, but that is straightforward. The Fisher equation (here in the form of continuously compounded rates) says that the
This ratio is unity only in the random walk model (12.26). Since the duration equals nominal interest rate includes compensation both for inflation expectations, E t  t Cn ,the
the maturity (for a zero coupon bond), the hedge ratio in (12.13) becomes real interest rate, y tr .n/, and possibly a constant (across time) risk premium, .n/,
s  C.s/=s C.s/
hD D : (12.29) y t .n/ D E t  t Cn C y tr .n/ C .n/: (12.31)
q  C.q/=q C.q/
Clearly, the hedge using (12.29) will still suffer from the approximation error (convexity). Example 12.16 (Fisher equation) Suppose the nominal interest rate is y.n/ D 0:07, the
real interest rate is y r .n/ D 0:03, and the nominal bond has no risk premium ( D 0),
Example 12.15 (Hedging in a Vasicek model) If we want to hedge the 4-period bond by then the expected inflation is E t  t Cn D 0:04.

52 53
 US inflation and interest rate US interest rate − inflation Interest rate and inflation: levels Interest rate and inflation: changes
10 15 10
15

Change in inflation
Infl
T−bill 5
10 10 5

Inflation
5 0
5 0
0 −5

−5 −10 0 −5
1960 1970 1980 1990 2000 2010 1960 1970 1980 1990 2000 2010 0 5 10 15 −6 −4 −2 0 2 4
Year Year interest rate Change in interest rate

Sample: US 12−month interest rates and next−year inflation 1955:1−2009:5

Figure 12.9: US inflation and 3-month interest rate

US 10−year interest rates Implied 10−year US inflation expectations Figure 12.11: US nominal interest rates and subsequent inflation
4
6 nominal
real 3 phisticated (and complicated) model of the yield curve. This involves using macro the-
4 2
ory/empirics to model how real interest rates and inflation expectations (for different ma-
turities) depend on the state of the economy.
1
2

1998 2000 2002 2004 2006 2008 2010

0
1998 2000 2002 2004 2006 2008 2010 12.4.2 The Expectations Hypothesis of Interest Rates
Year Year
The expectations hypothesis of interest rates says that long interest rates equal an average
of expected future short rates, possibly with a constant (across time, not maturitites) risk
Figure 12.10: US nominal and real interest rates premium as in (12.21). Alternatively, that forward rates equal expected future spot rates.

The same type of relation holds for forward rates. The Fisher equation suggests a Expectations hypothesis: levels Expectations hypothesis: changes

Change in avg short rate

5
framework for analysing nominal interest rates in terms of real interest rates and inflation 15

Avg short rate

expectations. This is commonly used for long rates. Information about real interest rates
10
can be elicited from index-linked bonds, that is, bonds which give automatic compensation 0
for actual inflation. 5
Empirical results typically indicate that there are non-trivial movements in the real
0 −5
interest rate and/or risk premia—especially for short forecasting horizons. This holds also 0 5 10 15 −5 0 5
Interest rate Change in interest rate
when inflation expectations, as measured by surveys, are used as the dependent variable.
Inflation expectations seems to vary by less than the interest rate. It is therefore not Sample: US 12−month interest rates and next−year average federal funds rate: 1970:1−2009:5
straightforward to extract inflation expectations from nominal interest rates.
The Fisher equation could also be embedded in a macro model to construct a so-
Figure 12.12: US 12-month interest and average federal funds rate (next 12 months)

54 55
 The expectations hypothesis is often used to calculate implied “forecasts” of future where y t .n/ is a (continuously compounded) foreign interest rate, and s t is the logarithm
short interest rates. For instance, suppose the central bank increases its policy rate (typi- of the exchange rate (number of domestic currency units per foreign currency unit). If
cally a very short rate, at most a week or two). This is likely to affect also longer interest this condition hold with a zero risk premium, then the expected return from investing in
rates, but how is another matter. Let us consider a few different cases. For simplicity we foreign bonds and then buy domestic currency equals the known return from investing in
assume that risk premia are unaffected by this move in the policy rate. domestic bonds.
First, one possibility is that only the very short interest rates change, and that all longer
GBP/USD GBP/USD depreciation, %
interest rates stay unchanged. This would happen if the policy move was well anticipated. 0.3
0.7

Exchange rate, t+90

Depreciation, t+90
Second, another possibility is that most long interest rates increase. Under the expec-
0.65 0.2
tations hypothesis of interest rates the interpretation is that the market now expects high
0.6 0.1
short interest rates also in the future. That is, that the central bank will not reverse its pol-
0
icy action in the foreseeable future. If we are willing to assume that the real interest rate 0.55
−0.1
was not affected by the policy move, then one possible interpretation is that the central 0.5
0.5 0.55 0.6 0.65 0.7 −0.1 0 0.1 0.2 0.3
bank has received information about a long-lasting inflation pressure. Forward exchange rate, t Forward premium, t
Third, and finally, short rates may increase, but really long interest rates decrease. A
Sample: 1988:7−2009:6
common interpretation of this scenario is that the central bank has become more inflation
Exchange rate level:
averse. It therefore raises the policy rate to bring down inflation. If the market believes Regression of realized exchange rate on forward exchange rate: Coefficient = 0.80, R2 = 0.68
MSE of various methods (OLS, random walk, forward rate): 9.84, 9.51, 9.59
that it will succeed, then it follows that it will eventually be possible to lower interest rates
(when inflation and inflation expectations are lower). Depreciation over 90 days:
Regression of realized depreciation on forward premium: Coefficient = 0.97, R2 = 0.01
The expectations hypothesis has been tested many times, typically by an ex post linear
MSE of various methods (OLS, random walk, forward premium): 29.14, 29.48, 29.19
regression (realized interest rates regressed on lagged forward rates). The results often
reject the expectations hypothesis, but the results depend on how the test is done. It is not
clear, however, if the rejection is due to systematic risk premia or to fairly small samples Figure 12.13: GBP/USD spot and forward exchange rates
(compared to the long swings in interest rates). The expectations hypothesis gets more
Empirical evidence suggests that there might be large movements in the risk premia
support when survey data on interest rate expectations is used instead on realized interest
over time (or that there have been systematic surprises in historical samples).
rates.

12.4.4 A New-Keynesian Model of Monetary Policy

12.4.3 Uncovered Interest Rate Parity
Monetary policy is a crucial part of the macroeconomic picture these days, so it is impor-
Uncovered interest rate parity says that the difference between a domestic and foreign
tant to understand how monetary policy is formed. It has not always been this way: there
interest rate equals the expected depreciation plus a constant (across time, not maturities)
are long periods when many countries adopted a very simple (or so it seemed) mone-
risk premium
tary policy by pegging the currency to another currency. Macroeconomic policy was then
y t .n/ y t .n/ D E t s t Cn s t C 'n ; (12.32)
synonymous with fiscal policy. Recently, the roles have changed.
Modern macro models are often smaller than the older macroeconometric models and

56 57
they pay more attention to both the supply side of the economy and the role of expecta-
tions. These models try to capture the key elements in the way central banks (and most
other observers) reason about the interaction between inflation, output, and monetary pol-
icy.
In these models, inflation depends on expected future inflation (some prices are set
today for a long period and will therefore be affected about expectations about future
costs and competitors’ prices), lagged inflation, and a “Phillips effect” where an output
gap (output less trend output) affects price setting via demand pressure. For instance,
inflation ( t ) is often modelled as
 t D ˛ E t  t C1 C ˇ t C x t C " t ; (12.33)
1
where x t is the output gap and " t can be interpreted as “cost push” shocks (wage de-
mands, oil price shocks). This equation can be said to represent the supply side of the
economy and it is typically derived from a model where firms with some market power
want to equate marginal revenues and marginal costs, but choose to change prices only
gradually.
The demand side of the economy is modelled from consumers’ savings decision,
where the trade off between consumption today and tomorrow depends on the real in-
terest rates. Simplifying by setting consumption equal to output we get something like
the following equation for the output gap
xt D xt 1
.i t E t  t C1 / C u t ; (12.34) interest rate decision and its effect on inflation (for instance, by letting inflation in (12.33)
where i t is the nominal interest rate (set by the central bank) and u t is a shock to demand.
Note that the expected real interest rate affects demand (negatively).
In some cases, the real exchange rate is added to both (12.33) and (12.34), capturing
price increases on imported goods and foreign demand for exports, respectively. The
exchange rate is then linked to the rest of the model via an assumption of uncovered
interest rate parity (that is, expected exchange rate depreciation equals the interest rate
differential).
Some of the important features of this simple model are: (i) inflation expectations
matter for today’s inflation (think about wage inflation), (ii) the instrument for monetary
policy, the short interest rate i t , can ultimately affect inflation only via the output gap; (iii)
58
it is the real, not the nominal, interest rate that matters for demand.
To make the model operational, two more things must be added: the monetary policy
(the way the interest rate is set) and the expectations in (12.33)–(12.34) must be specified.
It is common to assume that the central bank has some instrument rule like the famous
“Taylor rule”
i t D 0 C 0:5x t C 1:5 t C v t : (12.35)
The residual v t is a “monetary policy shock,” which picks up factors left out of the model
(for instance, the central bank’s concern for the banking sector or simply changes in the
central bank’s objectives). This simple reaction function has been able to track US mone-
tary policy fairly well over the last decade or so. Another approach to find a policy rule is
to assume that the central bank has some loss function that it minimizes by choosing an
policy rule. This loss function is often a weighted average of the variance of inflation and
the variance of the output gap. The policy rule is the solution of the minimization prob-
lem, and can often look more complicated than the Taylor rule. However, there is one
interesting special case. Suppose the central bank wants to minimize the (unconditional)
variance of inflation. The formal optimization problem is then
min Var. t /, subject to (12.33) and (12.34). (12.36)
it
The solution is then that the interest rate should be set so that actual inflation is zero (here
the mean) in every period. If the model is changed so there is a time lag between the
react to x t 1 instead of x t ), then the interest rate should be set so that the conditional
expectation of next period’s inflation is zero (the mean), E t  t C1 D 0. This type of “rule”
is used in much of the monetary policy debate.
The expectations in (12.33)–(12.34) can be handled in many ways. The perhaps most
straightforward way is to assume that the expectations about the future equal the current
value of the same variable (a “random walk”). A more satisfactory way is to use survey
data on inflation expectations. Finally, many model builders assume that expectations are
“rational” (or “model consistent”) in the sense that the expectation equals the best guess
we could do under the assumption that the model is correct. This latter approach typically
requires a sophisticated way of solving the model (as the model both generates the best
guesses and depends on them).
59
12.5 Forecasting Interest Rates
12.5.1 Forecasting Monetary Policy or Inflation?
There is a two-way causality: inflation and the real economy (which depend on the real
interest rate) affect monetary policy, and monetary policy can surely affect inflation and
the real economy. This makes it difficult to analyse and forecast interest rates. However,
for short term forecasting, the emphasis is typically on forecasting the next monetary
policy move. Long run forecasting relies more on understanding the determinants of real
interest rates and inflation, which depends on the general business cycle prospects, but
also on the long run stance of monetary policy (“tough on inflation or not?”).
12.5.2 Interest Rate Forecasts by Analysts
Kolb and Stekler (1996) use a semi-annual survey of (12 to 40) professional analysts’
interest rate forecasts published in Wall Street Journal. The (6 months ahead) forecasts
are for the 6-month T-bill rate and the yield on 30-year government bonds. The paper
studies four questions, and I summarize the findings below.
1. Q. Is the distribution of the forecasts (across forecasters) at any point in time sym-
metric? (Analyzed by first testing if the sample distribution could be drawn from a
normal distribution; if not, then checking asymmetry (skewness).) A. Yes, in most
periods. (The authors argues why this makes the median forecast a meaningful
representation of a “consensus forecast.”)
2. Q. Are all forecasters equally good (in terms of ranking of (absolute?) forecast
error)? A. Yes for the 90-day T-bill rate; No for the long bond yield.
3. Q. Are some forecasters systematically better (in terms of absolute forecast error)?
(Analyzed by checking if the absolute forecast error is below the median more than
50% of the time) A. Yes.
4. Q. Do the forecasts predict the direction of change of the interest rate? (Analyzed
by checking if the forecast gets the sign of the change right more than 50% of the
time.) A. No.
60
12.5.3 Market Positions as Interest Rate Forecasts
Hartzmark (1991) has data on daily futures positions of large traders on eight different
markets, including futures on 90-day T-bills and on government bonds. He uses this data
to see if the traders changed their position in the right direction compared to realized
prices (in the future) and if they did so consistently over time.
The results indicate that these large investors in T-bills and bond futures did no better
than an uninformed guess of the direction of change of the bill and bond prices. He gets
essentially the same results if the size of the change in the position and in the price are
also taken into account.
There is of course a distribution of how well the different investors do, but it looks
much like one generated from random guesses (uninformed forecasts). The investors
change places in this distribution over time: there is very little evidence that successful
investors continue to be successful over long periods.
12.5.4 Long Rates as Forecasts of Future Short Rates: The Expectations Hypothe-
sis
The expectations hypothesis has been tested many times, typically by an ex post linear
regression (realized interest rates regressed on lagged forward rates). The results typi-
cally reject the expectations hypothesis. It is not clear, however, if the rejection is due to
systematic risk premia or to fairly small samples (compared to the long swings in interest
rates). The expectations hypothesis gets more support when survey data on interest rate
expectations is used instead on realized interest rates.
12.6 Risk Premia on Fixed Income Markets
There are many different types of risk premia on fixed income markets.
Nominal bonds are risky in real terms, and are therefore likely to carry inflation risk
premia. Long bonds are risky because their market values fluctuate over time, so they
probably have term premia. Corporate bonds and some government bonds (in particular,
from developing countries) have default risk premia, depending on the risk for default.
Interbank rates may be higher than T-bill of the same maturity for the same reason (see
the TED spread, the spread between 3-month Libor and T-bill rates) and illiquid bonds
61
may carry liquidity premia (see the spread between off-the run and on-the-run bonds). TED spread (3−month LIBOR − T−bill)
Figures 12.14–12.17 provide some examples. 4

Long−term interest rates 3.5

3
0.15 Baa (corporate)
Aaa (corporate) 2.5
10−y Treasury
2
0.1 1.5
1
0.5
0.05
0
1990 1992 1995 1997 2000 2002 2005 2007

0
1970 1975 1980 1985 1990 1995 2000 2005
Figure 12.15: TED spread

Nelson, C., and A. Siegel, 1987, “Parsimonious modeling of yield curves,” Journal of
Figure 12.14: US interest rates
Business, 60, 473–489.

Bibliography
Cochrane, J. H., 2001, Asset pricing, Princeton University Press, Princeton, New Jersey.

Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann, 2007, Modern portfolio

theory and investment analysis, John Wiley and Sons, 7th edn.

Hartzmark, M. L., 1991, “Luck versus forecast ability: determinants of trader perfor-
mance in futures markets,” Journal of Business, 64, 49–74.

Hull, J. C., 2006, Options, futures, and other derivatives, Prentice-Hall, Upper Saddle
River, NJ, 6th edn.

Kolb, R. A., and H. O. Stekler, 1996, “How well do analysts forecast interest rates,”
Journal of Forecasting, 15, 385–394.

McDonald, R. L., 2006, Derivatives markets, Addison-Wesley, 2nd edn.

62 63
 TED spread (3−month LIBOR − T−bill)

4
13 Basic Option Pricing
3.5
3 Main References: Elton, Gruber, Brown, and Goetzmann (2007) 23–24 and Hull (2006)
2.5 5 and 8–10
2 Additional references: McDonald (2006) 9–12; Cochrane (2001) 17–18
1.5
1 13.1 Introduction to Options
0.5
13.1.1 Definition of European Calls and Puts
0
2007 2008 2009
A European call option contract traded in t may stipulate that the buyer of the contract
has the right to buy one unit of the underlying asset from the issuer of the option on the
expiration date t C m at the strike price K. See Figure 13.1 for the timing convention.
Figure 12.16: TED spread recently
The payoff at exercise is zero or, if larger, the price of the underlying asset, S t Cm ,
minus the strike price

call payoff t Cm D max .0; S t Cm K/ : (13.1)

Liquidity premium on Treasury market

0.35 Clearly, an owner of a call option benefits from an increase in the price of the underlying
asset (exercise the right to buy for K and sell asset at a higher price). The payoff of
0.3
the original seller of the option (the option writer who has a short option position) is the
0.25
mirror image of the buyer’s payoff: the buyer’s gain is the writer’s loss. See Figure 13.2
0.2

0.15

0.1
-
0.05
Spread between off−the−run and on−the−run Treasury bonds
t t Cm
0
1998 2000 2002 2004 2006 2008 European buy option, if S > K: pay
call option: agree on K, pay C K and get asset

Figure 12.17: Off-the-run liquidity premium

Figure 13.1: Timing convention of a European call option contract

64 65
 Profit of options

Call(K)
Put(K)

0 SMI call options (Sep 2009) with trade

7500

7000

K 6500

6000

Strike price
Stock price
5500

5000
Figure 13.2: Profit of options
4500

for an illustration. 4000

A put option instead gives the buyer of the contract the right to sell one unit of the 3500
underlying asset. The put price is here denoted by P . An owner of a put option benefits
3000
from a decrease in the price of the underlying asset (buy the asset cheaply and exercise Jan Feb Mar Apr May Jun Jul Aug Sep Oct

the right to sell for K). The payoff is

put payoff t Cm D max .0; K S t Cm / : (13.2)

Figure 13.3: Traded options
An option that would be profitable to exercise now is called in-the-money; an option
that would be unprofitable to exercise is called out-of-the-money—and an option that
would just break even is called at-the-money.
Figures 13.3–13.5 illustrates the trade intensity of options with different strike prices
(but same expiration and underlying asset).

