OPTIONS MARKETS & CONTRACTS *Call Right to buy at X. *Put Right to sell at X.

X. *EU option Exercised only at expiration 1. Fiduciary call is portfolio of: a. Long (Buy) EU call option with exercise price (X) that matures in T years on stock (with price St at time t) b. Long pure-discount riskless bond that pays X in T years. c. Cost = Call (C0) + Bond (PV of X)

2. Protective put is portfolio of: a. Long EU put option with exercise price (X) that matures in T years. b. Long underlying stock. c. Cost = Put (P0) + Stock (S0)

3. Put-call parity for EU options: a. Payoff to (Cost of) Fiduciary Call = Payoff to (Cost of) Protective Put

4. Create synthetic position in one of four Put-Call Parity instruments by combining other three. a. + = Long; - = Short.

b. Create synthetic EU call option by: (1) Buy EU put option (2) Buy Stock (3) Short/Borrow PV of X worth of pure-discount riskless bond. c. Synthetic positions used to: i. Price options by using combinations of other instruments with known prices ii. Earn arbitrage profits by exploiting relative mispricing among four securities. 5. If Put-Call parity doesnt hold, long underpriced and short overpriced. a. No-arbitrage price of put option = $3.59 b. By put-call parity: fiduciary call of $78.59 <> protective put of $78.80.

c. Hence, call is underpriced and put is overpriced.

6. Binomial Model Over next period, asset will change to one of two possible values. 7. One period model: a. Factors i. U = size of up move ii. D = size of down move (1/U) iii. U = Risk neutral prob of up move = (1 + Rf D)/(U-D) iv. D = Risk neutral prob of down move (1- U) b. Calculate option value i. Option payoffs at maturity in up and down states = max (0, S X) ii. Expected value of option in one year using prob weights. iii. Discount expected value to today at Rf. c. Example: Calculate call option value

i. Expected Value = ($10 x 0.55) + ($0 x 0.45) = $5.50 ii. Value of Option today = $5.50/1.07 = $5.14 8. If call option <> $5.14, arbitrage opportunity exist.

a. If option overpriced (underpriced), short (long) option and long (short) fractional share of stock for each option shorted (longed). b. Fractional share (hedge ratio): Change in option price for one-unit change in asset price.

c. If option is overpriced ($6.50), delta is 0.5714 and short 100 options: i. Total shares to buy = 100 x 0.5714 = 57.14 ii. Net portfolio cost = (57.14 x $30) (100 x $6.50) = $1064. iii. If up-move: portfolio = (57.14 x $40) (100 x $10) = $1286 iv. If down-move: portfolio = (57.14 x $22.50) (100 x $0) = $1286 v. Risk free since same return regardless of next period state. d. Arbitrage trades: i. Borrow $1064 at 7% for one year to buy hedged portfolio. ii. In one year, collect $1286, repay loan of ($1064 x 1.07) and keep arbitrage profits of $147.52 9. Two-period Binomial Model: a. Calculate option value: i. Calculate stock values, option payoffs at t=2. ii. Use weighted (expected) option payoffs and discount to obtain option values at t=1. iii. Use weighted option value and discount to obtain option value today. b. Example: Call option

10. Binomial I/R Tree Possible I/R paths to value bonds with binomial model

a. Values for on-the-run issues generate using I/R tree should prohibit arbitrage opportunities. (equal value of market price). b. Risk neutral probability always 50%. 11. Options on Fixed Income Securities a. (1) Price bond at each node using projected I/R (2) Calculate intrinsic value of option at each node at option maturity (3) Discount terminal option value to today. b. Example: EU call option with 2 years to expiration and $100 strike price on bond with $100 par value, 7% annual coupon, 3 years to maturity.

i. T=2, Middle node, Bond Price: ii. T=1, Top node:

iii. Today price:

iv. T=2, Top node, Option intrinsic value: $0 because bond price < call price v. T=2, Bottom node: $102.20 - $100 = $2.20 vi. T=1, Top node:

c. Note: If asked to value an American option, value at any node is greater of PV of future payoffs and current intrinsic value. 12. Caplets and Floorlets Bundles of EU options on I/R. a. Cap/Floor = Sum of caplets/floorlets.

