Level II of the CFA® 2023 Exam

Study Notes - Derivatives

Offered by AnalystPrep

Last Updated: Nov 7, 2024

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 Table of Contents

33 - Pricing & Valuation of Forward Commitments 3

34 - Valuation of Contingent Claims 43

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 Reading 33: Pricing & Valuation of Forward Commitments

LOS 33a: Describe the carry arbitrage model without underlying cash
flows and with underlying cashflows

A carry arbitrage model is a no-arbitrage approach where the underlying asset is either sold or

bought and a forward position established. This model accounts for the cost to hold or carry the

underlying instrument. The carry costs for an underlying physical asset such as gold would be

the financing cost plus insurance and storage costs. The carry arbitrage model also adjusts for

dividends, and interest received, collectively referred to as carry benefits.

To bring the carry arbitrage model closer to real market conditions, we must address specific

additional factors. There are carry arbitrage models when there are no underlying cash flows

and carry arbitrage with underlying cash flows.

Carry Arbitrage Model Without Underlying Cash Flows

Let us assume that an arbitrageur has entered a forward contract to sell an underlying for

delivery at time T. To reduce their exposure to market risk, they can buy the underlying at time 0

with borrowed money and carry it to the forward expiration date T. The risks of this scenario are:

Time Time
(0) (T)
Borrowing funds to purchase and carry an underlying instrument
Underlying − S0(Purchase) + ST (Sale)
Borrowed Funds + S0(Inflow) − FV ( S0)(Repayment)
Net Cash Flow + S0 − S0 = 0 + S0 − FV (S0 )
Short Forward V0 = 0 V T = F 0 − ST
Overall Position: Long Position+Short Position+Borrowed Funds
+ S0 − S0 + V 0 = 0 + ST − FV (S0 ) + V T =
+ ST − FV (S0 ) + ( F0 −
+ F0 − FV (S 0) = 0
Net 0 F 0 = FV ( S0)

Using borrowed funds, the underlying investment is purchased at S0. Further, note that the asset

can be sold at time T for ST. Moreover, the borrowed funds will be repaid at time T at the cost of

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FV(S0). It is equally noteworthy that our underlying transaction will suffer a loss when ST is

below FV(S0). A short forward position will be added to the long position to offset any profit or

loss, with both positions having no initial cash flow. The overall portfolio should have a value of

zero at time T to prevent arbitrage. Most importantly, remember that there is no arbitrage profit

when the initial agreed forward price F0 = F V (S0 ).

Given that carry arbitrage rests on the no-arbitrage assumptions, the arbitrageur borrows money

to purchase the underlying and lends money to sell the underlying. The borrowing and lending

are done at a risk-free interest rate, and the arbitrage does not take any price risk. When we

assume continuous compounding (rc), then F0 = F V (S0 ) = S0 er cT and when we assume annual

compounding (r), F0 = F V (S0 ) = S0 (1 + r)T .

Let us use an example to illustrate the price exposure for holding the underlying investment.

Example: Carry Arbitrage

Assume that company Z has a long financial position from carrying a non-dividend-paying stock.

Further, assume that S0 = 100, r = 6% and T = 1. We allow the stock price to go up to ST + = 110

and to decrease to ST − = 90 at expiration. At the expiration date, the loan will be 100(1.06) =

106. At times, 0 and T, the initial transactions, will generate cash flows. The two transactions

that produce a levered equity purchase at time 0 are:

1. Purchase of one unit of the underlying at time 0.

2. Borrowing of the purchase price at a risk-free rate.

At time T, the stock price will be ST + =110 or ST − = 90, which carries a price risk. After the loan

repayment, if the stock price increases, the net cash flow will be 110 – 106 = +4 or – 16 if it

decreases (90 – 106). We need to eliminate the price risk. To do this, we must add another step

which is: Sell a forward contract to set price at F0 = 106 for the future sale of our underlying

stock.

Since we have two outcomes, 110 or 90, at expiration, we short the forward. Consequently, there

will be zero net cash flow at time T.

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When stock price increases at time T:

ST + = 110

Short Forward(VT ) = F0 – ST = 106 − 110 = −4

CFT+ = ST+ − Loan + Forward = 110 − 106 + (−4) = 0

When stock price decreases at time T:

ST − = 90

Short Forward(VT ) = F0 – ST = 106 − 90 = 14

CFT− = ST+ − Loan + Forward = 90 − 106 + 14 = 0

Since there was no uncertainty about value at time T:

F0 = Future value of underlying stock = F V (S0 ).

If F0 > F V (S0 ) , the forward contract will be sold, and the underlying stock bought. This has the

effect of reducing the forward price and increasing the underlying price until F0 = F V (S0 ). The

risk-free positive cash flows will cease to exist. If F0 < F V (S0 ), we buy the forward contract and

sell the underlying short (reverse carry arbitrage) to increase the forward price and reduce the

underlying price.

The quoted forward price does not directly reflect expectations of future underlying prices. The

current price, the absence of arbitrage, time to expiration, and the interest rate are important.

When we carry the asset, an assumption that the underlying price will increase in value does not

affect the forward price. Once a forward contract has been entered, its fair value is derived from

knowing if it will make or lose money.

To explain forward valuation, we will use the illustration below.

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The first transaction will be the purchase of a forward contract at a price of F0 at time 0. Imagine

selling a new forward contract at time t at a price of Ft . Time t, in this context, is the date of

valuation of the forward contract. The offsetting forward entered at time t is not subject to

market risk because the spot price does not affect the cash flow at time T . The value of the

original forward contract at the time entered at time 0 is P V (Ft − F0 ) at time t. Under annual

compounding, the long forward value at time t is Vt (long) = Present value of the difference in

forward prices:

Equation 1 below can be used when market frictions cause the forward price to differ from the

correct arbitrage-free price.

[Ft– F0 ]
Vt = [Ft − F0 ] =
(1 + r)T−t

Where:

Ft = Current forward price.

F0 = Initial forward price.

Equation 2 below is used when the spot rate St is more readily observed than the forward price.

F
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 F0
V t = St − [F0 ] = St −
(1 + r)T −t

The short forward contract value is the present value of the difference between the negative long

position value and forward prices. Value of the short forward contract before maturity (Time t) =

−V t.

[Ft– F0 ]
−Vt = [Ft − F0 ] =
(1 + r)T−t

or

F0
−Vt = St − [F0 ] = − St
(1 + r)T −t

Carry Arbitrage Model with Underlying Cash Flows

Carry arbitrage requires payment of interest costs for borrowing funds to buy the underlying

stock. Reverse carry arbitrage, on the other hand, requires receipt of interest benefit from

lending the proceeds short-selling the underlying stock. There are other carry benefits and costs

for many instruments which will be incorporated in forward pricing.

Carry benefits (CB) are the cash flows an investor might receive for holding the underlying

instrument.

CBT = The future value of underlying stock carry benefits at time T .

CB0 ) = The present value of underlying stock carry benefit at time 0.

Carry costs (CC) for commodities include storage, insurance, and waste management expenses.

Carry cost for financial instruments are 0.

CC T = The future value of underlying carry cost at time T .

CC 0 = The present value of underlying carry cost at time 0.

Holding financial assets results in the opportunity cost of the interest earned on the money tied

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to carrying the spot asset; thus, they have no direct carry cost. To determine a forward price, the

cost to finance the spot asset purchase, storage cost, and any benefit from holding the asset, will

all be used. The forward pricing equation is expressed as:

F0 = Future value of the underlying adjusted for cash flows =F V [S0 + CC 0 − CB0 ]

The equation above is called the future-spot parity of cost of carry model and considers the

carry cost in relation to the forward price of an asset to the spot price. These costs are added to

the equation because the carry costs and a positive interest rate increase the burden of carrying

the underlying asset over time. On the other hand, carry benefits reduce the burden of carrying

the underlying asset over time; thus, the benefits are deducted from the equation.

Many financial assets do not have carry cost; hence the equation for such assets will be:

F0 = F V (S0 ) − C B0 = F V (S0) − Benefit

For a dividend-paying stock, the benefit will be the dividend (D). The future value computation

for the dividends will differ from that of the stock price because the future value is only

compounded from the time the dividend is received to the day when the forward expires. Hence

for a dividend received at time t and held until time T , the equation would be,

D D
F V [P V (D)] = F V [ ] = (1 + r)t × [( )] = D(1 + r)T−t
(1 + r)t (1 + r)t

The long forward position when the underlying with carry costs and benefits is calculated the

same way as in the previous discussion, but the initial forward price and the new forward price

are adjusted for the benefits and costs.

Vt is the present value of the difference in forward prices adjusted for carry benefits and costs:

Vt = P V [Ft − F0 ]

Where:

Ft = F V (St + CCt − CB t)

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F0 =F V (S0 + CC 0 − CB 0 )

Example: Carry Arbitrage with Underlying Cash Flows

A UK stock that pays a £20 dividend in two months is trading at £2000. The UK interest rate is

6% with annual compounding. Based on the no-arbitrage approach and the current stock price,

the equilibrium three-month forward price will be closest to:

Solution

F0 = F V (S0 ) − (D)

S0 = £2000, r = 6% and T = 3/12

F0 = 2 , 000(1 + 0.06)3/12 − 20(1 + 0.06)1/12

= £2, 029.35– £20.097
= £2, 009.253

Carry Arbitrage with a Continuous Dividend Yield

When dealing with index stock, it isn't easy to account for the many dividend payouts by the

underlying stock with varying amounts and time. The dividend index point solves this problem by

measuring the number of dividends attributable to a particular index. A continuous dividend

yield is assumed to simplify the problem. This means that we assume that the dividends

continuously accrue throughout the contract rather than having dividends paid on specific dates.

The carry costs and benefits can be expressed as:

F0 = S0 e(r c+CC −C B)T

Where rc, CC, and CB are continuously compounding rates.

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Question

Assume that at time 0, a one-year forward contract was entered with a price of 106.

Six months later, at time t= 0.5, the underlying asset's price is S0.5 = 112, and the

interest rate is 6%. The value of the existing forward in six months is likely to be:

A. 9.

B. 9.3.

C. 9.043.

Solution

The correct answer is C.

T − t = 1 − 0.5 = 0.5

The six months forward price at time t is

Ft = F V (St) = 112(1 + 0.06)0.5 = 115.311

The the existing forward will be the

value of

difference between Ft and F0 .

[115.311– 106]
Vt = [Ft − F0 ] = = 9.043
(1 + 0.06)0.5

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LOS 33b: Describe how equity forwards and futures are priced, and
calculate and interpret their no-arbitrage value

A forward contract is a contract that promises to buy or sell an asset on a specific date in the

future at a prearranged price. We need to construct a portfolio with cash flows equal to the

forward to price forwards and futures. From there, we can use the law of one price to determine

the value of the forwards. Investment managers use equity index futures and swaps to hedge

equity risk on a low tax basis. This section will illustrate the carry arbitrage model with equity

forward pricing and valuation for equity forward and futures contracts. We assume that futures

and forward contracts are priced the same way and that interest rates are compounded annually.

Example 1: Equity Futures Contract Prices With Continuous

Compounded Interest Rates

The dividend yield on the EURO STOXX 50 is 5%, and the current stock index level is 3,200. The

continuously compounded annual interest rate is 0.2%. Based on the carry arbitrage model, the

three-month futures price is most likely to be:

Solution

The formula we will be using is:

F0 = S0 e(r c+CC −C B)T

Let us assume that the carry costs are 0 for the stock index. The carry benefit will be 5%, and

the financing cost will be 0.2%. Since the dividend yield is greater than the financing cost, the

future price will be lower than the spot price. The future value of the underlying adjusted

carrying dividend payments over the next three months is:

F0 = 3200e(0.002+0−0.5)3/12 = 3, 161.829

Example 2: Equity Forward Pricing and Forward Valuation With Discrete

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Dividends

Kraft Heinz common stock trades for $36.40 and pays a $1.50 dividend in one month. Assume

that the dollar one month risk-free is 1% on an annual compounding basis. Further, assume that

the stock goes ex-dividend the same day the contract expires in one month. The one-month

forward price for Kraft Heinz common stock will be closest to:

Solution

S0 = 36.4, r = 1.0% T = 1/12 and F V (CB 0 ) = 1.5 = CBT

F0 = F V (S0 + C C0 − CB0 )
= 36.4(1 + 0.01)1/12 + 0 − 1.5
= $34.93

The value before the contract expires is the present value of the difference between the initial

equity forward price and the current forward price.