66 67
 SMI put options (Sep 2009) with trade SMI call and put options (Sep 2009), trade volume

7500
10000
7000 9000
6500 8000

Number of contracts
6000 7000
Strike price

5500 6000
5000
5000
4000
4500
3000
4000
2000
3500 1000
3000 0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Jan Feb Mar Apr May Jun Jul Aug Sep Oct

Figure 13.4: Traded options Figure 13.5: Option trade volume

68 69
13.1.2 Financial Engineering Synthetic forward, C(K) − P(K) Protective put, P(K) + S

Replicating a Forward Call(K) Underlying, S−S0

−Put(K) Put(K), atm
Options markets are often very liquid—and are therefore useful for constructing replicat- Synthetic forward Protective put
ing portfolios. The portfolio Call(K) - Put(K) for K D F (the forward price) replicates
a forward contract, so it is a synthetic forward. Clearly, we can then replicate a short 0 0
position in a forward contract by selling such a portfolio. See Figure 13.6.
K K=S0

Portfolio Insurance Stock price Stock price

A protective put is a combination of a put and a position in the underlying asset. This Covered call, C(K) − S
allows the owener to capture the upside of the price movement (of the underlying), at the
−Underlying, −(S−S0)
same time as insuring against the downside. This is indeed very similar to just buying a
Call(K), atm
call option. See Figure 13.6. −covered call

Betting on Large Changes 0

An option is a bet on a change in a specific direction. Option portfolios can be constructed K=S0
to instead make a bet on a large change in either direction (that is, high volatility): a
Stock price
straddle is Call(K) + Put(K), and a strangle is Call(K2 ) + Put(K1 ) where K1 < K2 . See
Figure 13.7.
Figure 13.6: Profits of option portfolios
Betting on a Large Price Decrease 2
prices, but a a payoff that increases with the underlying asset between them. Selling a
A variation on the synthetic short forward is the collar: Call(K2 ) + Put(K1 ) where
bull spread creates a bear spread, which is a bet on a small decrease of the underlying
K1 < K2 . It also looks like a short position in a forward contract, except that the payoff
price. (These spreads can also be constructed by combing puts.) See Figure 13.7.
is flat between the strike prices. Clearly, this is betting on a large price decrease. Selling
a collar (or reversal) is instead a bet on a large price increase.
13.1.3 Basic Properties of Options
A collar (reversal) can be used to hedge a long (short) position in the underlying asset,
except that there is no hedge between the strike prices. It provides insurance outside the Options Are Risky Assets
strike prices. See Figure 13.7.
The buyer always stands the risk of getting a zero payoff, that is, a return of 100%. For
instance, the net return on a European call option is
Betting On a Small Price Increase
max .0; S t Cm K/
To bet on a small increase in the price of the underlying asset we can use a bull spread: 1; (13.3)
C
Call(K1 ) - Call(K2 ) where K1 < K2 . This portfolio has flat payoffs outside the strike

70 71
 Straddle, C(K) + P(K) Strangle, C(K ) + P(K ) Option price
2 1
14
Call(K) Call(K ) Call
2 12 Put
Put(K) Put(K )
Straddle 1
Strangle 10

0 0 8

6
K K1 K2
4
Stock price Stock price
2
Collar, P(K1) − C(K2) Bull spread, C(K1) − C(K2)
0
30 35 40 45 50
−Call(K2) Call(K1) Strike price
Put(K1) −Call(K2)
Collar Bull spread
Figure 13.8: Option price as a function of the strike price
0 0
someone and then sold it) can hedge by buying a call option. This puts a limit (the strike
K1 K2 K1 K2
price) on how much he/she will have to pay for the asset when it is time to turn it back to
Stock price Stock price the lender.

Basic Properties of Option Prices

Figure 13.7: Profits of option portfolios
where C is the call option price. Whenever the option isn’t exercised, the whole invest-
ment is lost (and the return is 100%).
It is the clear that option returns cannot be normally (or even lognormally) distributed:
the density function has a spike at 100% (whose probability is the same as the proba-
bility of S t Cm  K). This means, that we cannot motivate “mean-variance” pricing of
options by referring to a normal distribution of the return. (This does not rule out mean-
variance pricing, which could be motivated by, for instance, mean-variance preferences.)
Since options are exposed to risk factors, they can be used to hedge risk, that is, to
create an “insurance.” For instance, an owner of the underlying asset can hedge by buying
a put option. This guarantees that he/she always gets at least the strike price.
Similarly, an investor who has short-sold the underlying asset (borrowed the asset by
Options prices depend on many things, but there are some fairly general results
First, call option prices are decreasing in the strike price, while put options prices are
increasing in the strike price. See Figure 13.8 for an illustration.
The intuition is that a higher strike price means that an owner of a call option will
have to pay more in case of exercise—and there is also a lower chance of exercise. This
is illustrated in Figure 13.9.
Second, both call and put option prices are typically increasing in the dispersion of the
distribution of the future price of the underlying asset. The intuition for the second result
is that a wider dispersion increases the probability of a really high price of the underlying
asset (which is good). Of course, it also increases the probability of a really low asset
price, but that is of less concern is the the call option payoff is bounded below at zero.
This is illustrated in Figure 13.10.

72 73
 Distribution of future asset price Distribution of future asset price

0.06 K = 42 0.06 K = 47
Std = 0.14 Std = 0.14 -
0.04 0.04 t t Cm
Write contract, Pay F ,
0.02 0.02
agree on F get asset
0 0
20 30 40 50 60 70 20 30 40 50 60 70
Asset price Asset price
Figure 13.11: Timing convention of forward contract

13.2 Forward and Futures

Figure 13.9: Distribution of future stock price
13.2.1 Forward-Spot Parity
Distribution of future asset price Distribution of future asset price
Forward prices play an important role in simplifying option analysis, so we first discuss
0.06 K = 42 0.06 K = 42
Std = 0.14 Std = 0.21 the forward-spot parity.
0.04 0.04 The present value of one unit paid m periods into the future must be the price of a
bond, B.m/, maturing at the same time. We therefore have that the present value of Z is
0.02 0.02

0 0 Present valuem .Z/ D B t .m/Z, or (13.5)

20 30 40 50 60 70 20 30 40 50 60 70
m
Asset price Asset price D Œ1 C Y t .m/ Z, or (13.6)
my t .m/
De Z; (13.7)
Figure 13.10: Distribution of future stock price
where Y t .m/ is effective spot interest rate, and y t .m/ is the continuously compounded
interest rate (y t .m/ D ln Œ1 C Y t .m/).
13.1.4 Definition of American Calls and Puts

An American option is like a European option, except that it can be exercised on any day Example 13.1 (Present value) With y t .m/ D 0:05 and m D 3=4 we have the present
before or on the expiration date. This means that an American option has more rights than value e 0:053=4 Z  0:963Z.
a European option and is therefore worth at least as much
A forward contract specifies (among other things) which asset that should be derlived
CA  CE and PA  PE : (13.4) at the expiration and what the price is then (the forward price). See Figure 13.11 for an
illustration.
If there are no dividends, then it is never optimal to exercise an American call option
early (such a call option will have the same price as a European call option), but it can Proposition 13.2 (Forward-spot parity, no dividends) The forward price, F t .m/, con-
still be optimal to exercise an American put option early. If there are dividends, then the tracted in t (but to be paid in t C m) on an asset without dividends satisfies
American call option should only be exercised just prior to the dividend payments, while my t .m/
e F t .m/ D S t : (13.8)
an American put should perhaps also be exercised also at other times.

74 75
 The intuition is that the forward contract is like buying the underlying asset on credit—
e F t .m/ can be thought of as a prepaid forward contract.
my t .m/
Proof. (of Proposition 13.2) Portfolio A: enter a forward contract, with a present value
of e my F . Portfolio B: buy one unit of the asset at the price S . Both portfolios give one
asset at expiration, so they must have the same costs today.
Proposition 13.3 (Forward-spot parity, discrete dividends) Suppose the underlying asset
pays the dividend Di at mi (i D 1; :::; n) periods into the future (but before the expiration
date of the forward contract). The dividends must be known already in t. The forward
price then satisfies
Xn
my t .m/ mi y t .mi /
e F t .m/ D S t e Di :
i D1
The last term is the sum of the present values of the dividend payments. The intuition
is that the forward contract does not give the right to these dividends so its value is the
underlying asset value stripped of the present value of the dividends.
Proof. (of Proposition 13.3) Portfolio A: enter a forward contract, with a present value
of e my F . Portfolio B: buy one unit of the asset at the price S and sell the rights to the
known dividends at the present value of the dividends. Both portfolios give one asset at
expiration, so they must have the same costs today.
Proposition 13.4 (Forward-spot parity, continuous dividends) When the dividend is paid
continuously as the rate ı (of the price of the underlying asset), then
my t .m/ ım
e F t .m/ D S t e : (13.10)
Proof. (of Proposition 13.4) Portfolio A: enter a forward contract, with a present value
of e my F . Portfolio B: buy e ım units of the asset at the price e ım S, and then collect
dividends and reinvest them in the asset. Both portfolios give one asset at expiration, so
they must have the same costs today.
Remark 13.5 (Forward-spot parity, currencies) Investing in foreign currency effectively
means investing in a foreign interest bearing instrument which earns the continuous in-
terest rate (“dividend”) y t .m/. Use ı D y t .m/ in (13.10).
13.2.2 Forwards versus Futures
A forward contract is typically a private contract between two investors—and can there-
fore be tailor made. A futures contract is similar to a forward contract (write contract,
get something later), but is typically traded on an exchange—and is therefore standard-
ized (amount, maturity, settlement process). The settlement is either cash settlement or
physical settlement. The latter does not work for synthetical assets like equity indices.
Another important difference is that a forward contract is settled at expiration, whereas
a futures contract is settled daily (“marking-to-market”), which essentially means that
gains and losses (because of prices changes) are transferred between issuer and owner
daily—but kept at the at an interest bearing account at the exchange. If interest rates
(13.9) change randomly over time (and they do), the rate at which these gains (losses) are rein-
vested (refinanced) will therefore be different from the rate when the futures was issued.
This difference is embedded in the futures price. The proposition below show that, if
(hypothetically) the interest rate path was non-stochastic, then the forward and futures
prices would be the same. In practice, the difference between forward and futures prices
is typically small.
Proposition 13.6 (Forward vs. futures prices, non-stochastic interest rates) The forward
and futures prices would be the same if the interest rate only changed in a non-stochastic
way.
Proof. (of Proposition 13.6) To simplify the notation, let t D 0 and m D 2. Also,
let rs be the continuously compounded one-day interest rate and fs be the futures price.
Strategy A: have e r0 long futures contracts on (the end of) day 0, increase it to e r0 Cr1 on
day 1. Provided we reinvest the settlements in one-day bills, we have
Day (s) Position Settlement End-value of reinvested settlement
0 e r0 0 0
1 e r0 Cr1 e r0 .f1 f0 / e r0 .f1 f0 / e r1
2 0 e r0 Cr1 .f2 f1 / e r0 Cr1 .f2 f1 /
The end-value of strategy A is therefore e r0 Cr1 .f2 f0 /, which equals e r0 Cr1 .S2 f0 /
since the value at expiration is the value of the underlying asset. Strategy B: be long e r0 Cr1
forward contracts, which gives a payoff on day 2 of e r0 Cr1 .S2 F0 /. Both strategies take
76 77
on exactly the same risk, so the prices must be the same: f0 D F0 . (The proof relies on Example 13.8 (Put-call parity) S D 42; m D 1=2; y D 5%; K D 38. If C D 5:5 for an
knowing r1 already on day 0.) underlying asset without dividends, then (13.12) gives

0:50:05
5:5 P D 42 e 38 or P  0:56:
13.3 Put-Call Parity for European Options

There is a tight link between European call and put prices. If you know one of them (and 13.4 Early Exercise of American Options
the forward price), then you can easily calculate that the other must be. The following
proposition is more precise. This section discusses early exercise of American options. There are some cases where
we can exclude early exercise, so the American option is priced as a European option. In
Proposition 13.7 (Put-call parity for European options) The put-call parity for European other cases, we cannot exclude early exercise—but we may still be able to say something
options is about when early exercise is likely. More precise answers will require building a model
C P D e my .F K/; (13.11) for the pricing. Clearly, the answer is then model dependent.

where e my
.F K/ is the present value of the forward price minus the strike price.
13.4.1 Early Exercise of American Call Options (No Dividends)
Time subscripts and indicators of maturity have been suppressed to make the notation American call options on an asset without dividends (until expiration of the option) are
a bit easier. The parity holds irrespective of whether the underlying asset has dividends or not exercised early. The following proposition is more precise.
not (since the expression uses the forward price). Its practical importance is that it allows
us to use two of the assets to replicate the third asset. For instance, we can combine a Proposition 13.9 (No early exercise, American call, no dividends) An American call op-
call option and a forward contract to replicate a put option, or buy a call and sell a put to tion on an asset without dividends should never be exercised early—but perhaps sold. It
replicate a forward contract. therefore has the same price as a European call option.
See Figure 13.6 for an illustration.
Proof. (of Proposition 13.7) Buy one call option and sell one put option, both with Suppose that you are pretty sure that price of the underlying will drop tomorrow. The
the strike price K. This will with certainty give one asset at maturity at the price K. The above argument shows that you should still not exercise the call option, but it might be
present value of the cost is C P C e my K. The same is achieved by entering a forward sensible to sell the option today. If we exercised early, then we would effectively through
contract—the present value of the cost is e my F . away the put protection (against downside movements) inherent in the call option and be
This formula is very general, but a few special cases are of particular interest. First, left with the underlying asset (recall from the European put-call parity that the call option
when the underlying asset pays no dividends, then (13.11) together with (13.8)–(13.10) can be thought of as a portfolio of the underlying, a put, and some cash) and also pay the
give strike price now instead of later—neither of which is good (and which a potential buyer
of the call option would be willing to pay for).
C P DS e my K if no dividends, (13.12) Proof. (of Proposition 13.9) To avoid early exercise, selling (getting CA ) should be
Xn
C P DS e mi yt .mi / Di e my
K if dividends, (13.13) more profitable than exercising (getting S K), CA > S K. Put-call parity for European
i D1
ım my
options (13.12) says
C P D Se e K if continuous dividend rate ı: (13.14)
CE D S K C .1 e my /K C PE :

78 79
 American put, BOPM nodes American put, early exercise American put price, BOPM
150 150
Shaded area: Shaded area: 10 American put

Option price
nodes used in calculation nodes with early exercise C−S+K
−ym
100 100 C − S + e K = PE
Spot price

Spot price
5
K, m, y, and σ are 42 0.5 0.05 0.2
50
S 50 Binomial solution uses 100 time intervals
t 0
32 34 36 38 40 42 44 46 48 50 52
Stock price
0 0
0 0.1 0.2 0.3 0.4 0.5 0 0.1 0.2 0.3 0.4 0.5
Time interval, m Time interval, m
American put price at higher interest rate, BOPM
S, K, m, y, and σ are 42 42 0.5 0.05 0.2
Binomial solution uses 100 time intervals 10

Option price
Figure 13.12: Numerical solution of an American put price (no dividends) 5
y is 0.15

The sum of last two terms is positive (before the expiration date), so CE > S K. Since 0
32 34 36 38 40 42 44 46 48 50 52
CA  CE we have Stock price
CA > S K;

so selling the option is always more profitable than exercising early. The reason is that
early exercise throws away the put protection (PE ) and also the “rebate” due to later
payment of the exercise price (pay K instead of the present value e my K).
13.4.2 Early Exercise of American Put Options (No Dividends)
American put options on an asset without dividends (until expiration of the option) may
be exercised early. The following proposition is more precise.
Proposition 13.10 (Early exercise, American put, no dividends) An American put option
on an asset without dividends could be exercised early. However, there is no early exercise
if the put option is deep out-the-money (high asset price/low strike price) and the interest
rate is low. In particular, there is no early exercise if the corresponding European call
option satisfies CE > .1 e my /K. For instance, this is always the case if the interest
rate is zero.
Figure 13.13: Numerical solution of an American put price (no dividends)
This means that the American put price is close to the European put price for high
asset price/low strike price and low interest rates, but is higher otherwise.
See Figures 13.12–13.13 for an illustration, based on a numerical solution for the
price on an American put option. The first figure shows in which nodes early exercise is
optimal. The second picture illustrates how the price is related to the European put price
and a upper boundary (to be discussed later).
Example 13.11 (Early exercise of American put option?) When the underlying asset
goes bankrupt, then S D 0 and it is known that it will stay at S D 0. Exercising the
American put option now gives K, whereas waiting until expiration has a present value
of e my K (which is lower): early exercise is optimal.
Example 13.12 (Early exercise of American put option?) Using the same parameters as

80 81
 P
in Example 13.8, we have that CE > .1 e my
/K is satisfied since Conversely, there is no early exercise if .1 e my /K > niD1 e mi y t .mi /
Di , that is, with
a high strike price and low present value of the dividends.
1=20:05
5:5 > .1 e /38 D 0:94;
Example 13.14 (Early exercise, American call, dividends?) Suppose there is one divi-
so there is no early exercise of the American put option. The reason is that we from the
dend payment one month ahead: D1 D 0:95 at m1 D 4=12. If we use the same parame-
put-call parity for European options (13.12) and the fact PA  PE then have
ters as in Example 13.8, we then have
PA  PE D CE C K S .1 e my /K ; 1=20:05 4=120:05
„ƒ‚… „ ƒ‚ … .1 e /38 D 0:94 > e 0:95 D 0:93;
5:5 0:94

so selling the put option (getting PA ) gives the same as exercising (K S ) plus at least so we can rule out early exercise. However, if the dividend payment is at m1 D 1=12, then
5:5 0:94. If, for some reason, we instead have y D 35% (so .1 e my /K D .1 we cannot.
e 1=20:35 /38 D 6:1) but the same prices, then we would perhaps get early exercise.
Proof. (of Proposition 13.13) To avoid early exercise, selling (getting CA ) should be
Proof. (of Proposition 13.10) To avoid early exercise, selling (getting PA ) should be more profitable than exercising (getting S K), CA > S K. Put-call parity for European
more profitable than exercising (getting K S ), PA > K S. Put-call parity for European options (13.13) says
options (13.12) says Xn
mi y t .mi / my
CE D S K e Di C .1 e /K C PE :
PE D CE C K S .1 e my /K: i D1

If If
Xn
my mi y t .mi /
CE > .1 e my
/K; .1 e /K > e Di ;
i D1

then PA  PE > K S so selling is better than exercising. This means that there is
no early exercise if the European call price is high (high asset price compared to strike
price), the strike price is low, or if the discounting until expiration is low (low interest rate
or small time to expiration). For instance, with a zero interest rate, PA  CE C K S, so
there is never early exercise as long as CE > 0. If these conditions are not satisfied, we
cannot rule out early exercise.
and PE  0 (always true), then CA  CE > S K: selling is better than early exercise.
Hence, there is no early exercise if the present value of dividends is low, the strike price
is high or if the discounting until expiration is large (high interest rate or long time to
expiration). In the opposite case, we cannot rule out early exercise.
Proposition 13.15 (Early exercise, American put, dividends) Early exercise is possible...