b. Example: 2 year cap, annual reset, strike rate of 5%, notional principal $25 million.

i. T=2, Middle Node, Caplet:

ii. T=1, Top node, Opion Value:

iii. 2 year caplet:

iv. T=1, Top box, Caplet:

v. 1 year caplet:

vi. Value of 2 year cap:

13. Black-Scholes-Merton a. Values options in continuous time b. Underlying asset follows log distribution, has no cash flow, constant and known volatility. c. Rf is constant and known; Markets are frictionless. d. Only for EU options.

14. Delta a. Able to approximate change in option value based on delta and small change in stock value.

b. Note that call options delta is N(d1) and put options delta is N(d1) 1. c. Payoff Diagram: At Expiration vs Prior to expiration (due to time value)

d. Delta = Slope of Prior-to-Expiration curve. i. Call option delta increase from 0 to +1 as stock price increase. If deep out-ofthe-money, delta close to zero. ii. Put option delta increase from -1 to 0 as stock price increase. If deep out-of-themoney, delta close to zero. e. Delta-neutral portfolio/hedge - Risk-free combination of long stock with short call so value of portfolio unchanged when stock value change. i. No. of options = No. of shares hedged/delta of call option

ii. Eg. 60,000 shares with $50 current price. Call option strike price $50 selling at $4 with delta 0.60. If stock up by $1, increase in stock position (60,000 x $1) $60,000; decrease in option position (100,000 x $0.60) $60,000. Change in portfolio $0. iii. Holds only for very small change in underlying stock value. Must be continuously rebalanced to maintain hedge high transaction costs. 15. Gamma Rate of change in delta as underlying stock price change. a. Gamma of 0.04 implies $1 increase in stock will cause call option delta to increase by 0.04, making call more sensitive to changes in stock price. b. Options on same asset with same exercise price and time to maturity have equal gammas; long positions have positive gammas. c. Max when option at-the-money and close to expiration Measure how poorly hedge perform if not rebalanced to change in stock price. 16. Underlying Asset Cash Flows a. Decrease/increase value of call/put b. Gordon growth model suggest higher dividend yield reduce growth rate in stock price (all else equal). As option based on change in stock price, lower stock price decrease call value and increase put value. 17. Historical Volatility a. Convert time series of N prices to returns:

b. Convert returns to continuously compounded returns: c. Calculate variance and standard deviation of continuously compounded returns:

d. Implied volatility is value for standard deviation implied by market price of option. Can solve using BSM and four inputs. 18. Demonstrate put-call parity for options on forwards/futures a. Portfolio 1 i. Call on forward contract with exercise price (X) that matures at T on forward contract FT. ii. Pure-discount bond that pays (X- FT) at T. iii. Cost =

iv. Payoff: Out-of-money when (ST <= X) = (X- FT); In-the-money when (ST > X) = (ST - X) + (X- FT) = (ST -FT) b. Portfolio 2 i. Put on forward contract with exercise price (X). ii. Long forward contract. iii. Cost = Cost of option since costless to enter forward. iv. Payoff: In-the-money when (ST <= X) = (X - ST) + (ST -FT) = (X- FT); Out-of-money when (ST > X) = (ST -FT) c. Payoffs to both positions are identical. For asset with no CF or storage cost

19. Am options on futures more valuable than EU due to benefits of early exercise when deep inthe-money a. Early exercising generate cash from mark to market, which can earn interest. 20. Black Model price EU options on forwards and futures

SWAP MARKETS AND CONTRACTS

* Eg. 1-year LIBOR-based I/R call option with notional amount of $1,000,000 and strike rate of 5%. - Long position: LIBOR >5% at expiration, option exercised and owner receives $1,000,000 x (LIBOR 5%). LIBOR<5%, option worthless and owner receives nothing. - Short position: LIBOR<5% at expiration, option writer pay put holder $1,000,000 x (5% - LIBOR). LIBOR>5%, option expire worthless and writer makes no payments. *In $1 mil plain vanilla currency swap, if want to hedge existing exposure to C$ fixed-rate liability, will receive fixed rate based on C$ yield curve.

