BOOK III - DEFINITIONS, NOTES AND FORMULAS

CH1 Introduction: Futures and Options Markets - Institute for Financial Markets
2011
1. Use of Futures Contracts to Mitigate Risk
a. Allow producers, distributors, dealers and investors to manage uncertainty of prices
b. Manage price risks, business risks (supply and demand, storage problems, variations in
quality, price transparency , resale problems, counterpart risk, lack of standardized contracts
before Futures
c. Storage
i. Before Markets would come together and sell on Mkt day. Because they could not
store, everything would be dumped.
ii. Futures exchanges played a major role in develop of storage factories, , laws and
regulations governing the handling of commodities and have developed systems for
the licensing and inspection of warehouses.
d. Quality Risk
i. CBOT (Chicago Board of Trade) introduced grading weighing and measurements
standards
ii. Standardization allows for more transparent, efficient, and trusted system of trading,
ensuring standardized deliverable grades.
e. Price Discovery
i. Buyers and sellers communicate competitive bids and offers from a physical or
electronic location.
ii. Completed transactions are immediately communicated to a wide audience
iii. Standardized payments as well (cash )
iv. All trades must be cleared through members of the exchange who meet exchange
approve standards.
f. Offsetting Transactions
i. Ability to buy and sell futures contracts quickly and easily is cucial for an efficient and
effective market.
g. Speculators Attempt to take advantage of price discrepancies
h. Hedgers - looking to transfer risk
i. Futures clearing house allow for offsetting transactions by guaranteeing that the holder of
the long position is able to sell to any willing buyer n the futures markets.
i. Allows for liquid, low cost futures markets.
j. Counterparty Risk
i. Both sides need to be confident that the other party will perform as expected
ii. Clearing house guarantees the financial integrity of every futures contract.
k. Trading Risk
i. Minimzed by having standardized contracts under pulished exchange rules that
describe methods of operations and permitted trading procedures.
2. Futures Contracts - is an agreement between two parties to buy and sell a preset quantity, and
grade of a specific item, e.g. commodity, security, currency, or index at an agreed-upon price on or
before a given data I the future.
a. Buyer long futures contract and receives delivery
b. Seller short fuures contract andmakes delivery
c. Offsetting position transactions can extinguish (close) futures contract positions.
d. Settlement can be a physical delivery or in cash, depending on contract specs.
3. Standardized terms of futures contracts
a. Underlying instruments also called spot instrument they physical commodity , security,
index, or currency underlying the contract
b. Contract size Determines how much of the underlying contract represents.
c. Settlement mechanism (by cash of physical delivery)
d. Delivery Date (also called Maturity date) Contrtual date whenthe buyer is obligated t pay
the seller and the seller is obligated to deliver to thebuyer, or the date when cash
settlement takes place.
e. Grade or Quality Delivery grade higher or lower than specified grade is permitted at a
premium or discount to the futures contract grade.
4. Certified Stock - After physical commodities have been inspected and approved for delivery.
Inventory level information is available from the exchange where futures contracts are traded.

a. Unexpected decreases or increases in the certified stock of a particular commodity can

produce an immediate market response.
5. DIFFERENCES between EQUITY SECURITIES and FUTURES CONTRACTS
EQUITIES SECURITIES
FUTURES CONTRACTS
Designed to assist in capital formation
Designed for more risk shifting and price discovery
Shorting stock requires borrowing shares and other Shorting is easier in the futures market. A Short for
complications
Every long in futures market shorting can just be
a contract.
No finite timeframe to hold stock(buy or sell)
Finite timeframe.
Individual stocks do not have limits on price
Limits on price and positions- range of possible
movement or position size.
prices and maximum positions allowed for a given
futures instrument.
Finite number of shares issued on individual stock
No limit on number of futures contracts that my
exist at any point
Owners of equities can request stock certificate
No certificate of ownership for futures contracts.
showing ownership
Record f ownership is held with the brokerage
house through which trade was made, and trade
confirmation usually sent to client.
Stock markets have a specialist to maintain orderly Futures markets have an open-outcry system,
mkt on particular stock
where members on the floor compete for the best
price
Regulated by SEC and FINRA
Regulated by CFTC commodity futures Trading
Commission
6. Forward Contracts
a. Not standardized and between private parties
b. Useful when actual deliver is preferred
c. Contracts can be customized to needs of two parties
d. Comes at higher cost
e. Less liquidity than futures ocntracts
f. Not guaranteed by centralized clearing house- which introduces counterparty risk into the
agreement.
7. VOLUME
a. The total amount of purchases or sales during a trading session (not purhcases and sales)
b. There is a buyer and seller for each contract traded; as a result, total purchases must equal
total sales.
c. Technically, volume is no. of exchanges (a purchase and sale together)
d. Trades that cannot be settled are called OUT-TRADE DISCREPANCY
e. OUT-TRADES
i. Resolved by the exchange or clearing house and not included in the total volume
data.
8. OPEN INTEREST
a. Total number of futures ocntracts that remain open at the end of a trading session is known
as Open Interest.
b. Open interest includes those contracts not yet LIQUIDATED by either an offsetting futures
market transaction or delivery.
c. E.g Cient A buys one contract(long) of January wheat from Client B (short position), and
neither client started with a position in January Wheat, one futures contract will be created
and open interest will increase by 1. (shorter did not have Wheat to sell- just entered
contract) .
d. Now, if client be buys wheat (enters into an offsetting position or covering his short position)
and Clients A Long position to sold to a new buy (Client C, there will be no change to open
Interest.
9. Requisites for Successful Futures Markets
a. Mkt is more successful if there is the existence of real economic or business risk. If there is
little volatility in the price of commodities, etc. there is little incentive to trade or manage
risk.
b. Volatility can be dampened by natural mkt forces but also by government action.
i. If governments enact price controls, then there is no need for hedging and as a
result, no need for futures markets.

c. For Mkt participants

i. An available underlying cash market must be based on real supply and demand
economics
ii. Transparency information must be widely available if opague people will not trust
mkt.
iii. Standardization the grade or type of commodity must meet quality standards called
for in contract.
iv. Efficient Delivery infrastructure exchanges have made delivery easy with cash
settled contracts
v. No other liquid contracts no other liquid futures contracts can be available to hedge
the same or similar risks.
10. USES of Futures and Options
a. Hedging to produce, distribute, process, store or nvest in an underlying commodity or
financial instrument. Hedging can lower business costs and allow risk to be taken in other
areas.
b. Speculating does not mitigate risk but is risk-taking. Essential because they usually enter
into offsetting positions. Profit is the motive of a speculator.
c. Carrying a commodity inventory Hedger interested can use futures to carry costs who hold
inventory until consumption.
i. Futures prices often include all or part of the cost of storage, insurance, and interest
payments to carry the commodity until expiration.
ii. A short position in the commodity can cover some of these costs.
iii. A commodity user, can take a long position to carry a commodity until needed. (does
not need to store it, but receives it until needed, therefore inventory is taken by other
position)
iv.
d. Arbitrage - ensures futures and cash mkts stayin balance. Buying cheaper and selling in
overpriced market will bring mkts back into alignment and provide a riskless profit for an
arbitrageur. Arbitrage heps keep markets closer to fair market value.
e. Position taking taking a futures position without an offsetting cash position would be
considered speculation. (e.g. selling a futures(with no one to buy yet))
f. Price discovery a competitive market helps o establish a single known price. Openness of
futures market and the speed at which prices are disseminated puts all participants on a
level playing field.
i. Assessing risk is critica for hedging and speculating, and assessing risk cannot
happen without effective price discovery!!!
g. Participants acting in their own self-interest make the futures maket function, providing
liquidity and price discovery. Speculators take on risk to earn a positive return and risk is
absorbed by other speculators or hedgers.
i. Long term speculators help to smooth price fluctuations by injecting capital into the
market place.

CH2 Futures Industry Institutions and Professionals - Institute for Financial Markets
2011
1. Futures Exchange
a. Do not own the underlying instruments, nor do they trade or take positions.
b. For-profit futures Exchanges issue two types of stock Class A Shares and Class B Shares
i. Class A represent equity ownership in the exchange and voting rights
ii. Class B represents trading rights. Trading rights are often leased or used directly by
owners of Class B shares.
c. Role is to provide electronic or physical trading facilities, rules to conduct trading, and
operational mechanisms.
d. Futures exchange members trade amongst themselves for their own accounts or for
customers accounts.
e. Differ from stoch exchanges in that they write all terms and conditions of standardized
contracts
2. Common contract terms
a. Contact/delivery months available for trading.
b. Required initial and maintenance margin levels for each commodity.

3.

4.

5.

6.

c. Grades andlocation designations for physical delivery contracts.

d. Cash price series (used fr final settlement of cash-settled contracts)
e. Pricing conventions and minimum price fluctuations.
f. Supervision of day-today activities of all trading participants.
g. Market Surveillance (prevents manipulaition and congestion)
h. Real-time distribution of price data.
Organization of Futures Exchanges
a. Futures echanges provide an orderly market for trading futures and options on futures.
b. Only individuals can obtain exchange membership
c. With exchange approval, individuals may grant some membership privileges to an affiliated
person, organization, or corporation.
d. Membership elected Board of Directors oversees exchange
e. Day-to-day administrative oversight is responsibility of full-time, paid, non-member
president. President carries out policies approved by the Board.
f. Exchange staff handle day to day legal, compliance, data processing
g. In U.S. every exchange has an affiliated CLEARING HOUSE
h. Clearing house
i. Provide financial mechanisms and guarantee performance on the exchanges futures
and options contracts.
ii. Clearing house acts as a counterparty by substituting itself for each counterparty for
the purpose of settling gains and losses.
iii. It pays out funds to those receiving profits and collects funds from those with losses.
iv. Counterparty substitution is known as principle of substitution
i. Clearing house for most US commodity exchanges is organized as a SEPARATE member
corporation. CME and NYMEX is structured so that clearing house is recognized as another
department.
j. Clearing house membership is carefully screened with strict standards for financial strength,
administrative ability, and integrity.
k. Revenue from clearing houses is earned by charging fees for clearing trades, interest from
invested capital, temporary investment of member guaranty deposits, and by providing
other services such as handling of delivery notices.
Exchange Membership - individuals who participate in exchange trading must be exchange
members or process trading privileges.
a. Local member uses personal capital to trade for a personal account. Relies on short-term
trading skills and market analysis.
b. Scalper member trades frequently in an attempt to make money on small price
movements.
c. Day Trader - trades frequently throughout the day, but has zero (flat) net position at the end
of the day.
d. Floor Broker - trades for others and earns a commission.
Rules of exchange membership
a. Can comlete a transaction after making an open, competitive outcry of the bid or offer in
hand.
b. Due diligence is required by the floor broker when executing orders.
c. Losses resuting from broker error are the brokers liability.
d. Bids or offers not made openly in the pit (i.e. non-competitive trades) are typically
considered invalid trades.
e. Members participating in a trade that fails to conform to exchange rules may be subject to
disciplinary actions
Dual Trading practice of members trading for their own account and for customer accounts. Rules
regard dual trading are that customer orders have priority over member orders.