13.4.3 Early Exercise of American Call and Put Options (Dividends) 13.5 Put-Call Relation for American Options

American call and put options on an asset with dividends (until expiration of the option) There is no put-call parity for American options. However, pricing bounds can be derived.
may be exercised early. The following propositions are more precise.
Proposition 13.16 (Put-call, American option, no dividend) For an American option on
Proposition 13.13 (Early exercise, American call, dividends) An American call option an asset without dividends, the put price must be inside the interval
on an asset with dividends could be exercised early, especially just before a dividend
my
CA S Ce K  PA  CA S C K: (13.15)
payment and when the option is deep in-the-money (low strike price/high asset price). „ ƒ‚ … „ƒ‚…
PE CE

82 83
 Bounds, American put, no dividends B: one put option plus one underlying asset. If the put option is held until expiration (the
10 call is not exercised early), then portfolio A will be worth max.0; Sm K/ C e my K in
C−S+K
−my
C−S+e K = PE
period m (where m is date of expiration), and portfolio B will be worth max.0; K Sm /C
8
Sm , so portfolio A is worth (weakly) more. If, instead, the put is exercised earlier (l < m),
then portfolio A will be worth CA;l C e ly K in period l, and portfolio B will be worth
6
K Sl C Sl D K, so portfolio A is worth (weakly) more. In period 0 (0  l < m) we
S, m, y, and σ: 42 0.5 0.05 0.2
4 The call price is from Black−Scholes
don’t know when/if the early exercise of the put will happen—but we know that in either
case A portfolio will then be worth more than a portfolio B: portfolio A must therefore
2 be worth (weakly) more than B already in 0: CA;0 C K  PA;0 C S0 , which is the upper
bound in (13.15).
0
30 35 40 45 50
Proposition 13.18 (Put-call, American option, dividends) With dividends, the upper bound-
Strike price
ary in (13.15) is changed by adding the present value of the dividend stream
Xn
my mi y t .mi /
Figure 13.14: Option price as a function of the strike price CA S Ce K  PA  CA S CK C e Di : (13.16)
i D1

The lower boundary is the European put price from (13.12). The reason is that the
American and European call options have the same prices (the American call option on
an asset without dividends is never exercised early—see Section 13.4). The upper bound
is very similar, except that it involves the strike price, not its present value. Clearly,
when the interest rate is low, then the interval is narrow—and with a zero interest rate it
collapses to the put-call parity of European options. (The latter corresponds to the fact
that an American put option on an asset without dividends is never exercised early if the
interest rate is zero, see Section 13.4).
See Figures 13.13 and 13.14 for illustrations.
Example 13.17 (Bounds for an American put option) Using the same parameters as in
Example 13.8, we get the following bounds for an American put option (no dividends)
Notice that the lower boundary is not equal to the European put price anymore (since
CA  CE and the present value of the dividends is not added). Together this means that
the interval is wider with dividends than without dividends.
Proof. (of Proposition 13.18) The lower boundary follows from the following argu-
ment. Buy one call option, lend e my K, and sell one asset—the total value is CA C
e my K S , which is the left hand side of (13.16). If the call is exercised prior to expiry,
the payoff is S K C e my K S D .e my 1/K < 0 which must be less than the value
of the put whose value is nonnegative. If no early exercise, then the payoff at expiration
is max.0; S K/ C K S D max.0; K S/ which is the same as the put payoff.
The upper boundary is a bit trickier, so we leave it for now.

0:56  PA  5:5 42 C 38 D 1:5:

Proof. (of Proposition 13.16) The lower boundary is the European put price (since
CA D CE when there are no dividends) and it is always true that PA  PE .
The upper boundary follows from the following argument where we compare two
portfolios. Portfolio A: one call option with strike price K plus a deposit of K. Portfolio

84 85
 Price bounds on European call SMI call option prices, 2009−07−14
50 6000

40 5000

4000
30 C
C ≤ PV(F) ≤ S
3000 C ≤ PV(F)
0≤C
20 0≤C
PV(F−K) ≤ C 2000 PV(F−K) ≤ C
10
1000
S, m, y: 42 0.5 0.05
0 0

30 35 40 45 50 3000 3500 4000 4500 5000 5500 6000 6500 7000 7500
Strike price Strike price

Figure 13.15: Option price bounds as a function of the strike price Figure 13.16: Prices and bounds for SMI options

13.6 Pricing Bounds and Convexity of Pricing Functions ple 13.8, we get the following bounds

13.6.1 Pricing Bounds for (European and American) Call Options 4  C  42:

The price of both American or European call option must satisfy the following restrictions In this case, the second bound (0  C ) is superfluous.
my
C e F S (13.17)
13.6.2 Prices of Call Options for Different Strike Prices
0C (13.18)
e my
.F K/  C: (13.19) Suppose we have American or European call options with different strike prices, K1 <
K2 . We the have the following price relations
The motivations are basically as follows (the intuition based on European options, but
the results extend to Americal options as well. First, a call option with a zero strike price C.K2 / C.K1 /  0 (13.20)
(K D 0) would be the same as owning a prepaid forward contract (which is worth as C.K2 / C.K1 /
 1 (13.21)
much or less than the underlying asset). Whenever the strike price is higher, the call price K2 K1
will lower. Second, the call option gives rights, not obligations: its price value cannot be C ŒK1 C .1 /K2   C.K1 / C .1 /C.K2 /, for 0    1: (13.22)
negative. Third, the lowest possible value of a put option is zero, so the put-call parity
The first relation says that the call option price is decreasing in the strike price. The
(13.11) immediately gives that the call price must exceed the present value of F K. See
intuition is that a higher strike price means that an owner of a call option will have to
Figures 13.15 and 13.16 for illustrations.
pay more in case of exercise—and there is also a lower chance of exercise. The second
Example 13.19 (Pricing bounds for call option) Using the same parameters as in Exam- relation says that change is smaller than the change in the strike price. The third relation

86 87
says that the relation is convex. If these relations do not hold, then there are arbitrage investment). The payoff at expiration (m period later) is then
opportunities (see the proofs below).
 max.0; S K1 / max.0; S N C .1
K/ / max.0; S K2 /
In other words, these three conditions say that we have the following partial derivatives 8̂
(if they exist) of the call option price function ˆ
ˆ 0 D0 if S  K1
ˆ
< .S K1 / D .S K1 / if K1 < S  KN
1  dC.K/=dK  0 and dC 2 .K/=dK 2  0: (13.23) D
ˆ N D .1 /.S K2 / if KN < S  K2
ˆ .S
ˆ K1 / .S K/
:̂ .S K1 / .S N C .1
K/ /.S K1 / 0 if K2 < S;
This means that the call option price is decreasing in the strike price, but slower than the
strike price itself, but that the curve flattens out at high strike prices. where the second column uses the definition of K. N All payoffs are non-negative, and some
See Figure 13.8 for an illustration. are positive. Since the initial investment is zero, this creates arbitrage opportunities.
Proof. (of (13.20)) If (13.20) was not true, so C.K2 / > C.K1 /, then a bull spread (buy
C.K1 / and sell C.K2 /), would have a negative price (C.K1 / C.K2 / < 0). However,
the payoff of a bull spread is Bibliography
8̂
if S  K1 Cochrane, J. H., 2001, Asset pricing, Princeton University Press, Princeton, New Jersey.
< 0
max.0; S K1 / max.0; S K2 / D S K1 if K1 < S  K2
:̂ Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann, 2007, Modern portfolio
K2 K1 if K2 < S:
theory and investment analysis, John Wiley and Sons, 7th edn.
This would give a non-negative payoff for a negative asset price, which creates arbitrage
Hull, J. C., 2006, Options, futures, and other derivatives, Prentice-Hall, Upper Saddle
opportunities.
River, NJ, 6th edn.
Proof. (of (13.21)) If (13.21) was not true, so C.K1 / C.K2 /  K2 K1 , then we
can sell a bull spread (sell C.K1 / and buy C.K2 /) and invest the proceeds in a T-bill (zero McDonald, R. L., 2006, Derivatives markets, Addison-Wesley, 2nd edn.
investment). The payoff at expiration (m period later) is then
8̂
< 0 if S  K1
max.0; S K2 / max.0; S K1 / D ŒC.K1 / C.K2 /e rm C .S K1 / if K1 < S  K2
„ ƒ‚ … :̂
>K2 K1 .K2 K1 / if K2 < S:

In either case, there is a positive profit (recall that the initial investment is zero), which
creates arbitrage opportunities.
Proof. (of (13.22)) Let KN D K1 C .1 /K2 . If (13.22) was not true, so C.K/ N >
C.K1 / C .1 /C.K2 /, then we can sell C.K/ N and buy C.K1 / C .1 /C.K2 / (zero

88 89
 *
 Su

q 



S
H
14 The Binomial Option Pricing Model H HH
HH
H
Main references: Elton, Gruber, Brown, and Goetzmann (2007) 23 and Hull (2006) 11 HH
j Sd
and 17
Additional references: McDonald (2006) 9–12; Cochrane (2001) 17–18
Figure 14.1: Natural binomial process for S


* 11
14.1 Ovierview of Option Pricing 

0:6

There are basically two ways to model option prices: by some sort of factor model (like 

10HH
CAPM) or by a no-arbitrage argument. The latter is clearly much more precise, so it HH
H
is typically preferred—when it works. These notes focus on a particularly simple case: HH
H
j
H 9:5
when the underlying asset follows a binomial process.

14.2 The Basic Binomial Model Figure 14.2: Natural binomial process for S

The binomial model (where the change of the price of the underlying asset only can take
two values) is very stylized, but it is useful for establishing the key ideas of option pricing.
It can also be transformed into a realistic model by cumulating many (short) subperiods.
In the limit (as the subperiods became very many/very short) it converges to the well-
known Black-Scholes model.
Example 14.2 (Binomial process) Suppose S D 10; u D 1:1; d D 0:95, and q D 0:6.
Then, the process has a 60% probability of increasing from 10 to 11 and a 40% probability
of decreasing to 9.5. See Figure 14.2. This gives an expected relative change of 0:61:1C
0:4  0:95 D 1:04 and a variance of the relative change of 0:6  0:4  .1:1 0:95/2 D
0:0054:

14.2.1 Binomial Process for the Stock Price

14.2.2 No-Arbitrage Pricing of a Derivative
The binomial tree for the underlying asset starts at the price S and has probability q of
moving to Su in the next period and a probability of 1 q of moving to Sd . This is Consider a derivative asset that will be worth fu in case we end up at S u and fd if we
illustrated in Figure 14.1. These probabilities are the true (“natural”) probabilities. If we end up at Sd —see Figure 14.1. Notice that fu is the notation for the value (price) of
denote the price today by S t and in the next period by S tCh , then we have the derivative in the up state (it should not be read as f times u). As an example, the
( derivative could be a call option with strike price K, so if the next time period is the time
u with probability q expiration, then
S t Ch =S t D (14.1)
d with probability 1 q:
fu D max.Su K; 0/ and fd D max.Sd K; 0/: (14.2)
Remark 14.1 (Mean and variance of a binomial process) The mean of a (shifted) bino-
mial process like (14.1) is qu C .1 q/d and the variance is q.1 q/.u d /2 .

90 91
Alternatively, it could be a forward contract (and the next time period is the time of expi- With this choice of
(also called the “delta hedge”) the portfolio is riskfree and must
ration), so therefore have the same return as the riskfree rate.
fu D S u F and fd D Sd F: (14.3)
Example 14.4 (European call option) Continuing Example 14.3 we get
We next use a no-arbitrage argument to derive what today’s price of the derivative
(denoted f ) must be. In doing so, we take it for granted that 1 0 2 2 0:5

D D for K D 10; and
D D 1 for K D 9:
10.1:1 0:95/ 3 10.1:1 0:95/
u > e yh > d: (14.4)
Step 2: Make the Return of the Portfolio Equal to the Riskfree Rate
If this condition is not satisfied, then there are a trivial arbitrage opportunities. For in-
The present value of our riskfree portfolio is e yh .
S u fu /, where y is the interest
stance, if e yh > u, then we could short the stock and buy bonds: this would guarantee a
rate per year and h is the length of the time interval. (The present value is also equal
positive payoff for a zero investment (an arbitrage possibility).
to e yh .
Sd fd /, but that is the same, as discussed before.) Since the portfolio is
riskfree, this present value must be equal to the cost of the portfolio,
S f ,
Example 14.3 (European call option) With the parameters in Example 14.2, equation
(14.2) shows that a European call option with strike price of 10 has e yh
.
Su fu / D
S f: (14.7)

fu D max.11 10; 0/ D 1 and fd D max.9:5 10; 0/ D 0; Solve for the price of the derivative, f , and use the value of
from (14.6) that ensures
that the portfolio is riskfree
while a strike price of 9 gives
 
f D
S 1 e yh u C e yh fu (14.8)
fu D max.11 9; 0/ D 2 and fd D max.9:5 9; 0/ D 0:5:
fu fd  
D 1 e yh u C e yh fu (14.9)
Step 1: Construct a Riskfree Portfolio u d
yh
e d
D e yh Œpfu C .1 p/ fd  with p D : (14.10)
We now construct the following portfolio u d
Equation (14.9) shows what the price of the derivative must be—and is written in terms

of the underlying asset, and
of the possible outcomes and the interest rate. Notice that neither probabilities (of the
1 of the derivative, (14.5)
different outcomes), nor risk preferences enter this expression—since we have used a no-
where will pick the value of
to make the portfolio riskfree. arbitrage argument to price this derivative. This works (that is, we can construct a riskfree
The payoff of the portfolio at expiry is
S u fu in the “up” state and
Sd fd in portfolio) because we have as many (relevant) assets (riskfree and underlying risky asset)
the “down” state. To make the portfolio riskfree,
must be such that the payoff is the as there are possible outcomes (up or down).
same in both cases Equations (14.9) and (14.10) are alternative ways to write the price of the derivative.
The latter shows that the current price of the derivative is the discounted value (e yh )

S u fu D
Sd fd , so times what seems as an expectation of the payoff of the derivative. This expression is
fu fd quite useful since we can think of p as a “risk neutral probability”—although it is not a

D : (14.6)
S .u d / probability in the usual sense: it is just a convenient construction. Notice that p does not

92 93
 *
 S u; fu A forward contract has a zero current price (nothing is paid until expiry), and the

p 
 payoff at expiry is fu D S u F in the up state (the value of the underlying asset minus

 the forward price) and fd D Sd F in the down state. Using this in (14.10) gives
S; f 
H
HH
H
HH 0De yh
Œp .Su F / C .1 p/ .Sd F / , so (14.12)
H
HH
j Sd; fd F D pSu C .1 p/ Sd: (14.13)

This shows that the mean of the risk neutral distribution equals the forward price. Com-
Figure 14.3: Risk neutral binomial process for S and f
bining (14.11) and (14.13) clearly gives the spot-forward parity, F D e yh S .
A riskfree asset can also be priced by this method. The only way an asset can be
depend on which derivative asset (with the same underlying asset) we consider. Under
riskfree in this setting is if fu D fd . We then get a zero hedge ratio (
) and (14.10) gives
the restrictions in (14.4), 0 < p < 1, as any “probability” should be.
yh
f De fu ; (14.14)
Example 14.5 (European call option) Continuing Example 14.3 and assuming that y D
0, equation (14.10) gives the price of a call option with strike price 10 as which is the discounted value of the (sure) payoff.
0 1 0:95 An “Arrow-Debreu asset” (a sort of theoretical derivative often used in asset pricing
f De Œp1 C .1 p/ 0 with p D D 1=3
1:1 0:95 models) for the “up” pays off one unit in the up state and zero otherwise (fu D 1 and
D 1=3: fd D 0). This is also a so-called “cash-or-nothing” call option provided the up state
means that the option is in the money (Su > K). From (14.10) we have
For the call option with a strike price of 9, we get
yh
f De p: (14.15)
0
f De Œ.1=3/  2 C .2=3/  .1=2/ D 1:

14.2.4 Replicating (and Hedging) a Derivative

14.2.3 Applying the No-Arbitrage Pricing on Different Derivatives
The no-arbitrage argument in (14.6) was based on the fact that a portfolio of
of the
This section discusses how we apply (14.10) on some special derivatives.
underlying asset and of 1 of the derivative replicated a bond.
Consider the underlying asset itself. It is clearly a (trivial) derivative with fu D Su
This argument can be turned around to replicate the derivative by holding the follow-
and fd D Sd . According to (14.10) the current price of the underlying asset should be
ing portfolio
yh
S De ŒpS u C .1 p/ Sd  : (14.11)

of the underlying asset, and
yh
This looks (again) like a discounted expected future payoff. e .
Su fu / bills. (14.16)

Example 14.6 (The underlying asset itself) Continuing Example 14.5, equation (14.11) The payoff of this portfolio in the up state is
S u .
Su fu / D fu and in the down
gives state it is
Sd .
Sd fd / D fd (since
Su fu D
Sd fd ) . This replicates the
S D e 0 Œ.1=3/  11 C .2=3/  9:5 D 10: derivative’s payoff. We can therefore hedge a short position in the derivative by holding

of the underlying asset (“delta hedging”).

94 95
14.2.5 Where is the Risk Premium? 14.3.2 The Relation between q and p: If Risk Premium

We have used a no-arbitrage method to price the derivative. It works since the derivative When there is a positive risk premium, then we know that e yh S t D F < E t S tCh . This
is a redundant asset: it can be replicated by a portfolio of the underlying asset and a means that the expected capital gain is larger than motivated by the riskfree rate alone—
riskfree asset—and therefore must have the same price as this portfolio. This does not to compensate for the risk. Then, (14.18) shows that p < q (since u > d ), that is, the
mean, however, that the option is in itself riskfree. In fact, options are typically very risky risk neutral probability of the up state is lower than the true (natural) probability. One
and therefore carry large risk premia. It may seem as if the pricing formula (14.10) is interpretation is that a risk neutral investor would be happy with a lower probability of the
free from the preference parameters that would determine the risk premium. Not correct. up state (and thus a lower expected return), than a risk averse investor.
The pricing formula contains the current asset price (through fu and fd ) which is indeed
affected by preference parameters. Example 14.7 (Natural versus risk neutral probability) With the parameters in Example
The easiest way to see this is perhaps to recall that we can replicate the portfolio by 14.2, equation (14.17) gives
holding a portfolio of the underlying asset and bills, see (14.16). Clearly, this portfolio
E t S t Ch D 0:6  11 C .1 0:6/  9:5 D 10:4:
will incorporate a risk premium—and so must the derivative.
The only case without a risk premium is when the derivative payoffs are unrelated to With y D 0, F D S D 10, so (14.18) gives
the asset price—so the derivative is actually a safe asset as in (14.14).
.10 10:4/=10 D .1=3 0:6/.1:1 0:95/ D 0:04:

14.3 Interpretation of the Riskneutral Probabilities In this case, there is a positive risk premium and p < q (1/3 and 0.6 respectively).

