Last Revised: 05/12/2023

2024 Level 1 - Derivatives

Readings Page

Derivative Instrument and Derivative Market Features 2

Forward Commitment and Contingent Claim Features and

6
Instruments

Derivative Benefits, Risks, and Issuer and Investor Uses 13

Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives 18

Pricing and Valuation of Forward Contracts and for an Underlying

24
with Varying Maturities

Pricing and Valuation of Futures Contracts 30

Pricing and Valuation of Interest Rates and Other Swaps 34

Pricing and Valuation of Options 38

Option Replication Using Put-Call Parity 43

Valuing a Derivative Using a One-Period Binomial Model 47

This document should be used in conjunction with the corresponding readings in the 2024 Level 1 CFA® Program curriculum.
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1
 Last Revised: 05/12/2023

Derivative Instrument and Derivative Market Features

a. define a derivative and describe basic features of a derivative instrument

b. describe the basic features of derivative markets, and contrast over-the-counter

and exchange-traded derivative markets

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 Last Revised: 05/12/2023

Derivative Instrument & Derivative Market Features

Page 1/
Derivative - financial instrument that derives its value from
the performance of an underlying asset
the underlying - an asset,
- cash flows are exchanged in the
a group of standardized assets,
future at a price agreed on today
or variables (i.e. interest rate)
one is typically a financial intermediary

- a legal agreement between counterparties with a specific

maturity (settlement date), a specific quantity of underlying,
and a specific price
buyer is long, seller is short
takes delivery delivers

- derivatives can be stand-alone ➞ separately traded

or/ embedded ➞ as part of another financial product (callable bond)

* Define a derivative and describe basic features of a derivative instrument

Page 2/
Derivatives: can be - commitments - both parties obligated
- contingencies - one party has a right (buyer)
the other has an obligation (seller)
- expand market opportunities:
allow short selling - benefit from a price decline
allow diversification ➞ e.g. direct commodity/forex exposure
allow for hedging of risk ➞ financial, operational
reduce capital requirements
typically have lower transaction costs and can be more
liquid than the underlying (esp. commodities)
Underlyings/
① Equities - individual stocks, a group of stocks, stock index

e.g./ GM OIH SPX

* Define a derivative and describe basic features of a derivative instrument

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 Last Revised: 05/12/2023

Page 3/
① Equities - options most common at stock level
- index level ➞ options/futures/forwards/swaps
floating (+sp)
equity swaps ➞ pay equity, rec.
equity
(rec.) (pay)
- allows an investor to get (or remove) exposure without
buying (or selling), or having the risk of taking delivery/delivering
- derivatives also available on the realized volatility of equities
- manage the dispersion of returns separately from price
direction
② Fixed Income - bonds - options/futures/forwards/swaps

ZN 10 yr. UST (100k)

ZT 2 yr. UST (200k)

generic 6% underlying ➞ associated with

a CTD actual bond + conversion factor

* Define a derivative and describe basic features of a derivative instrument

Page 4/
② Fixed Income - interest rates - options/futures/forwards/swaps

MRR - market reference rate (e.g. SOFR - secured - by UST

overnight funding rate)
swaps - pay fl./rec. fx. convert a fixed rate to a floating rate
pay fx./rec. fl. or opposite
add Dp reduce Dp

③ Currencies - take a directional view of a currency or hedge a

currency exposure

④ Commodities - same as
- brokers do not allow delivery so contract must be closed
before the delivery period

* Define a derivative and describe basic features of a derivative instrument

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 Last Revised: 05/12/2023

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⑤ Credit - CDS ➞ Credit Default Swap
long CDS = short credit quality i.e. long the spread, benefit if spread
↑
short CDS = long credit quality i.e. short the spread, benefit if spread ↓

⑥ Other - weather, cryptocurrencies

* Define a derivative and describe basic features of a derivative instrument

Page 6/
OTC - over the counter (dealer market)
market makers
- terms can be customized, less transparency, no daily settlement
- less liquid - though not quite true
Exchange traded - standardized
- liquid - but not always
- transparency
- clearinghouse is counterparty to all contracts
- margin deposit required, gains/losses settled daily

Central Clearing - recent addition for some OTC contracts - swaps

- mgmt. of credit risk, clearing, and settlement

old/ party 1 new/ party 1 C. Clearing

swap party 2 party 2
swap

* Describe the basic features of derivative markets, and contrast over-the-counter and exchange-traded derivative markets

5
 Last Revised: 05/12/2023

Forward Commitment and Contingent Claim Features and Instruments

a. define forward contracts, futures contracts, swaps, options (calls and puts), and
credit derivatives and compare their basic characteristics

b. determine the value at expiration and profit from a long or a short position in a call
or put option

c. contrast forward commitments with contingent claims

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 Last Revised: 05/12/2023

Forward Comm./Cont. Claim Features & Inst.

Page 1/
Commitments: all have 1/ specific contract size
2/ specific underlying
3/ one or more exchanges of cash flow or
underlyings on specific dates
4/ an agreed on price
1/ Forwards: OTC contracts
buyer (long) will buy (take delivery of) the underlying from the seller
(short, delivers) at some future date at some agreed on price set at
contract inception
- if underlying price ↑, buyer gains, seller loses
+
Profit/ linear function of S if ST > F0(T)
Payoff buyer gains ST - F0(T)
ST - spot price
F0(T) seller loses - (ST - F0(T))
maturity
-
forward price agreed on at 𝐭 = 0 zero sum game
* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

Page 2/
- if ST < F0(T): buyer loses F0(T) - ST
seller gains - (F0(T) - ST)

forwards can be physically or cash settled

② Futures: exchange-traded forwards ➞ standardized sizes, dates,
underlyings
F0(T) ➞ futures price ( = 𝐒𝟎 𝐞𝐫𝐓 )
- will have daily settlement (mark-to-market or MTM)
buyer in gains - money taken from seller’s account
and added to buyer’s account at the end of the trading day
- clearinghouse is counterparty to all contracts
- each side (buyer/seller) posts a margin (initial margin)
maintenance margin - a level below the initial margin that
the account must have

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

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 Last Revised: 05/12/2023

Page 3/
e.g./ GC - gold, 100 oz., F0(T) = 1792.13, initial margin = 4,950
maintenance margin = 4,450
Buyer f0(T) = 1792.13 Seller

+500 -500
f1(T) = 1797.13
5450 4450 - margin call
+ 500 ➞ variation
-1000 f2(T) = 1787.13 4950 margin
margin call - 4450 + 1000
500 5950
4950 etc.

- if margin call is not met, contract is closed (forced liquidation)

- clearinghouse guarantees performance to both sides
- as volatility ↑, exchanges usually increase initial margin requirements

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

Page 4/
Price limits: contracts typically have daily price limits

+% upper limit - price is ‘limit up’ - only trades at lower

circuit prices can occur
F0(T)
breakers
-% lower limit - price is ‘limit down’ - only trades at higher
prices can occur
- futures have same linear payoff/profit profile as forwards
- can also be physically or cash-settled
③ Swaps: 2 counterparties exchange a series of cash flows
in the future
- one leg is floating ➞ tied to a short-term market reference
rate that resets each period
- the other is fixed or tied to a different asset or rate

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

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 Last Revised: 05/12/2023

Page 5/
𝐫𝐟𝐥 𝐍𝐀
fixed rate floating rate
payer payer
𝐫𝐟𝐱 𝐍𝐀
(pay fx., rec. fl.) (pay fl., rec. fx.)

agreed on rates, term, payment dates

Interest rate swaps ➞ plain vanilla ➞ fixed for floating

pay fx. 𝐫𝐟𝐱 𝐍𝐀 5 yr./annual resets

pay fl. MRR1 NA MRR2

fixed rate also
MRR3 MRR4 MRR5
called the swap rate
netted out
no notional principal is exchanged (they are in currency swaps)
used to determine the
size of the payments

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

Page 6/
pay fl., rec. fx. ➞ same as being short a floating rate bond
and being long a fixed rate bond (low D)
(high D)
+ (high D) - (low D) = net positive duration
- add D to a portfolio with a rec. fx. swap.

- on Day0, fl. leg = 100

∴ fx. rate ➞ coupon rate that results in a par bond given
the structure of interest rates
- swap may or may not include: collateral
Central Counterparty (CCP)

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

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Contingent Claims: OTC or ETD - options most common
- buyer (long position) has a right to determine if delivery
takes place
- all have a specific underlying/size/price/maturity date
Options/ buyer pays seller a premium
e.g./ C0 = 5 @ 𝐭=0 X = 30 (exercise or strike price)

at ST = 40 ➞ buyer exercises call, pays 30

Value of call = ST - X = 40 - 30 = 10
profit = VT - C0 = 10 - 5 = 5 zero-sum
seller loses 5: C0 - VT = 5 - 10 = -5 game
at ST = 25 ➞ buyer does not exercise call - no wealth is
Value of call = 0 created, only
profit = VT - C0 = 0 - 5 = -5 transferred
seller gains 5: C0 - VT = 5 - 0 = 5

* Determine the value at expiration and profit from a long or a short position in a call or put option

Page 8/
European options - exercise at maturity only (typically OTC)
American options - anytime exercise (typically ETD)
call option - right to buy, put option - right to sell
puts calls
ITM 𝐗𝟐 OTM TV only - longer the time to maturity,
𝐈𝐕 = 𝐗 𝟐 − 𝐒 the higher the TV component
time value
intrinsic ATM S ATM - at expiration: TV = 0
value 𝐂𝐓 = IV only
𝐈𝐕 = 𝐒 − 𝐗 𝟏
OTM 𝐗 𝟏 ITM 𝐂𝐓 = 𝐈𝐕 + 𝐓𝐕
- long puts - benefit - long calls - benefit
when S ↓ when S ↑

