Lecture notes for STAT3006 / STATG017

Stochastic Methods in Finance

Part 5 Julian Herbert Department of Statistical Science, UCL 2010-2011

Contents
12 Martingale Pricing 12.1 A closer look at risk-neutral pricing - the problem set-up 12.2 Martingales - Fair Game processes . . . . . . . . . . . . . 12.3 Complete economies and changing probability worlds . . 12.4 The fundamental theorem of asset pricing . . . . . . . . 12.5 Martingale Pricing technique . . . . . . . . . . . . . . . . 12.6 Constructing a martingale process . . . . . . . . . . . . . 12.6.1 Theorem for changing probability worlds . . . . . 12.7 Example - the Black-Scholes framework . . . . . . . . . . 12.8 Further reading . . . . . . . . . . . . . . . . . . . . . . . 100 100 101 102 104 105 106 106 107 109 110 110 112 113 114 114 114 115 115 116 117

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13 An Introduction to Interest Rate products 13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.2 Forward rates . . . . . . . . . . . . . . . . . . . . . . . . . . 13.2.1 Obtaining forward rates from zero coupon bond rates 13.3 Relationship between forward prices, Bond prices and yields 13.4 More xed income products . . . . . . . . . . . . . . . . . . 13.4.1 Floating rate bonds . . . . . . . . . . . . . . . . . . . 13.5 An introductory example of Interest Rate Derivative Pricing 13.5.1 Forward pricing revisited . . . . . . . . . . . . . . . . 13.5.2 Example: Forward rate agreements . . . . . . . . . . 13.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . .

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Chapter 12 Martingale Pricing

12.1 A closer look at risk-neutral pricing - the problem set-up

We have seen that the derivative pricing problem in continuous time can be solved by calculating a discounted expectation of the derivative payo under the distribution under which all assets have an expected return equal to the risk-free rate, i.e. the risk-neutral distribution. But why is this the case? We revert back to our replicating, no-arbitrage approach to pricing to see an outline of why this useful result holds. We used this replicating argument to demonstrate that the risk-neutral pricing approach can be used in the discrete time Binomial model, as well as to determine the Black-Scholes-Merton PDE for a derivative price process. We will also look at what drives this risk-neutral pricing result, and generalise it to extend the range of derivative pricing techniques we have in our tool box. This will help address problems that are more complicated than the pricing stock derivatives considered so far in the course. To do this we look at a useful and interesting interpretation of some of the pricing results we have used and how they relate to replication. We also introduce the concept of a random process that is a fair game, and show how this relates to our derivative pricing techniques. Many of the problems that motivated early study of probability came from questions arising out of gambling, and there is a natural connection between probability and games of chance. Lets remind ourselves of the problem set-up we have. We have a tradable underlying asset with price process St , and a European style derivative with price process Xt and payo function at maturity XT (ST ). 100

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We also have an additional tradable asset which has price process Bt . Up to now we have used a bond (riskless asset) process for this additional tradable asset, but lets keep this as general as possible. In this chapter we will not assume anything about the dynamics of Bt yet. In particular, we do not assume that Bt is necessarily deterministic, and so may be a stochastic process. This additional tradable asset we will call the numeraire, for reasons that will become clear later. We want to try to nd a dynamic portfolio, or equivalently a trading strategy, using amounts of our two tradables - the underlying asset and the numeraire. Consider the trading strategy where we hold a portfolio t t of the underlying asset of the numeraire asset.

Call the price process for this portfolio Vt , and write Vt = t St + t Bt . We are simply extending the approach taken in the previous chapters, Black-Scholes and Risk-neutral Pricing. As we had there and unlike the binomial model under which we calculated replicating portfolios, we are now in a continuous time framework, and both t and t will need to be continually adjusted as we move through time. Can we establish a technique for constructing a replicating process in this more general framework? We are after something that explains and supports the risk-neutral pricing technique we used in previous lectures, and if this can also give us a technique that applies under a wider range of assumptions (for example models other than those governed by the Black-Scholes assumptions) then this will prove invaluable to help us price more complicated derivative structures. However as is often the case, before we go down this useful line, we need some further development of our mathematical language. We introduce a class of stochastic processes called fair games, or martingales.

