Beruflich Dokumente
Kultur Dokumente
MAJU ISLAMABAD
2015
WASEEM A. QURESHI
MM 141063
0344-5599155
waseemqurashi@hotmail.com
6/16/2015
ACKNOWLEDGEMENT
I would like to express my sincere gratitude to Dr. Arshad Hassan, Dean, Faculty of
Management science Muhammad Ali Jinnah University, Islamabad for his guidance,
constant inspiration and valuable suggestions during writing of these notes on FRM
based on class lectures of the legend professor.
The completion of this task could not have been possible without the backing and
guidance of Sir Arshad Hassan whose contributions are gratefully acknowledged.
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Waseem A. Qureshi MM141063
CONTENTS:
S.NO.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
PARTICULARS
Risk, Systematic & unsystematic
Risk Management, sources of risk
Exchange rate factors
Artificial Hedging
Financial derivatives
Margin Call
Hedging & speculation
Examples (forwards, futures ,options)
Assignment No. 1(Hedging)
Assignment No. 2(Hedging)
Pricing & Evaluation of Forwards
Commodity forward
Equity forward
Bond forward
Currency forward
Interest rate forward
Questions from book (forwards chapter)
Swap markets and contracts
Interest rate swap
Currency swaps
Equity swaps
Credit default, subordinate risk swaps
Options market & Evaluation
Concepts and basic strategies of options
Duration of bond
Valuation of options
Valuation of options (Binomial model, one period)
Valuation of options (Binomial model, Two period)
The Black-Scholes-Merton Model
The Merton model
Option Sensitivities (Greeks)
Assignment No. 3 (Option sensitivities)
Valuation at Risk (VaR)
Credit risk
Credit risk, Estimation Techniques
Operation Risk
Sovereign Risk
Country Ratings
Page No.
04
05
08
09
12
14
20
21-40
41
44
46
49
51
55
54
55
56-68
69
70
71
75
78
79
79
93
93
94
98
100
104
105
109
111
117
124
143
146
148
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Waseem A. Qureshi MM141063
RISK:
It is defined as uncertainty about future outcomes. Or it is the probability of loss, probability
that actual return may differ from expected return. The risk may be categorized as Systematic
risk and unsystematic risk.
A. SYSTEMATIC RISK:
() beta
Risk which is common to an entire market because of the economic changes or other events
that impacts large portion of the market. for example a significant political event may affect
several securities. This risk is based on macro economic variables so no individual business
can have control over it. Therefore it is unavoidable, uncontrollable and undiversifiable.
B. UNSYSTEMATIC RISK:
It is company or industry specific risk that is inherent in each investment. It is also known as
diversifiable, avoidable, controllable and specific risk.
Volatility due to firm-specific events
Can be eliminated through diversification
Also called firm-specific risk and diversifiable risk
An investor can only reduce unsystematic risk. This can be done by spreading
investments over a number of different assets
REDUCING UNSYSTEMATIC RISK THROUGH DIVERSIFICATION:Risk
0
0
Unsystematic
0
0
0
Systematic
0
0
0
Number of
Investments
8-12
30
Risk management
Businesses, nonprofits, governments, and individuals engage in risk-taking activities.
Although they may hedge their risks on occasion, they should not restrict their activities to
those that are risk free. The fact that these entities engage in risky activities raises a number of
important questions:
- How is risk defined?
- How does one recognize and measure risk?
- Which risks are worth taking on a regular basis, which are worth taking on occasion, and
which should never be take?
- How are risks reduced or eliminated? What strategies should be used?
- How are the processes of risk taking and risk elimination monitored?
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Waseem A. Qureshi MM141063
These questions and many others collectively define the process of risk management. In short,
how is risk managed? To understand this concept, we start with a formal definition of risk
management.
Risk management is the process of identifying the level of risk that an entity wants,
measuring the level of risk that an entity currently has, taking actions that bring the actual
level of risk to the desired level of risk, and monitoring the new actual level of risk so that it
continues to be aligned with the desired level of risk. The process is continuous and may
require alterations in any of these activities to reflect new policies, preferences, and
information.
An important thing to note is that, risk management not means always decreasing the risk, as it
is done through hedging. Sometimes we need to increase the risk to go for some extra rewards.
Risk management is a general practice that can entail reducing or increasing risk.
Risk Management Process:
Sources of Risk:
The sources of risk can be divided in two broad categories.
A. Financial risk.
1. Exchange rate risk
2. Interest rate risk
3. Credit risk
4. Equity risk
5. Liquidity risk
6. Commodity risk
B. Non-financial risk
1. Operational risk
2. Legal risk
3. Regulation risk
4. Accounting risk
5. Settlement risk
6. Taxation risk
7. Model risk
5
Accounting
Liquidity
Taxes
Credit
Legal
Commodity
Regulatio
ns
Non-Financial
Financial
Company
Equity
Settlement
Exchange
rate
Mode
l
Operational
Interest
rate
Financial risk
Financial risk is an umbrella term for multiple types of risk associated with financing. It is a
risk that a firm will be unable to meet its financial obligations. Five categories under financial
risk are discussed below:
a. Exchange Rate Risk:
Uncertainty about future Changes in exchange rates of one currency in relation to another
currency is exchange rate risk. It may be further classified in three categories.
Translation risk, transaction risk, economic risk.
i. Transaction risk: It is the risk that an exchange rate will change unfavorably over time. It
deals with imports and exports. If rates move unfavorably, the receivables may decrease or
payables may increase.
ii. Translation risk:
A firm's translation exposure is the extent to which its financial
reporting is affected by exchange rate movements. As all firms generally must prepare
consolidated financial statements for reporting purposes, the consolidation process for
multinationals entails translating foreign assets and liabilities or the financial statements of
foreign subsidiary / subsidiaries from foreign to domestic currency. While translation exposure
may not affect a firm's cash flows, it could have a significant impact on a firm's reported
earnings and therefore its stock price. Translation exposure is distinguished from transaction
risk as a result of income and losses from various types of risk having different accounting
treatments.
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Waseem A. Qureshi MM141063
iii. Economic risk: A firm has economic exposure (also known as forecast risk) to the degree
that its market value is influenced by unexpected exchange rate fluctuations. Such exchange
rate adjustments can severely affect the firm's market share position with regards to its
competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure
can affect the present value of future cash flows. Any transaction that exposes the firm to
foreign exchange risk also exposes the firm economically, but economic exposure can be
caused by other business activities and investments which may not be mere international
transactions, such as future cash flows from fixed assets. A shift in exchange rates that
influence the demand for a good in some country would also be an economic exposure for a
firm that sells that good.
Example:
The cost of a product per unit is Rs. 100 in Pakistan. Sales price is cost plus 20%. The
dollar rate is Rs. 100 / $ today. The international market price of the product is $1.3.
It means they want to sell it for Rs. 120 or $1.2 in the market which is feasible as it is
below than international price of $1.3. suppose dollar price goes down to Rs. 80 / $ . Now the
product cost becomes $ 1.25 and selling price will be cost plus 20%, i.e. $1.5 now it becomes
more than $1.3 and cannot be sold in international market.
b. Interest rate risk:
The risk that an investment's value will change due to a change in the absolute level of interest
rates, in the spread between two rates, in the shape of the yield curve or in any other interest
rate relationship. Such changes usually affect securities inversely and can be reduced by
diversifying (investing in fixed-income securities with different durations) or hedging).
c. Credit risk:
Credit risk refers to the risk that a borrower will default on any type of debt by failing to make
required payments. The risk is primarily that of the lender and includes lost principal and
interest, disruption to cash flows, and increased collection costs.
d. Market risk / equity risk:
Market risk is the risk that the value of an investment will decrease due to moves
in market factors. Volatility frequently refers to the standard deviation of the change in value
of a financial instrument with a specific time horizon.
e. Liquidity risk:
Liquidity risk is the risk that a financial instrument may not be traded without a significant
concession in price due to the size of the market. This risk manifests itself much more on the
sell side of a transaction than on the buy side.
NON FINANCIAL RISKS:
These are the risks that may not cause some direct financial losses but the results can cause
some serious affects for the continuation of business and ultimately cause financial loss.
Following are some sources of non financial risk faced by organizations.
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Waseem A. Qureshi MM141063
a. Operational risk:
Operational risk is defined as the risk of loss resulting from inadequate or failed processes,
people and systems or from external events. This definition includes legal risk, but excludes
strategic and reputational risk.
b. Regulation risk:
The risk that a change in laws and regulations will materially impact a security, business,
sector or market. A change in laws or regulations made by the government or a regulatory
body can increase the costs of operating a business, reduce the attractiveness of investment
and/or change the competitive landscape.
c. Legal Risk:
The potential loss that may occur to an investment as a result of insufficient, improperly applie
d, or simply unfavorable legalproceedings in the country in which the investment is made. For
example, a country may have inadequate bankruptcy protection or, inan extreme circumstance,
the government may be able to seize property without provocation. On the other hand, legal ri
sk existseven in countries that operate under the rule of law: a court, for instance, may find aga
inst a company in a given lawsuit, creating aprecedent for other companies with similar operati
ons.
d. Taxation risk:
The risk that tax laws relating to dividend income and capital gains on shares and other
securities might change, making stocks less attractive.
e. Accounting risk:
It is the risk associated with the financial statements of an organization that can be affected
by exchange rate fluctuations. It is also called accounting exposure or translation risk.
f. Settlement risk:
The payments involved in swaps, forward contracts and options are referred to as settlements.
The process of settlement involves one or both parties making payments. Any bankruptcy
from any side can cause breach of agreement and creates risk of losses.
Exchange rate factors: / factors influencing exchange rates.
The exchange rate is one of the most important determinants of a country's relative level of
economic health. It plays a vital role in trade, which is critical to most free market economies.
But exchange rates matter on a smaller scale too. They even impact the real return of an
investor's portfolio. Here well look at the main factors influencing exchange rates.
Factor 1: Differentials in Inflation. As a general rule, a country with a consistently lower
inflation rate exhibits a rising currency value, as its purchasing power increases relative to
other currencies. Those countries with higher inflation typically see depreciation in their
currency's value in relation to the currencies of their trading partners.
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Waseem A. Qureshi MM141063
Factor 2: Differentials in Interest Rates. By manipulating interest rates, central banks exert
influence over both inflation and exchange rates. Higher interest rates offer lenders a higher
return relative to other countries. The impact of higher interest rates is mitigated, however, if a
country's inflation is much higher than other countries', or if additional factors serve to drive
their currency value down. The opposite relationship exists for decreasing interest rates.
Factor 3: Current-Account Deficits. The current account is the balance of trade between a
country and its trading partners, reflecting all payments between countries for goods, services,
interest and dividends. A deficit in the current account shows a country is importing goods and
services more than it is exporting them. The country will then typically borrow capital from
foreign sources to make up the deficit, causing its currency to depreciate relative to its trading
partner.
Factor 4: Public Debt. Countries will engage in large-scale deficit financing to pay for
public sector projects using governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to foreign investors.
This is because a large debt encourages more inflation, and higher inflation translates into
lower currency value.
Factor 5: Terms of Trade. A country's terms of trade is a ratio comparing export prices to
import prices. If the price of a country's exports rises by a greater rate than that of its imports,
its terms of trade have favorably improved, which tends to show currency appreciation.
However, if the price of a country's imports rises more than the rate of exports, their currency's
value will decrease in relation to trading partners.
Factor 6: Political Stability and Economic Performance. Foreign investors inevitably seek
out stable countries with strong economic performance in which to invest their capital.
Political turmoil, for example, can cause a loss of confidence in a currency, and a movement
of capital to the currencies of more stable countries.
Choices available to address instability in the exchange rate.
1.
2.
3.
4.
5.
(1+i)
PV = 100 / (1 + .08)1/2
96.2250m $
A
B
C
Exports
500m
$ 400m
50m
Imports
-- 50m
$ 200m
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Waseem A. Qureshi MM141063
,
=
190.6925m $
PV (1+ )
(1+ )
1.5(1+.05)1/2
(1+.08)1/2
$ 1.4790
is interest rate of foreign currency
The rate calculated through inflation is $ 1.4790/ which is lower than 1.5, means we dont
need to hedge. If we convert $200 at 1.4790 per pound, we will get ($200 / 1.4790 = 135 m)
which is more than 133.33
This is the formula we use to calculate the future prices of currency.
HINT 2: sometimes direction of the currency becomes basis for decision. In depreciation
exporters dont need and importers must hedge to save their position.
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Waseem A. Qureshi MM141063
EXAMPLE 3:
Suppose for example 2, exports are replaced with imports. Do we need to hedge?
A
B
C
Imports
500m
$ 400m
50m
Exports
-- 50m
$ 200m
Lending
Borrowing
Inflation
Spot rate
US $
8%
10%
5%
1.5
=
UK
10%
13%
8%
1
Solution:
Now we need to invest those $ 200m for future payables.
Step 1: calculate PV of $200m using lending rate.
= PV(1 + i)
Pv = 200 / (1 + .08)1/2
Categories of derivative.
There are two categories of derivatives.
1.
Forward commitments
2. Contingent claims
These are the obligations to be paid in the future. They have two main types on the
basis of trading.
13
Waseem A. Qureshi MM141063
Beginning
Balance
Funds
deposited
Futures
price
Price
change
Gain / loss
Ending
balance
100
82
100
100
84
40
140
140
78
-6
-120
20
20
80
73
-5
-100
100
79
120
220
220
82
60
280
280
84
40
320
On day 0, you deposit $100 because the initial margin requirement is 45 per contract and you
go long 20 contracts. At the end of day 2, the balance is down to $20, which is $20 below the
$40 maintenance margin requirements ($2 per contract times 20 contracts). You must deposit
enough money to bring the balance up to the initial margin requirement of $100. So on day 3,
you deposit $80. The price change on day 3 causes a gain/loss of -100, leaving you with a
balance of $0 at the end of day 3. On day 4, you must deposit $100 to return the balance to the
initial margin level.
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Waseem A. Qureshi MM141063
A price decrease to $79 would trigger a margin call. This calculation is based on the fact that
the difference between the initial margin requirement and the maintenance margin requirement
is $3. If the futures price starts at $82, it can fall by $3 to $79 before it triggers a margin call.
Types of forwards
Following are the main types of forwards.
1.
Equity forward
It is a forward contract where underlying is a stock, portfolio of stock or stock market index.
2.
Commodity forward
Currency forward
Bond forward
It is a forward contract where underlying is a loan. The FRA is written as 3 x 9. It means one
will take a loan after 3 months for a period of 6 months. The transaction will take 9 months to
be completed.
2. FUTURE CONTRACT
Future contract or simply a future is a standardized contract between two parties, to buy or to
sell an asset at a specified future time at a price agreed upon today, making it a type of
derivative instrument.
These contracts are standardized and market specific.
Types of futures
All the forward contracts type is replaced with future contracts.
1. Equity future
It is a future contract where underlying is a Stock, Portfolio of stock or stock market index.
2. Commodity future
It is a future contract where underlying is a commodity.
3. Currency future
It is a future contract where underlying is a currency or basket of currencies.
4. Bond future
It is a future contract where underlying is a bond or bond market index.
5. Interest rate future.
It is a future contract where underlying is a loan.
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Waseem A. Qureshi MM141063
Differences:
The forward market is a private and largely unregulated market. Any transaction
involving a commitment between two parties for the future purchase/sale of an asset is a
forward contract. They are private transactions for a reason that, parties want to keep them
private and want little government interference.
A future contract is a variation of a forward contract that has essentially the same basic
definition but some additional features that clearly distinguish it from a forward contract.
Difference between forward and future.
Difference
Contract size
Forward
Customer specific
Future
Market specific
Maturity period
Customer specific
Market specific
In Pakistan it is last Friday
of the following month.
Settlement
On maturity
Daily settlement
Marking to market
Tradability
Risk management
mechanism
An example:
Following is an example of marking-to-market process that occurs over a period of six days.
We start with the assumption that the futures price is $100 when the transaction opens, the
initial margin requirement is $5 and the maintenance margin requirement is $3. The trader
takes a long position of 10 contracts on day 0, depositing $50. ($5 per contract).
Initial future price $100. Initial margin requirement $5. Maintenance margin requirement $3.
Day
Beginning
Balance
Funds
deposited
Futures
price
Price
change
Gain / loss
Ending
balance
50
100
50
50
99.20
-.80
-8
42
42
96.00
-3.20
-32
10
10
40
101.00
5.00
50
100
100
103.50
2.50
25
125
125
103.00
-0.50
-5
120
120
104.00
1.00
10
130
d. Tradability
The forwards are not tradable and settled over the counter while futures are traded on
the floor of exchange.
e. Risk management mechanism
The most important difference in management of default risk associated with the
contracts. In a forward contract, the risk of default is a major concern. Specifically, the party
with a loss on the contract could default. In a future contract, however, the future exchange
guarantees to each party that if the other fails to pay, the exchange will pay.
f. Financial intermediary.
A forward is a customized contract between two parties and involves no intermediary
while futures are actually contracts organized by exchanges or banks who work as
intermediaries and clearing houses. They are the agents and guarantors of the futures.
g. Liquidity.
Futures are the contracts with generally accepted terms. Standardizing the instrument
makes it more acceptable to a broader group of participants with the advantage being the
instrument can then more easily trade in a type of secondary market. In contrast, forward
contracts are quite heterogeneous because they are customized.
A futures contract is therefore said to have liquidity in contrast to forward contract,
which does not generally trade after it has been created.
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Waseem A. Qureshi MM141063
3. SWAP
A swap is a derivative in which two counter parties exchange cash flows of one
party's financial instrument for those of the other party's financial instrument. It is an
agreement between two parties to exchange a series of future cash flows. Typically at least one
of the two series of cash flows is determined by a later outcome. In other words, one party
agrees to pay the other a series of cash flows whose value will be determined by the unknown
future course of some underlying factor, such as interest rate, exchange rate, stock price or
commodity price.
Types of SWAPS.
1.
2.
3.
4.
5.
B. CONTINGENT CLAIMS
A claim that can be exercised when certain specified outcome occurs. It depends on the state
of nature of the financial claim. These claims may be OTC or exchange traded. Option is a
type of exchange traded contingent claims.
OPTIONS:
An option is a contract which gives the buyer (the owner) the right, but not the obligation, to
buy or sell an underlying asset or instrument at a specified strike price on or before a
specified date. The seller has the corresponding obligation to fulfill the transaction that is to
sell or buy if the buyer (owner) "exercises" the option. The buyer pays a premium to the
seller for this right.
An option which conveys to the owner the right to buy something at a specific price is referred
to as a call; an option which conveys the right of the owner to sell something at a specific price
is referred to as a put. Both are commonly traded, but for clarity, the call option is more
frequently discussed.
A. CALL OPTION
A Call Option is security that gives the owner the right to buy a fix no. of shares of a stock or
an index at a certain price by a certain date. That "certain price" is called the strike price, and
that "certain date" is called the expiration date.
The buyer of a call option is called long call and the seller is called short call.
A call option is defined by the following 4 characteristics:
A call option is called a "call" because the owner has the right to "call the stock away" from
the seller. It is also called an "option" because the owner has the "right", but not the
"obligation", to buy the stock at the strike price. In other words, the owner of the option (also
known as "long a call") does not have to exercise the option and buy the stock--if buying the
stock at the strike price is unprofitable, the owner of the call can just let the option expire
worthless.
B. PUT OPTION
A put option is the right to SELL a fix no. of shares of a stock or an index at a certain price by
a certain date. That "certain price" is known as the strike price, and that "certain date" is
known as the expiry or expiration date. A put option is a security that you buy when you think
the price of a stock or index is going to go down.
