Options and Futures GMSF – FIN 524A – Summer 2016 Prof. Thomas Maurer
Washington University in St. Louis
OLIN BUSINESS SCHOOL
“Creating knowledge…Inspiring individuals…Transforming business.”
Class Time: 
July 12, 14, 16, 19, 21 
9.00am – 1pm 
Location: 
Bauer Hall 150 

Credit Hours: 
1.5 Units 
Course office hours: 
July 13, 15, 18, 20: 6.30pm7.30pm; July 12, 14, 16, 19, 21, 22: 3pm6pm 
Office Location: 
Simon Hall 210 
Office Phone: 
314 935 3318 
Email: 
thomas.maurer@wustl.edu 
Summer 2016
COURSE DESCRIPTION
_{2}
A 
derivative contract is a financial instrument whose value depends on or derives from the value 
of 
an underlying asset or variable. Derivatives are used to manage and hedge risks (similar to an 
insurance contract), engineer or structure payoff schedules, exploit arbitrage opportunities
(realize riskfree profits), or speculate (apply leverage to a risky position).
Commodity derivatives have been traded overthecounter for many centuries. However, financial derivatives written on currencies, interest rates and stocks were not traded until the 1970s. In the 1970s Fischer Black, Myron Scholes and Robert Merton developed arguably the most famous pricing formula in finance which allows traders to determine the fair price of a derivative contract. Over the past few decades, derivatives markets have experienced an enormous growth measured in trading volume and in the amount of financial innovations. However, despite the importance of derivative contracts in economics, derivatives were often subject to serious criticism in the public press and politics due to severe events of fraud, moral hazard, excessive risk taking and speculation. Accordingly, there is a large interest to regulate derivatives trading and proprietary trading activities.
The objective of this course is to obtain a profound understanding of the mechanics of derivative contracts and their applications in finance. We discuss specifications of different kinds of derivative contracts (forwards, futures, swaps, options, etc) written on various underlyings, their use to manage and eliminate risks, the fundamental concept of pricing contingent claims based on the notion of noarbitrage and payoff replication, and various approaches to implement the ‘noarbitrage’ valuation concept (binomial trees, BlackScholes formula, Monte Carlo simulations).
COURSE PREREQUISITES
Basic mathematical skills for economists are assumed (level of Blume, Lawrence and Carl P. Simon, Mathematics for Economists, Norton & Co, 1994.)
READING 

Required: 
1. Lecture Notes. 2. Hull, John C. Options, Futures, and Derivatives, PrenticeHall, 9th Edition, 2014. 
Summer 2016
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HOMEWORK ASSIGNMENTS
There are several homework assignments. I do not grade the assignments, but we will discuss some of the problem sets in class and I expect you to actively participate the discussions. I encourage you to solve the problem sets first on your own and then discuss your work in small groups. Spending enough time and thinking on your own about a problem is key to get an in depth understanding of the concepts!
TAKEHOME EXAM
There is one takehome exam. The takehome exam is due on Saturday July 23th 6pm (Submission by email.) Late submissions will not be considered and your takehome exam will be marked with zero. You are allowed to work in small groups (4 or less students).
EXAM
There is one final exam on Saturday July 23th from 10am – 12pm in Bauer Hall 150. The final exam covers the material of the entire course.
The exam time is fixed. If you have a (foreseeable) conflict with this schedule, you must inform me by the end of the second class!
Important Exam Policy:
(1) Calculators with logarithm and exponential functions are allowed and necessary – computers, tablets, cell phones or programmable calculators are not permitted. You also must describe in detail the exact solution path showing how you get to the solution you provide. Providing the exact formulas needed to derive a result is key to get credit – a (correct) solution without any derivations will be marked as zero. (2) The exam is closed book (and notes) except for 1 “cheatsheet” (not to exceed A4 size or 11in x 8.5in, printed front and back).
CLASS PARTICIPATION
You are supposed to attend all classes. Thorough preparation (reading the relevant chapters in the textbook and the lecture notes) and active participation in class are key to stay on top of the material and to succeed. I do not grade class participation.
Summer 2016
GRADING
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Takehome exam 
40% 
Final Exam 
60% 
TOTAL 
100% 
COURSE SCHEDULE [Summer Term]
# DATE 
TOPICS 
READINGS 
HAND IN 