1. Price vs Value a. Price of forward contract Forward rate that yields zero value for contract at initiation. b. Value of forward contract To either long/short as rates/prices change after initiation. c. Price of swap Fixed rate where PV of floating-rate payments equal to PV of fixed-rate payments for plain vanilla i/r swap. ie. Value zero to both parties.

d. Value of swap ST rates change over term of swap, giving value to one party. Eg. if i/r increase, fixed-rate payer receive higher than expected floating-rate payments +ve value. 2. Swap vs Forward Rate Agreements (FRA) a. Swaps are series of off-market FRA (forward price is different from that which gives forward zero value at initiation). i. Some of +ve value to long, others have ve value. When all values summed together, value of zero at initiation. ii. FRAs have variety of fixed rates expiring on swaps payment dates. Complex average of FRA rates = swap fixed rate.

b. In swap, next payment always known one period ahead when next period floating rate becomes known. i. Unlike FRA, where payment made at expiration based on 1-period rate for next period. c. Can still view currency/equity swaps as series of current/equity forward contracts. 3. Swap vs Options a. Fixed-rate swap can be replicated with series of put/call positions with expiration dates on swap payment dates. i. Need two options to create equivalent of forward agreement. Mimic gain and loss. ii. Series of long call and short put positions with strike rates equal to swap fixed rate. Eg. If payer swap, use long i/r call (receive when floating rates increase) and short i/r put (pay when rates fall). b. Can view currency/equity swaps as series of long call/short put combinations. 4. Plain Vanilla Swaps vs Combination of Bonds a. I/R Swap - Fixed-payer gain identical exposure by issuing fixed-coupon bond and investing proceeds in floating-rate bond with same maturity and payment dates. b. Equity Swap Fixed-payer gain identical exposure by borrowing at fixed rate and investing in stock/portfolio/index. c. Currency Swap Issue bond in one currency, exchanging proceeds for another currency at spot exchange rate, and purchasing bond denominated in other currency with same payment and maturity dates. 5. Swap Rate a. Using (4a), values of floating-rate and fixed-rate bonds must be equal at swap initiation. b. Discount factor(Zn) gives PV of any CF occurring in n days = 1/[1+Rnx(n/360)]

c. Fixed swap rate = (1-Zn)/(Z1++Zn) d. Eg. 1 year swap with quarterly payments and $5 mil notional principal. Annualised LIBOR spot rates today are: 90-day = 0.03, 180-day = 0.035, 270-day = 0.04, 360-day = 0.045.

Quarterly fixed rate: Quartery Fixed payments: $5 mil x 0.011 = $55,000 Fixed rate in annual terms = 0.011 x (360/90) = 4.4% 6. Swap Market Value = Value of (floating-rate bond fixed-rate bond) 7. Floating Rate Bond Repricing to Par a. At each settlement date, coupon rate on floating-rate bond (which determines payment at next settlement date) is set to market rate. Hence, bond sells at par. b. Eg. 2 year floating rate bond with $100 par value and annual payments at end of year based on LIBOR. When issued, coupon rate set at 5% (current market 1 year LIBOR). i. After 6 months, 6-month LIBOR is 6% annual. Value of bond is PV of remaining CF ($100 + $5)/1.03 = $101.94 ii. Trade at par ($100) at end of year where $5 coupon paid and next coupon is determined. As long as second coupon equal to 1-year LIBOR at end of first year, bond worth $100. c. To valuate plain vanilla swap between payment dates: i. Eg. 1-year LIBOR swap with quarterly payments priced at R1 at initiation when 90-day LIBOR is R2. ii. Find quarterly fixed payments at per $ of notional principle: R1 x (90/360). Recall will also pay $1 final principal payment. iii. Use discount factors at each quarter+ principal to obtain PV of payments Fixed-rate value of swap. iv. Find first floating payment: R2 x (90/360). Note bond value at first payment date is par since coupon rate will be reset to current market rate. v. Use discount factor for first payment + principal to obtain PV floating-rate value of swap. vi. Swap value to payer = fixed floating values. Total value = multiply by notional principal.