The buyer of a put option is called long put and the seller is called short put.
A put option, like a call option, is defined by the following 4 characteristics:
It is called a "put" because it gives you the right to "put", or sell, the stock or index to
someone else. A put option differs from a call option in that a call is the right to buy the stock
and the put is the right to sell the stock.
C. EXOTIC OPTION
An exotic option is an option which has features making it more complex than commonly
traded vanilla options. Like the more general exotic derivatives they may have several triggers
relating to determination of payoff. An exotic option may also include non-standard
underlying instrument, developed for a particular client or for a particular market. Exotic
options are more complex than options that trade on an exchange, and are generally
traded over the counter (OTC).
Option general categories
Exotic option any of a broad category of options that may include complex financial
structures.
Vanilla option any option that is not exotic.
(Further details on pricing and types of options is available in the topic of options at page 80)
HEDGING:
A hedge is an investment position intended to offset potential losses/gains that may be
incurred by a companion investment. In simple language, a hedge is used to reduce any
substantial losses/gains suffered by an individual or an organization.
A hedge can be constructed form many types of financial instruments, including stocks,
exchange-traded funds, insurance, forward contracts, swaps, options and many types of over
the counter and derivative products and future contracts.
SPECULATION:
Speculation is the practice of engaging in risky financial transactions in an attempt to
profit from fluctuations in the market value of a tradable good such as a financial instrument,
rather than attempting to profit from the underlying financial attributes embodied in the
instrument such as capital gains, interest, or dividends. Many speculators pay little attention to
the fundamental value of a security and instead focus purely on price movements. Speculation
can in principle involve any tradable good or financial instrument. Speculators are particularly
common in the markets for stocks, bonds, commodity, futures, currencies, fine art,
collectibles, real estate and derivatives.
Hedger and Speculator
Hedger seeks to eliminate risk and need speculator to assume risk, but such is not
always the case. Hedgers often trade with other hedgers and speculator often trade with other
speculator. All one needs to hedge or speculate is a party with opposite beliefs or opposite risk
exposure.
Why corporations need to hedge?
Hedgers shun the risk of price change and look for ways to transfer it, while speculators
assume the risk of price change by taking one position (either long or short) in a market, and
waiting for the price of their commodity to go in their direction. Hedger, on the other hand,
have a position, either long of short usually in the cash market, and attempt to limit their risk
of price change loss by entering into an opposite and approximately equal position in another
market (usually futures or options).
A short hedger is someone who has a long position (owns the commodity) in the cash market
and transfer the risk of price decline by selling a futures contract or buying a put option. If the
cash market price declines and the futures market price also declines, the loss he suffers in the
cash market will be offset by the gain he realizes in the futures market.
any investmentthen he stands to lose money if things do not go as he planned. A hedge can
help his offset these losses and thus reduce any unwanted risk.
The main disadvantage of a hedge is that, in reducing risk, the hedge is also cutting into the
investors potential reward. Hedges are not free, but must be purchased from another party.
Like an insurance policy, a hedge costs money, and if the main position produces profits as
planned, then the hedge will have been an unnecessary expenditure. Some investors would
question the benefit of second-guessing the original investment in this way.
The relative advantages and disadvantages of a hedge will depend greatly on the situation in
which the hedge is applied, as well as the hedges cost. In some situations, a hedge will be
absolutely necessary to make sure that an investor will remain financially solvent, regardless
of what happens. In other cases, it merely signals an overcautious investor cutting into his own
position.
Following are the main reasons for which corporations go for hedging.
Price risk transfer
Cash market prices change and theres nothing you can do about it. Whats more, they
are going to keep changing, no matter what you do. So you have three choices: assume
the risk (be a speculator), transfer the risk of price change to a speculator (be a hedger),
or get out of the market.
Instead of waiting until you have the cash market product in hand, you can do a
substitute sale in the future market, this is called hedging. This means that you sell
now in the future market, substituting your actions in the future market today and
transfer the price risk.
Profit potential
It is possible (but not guaranteed) that after a short hedge has been put in place, both the
cash and futures prices will drop, with the futures price dropping more than the cash
price. This is a favorable change and a basis for profit potential.
Cash flow smoothing
If you establish a hedge six months before your cash market transaction and then prices
move unfavorably, your futures market position will start to earn you cash in the short
run. The reason is that futures positions are marked to market daily. If your futures
position has a gain during todays trading, the gained amount will be deposited to your
account at the close of business day. This cash may help your cash flow until your cash
market transactions.
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Waseem A. Qureshi MM141063
EXAMPLE 4:
Friends Co. is a UK based company that regularly trades with companies in the USA.
Several large transactions are due in four months time. The transactions are shown below. The
transactions are in 000 units of the currencies shown. Assume that it is now 1 st July and that
futures and options contracts mature at the relevant month end.
Friends Co.
Exports $ 490
Imports $150
Exchange Rates:
$/
Spot :
1.5166
3 months forward:
1.5286
6 months forward:
1.5401
CME $ / Currency futures ( 75,500) , contract size
Future rates:
September 1.5245
December 1.5586
CME currency options prices, $ / options 31,250 (cents per pound)
Strike price
1.5200
1.5500
September
3.55
2.38
Call
December
4.50
3.76
September
2.30
3.50
Put
December
4.50
6.50
Required: prepare a report for the managers of Friends co. on how the five month risk should
be hedged by using financial derivatives.
Solution:
We need to decide whether to hedge or not. If we need to hedge what is the best choice out the
four available choices.
1.
2.
3.
4.
5.
Hedge or not
Money market hedge
Forwards
Futures
Options
1. Hedge or not
Net exposure
$490,000 - $150,000 = $340,000
An amount of $ 340,000 is receivable in four months time. So we need to hedge for this
amount.
2. Money market hedge
We are not given the borrowing and lending rates, so we cannot use this money market
hedge option.
22
Waseem A. Qureshi MM141063
3. Forwards
First calculate 4 month future rate.
3 months forward:
6 months forward:
1.5286
1.5401
-------Increase in rates
0.0115
-------Average rate per month = 0.0115 / 3 = .0038
4 months forward
= 1.5286 + 0.0038 = 1.5324
Conversion in with rate 1.5324
$ 340,000 / 1.5324 = 221,874
Forward option will give 221,874 for investment.
4. Futures
CME $ / Currency futures ( 75,500) , contract size
Spot rate:
1.5166
Future rates:
September 1.5245
December 1.5586
4 month period ends
October 31st
Position
long call
First calculate 4 month future rate on Basis risk.
Basis risk = spot rate future rate
Basis risk = 1.5166 1.5586 = 0.0420
(rate is increasing in future time)
Basis risk per month = 0.0420 / 6 = 0.0070
Expected future price = 1.5166 +4(.0070) = 1.5446 (used plus sign as rates increased)
Conversion of amount in home currency , 340,000 / 1.5446 = 220,121
Contract size = 75,500
No. of contracts = 220,121 / 75,500 = 2.91 means 2 or 3 contracts.
Here we take 2 contracts: 75,500 x 2 = 151,000
Convert in dollars 151,000 x 1.5446 = $ 233,235
Unhedged amount = $ 340,000 233,235 = $ 106,765 (amount covered by forwards)
Convert unhedged amount in = $ 106,765 / 1.5324 = 69,672
Total amount received through this choice =
Amount received in futures
=
151,000
+ Amount in forwards
=
69,672
Total
220,672
Decision: 220,672 is amount received through futures and 221,874 is amount received
using the choice of forwards calculate in previous situation. When there is a nominal or no
difference in these two choice we will opt the forwards, as it more customized and bears less
restrictions.
23
Waseem A. Qureshi MM141063
5. options
CME currency options prices, $ / options 31,250 (cents per pound)
Strike price
Call
September
December
September
1.5200
3.55
4.50
2.30
1.5500
2.38
3.76
3.50
Put
December
4.50
6.50
Hint: while selecting the rates always use that rates which are in the benefit of the bank. Bank
will charge higher rates we borrow and will give the lower rates when we lend or invest in the
bank.
Contract size:
31,250 (cents per pound)
Exercise price:
1.5200 $ / ( we use this price as it is lower than 1.5324 of forwards)
Position:
long call (because we need to buy)
Contract used:
December as the contracts mature in October)
Amount in
= 340,000 / 1.5200 = 223,684
No. of contracts
= 223,684 / 31,250 = 7.16 contracts ( we take 7 contracts)
Amount covered in options = 31,250 x 7 = 218,750
Convert in dollars
= 218,750 x 1.5200 = $ 332,500 (option rate is used)
Unhedged amount
= 340,000 332,750 = $ 7,500 ( covered in forwards)
Unhedged amount in
= $ 7,500 / 1.5324 = 4,894 (forwards rate used)
Cost of options (premium) = 218,750 x .045 = $ 9844
Convert option premium in , $ 9844 / 1.5166 = 6491
(spot rate used)
Net value received from options:
Amount covered in 7 contracts
= 218,750
+
Amount covered in forwards
= 4,894
Cost of options (premium)
= (6,491)
=
Net amount receive in option
= 217,153
Decision:
amount received through options is 217,153 which is lower than all other
choices, therefore forward is the best choice in all cases.
EXAMPLE 5:
Lammer Co. is a UK based company that regularly trades with companies in the USA.
Lammer co. has exported goods worth $ 120 m which is receivable in five months time. These
are shown below. Assume that its 1st June and that, future contracts mature at the relevant
month end.
Exchange Rates:
Spot :
November forward:
December forward:
$/
1.9156 1.9210
1.9066 1.9120
1.8901 1.8945
24
Waseem A. Qureshi MM141063
1.9210
1.9120
-------0.0090
0.0090 / 6 = .0015
25
5 months forward
= 1.9210 5(0.0015) = 1.9135
Conversion in with rate 1.9135
$ 120,000,000 / 1.9135 = 62,712,307
It means forward will give a sum of 62,712,307 which is better than amount of money market
hedge that gives 62,517,491. Therefore forward is better choice than money market hedge.
3. Futures
CME $ / Currency futures ( 62,500) , contract size
Spot rate:
1.9156 1.9210
Future rates:
September 1.9045
December 1.8986
5 month period ends
October 31st
Position
long call
First calculate 5 month future rate on Basis risk.
Basis risk = spot rate future rate
Basis risk = 1.9210 1.8986 = 0.0224
(rate is decreasing in future time)
Basis risk per month = 0.0224 / 7 = 0.0032
Expected future price = 1.9210 5(.0032) = 1.9050
Conversion of amount in home currency 120,000,000 / 1.9050 = 62,992,126
Contract size = 62,500
No. of contracts = 62,992,126 / 62,500 = 1007.87 means 1007 contracts.
Here we take 2 contracts: 62,500 x1007 = 62,937,500
Convert in dollars 62,937,500 x 1.9050 = $ 119,895,938
Unhedged amount = $ 120,000,000 119,895,938 = $ 104,062 (amount covered by forwards)
Convert unhedged amount in = $ 104,062 / 1.9135
= 54,383
Total amount received through this choice
Amount received in futures
=
62,937,500
+ Amount in forwards
=
54,383
Total
62,991,883
Decision: future choice will give a sum of 62,991,883 that is best of all three choices. So we
will consider the future option.
EXAMPLE 6:
ABC Co. is a UK based company that regularly trades with companies in the USA. Several
large transactions are due in five months time. The transactions are shown below. The
transactions are in 000 units of the currencies shown. Assume that it is now 1st June and that
futures and options contracts mature at the relevant month end.
LMN Co.
PQR Co.
XYZ Co.
Exports
$ 890
150
Imports
150
$ 490
$ 50
26
Waseem A. Qureshi MM141063
Exchange Rates:
$/
Spot :
1.9156 1.9210
3 months forward:
1.9066 1.9120
1 year forward:
1.8901 1.8945
Annual interest rates available to ABC co.
Borrowing
Investing
UK
5.5%
4.2%
USA
4.0%
2.0%
CME $ / Currency futures ( 62,500) ,
Future rates:
September 1.9065
contract size
December 1.8985
September
4.70
3.53
2.28
Call
December
5.90
4.70
3.56
September
1.60
2.36
3.40
Put
December
2.95
4.34
6.55
Required: Prepare a report for the managers of ABC Co. on how the five month currency
risk should be hedged. Include in your report all relevant calculations relating to the alternative
types of hedge.
Solution:
We need to decide whether to hedge or not. If we need to hedge what is the best choice out the
four available choices.
1.
2.
3.
4.
5.
Hedge or not
Money market hedge
Forwards
Futures
Options
1. Hedge or not
150 is receivable and the same amount is payable, so we dont need to hedge for that. In
dollars $ 890 is receivable and $ 540 (490+50) is payable. A net of $ 350m (350,000) is
receivable and it is the amount for which we need to hedge. Now we have to decide what
the best available option for this hedge is.
2. Money market hedge
Money market hedge is always based and calculated through borrowing and lending
rates. Here the rates are available so we first check this option.
27
Waseem A. Qureshi MM141063
,
=
$344,328
1.9120
1.8945
-------Decrease in rates
0.0175
-------Average rate per month = 0.0175 / 9 = .0019
5 months forward
= 1.9120 2(0.0019) = 1.9082
Conversion in with rate 1.9082
$ 350,000 / 1.9082 = 183,419
Hint: Here we use minus sign 1.9120 2(0.0019) because rates are decreasing. If the rates
were increased we should use the + sign in this equation.
It means forward will give a sum of 183,419 which is better than amount of money market
hedge that gives 182,343. Therefore forward is better choice than money market hedge.
4. Futures
CME $ / Currency futures ( 62,500) , contract size
Spot rate:
1.9156 1.9210
Future rates:
September 1.9065
December 1.8985
st
5 month period ends
October 31
Position
long call
28
Waseem A. Qureshi MM141063
September
4.70
3.53
2.28
Call
December
5.90
4.70
3.56
September
1.60
2.36
3.40
Put
December
2.95
4.34
6.55
Hint: while selecting the rates always use that rates which are in the benefit of the bank. Bank
will charge higher rates when we borrow and will give the lower rates when we lend or invest
in the bank.
Contract size:
31,250
Exercise price:
1.8800 $ / ( we use this price as it is lower than 1.9082 calculated)
Position:
long call (because we need to buy)
Contract used:
December ( as the contracts mature in October)
Amount in
= 350,000 / 1.8800 = 186,170
No. of contracts
= 186,170 / 31,250 = 5.95 contracts ( we take 5 contracts)
Amount covered in options = 31,250 x 5 = 156,250
Convert in dollars
= 156,250 x 1.8800 = $ 293,750
Unhedged amount
= 350,000 293,750 = $ 56,250 ( covered in forwards)
29
Waseem A. Qureshi MM141063
Unhedged amount in
= $ 56,250 / 1.9082 = 29,478 (forward rate used)
Cost of options (premium) = 156,250 x .059 = $ 9219
Convert option premium in $ 9219 / 1.9156 = 4812
(used spot rate)
Options:
Contract size:
Calls, Puts.
exercise price
1.36
1.38
2 month expiry
2.47
4.23
Put
5 month expiry
2.98
4.64
2.20%
10.80%
1.80%
Mazabias current annual inflation rate is 9.7% and is expected to remain at this level for the
next six years. However, after that, there is considerable uncertainty about the future and the
annual level of inflation and it could be anywhere between 5% and 15% for the next few years.
The country where Casasophia co is based is expected to have a stable level of inflation at
1.2% per year for the foreseeable future. A local bank in mazabia has offered Casasophia co
the opportunity to swap the annual income of MShs 1.5 billion receivable in each of the next
three years for Euro, at the estimated annual MShs / forward rates based on the current
government base rates.
Required:
a. Advise Casasophia co on, and recommend an appropriate hedging strategy for the US$
income it is due to receive in four months. Include all relevant calculations.
b. Provide a reasoned estimate of the additional amount of loan finance Casasophia so
needs to obtain to undertake the project in Mazabia in six months.
c. Given that Casasophia co agrees to the local banks offer of the swap, calculate the net
present value of the project in six months time in . Discuss whether the swap would
be beneficial to Casasophia co.
Solution:
Query (a) Recommend the hedging strategy.
We need to decide whether to hedge or not. If we need to hedge what is the best choice out the
four available choices.
1.
2.
3.
4.
5.
Hedge or not
Money market hedge
Forwards
Futures
Options
We need to decide whether to hedge or not. If we need to hedge what is the best choice out the
four available choices.
31
Waseem A. Qureshi MM141063
1. Hedge or not
An amount of $ 20,000,000 is receivable in four months time. So we need to hedge for
this amount.
2. Money market hedge
We are not given the borrowing and lending rates, so we cannot use this money market
hedge option.
3. Forwards
As opposed to previous examples, here forward rates for future are given. So we not
need to calculate these rates and use the higher rate to convert the dollar amount in
Euro. Rates given are:Exchange Rates:
Spot :
4 months forward:
$/
1.3585 1.3618
1.3588 1.3623
MShs /
MShs 116 MShs 128
Not available
Convert $ amount in =
4. Futures
CME $ / Currency futures ( 125,000) , $ / contract size
Spot rate:
1.3585 1.3618
Future rates:
2 months expiry 1.3633
5 months expiry 1.3698
Period:
4 months
Contract period used:
5 months future 1.3698
Position:
Long call
First calculate 5 month future rate on Basis risk.
Basis risk = spot rate future rate
Basis risk = 1.3618 1.3698 = 0.008 (rate is increasing in future time)
Basis risk per month = 0.008 / 5 = 0.0016
Expected future price = 1.3618 + 4(.0016) = 1.3682 (used plus sign as rates increased)
Conversion of amount in home currency $ 20,000,00 / 1.3682 = 14,617,746
Contract size = 125,000
No. of contracts = 183,734 / 125,000 = 116.96 contracts.
Here we take 116 contracts: 125,000 x 116 = 14,500,000 amount covered
Convert in dollars 14,500,000 x 1.3682 = $ 19,838,900
Unhedged amount = $ 20,000,000 19,838,900 = $ 161,100 (covered by forwards)
Convert unhedged amount in = $ 161,100 / 1.3623 = 118,255 (forward rate used)
Total amount received through this choice =
Amount received in futures
=
14,500,000
+ Amount in forwards
=
118,255
Total
14,618,255
32
Waseem A. Qureshi MM141063
Contract size:
exercise price
1.36
1.38
Call
2 month expiry 5 month expiry
2.35
2.80
1.88
2.23
Put
2 month expiry 5 month expiry
2.47
2.98
4.23
4.64
Contract size:
125,000
Exercise price:
1.3600 $ / ( we use this price as it is lower than 1.3682 calculated)
Position:
long call (because we need to buy)
Contract used:
5 months
Amount in
= 20,000,000 / 1.3600 = 14,705,882
No. of contracts
= 14,705,882/ 125,000 = 117.64 contracts
Amount covered in options = 125,000 x 117 = 14,625,000
Convert in dollars
= 14,625,000 x 1.3600 = $ 19,890,000
Unhedged amount
= 20,000,000 19,890,000 = $110,000 ( covered in forwards)
Unhedged amount in
= $ 110,000 / 1.3623 = 80,746 (forward rate used)
Cost of options (premium) = 14,625,000 x .028 = $ 409,500
Convert option premium in $ 409,500 / 1.3585 = 301,435 (lower of spot rate used)
Now see it on time line: (future value) = = PV(1 + i)
= PV(1 + i) = = 301,435(1 + .022)4/12 = 303,630
Net value received from options:
Amount covered in 5 contracts
+
Amount covered in forwards
Cost of options (premium)
=
Net amount receive in option
= 14,625,000
=
80,746
=
303,630
= 14,402,116
Decision:
amount received through options is 14,402,116.which is lower than all other
choices, therefore forward is the best option in all cases.