14.3.1 The Relation between q and p: If No Risk Premium

14.4 Numerical Applications of the Binomial Model
The “natural” expected value of the future asset price (denoted S t Ch )
14.4.1 How to Construct a Tree for the Asset Price
E t S t Ch D qS u C .1 q/ Sd; (14.17)
We now discuss how to construct a binomial tree with many small time steps—so that it
where q is the natural probability of the up state. mimics the behaviour of the asset price process.
Combine (14.13) and (14.17) to get The binomial distribution converges to a normal distribution as we chop up a given
time to expiration into smaller and smaller time steps—and the normal distribution is
.F E t S tCh /=S D .p q/.u d /: (14.18)
fully described by the mean and variance. It is therefore common practice to construct the
If the underlying asset has no risk premium, then the forward price equals the expected binomial tree to match the mean and variance of the underlying series.
future price (the left hand side is zero), so p must equal q. This motivates the name of p as Suppose the price of the underlying asset has a (continuously compounded) drift of
a “risk neutral probability”: it would be the probability (that is compatible with observed  and a variance of  2 per period (most often a year). This means that for a horizon of
price) if investors were risk neutral. length h, we have

ln S t Ch ln S t D h C " t Ch ; with (14.19)

E " tCh D 0 and Var." t Ch / D  h:
2

96 97
 -
For instance, if we measure periods in years, then h D 1=52 corresponds to a horizon of 0 2h m D nh
h
one week. In the binomial tree, h will be the length of a time step.
If we approximate this price process with the binomial model (14.1), then the log price
process becomes
( -
ln u with probability q 0 h 2h m D nh
ln S t Ch ln S t D (14.20)
ln d with probability 1 q:

(Notice that (14.1) says that S t Ch =S t D u with probability q. Just take logs to get the
results here.) The binomial process implies that the mean and variance of the asset price Figure 14.4: Two different time steps with same time to expiration m
change are therefore (see Remark 14.1)
Using this on the left hand side of (14.26) gives
E.ln S t Ch ln S t / D q ln u C .1 q/ ln d; (14.21)
p p
Var.ln S t Ch ln S t / D q.1 q/.ln u ln d /2 : (14.22) .h C  h/. h h/ D  2 h 2 h2 : (14.28)

There are three parameters (u; d , and q) which can be chosen to match the two moments
(mean and variance) in (14.19), so we can make one arbitrary choice. The following is a
common approach.
First, for any u and d (not yet decided), pick q to match the mean drift over a time
step of size h (which is h, see (14.19)), that is,
This clearly does not fit the volatility exactly (compare with the right hand side of (14.26)),
but the approximation improves quickly as h decreases (the second order term h2 vanishes
fast). There are other ways to construct the binomial tree, but they have similar properties.
Notice that once we have the values of u and d , the pricing of derivatives does not use
the natural probability of the up state (q).

q ln u C .1 q/ ln d D h; so (14.23)
14.4.2 Multiperiod Trees
h ln d
qD : (14.24)
ln u ln d The binomial model is very useful for numerical calculations of the implied option price.
In such numerical applications, the time to expiry is divided into many small time steps,
Second, pick u and d to match the variance over a time step of size h (which is  h, 2
and it is assumed that the price of the underlying asset can make an up or down movement
see (14.19)), that is,
in each subinterval—and that the no-arbitrage portfolio is rebalanced every time step. Of
q.1 q/.ln u ln d /2 D  2 h: (14.25)
course, the size of the up and down movements (u and d in the previous analysis), as well
Use (14.24) to substitute for q and simplify as the discounting, is scaled by the number of subintervals.
Let m be the time to expiration of the derivative. With n short time intervals, the
.h ln d / .ln u h/ D  2 h: (14.26)
length of each interval is h D m=n. The perhaps most common way to construct the tree
There are several ways to proceed from here, but the most common is approach of Cox, is that of Cox, Ross, and Rubinstein (1979). In short, it implies (from using (14.10) and
Ross, and Rubinstein (1979) where (14.27))
p p p p
u D e h
and d D e  h
: (14.27) u D e h
;d D e  h
; p D .e yh d /=.u d /, and discounting by e yh
: (14.29)

98 99
 Suu fuu
*
 *

 
 
 
 
 
*

S u
H
HH *

fu
H
HH
 H  H
  HH   HH
 H  H
  HH
j   HH
j
SH H
S ud D Sdu fH fud
H *
 HH 
*
HH  HH 
H  H 
HH  HH 
j 
H j
H 
SdHH fd
H
H HH
HH HH
H H
HH HH
j
H j
H
Sd d fdd

Figure 14.5: Binomial tree for underlying asset (n D 2) Figure 14.6: Binomial tree for derivative (n D 2)

Notice that we must keep h small enough so (14.4) holds (to rule arbitrage opportunities), 14.4.3 Using a Binomial Tree for Pricing American Options
that is, p p The binomial tree we have used so far assumes that the derivative is “alive” until the end
e  h > e yh > e  h ; (14.30)
of the period. This is not necessarily the case for American options, so the approach needs
p
which requires h < =y. to be modified to handle the possibility of early exercise.
Figure 14.5 is an illustration of a binomial tree with two subintervals. This tree has The option value is then the maximum of the exercise value and the value if keeping
only three final nodes, since Sud D Sdu—it is “recombining,” which is very useful to the option “alive.” The latter is defined in the same way as in (14.10). Together this gives
keep the number of nodes manageable (when we have many time steps). The correspond- the price of the derivative as
ing prices of the derivative are illustrated in Figure 14.6.
f D max.value if exercised now, e yh
Œpfu C .1 p/ fd /, (14.31)
Example 14.8 (A European call option) For a European call option with strike price K
where p is defined as before (in (14.10)). For instance, for an American put option we
and three months (0.25 years) to expiration, the nodes for two steps (n D 2, so the length
have
of each time interval is 0:25=2 D 1=8 long) in Figure 14.6 are
2 3 f D max.K S, e yh
Œpfu C .1 p/ fd /, where (14.32)
" # fuu D max.Suu K; 0/
y=8
fu D e Œpfuu C .1 p/fud  6 7
f D e y=8 Œpfu C.1 p/fd , , and 4 fud D max.S ud K; 0/ 5 fu D max.K Su; 0/ and fd D max.K Sd; 0/: (14.33)
fd D e y=8 Œpfdu C .1 p/fdd 
fdd D max.Sdd K; 0/
Example 14.9 (An American put option) With an American put option with strike price
where p D .e y=8 d /=.u d /. Notice that the calculation begins at the end (right) and K and six months (0.5 years) to expiration the nodes for two steps (n D 2, so the length
works backwards towards the start of the tree (left). of each time interval is 0:5=2 D 1=4 long) in Figure 14.6, we must account for the
possibility of an early exercise. At each node, the option value is the maximum of the

100 101
value if exercised (K minus the asset price) and the value if kept “alive” (denoted f a American put price, BOPM
below) The latter is the discounted risk-neutral expected value of the option value next
10 American put
period—just like for a European option. We therefore have

Option price
C−S+K
−ym
C − S + e K = PE
f D max.K S; f a /, where f a D e y=4
Œpfu C .1 p/fd  5
K, m, y, and σ are 42 0.5 0.05 0.2
Binomial solution uses 100 time intervals
0
fu D max.K S u; fua /, where fua D e y=4
Œpfuu C .1 p/fud  32 34 36 38 40 42 44 46 48 50 52
Stock price
fd D max.K Sd; fda /, where fda De y=4
Œpfdu C .1 p/fdd 

fuu D max.K S uu; 0/ American put price at higher interest rate, BOPM

fud D max.K S ud; 0/ 10

Option price
fdd D max.K Sdd; 0/;
5
where p D .e y=4 d /=.u d /. As always, the calculation begins at the end and works
y is 0.15
backwards down the tree.
0
32 34 36 38 40 42 44 46 48 50 52
Figure 14.7 illustrates the solution for an American put option on an asset without Stock price
dividends. Notice that the American put price exceeds the European put price—and more
so at low asset prices and high interest rates, that is, when it is likely that the option will Figure 14.7: Numerical solution of an American put price
be exercised early.
Figure 14.8 illustrates the calculations of the American put price for one current value portfolio riskfree the delta must be
of the underlying asset. The shaded areas show the location of the nodes (future prices
fu fd
of the underlying asset) that are used in the calculation—and at which nodes that early
D : (14.34)
Se ıh .u d /
exercise will happen.
Second, to make the return of the portfolio equal to the riskfree rate, we set the present
14.4.4 A Binomial Tree with Continuous Dividends  value of our riskfree portfolio equal to the cost of the portfolio
 
It is straightforward to construct another tree that allows for continuous dividends. e yh
Se ıh u fu D
S f: (14.35)
Suppose dividends are paid at the continuous rate ı. Let the up and down move-
ments in the asset price reflect the ex-dividend price, and assume that any dividends are
reinvested in the stock.
First, to construct a riskfree portfolio, hold
of the underlying asset and 1 of the
derivative. The payoff of the portfolio at expiry is
Se ıh u fu in the “up” state and

Se ıh d fd in the “down” state. The e ıh factor comes from reinvestment. To make the

102 103
 American put, BOPM nodes American put, early exercise Cox, J. C., S. A. Ross, and M. Rubinstein, 1979, “Option pricing: a simplified approach,”
150 150 Journal of Financial Economics, 7, 229–263.
Shaded area: Shaded area:
nodes used in calculation nodes with early exercise
Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann, 2007, Modern portfolio
100 100
Spot price

Spot price
theory and investment analysis, John Wiley and Sons, 7th edn.

50
S 50 Hull, J. C., 2006, Options, futures, and other derivatives, Prentice-Hall, Upper Saddle
t
River, NJ, 6th edn.

0
0 0.1 0.2 0.3 0.4 0.5
0
0 0.1 0.2 0.3 0.4 0.5
McDonald, R. L., 2006, Derivatives markets, Addison-Wesley, 2nd edn.
Time interval, m Time interval, m

S, K, m, y, and σ are 42 42 0.5 0.05 0.2

Binomial solution uses 100 time intervals

Figure 14.8: Numerical solution of an American put price

Use (14.34) and rearrange as

 
f D
S 1 e .ı y/h
u Ce fu yh
(14.36)
fu fd  
D ıh 1 e .ı y/h
u Ce yh
fu (14.37)
e .u d /
yh e .y ı/h d
De Œpfu C .1 p/ fd  with p D : (14.38)
u d
With this new definition of p, the rest of the computations are as in the case without
dividends. In particular, the drift of the asset price does not matter, so u and d can be
chosen as before, for instance, as in (14.27).

Remark 14.10 (Risk neutral drift with continuous dividends) With continuous dividends,
the risk-neutral expected value is Ept S t Ch =S t D e .y ı/h , so the drift is .y ı/h over the
short time interval h.

Bibliography
Cochrane, J. H., 2001, Asset pricing, Princeton University Press, Princeton, New Jersey.

104 105
 BS call, S varies BS call, K varies BS call, σ varies
15 15
6

15 The Black-Scholes Model and the Distribution of As- 10 10

4

set Prices 5 5 2

0 0 0
Main references: Elton, Gruber, Brown, and Goetzmann (2007) 23 and Hull (2006) 13–15 30 40 50 60 30 40 50 60 0 0.2 0.4
Additional references: McDonald (2006) 9–13; Cochrane (2001) 17–18; Cox, Ross, and Asset price Strike price Standard deviation

Rubinstein (1979)

BS call, m varies BS call, y varies The base case has

15.1 The Black-Scholes Model S, K, m, y, and σ:
6 6
42 42 0.5 0.05 0.2
15.1.1 The Basic Black-Scholes Model without Dividends 4 4

Assume that the change over a short interval (between t and t C h) in the log asset price 2 2
is an iid process
0 0
0 0.2 0.4 0 0.05 0.1
ln S t Ch ln S t D h C " t Ch ; with " t Ch  i id N .0;  2 h/: (15.1) Expiration Interest rate

This implies that, based on the information in period 0, the logarithm of the stock price in
period m, Sm , is normally distributed Figure 15.1: Call option price, Black-Scholes model

ln Sm  N .ln S C m;  2 m/; (15.2) In this formula, ˚.d / denotes the probability of x  d when x has an N.0; 1/ distribution
(that is, the distribution function value at d ).
where S is the current asset price (the subscript is dropped to reduce clutter). For instance,
if there is no volatility ( 2 D 0), then Sm D e m S . If we take the proper limit as the 15.1.2 The Black-Scholes Model with Dividends
time interval h goes towards zero, then we have a Brownian motion for the log asset price
(d ln S t D dt C d W t , where d W t are the increments to a Wiener process). Consider a European option on an underlying asset that pays (continuous or discrete)
A hedging/no arbitrage argument similar to the binomial model then leads to the dividends before expiration. Then, the Black-Scholes formula is not correct. It may seem
Black-Scholes formula (for an asset without dividends) where the European call option as if dividends would just affect the mean drift in (15.1), and therefore not affect the
price is option price—but this is wrong. The basic reason is that buying the underlying asset now
is different from knowing that you will get the asset at the expiration of the option, since
ym
C D S˚ .d1 / K˚ .d2 / , where
e (15.3) you get the dividends if you hold the asset.


ln.S=K/ C y C  2 =2 m p In contrast, we could apply the BS formula on a forward contract (expiring on the
d1 D p and d2 D d1  m: (15.4)
 m same day as the option) instead. Let a prepaid forward contract (present value of forward

106 107
price), worth e y m F , play the role of the underlying asset in (15.1). This gives the BS Remark 15.5 (Practical hint: finding the dividend rate) If you don’t know what the
formula (15.3)–(15.4) but with e y m F substituted for S dividend rate is, use the forward-spot parity, F D Se .y ı/m , to calculate it as ı D
y ln.F=S /=m.
ym ym
C De F ˚ .d1 / e K˚ .d2 / , where (15.5)
ln.F=K/ C . =2/m 2 p Remark 15.6 (The “greeks”) The derivates of the Blac-Scholes formula for an asset with
d1 D p and d2 D d1  m: (15.6)
 m continous dividends (15.7)–(15.8) are

This is Black’s model which has many applications. @C

D D e ım ˚ .d1 /
@S
Remark 15.1 (Approximation of option price) A Taylor approximation gives that the call @2 C e ı m  .d1 /
p D D p
option price close to F D K and  D 0 is C  e y m F  m=.2/. @S 2 S m
@C @C 1
D D D ıS ı m ˚.d1 / yKe ym
˚.d2 / p e ım
S.d1 /
Remark 15.2 (Practical hint: code for Black’s model with a forward price) Suppose you @t @m 2 m
have a computer code for the BS model (15.3)—(15.4) which takes the inputs .S; K; y; m;  /. @C p
vega D D Se ım  .d1 / m
To use that code for Black’s model (15.5)–(15.6), substitute (F; 0) for (S; y) and multiply @
@C
the results by e y m . D D mKe y m ˚.d2 /;
@y
Remark 15.3 (Black-Scholes formula when  D 0 or m D 0) From (15.6) lim !0 d1 D where ./ is the standard normal probability density function (the derivative of ˚./).
lim !0 d2 D 1 if F > K and 1 otherwise. Therefore, lim !0 ˚ .d1 / D lim !0 ˚ .d2 / D
0 if F < K and 1 otherwise. The call option price is therefore 0 if F < K and 15.1.3 Implied Volatility: A Measure of Market Uncertainty
e y m .F K/ otherwise. The same applies to the case m D 0. These results are clearly
The Black-Scholes formula contains only one unknown parameter: the variance  2 m in
correct, since in either case the payoff is known so the price (present value) must be
the distribution of ln Sm (see 15.2). With data on the option price, spot and forward prices,
e y m max.0; F K/.
the interest rate, and the strike price, we can solve for the variance. The term  is often
For instance, for an asset with a continuous dividend rate of ı, the forward-spot parity called the implied volatility—and it is often used as an indicator of market uncertainty
says F D Se .y ı/m . In this case (15.5)–(15.6) can also be written about the future asset price, Sm . It can be thought of as an annualized (provided a period
is defined as a year) standard deviation. See Figure 15.2 for an example.
ım ym
C De S˚ .d1 / e K˚ .d2 / , where (15.7) Note that we can solve for one implied volatility for each available strike price. If the
ln.S=K/ C .y ı C  =2/m 2 p Black-Scholes formula is correct, that is, if the assumption in (15.1) is correct, then these
d1 D p and d2 D d1  m: (15.8)
 m volatilities should be the same across strike prices. On currency markets, we often find
When the asset is a currency (read: foreign money market account) and ı is the foreign a volatility “smile” (volatility is a U-shaped function of the strike price). One possible
interest rate, then this is the “Garman-Kolhagen” formula. explanation is that the (perceived) distribution of the future asset price has relatively more
probability mass in the tails (“fat tails”) than a normal distribution has. On equity markets,
Remark 15.4 (Practical hint: code for BS model with continuous dividends) Suppose we often find a volatility “smirk” instead, where the volatility is very high for very low
you have a computer code for the BS model (15.3)—(15.4) which takes the inputs .S; K; y; m;  /. strike prices. This is often interpreted as that investors are willing to pay a lot for put
To use that code for Black’s model (15.5)–(15.6), substitute e ı m S for S . options that protect them from a dramatic fall in the stock price. One possible explanation

108 109
 CBOE volatility index (VIX) Implied volatility, SMI option
Kuwait Stock market crash LTCM/Russia pharma Higher rates Lehman 1
80 Gulf war Asia 9/11 Iraq sub prime 2009−07−14
2009−08−14
0.8
70

60 0.6

50 0.4

40
0.2
30
0
20 3000 4000 5000 6000 7000 8000
Strike price
10
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Figure 15.3: Implied volatilities of SMI options, selected dates

Figure 15.2: CBOE VIX, summary measure of implied volatities (30 days) on US stock For the Black-Scholes model, the normal distribution for the log asset price (15.2)
markets
implies that the risk neutral distribution of ln Sm is
is thus that the distribution has more probability mass than a normal distribution at very
ln Sm  N .ln S C y m  2 m=2;  2 m/: (15.10)
low stock prices (negative skewness). See Figure 15.3 for an example.
This gives
Remark 15.7 (Starting value for finding ) From Remark 15.1 we get a starting guess E Sm D S y m D F; (15.11)
p
of   C =Œe y m F m=.2/. Alternatively, it is often recommended to use the starting
p which equals the forward price (the mean of a risk neutral distribution) and the same
value  D jln.F=K/j 2=m.
variance as in the true (natural) distribution.
Proof. (that (15.11) has a mean equal to the forward rate) Recall that EŒexp.x/ D
15.2 Convergence of the BOPM to Black-Scholes exp.Cs 2 =2/, if x  N.; s 2 /. Applying on the distribution in (15.10) gives E Œexp.ln Sm / D
This section demonstrates that the option prices from the BOPM converges to the prices exp.ln S C y m/ D S y m , which equals the forward price (by the forward-spot parity).
from the Black-Scholes model. See Figure 15.4 for an illustration. For the binomial option pricing model (BOPM) we have that, in the risk neutral bino-
We know that the risk neutral pricing of a European call option is mial tree, the movements of the log price of the underlying asset are
(
ln u with probability p
C De ym
E max.0; Sm K/; (15.9) ln S t Ch =S t D (15.12)
ln d with probability 1 p:
where E denotes the expectation according to the risk neutral distribution.
(In the risk neutral binomial tree since S t Ch D S t u with probability p and S t d other-

110 111
 European call option price, binomial solution Pdf, normal and binomial (n=5) Pdf, normal and binomial (n=10)
3.5 3 3
S, K, m, y, and σ: 42 42 0.5 0.05 0.2 Binomial
Black−Scholes 2 2
3
1 1

2.5 0 0
0 5 10 15 20 25 30 35 40 45 50 3.2 3.4 3.6 3.8 4 4.2 3.2 3.4 3.6 3.8 4 4.2
n (no. steps in binomial model) Log asset price Log asset price

Figure 15.4: Convergence of the binomial price to the Black-Scholes price Pdf, normal and binomial (n=25) Pdf, normal and binomial (n=50)
3 3
wise.) The parameters u; d and p all depend on the time step length h in such a way
2 2
that we match the mean and variance of the price series. In fact, if they are chosen so that
the mean and variance of ln S t Ch =S t are (at least in the limit) proportional to h. The risk 1 1
neutral distribution is clearly a binomial distribution.
I demonstrate the convergence in two steps: first, that the binomial distribution con- 0
3.2 3.4 3.6 3.8 4 4.2
0
3.2 3.4 3.6 3.8 4 4.2
verges to a normal distribution; and second that both distributions have the same mean Log asset price Log asset price
and variance in the limit.
Figure 15.5: Convergence of the binomial model to the Black-Scholes model
15.2.1 The Central Limit Theorem at Work

If we can show that the risk neutral distribution implied by the binomial model converges Proposition 15.8 If u; d and p in the binomial process (15.12) are such that the mean
(as the number of time steps increase, keeping time to expiration constant) to a normal and variance of ln S tCh =S t are proportional to h, then the distribution converges to a nor-
distribution, then it is plausible that the Black-Scholes model can be thought of as the mal distribution as the number of time steps n increases, keeping the maturity m constant
limit of the binomial model. (so h D m=n).
The Black-Scholes model is based on normally distributed changes of log prices. In Remark 15.9 (The Lindeberg-Lévy central limit theorem) If xi is independently and iden-
the binomial model, the log price changes can only take two values, but the sum of many tically distributed with E xi D  and Var.xi / D  < 1, then,
such changes will converge to a normally distributed variable as the number of time steps
p 1 Pn P p d
increases (but the step size decreases). This may seem counter intuitive since central n .xi / D niD1 .xi /= n ! N.0;  2 /:
n i D1
limit theorems apply to samples averages (time the square root of the sample size), not Proof. (of Proposition 15.8) The binomial model (15.12) means that we can write the
to sums. However, the rescaling of the log price changes as the number of time steps p
de-meaned log price change over a time step of length as "i h, where "i is an iid zero
increases, means that the sum is effectively a (scaled) sample average—so a CLT indeed mean random variable with variance  2
applies.
p
See Figure 15.5 for an example of how the distribution converges. "i h D ln S t Cih =S t C.i 1/h E ln S t Cih =S t C.i 1/h , where E "i D 0 and Var."{O / D  2 :

112 113
 p
For instance, the for the first time interval we have "1 h D ln S t Ch =S t . Since we take Mean of log asset price changes, annualized
n steps (of length h D m=n) to get from from t to t C m, we can write the de-meaned
p S, K, m, y, and σ: 42 42 0.5 0.05 0.2 Binomial
change in the log price (from t to t C m) as the sum of h"i from i D 1 to n Black−Scholes
p Pn 0.03
ln S t Cm = ln S t E ln S t Cm =S t D
h i D1 "i
p P p
D m niD1 "i = n;
p 0.0295
p 0 5 10 15 20 25 30 35 40 45 50
where we have used h D m=n. This is of the same form (except the constant m) as n (no. steps in binomial model)
in the central limit theorem in Remark 15.9.