12.2

Martingales - Fair Game processes

We can consider a stochastic process as the net position of a gambler playing at a casino. For a discrete time stochastic process each time point represents a new game, for a continuous time process we need to assume that the gambler plays in a continuous manner. Consider a starting position for the gambler of x. We can ask the question, what is the expectation of the gamblers net position after he has played the game n times?

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If this expectation is above his starting position of x then the game is favourable to the gambler, if it is below the starting point then it is favourable to the casino. However, if the expectation of his net position after game n is the same as his position now, then we might consider the game he is playing to be a fair game, in the sense that in expectation at least, neither the casino or the gambler is a priori likely to gain. Extending this idea to a stochastic process, we can say that a discrete time stochastic process, Xn is a fair game if the expectation of the process at some point in the future, conditional on its value today, is simply the value today. In expectation we do not expect the process to rise or fall, so that E [Xn+j |Xn ] = Xn . For a continuous time stochastic process Xt , we similarly say that Xt is a fair game if E [Xt+ |Xt ] = Xt for > 0. SDEs for continuous time fair game processes Consider the SDE for geometric Brownian motion, dS = Sdt + SdZ. We have already seen in earlier lectures that the expectation of the process St is E [St ] = S0 et , and equivalently that E [St+ |St ] = St e . For St to be a fair game we need E [St+ |St ] = St . From this result we can see that the geometric Brownian motion will be a fair game only if = 0, i.e. if the drift of the SDE is zero. Then we have that a price process Xt with no drift and hence following the SDE dX = Xdz will be a fair game.

12.3

Complete economies and changing probability worlds

We introduce some further concepts that we will need to use in developing our pricing techniques further.
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The numeraire and the relative price process In the section above we introduced the idea of a numeraire asset. Any tradable asset that has a strictly positive price process can be a numeraire. Once we have chosen a numeraire (which has price process Bt say), we can express the price processes of all other tradable assets in terms of this numeraire. A numeraire is therefore simply a choice of unit for measuring value. If no numeraire is specied, the numeraire is implicitly assumed to be one unit of some currency. For any asset price process Xt , this leads to Rt := Xt /Bt , which we call the relative price process, as it describe the price process for the asset relative to the numeraire, Bt . This is why the term numeraire is used, as it the unit in which we assess the price of the underlying.

Self-nancing portfolios Here we recap the discussion on self-nancing portfolios from previous lectures. Recall the no-arbitrage argument we used to demonstrate that any portfolio that replicates the derivative payo must have the same value as the derivative at times before maturity. This argument also relies on the trading strategy we are using to replicate the derivative not having an injection or withdrawal of money at any point prior to maturity - the no-arbitrage argument breaks down if at any point funds are added to the portfolio. Exercise: Convince yourself of this by re-visiting the proof of this result. This means that for example any change in the amount of stock in the portfolio must be funded entirely by changes in the amount of bond, and vice-versa. We say that the portfolio must be self-nancing. In other words, whatever the cost of setting up the portfolio, it must not use additional, exogenous money to subsidise it at any point, nor have money taken out of it. Mathematically this requires dVt = t dS (t) + dB (t), (12.1)

so that changes in the portfolio value are driven by changes to the stick and bond prices only. Changes in the value of the portfolio are explainable in term of changes in the value of the tradable constituent assets alone. Any replicating portfolio we use to price must satisfy this result. Complete Economies We can consider a European style derivative as being represented by a payo function that depends on the underlying asset price at maturity date, T . The payo function is
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XT say. If we can nd a trading strategy that is self nancing and also replicates the derivative payo, then we say that the derivative is attainable. As we have seen, in a no-arbitrage economy the value of this replicating trading strategy will also provide our derivative value for an attainable derivative. If, in an economy, all derivatives assets are attainable, then we say that the economy is complete. Martingale probability worlds Recall that we have been working with risk-neutral probability distributions for the asset price processes. These provide probability distributions for asset prices that do not necessarily hold in the real world, but we can consider them as holding in imaginary conceptual world - the risk-neutral world. We can extend this idea to consider a wider range of probability distribution worlds. We say that a probability world is called an equivalent martingale probability world1 if under the probability distributions of this new world, the relative price processes of all tradable assets are martingale processes2