Query (b)
Provide a reasoned estimate of the additional amount of loan finance Casasophia so needs to
obtain to undertake the project in Mazabia in six months.
33
Waseem A. Qureshi MM141063
Solution:
Mazabian government requires Casasophia to deposit MShs 2.64 Billion as security.
We receive 14,681,054 from forwards at the end of month 4. These should be invested for 2
months in a bank. The risk free lending rate on treasury bills is 1.80%.
First see what will be value of this amount after 2 months investment.
= PV(1 + i) = = 14,681,054(1 + .018)4/12 = 14,724,770
Convert into MShs at spot rate 116/ (here we use purchasing power parity theory)
=
PV (1+ )
(1+ )
116(1+.097)1
(1+.012)1
MShs 125.74
125.74116
=
116 + (
) =
MShs 120.86
2
Required amount in
=
2,640,000,000 / 120.86 = 21,843,455
(less)
Available amount
= 14,724,770
Short amount in
7,118,685
This short amount will be borrowed from bank. A local bank in mazabia has offered
Casasophia co the opportunity to swap the annual income of MShs 1.5 billion receivable in
each of the next three years for Euro, at the estimated annual MShs / forward rates based on
the current government base rates. 10.80%.
Query (c)
Given that Casasophia co agrees to the local banks offer of the swap, calculate the net present
value of the project in six months time in . Discuss whether the swap would be beneficial to
Casasophia co.
We need to calculate the value of the funds of 1.5 billion to be received every year with the
future rates of MShs to Euro.
We need rates for these periods.
0____________1___________2________3___________4__________
Spot 116
6 month
1.5 year
2.5year
3.5 year
=
PV (1+ )
(1+ )
=
116 + (
116(1+.108)
MShs 125.74
) =
MShs 120.86
(1.022)
125.74116
2
--------------------- =
PV (1+ )
(1+ )
=
=
PV (1+ )
(1+ )
=
128 + (
=
128(1.108)
(1.022)
138.77128
2
) =
133.38(1.108)
(1.022)
MShs 138.77
MShs 133.38
MShs 144.60
34
=
=
PV (1+ )
(1+ )
PV (1+ )
(1+ )
=
=
144.60(1.108)
(1.022)
156.77(1.108)
(1.022)
MShs 156.77
MShs 169.96
Year 1
Year 2
1500 / 144.60 = 10.37 1500 / 156.77 = 9.57
.893
.797
9.25
7.63
PV of cash flows
= 9.25+7.63+6.30 = 23.1m
21.8 m
1.3 m
Decision:
Year 3
1500 / 169.96 = 8.83
.712
6.30
NPV is positive, therefore project is favorable and they should go for it.
EXAMPLE: 8
Tertial company of UK has recently commenced exports to Buldonia, a developing country. A
payment of 100 million pesos is due from a customer in Buldonia in three months time. The
Buldonia government sometimes restricts the movement of funds from the country, but has
indicated that payment to Tertial has a good chance of receiving approval. No forward market
or derivatives market exist for the Buldonian peso. The Buldonian peso is currently liked to
the US Dollar.
Exchange rates:
Spot rate B. Peso / $
Spot rate $ /
3 month forward rate B Peso /
3 month forward rate $ /
126.4 128.2
1.775 1.782
not available
1.781 1.789
Tertial can borrow at 6% per annum or invest at 4% per annum in the UK, can borrow at 7%
and invest at 4.5% in the USA, and at 14% and 10% respectively in Buldonia.
Inflation rates: UK 3%, USA 4%,
Buldonia 14%
Tertials Buldonian customer has indicated that it might be willing to make a lead payment in
return for a 1.5% discount on the sale price.
Required:
Discuss the advantages and disadvantages of the alternative currency hedges that are available
to Tertial. Calculate the expected outcome of each hedge and recommend which hedge should
be selected.
35
Waseem A. Qureshi MM141063
Solution:
We have three choices available to hedge the amount.
1. Discounting
2. Money market hedge
3. Forwards
1. Allow a discount of 1.5% and receive the amount.
Customer is willing to pay a lead payment at a discount of 1.5%. (payment today)
For three months discount = 1.5% x 3/12 =
0.375
Net amount received will be :
100 0.375 = 99.625 m BP. (Buldonia Peso)
Convert in US$:
99.625 / 128.2
= 0.7771 m US$
Convert in :
0.7771 / 1.782
= 0.4360 m (PV)
0.4360 m will be net amount received today, if we allow a discount of 5% to customer.
We can calculate FV using investment rate, 4% per annum (net received through discount)
= PV(1 + i)
,
FV = 0.4360(1 + .04)3/12 = 0.4402m
2. Money Market Hedge
Annual interest rates available to ABC co.
Borrowing
Lending
UK
6%
4%
USA
7%
4.5%
Buldonia
14%
10%
Step 1: calculate PV of 100m using borrowing rate.
= PV(1 + i)
Pv = 100 / (1.14)3/12
BP96.78 = $?
Step 3: calculate FV for investable amount in the home currency at lending rate in UK.
= PV(1 + i)
, FV = 0.4236(1.04)3/12 = 0.4278m
3. Forwards
Convert 100 m BP in $ with conversion rate 131.28 =
Convert in = 0.7621 / 1.789 = 0.4260 m
36
Waseem A. Qureshi MM141063
Conversion rates for Buldonian Peso after 3 months (inflation rate Buldonia 14%, USA 4%)
$ =
PV (1+ )
(1+ )
$ 3 =
128.2(1+.14)
(1.04)
128.2 + (
140.53128.2
12
BP 140.53 / $
) x 3 = BP 131.28 /$
Conversion rates for dollar $ to Pound after 3 months (inflation rate USA 4%, UK 3%)
$ =
PV (1+ )
(1+ )
$ 3 =
1.782(1+.04)
1.782 + (
(1.03)
1.79991.7822
12
$1.7999 /
) x 3 = $1.7863 /
Decision: 0.4402m is amount received through discount option, through money market
hedge it is 0.4277m and forward choice will give 0.4264 m. Form the all three situations
money market hedge is the better choice.
HINT: we can calculate exchange rates for 3 months directly as well: (calculated below).
Rates for peso after 3 months:
$ =
PV (1+ )
(1+ )
128.2(1+.14)3/12
(1+.04)3/12
BP 131.28/ $
PV (1+ )
(1+ )
1.78(1+.04)3/12
(1+.03)3/12
$1.7863 /
EXAMPLE 9:
Awan co. is expecting to receive $48,000,000 on 1st February 2014, which will be invested
until it is required for a large project on 1st June 2014. Due to uncertainty in the market, the
company is of the opinion that it is likely that interest rates will fluctuate significantly over
the coming months, although it is difficult to predict whether they will increase or decrease.
Awan cos treasury team want to hedge the company against adverse movements in interest
rate futures; or options on interest rate futures.
Awan co. can invest funds at the relevant inter-bank rate less 20 basis points. The current
inter-bank rate is 4.09% over the coming months.
The following information and quotes are provided from an appropriate exchange on $ futures
and options. Margin requirements can be ignored.
Three month $ futures, $2,000,000 contract size.
Prices are quoted in basis points at 100- % yield.
December 2013:
March 2014:
June 2014:
94.80
94.76
94.69
37
Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual %.
Calls
strike
Puts
December March
June
December
March
June
0.342
0.432
0.523
94.50
0.090
0.119
0.271
0.097
0.121
0.289
95.00
0.312
0.417
0.520
Vobalka bank has offered the following FRA rates to Awan co.
1 7: 4.37%
3 4: 4.78%
3 7: 4.82%
4 7: 4.87%
It can be assumed that settlement for the futures and options contracts is at the end of month
and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time
intervals. Assume that it is 1st November 2013 now and that there is no basis risk.
Required:
(a) Based on the three hedging choices Awan Co is considering, recommend a hedging
strategy for the $48,000,000 investment, if interest rates increase or decrease by 0.9%. support
your answer with appropriate calculations and discussions.
(b) A member of Awan cos treasury team has suggested that if option contracts are
purchased to hedge against the interest rate movements, then the number of contracts
purchased should be determined by a hedge ratio based on the delta value of the option.
(c) Discuss how the delta value of an option could be used in determining the number of
contracts purchased.
Query (a)
1. Making investment in the bank / FRA
Using FRA forward rate agreements. (Interest rate 0.9% in the coming months)
Selection of FRA / Period.
Today its November 1st, 2013
Cash receivable on February 1st, 2014 (after 3 months)
Needed to invest in project on June 1st, 2014 (after 7 months)
Our FRA will be: 3 7 , that has the rate of: 4.82%
Situation a. If interest increases by 0.9%(rate is 4.99%)
(if invested in bank at 20 basis points less)
Current rate + rate after 3 months = 4.09 + 0.9 = 4.99%
Lending rate is 20 basis points less = 4.99 - .20 = 4.79% (rate at which to invest)
Return on investment = $48,000,000 x (4.79/100) x (4/12) = $766,400
(if opted to use FRA, 3 7 , 4.82%)
38
Waseem A. Qureshi MM141063
$2,000,000
48,000,000 / 2,000,000 x (4/3) = 32 contracts.
Long call
94.50
94.55
Yes
.05%
766,400
8,000
(69,120)
705,280
4.40%
95.00
94.55
No
-766,400
0
(19,360)
747,040
4.67%
94.50
96.35
Yes
1.85%
478,400
296,000
95.00
96.35
Yes
1.35%
478,400
216,000
(69,120)
705,280
4.40%
(19,360)
675,040
4.22%
40
Waseem A. Qureshi MM141063
41
Waseem A. Qureshi MM141063
Required:
Advise National co on, and recommend an appropriate hedging strategy for the US$ cash
flows it is due to receive or pay in three months, form Lakama co. show all relevant
calculations to support the advice given.
Solution:
We need to decide whether to hedge or not. If we need to hedge what is the best choice out the
three available choices.
1.
2.
3.
4.
Hedge or not
Money market hedge
Forwards
Options
Hedge or not
National company has two bilateral transactions with Lakama Co. after three months.
Payable amount is US$ 4.5 million and receivable amount is US$ 2.1 million. Net
exposure is US$ 2.4 million payable after three months, for which company needs to
hedge.
Money market hedge
PV = 2,400,000 / (1.031)3/12
$ 2,381,752
Forwards
3 month forward
1.5996-1.6037
We use the 1.5996 which is the buying rate for dollar in the market.
Conversion in with rate 1.5996
Options
CME currency options prices, $ / options 62,500 (cents per pound)
Exercise price
1.60
1.62
Call options
3 month
6 month
Expiry
expiry
1.55
2.25
0.98
1.58
Put options
3 month
6 month
expiry
expiry
2.08
2.23
3.42
3.73
Contract size:
62,500
Exercise price:
1.62 $/
Position:
long put
Contract used:
three months ( as the contracts mature at same period)
Amount in
= 2,400,000 / 1.62 = 1,481,481
No. of contracts
= 1,481,481 / 62,500 = 23.70 contracts ( we take 23 contracts)
Amount covered in options = 62,500 x 23 = 1,437,500
Convert in dollars
= 1,437,500 x 1.62 = $ 2,328,750
Unhedged amount
= 2,400,000 2,328,750 = $ 71,250 ( covered in forwards)
Unhedged amount in
= $ 71,250 / 1.5996 = 44,542
Cost of options (premium) = 1,437,500 x .0342 = $ 49,162
Convert option premium in $ 49,162 / 1.5938 = 30,846
Now see it on time line: (future value) = = PV(1 + i)
= PV(1 + i) = = 30,846(1 + .028)3/12 = 31,060
Net value from options:
Amount covered in 23 contracts
+
Amount covered in forwards
+
Cost of options (premium)
=
Net amount receive in option
= 1,437,500
=
44,542
=
31,060
= 1,513,102
Hint: we add all three amounts as it is payable and cost is also an expense payable.
Decision: Amount required through options is 1,513,102 through money market hedge it is
1,509,110 and through forwards it is 1,500,375. For forward choice it is lower in all three
cases, means we need lowest amount to pay an amount of $2.4 million payable after 3 months.
Therefore forward is the best choice.
43
Waseem A. Qureshi MM141063
Strike Price
95.50
96.00
March Puts
0.662
0.902
Options prices are quoted in basis point at 100 minus the annual % yield and settlement of the
options contracts is at the end of March, 2015. The current basis on the March futures prices is
44 points, and it is expected to be 33 points on 1st January 2015, 22 points on 1st February
2015 and 11 basis points on 1st march 2015.
Prime Bank has offered National co. a swap on a counterparty variable rate of LIBOR plus 30
basis points or a fixed rate of 4.6%, where National Co. receives 70% of any benefits accruing
from undertaking the swap, prior to any bank charges. Prime Bank will charge National co 10
basis points for the swap.
National cos chief executive officer believes that a centralized treasury department is
necessary in order to increase shareholder value, but National cos new chief financial officer
(CEO) thinks that having decentralized treasury departments operating across the subsidiary
companies could be more beneficial. The CFO thinks that this is particularly relevant to the
situation which Omega Co., a company owned by Nation Co. is facing. Omega Cooperates in
a country where most companies conduct business activities based on Islamic finance
principles. It produces confectionery products including chocolates. It wants to use Salam
contracts instead of commodity futures contracts to hedge its exposure to price fluctuations of
cocoa. Salam contracts involve a commodity which is sold based on currently agreed prices,
quantity and quality. Full payment is received by the seller immediately, for an agreed
delivery to be made in the future.
44
Waseem A. Qureshi MM141063
Required: Based on the two hedging choices National Co. is considering, recommend a
hedging strategy for the $18,000,000 borrowing. Support your answer with appropriate
calculations and discussion.
Solution:
4. Options
Contract size :
No. of contracts:
Position
$1,000,000
18,000,000 / 1,000,000 x (7/3) = 42 contracts.
Long Put
95.50
95.48
Yes
.02%
96.00
95.48
Yes
0.52%
$493,500
2,100
$493,500
54,600
69,510
560,910
5.34%
94,710
533,410
5.08%
Exercise price:
Expected future price
Decision to exercise
Gain / loss
Borrowing at 3.30 + .40 = 3.7%
$18,000,000 x (3.70/100) x (7/12) =
Option premium (.00662x1,000,000x42x(3/12) =
(.00902x1,000,000x42x(3/12) =
Net position (gain/loss)
Net percentage: 458,010/18,000,000x(12/7) =
483,210/18,000,000x(12/7)
95.50
96.48
No
0
96.00
96.48
No
0
$388,500
69,510
$388,500
458,010
4.36%
94,710
483,210
4.60%
45
SWAP:
National Co.
Fixed Rate
Prime Bank
5.5%
Floating Rate
4.6%
LIBOR + .4%
0.9%
LIBOR + .3%
0.8%
0.56%
Bank Charges:
0.10%
Net gain:
0.465
National Co.
Prime Bank
LIBOR+0.4%
Net effect:
0.1%
Loan
Basis Difference
(4.6%)
(4.6%)
4.6%
LIBOR+0.6%
LIBOR+0.6%
-------------------
------------------
4.94%
LIBOR+0.6%
46
Waseem A. Qureshi MM141063
So let us begin by defining value: Value is what you can sell something for or what you must
pay to acquire something. This applies to stocks, bonds, derivatives, and used cars.'"
Accordingly, valuation is the process of determining the value of an asset or service. Pricing
is a related but different concept; let us explore what we mean by pricing a forward contract.
A forward contract price is the fixed price or rate at which the transaction scheduled to occur
at expiration will take place. This price is agreed to on the contract initiation date and is
commonly called the forward price or forward rate. Pricing means to determine the forward
price or forward rate. Valuation, however, means to determine the amount of money that one
would need to pay or would expect to receive to engage in the transaction. Alternatively, if
one already held a position, valuation would mean to determine the amount of money one
would either have to pay or expect to receive in order to get out of the position. Let us look at
a generic example.
The price of the underlying asset in the spot market is denoted as So at time 0, St at time t, and
ST at time T. The forward contract price, established when the contract is initiated at time 0, is
F(0,T). This notation indicates that F(0,T) is the price of a forward contract initiated at time 0
and expiring at time T. The value of the forward contract is Vd0,T). This notation indicates
that Vo(O,T) is the value at time 0 of a forward contract initiated at time 0 and expiring at time
T. In this book, subscripts always indicate that we are at a specific point in time.
We have several objectives in this analysis. First, we want to determine the forward price
F(0,T). We also want to determine the forward contract value today, denoted Vo(O,T), the
value at a point during the life of the contract such as time t, denoted Vt(O,T), and the value at
expiration, denoted VT(O,T). Valuation is somewhat easier to grasp from the perspective of
the party holding the long position, so we shall take that point of view in this example. Once
that value is determined, the value to the short is obtained by simply changing the sign.
'' From your study of equity analysis, you should recall that we often use the discounted cash
flow model, sometimes combined with the capital asset pricing model, to determine the fair
market value of a stock.
'' Be careful. You may think the "value" of a certain used car is $5,000, hut if no one will give
you that price, it can hardly be called the value.
If we are at expiration, we would observe the spot price as ST. The long holds a position to
buy the asset at the already agreed-upon price of F(0,T). Thus, the value of the forward
47
Waseem A. Qureshi MM141063
contract at expiration should be obvious: ST - F(0,T). If the value at expiration does not equal
this amount, then an arbitrage profit can be easily made.
A forward contract may be for any one of the five assets, i.e. commodity forward, equity
forward, bond forward, currency forward and loan or interest rate forward. Here, we will see
separate calculations in either case or asset. In every case we need to find three results.
a. Fair price of the forward
b. Settlement price at maturity
c. Settlement price at any time before maturity
1. Commodity forward.
Calculations:
Fair price:
(0, ) = 0 (1 + )T
0, =
Settlement on maturity:
(0, ) = T (0, )
F(0,T)
(1+)
2. Equity forward.
Calculations:
Fair price:
(0, ) = {0 (, 0, )} (1 + )T
0, = {t (, , )}
Settlement on maturity:
(0, ) = T (0, )
F(0,T)
(1+)
3. Bond forward.
Calculations:
Fair price:
(0, ) = {0 (, 0, )} (1 + )T
0, = {t (, 0, )}
Settlement on maturity:
(0, ) = T (0, )
F(0,T)
(1+)
4. Currency forward.
Calculations:
Fair price:
d = domestic risk free rate,
(0, ) =
0(1+ )
(1+ )
0, =
F(0,T)
(1+ )
(1+ )
Settlement on maturity:
(0, ) = T (0, )
0, , =
1+Lg + 360
h
1+L0
360
0, , =
1
1+Lg
h g
360
360
m
m
360
h +m g
360
1+(0,, )
1+Lg +
Settlement at maturity:
0, , = 1
1+(0,,) 360
m
1+Lh 360
EXAMPLE 12:
1. Commodity forward.
An investor holds title to an asset worth 125.72. To raise money for an unrelated purpose, the
investor plans to sell the asset in nine months. The investor is concerned about uncertainty in
the price of the asset at that time. The investor learns about the advantages of using forward
contracts to manage this risk and enters into such a contract to sell the asset in nine months.
The risk-free interest rate is 5.625 percent.
A. Determine the appropriate price the investor could receive in nine months by means of the
forward contract.
B. Suppose the counterparty to the forward contract is willing to engage in such a contract at a
forward price of 140. Explain what type of transaction the investor could execute to take
advantage of the situation. Calculate the rate of return (annualized), and explain why the
transaction is attractive.