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Question

Assume that a dividend payment is announced between the forward’s valuation and

expiration date. If the announcement remains unchanged the current underlying

price, the forward value is most likely to:

A. Remain the same.

B. Decrease.

C. Increase.

Solution

The correct answer is B.

Payment of dividends is likely to reduce the forward price and therefore, lower the

value of the initial forward contract.

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LOS 33c: Describe how interest rate forwards and futures are priced, and
calculate and interpret their no-arbitrage value

The most used interest rate in the derivatives market is the LIBOR which stands for London

Interbank Offered Rate. LIBOR is the rate at which London banks can borrow from one another.

When the loans are in dollars, they are referred to as Eurodollar time deposits, and the rate will

be referred to as dollar LIBOR. Participants and lenders use the Libor to determine the interest

payments on loans and derivatives payoffs.

The LIBOR will be phased out by the end of 2021 and replaced with a new market reference rate

(MMR) such as SOFR and SONIA. Currently, there are active futures and forward markets for

derivatives based on LIBOR. To understand the forward market, we need to look at the MRR spot

market first. Let us use the following notations:

L m = MRR spot rate (time=0) for any m-day deposit.

N A = Notional amount, the number of funds initially deposited.

N TD = Number of total days in a year used to calculate interest (360 in LIBOR market).

tm = Accrual period.

T A = Terminal amount, the amount paid when LIBOR deposit is withdrawn.

In the forward market for LIBOR, a forward rate agreement is used. The forward rate agreement

is an over-the-counter forward contract in which the underlying is an interest rate on a deposit.

The forward rate agreement (FRA) has two counterparties:

1. The fixed-rate payer (long), also known as the floating receiver, pays interest on fixed

rates and receives interest from floating rates. The fixed-rate payer profits from an MRR

increase. A long FRA would suit a company looking to hedge against rising rates and is

planning to borrow in the future.

2. The fixed-rate receiver (short), otherwise known as the floating rate payer, receives

interest on fixed rates and pays interest on floating rates. The fixed-rate receiver profits

from MRR decreases. A fixed-rate receiver is suitable for banks looking to have a fixed

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 lending rate in the future.

To eliminate arbitrage opportunities, the FRA value is zero on the initiation date when there is no

initial exchange of cash flows. FRAs are identified in the form of “X by Y,” where X and Y are the

months. For example, a 4 by 10 indicates that in four months, the FRA will expire.

After the fourth month, the FRA payoff is based on the underlying rate, which is implied by the

difference between 4 and 10, 6 months. Therefore, the payoff will be in 180 days MRR. If LIBOR

is used, the rate will be computed based on the relationship between the spot rate on a four-

month LIBOR deposit at the time of its initiation and the spot rate on a ten-month LIBOR deposit.

A short FRA will use a four-month LIBOR deposit while a long FRA will use a ten-month LIBOR

deposit. We assume that all months are 30 days long.

The difference between a floating interest payment and a fixed interest payment is settled in

cash through the contract. The underlying of an FRA is just an interest payment. The

counterparties to an FRA are not engaged in LIBOR deposit in the spot market. Rather, the spot

market is used as a benchmark to determine FRA payoffs.

Using the illustration above, we can describe key points in an FRA transaction. The FRA is priced

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on the initiation day at time 0 and it expires in time h . The underlying has m days from FRA

expiration before it matures at time T . The FRA payoff is based on the spot m-day MRR observed

in h days from the initiation of the FRA. Two spot rates: Lh and L T are required to price the FRA.

L h makes use of the expiration of the FRA, while L T makes use of the underlying maturity. The

FRA hedges single period interest rate risk for the m-day period starting from h days in the

future.

As MRR changes, our interest rate agreement’s value may either become positive or negative.

Interest rate derivatives are settled in two ways at the expiration date:

1. Advanced Set, Settled in Arrears

This method is mainly used to settle swaps and interest rate options. The term advanced set

refers to the interest rate that was set at the time money was deposited. The advanced set

convention is always used because most market participants who have a position in a financial

instrument would like to know a rate on the financial instrument. The term settled in arrears is

used when an interest payment is made when the underlying instrument matures. For this

reason, FRA with an advanced set settled in arrears works in a similar way a bank deposit works.

The interest rate at time h is set at L m, and the interest is paid at time h + m.

2. Advanced Set, Advanced Settled

FRAs are settled using this method. Advanced settled is used when the settlement is made at

time h. Note that in the advanced set the settlement is made when the FRA expires. Settlement

amounts for the advanced set and advanced settled are discounted as follows:

Settlement amount at h for long (receive-floating):

[Lm − F RA0 ]tm

NA ×
[1 + Dm tm ]

The floating receiver loses when rates decrease. The floating rate L m is received, and the FRA0 is

paid.

Settlement amount at h for short (receive-fixed):

[F RA − L ]t
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 [F RA 0 − L m ]tm
NA ×
[1 + Dm tm ]

The denominator,1 + Dm tm , shows that the rate used to determine the payoff is derived from the

spot market, which is settled in arrears. The discount factor is applied to the FRA payment

because payment is advanced settled, but the loan's interest is settled in arrears. It is assumed

that at time h , L m =Dm .

Example:

A company in the UK expects to deposit £2,000,000 in the next 30 days for 90 days. A 90-day

LIBOR is set 30 days from today. One of the company’s major concerns is that the interest rates

could decrease. They have, therefore, been advised to negotiate a 1 by 4 FRA that expires in 30

days and is based on the 90-day LIBOR. The company agrees to enter a £2,000,000 notional

amount 1 by 4 receive-fixed FRA that is advanced set and advanced settled. The discount rate for

the FRA settlement cashflows is 3% and after 30 days, the 90-day LIBOR in pounds is 2.8%.

Interest paid at maturity on the company’s deposit is most likely to be:

Solution

Since m is 90,

L 90 = 2.8%

Settlement amount = 2 , 000, 000 × [1 + 0.03(0.25)] = £2, 014, 000

Interest Paid = £2, 014, 000 − £2, 000, 000 = £14, 000

The value of an FRA is the present value of the difference between the new FRA rate and the old

FRA rate:

Long FRA value at time g:

[F RA − F RA ]t
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 [F RAg − F RA 0 ]tm
Vg = NA ×
[1 + DT−g tT −g ]

Short FRA value at time g :

[F RA0 − F RA g ]tm
Vg = NA ×
[1 + DT−g tT −g ]

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Question

ABC Investment Bank entered into a 6 × 9 FRA three months ago as the receive

floating party. The following Exhibit gives the FRA data.

FRA Data
FRA term 6∗ 9
FRA rate 0.75%
FRA notional amount $300, 000

The 90-day US LIBOR is 0.80%, and the 180-day LIBOR is 0.85%. At the time of

expiration, the 3-month US dollar LIBOR is 1.00%, and the 6-month US dollar LIBOR

is 1.10%. Assume that the applicable discount rate for the FRA settlement cashflows

is 1%.

The value of the 6 × 9 FRA three months after initiation using the 30/360 convention

is closest to:

A. $ 111.15.

B. $ 110.6.

C. $ 112.45.

Solution

The correct answer is B.

The value of an FRA is the present value of the difference between the new FRA rate

and the old FRA rate:

{[F RA(g, h−g, m) − F RA(0,h ,m )] tm }

V g (0,h, m) =
[1 + Dg (h + m − g) th+m−g ]

Note that 6 × 9 FRA implies that the forward contract expires six months after

initiation. Since the bank entered the contract three months ago, this contract will

expire in another three months.

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The FRA value of receive floating can be determined using the following steps:

Calculate the new FRA rate at time g:

Here, we want to calculate F RA(g ,h−g ,m) .

Formula:

[1+L g(h–g+m )th–g+m ]

{ – 1}
[1+L 0 (h–g) th–g]
F RA (g ,h–g, m) =
tm
⎧
⎪ [1+L 90 (180)× 180] ⎫
⎪
360
⎨ – 1⎬
⎩
⎪ [1+ L0( 90)90] ⎭
⎪
(360)
F RA(90,90,90) =
90
360
180
⎡ 1 + 0.0085 × ⎤ 360
360
= −1 × = 0.8982%
⎣ 1 + 0.0080 × 90 ⎦ 90
360

Compute the payoff at (h + m ):

m
Payoff = (F RA g − F RA0 ) × × Notional amount
360
90
Payoff = (F RA 90 − F RA0 ) × × $300, 000
360
90
= (0.8982% − 0.75%) × × $300, 000 = $111.15
360

Discount back to time g, to determine Vg (0 , h, m):

$111.15
Vg (0 , h, m) = V90 (0 , 180, 90) = = $110.60
180
1 + (0.01 × )
360

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LOS 33d: Describe how fixed-income forwards and futures are priced,
and calculate and interpret their no-arbitrage value

A coupon-paying bond's pricing and valuation are the same as those of a dividend-paying stock.

The difference is that the cash flows are coupons and not dividends. Fixed income forward and

futures have several problems that are related to the carry arbitrage model.

1. The bond price is usually quoted as a clean price in some countries. This means that the

bonds' prices are quoted without the interest accrued since the last coupon date. The

quoted price is sometimes known as the clean price. When buying a bond, one must pay

the full price, which includes the accrued interest. This is referred to as the dirty price.

It is important to understand how the quoted bond price and accrued interest make up

the true price and its effect on the pricing of derivatives. The quotation convention for

futures contracts is based on the corresponding quotation convention in the bond

market.

Accrued interest = Accrual period × Periodic coupon amount

2. Fixed-income futures contracts often consist of more than one bond that a seller can

deliver. Since bonds are traded at different prices, a conversion factor (CF) is used to

equalize all the deliverable bond prices.

3. The cheapest-to-deliver bond arises when multiple bonds are delivered for a futures

contract after conversion factor adjustment. Since the conversion factor is not precise,

the cheapest bond in the open market will be availed for the seller to buy to settle the

obligation.

The formula for a bond where the quoted price includes the accrued interest is:

F0 = F V (S0 + CC0 − CB 0 )

Where the quoted price of a bond does not include accrued interest, the spot bond price will be:

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 S0 = Quoted bond price + Accrued interest = B0 + AI0

The future price is:

F0 = F V (B0 + AI0 − PV CI)

Where:

F0 = The future value of adjusted for carry cash flows.

B0 = Quoted bond price at time 0.

AI0 = Accrued interest.

P V CI = The present value of all coupon interest paid over from time 0 to time T .

The quoted futures price is:

1
Q0 = [ ]F V [B0 + AI0 ] − AIT − F V CI
CF

Where:

CF = The conversion factor.

B0 = Quoted bond price at time 0.

AI0 = Accrued interest at time 0.

AIT = Accrued interest at time T .

F V CI = The future value of all coupon interest paid at time T .

Example: Calculating Equilibrium Bond Futures Price

The following information relates to a six-month Euro bond futures contract with a value of

€50,000. The underlying is a 5% bond quoted at €110 with an accrued interest of €1.00. Suppose

there are no coupon payments due until after the futures contract expires.

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 Futures Contract Underlying Bond
Euro Bond Contract Value €50 , 000 Quoted Bond price €110
Conversion factor 0.65 Accrued interest since €1.00
last coupon payment
Time to contract expiration 0.5 Accrued interest at €3.00
futures contract
expiration
Accrued interest over the 0
life of futures contract
Risk-free rate 4.00%

The equilibrium bond futures price based on the carry arbitrage model is closest to:

1
QF0 (T ) = [ ] × F V0 ,T [B0 (T + Y ) + AI0 ] – AIT – F V CI0,T
CF (T )

Where:

6
T = 12

CF (T ) = 0.65

B0 (T + Y ) = €110

F V CI0 ,T = 0

AI0 = €1.00,

AIT = €3.00

r = 4%

Therefore,

1
QF0 (T ) = [ ] × 110 + 1 × 1.040.5– 3– 0 = €169.54
0.65

The value of a bond future is the change in price since the previous day's settlement. This is

because bond futures are marked to market. The futures value is captured at the end of the day

during the bond settlement, at which time the contract value is zero. The value of a bond is the

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present value of the difference in forward prices. Carry benefits reduce forward prices and carry

costs increase forward prices.