12.4

The fundamental theorem of asset pricing

The fundamental theorem of asset pricing tells us that: A market is arbitrage free if, and only if, there exists an equivalent martingale probability world measure; and An arbitrage free market is complete if and only if there exists a unique equivalent martingale measure for every choice of numeraire. The proof is not given in this course, but there is a rich theory underlying this result. This result tells us that, given a choice of numeraire, we can nd a probability world under which relative price processes are martingales. The martingale property that is required in the martingale probability world is in fact the mathematical reection of the fact that, in an arbitrage-free economy, it us not possible to systematically outperform the market (hence the relative prices) by trading in the tradable assets. With selfnancing trading strategies that use the tradable assets, we still cannot outperform the market, hence these trading strategies need to be martingales as well.
This is also referred to as an equivalent martingale probability measure. This is because probability can be viewed as a measure, so that dierent measures provide dierent mappings from the event space to the probabilies (on [0,1]), and hence dierent probability distributions, and hence what we have called probability worlds 2 We also need an additional technical condition that the events that have zero probability (ie. null sets) are the same in the martingale probability world as the real objective world. This condition relates to the term equivalent in this expression. 104 J Herbert UCL 2010-11
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12.5

Martingale Pricing technique

Now we can use this pricing theorem to help us to price our derivatives. Given any numeraire with price process, Bt , the relative price process for a self nancing trading strategy will be a martingale in the martingale probability world for this numeraire. Hence we can immediately write, in this probability world, Vt t XT =E Bt BT [] indicates an expectation with respect to the equivalent martingale probwhere the E ability world. Putting our results together, we can see that we can nd a generalisation of the risk-neutral pricing result we outlined in previous lectures. [ ] [ ] XT VT Et = Et (12.2) BT BT (12.3) because Vt will replicate the derivative payo XT at time T , by denition. We can now use the fact that the relative price process Vt /Bt is a fair game (martingale) to write this as [ ] ] [ XT VT Et = Et BT BT Vt = Bt by the denition of a martingale, so that we have
1 t BT Vt = Bt E XT .

(12.4)

As this portfolio replicates the derivative, we can argue that this is our pricing result for the derivative, using a general numeraire Bt . Notice that this pricing result is independent of both our choice of model and our choice of numeraire. We can summarise our new pricing technique as: Choose a numeraire (we have been using the riskless asset (bond process) up to now but for more complicated derivatives another choice may be more suitable); Construct the relative price process for the underlying asset (i.e. the price process relative to the numeraire); Determine a new probability measure under which this relative price process will be a fair game process (or equivalently a martingale), and nd the SDE and hence the probability distribution of the underlying under this new measure; Find the expectation of the derivative payo under this new probability distribution, and apply formula (12.4) above to obtain the derivative price.
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12.6

Constructing a martingale process

We have seen that our pricing problem involves nding the expectation of the derivative payo under the new probability measure that results in the underlying asset relative to the numeraire being a martingale or fair game process. To do this we need to nd the distribution of the underlying asset price under this probability measure. We now look briey at how we can determine this. We can rely on the following result:

12.6.1

Theorem for changing probability worlds

Assume that Zt is a Brownian motion under a probability world, where we denote this probability world denoted by P . Consider a (possibly stochastic) process (t) such that 0t (u)2 du < with probability 1. Then denes a transformation to a new probability world, P , in which dZ = dZ + (t)dt, or equivalently, where Z (t) = Z (t)

(u)du.

