Theory of Finance II Week Nine Exercise & Solution

Currency Option and Swaption

Exercise 1.1 1 Consider the European call on the exchange rate. Denote the price of the call by C(Xt , K, T ), and denote the price of the corresponding put option (with the same exercise price K and exercise date T by P (Xt , K, T ).) Show that the put-call parity relation between p and c is given by P (Xt , K, T ) = C(Xt , K, T ) xerf (T t) + Kerd (T t) Solution: We have, under the objective probability measure, the following processes for the spot exchange rate X (units of domestic currency d per foreign currency unit f ), and the f d domestic , Bt , and foreign, Bt , riskless assets: dXt = x Xt dt + x Xt dWt d d dBt = rd Bt dt f f dBt = rf Bt dt (1) (2) (3) (4)

where rd and rf are the domestic and foreign short rates which are assumed to be deterministic. Hence the Q-dynamics of X are given by dXt = (rd rf )Xt dt + x Xt dWt . From the standard call-put parity, which must be valid, we have the following relation between call and put options with the same maturity T and exercise price K: P (Xt , K, T ) = C(Xt , K, T ) (t, XT ) + erd (T t) K. But we also know that (t, X(T )) = erd (T t) EtQ [XT ] = erd (T t) Xt e(rdrf )(T t) = Xt erf (T t) . So, P (Xt , K, T ) = C(Xt , K, T ) Xt erf (T t) + erd (T t) K.
1

(5) (6) (7)

(8)

This exercise is copied from Arbitrage Theory in Continuous Time by Tomas Bjrk. o

Exercise 1.2 2 Compute the pricing function (in the domestic currency) for a binary option on the exchange rate. This is a T-claim, , of the form = 1[aX(T )b] , i.e. if a X(T ) b then you will obtain one unit of the domestic currency otherwise you get nothing. Solution: The dynamics under Q of the exchange rate X are given by dXt = (rd rf )Xt dt + x Xt dWt . where rd and rf are the domestic and foreign short rates which are assumed to be deterministic. Integrating the above expression we get
T T

XT = Xt +
t

(rd rf )Xu du +
t

x Xu dWu

and so we have (by solving the SDE) XT = Xt e

rd rf
2 x 2

(T t)+x (WT Wt )

we see that we see from taking the logarithm that log( XT 2 2 ) N (rd rf x )(T t), x (T t) Xt 2

So, the price, t of the binary option is given by t = erd (T t) EtQ [] = Letting Z = erd (T t) EtQ 1[aX(T )b] (9) (10)

(WT Wt ) , T t

Z N(0, 1), we see that (11)

1 2 XT = Xt exp (rd rf x )(T t) + T tZ 2 Hence, = erd (T t) Q(a X(T ) b) = erd (T t) Q(da z db )

2

by the results of week 8.

(12) (13) (14)

= erd (T t) Q(log a log X(T ) log b)

This exercise is copied from Arbitrage Theory in Continuous Time by Tomas Bjrk. o

Where Q is a probability of Z, log(a/Xt ) (rd rf da = x T t and

2 x )(T 2

t)

log(b/Xt ) (rd rf 2x )(T t) db = . x T t Hence we have that the price of the binary exchange option is: t = erd (T t) [(db ) (da )] . Exercise 1.3 3 This exercise explains how to value interest rate swaps by a simple noarbitrage argument. a) Let Lt (T, T + ) be the forward -LIBOR rate, set at t, for borrowing over the future time period [T, T + ]. Show that Lt (T, T + ) = 1 Pt,T 1 . Pt,T +

b) Consider a xed rate coupon bond, with nominal 1, coupon rate k, and coupon payments at equally spaced times Tj = T0 + j, j = 1, , N. Derive the price of this bond at times t T0 . What if t falls between two coupon payment dates? We next consider a oating rate bond, with coupon payments at times Tj , 1 j N , and with a principal of 1. At Tj , the coupon payed will equal L(Tj1 ), with L(Tj1 ) := LTj1 (Tj1 , Tj ), the -LIBOR rate set at time Tj1 . (We use the index j 1 to remind ourselves that payment is in arrears, that is, the oating coupon rate is set 1 period before payment). c) Show that the value, at T0 , of this oating rate bond is simply equal to 1. What is the price t < T0 ? d) A xed receiver swap will exchange the oating rate coupons L(Tj1 for xed coupons k. Determine its price for any t T0 . Show that if the contract is written at t, then the xed rate k will be given by the forward swap rate st (T0 , TN , ) dened by st (T0 , TN , ) = with Tj = T0 + j, as before.
3

Pt,T0 Pt,TN
N j=1

Pt,Tj

This exercise is copied from Raymond Brummelhuiss pricing class notes.

Solution: If one borrows 1 sterling at T, and reimburses (1 + Lt (T, T + )) at T + , then the net present value at t of the combined money-ow is: Pt,T + (1 + Lt (T, T + ))Pt,T + . The time t-value of this contract has to be 0 (since no money changes hands at t), which gives an equation for Lt (T, T + ) with the stated solution. b) The value of the bond at t is simply the sum of the present values at t of the coupons + nal principal:
N

kPt,Tj + Pt,TN .
j=1

If t falls between coupon payments, then we simply sum over those js such that Tj t: kPt,Tj + Pt,TN .
j:Tj t

c) From the borrowers point of view, the loan of 1 sterling starting at T0 can be hedged using the following strategy At T0 , take the 1 Sterling and invest it in T1 -bonds. These will give a yield of 1 1 PT0 ( ) = LT0 (T0 , T1 ) = L(T0 ). PT0 At T1 , collect (1 + L(T0 )), pay out the required coupon of L(T0 ), and invest the remaining 1 Sterling in T2 -bonds, whose yield over [T1 , T2 ] is exactly L(T1 ). At T2 , collect (1 + L(T1 )), pay out the coupon, and invest the remaining 1 Sterling in Tr -bonds. Repeat this until time TN , at which time you pay out the nal coupon, together with the 1 Sterling you had to deliver. It follows that the oating bonds price is exactly 1 sterling (if it were dierent, you could set up an arbitrage, by either going long or short such a bond, and hedging with the above strategy). If t < T0 , we simply discount using a T0 -bond, so that the oating rates price becomes Pt,T0 . d) We can replicate such a swap by going short a oating rate bond, and going long a xed rate bond (the exchange of principals will cancel each other out). It follows from parts b) and c) that the swaps price at t < T0 is: kPt,Tj + Pt,TN Pt,T0 .
j

If the contract is set-up ay t T0 , the xed rate k will be chosen such that the net present value of the swap is 0 (buyer and seller should be indierent at t), which leads to the stated swap rate. 4