8. Fixed Rate and Foreign Notional Principal for Currency Swap a. Currency swaps have two yield curves and two swap rates, one for each currency. b. Eg. 1-year quarterly $5 mil I/R swap. Current exchange rate = 0.5 per $.

i. Calculate quarterly discount factors. ii. Obtain quarterly fixed rate on swap.

iii. Convert to annual terms: 1.7% x (60/90) = 6.8%. iv. Pay $ fixed, receive fixed currency swap At initiation, exchange ($ 5 mil x 0.5) 2.5 mil for $5 mil. Pay 1.1% (5d) quarterly on $5 mil principal and receive 1.7% on 2.5 mil quarterly. At end of one year, exchange original principal amounts. v. Pay $ fixed, receive floating currency swap Exchange of principal at initiation and termination same. Pay 1.1% quarterly on $5 mil and receive floating British rate on 2.5 mil. c. Value of swap = PV of CF expect to receive PV of CF expect to pay. d. Four possible structures of $ and : Fixed, Fixed / Fixed, Floating/ Floating, Fixed/ Floating, Floating. e. Eg. Value of swap after initiation: After 300 days, 60-day $ i/r = 5.4%, i/r = 6.6%, exchange rate 0.52 per $; At last settlement date, 90-day $ i/r on last settlement date= 5.6%, 90-day i/r = 6.4%. Receive $ floating and Pay Fixed. i. Calculate discount factor for remaining period for both currencies.

ii. Calculate PV of floating using discount factor on principal + coupon ($ 5mil x 0.056/4) value of floating in $ iii. Calculate PV of fixed using discount factor on principal + coupon (2.5 mil x 0.068/4) (8b) value of fixed in iv. Value of fixed in $ = v. Value of swap = $5,024,776 - $4,836,227 = $188,549. 9. Fixed rate and Value of Equity Swap a. Eg. $10 mil principal equity swap with fixed quarterly rate of 0.01513 and other paying quarterly return on index (currently trading at 985). After 30 days, index = 996. Discount factor: 60 day = 0.99010, 150 day= 0.97363, 240 day=0.95541, 330 day=0.93567. Value of pay-fixed side swap = $0.99393 per $1 of principal. i. Value of fixed-pay side = 0.993993 x $10 mil = $9,939,930

ii. Value of investment in index after 30 days = $10 mil x (996/985) = $10,111,675. iii. Value of swap after 30 days = $10,111,675 - $9,939,930 b. Swap of returns on two different stocks = buying one stock (receive return) and short equal value of different stock (paying returns). i. Value of swap = difference in returns (since last payment date) x notional principal. ii. Eg. Stock A returns payer and Stock B returns receiver in $1 mil quarterly-pay swap. After one month, A up 1.3% and B down 0.8%. Value of swap = (-0.013 0.008) x $1 mil = -$21,000. 10. Swaption - Option that gives holder right to enter into i/r swap. a. Eg. 2x5 swaption: matures in 2 years an gives holder right to enter 3-year swap at end of 2nd year. b. Payer swaption Right to enter into swap at future date as fixed-rate payer at rate specified in swaption. i. If swap fixed rates (i/r) increase, payer swaption becomes more valuable. ii. Holder of EU payer swaption exercise if market rate for fixed-rate swaps>exercise rate at maturity. c. Receiver swaption Right to enter into swap at future date as fixed-rate receiver at rate specified in swaption. i. If swap fixed rates (i/r) decrease, receiver swaption become more valuable. ii. Holder of EU receiver swaption exercise if market rate for fixed-rate swaps<exercise rate at maturity. (in the money) d. Purchased at premium depending on strike (fixed) rate specified. e. Primary uses: i. Lock in fixed rate if anticipate floating-rate exposure in future (issue bonds/get loan), payer swaption locks in fixed rate. ii. I/R speculation buy payer swaption if expect rate to rise. iii. Swap termination Fixed rate payer on 5-year swap can buy 2x5 swaption at same fixed rate to offset 3-year swap at end of 2 years. 11. I/R Swaption a. Exercising in-the-money swaption generates annuity (interest savings from paying lower rate than market for payer swaption) over term of underlying swap. b. Eg. Exercise receiver swaption on 1-year quarterly pay LIBOR $1 mil swap with 5% fixed rate when mkt rate on current i/r swap is 4%. i. Extra interest per quarter = (0.05-0.04) x (90/360) x $1 mil = $2,500 12. Expiration Value of I/R Swaption a. Eg. Exercise at maturity a payer swaption on 1 year quarterly pay LIBOR $10 mil swap with fixed rate 5% when market rate is 6.052%.