15.2.2 Convergence of the Mean and Variance Variance of log asset price changes, annualized
0.0405
This section demonstrates that the mean and variance of the binomial distribution con-
verges to the same values as in the risk neutral distribution of the Black-Scholes model
0.04
(15.10). This would be trivial if u; d and p in the binomial process (15.12) were cali-
brated to always (for any n) give the same mean and variance of the log price changes.
In practice, most ways to calibrate the BOPM parameters only satisfy this in the limit. In 0.0395
0 5 10 15 20 25 30 35 40 45 50
particular, that is the case for the CRR tree, which is the focus of this section. n (no. steps in binomial model)
See Figure 15.6 for an illustration.

Proposition 15.10 (Moments of CRR steps) In the Cox, Ross, and Rubinstein (1979) tree, Figure 15.6: Convergence of the binomial mean and variance
the parameters in (15.12) are
p p 15.3 The Probabilities in the BOPM and Black-Scholes Model
ln u D  h; ln d D  h and p D .e yh d /=.u d /:
The price of a European (call or put) option calculated by the binomial model converges
As n ! 1, but h D m=n we have (since the price changes are independent) the following to the Black-Scholes price as the number of subintervals increases (keeping the time to
results for the sum of them expiration constant, so the subintervals become shorter). This is illustrated in Figure 15.4.
Both the binomial option pricing model (BOPM) and the Black-Scholes model imply
E ln S t Cm =S t D m.y  2 =2/ and Var.ln S t Cm =S t / D m 2 :
that the call option price can be written as the discounted risk neutral expected payoff
This the same as in the risk neutral distribution of the Black-Scholes model. (15.9), which we can write as
Z 1
Proof. (of Proposition 15.10) Both the mean and the variance (of the sum) scales lin- C D e ym .Sm K/ f  .Sm /dSm ; (15.13)
early with the number of terms (since the terms are uncorrelated). The mean and variance K

of ln S t Ch =S t are p ln u C .1 p/ ln d and p.1 p/.ln u ln d /2 . Substitute for u; d and 

where f .Sm / is the risk neutral density function of the asset price at expiration (Sm ).
p and take the limits of n E ln S tCh =S t and n Var.ln S t Ch =S t / as n ! 1, but h D m=n.
(This is straightforward, but slightly messy, calculus.)

114 115
 p2 Cuu
*

 
*
 
 

p  
H Cu
H
*
 HH *
 HH
 H  H
  HH
H    HH
H
  HH
j   HH
j
SH p.1 p/ C .1 p/p D 2p.1 p/ CH Cud
H H 
* H H 
*
HH  HH  
H  H 
HH 1 p  HH 
j
H  j
H 

HH Cd
H
H HH
HH HH
H H
HH HH
j
H j
H
.1 p/2 Cd d

Figure 15.7: Probabilities of different nodes in a binomial tree Figure 15.8: Binomial tree for derivative (n D 2)

We can clearly rewrite this expression as in the next period

2 3
" # Cuu D max.Suu
C De ym
E .Sm KjSm > K/ Pr .Sm > K/ (15.14) Cu D e yh
ŒpCuu C .1 p/Cud 
K; 0/
yh 6 7
C De ŒpCu C.1 p/Cd , , and 4 Cud D max.Sud K; 0/ 5
De ym
E .Sm jSm > K/ Pr .Sm > K/ e ym
K Pr .Sm > K/ : (15.15) Cd D e yh
ŒpCdu C .1 p/Cdd 
Cdd D max.Sdd K; 0/
The first term is (the present value of) the expected asset price conditional on exercise, (15.16)
times the probability of exercise. The second term is (the present value of) the strike price where p D .e y= h d /=.u d /.
times the probability of exercise.
Remark 15.11 (Probabilities for the final nodes) With two trials (n D 2), the probabili-
The discussion below demonstrates that these probabilities are the same (in the limit)
ties for the final nodes are
in the BOPM and the Black-Scholes models.
Pr.uu/ D p 2

15.3.1 The Probabilities in the Binomial Tree Pr.ud / D 2p.1 p/
To understand the binomial model a bit better, consider a binomial tree with 2 subintervals Pr.dd / D .1 p/2 :
(n D 2) of length h as illustrated in Figures 15.7–15.8.
Combining (and using 2h D m)
The price of the call option is the discounted risk neutral expected value of the value
ym
 2 
C De p max.Suu K; 0/ C 2p.1 p/ max.Sud p/2 max.Sdd
K; 0/ C .1 K; 0/ ;
(15.17)
which expresses the call option price as the discounted risk-neutral expectation of the
option payoff.

116 117
 Suppose only Suu > K, that is, it is only at the up and up branch, uu, that we Proof. (of Proposition 15.14) The risk neutral probability of ln Sm is N.ln S C y m
exercise. Then  2 m=2;  2 m/. To calculate the probability PrŒSm > K D ˚. k0 /, notice that k0 is
mean
C De ym
p 2 .S uu K/ ‚ …„ ƒ

ln K ln S C y m  2 m=2
De ym
S uu
„ƒ‚… p2 e ym
K p2 : (15.18) k0 D p :
„ƒ‚… „ƒ‚…  m
Ep .Sm jSm >K/Prp .uu/ Prp .uu/ „ƒ‚…
std

The first term is the (discounted value of) the risk-neutral expected value of the asset price,
Clearly, k0 is then the same as the argument d2 in (15.4)
conditional on being so high that we exercise the call option, times the risk neutral prob-

ability of that event. The second term is the (discounted value of) the strike price times ln.S=K/ C y  2 =2 m
d2 D p :
the risk neutral probability of exercise. This clearly has the same form as (15.15). This  m
extends to n steps, except that the expressions for the probabilities are more complicated.
Proof. (of Proposition 15.15) First, the first term in (15.15) can be written
Remark 15.12 (Bernoulli and binomial distributions) The random variable X can only
ym


take two values: 1 or 0, with probability p and 1 p respectively. This gives E.X / D p F i rst T erm D e exp  C s 2 =2 ˚.s k0 /;
and Var.X/ D p.1 p/. After n independent trials, the number of successes (y) has the
since the two ˚. k0 / terms cancel. Clearly,
binomial pdf, nŠ=ŒyŠ.n y/Šp y .1 p/n y for y D 0; 1; :::; n. This gives E.Y / D np
and Var.Y / D np.1 p/. To find the probability of at least z successes, sum the pdf over  C s 2 =2 D ln S C y m;
y D z; z C 1; z C 2; : : :

p ln K ln S C y m  2 m=2
s k0 D  m p D d1 ;
 m

15.3.2 The Probabilities in the Black-Scholes Model
where the last line follows from comparing with (15.4). We can therefore write F irstT erm
The following remark is useful for the proofs further on. as S˚.d1 /, since the e y m e y m term cancels. This is the same as in the Black-Scholes for-
mula.
Remark 15.13 (Properties of a lognormal distribution) Let x  N.; s 2 / and define
k0 D .ln K / =s. First, PrŒexp.x/ > K D ˚. k0 /. Second, EŒexp.x/j exp.x/ >

15.4 Hedging an Option
K D exp  C s 2 =2 ˚.s k0 /=˚. k0 /. (To prove this, just integrate.)

Proposition 15.14 (Riskneutral probability of Sm > K) The ˚ .d2 / term in the Black- This section discusses how we can hedge a European call option. The setting might be
Scholes formula (15.3)–(15.4) is the risk-neutral probability that Sm > K. that we have written such an option, but we do not want to carry the risk.

Proposition 15.15 (S˚ .d1 / in Black-Scholes) The S ˚ .d1 / term in the Black-Scholes 15.4.1 Delta Hedging
formula (15.3)–(15.4) is (the present value of) the expected asset price conditional on
Consider a portfolio with h t of the underlying asset (the hedging portfolio) and short one
exercise, times the probability of exercise, that is, the first term in (15.15).
call option. The value of the overall position is

Vt D ht St Ct : (15.19)

118 119
 Probability of exercise Delta, ∂C/∂S Gamma, ∂2C/∂S2 Theta, ∂C/∂m
1
Binomial 0.06
Black−Scholes 0.8 −1
0.5 0.6 0.04
−2
0.4
0.02
0.2 −3
0
0 5 10 15 20 25 30 35 40 45 50 30 40 50 60 30 40 50 60 30 40 50 60
n (no. steps in binomial model) Asset price Asset price Asset price

Expected asset value, conditional on exercise Rho, ∂C/∂r Vega, ∂C/∂σ Properties of BS call
50 option price formula
20
10
48 15 S, K, m, y, and σ:
8
6 42 42 0.5 0.05 0.2
10
46 4
5
2
44
0 5 10 15 20 25 30 35 40 45 50 30 40 50 60 30 40 50 60
n (no. steps in binomial model) Asset price Asset price

Figure 15.9: Convergence of the binomial model to the Black-Scholes model Figure 15.10: The Greeks (in the Black-Scholes model)

Assume that only the price of the underlying asset can change (clearly not true, but In the Black-Scholes model for an asset with dividends, the delta is
at least a starting point for the analysis). A first-order Taylor approximation of the call
@C ım
option price is
D De ˚ .d1 / ; (15.22)
@C t @S
C t Ch C t 
t .S t Ch S t / ; where
t D : (15.20)
@S where d1 is given by (15.8). Without dividends, just set ı D 0. From the put-call partity,
Use (15.20) to approximate the change of the value of the overall portfolio as it is clear that the delta of a put option is

V t Ch V t D h t .S t Ch St / C tCh Ct @P ım ım
De Œ˚ .d1 / 1 D e ˚ . d1 / ; (15.23)
@S
 h t .S t Ch St /
t .S t Ch St /
which is negative (the second equality follows from the symmetry of the normal distribu-
 0 if h t D
t : (15.21)
tion.
This is a delta hedge. Clearly, the delta is likely to change from period to period, so the Proof. (of (15.22)) From (15.7)–(15.8) we have @C@S
@
D e ı m ˚ .d1 /Ce ı m S @S ˚ .d1 /
portfolio needs to be frequently rebalanced. e ym
K @S ˚ .d2 /, but it straightforward to show that the last two terms cancel. The key
@

to that proof is to note that ˚ 0 .d1 / D ˚ 0 .d2 / K=F . To demonstrate that, recall that

120 121
 Delta, SMI call, 5500 SMI futures where B t is the amount held in the riskfree asset. In t C h (say, after one day), this
1 6500 portfolio is worth (assuming no dividends)
6000
V t Ch D
t S t Ch e ıh C t Ch C B t e yt h ;
0.5 5500

5000 where the underlying pays continuous dividends at the rate ı (ı D 0 if no dividends),
0 4500
the prices are measured after dividends and y t is the interest rate. After rebalancing in
May Jun Jul Aug Sep Oct May Jun Jul Aug Sep Oct t C h, we need
t Ch units of the underlying assetand we are still short one option—and
the balance is invested in the short term bill,

B t Ch D V t Ch
t Ch S t Ch C C t Ch ;
Daily change of C and hedge portfolio Value of C and hedge portfolio
150
Option
1000
Option which is very similar to the first equation. Clearly, the value of the portfolio in t C 2h is
100
Hedge Hedge computed as in the second equation, but with subscripts advanced one period.
50
500
0
15.4.2 Delta Hedging an Option on a Forward Contract
−50
0
−100 When the underlying is a forward contract as in Black’s model (15.5)–(15.6), the sensi-
May Jun Jul Aug Sep Oct May Jun Jul Aug Sep Oct
tivity of the call option price to the forward price is

@C ym

t D De ˚ .d1 / ; (15.24)
Figure 15.11: Delta hedging an SMI call option @F
where d1 is given by (15.6). The sensitivity of a put option is
˚ 0 .d1 / D p12 exp. d12 =2/.
@C ym ym
See 15.10 for an illustration of the “Greeks” in the B-S model and Figure 15.11 for an De Œ˚ .d1 / 1 D e ˚ . d1 / : (15.25)
@F
example of how a delta hedge works on real data.
Proof. (of (15.24)) Similar to the proof of (15.22).
Clearly, 0 
 1 and increasing in the price of the underlying asset. Intuitively, an
option that is deep out of the money will not be very sensitive to the asset price—since
15.4.3 Delta-Gamma Hedging
the chance of exercising is so low. Conversely, an option that is deep in the money moves
almost in tandem with the asset price, since it will almost for sure be exercised. Delta hedging can be imprecise if the price of the underlying asset changes much. A
In practice, the hedging portfolio also includes a small position in a short-term money second-order Taylor approximation of the option price gives
market account—to the overall portfolio have a zero value (at least initially).
1 @2 C t
@C t

C t Ch C t 
t .S t Ch St / C t .S t Ch S t /2 , where
t D : and t D
Example 15.16 (Overall portfolio value over several subperiods ) Start by creating a 2 @S 2@S
(15.26)
hedge portfolio with a zero initial value
This movement can be hedged by holding v t of the underlying asset and w t of other
0 D
t St C t C B t , so B t D 0
t St C Ct ; option. Let
t and t be the delta and gamma of this other option. A second-order

122 123
Taylor approximation of the value of this portfolio (denoted U t ) is 15.5 Options on Currencies and Interest Rates
1
U t Ch U t  v t .S t Ch S t / C w t
t .S t Ch St / C wt t

.S t Ch S t /2 : (15.27) 15.5.1 FX Options: Put or Call?
2
Subtracting (15.26) from (15.27) Buying one currency entails selling another. It should therefore come as no surprise that
a call option on a currency is also a put option on the other currency. To be precise, the


1
.U t Ch U t / .C t Ch C t /  v t C w t
t
t .S t Ch S t /C w t t t .S t Ch S t /2 : option prices are related according to
„ ƒ‚ … „ ƒ‚ …2
At Bt
(15.28) Cd .strike D K/ D S t KPf .strike D 1=K/: (15.31)
By first choosing w t to make the B t term zero and then v t to make the A t term zero, we
On the left hand side, Cd is the domestic price of a call option on the foreign currency—
get a hedge. This clearly gives
with the strike price (K) is expressed in the domestic currency. On the right hand side, S t
wt D 
t= t , and (15.29) is the current exchange rate (domestic price of one unit of the foreign currency), and Pf


is the foreign price of a put option on the domestic currency—with the strike price (1=K).
vt D
t t= t
t : (15.30)
Example 15.19 Let Cd D £0:01 for an option on US dollars and the strike price is
Example 15.17 (Delta-gamma hedging) Suppose .
t ; t / D .0:5; 0:07/ and .
t ; t / D £0.6 (to get one dollar). If the current exchange rate is £0.58 (per dollar), then the
.0:3; 0:03/, then B t D w t 0:03 0:07 D 0 requires w t D 2:33 and A t D v t C2:330:3 dollar price of a put option on GBP with a strike price of 1=0:6 dollars per GBP is
0:5 D 0 requires v t D 0:2. Clearly, this is quite different from a delta hedge (which 0:01=.0:58  0:6/ D $0:0287:
has v t D 0:5 and w t D 0). Here, the lower sensitivity (gamma) of the second option to
Proof. (of (15.31)) The payoff of a call option (denominated in the domestic currency)
the quadratic term, means that the hedge portfolio includes a lot of the second option. As
on foreign currency with strike price K is
a consquence, it becomes overexposed to the linear term, which is compensated for by a
short position in the underlying asset. max.0; S tCm K/;

Proposition 15.18 ( in Black-Scholes) In the Black-Scholes model for an asset with where K is the strike price and S t Cm is the exchange rate at expiration—both expressed
dividends, the gamma is as the domestic price of one unit of foreign currency (for instance, GBP 0.6 per USD).
@2 C ım 1 @˚ .d1 / The payoff is clearly expressed in the domestic currency. In contrast, the payoff of a put

D De p :
@S 2 S m @d1 option (denominated in the foreign currency) on the domestic currency (with strike price
1=K) has the payoff
where d1 is given by (15.7). Without dividends, just set ı D 0. Clearly, @˚ .d1 / =@d1 is
max.0; 1=K 1=S t Cm /;
the probability density function (at d1 ) of a N.0; 1/ variable.
which is clearly expressed in the foreign currency. Notice that both options are exercised
Proof. (of Proposition 15.18) Just differentiate delta. when S t Cm > K. In fact, these options are identical, except for a scaling factor and
the currency denomination. To see that, consider buying K of the foreign denominated
options and then convert the payoff to the domestic currency (multiply by S tCm )

S t Cm K max.0; 1=K 1=S t Cm / D max.0; S t Cm K/;