From this we can see that changing the probability world, and hence the probability measure, transforms the drift of a stochastic process, but not the volatility. So that if a process follows the SDE dX = a(X, t)dt + b(X, t)dZ and we change the probability measure3 , then the SDE for X under this new probability measure will have a dierent drift rate, but will have the same volatility rate4 . We can therefore think of drift as in some sense being the same as probability measure, and vice-versa5 . This will help us to work with new probability measures under which the relative price processes are fair game processes as we require.
In fact this result only applies to equivalent probability measures, which means that both the original and the new probability measure will have the same null sets, i.e. map the same events onto zero probability. This will be sucient for our purposes in this course. 4 This is a very simplied version of a result know as Girsanovs theorem, sometimes also called Cameron-Martin-Girsanov theorem. 5 Subject to various mathematical restrictions
3

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12.7

Example - the Black-Scholes framework

We demonstrate the analysis outlined above in our familiar Black-Scholes world. the price process for the underlying asset follows geometric Brownian motion. so we have dS = Sdt + SdZ The numeraire - the riskless asset price process We are going to choose the tradable bond (or equivalently the riskless asset) as our numeraire, with price process dB = rBdt . Recap: We saw in the earlier lectures that the government bond (riskless asset) that pays 1 in time T from now, is worth erT today. Equivalently we can say that if Bt is the value of a bond over time, we have that Bt = B0 ert . So the riskless bond grows at the risk-free rate, as we would expect, and the dierential equation for the price process is dB = rBdt. See Calculus Refresher notes for a discussion of this dierential equation. The relative price process We consider the process for the stock price relative to the riskless bond price, which is our chosen numeraire. Based on the pricess process for Bt , the relative price process is Rt := St /Bt which can be written as Rt := St /Bt = ert S (t). Finding the martingale probability world and probability distribution We can use Itos lemma to nd that the relative price process Rt follows the following SDE in the objective, real world: dR = ( r)Rdt + RdZ. To nd the equivalent martingale probability world we can use the transformation (t) = r

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and our theorem from section 12.6.1 above, so we obtain under this new probability world P dR = ( r)Rdt + R (dZ + (t)dt) ( ) r = ( r)Rdt + R dZ dt = RdZ which is a martingale process as required. Now the next step is to nd the probability distribution of the price process for the underlying asset, St , under this new probability world. Under this new world, the St follow the process dS = Sdt + S (dZ (t)dt r = Sdt + S (dZ dt) = rSdt + SdZ . We can see here that this is in fact the risk neutral process that we previously stated and used in our risk-neutral pricing approach (ie the process that St follows in a risk neutral world). The drift rate is now the risk-free rate, r. Alternatively, we can guess and start from this risk-neutral process for St , and then use Itos lemma to show that under the probability distribution of this probability world (i.e. in this risk-neutral world), the relative price process follows the SDE dR = Rdz, and so has no drift and so is fair game as required (see exercises). We can then use Itos lemma to nd the SDE and hence probability distribution for S (t) under this S 2S new probability world. We have St = ert Rt so that S = rert R, R = ert and R 2 = 0. t Then Itos result gives us dS = ert dR + rert Rdt = ert RdZ + rert Rdt = rSdt + SdZ which is again the SDE we are familiar with for St in a risk-neutral world. We can see that it turns out that the risk-neutral probability distribution (in the risk-neutral world) that we have been using is in fact the probability distribution under which the stock price process relative to the bond price process (S (t)/B (t)) is a fair game (martingale).
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The pricing result Finally we now apply the martingale pricing result (12.4) to give the derivative price as t [B 1 XT ]. ft = Bt E T (12.5)

In this case, we are assuming that the price process of the numeraire is deterministic (i.e. the bond price process is not stochastic). We have BT = Bt er(T t ) because the bond price process grows at the risk-free rate. Note also that this is a deterministic process. The pricing result (12.5) will therefore give us t [{Bt er(T t )}1 XT ] ft = Bt E t [XT ] = Bt {Bt er(T t) }1 E t [XT ] = er(T t) E which is therefore equivalent to taking the discounted expectations in the risk-neutral world, which is the risk-neutral pricing result we are familiar with.

Note on terminology In probability theory, a probability is dened as a measure, so you may also hear the probability world distributions described as the probability measures, so the equivalent martingale probability world can also be described as the equivalent martingale probability measure.

