FORMULAS

CHAPTER 5: Financial Forwards and Futures

1. Prepaid forward price with no dividend: F0,PT = S 0
n
2. Prepaid forward price with discrete dividends: F0,PT = S0 − ∑ PV ( Di )
i =1

3. Prepaid forward price with continuous dividends: F0,PT = S0 e−δ T

δ
4. Daily dividend = × S0
365
365×T
 δ 
5. Number of increasing shares after T = 1 +  ≈ eδ T
 365 

6. Forward price with no dividend (continuously compounded): F0,T = FV (F0,PT ) = S0e rT

n
7. Forward price with discrete dividends (continuously compounded): F0,T = S0 e rT − ∑ e r (T −i ) ( Di )
i =1

8. Forward price with continuous dividends (continuously compounded): F0,T = S0 e( r −δ )T

F0,T
9. Forward premium =
S0

1  F0,T 
10. Annualized forward premium = ln  
T  S0 

11. Annualized forward premium = r − δ if continuous dividends

12. Future contracts:
Notional value = 250 × Index price × number of contracts
Initial margin = Initial% × Notional value
Maintenance margin = Maintenance% × Initial margin
Profit (loss) on Future index = (PT − P0 ) × 250 × number of contracts
Account balance = Profit (loss) on Future index + Initial margin + Interest earned on Initial margin
13. Hedging portfolio with future (with annual rate of return on Index rindex):
Value needed to hedge Value needed to hedge
Adjusted number of contracts = β × =β×
PV(Value of a future contract) 250 × Current Index price
Gain on future contracts = (PT − P0 ) × 250 × number of contracts
 PT − P0
rindex = ; rp = rf + β × ( rindex − rf )
P0
Portfolio value at T = Current value of portfolio × (1 + rp )

1 + rannual = e continuous compounded

r
If continuous compounded, convert to annual rate, using
Total value = Gain on future contracts + Portfolio value at T
14. Forward = Stock – zero-coupon bond
15. Creating synthetic forwards:

Long synthetic forward

Transaction Time 0 Time T
Buy e−δ T units of index − S 0 e −δ T + ST
Borrow S 0 e −δ T + S 0 e −δ T − S0 e( r −δ )T
Total payoff 0 ST − S 0 e ( r −δ )T

Short synthetic forward

Transaction Time 0 Time T
−δ T
Short e units of index + S 0 e −δ T − ST
Lend S 0 e −δ T − S 0 e −δ T + S 0 e ( r −δ ) T
Total payoff 0 S 0 e ( r −δ )T − S T
16. Arbitrage:

If F0,T > E ( F0,T ) = S0 e( r −δ )T

Transaction Time 0 Time T
Buy e−δ T units of index − S 0 e −δ T + ST
Borrow S 0 e −δ T + S 0 e −δ T − S0 e( r −δ )T
Short forward 0 F0,T − ST
Total payoff 0 F0,T − S0 e( r −δ )T

If F0,T < E ( F0,T ) = S0e( r −δ )T

Transaction Time 0 Time T
Short e−δ T units of index + S0 e( r −δ )T − ST
Lend S 0 e −δ T − S 0 e −δ T + S 0 e ( r −δ ) T
Long forward 0 ST − F0,T
Total payoff 0 S0e( r −δ )T − F0,T

CHAPTER 7: Interest Rate Forwards and Futures

Par value B = $1; Pt1 ,t2 = price of zero-coupon bond issued at t1, matures at t2;

n = number of coupon payments (paid at the end of period)

1. Implied forward rate: (1 + r0,1 )(1 + r1,2 )...(1 + rn −1,n ) = (1 + r0,n ) n

t −t
P0,t1 1
2. (1 + rt1 ,t2 ) 2 1 = =
P0,t2 Pt1 ,t2

1 − Pt1 ,t2
3. Coupon rate: ct1 ,t2 = n

∑P
i =1
t1 , ti

4. Forward rate agreement (FRA):

 Settlement in arrears (at maturity t + s): Payment = notional × (rt + s − rFRA )
(rt + s − rFRA )
 Settlement at the time of borrowing (at t): Payment = notional ×
1 + rt + s

 rt + s < rFRA : borrower pay; rt + s > rFRA : lender pay

5. Creating synthetic FRAs:

Synthetic FRA for lending $1 at t (Short FRA)

Transaction Time 0 Time t Time t + s
Buy ( 1 + rt ,t + s ) zero-coupon − P0,t + s × (1 + rt ,t + s ) + (1 + rt ,t + s )
bonds maturing at t + s
Short 1 zero-coupon bond + P0,t −1
maturing at t
Total payoff 0 −1 +(1 + rt ,t + s )

Synthetic FRA for borrowing $1 at t t (Long FRA)

Transaction Time 0 Time t Time t + s
Short ( 1 + rt ,t + s ) zero-coupon + P0,t + s × (1 + rt ,t + s ) −(1 + rt ,t + s )
bonds maturing at t + s
Buy 1 zero-coupon bond − P0,t +1
maturing at t
Total payoff 0 +1 −(1 + rt ,t + s )
6. Hedging against FRAs, using synthetic FRAs:

Hedging against long FRA (for borrower)

