Professional Documents
Culture Documents
Lecture Notes 16
I.
Buzz Words:
I.
1.
2.
F0
P0
forward price
spot price
F0 = P0 + cost of carry
Underlying = bond
financing cost
- interest received by bondholder
V.
10
Arbitrage:
Borrow $650
Buy index
Short the futures
Net cash flow
+650
- 650
0
0
Unwind at maturity:
Collect divs [3%(650)]
Sell stock (index)
Settle futures
Repay loan [1.05x650]
Total
19.5
+ ST
-(ST - 665)
- 682.5
+2
0
+650
- 650
0
At maturity:
Settle futures
Pay dividends [3%(650)]
Repurchase stock
Investment matures
Total
(ST - 660)
-19.5
-ST
682.5
3
11
Example
The spot (E0) and forward (F0) rates are dollar per pound $/.
E0 is the number of dollars you can get today for 1
(E0 is the spot $/ exchange rate).
F0 is the number of dollars you can, contracted upon today, to
get in the future for 1
(F0 is the forward $/ exchange rate)
(No) Arbitrage enforces the following relation:
1 + rUS
F 0 = E 0
1 + rUK
12
Explanation
You can either commit to pay in the future F0 dollars for 1,
Or
Step 1: You can borrow E0/(1+rUK) dollars to buy 1/(1+rUK).
Step 2: The 1/(1+rUK) in a pound-based account will compound
to 1 next period, and you will owe [E0/(1+rUK)] (1+rUS)
dollars in the next period.
(you essentially took a dollar loan to synthesize 1).
13
VII. Swaps
Definition: A swap is a contract for exchange of future cash flows.
(Leading examples are swaps between currency
payments or between floating and fixed interest rates.)
(1 + rUS )
(1 + rUK )
14
E0
(1 +
(1 +
rUS
rUK
)+L
)
is :
(1+r US )10
1
1
= E0
+L +
(1+r UK )10
(1+r UK )
= E 0 [PV of a 1 pound (annuity)
E0
(1 +
(1 +
obligation
rUS
rUK
)10
)10
15