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

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long call short call
+ - not limited
+
limited gain
gain
x 𝐂𝟎 𝐱 + 𝐂𝟎 = 𝐁𝐄𝐏
𝐒𝐓 𝐒𝐓
-𝐂𝟎 x
𝐱 + 𝐂𝟎 = 𝐁𝐄𝐏
- limited loss - not limited loss

not limited
long put short put
gain + +

𝐏𝟎 limited gain
x
𝐒𝐓 𝐒𝐓
x
-𝐏𝟎
𝐱 − 𝐏𝟎 = 𝐁𝐄𝐏 - 𝐱 − 𝐏𝟎 = 𝐁𝐄𝐏
- limited
loss not limited
loss
- long side has counterparty risk - seller either owes nothing or something
* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

Page 10/
Credit Derivatives: based on the default risk of an issuer or
group of issuers
CDS - credit default swap - most common (contingent claim)
IG bonds - CDS spread = 1%
CDS credit spread
HY bonds - CDS spread = 5%
credit protection buyer pays regular credit protection seller
long CDS premiums to Short CDS
short credit quality long credit quality
1%/yr.
5%/yr.
- based on some notional amount
- if issuer defaults ➞ seller covers buyers losses on the bond
- can be used to hedge existing credit risk corporate
or to take a directional view on credit sovereign
spreads index of either HY or IG
SPV
* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

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Page 11/

once a
premium default
- typically paid occurs, called
quarterly a credit
i.e. 25bps × NA event, buyer
stops paying
CDS gains the premiums
value as
credit spread
widens
(for the buyer)

* Define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics

Page 12/

forward profit
forward profit
> forward outperforms
F0(T) or option
option profit option
x
(by Co) profit
𝐒𝐓 𝐒𝐓
indifference
forward profit = option profit point

option outperforms
option outperforms forward forward

long forward vs. long call long forward vs. short put

* Contrast forward commitments with contingent claims

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 Last Revised: 05/12/2023

Derivative Benefits, Risks, and Issuer and Investor Uses

a. describe benefits and risks of derivative instruments

b. compare the use of derivatives among issuers and investors

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 Last Revised: 05/12/2023

Derivative Benefits, Risks, Uses

Page 1/
Benefits/
1/ Risk allocation, transfer, management - all without trading the
underlying
gain a risk exposure hedge/offset some risk
from: to: from: +
+ + + +

𝐒𝐓 𝐒𝐓 𝐒𝐓 𝐒𝐓 = 𝐒𝐓

- - - - -
pos. exp. adding exp. = neutral

- manage short
from: long stock + call option = covered call
return distribution + +

sell 𝐒𝐓 𝐒𝐓

E(R) - -

* Describe benefits and risks of derivative instruments

Page 2/
1/ Risk allocation, transfer, management
allocate or transfer risk across time as well
re-invest today Dividends

𝐭=0 𝐭 = 30
sell puts
long equity index futures

2/ Information discovery - derivatives (futures) can trade outside of cash

market hours ➞ can signal where cash market will
open (equity indexes, commodities, bonds)
- can also signal market belief ➞ FFF ➞ will anticipate future Fed.
actions
3/ Operational advantages - reduced cash outlay
- lower transaction costs - esp. commodities
- eliminate transportation/storage costs

* Describe benefits and risks of derivative instruments

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 Last Revised: 05/12/2023

Page 3/
3/ Operational advantages
- increased liquidity (vs. cash market) - as a result of much
lower capital requirements
- ability to short - esp. commodities
4/ Market efficiency - less costly for arbitrage

Risks/
1/ Greater potential for speculative use - high degree of implicit leverage
e.g. CL @ 108/bbl ➞ $108,000 𝟏𝟎𝟖𝐤
leverage = = 12.7×
margin ➞ 8500 𝟖.𝟓𝐤

+⁄− $1 ➞ ( 𝟏𝟎𝟎𝟎-
𝟖𝟓𝟎𝟎 ( = 11.76% gain or loss
(.926%)

* Describe benefits and risks of derivative instruments

Page 4/
2/ Lack of transparency - adds complexity to a product or portfolio that
may not be well understood

3/ Basis risk - divergence between spot & forward/future price return

futures expiration of derivative does not match

converge at 𝐭 = T future date of expected underlying transaction
spot imperfect hedges - e.g.: using heating oil (HO)
end of hedge to hedge out jet fuel price risk

4/ Liquidity risk - from MTM

LME: Nickel
> 100k ➞ Chinese producer - short LME Nickel futures
but is a nickel producer - ability to deliver
- had to get massive bank loans to meet the
20k
mark to stay in the contracts

* Describe benefits and risks of derivative instruments

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 Last Revised: 05/12/2023

Page 5/
4/ Counterparty credit risk - lower with ETD (esp. with price limits)
OTC - commitments - both sides have this risk
- contingencies - only the long side has this risk

5/ Destabilization and systemic risk - excessive risk taking and leverage

can create market stress when equity depletes and
credit for margin calls dries up.

* Describe benefits and risks of derivative instruments

asset values Page 6/

Issuers: primarily hedge liabilities
revenues/expenses
- issuers (companies) must report all gains/losses on derivatives through
the Income Statement (not OCI) unless it qualifies for hedge accounting
- allows for offsetting - dates, notional amounts ➞ must closely match
features of the underlying transaction
∴ primarily use OTC derivatives

Cash flow hedges - absorbing variable cash flows of a floating

rate (or price) asset or liability
e.g.: forex, interest rates, commodity prices (inventory)

Fair Value hedges - offset fluctuations in FV of an A or L

e.g. rec. fx., pay fl. swap - increases D against an existing
bond issue (-D)

* Compare the use of derivatives among issuers and investors

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 Last Revised: 05/12/2023

Page 7/
Net investment hedge - offset the foreign exchange risk of
the equity (A - L) of a foreign operation

- with hedges ➞ all gains/losses are held in OCI until the underlying
transaction is recognized

Issuers Investors
- offset/hedge exposures - replicate a cash strategy
in their commercial or - hedge financial risk
financing activities - modify a risk exposure
Retail - ETD exclusively
Institutional - mix of ETD/OTC

* Compare the use of derivatives among issuers and investors

17
 Last Revised: 05/12/2023

Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives

a. explain how the concepts of arbitrage and replication are used in pricing
derivatives

b. explain the difference between the spot and expected future price of an underlying
and the cost of carry associated with holding the underlying asset

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Arbitrage, Replication, and Cost of Carry

Page 1/
Arbitrage - opportunity for a riskless profit
- a derivative is priced so that no arbitrage opportunities
exist (no-arbitrage pricing)
TVM: Recall
FV = 𝐏𝐕(𝟏 + 𝐫)𝐓 - discrete compounding - will be used for individual underlying
FV = 𝐏𝐕𝐞𝐫𝐓 - continuous compounding forex assets

portfolios - equity
r = discount rate - fixed income indexes
a risk-free rate - commodity
- typically a market reference rate (MRR)
(not a gov’t. rate)
e.g./ gold @ 1770/oz., r = 2%, T = 3 mos.
borrow 1770 for 3 mos. ➞ FV = 𝟏𝟕𝟕𝟎(𝟏. 𝟎𝟐).𝟐𝟓 = 1778.78/oz.
GC - futures contract for 100 oz.
- contract value = 177,878.00

* Explain how the concepts of arbitrage and replication are used in pricing derivatives

Page 2/
e.g./ gold @ 1770/oz., r = 2%, T = 3 mos. FV = 1778.78
Let F0(T) = 1792.13
Rule of arbitrage: Buy low, sell high
Buy gold @ 1770 oz. with borrowed funds at 𝐭 = T, deliver 100 oz.
Sell futures @ 1792.13 for 179,213, pay loan of
177,878, make 1334.56

∴ F0(T) = 𝐒𝟎 (𝟏 + 𝐫)𝐓 or F0(T) = 𝐒𝟎 𝐞𝐫𝐓 - assuming no transaction

costs, storage or transportation,
and no other cash inflows
higher r, higher (div./int.)