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Question

Consider a $100 par, 4% semiannual coupon bond with a spot price of $100 that

matures in 200 days. The bond has just made a coupon payment and the next coupon

payment will be made after 60 days. What will be the value of the bond after 120

days?

Given that the risk-free rate of interest is 8%, the value of the forward contract on the

bond to the long position is closest to:

A. $112.72.

B. -$2.56.

C. $127.

Solution

The correct answer is B.

Coupon payment = 4% × 0.5 × 100 = $2

2
Present value of coupon payment = 160 = $1.93
(1.08) 365

200
F0 (T ) = (100 − 1.93) × (1.08) 365 = $102.29
F0 (T )
Vt (Long) = (St − P V C t) −
T−
(1 + rf ) t

After 120 days, only one coupon payment is due in 40 days (160-120) before the

contract maturity in 80 days (200-120).

2
P V Ct = 40 = $1.9832
(1.08) 365

$102.29
V120 (Long) = $100 − 1.9832 − 80 = −$2.56
(1.08) 365

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LOS 33e: Describe how interest rate swaps are priced, and calculate and
interpret their no-arbitrage value

Swaps are typically derivative contracts in which two parties exchange (swap) cash flows or

other financial instruments over multiple periods for a give-and-take benefit, usually to manage

risk.

Both swap contract parties have future obligations. Therefore, similar to forwards and futures,

swaps are forward commitments since both parties are bound by a future obligation. The net

initial value of a swap to each party should be zero, and as one side of the swap contract gains,

the other side loses by the same amount.

Interest Rate Swaps

An interest rate swap allows the parties involved to exchange their interest rate obligations

(usually a fixed rate for a floating rate). Interest rate swap allows the parties to manage interest

rate risk or lower their borrowing costs, among other benefits.

Interest rate swaps have two legs, a floating leg (FLT) and a fixed leg (FIX). The floating rate

cash flows are expressed in the following equation:

N ADF LT ,i
Si = ( ) rF LT ,i
N TDF LT ,i

On the other hand, the fixed-rate cash flows are given by:

N ADF IX,i
FS = ( ) rFI X
NT DF IX,i

Where:

rFLT = Observed floating rate appropriate for the time i.

rFI X = Fixed swap rate.

26
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 N ADi = Number of accrued days during the payment period.

N TDi =Total number of days during the year applicable to cash flow i.

In a case where the accrual periods are constant, the receive-fixed, pay-floating net cash flow

can be determined as:

F S − Si = AP (rF IX − rF LT ,i )

On the other hand, the receive-floating, pay-fixed net cash flow can be expressed as:

Si − F S = AP (rF LT ,i − rF IX )

30/360 and ACT/ACT are the most popular day count methods. The 30/360 suggests that each

month has a total of 30 days, making a 360-day year. The ACT/ACT treats accrual periods as

having the actual number of days in the year. The floating interest rate is assumed to be

advanced set and settled in arrears. Therefore, it is set at the beginning and paid when the

period ends.

Example: Interest Rate Swaps Cashflows

Assume that the fixed rate is 5%, and the floating rate is 4.25%. Given that the accrual period is

60 days based on a 360-day year, the payment of a receive-fixed, pay-floating swap, is closest to:

Solution

F S– Si = AP (rFIX – rF LT ,i )
60
=( ) 5%– 4.25% = 0.00125 per notional of 1
360

Pricing of Interest Rate Swaps

The value of a swap to the receiver of a fixed rate and payer of a floating rate is given by:

V = Value of fixed bond– Value of floating bond = F B– V B

27
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Where:

Value of fixed bond (FB) = C ∑ni=1 P V 0,ti (1) + P V 0 ,tn (1)

Where:

C = Coupon payment for the fixed-rate bond.

P V 0, ti = Appropriate present value factor for the ith fixed cash flow.

The value of a floating rate bond is par. The assumption is that we are on a reset date, and the

interest payment matches the discount rate.

At the contract inception, the fixed rate is determined to deliberately equate the present value of

the floating rate payments to the present value of the fixed-rate payments. The fixed rate is

known as the swap rate. Determining the fixed (swap) rate is similar to pricing the swap:

1 − P V 0 ,tn (1)
rFI X =
∑ni=1 P V 0, ti (1)

In other words, the fixed swap rate is simply one minus the final present value term divided by

the sum of present values.

Example: Calculating the Price of an Interest Rate Swap

Consider a one-year LIBOR based interest rate swap with quarterly resets. The annualized

LIBOR spot rates are given below:

Year Spot rates

90-day LIBOR 1.90%
180-day LIBOR 2.30%
270-day LIBOR 2.60%
360-day LIBOR 3.00%

The swap rate is closest to:

Solution

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Recall that the swap rate is equivalent to the fixed rate:

1 − P V 0 ,tn (1)
rFI X =
∑ni=1 P V 0, ti (1)

We first need to calculate the discount factors:

1
D90 = = 0.9953
90
1 + (0.019 × )
360
1
D180 = = 0.9886
180
1 + (0.023 × )
360
1
D270 = = 0.9809
270
1 + (0.026 × )
360
1
D360 = = 0.9709
1 + (0.03 × 360 )
360

The quarterly swap rate is then calculated as:

1 − 0.9709
rF IX = = 0.0074 = 0.74%
(0.9953 + 0.9886 + 0.9809 + 0.9709)

We then calculate the annualized fixed rate as follows;

360
Annual fixed rate = 0.74% × = 2.96%
90

Note to candidates: The swap rate (fixed rate) is very close to the last spot rate. You can use

this tip to check whether your resulting swap rate is close to the last spot rate. Additionally, the

swap rate should lie within the spot rates range as it is seen as the average of spot rates.

Valuation of an Interest Rate Swap

The value of a fixed-rate swap at some future point in time, t, is determined as the sum of the

present value of the difference in fixed swap rates times the notional amount.

The swap value to the receive fixed party is:

29
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 n′
V = N A (F S0 − FS t) ∑ P V t,ti
i=1

Note that the above equation provides the value to the party receiving fixed.

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Question

A bank entered a $500,000, five-year receive-fixed LIBOR-based interest rate swap,

which is reset annually one year ago. Suppose that the fixed rate in the swap contract

entered one year ago was 1.5%. The estimated discount factors are given in the

following table:

Year Discount factor

1 0.9723
2 0.9667
3 0.9625
4 0.9569

The value for the party receiving the floating rate is closest to:

A. −$7,389.

B. $7,500.

C. $7,389.

Solution

The correct answer is A.

We need first to calculate the fixed rate of the swap as follows.

1 − P V 0,tn (1)
rF IX =
∑ni=1 P V 0 ,ti (1)
1 − 0.9569
rF IX = = 1.117%
0.9723 + 0.9667 + 0.9625 + 0.9569

n′
V = N A (FS0 − F St ) ∑ P V t,ti
i =1

= $500, 000(1.5% − 1.117%) × (0.9723 + 0.9667 + 0.9625 + 0.9569)

= $7, 389

Therefore, the swap value to the receive floating party is −$7,389.

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Since the fixed rate exceeds the floating rate, the party that receives fixed (and pays

floating) would receive this amount from the party that pays fixed (and receives

floating).

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LOS 33f: Describe how currency swaps are priced, and calculate and
interpret their no-arbitrage value

A currency swap is an agreement between two counterparties to exchange future interest

payments in different currencies. The payments can be based either on a fixed interest rate or a

floating interest rate. By swapping future interest obligations, the two parties can manage

currency risk.

Currency swaps may also involve exchanging notional amounts both at the beginning of the

contract and the contract expiration. The counterparties can exchange payments denominated in

one currency to equivalent payments denominated in another currency.

Pricing Currency Swaps

Pricing a currency swap involves solving the appropriate notional amount in one currency, given

the notional amount in the other currency, and determining the two fixed interest rates. The

currency swap value is zero at the time of initiation.

Similar to interest rate swaps, currency swaps are priced by determining the fixed swap rate.

The equilibrium fixed swap rate equation for a currency X is given as:

1 − P V 0 ,tn,X (1)
rF IX,X =
∑ni=1 P V 0,ti, X (1)

The equilibrium fixed swap rate equation for currency Y is given as:

1 − P V 0,tn, Y (1)
rF IX,Y =
∑ni=1 PV 0 ,ti,Y (1)

Example: Calculating the Price of a Currency Swap

A French company needs to borrow 500 million dollars ($) for one year for one of its American

subsidiaries. The company decides to issue Euro-denominated bonds in an amount equivalent to

$500 million. The company enters a one-year currency swap agreement that resets quarterly and

33
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agrees to exchange notional amounts at the contract inception and maturity. The following spot

rates and present values are observed at time 0.

Days to EUR Spot US$ Spot(%)

Maturity Interest Rates Interest Rates
90 2.13% 0.09%
180 2.21% 0.13%
270 2.30% 0.17%
360 2.38% 0.21%

Given that the spot exchange rate of EUR/USD is 0.8163, the annual fixed swap rates for EUR

and USD are closest to:

Solution

The present values for each reset date are calculated as follows:

EUR present values:

1
D90 = = 0.9947
90
1 + (0.0213 × )
360
1
D180 = = 0.9891
180
1 + (0.0221 × )
360
1
D270 = = 0.9831
270
1 + (0.0230 × )
360
1
D360 = = 0.9768
360
1 + (0.0238 × )
360

Annual fixed rate for EUR:

1 − P V 0,tn, EUR (1)

rFI X,EU R =
∑ni=1 P V 0 ,ti,E UR (1)
1 − 0.9768
rFI X,EU R = = 0.5895%
0.9947 + 0.9891 + 0.9831 + 0.9768
360
Annual rate = 0.5895% × = 2.358%
90

USD present values:

1
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 1
D90 = = 0.9998
90
1 + (0.0009 × )
360
1
D180 = = 0.9994
180
1 + (0.0013 × )
360
1
D270 = = 0.9987
270
1 + (0.0017 × )
360
1
D360 = = 0.9979
360
1 + (0.0021 × )
360

Annual fixed rate for USD:

1 − P V 0,tn, USD (1)

rFI X,USD =
∑ni=1 P V 0 ,ti,U SD (1)
1 − 0.9979
rFI X,USD = = 0.0531%
0.9998 + 0.9994 + 0.9987 + 0.9979
360
Annual rate = 0.0531% × = 0.212%
90

The EUR notional amount is calculated as USD 500 million multiplied by the current spot

exchange rate at which US$1-dollar trades for EUR 0.8163

EUR Notional = 500 million × 0.8163 = EUR 408.15 million

The fixed swap payments in currency units equal the periodic swap rate times the appropriate

notional amounts:

90
F SEU R = N AE UR (AP) rFIX = EU R408.15M × ( ) (2.358%)
360
= EUR2.406 million
90
F SU S$ = N AU S$ (AP ) rFIX, US$ = $500m ( ) (0.212%)
360
= $0.265 million

In summary, currency swap pricing has three key variables: two fixed interest rates and one

notional amount.

Valuing Currency Swaps

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The value of a currency swap is 0 at the time of contract inception.

The value of a fixed-to-fixed currency swap at some future point in time, t, is determined as the

difference in a pair of fixed-rate bonds, one expressed in currency a and one expressed in

currency b .

⎛ n‘ ⎞
Va = N Aa, 0 rF IX,a,0 ∑ P Vt, ti , a + P Vt,t‘na
⎝ i=1 ⎠

⎛ n‘ ⎞
− StN Ab ,0 rF IX,b ,0 ∑ P Vt , ti, b + P Vt , tn‘ , b
⎝ i=1 ⎠

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Question

Bright Investment firm has entered a one-year currency swap agreement with

quarterly reset (30/360-day count). The exchange of notional amounts is done at the

initiation and maturity of the swap. The annualized fixed rates are 1%

(0.25%/quarter) for GBP and 0.50% (0.125%/quarter) for AUD. The notional amounts

were AUD 500,000 and GBP 200,000.