CLEARING HOUSE FUNCTIONS

7. Original Margin Member firms are required to deposit funds to support open contracts submitted
for clearance.
a. Amount (per contract) of original margin is determined by the clearinghouse board of
directors.
b. CFTC regulates that client funds be segregated from a member firms proprietary funds.
c. Members must maintain a one acct for proprietary funds and a separate acct for client
funds.

d. Margin deposits for customers may include other negotiable instruments, such as warehouse
receipts.
e. Clearing house members may submit letters of credit, cash, government securities, or
registered securities to satisfy margin requirements.
8. Margin levels historical volatility of futures prices are often used to set margin levels. Levels used
to protect the clearing house against one-day large price movement.
a. Spot month positions (those positions near delivery) may have different margin levels than
hedge positions.
9. Margin Collection (gross and Net positions)
a. Margins may be collected by clearing house on either gross or net positions basis for each
customer.
b. CME and NYMEX require gross margins
c. Some exchanges allow for margins on net postions. E.g. long 100 contracts and short 900
contracts of July Wheat, net basis would charge margin on the net long 100 contracts.
d. If Gross, it would charge a margin on the 1900 contracts.
10. Settlement prices for actively traded delivery months, settlement rices usualy fall within the range
of prices traded at the close.
a. Closing bid and offer are usually averaged to reach the settlement price.
b. For inactive months with not much activity, a nominal price may be designated by an
exchange member committee. A nominal price is not an actual traded price but a fabricated
price based on the closing prices of similar contractsthat traded on the closing day in
question.
11. Variation margin
a. The settlement of daily gains and losses between member firms.
b. Exchange committee, committee on quotations determines the settlement price for each
contract for trading day
c. Clearinghouse member firms are required to pay to, receive from, the clearinghouse the
difference between the current settlement price and the trade price for that day or the
previous days settlemtn price for an existing position.
d. Variation margin collected separately for member firm positions from client account
positions.
e. Margin is collected by automatic debit/credit before opening of trading on the following
business day to the member firms house account or customers margin account.
12. Guaranty Deposit a. Clearinghouse members must maintain a large guaranty deposit with the clearing house in
addition to original and variation margin in order to maintain their own and customer
positions.
b. Maintained with the clearinghouse as long as firm/client is a member of the clearinghouse.
c. Deposit can be made with cash, letters of credit, or securities.
13. Defaulting Client
a. Individual client account falls with the carrying member firm, using its own fnds if delivery of
funds or a is not satisfied.
b. Commodity Account Agreement gives the broker the right to liquidate any customer
position, without recourse, in the event that margin calls are not met.
c. Brokes insit margin calls are satisfied promptly as they are responsible for any deficit.
14. Clearing Process a. Members provide ongoing data on trades executed on behalf of customers throughout the
day.
b. Clearing house must have confirmed records of a trade both from the buying and selling
clearing house members bfore it can insert itself as the opposite party to a trade (the
counterparty)
c. Clearinghouse does not assume legal and financial obligations of the other party to the trade
until the accuracy of all reported transactions has been verified and the original margin has
been deposited.
d. Becomes buyer for anyone who as sold and seller for anyone who has bought
e. Acting as a counterparty to every trade allows traders to close out positions even when
original counterparty is not ready to close out its own position.
f. OFFSETTING Transactions on the clearing house books allows traders to move freely in and
out of the futures markets without any obligation to the original party involved.
g. Difference betwwen purchase price and sales price represents traders gross profit.
15. Steps taken when member unable to meet financial obligations

a. Solvent member takes position of all open fully margined customer positions. All undermargined customer positions and firms proprietary positions are liquidated.
b. If member customer account is in deficit of because of liquidiation, any additional margin
member had deposited is applied toward the deficit on customers positions.
c. If defunct member deposits are insufficient, members exchange membership may be sold
and funds in guaranty fund may be used.
d. If deficit still exists, surplus fund of the clearing house may be used at the discretion of
clearinghouse board.
e. Contributions by other solvent clearinghouse members to the guaranty fund may also be
used. Guaranty fund may be replenished by a pro rata special assessment made by the
remaining members of the clearinghouse.
f. NOTE: financial integrity of each futures contract is strengthened by:
i. Selection criteria of clearinghouse members
ii. Guaranty fund
iii. Ability of the clearinghouse to assess members ability to fulfull obligations.
Mechanics of Futures Delivery
16. Actual Delivery physical transfer of a commodity or financial instrument.
a. Financial fulfillment guaranteed by clearing house, but physical delivery is not.
b. Clearing house member firm guarantees physical delivery. If customer defaults, member firm
is liable to fulfill obligation.
c. Physical delivery is made easier by Clearing house as counterparty
i. Clearing house receives delivery notices from sellers(shorts) and assigns notices to
buyers (long).
ii. Clearing house may also arrange inspection of commodities, act as depository for
warehouse receipts, or receive delivery of foreign currencies and some financial
instruments.
17. Sellers option gives the seller(short) the right to designate the day when physical delivery is to be
made if more than one day is allowed
i. Can also designate the location or warehouse whre the delivery will be mde
ii. Buyer has no say in specific location, day, or grade of the commodity or financial
instrument (decided by contract)
iii. Seller ready to make delivery, seller instructs broker to send notice of intention to
deliver
iv. Delivery procedures can vary with contracts and exchanges.
b. Exchange handled by Clearing house i. Decide to allocate based on oldest long position, largest net long position open, r
largest gross long position open.
ii. Buyer and seller brought together by clearinghouse.
1. Clearing member of delivery customer must provide required documents
2. Once payment is received, clearing house wil release documents to receivers
carrying firm
3. Procedure completed within time span specified by exchange rules
4. Clearinghouse provides check to the delivering customers firm to provide to
its customer.
18. Open Positions
i. Offset up to and including last trading day of futures contract.
ii. Positions remaining open must be settled by actual delivery or cash settlement
depending on exchange procedures.
iii. TENDER DAY is the last day on which notices of intention to make delivery may be
issued. Last trading day and tender day are usually the same.
19. SEQUENCES OF DELIVERY FOR THREE TYPES OF DELIVERY PROCEDURES
a. Physical Trading with Concurrent Trading and Delivery
i. First Notice Day
1. Shorts may, but not required to, issue delivery notice
2. Trading continues along with deliveries, shorts may issue notices, ad longs are
liable for delivery.
ii. Last Notice Day last day for delivery notices to be sent
iii. Last Trading Day last day for trading the contract.
b. Physical Delivery Following the End of Trading
i. Last Trading day last day to trade contracts, remaining open positions are to be
satisfied by delivery.

ii. First Notice Day shorts, may, but are not required to, issue delivery notice on this
day, subsequent days, according to terms of contract.
iii. Last notice Day - last day a short can issue a delivery notice.
c. Cash Settlement
i. Last Trading Day last day to trade contracts, remaining open contracts are settled
after trading is over
ii. Cash Settlement Day all remaining open positions are settled by cash debit or credit
using cash-market value; must be done by exchange specified date and time.
d. Speculators have little interest in actual delivery of a commodity
i. If delivery notice is received, speculators are required for all picking up and all
associated expenses of delivery and ownership, such as carrying broker fees, interest
expense, insurance, additional inspections.
ii. One Option is for the long position speculator to sell his position in the spot month
and buy the same number of contracts for a later month. This is known as
SWITCHING or ROLLING OVER a FUTURES POSITION The extra cost of commission
and transaction fees is less expensive that taking ownership.
FUTURES MARKETS PARTICIPANTS
20. Futures Commission Merchants (FCMs)
a. Futures brokeraes firms designated by Commodity Exchange Act to operate as
intermediaries between public customers, hedgers and institutional investors, and the
exchanges.
b. Also known as a Commission house or Carrying Firm.
c. They:
i. Provide facilities to execute customers orders
ii. Maintain records of each customers open position, margin balance, and transactions.
iii. Earns a commission for the services it provides
iv. Only entity that can hold customer funds other than clearinghouse
v. May be full service or discount firm
vi. May be national, regional brokerage offering other financial services
vii. May have a parent company or related company in agribusiness, commercial
banking, or other commercial enterprise.
21. Introducing Brokers
a. And individual or firm that has established relationships with one or more futures brokerages
firms
b. Responsible for maintain and servicing customer accounts and relationships.
c. Like FCMs in that its sales force receives commissions.
d. Unlike FCMs IB cannot hold customer funds, so as a result, all IB customers must maintain
accounts with an FCM where each customer account is identidied and carried separately on
the books of an FCM.
e. Two types Independent and guaranteed IBs firms. (operate independently of any particular
brokerage firm and can meet regulatory requirements where guaranteed IB firm has a legal
and regulatory relationship with guarantor futures commission merchant through which IB
introduces its customers. FCM and IBs must be registerd under Commodity Exchange Act.
22. Account Executives
a. Of FCMs and IBs must be registered as ASSOCIATE PERSONS.
b. They are agents of FCM or IB and deal directly with firms customers.
c. Role is to:
i. Provide appropriate docs for new accounts and confirm they are signed.
ii. Clarify trading rules, discolure requirements, and procedures to customers
iii. Inform clients of prices and market conditions.
iv. Enter orders for clients
v. Convey executed prices f trades and pending order statuses.
vi. Act as liaison between the customer and the firms research dept.
vii. Notify customers of margin calls
viii. Identify their customers according to NFA rule 2-30; obtain customer name, address,
occupation, estimated annual income and net worth, approx. age, previous
investment and futures trading experience. 0 FOR DUE DILIGENCE. to ensure
futures contracts are a appropriate investment vehicle.
ix.
23. Commodity Trading Advisors (CTA)
a. Trade individual accounts for single clients

b. Act as an individual or organization that, for compensation advises futures and options on
futures
c. Similar to brokerage accounts
d. Power of attorney gives CTA discretionary authority
e. Trading philosophy should achieve investors goals
f. Can trade and manage funds
g. If CTAs are also FCMs, they may accept funds from customers in CTAs name
h. Service fees include
i. Performance(trading) fee
ii. Management fee
iii. Brokerage commissions not all CTAs participate, but if commissions are shared with
its FCM, it must be disclosed to CTAs clients.
24. Commodity Pool Operators
a. Pool the funds of many investors and trade for all individuals under a pooled account.
b. Similar to a securities mutual fund
c. Benefits include:
i. Professional management of lcinets funds for as litte as $5000 Individual managed
accounts may have a minimum of more than $50,000.
ii. Allow access to different CTAs with different styles, systems, offering diversification.
iii. CPOs usually the general partners of a limited partnership offering limite liability for
investors.
iv. Pool offers fow-through taxation benefits and limits investor risk to the capital
invested.
v. Investors in individual accounts can lose more than they initially placed in the
account.
vi. Have dissolution clauses a unit with 75% dissolution clause and an initial value of
$1000, would stop trading when its value reached 250 and investor would receive
$250 of his boney back.
25. Customers of an FCM
a. Firms or companies wishing to hedge
b. Individual speculative traders
c. Money management firms, money managers, and institutional investors.
d. Floor brokers not belonging to the clearinghouse wishing to use clearing facilities of the
commission house.
e. Brokerage firms that are not members of a particular exchange or clearinghouse.