C. Suppose the forward contract is entered into at the price you computed in Part A. Two
months later, the price of the asset is 118.875. The investor would like to evaluate her
position with respect to any gain or loss accrued on the forward contract. Determine the
market value of the forward contract at this point in time from the perspective of the investor
in Part A.
49
Waseem A. Qureshi MM141063
D. Determine the value of the forward contract at expiration assuming the contract is entered
into at the price you computed in Part A and the price of the underlying asset is 123.50 at
expiration. Explain how the investor did on the overall position of both the asset and the
forward contract in terms of the rate of return.
Solution:
Forward price in the market is 140 and fair price is 131. It is overvalued. Therefore, the
decision is to short sell.
Rf = 5.625%
maturity = 9 months,
rate 123.50
(0, ) = 0 (1 + )T
Fair price:
0, =
F(0,T)
(1+)
131
(1+.05625)92
0, = 118.875 126.90 =
-8.025
Result is -8.025, which shows that it is loss for long/buyer. Our position is Short, and it is a
profit for short seller after 2 months time.
(0, ) = T (0, )
c. Settlement on maturity:
d.
= 0.154 , 15.4%
EXAMPLE 13:
2. Equity forward
An asset manager anticipates the receipt of funds in 200 days, which he will use to
purchase a particular stock. The stock he has in mind is currently selling for $62.50 and
will pay a $0.75 dividend in 50 days and another $0.75 dividend in 140 days. The risk-free
rate is 4.2 percent. The manager decides to commit to a future purchase of the stock by
going long a forward contract on the stock.
A. At what price would the manager commit to purchase the stock in 200 days through a
forward contract?
B. Suppose the manager enters into the contract at the price you found in Part A. Now, 75
days later, the stock price is $55.75. Determine the value of the forward contract at this
point.
C. It is now the expiration day, and the stock price is $58.50. Determine the value of the
forward contract at this time.
Solution:
Rf = 4.2%
a. Fair price:
(1+g)
(1+g)
0.75
(1+.042)50/365
200/365
(1+g)
0.75
(1+.042)140/365
= 1.483
= 62.41
51
0, = {t (, , )}
F(0,T)
(1+)
(1+g)
0.75
(1+.042)65/365
0, = {t (, , )}
(1+g)
= 0.74
F(0,T)
(1+)
= {55.75 0.74}
62.41
(1+.042)125 /365
= -6.5
(0, ) = T (0, )
(0, ) = 58.50 62.41 = -3.91
52
Waseem A. Qureshi MM141063
calculations of the forward contract value must reflect this fact. The new risk-free rate is
used instead of the old rate in the valuation formula.
Solution:
Rf = 8%
maturity = 5 years
Coupon value = 50
At what price to enter the bond if he wants to sell after 4th coupon.
S0___Bo_______C,50 _______C,50______t________C,50______C,50______sell point____ ST
0 150 days 181 days
Position: short sell (he wants to sell the bond 731 days)
Calculations:
(0, ) = {0 (, 0, )} (1 + )T
a. Fair price:
(1+g)
(1+g)
50
(1+.08)31/365
(1+g)
50
(1+.08)215 /365
(1+g)
50
(1+.08)397 /365
50
(1+.08)580 /365
= 187.50
0, = {t (, , )}
F(0,T)
(1+)
Calculate PV of coupon.
(, , ) =
(, , ) =
(1+g)
50
(1+.07)32/365
(1+g)
50
(1+.07)215/365
0, = {1025.375 97.75}
97.75
929.97
216/365
(1+.07)
= 34.36
Result is 34.36, it is gain for long, our position is short. It is loss for our short position.
53
Waseem A. Qureshi MM141063
(0, ) = T (0, )
a. Settlement on maturity:
(0, ) = T 929.97
As no value of BT is given in the example, it is left blank.
EXAMPLE 15:
4. Currency forward.
A corporate treasurer needs to hedge the risk of the interest rate on a future transaction.
The risk is associated with the rate on 180-day Euribor in 30 days. The relevant term
structure of Euribor is given as follows:
30-day Euribor 5.75%
2 10-day Euribor 6.15%
A. State the terminology used to identify the FRA in which the manager is interested.
B. Determine the rate that the company would get on an FRA expiring in 30 days on 180day Euribor.
C. Suppose the manager went long this FRA. Now, 20 days later, interest rates have moved
significantly downward to the following:
10-day Euribor 5.45%
190-day Euribor 5.95%
The manager would like to know where the company stands on this FRA transaction.
Determine the market value of the FRA for a 20 million notional principal.
D. On the expiration day, 180-day Euribor is 5.72 percent. Determine the payment made to
or by the company to settle the FRA contract.
Solution:
Spot rate: 1 = $ 1.76
Current forward rate: $1.75
USA Rf = 5.1%
Time = 1 year
UK Rf = 6.25
short sell after 1 month.
Calculations:
a.
(0, ) =
Fair price:
(0, ) =
1.76(1+.051)1
(1+.062)1
0(1+ )
(1+ )
Market quoted value is $1.75 and fair value is $1.74, means it is overvalued. Position will be
short / sell. Sell the forward and buy currency.
What is the present value of and $.
0 ------------------------------------------ $1.75 / 1
54
(present value of 1 )
(1+g)
(present value of 1 $)
(1+.062)1
= 0.9416
0.9416 x 1.76 =
$ $ 1.6752
1/
PV
1 =
1.75
1.6572
1 =
0.056
= 5.6%
0, =
(1+ )
T = 1 year , $ 1.75
0, =
1.72
(1+.062)11/12
F(0,T)
(1+ )
t = 1 month , $ 1.72
1.75
(1+.051)11/12
= -0.045
Result is -0.045, which is loss for long and ultimately a profit to short.
c. Settlement on maturity:
On expiry the rate of is $1.69/
(0, ) = T (0, )
ST = 1.69
55
Waseem A. Qureshi MM141063
C. At expiration, the pound is at $1.69. What is the value of the forward contract to the
short at expiration?
Solution:
Agreement for taking a loan after 30 days for a period of 180 days. FRA = 1x7
h = 30
m = 180
h+m = 210 L0(h) = 5.75%
Lg(h+m) = 6.15%
Calculations:
h +m
1+Lg + 360
h
1+L0
0, , =
360
0, , =
210
360
30
1+.0575 360
1+.0615
360
1.0359
180
1.0048
360
1
h g
1+Lg 360
= 0.0619
180
360
m
360
h +m g
1+Lg + 360
1+(0,, )
0, , =
1
10
1+.0545 360
180
360
180
1+.0595 360
1+.0619
1
1.01513
1.0310
1.0314
= - 0.0011 (loss)
c. Settlement at maturity:
0, , = 1
180
360
180
1+.0572
360
1+.0619
0, , = 1
=1
1.0310
1.0286
1+(0,, ) 360
m
1+Lh 360
56
Waseem A. Qureshi MM141063
Solution:
a. Calculate PV of the T-Bill.
=
=
=
10,000
= $ 9,926.95
(1+0.0174)153/360
(1+g)
PV
1/
1 g=
10,000
9950
1 = 0.0261 = 2.61%
2. Assume that 60-day LIBOR is 4.35 percent. You are based in London and need to borrow
$20,000,000 for 60 days. What is the total amount you will owe in 60 days?
Solution:
Calculate FV of amount after 60 days.
= PV(1 + i) =
= 20,000,000 1 + .0435 60/360 = 20,142,440
3. The treasurer of Company A expects to receive a cash inflow of $15,000,000 in 90 days.
The treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge
against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on
90-day LIBOR. The FRA is quoted at 5 percent. At expiration, LIBOR is 4.5 percent. Assume
that the notional principal on the contract is $ l5, OOO, OOO.
A. Indicate whether the treasurer should take a long or short position to hedge interest rate risk
B. Using the appropriate terminology, identify the type of FRA used here.
C. Calculate the gain or loss to Company A as a consequence of entering the FRA.
Solution:
a. Taking short position will short will hedge the interest rate risk for company A. The
gain on the contract will offset the reduced interest rate that can be earned when rates
fall.
b. This is a 3 x 6 FRA.
m
1+(0,,) 360
0, , = 1
c. Settlement at maturity:
1+Lh 360
0, , = 1
1+.05 360
90
1+.045360
= 1
1.0125
1.01125
m = 90
= - 0.001236
FRA(o,h,m) = .0475
Settlement at maturity:
0, , = 1
137
0, , = 1
1+.0475 360
137
1+.04 360
= 1
1.01817
1.01522
1+(0,,) 360
m
1+Lh 360
= - 0.002811
(1+g)
1100
(1+.0675)
= $ 1030.40
Solution:
a. Find F(O,T) when,
S0 = $500
.16667
Rf = 3.5%
= $502.88
b. Sell the security for $500 and invest at 3.5 percent for two months. At the end of two
months, you will have $502.88. Enter into a forward contract now to buy the security at
$498 in two months. Arbitrage profit = $502.88 - $498 = $4.88
c. Calculate the value after one month:
St = $490 t = 1/12 = 0.0833 T = 2/12 = 0.1667
0, = {t (, , )}
F(0,T)
(1+)
T - t = 1/12 = 0.0834
= 490
502.88
(1+.035)0.0834
r = 0.035
= $ - 11.44
F(0,T)
(1+)
= 90
= $105
r = 0.035
105
(1+.035)0.075
= $ - 11.23
0.583
(1+)
(1+.035)
T = 12 months
F(O,T) = $105
r = 0.035
F(0,T)
(1+)
= 250
= $235.69
r = 0.0475
235.69
(1+.0475)0.6667
= $21.49
F(0,T)
(1+)
= 200
r = 0.0475
235.69
(1+.0475)0.3333
= $-32.07
T = 12 months
F(O,T) = $235.69
r = 0.0475
60
Waseem A. Qureshi MM141063
10. Assume that a security is currently priced at $200. The risk-free rate is 5 percent.
A. A dealer offers you a contract in which the forward price of the security with delivery in
three months is $205. Explain the transactions you would undertake to take advantage of the
situation.
B. Suppose the dealer were to offer you a contract in which the forward price of the security
with delivery in three months is $198. How would you take advantage of the situation?
Solution:
a. The no-arbitrage forward price is F(0,T) = $200(1.05)3112 = $202.45. Because the
forward contract offered by the dealer is overpriced, sell the forward contract and buy the
security now. Doing so will yield an arbitrage profit of $2.55.
Borrow $200 and buy security, at the end of three months, repay
$202.45
At the end of three months, deliver the security for
$205.00
Arbitrage profit
$2.55
b. At a price of $198.00, the contract offered by the dealer is underpriced relative to the
no-arbitrage forward price of $202.45. Enter into a forward contract to buy in three months at
$198.00. Short the stock now, and invest the proceeds. Doing so will yield an arbitrage profit
of $4.45.
Short security for $200 and invest proceeds for three months
$202.45
At the end of three months, buy the security for
$198.00
Arbitrage profit
$4.45
11. Assume that you own a dividend-paying stock currently worth $150. You plan to sell the
stock in 250 days. In order to hedge against a possible price decline, you wish to take a short
position in a forward contract that expires in 250 days. The risk-free rate is 5.25 Over the next
250 days, the stock will pay dividends according to the following schedule:
Days to next dividend
dividends per share
30
$ 1.25
120
$ 1.25
210
$ 1.25
A. Calculate the forward price of a contract established today and expiring in 250 days.
B. It is now 100 days since you entered the forward contract. The stock price is $1 15.
Calculate the value of the forward contract at this point.
C. At expiration, the price of the stock is $130. Calculate the value of the forward contract at
expiration.
Solution:
a. Find F(O,T) when, S0 = $150 T = 250/365
Rf = 5.25% Dividend = 1.25
(0, ) = {0 (, 0, )} (1 + )T
First calculate PV of each dividend paid at different times:
Dividend after 30, 120 and 140 days is $1.25
S0_________D__________D____________ D_____________ ST
$ 150
30 days
120 days
210 days
250 days
61
Waseem A. Qureshi MM141063
(, , ) =
(1+g)
0, =
(1+g) (1+g)
1.25
(1+.0525)30/365
250/365
0.75
(1+.0525)120/365
0.75
(1+.0525)210 /365
= 3.69
= $ 151.53
T - t = 150/365
r = 0.0525
(1+g)
, , =
1+g
(1+g)
0, = {t (, , )}
1.25
(1+.0525)20/365
F(0,T)
(1+)
0.75
(1+.0525)110/365
= {115 2.48}
= 2.48
151.53
(1+.0525)150 /365
= -35.86
T = 90/365
T - t = 62/365
r = 0.0425
c = 0.0175
1+g
(1+g)
40
(1+.06)165/365
365/365
40
(1+.06)347 /365
= $ 76.80
= $ 1134.32
T - t = 185/365
r = 0.04
Div. $40
We are now on the 380th day of the bond's life. One more coupon payment remains until the
expiration of the forward contract. The coupon payment is in 547 - 380 = 167 days.
First calculate present value of Dividend for remaining period =
, , =
1+g
40
(1+.04)167/365
0, = {t (, , )}
(1+g)
= $39.29
F(0,T)
(1+)
63
Waseem A. Qureshi MM141063
= {1302.26 39.29}
1134.32
= -$510.98
(1+.04)185/365
m = 180
h + m = 360
LO(h + m) = 0.0595
h +m
0, , =
1+Lo + 360
h
1+L0 360
360
m
360
0, , =
0, , =
1
1+Lg
h g
360
1
1+0.0590
1+.0595 360
180
1+.057 360
0, , =
135
360
Lo(h) = 0.057
1
1+Lg
h g
360
360
180
= 0.0603
m
360
h +m g
360
1+(0,, )
1+Lg +
1+(0,, )
1+Lg +
180
360
315
1+0.0615
360
1+0.0603
0.0081
0, , = 1
Settlement at maturity:
180
0, , = 1
1+.0625 360
180
1+.0625 360
1+(0,,) 360
m
1+Lh 360
= 0.001067
Based on a notional principal of $10,000,000, the corporation, which is long, will receive
$10,000,000 X 0.001067 = $10,670 from the dealer.
15. A financial manager needs to hedge against a possible decrease in short term interest rates.
He decides to hedge his risk exposure by going short on an FRA that expires in 90 days and is
based on 90-day LIROR. The current term structure for LIBOR is as follows:
Term
Interest Rate
30 day
5.83%
90 day
6.00%
180 day
6.14%
360 day
6.51%
A. Identify the type of FRA used by the financial manager using the appropriate terminology.
B. Calculate the rate the manager would receive on this FRA.
C. It is now 30 days since the manager took a short position in the FRA. Interest rates have
shifted down, and the new term structure for LIBOR is as follows:
Term
Interest Rate
60 day
5.50%
150 day
5.62%
Calculate the market value of this FRA based on a notional principal of $15,000,000.
Solution:
a. 3 X 6 FRA expires in 90 days and is based on 90-day LIBOR.
b. value of FRA(o,h,m)
h = 90
m = 90
h + m = 180
0, , =
1+Lo + 360
h
1+L0 360
LO(h + m) = 0.06
h +m
360
m
0, , =
1
1+Lg
180
1+.0614 360
0, , =
h g
360
Lo(h) = 0.0614
90
1+.06 360
1
1+Lg
h g
360
360
90
= 0.0619
m
360
h +m g
360
1+(0,, )
1+Lg +
1+(0,, )
1+Lg +
65
Waseem A. Qureshi MM141063
0, , =
1
1+0.055
60
360
90
360
150
1+0.0562
360
1+0.0619
- 0.001323
(0, ) =
0(1+ )
(1+ )
0.5974(1+.02)90/365
1+.05 90/365
0, =
$0.5931
(1+ )
St = $0.55
0, =
60/365
0.5931
(1+.02)60/365
F(0,T)
(1+ )
= - $ 0.0456
This represents a gain to the short position of $0.0456 per Swiss franc. In this problem, the
U.S. company holds the short forward position.
66
Waseem A. Qureshi MM141063
17. The euro currently trades at $1.0231. The dollar risk-free rate is 4 percent and the euro
risk-free rate is 5 percent. Six-month forward contracts are quoted at a rate of $1.0225.
Indicate how you might earn a risk-free profit by engaging in a forward contract. Clearly
outline the steps you undertake to earn this risk-free profit.
Solution:
a. Fair value of Currency.
Rfd = domestic risk free rate,
So = $1.0231
(0, ) =
0(1+ )
(1+ )
$1.0183
Decision: F(O,T) is less then Spot rate: The dealer quote for the forward contract is $1.0225;
thus, the forward contract is overpriced. To earn a risk-free profit, you should enter into a
forward contract to sell Euros forward in six months at $1.0225. At the same time, buy Euros
now.
Calculate PV of 1 :
1+g
1
1+.05 6/12
= 0.9759
Calculate yield rate using forward rate available after 3 months i.e. $ 1.0225
g=
1/
PV
1=
1.0225
0.9984
1/0.5
1 = 0.0489 = 4.98%
18. Suppose that you are a U.S.-based importer of goods from the United Kingdom. You
expect the value of the pound to increase against the U.S. dollar over the next 30 days. You
will be making payment on a shipment of imported goods in 30 days and want to hedge your
currency exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is 4.5
percent. These rates are expected to remain unchanged over the next month. The current spot
rate is $1.50.
A. Indicate whether you should use a long or short forward contract to hedge the currency risk.
B. Calculate the no-arbitrage price at which you could enter into a forward contract that
expires in 30 days.
C. Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the
value of your forward position.
Solution:
a. The risk to you is that the value of the British pound will rise over the next 30 days
and it will require more U.S. dollars to buy the necessary pounds to make payment. To hedge
this risk you should enter a forward contract to buy British pounds.
67
Waseem A. Qureshi MM141063
b. So = $1.50
(0, ) =
0(1+ )
(1+ )
1.50(1+.055)30/365
1+.045 30/365
$1.5012
t
0, =
(1+ )
St = $1.53
0, =
20/365
1.5012
(1+.055)20/365
F(0,T)
(1+ )
19. Consider the following: The U.S. risk-free rate is 6 percent, the Swiss risk-free rate is 4
percent, and the spot exchange rate between the United States and Switzerland is $0.6667.
A. Calculate the continuously compounded U.S. and Swiss risk-free rates.
B. Calculate the price at which you could enter into a forward contract that expires in 90 days.
C. Calculate the value of the forward position 25 days into the contract. Assume that the spot
rate is $0.65.
Solution:
a. Continuously compounded rates:
rfc = ln(1.04) = 0.0392
T = 90/365
rfc = 0.0392
rdc = 0.0583
0(1+ )
(1+ )
.00812 (1+.045)90/365
1+.02 90/365
$0.00817
68
Decision: F(O,T) is more than Spot rate: The dealer quoted rate for the forward contract is
$0.008 13. Therefore, the forward contract is underpriced. To earn a risk-free profit, you
should enter into a forward contract to buy yen in three months at $0.00813. At the same time,
sell yen now.
The spot rate of $0.00812 per yen is equivalent toV123.15 per U.S. dollar.
123.15
Calculate PV of 1 :
= 121.82
3/12
1+g
Calculate PV of 1 $:
1+.045
1+g
1+.045 3/12
= 0.9892
Calculate yield rate using forward rate available after 3 months i.e. 123 and spot rate
for 121.82
g=
1/
PV
1=
123
121.82
1/0.25
1 = 0.0393 = 3.93%
Because we began our transactions in yen, the relevant comparison for the return from our
transactions is the Japanese risk-free rate. The 3.93 percent return above exceeds the Japanese
risk-free rate of 2 percent. Therefore, we could borrow yen at 2 percent and engage in the
above transactions to earn a risk-free return of 3.93 percent that exceeds the rate of borrowing.