After one month, the GBP/AUD spot exchange rate changes to 0.60. Consider the

following market information:

Days to £ Spot Interest A$Spot Interest PV PV

Maturity Rates Rates (£1) (A$1)
60 6.000% 2.000% 0.9901 0.9967
150 7.000% 3.000% 0.9717 0.9877
240 8.000% 4.000% 0.9494 0.9740
330 9.000% 5.000% 0.9238 0.9562
Sum 3.8349 3.9145

The value of the swap entered 60 days ago is closest to:

A. £186,677.45.

B. £288,327.94.

C. −£101,650.49.

Solution

The correct answer is C.

⎛ n‘ ⎞
Va = N Aa,0 rF IX, a,0 ∑ P Vt ,ti , a + P Vt,t‘na
⎝ i=1 ⎠

⎛ n‘ ⎞
− StN Ab,0 rFI X,b, 0 ∑ P Vt, ti , b + P Vt, tn ‘, b
⎝ i=1 ⎠
Va = 200, 000 [(0.0025 × 3.8349) + 0.9238] − 0.60
× 500, 000(0.00125 × 3.9145) + 0.9562]
= 186, 677.45 − 288, 327.94 = −£101, 650.49

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38
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LOS 33g: Describe how equity swaps are priced, and calculate and
interpret their no-arbitrage value

An equity swap is an OTC derivative contract in which two parties agree to exchange a series of

cash flows. In this arrangement, one party pays a variable series determined by equity. The other

party pays a variable series determined by different equity or rate or a fixed series.

Types of Equity Swaps

Pay a fixed rate and receive equity return.

Pay floating rate and receive equity return.

Pay one equity return and receive another equity return.

We can look at an equity swap as a portfolio of an equity position and a bond.

The equity swap cashflows are expressed as :

NA(Equity return – Fixed rate) (for pay fixed, receive equity party)

NA(Equity return – Floating rate) (for pay floating, receive equity)

NA(Equity return X – Equity return Y) (for pay equity, receive equity) where X and Y

denote different equities.

Pricing Equity Swaps

An equity swap is priced at the same rate as a comparable interest rate swap. Note, however,

that the cashflows involved are very different.

The fixed swap rate is:

1 − P V 0 ,tn (1)
rFI X =
∑ni=1 P V 0, ti (1)

Example: Calculating the price of an Equity Swap

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Consider a four-year annual reset Libor floating-rate bond trading at par. A comparable interest

rate swap has a fixed rate of 1.117%. The information used to price the interest rate swap is

given in the following table:

Year Discount factor

1 0.9723
2 0.9667
3 0.9625
4 0.9569

Using the same data, the fixed interest rate for a 4-year pay fixed rate and receive equity return

equity swap is closest to:

Solution

The fixed-rate on an equity swap is identical to the fixed rate on a comparable interest rate swap.

This means that the fixed rate on the equity swap will be 1.117%, which is similar to the fixed

rate on a comparable interest rate swap.

Valuing an Equity Swap

Valuing an equity swap after it is initiated is comparable to valuing an interest rate swap.

However, instead of adjusting the floating-rate bond for the last floating rate observed (advanced

set), the value of the notional amount of equity is adjusted.

Therefore, the value of an equity swap is expressed as:

St
Vt = F Bt (C 0 ) − N AE − P V (Par − NA E)
St−

Where:

F Bt (C0 ) = Time t value of a fixed-rate bond initiated with coupon C0 at time 0.

St = Current equity price.

St– = Equity price observed at the last reset date.

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Question

An equity swap has an annual swap rate of 4% and a notional principal of $ 2 million.

The underlying index is currently trading at 2,000.

After 30 days, the index trades at 2,200, and the LIBOR spot rates are as given in the

following table:

Year Spot rates

60 − day Libor 3.90%
150 − day Libor 4.55%
240 − day Libor 5.20%
330 − day Libor 5.85%

The value of the equity swap to the fixed-rate payer is closest to:

A. $301,800.

B. $23,980.

C. $223,980.

Solution

The correct answer is C.

The first step is to calculate the discount factors:

1
D60 = = 0.9935
60
1 + (0.0390 × )
360
1
D150 = = 0.9814
150
1 + (0.0455 × )
360
1
D240 = = 0.9665
240
1 + (0.0520 × )
360
1
D330 = = 0.9491
330
1 + (0.0585 × )
360

41
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The value of the fixed-rate bond is then calculated as:

(4%)
P (fixed) = × (0.9935 + 0.9814 + 0.9665 + 0.9491) + 1 × 0.9491
4
= 0.98801

The value of the index investment :

2200
P (Index) = = 1.1
2000

The swap value to the fixed-rate payer is, therefore:

V = [P (index) − P (fixed)] × notional principal

= (1.1 − 0.98801) × $2 million
= $223, 980

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 Reading 34: Valuation of Contingent Claims

LOS 34a: Describe and interpret the binomial option valuation model and
its component terms

Contingent Claims

A contingent claim is a derivative contract that gives the owner the right but not the obligation

to receive a future payoff that depends on the value of the underlying asset. Call and put options

are examples of contingent claims.

So far, the approaches we have used to price and value derivative contracts rest on the no-

arbitrage principle. This principle states that prices adjust so as not to follow arbitrage profits.

The arbitrageur must follow the following two rules:

Rule 1: Do not use your own money.

Rule 2: Do not take any price risk.

The no-arbitrage valuation methodology applied in this reading is based on the law of one price.

This law argues that two investments with comparable future cash flows have the same current

price regardless of what happens in the future.

Binomial Option Valuation Model

One-period Binomial Option Valuation Model

In the one-period binomial model, we start today (at time t = 0) when the stock price is S0 . The

stock price can then either jump upwards or downwards over the one-period time interval, to

t = 1. This is illustrated below:

S0 u, if the stock price jumps up

S1 = {
S0 d, if the stock price jumps down

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This can be shown in the following binomial tree:

Where:

S0 u
u=
S0
S0 d
d=
S0

One-period Binomial Option Payoffs

Consider a call option that pays c u if the price of the underlying asset jumps up and cd if the

price of the underlying asset jumps down.

The value of the call option at expiry is expressed as:

c u = Max (0, S0 u − K) , if the price of the underlying jumps up

44
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and

c d = M ax(0, S0 d − K), if the stock price jumps down

Where K is the strike price.

This is shown in the following binomial tree:

Similarly, the value of a put option at expiration is given by:

pu = Max (0 , K − S0 u) , if the price of the underlying asset jumps up $

and

pd = Max (0 , K − SO d) if the price of the underlying asset jumps down.

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One-period Binomial Option Values

The initial values of call and put options with a one period to expiry are determined using the

following formulas:

qc u + (1 − q) cd
c0 =
1 +r

and

qpu + (1 − q) p d
p0 =
1 +r

Where:

(1 + r) − d
q=
u −d

46
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Where:

r is the risk-free rate for a single period.

q gives the risk-neutral probability of an upward move in price

1 − q gives the risk-neutral probability of a downward move

Example: Calculating the Price of an Option Using the One-period

Binomial Option Valuation Model

Consider a European put option with a strike price of $50 on a stock whose initial price is $50.

The risk-free rate of interest is 4%, the up-move factor u = 1.20, and the down move factor d =

0.83. The price of the put option can be determined using the one-period binomial model as

follows:

S0 u = 50 × 1.20 = $60
S0 d = 50 × 0.83 = $41.50

Recall that put payoff is given by:

pu = Max (0 , K − S0 u) , if the price of the underlying asset jumps up

and

pd = Max(0, K − SO d) if the price of the underlying asset jumps down.

pu = Max (0, 50 − 60) = $0

pd = Max (0, 50 − 41.50) = $8.50

The value of the put is then calculated using the formula:

qpu + (1 − q) p d
p0 =
1 +r

Where:

(1.04) − 0.83
47
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 (1.04) − 0.83
q= = 0.5676
1.20 − 0.83
0.5676 × $0 + 0.4324 × $8.50
p0 = = $3.53
1.04

Two-Period Binomial Option Valuation Model

The one-period binomial model can be extended into a multi-period context. The two-period

binomial lattice can be seen as three-one period binomial lattices as shown below:

The underlying asset can result in only three possible values:

S0 uu = When price moves up twice.

S0 ud = When price either moves up then down or down then up.

S0 dd = When price moves down twice.

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Call Payoffs

A call option under the two-period binomial option model will have three possible payoffs at

expiry as follows:

c uu = max (0, S0 u2 − K)
C u d = Max (0, S0 ud − K)
c dd = Max(0, S0 d 2 − K)

Put Payoffs

Similar to a call option, a put option will have three possible payoffs:

puu = Max(0, K– S0 u 2 )
pu d = Max(0, K– S0 ud)
pdd = Max(0, K– S0 d 2)

Option Values

A European call option’s value can be determined using the two-step binomial valuation model

using the following formula.

q 2c uu + 2q (1 − q) c ud + (1 − q)2 cdd
co =
(1 + r)2

The two-period European put value is given as:

q 2 puu + 2q (1 − q) p ud + (1 − q)2 pdd

po =
(1 + r)2

These concepts will be explained more with examples in the sections that follow.

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Question

A one-year European call option has a strike price of £60. The underlying non-

dividend-paying stock is currently trading at £60. Over one year, the stock price can

either jump up to £90 or jump down to £50. The annual risk-free interest rate is 4%.

Using a one-period binomial option valuation model, the price of the call option is

closest to:

A. £2.44.

B. £9.04.

C. £15.64.

Solution

The correct answer is B.

The payoff of a European call option at expiration is given by:

c u = Max (0, S0 u − K) , if the price of the underlying jumps up

and

c d = M ax(0, S0 d − K), if the stock price jumps down

90
u= = 1.5
60
50
d= = 0.83
60
c u = Max (0, 90 − 60) = £30
c d = Max (0, 50 − 60) = £0

The value of a call option is then calculated using the formula:

qc u + (1 − q) cd
c0 =
1 +r

Where:

1.04 − 0.83
50
© 2014-2024 AnalystPrep.
 1.04 − 0.83
q= = 0.3134
1.5 − 0.83
0.3134 × £30 + 0.6866 × £0
c0 = = £9.04
1.04

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LOS 34b: Calculate the no-arbitrage values of European and American
options using a two-period binomial model

Valuing European Options

A European option is an option that can only be exercised at expiry. Let's consider a simple

example to better illustrate the concept.

Example: The Value of a European Option

Consider a stock with an initial price of $70 and a risk-free rate of 1% per year. The asset price

can move up by 10% or down by 10%. The price of a European (1) call option and (2) put option

with two years to maturity and a strike price of $80 using a two-period binomial model is closest

to:

Solution 1: Call Option

Remember that the two-period binomial formula for pricing a call option from the previous

section:

q 2 cuu + 2q (1 − q) c ud + (1 − q)2 cdd

co =
(1 + r)2

Where:

u = Up-move factor = 1.10

d = Down-move factor = 0.90

and the risk-neutral probability, q, is given by:

(1 + r) − d
q=
u −d

The stock prices at each node and the call option payoffs are shown in the following binomial

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tree.

The risk-neutral probability, q, is given by:

(1 + r) − d
q=
u− d
(1.01) − 0.9
q= = 0.55
(1.1 − 0.9)

The two-period binomial value of the call option:

q 2 cuu + 2q (1 − q) c ud + (1 − q)2 cdd

co =
(1 + r)2
0.552 × $4.70 + 2 × 0.55 (1 − 0.55) × 0 + (1 − 0.55)2 × 0
c0 =
(1.01)2
c 0 = $1.39

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Solution 2: Put Option

The stock prices and the put option payoffs are shown in the following two-period binomial tree:

We determined q to be 0.55.

Using the formula:

q 2 puu + 2q (1 − q) pu d + (1 − q)2 p dd
po =
(1 + r)2
0.552 × 0 + 2 × 0.55 × 0.45 × $10.70 + 0.452 × $23.30
p0 =
1.012
p 0 = $9.82

Valuing American Options

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The difference between an American and a European option is that with an American option,

the holder can exercise the option before the expiry date, not just on the expiry date as is the

case with a European option. Thus, the value of an American option may be higher than that of a

comparable European option due to the early exercise feature.