CH 7 Hedging with Futures and Options - Institute for Financial Markets 2011

1. BASICS OF HEDGING
a. Futures and options rarely used to actually acquire underlying assets.
b. Physical delivery rarely occurs with future contracts primarily because
i. Contracts are mismatched in desired quality, location, and timing relative to a
hedgers preferences.
ii. Rather used to control price risk associated with underlying asset.
c. Hedgers should seek contracts that closely align with characteristics of underlying asset to
minimize the risk associated with a mismatched hedge:
d. Fortunately price correlations between futures price and cash (spot) price of a commodity
tends to be very high. BASIS used to examine relationship.
2. USE OF FUTURES TO MANAGE PRICE RISK HEDGING
a. Futures can be used in place of cash transaction that would occur at a later date. (serve as a
temporary substitute) simply a contract.
b. Futures contracts and cash positions can be considered equal and opposite positions
c. Hedging with Futures
SITUATION
HEDGING STRATEGY
Individual who owns or will soon own the
Sell futures contract now and offset this
underlying asset and wants to lock in the price
a later date with the sale of the physica
(e.g. farmer who will harvest corn in three months) the cash market.
Individual who needs to acquire the underlying
Buy futures contracts now and either ac
asset in the future and wants to lock in the price.
delivery or purchase in the cash market
date and offset the futures position. (mo
than taking delivery)

3. Basis Defined as the cash price less the futures price.

a. basis =

S t F0

b.

S t = cash or (spot price) of the underlying

c.

F0

= current price of the futures contract

4. Positive Basis (cash over futures) exists when the cash price exceeds the futures price
5. Negative basis (cash under futures) Futures price exceeds the cash price.
6. Basis Risk Even though futures and options reduce price risk, they do contain basis risk
a. Potential change in basis is unavoidable, but often assumed to be stable uring hedging
period to allow clearer illustration
b. Hedgers who utilize futures can choose a set of positions that are either long the basis or
short the basis.
7. Long the basis a set of positions that consist of a short futures position and a long cash
position(commodity, underlying asset) .
a. Positions long the basis benefit when the basis is strengthening.
b. Occurs when the cash price increases at a faster rate than the futures price price or when
the cahs price decreases at a rate slower than the futures price.
c. SELLING HEDGE (short Hedge) occurs when the hedger shorts a futures contract to hedge
against a price decrease in the existing long cash position.
d. Appropriate when a hedger possesses inventory of an asset and expects prices to decline.
e. E.G. a gold-mining company maintains a significant position in the precious metal. However, because

the price of gold is susceptible to market pressures and may fluctuate wildly at times, the company
may choose to hedge its position (through the sale of futures contracts) and thus lock in a guaranteed
range of value. An individual or company that does this (owns the physical commodity and hedges
their position) is said to be "long the basis".

8. Short the basis a set of positions that consist of a long futures position and a short cash position.
a. Position short the basis benefit when the basis is weakening.
b. Occurs when futures prices increases at a faster rate than the cash price or when futures
price decreases at a rate slower than the cash price.
c. A BUYING HEDGE (long hedge) occurs when the hedger buys a futures contract to hedge
against an increase in the value of the asset that underlies a short position. (wants price to
drop(but expects price to rise) to take advantage of lower price, but put a price ceiling on
rising prices)
d. Appropriate when hedger needs to acquire inventory at some point in the future and expects
prices to rise. (buy the product at a lower price. Sell it at a higher price. (short cash position)
e. E.G. A flour miller will need wheat to produce flour. He purchases wheat futures. A rise in
wheat prices increases the cost of his input and reduces his profit. However, the profit on the
long futures position offsets the increased cost of wheat. The long position locks in the cost
of wheat that he will need to buy in order to produce and sell flour, which he has already
agreed to do. (buy futures underlying at a cheaper price will offset higher future prices)
f. Long hedgers want the basis to weaken since it will reduce the effective price of purchasing
the commodity in the cash market at a later date. Futures Price + basis = Effective
Price
9. Exchange for Physical (EFP) Transactions
a. An off-exchange, private transactions between two parties where one party purchases the
physical asset and sells a futures contract on that asset to a counterparty while the
counterparty sells the physical asset and buys a futures contract.
b. Agree on all stipulations before transaction and after transaction they report it to the
appropriate clearing house
c. EFP one exception to US FEDERAL LAW that all trades take place on the floor of the
exchange(i.e. cannot be prearranged). Allows EFP transactions to occur during periods when
exchange is closed.
d. Tend to be restricted to those who actually trade the underlying asset. And allows EFP
parties to easily close their hedge at expiration of the agreement will allowing the to remove
any price or counterparty variability because prices are fixed throughout the term of the
transaction.
e. Frequently used in energy and financial futures markets.
f. ENERGY MARKET

i. Price often quoted based on basis differential. The differential is theprice difference
that is attributable to difference in the characterisitics of the physical asset and the
product specified in the futures contract.
g. FINANCIAL FUTURES MARKET
i. Currency dealers , trading desks, hedgers, speculators, use EFPs to establish or offset
hedges and improve transactional efficiency.
ii. E.g. a given market may lack the necessary depth for large position to be established
at a single priceand a participant who wishes to take a large position will encounter
price slippage (difference between expected transaction costs and the actual amount
paid)
iii. By using an EFP, participant can avoid this issue.
10. Options on Futures
a. Give the holder the right to buy or sell a specified futures contract on or before a given data
at a given futures price (the strike price)
b. Similar to futures, option hedger would select options in the amount and type that allow for
the elimination of the risk present in their long or short cash position. (tak a position
inoptions on futures that is equal and opposite to their cash position)
c. MORE COMPLEX because the are priced based on relationship between:
i. The cash price and the futures price
ii. The futures price and the option price.
Futures posiions assumed upon option exercise
Buyer Assumes
Seller Assumes
Call option
Long Futures Position
Short Futures Position
Put Option
Short Futures Position
Long Futures Position
11. Long Put Option on Futures (purchase Put Options on Futures)
a. Can take a short futures position. (sell futures at certain price)
b. Point of View holds inventory or asset and wants to protect against downward price risk.
Buy put options will guarantee a certain higher price.

c. Strategy - buy put option for $X. at t=0 at Strike $K. If at Maturity =

( KF T )

execute

option to sell short futures. E.g. Sell for 1300 when you bought for 1200. $100 profit cost of
option.
i. If price goes up, you can sell at higher price.
ii. If price goes down, you minimize risk with ability to sell at higher price(profit from
option on futures if executed)
iii. Unwinde cash position at maturity but your loss maybe minimized and unlimited
potential for sales growth if price goes up.
12. Short Call options on Futures (sell a call option ) sell option to buy become s short Futures position. )
a. Take a short futures position. (option to buy at lower price but seller hoping price will fall
and option will be out of the money)
b. Point of view, holds inventory, does not sell it in first period, but wants to protect against
price drop. Sell a call. If price goes up cash position will become more worthwile even if
option expires in money.
c. This is why cash position is opposite futures position. (always depends if you want to sell or
buy)
13. Long Call Option on Futures
a.
14. Short Put Option on Futures
a.

CH 1 Introduction - Hull Options Futures and Other Derivatives 9Ed.

1. Open-Outcry System
2. Electronic trading system
3. Advantages and Disadvantages of over-the counter trading
a. Advantages

4.

5.

6.

7.

i. Terms not set by an exchange

ii. Participants have flexibility to negotiate
iii. In event of misunderstanding, calls are recorded
b. Disadvantages
i. OTC trading has more credit risk than exchange trading
Options Contract
a. Contract that in exchange for the option price, gives the option buyer the right, but not the
obligation to buy (or sell) an asset at the exercise price from (to) the seller (or buyer) within
a specified time period, or depending on the type of option, a precise date (i.e. expiration
date)
b. Call Option gives the holder the right to purchase an underlying asset
c. Put Option gives buyer the right to sell.
Forward Contract - contract that specifies the price and quantity of an asset to be delivered
sometimes in the future.
a. no standardization
b. one party takes long and other party takes short position.
c. Often used in foreign exchange market to be used to hedge foreign exchange risk.
Futures Contract
a. More formalized, legally binding agreement to buy/sell a commodity/ financial instrument in
a pre-deisgned month in the future, at a price agreed upon today by the buyer/seller. Futures
contracts are highly standardized regarding quality, quantity, delivery time, and location for
each specific commodity
Call option Payoff
a. Buyer
b. Seller -

CT =max ( 0, ST K )
CT

c. Profit Buyer =

CT C 0

d. Profit Seller =

C0 CT

8. Put Option payoff

a. Buyer
b. Seller -

PT =max(0, KS T )
PT

c. Profit Buyer =

PT P 0

d. Profit Seller =

P0PT

9. Forward Contract Payoff- Long and Short

a. Long -

S T K

can have profit or loss because you are locked in to buy even if

Loss ST < K
b.

Profit if ST > K

c. Short -

KST

can have profit and loss. Loss if

S T > K Profit if K > S T

10. Hedging Payoff Strategies Compare

a. Forwards used to lock in price to eliminate financial exposure (mostly price movement) BUT
give up any price movement that may have
b. Investor with long exposure (holds asset) can hedge buy entering into a short position (short
futures to sell at a minimum exercise price K)
c. Investor with short exposure (needs to buy) can hedge with a long futures to buy at a max
price K . so if price goes above, we will pay no more than K )
d. Options also create significant leverage as investor only need to pay the option premium t
purchase an option instead of the face-value of the underlying. Asymmetric payoffs as they
limit loss to the option premium but unlimited gains from favorable movement in the
underlying value. For hedging, act as insurance
11. Speculative Strategies Compare

a. Motivation for using futures is that limited amount of initial investment is required, and
creates significant leverage.
b. Investment required is just the initial margin.
c. Futures contracts can result in large gains or large losses.
d.
12. Arbitrage Opportunity explain how they are temporary
a. Supply and demand forces will adjust prices quickly and eliminate the arbitrage position.
13. Arbitrageur
14. Some risk that can arise from derivatives
15. Derivative - a financial security(e.g. options) whose value is derived in part from another securitys
characterisitics or value. The other security is referred to as the underlying asset. A derivative
derives its price from some other variable.
16. Market maker individual that makes a market in a security. The market maker maintains bid and
offer prices in a given security and stands ready to buy and sell lots of said security, at publicly
quoted prices.
17. Spot contract - agreement to buy/sell an asset today.
18. Forward contract spepcifies price/quantity of an asset to be delivere on or before a future prespecified dat.
19. Futures contract - legally binding agreement to buy/sell a commodity or financial instrument in a
designated future month at a previously agreed upon pric by the buy/seller.
20. Call option - gives its holder the right to buy a specified number of shares of the underlying
security at the given strike price (exercise price) on or before the options contract. (before is an
American Option)

Call suitable if investor wishes to benefit from or protect themselves from an increase in asset
value. However, given same bullish directional view on asset rice, writing a put provides an
immediate inflow of premium against potential risk of having to buy asset at the stike price if the

value should fall. Both strategies provide a potential gain, but because of the asymmetrical
payoffs from the different sides of option positions provide very different risks.
Covered Call provides the opportunity for the write to reduce the costs of ownership by receiving
premium income up-front.
Covered Put An income-generating strategy allowing the write to reduce cost of a future purchase.
21. Put option gives the investor the right to sell a fixed number of shares at a fixed price within a
given pre-specified time period.
22. Short Call option obligation to sell asset if option is executved by Call Option buyer
23. Short Put option - obligation to buy asset if option is executed by Put option buyer
24. European Option Option that must be exercised or not exercise at option maturity. (only time
granted to exercise)
25. American option can be exercised any time on or before Option maturity date.
26. Value of American vs European Option a. American Option will be worth more than European Option when the right to exercise is
VALUABLE, and theywill have equal value when it is not.
27. Long Position - refers to actually owning the security.
28. Short Position - when a person sells a security he does not own. An investor
29. Strike Price price at whiche the security underlying an options contract may be bought/sold
30. Expiration - date is the last date on which an option may be exercised.
31. Bid price quoted bid or the highest price,which a ealer is willing to pay to purchase a security
32. Offer price (ask proce) is price at which the security is offered for sale, also known as the asking
price.
33. Bid-ask spread - difference between the ask price and the bid-price.
34. Hedgers reduce risks typically through the use of forwards contracts or options.
35. Speculators take positions in the market in order to profit from positions. Can use futures for large
potential gain / loss. Using options less risky since maximum loss is curtailed by option premium,
but can be highly leveraged
36. Arbitrageurs take offsetting positions in financial instruments in order to lock in a riskless profit.