i. Net cash flow at each payment date = (0.06052 0.05) x (90/360) x $10 mil = $26,300. ii. PV using discount factor for each payment = $101,134. 13. Credit Risk Probability that counterparty will default on required payments (esp if swap has +ve value) a. Current Credit Risk Risk on counterpartys default on payment currently due. b. Potential Credit Risk Future risk on remaining term of swap. c. Inception low credit risk as credit quality of institutions in swaps market very good. d. Middle of Swap Term highest credit risk as quality can deteriorate and significant future payments remaining. e. End of Swap Term low credit risk as few payments left. f. Currency Swaps Higher risk at end as exchange principal g. I/R Swaps Interest payments usually netted (only one party pays). Without netting, credit risk higher. h. Marking to Market Make payment equal to swap value at periodic settlement dates and repricing swap by resetting swap rate. Helps reduce credit risk. 14. Swap Spread Spread between swap rate and comparable maturity Treasury notes. a. LIBOR is not riskless rate. Default premium in LIBOR reflected in swap rate calculated. b. Swap spread will respond to same factors as other quality spreads. INTEREST RATE DERIVATIVES 1. I/R Cap Agreement where one party agrees to pay other at regular intervals over time period when benchmark i/r > strike (cap) rate specified. a. Multi-period agreement. Portfolio of call options on LIBOR (caplets). Eg. 2 year-cap that pays at end of any quarter has 8 options. b. Buyer Similar to cap buyer. Benefit when I/R rise. Pays premium to seller and exercise if market rate> cap strike. c. Long cap = Portfolio of long put options on fixed-income security prices.

2. I/R Floor Agreement where one party agrees to pay other at regular intervals over time period when benchmark i/r < strike (floor) rate. a. Multi-period agreement of put option (floorlets) portfolio.

b. Buyer Similar to put buyer. Benefit when i/r fall. Pays premium and exercise when market rate<floor strike. c. Long floor = Portfolio of long call options on fixed-income security prices.

3. Floating Rate borrower can use cap to limit interest expense during life of cap. a. Payoff to cap buyer:

4. Floating Rate investor can use floor to limit reductions in interest income during life of floor. a. Payment to floor buyer:

5. I/R collar simultaneous position in floor and cap on same benchmark rate over same period with same settlement dates. a. Strike on floor < cap b. Buy cap, Sell floor i. Eg. Investor with LIBOR-based liability buy cap on LIBOR at 8% and sell floor on LIBOR at 4% over next year borrowing cost hedged to collar of 4-8%. ii. Zero-Cost Collar : Premium paid from buying cap = premium from selling floor. c. Buy floor, Sell Cap i. Eg. Investor with LIBOR-based asset buy floor on LIBOR at 3% and sell cap at 7% over next year hedge asset returns to collar of 3-7%. 6. Binomial I/R Tree

a. Spot rates (zero coupon bond): Use Par ($1) as final value and discount back using spot discount rates for each period. Risk neutral probability is 0.5 each branch. (Discount = 1+r) b. Options (zero coupon bond): Based on strike price, choose branch to exercise. Deduct strike price from return to obtain option value, then discount back to initial branch using 0.5 per branch. (Discount = 1+r) c. Coupon-paying bond: from (6a), multiply by (1+coupon) for last branch. For next branches, multiply by coupon % for non-last returns + multiply by (1+coupon) for last return.