The difference between the value of an American option and a comparable European option is

referred to as the early exercise premium.

Early exercise premium = American option value– European option value

American calls on non-dividend paying stocks do not benefit from the early exercise feature.

However, American puts may have an early exercise premium and must be checked for early

exercise. An early exercise captures the options’ intrinsic value and forgoes the time value.

It is worth noting that deep in the money, American put options cannot be valued simply as the

discounted value of the expected future option payouts. Therefore, we must establish whether or

not early exercise is optimal at each node by working backward through the binomial tree.

The unexercised American option values at time one is determined using the following formula:

qp uu + (1 − q) pu d
pu =
(1 + r)
qp ud + (1 − q) p dd
pd =
(1 + r)

The next step is to check each node for early exercise.

Example: Calculating the Value of an American Put Option

Consider a non-dividend-paying stock with an initial price of $70 and a risk-free rate of 1%

compounded annually. The asset price can either move up by 10% or down by 10%. The price of

an American put option with two years to maturity and a strike price of $80 using a two-period

binomial model is closest to:

Solution

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The put option’s payoffs at time two have been calculated as illustrated in the following binomial

tree.

At time one, the unexercised values of the option are determined as follows:

qp uu + (1 − q) pu d
pu =
(1 + r)
0.55 × $0 + (1 − 0.55) × $10.70
pu = = $4.77
(1.01)
qp ud + (1 − q) pdd
pd =
(1 + r)
0.55 × $10.70 + (1 − 0.55) × $23.30
pd = = $16.21
1.01

The next step is to evaluate whether it is optimal for early exercise at each node:

The value at the up-jump node = max($4.77 , $80 − $77) = $4.77 .

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 The value at the down-jump node = max($16.21, $80 − $63) = $17 .

The value of the American put at t = 0 is then calculated as follows:

qp u + (1 − q) p d
p0 =
1+ r
(0.55 × $4.77) + (1 − 0.55) × $17
p0 = = $10.17
1.01

Remember that the value of a comparable European put option was determined as $9.82.

In addition, notice that the American put is worth more than a similar European put.

Early exercise premium = $10.17 − $9.82 = $0.35

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Question

Consider the following information:

S0 = $30

K = $29

u = 1.3333( 43 )

d = 0.75

n = 2 years

r = 2% compounded annually

No dividends

Using a two-period binomial model, the early exercise premium of an American-style

put option is closest to:

A. $0.00.

B. $0.06.

C. $3.36.

Solution

The correct answer is B.

Early exercise premium = American put value– European put value

European Put Value

We determine the value of the European put by constructing an appropriate binomial

tree and applying the relevant formulas as follows:

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Formula:

q 2 puu + 2q (1 − q) p ud + (1 − q)2 pdd

po =
(1 + r)2

Where:

(1 + r) − d
q=
u−d
1.02 − 0.75
q= = 0.463
1.3333 − 0.75
0.463 2 × 0 + 2 × 0.463 × 0.537 × $0 + 0.537 2 × $12.125
p0 =
1.022
p0 = $3.361

American Put Value

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At time one, the unexercised values of the option are determined as follows:

qp uu + (1 − q) pu d
pu =
(1 + r)
0.463 × $0 + 0.537 × 0
pu = = $0
(1.02)
qp ud + (1 − q) pdd
pd =
(1 + r)
0.463 × $0 + 0.537 × $12.125
pd = = $6.383
1.02

The next step is to evaluate whether it is optimal for early exercise at each node:

The value at the down-jump node = max($6.383, $29 − $22.50) = $6.50 .

The value of the American put at t = 0 is then calculated as follows:

qpu + (1 − q) pd
p0 =
1 +r
(0.463 × $0) + 0.537 × $6.50
p0 = = $3.422
1.02

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The American put is worth more than a comparable European put as $3.422 > $3.361

Therefore,

Early exercise premium = $3.422 − $3.361 = $0.061

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LOS 34c: Identify an arbitrage opportunity involving options and
describe the related arbitrage

Call Option

A hedging portfolio can be created by going long ϕ units of the underlying asset and going short

the call option such that the portfolio has an initial value of:

V0 = ϕS0 − c 0

Where:

S0 = The current stock price

c 0 = Current call value

After a one-time-period, this portfolio will be worth:

V1 = ϕSou − cu if the asset price jumps up

or

V1 = ϕSod − cd if the asset price jumps down

If we equate the values of the up and down portfolios, the number of units of the underlying

asset can be obtained as:

c u − cd
ϕ=
S0 u − S0 d

ϕ is referred to as the hedge ratio. It is the ratio that makes a trader indifferent to the

movement of the underlying asset price. An arbitrageur creates a hedged portfolio to eliminate

price risk. This way, they satisfy Rule 2: “Do not take any price risk.”

Suppose at time step 0, a trader borrows the present value of:

−ϕSod + cd

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Assuming there is no-arbitrage, we shall have:

c 0 − ϕS0 = P V (– ϕS0 d + c d )

Since – ϕS0 d + cd =– ϕS0 u + cu .

This is can also be expressed as:

c 0 – ϕS0 = P V – ϕS0 u + c u

The no-arbitrage single-period valuation approach leads to the following single-step call option

valuation equation for call options:

c 0 = ϕS0 + P V (– ϕS0 d + c d )
c 0 = ϕS0 + P V (– ϕS0 u + c u )

Therefore, a call option is similar to owning ϕ units of the underlying asset and borrowing

P V (−ϕSo d + cd ) . This makes the transaction completely arbitrage-free, hence satisfying Rule 1:

“Do not use own money.” Moreover, we can view a call option as a leveraged position in the

underlying asset.

We can use the idea that a hedged portfolio returns the risk-free rate to determine the initial

value of a call or a put option.

Example: Value of a Call Option

Consider a one-period binomial model of a non-dividend-paying stock whose current price is $20.

Assume that:

Over the single period under consideration, the stock price can either jump up to $25

or down to $16.

The continuously compounded risk-free rate of return is 4% per period.

The current value of a one-period European call option that has an exercise price of $20 is

closest to:

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Solution

The binomial tree in respect of the stock price is as follows:

Similarly, consider a corresponding binomial tree with respect to the payoff provided by the call

option at time 1, i.e., the profit paid at exercise:

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We can determine c0 by using the single-period call option valuation equation as follows:

c 0 = ϕS0 + P V (– ϕSd + c d )
c − cd
ϕ= u
S0 u − S0 d
5 −0
ϕ= = 0.56
25 − 16

Therefore,

c0 = 0.56 × 20 + e−0.04 [−0.56 × 16 + 0] = $2.59

This implies that buying a call option for $2.59 is equivalent to buying 0.56 units of the

underlying stock for $11.20 and lending $8.61 such that the effective payment is $2.59.

Put Options

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The no-arbitrage single period valuation equation for put options is expressed as:

p = ϕS0 + P V (−ϕS0 d + p d )

Equivalently,

p = ϕS0 + P V (−ϕS0 u + p u )

Where the hedge ratio, ϕ , is given as:

pu − pd
ϕ= ≤0
S0 u − S0 d

Note that the hedge ratio, in this case, will be negative as pu is less than p d. Therefore, the

arbitrageur should short-sell the underlying and lend a portion of the proceeds to replicate a

long-put position.

Therefore, a put option can be viewed as equivalent to shorting the underlying asset and lending

P V – ϕS0 u + p u .

Example: Value of a Put Option

Consider a one-period binomial model of a non-dividend-paying stock whose current price is $20.

Assume that:

Over the single period under consideration, the stock price can either jump up to $25

or down to $16.

The continuously compounded risk-free rate of return is 4% per period.

The current value of a one-period European put option that has an exercise price of $20 is

closest to:

Solution

The payoff provided by the put option at time one is represented in the following binomial tree:

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 p = ϕS0 + P V – ϕS0 u + pu

Where:

pu − pd
ϕ= ≤0
S0 u − S0 d
0− 4
ϕ= = −0.44
25 − 16
p = −0.44 × 20 + e−0.04 (− − 0.44 × 25 + 0) = $1.77

Notice that buying a put option for $1.77 is equivalent to short selling 0.44 units of the

underlying stock for $8.80 and lending $10.57.

Exploiting Arbitrage Opportunities

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Consider a one-period binomial model of a non-dividend-paying stock whose current price is $20.

Imagine that:

Over the single period under consideration, the stock price can either jump up to $25

or down to $16.

The continuously compounded risk-free rate of return is 4% per period.

In the previous section, we determined the current value of this call option as $2.59, given a

strike price of $20.

Now, assume that the call option has a market price of $4.50. Assuming that we trade 1,000 call

options, we can illustrate how this opportunity can be exploited to earn an arbitrage profit.

Since the call option is overpriced, we will sell 1,000 call options and buy several shares of the

underlying determined by the hedge ratio.

cu − cd
ϕ=
S0 u − S0 d
$5 − $0 5
ϕ= = shares per option
$25 − $16 9

Therefore, we will purchase 1, 000 × 59 = 555.5555 shares.

The net cost of a portfolio with 555.55 shares of the stock held long at $20 per share and 1,000

calls held short at $4.50 is:

Net cost of the portfolio = (555.55 × $20) − (1 , 000 × $4.50) ≈ $6, 611

Assume that we begin with $0.

Then, we borrow $6,611 at 4%.

At the end of the one-time period, we repay the loan of $6, 611 × 1.04 ≈ $6 , 875 .

The portfolio value will be the same at maturity regardless of whether the stock price moves up

to $25 or down to $16.

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The value of the portfolio after stock price moves up is:

Vu = (555.55 × $25) – 1 , 000 × $5 ≈ $8 , 889

The value of the portfolio after stock price moves down is:

Vd = (555.55 × $16) – 1 , 000 × $0 ≈ $8 , 889

The arbitrage profit on this portfolio at the end of one year if the price moves up or down after

repayment of the loan is $8,889 – $6,875 = $2,014.

The discounted value of the arbitrage profit is therefore:

$2, 014
P V (Arbitrage profit) = = $1, 936.54
1.04

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Question

Consider a non-dividend-paying stock with a current price of $50 and an exercise

price of $50. The stock price can be modeled by assuming that it will either increase

by 12% or decrease by 10% each year, independent of the price movement in other

years. A trader constructs a portfolio consisting of 100 call options. If a call option is

overpriced, which portfolio most likely leads to an arbitrage profit?

A. Buy 100 call options, short 54.55 shares.

B. Buy 100 call options, short 45.45 shares.

C. Sell 100 call options, buy 54.55 shares.

Solution

The correct answer is C.

u = 1.12

d = 0.90

We can represent the above information in the following binomial tree:

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The call payoffs are as follows:

c u = max($56 − $50, 0) = $6
c d = max($45 − 50, 0) = $0

Since the option is overpriced, the trader will sell 100 call options and purchase

several shares determined by the hedge ratio:

cu − cd
ϕ=
S0 u − S0 d
$6 − $0
ϕ= = 0.5455 shares per option
$56 − $45

Total number of shares to purchase = 100 × 0.5455 = 54.55

Buying 54.55 shares of stock will produce a riskless hedge. The payoff at expiry will

return more than the risk-free rate on the hedge portfolio’s net cost. Borrowing to

finance the hedge portfolio and earning a higher rate than the borrowing rate

produces riskless profits.

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LOS 34d: Calculate and interpret the value of an interest rate option
using a two-period binomial model

Interest rate options are options with an interest rate as the underlying. A call option on

interest rates has a positive payoff when the current spot rate is greater than the exercise rate.

Call option payoff = Notional amount ×

[max (Current spot rate − Exercise rate,0)]

On the other hand, a put option on interest rates has a positive payoff when the current spot rate

is less than the exercise rate.

Put payoff = Notional amount × [max (Exercise rate − Current spot rate, 0)]

We can apply the binomial model to value such interest rate options.