CH 2 Mechanics of Futures Markets

Derivatives 9Ed.

- Hull Options Futures and Other

1. Compare and Contrast Forward and Futures Contracts.

a. Futures contracts
i. Exchange traded obigations to buy or sell
ii. Most futures positions not held to take delivery of underlying, instead they are closed
out or reversed prior to settlement date.
iii. Purchase of futures gone long. Seller of Futures Gone short
iv. Futures used by speculatos to gain exposure to changes in price of the asset
underlying futures contract.
v. Hedger will use futures contracts to reduce exposure to price changes in the asset.
2. Open Interest the total number of long positions in a give futures contract. It also equals the total
number of short positions in a futures contract. Possible that on any given day for the trading
volume ona contract to be higher than its open interest.
3. Characteristics of Futures Contract
a. Quality of Underlying asset specification of the quality of the underlying under the
contract. May not ave one if contract is a financial asset.
b. Contract Size specifies the quantity of the asset that must be delivered per contract.
c. Delivery Time contracts referred to by the month in which delivery is to take place. Some
contracts not settled by delivery but by payment in cash, based on difference between
futures price and the market price at settlement.
d. Delivery Location - exchange specifies the place where delivery will take place.
e. Price Quotation and tick size exchange determines how the price of a contract will be
quoted as well as minimum price fluctuations (tick size) for the contract. E.g. grain quoted as
$dollars/bushel . minimum tick size of of a cent per bushel. $.0025 and grain contract of
5000 bushels = minimum tick size of (.0025*5000) = 12.50 per contract.
f. Daily price limits - exchange sets maximum price movements for a contract during the
day. When contract moves down by its daily price limit, it is said to be limit down when

4.

5.

6.

7.

8.

9.

contract moves up by its price limit, it is said to be limit up. If that happens, trading is
closed for this contract.
g. Position limits - exchange sets maximum number of contracts that a speculator may hold
in order to prevent speculatos from having an undue influence on the market. Such limits to
dont apply to hedgers.
Convergence of Futures and Spot prices
a. Basis is the difference between spot price and the futures price.
b. Basis = spot price futures price
c. As maturity nears, basis converges towards zero. At Expiration, the spot price must equal
the futures price because the futures price has become the price today for the delivery
today; which is the same as the spot. Arbitrage will force the prices to be the same at
contract expiration.
Operation of Margins
a. Margin is cash or highly liquid collateral placed in an account to ensure that any trading
losses will be met.
b. Marking to Market is the daily procedure of adjusting the margin account balance for daily
movements in the futures price. The amount required to open a futures position is called the
Initial Margin.
c. Maintenance Margin is the minimum margin account balance required to retain the futures
position. When the margin account balance falls below the maintenance margin, the investor
gets a margin call, and he must bring the margin account back to the initial margin amount.
d. Variation Margin the amount necessary to bring the bring the margin value back up to
Initial Margin if it falls below the maintenance margin.
e. Depending on the type of clinet, typically brokers or brokerage houses require clients to post
a balance in the margin account more than the maintenance margin requirements
established by exchanges. Management of daily cash flows are withdrawn or contributed
appropriately by the clearinghouse.
Clearinghouse each exchange has one.
a. Guarantees that trades in the futures market will honor their obligations.
b. Clearinghouse does this by splitting each trade once it is made and acting as the opposite
side of each position.
c. Acts as buyer to seller and seller to buyer. By doing this, clearinghouse allows either side of
the trade to reverse positions at a future date without having to contract the other side of
the initial trade.
d. This allows traders to enter the market knowing that they will be able to reverse their
position at a future date.
e. Traders free from worrying about counterparty defauting since the counterparty is now the
clearinghouse. In history of US futures trading, clearinghouse has never defaulted.
f. All members collateralize it, ensuring that no dafulats take place. All trades go through the
learinghouse members, who must post a clearing margin (guarranty margin) in same way
an investor has a margin account with a broker. Ensures clearinghouse is liquid at all times.
Collaterlization in Over the Counter Markets (OTC)
a. Subject to a good deal of credit risk since the other side of an OTC contract could default on
its payments.
b. A marked to market feature for OTC market where any loss is setted in cash at the end of
the trading day. A cash payment is made to the party with a positive account balance. This is
similar to trading on margin where futures trader needs to restore funds if the vallu eof the
contract drops below the maintenance margin.
c. Recently passed legislation requires OTC markets to use a clearing house and therefore
investors etc. to post a margin account and any variation margins on a daily basis. Credit
risk assumed by clearinghouse.
Arguments for use of clearing houses in OTC markets.
a. Automatic posting of collateral
b. Increased transparency of OTC trades. Governments push for use of clearinghouses to limit
systemic risk, which is the risk that a failure by a significant financial institution wil impact
other institutions
c. Reduced financial system credit risk
Normal Futures vs. Inverted Futures Market.
a. Settlement Price analogous to the closing price for a stock but is not simply the price of the
last trade.

i. It is an average of the prices of the trades during the last period of trading- called the
Closing Period, which is set by the exchange. This feature of the settlemet price
prevents Manipulation by traders.
ii. Settlement price is used to make margin calculations a the end of each trading day.
b. Normal Market increased settlement prices over time indicates a normal market.
c. Decreaseing settlement prices over time indicates an inverted market.
10. Mechanics of Delivery Process.
a. Physical Delivery
i. Terminate the contract by delivering the goods/commodity. The location for delivery,
terms of delivry and details of exactly what is to be delivered are all specified in the
Notice of Intention to Deliver file. Each exchange has specific rules as to the
conditins for making an intent to deliver.
ii. Price paid or received is determined by the settlement period on the exchangedetermined last trading day of the contract.
b. Cash-settlement contract delivery not an option and futures account is marked to market
based on the settlement price on the last day of trading.
c. Reverse of Offsetting,
i. With futures, the other side of your position is held by the clearinghouse- if you make
an exact an opposite trade (maturity, quantity, and good) to your current position,
the clearinghouse will net your positions out, leaving you with a zero balance.
ii. Contract price can differn between two contracts.
1. E.g. if you are long one contract of gold at $970 per ounce and subsequently
sell (taking short position) an identical gold contract when price is $970 per
ounc, $20 multipled by number of ounces of gold specified in the contract will
be deducted from the margin deposit(s) in your account.
iii. Sale of futures contract ends the exposure to future price fluctuations on the first
contract. Your position has been REVERSED or CLOSED OUT, by closing a trade.
d. Exchange for Physicals
i. You find a trader with an opposite position to your own and deliver goods and settle
up between yourselves, off the floor of the exchange (an ex-pit transaction) This is
the sole exception to federal law that requires all trades to occur on the floor o the
exchange. Exchange is then notified.
ii. Differs from delivery in that traders actually exchange the goods, the sontract is not
closed on the floor of the echange, and the two traders privately negtotiate terms of
the transaction. REGULAR delivery ONLY requires one trader and the clearinghouse.
11.TYPES OF ORDERS
a. Market orders orders to buy or sell at the best price available.
i. Discretionary order a market order where the broker has the option to delay
transaction in search of a better price .
b. Limit Orders orders to buy or sell away from the current market price.
i. Limit Buy Order is placed below the current price.
ii. Limit Sell Order is placed above the current price
iii. Limit Orders have a time limit, such as instantaneous, one day, one week, one
month, or good till canceled.
iv. Limit orders are turned over to the specialist by the commission broker.
c. Stop-loss Orders are used to prevent losses or protect profits.
i. Stop-loss Sell - afraid of a drop in price, and if it does, you want broker to sell it.
ii. Stop-loss buy - afraid of a rise in price, if it does, you want broker to buy it.
usually combined with a short sale to limit losses. (if the stock price rises to the
stop price, the broker enters a market to buy the stock. )
d. Stop-Limit Orders a combination of a stop and limit order.
i. The stop price and limit price must be specified, so that once the stop level is
reached, or bettered, the order would turn a limit order and hopefully transact at the
limit price.
e. Market-if-touched Orders (MIT order) orders that would become market orders once a
specified price is reach in the market place.
f. Time-of-Day Order - For those orders that remain outstanding until the designated price
range is reached, the trader making the order needs to indicate the time period for the
order.

g. Good-till-Canceled (GTG) orders (a.k.a open orders) - orders that remain open until they
either transact o are canceled. A popular method to submitting a limit order is to have it
automatically canceled at the end of the trading day in which it was submitted.
h. Fill-or-Kill orders - must be executed immediately or the trade will not take place.
12. REGULATION
a. Commodity and Futures Trading Commision responsible for regulating futures markets.
i. Licenses futures exchanges as well as traders who offer futures trading services to
public.
ii. Also approves new futures contracts and any revisions to existing futures contracts.
iii. When approving, it must ensure each contract serves useful economic purpose. (for
either hedging or speculating)
iv. Responsible for communicating prices to public, addressing public complaints, and
takig disciplinary actions against members who violate futures exchange rules.
b. National Futures Association (NFA)
c. Securities and Exchange Commision d. Federal Reserve Board
e. U.S. Treasury Department
f. SEC, Fed, and Treasury are mainly concered with how futures trading impacts spot market
trading in stocks and bonds.
g. NFA has more prominent role by attempting to prevent fraud and ensuring that futures
markets operate in best interests of the public. E.g of futures fraud includes cornering the
market. (taking excessive long positions while influencing the supply of the commodity) and
front-running (traders using privileged information to trade in their own accounts before
customer accounts.)
13. Accounting
a. When accounting for changes in market value of futures contract, changes must be
recognized when they occur
b. Hedge accounting an exception that specifies gains/losses from a hedging instrument be
recognized in the same period as gains/losses from the asset being hedged.
c. Under FAS 133 [Financial Accounting Board (FASB) Statement No.133] the fair market
value of all derivative contract must be included on the balance sheet.
i. To use this accounting method, it must be shown that the hedging instruments
frequently and effectively offsets intended risk exposure.
14. Taxes
a. Corporate Tax payers capital gains taxed at the same level as ordinary income and capital
losses are restricted.
b. Non-corporate tax payers Capital gains are taxed at the same level as ordinary income, but
long-term gains (investments held over one year) are subject of maximum 15% tax rate.
Another difference is that capital losses are deductible for non-corporate taxpayers.
c. Futures contracts for tax purposes, contracts are considered closed out at the end of each
year. This gives rise to 60/40 rule for non-corporate tax payers where capital
gains/losses are treated as 60% long term and 40% short term.
i. Rule does not apply to hedging activities. Using futures for hedging purposes must be
declared on the same day the transaction is entered. Gains/losses on hedging
transactions taxed at same rate as ordinary income.