𝐅 (𝐓) futures price

𝟎

𝐭=0 𝐅𝟏 (𝐭) 𝐭=T

𝐒𝟎 longe time, higher futures price

* Explain how the concepts of arbitrage and replication are used in pricing derivatives

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Page 3/
Replication - using borrowing/lending to buy/sell the underlying to
replicate a forward contract (or using a forward to
replicate a cash transaction)
e.g./ need 1000 barrels of oil in 6 mos.
𝐒𝟎 = 108/bl. T = 6 mos. r = 2%
borrow 108k @ 2% for 6 mos. and buy 1000 barrels of oil
in 6 months, pay back 𝟏𝟎𝟖, 𝟎𝟎𝟎(𝟏. 𝟎𝟐).𝟓 = 109,074.65
F0(T) = 𝟏𝟎𝟖(𝟏. 𝟎𝟐).𝟓 = 109.07465
- buy forward contract - in 6 mos. take delivery, pay 109,074.65

- if oil is 115/bl. at 𝐭 = T, gain on F0(T) = 115,000 - 109,074.65 = 5,925.35

- oil inventory FMV = 115,000, gain on inventory = 7000
interest exp. = 1074.65
5925.35

* Explain how the concepts of arbitrage and replication are used in pricing derivatives

Page 4/
- a complete hedge will earn 𝐫𝐟

- assume we hold 1000 barrels of oil

- sell a forward contract at F0(T) = 109.07465

- at expiration, deliver underlying for F0(T)

108

× (𝟏. 𝟎𝟐).𝟓
𝟏𝟎𝟗. 𝟎𝟕𝟒𝟔𝟓 𝟐
𝐫=6 ; − 𝟏 = 𝟐%
𝟏𝟎𝟖
=

109.07465

* Explain how the concepts of arbitrage and replication are used in pricing derivatives

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Page 5/
Cost of carry - net of costs and benefits related to owning
the underlying for a specific period
r - discount rate ➞ opportunity cost of holding an asset
(carrying)

dividends
𝐅𝟎 (𝐓)
costs > benefits CFs interest
non-CF - convenience yield
r
F0(T) ➞ benefits = costs
𝐒𝟎 higher r, higher F0(T)
storage
F0(T) < S0 ➞ benefits > costs
insurance
transportation
F0(T) = [𝐒𝟎 − 𝐏𝐕𝟎 (𝐈) + 𝐏𝐕𝟎 (𝐜)](𝟏 + 𝐫)𝐓
known amounts
(𝐫&𝐜(𝒊)𝐓
F0(T) = 𝐒𝟎 𝐞
known rates, all continuously compounded

* Explain the difference between the spot and expected future price of an underlying and the cost of carry associated with holding the underlying asset

Page 6/
e.g./ S0 = 50 r = 5% T = 6 mos. Div. = I = 0
F0(T) = 𝟓𝟎(𝟏. 𝟎𝟓).𝟓 = 51.23
- now assume a quarterly dividend of 0.30 at T = 3 mos. and T = 6 mos.

F0(T) = >𝟓𝟎 − .𝟑 .𝟑
− @ (𝟏. 𝟎𝟓).𝟓
(𝟏. 𝟎𝟓) .𝟐𝟓 (𝟏. 𝟎𝟓).𝟓
= (50 - .2964 - .2928)(1.05).5 = 50.631
.30 .30

borrow: 50 50.93107
50.6136
- .3 vs.
× (𝟏. 𝟎𝟓).𝟐𝟓 - .3
50.631 𝟓𝟎𝐞(.𝟎𝟓+.𝟎𝟐𝟒).𝟓
50.3136 × (𝟏. 𝟎𝟓).𝟐𝟓
= 50.654
Now: assume div. is 2.4%
LN(1.05) = .04879 F0(T) = 𝟓𝟎𝐞(.𝟎𝟒𝟖𝟕𝟗+.𝟎𝟐𝟑𝟕𝟏𝟔).𝟓 = 50.6307
LN(1.024) = .023716

* Explain the difference between the spot and expected future price of an underlying and the cost of carry associated with holding the underlying asset

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Page 7/
Forex: 𝐒𝐏. ➞ 𝐒𝐩𝐫𝐢𝐜𝐞5 ➞ the amount of the price currency needed
𝐁 𝐛𝐚𝐬𝐞
to buy 1 unit of the base
long FX forward - purchase the base at expiration and pay the price
e.g.: 𝐂𝐀𝐃/𝐔𝐒𝐃 = 1.2590 ➞ buy 1 USD for 1.2590 CAD

1000 B
invest @ 𝐫𝐁 convert to P @ 𝐒𝐏, , invest at 𝐫𝐏
𝐁

1000 1000(𝟏 + 𝐫𝐁 )𝐓 1000 · 𝐒𝐏' 1000 · 𝐒𝐏' (𝟏 + 𝐫𝐏 )𝐓

𝐁 𝐁

- for there to be no arbitrage: convert back to B

𝐓
1000(𝟏 + 𝐫𝐁 )𝐓 = 𝟏𝟎𝟎𝟎 𝐒𝐏,𝐁 (𝟏 + 𝐫𝐏 ) 𝟏𝟎𝟎𝟎 𝐒𝐏, (𝟏 + 𝐫𝐏 )𝐓
𝐁
𝐅𝐏, 𝐅𝐏,
𝐁 𝐁
𝐒𝐏, (𝟏 + 𝐫𝐏 )𝐓 (𝟏 + 𝐫𝐏 )𝐓
(𝟏 + 𝐫𝐁 )𝐓 = 𝐁
⇒ 𝐅𝐏, = 𝐒𝐏, (𝐫 )𝐓
𝐅𝐏,
𝐁
𝐁 𝐁 (𝟏 + 𝐫𝐁 )𝐓 or/ 𝐅𝐏6 = 𝐒𝐏6 𝐞 𝐏 +𝐫𝐁
𝐁 𝐁

* Explain the difference between the spot and expected future price of an underlying and the cost of carry associated with holding the underlying asset

Page 8/
𝐅𝐏6 = 𝐒𝐏6 𝐞 (𝐫𝐏 +𝐫𝐁 )𝐓
Forward
𝐁 𝐁
𝐫𝐏 − 𝐫𝐁 < 0 ➞ 𝐅𝐏6 < 𝐒𝐏6 - base trades at a discount (or price
𝐁 𝐁
trades at a premium)
𝐫𝐏 − 𝐫𝐁 > 0 ➞ 𝐅𝐏6 > 𝐒𝐏6 - base trades at a premium (or price
𝐁 𝐁
trades at a discount)
Commodities:
convenience yield - a non-cash benefit of holding a physical
commodity vs. a derivative
tight spot
contango backwardation
- well supplied market market
𝐒𝟎
- high storage costs - low storage
F1(T) F1(T)
- low convenience costs
yield - high convenience
𝐒𝟎 yield
all F(T) > 𝐒𝟎
all F(T) < 𝐒𝟎
F0(T) = [𝐒𝟎 + 𝐏𝐕𝟎 (𝐜)](𝟏 + 𝐫)𝐓 or F0(T) = 𝐒𝟎 𝐞(𝐫7𝐜)𝐓

* Explain the difference between the spot and expected future price of an underlying and the cost of carry associated with holding the underlying asset

22
 Last Revised: 05/12/2023

Page 9/

e.g./ gold @ 1783.28/oz. r = 2% T = 3 mos. Storage = 2/oz. at 𝐭 = T

𝟐
F0(T) = 5𝟏𝟕𝟖𝟑. 𝟐𝟖 + 7 (𝟏. 𝟎𝟐).𝟐𝟓 = 1794.13
(𝟏. 𝟎𝟐).𝟐𝟓

since c is at time T

F0(T) = 𝟏𝟕𝟖𝟑. 𝟐𝟖(𝟏. 𝟎𝟐).𝟐𝟓 + 2 = 1794.13

𝐒𝟎 = 1097 𝐫𝐟 = 1.5% costs = $1/oz. at quarter end

3 mos.: F0(T) = 𝟏𝟎𝟗𝟕(𝟏. 𝟎𝟏𝟓).𝟐𝟓 + 1 = 1102.09

6 mos.: F0(T) = >𝟏𝟎𝟗𝟕 + G𝟏-(𝟏. H@ (𝟏. 𝟎𝟏𝟓).𝟓 + 1 = 1107.20

𝟎𝟏𝟓).𝟐𝟓

1 yr.: F0(T) = 𝟏𝟎𝟗𝟕 + 7𝟏/(𝟏. 𝟎𝟏𝟓).𝟐𝟓 + 𝟏/(𝟏. 𝟎𝟏𝟓).𝟓 + 𝟏/(𝟏. 𝟎𝟏𝟓).𝟕𝟓 : (𝟏. 𝟎𝟏𝟓) + 1 = 1117.48

* Explain the difference between the spot and expected future price of an underlying and the cost of carry associated with holding the underlying asset

23
 Last Revised: 05/12/2023

Pricing and Valuation of Forward Contracts and for an Underlying

with Varying Maturities

a. explain how the value and price of a forward contract are determined at initiation,
during the life of the contract, and at expiration

b. explain how forward rates are determined for interest rate forward contracts and
describe the uses of these forward rates.

24
 Last Revised: 05/12/2023

Pricing/Valuation of Forward Contracts

Page 1/
𝐕𝟎 (𝐓) = 𝟎 for forward contracts
➞ 𝐕𝐭 (𝐓) changes as: time passes
interest rates change
the underlying price changes
𝐅𝟎 (𝐓) = 𝐒𝟎 (𝟏 + 𝐫)𝐓 𝐅𝟎 (𝐓) = 𝐒𝟎 𝐞𝐫𝐓
𝐒𝟎 𝐅𝟎 (𝐓) 𝐅𝟎 (𝐓) = [𝐒𝟎 + 𝐏𝐕(𝐜) − 𝐏𝐕(𝐈)](𝟏 + 𝐫)𝐓
carry 𝐅𝟎 (𝐓) = 𝐒𝟎 𝐞(𝐫.𝐢0𝐜)𝐓

Payoff at T: 𝐕𝐓 (𝐓) = 𝐒𝐓 − 𝐅𝟎 (𝐓)

𝐭 𝐓−𝐭

𝐒𝟎 𝐒𝐭 𝐅𝟎 (𝐓) 𝐕𝐭 (𝐓) = 𝐒𝐭 − 𝐅𝟎 (𝐓)

(𝟏 + 𝐫)𝐓(𝐭
T

* Explain how the value and price of a forward contract are determined at initiation, during the life of the contract, and at expiration