Example: Calculating the Value of an Interest Rate European Option

Consider a two-year European-style call option with a one-year spot rate compounded annually

as the underlying. The exercise rate is 6%. The two-period interest rate tree is given below:

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Assume that the notional principal of each option is $500,000, and the risk-neutral probability of

an up jump is 0.5. The value of the European call option can be determined as follows:

Payoffs at Time 2

c uu = max(0, S0 u2 − K)
c uu = max(0, 0.11 − 0.06) = 0.05
C ud = Max (0, S0 ud − K)
C ud = max(0, 0.07 − 0.06) = 0.01
c dd = Max(0 , S0 d 2 − K)
c dd = max(0, 0.05 − 0.06) = 0

Value of Call at Time 1

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 c u = P V1 ,2 [qc uu + (1 − q) c ud ]
1
cu = [0.5 × 0.05 + (1 − 0.5) × 0.01] = 0.028302
1.06
c d = P V1 ,2 [qc ud + (1 − q) c dd ]
1
cd = [0.5 × 0.01 + (1 − 0.5) × 0)] = 0.004808
1.04

Value of Call at Time 0

c 0 = P V0 ,1 [qc u + (1 − q) cd ]
1
c0 = [0.5 × 0.028302 + (1 − 0.5) × 0.004808] = 0.01607
1.03

The call value at time 0 is then obtained by multiplying with the notional amount:

Call value = 0.01607 × $500, 000 = $8, 035

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Question

Consider a two-year European-style put option with the annually compounded one-

year spot interest rate as the underlying. The exercise rate is 6%. The two-period

interest rate tree is given below:

Assume that the notional principal of each option is $500,000, and the risk-neutral

(RN) probability of an up jump is 0.5. The value of the European put option is closest

to:

A. $1,167.

B. $5,835.

C. $8,035.

Solution

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The correct answer is A.

Put Payoffs at time 2

Similar to a call option, a put option will have three possible payoffs:

puu = Max(0, K– S0 u 2 )
puu = Max(0, 0.06– 0.11) = 0
pu d = Max(0, K– S0 ud)
pu d = Max(0, 0.06– 0.07) = 0
pdd = Max(0, K– S0 dd)
pdd = Max(0, 0.06– 0.05) = 0.01

Value of Put at Time 1

pu = P V1, 2 [qpuu + (1 − q) p ud ]
1
pu = [0.5 × 0 + (1 − 0.5) × 0] = 0
1.06
pd = P V1, 2 [qpu d + (1 − q) c dd ]
1
cd = [0.5 × 0 + (1 − 0.5) × 0.01)] = 0.004808
1.04

Value of Put at Time 0

po = P V0, 1 [qpu + (1 − q) pd ]
1
c0 = [0.5 × 0 + (1 − 0.5) × 0.004808] = 0.00233398
1.03

The put value at time 0 is then obtained by multiplying by the notional amount:

put value = 0.002334 × $500, 000 = $1 , 167

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LOS 34e: Describe how the value of a European option can be analyzed as
the present value of the option’s expected payoff at expiration

One-step Binomial Tree

Since a hedged portfolio returns the risk-free rate, it can determine the initial value of a call or

put. The expectations approach calculates the values of the option by taking the present value of

the expected terminal option payoffs. This approach utilizes risk-neutral probabilities instead of

true probabilities.

Therefore, the initial value of a call and put respectively are determined using the following

formulas:

qc u + (1 − q) cd
c0 =
1 +r

And

qpu + (1 − q) p d
p0 =
1 +r

Where:

(1 + r) − d
q=
u −d

Where

r is the risk-free rate for a single period.

q gives the risk-neutral probability of an upward move in price, while (1 − q) gives the probability

of a downward move.

Example: Expectations Approach for One-step Binomial Tree

Consider a stock that is currently trading at $50. Assume that the up jump and down jump

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factors for the stock price are u = 1.20 and d = 0.80. The risk-free rate compounded periodically

is 4%. Given a strike price of $50, we can use a single period binomial model to price European

call and put options.

Price of a European Call Option

Note that:

c T = max(ST − K, 0)
S0 u = 50 × 1.20 = $60
S0 d = 50 × 0.80 = $40
c u = max ($60 − $50, 0) = $10
c d = max ($40 − $50, 0) = $0

The value of the call option can then be determined using the formula:

qc u + (1 − q) cd
c0 =
1 +r

Where:

(1 + r) − d
q=
u−d
(1.04) − 0.8
q= = 0.6
1.20 − 0.80
0.6 × $10 + (1 − 0.6) × 0
c0 = = $5.77
1.04

Price of a European Put Option

p T = max(K − ST , 0)
p u = max ($50 − $60 , 0) = $0
p d = max ($50 − $40 , 0) = $10
qp u + (1 − q) p d
p0 =
1+ r
0.60 × 0 + (1 − 0.60) × $10
p0 =
1.04
p 0 = $3.85

Two-step Binomial Tree

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The expectations approach can also be applied to the two-step binomial model to determine the

value of options.

Let q be the risk-neutral probability of an up move. In this instance, the price of a European call

option can be determined using the two-step binomial model:

q 2 cuu + 2q (1 − q) c ud + (1 − q)2 cdd

co =
(1 + r)2

The two-period European put value is given as:

q 2 puu + 2q (1 − q) p ud + (1 − q)2 pdd

po =
(1 + r)2

Example: Expectations Approach for two-Step Binomial Model

Assume that you have a stock that is currently trading at $60. A two-year European call option

on the stock is available with a strike price of $60. The risk-free rate is 2% per annum. Given that

the up-move factor is 1.10 and the down-move factor is 0.90, the value of the call option using a

two-period binomial model is closest to:

Solution

The risk-neutral probability of an up-move is given by:

(1 + r) − d
q=
u− d
1.02 − 0.90
q= = 0.6
1.1 − 0.9

The probability of down move (1 − q) = 1 − 0.6 = 0.4

The two-period binomial tree is shown below:

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The two-period binomial value of the call option:

q 2 cuu + 2q (1 − q) c ud + (1 − q)2 cdd

co =
(1 + r)2
0.6 × $12.60 + 2 × 0.6 × 0.4 × 0 + 0.42 × 0
2
c0 =
(1.02)2
c 0 = $4.36

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Question

Nabi Gudka, CFA, applies the expectations approach to value a European call option

on the common shares of Wipro Inc. The expectation approach most likely utilizes:

A. A risk premium for discounting.

B. Risk-neutral probabilities.

C. Actual probabilities.

Solution

The correct answer is B.

Under the expectations approach, the expected future payoff is calculated using risk-

neutral probabilities, and the expected payoff is discounted at the risk-free rate.

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LOS 34f: Identify assumptions of the Black–Scholes–Merton option
valuation model

The Black-Scholes-Merton (BSM) model is an optional pricing model. Under this model, the

underlying share prices evolve in continuous time and are characterized at any point in time by a

continuous distribution rather than a discrete distribution.

The following key assumptions underpin the BSM model:

1. The price of the underlying share follows a geometric Brownian motion. This implies that

there are no jumps in share prices.

2. There are no risk-free arbitrage opportunities.

3. The risk-free rate of interest is constant, equal for all maturities, and identical for

borrowing or lending.

4. The volatility of the return of the underlying is known and constant.

5. Unlimited short selling of the underlying is permitted.

6. No taxes or transaction costs are payable.

7. The underlying share can be traded continuously and in very small numbers of units.

8. Early exercise of the options is not allowed (BSM, therefore, can only be used to value

European options).

These assumptions result in a complete market.

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Question

Which of the assumptions of the Black-Scholes-Merton Model is least accurate:

A. There are no taxes or transaction costs.

B. The risk-free rate of interest is known and constant. It is the same for all

maturities, borrowing, and lending.

C. Unlimited short selling is not allowed.

Solution

The correct answer is C.

Unlimited short selling is permitted. This means that we can sell securities that we do

not own. This is a necessary assumption because to hedge a derivative whose price is

positively correlated with that of the underlying asset – e.g., a call option, which will

have a positive delta – we need to hold a negative quantity of the underlying asset.

A and B are assumptions of the BSM model.

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LOS 34g: Interpret the components of the Black–Scholes–Merton model
as applied to call options in terms of a leveraged position in the
underlying

The BSM model for pricing options on a non-dividend-paying stock is given by:

European Call

c0 = S0 N(d 1 )– e(−rT )KN(d 2)

European Put

p0 = e−rT KN (−d2 ) − S0 N (−d1 )

Where:

ln( SK ) + (r + 12 σ 2 ) T
d1 =
σ√T
d 2 = d 1 − σ√ T

N (x) = Standard normal cumulative distribution function.

N (– x) = 1– N(x)

BSM Model has the following variables:

T = Time to option expiration.

r = Continuously compounded risk-free rate.

S0 = Current share price.

K = Exercise price.

σ = Annual volatility of asset returns.

Interpretation of the BSM Model

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The BSM model can be interpreted as the present value of the expected option payoff at

expiration. It can be expressed as:

c 0 = P V (S0er T N (d1 ) – KN (d2 ))

p0 = P V (KN (−d2 ) − S0 erT N (−d1 ))

Where the present value factor, in this case, is e−r T .

Alternatively, the BSM model can be described as having two components, a stock component,

and a bond component.

The stock component for call options is S0 N (d 1 ) while the bond component is e– rT KN(d 2 ).

Therefore, the BSM model call value is the difference between the stock component and the

bond component.

The stock component is (S0 N(d 1 )) and the bond component is er T KN (−d 2 ) for put options.

Therefore, the BSM model put value is the bond component minus the stock component.

An option can be thought of as a dynamically managed portfolio of the underlying stock and zero-

coupon bonds. The initial cost of this replicating strategy is given as:

Replicating strategy cost = nS S + nB B

Call Options

The equivalent number of underlying shares is nS = N (d1 ) > 0. nS greater than 0 implies that we

are buying the stock. On the other hand, the equivalent number of bonds is nB = −N (d2 ) < 0 . nB

less than 0 implies that we are selling the bond. Note that selling a bond is the same as

borrowing money. Therefore, a call option can be viewed as a leveraged position in the stock

where N(d 1 ) units of shares are purchased using e–r T KN(d 2 ) of borrowed money.

Put Options

The equivalent number of underlying shares is nS = −N (−d1 ) < 0. This can be interpreted as

selling the shares of the underlying stock as n S < 0.

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Further, the equivalent number of bonds is nB = N (−d 2 ) > 0 . The bond is being bought here

since n B is greater than 0. Buying a bond is similar to lending money. Therefore, a put can be

viewed as buying a bond where this purchase is partially financed by short selling the underlying

stock.

Example: Interpreting BSM Model Components

Consider the following information relating to call and put options on an underlying stock

S0 = 48

K = 40

r = 2.5% (Continuously compounded)

T =2

σ = 30%

The current market price of call option = 14

The current market price of put option = 3

The following values have been calculated using the above information:

PV (K) = 40 × e−0.025×2 = 38.05

d1 = 0.7597

d2 = 0.3354

N (d 1) = 0.7763

N (d 2) = 0.6314

We can determine the replicating strategy cost and arbitrage profits on both options as follows:

According to the no-arbitrage approach to replicating the call option, a trader can purchase

nS = N(d 1 ) = 0.7763 shares of stock by borrowing nB =– N(d 2 ) = −0.6314 shares of zero-coupon

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bonds priced at B = Ke– rT = $38.05 per bond.

Replicating strategy cost = n SS + n BB

Replicating strategy cost = 0.7763 × 48 + (−0.6314 × 38.05) = $13.24

An arbitrage profit can be realized on the call option by writing a call at the current market price

of $14 and purchasing a replicating portfolio for $13.24.

Therefore,

Arbitrage profit = $14 − $13.24 = $0.76

For the put option, we have:

N (– d 1 ) = 1– N (d1 ) = 1– 0.7763 = 0.2237

N (– d 2 ) = 1– 0.6314 = 0.3686

The no-arbitrage approach to replicating the put option involves:

Purchasing n B = N (−d2 ) = 0.3686 shares of zero-coupon bonds priced at 40e−0.025×2 = $38.05

per bond and short-selling nS =– N(−d1 ) =– 0.2237 shares of stock resulting in short proceeds of

$48 × 0.2237 = $10.74.

Therefore, the replicating strategy cost for the put option is:

Replicating strategy cost = −0.2237 × $48 + 0.3686 × $38.05 = $3.29

A trader can exploit arbitrage profits by selling the replicating portfolio and purchasing puts for

an arbitrage profit of $0.29 per put.