1 Tue, 7.12.2016 
Introduction, Interest Rates 
Chapter 1, 4 

2 Thu, 7.14.2016 
Forward Contracts 
Chapter 2, 3, 5 

3 Sat, 7.16.2016 
Futures Contracts 
Chapter 2, 3, 5 

4 Tue, 7.19.2016 
Options, Option Pricing in Discrete Time 
Chapter 10, 11, 12, 

13 

5 Thu, 7.21.2016 
Option Pricing in Discrete Time, Continuous Time Limit: BlackScholes 
Chapter 13 

6 Sat, 7.23.2016 
Final Exam 

7 Before Sun, 7.23.2016, 6pm 
Takehome exam 
* The schedule may change.
Summer 2016
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ACADEMIC INTEGRITY AND CLASSROOM ETIQUETTE
I take the matters of academic integrity seriously and expect that you do, too. Please refer to “The Olin Honor Code” for specific responsibilities, guidelines and procedures regarding academic integrity.
I expect all of you as Olin students to conduct yourselves professionally. This includes, but is not limited to:
• Punctuality: Students are expected to arrive and be seated prior to the start of each class session. They should display their name cards in all classes at all times.
• Behavior: Classroom interaction will be conducted in a spirited manner but always while displaying professional courtesy and personal respect.
• Preparation: Students are expected to complete the readings, case preparations and other assignments prior to each class session and be prepared to actively participate in class discussion.
• Distractions:
! Exiting and Entering: Students are expected to remain in the classroom for the duration of the class session unless an urgent need arises or prior arrangements have been made with the professor.
! Laptop, PDA, Tablet and Other Electronic Device Usage: Students are expected to not use laptops, PDAs, tablets, and other electronic devices in classrooms unless with the instructors consent and for activities directly related to the class session. Accessing email or the Internet during class is not permitted as they can be distracting for peers and faculty.
! Cellular Phone and Pager Usage: Students are expected to keep their mobile phones
and pagers turned off or have them set on silent/vibrate during class. Answering phones or pagers while class is in session is not permitted.
! Other distractions: Those identified by individual instructors, such as eating in the classroom.
DISABILITIES
Reasonable accommodations will be made for students with verifiable disabilities. Students who qualify for accommodations must register through Washington University’s Center for Advanced Learning Disability Resources (DR) in Cornerstone. Their staff members will assist me in arranging appropriate accommodations.
FIN 524A: Options and Futures
Thomas Andreas Maurer
Olin Business School, Washington University in St Louis
July 2016
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Chapter 0: Course Details
Content
Content I
Chapter 1: Introduction Chapter 2: Interest Rates Chapter 3: Forward Contracts Chapter 4: Futures Contracts Chapter 5: Options Chapter 6: Option Pricing in Discrete Time Chapter 7: Continuous Time Limit: BlackScholes
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Chapter 0: Course Details
Objectives
Objectives
Introduction to derivative markets
Indepth discussion of most common derivative contracts (forwards, futures, swaps and options) written on various underlyings (stocks, currencies, interest rates, commodities, etc)
SpeciÖcation of contracts and organization of markets Use of derivatives to manage risk Pricing of derivative contracts (concept of "payo§ replication" and "no arbitrage") Practical implementation of pricing concepts (Binomial trees, BlackScholes formula)
= > Balance between theoretical concepts in asset pricing, computations and real world applications
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Chapter 0: Course Details
Readings
Readings
Lecture notes
John C. Hull, Options, Futures, and other Derivatives , 9th Edition
Standard text on derivatives Popular among academics, students, and practitioners Useful reference
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Chapter 0: Course Details
Lectures
Lectures
Lectures: July 12, 14, 16, 19, 21; 9am until about 1pm; Bauer Hall
150
O¢ce hours (Simon Hall 210):
July 11, 13, 15, 18, 20: 6.30pm7.30pm July 12, 14, 16, 19, 21, 22: 3pm6pm
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Chapter 0: Course Details
Assessment
Assessment
Requirement
Weight
Schedule
TakeHome Exam 
40% 
before July 23, 6pm 
Final Exam 
60% 
July 23, 10amnoon 
Takehome Exam has to be sent to me by email anytime before 6pm on July 23 2 hour Exam takes place on the 22th of July, 10amnoon in Bauer Hall 150 Exam policies:
Closed book (and notes) except for 1 page "cheatsheet" (front and back) Calculator (no cell phones or laptops) allowed and necessary  BUT, you also have to show how to derive and calculate your results in detail
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Chapter 0: Course Details
Expectations
My Expectations of You
Prerequisites Class attendance Preparation for class Participation in class Homework If you have questions, please ask me
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Chapter 0: Course Details
Expectations
What You get from Me
Lecture notes I will answer your questions:
In class O¢ce hours Email: thomas.maurer@wustl.edu
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Chapter 1: Introduction
Chapter 1: Introduction
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Chapter 1: Introduction
Basics of Derivatives
What is a Derivative?
DeÖnition A derivative is a Önancial instrument whose value depends on or derives from the value of an underlying asset or variable.
Limited time to maturity
Payo§ at maturity is a function of the underlying variable
Current value depends on:
Characteristics of underlying variable  current level, volatility, etc Time to maturity Risk free interest rate Other special characteristics of derivative contract
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Chapter 1: Introduction
Basics of Derivatives
Examples of Derivatives
Examples of derivatives: futures, forwards, swaps, options, warrants, structured products, etc
The underlying variables can be almost anything:
Stocks, interest rates, foreign exchange rates Commodities  grains, oilseeds, livestock, meat, food, Öber, metals Credit risks, energy (electricity), weather, insurance payouts Even derivatives such as futures and swaps
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Chapter 1: Introduction
Basics of Derivatives
Examples of Derivative Payo§s: Forward (I)
A forward contract is an agreement to trade the underlying asset in future (at maturity T ) for a Öxed price speciÖed today (forward price
F
( T )
t
at current time t )
Party that agrees to buy the underlying (long position) makes a proÖt if at maturity T the price of the underlying ( S _{T} ) is higher than the
prespeciÖed forward price ( F
S _{T} < F
( T )
t
), and makes a loss if at maturity
( T )
= S _{T} ! F
t
( T )
t
_{(} long forward _{)}
T
ñ > Payo§
Party that agrees to sell the underlying (short position) makes a proÖt if at maturity T the price of the underlying ( S _{T} ) is lower than the
prespeciÖed forward price ( F
S _{T} > F
( T )
t
), and makes a loss if at maturity
( T )
= F
t
! S _{T}
( T )
t
_{(} short forward _{)}
T
ñ > Payo§
Typically, no money is exchanged between long and short position at time t
Futures contracts are similar (more details later)
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Chapter 1: Introduction
Basics of Derivatives
Examples of Derivative Payo§s: Forward (II)
On the 4th of June, the treasurer of a corporation enters into a long forward contract with a bank to buy £1 million in six months at an exchange rate of 1.55
$
£
Do the corporation and the bank have an obligation? If so, what is it?
Corporation: A long position obligates the corporation to pay on the 4th of December $1í550í000 to the bank and it receives in exchange £1 million Bank: A short position obligates the bank to pay on the 4th of December £1 million to the corporation and it receives in exchange
$1í550í000
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Chapter 1: Introduction
Basics of Derivatives
Examples of Derivative Payo§s: Forward (III)
What is the payo§ of the forward contract if the exchange rate on the
4th of December is 1.45 _{£} , 1.5 _{£} , 1.55 _{£} , 1.6 _{£} or 1.65
$
$
$
$
$
£ ^{?}
Corporation: a long position in the forward pays o§
0
B
B
B
@ change
1
C
C
_{r}_{a}_{t}_{e} % " £1million ! $1í550í000 C
}
A
$

current ex
{z

{z
}
pay $1í550í000
receive £1million
or ! $100í000, ! $50í000, $0, $50í000, $100í000 Bank: a short position in the forward pays o§
0
B
B
B
@
1
C
_{r}_{a}_{t}_{e} % " £1million C
A
C
receive $1í550í000 ! $
$1í550í000