Page 2/
I I
𝐕𝐭 (𝐓) = J𝐒𝐭 − 𝐏𝐕(𝐈)L − 𝐅𝟎 (𝐓)
𝐒𝟎 𝐒𝐭 𝐅𝟎 (𝐓) (𝟏 + 𝐫)𝐓+𝐭

change in rates: 𝐒𝟎 = 50 r = 2% T = 6 mos.

gains
𝐅𝟎 (𝐓) = 𝟓𝟎(𝟏. 𝟎𝟐).𝟓 = 𝟓𝟎. 𝟓𝟎
𝐅𝟎 (𝐓) r ↑ 20 bps
𝐒𝐓
𝐒𝟎 losses 𝐕𝟎 (𝐓) = 𝟓𝟎 − 𝟓𝟎. 𝟓𝟎 = 𝟓𝟎 − 𝟒𝟗. 𝟗𝟓 = . 𝟎𝟓
r = 2% (𝟏. 𝟎𝟐𝟐).𝟓
passage of time: 𝐭 = 2 mos.
𝟓𝟎. 𝟓𝟎
𝐕𝐭 (𝐓) = 𝟓𝟎 − 𝟒'
= 𝟓𝟎 − 𝟓𝟎. 𝟏𝟕 = −. 𝟏𝟕
𝐭 = 2 mos., 𝐫𝟏𝟐𝟎 = 1.6%, 𝐒𝐭 = 50.25 (𝟏. 𝟎𝟐) 𝟏𝟐

𝟓𝟎. 𝟓𝟎 underlying adds 0.25

𝐕𝐭 (𝐓) = 𝟓𝟎. 𝟐𝟓 − 𝟒 = . 𝟎𝟐
(𝟏. 𝟎𝟏𝟔) '𝟏𝟐 time + lower r takes away 0.23

* Explain how the value and price of a forward contract are determined at initiation, during the life of the contract, and at expiration

25
 Last Revised: 05/12/2023

Page 3/
I = .50 4m I = .50 7m 9m r(90) = 2%
60 3m c = .25 5 6m c = .25 𝐅𝟎 (𝐓) = 60.57 r(120) = 2.1%
r(180) = 2.2%
𝐒𝐭 = 61.60
r(210) = 2.3%
r(270) = 2.4%
.𝟓 .𝟓 . 𝟐𝟓 . 𝟐𝟓 𝟗
𝐕𝟎 (𝐓) = <𝟔𝟎 − − + + ? (𝟏. 𝟎𝟐𝟒) ,𝟏𝟐
(𝟏. 𝟎𝟐).𝟐𝟓 (𝟏. 𝟎𝟐𝟐).𝟓 (𝟏. 𝟎𝟐𝟏)𝟒,𝟏𝟐 (𝟏. 𝟎𝟐𝟑)𝟕,𝟏𝟐
𝟗6
= (60 - .49753 - .49458 + .24827 + .2467)(𝟏. 𝟎𝟐𝟒) 𝟏𝟐 = 60.57

. 𝟓𝟎 . 𝟐𝟓 𝟔𝟎. 𝟓𝟕 r(30) = 1.6%

𝐕𝐭 (𝐓) = <𝟔𝟏. 𝟔𝟎 − 𝟏,
+ 𝟐,
?− 𝟒, r(60) = 1.7%
(𝟏. 𝟎𝟏𝟔) 𝟏𝟐 (𝟏. 𝟎𝟏𝟕) 𝟏𝟐 (𝟏. 𝟎𝟐) 𝟏𝟐
r(120) = 2%
= (61.60 - .49934 + .249298) - 60.1715 = 1.18

* Explain how the value and price of a forward contract are determined at initiation, during the life of the contract, and at expiration

Page 4/
Forex/ 𝐅𝟎𝐏 (𝐓) = 𝐒𝟎𝐏 𝐞 (𝐫𝐏 +𝐫𝐁 )𝐓
and 𝐕𝟎 (𝐓) = 0
'𝐁 '𝐁

𝐒𝟎𝐏 𝐒𝐭 𝐏 𝐅𝟎𝐏
'𝐁 '𝐁 '𝐁
𝐫𝐏𝟎 (𝐓) 𝐫𝐏𝐭 (𝐓 − 𝐭)
𝐫𝐁𝟎 (𝐓) 𝐫𝐁𝐭 (𝐓 − 𝐭)
(𝐫𝐏 − 𝐫𝐁 )𝟎 (𝐫𝐏 − 𝐫𝐁 )𝐭 - for a long position, a widening
interest rate differential will
support gains
long 𝐔𝐒𝐃B𝐄𝐔𝐑 forward at 1.2010
gains if: 𝐫𝐏 ↑
𝐫𝐔𝐒𝐃 = .5% 𝟏. 𝟏𝟗𝟐(𝟏. 𝟎𝟎𝟓)𝐓
𝐫𝐁 ↓
(. 𝟗𝟗𝟕𝟓)𝐓
𝐫𝐄𝐔𝐑 = -.25% or 𝐒𝐏6
𝐁
↑
𝐒𝐔𝐒𝐃6 = 1.192
𝐄𝐔𝐑

* Explain how the value and price of a forward contract are determined at initiation, during the life of the contract, and at expiration

26
 Last Revised: 05/12/2023

Page 5/
𝐔𝐒𝐃.
𝐄𝐔𝐑 1 yr. - take delivery of EUR, pay USD

1.192 1.2010
𝐫𝐔𝐒𝐃 (360) = .5%
𝐫𝐄𝐔𝐑 (360) = -.25% 𝐕𝐭 (𝐓) = 𝟏. 𝟏𝟗𝟐 − 𝟏. 𝟐𝟎𝟏𝟎𝐞(.𝟎𝟎𝟕𝟓0.𝟎𝟎𝟐𝟓) = . 𝟎𝟎𝟐𝟗𝟓
(𝐭 = 0)
- raise 𝐫𝐔𝐒𝐃 (360) by 25 bps [ × €50M = 147,500 USD]

e.g./ short 6 mos. 𝐙𝐀𝐑F𝐄𝐔𝐑 at 17.2506 €50m

6 mos.
𝐫𝐙𝐀𝐑 (180) = 3.5% - deliver EUR,
16.909 17.02 4 mos. 17.2506 get paid ZAR
𝐫𝐄𝐔𝐑 (180) = -.50%
𝐫𝐙𝐀𝐑 (120) = 3%

𝐕𝐓 (𝐓) = 𝐅𝟎 (𝐓) − 𝐒𝐓 𝐫𝐄𝐔𝐑 (120) = -.30%

𝟒'
∴ 𝐕𝐭 (𝐓) = N𝐅𝟎 (𝐓)𝐞+(𝐫𝐏 +𝐫𝐁)𝐓+𝐭 O − 𝐒𝐭 = 𝟏𝟕. 𝟐𝟓𝟎𝟔𝐞+(.𝟎𝟑7.𝟎𝟎𝟑) 𝟏𝟐
− 𝟏𝟕. 𝟎𝟐 = . 𝟎𝟏𝟒𝟖𝟖

× €50M = 2,094,162.26 ZAR

* Explain how the value and price of a forward contract are determined at initiation, during the life of the contract, and at expiration

Page 6/
Interest rate forward contracts: FRA - forward rate agreement

term structure of quoted MRRs

forward rates: 𝐟𝐰𝐡𝐞𝐧,𝐰𝐡𝐚𝐭 or 𝐈𝐅𝐑 𝐱,𝐲

spot rates
e.g.: 𝐈𝐅𝐑 𝟐,𝟑 ➞ the implied forward
rate in 2 periods for
𝒕 3 periods
1 2 3 4 5 6
𝟑
(𝟏 + 𝐙𝟐 )𝟐 D𝟏 + 𝐈𝐅𝐑 𝟐,𝟑 E = (𝟏 + 𝐙𝟓 )𝟓 ➞ forward rate model
𝟏5
)𝟓 𝟑
𝐈𝐅𝐑 𝟐,𝟑 = 8(𝟏 + 𝐙𝟓 : − 𝟏
(𝟏 + 𝐙𝟐)𝟐

* Explain how forward rates are determined for an underlying with a term structure and describe their uses

27
 Last Revised: 05/12/2023

Page 7/
Note: all rates are quoted annually
MRRs
Z(180)
𝐈𝐅𝐑 𝟑𝐦𝟐𝐦 :
Z(30) @𝟏 + 𝐙(𝟗𝟎)/𝟒C @𝟏 + 𝐈𝐅𝐑(𝟔𝟎)/𝟔C = @𝟏 + 𝐙(𝟏𝟓𝟎)/𝟐. 𝟒C
Z(150)
90d = 3m 60d = 2m 150d = 5m
𝒕 𝟏𝟐5 = 4
𝟑
𝟏𝟐5 = 6
𝟐
𝟏𝟐5 = 2.4
𝟓
30 60 90 120 150 180

IFR(60) = G𝟏 + 𝐈𝐅𝐑(𝟏𝟓𝟎)- H
e.g. Z(30) = 1.204 𝟐. 𝟒
Y − 𝟏Z × 𝟔
Z(60) = 1.390 G𝟏 + 𝐈𝐅𝐑(𝟗𝟎)-𝟒H
Z(90) = 1.568
Z(120) = 1.691 K𝟏 + . 𝟎𝟏𝟖𝟕𝟔F𝟐. 𝟒M
=P − 𝟏Q × 𝟔 = 𝟐. 𝟑𝟐𝟖𝟗%
Z(150) = 1.876 H𝟏 + . 𝟎𝟏𝟓𝟔𝟖F𝟒J