Arbitrage profit = $3.29 − $3 = $0.29

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Question

Common stock is currently trading at $50. A call option is written on it with an

exercise price of $45. Further, the continuously compounded risk-free rate of interest

is 4%, the interest rate volatility is 30%, and the time to the option expiry is 2 Years.

Using the BSM model, the following components have been calculated:

P V (K) = $41.54

d1 = 0.6490

d2 = 0.2248

N (d 1) = 0.7418

N (d 2) = 0.5889

c 0 = 12.63

The value of the replicating portfolio is closest to:

A. $9.57.

B. $11.94.

C. $12.63.

Solution

The correct answer is C.

The no-arbitrage approach to replicating the call option involves purchasing

nS = N (d1 ) = 0.7418 shares of stock partially financed with n B =– N (d2 ) =– 0.5889

shares of zero-coupon bonds priced at B = Ke–r T = $41.54 per bond.

Cost of replicating portfolio = nS S + nB B

c = 0.7418 (50) + (– 0.5889)41.54 = $12.63

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LOS 34h: Describe how the Black–Scholes–Merton model is used to value
European options on equities and currencies

Some underlying instruments have carry benefits. These benefits include dividends for stock

options, foreign interest rates for currency options, and coupon payments for bond options.

The BSM model should be adjusted to incorporate carry benefits in the option value. Let the

carry benefit be a continuous yield, γ. The carry adjusted BSM model is expressed as:

European call : c 0 = S0 e−γ T N (d1 ) − e−rT KN (d 2)

European put : p0 = e−rT KN (−d 2 ) − S0 e−γT N (−d1 )

Where:

2
ln ( SK0 ) + (r − γ + σ
)T
2
d1 =
σ√T

and

d2 = d1 − σ√T

It is worth noting that carry benefits lower the expected future value of the underlying. Further,

an increase in carry benefits lowers the value of a call option and raises the put option’s value.

BSM Valuation for Equities

Assume that the underlying equity has a continuously compounded dividend yield γ = δ . The

BSM model can be adjusted for dividends as follows:

European call : c 0 = S0 e−δ T N (d1 ) − e−rT KN (d2 )

European put : p0 = e−rT KN (−d 2 ) − S0 e−δT N (−d1 )

Where:

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 S σ2
ln ( K0 ) + (r − δ + 2
) T
d1 =
σ√T

and

d2 = d1 − σ√T

The arbitrageur of a dividend-paying stock receives dividend payments when they long the stock

and pays dividends when they short the stock. Dividends reduce the number of shares to buy for

calls and the number of shares to short-sell for puts. The higher the dividends, the lower the

value of d 1 and hence the lower the value of N (d1 ) .

Example: Valuing Stock Options Using the BSM Model

Consider a stock that is trading on the London Stock Exchange at £50. A trader believes that the

stock price will rise in the next month and decides to buy one-month call options with an exercise

price of £53. The risk-free annual rate of interest is 2%, and the yield on the stock is £0.35%. The

volatility of the stock is 20%.

The BSM model inputs are as follows:

The spot price of the underlying = £50

Exercise price = £53

Expiration = 1 month

Risk-free rate = 2%

Dividend yield = 0.35%.

Volatility = 0.20

BSM Valuation of Currencies

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The BSM model can also be used to value foreign exchange options. The carry benefit for a

foreign exchange option is the continuously compounded foreign risk-free interest rate.

The values of European call and put options are determined using the following formulas:

f
European call : c 0 = S0 e−r T N (d1 ) − e−rT KN (d2 )
f
European put : p0 = e−rT KN (−d 2 ) − S0 e−r T N (−d1 )

Where:

S0 (r − rf + σ2 ) T
d 1 = ln ( ) +
K σ√T

and

d2 = d1 − σ√T

Note that:

r = Domestic risk-free rate.

rf = Foreign risk-free rate.

Example: BSM Model Applied to Value Options on Currency

A swiss exporter will receive Euros for his watches. The exporter purchases a three-month put

option with an exercise price K = 1.07CHF/EUR to protect themselves against a decrease in the

EUR exchange rate. The current exchange rate is 1.08CHF/EUR.

The BSM model inputs for this currency option are as follows:

The underlying, S0 (the value of the domestic currency per unit of the foreign currency)

= 1.08CHF/EUR

r = The annualized swiss risk-free rate

rf = The EUR rate (Carry rate)

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Time to expiration = 0.25 years (three months)

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Question

An Australian importer has to pay fixed pound (£) amounts every three months for

goods. The spot price of the currency pair is 1.78A$/£. If the exchange rate rises to,

say 1.80 A$/£, then the Aussie will have weakened as it will take more Aussie dollars

to buy one pound. The importer believes that the Australian dollar will depreciate in

the following months. The importer, therefore, decides to buy an at-the-money spot

pound call option to protect herself against this depreciation. The risk-free Australian

rate is 3.00%, and the British risk-free rate is 2.00%.

The underlying price, the risk-free rate, and the carry rate to use in the BSM model to

get the pound call option value is most likely:

A. 1.78, 2.00%, 3.00%.

B. 0.56, 2.00%, 3.00%.

C. 1.78, 3.00%, 2.00%.

Solution

The correct answer is C.

The underlying, S0 (the value of the domestic currency per unit of the foreign

currency) = 1.78A$ /£. The risk-free rate is the Australian rate, 3.00%, and the carry

rate is the British rate of 2.00%

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LOS 34i: Describe how the Black model is used to value European
options on futures

The Black options valuation model is a modified version of the BSM model used for options on

underlying securities that are costless to carry, including options on futures and forward

contracts.

Similar to the BSM model, the Black model assumes that future prices follow geometric

Brownian motion. The Black option model values for European call and put options are expressed

as:

European call : c 0 = e–r T [F0 (T )N(d 1 )– KN (d 2 )]

European put : p0 = e−rT [KN (−d2 ) − F0 (T ) N (−d 1 )]

Where:

F0 (T) σ2
ln ( )+ T
K 2
d1 =
σ√T

and

d2 = d1 − σ√T

F0 (T ) = Futures price at time 0 that expires at time T.

σ = Volatility of returns on the futures price.

Example: Black Option Valuation

The NASDAQ index currently stands at $12,900. A three-month futures contract on the index

trades at $12,800. The exercise price is $12,750, the continuously compounded risk-free rate is

1%, and volatility is 15%. Finally, the index has a dividend yield of 2%.

The above information has been used to obtain the following results for both call and put options

on the futures contract:

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 Calls Puts
N (d1 ) 0.5636 N (– d 1 ) 0.4364
N (d2 ) 0.5339 N (– d 2 ) 0.4661
c0 405.84 p0 355.83

The values of a European call option and the put option on the futures contract are closest to:

Solution

European call : c 0 = e– rT [F0 (T )N (d1 )– KN (d2 )]

c 0 = e–0.01×0.25 [12 , 800 × 0.5636– 12 , 750 × 0.5339]
= $405.84
European put : p 0 = e−r T [KN (−d 2 ) − F0 (T ) N (−d1 )]
p 0 = e−0.01 ×0.25 [12 , 750 × 0.4661 − 12 , 800 × 0.4364]
= $355.96

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Question

The US 30 index is at $30,605. A futures contract on it trades at $30,400. The

exercise price is $30,000, the continuously compounded risk-free rate is 1.75%, the

time to a futures contract and options expiration is two months, and the volatility is

15%. The US 30 dividend yield is 1.8%. The following results have been determined

using the above information:

Calls Puts
N (d1 ) 0.6388 N (– d 1 ) 0.3612
N (d2 ) 0.6156 N (– d 2 ) 0.3844
c0 948.75 p0 549.91

Which of the following options best describes how the black model is used to value a

European call option on the futures contract?

The call value is the present value of the difference between:

A. The current futures price times 0.6388 and the exercise price times 0.6156.

B. The exercise price times 0.6156, and the current futures price times 0.6388.

C. The current spot price times 0.6388, and the exercise price times 0.6156.

Solution

The correct answer is A.

The value of a European call option on a futures contract is obtained using the

formula:

c 0 = e– rT [F0 (T )N (d1 )– KN (d2 )]

The above formula implies that the valuation of a European call option based on the

black model involves calculating the present value of the difference between the

futures price and the exercise price.

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LOS 34j: Describe how the Black model is used to value European
interest rate options and European swaptions

Interest Rate Options

The underlying instrument in an interest rate swap is a reference interest rate. Reference rates

include the Fed funds rate, LIBOR, and the rate on benchmark US Treasuries.

Interest rate options are, therefore, options on forward rate agreements (FRAs). An interest

rate call option pays off when FRA rises above the exercise rate. The holder pays the exercise

rate and receives the reference rate (usually Libor). On the other hand, the interest rate put

option pays off if the FRA falls below the exercise rate. The holder pays the reference rate and

receives the exercise rate.

Assume that an interest rate call option expires in one year. The underlying interest rate is an

FRA that expires in one year and is based on a three-month LIBOR. This FRA is the reference

rate used in the Black model.

Options on FRAs use the actual/365 convention. This is unlike FRAs, which generally apply the

30/360 convention.

The values of interest rate call and put options using Black’s model is given by:

European Call:

c 0 = (AP ) e−r(tj−1+tm ) [F RA(0,tj−1, tm ) N (d1 ) − RK N (d 2 )]

European Put:

p0 = (AP ) e−r(tj−1+tm ) [RK N (−d2 ) − F RA(0, tj−1 ,tm )N (−d 1 )]

FR A(0 ,t
j−1 ,tm ) 2
ln[ ] + ( σ2 ) tj−1
RK
d1 =
σ√tj−1

Where:

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 d 2 = d 1 − σ√tj−1

F RA(0 ,tj–1,tm ) is the fixed rate on an FRA at time 0 that expires at the time tj–1 where the

underlying matures at time (tj–1 + tm ), with all times expressed on an annual basis.

R K is the exercise rate expressed on an annual basis

σ is the underlying FRA interest rate volatility

AP is the accrual period in years

Example: Valuing an Interest Rate Option

An interest rate call option expires in one year. The underlying interest rate is an FRA that

expires in one year and is based on a three-month LIBOR. This FRA is the underlying rate used in

the Black model.

The above information is illustrated below:

The value of a European call option can now be calculated using the formula:

European call :
c 0 = (AP) e−r(1.25) [F RA(0,1 ,0.25) N (d1 ) − RK N (d2 )]

Where F RA(0, 1,0.25) is the FRA rate at time 0 that expires in time one and is based on the 0.25-

year LIBOR.

Key Points

Notice the following from the interest rate option valuation model:

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 The underlying is an FRA, not a futures price.

The discount factor applies to the expiration of the underlying F RA (tj−1+tm ) , but not to

option expiration.

The time to option expiration, tj– 1 , is used in the calculation of d1 and d2 .

The exercise price is an interest rate, Rknot a price

Swaptions

A swaption (swap option) is an option on a swap that gives the owner the right but not the

obligation to enter an interest rate swap at a pre-determined swap rate (exercise rate).

A payer swaption is a swaption to pay fixed, receive floating, while a receiver swaption is a

swaption to receive fixed, pay floating. The buyer of a payer swaption option gains when the

fixed-rate goes up before the swaption expires. On the other hand, a receiver swaption has a

positive value if the market swap fixed-rate at expiration is less than the exercise rate. When

exercised, the buyer of a payer swap option can enter a pay-fixed and receive a floating swap at

a predetermined swap rate, RK .

The payer swaption buyer may immediately enter an offsetting at-the-market receive fixed and

pay floating swaption at a higher (current) fixed swap rate. The floating legs cancel out. The

investor is then left with an annuity of the difference between the current fixed swap rate and

the lower swaption exercise rate.

The present value of this annuity is given by:

n
Present value of an annuity (PVA) = ∑ P V0 , tj (1)
j=1

The values of a payer and receiver swaptions are determined as follows:

P AYSW N = (AP) P V A [RF IXN (d1 ) − RK N (d 2 )]

RECSW N = (AP) P V A [RK N (−d2 ) − RF IXN (−d1 )]

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Where:

RF I X 2
σ
ln ( )+ T
RK 2
d1 =
σ√T

and

d2 = d1 − σ√T

R FIX is the fixed swap rate starting when the swaption expires while T is the swaption expiration

quoted on an annual basis.