12.8

Further reading

For more on martingale pricing, see for example Rennie and Baxtor chapter 2 and 3, Neftci chapter 6, 14 and 15, or Hull chapter 19 (in the 4th edition). Details of these books are provided in the course reading list.

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Chapter 13 An Introduction to Interest Rate products

13.1 Introduction

We now start to look further at the problem of varying interest rates. The uncertainty in future interest rates gives rise to a vast market of dierent interest rate products, and we look at the problem of pricing them in this lecture. We start here with a recap of the introduction to varying interest rates and related terminology at the start of the course.

Recap on some xed income products Fixed income securities are nancial contracts between two counterpartie where a xed exchange of cash ows is agreed (which depends on the interest rate). Interest rate is the cost of borrowing or the price paid for the rental of funds and is usually expressed as % per year. Bond: a debt security that promises to make payments periodically (are issued by government, companies, local authorities, etc.) zero-coupon bond: pays only a known xed amount (the principal) at some given date in the future (the maturity date). coupon-bearing bond: similar to zero-coupon bond, except that it also pays smaller quantities (the coupons) at specic intervals up to and including the ma-

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turity date.

Spot interest rates and discount bonds Now that we are allowing the interest rate to vary according to the time period over which we look, an interest rate must be dened with respect to a particular time period of borrowing. A spot interest rate for maturity n years is the interest rate earned on an investment that starts today and lasts for n years, where the interest accumulates to maturity. Spot rates are sometimes called zero-coupon rates because they are the rates of interest payable on obligations that accumulate all interest to maturity, without intermediate payments. Discount Bonds An asset that pays a unit of currency at time T in the future is called a discount, or zero-coupon bond. We denote its value at time t by P (t, T ). This price will be a process that may change over time. Bonds yields The yield to maturity on a coupon bearing bond is the discount rate that equates the cash ows on the bond to its market value (or equivalently current price). For a zero-coupon bond (as opposed to a bond that pays coupons before maturity) the yield will be the same as the spot or zero rate we described above in section 13.1. We write the yield of a zero-coupon bond as R(t, T ). Consider a zero-coupon government bond maturing a time T , when it pays 1, which has value P (t, T ) at time t. Applying a constant rate of return of say y over the remaining life of the bond (i.e. between t and T ), then the 1 received at time T has a present value of P (t, T ) at time t, where P (t, T ) = ey(T t) . We can therefore write yield y = and thus equivalently yield R(t, T ) = ln(P (t, T )) . T t ln(P (t, T )) T t

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For a coupon bearing bond with principal P and N remaining coupons of Ci each at time ti , and with bond price Bc , the yield to maturity satises Bc = P ey(T t) + The short rate The short rate is the instantaneous cost of money now. It summarises the current cost of borrowing now, i.e. borrowing that is paid back almost instantaneously. It is also sometimes called the instantaneous rate. If at time t we borrow over a period from t to t + t, where t is a small time increment, then the interest rate is the yield (or equivalently the spot discount rate) We can dene it in terms of our discount bonds as R(t, t + t) = logP (t, t + t) t
N i1

Ci ey(ti t) .

(13.1)

As t gets smaller, this value approximate to the left-most point of the yield curve at time t, which is R(t, t). It is this value that we call the short rate. We write the short rate as rt := R(t, t) = logP (t, t). T

13.2

Forward rates

Forward interest rates are interest rates that are implied by current zero rates for a specied future time period. They are therefore interest rates that are assumed to apply over xed periods in the future for all instruments. To see how forward rates are calculated, suppose that we have a continuous set of zero coupon bonds for all maturities up to time T, with prices today at time t, as before, of P (t, T ) for maturity date T . The market implied forward rate is the curve of a time-dependent spot interest rate that is consistent with the market price of products, so that the rate at time , r( ) day, satises P (t, T ) = e
T
t

r ( )d

(13.2)

We have already seen something similar when we considered time dependent interest rates in the Black-Scholes model in the section Simple Extensions to the Black-Scholes model in the The Black-Scholes model lecture. We can dierentiate and re-arrange equation (13.2) to get r(T ) =
112

(ln(P (t, T ))) T

(13.3)
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which is the forward rate at time t today. This forward rate is specic to the time t, and can itself change over time, so that the forward rate is usually denoted by F (t, T ) to indicate the time it is taken at. Therefore we have that the forward rate at time t applying at time T in the future is F (t, T ) = (ln(P (t, T ))) . T (13.4)

As we might expect, the forward rate for borrowing now, i.e. at time T = t, is exactly the short rate, so that F (t, t) = rt .