{z
}

current ex
change
{z
}
pay £1million
or $100í000, $50í000, $0, ! $50í000, ! $100í000
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Chapter 1: Introduction
Basics of Derivatives
Importance of Derivatives
Derivatives play a key role in transferring risks in the economy
Many Önancial transactions have embedded derivatives
In corporate Önance, the concept of real options is essential for the assessment of capital investment decisions
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Chapter 1: Introduction 
Derivatives Markets 

Derivatives Markets (I) 

Exchange traded 
OvertheCounter (OTC) traded 

Futures, Options 
Forwards, Swaps, Options, Warrants, Structured Products 

Standardized contracts as speciÖed by exchange 
Tailormade and not (necessarily) standardized contracts 

Trading áoor 
Network of dealers linked through telephones and computers 

Closingout before maturity with o§setting position (delivery is uncommon) 
Held until maturity; often cash settlement 

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Chapter 1: Introduction
Derivatives Markets
Derivatives Markets (II)
Exchange traded
OvertheCounter (OTC) traded
Marking to market, daily settlement 
Mostly no cash áows until maturity 
Margin requirements 
Collateral possible 
No credit, default, counterparty risk 
Credit risk 
Liquidity depends on contract 
Potential liquidity risk 
Regulated 
Few regulations in the past, but strong tendency to increase regulation (Dodd Frank Act, Volcker Rule, etc) 
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Chapter 1: Introduction
Derivatives Markets
Exchanges
CME Group (www.cmegroup.com)
Chicago Board of Trade (CBOT, www.cbot.com) Chicago Mercantile Exchange (CME, www.cme.com) Chicago Board Options Exchange (CBOE, www.cboe.com)
NYSE Euronext (www.euronext.com)
American Stock Exchange (AMEX, www.amex.com)
Philadelphia Stock Exchange (PHLX, www.phlx.com), acquired by Nasdaq (www.nasdaqtrader.com)
Eurex, Europe (www.eurexchange.com)
Bolsa de Mercadorias y Futuros, Brazil (BM&F, www.bmf.com.br)
Tokyo Financial Exchange, Japan (TFX, www.tfx.co.jp)
Many more (see the list at the end of Hull, page 799)
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Chapter 1: Introduction
Derivatives Markets
Size of OTC and ExchangeTraded Markets
Figure: Source: Bank for International Settlements (www.bis.org). Total notional principal amounts for OTC market and value of underlying assets for exchange market.
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Chapter 1: Introduction
Derivatives Markets
Size of OTC Market: Notional Amount vs Market Value
Figure: Source: Bank for International Settlements (www.bis.org). Total notional principal amounts and gross market value for OTC market.
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Chapter 1: Introduction
Derivatives Markets
OTC Market: Notional Amount
Figure: Source: Bank for International Settlements (www.bis.org). Total notional principal amounts outstanding for diverse underlyings in OTC market.
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Chapter 1: Introduction
Derivatives Markets
OTC Market: Market Value
Figure: Source: Bank for International Settlements (www.bis.org). Gross market value of diverse derivatives in OTC market.
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Chapter 1: Introduction
Derivatives Markets
OTC Credit Risk: Lehman Bankruptcy
Lehmanís Öled for bankruptcy on the 15th of September 2008
Biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives markets and got into Önancial di¢culties because it took high risks and found it was unable to roll over its short term funding
Hundreds of thousands of transactions outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties
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Chapter 1: Introduction
Derivatives Traders
How do Investors use Derivatives?
Managing risk
"Hedgers": hedging risk Changing the nature of a liability Changing the nature of an investment without incurring the costs of selling one portfolio and buying another
"Speculators": trade/ bet on a view on the future direction of the market
"Arbitrageurs": locking in an arbitrage proÖt
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Chapter 1: Introduction
Derivatives Traders: Hedging
Hedging Risk
Hedging reduces or eliminates risk associated with potential (unknown) future movements in a market variable  for instance, price of an asset currently owned or potentially to be owned
Hedging may increase or reduce future payo§s which at Örst may seem undesirable (looks like gambling)
BUT: the uncertain payo§ of a derivative is strongly correlated with the uncertain payo§ of the underlying, and an appropriate (long or short) position in the derivative can o§set the risk in the underlying and thus, one can reduce risk
Forwards/Futures neutralize risk by Öxing the price
Options provide insurance  that is, protection against adverse price movement but still proÖt from favorable price movements
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Chapter 1: Introduction
Derivatives Traders: Hedging
Hedging Risk: Examples
A Örm which does business abroad may Önd it useful to trade foreign
exchange rate derivatives  hedge risk in forex market
An airline may Önd it useful to trade crude oil derivatives  hedge risk
in jet fuel prices
A stock trader may Önd it useful to trade derivatives on stock indices
 hedge market risk
A producer of electricity may Önd it useful to trade heating degree