124 125
which is clearly the same as for the first option. For that reason, buying K of the for- an increase in the underlying—so it captures skewness.
eign currency denominated put options should have the same price (when measured in A 25-delta strangle has a long position the 25-delta call and also in the 25-delta put.
domestic currency—multiply by S t ) as the domestically denominated call option. It is typically quoted as heir average implied volatility minus the at-the-money volatility
and is therefore also called a butterfly
15.5.2 FX Options: Risk Reversals and Strangles 2 C 1
bf D atm : (15.35)
Options on the FX (exchange rate) markets are often sold (on the OTC market) as special 2
portfolios (consisting of straddles, risk-reversals and strangles) and quoted in terms of (A butterfly is a long position in a strangle and a short position in a straddle, so it looks
the implied volatilities. Apart from these conventions, options on exchange rates are similar to bf —which is just a convention for quoting a price of a strangle or sometimes a
no different from options on other assets (but, remember that currencies typically carry butterfly.) An increase in bf signals a belief in fatter tails, so it captures kurtosis. Notice
“dividends” since holding a currency in practice means holding a money market account that a proportional increase of all volatilities does not change bf (it is “vega” neutral).
in that currency). With the quotes on the risk reversal (15.34) and the butterfly (15.35), we can solve for
A delta-neutral straddle (in terms of the forward contract), that is, a long position in the implied volatilities 1 and 2 as
a call and also in a put. To make it delta-neutral, we need
1 D bf C atm rr=2
@C @P
C D 0; (15.32) 2 D bf C atm C rr=2: (15.36)
@F @F
which from (15.22)–(15.23) and (15.5)–(15.6) gives (using F D Se .y ı/m
) It is straightforward to invert the formulas for the deltas to derive what the strike
prices are. If we use the convention that the deltas are with respect to the spot price, then
2 =2
d1 D 0, that is, Katm D F e m : (15.33) by setting @C =@S D 0:25 in (15.22) and @P =@S D 0:25 in (15.23) give the following
strike prices (using F D Se .y ı/m )
This straddle is typically quoted in terms of the implied volatility (atm ) of an option at
Kat m . A higher value of the straddle indicates more overall uncertainty. p
K2 D F expŒ 2 m˚ 1 .e ı m 0:25/ C m22 =2
See Figure 15.12 for illustrations. p
K1 D F expŒ1 m˚ 1 .e ı m 0:25/ C m12 =2; (15.37)
A 25-delta risk reversal is a portfolio of one call option with a strike price K2 such
that the delta is 0:25 and short one put option with a strike price K1 such that the delta where ı equals the foreign interest rate. Clearly, by changing 0.25 to x, we get the results
is 0:25. Both options are out of the money so the strike price for the put is lower than for a x-delta risk reversal instead.
the forward price, which in turn is lower than the strike price of the call (K1 < F < K2 ). See Figure 15.13 for an empirical illustration.
The risk reversal is typically quoted as the difference of the two implied volatilities
15.5.3 Interest Rate Options: Caps and Floors
rr D 2 1 ; (15.34)
Options on bonds are basically no different from options on equity, especially since bonds
where 2 and 1 are the implied volatilities of the options with strike prices K2 and K1 typically pay coupons (“dividends”). For instance, a call option on a bond gives the right
respectively (notice that, by the put-call parity, a put and a call with the same strike price to buy the bond (at the expiration of the option) at the strike price.
have the same implied volatility). A higher value of the risk reversal indicates beliefs of Options on interest rates are also very similar, but often have a more complicated

126 127
 Straddle (atm), C(K=F) + P(K=F) Risk reversal, C(K ) − P(K ) atm straddle, iv quote 25−delta risk reversal, iv quote
2 1
DM/GBP options, 1992
15 0
Call(K) Call(K)
Put(K) −Put(K) −1
Straddle Risk reversal 10
−2
0 0 5
−3
0
Apr Jul Oct Apr Jul Oct
K1 Katm K2 K1 Katm K2

Underlying price Underlying price

Strangle, C(K2) + P(K1) Butterfly, iv quote iv, deviation from ivatm

Butterfly, strangle − straddle
2
0.03 low strike
Call(K) Strangle 1.5
Put(K) −Straddle high strike
0.02
Strangle Butterfly 1
0.01
0 0 0.5
0
0
Apr Jul Oct Apr Jul Oct
K1 Katm K2 K1 Katm K2

Underlying price Underlying price

Figure 15.13: DM/GDP options, 1992

Figure 15.12: Option portfolios on FX market

value
maxŒ0; m.Z t Cs ZK /
: (15.39)
structure. A caplet is a call option that protects against higher interest rates (typically a 1 C mZ tCs
floating 3-month market rate or similar). Let Z tCs be the (annualized) market interest The payoff in (15.39) can be rewritten as
rate for a loan between t C s and t C s C m and let ZK be the (annualized) cap rate. The  
1
payoff in t C s C m (notice: paid at the end of the borrowing period) is .1 C mZK / max 0; B t Cs .m/ (15.40)
1 C mZK
maxŒ0; m.Z t Cs ZK /: (15.38) Notice that the max./ term defines the payoff of a put option on an m-period bond in
t C s (whose value turns out to be B t Cs .m/ D 1=.1 C mZ tCs /)—with a strike price of of
The second term is the interest rate cost for a loan (with a face value of unity) between
1=.1 C mZK /. The caplet is therefore proportional to a put option on a bond.
t C s and t C s C m according to the market rate minus the same cost according to the
cap rate. Clearly, buying such an option is a way to make sure that interest rate paid on a
future loan will not exceed the cap rate. If settled at t C s the payoff is just the discounted

128 129
 Proof. (of (15.40)) Multiply and divide (15.39) by .1 C mZK / and rearrange and the last payment is done on the the maturity date S C n. Therefore, the tenors are
  ŒS Cm; S C2m, ŒS C2m; S C3m and so forth until the last one which is ŒS Cn m; S Cn
mZ t Cs mZK
.1 C mZK / max 0; so there are n=m 1 caplets. (The start/end of a tenor is called a reset/settlement date.)
.1 C mZ t Cs / .1 C mZK /
  For instance, a 1-year cap, starting 6 months from now, on the 3-month Libor consists of
1 1
D .1 C mZK / max 0; :
1 C mZK 1 C mZ t Cs 3 caplets. See Figure 15.14 for an illustration.
If we apply the same volatility to all caplets (“flat volatilities”), then the price of a cap
Notice that B t Cs .m/ D 1=.1 C mZ t Cs /.
(according to the Black-Scholes model) starting in S ending in S C n, so the last caplet
We can apply the Black’s formula (15.5)–(15.6) to price the caplet by assuming that a
starts in S C n m. The value of the cap is therefore
forward contract on either Z tCs or (somewhat less often) B t Cs has a lognormal distribu-
Xn=m
tion. (These two assumptions are not compatible, since the latter is the same as assuming Cap.S; n; mI ; ZK / D
1
Caplet.S C i m; mI ; ZK /: (15.43)
i D1
that 1 C mZ tCs has a lognormal distribution.)
Caps are often quoted in terms of the implied volatility ( ) that solves this equation—
Remark 15.20 (Simple interest rates) If Z is a simple interest rates, then of a zero- meaning that there is one implied volatility per cap contract, but it may differ across cap
coupon bond that gives unity at maturity is rates (“strike prices”) and maturities.
1 1=B .m/ 1
B .m/ D , or Z.m/ D : Example 15.21 (1-year Cap starting 6 months ahead, 3-month tenors) Let n D 1, m D
1 C mZ.m/ m
1=4 S D 1=2. The payoffs are based on the difference between the 3-month Libor and
A simple forward rate for the period s to s C m periods in the fture is defined as
the cap rate at the beginning of the tenors (3=4; 1; 5=4), but are paid one quarter (1=4)
 
1 B.s/ later. Equation (15.43) is therefore
Z f .s; s C m/ D 1 :
m B.s C m/
Cap.2=4; 6=4; 1=4I ; ZK / D Caplet.3=4; 1=4I ; ZK /CCaplet.1; 1=4I ; ZK /CCaplet.5=4; 1=4I ; ZK /:
A forward rate (determined t ) for the future investment period t C s to t C s C m,
denoted Z f , clearly coincides with the market rate in t C s. We can therefore apply Clearly, the first caplet starts in S D 2=4 C 1=4 D 3=4 and the last starts in S C .n=m
Black’s formula to the underlying mZ f by assuming that it is lognormally distributed— 1/m D 2=4 C 1 1=4 D 5=4.
and using the strike “price” mZK . However, we need to discount by expŒ .s C m/y
instead of exp. sy/ since the payoff (15.38) is paid in t C s C m (not in t C s). The value Floorlets and floors are similar to caplets and caps, except that they pays off when the
of this caplet is therefore interest goes below the cap rate.

Caplet.s; mI ; ZK / D me .sCm/y
ŒZ f ˚ .d1 / ZK ˚ .d2 /, where (15.41)
15.6 Estimating Riskneutral Distributions
ln.Z f =ZK / C . 2 =2/s p
d1 D p and d2 D d1  s; (15.42)
 s We have seen that the price of a derivative is a discounted risk-neutral expectation of the
derivative payoff, see (15.9).
where  is the (annualized) volatility of the log forward rate.
In the Black-Scholes model, this risk-neutral distribution is that ln Sm is normally
An interest rate cap is a portfolio of different caplets which protects the owner over
distributed as in (15.2) except that the mean is different (this is the difference between
several tenors (subperiods) starting S periods ahead and lasting until S C n. Typically,
the natural and the risk-neutral distribution). However, risk neutral distributions can be
the first caplet is deleted (as there is no uncertainty about what the short rate is today)

130 131
 Example 15.23 (Extracting probabilities) Suppose we observe the option prices in Ex-
ample 15.22, and want to use these to recover the probabilities. We know the possible
states, but not their probabilities. Let Pr.x/ denote the probability that Sm D x. From
cap rate
Example 15.22, we have that the option price for K D 109 equals
market rate
C .K D 109/ D 0:1
D Pr.90/  0 C Pr.100/  0 C Pr.110/.110 109/;

+ 0 +
which we can solve as Pr.110/ D 0:1. We now use this in the expression for the option
t t+m t+2m t+3m t+4m t+5m t+6m
price for K D 99
start of cap end of cap
The payoffs are marked by 0 and + C .K D 99/ D 1: 5
D Pr.90/  0 C Pr.100/.100 99/ C 0:1.110 99/;
Figure 15.14: Interest rate cap
which we can solve as Pr.100/ D 0:4. Since probabilities sum to one, it follows that
Pr.90/ D 0:5.
derived from other assumptions than those in the Black-Scholes model, and (15.9) would
still be valid. For instance, it holds in the binomial model, whose distribution is not normal A common approach is to make an assumption about the form of the distribution, for
(unless we make the time steps very many and small). Alternatively, we could construct instance, that it is mixture of two normal distributions. The parameters of this distribution
a binomial tree where the time steps have different volatilities (this is often done to fit are then chosen (estimated) by minimizing the sum (across strike prices) of squared dif-
the yield curve)—and even in the limit (with many and small time steps) the distribution ferences between observed and predicted prices. (This is like the minimization problem
would be non-normal. Once again, the Black-Scholes formula would not be exact, but behind the least squares method in econometrics.) This allows the possibility to pick up
(15.9) would still be true. skewed (downside risk different from upside risk?) and even bimodal distributions.
Figure 15.15 shows some data and results (assuming a mixture of two normal distribu-
Example 15.22 (Call prices, three states) Suppose that Sm only can take three values: tions) for German bond options around the announcement of the very high money growth
90, 100, and 110; and that the risk neutral probabilities for these events are: 0.5, 0.4, and rate on 2 March 1994.
0.1, respectively. We consider three European call option contracts with the strike prices
89, 99, and 109. From (15.9) their prices are (if y D 0)
Bibliography
C .K D 89/ D 0:5.90 89/ C 0:4.100 89/ C 0:1.110 89/ D 7
Cochrane, J. H., 2001, Asset pricing, Princeton University Press, Princeton, New Jersey.
C .K D 99/ D 0:5  0 C 0:4.100 99/ C 0:1.110 99/ D 1: 5
C .K D 109/ D 0:5  0 C 0:4  0 C 0:1.110 109/ D 0:1: Cox, J. C., S. A. Ross, and M. Rubinstein, 1979, “Option pricing: a simplified approach,”
Journal of Financial Economics, 7, 229–263.
With prices on several options with different strike prices (but otherwise identical), it
Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann, 2007, Modern portfolio
is possible to estimate the risk-neutral distribution.
theory and investment analysis, John Wiley and Sons, 7th edn.

132 133
 June−94 Bund option, volatility, 06−Apr−1994 June−94 Bund option, pdf on 06−Apr−1994
0.1
15 N
0.09 mix N
10
0.08

0.07 5

0.06 0
5.5 6 6.5 7 7.5 5.5 6 6.5 7 7.5
Strike price (yield to maturity, %) Yield to maturity, %
Distribution of CHF/EUR, 1m, 16−Sep−2008 Distribution of CHF/EUR, 1m, 16−Oct−2008
8
June−94 Bund option, pdfs of 2 dates Options on German gov bonds, 10 6
traded on LIFFE
15 23−Feb−1994 4
03−Mar−1994 The distributions are estimated mixtures 5
10 of 2 normal distributions, unless indicated 2

0 0
5 1.3 1.4 1.5 1.6 1.7 1.3 1.4 1.5 1.6 1.7

0
5.5 6 6.5 7 7.5
Yield to maturity, %
Distribution of CHF/EUR, 1m, 16−Feb−2009 Distribution of CHF/EUR, 1m, 16−Mar−2009
8
Figure 15.15: Bund options 23 February and 3 March 1994. Options expiring in June 8
1994. 6
6

4 4
Hull, J. C., 2006, Options, futures, and other derivatives, Prentice-Hall, Upper Saddle 2
2
River, NJ, 6th edn.
0 0
1.3 1.4 1.5 1.6 1.7 1.3 1.4 1.5 1.6 1.7
McDonald, R. L., 2006, Derivatives markets, Addison-Wesley, 2nd edn.

Figure 15.16: Riskneutral distribution of the CHF/EUR exchange rate

134 135
 CHF/EUR 80% conf band and forward, 1m CHF/EUR, distance from forward, 1m
1.65
0.1 percentile 10
percentile 90
1.6

0.05
1.55

1.5
0

1.45
−0.05
1.4

1.35 −0.1

200807 200810 200901 200904 200807 200810 200901 200904

Figure 15.17: Riskneutral distribution of the CHF/EUR exchange rate Figure 15.18: Riskneutral distribution of the CHF/EUR exchange rate

136 137
 VIX (solid) and S&P 500 (dashed)

Correlation of VIX changes with

16 Trading Volatility S&P 500 returns: −0.78

Reference: Gatheral (2006) and McDonald (2006)

More advanced material is denoted by a star ( ). It is not required reading. 1000
50

16.1 VIX

By using option portfolios (for instance, straddles) it is possible to create a position that
is a bet on volatility—and is (in principle) not sensitive to the direction of change of the
underlying. See Figure 16.1 for an illustration.
Volatility, as an asset class, has some interesting features. In particular, returns on the
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
underlying asset and volatility are typically negatively correlated: very negative returns

Figure 16.2: S&P 500 and VIX

Profit of straddle, call + put

Call(K) are typically accompanied by increases in future actual volatility as well as beliefs about
Put(K)
Straddle higher future volatility (as priced into options). See Figure 16.2 for an illustration, where
changes in the VIX are taken to proxy the one-day holding return on a straddle.
The VIX is an index of volatility, calculated from 1-month options on S&P 500. It
used to be calculated as an average of implied volatilities, but since 2003 the calculation
is more complicated (the old series is now called VXO). It can be shown (although it is
a bit tricky) that the VIX is a very good approximation to the square root of the variance
0 swap rate (see below) for a 30-day contract. There is also a futures contract on VIX with
payoff
VIX futures payoff t Cm D V IX t Cm futures price t : (16.1)

K Notice that V IX t Cm is really a guess of what the volatility will be during the month after
t C m, so the futures contract pays off when the expected volatility (in t C m) is higher
Stock price than what was thought in t.

Remark 16.1 (Calculation of VIX) Let F be the forward price,
Ki D .Ki C1 Ki 1 /=2
Figure 16.1: Profit of straddle

138 139
and let K0 denote the first strike price below F . Then, the VIX is calculated as VIX (solid) and realized volatility (dashed)

2 P
Ki 2 P
Ki 1 80
V IX 2 D exp.y m/ 2
P .Ki /C exp.y m/ 2
C.Ki / .F=K0 1/2 ;
m Ki K0 Ki m Ki >K0 Ki m
70
where m is the time to expiration (around 1/12), y the interest rate, P ./ the put price and
60
C./ the call price.
50

16.2 Variance and Volatility Swaps 40

Instead of investing in straddles, it is also possible to invest in variance swaps. Such a 30

contract has a zero price in inception (in t ) and the payoff at expiration (in t C m) is
20

Variance swap payoff t Cm = realized variance t Cm variance swap rate t , (16.2)

10

where the variance swap rate (also called the strike or forward price for ) is agreed on at 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

inception (t) and the realized volatility is just the sample variance for the swap period.
Both rates are typically annualized, for instance, if data is daily and includes only trading Figure 16.3: VIX and realized volatility (variance)
days, then the variance is multiplied by 252 or so (as a proxy for the number of trading
days per year). month later).
A volatility swap is similar, except that the payoff it is expressed as the difference Since VIX2 is a good approximation of variance swap rate for a 30-day contract, the
between the standard deviations instead of the variances return can be approximated as
p
Volatility swap payoff tCm = realized variance t Cm volatility swap rate t , (16.3) Return of a variance swap t Cm D .RV tCm V IX t2 /=V IX t2 : (16.5)

If we use daily data to calculate the realized variance from t until the expiration(RV tCm ), Figures 16.3 and 16.4 illustrate the properties for the VIX and realized volatility of
then the S&P 500. It is clear that the mean return of a variance swap (with expiration of 30
252 Pm
RV t Cm D R2 ; (16.4) days) would have been negative on average. (Notice: variance swaps were not traded
m sD1 tCs
for the early part of the sample in the figure.) The excess return (over a riskfree rate)
where R t Cs is the net return on day t C s. (This formula assumes that the mean return is
would, of course, have been even more negative. This suggests that selling variance
zero—which is typically a good approximation for high frequency data. In some cases,
swaps (which has been the speciality of some hedge funds) might be a good deal—except
the average is taken only over m 1 days.)
that it will incur some occasional really large losses (the return distribution has positive
Notice that both variance and volatility swaps pays off if actual (realized) volatility
skewness). Presumably, buyers of the variance swaps think that this negative average
between t and t C m is higher than expected in t . In contrast, the futures on the VIX pays
return is a reasonable price to pay for the “hedging” properties of the contracts—although
off when the expected volatility (in t C m) is higher than what was thought in t. In a way,
the data does not suggest a very strong negative correlation with S&P 500 returns.
we can think of the VIX futures as a futures on a volatility swap (between t C m and a

140 141
 Histogram of return on (synthetic) variance swaps

1.5 Daily data on VIX and S&P 500 1990:1−2009:6

Correlation with S&P 500 returns: −0.17

17 Dynamic Portfolio Choice
More advanced material is denoted by a star ( ). It is not required reading.
1

17.1 Optimal Portfolio Choice: CRRA Utility and iid Returns

0.5 Suppose the investor wants choose portfolio weights (v t ) to maximize expected utility,
that is, to solve
max E t u.W t Cq /; (17.1)
vt

where and E t denotes the expectations formed today, u./ is a utility function and W t Cq is
0
−1 −0.5 0 0.5 1 1.5 2 2.5 the wealth (in real terms) at time t C q.
This is a standard (static) problem if the investor cannot (or it is too costly to) rebalance
Figure 16.4: Distribution of return from investing in variance swaps the portfolio. (In some cases this leads to a mean-variance portfolio, in other cases not.)
If the distribution of assets returns is iid, then the portfolio choice is unchanged over
Bibliography time—otherwise it changes. For instance, with mean-variance preferences, the tangency
portfolio changes as the expected returns and/or the covariance matrix do.
Gatheral, J., 2006, The volatility surface: a practitioner’s guide, Wiley. Instead, if the investor can rebalance the portfolio in every time period (t C 1; :::; t C
McDonald, R. L., 2006, Derivatives markets, Addison-Wesley, 2nd edn. q 1), then this is a truly dynamic problem—which is typically more difficult to solve.
However, when the utility function has constant relative risk aversion (CRRA) and returns
are iid, then we know that the optimal portfolio weights are constant across time and
independent of the investment horizon (q). We can then solve this as a standard static
problem. The intuition for this result is straightforward: CRRA utility implies that the
portfolio weights are independent of the wealth of the investor and iid returns imply that
the outlook from today is the same as the outlook from yesterday, except that the investor
might have gotten richer or poorer. (The same result holds if the objective function instead
is to maximize the utility from stream of consumption, but with a CRRA utility function.)
With non-iid returns (predictability or time-varying volatility), the optimization is typ-
ically much more complicated. The next few sections present a few cases that we can
handle.