GH𝟏 + . 𝟎𝟏𝟓𝟔𝟖F𝟒J K𝟏 + . 𝟎𝟐𝟑𝟐𝟖𝟗F𝟔M − 𝟏N × 𝟐. 𝟒 = 𝟏. 𝟖𝟕𝟔%

* Explain how forward rates are determined for an underlying with a term structure and describe their uses

Page 8/
FRA: the rate for a deposit at a future period

for this period

B long FRA ➞ will pay
forward rate the fixed forward rate
NA × deposit period
agreed to A and receive the MRR
for the period A - B
settlement date
- called advanced set
- called advanced settled
long position:
pays: 𝐏𝐕𝐀 S𝐍𝐀 × 𝐈𝐅𝐑 𝐀,𝐁+𝐀 × 𝐏𝐞𝐫𝐢𝐨𝐝-𝟑𝟔𝟎W
receives: 𝐏𝐕𝐀 S𝐍𝐀 × 𝐌𝐑𝐑 𝐁+𝐀 × 𝐏𝐞𝐫𝐢𝐨𝐝-𝟑𝟔𝟎W

Net: 𝐏𝐕𝐀 S 𝐍𝐀 × J𝐌𝐑𝐑 𝐁+𝐀 − 𝐈𝐅𝐑 𝐀,𝐁+𝐀 L × 𝐏𝐞𝐫𝐢𝐨𝐝-𝟑𝟔𝟎W

* Explain how forward rates are determined for an underlying with a term structure and describe their uses

28
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Page 9/

2.24299;𝟗𝟎5𝟑𝟔𝟎>

𝐌𝐑𝐑 537,500 𝟐. 𝟐𝟒𝟐𝟗𝟗

=
𝟒 𝟒
(not IFR)
simple
interest
560,747.50 only

* Explain how forward rates are determined for an underlying with a term structure and describe their uses

29
 Last Revised: 05/12/2023

Pricing and Valuation of Futures Contracts

a. compare the value and price of forward and futures contracts

b. explain why forward and futures prices differ

30
 Last Revised: 05/12/2023

Pricing and Valuation of Futures Contracts

Page 1/
e.g./ 𝐒𝟎 = 1770 r = 2% 100 oz. gold contract long position
T = 91 days
𝐅𝟎 (𝐓) = 1778.76 𝐕𝟎 (𝐓) = 0
𝐟𝟎 (𝐓) = 1778.76 𝐕𝟎 (𝐓) = 0 margin = 4950, maint. mrg. = 4450

Day 1/ 𝐟𝟏 (𝐓) = 1773.76 (↓ $5)∆𝐟𝐭 (𝐓) is MTM, not 𝐕𝐭 (𝐓)

long position ➞ $500 MTM loss 𝐕𝟏 (𝐓) = 0 - reset to
∅ each day
𝐒𝟏 = 𝟏𝟕𝟕𝟑. 𝟕𝟔H 𝟗𝟎 = 𝟏𝟕𝟔𝟓. 𝟏𝟐
(𝟏. 𝟎𝟐) ,𝟑𝟔𝟓
Forward: 𝐕𝟏 (𝐓) = 1765.12 - 𝟏𝟕𝟕𝟖. 𝟕𝟔H 𝟗𝟎 = -4.98 (´ 100 oz. = -498)
(𝟏. 𝟎𝟐) ,𝟑𝟔𝟓
Day 2/ 𝐟𝟐 (𝐓) = 1769.76 (↓ $4) 𝐟𝐭 (𝐓) − 𝐟𝐭+𝟏 (𝐓)
long position ➞ $400 MTM loss 𝐕𝟐 (𝐓) = 0
𝐒𝟐 = 𝟏𝟕𝟔𝟗. 𝟕𝟔S = 𝟏𝟕𝟔𝟏. 𝟐𝟒
𝟖𝟗
(𝟏. 𝟎𝟐) ,𝟑𝟔𝟓 cumulative

Forward: 𝐕𝟐 (𝐓) = 1761.24 - 𝟏𝟕𝟕𝟖. 𝟕𝟔H 𝟖𝟗 = -8.95 (´ 100 oz. = -895)

(𝟏. 𝟎𝟐) ,𝟑𝟔𝟓
* Compare the value and price of forward and futures contracts

Page 2/
Forward: 𝐅𝟎 (𝐓) remains fixed Futures: 𝐟𝐭 (𝐓) changes every day
𝐕𝐭 (𝐓) = 𝐬𝐩𝐨𝐭 𝐭 − 𝐏𝐕K𝐅𝟎 (𝐓)M 𝐕𝐭 (𝐓) = 0 at end of each day
settled at maturity Settled every day

gain/loss at T identical - cash flows differ

Interest Rate Futures/ decimal percent
𝐟𝐀,𝐁+𝐀 = 100 - J𝟏𝟎𝟎 × 𝐌𝐑𝐑 𝐀,𝐁+𝐀 L or/ 𝐟𝐀,𝐁+𝐀 = 𝟏𝟎𝟎 − 𝐌𝐑𝐑 𝐀,𝐁+𝐀

futures price (‘index’ or ‘price’ basis)

- same process as FRA ➞ advanced set, advanced settled
long position ➞ earn the fixed rate
e.g./
𝐟𝐀,𝐁.𝐀 = 𝟗𝟖. 𝟐𝟓 ➞ 𝐌𝐑𝐑 𝐀,𝐁.𝐀 = 𝟏. 𝟕𝟓%

- at expiration, if 𝐌𝐑𝐑 𝐁+𝐀 = 1%, index at 99, pays out .75% ´ NA

* Compare the value and price of forward and futures contracts

31
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Page 3/
Short position ➞ pay the fixed rate of 1.75%
at exp. 𝐌𝐑𝐑 𝐁+𝐀 = 2%, index ends at 98, contract pays .25% ´ NA
➞ borrow at 2%, offset by .25% gain
𝐌𝐑𝐑 𝐁+𝐀 = 1%, index ends at 99, contract loss of .75% ´ NA
➞ borrow at 1%, plus .75% contract loss

Futures/Forward - difference in valuation and pricing due to

differences in cash flows

forward/futures prices would be identical if:

1/ Interest rates are constant
𝐅𝟎 (𝐓) = 𝐟𝟎 (𝐓)
cash flows based on ∆𝐟𝐭 (𝐓)
𝐕𝐭 (𝐓) based on ∆𝐒𝐭
𝐟𝐭 (𝐓) = 𝐒𝐭 (𝟏 + 𝐫)𝐓.𝐭
𝐕𝐭 (𝐓) = 𝐒𝐭 − 𝐏𝐕D𝐅𝟎 (𝐓)E

* Explain why forward and futures prices differ

Page 4/
1/ Interest rates are constant
- if r is constant over the life of the contract, since both
have 𝐒𝐓 − 𝐅𝟎 (𝐓) [𝐨𝐫 𝐟𝟎 (𝐓)] as the payoff, the interest rate
effects cancel out

2/ futures prices and interest rates are uncorrelated

if 𝐟𝟎 (𝐓) and r are positively correlated
- gains are invested at higher r (forwards forgo this)
- losses are borrowed at lower r (forwards save this)

- Interest Rate Forwards vs. Futures/

short futures
- to hedge against MRR ↑
long FRA

long futures
MRR ↓
short FRA

* Explain why forward and futures prices differ

32
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Page 5/
- Interest Rate Forwards vs. Futures/
e.g./ need to borrow $50M in 6 mos. for 3 months, pay MRR at that
time
if MRR ↑, borrowing costs ↑
- hedge by shorting interest rate futures
- if MRR ↑, futures price ↓ = gains
pay higher MRR borrowing cost offset by gain
on futures
or/ long FRA (pay fx., rec. fl.)
MRR ↑, borrowing costs up, but gains on FRA offset
higher costs
Convexity Bias/ 1 bps

futures MTM/bps: BPV = NA ´ .0001 ´ 𝐏𝐞𝐫𝐢𝐨𝐝F𝟑𝟔𝟎

e.g. 1m BPV = 1,000,000 ´ .0001 ´ 𝟗𝟎F𝟑𝟔𝟎 = 25

3-mos.
i.e. BPV = +⁄−$25

* Explain why forward and futures prices differ

Page 6/
Convexity Bias/ FRA/ r = 2.21% (+1 bps to 2.22%)

Net Payment = (. 𝟎𝟐𝟐𝟐 − . 𝟎𝟐𝟐𝟏)𝟏𝐌 × 𝟗𝟎B𝟑𝟔𝟎 = 24.86

𝟗𝟎,
(𝟏. 𝟎𝟐𝟐𝟐) 𝟑𝟔𝟎

Central Clearing/ futures: lack of liquidity to meet the MTM would result
in a forced liquidation
forwards: if no margin or MTM, contract survives to expiration
central clearing/margin: cash flow impacts between
futures & forwards closer to
each other
* Explain why forward and futures prices differ

33
 Last Revised: 05/12/2023

Pricing and Valuation of Interest Rates and Other Swaps

a. describe how swap contracts are similar to but different from a series of forward
contracts

b. contrast the value and price of swaps

34
 Last Revised: 05/12/2023

Pricing/Valuation of Interest Rate Swaps

Page 1/
Review/ 3.01% 5.03% 𝟐
𝐈𝐅𝐑 𝟏,𝟏 = (𝟏. 𝟎𝟐)
` − 𝟏a = 𝟑. 𝟎𝟏%
𝟏. 𝟎𝟏
𝐙𝟏 = 1% 𝐙𝟐 = 2% 𝐙𝟑 = 3%
𝐈𝐅𝐑 𝟐,𝟏 = (𝟏. 𝟎𝟑)𝟑
1.022 = (1.01)(1.0301) ` − 𝟏a = 𝟓. 𝟎𝟑%
(𝟏. 𝟎𝟐)𝟐
1.0404 = 1.0404
1.033 = (1.01)(1.0301)(1.0503)
deposit @ 1% for 1 yr. 1.0927 = 1.0927
short FRA @ 3.01%
deposit @ 1% for 1 yr.
or/
short 𝐅𝐑𝐀𝟏,𝟏 @ 3.01%, short 𝐅𝐑𝐀𝟐,𝟏 @ 5.03%
deposit @ 2% for 2 yrs.

borrow @ 1% for 1 yr.

borrow @ 1% for 1 yr.
long FRA @ 3.01%
long 𝐅𝐑𝐀𝟏,𝟏 @ 3.01%, long 𝐅𝐑𝐀𝟐,𝟏 @ 5.03%
or/
borrow @ 2% for 2 yrs.