days (HDD) or cooling degree days (CDD) derivatives  hedge risk of demand shocks
A farmer, a holiday resort or a theme park may Önd it useful to trade
weather derivatives  hedge against unfavorable weather conditions
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Chapter 1: Introduction 
Derivatives Traders: Hedging 
Hedging Risk: Illustration (I) 
Suppose you produce corn
You expect to harvest 20í000 bushels (500 metric tons, Öeld of 125 acres) of corn by December and want to sell it in December
The current price of corn per bushel is $5.63
On the Chicago Mercantile Exchange corn futures contracts are traded
One futures contract is an agreement to trade 5í000 bushels of corn in the future
The current futures price for a contract with maturity in December is $5.24 per bushel of corn, or $26í200 per contract
The price of corn is volatile
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Chapter 1: Introduction
Derivatives Traders: Hedging
Hedging Risk: Illustration (II)
Figure: Source: Wikiposit. Historical corn price.
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Chapter 1: Introduction
Derivatives Traders: Hedging
Hedging Risk: Illustration (III)
Why would you consider to trade in the futures market?
Your skills/ advantages lie in farming, not in the ability to forecast market price movements
What position would you take in the futures market? Long or short? How many contracts?
Short sell 4 contracts to o§set any risk and receive for sure $5.24 per bushel, or $104í800 for your entire harvest
How much does your futures position payo§ in December if the price per bushel is $3, $4.5, $5, $5.5, $6, $6.5, or $8?
You have to deliver 20í000 bushels of corn which is worth $60í000, $90í000, $100í000, $110í000, $120í000, $130í000, or $160í000 You receive $104í800 The payo§ of your futures position is $44í800, $14í800, $4í800, ! $5í200, ! $15í200, ! $25í200, or ! $55í200
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Chapter 1: Introduction
Derivatives Traders: Hedging
Hedging Risk: Illustration (IV)
This payo§ schedule is risky. Is it desirable to take on this risk?
The payo§ is perfectly negatively correlated with the corn price ñ > you can eliminate the corn price risk
For how much can you sell your corn in the market conditional on the above prices?
You can sell your 20í000 bushels of corn for $60í000, $90í000, $100í000, $110í000, $120í000, $130í000, or $160í000
How much do you earn in December from your futures position and selling your corn in the market?
Independent of the corn price you earn $104í800
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Chapter 1: Introduction
Derivatives Traders: Speculation
Speculation
Taking risk by betting on a view on the future direction of a market variable and use derivatives to get extra leverage
Speculation on the gold price:
A view: The price of gold is likely to increase in the near future One approach is to purchase gold in the spot market and sell it later hoping the price goes up Another approach is to trade in the derivatives market, that is, take a long position in a forward or futures contract to lock in a price in the near future or to buy a call option The second approach needs only a small amount of cash as collateral or deposited in a ìmargin accountî or to purchase a call option instead of an entire upfront investment to buy gold to take a speculative position
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Chapter 1: Introduction
Derivatives Traders: Arbitrage
Arbitrage
DeÖnition An arbitrage is a strategy that generates (today or in future) a positive payo§ with nonzero probability and a negative payo§ with zero probability
In other words: locking in a riskless proÖt by taking o§setting positions simultaneously
Arbitrage across markets:
In market A, 1 ounce of gold is traded for $1í640 In market B, 1 ounce of gold is traded for $1í630
ñ > Buy gold in market B and sell it in market A ñ > Receive instantly $10 for every ounce of gold traded
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Chapter 1: Introduction
Derivatives Traders: Arbitrage
Arbitrage: Illustration in the Forward Market (I)
The current stock price of Apple is $571.5
Apple has a market beta of 0.93 and an expected return of 7.5%  this means that its stock price is expected to increase to $614 next year (assuming Apple does not pay dividends)
Suppose you could enter a forward contract (long or short position) to buy in 1 year 1í000 shares of Apple for $600í000 (assume no counterparty risk)
The one year risk free interest rate o§ered by a bank to you (lend or borrow) is 1%
Is there an arbitrage opportunity? What do you do?
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Chapter 1: Introduction
Derivatives Traders: Arbitrage
Arbitrage: Illustration in the Forward Market (II)
Today:
Borrow $594í000 from the bank for 1 year at 1% interest Buy 1í000 shares of Apple for $571í500 Enter a short position in the forward contract  that is, agree to sell 1í000 shares for $600í000 in one year Cash áow today: $594í000 ! $571í500 = $22í500
In 1 year:
Deliver 1í000 shares of Apple and receive $600í000 in cash (short position in forward contract) Pay back loan of ($594í000 " 1.01 = ) $600í000 from bank Cash áow in 1 year: $600í000 ! $600í000 = 0 (for sure)
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Chapter 1: Introduction
Derivatives Traders: Arbitrage
Principle of Asset Pricing