142 143
17.2 Optimal Portfolio Choice: Logarithmic Utility and Non-iid Re- where  2 is the conditional variance of r t . (That is,  2 is the variance of u t in r t D
turns E t 1 r t C u t .) Instead, if we let r t denote an n  1 vector of risky log returns and v the
portfolio weights, then the multivariate version is
Reference: Campbell and Viceira (2002)

rpt  rf t C v 0 r t rf t C v 0  2 =2 v 0 ˙ v=2; (17.5)
17.2.1 The Optimization Problem 1
where ˙ is the nn covariance matrix of r t and  2 is the n1 vector of the variances (that
Let the objective in period t be to maximize the expected log wealth in some future period is, the the diagonal elements of that covariance matrix). The portfolio weights, variances
and covariances could be time-varying (and should then perhaps carry time subscripts).
max E t ln W t Cq D max.ln W t C E t r t C1 C E t r t C2 C : : : C E t r t Cq /; (17.2) Proof. (of (17.4) ) The portfolio return Rp D vR1 C .1 v/Rf can be used to write
 
where r t is the log return, r t D ln.1 C R t / where R t is a net return. The investor can 1 C Rp 1 C R1
D1Cv 1 :
rebalance the portfolio weights every period. 1 C Rf 1 C Rf
Since the returns in the different periods enter separably, the best an investor can do
The logarithm is
in period t is to choose a portfolio that solves ˚  
rp rf D ln 1 C v exp.r1 rf / 1 :
max E t r t C1 : (17.3) The function f .x/ D ln f1 C v Œexp.x/ 1g has the following derivatives (evaluated at
x D 0): df .x/=dx D v and d 2 f .x/=dx 2 D v.1 v/, and notice that f .0/ D 0. A
That is, to choose the one-period growth-optimal portfolio. But, a short run investor who
second order Taylor approximation of the log portfolio return around r1 rf D 0 is then
maximizes E t lnŒW t .1 C R t C1 // D max.ln W t C E t r t C1 / will choose the same portfolio,

1
2
so there is no horizon effect. However, the portfolio choice may change over time, if the rp rf D v r1 rf C v.1 v/ r1 rf :
distribution of the returns do. (The same result holds if the objective function instead is to 2
maximize the utility from stream of consumption, but with a logarithmic utility function.) In a continuous time model, the square would equal its expectation, Var.r1 /, so this further
approximation is used to give (17.4). (The proof of (17.5) is just a multivariate extension
17.2.2 Approximating the Log Portfolio Return of this.)

In dynamic portfolio choice models it is often more convenient to work with logarithmic
portfolio returns (since they are additive across time). This has a drawback, however, on
the portfolio formation stage: the logarithmic portfolio return is not a linear function of the
logarithmic returns of the assets in the portfolio. Therefore, we will use an approximation
(which gets more and more precise as the length of the time interval decreases).
If there is only one risky asset and one riskfree asset, then Rpt D vR t C .1 v/Rf t .
Let ri t D ln.1 C Rit / denote the log return. Campbell and Viceira (2002) approximate
the log portfolio return by


rpt  rf t C v r t rf t C v 2 =2 v 2  2 =2;
17.2.3 The Optimization Problem 2
The objective is to maximize the (conditional) expected value of the portfolio return as
in (17.3). When there is one risky asset and a riskfree asset, then the portfolio return is
given by the approximation (17.4). To simplify the notation a bit, let etC1 be the condi-
tional expected excess return E t .r t C1 rf;t C1 / and let  t2C1 be the conditional variance
(Var t .r t C1 /). Notice that these moments are conditional on the information in t (when the
portfolio decision is made) but refer to the returns in t C 1.
(17.4)

144 145
 The optimization problem is then Mean excess returns (annualized Mean excess returns (annualized

maxvt rf;t C1 C v t etC1 C v t  t2C1 =2 v t2  t2C1 =2: (17.6) 0.15 0.15

The first order condition is 0.1 0.1

Cnsmr HiTec
0D etC1 C  t2C1 =2 v t  t2C1 , so Manuf Hlth
0.05 0.05
etC1 C  t2C1 =2 1990 2000 1990 2000
vt D ; (17.7)
 t2C1

which is very similar to a mean-variance portfolio choice. Clearly, the weight on the risky
asset will change over time—if the expected excess return and/or the volatility does. We Mean excess returns (annualized
could think of the portfolio with v t of the risky asset and 1 v t of the riskfree asset as a
managed portfolio. 0.15

Example 17.1 (Portfolio weight, single risky asset) Suppose etC1 D 0:05 and  t2C1 D 0.1

0:15, then we have v t D .0:05 C 0:15=2/=0:15 D 5=6  0:83. Other

0.05
1990 2000
With many risky assets, the optimization problem is to maximize the expected value
of (17.5). The optimal n  1 vector of portfolio weights is then

1
v t D ˙ t C1 .etC1 C  t2C1 =2/; (17.8) Figure 17.1: Dynamicically updated estimates, 5 U.S. industries

where ˙ tC1 is the conditional covariance matrix (Cov t .r t C1 /) and  t2C1 the n  1 vector Proof. (of (17.8)) From (17.5) we have
of conditional variances. The weight on the riskfree asset is the remainder (1 10 v t , where
1 is a vector of ones). E rp  rf C v 0 e C v 0  2 =2 v 0 ˙ v=2;

Proposition 17.2 If the log returns are normally distributed, then (17.8) gives a portfolio so the first order conditions are
on the mean-variance frontier of returns (not of log returns).
e C  2 =2 ˙ 1
v D 0n1 :
Figures 17.1–17.2 illustrate mean returns and standard deviations, estimated by expo-
Solve for v.
nentially moving averages (as by RiskMetrics). Figures 17.3–17.4 show how the optimal
Proof. (of Proposition 17.2) First, notice that if the log return r t in (17.5) is normally
portfolio weights change (assuming mean-variance preferences). It is clear that the port-
distributed, then so is the log portfolio return (rpt ). Second, recall that if ln y  N.;  2 /,
folio weights change very dramatically—perhaps too much to be realistic. The portfolio
p
then E y D exp  C  2 =2 and Std .y/ = E y D exp. 2 / 1, so that ln E y  2 =2 D
weights seem to be particularly sensitive to movements in the average returns, which po-
tentially a problem since the averages are often considered to be more difficult to estimate
(with good precision) than the covariance matrix.

146 147
 Std (annualized Std (annualized Portfolio weights, Cnsmr Portfolio weights, Manuf
0.25 0.25 6 10
Cnsmr HiTec fixed mean
Manuf Hlth 4
fixed cov
0.2 0.2 2 5
0
0.15 0.15
−2
1990 2000 1990 2000 0
1990 2000 1990 2000

Std (annualized
0.25
Portfolio weights, HiTec Portfolio weights, Hlth
Other
4
0.2 2
2
1
0
0.15 0
1990 2000
−2
−1
−4
1990 2000 1990 2000

Figure 17.2: Dynamicically updated estimates, 5 U.S. industries

 and lnŒVar .y/ =.E y/2 C 1 D  2 . Combine to write Figure 17.3: Dynamicically updated portfolio weights, T-bill and 5 U.S. industries

 D ln E y lnŒVar .y/ =.E y/2 C 1=2; 17.2.4 A Simple Example with Time-Varying Expected Returns (Log Utility and
Non-iid Returns)
which is increasing in E y and decreasing in Var.y/. To prove the statement, notice that
y corresponds to the gross return and ln y to the log return, so  corresponds to E t rptC1 . A particularly simple case is when the expected excess returns are linear functions of
Clearly,  is increasing in E y and decreasing in Var.y/, so the solution will be on the some information variables in the (k  1) vector z t
MV frontier of the (gross and net) portfolio return.
etC1 D a C bz t ; with E z t D 0; (17.9)

at the same time as the variances and covariances are constant. In this expression, a is an
n  1 vector and b is an n  k matrix. Assuming that the information variables have zero
means turns out to be convenient later on, but it is not a restriction (since the means are
captured by a). The information variables could perhaps be the slope of the yield curve

148 149
 Portfolio weights, Other Portfolio weights, riskfree portfolio is clearly on them. However, the portfolio is not on the unconditional mean-
0
4 variance figure (where the means and covariance matrix are calculated by using both
states).
−2 2

−4 0
Example 17.3 (Dynamic portfolio weights when z t is a scalar that only takes on the
fixed mean values 1 and 1; with equal probabilities) The expected excess returns are
−6 fixed cov −2 (
a b when z t D 1
1990 2000 1990 2000 etC1 D
a C b when z t D 1:

The portfolio weights on the risky assets (17.13) are then

Figure 17.4: Dynamicically updated portfolio weights, T-bill and 5 U.S. industries (
˙ 1 .a C  2 =2/ ˙ 1 b when z t D 1
vt D
˙ 1 .a C  2 =2/ C ˙ 1 b when z t D 1:
and/or the earnings/price ratio for the aggregate stock market.
For the case with one risky asset, we get Example 17.4 (Numerical values for Example 17.3). Suppose we have three assets with
etC1 02 31 2 3
‚ …„ ƒ r1 1:19 0:32 0:24
a C bz t C  2 =2 B6 7C 6 7
vt D , or (17.10) Cov @4r2 5A D 4 0:32 0:81 0:02 5 =100;
2 r3 0:024 0:02 0:23
a C  2 =2 bz t
D C ! t , with D and ! t D 2 : (17.11)
2  and 2 3 2 3
0:41 0:63
so the weight on the risky asset varies linearly with the information variable bz t . (Even if 6 7 6 7
e 1 D 4 0:295 =100 and e1 D 40:435 =100;
there are many elements in z t , bz t is a scalar so it is effectively one information variable.)
0:07 0:21
In the second equation, the portfolio weight is split up into the static (average) weight
( ) and the time-varying part (! t ). Clearly, a higher expected return implies a higher In this case, the portfolio weights are
portfolio weight of the risky asset. 2 3 2 3
0:112 0:709
Similarly, for the case with many risky assets we get 6 7 6 7
v 1  40:0945 and v1  40:7365 :
etC1 0:065 0:610
‚ …„ ƒ
1 1
vt D ˙ .a C bz t / C ˙  2 =2, or (17.12)
Example 17.5 (Details on Figure 17.5) To transfer from the log returns to the mean and
D C ! t , with D˙ 1
.a C  =2/ and ! t D ˙
2 1
bz t : (17.13) std of net returns, the following result is used: if the vector x  N.;  2 / and y D
  
exp.x/, then E yi D exp .i i C i i =2/ and Cov.yi ; yj / D exp i C j C .i i C jj /=2 exp.ij / 1.
See Figure 17.5 for an illustration (based on Example 17.3). The figure shows the
basic properties for the returns, the optimal portfolios and their location in a traditional
mean-std figure. In this example, z t can only take on two different values with equal
probability: 1 or 1. The figure shows one mean-variance figure for each state—and the

150 151
 MV frontiers of basic assets in different states MV frontier from unconditional moments Combine the time series processes (17.14) and (17.15) to get the following expression for
8 8 the excess return
Mean of net return, %

Mean of net return, %

state −1
state 1
7 7 r teC1 D r t C1 rf D a C z t C u t C1 ; (17.16)

6 6 where u t C1 is the innovation, so the conditional variance is Var t .r teC1 / D Var.u t C1 / D

 2 . This temporary innovation is allowed to be correlated with  t C1 , Cov.u t C1 ;  t C1 / D
5 5
u . For instance, a negative correlation could be interpreted as a mean-reversion of
0 5 10 15 20 0 5 10 15 20 the asset price level: a temporary positive return is followed by lower future (expected)
Std of net return, % Std of net return, %
returns.

Average impulse response of return to a return innovation, ut

Figure 17.5: Portfolio choice, two different states
1.2
Cov(u,η) = 0
17.3 Optimal Portfolio Choice: CRRA Utility and non-iid Returns 1 Cov(u,η) < 0
0.8
17.3.1 Basic Setup
0.6
An important feature of the portfolio choice based on the logarithmic utility function is
that it is myopic in the sense that it only depends on the distribution of next period’s return, 0.4

not on the distribution of returns further into the future. Hence, short-run and long-run 0.2
investors choose the same portfolios—as discussed before. This property is special to the
0
logarithmic utility function.
−0.2
With a utility function with a constant relative risk aversion (CRRA) different from 0 1 2 3 4 5 6 7 8 9
one, today’s portfolio choice would also depend on distribution of returns in t C 2 and Future period

onwards. In particular, it would depend on how the (random) returns in t C1 are correlated
with changes (in t C1) of expected returns and volatilities of returns in t C2 and onwards. Figure 17.6: Average impulse response of the return to changes in u0 , two different cases.
This is intertemporal hedging.
In this case, the optimization problem is tricky, so I will illustrate it by using a simple It is important to realize that the unconditional and conditional autocovariances differ
model. As in Campbell and Viceira (1999), suppose there is only one risky asset and let markedly
the (scalar) information variable be an AR(1)
Cov.r teC1 ; r teC2 / D  Var.z t / C u (17.17)
z t D z t 1 C  t , where  t  i idN.0; 2 /: (17.14) Cov t .r teC1 ; r teC2 / D u : (17.18)

In addition, I assume that the expected return follows (17.9) but with b D 1 (to simplify This shows that the unconditional autocovariance of the return can be considerable at
the algebra) the same time as the conditional autocovariance may be much smaller. It is the latter
etC1 D a C z t : (17.15) than matters for the portfolio choice. For instance, it is possible that the unconditional
autocovariance is zero (in line with empirical evidence), while the conditional covariance

152 153
is negative. several periods—to be discussed below). (See lecture notes for Finance 1 for a proof.)
Figure 17.6 shows the impulse response function (the forecast based on current infor-
mation) of a shock to the temporary part of the return (u) under two different assumptions 17.3.2 One-Period Investor
about how this temporary part is correlated with the mean return for the next period re-
With one risky and a riskfree asset, a one-period investor maximizes
turn. When they are uncorrelated, then a shock to the temporary part of the return is just
a “blip.” In contrast, when today’s return surprise indicates poor future returns (a negative E t rptC1 C .1 / Var t .rpt C1 /=2: (17.20)
covariance), then the impulse response function is positive (unity) in the initial period, but
then negative for a prolonged period (since the mean return is autocorrelated). This gives the following weight on the risky asset
Proof. (of (17.17)–(17.18)) The unconditional covariance is etC1 C  2 =2 a C z t C  2 =2
vt D 2
D ; (17.21)
  2
Cov.r teC1 ; r teC2 / D Cov.z t C u t C1 ; z t C  t C1 C u t C2 /
and the weight on the riskfree asset is 1 v t . With D 1 (log utility), we get the same
D  Var.z t / C u ;
results as in (17.7). With a higher risk aversion, the weight on the risky asset is lower.
since z t C u t C1 is uncorrelated with  t C1 C u t C2 . The conditional covariance is Clearly, the portfolio choice depends positively on the (signal about) the expected returns.
Figure 17.7 for how the portfolio weight on the risky asset depends on the risk aversion.
Cov t .r teC1 ; r tC2
e
/ D Cov t .z t C u t C1 ; z t C  t C1 C u t C2 /
D u ; Weight on risky asset, 2−period investor (CRRA)

1.2 myopic
since z t is known in t and u t C1 is uncorrelated with u tC2 . It is also straightforward to 2−period
show that the unconditional variance is 1 2−period (no rebal)

0.8
Var.r teC1 / D Cov.z t C u t C1 ; z t C u t C1 /
σ, a, σuη, ση = 0.40 0.05 −0.40 2.00
D Var.z t / C Var.u t /; 0.6

0.4
since z t and u t C1 are uncorrelated. The conditional variance is
0.2
Var t .r teC1 / D Cov.z t C u t C1 ; z t C u tC1 /
0
D Var.u t /; 1 1.5 2 2.5 3 3.5 4 4.5 5
Risk aversion (γ)
since z t is known in t .
To solve the maximization problem, notice that if the log portfolio return, rp D ln.1 C
Figure 17.7: Weight on risky asset, two-period investor with CRRA utility and the possi-
Rp /, is normally distributed, then maximizing E.1 C Rp /1 =.1 / is equivalent to bility to rebalance.
maximizing
E rp C .1 / Var.rp /=2; (17.19)

where rp is the log return of the portfolio (strategy) over the investment horizon (one or

154 155
 Proof. (of (17.21)). Using the approximation (17.4), we have The solution (see Appendix) is

E rp D rf C ve C v 2 =2 v 2  2 =2 a C  2 =2 C .1 C /z t =2
vD : (17.23)
 2 .1 /ŒVar. tC1 /=2 C u 
Var.rp / D v 2  2 :
Similar to the one-period investor, the weight is increasing in the signal of the average
The optimization problem is therefore return (z t ), but there are also some interesting differences. Even if the utility function
is logarithmic ( D 1), we do not get the same portfolio choice as for the one-period
max rf C ve C v 2 =2 v 2  2 =2 C .1 /v 2  2 =2;
v investor. In particular, the reaction to the signal (z t ) is smaller (unless  D 1). The reason
so the first order condition is is that in this case, the investor commits to the same portfolio for two periods—and the
movements in average returns are assumed to be mean-reverting.
e C  2 =2 v 2 v 2 D 0: There are also some important patterns on average (when z t D 0). Then, D 1
actually gives the same portfolio choice as for the one-period investor. However, if > 1,
Solve for v.
and there are important shocks to the expected return, then the two-period investor puts a
−3 Normalized log(E/P), (z) Myopic portfolio weight on risky asset lower weight on the risky asset (the second term in the denominator tends to be positive).
x 10
5 The reason is that the risky asset is more dangerous to the two-period investor since rpt C2
4 γ=1
γ=2 is more risky than rptC1 , since rptC2 can be hit by more shocks—shocks to the expected
0 2 return of rpt C2 . In contrast, if data is iid then those shocks do not exist (Var. t C1 / D 0),
so the two-period investor makes the same choice as the one-period investor.
0
One more thing is worth noticing: if u < 0, then the demand for the risky asset is
−5
1970 1980 1990 2000 1970 1980 1990 2000 higher than otherwise. This can be interpreted as a case where a temporary positive return
leads to lower future (expected) returns. With this sort of mean-reversion in the price level
(conditional negative autocorrelation), the risky asset is somewhat less risky to a long-run
US stock returns 1970:1−2008:12
investor than otherwise. When extended to several risky assets, the result is that there us
a higher demand for assets that tend to be negatively correlated with the future general
Figure 17.8: Dynamic portfolio weights investment outlook. See 17.6 for an illustration of this effect and Figure 17.7 for how the
portfolio weight on the risky asset depends on the risk aversion.