CH 3** Hedging strategies Using Futures - Hull Options Futures and Other
Derivatives 9Ed.
1. Short Hedge - occurs when the hedger shorts (sells) a futures contract to hedge against a price
decrease in the existing long position.
a. When the price of the hedge asset decreases, the short position realizes a positive return,
offsetting the decline in asset value.
b. Short hedge appropriate when you have a long position and expect prices to decline.
2. Long hedge - - occurs when the hedger buys (goes long) a future contract to hedge against an
increase in the value of the asset that underlies a short position.
a. An increase in the value of a shorted asset will result in a loss to the short seller.
b. One hedge is to offset a loss in the short position with a gain from the long futures position.
c. Long hedge appropriate when you have a short position and expect prices to rise.
3. Advantages of Hedging -

a. Reduce or eliminate the price of risk of an asset or a portfolio from anticipated negative
movements in the price of an underlying.
b. Lock in prices and prevent losses.
c. Hold an asset, a short hedge is advantageous
d. Need to buy an asset, long hedge advantageous to limit loss.
4. Disadvantages of Hedging
a. Hedging reduces risk but there is belief that shareholders can more easily hedge risk on
their own.
b. If competitors do not hedge, there is an incentive to keep the status quo. In this way,
company ensures that profitability will remain more stable than if it were to hedge frequent
changes.
5. Perfect Hedge when all existing position characteristics match perfectly with those of the futures
contract specifications. Loss on a hedge position will be perfectly offset by the gain on the futures
position. Perfect hedges are not very common.
a. Asset in existing position is often not the same as that of the underlying futures(e.g we may
be hedging a corporate bond portfolio with a futures contract on US treasury Bond)
b. Hedging horizons may not match perfectly with the maturity of the futures contract.
c. Existence of either leads to basis risk.
6. Basis - in a hedge is defined as the difference between the spot price on a hedge asset and the
futures price of the hedging instrument (e.g. futures contract) basis = spot price of asset being
hedged futures price of contract used to hedge. When hedge asset and hedging instrument
are the same, the basis will be zero at maturity. For Financial Asset Futures - Basis = futures
price-Spot Price.
a.
7. Strengthening Basis When spot price increases faster than futures price over the hedging horizon.
Basis increases and a strengthening basis is said to occur.
8. Weakening Basis - when futures price increases faster than the spot price and the basis decreases.
9. Basis risk when hedging a change in basis is unavoidable. This is the change in basis over the
hedge horizon.
a. To minimize basis risk, hedgers should select the contract on an asset that is most highly
correlated with the spot position and a contract maturity that is closest to the hedging
horizon.
b. Contract Liquidity also important when selecting a futures contract for hedging.
10. Sources of Basis Risk
a. Interruption in the convergence of the Futures and Spot Price
i. Normally spot converges to futures price as maturity decreases and basis converges
to 0.
ii. If position is unwound prior to maturity, return to futures position could be different
from cash position.
iii. More rapid convergence results in more rapid transfer of margin payments.
iv. Less rapid Convergence results would delay payments.
v. Interruption in convergence could result in payments from seller to the buyer.
b. Changes in the cost of carry
i. Includes storage and safekeeping, interest, insurance and related costs. E.g. an
increase in interest rates increases the opportunity cost of holding the asset, s the
cost of carry, ad hence the basis of the contract rises. Cash price goes up (affects
person with long exposure (short hedge) already with contract already made.
c. Imperfect Matching between the cash asset and the hedge asset.
i. cross hedging sometimes useful to hedge a cash position with a hedge asset that is
closely related but different from the cash asset.
ii. maturity or duration mismatch Hedging a portfolio of mortgages with 10-year
Treasury notes may seem reasonable if the effective duration of the mortgage
matches the duration of the t-notes. However, if rates fall and the mortgage prepay
faster(resulting in a shorter duration) the position will not be matched.
iii. Liquidity Mismatch - hedgina liquid asset with more liquid will result in greater basis
risk. Difference in liquidity may result in large gaps between the price of the two
assets. as price changes occur at different rates. Basis risk is inversely proportional
to the liquidity of the hedge asset.
iv. Credit risk mismatch - widening or narrowing of credit spreads constitutes another
form of basis risk when the credit risk of the hedged asset is different (or becomes
different) from the credit risk of the hedge instrument.

11. Optimal Hedge Ratio - incorporates the imperfect relationship between the spot and futures
position by calculating the degree of correlation between the rates. Hedge ration that minimizes
the variance of the combined hedge position.
12. Hedge Ratio the size of the futures position relative to the spot position.
a.

OHR= S , F

S
F

b. The Beta of spot prices with respect to futures contract prices since:
i.

Co v S , F
Co v S , F
SF
S
=
= S , F
S F
F

13. Effectiveness of the Hedge - measures the variance tha is reduced by implementing the optima
hedge. This effectiveness can be evaluated with a coefficient of Determination (

R2 term where

the independent variable is the change in futures prices and the dependent variable is the change
in spot prices.
a. Recall

R2 measures the goodness-of-fit of a regression.

b. Beta of spot prices w.r.t to futures prices is equal to the hedge ration (HR) which is also the
slope of the regression.
c.

measure for this simple linear regression is the square of the correlation coefficient (

2 between spot and futures prices.

14. Compute Optimal Number of Futures Contract
a. Common hedging applications is the hedging of equity portfolios using futures contracts on
stock indices. The number of futures contracts required to completely hedge an equity
position is determined with the following formula:
b. No. of contracts =

portfolio

value
=
( valueportfolio
of futures contract )

portfolio

portfolio value
( futures price
contract multiplier )

c. E.g. $20mil growth portfolio, beta 1.4 relative to S&P500. S&P Futures trading at 1,150. And
multiplier is 250. Goal to hedge exposure to market risk over the next few months.
i. You are long S&P500, so you should conduct a short hedge, and sell futures contract.
ii. No. of contracts =

1.4

20,000,000
=97 contracts
( $1,150
250 )

15. Tailing the Hedge a. A hedger may actually over-hedge the underlying exposure if daily settlement is not properly
accounted for. To correct for the possibility of over-hedging, a hedger can implement a
trailing the hedge strategy.
b. EXTRA STEP needed to carry out this strategy is to multiply the hedge ration by the daily
spot price to futures price ratio.
c. IN PRACTICE, NOT efficient to adjust the hedge for every daily change in the spot-to-futures
ratio.
d. E.g. now S&P Spot Price is 1,095 and Futures is 1,1,60. The number of contracts needed
after making a tailing hedge adjustment is HR*(Spot SP500/Fut SP500)
i.

97

=92 contracts
( 1,160
1095 )

ii. Sell three contracts .

16. How to adjust Portfolio Beta
a. Hedging an existing equity portfolio is an attempt to reduce the systematic risk of the
portfolio.
b. If CAPM beta is used then hedging boils down to reduction of portfolio beta.
c. B* be target beta and B be beta portfolio before strategy.
d. To computer the number of futures , we use:

i. No. of Contracts =

( )

( PA )

ii. Negative values indicate selling (decreasing systemic risk). Positive Values indicate
buying (increasing systemic risk).
e. Have 100mil diversified portfolio. B =1.2 . 3month S&P500 Index is 1,080. Completely hedge
systemic risk.
i.

( 01.2 )

=444.44
( 100,000,000
1,080 250 )

negative sign indicates we need to sell 444

contracts.
17. Rolling a Hedge Forward - When hedging horizon is long relative to the maturity of the futures
used in the hedging strategy, hedgers have to be rolled forward as the futures contracts in the
hedge come to maturity or expiration.
a. As maturity date approaches, the hedger must close out the existing position and replace it
with another contract with a later maturity. called rolling the hedge forward.
b. Not only exposed to basis risk of original hedge, they are also exposed to the basis risk of a
new postion each time the hedge is rolled forward. called rollover risk.

CH 4** Interest Rates - Hull Options Futures and Other Derivatives 9Ed.
1. Treasury Rates rates that correspond to government borrowing in its own currency. They are
considered risk-free rates.
2. LIBOR London Interbank Offered Rate the rate at which large international banks fund their
activities. Some credit risks exist with LIBOR.
3. Repo Rates rep or reputhase agreement rate is the implied rate on a repurchase agreement. In
agreement, one party agrees to sell a security to another with an understanding that the selling
party will buy it back later at a specified higher price. (interest rate implied by the price differential
is the repo rate) e.g. overnight repurchase agreement.
a. Longer term repos called term repos
b. Depeding on parties and structure , there is some credit risk involved.
4. Reverse Floater (inverse Floater) Debt instrument whose coupon payments fluctuate inversely
with the referenced rate (e.g. LIBOR) . e.g inverse floaters coupon rate will increase when LIBOR
decreases and vice versa.
5. Fed Funds Rate
6. Why do traders in derivatives not use TBills or T-Bonds a. Rates too low to be risk free (since part of the demand for these bonds comes from fulfilling
regulatory requirements, which drives price up and rates down) . Instead they use LIBOR
rates for short term risk free rates, LIBOR better represents traders opportunity cost of
capital.
7. Compounding - Derivatives pricing uses continuous time maths and assumes returns are
continuously comounded.
a. Theoretical construct only. converting Continuous to Discrete is straightforward.

R
F V 1= A 1+
M

b. Discrete Compounding c. Continuous Compounding -

F V 1= A e R

d. Setting them equal and solving for

i.

Rc A 1+

R
M

( mR )=R n , R =m ln ( 1+ mR )

m n ln 1+
e

ii.

m n

Rc
1)
m
R=

m (

m n

=Ae

RCn

e. As m increases

RR c 0

8. Spot Rates rates that correspond to zero-coupon bond yields. They are the appropriate discount
rates for a single cashflow at a particular future time or maturity.
a. Spot rates are also often called zero rates.
b. Most interest rates that are observed in the market, such as coupon bond yields, are NOT
spot rates.
9. Coupon Bond Price an instrument that makes a series of cash flows.
10. Zero-Coupon bond each cash flow considred in isolation. A coupon bond is a series of zero coupon
bonds, and its value, assuming continuous compounding and semiannual coupons is:

a.

FV e

zN
( N )
m
z
N
j
c
e m
m j=1
B=
j

b. c = annual coupon
c. N = number of semiannual payment periods
d. z_j = bond equivalent spot rate that corresponds to j periods (j/2) on a continuously
compounded basis.
e. FV face value of the bond.
f. Value of the bond is the present value of the cash flows, where each cash flow is discounted
at the appropriate spot rate for its maturity.
g. m - No of compounding periods
11. Bond Yield - is the single discount rate that equates the present value of a bond to its market price.
Overall Rate of return on the bond.
12. Par Yield rate at which makes the price of a bond equal to its par value. When bond is trading at
par, te coupon will be equal to the bond yield.
13. Bootstrapping Spot Rates
a. Theoretical spot curve derived by interpreting each Treasury bond(T-bond) as a package of
zero-coupon bonds. Using the prices for each bond, the spot curve is computed using the
bootstrapping methodology.
b. Find 6 month, then use 6 month in 1 yr semi-annual coupon bond, to bootstrap 1 year spot
(ero-rate)
14. Forward Rates interest rates implied by the spot curve for a specified future period.
R2

T2
m

a.

b.