R K is the exercise rate starting at time T (annual basis).

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AP is the accrual period. If the swap is settled quarterly, AP = .
360

σ is the volatility of the forward swap rate.

Key points

The swaption valuation model has the following features that make it different from the standard

Black model:

It does not have a discount factor but the present value of an annuity (PVA) that

embeds the discount factor.

The underlying is the fixed rate on the forward interest rate swap.

The exercise price is an interest rate

Example: Swaptions

Consider a European payer swaption that expires in one year. The underlying is a five-year swap

with a fixed rate of 6% that makes annual payments. At the swaption expiry in one year, the fixed

rate of a five-year annual pay swap is 7%.

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R K , the exercise rate, is 6%

R FIX , the fixed swap rate starting when the swaption expires, is 7%.

The buyer of the payer swaption can benefit by entering a five-year swap at a fixed rate of 6%

even though the market rate is higher, at 7%. The buyer is now left with an annuity of the

difference between the current fixed swap rate (7%) and the lower swaption exercise rate (6%).

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Question

A payer swaption is most likely interpreted as:

A. The difference between bond component and swap component.

B. The difference between the swap component and bond component.

C. The sum of the swap component and bond component.

Solution

The correct answer is B.

The formula for the payer swaption value is:

PAYSW N = (AP ) P V A[R FI XN (d 1 ) − R K N (d 2)]

Where (AP)P V A(R FI X)N (d1 ) is the swap component and (AP)P V A(R K )N(d 2 ) is the

bond component. Therefore, the payer swaption model value is the swap component

minus the bond component.

The following formula gives the receiver swaption model value:

RECSW N = (AP) P V A [RK N (−d2 ) − RF IX N (−d1 )]

Where:

(AP )P V A(RF IX )N(– d1 ) is the swap component and

(AP )P V A(RK )N (– d 2 ) is the bond component.

This, the receiver swaption model value is the bond component minus the swap

component.

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LOS 34k: Interpret each of the option Greeks

The Greeks are a group of mathematical derivatives applied to help manage or understand

portfolio risks. They include delta, gamma, theta, vega, and rho.

Delta

Delta is the rate of change of the option’s price attributable to a given change in the price of the

underlying instrument, other parameters held constant. The delta of long one stock share is +1

while that of short one share of stock is -1.

The option deltas of a call and put options are given as:

Deltac = e−δT N (d1 )

Delta = −e−δT N (−d1 )

Where δ is the continuously compounded dividend yield of the underlying stocks. Note that δ will

be zero for non-dividend paying stocks.

Call options have positive deltas as the value of a call option increases with an increase in the

underlying asset price. Conversely, put options have negative deltas as the value of a put

decreases with an increase in the underlying price.

Gamma

Gamma is the rate of change of portfolio delta with a change in the underlying price, with all the

other parameters held constant.

Option gamma measures the convexity or curvature of the relationship between the price of the

option and the price of the underlying asset.

A high value of gamma means that the delta is more sensitive to the share price changes and

vice versa. The gamma of a long or short position in one share of stock is zero. Note that the

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delta of the underlying share is equal to one. The derivative of a constant is zero, and so the

gamma of the underlying asset must be zero.

Gamma is always positive, and its value is highest when the option is near the money and close

to expiration. The portfolio gamma can be lowered by going short options and increased by going

long options.

Even then, it is noteworthy that both put and call options have equal gamma.

e− δ T
Gammac = Gammap = n (d1 )
S σ√ T

Where:

n (d1 ) is the standard normal probability density function.

Theta

Theta measures the sensitivity of the option value to a small change in calendar time, all else

held constant. Note that time is a variable that progresses with certainty. Therefore, it does not

make sense to hedge against changes in time at the commencement of a contract. This is a

departure from what we do to unexpected changes in the underlying asset price.

The greater the time to expiry, the higher the possibility that the share price will move in favor of

the holder, given that the downside loss is capped. However, theta is usually negative for both a

call and a put option as the expiration date gets nearer. The speed of the decline in the option

value increases as time goes by. The option will therefore expire and become worthless, i.e.,

S = K . The change in option prices as time advances is known as time decay. The theta of a

stock is zero since stocks do not have an expiry.

Vega

Vega is the sensitivity of a portfolio to a given small change in the assumed level of volatility, all

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else held constant. The assumption of future volatility makes vega a subjective risk management

tool.

The vega of both call and put options are equal and always positive. If the underlying security

becomes more volatile, then there is a greater chance of the price moving in favor of the option

holder.

Vega is high for at or near-the-money options and short-dated options.

Rho

Rho is defined as the change in a portfolio with respect to a small change in the risk-free rate of

interest, everything else held constant. Although the risk-free rate of interest can be determined

with a good degree of certainty, it can vary by a small amount over the contract term.

Holding a call option can be viewed as having cash in the bank waiting to purchase a share. The

holder of the call option will benefit in the meantime when interest rates rise.

Conversely, we can think of a holder of a put as one who already owns a share and is waiting to

sell it for cash. The holder of the put will therefore lose out on the interest in the meantime when

interest rates rise.

Therefore, rho is positive for a call option and negative for a put option.

Above all, rho changes over time. The option price will be less sensitive to the interest rate as the

expiration date nears because interest rates lose much importance then.

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Question

The sensitivity of a portfolio value to a small change in calendar time, all else held

constant is most likely:

A. Vega.

B. Theta.

C. Rho.

Solution

The correct answer is B.

Theta measures the change in the value of a portfolio given a small change in

calendar time, all else held constant.

A is incorrect. Vega is the sensitivity of a portfolio to a given small change in the

assumed level of volatility, all else held constant.

C is incorrect. Rho is defined as the change in a portfolio with respect to a small

change in the risk-free rate of interest, everything else held constant.

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LOS 34l: Describe how a delta hedge is executed

Delta hedging involves adding up the deltas of the individual assets and options that make up a

portfolio. A delta hedged portfolio is one for which the weighted sums of deltas of individual

assets are zero. A position with a zero delta is referred to as a delta-neutral position.

Denote the delta of a hedging instrument by DeltaH and the optimal number of hedging units

N H = − Portfolio Delta.
Delta H

To achieve a delta hedged portfolio, short the hedging instrument if N H is negative and long the

hedging instrument if N H is positive.

A delta-neutral portfolio is one that does not change in value as a result of small changes in the

underlying price. Delta neutral implies that:

Portfolio delta + N H DeltaH = 0

A portfolio should be rebalanced regularly to ensure that the sum of deltas remains close to zero.

Static delta hedging involves the construction of an initial portfolio with a sum of deltas of

On the other hand,

zero, at time 0. In fact, the sum of deltas is never adjusted.

dynamic delta hedging involves continuously rebalancing

the portfolio to maintain a constant total portfolio delta of
zero.

Example: Delta Hedging #1

Consider a portfolio composed of 1,500 shares. Call options with a delta of +0.50 are used to

hedge this portfolio. A delta hedge could be implemented by selling enough calls to make the

portfolio delta neutral.

The optimal number of hedging units is determined as follows:

Portfolio Delta
NH = −
DeltaH

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Portfolio delta = 1,500

DeltaH = +0.50

1 500
,
Therefore, N H = − 0.50 = −3, 000

This means that we must sell 3,000 calls to achieve delta neutrality.

Example: Delta Hedging #2

Given the following information:

S0 = 60

K = 50

r = 2%

T =1

σ = 20%

Deltac = 0.537

Deltap = −0.463

Assume that the underlying asset does not pay a dividend consider a short position of 5,000

shares of stock.

Delta hedge this portfolio using call options and put options.

Hedging Using Call Options

The optimal number of hedging units,

Portfolio Delta
NH = −
DeltaH

Where:

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Portfolio Delta = -5,000

DeltaH = 0.537

−(−5,000)
NH = − = 9,311
0.537

This means that we must buy 9,311 calls to make the portfolio delta neutral.

Hedging Using Put Options

We have portfolio delta = -5,000

DeltaH = -0.463

−5 000
,
N H = − −0.463 = −10, 799

This means that we must sell 10,799 put options.

Note to candidates: The amount of call options to be bought is not the same amount as the

number of put options to be sold.

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Question

An investor owns a portfolio with 10,000 shares of Contagia Inc. common stock

currently trading at $30 per share. The investor wants to delta hedge the portfolio

using call options. A call option on the Contagia shares with a strike price of $30 has

a delta of 0.5.

The strategy to create a delta-neutral hedge most likely involves:

A. Selling 10,000 call options.

B. Buying 20,000 call options.

C. Selling 20,000 call options.

Solution

The correct answer is C.

Portfolio delta = 10,000

DeltaH = 0.5

The optimal number of call options required to hedge against movements in the stock

price is determined as:

Portfolio Delta
NH = −
DeltaH
−10 , 000
NH = = −20, 000
0.5

This means that the investor must sell 20,000 calls to achieve delta neutrality.

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LOS 34m: Describe the role of gamma risk in options trading

Gamma measures the risk that remains once a portfolio is delta neutral (non-linearity risk).

The BSM model assumes that share prices change continuously with time. In reality, however,

stock prices do not move continuously. Instead, they often jump, and this creates gamma risk.

Gamma risk derives its name from the fact that gamma measures the risk of share prices

jumping when hedging an options position, leaving an otherwise hedged option position abruptly

unhedged.

A delta-hedged portfolio is said to have a negative net gamma exposure if it has a short position

in calls and a long position in stocks.

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Question

Which of the following statements is most accurate?

A. Gamma measures linearity risk.

B. Gamma risk is created when stock prices move continuously.

C. Gamma risk results from share prices jumping when hedging an options

position, leaving the hedged position suddenly unhedged.

Solution

The correct answer is C.

Gamma risk is so-called because gamma measures the risk of share prices jumping

when hedging an options position, leaving an otherwise hedged option position

abruptly unhedged.

A is incorrect. Gamma measures non-linearity risk, i.e., the risk that remains once

the portfolio is delta neutral.

B is incorrect. The BSM model assumes that share prices change continuously with

time. In reality, stock prices do not move continuously. Instead, they often jump, and

this creates gamma risk.

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LOS34n: Define implied volatility and explain how it is used in options
trading/

Implied Volatility

We have seen that both the BSM model and Black model require the parameter, σ, which is the

volatility of the underlying asset price. However, future volatility cannot be observed directly

from the market but rather estimated.

One way of estimating volatility is by using an observed option price from the market and

determining the volatility in line with this price. The values of other model parameters, including

the underlying share price, the risk-free rate of interest, and the dividend yield, can be observed.

This makes it possible to determine the volatility as it will be the only unknown parameter in the

formula. The resulting estimate is known as the implied volatility.

The values of both European options are directly related to the volatility of the underlying asset.

A call holder gains from the price increase but has limited downside risk. Moreover, the holder of

a put gains from the price decrease but has limited upside risk. Therefore, the value of options

increases with an increase in volatility.

Lastly, implied volatility gives an understanding of the investor’s opinions on the volatility of the

underlying asset. Higher implied volatility relative to the investor’s volatility expectations

suggests that the option is overvalued. Additionally, implied volatility helps in revaluing existing

positions over time.

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Question

An options dealer offers to sell a one-month in-the-money put on PayPal Holdings at

20% and a two-month at-the-money call on the SET index option at 15% implied

volatility. Based on the current forecast, an options trader believes that PayPal

volatility should be closer to 16%, and SET volatility should be closer to 22%. To

benefit from his views, the trader should most likely:

A. Buy the PayPal put and the SET call.

B. Sell the PayPal put and the SET call.

C. Sell the PayPal put and buy the SET call.

Solution

The correct answer is C.

The trader believes that the PayPal put is overvalued and that the SET call is

undervalued. Therefore, he expects the PayPal volatility to fall and that of SET to rise.

Therefore, the PayPal put would be expected to decrease in value while the SET call

would increase in value.

As a result, the FTSE call would be expected to increase in value. The VOD put, on

the other hand, would be expected to decrease in value. The trader would then Sell

the PayPal put and buy the SET call.

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