In simple, SWAP is an agreement between two parties to exchange a series of cash flows. To
explain, a swap is a derivative in which two counter parties exchange cash flows of one
party's financial instrument for those of the other party's financial instrument. Typically at
least one of the two series of cash flows is determined by a later outcome.
In other words, one party agrees to pay the other a series of cash flows whose value will
be determined by the unknown future course of some underlying factor, such as interest rate,
exchange rate, stock price or commodity price. These payments are commonly referred to as
variable or floating. The other party makes fix payment.
The swap market is almost exclusively an over-the-counter market, so swap contracts
are customized to the parties specific needs When a swap is initiated, neither party pays any
amount to the other. Therefore, a swap has zero value at the start of the contract, although this
is not necessary in all cases. Each date on which the parties make payments is called a
settlement date and the time between settlement dates is called settlement period. It always
have an expiration date, the date of final payment. The swap can be terminated through cash
payment on expiry or any time before expiration, terminating early by entering into a separate
and off setting swap, or by selling the swap to some other counterparty.
.
69
Waseem A. Qureshi MM141063
8.65%
ABC Co.
8.50%
BANK
KIBOR + 0.55%
XYZ Co.
KIBOR+0.70%
KIBOR+
1.50%
FLOATIN
G 9.60%
NET:
8.50%
FIXED
NET: KIBOR + 0.70%
ABC is currently paying floating, but wants to pay fixed. XYZ is currently paying fixed but
wants to pay floating. By entering into an interest rate swap, the net result is that each party
can 'swap' their existing obligation for their desired obligation. Normally, the parties do not
swap payments directly, but rather each sets up a separate swap with a financial intermediary
such as a bank. In return for matching the two parties together, the bank takes a spread from
the swap payments.
There are three transactions involved in interest rate swap.
i. Initial exchange.
( it may be cash or notional basis)
ii. Interim exchange. (it is always cash basis).
iii. Terminal exchange. ( it may be cash or notional basis).
Types of SWAPS.
1. Interest rate swaps
2. Currency swaps / exchange rate swaps
3. Equity swaps
4. Credit default swaps
5. Subordinate risk swaps
1. Interest rate swaps. / Plain vanilla
The most common type of swap is a "plain Vanilla" interest rate swap. It is the exchange of
a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15
years.
The reason for this exchange is to take benefit from comparative advantage. Some companies
may have comparative advantage in fixed rate markets, while other companies have a
comparative advantage in floating rate markets. When companies want to borrow, they look
for cheap borrowing, i.e. from the market where they have comparative advantage. However,
this may lead to a company borrowing fixed when it wants floating or borrowing floating
when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a
fixed rate loan into a floating rate loan or vice versa.
70
Waseem A. Qureshi MM141063
Examples:
Following are the options for company A and B to borrow from the market.
A
B
Difference
Variable
k + 2%
k + 4%
Fix
12%
16%
( 2%)
4%
Total difference between two is 4% 2% = 2%. Two parties can take only advantage
from swap when there is a difference between two answers. When the net is zero, there is no
advantage of swap. This 2% is the gain which can be divided between two parties involved
according to their agreement.
EXAMPLE 17:
Currently company A is paying a fix rate of 12% and B is on floating rate of K+ 4%,
where K is 11%. They want to exchange their series of cash flows.
Solution:
A
Loan
(12%)
(K+4%)
12%
(12%)
Difference gain(cost)
(K+1%)
K+1%
Net effect
(k+ 1%)
(15%)
When, K is 11%.
12% FIX
A
11%
BANK A
k%
KIBOR + 4%
BANK B
with the cash flows in one direction being in a different currency than those in the opposite
direction. It is also a very crucial uniform pattern in individuals and customers.
Currency swaps have three main uses:
30m in
1 = 1.6
4.5%
3.25%
3%
30 m @ 4.5%
Company
BANK A
48.6 m @3.25%
30m
@ 5%
Bond Holder
b. Calculation of interest:
Interest income
Expense on loan in :
Bond holder interest exp.:
Cost in :
Cost in :
30 m @ 4.5%= 1.35 m
48.6 m @3.25% = 1.5726 m
30 m @ 5% = 1.5 m
1.5 m 1.35m = 0.15 m
1.5795 m
(income) 1.35 m
Company
BANK A
(expense) 1.5726 m
1.5 m
Interest expense
Bond Holder
72
Waseem A. Qureshi MM141063
c. Termination:
Company will repay its loan of 48.6 m to bank and in return bank will pay 30m to
company which is payable to bond holder.
30 m
Company
BANK A
48.6 m
30m
Bond Holder
6%/ 4 = 1.5%
6.8%/ 4 = 1.7%
300 m
300 / .015 = 20,000 m
20,000 / 132 = 151.5 m $
151.5m $@6.8%
20,000 m @ 6%
151.5 m $ @ 6.8%
Company
USA BANK
20,000 m @ 6%
b. Calculation of interest:
Quarterly Interest in $:
Quarterly Interest in :
(Income) 2.5755 m $
Company
USA BANK
(Expense) 300m
300 m
JAPAN BANK
Waseem A. Qureshi MM141063
73
c. Termination:
Company will clear its position by paying 20,000 and receiving 151.1 m $.
151.5 m $
Company
USA BANK
20,000 m
10 m $ or 12.5 m
12.5 m @ 4.5%
12.5 m @ 4.5%
10 m $ @ 5%
10 m $ @ 5.25%
10 m $= 12.5 m
Omega Co
BANK
10 m $ @ 5.25%
KINS
74
Waseem A. Qureshi MM141063
b. Calculation of interest:
Interest on borrowing in $:
Interest on investment in :
Interest on investment in $:
Interest on investment in :
Net position:
10 m $ @ 5% = 0.5 m
12.5 m @4.5% = 0.563 m
10 m $ @ 0.525% = 0.525 m $
12.5 m @4.5% = 0.563 m
0.525 0.5 = 0.025 m $ gain.
0.5 m $ @ 5%
TMAR
BANK
0.563m @ 4.5%
0.563 m @ 4.5%
0.525 m $ @ 5.25%
Omega Co
KINS
c. Termination:
10m $
TMAR
BANK
12.5m
10 m $
10 m $
Omega Co
KINS
3. Equity swaps
A swap where the rate considered is, the rate of return on a stock or stock index. Following are
the main uses of equity swaps.
Example 21:
a. Diversifying a concentrated portfolio.
CWF is a company that wants to hedge its non-diversified stock of 30m $. There
total concentrated portfolio is 80m $, the difference 50m$ is diversified.
JAN-1
100
5000
ZYKT
S&P 500
Difference in return:
Amount of difference:
DEC-31
RETURN
120
20%
5300
16%
20% - 16% = 4%
4% of 30m$ = 1.2 m$
75
CAPS
80 m
Concentrated portfolio = 80m $
Diversified stock = 50m $, non-diversified = 30m$
b. Achieving international diversification.
JAN-1
DEC-31
RETURN
Russle 3000
5000
5500
10%
E&FE index
6000
6700
11%
Difference in return:
10% - 11% = 1%
Amount of difference:
1% of 50m$ = 0.5 m$
This 1% of 50m $ will be paid by A&B to USR-M
A&B
Return
Concentrated portfolio 500m $
LMS
10.2 m
35 $ / share
10.2 x 35 = 357 m $
0.5 x 35 = 17.5 m $
17.5 x 0.80 = 14 m $
17.5 x 0.20 = 3.5 m $
Russle 3000
LGBI
76
Waseem A. Qureshi MM141063
M.S.
SSI
357 m $
SPST
d. Changing asset allocation between stocks and bonds.
A company invests in endowment fund (waqf funds). Endowment is a type of fund for
which only returns are utilized and the original amount remains in the investment for
life time. Principal amount cannot be used. Following info is available:Size of fund:
200 m $
Invests in stocks:
75%
Invests in bonds:
25%
Benchmark for stock:
S&P 500 on large Cap
Benchmark for stock:
S&P 600 on small Cap
Benchmark for Govt. bond:
LLTBI
Benchmark for corporate bond: MLCBI
Description
Size of fund
75% in stock
60% large caps
30% mid caps
10% small caps
25% in Bonds
Govt. Bonds
Corporate Bonds
Current Investments
200 m $
150 m $
90 m
45 m
15 m
50 m $
40 m
10 m
JAN-1
Description
Proposed Investments
Size of fund
200 m $
90% in stock
180 m $
65% large caps 117 m
25% mid caps
45 m
105 Small caps
18 m
25% in Bonds
20 m $
Govt. Bonds
15 m
Corporate Bond 5 m
DEC-31
RETURN
S&P 500
10000
S&P 600
8000
LLTBI
5000
MLCBI
7000
RETURNS: S&P 500
27 x 7% =
S&P 600
3 x 10% =
Total receivable:
LLTBI
25 x 5% =
MLCBI
5 x 6% =
Total payable:
Net Receivable / gain.
10700
8800
5250
7420
1.89 m
0.30 m
Change
-+ 30m$
+ 27 m
--+3 m
-25 m
-5 m
7%
10%
5%
6%
2.19m $
1.25 m
0.30 m
1.55m $
0.64m $
M.S.
SSI
Portfolio 200 m$
been
compared
the buyer pays a premium and, in return, receives a sum of money if one of the events
specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to
profit from the contract and may also cover an asset to which the buyer has no direct exposure.
78
Waseem A. Qureshi MM141063
79
Waseem A. Qureshi MM141063
Requirements Position
Expectation
Premium
profit
Long
Call
He wants to
buy some
particular
asset on a
future date.
Asset Price
will rise in
the future.
Cost/expense.
The
difference
between
market
price and
strike price
minus
premium
paid
Asset Price
will decrease
in the future.
Cost/expense.
Asset Price
will decrease
in the future.
Profit/gain.
Asset Price
will rise in
the future.
Profit/gain.
Bullish
Right to buy
an asset at a
future time at
specific rate.
(Buy a
contract)
Long
Put
He wants to
Sell particular
asset on a
future date.
Bearish
Short
Call
Bearish
Short
Put
Bullish
Right to sell
an asset at a
future time at
specific rate.
(Buy a
contract)
He wants to
earn the profit
when contract
expires
worthless.
Obligated to
He wants to
earn the profit
when contract
expires
worthless.
Obligated to
sell
an asset at a
future time at
specific rate.
buy
an asset at a
future time at
specific rate.
He will pay
the premium
to
counterparty
that is a short
call.
He will pay
the premium
to
counterparty
that is a short
put.
He will
receive the
premium from
the
counterparty
that is a long
call.
He will
receive the
premium from
the
counterparty
that is a long
put.
The
difference
between
market
price and
strike price
minus
premium
paid
The only
profit is
premium
received if
contract
expires
worthless.
The only
profit is
premium
received if
contract
expires
worthless.
Counterparty
(gain for)
Long call
short call
long call
short put
Long put
short put
long put
short call
80
HINT: premium is always paid by long to short, whether the position of long is call or put. It
is an expense for long and gain for short. And the decision always lies with long because he
buys the right.
Strategies for long and short positions:
1. Long call option strategy
The long call option strategy is the most basic option trading strategy whereby the options
trader buys call options with the belief that the price of the underlying security will rise
significantly beyond the strike price before the option expiration date.
However, call options have a limited lifespan. If the underlying stock price does not move
above the strike price before the option expiration date, the call option will expire worthless.
STRATEGIES:
Long calls (right to buy) = when you believe the underlying stock will go up.
Long puts (right to sell) =when you believe the underlying stock will go down.
Short on calls (obligated to sell) = when you believe the underlying stock go down.
Short on puts (obligated to buy) = when you believe the underlying stock go up.
Uses of options:
There are two main uses op options.
1. Hedging
2. Speculation
Following may be some different situations that may occur on the basis of situation a
speculator or hedger expects in the future.
1.
2.
3.
4.
5.
6.
7.
8.
9.
Buy 1 call option at low price and sell one call option at high price. (Bull Spread)
Buy 1 call option at low, 1 call at high and sell 2 call options at middle. (Butterfly)
Buy 1 call option and 1 put option at same exercise price. (V-Shape)
Buy 1 call option and 1 put option when these are out of money. (Strangle)
Buy 2 call option and 1 put option at same exercise price. (Strip)
Buy 1 call option and 2 put option at same exercise price. (Strap)
Buy 1 call option at high price and sell 1 call option at low price. (Bear Spread)
Buy 1 put option at low price and sell 1 put option at high price. (Spread)
Buy 1 put option at high and sell 1 put option at high price. (Bear Spread)
Long Call
(6)
(6)
(6)
4
14
24
34
44
Short Call
4
4
4
4
4
(6)
(16)
(26)
Net position
(2)
(2)
(2)
8
18
18
18
18
83
20
18 --------16
12
8
4
0
70
80
90
100
110
120
130
140
-2
-4
-8
HINT: when ever Market price is lower to exercise price, the option will not be exercised and
the contract will be closed. The only expense or cost is premium which is paid in start or at the
time of contract.
For situation 1, where MPS is 70, exercise price is 90 and premium is 6 for long call, the
option will not be exercised and the buyer will pay 6 to leave the contract. At the same price
the decision for short call will be made by long. Here contract price is 110 and market price is
70, it is unfavorable for long as he can buy at lower price from market and will not exercise
the option. He will leave the contract and only $4 will be loss to him which is a gain for short
position. Result is, 6 loss for long call and 4 gain for short call.
For situation 6, where MPS is 120, exercise price is 90 and premium is 6 for long call, the
option will be exercised and the buyer will receive $30 by selling at 120 which is bought for
90. The cost is $6 for premium, so net gain is 30-6 = 24. At the same price the decision for
short call will be made by long. Here contract price is 110 and market price is 120, it is
favorable for long and he will not exercise the option. He will earn a profit of $10 by selling at
120 and his cost is 4. So net for long is 10-4 = 6, a gain for long is loss for short. Here our
position is short, so 6 is a loss for short.
Net position:
Minimum loss is $2 and maximum gain is $18 for the combination. This combination is called
Bull Spread.
84
Waseem A. Qureshi MM141063
2. Buy 1 call option at low, 1 call option at high and sell 2 call options at middle.
(Butterfly spread)
Exercise price
Call option
90
Long
100
4.5
Short
110
Long
90 at a premium of 6
MPS
70
Long Call-I
(6)
Long Call-II
(4)
Short Call
9
Net position
(1)
80
(6)
(4)
(1)
90
(6)
(4)
(1)
100
(4)
110
14
(4)
(11)
(1)
120
24
(31)
(1)
130
34
16
(51)
(1)
140
44
26
(71)
(1)
9
7
5
3
=Counter party
1
0
70
-1
80
90
100
110
120
130
140
=
Main
party
-3
-5
-7
-9
3. Buy 1 call option and 1 put option at same exercise price. (V-shape)
Exercise price
call option
90
put option
100
4.5
3.5
110
Long Call
Long Put
Net position
70
(6)
17
11
80
(6)
90
(6)
(3)
(9)
100
(3)
110
14
(3)
11
120
24
(3)
21
130
34
(3)
31
140
44
(3)
41
80
90
100
110
120
130
140
-5
-10
-15
86
Waseem A. Qureshi MM141063
4. Buy 1 call option and 1 put option when these are out of money. (Strangle)
Exercise price
call option
90
Put option
100
4.5
3.5
110
Long Call
Long Put
Net position
70
(4)
17
13
80
(4)
90
(4)
(3)
(7)
100
(4)
(3)
(7)
110
(4)
(3)
(7)
120
(3)
130
16
(3)
13
140
26
(3)
23
20
15
10
5
0
70
80
90
100
110
120
130
140
-5
-10
-15
87
Waseem A. Qureshi MM141063
5. Buy 2 call option and 1 put option at same exercise price. (Strip)
Exercise price
call option
90
Put option
100
4.5
3.5
110
Buy 2 Call options and 1 put option at 90 on a premium of 6 (same exercise price).
MPS
Long Call
Long Put
Net position
70
(12)
17
80
(12)
(5)
90
(12)
(3)
(15)
100
(3)
110
28
(3)
25
120
48
(3)
45
130
68
(3)
65
140
88
(3)
85
Here the investor expects an abnormal movement in future, but probability of increase is
double to probability of decrease. Chance of movement on either sides are not equal.
28
20
15
10
5
0
-2
70
80
90
100
110
120
130
140
-5
-10
-15
This is called STRIP.
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Waseem A. Qureshi MM141063
6. Buy 1 call option and 2 put option at same exercise price. (Strap)
Exercise price
call option
90
Put option
100
4.5
3.5
110
Buy 2 Call options and 1 put option at 90 on a premium of 6 (same exercise price).
MPS
Long Call
Long Put
Net position
70
(6)
34
28
80
(6)
14
90
(6)
(6)
(12)
100
(6)
(2)
110
14
(6)
120
24
(6)
18
130
34
(6)
28
140
44
(6)
38
Here the investor expects an abnormal movement in future, but probability of increase is
double to probability of decrease. Chance of movement on either sides are not equal.
28
24
20
15
10
5
0
-2
70
80
90
100
110
120
130
140
-6
-10
-16
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Waseem A. Qureshi MM141063
7. Buy 1 call option at high price and sell 1 call option at low price. (Bear Spread)
Exercise price
call option
50
Put option
60
5.5
70
Long Call
Long Put
Net position
30
(4)
40
(4)
50
(4)
60
(4)
(2)
(6)
70
(4)
(12)
(16)
80
(22)
(16)
90
16
(32)
(16)
70
80
90
100
110
120
130
140
-8
-12
-16
90
Waseem A. Qureshi MM141063
8. Buy 1 put option at low price and sell 1 put option at high price. (Spread)
Exercise price
call option
Put option
50
60
5.5
70
Long Put
Short Put
Net position
30
14
17
40
50
(6)
(3)
60
(6)
(3)
70
(6)
(3)
80
(6)
(7)
(13)
90
(6)
(17)
(23)
30
40
50
60
70
80
90
100
-8
-12
-16
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Waseem A. Qureshi MM141063
9. Buy 1 put option at high and sell 1 put option at low price. (Bear Spread)
Exercise price
call option
Put option
50
60
5.5
70
Buy 1 Call option and 1 put option at 70 on a premium of 3, and sell 1 put option at 70 on a
premium of 3, both at high rates.
MPS
Long Put
Short Put
Net position
30
37
43
40
27
33
50
17
23
60
(4)
70
(3)
(14)
(17)
80
(3)
(24)
(27)
90
(3)
(34)
(37)
30
40
50
60
70
80
90
100
-16
-24
-32
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Waseem A. Qureshi MM141063
Duration:
Duration is the average life of Bond. The life of bond is inversely related with bond
value. Longer the life, lower will be the value of bond and vice versa.
EXAMPLE 22:
An 8% bond is traded in the market. The maturity period is 5 years. Interest is payable on
annual basis. Market yield rate is 10%. What is fair value of bond? What is duration of bond?
What is convexity of bond if interest rate increases to 11%.
YEAR
1
2
3
4
5
a.
CASH FLOWS
80
80
80
80
1080
PVF = 1/ (1+i)n
.909
.826
.751
.683
.621
PV of CF
72.72
66.08
60.08
54.64
670.68
= 924.20
PV of CF * t
72.72
132.16
180.24
218.40
3353.40
= 3956.92
b.