Transaction Time 0 Time t Time t + s
Long FRA at t, maturing at t + s +1 −(1 + rt ,t + s )
Buy ( 1 + rt ,t + s ) zero-coupon bonds − P0,t + s × (1 + rt ,t + s ) + (1 + rt ,t + s )
maturing at t + s
Short 1 zero-coupon bond + P0,t −1
maturing at t
Total payoff 0 0 0
 Hedging against short FRA (for lender)
Transaction Time 0 Time t Time t + s
Short FRA at t, maturing at t + s −1 +(1 + rt ,t + s )
Short ( 1 + rt ,t + s ) zero-coupon + P0,t + s × (1 + rt ,t + s ) −(1 + rt ,t + s )
bonds maturing at t + s
Buy 1 zero-coupon bond maturing − P0,t +1
at t
Total payoff 0 0 0

7. Duration:
T

∑ [t × PV (C )]
i i
Macaulay Duration = D = i =1
T

∑ PV (C )
i =1
i

1 ∑ [t × PV (C )] i i
D
Modified duration = − i =1
=−
1+ r T
1+ r
∑ PV (C )
i =1
i

1 ∑ [t × (t
i i + 1) × PV (Ci )]
8. Convexity: Convexity = × i =1
(1 + ym ) 2 T

∑ PV (C )
i =1
i

9. Duration matching: own 1 bond I, and short N bonds II. To make the portfolio insensitive to interest rate
D1 P1 ( y1 ) / (1 + y1 )
changes, N = −
D2 P2 ( y2 ) / (1 + y2 )

CHAPTER 8: Swaps

CHAPTER 9: Parity and Other Option Relationships

C ( K , T ) − P( K , T ) = PV ( F0,T − K ) = S0 − PV ( Div) − PV ( K ) = S0 e−δ T − PV ( K )
1.
Note: the components above are costs, not cash flows. If >0, mean you have to pay (buying). If <0, mean
you are paid (selling)
 Synthetic stock = buy call + sell put + lend PV(Div) and PV(K)
S0 = C ( K , T ) − P ( K , T ) + PV ( Div) + PV ( K )
 Synthetic T-bill (that pays K + FV(Div) at expiration) = buy stock + buy put + sell call (conversion)
PV ( Div) + PV ( K ) = S0 + P ( K , T ) − C ( K , T )
 Reserve conversion (short synthetic T-bill) = short stock + buy call + sell put
  Synthetic option:
Synthetic call = buy stock + sell put + borrow PV(Div) and PV(K)
C ( K , T ) = S0 + P( K , T ) − PV ( Div) − PV ( K )
Synthetic put = short stock + buy call + lending PV(Div) and PV(K)
P( K , T ) = − S0 + C ( K , T ) + PV ( Div) + PV ( K )
2. Conditions in options:
 S0 > Camerican ≥ Ceuropean ≥ max  0; PV ( F0,T ) − PV ( K ) 

 K > Pamerican ≥ Peuropean ≥ max  0; PV ( K ) − PV ( F0,T ) 

 If no dividend, 0< t <T: Camerican ≥ Ceuropean > St − K (non-profitable to excise a call before expiration

 C (low strike) ≥ C (high strike) ; (violated  call bull spread)

P(low strike) ≤ P(high strike) ; (violated  put bear spread)
 C (low strike) − C (high strike) ≤ high strike − low strike ; (violated  call bear spread)
P(high strike) − P(low strike) ≤ high strike − low strike ; (violated  put bull spread)
C ( K1 ) − C ( K 2 ) C ( K 2 ) − C ( K 3 )
 K1 < K 2 < K 3 ⇒ ≥ ;
K 2 − K1 K3 − K 2
P ( K 2 ) − P ( K1 ) P ( K 3 ) − P ( K 2 )
K1 < K 2 < K 3 ⇒ ≤
K 2 − K1 K3 − K 2
(violated  asymmetric butterfly spread)

CHAPTER 10: Binomial Option Pricing

uS0 Cu
S0 C0
dS0 Cd
h = expiration time
r = continuously compounded interest rate
Cu − Cd
1. Number of shares: ∆=
S0 (u − d )

uCd − dCu
2. Borrowing/lending amount: B = e − rh
u−d
 erh − d u − e rh 
3. Cost of the option: C0 = ∆ × S0 + B = e− rh  Cu + Cd 
 u−d u−d 

4. If u > e rh > d : no arbitrage; If e rh > u or e rh < d : arbitrage opportunities

5. At time h: ∆ × S h + B × e rh = Ch
6. With uncertainty:

uSt = Ft ,t + h e +σ h
= St e( r −δ ) h +σ h
; dSt = Ft ,t + h e −σ h
= St e ( r −δ ) h −σ h

u = e( r −δ ) h +σ h
; d = e( r −δ ) h −σ h

Binomial tree two-period for call option K-strike

Suu = u × u × S0
Cuu = max [ 0, Suu − K ]
Su = u × S 0
Cu = ∆u × Su + Bu
 erh − d u − erh 
= e− rh  Cuu + Cud 
 u−d u−d 
C − Cud
∆ u = uu
Su (u − d )
uC − dCuu
Bu = e− rh ud
u−d
S0 Sud = u × d × S0
C0 = ∆ × S + B
 e rh − d u − e rh 
= e− rh  Cu + Cd 
 u−d u −d 
C − Cd Cud = max [ 0, Sud − K ]
∆= u
S0 (u − d )
uC − dCu
B = e − rh d
u−d
S d = d × S0
Cd = ∆ d × S d + Bd
 erh − d u − erh 
= e− rh  Cud + Cdd 
 u−d u−d 
C − Cdd
∆ d = ud
Sd (u − d )
uC − dCud
Bd = e− rh dd
u−d
S dd = d × d × S0
Cdd = max [ 0, S dd − K ]