d. Options (coupon-paying bond): same as (6b). CREDIT DERIVATIVES 1. Credit Default Swap (CDS) insurance contract. a. Reference obligation fixed income security on which swap is written. Usually bond but loan possible. b. Buyer (buying protection) of swap pays seller (seller of protection and assumes risk) premium (default swap spread) that is paid upfront or over time period i. Eg. Swap on $10 mil par value 3- year maturity bond. If swap premium 70 bps annually, buyer pays $10 mil x 0.70% = $70,000 per year (usually paid on quarterly basis). ii. Swap matures in three years, assuming no credit event. c. If default occurs on obligation, buyer of swap receives payment from seller. d. CDS creates short position in obligation for swap buyer because CDS value increases as obligations credit quality and market price declines. e. CDS only protects credit risk, not market-wide i/r risk. f. When credit event, swap settle in: i. Cash seller owe buyer net amount of (notional market value) ii. Physical delivery Usual. Seller receives obligation and pays buyer notional amount. 2. Similarity to Corporate Bonds a. When credit risk increase, both CDS premiums and bond yields increase. b. Difference:

i. Corporate bond yield spread reflects compensation over risk-free rate for bond i/r risk and issuer credit risk. ii. CDS only reflect obligation credit risk. 3. Advantage of CDS a. Risk Management Allow credit risk to be managed separately from i/r risk. b. Short positions Can take short position in fixed income securities. If short underlying obligation, challenging and cost prohibitive esp if obligation higher demand in repo mkt. c. Liquidity CDS more liquid than cash market even 3 to 10 year maturity swaps. d. Flexibility Facility credit, maturity and currency positions not available in cash market. e. Confidentiality Confidential OTC contracts. Contrast loan where issuer has knowledge of contract. 4. Participants a. Commercial Banks Largest participants. i. Use to hedge exposures arising from loan portfolios ii. Satisfy regulators by buying credit protection. b. Investment Banks i. Dealers providing liquidity to rest of market. ii. Use to hedge corporate bonds iii. Trading desks to exploit mispricing. c. Hedge Funds Fastest growing segment. i. Providers of liquidity to market. ii. Trade credit risk, traditional convertible arbitrage (take long position in convertible bond and sell short associated stock), distressed debt d. Life insurance, property and casualty insurance, reinsurers, monoline companies i. Take long positions in credit by selling protection e. Fund managers i. Exploit mispricing f. Corporations i. Hedging ii. Income enhancement 5. Structured Credit Products a. Credit investments with various tranches of risk. Higher-risk tranche offer higher yield. b. For synthetic collateralised debt obligation (CDO), exposure to basket of CDS is sold. CDO can have customised or standardised terms. c. Insurance companies invest in senior tranche while hedge funds pursue higher risk subordinated tranches. Commercial and investment banks take all positions. Trading Strategies 6. Basis Trade a. CDS premium compared to asset swap spread (bonds yield above benchmark swap rate) of underlying bond.

b. If asset swap spread > CDS premium, basis is negative, investor should buy bond and buy CDS (protection against long) c. Weakness: investor must finance trade. Opportunities disappear quickly, underlying bond scarce or not same terms as CDS. d. Eg. Bond 240 bps above LIBOR in asset swap. CDS premium 210 bps. i. Long bond and buy CDS. ii. Earn 240 bps, pay 210 bps, net 30 bps and protected against credit risk. 7. Index Trade a. Credit indices represent opp to use CDS to exploit perceived mispricings. b. Short index position to hedge portfolio of credits or exploit expected increase in marketwide credit risk. c. If bullish on market/sector but bearish on particular issues, can long index and short issues. d. If bearish on bonds and bullish on stocks, short credit index and long equity index.