Duration of Bond
CF T/(1+i)n
=
=
b.
or
CF /(1+i)n
3956.92
924.20
(PV of CF t)
(PV of CF )
4.32 years
Convexity of Bond
Change in Bond value due to change in interest rate.
New interest rate is 11%, old is 10%, it is denoted by R
Convexity = -
R
1+
= -4.32 *
.11.10
1+.10
= -.39 , -3.9%
It means every 1% increase in interest rate will decrease a value of bond by 3.9%.
Valuation of Options
Until now, we have looked only at some basic principles of option pricing. Other than put-call
parity, all we examined were rules and conditions, often suggesting limitations, on option
prices. With put-call parity, we found that we could price a put or a call based on the prices of
the combinations of instruments that make up the synthetic version of the instrument. If we
wanted to determine a call price, we had to have a put; if we wanted to determine a put price,
we had to have a call. What we need to be able to do is price a put or a call without the other
instrument. In this section, we introduce a simple means of pricing an option. It may appear
93
Waseem A. Qureshi MM141063
that we oversimplify the situation, but we shall remove the simplifying assumptions gradually,
and eventually reach a more realistic scenario.
Binomial Model
The word "binomial" refers to the fact that there are only two outcomes. In other words, we let
the underlying price move to only one of two possible new prices. As noted, this framework
oversimplifies things, but the model can eventually be extended to encompass all possible
prices. In addition, we refer to the structure of this model as discrete time, which means that
time moves in distinct increments. This is much like looking at a calendar and observing only
the months, weeks, or days. Even at its smallest interval, we know that time moves forward at
a rate faster than one day at a time. It moves in hours, minutes, seconds, and even fractions of
seconds, and fractions of fractions of seconds. When we talk about time moving in the tiniest
increments, we are talking about continuous time. We will see that the discrete time model
can be extended to become a continuous time model.
Two models:
1. Discrete model
Discrete model can be
2. Continuous model.
Continuous model can be a. Black-Schole Model
b. Merton Model
Some basic calculations, signs & formulas and model:
We start with a call option. If the underlying goes up to S+, the call option will be worth c+.
If the underlying goes down to S, the option will be worth C. We know that if the option
is expiring, its value will be the intrinsic value.
S0 = Spot price
S+ =
Su
S = Sd
= S0(1+u)
= S0(1-d)
C+ = Max(0, S+ - X)
Maximum of 0 or S+ - X
C = Max(0, S - X)
Maximum of 0 or S - X
X= exercise price
+ + 1
1+r
1+
ud
+
+
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Waseem A. Qureshi MM141063
(initial outlay)
H+ = nS+ C+
H= nS C
S0
C=?
C+ = Max(0, S+ - X)
S = S0(1-d)
1-
C = Max(0, S - X)
The call price today is C, which is weighted average of the next two possible call prices, C+
and C+. The weights are and 1-. This weighted average is then discounted one period at the
risk free rate.
Example 23: (One period binomial)
Suppose the underlying is a non-dividend-paying stock currently valued at $50. It can either
go up by 25 percent or go down by 20 percent. Thus, u = 1.25 and d = 0.80.
S+ = Su = 50(1.25) = 62.50
S = Sd = 50(0.80) = 40
Assume that the call option has an exercise price of 50 and the risk-free rate is 7 percent.
Thus, the option values one period later will be:
Option values at expiration:
C+ = Max(0, S+ - X) = Max(0, 62.50 - 50) = 12.50
C = Max(0, S - X) = Max(0, 4O - 50) = 0
S+ = 50(1.25) = 62.50
S0 = 50
C=?
S = 50(0.80) = 40
1-
C = Max(0, 4O - 50) = 0
95
Waseem A. Qureshi MM141063
1+
ud
+ + 1
1+r
1+.07.80
1.25.80
= 0.60
ARBITRAGE OPPORTUNITY:
Suppose the option is selling for $8. If the option should be selling for $7.01 and it is selling
for $8, it is overpriced-a clear case of price not equaling value. Investors would exploit this
opportunity by selling the option and buying the underlying. The number of units of the
underlying purchased for each option sold would be the value n:
Calculate no. of underlying to be purchased or sold against one unit of option.
=
12.50
62.540
= 0.556
Thus, for every option sold, we would buy 0.556 units of the underlying. Suppose we sell
1,000 calls and buy 556 units of the underlying. Doing so would require an initial outlay of :H = nS C = 556(50) - 1,000(8) = $19,800.
One period later, the portfolio value will be either
H+ = nS+ C+ = 556(62.5) - 1,000(12.5) = $22,250.
OR
g=
22,250
19,800
1 = 0.1237 = 12.37%
The arbitrage will give 12.37% risk free which is better to risk free of 7%.
Example 24: (One period binomial)
Consider a one-period binomial model in which the underlying is at 65 and can go up 30
percent or down 22 percent. The risk-free rate is 8 percent.
A. Determine the price of a European call option with exercise prices of 70.
B. Assume that the call is selling for 9 in the market. Demonstrate how to execute an arbitrage
transaction and calculate the rate of return. Use 10,000 call options.
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Waseem A. Qureshi MM141063
Solution:
First find underlying prices in the binomial tree. We have u = 1.30 and d = 1 - 0.22 =0.78.
S+ = Su = 65(1.30) = 84.50
S = Sd = 65(0.78) = 50.70
Option values at expiration:
C+ = Max(0, S+ - X) = Max(0, 84.50 - 70) = 14.50
C = Max(0, S - X) = Max(0, 50.70 - 70) = 0
The risk-neutral probability is
=
ud
1+
1+.08.78
1.30.78
= 0.5769
+ + 1
1+r
ARBITRAGE OPPORTUNITY:
Suppose the option is selling for $9. If the option should be selling for $7.75 and it is selling
for $9, it is overpriced-a clear case of price not equaling value. The number of units of the
underlying purchased for each option sold would be the value n:
Calculate no. of underlying to be purchased or sold against one unit of option.
=
14.50
84.550.70
= 0.4290
Thus, for every option sold, we would buy 0.4290 units of the underlying. Suppose we sell
10,000 calls and buy 4290 units of the underlying. Doing so would require an initial outlay of:
n= 10,000 x .4290 = 4290 options
H = nS C = 4290(65) - 10,000(9) = $188,850.
One period later, the portfolio value will be either
H+ = nS+ C+ = 4290(84.5) - 10,000(14.5) = $217,505.
OR
217,505
188,850
1 = 0.1517 = 15.17%
The arbitrage will give 15.17% risk free which is better to risk free of 8%.
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Waseem A. Qureshi MM141063
S+ +
C+ +
S+
C+
S+
C+
S +
C+
S0
C=?
1-
S
C
S
C
S0 =
spot price
S+ =
Su = S0(1+u)
S =
Sd = S0(1-d)
C+ =
Max(0, S+ - X)
Maximum of 0 or S+ - X
C =
Max(0, S - X) Maximum of 0 or S - X
S+ + =
= S0(1+u)2
S+ = S+d = Sud =
S0(1+u) (1-d)
S + = Su = Sdu =
S0(1+u) (1-d)
S = Sd = sdd =
Sd2 = S0(1-d)2
C+ + = Max(0, S+ + - X)
C+ = Max(0, S+ - X)
C = Max(0, S - X)
=
1+
ud
++ + 1 +
1+r
+ + 1
1+r
+ + 1
1+r
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Waseem A. Qureshi MM141063
+ =
=
++ +
++ +
+
+
Su = S0(1+u)
S =
Sd = S0(1-d)
30(1.14) = 34.20
= 30(0.89) = 26.70
Sud =
= 30(0.89) 2= 23.76
30(1.14)(0.89) = 30.44
1+
ud
1- =
1+.030.89
= 0.56
1.140.89
1 - 0.56
0.44
++ + 1 +
+ =
1+r
+ + 1
1+r
0.56(0.44)+ 0.44 0
1.03
+ + 1
1+r
HINT: value of + and used for calculation of C are taken from above formula calculation
Where + = 5.08 and = 0.24
Number of units of underlying for each unit of option.
=
+
+
+ =
=
++ +
5.080.24
34.2026.70
+ =
++ +
+
8.990.44
38.9930.44
0.440
30.4423.76
= 0.6453
= 1.00
= 0.0659
The number of units of the underlying required for 10,000 calls would thus be 6,453 today,
10,000 at time 1 if the underlying is at 34.20, and 659 at time 1 if the underlying is at 26.70.
Putting the values in the tree:
S+ + = 39.98
C+ + = 8.99
S+ = 34.20
= 0.56
C+ = 5.08
S+ = 30.44 or S +
C+ = 0.44 or C+
S + = 30.44
C+ = 0.44
S0 = 30
C = 2.86
1- =0.44
S = 26.70
C = 0.24
S = 23.76
C = 0
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Waseem A. Qureshi MM141063
Black-Schole Model gives a closed-form solution for the price of a European option on a nondividend stock while Merton model provides a solution for the price of a European option on a
stock paying a continuous dividend.
ASSUMPTIONS OF THE MODEL:
1. The underlying price follows a log normal diffusion process.
This assumption is probably the most difficult to understand, but in simple terms, the
underlying price follows a lognormal probability distribution as it evolves through time
Log returns are often called continuously compounded returns. If the log or continuously
compounded return follows the familiar normal or bell-shaped distribution, the return is said to
be log normally distributed.
2. The risk free rate is known and constant.
The Black-Scholes-Merton model does not allow interest rates to be random. Generally, we
assume that the risk-free rate is constant. This assumption becomes a problem for pricing
options on bonds and interest rates, and we will have to make some adjustments then.
3. The volatility of the underlying is known and constant.
The volatility of the underlying asset, specified in the form of the standard deviation of the log
return, is assumed to be known at all times and does not change over the life of the option.
This assumption is the most critical. In reality, the volatility is definitely not known and must
be estimated or obtained from some other source. In addition, volatility is generally not
constant. Obviously, the stock market is more volatile at some times than at others.
Nonetheless, the assumption is critical for this model.
4. There are no taxes and transaction cost.
We have made this assumption all along in pricing all types of derivatives. Taxes and
transaction costs greatly complicate our models and keep us from seeing the essential financial
principles involved in the models. It is possible to relax this assumption, but we shall not do so
here.
5. There no cash flows on the underlying.
There are no any cash flows like dividend on the securities during the period.
6. The options are European.
With only a few very advanced variations, the Black-Scholes-Merton model does not price
American options. Users of the model must keep this in mind, or they may badly misprice
these options.
Black-Scholes-Merton formula:
The input variables are some of those we have already used: So is the price of the underlying,
X is the exercise price, rC is the continuously compounded risk-free rate, (that is ln of r) and T
is the time to expiration. The one other variable we need is the standard deviation of the log
return on the asset. We denote this as and refer to it as the volatility.
HINT: r is always used after calculating natural log of r. that is , rc = ln(1+r)
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Waseem A. Qureshi MM141063
Black-Scholes-Merton formulas for the prices of call and put options are:Call option value,
C= S0 N(d1) Xe
P = Xe-
rT
-rT
N(d2)
1 N(d2) S0 1 N(d1)
P = Xe- S0 + C
1 =
So
2
+ r+
T
x
2
d2 = d1 T
N(d1) = Value of d1 from normal distribution table.
N(d2) = Value of d2 from normal distribution table.
Put-Call Parity.
In financial mathematics, putcall parity defines a relationship between the price of
a European call option and European put option, both with the identical strike price and
expiry, namely that a portfolio of a long call option and a short put option is equivalent to (and
hence has the same value as) a single forward contract at this strike price and expiry.
In simple when we calculate the price of put option through price of call option, it is called
put-call parity.
NORMAL DISTRIBUTION:
102
Waseem A. Qureshi MM141063
103
Waseem A. Qureshi MM141063
S0 = 52.75 = 0.35
Call option value,
C= S0 N(d1) Xe
P = Xe-
rT
-rT
T = 9/12
N(d2)
1 N(d2) S0 1 N(d1)
So
2
+ r+
T
x
2
1 =
d2 = d1 T
52.75
.1225
+ 0.0488+
.75
50
2
.35 (0.87)
0.4489 = 0.45
C= 52.75(.6736) -50 e
C = 35.50 48.20 (.5596) =
P = Xe-
rT
.5596
8.53
1 N(d2) S0 + C
-(.0488)(.75)
P = 50 e
1 0.5596) 52.75+8.53
P = 48.2 52.75 + 8.53 =
3.98
Merton Model:
Merton added the concept of interim cash flows. He said that we can calculate the value
of option even if there are some cash flows involved. E.g. dividends. The only difference
between Black-Schole and Merton is the calculation of So. For Merton model So is denoted as
So/ and is calculated by:So/ = So e
-rT
Example 27:
So = 100 T = 180/365 Dividend rate = 8%
So/ =
So e
-rT
The formula will be same as Black-Schole model. Only change is, we use value
of So/ instead of So.
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Waseem A. Qureshi MM141063
OPTION SENSITIVITIES
Determinants of option price / factors influencing option price.
Following are the five factors or inputs of Black-Schole-Merton Model, that influence the
price of options to change.
1.
2.
3.
4.
5.
Now, we explore, what is the response of option price to these factors that determine the price.
This is called sensitivity of option prices to these factors.
The option price sensitivities all derive from calculus. For example, the sensitivity of
the option price with respect to the stock price is simply the first derivative of the option
pricing formula with respect to the stock price. The first derivative of the call price with
respect to the stock price is just the change in the call price for a change in the stock price.
C / S
These sensitivities are calculated through Greeks.
GREEKS
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price
of derivatives such as options to a change in underlying parameters on which the value of an
instrument or portfolio of financial instruments is dependent. The name is used because the
most common of these sensitivities are denoted by Greek letters (as are some other finance
measures). Collectively these have also been called the risk sensitivities, risk measures
or hedge parameters.
USE OF THE GREEKS
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the
value of a portfolio to a small change in a given underlying parameter, so that component risks
may be treated in isolation, and the portfolio rebalanced accordingly to achieve a desired
exposure; see for example delta hedging.
The Greeks in the BlackScholes model are relatively easy to calculate, a desirable property
of financial models, and are very useful for derivatives traders, especially those who seek to
hedge their portfolios from adverse changes in market conditions. For this reason, those
Greeks which are particularly useful for hedging--such as delta, theta, and vega--are welldefined for measuring changes in Price, Time and Volatility. Although rho is a primary input
into the BlackScholes model, the overall impact on the value of an option corresponding to
changes in the risk-free interest rate is generally insignificant and therefore higher-order
derivatives involving the risk-free interest rate are not common.
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Waseem A. Qureshi MM141063
1. Delta
Change in option premium due to change in spot price is called Delta .
HINT: is used for partial change. It is a sign of partial derivative.
Delta =
C
So
= N (d1)
2. Theta
Change in option premium due to change in time to expiration is called Theta
Theta =
C
T
S0 N(d1)
2 T
- r x e-rT N(d2)
3. Vega
Change in option premium due to change in risk or volatility is called Vega
Vega =
change in risk
= S0T N(d1)
4. Rho
Change in option premium due to change in risk free rate is called Rho
Rho =
= x T e-rT N(d2)
5. Gamma
Change in option premium due to change in Delta is called Gamma
Gamma =
Change in Delta
change in spot price
So
N(d1)
So T
Whereas:N(d1) =
1
2
e-0.5 (d1)
CALL OPTOIN
Increase
Decrease
Increase
Decrease
Increase
PUT OPTION
Decrease
Increase
Decrease
Increase
decrease
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Waseem A. Qureshi MM141063
Example 28:
Suppose spot price for an underlying is 100, exercise price is 100, compounded risk free is
8%, volatility is 30% and time is 180 days. Calculate all the sensitivities.
Solution:
S0 = 100
= 0.30
-(.08)(.5)
0.9608
2 = 0.09
T = 180/365
Xe-
rT
C= S0 N(d1) Xe
P = Xe-
rT
= 100e-(.08)(.5) = 96.08
-rT
N(d2)
1 N(d2) S0 1 N(d1)
So
2
+ r+
T
x
2
1 =
d2 = d1 T
100
.09
+ 0.08+
.493
100
2
.30 (0.70)
= 0.29
0.08
P = Xe- S0 + C
rT
= N (d1)
So
.6141
2. Theta
C
T
S0 N(d1)
2 T
- r x e-rT N(d2)
Whereas:107
Waseem A. Qureshi MM141063
N(d1) =
2(3.142)
-0.5 (0.29)2
1
2.50
- .08(96.08)(.5319)
3. Vega
4. Rho
C
r
5. Gamma
=
So
N(d1)
So T
.3836
100 .30 (.70)
= .018
Changes in values.
Call option is 10.31 and the spot price is 100. Calculate the changes.
1. Change in delta due to change in spot price. (Delta through Gamma) = .6141
New price is 101, old was 100.
New = .6141 + .018 = .6321
New C = 10.31 + . 6141 = 10.92
2. Change in call option premium due to change in expiry. (Theta) = -12.22
It is 37 days from start of period, t=180 = 37/365 = 0.1014
New C = 10.31 + .1014(-12.22) = 9.07
3. Change in call option premium due to change in risk / volatility. (Vega) = 26.85
increase by 1%, from 0.3 to 0.4 ,
New C = 10.31 + .1(26.85) = 12.98
(call premium increases due to increase in risk)
4. Change in call option premium due to change in risk free rate (Rho). = 25.50
Risk free increases by 1%.
New C = 10.31 + .01(25.50) = 10.55
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Waseem A. Qureshi MM141063
R
0.024
0.129
-0.085
0.015
-0.075
-0.03
-0.138
-0.002
-0.036
0.027
-0.009
0.126
S.D.
0.0786
Annualized S.D. 0.2722
2
0.741
r
0.08
ln(1+r)
0.077
So
94.61
X
104.07
T
180/365
T
0.5
T
0.71
Solution:
S0 = 94.61
= 0.27 2 = 0.741
X = So + 10% = 104.07
T = 180/360
-(.077)(.50)
= .9622
-rT
C= S0 N(d1) Xe
P = Xe-
OR
P = Xe- S0 + C
rT
Xe-
rT
= 104.07e-(.077)(.50) = 100.14
N(d2)
1 N(d2) S0 1 N(d1)
rT
1 =
94.61
So
2
+ r+
T
x
2
1 =
d2 = d1 T
1 =
.741
.50
= 0.67
0.48
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Waseem A. Qureshi MM141063
-rT
N(d2)
rT
P = Xe- S0 + C
P = 100.14 94.61 + 2.28 = 7.81
Sensitivity measures:
1. Delta
C
= N (d1)
So
0.7486
2. Theta
S0 N(d1)
2 T
- r xe-rT N(d2)
Whereas:N(d1) =
N(d1) =
1
2
e-0.5 (d1)
1
2(3.142)
-0.5 (0.67)2
1
2.50
(.7153)
1.42
- .077(100.14)(.6844)
3. Vega
=
4. Rho
C
r
5. Gamma
=
So
N(d1)
So T
.2861
94.61 .27 (.71)
= .016
110
Changes in values
Call option is 2.28 and the spot price is 94.61. Calculate the changes.
1. Change in delta when spot price increase by Re.1.
Delta = .7486
New =
a. There is a 5% chance that the firm could lose more than $1000 million in any given
month.
b. There is a 95% chance that in any given month the firm will not suffer a loss of $1000.
Suppose $1000 represents 12% chance of a loss, we say that;
a. There is a 5% chance that the loss will exceed 12%.
b. There is a 95% chance the loss will not exceed 12%.
Methods for computing the VaR.