Fact In asset pricing we usually assume that there exist no arbitrage opportunities in the economy.
If two investment strategies have the same payo§ schedule in every possible state of the world, then they must have the same price/ cost, otherwise there exists an arbitrage opportunity
If investment strategy A pays o§ more than strategy B in every possible state of the world, then strategy A must have a higher price/ cost than strategy B, otherwise there exists an arbitrage opportunity
= > The payo§ of a derivative depends on the payo§ of the underlying ñ > Use derivative, underlying and risk free asset and build strategy which pays o§ nothing and thus, must cost nothing ñ > Recover price of derivative from price of underlying and risk free interest rate
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Chapter 1: Introduction
Dangers of Derivatives
Dangers of Derivatives Trading
Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators; it is important to set up controls to ensure that traders are using derivatives for their intended purpose
Limits to arbitrage, Önancial constraints and liquidity risks are very important issues in reality; however, they are often ignored by arbitrageurs!
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Chapter 1: Introduction
Dangers of Derivatives
Example of Barings Bank Disaster, 1995
Nick Leeson, a trader in the Singapore o¢ce, was employed to exploit arbitrage opportunities between the Nikkei 225 futures prices traded on exchanges in Singapore and Japan
He started to move from trading as an arbitrageur to become a speculator without letting the head o¢ce in London know
At some point he made some losses, which he was able to hide from the head o¢ce for a while
Subsequently he started to take bigger speculative positions in the hope to recover his previous losses
By the time his activity was uncovered his total loss accounted for almost $1 billion
Barings bank (over 200 years old) was bankrupt
Nick Leeson was sentenced to 6.5 years in prison in Singapore
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Chapter 1: Introduction
Dangers of Derivatives
Other Examples (I)
Clinton (cattle futures, $100í000, 1979)
Hammersmith and Fulham (interest rate swaps, $600 million, 1989)
Metallgesellschaft (oil futures, $1.3 billions, 1993)
Shell (FX forwards, $1 billion, 1993)
Kidder Peabody (bond market, $350 millions, 1994)
Gibsons Greetings (derivatives trading through Bankers Trust, $20 millions, 1994)
Procter and Gamble (derivatives trading through Bankers Trust, $90 millions, 1994)
Orange County (interest rate derivatives, $2 billions, 1994)
Barings Bank (Nikkei futures, $1 billion, 1995)
Daiwa Bank (bond market, $1 billion, 1995)
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Chapter 1: Introduction
Dangers of Derivatives
Other Examples (II)
Sumitomo (copper futures, $2 billions, 1996)
LTCM (various derivatives, $4 billions, 1998)
Enronís special purpose entities (Several over $1 billion, 2001)
Allied Irish Bank (FX derivatives, $700 millions, 2002)
Amaranth (natural gas derivatives, $6 billions, 2006)
Subprime Mortgages (credit derivatives, tens of billions, 2007)
Aracruz (FX options, $2 billions, 2008)
SociÈtÈ GÈnÈrale (Euro Stoxx 50 futures, $5 billions, 2008)
Bernard L. Mado§ Investment Securities (Ponzi scheme, several billions, 2008)
UBS (Euro Stoxx, DAX, S&P 500 futures, $2 billions, 2011)
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Chapter 1: Introduction
Dangers of Derivatives
Lessons to be learnt (I)
Be diversiÖed
Risk must be quantiÖed and risk limits well deÖned
Exceeding risk limits is not acceptable even when proÖts result
Never ignore risk management, even when times are good
Scenario analysis and stress testing is important
Liquidity risk is important
Beware of potential liquidity problems when longterm funding requirements are Önanced with shortterm liabilities (e.g. credit crisis
2007)
Models can be wrong; be conservative in recognizing inception proÖts (market vs model value)
There are dangers when many are following the same strategy
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Chapter 1: Introduction
Dangers of Derivatives
Lessons to be learnt (II)
It is important to fully understand the products you trade
Do not sell clients inappropriate products
Market transparency is important (e.g. complex structured securities)
Mange incentives
Beware of hedgers becoming speculators
It can be dangerous to make the Treasurerís department a proÖt center
Do not assume that a trader with a good track record will always be right
Do not give too much independence to star traders
Separate the front, middle and back o¢ce
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Chapter 2: Interest Rates
Chapter 2: Interest Rates
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Chapter 2: Interest Rates
Types of Interest Rates
Treasury Rates
Interest rates on securities issued by a government in its own currency
Treasury Bills: zerocoupon bonds; issued weekly; maturities of 4, 13, 26, 52 weeks
Treasury Notes: coupon bonds (semiannual payments); maturities between 2 and 10 years (2, 3, 5, 7, 10 years)
Treasury Bonds: coupon bonds (semiannual payments); maturities between 20 and 30 years
Treasury InáationProtected Securities (TIPS): principal adjusted to CPI; coupon bonds (semiannual payments); maturities of 5, 10, 30 years
Considered to be risk free (in nominal terms)
But ináation should be considered as risk!