RFwd =

=e

R 1T 1
m

RFwd (T 2T 1)
m

R2 T 2R 1 T 1 R2 T 2 + R2 T 1R 2 T 1R1 T 1
T1
=
=R2 + ( R2R 1)
T 2T 1
T 2 T 1
T 2T 1

c. Shape of the spot curve and forward curve can be made.

i. Second term always positive for upward sloping curve. When there is an upward
sloping curve , corresponding fwd curve is upward sloping and above spot curve.
ii. When R1>R2, curve is downward sloping, forward rate curve is downward sloping
and below the spot curve.
15. Forward Rate Agreement is a forward contract obligating two parties to agree that a certain
interest will apply to a principal amount during a specified future time.
a. Forward rates play a crucial role in the valuation of FRAs.
b.
16. Duration of a Bond is the average time until the cash flows on the bond are received.
a. For Zero-coupon bond this is simply Time to Maturity.
b. For coupon bond, its duration will be necessarily than its maturity.
c. Weights on time in years until each cash flow is to be received are the proportion of the
bonds value represented by each othe coupon payments and the maturity payment.
d. DURATION FORMULA for Continuously Compounded Returns are

i.

Duration= t i

ii.

t=time years

i=1

c j e yt
B

iii. y = continuously compounded yield (discount rate) based on the Bond Price B.
17. %Change in Bond Price
a. Usefulness of Duration measure lies in the fact that the approximate change in the bond
price, B, for a parallet shift in the yield curve of
b.
c.
d.
e.
f.
g.

is:

B
=duration y
B
Note: Change in yield is often expressed as a basis point change
1 basis point is = 0.01% = 0.0001
100 basis point change is equal to 0.01 = 1% change in yield.
Y = 3.567% y changes 15 basis point up. 0.03567 + 0.0015 = 0.3717 = 3.717%
Or 3.567% + .15% = 3.717%

18. Modified Duration - is used when the yield given is something other than a continuously
compounded rate. When yield is expressed as a semiannually compounded rate, for example.
a. Modified Duration =

duration
y
1+
m

, where m is the number of compounding periods per

year.
b. As m goes to infinity , two measures become equal.
19. Dollar Duration simply modified duration multiplied by the Price of the Bond.
20. Limitations of Duration
a. Duration is good approximation for price changes for an option free bond, but its only good
for relatively small changes in interest rates. (i.e. derivative/slope/ instantaneous change,
incremental changes)
b. As rate changes grow larger, curvature of the bond price/yield relationship becomes more
important, (more convex) and Linear estimate of price changes, such as duration, will
contain errors.
c. In fact, relationship is not linear but convex, and convexity shows that the difference
between actual and estimated prices widens as the yield swing grows.
d. Widening Error in estimated price is due to the curvature of the actual price path. known as
DEGREE of CONVEXITY.
21. Convexity - account for amount of error in the estimated price change based on duration. Other
words, it picks up where duration left off and converts the straight (estimated price) line into a
curved line that more closely represents the convexity (actual price) line.
22. Convexity Effect formula needed to obtain an estimate of the percentage change in the bond price
due to convexity.
a. Convexity Effect =

1
2
convexity y
2

b. Convexity effect is typically quite small. Recall convexity is simply correcting the error, so
you will expect convexity to have a much smaller effect that duration.
c. For option-free bond , convexity effect is always positive no matter which way rates move.
For option-Free bonds, convexity is always added to duration effect to modify price volatility
errors embedded in duration.
d. This decreases the drop in price (due to an increase in yields) and adds to the rise
in price(due to a fall in yields)

Percentage Bond price change

( BB )=duration effect+ convexity effect

23. Using Convexity to Improve Price Change Estimates -

a.

b.

c.

Estimate the change of 100 basis point increase and decrease in 10-year, 5%,option-free
bond currently trading at par, using duration-conveity approach. Bond duration is 7 and
convexity of 90

B
1
=7 .01+ 90 .012=.0655=6.55
B
2
.01

B
1
=7 .01+ 90
B
2

d.
24. Theories of Term Structure a. Expectations theory suggest that forward rates correspond to expected future spot rates.
i. That is, forward rates are good predictors of expected future spot rates.
ii. In reality, expectations theory fails to explain all future spot rate expectations.
b. Market Segmentation Theory
i. Bond market is segmented into different maturity sectors and that supply and
demand for bonds in each maturity range dictates rates in that maturity range.
c. Liquidity Preference theory
i. Most depositors prefer short-term liquid deposits. In order to coax them to lend
longer term, the intermediary will raise longer-term rates by adding a Liquidity
premium

CH 5 Determination of Forwards and Futures Prices - Hull Options Futures and

Other Derivatives 9Ed.
1.
2.
3.

4.
5.
6.
7.

8.

Investment Asset - an asset that is held for the purpose of investing and growth e.g. stocks and
bonds.
Consumption Asset - an asset held for the purpose of consumption. e.g. commodities , such as
good, metals, energy , gas
Short Sales - are orders to sell securities that seller does not own. Also known as shorting and is
possible with some investment assets.
a. For a Short sale, the short seller
i. (1) simulateneously borrows and sells securities through a broker
ii. (2) must return the securities at the request of the lender or when the short sale is
closed out , and
iii. (3) must keep a portion of the proceeds of the short sale on deposit with the broker.
Short Squeeze - When the short seller may be forced to close his position if the broker runs out of
securities to borrow. This is known as a short squeeze and shorter will need to close his position
immediately.
Rules apply to short selling
a. Short seller must pay all dividends due to the lender of the security
b. Short seller must deposit collateral to guarantee the eventual repurchase of the security.
Net Profit from Short Sale of Dividend Paying Stock a.
Compare Forward and Futures contracts a. Forwards and Futures SIMILAR :
i. Can be either deliverable or cash settlement contracts
ii. Are priced to have zero value at time an investor enters into the contract.
b. Forwards and Futures DIFFER:
i. Futures traded on organized exchanges. Forwards are private contracts and do not
trade on exchange.
ii. Futures highly standardized. Forwards are customized contracts satisfying needs of
parties involved.
iii. Single clearinghouse is counterparty for all futures contracts. Forwards are contracts
with originating counterparty
iv. Government regulates futures markets. Forward contracts are usually not regulated.
Forward Price Model
a. Assumptions
i. No transaction costs or short-sale restrictions.

ii. Same Tax rates on all net profits

iii. Borrowing and lending at the risk-free rate
iv. Arbitrage opportunities are exploited as they arise
b. Forward Price =

F0 =S 0 erT

i. r cost of borrowing funds to by the underlying asset and carrying it forward to T.

if F 0> S 0 e rT , arbitrage can profit by selling Forward short and buying the asset

ii. If

with borrowed funds.

F0 < S 0 e rT , arbitrage can profit selling So short, lending out excess proceeds and

iii. If

buying F0.
9. Relationship between Forward and Spot Prices a. The forward price is the expected realized price at time , T, at a growth rate (cost of carry) of
r.
b. If one is more expensive that the other based on expectations and what you can earn
holding the asset, you short(sell) the more expensive, and nuy the cheap one. At maturity
10. Forward prices using cost-of-carry model a. Since the owner of the forward contract does not receive any of the cash flows from the
underlying asset between contract origination and delivery, the present value of these
cashlows must be deducted from the spot price when calculating the forward price.
b. This is most easily seen when the underlying asset makes periodic payment. I then
represents the present value of the cashflows over T years.
c.

F0 =( S 0I ) e

rT

11. Effect of known Dividend to Forward Price a. Since dividend can be represented as a percentage and assume it is paid continuously.
Letting q represent the continuously compounded dividend yield paid by the underlying
asset expressed on a per annum basis. The forward price equation becomes:
b.

( rq ) T

F0 =S 0 e

12. Value of a Forward Contract a. You price a forward contract so that its initial value is zero. ; therefore,
b.

f =( F 0S0 e rT ) =0

f value of a forward contract.

c. After its inception. The contract can have a positive or negative value only after contract is
entered into .
d. If we denoted obligated delivery price as

, then the value of a long contract with no

cash flows is :
e.

S 0K e rT

f.

S 0I K e rT

g.

qT

S0 e

as the current price over the delivery price.

K e

rT

with known cash flows

with a continuous dividend yield.

13. Currency Futures : Calculate Foreign Exchange rate using Interest Parity relationship
a. Interest Rate parity states that the forward exchange rate, F, (measured in domestic per unit
foreign currency), must be related to the spot exchange rate, S, and to the interest rate
differential between the domestic and Foreign Currency .
b.

F0 =S 0 e(

rr f )T

rr f

This is a no arbitrage relationship as well.

c. Same as using a dividend yield because of the other person earning returns @ Foreign risk
free rate in foreign currency.
d. If S_o is domestic currency then you use r as domestic and r_f as foreign. Domestic is
e. S_o = domestic currency/foreign currency.
14. Forwards Vs. Futures Prices -

a. When interest rates are known over the life of the contract, it can be shown that forwards
and futures are the same.
b. Approx. same when T is small.
c. If underlying is positively correlated with interest rate, R Futures more valuable.
i. When interest rate increases, futures is greater than forward. (more valuable)
proceeds grow at a better rate. When interest rate decreases-cost of borrowing to
refinance margin payment is cheaper.
d. If underlying is negatively correlated Forwards more valuable.
i. If S_0 increases, realize a futures gain, but proceeds reinvested at a smaller rate.
ii. If S_0 decreases, interest increases, immediate futures loss and loss is refinanced at
a higher rate.
iii. Forward more valuable here.
15. Commodity Futures a. When underlying is a consumption asset (commodity), the pricing relationship developed is
not adequate. There are storage costs, carrying costs, convenience yields, etc that need to
be considered.
b.

by not having
U present value of storage costs . ucarrying costs yconvenience yield ( hold asset )

c. Income -

S
( 0+U ) e storage cost is accounted forforward price
F 0=
rT

expressed as a known

cashflow.
d. Storage Costs as continuous yield

F0 =S 0 e( r+u ) T

as a continuous yield

e. If owner does not want to sell, there is a benefit to owning consumable asset compared to
futures contract, then equations above become:
i.

ii.
f.