Calculating VaR is a simple matter but requires assuming that asset returns conform to
a standard normal distribution. Recall that a standard normal distribution is defined by two
parameters, its mean (=0) and standard deviation (=1), and is perfectly symmetric with 50%
of the distribution lying to the right of the mean and 50% lying to the left of the mean. The zscore may be measured at any one of two confidence levels. i.e. 95% or 99%. The z-score at
these two levels are:z-score at 95% confidence level is 1.65
z-score at 99% confidence level is 2.31
There are three methods to measure the VaR.
1. Historical method
2. Monte Carlo Method.
3. Variance, covariance method / parametric method.
1. Historical method
The fundamental assumption of the Historical Simulations methodology is that you base your
results on the past performance of your portfolio and make the assumption that the past is a
good indicator of the near-future. The data should be for last 200 to 500 days.
For example, we take the data for last 240 days. Our confidence level is 95%. We compute it
is as under:
Steps:
a. Pick the data for last 240 days.
b. Arrange the data in descending order.
c. Take 5% of 240, 240 x 5% = 12
d. Now see the 12th value from bottom. (in the return column)
Suppose the 12th value from bottom is -.17. It means that there is a 5% chance that the loss will
be more than 17% in a day.
2. Monte Carlo Method.
Monte Carlo Simulations correspond to an algorithm that generates random numbers that are
used to compute a formula that does not have a closed (analytical) form this means that we
need to proceed to some trial and error in picking up random numbers/events and assess what
the formula yields to approximate the solution. Drawing random numbers over a large number
of times (a few hundred to a few million depending on the problem at stake) will give a good
indication of what the output of the formula should be.
The only difference from historical simulation is to use the random numbers instead of
continuous series of returns.
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Waseem A. Qureshi MM141063
VaR($) = - z (p) =
= -.0122430
Thus, there is a 5% chance that, on a given day, the loss in the value of asset will exceed from
2.31% or $122,430.
Time Conversion of VaR
VaR, as calculated above measures the risk of a loss over a period of one day. We can
calculate it for longer periods such as a week, month, quarter or year. It can be converted
simply by multiplying the daily VaR to the required period.
HINT: (always consider 5 days in a week, 20 days in a month and 240 days in a year)
To calculate multiply the daily value with n
Example 31:
VaR(5%)daily = - z
-1.65(.014) = -.0231
VaR(5%)weekly = VaR(5%)daily n
= -.0231 x 5 =
-.052
VaR(5%)month = VaR(5%)daily n
-.0231 x 20 =
-.10
VaR(5%)quarter = VaR(5%)daily n
-.0231 x 60 =
-.18
113
VaR(5%)year = VaR(5%)daily n
-.0231 x 240 =
-.358
-.10 x 3 =
-.18
VaR(5%)year = VaR(5%)monthly n
-.10 x 3 =
-.358
HINT: in the same way VaR($) can be calculated by simply multiplying the value of VaR%
to asset value.
Assumptions of VaR
1. Stationarity
Stationary assumes that the probability of experiencing a fluctuation is the same in all
periods. It also assumes that mean and variance do not change over the time.
Stationarity can be defined in precise mathematical terms, but here, we mean a flat
looking series, without trend, constant variance over time, a constant autocorrelation
structure over time and no periodic fluctuation.
2. Random walk
It means, a deviation in one period I independent form a deviation in another period.
Price follow a random behavior.
3. Non-negativity
Limited liability asset values are never negative. This assumption is violated by
derivatives such as futures, forwards and swaps, which can have negative value.
4. Time consistency
All assumptions that apply in one period also apply in a multiple-period scenario. The
assumptions for a 1-day period and a 1-week period are same.
5. Normal distribution
One period fluctuation in return is assumed to be normally distributed with a mean of
zero and standard deviation of one.
Continuously Compounded Rates of Returns
Normally, we calculate VaR on daily basis. A risk manager may be interested in
calculating VaR on a multi-period basis by extending the daily VaR using the square root rule.
In doing so, however, it is important that the distributional assumptions of the single-period
VaR are preserved after transforming the measure into a multiple-period VaR. using
continuously compounded rates of return allows the preservation of the single-period
assumptions. We calculate compounded returns by natural log of returns.
Rt = ln(Pt / Pt-1)
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Waseem A. Qureshi MM141063
Thus, it preserves the assumption that VaR is normally distributed no matter what time period
is used. In addition, continuously compounded returns also preserve the assumptions of
Stationarity and time consistency.
Exception: although it is generally preferable to use continuously compounded rates
of return to calculate VaR, there is one exception. For interest rate related variables (i.e. yield
to maturity, credit spread etc), compounded rates are inappropriate since the focus is on the
absolute yield change in basis points. In this situation, VaR must be adjusted to account for
duration and convexity.
Portfolio VaR
Portfolio risk, as measured by standard deviation, decreases as the correlation among assets
within the portfolio decreases. In a similar manner, VaR is affected by the diversification
effect that assets with low correlation bring to the portfolio. For a two-asset portfolio, VaR(%)
is calculated as follows:
VaR(%)portfolio = - z p
VaR($)portfolio = - z p(a,b) =
Whereas: =
11 + 22 + 21 2 12 r1,2
p2 = 11 + 22 + 21 2 12 r1,2
or
Example 32:
A fund manager manages a portfolio of two investments: A and B. Of the portfolios current
value of $6 million, A make up 4 million and B, 2 million. The standard deviation for A is .06
and for B 0.14. Correlation (r1,2) is -0.5. Calculate the VaR for this portfolio.
Solution:
A = 4 m B= 2 m 1 = 0.06 2 = 0.14 1 = 4/6 = 0.67 2 = 2/6 = 0.33 r1,2 = -.5
VaR(%)portfolio = - z p
=
=
and
VaR($)portfolio = - z p(a,b)
11 + 22 + 21 2 12 r1,2
. 67
. 06
VaR(%)portfolio = - z p
.0726
0.43 million
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Waseem A. Qureshi MM141063
VaR = -zi i p
We use the absolute value of the weight because both long and short positions pose risk.
Example:
VaR1 = 2.4, VaR2 = 1.6, what is VaR when r1,2 is 0 ?
Solution:
=
Var + VaR2 =
2.4
+ (1.6)
= 8.32
Var + VaR2
r1,2 =
or
() = W1(Var1) + W2(Var2)
2. Positively correlated
r1,2 = + 1
= W1(Var1) + W2(Var2)
3. Negatively correlated
r1,2 = - 1
= W1 Var1 + W2 Var2
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Waseem A. Qureshi MM141063
VaR for portfolio with more than two assets (n, number of assets)
a. Equally weighted;
=
Whereas
1
N
+ 1
11
21
31
12
22
32
13
23
33
1
2
3
VaR
P
or
Incremental VaR
Incremental VaR is the change in VaR from the addition of a new position in a portfolio. It can
be calculated precisely from a total revaluation of the portfolio.
Component VaR
Component VaR for position I, denoted CVaRi is the amount a portfolio VaR would change
from deleting that position in a portfolio. In a large portfolio with many positions, the
approximation is simply the marginal VaR multiplied by the dollar weight in position.
CVaRi = MVaRi (i x p)
Credit risk
Credit risk refers to the risk that a borrower will default on any type of debt by failing to
make required payments.[1] The risk is primarily that of the lender and includes
lost principal and interest, disruption to cash flows, and increased collection costs. The loss
may be complete or partial and can arise in a number of circumstances. For example:
Bond.
A business or government bond issuer does not make a payment on a coupon or
principal payment when due
Loan.
A consumer may fail to make a payment due on a mortgage loan, credit
card, line of credit, or other loan
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Waseem A. Qureshi MM141063
Firm.
A company is unable to repay asset-secured fixed or floating charge debt
Individual.
A consumer does not pay mortgage loan, credit card, line of credit, or
other loan
i = T. Bill rate
k = Corporate Bond rate
When interest rate increases, risk will also increase. Default risk on T. Bills is normally
very low as they are Government guaranteed.
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Waseem A. Qureshi MM141063
1+
1+k
1 P or
Probability to default =
=1
1+
1+k
=1
1+
1+k
1+.08
1+.11
= 0.027
1d
1 - .027 =
0.973
=1
1+
1+k
1+.08
1+.13
= 0.044
1d
1 - .044 =
0.956
Solution:
Year 1.
=1
Probability to default
1+
1+k
1+.10
1+.14
= 0.035
Probability to pay =
1 - .035 =
0.965
T. Bills
Corporate Bond
1 + 1 =
f1
1 + 1 =
c1
(1+2)2
(1+i)
0.12
1 + 1 =
(1+.11)2
(1+.10)
= 1.12
(1+2)2
(1+k)
0.18
1 + 1 =
(1+.16)2
(1+.14)
= 1.18
=1
1+1
1+c1
1+.12
1+.18
= 0.051
1d
1 - .051 =
0.949
There is 8.4% probability that Bond will default in next two years.
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Waseem A. Qureshi MM141063
Example 35:
Compute the Probabilities of default for the following data (Three periods)
T. Bill rate (1 year)
=
i = 8%
T. Bill rate (2 years)
=
i2 = 7%
T. Bill rate (2 years)
=
i3 = 9%
Coupon rate (1 year)
=
k = 11%
Coupon rate (2 years)
=
k2 = 10%
Coupon rate (2 years)
=
k3 = 12%
Required:
1.
2.
3.
4.
Solution:
Year 1.
=1
Probability to default
1+
1+k
1+.08
1+.11
= 0.027
Probability to pay =
1 - .027 =
0.973
T. Bills
Corporate Bond
1 + 1 =
f1
1 + 1 =
c1
(1+2)2
(1+i)
0.06
6%
(1+2)2
(1+k)
0.09
9%
1 + 1 =
(1+.07)2
(1+.08)
= 1.06
1 + 1 =
(1+.10)2
(1+.11)
= 1.09
=1
1+1
1+c1
1+.06
1+.09
= 0.028
1d
1 - .028 =
0.972
Year 3
We first calculate new rate of interest for year 3. We need an average rate of return for
three years. We denote the T. Bill average interest rate (f2) and corporate Bond rate
(c2).
Calculations for 3 years average rates are.:b. Marginal Probability of default (year 3)
T. Bills
Corporate Bond
1 + 2 =
F2
1 + 2 =
C2
(1+3)3
(1+2)2
0.13
1 + 2 =
(1+.09)3
(1+.07)2
= 1.13
(1+3)3
(1+2)2
0.16
1 + 2 =
(1+.12)3
(1+.10)2
= 1.16
Probability to default
1+2
1+c2
1+13
1+.16
= 0.025
1d
1 - .025 =
0.975
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Waseem A. Qureshi MM141063
Example 36:
Suppose that there are two observed characteristics of the borrower. Fixed cost is 35%
and leverage is 25%. Further suppose that the linear probability model for the probability of
default of borrower A is represented by the equation Z = 0.45(FC) + 0.2(LEV),
The probability of default is Z = 0.45(0.35) + 0.2(0.25) = 20.75%
Z_Score model
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I.
Altman, who was, at the time, an Assistant Professor of Finance at New York University.
The formula may be used to predict the probability that a firm will go
into bankruptcy within two years.
Z-scores are used to predict corporate defaults and an
easy-to-calculate control measure for the financial distress status of companies in academic
studies. The Z-score uses multiple corporate income and balance sheet values to measure
the financial health of a company.
Z Score = 1.2X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5
Whereas:X1 = WC / TA
liquidity
X2 = EBIT / TA
Profitability
X3 = retained earnings / TA
Growth
X4 = MV of equity / BV of debt
leverage
X5 = sales / TA
efficiency
Hint: Z in this context is a measure of ability to pay, but in other applications Z refers to
default probability.
Example 37:
Income statement of A
Sales
50,000
CGS
30,000
G.P.
20,000
Op. exp. 10,000
EBIT
10,000
Int. exp
2,000
Net Profit 8,000
Balance Sheet of A
cash
20,000
Creditors
A/R
25,000
Accruals
investmnts 35,000
L.T. Debt
F.A.
120,000
Ret. Earning
Capital
Assets total 200,000
Net liabs.
30,000
20,000
80,000
20,000
50,000
200,000
123
Solution:
X1 = WC / TA
30,000 / 200,000 =
0.15
X2 = EBIT / TA
20,000 / 200,000 =
0.10
X3 = retained earnings / TA
10,000 / 200,000 =
0.05
X4 = MV of equity / BV of debt
55,000 / 80,000
0.68
X5 = sales / TA
50,000 / 200,000 =
0.25
Under Basel I, the risk weights depend on the categorization of obligors. They do not consider
the actual obligor risk rating or the tenor of the facility and do not recognize any form of
collateral. Therefore, the credit risk capital required as a percentage of exposure will be a
constant 8% across all facility ratings.
Under Basel II, banks are expected to employ the standardized approach to estimate their
economic capital for credit risk. In Basel II, banks are allowed to use their own credit risk
models, which enable them to better segregate risk and include diversification effects of the
bank's portfolio.
Focus of the study
This document focuses on issuer risk and the associated parameter estimation techniques
applicable to retail and wholesale banks. Therefore, the term credit risk used is meant to imply
issuer risk. Issuer risk is applicable to loans, exchange-traded products, and OTC-traded
products.
Credit Capital Calculation Approaches
Regulatory framework prescribed by the BIS is used as the foundation for exploring the
calculation structure of credit regulatory capital and the various parameter estimation
techniques.
The three credit capital calculation approaches suggested by the BIS are discussed
Standardized,
Internal Ratings Based-Foundation
Internal Ratings Based-Advanced.
Components of Credit Risk
The integral components of credit risk, as recognized by the Bank of International Settlements
(BIS), are:
Probability of Default (PD): Probability that the obligor will default within a given time
horizon
Exposure at Default (EAD): Amount outstanding with the obligor at the time of default
Loss given Default (LGD): Percentage loss incurred relative to the EAD
Maturity (M)1: Effective maturity of the exposure
Regulatory Framework
Under Basel II, the credit risk measurement techniques proposed under capital adequacy rules
can be classified under:
Standardized Approach: This approach uses a simplistic categorization of obligors,
without considering their actual credit risks; external credit ratings are used
Internal Ratings-Based (IRB) Approach: In this approach, banks that meet certain
criteria are permitted to use their own estimated risk parameters to calculate
regulatory capital required for credit risk
125
Waseem A. Qureshi MM141063
PD
Regulator
determined
Internal model
Advanced-IRB
Internal model
LGC
Regulator
determined
Regulator
determined
Internal model
M
Regulator
determined
Regulator
determined
Formula
provided
EAD
Regulator
determined
Regulator
determined
Internal model
126
Waseem A. Qureshi MM141063
o The internal model should be able to capture obligor characteristics and should have
sufficient information to estimate the key risk parameters within statistical confidence
levels
o There should be proper corporate governance and internal controls
o The modeling and capital estimation framework should be linked to the day-to-day
operations of the bank
o There should be an appropriate validation and testing process, ensuring the estimation of
the precise PD, LGD, EAD, and capital estimates for credit risk.
The following sections discuss the standardized approach, the IRB approach, and the various
internal models that can be employed to estimate credit risk capital.
1. Standardized Approach
In the standardized approach (Basel II), the risk weights for different exposures are specified
by the Basel committee. To determine the risk weights for the standardized approach, the bank
can take the help of external credit rating agencies that are recognized as eligible by national
supervisors in accordance to the criteria specified by the Basel committee.
Types of claims and their risk-weights
Following are the different types of claims and the risk-weights specified by Basel committee.
Sovereign loan, public sector entities, multilateral development banks, banks, securities
firms, and corporate: These categories have different risk weights, specified according to
their ratings e.g. (A+ rated sovereign claim has a risk weight of 20%). Each of the six
categories has tables mentioning the risk weights to be used for different ratings and other
points that should be taken into consideration while deciding on the risk weights.
Regulatory retail portfolio: Claims falling under this category are given risk weight of 75%.
Residential property: Minimum risk weight of 35% is advised by the Basel committee
Commercial real estate: Risk weight of 100% is advised by the Basel committee
Past due loans: Only the unsecured portion of the loan, which is more than 90 days are
considered and different risk weights are assigned depending on the outstanding amount
Higher risk categories: These claims are given risk weight of 150%
Other assets: These claims are given risk weight of 100%
Off balance sheet items: These are converted into credit exposure equivalents by using
credit conversion factors (CCF).
Securitized transactions: Risk weights are assigned according to their ratings and maturity
OTC transactions: Specified guidelines (mathematical formula) are provided to calculate the
exposure
Classifying the securities into different categories and then determining the risk weights
of the instrument is a critical task. This requires an in-depth understanding of all the products
of the bank, and also the Basel norms specifying guidelines for the classification. Furthermore,
while dealing with OTC derivatives, it is essential to go through the terms and conditions of
these products. Sound knowledge of the business as well as legal aspects of the products is
essential.
Once the risk weights are determined, the capital required could be calculated as:
Capital Requirement = Asset Value x Risk-Weight x 8%
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Waseem A. Qureshi MM141063
Calculation of credit capital requirement under Standardized Approach for Sovereign Loan is
shown below:
Category
AAA to AAA+ to ABBB+ to
BB+ to
Below unrated
BBBBBRisk Weight 0%
20%
50%
100%
150%
100%
Asset Value
$100m
$100m
$100m
$100m
$100m
$100m
RW * AV
$0m
$20m
$50m
$100m
$150m
$100m
Capital
$0m
$1.6m
$4m
$8m
$12m
$8m
Reqrd
Credit Risk Mitigation
Banks are allowed to use credit risk mitigation (CRM) techniques to reduce their capital
requirement. Below are the CRM techniques that banks can use:
Collateralized transactions
On-balance sheet netting
Guarantees and credit derivatives
Maturity mismatch
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Waseem A. Qureshi MM141063
a. The obligor is unlikely to be able to repay its debt without giving up any pledged
collateral
b. The obligor has passed more than 90 days without paying a material credit obligation.
Estimation of PD depends on two broad categories of information:
Macroeconomic unemployment, GDP growth rate, interest rate
Obligor specific financial ratios/growth (corporate), demographic information (retail)
PD categories and modeling techniques
a. Unstressed/stressed PD. If the PD is estimated considering the current macroeconomic
and obligor-specific information, it is known as unstressed PD. Stressed PD is estimated
using current obligor-specific information and stressed macroeconomic factors
(independent of the current state of the economy).
b. Through-the-cycle/point-in-time PD.
Point-in-time PD estimates incorporate
macroeconomic and the obligors own credit quality, whereas through-the-cycle PD
estimates are mainly determined by factors affecting the obligors long-run credit quality
trends.
Any of the following four modeling techniques can be used to estimate PD:
Pooling estimated empirically using historical default data of a large universe of
obligors
Statistical estimated using statistical techniques through macro and obligor-specific
data
Reduced-form estimated from the observable prices of CDSs, bonds, and equity
options
Structural estimated using company level information
i. Pooling Approach
a. Corporate Exposures
Empirical survey takes into consideration all the historical defaults that have occurred in the
past.
Historical PD is calculated by taking the ratio of the bonds that have defaulted to the total
bonds issued in the past, provided the bonds taken into consideration are identical in nature.
Calculation for this method is divided into two categories:
Cohort method
Duration (intensity)-based method
Under the cohort method, the ratio of default bonds to the total bonds are taken without
considering the time taken to default; only the status at the end of period is taken into
consideration.
=
For example: Total number of bonds is 5,000,000 and bond defaulted during period are
600,000
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Waseem A. Qureshi MM141063
600,000
5,000,000
= .12 =
12%
However, under the duration-based method, the time taken by the bond to default is also
included in the calculation. Therefore, in the duration-based method, the numerator is the
proportion of bond years defaulted and the denominator is the total number of bond years.