13.2.1

Obtaining forward rates from zero coupon bond rates

In practice bonds are only traded in the market at discrete maturity dates, and so bond prices are only available for a discrete set of data points, so that we do not have the continuous set of bond prices for all maturities times that we assumed above. As a result, we can only derive discrete points on the forward curve from bond prices. To do this, we follow a bootstrap procedure. Suppose the discrete maturity times of the bonds that we have prices for are T1 , T2 , ..., TN , all in the future. Start by using the price of the bond with the shortest maturity to determine the interest rate over the period (t, T1 ) that this price implies. If we assume that over this period only the interest rate is not time dependent and is denoted by f1 , then we have P (t, T1 ) = ef1 (T1 t) ln(P (t, T1 )) f1 = . T1 t This gives us the rate that applies today between time t and time T1 . To determine the rate that applies today for the time period between T1 and T2 (f2 say) we use the price of the bond with maturity T2 , and we have P (t, T2 ) = ef1 (T1 t) ef1 (T2 T1 ) ln (P (t, T1 )/P (t, T1 )) . f2 = T2 T1 We can iteratively apply this approach to nd the forward rate between Ti and Ti+1 , and complete the bootstrap and determine all points on the forward curve up to the maximum maturity we have bond prices for, TN . This gives the general result for the ith forward rate for i > 1 fi = ln (P (t, Ti )/P (t, Ti1 )) Ti Ti1

. Exercise: Prove the above general result for the ith forward rate by induction.
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13.3

Relationship between forward prices, Bond prices and yields

To summarise, the forward rate and the yields can be written in terms of the zero coupon bond prices as: logP (t, T ) T logP (t, T ) R(t, T ) = , T t f (t, T ) = (13.5) (13.6)

and conversely the bond prices can be given in terms of the forward rates of the yields as follows:
(
T

P (t, T ) = exp
t

f (t, u)du

(13.7) (13.8)

P (t, T ) = exp ((T t)R(t, T ))

In terms of modelling therefore, we can chose to specify the behavior of only any one of these three, and the other two will follow automatically.

13.4
13.4.1

More xed income products

Floating rate bonds

In its simplest from a oating interest rate is the amount that you get on your bank account. This amount varies from time to time, reecting the stage of the economy and in response to pressure from other bank for your business. This uncertainty about the interest rate you receive is compensated for by the exibility of your deposit, in that it can be withdrawn at any time. The most common measure of interest in recent times has been the London Interbank Oer Rate, or LIBOR. LIBOR comes in various maturities, one month, three month, six month etc., and is the rate of interest oered between Eurocurrency banks for xed term deposits.