S
rT
( 0+U )e
F 0
( r+u ) T

F0 S 0 e

Convenience Yield if we introduce a convenience yield , y, to balance Equations 7 and 8,

we have:
i.
ii.

yt

F0 e =S0 e

( r +u) T

( r+u y ) T

F0 =S 0 e

to balance the effect and then:

a convenience yield which is simply the yield required to produce

an equality and is thus a measure of the benefit of owning spot, or physical,

consumption commodities.
16. Delivery Options in Futures markets (how do they influence futures prices)
a. Some futures grant delivery options to the short options as to where, when and what to
deliver- which is then adjusted by the exchanged or adjusted by stipulations of contract.
b. Some Treasury Bonds give the short seller options that are acceptable to deliver.
c. If cost of carry > convenience yield, its beneficial to deliver contract early. Scenario suggests
that futures price will increase over time because the seller(shorter) has an incentive to
delivery early.
d. When cost of carry is less < convenience yield, the short position will delay delivery since
the futures price is expected to fall over time. (compare this to a higher rate in foreign
exchange case of earning (convenience) on the other side when you dont have the asset.
17. Relationship between Current Futures Prices and Expected Future Spot Prices
a. Cost of carry model is widely used.
b. Also

F0 =E ( S T ) expectations theory
i. This theory acts to keep the futures price in line with expected spot price using
monte carlo simulation or martingale pricing.

ii. Many factors affect the difference in prices. As suggested if there was no difference in
the rate of returns, cost of carry, etc. there would be no incentive to trade(buy or sell)
the products (contracts)
18. Cost of Carry vs. Expectations
a. Keynes suggests model is flawed because it provides no incentive for speculators to enter
market (because of holding asset and wanting asset in future) (for producers or distributors
only)
b. Suggests that there needs to be an expectation of profit greater than risk free rate

F0 < E ( S T ) and must continuously increase during the term of the contract. Called
NORMAL BACKWARDATION
c. Asset underlying contract exhibits positive systemic risk.
d. And the users of the commodity you ask? speculators must be enticed to take on risk of
futures price if they will enter other side of the contract from the hedgers. Therefore, F_0 >
E(S_T)
e. Keynes called this expectations as contango.
19. Normal backwardation a. Refers to where the futures price is below the spot price. For this to occur there must be
significant benefit to holding the asset. This might occur if there are benefits to hold the
asset that offset opportunity cost of holding the asset (risk free rate) and additional net
holding costs.
b. If no benefit to hold asset such as dividends, coupons, higher convenience yield, contango
will occur because the futures price will be greater than the spot price.

CH 6** Interest Rate Futures - Hull Options Futures and Other Derivatives 9Ed.
1. Day count conventions for different Markets
a. Day count conventions play a role when computing the interest that accrues on a fixed
income security.
b. When a bond is purchased, the buyer must pay any accrued interest earned through to
the settlement date.

2. Accrued Interest =

days
last coupon the settlement date

dayscoupon period

a. US market three commonly used day count conventions:

i. US Treasury bonds use actual/actual
ii. T-Bills = actual/360 day count
iii. US corporate and municipal bonds use 30/360 - (30 days/month / 360 days/yr )
iv. US money market instruments (Treasury bills) use actual/360
3. T-Bond Quotations
a. Bonds are quoted relative to a $100 par amount in dollars and 32nds. E.g. a 95-05 is
b. 95 5/32 or 05.15625
c. Quoted price (or clean price) not the same as the cash price.
d.
e.
4. Clean
a.
b.
c.
d.
e.
f.

cash price=quote price+accrued interest

price that the seller of the bond must be paid to

give up ownership.
and Dirty prices for US Treasury Bond
Cash price Invoice price or dirty price
Quoted price clean price.

Quoted price = cash price accrued interest

Clean price = dirty price accrued interest
T-bond current price at 102-11 (102 11/32) . cash price is :
i. 102.34375 +2.1848
5. Conversion of Discount Rate to a price for US Treasury Bill
a. T-Bills and other money market instruments use:
i. A discount factor rate basis and
ii. An actual/360 day count.

b. A T-bill with $100 face value with n days to maturity and a cash price of Y is quoted as:
c. T-Bill discount rate =

360
( 100Y )
n

( 360n )

F V 100 r annual

d. Cash Price , Y =

= FV accrued interest.

e. This is referred to as the discount rate in annual terms. However, this discount rate is not the
actual rate earned on the T-Bill.
f. E.g. you have a 180-day T-Bill with discount rate, or quoted rate of five(i.e. annualized rate
of interest earned is 5% of face value). If facevalue is $100, what is the true rate of interest
and the cash price?
g. Interest = 100*.05*(180/360) = $2.5 for a 180-day period. True rate is then 2.5/100 = 2.5%
h. Cash price = FV - t-Bill annualized rate*(n/260)
i. 100 - .05*(180/360) = $97.5
6. US Treasury bond futures contract conversion factor a. In s UD Treasury Bond (T-Bond) Futures contract, any government bond with more than 15
years to maturity on the first of the delivery month (and not callable within 15 years) is
deliverable on the contract.
b. This produces a large supply of potential bonds that are deliverable on the contract and
reduces the likelihood of market manipulation.
c. Since the deliverable bonds have very different market values, CBOT has created
Conversion Factors
d. Conversion factor defines the price received by the short position of the contract. (the
short position is delivering the contract to thelong)
e. Cash received = Quoted futures price * CF + Accrued interest
i.

cash price=QFP CF+ AI QFP quoted futures price (most recent settlement

price)
ii.

CFconversion factor for the bodn delivered

iii. Accrued interest since the last coupon date on the bond delivered.
f. Conversion factors are supplied by CBOT on a daily basis.
g. Conversion factor calculated as: (discounted price of bond-accrued interest)/face value
i. E.g.

CF=

P V bond AI
FV

PV=$142 AI=2 FV =100 , CF = 140/100=1.4

7. Calculate cost of delivering bond into a Treasury bond futures contract a. Cheapest to Deliver Bond
i. Conversion actor system is not perfect and often results in one bond that is the
cheapest (or most profitable) to deliver. The procedure to determine which bond is
the cheapest-to-deliver bond (CTD) is as follows:
ii. Cash received by short= (QFP*CF)+AI
iii. Cost to purchase bond = (quoted bond price + AI )
iv. CTD bond minimizes the following
1.

min Quoted Bond Price( QFP CF ) This calculates the cost of delivering

the bond.
2. SEE page 126 book III Schweser for important practice problem.
8. Impact of level and shape of yield curve on the cheapest-to-deliver Treasury bond decision
a. When yields>6% CTD bonds tend to be low-coupon, long maturity bonds
b. When yields are < 6% CTD bonds then to be high-coupon, short maturity bonds
c. Yield curve is upward sloping, CTD bonds tend to have longer maturities
d. Yield curve is downward sloping CTD bonds tend to have shorter maturities.
e.

9. Calculate theoretical futures price for Treasury bond futures

10. Final Contract Price on Eurodollar Futures contract (US dollar deposited outside US)
a. E.g. the 3month Eurodollar futures contract trades on the Chicago Mercantile Exchange
(CME) and is the most popular interest rate futures in the US.
b. Contract settles in cash and the minimum price changes is one tick which is 1 basis point
= 0.01% or 0.0001 (1/100th of a percent)
c.
11. Compute Eurodollar futures contract convexity adjustment a. Daily marking ot market aspect of the futures contract can result in differences between
actual forward rates and those implied by futures contracts.
b. The difference is reduced by using the convexity adjustment.
c. In general, long-dated Eurodollar futures contracts result in implied forward rates larger than
actual forward rates.
i.

1
actual forward rate=forward rateimplied by futures 2 T 1 T 2
2

ii.

T 1 =maturity on futures ontract

iii.

T 2 =time maturity of the rateunderlying the contract

iv.

2=annual std dev of the changethe rateunderlying the futures contract ,90day LIBOR

12. Eurodollar futures contract that settled to (sell/Buy) US dollars deposited in an Overseas Bank at a
rate specified by a FV 100 the rate.
13. Eurodollar futures to extend IBOR Zero curve
a. Forward rates implied by convexity-adjuted Eurodollar utures can be used to prouce a LIBOR
Spot curve (also called LIBOR zero Curve ince spot rates are sometimes referred to as zero
rates)
b. Recall:

Rfwd =

c. Solving for

R2 T 2R1 T 1
T 2T 1

R 2 , R2 =

R fwd ( T 2T 1 ) + R1 T 1
T2

d. Given the first Libor spot rate

R1 and the length of each forward contraxt period , we can

calculate next spot rate R_2 . The rate is the generated LIBOR Spot(zEro) Curve.
14. Duration-Based Hedging a. Objective is to create a combined position that does not change in value when the yields
change by a small amount.
b. In other words, a position that has a duration of zero needs tobe produced.
c. The combined position consist of our portfolio with a HEDGE HORIZON VALUE of P and a
futures position with a contract value of F.
d. Denote the duration of the portfolio at the hedging horizon as
duration of the futures contract as

DP

and the corresponding

D F . Use this notation, the duration-based hedge ration

can be expressed as follows:

i.

N=

P DP
F DF

N = no. o contracts to hedge.

ii. Minus sign suggests that the futures position is the opposite of the original position.
iii. If the investor is long the portfolio, he must short N contracts to produce a position
with zero duration.
15. Limitations of Duration a. The price yield relationship of a bond is convex, meaning it is nonlinear in shape.
b. **Duration measures are linear approximations of this relationship.
c. Therefore, as the change in yield increases, the duration measures become progressively
less accurate.
d. Moreover, duration implies that all yields are perfectly correlated. Both of these assumptions
place limitations on the use of duration as a single risk measurement tool.

CH 7** Swaps - Hull Options Futures and Other Derivatives 9Ed.

1. Plain vanilla swap A swap of payment (interest pmts) where Company X agrees to pay Company Y
a periodic fixed rate on a notional Principal over the tenor of the swap. In return Company Y agrees
to pay Company X a periodic floating rate on the same notional principal.
a. Both payments in same currency
b. Most Interest rate Swaps use LIBOR
c. No need for exchange of principal since in same currency reasons its called a notional
principal.
d. Fixed Leg cashflow =
e. Floating Leg Cashflow =

1
( r LIBOR r )
m

1
(r r LIBOR )
m

2. Swap to Transform a Liability and Assets

a. Swaps can be used to transfer any time of payment or receipt. As you change the type of
receipts/pmts, so does your exposure.
3. How are swaps similar to Forwards
a. Swaps typically require n payment by either party or initiation

4.

5.

6.

7.