1
1
For example: Total number of bonds is 1,000,000 and bond defaulted during year 1 are 20,000
=
1
1
20,000
1,000,000
= .02 =
2%
If the output of the regression is PD< T1 then loan is considered to be of good quality
If the output is PD> T2 then the loan is most likely to default
If the output of the regression Yi is between T1 and T2, then there are less chances of
default and needs more evaluation
Some of the common variable sources used to estimate the PD of a corporate are financial
statements, owners data, type of loan, size of loan, and industry of the company.
Similarly, for retail obligors, variable sources could be customer demographics, income
statistics, age of loan, and the number of late payments.
Calculations:
First calculate Z value and then PD.
Z = 1X1 + 2X2 + 3X3 + nXn
e
1+ e
e
1+ e
e 1.5
1+ e 1.5
4.48
5.48
= 0.83
where,
N = Cumulative standard normal distribution (Value in table)
At = Value of the firm/assets at time t
L = loan / debt of the firm
V = mean value of assets
V= standard deviation of log of assets return
Example 38:
At = 100m
V = .10
Loan = 60m
V = 0.30
a. what is PD?
PD =
PD =
ln
At
2
+( V )(Tt)
L
2
(Tt)
.5102+ .0225
PD = 1-0.9948
.21
PD =
N (-2.56) =
= .0052 = .52%
ln
100
.09
+(.10 )(0.5)
60
2
.30(.50)
Probability of default.
40
PD = 1 DD
2
ln
V
Defalut Threshold
Whereas:
DD = Distance to default
Ln V = log for value of assets
Default threshold = weighted average loan
E(RoA) = expected rate of return
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Waseem A. Qureshi MM141063
Example 39:
Loan
2,000
3,000
5,000
A
B
Total
=
Time
2 years
5 years
19,000
CF * T
4,000
15,000
19,00
5,000
Threshold value =w1*CF + w2*CF = .5 * 2000 + .5 * 3000 =2500 (assume equal weights)
Asset value = 6,000
ln
m = 3.8
V
Defalut Threshold
Th = 2500
ln
= .30
ROA = .04
6000
.09
+ .04
3.8
2500
2
.303.8
R = .08
= 1 1 P + P
1 - .3P = 0.887/0.923
1 - .3P = .962
.3P = 1 - .962
.3P = .038
1. Market LGD
Market LGD is a historical-data-based method. In this technique, the observable default price
of the bonds and loans that trade in the market after the firm has defaulted are used as the
proxy for LGD.
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Waseem A. Qureshi MM141063
The actual prices of the bonds are based on par and thus can be easily converted into LGD as:
{100% of par value - default price}.
This technique reflects the investors expectations about the recovery (i.e. 100% - LGD)
through market prices of defaulted bonds and marketable loans.
2. Workout LGD
Workout LGD calculates the LGD based on the actual cash flows that can be recovered from
the firm by the workout process, once the firm has defaulted.
The Workout LGD methodology involves prediction of the future cash flows that can be
recovered from the company, after the company has defaulted on its payments.
The forecasted cash flows are discounted using an appropriate discount rate for the defaulted
firm. These discounted cash flows are added to provide the expected recovery amount. The
total exposure of the firm at the time of default minus the expected recovery amount gives the
loss given default in absolute terms. The ratio of loss given default in absolute value to
exposure at default gives the LGD in percentage terms.
Computation of workout LGD can be shown as below:
R ) + (
= t
Ct )
Whereas:
= Exposure at default at time t
= = T is end time of recovery and t=m is start time of recovery
Rt
Ct
Example 41:
A recovery for loan starts on June 8, 2013. Amount is 100m. recovery during year 1 is
30m and in year 2 is 40m, cost for respective years is 2m and 3m. opportunity cost of capital is
10%. Calculate workout LGD.
R ) + (
= t
Ct )
30
1.10
2
1.10
+
+
40
(1.10)2
3
(1.10)2
100 60.3+4.28
100
1.8 + 2.48
=
= 4.28
.439 or 43.90%
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Waseem A. Qureshi MM141063
3. Implied LGD
Implied market LGD calculated LGD from market-observable information i.e. market prices.
The assumption in these models is that the market prices incorporate all the risk parameters.
So, by using these prices, the risk parameters such as PD and LGD can be extracted. The
advantage of implied market LGD is that it is forward looking, as the prices incorporate the
future expectation.
Implied LGD can be calculated by the following two methods:
Structural-form model
Reduced-form model
structural model is based on the framework developed by Merton. It uses the option pricing
theory developed by Black and Scholes. Here the term structural is used as these models use
the structural characteristics of the company, such as assets and their volatility, and leverage of
the company.
The basic idea behind these models is that the company will default if the company's assets
value fall below its debt at maturity.
So the company's default risk is driven by the assets value and its volatility, which need to be
estimated.
The value of LGD is calculated as 1 Recover rate (RR). Recovery rate is the estimated value
of assets in case of default i.e. the value of assets if it is less than the value of debt at maturity.
Using the Black Scholes option pricing theory, recovery rate is given by:
Implied LGD = 1 RR
where,
=
d1 =
A0 N(d1)
V (
)
D
N(d2)
ln
A
2
+( V + )T
D
2
d2 = d1 - T
RR = Recovery Rate
N = Cumulative standard normal distribution
A0 = Value of the firm at time t
D = Strike of the option which is the debt of the firm
V = expected growth rate of assets
= standard deviation of log of assets return
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Waseem A. Qureshi MM141063
Example 42:
A0 = 100m D = 70m
= 0.30 T = 6 months
what is RR?
A0 N(d1)
V (
)
D
N(d2)
d1 =
V= 0.05
ln
A
2
+( V + )T
D
2
d2 = d1- T =
d1 =
1.90 - .3(.5)
ln
100
.09
+ .05+
.50
70
2
.30.5
N(-d1) = .0287
N(-d2) = .0401
100
70
.05.5 (
.0287
.0401
) =
1%
4. Statistical LGD
Loss given default can be estimated with the help of statistical techniques using historical data.
The LGD will be the dependent variable and other factors that can change the value of LGD
form the independent variables. LGD of the past facilities for the retail exposure or the default
price for corporate exposure is used as a proxy for LGD.
The independent variables consist of factors such as issuer's rating, rating of the facility,
seniority of the facility, maturity, interest rates, labour market data, and business indicators
such as gross domestic product, consumer price index, and inflation data
Here, is a linear equation formed by the linear combination of independent variables and is
given by the following equation:
Xt= b0+b1Y1+..+bnYn
Xt=ln(LGD/1-LGD)
or it can be written as
Z = 1X1 + 2X2 + 3X3 + nXn
e
1+ e
Following are the points to be kept in mind while implementing this model:
Only the statistically significant variables should be considered in the final model
Variables should have economic meaning in explaining the variation of LGD
Independent variables should be able to explain the LGD significantly
Data should be properly processed. For instance, removal of outliers to get the correct
relationship
137
EAD for the fixed exposures will equal to the current amount outstanding on the balance sheet
and as a result no modeling is required for Basel ll requirements.
Variable exposure: Exposures in which the bank provides future commitments, in
addition to the current credit. Therefore, the exposure will contain both on- and offbalance sheet values. The value of exposure is given by the following formula:
EAD = Drawn Credit Line + Credit Conversion Factor * Undrawn Credit Line
where,
Drawn Credit Line = Current outstanding amount
Credit Conversion Factor = Expected future drawdown as a proportion of undrawn amount
Undrawn Credit Line = Difference between the total amount which the bank has committed
and the drawn credit line
As the future draw downs are not known, to estimate EAD we need to model for the CCF
factor of each exposure.
Credit Conversion Factor (CCF) Modeling
The CCF is the ratio of the estimated extra drawn amount during 12 months before default
over the undrawn amount at the time of estimation. It can be defined as the percentage of
undrawn credit lines (UCL) which has not been paid out, but can be utilized by the borrower
until the point of default. The CCF should lie between 0 and 1.
=
The CCF is calculated for the default exposures which are used to estimate the CCF for the
non-default exposures.
The following steps are employed to estimate the CCF of non-default exposures:
Exposures which had defaulted in the past are divided into pool on the basis of Exposure at
default risk drivers(EADRD) attributes of the exposure viz. factors affecting borrowers
demand for funding/facilities, nature of particular facility
Each individual default-exposures CCF is estimated within the pools
The average CCF for each pool is calculated the CCF of the pool is defined as the
weighted average of the CCF which were estimated for the defaulted individual exposures
If the volatility of CCFs is low and lies around the average, it is advisable to use the
average CCF; if the CCF values are volatile then it should represent the economic
downturn conditions appropriately
The average CCFs of default-exposure pools is used to estimate the CCFs for the nondefault exposures using lookup tables
The CCF obtained is checked whether it is appropriate for the current macroeconomic
scenario and then used to calculate the EAD
CCF Estimation for Defaulted Exposures
Estimation of the CCF for defaulted exposures is primarily done by two methods:
Fixed-horizon method
Cohort method
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Waseem A. Qureshi MM141063
In both the methods, the observation time period is fixed (as fixed by the regulators) and is
usually one year.
Fixed horizon method
This methodology assumes that all the exposures that are in non-default state will default at
the same time over the time horizon chosen for the estimation. The CCF is calculated with
respect to the time horizon that is always fixed.
The CCF is the ratio of the increase in the exposure until the default day to the maximum
possible increase in exposure. These values are calculated with respect to the fixed time
horizon. Therefore, the numerator indicates how much the exposure of the bank increased
from the exposure at the fixed interval prior to default and the denominator indicates the
maximum increase in the exposure that could have happened during the fixed interval.
Here the amount that will be drawn at the maturity is related to the drawn/undrawn amount at
a fixed time prior to default. The CCF is given by the formula:
_
_
Where,
-EAD: Exposure at the time default occurred
-On_balance (fixed horizon): Exposure of the bank at fixed time horizon (one year) prior to
default
-Limit (fixed horizon): Maximum exposure that the bank can have with the counterparty at
the
fixed horizon
Cohort method
The observed time horizon is divided into different short time windows (default can occur at
any time in the time window). Therefore, the time horizon with respect to which the CCF is
calculated is not fixed.
The CCF is the ratio of the increase in the exposure until the default day to the maximum
possible exposure. These values are calculated with respect to the start of the time window.
The numerator indicates how much the exposure of the bank increased from the exposure at
the start of time window prior to default. The denominator indicates the maximum increase in
the exposure that could have happened during the time window. As the default can occur at
any time within the time window, the time interval between the start of window and the
default is not fixed.
Here the amount that will be drawn at maturity is related to the drawn/undrawn amount at the
beginning of the different time horizons. The CCF is given by the formula:
_
_
where,
-EAD: Exposure at the time default occurred
-On_balance (start of window): Exposure of the bank at the start window period prior to
default
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Waseem A. Qureshi MM141063
-Limit (start of window): Maximum exposure that the bank can have with the counterparty at
the
start of the time window
In the event of the CCF being negative or greater than 1, appropriate adjustment is made to
make it applicable for calculation of EAD.
CCF Estimation for Non-Defaulted Exposures
The CCF for non-default exposure is calculated using the CCFs from the defaulted exposures.
The current non-default EADRD pools are compared with the EADRD pools of the defaulted
exposure whose CCFs have been calculated. The lookup table method is employed to
achieve this. Apart from the approach discussed above, regression analysis can be used to
estimate the non-default exposure CCFs. Once the CCFs for default exposures are calculated,
the EADRDs can be grouped as independent variables and the CCFs calculated as dependent
variable. A regression model for the universe of exposure data can be developed or regression
models for each pool can also be calibrated. On entering the non-default exposure EADRD
data, the corresponding CCF is estimated.
2. Current Exposure Method
The Current Exposure Method comprises of two components: Current Exposure (CE) and
Potential Future Exposure (PFE). The formula for EAD under this method is given by the
formula:
Equation 1: EAD = CE + PFE
where,
Current Exposure is the current market value of the contract or the replacement costs
for a party if counterparty defaults today. It equals the market value if it is positive and zero if
the market value is negative. Therefore, CE = max {market value; 0}
Potential Future Exposure is the maximum amount of exposure expected to occur on a
future date with a high degree of statistical confidence.
The PFE is calculated by multiplying the notional values of the contracts with a fixed
percentage which is the Credit Conversion Factor (CCF) as shown below:
Remaining
Interest rates
FX & gold
Equities
< 1year
1-5 years
>5 years
0.0%
0.5%
1.5%
1.05
5.0%
7.5%
6.0%
8.0%
10.0%
Precious
metal
7.0%
7.0%
8.0%
Other comdty
10.0%
12.0%
15.0%
3. Standardized Method
This method is employed by banks which are not capable of computing their OTC derivative
exposures using the internal model method (discussed in the following section). However, this
method is more risk sensitive than the Current Exposure Method. The Standardized method is
used only for OTC derivatives.
Exposure at Default using the standardized method is calculated according to the following
formula:
EAD = * max [Current Exposure; k(NPRk * CCFk)]
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Waseem A. Qureshi MM141063
where,
Current Exposure is the mark-to-market value after netting and collateral reduction
NRPs are the absolute value of the net risk positions in the hedging sets
CCFs are the credit conversion factors applied for the k hedging sets
k is the index that designates hedging sets
represents extra reserve for potential downturns in the economy and also captures
model risk; its value is fixed by regulators at 1.4
The CCF values for the standardized method are provided in the following table:
Asset Class
Interest rate
derivatives
Credit derivatives
Debt instruments
CCF
0.2%
Exchange rate
Electricity
2.5%
4%
0.3%
0.6%
Asset Class
Gold
Equity
Precious metal w/o
gold
Other commodities
Other derivatives
CCF
5%
7%
8.5%
10%
10%
Operational Risk
Operational risk refers to as the risk of losses resulting from inadequate or failed
internal processes, people and systems or from external events.
Although designed for financial institutions, this definition should be applicable for any
industry, institution or individual. The banking and insurance industries are addressing
operational risk under Basel II and solvency II accords.
The Basel and solvency approach to operational risk breaks it into seven major
categories, 18 secondary categories and 64 subcategories. The great majority is not unique
to financial services and can provide a good framework for addressing operational risk in
any industry.
1. Internal frauds
a. Unauthorized activities
i. Transactions not reported (informational)
ii. Transaction type unauthorized (with monetary loss)
iii. Mismarking of position (international)
b. Theft and Fraud
i. Fraud / credit fraud / worthless deposits
ii. Theft / extortion / embezzlement / robbery
iii. Misappropriation of assets
iv. Forgery
v. Check kiting
vi. Smuggling
vii. Account takeover / impersonation etc.
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Waseem A. Qureshi MM141063
c. Product Flaws
i. Product defects
ii. Model errors (poor design)
d. Selection, sponsorship and exposure
i. Failure to investigate client per guidelines
ii. Exceeding client exposure limits
e. Advisory activities
i. Disputes over performance of advisory activities.
5. Damage to physical assets
a. Disaster and other events
i. Natural disaster losses
ii. Human losses from external sources
6. Business Disruptions and Systems Failure
a. Systems
i. Hardware
ii. Software and middleware
iii. Telecommunications
iv. Utility outage / disruptions
7. Execution Delivery and process management
a. Transaction capture, Execution and Maintenance
i. Miscommunication
ii. Data entry, maintenance or loading error
iii. Missed deadline or responsibility
iv. Model / system disoperation
v. Accounting error / entity attribution error
b. Monitoring and Reporting
i. Failed mandatory reporting obligation
ii. Inaccurate external report
c. Customer instate and documentation
i. Client permission / disclaimer missing
d. Customer / client Account Management
i. Unapproved access given to accounts
ii. Incorrect client record (loss incurred)
iii. Negligent loss or damage of client assets
e. Trade counterparties
i. Non client counterparty performance
ii. Miscellaneous non client counterparty disputes
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Waseem A. Qureshi MM141063
Sovereign Risk
The risk that a government could default on its debt (sovereign debt) or other obligations.
Also, the risk generally associated with investing in a particular country, or providing funds to
its government. It is also called country risk.
Economic factors
1.
2.
3.
4.
5.
Debt rescheduling
Following choice are available for rescheduling.
1. Multiyear restructuring
It involves revisiting the terms and conditions of loan. Revisiting may involve increase
in rates or some debt concessions.
Example 43:
Consider a loan of 300 million for a period of 3 years. The borrower agrees to pay 8%
interest on loan. Cost of fund for lender is 7%. It is agreed to repay 100 million principal every
year plus interest.
The borrower is unable to pay back the loan and lender agrees to restructure the loan.
He agrees to increase the maturity period up to 5 years and allowing a grace period of 1 year.
New loan interest rate will be 8% and borrower will pay 1% upfront restricting fee. Loan is
payable in equal installments and will cost 10% to the lender. Calculate the cash flows in both
conditions.
Solution:
Existing conditions:
Maturity period:
Interest rate:
Loan payable:
Cost to lender:
3 years
8%
100 million per year + interest
7%
146
0
1
0
100
0
24
124
1
.935
116
116 + 101 + 89 =
Principal
Interest 8%
Cash flows
P V F 1/(1.07)n
PV of CF
Net cash flows
=
2
100
16
116
.873
101
306 million
3
100
8
108
.826
89
Principal
Interest 8%
Upfront fee
Cash flows
P V F 1/(1.10)n
PV of CF
Net cash flows
5 years
1 year
8%
3 million
equal installments
10%
0
3
3
1
3
=
1
2
3
4
75
75
75
24
24
18
12
24
99
93
87
.909
.826
.751
.683
22
82
70
59
3 + 22 + 82 + 70 + 59 + 50 = 286 million
5
75
6
81
.621
50
Borrower will pay 286 million under new restructured conditions, which is less than 306
million. It means borrower is granted a concession.
2. Debt for development SWAP
Financing part of a development project through the exchange of a foreign-currencydenominated debt for local currency, typically at a substantial discount. The process
normally involves a foreign nongovernmental organization (NGO) that purchases the
debt from the original creditor at a substantial discount using its own foreign currency
resources, and then resells it to the debtor country government for the local currency
equivalent (resulting in a further discount). The NGO in turn spends the money on a
development project, previously agreed upon with the debtor country government.
3. Debt for debt SWAP
Replacement of new loan for an old loan is called debt for debt swap. The country may
take some new loans to repay the old loan and hence no actual cash transactions take
place. Brady bonds are a good example of debt for debt swaps. Under this the state
issues the bonds to repay the loan.
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Waseem A. Qureshi MM141063
Country Ratings:
International Country Risk Guide Methodology
The International Country Risk Guide (ICRG) rating comprises 22 variables in three
subcategories of risk: political, financial and economic. A separate index is created for each of
the subcategories. The political risk index is based on 100 points, financial risk on 50 points
and economic risk on 50 points. The total points from three indices are divided by two to
produce the weights for inclusion in the composite country risk score. The composite scores,
ranging from zero to 100, are then broken into categories from very low risk (80 to 100) to
very high risk (0 to 49.90) points.
1. Political risk components:
1. Government stability
2. Socioeconomic conditions
3. Investment profile
4. Internal conflict
5. External conflict
6. Corruption
7. Military in politics
8. Religious tensions
9. Law and order
10. Ethnic tensions
11. Democratic accountability
12. Bureaucracy quality
Total
(100 points)
12
12
12
12
12
6
6
6
6
6
6
4
100
(50 points)
5
10
10
10
15
50
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Waseem A. Qureshi MM141063
(50 points)
10
10
15
5
10
50
* BEST OF LUCK *
149
Waseem A. Qureshi MM141063