17.3.3 Two-Period Investor (No Rebalancing) 17.3.4 Two-Period Investor (with Rebalancing)
In period t, a two-period investor chooses v t to maximize It is more reasonable to assume that the two-period investor can rebalance in each period.
Rewrite (17.22) as
E t .rptC1 C rptC2 / C .1 / Var t .rpt C1 C rpt C2 /=2: (17.22)
E t rptC1 C E t rptC2 C .1 /ŒVar t .rptC1 / C Var t .rptC2 / C 2 Cov t .rpt C1 ; rp2C1 /=2;
(17.24)

156 157
and notice that the investor (in t ) can affect only those terms that involve rptC1 (as the in t C 1 (that is, the distribution of the portfolio returns in t C 2). The key to getting
portfolio will be rebalanced in t C 1). He/she therefore maximizes intertemporal hedging is thus that the temporary movements in the return partially offset
future movements in the investment outlook.
E t rpt C1 C .1 /ŒVar t .rpt C1 / C 2 Cov t .rptC1 ; rp2C1 /=2: (17.25) While this simplified case only uses one risky asset, it is important to understand that
this intertemporal hedging is not about that a particular asset hedging the changes in its
The maximization problem is the same as for a one-period investor (17.20) if returns are
own return distribution. Indeed, if the outlook for a particular asset becomes worse, the
iid (so the covariance is zero), or if D 1.
investor could always switch out of it. Instead, the key effect depends on how a particular
Otherwise, the covariance term will influence the portfolio choice in t . The difference
asset hedges the movements in tomorrow’s optimal portfolio—that is, tomorrow’s overall
to the no-rebalancing case is that the investor in t takes into account that rpt C2 will be
investment outlook.
generated by a portfolio with the weights of a one-period investor

a C z t C1 C  2 =2 Remark 17.6 (How to estimate (17.14) and (17.16)). First, regress the excess returns
v t C1 D : (17.26)
 2 on some information variables z t : r t C1 rf D a C b  z t C u t C1 . Second, define
(This is the same as (17.21) but with the time subscripts advanced one period). This z t D b  .z t E z t /. Then, a regression of the return on z t gives a slope coefficient of one
affects both how the signal about future average returns (z t ) and the risk are viewed. The as in (17.16). Third, estimate an AR(1) on z t as in (17.14). Fourth and finally, estimate
solution is (a somewhat messy expression) the covariance matrix of the residuals from the last two regressions.

etC1 C  2 =2 1 2 1

vt D
 2
C
 2 2  2
a C  2 =2 C z t u : (17.27) 17.4 Performance Measurement with Dynamic Benchmarks

(The proof is in the Appendix.) See Figure 17.7 for how the portfolio weight on the risky Reference: Ferson and Schadt (1996), Dahlquist and Söderlind (1999)
asset depends on the risk aversion and for a comparison with the cases of myopic portfolio Traditional performance tests typically rely on the alpha from a CAPM regression.
choice and and no rebalancing. The benchmark in the evaluation is then a fixed portfolio consisting of assets that are
As before, the portfolio choice depends positively on the expected return (as signalled correctly priced by the CAPM (obeys the beta representation). It often makes sense to use
by z t ). But, there are several other results. First, when D 1 (log utility), then the a more demanding benchmark—by including managed portfolios.
portfolio choice is the same as for the one-period investor (for any value of z t ). Second, Let v.z/ be a vector of portfolio weights that potentially depend on the information
when u D Var t .u t C1 ;  t C1 / D 0, then the second term drops out, so the two-period variables in z. The return on such a portfolio is
investor once again picks the same portfolio as the one-period investor does.
Third , > 1 combined with u < 0 increases (on average, z t D 0) the weight on Rpt D v.z/0 R t C Œ1 10 v.z/Rf D v.z/0 Ret C Rf : (17.28)
the risky asset—similar to the case without rebalancing. In this case, the second term of
However, without restrictions on v.z/ it is impossible to sort out what sort of strategies
(17.27) is positive. That is, there is a positive extra demand (in t) for the risky asset: such
that would be assigned neutral performance by a particular (multi-factor) model. There-
an asset tends to pays off in t C 1 (since u t C1 > 0, which only affects the return in t C 1,
fore, assume that v.z/ are linear in the K information variables
not in subsequent periods) when the overall investment prospects for t C 2 become worse
(etC2 is low since  t C1 and thus z t C1 tends to be low when u t C1 is high). In this case, the v.z t 1/ D „ƒ‚…
d zt 1 (17.29)
„ƒ‚…
return in t C 1, driven by the temporary shock u t C1 , partially hedges investment outlook N K K1

158 159
for any N  K matrix d . For instance, when the expected returns are driven by the infor- is a good measure of performance.
mation variables z t as in (17.9), then the optimal portfolio weights (for an investor with On the other hand, it may also be argued that a dynamic trading rule that investors
logarithmic preferences) are linear functions of the information variables as in (17.11) or can easily implement themselves should be assigned neutral performance. This can be
(17.13). done by changing the “benchmark” portfolio from being just the market portfolio to in-
It is clear that the portfolio return (17.28)–(17.29) can be written clude managed portfolios. As an example, we could use the intercept from the following
“dynamic CAPM” (or “conditional CAPM”) as a measurement of performance
Rpt D Re0
t v.z t 1/ C Rf
e e
D Re0 C Rf Rpt D ˛ C .ˇ C z t 1 / Rmt C "t
t dz t 1
e e
D .vec d /0 .z t 1 ˝ Ret / C Rf : (17.30) D˛C ˇRmt C z t 1 Rmt C "t : (17.33)

Remark 17.7 (Kronecker product) For instance, we have that if where the second term are the dynamic benchmarks that capture the effect of time-varying
2 3 portfolio weights. In fact, (17.33) would assign neutral performance (˛ D 0) to any pure
z1 f1
6 7 “market timing” portfolio (constant relative weights in the sub portfolio of risky assets,
2 3 6z1 f2 7
" # f1 6 7 but where the split between riskfree and risky assets change).
z1 6z f 7
6 7 6 1 37
zD ; f D 4f2 5 , then z ˝ f D 6 7:
z2 6z2 f1 7 Remark 17.8 In a multi-factor model we could use the intercept from
f3 6 7
6z f 7
4 2 25
e
z3 f3 Rpt D ˛ C ˇf t C .z t 1 ˝ ft / C "t ;

Proof. (of (17.30)) Recall the rule that vec .ABC / D .C 0 ˝ A/ vec B. Here, notice where f t is a vector of factors (excess returns on some portfolios), where ˝ is the Kro-
that Re0 dz is a scalar, so we can use the rule to write Re0 dz D .z 0 ˝Re0 / vec d . Transpose necker product.
and recall the rule .D ˝ E/0 D D 0 ˝ E 0 to get .vec d /0 .z ˝ Re /
This shows that the portfolio return can involve any linear combination of z ˝ Re so 17.4.1 A Simple Example with Time-Varying Expected Returns
the new return space is defined by these new managed portfolios. We can therefore think
To connect the performance evaluation in (17.32) and (17.33) to the optimal dynamic port-
of the returns
folio strategy (17.13), suppose the optimal strategy is a pure “market timing” portfolio.
RQ t D .z t 1 ˝ Ret / C Rf (17.31)
This happens when the expected returns (17.9) are modelled as
as the returns on new assets—which can be used to define, for instance, mean-variance
frontiers. etC1 D a C bz t ; with b D c.a C  2 =2/; (17.34)
It is not self-evident how to measure the performance of a portfolio in this case. It
where c is some scalar constant, while a and  2 are vectors. This gives the portfolio
could, for instance, be argued that the return of the dynamic part of the portfolio is to be
weights (17.13)
considered non-neutral performance. After all, this part exploits the information in the
v t 1 D C cz t 1 D .1 C cz t 1 /; (17.35)
information variables z, which is potentially better than keeping a fixed portfolio. In this „ ƒ‚ …
!t
case, the alpha from a traditional CAPM regression
where is defined in (17.13). There are constant relative weights in the sub portfolio of
e
Rpt e
D ˛ C ˇRmt C "it (17.32) risky assets, but the split between the risky assets (the vector v t 1 ) and riskfree (the scalar

160 161
1 10 v t 1 ) and change as z t 1 does: market timing. MV frontiers of basic assets in different states MV frontier from unconditional moments
Proof. (of (17.35)) Use b D c.a C  2 =2/ from (17.34) in (17.13) 8 8

Mean of net return, %

Mean of net return, %

state −1 of basic assets (R)
state 1 of managed portfolios (R,zR)
1 2
7 7
D˙ .a C  =2/
1 6 6
!t D ˙ .a C  2 =2/cz t D cz t :
5 5

0 5 10 15 20 0 5 10 15 20
With these portfolio weights, the excess return on the portfolio is Std of net return, % Std of net return, %

e 0
Rpt D Ret .1 C cz t 1 /: (17.36) Returns:
Asset 1 Asset 2 Asset 3
Portfolio weights:
ψ ω−1/ψ ω1/ψ
ER, state −1 5.1 5.2 5.1 Asset 1 −0.03 −0.75 0.75
First, consider using the intercept (˛) from the the CAPM regression (17.32) as a ER, state 1 5.9 6.3 5.4 Asset 2 0.91 −0.75 0.75
Std(R) 10.9 9.0 4.8 Asset 3 1.03 −0.75 0.75
measure of performance. If the market portfolio is the tangency portfolio (for instance,
The states have equal probabilities
we could assume that the rest of the market do static MV optimization so the market Alpha against:
Correlation matrix: Rm (Rm,z Rm)
equilibrium satisfies CAPM), then the static part of the return (17.36), 0 Ret , will be 1.00 0.33 0.45
0.33 1.00 0.05 Asset 1 0.00 0.00
assigned neutral performance. The dynamic part, 0 cz t 1 Ret , is different: it is like the 0.45 0.05 1.00 Asset 2 0.00 0.00
Asset 3 0.00 0.00
return on a new asset—which does not satisfy CAPM. It is therefore likely to be assigned
DynamicP 0.52 0.00
a non-neutral performance.
Second, consider using the intercept from the dynamic CAPM regression (17.33) as a
measure of performance. As before, the static part of the return should be assigned neutral Figure 17.9: Portfolio choice, two different states where market timing is optimal
performance (as the market/tangency portfolio is one of the regressors). In this case, also
case, this would require using z t 1 ˝ Ret (where Ret are the returns on the original assets)
the dynamic part of the portfolio is likely to be assigned neutral performance (or close
as the regressors
to it). This is certainly the case when the static portfolio weights, , are proportional
e e
Rpt D ˛ C ˇRmt C .z t 1 ˝ Ret / C " t : (17.37)
weights in the market portfolio. Then, the z t 1 Rmt e
term in dynamic CAPM regression
(17.33) exactly matches the 0 Ret z t 1 part of the return of the dynamic strategy (17.36). With those benchmarks all strategies where the portfolio weights on the original assets are
See Figure 17.5 for an illustration (based on Example 17.3). Since, the portfolio is not linear in z t 1 would be assigned neutral performance. In practice, evaluation of mutual
on the unconditional mean-variance figure, it does not have a zero alpha when regressed funds typically define a small number (perhaps 5) of returns and even fewer instruments
against the tangency (as a proxy for the “market”) portfolio. (All the basic assets do, by (perhaps 2–3). The instruments are typically inspired by the literature on return pre-
construction, have zero alphas.) However, it does have a zero alpha when regressed on dictability and often include the slope of the yield curve, the dividend yield or lagged
(Rm ; zRm ). returns.
However, dynamic portfolio choices that are more complicated than the market timing Figures 17.9 illustrates the case when the portfolio has a zero alpha against (Rm ; zRm ),
strategy in (17.35) would not necessarily be assigned neutral performance in (17.33). while 17.10 shows a case when the portfolio does not.
However, also such strategies could be assigned a neutral performance—if we augmented
the number of benchmarks to properly capture the time-varying portfolio weights. In this

162 163
 MV frontiers of basic assets in different states MV frontier from unconditional moments so the derivative with respect to v
8 8
Mean of net return, %

Mean of net return, %

state −1 of basic assets (R)
@ E t .rptC1 C rptC2 /
state 1 of managed portfolios (R,zR) D etC1 C E t etC2 C  2 2v 2 : (foc1)
7 7 @v t
6 6 The variance of the two-period return is

5 5
Var t .rptC1 C rptC2 / D v 2 Var t .r teC1 C r teC2 /;
0 5 10 15 20 0 5 10 15 20
Std of net return, % Std of net return, % so the derivative is
Returns: Portfolio weights: @ Var t .rptC1 C rptC2 /
Asset 1 Asset 2 Asset 3 ψ ω−1/ψ ω1/ψ D 2v Var t .r teC1 C r teC2 /: (foc2)
ER, state −1 5.1 5.8 5.1 Asset 1 −0.03 7.11 −7.11 @v t
ER, state 1 5.9 5.8 5.4 Asset 2 0.91 0.12 −0.12
Std(R) 10.9 9.0 4.8 Asset 3 1.03 −0.57 0.57 Combine (foc1) and (foc2) to get the first order condition
The states have equal probabilities
@ E t .rpt C1 C rpt C2 / 1 @ Var t .rptC1 C rptC2 /
Correlation matrix: Alpha against: Rm (Rm,z Rm) 0D C
1.00 0.33 0.45
@v t 2 @v t
Asset 1 0.00 0.00
0.33 1.00 0.05
Asset 2 0.00 0.00
D etC1 C E t etC2 C  2 2v 2 C .1 /v Var t .r teC1 C r tC2
e
/;
0.45 0.05 1.00
Asset 3 0.00 0.00
DynamicP 0.20 0.16 so we can solve for the portfolio weight as

etC1 C E t etC2 C  2
vD :
Figure 17.10: Portfolio choice, two different states where market timing is not fully opti- 2 2 .1 / Var t .r teC1 C r teC2 /
mal
Recall that
A Some Proofs
etC1 D a C z t
Proof. (of (17.23)) (This proof is a bit crude, but probably correct....) The objective is to E t etC2 D a C E t z t C1 D a C z t , so
maximize (17.24). Using (17.4) we have etC1 C E t etC2 D 2a C .1 C /z t :

rptC1  rf C vr teC1 C v 2 =2 v 2  2 =2 Notice also that r teC1 E t r teC1 D u t C1 and that r teC2 E t r tC2
e
D  tC1 C u t C2 ,
rptC2  rf C vr teC2 C v =2 2
v 2  2 =2;
Var t .r teC1 C r teC2 / D Var t .u t C1 C  t C1 C u t C2 / D  2 C Var. t C1 / C  2 C 2u ;
so
rptC1 C rptC2  2rf C v.r teC1 C r teC2 / C v 2 v2 2:

The expected value of the two-period return is

E t .rptC1 C rptC2 / D 2rf C v.etC1 C E t etC2 / C v 2 v2 2;

164 165
since Cov.u t C1 ; u t C2 / D Cov. t C1 ; u t C2 / D 0. Combining into the expression for v The covariance in (obj) is
gives 

Cov t .rptC1 ; rp2C1 / D v t Cov t u tC1 ; v t C1 r t C2 rf C v tC1  2 =2 v t2C1  2 =2 ;
2
2a C .1 C /z t C 
vD D v t Cov t .u t C1 ; v t C1 etC2 C v t C1  2 =2 v t2C1  2 =2/; (ff)
.1 /.2 2 C Var. tC1 / C 2u /
2 2 „ ƒ‚ …
B
a C .1 C /z t =2 C  2 =2
D 2
 .1 /. 2 C Var. t C1 /=2 C u / where the second line uses the fact that r t C2 rf D etC2 C u tC2 and that u tC2 is
a C .1 C /z t =2 C  2 =2 uncorrrelated with u t C1 and v t C1 . There are two channels for the covariance: u t C1 might
D 2 :
 .1 /ŒVar. t C1 /=2 C u  be correlated with the expected return, etC2 , or with the portfolio weight, v t C1 . The
portfolio weight from the one-period optimization (17.21), but for t C 1, is
Proof. (of (17.27)) (This proof is a bit crude, but probably correct....) The objective aQ C z t C1
v t C1 D ;
is to maximize  2

E t rpt C1 C .1 /ŒVar t .rpt C1 /=2 C Cov t .rptC1 ; rp2C1 /: (obj) where aN D a C  2 =2 (this notation is only used to make the subsequent equations shorter)
The B term in (ff) can then be written
Using (17.4) we have  
1 1

B D .aN C z t C1 / .aN C z t C1 / 2 1
rptC1  rf C v t r t C1 rf C v t  2 =2 v t2  2 =2  2
 

2

1 1
rptC2  rf C v t C1 r t C2 rf C v tC1  2 =2 v t2C1  2 =2: D 2az N t C1 C z t C1 1 + constants
 2 2
The derivative with respect to v of the expected return in (obj) is Since z tC1 D z t C  t C1 , we have z t2C1 D  2 z t2 C 2tC1 C 2z t  t C1 . Dropping variables
@ E t rptC1 known in t, we therefore have
D etC1 C  2 =2 vt  2: (foc1)  
@v t   1 1
B D 2 .aN C z t /  t C1 C 2tC1 1 C known in t
The variance term in (obj) is  2 2


Since Cov t u t C1 ; 2tC1 D 0 (since they are jointly normally distributed) the covariance
Var t .rpt C1 / D v t2 Var t .r t C1 / D v t2  2 ;
in (ff)  
1 1
since r t C1 rf D a C z t C u t C1 . The derivative of the variance part of (obj) is Cov t .rptC1 ; rp2C1 / D v t .aN C z t / u 2 2

1 @ Var t .rptC1 / The derivative of the corvariance part of (obj) is
D .1 /v t  2 : (foc2)
2 @v t  
@ Cov t .rptC1 ; rp2C1 / 1 aN C z t
.1 / D .1 / 2 u : (foc3)
@v t  2

166 167
 Combine the derivatives (foc1), (foc2) and (foc3) to the first order condition
@ E rpt C1 @ Var t .rptC1 /=2 @ Cov t .rptC1 ; rp2C1 /
0D C .1 / C .1 /
@v t @v t @v t
 
e 2 2 2 1 aN C z t
D . t C1 C  =2 v t  / C .1 /v t  C .1 / 2 u
 2
 
1 aN C z t
D etC1 C  2 =2 v t  2 C .1 / 2 u
 2
 
1 aN C z t
D etC1 C  2 =2 C .1 / 2 u  2 v t ;
 2
which can be solved as (17.27).

Bibliography
Campbell, J. Y., and L. M. Viceira, 1999, “Consumption and portfolio decisions when
expected returns are time varying,” Quarterly Journal of Economics, 114, 433–495.

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