* Describe how swap contracts are similar to but different from a series of forward contracts

Page 2/
Review/
floating rate
𝐭=0 1% 3.01% 5.03%

receive (pay) 1% at end of deposit (loan) term

imagine a $1 floating rate bond - each coupon = MRR
- each coupon discounted @ 𝐙𝐧

. 𝟎𝟏 . 𝟎𝟑𝟎𝟏 . 𝟎𝟓𝟎𝟑 + 𝟏
𝟏= + + ➞ par bond
𝟏. 𝟎𝟏 (𝟏. 𝟎𝟐) 𝟐 (𝟏. 𝟎𝟑)𝟐
- for a $1 fixed rate bond, a par bond would be =1
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 𝟏 𝟏 𝟏 𝟏
𝟏= + + = 𝐏𝐌𝐓 + 𝐏𝐌𝐓 + 𝐏𝐌𝐓 + 𝐅𝐕
(𝟏 + 𝐙𝟏 ) (𝟏 + 𝐙𝟐 ) 𝟐 (𝟏 + 𝐙𝟑 )𝟑 𝟏 + 𝐙𝟏 (𝟏 + 𝐙𝟐 )𝟐 (𝟏 + 𝐙𝟑 )𝟑 (𝟏 + 𝐙𝟑 )𝟑

𝐃𝐅𝟏 𝐃𝐅𝟐 𝐃𝐅𝟑 𝐃𝐅𝟑

𝟏 = 𝐏𝐌𝐓(∑ 𝐃𝐅) + 𝐃𝐅𝟑
⇒ 𝟏 − 𝐃𝐅𝟑 = 𝐏𝐌𝐓(∑ 𝐃𝐅) ⇒ PMT = 𝟏 − 𝐃𝐅𝐧
∑ 𝐃𝐅

* Describe how swap contracts are similar to but different from a series of forward contracts

35
 Last Revised: 05/12/2023

Page 3/
Review/
floating rate
𝐭=0 1% 3.01% 5.03%

receive (pay) 1% at end of deposit (loan) term

𝐙𝟏 = 𝟏% 𝐃𝐅𝟏 = 𝟏-𝟏. 𝟎𝟏 = . 𝟗𝟗𝟎𝟎𝟗𝟗

𝟏 − 𝐃𝐅𝐧
𝐙𝟐 = 𝟐% 𝐃𝐅𝟐 = 𝟏-(𝟏. = . 𝟗𝟔𝟏𝟏𝟔𝟗 𝟏 − . 𝟗𝟏𝟓𝟏𝟒𝟐
𝟎𝟐)𝟐
𝐫𝐟𝐱 = = 𝟐. 𝟗𝟔𝟎𝟒
𝐙𝟑 = 𝟑% 𝐃𝐅𝟑 = 𝟏-(𝟏. = . 𝟗𝟏𝟓𝟏𝟒𝟐 𝟐. 𝟖𝟔𝟔𝟒𝟎
𝟎𝟑)𝟑 ∑ 𝐃𝐅
𝟐. 𝟖𝟔𝟔𝟒𝟎
PV(fl.) PV(fx.)
PV(fl.)
9,900.99 29,310.89
rec. fl. +10,000 +30,099 +50,295
28,930.22 28,454.44
pay fx. = 46,027.05 27 091.85
-29,604 -29,604 -29,604
on $1M
PV(fx.) 84,858.26 84,857.18
𝐕𝟎 (𝐓) = 𝟎 rounding
discrepancy

* Describe how swap contracts are similar to but different from a series of forward contracts

Page 4/
Swap - an agreement to exchange a series of cash flows
whereas a forward contract involves a single exchange
FRA - single payment at the beginning of an interest rate
period
swap - multiple payments that occur at the end of each
interest rate period
𝐕𝟎 (𝐬𝐰𝐚𝐩) = 0 ⇒ PV (fl. rate payments to be received/paid)
= PV (fx. rate payments to be paid/received)
- at initiation, no initial cash flows exchanged but will
have counterparty risk
- 3 period swap - one fixed rate a single 3-period swap is the
same as 3 separate FRA
- 3 FRAs - 3 different rates
contracts

* Describe how swap contracts are similar to but different from a series of forward contracts

36
 Last Revised: 05/12/2023

Page 5/
- 𝐫𝐟𝐱 is called a par swap rate ➞ is a multi-period breakeven
an investor would be indifferent to: rate
paying 𝐫𝐟𝐱 or paying the forward rates
receiving 𝐫𝐟𝐱 or receiving the forward rates
rec. fl. pay fx.
𝐭=1 +10,000 -29,604
PV(fl.) = 74,957.27 PV(fx.) = 55,546.29
∴ since PV(fl.) > PV(fx.)
𝐕𝟏 (swap) = PV(fl.) - PV(fx.) = 19,410.98
𝐭=2 +30,099 -29604
PV(fl.) = 46,027.05 PV(fx.) = 27,091.85
𝐕𝟐 (swap) = 18,935.20
+ 50295 -29604
𝐭=3
PV(fl.) = 0 PV(fx.) = 0

* Describe how swap contracts are similar to but different from a series of forward contracts

Page 6/
𝐌𝐑𝐑 𝟎,𝟏 𝐌𝐑𝐑 𝟏,𝟏 𝐌𝐑𝐑 𝟐,𝟏
rec. fl. +10,000 +30,099 +50,295
$1M
NA pay fx. -29,604 -29,604 -29,604
𝐒𝐍 (CFAI notation)
Periodic settlement value = (MRR - 𝐫𝐟𝐱 ) ´ NA ´ Period
= (.01 - .029604) ´ 1M ´ 𝟑𝟔𝟓.𝟑𝟔𝟓
payments are netted ➞ = -19604
= 0 (rounding discrep.)
PV (fl.) - PV(fx.) = 19 411

Note: 𝐌𝐑𝐑 𝟎,𝟏 is known at contract initiation date but not 𝐌𝐑𝐑 𝐭,𝟏
𝐌𝐑𝐑 𝟏,𝟏 will be only be known at 𝐭 = 1 when it will be 𝐌𝐑𝐑 𝟎,𝟏
new spot rates will also be known, new 𝐌𝐑𝐑 𝟏,𝟏 can be calculated
∴ PV(fl.) - PV(fx.) will change as time passes
(𝐕𝟏 (𝟑) = 19,410.98, 𝐕𝟐 (𝟑) = 18,935.20, 𝐕𝟑 (𝟑) = 0)
but// also changes as rates change (Ex. #3, 4)
* Contrast the value and price of swaps

37
 Last Revised: 05/12/2023

Pricing and Valuation of Options

a. Explain the exercise value, moneyness, and time value of an option

b. Contrast the use of arbitrage and replication concepts in pricing forward

commitments and contingent claims

c. Identify the factors that determine the value of an option and describe how each
factor affects the value of an option

38
 Last Revised: 05/12/2023

Pricing and Valuation of Options

Page 1/
Note: all options are assumed to be European (last day exercise)
on non-dividend paying stocks

Exercise value at expiration: (𝐒𝐓 − 𝐗) > 𝟎 call

(𝐗 − 𝐒𝐓 ) > 𝟎 put
else expires worthless (loss = premium
Exercise value at any time 𝐭: paid)

X 𝐦𝐚𝐱 G𝟎, 𝐒𝐭 − 𝐗-(𝟏 H call

+ 𝐫)𝐓+𝐭
0 𝐒𝐭 T
𝐦𝐚𝐱 G𝟎, 𝐗-(𝟏 − 𝐒𝐭 H put
- must compare amounts + 𝐫)𝐓+𝐭
at the same point
in time

* Explain the exercise value, moneyness, and time value of an option

Page 2/
Moneyness:
value Price
ITM for OTM for
calls puts
ITM
X
𝐒𝐭
X
OTM ATM ATM
OTM
for calls ITM
for puts

value time
ITM
Call Put
𝐒𝐭 ITM 𝐒𝐭 > 𝐗 𝐒𝐭 < 𝐗
X OTM ATM 𝐒𝐭 = 𝐗 𝐒𝐭 = 𝐗
ATM
OTM 𝐒𝐭 < 𝐗 𝐒𝐭 > 𝐗

* Explain the exercise value, moneyness, and time value of an option

39
 Last Revised: 05/12/2023

Page 3/
Time Value: - at expiration, TV = 0 since 𝐂𝐓 = 𝐦𝐚𝐱(𝟎, 𝐒𝐓 − 𝐗)
- prior to expiration no time left
𝐂𝐭 = 𝐦𝐚𝐱 Q𝟎, 𝐒𝐭 − 𝐗B(𝟏 + 𝐫)𝐓.𝐭 T + 𝐓𝐕