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13.5
13.5.1

An introductory example of Interest Rate Derivative Pricing

Forward pricing revisited

We now need to revisit some of our previous pricing results and consider the impact of interest rates no longer being constant and deterministic. Once again we start with the fundamental derivative, the forward. What is the no-arbitrage price of a forward contract on a tradable asset in a world where interest rate products are themselves traded, and short rate or riskless bonds may themselves be stochastic processes? Fortunately we can use the same replicating portfolio argument to price forwards, even with this additional complication. Consider any tradable product with price process St . A forward on this asset, agreed for delivery at time T > t, is struck at delivery price K say. We wish to nd the value of K that allows no-arbitrage. As usual, the payo of a long position in the forward at time T will be ST F , as the holder of the long position will be paying the agreed delivery price, K , and receiving something worth ST in exchange (the underlying). This payo function holds for all values of ST , and so for all possible future states. Now consider another portfolio consisting of long 1 unit of underlying, and short K units of zero-coupon bond that matures at T , and hence is currently worth P (t, T ). At time T this portfolio will be worth ST KP (T, T ) = ST K , for all values of ST . So this portfolio replicates a forward with delivery prices of K . Therefore a forward struck at K must be worth the value of the replicating portfolio at time t in the absence of arbitrage, which is worth St KP (t, T ) at time t. And so for the forward with to be worth zero at the contract set-up time t as required, we therefore need St KP (t, T ) = 0, which gives K = St /P (t, T ) as the required forward price. Once again, we can see that this is a model independent result, so that we have not assumed anything about the stochastic dynamics of the underlying price process or the bond price process. Notice that if the cost of money is deterministic with constant short rate r across all maturities, as we assumed in previous lectures when valuing stock derivatives, then we simply have P (t, T ) = er(T t) , and we have our previous result for forward contract prices, namely F = St er(T t) .

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13.5.2

Example: Forward rate agreements

A forward rate agreement (called a FRA) is an agreement between two parties that a prescribed interest rate will apply to a prescribed principal over some specic person in the future. This means that we agree, at the current time t, to make a payment of an amount K at a future time T1 , and in return to receive a unit (1 say) at a later time T2 . Equivalently the cash ows for a FRA agreed at time t could be: Party A pays party B principal at time T1 > t Party B pays party A principal plus pre-agreed interest amount at time T2 > T1 . Often the value of a FRA is not equal to both parties at the start of the agreement, so that payment may be made at the start of the contract, i.e. the FRA may be bought or sold. However, in to determine what a FRA should be bought or sold for, we need to be able to assess what K should be to make this contract equal to both parties (ie of value zero). Lets assume that I will receive 1 unit at time T2 . How much should I pay at time T1 ? Consider a portfolio at time t consisting of short K units of a T1 bond at price P (t, T1 ), and long one unit of a T2 bond, worth P (t, T2 ). This portfolio will always payo K at time T1 and +1 at time T2 and hence replicates the FRA. At time t it is worth P (t, T2 ) KP (t, T1 ), and hence for this to have zero value at t we require P (t, T2 ) K= P (t, T1 ) Therefore we can see that the rate that we agree should be paid for borrowing between T1 and T2 for the FRA to be fair valued at time t < T1 , fr say, satises Kerf (T2 T1 ) = 1 so that is ln P (t,T2 ) ln [K ] fr = = T2 T1 T2 T1
[
P (t,T1 )

We can do a sense check on this result. In the special, simple case where the risk free rate is constant and deterministic for all maturities, at a rate r say, then we know that P (t, T1 ) = er(T1 t) and P (t, T2 ) = er(T2 t) , so that fr becomes = r, T2 T1 as expected. In other words, as we know that the risk-free rate will be r for the period between T1 and T2 , the fair, no arbitrage rate for borrowing in this period must also be r.
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ln er(T2 T1 )

Stochastic Methods in Finance

The value of a FRA If,as part of a FRA I have agreed to a pay a rate of fr between T1 and T2 , then what is the value of this FRA position to me at time t < T1 ? We know that a rate of fr will result in me being given an amount of erf (T2 T1 ) at time T1 for every unit I repay at time T2 . However, we have also determined above P (t,T2 ) that the no arbitrage value for this amount is P . So holding this FRA will yield a (t,T1 ) payo of erf (T2 T1 )
(
P (t,T2 ) P (t,T1 )

at time T1 , which is worth

)

P (t, T2 ) erf (T2 T1 ) P (t, T1 ) = P (t, T1 )erf (T2 T1 ) P (t, T2 ) P (t, T1 )

at time t. Exercise: Again, sense check this result by showing that in the special case when rates are constant for all maturities at rate r, and rf = r, the FRA is worth zero.

13.6

Further reading

See for example section 5.1 and 5.6 in Rennie and Baxter, Chapters 4 and 20 in Hull (4th edition) or chapters 14 and 17 in Wilmott.

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