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Chapter 2: Interest Rates
Types of Interest Rates
Federal Funds Rate
In the USA, banks have to hold reserves in Federal Reserve Bank
To meet requirements banks trade balances held at the Federal Reserve with each other
Federal funds e§ective rate is the interest rate that clears the market
Maturity: overnight
Uncollateralized contracts
Federal funds target rate is set by the Federal Open Market Committee
Federal Reserve Bank actively trades in the treasury market to achieve the target rate
"Discount rate": rate at which banks can borrow directly from Fed
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Chapter 2: Interest Rates
Types of Interest Rates
Repurchase Agreement (Repo Rate)
Agreement to sell a security today and buy it back in the future for a slightly higher price
The agreed price increase determines the Repo Rate
Equivalent to collateralized loan
Almost risk free
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Chapter 2: Interest Rates
Types of Interest Rates
London Interbank O§ered Rate (LIBOR)
Interest rate at which a banks is willing to deposit money with another bank
Borrowing banks typically have a AA rating
Rate is set once a day by the British Bankers Association on all major currencies for maturities up to 12 months
LIBOR is the interest rate commonly used for derivatives pricing as it is the "risk free" opportunity cost of Önancial institutions
Recently more popular (due to some defaults of large banks):
Overnight Indexed Swap (OIS) Rate OIS: swap áoating overnight LIBOR interest rate payments for a Öxed interest rate payment More secure than long term LIBOR because default risk of principal is greatly reduced and only small interest payments are subject to default risk of long term contract
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Chapter 2: Interest Rates
Compounding of Interest Rates
Compounding of Interest Rates (I)
The compounding frequency is the unit of measurement for interest rates
The e§ective annual interest rate (or annual equivalent rate, AER) depends on the compounding frequency of the stated annual interest rate
Compounding m times per annum (m times c.p.a.) at rate r yields the e§ective annual interest rate ^{} 1 + _{m} ^{.} ^{m} ! 1
r
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Chapter 2: Interest Rates
Compounding of Interest Rates
Compounding of Interest Rates (II)
The e§ective interest rate over time period _{(} T ! t _{)} is
^{} 1 +
r
m
^{.} m _{(} T ! t _{)} ! 1
In the continuous time limit (continuous compounding, c.c.), the e§ective interest rate over time period _{(} T ! t _{)} is
lim _{m} _{!} _{•} ^{} 1 +
r
_{m}
. ^{m} ^{(} ^{T} ^{!} ^{t} ^{)} ! 1 = e ^{r} ^{(} ^{T} ^{!} ^{t} ^{)} ! 1
Suppose r _{c} is the annual interest rate with c.c. and r _{m} is the annual interest rate with m times c.p.a., then r _{c} and r _{m} are equivalent i§ r _{c} = m ln ^{} 1 + ^{r} ^{m} ^{.} or r _{m} = m ^{} e ! 1 ^{.}
m
r
c
m
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Chapter 2: Interest Rates
Compounding of Interest Rates
Illustration for r = 10%
Compounding Frequency
E§ective Annual Interest Rate
Annual (m = 1) 
10% 
Semiannual (m = 2) 
10.25% 
Quarterly (m = 4) 
10.381% 
Monthly (m = 12) 
10.471% 
Weekly (m = 52) 
10.506% 
Daily ( m = 365) 
10.516% 
Continuously (m ! • ) 
10.517% 
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Chapter 2: Interest Rates
Term Structure of Interest Rates/ Yield Curve
Spot Rates
The _{(} T ! t _{)} year spot rate r _{t} _{,} _{T} is the stated annual interest rate promised at time t for a Öxed investment horizon of _{(} T ! t _{)} years Instantaneous spot rate at time t for a horizon _{(} T ! t _{)} ! 0 is called short rate r _{t} Illustration of the term structure of interest rates (yield curve) at time t :
Horizon T ! t
Spot Rate at time t (c.c.)
T ! t
0.5
1
2
3
4
5
10
30
r _{t} = 2.50%
= 4.00%
= 5.00%
= 5.50%
= 5.90%
= 6.10%
= 6.25%
r _{t} _{,} _{t} _{+} _{1}_{0} = 6.40%
r _{t} _{,} _{t} _{+} _{3}_{0} = 6.50%
r _{t} _{,} _{t} _{+} _{0} _{.} _{5} r _{t} _{,} _{t} _{+} _{1} r _{t} _{,} _{t} _{+} _{2} r _{t} _{,} _{t} _{+} _{3} r _{t} _{,} _{t} _{+} _{4} r _{t} _{,} _{t} _{+} _{5}
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Chapter 2: Interest Rates
Bond Pricing
Bond
A bond is a contract which promises future cash áows C _{i} at time
t _{i} 2 _{f} t _{1} , t _{2} ,
, t _{N} _{g} with t _{i} > 0
Time t _{N} is the maturity of the bond
A bond with (risk free) cash áows C _{i} at time t _{i} 2 _{f} t _{1} , t _{2} ,
should trade for
,
t N g
P _{0} = _{Â} _{=} _{1} e ^{!} ^{r} ^{0} ^{,} ^{t} i ^{t} ^{i} C _{i} if the spot rates are quoted as c.c.
P _{0} = _{Â}
N
i
N
i = 1
C i
^{/} _{1} _{+} ^{r} 0 , t _{i}
m
0 _{m}_{t} _{i} if the spot rates are quoted with m times c.p.a.
A zerocoupon bond is a bond which does not pay any coupons but
some face value F at maturity
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Chapter 2: Interest Rates
Bond Pricing
Coupon Bond (I)
A coupon bond pays face value F at maturity and frequently some
coupons C until maturity
The price of a (risk free) coupon bond is equal to the discounted cash áows using the appropriate spot rate as the discount rate
Illustration I: A coupon bond with n (risk free) coupon payments per year of size C = _{n} F for T years and face value F should trade for
c
P _{0} = _{Â} ^{n}^{T} =
t
1
c.c.
P _{0} = _{Â} ^{n}^{T} t = 1
_{e} ^{!} ^{r} 0 , _{(} t / n _{)} t n 