𝐏𝐭 = 𝐦𝐚𝐱 Q𝟎, 𝐗B(𝟏 + 𝐫)𝐓.𝐭 − 𝐒𝐭 T + 𝐓𝐕

always > 0 and

declines (decays) to 0
X as time passes

time value decays very fast in the

last few weeks

* Explain the exercise value, moneyness, and time value of an option

Page 4/
Options (contingent claims) have asymmetric payoffs
𝐂𝐓 = 𝐒𝐓 − 𝐗
𝚷𝐂 = 𝐦𝐚𝐱(𝟎, 𝐒𝐓 − 𝐗) − 𝐂𝟎
𝐏𝐓 = 𝟎
X 𝚷𝐏 = 𝐦𝐚𝐱(𝟎, 𝐗 − 𝐒𝐓 ) − 𝐏𝟎
𝐏𝐓 = 𝐗 − 𝐒𝐓
profit
𝐂𝐓 = 𝟎
𝐒𝐓

exercise value lower bound upper bound

with TV = 0
𝐦𝐚𝐱 G𝟎, 𝐒𝐭 − 𝐗-(𝟏 H < 𝐂𝐭 ≤ 𝐒𝐭 arbitrage available
+ 𝐫)𝐓+𝐭
outside these
𝐦𝐚𝐱 G𝟎, 𝐗-(𝟏 − 𝐒𝐭 H < 𝐏𝐭 ≤ 𝐗 ranges
+ 𝐫)𝐓+𝐭

* Contrast the use of arbitrage and replication concepts in pricing forward commitments and contingent claims

40
 Last Revised: 05/12/2023

Page 5/
Replication/
call with ∆ = .40 (e.g.) put with ∆ = .40 (e.g.)

borrow .4 G𝐗-(𝟏 H sell .40 share of underlying

+ 𝐫)𝐓+𝐭
lend .4 G𝐗-(𝟏 H
buy .4 shares of underlying + 𝐫)𝐓+𝐭

1/ Value of the underlying

S
call values ↑, put values ↓

call values ↓, put values ↑

𝐭
magnitude of change at
any price is approximated by
its delta (∆)

* Identify the factors that determine the value of an option and describe how each factor affects the value of an option

Page 6/
2/ Exercise Price higher option value
3/ Time to expiration lower 𝐒𝐭 higher delta
calls higher 𝐒𝐭 ITM
- higher option puts
value
- higher delta

𝐒𝐭 𝐒𝐭
OTM X X OTM
higher 𝐒𝐭
lower 𝐒𝐭 - lower option value
- lower option value - lower delta
- lower delta
3 mos. to exp.
2 mos. to exp.
1 mos. to exp.
* Identify the factors that determine the value of an option and describe how each factor affects the value of an option

41
 Last Revised: 05/12/2023

Page 7/
4/ Risk-free interest rate 𝐫𝐟 ↑ leads to 𝐂𝐭 ↑ and 𝐏𝐭 ↓
calls exercise value puts
𝐦𝐚𝐱 H𝟎, 𝐒𝐭 − 𝐗F(𝟏 J 𝐦𝐚𝐱 H𝟎, 𝐗F(𝟏 − 𝐒𝐭 J
+ 𝐫)𝐓.𝐭 + 𝐫)𝐓.𝐭

higher r = lower 2nd term higher r = lower 1st term

∴ higher 𝐂𝐭 ∴ lower 𝐏𝐭
5/ Volatility
higher volatility: affects the potential
higher put and upside value of a
call values
call without
(premiums)
affecting the downside
(since ST < X = 0)
higher vol.
- same logic for put

6/ Income/Costs - dividends/income ➞ call value ↓, put value ↑

- costs ➞ call value ↑, put value ↓

* Identify the factors that determine the value of an option and describe how each factor affects the value of an

42
 Last Revised: 05/12/2023

Option Replication Using Put-Call Parity

a. explain put-call parity for European options

b. explain put-call forward parity for European options

43
 Last Revised: 05/12/2023

Option Replication using Put-Call Parity

Page 1/
Note: European options, non-dividend paying stocks
Goal: get upside payoff without the downside risk
Strategy 1: long call with exercise price X fiduciary
invest 𝐗F(𝟏 + 𝐫)𝐓 (grows to $X at time T) call

cost = 𝐂𝟎 + 𝐗B(𝟏 + 𝐫)𝐓

Strategy 2: long stock protective
long put with exercise price X put
cost = 𝐒𝟎 + 𝐏𝟎
𝐒𝐓 < 𝐗 𝐒𝐓 = 𝐗 𝐒𝐓 > 𝐗
protective put 𝐗 𝐒𝐓 𝐒𝐓
= = =
fiduciary call 𝐗 𝐗 𝐒𝐓
- both have the same cash flows at time T

* Explain put-call parity for European options

Page 2/
- since both have the same payoff, their prices must be equal
or else an arbitrage opportunity arises
- relationship is called put-call parity
𝐒𝟎 + 𝐏𝟎 = 𝐂𝟎 + 𝐗B(𝟏 + 𝐫)𝐓 - given 3 inputs, can
Ex. #1, 2
always solve the fourth

Isolate each input: multiply by -1

𝐒𝟎 = 𝐂𝟎 − 𝐏𝟎 + 𝐗B(𝟏 + 𝐫)𝐓 - synthetic long − 𝐒𝟎 = −𝐂𝟎 + 𝐏𝟎 − 𝐗/(𝟏
+ 𝐫)𝐓
(synthetic short)
𝐏𝟎 = 𝐂𝟎 − 𝐒𝟎 + 𝐗B(𝟏 + 𝐫)𝐓 - synthetic long put
− 𝐏𝟎 = −𝐂𝟎 + 𝐒𝟎 − 𝐗/(𝟏
+ 𝐫)𝐓
𝐂𝟎 = 𝐒𝟎 + 𝐏𝟎 − 𝐗B(𝟏 + 𝐫)𝐓 - synthetic long call (synthetic short put)

𝐗B etc...
- synthetic long bond
(𝟏 + 𝐫)𝐓 = 𝐒𝟎 + 𝐏𝟎 − 𝐂𝟎
Ex. #3

* Explain put-call parity for European options

44
 Last Revised: 05/12/2023

Page 3/
𝐅𝟎 (𝐓)
𝐅𝟎 (𝐓) = 𝐒𝟎 (𝟏 + 𝐫)𝐓 ∴ 𝐒𝟎 = S(𝟏
+ 𝐫)𝐓
costless to 𝐅𝟎 (𝐓)
enter n(𝟏 + 𝐏𝟎 = 𝐂𝟎 + 𝐗-(𝟏
+ 𝐫)𝐓 + 𝐫)𝐓
cash position fiduciary call

synthetic protective put

𝐒𝐓 < 𝐗 𝐒𝐓 = 𝐗 𝐒𝐓 > 𝐗
𝐏𝟎 𝐗 − 𝐒𝐓 0 0
𝐅𝟎 (𝐓) 𝐒𝐓 − 𝐅𝟎 (𝐓) 𝐒𝐓 − 𝐅𝟎 (𝐓) 𝐒𝐓 − 𝐅𝟎 (𝐓)
𝐅𝟎 (𝐓) identical
S(𝟏
+ 𝐫)𝐓
𝐅𝟎 (𝐓) 𝐅𝟎 (𝐓) 𝐅𝟎 (𝐓)
payoffs
𝐗 𝐒𝐓 𝐒𝐓
∴ should
be the
𝐂𝟎 0 0 𝐒𝐓 − 𝐗
same
𝐗B 𝐗 𝐗 𝐗
(𝟏 + 𝐫)𝐓 price
𝐗 𝐗 (= 𝐒𝐓 ) 𝐒𝐓

* Explain put-call forward parity for European options

Page 4/
𝐅𝟎 (𝐓)
n(𝟏 − 𝐗-(𝟏 = 𝐂𝟎 − 𝐏𝟎
+ 𝐫)𝐓 + 𝐫)𝐓
synthetic long
(𝐅𝟎 (𝐓) − 𝐗)/(𝟏 + 𝐫)𝐓
- payoff of a long forward

𝐗- 𝐅𝟎 (𝐓)
(𝟏 + 𝐫)𝐓 − n(𝟏
+ 𝐫)𝐓
= 𝐏𝟎 − 𝐂𝟎
synthetic short
[𝐗 − 𝐅𝟎 (𝐓)]/(𝟏 + 𝐫)𝐓
- payoff of a short forward

𝐅𝟎 (𝐓) − 𝐅𝟎 (𝐓)
H(𝟏 + 𝐫)𝐓 = 𝐂𝟎 − 𝐏𝟎 + 𝐗B(𝟏 + 𝐫)𝐓 S(𝟏
+ 𝐫)𝐓
= 𝐏𝟎 − 𝐂𝟎 − 𝐗F(𝟏
+ 𝐫)𝐓

synthetic long synthetic short

forward forward
(Ex. #4)
* Explain put-call forward parity for European options

45
 Last Revised: 05/12/2023

Page 5/
Application: Credit analysis
ZCB with 𝐅𝐕𝐓 = 𝐃
𝐕𝟎 = 𝐄𝟎 + 𝐏𝐕(𝐃)
value of = equity + debt
firm
debtholders get 𝐃
at time T: 𝐕𝐓 > 𝐃
shareholders get 𝐕𝐓 − 𝐃

debtholders get 𝐕𝐓
𝐕𝐓 ≤ 𝐃
shareholders get 0

Debtholder ➞ limited upside, not limited downside 𝐦𝐢𝐧(𝐕𝐓 , 𝐃)

- long bond, short put

Shareholder ➞ limited downside, unlimited upside 𝐦𝐚𝐱(𝟎, 𝐕𝐓 − 𝐃)

- long assets, long put with
(long call) 𝐗=𝐃

* Explain put-call forward parity for European options

Page 6/

𝐒𝟎 + 𝐏𝟎 = 𝐂𝟎 + 𝐗-(𝟏
+ 𝐫)𝐓
(𝐗 = 𝐃)
𝐕𝟎 + 𝐏𝟎 = 𝐂𝟎 + 𝐃-(𝟏
+ 𝐫)𝐓

𝐕𝟎 = 𝐂𝟎 + S𝐃-(𝟏 − 𝐏𝟎 W
+ 𝐫)𝐓
risky debt
- valuing the put
leads to a measure of
credit risk
(can be interpreted as the
credit spread)

* Explain put-call forward parity for European options

46
 Last Revised: 05/12/2023

Valuing a Derivative Using a One-Period Binomial Model

a. explain how to value a derivative using a one-period binomial model

b. describe the concept of risk neutrality in derivatives pricing

47
 Last Revised: 05/12/2023

One-Period Binomial Model

Page 1/
𝐡 𝐑𝐮 𝐒𝟎 = 𝟏𝟏𝟎𝐡
𝐑𝐮 = 1.375
𝐂𝟏𝐮 = 10 𝐑𝐮 = 1.375 ➞ 137.5%
𝐒𝟏𝐮 = 𝐡 𝐑𝐮 𝐒𝟎 = 137.5% × 𝐒𝟎
𝐒𝟎 = 80
X = 100 𝐂𝟏𝐮 = 𝐒𝟏𝐮 − 𝐗

𝐑𝐝 = .75 𝐡 𝐑𝐝 𝐒𝟎 = 𝟔𝟎𝐡
𝐕𝟎 = 𝐡𝐒𝟎 − 𝐂𝟎
𝐂𝟏𝐝 = 0
hedge
ratio 𝐕𝟏𝐮 = 𝐡 𝐒𝟏𝐮 − 𝐂𝟏𝐮 = 𝐡 𝐑𝐮 𝐒𝟎 − 𝐦𝐚𝐱(𝟎, 𝐒𝟏𝐮 − 𝐗)

𝐭=0 𝐕𝐓
buy 𝐡 𝐒𝟎
𝐕𝟏𝐝 = 𝐡 𝐒𝟏𝐝 − 𝐂𝟏𝐝 = 𝐡 𝐑𝐝 𝐒𝟎 − 𝐦𝐚𝐱J𝟎, 𝐒𝟏𝐝 − 𝐗L
sell 𝐂𝟎
- select 𝐡 such that 𝐕𝟏𝐮 = 𝐕𝟏𝐝 ➞ risk-free
portfolio

* Explain how to value a derivative using a one-period binomial model

Page 2/
110𝐡 𝐡𝐒 𝐮
𝐑𝐮 = 1.375 10 𝐂𝐮 𝐕 𝐮 = . 𝟐(𝟏𝟏𝟎) − 𝟏𝟎 = 𝟏𝟐
𝐕 𝐝 = . 𝟐(𝟔𝟎) − 𝟎 = 𝟏𝟐
𝐒𝟎 = 80 - risk-free portfolio will earn 𝐫
X = 100

𝐑𝐝 = .75
60𝐡 𝐡𝐒 𝐝
∴ (𝐡𝐒𝟎 − 𝐂𝟎)(𝟏 + 𝐫)𝐓 = 𝐕𝐮 -= 𝐕 𝐝 .
0 𝐂𝐝 solve for 𝐂𝟎
𝐮 𝐮 𝐝 𝐝
𝐡𝐒 − 𝐂 = 𝐡𝐒 − 𝐂 𝐮
𝐡𝐒𝟎 − 𝐂𝟎 = 𝐕 -(𝟏
(solve for 𝐡) + 𝐫)𝐓
𝐮
𝐡𝐒 𝐮 − 𝐡𝐒 𝐝 = 𝐂 𝐮 − 𝐂 𝐝 𝐂𝟎 = 𝐡𝐒𝟎 − 𝐕 B(𝟏 + 𝐫)𝐓 𝐫 = 5%
𝐮 𝐝 𝐮 𝐝
𝐡J𝐒 − 𝐒 L = 𝐂 − 𝐂
𝐂𝟎 = . 𝟐(𝟖𝟎) − 𝟏𝟐B(𝟏. 𝟎𝟓)
𝐮 𝐝
𝐡 = 𝐂 −𝐂
𝐒𝐮 − 𝐒𝐝 𝐂𝟎 = 𝟏𝟔 − 𝟏𝟏. 𝟒𝟐𝟖𝟓𝟕
𝐡 = 𝟏𝟎 − 𝟎 = 𝟏𝟎F = . 𝟐 𝐂𝟎 = 𝟒. 𝟓𝟕
𝟏𝟏𝟎 − 𝟔𝟎 𝟓𝟎

* Explain how to value a derivative using a one-period binomial model

48
 Last Revised: 05/12/2023

Page 3/
example #1/
𝐒𝟎 = 50 −𝐂𝟎 at 𝐗 = 55 𝐑 = 1.20 𝐮
𝐑 = .80
𝐝
𝐫 = 5%
1/ calculate 𝐂𝟎
① 𝐡 = 𝟓-
𝐡 · 60 𝟐𝟎 = . 𝟐𝟓
1.20 5
② 𝐕𝟏 = . 𝟐𝟓(𝟔𝟎) − 𝟓 = 𝟏𝟎
𝐡 · 50
−𝐂𝟎 ③ 𝐂𝟎 = . 𝟐𝟓(𝟓𝟎) − 𝟏𝟎-(𝟏. 𝟎𝟓)
𝐗 = 55 .80
𝐡 · 40 𝐂𝟎 = 𝟏𝟐. 𝟓𝟎 − 𝟗. 𝟓𝟐𝟑𝟖
0
𝐂𝟎 = 𝟐. 𝟗𝟕𝟔
2/ calculate 𝐂𝟎 if 𝐑𝐮 = 1.40 and 𝐑𝐝 = .60
① 𝐡 = 𝟏𝟓- ③ 𝐂𝟎 = . 𝟑𝟕𝟓(𝟓𝟎) − 𝟏𝟏. 𝟐𝟓-(
𝟒𝟎 = . 𝟑𝟕𝟓 𝟏. 𝟎𝟓)

[ ]
= 𝟏𝟖. 𝟕𝟓 − 𝟏𝟎. 𝟕𝟏𝟒 = 𝟖. 𝟎𝟒
𝐒𝟏𝐮 = 𝟓𝟎 × 𝟏. 𝟒 = 𝟕𝟎 , 𝐂𝟏𝐮 = 𝟕𝟎 − 𝟓𝟓 = 𝟏𝟓
𝐒𝟏𝐝 = 𝟓𝟎 × . 𝟔 = 𝟑𝟎 , 𝐂𝟏𝐝 = 𝟎 3/ higher vol. = higher call value
(option value NOT affected by actual
②
𝐕𝟏 = . 𝟑𝟕𝟓(𝟕𝟎) − 𝟏𝟓 = 𝟏𝟏. 𝟐𝟓 probabilities of price ↑ or ↓)

* Explain how to value a derivative using a one-period binomial model

Page 4/
example #1/
𝐒𝟎 = 50 −𝐂𝟎 at 𝐗 = 55 𝐑𝐮 = 1.20 𝐑𝐝 = .80 𝐫 = 5%

4/ 𝐒𝟎 + 𝐏𝟎 = 𝐂𝟎 + 𝐗-(𝟏
+ 𝐫)𝐓

(@20%) 𝟓𝟎 + 𝐏𝟎 = 𝟐. 𝟗𝟖 + 𝟓𝟓F(𝟏. 𝟎𝟓) 𝟓𝟎 + 𝐏𝟎 = 𝟖. 𝟎𝟒 + 𝟓𝟓F(

𝟏. 𝟎𝟓)
(@40%)
𝐏𝟎 = 𝟓. 𝟑𝟔 𝐏𝟎 = 𝟏𝟎. 𝟒𝟐

Risk-neutral probability (𝟏 + 𝐫) − 𝐑𝐝 - based on volatility,

𝛑 =
𝐑 𝐮 − 𝐑𝐝
𝐂𝐮 not probability
𝛑
𝐂𝟎 = 𝛑𝐂𝐮 + (𝟏 − 𝛑)𝐂𝐝 e.g./ (𝐒 𝐮 = 110, 𝐑𝐮 = 1.375, 𝐑𝐝 = .75, 𝐫 = 5%)
𝐂𝟎 𝟏
𝟏+𝐫
(𝟏 − 𝛑) 𝛑 = 𝟏. 𝟎𝟓 − . 𝟕𝟓
𝐂𝐝 = . 𝟑/. 𝟔𝟐𝟓 = . 𝟒𝟖
𝟏. 𝟑𝟕𝟓 − . 𝟕𝟓
risk-free rate
risk-neutral pricing ∴ 𝐂𝟎 = . 𝟒𝟖(𝟏𝟎) + 𝟎
= 𝟒. 𝟓𝟕
risk neutral probabilities 𝟏. 𝟎𝟓
Ex. #2/
* Describe the concept of risk neutrality in derivatives pricing

49