_{n} c F + e ^{!} ^{r} 0 , T ^{T} F if the spot rates are quoted as 

c n ^{F} 
F 
_{0} _{m}_{T} if the spot rates are quoted 

^{/} _{1} _{+} ^{r} 0 , _{(} t / n _{)} m 
0 m 
t n ^{+} 
^{/} _{1} _{+} ^{r} 0 , T m 
with m times c.p.a.
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Chapter 2: Interest Rates
Bond Pricing
Questions
Consider the term structure as stated earlier
What are the prices of the halfyear, 1year, 2year and 3year (risk free) zerocoupon bonds with face value F = $ 1000?
_{(} T = 0 . 5 _{)}
P
0
= $ 1000e ^{!} ^{0} ^{.} ^{0}^{4} ^{"} ^{0} ^{.} ^{5} = $ 980
_{(} T = 1 _{)}
P
0
_{(} T = 2 _{)}
P
0
_{(} T = 3 _{)}
P
0
= $ 1000e ^{!} ^{0} ^{.} ^{0}^{5} = $ 951
$ 1000e ^{!} ^{0} ^{.} ^{0}^{5}^{5} ^{"} ^{2} = $ 896
= $ 1000e ^{!} ^{0} ^{.} ^{0}^{5}^{9} ^{"} ^{3} = $ 838
=
What is the price of a (risk free) 2% (annual) coupon bond with a maturity of 3 years and face value F = $ 1000? What if c = 10% ?
_{(} T = 3 , c = 0 . 02 _{)}
P
0
_{(} T = 3 , c = 0 . 1 _{)}
P
0
$ 1106
=
$ 20e ^{!} ^{0} ^{.} ^{0}^{5}
_{=}
_{$} _{1}_{0}_{0}_{e} ^{!} ^{0} ^{.} ^{0}^{5}
+
_{+}
$ 20e ^{!} ^{0} ^{.} ^{0}^{5}^{5} ^{"} ^{2} + $ 1020e ^{!} ^{0} ^{.} ^{0}^{5}^{9} ^{"} ^{3} = $ 891
_{$} _{1}_{0}_{0}_{e} ! 0 . 055 " 2 _{+} _{$} _{1}_{1}_{0}_{0}_{e} ! 0 . 059 " 3 _{=}
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Chapter 2: Interest Rates
Bond Pricing
Estimation of Term Structure of Interest Rates
The yield curve is not directly observable
But, many zerocoupon and coupon bonds are traded and we observe the market prices of these bonds
Given the market prices of traded bonds and using the above pricing formula, we can infer what the term structure looks like
= > Bootstrap Method
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Chapter 2: Interest Rates
Bond Pricing
Bond Yield
The bond yield y is a constant discount rate that makes the present value of the bondís cash áows equal to the bondís market price
Consider a bond with price P _{0} and cash áows C _{i} at time
t _{i} 2 _{f} t _{1} , t _{2} ,
,
t N g
c.c. yield y _{c} solves the equation P _{0} = _{Â}
m times c.p.a. yield y _{m} solves the equation P _{0} = _{Â}
N = 1 _{e} ! y _{c} t _{i} _{C} _{i}
i
N
i = 1
C
i
mt _{i}
_{(} 1 + ^{y} ^{m}
m
)
The bond yield is a weighted average of the spot rates
The yield of a (risk free) zerocoupon bond with T years maturity is equal to the T year spot rate
In general (except for some simple cases), we need a good calculator with optimization tools or computer software like excel or matlab to solve numerically
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Chapter 2: Interest Rates
Bond Pricing
Questions
What is the yield of a (risk free) 2% (annual) coupon bond with a maturity of 3 years, face value F = $ 1000, and current price
P
_{(} T = 3 , c = 0 . 02 _{)}
0
= $ 891? What if c = 10% and P
0
_{(} T = 3 , c = 0 . 1 _{)}
_{(} T = 3 , c = 0 . 02 _{)}
P
0
= $ 20e _{!} _{y} _{(} T = 3 , c = 0 . 02 _{)} + $ 20e _{!} _{y} _{(} T = 3 , c = 0 . 02 _{)} _{"} _{2}
$ 1020e ^{!} ^{y} ^{(} ^{T} ^{=} ^{3} ^{,} ^{c} ^{=} ^{0} ^{.} ^{0}^{2} ^{)} ^{"} ^{3} = $ 891
_{y} _{(} T = 3 , c = 0 . 02 _{)} _{=} _{5}_{.}_{8}_{9}_{%}
_{(} T = 3 , c = 0 . 1 _{)}
P
0
= $ 100e _{!} _{y} _{(} T = 3 , c = 0 . 1 _{)} + $ 100e _{!} _{y} _{(} T = 3 , c = 0 . 1 _{)} _{"} _{2}
$ 1100e ^{!} ^{y} ^{(} ^{T} ^{=} ^{3} ^{,} ^{c} ^{=} ^{0} ^{.} ^{1} ^{)} ^{"} ^{3} = $ 1106
_{y} _{(} T = 3 , c = 0 . 1 _{)} _{=} _{5}_{.}_{8}_{5}_{%}
+
+
= $ 1106?
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Chapter 2: Interest Rates
Duration
Duration
The duration of a bond is a measure of how long on average the bondholder has to wait for cash áows
Weighted average of times of cash áows
Duration D of a bond with price P _{0} , cash áows C _{i} at time
t _{i} 2 _{f} t _{1} , t _{2} ,
, t _{N} _{g} , and yield y is deÖned as
D
D
= _{Â}
= _{Â}
= 1 t i _{C} _{i} _{e} ! yt _{i}
N
i
N
i = 1 ^{t} i
P
0
^{C}
i y _{)} mt _{i}
m
_{(}
1 +
P
0
, if y is the c.c. yield
, if y is the m times c.p.a. yield
Duration of a bond is large (small) if the bond pays out much of its cash áows late (early) in time
The duration for a bond portfolio is the weighted average duration of the individual bonds in the portfolio with weights proportional to prices
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Chapter 2: Interest Rates
Duration
Questions
What is the duration of a 2% (annual) coupon bond with a maturity
of 3 years, face value F = $ 1000, current price P and c.c. yield y = 5.89% ? What if c = 10% , P and y = 5.85% ?
_{(} T = 3 , c = 0 . 02 _{)}
0
_{(} T = 3 , c = 0 . 1 _{)}
0
= $ 891,
= $ 1106,
_{D}
_{D}
_{(} T = 3 , c = 0 . 02 _{)} _{=} $ 20 e ^{!} ^{0} ^{.} ^{0}^{5}^{8}^{9}
$
891
_{(} T = 3 , c = 0 . 1 _{)} _{=} $ 100 e ^{!} ^{0} ^{.} ^{0}^{5}^{8}^{5}
$
1106
+ 2 _{$} _{2}_{0} _{e} ! 0 . 0589 " 2 + 3 _{$} _{1}_{0}_{2}_{0} _{e} ! 0 . 0589 " 3
$
891
$
891
+ 2 _{$} _{1}_{0}_{0} _{e} ! 0 . 0585 " 2 + 3 _{$} _{1}_{1}_{0}_{0} _{e} ! 0 . 0585 " 3
$
1106
$
1106
= 2.94
= 2.75
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Chapter 2: Interest Rates
Duration
Bond Price Volatility
The bond volatility with respect to changes in the yield is deÖned as
∂ P _{0} _{(} y _{)}
P 0
c.c.:
∂ P _{0} _{(} y _{)}
∂ ∂ y ^{(} ^{Â}
N = 1 _{e} ! yt _{i} _{C} _{i} _{)}
i
P 0
= ^{Â}
N _{=} _{1} _{(} ! t _{i} _{)} e ^{!} ^{y}^{t} i C _{i}
i
P 0
= ! D
∂ ∂ y $ ^{Â}
^{C}
y _{)} mt _{i} %
m
∂ P _{0} _{(} y _{)}
P
0
N
i = 1
i
_{(}
1 +
m times c.p.a.:
(known as "modiÖed duration")
^{=}
P
0
=
Â
N _{(} ! t _{i} _{)} C _{i}
i = 1
_{(} 1 +
y _{)} mt _{i} + 1
m
P
0
_{=} ! D
1
+
y
m
For a small change in the yield D y the percentage change in the bond
price is well approximated by ^{D} ^{P} ^{o}
P
0
'
To hedge the exposure of a portfolio against small unexpected parallel shifts in the yield curve, one has to match the duration of assets and liabilities
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Chapter 2: Interest Rates
Duration
Example: Duration based Hedge
You are a bank and you have short term debt (assume zerocoupon bonds with one year maturity; e.g. approximation of deposits) with current value of P _{L} = $ 10 ^{9} on your liability side of the balance sheet
Current 1year spot rate is r _{0} _{,} _{1} = 5% (c.c.) and the 30year spot rate is r _{0} _{,} _{3}_{0} = 7% (c.c.)
You want to lend some money to borrowers for 30 years; assume zerocoupon bonds
Lending rates are spot rates + x = 1%
How much money should you lend to minimize your exposure to interest rate risks (small parallel shifts in yield curve)?
Assume all the money you do not lend will be used for other operations without interest rate risk exposure
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Chapter 2: Interest Rates
Duration
Example: Duration based Hedge
Note:
yield of zerocoupon bond is equal to spot rate,
y _{L} = r _{0} _{,} _{1} , y _{A} = r _{0} _{,} _{3}_{0} + x
Duration of a zerocoupon bond is equal to its time left to maturity, D _{L} = 1, D _{A} = 30 If there are only small parallel shifts D y in the yield curve, then we can use the approximation D P = ! DP _{0} D y for bond price changes
Denote current value of money we decide to lend for 30 years by P _{A}
Current value of balance sheet with interest rate risk exposure:
V = P _{A} ! P _{L}
Change in value of balance sheet if small parallel shift D y in yield curve: D V = D P _{A} ! D P _{L} = ! D _{A} P _{A} D y ! _{(} ! D _{L} P _{L} D y _{)} = _{(} D _{L} P _{L} ! D _{A} P _{A} _{)} D y
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Chapter 2: Interest Rates
Duration
Example: Duration based Hedge
We want D V = 0 (no exposure to small parallel shifts in yield curve),
thus: P _{A} =
Lend only _{3}_{0} of your balance sheet for 30 years
In one year we have to borrow again money/ rolling over our debt because we have lend money for 30 years ñ What if there is a crisis and it is di¢cult to borrow?
1
_{A} P _{L} =
L
D
D
_{3}_{0} 1 $ 10 ^{9} = $ 33.333 ( 10 ^{6}
Duration based hedging does not help to manage liquidity risks
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Chapter 2: Interest Rates
Duration
Bond Price Volatility: Convexity
If changes in the yield D y are large, the approximation
D P _{o}
P 0
'
∂ P _{0} _{(} y _{)}
D y is not very good
A second order Taylor expansion delivers a better approximation
We deÖne a bondís convexity as
∂ ^{2} P _{0} _{(} y _{)}
∂ y ^{2}
P 0
∂ ^{2} P _{0} _{(} y _{)}
∂ y ^{2}
P
0
2 ( Â
∂
y
∂
^{2}
N
i
= 1 _{e} ! yt _{i} _{C} _{i} _{)}
in case of c.c.:
in case of m times c.p.a. :
=
P 0
= ^{Â}
N
i = 1 ^{t} i
2 _{e} ! yt _{i} _{C} _{i}
P 0
dP _{0}
P
0
=
2 $ Â
∂
^{2}
∂
y
N
i = 1
^{C} ^{i}
y _{)} mt _{i} %
m
_{(}
1 +
P
0
=
Â
= 1 t _{i} _{(} t _{i} +
N
i
m )
1
_{(}
1 +
y
m ^{)} ^{2}
^{C}
i
_{(}
1 +
y _{)} mt _{i}
m
P
0
The percentage change in the bond price in response to a change in
the yield D y is well described by ^{D} ^{P} ^{o}
∂ P _{0} _{(} y _{)}
∂ ^{2} P _{0} _{(} y _{)}
2 1 ( D y ) ^{2}
∂ y ^{2}
P
0
D y +
P
0
'
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Chapter 2: Interest Rates
Forward Rates
Forward Rates (I)
DeÖnition
The forward rate f
t
_{(} T _{1} , T _{2} _{)}
at time t for period _{[} T _{1} , T _{2} _{]} with t < T _{1} < T _{2}
is the future interest rate at which buyer and seller (lender and borrower) are willing to agree at time t to trade in the future (at time T _{1} ) a risk free zerocoupon bond (or an equivalent credit contract) with maturity at time T _{2} (and no money is exchanged today).
No arbitrage requires the forward rate to be:
f
t
f
t
_{(} T _{1} , T _{2} _{)}
_{(} T _{1} , T _{2} _{)}
@
= m 0
T _{2} ! t
^{/} _{1} _{+}
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