8.

b. Swaps are custom instruments

c. Swaps are not traded in any organized secondary market
d. Swaps are largely unregulated
e. Default risk is an important aspect of contracts
f. Most participants in the swaps mkt are large institutions
g. Individuals are rarely swap market participants
Role of financial intermediaries
a. Swap intermediaries bring together parties who need opposite side of a swap.
b. Dealers, large banks, brokers act as principals in trades just as forward contracts.
c. Many cases swap party on offsetting side of the swap since both will transact with an
intermediary.
d. Intermediaries typically earn a spread of about 3-4 basis points. .03-.04% points for bringing
two nonfinancial companies together in a swap agreement
e. Fee for intermediary risk involved. If one party defaults, intermediary responsible for makig
the other party whole!
Role of confirmation in a swap transaction
a. Confirmations as drafted by International Swaps and Derivatives Association (ISDA) outline
details of the swap agreement.
b. Representative of each party signs the confirmation, ensuring they agree with all swap
details(such as tenor and fixed/floating rates) and the steps taken in the event of a default.
Comparative advantage argument for existence of interest rate swaps.
a.
b. Y
c. Fixed 5%
d. Float LIBOR +10bps
e. X
Fixed 6.5%
g. Float LIBOR +100bps
h. Company Y has absolute advantage in both markets but a comparative advantage in fixed
market
i. Differential in fixed is 1.5% or 150basis points . corresponding differential 90 basis points
j. When a comparative advantage exists , a swap arrangement will reduce the costs of both
parties.
k. Here, the net potential borrowing savings by entering into a swap is the difference between
the differences, or 60bps.
l. By entering into a swap, net saving shared is 60bps.
m.
Explain some criticisms of comparative advantage argument of IRSwaps
a. Problem is that it assumes X can borrow at Libor + 1% over the life of the swap.
b. Also ignores the credit risk taken on by Y entering into the swap. (X more liable to default)
c. If X were to raise funds by borrowing in market directly, no credit risk is taken, so perhaps
savings is compensation for that risk.
d. Same criticisms exist when an intermediary is involved.
How are discount rates computed in Interest Rate Swap
a. Swap is a sequence of cashlows, and value is determined by discounting cashflows back to
present.
b. The forward rates implied by either forward rate agreements(FRAs) or the convexityadjusted Eurodollar futures are used to produce a LIBOR spot curve. The swap cash flows are
then discounted using the corresponding spot rate from this curve.
c. The swap cashlows are then discounted using the corresponding spot rate from this curve.
d. The connection between

RF =R2 + ( R 2R1 )

T1
T 2T 1

9. Valuation of an Interest Rate Swap with Bonds

a.

V swap ( X )=B flt B fix leg

b.

V swap ( Y )=Bfix B flt float leg

c.

V swap ( X ) +V swap ( Y )=0 By design so two positions mirror each other at start of contract.

10. Value an Interest Rate Swap with FRAs

a. FRA is simply aperiodic payment in a swap. A swap can then be regarded as the sum of FRAs
. valuing the swap then relies on using the expected forward rates to forecast the expected
net cash flows and then discount these expected cash flows at the corresponding spot
rates.- consistent with forward rate expectations.

11. Mechanics of a Currency Swap

a. Exchanges both principal and interest rate payments with payments in different currencies.
b. The exchange rate used in currency swaps is the spot exchange rate.
c. Similar to interest swap but principals are exchanged at the inception of the currency swap
so that they have equal value using the spot exchange rate.
d. Periodic cash flows throughout swap are not netted as they are in interest rate swaps.
12. Fixed-For-Fixed Currency Swap
a. Two companies A and B
b. A Pays 6% GBP to Company B and receives 5% in USD from Company B.
c. However, since principals in a currency swap are not the same currency, exchanged at
inception.
d. Company A pays 175mil USD B pays GBP 100mil
e. A has effectively borrow GBP from B and so it must pay interest on that loan.
f. Similarly B has borrowed USD from A.
g. At the end of the swap, the principals are re-exchanged.
h. A has long position in USD (inflow) and short position in GBP(outflow)
i.

AV Swap (USD )=BUSD ( S 0 B GBP )

j.

S 0=spot rateUSD per GBP

B USD =PV of USD pmts BGBP =PV of GBP pmts

k.

13. Value of a currency based swap on two simultaneous bond positions

a. Calculate the value of each coupon cashflow at the stated exchange rate
T

b. E.g.

( C F USDS i C F GBP ) er t + ( F V USDST F V GBP )

i

i1

14. Calculate value of currency swap on a sequence of FRAs

a. In this case, just use the corresponding forward exch rate for the cashflow pmts.
15. How can a currency swap be used to transform an asset or liability calculate its cash flows
a. Suppose a company,A, has a dollar-based liability. By entering into a currency swap, the
liability has become a pound-based liability at the GBP fixed (or floating) rate.
b. Comparative Advantage
i. Typically domestic borrow has an easier time borrowing in his own currency. Often
results in comparative advantage that can be exploited in a currency swap.
ii. Same analogy of that of interest rate swaps
16. Credit risk exposure in a swap position
a. When one side of a swap has a positive value, the other side has a negative value.
b. If

V Swap ( A ) >0V Swap ( B )< 0. Whenever As value increases, Bs value becomes more

negative. This results in credit risk to A since likelihood of default increases as B has a larger
and larger pmts to make to A.
c. Potential losses in swaps are much smaller than the potential losses from defaults on debt
with the same principal. Value of the Swap is generally much smaller than the value of the
debt.
17. Describe different types of swaps, including commodity, volatility, and exotic swaps
a. Equity Swap
i. The return on a stock, a portfolio, or a stock index is paid each period by one party in
reurn for a fixed-rate or floating-rate pmt.
ii. Return can be the capital appreciation or the total return including dividends on the
stock, portfolio or index.
iii. E.g to reduce equity risk, portfolio manager enter ina 1-yr quarterly pay S7P500 index
swap an agree to receive a fixed rate. %incr in index is netted against fixed rate. If
index is negative, fixed rate payer must also pay %decline in index. If
iv. Equity swaps can also be floating on both sides and are not known until the end of
the quarter.
v. For interest swap both fixed and floating are known at the beginning of the quarter.
b. Swap on a single stock
i. Motivated by a desire to protect the value of a position over the period of a swap.

ii. To protect large capital gain in a single stock, and to avoid a sale for tax or control
reasons, an investor could enter into an equity swap as the equity returns payer and
receive a fixed rate in return.
iii. Any decline in the stock price would be paid to the investor at settlement dates, plus
the fixed rate payments. If the stock appreciates, the investor must pay the
appreciation less the fixed payment.
c. Swaption
i. Is an option which gives the holder the right to enter into an interest rate swap.
Swaptions can be American or Equropean Style options. Like any option, a swaption
is purchased for a premium that depends on the strike rate specified on the swaption.
d. Commodity Swap
i. Agreement to pay a fixed-rate for the multi-period delivery of a commodity and
receive a corresponding floating rate based on the average commodity spot rate at
the time of delivery.
ii. Most common use is to manage the cost of purchasing energy resources such as oil
and electricity.
e. Volatility Swap
i. The exchanging of volatility based on the notional principal. One side of the swap
pays based on the pre-specified volatility while the other side pays based on
historical volatility.
f. Other types of swaps accrual swaps, cancelable swaps, index amortizing swaps, and
constant maturity swaps.
i. Swaps also sometimes used for exotic structures.

CH 10 Mechanics of Options Markets - Hull Options Futures and Other Derivatives

9Ed.
1. Option types, position variations and typical underlying assets in options
a. Options have asymmetric payoffs. Buyer has the right to exercise the option but not
obligated.
b. Max loss is the premium payed to enter the contract. Potential gain is theoretically infinite.
c. Two essential types by Exercise Time European Options and American Options.
d. Option writers obligated to sell (Call Writer) or buy (Put Writer) at Maturity, T.
e. Option buyers hold right to buy (Call buyer) or sell (Put Buyer) at Maturity T or before T
(American Option)
f.

Payoffs Call Option Buyer max(0,

S T K ) Premium.

g. Pay off to Call Option Writer = Premium +

h. Payoff to Put Option Buyer =
i.

KST

Or

CT C 0

Or

C0 CT

max ( 0, KST ) -Premium Or

PT P 0

S T K

P0PT

Payoff to Put Option Writer = Premium +

Or

j.
2. Call Option and Put Option payoffs (LONG and SHORT)
a. See above.
b. See page 153 of schweser notes.
3. Typical Underlying assets
a. Stock Options typically exchange traded, American style options
a. Normally for a 100 shares. E.g. Option price is Price/share . if price 3.60 Contract
would cost $360.
b. After issuance, stock opton contracts are adjusted fo stock splits but not cash
dividends.
c. Primary exchanges are CBOE, NYSE Euronext, International Securities Exchange.
b. Currency Options
a. Right to buy or sell an amount of foreign currency bsed on a domestic currency
amount.
b. Mostly traded on OTC markets, remainder on Exchange traded market.
c. NASDAQ OMX trades European style options for several currencies
d. Unit size for currency options is much larger than stockoptions. e.g 1 million units
for yen and 10,000 units for other currencies.

c. Index
a.
b.
c.

Options
Usualy European Style options and are cash settled.
Can be found on OTC and exchange traded markets.
E.g. payoff of call is is the amount index level at expiration exceeds a specified level
multiplied by the contract multiplier (typically 100 or 20 for smaller index option)

d. Futures Options
a. American-style, exchange traded options are most often utilized for futures ocntracts.
b. The futures optin expiration date is set to a date shortly before the expiration of the
futures contract.
c. Market value of the underlying asset for futures options is the value of the underlying
futures contract. The payoff for call options is calculated as the futures price less the
strike price, while the payoff for put option is calculated as the strike price less the
futures price.
4. Stock Option contracts Specifications
a. Expiration
a. Expiration dates dictate how option is named. E,g, June Put Option on Intel means
that Option expires in June.
b. Actual day of expiration is Saturday following the third Friday of the expiration month.
c. Different expiration cycles dictate the actual expiration months of a stock option over
a given year.
d. Long-term equity anticipation securities (LEAPS) are simply long-date options wih
expirations greater than one year. All Leaps have January expirations.
b. Strike Prices
a. Dictated by value of the stock.
b. Low value stocks have smaller strike increments than higher-value stocks.
c. Typically $20 value stck have increments of 2.50 strikes. Stocks priced at $50 have
$5 increments.
c. Moneyness, Time Value, and Intrinsic Value
a. Option class refers to al options of the same type, whether calls or puts
b. Option series refers to an option class with the same expiration. underlying
c. Out of the money
1. call when strike is above underlying asset price
2. Put when underlying asset is above strike.
d. At the money underlying asset equals strike
e. In the money
1. Call - Underlying asset price is above strike
2. Put Strike is above Underlying asset price
f. Time value difference between the option premium and the intrinsic value.
1. Premium = intrinsic value+ options time value.
2. As a general rule, the more time that remains until expiration, the greater the
time value of the option. This is because investors are willing to pay a higher
premium for more time since the contract will have longer to become
profitable due to a favorable move in the underlying.
g. Intrinsic value maximum of zero or the difference between the underlying asset and
the strike price. Call = max(0, S_T K)
Put = max(0, K S_T)
5. Nonstandard Products
a. FLEX Options exchange traded options on equity indices and equities that allow
some alteration of the options contract specifications
1. Nonstandard terms include alteration of the strike price, different expiration
dates, or European style(rather than standard American Style)
2. Developed to compete with nonstandard products that trade OTC. Min size
contract is for 100 shares.
b. ETF Options similar to index options, ETF options are American style options and
utilize delivery of shares rather than cash at settlement.
c. Weekly Options - Weeklys are short-term options that are created on a Thursday and
have an expiration date on Friday of the next week.

d. Binary Options generate discontinuous payoff profiles because they pay only one
price. ($100) at expiration if the asset is above the strike price. Binary means one of
two states. (Option pays $100 or pays nothing)
e. CEBOs specific form of a credit default swap(CDS) . The pay of in a CEBO is
triggered if the reference entity suffers a qualifying credit event. (e.g. bankruptcy,
missed debt payment, or debt restructuring) prior to the options expiration date
(which always occurs in December). Option payoff, if any, occurs on the expiration
date. CEBOs are European options that are cash settled.
f. DOOM Options - These put options are structured to only be in the money in the
event of a large-downward price movement in the underlying asset. Due to their
structure, the strike price of these options is quite low. In terms of protection, DOOM
options are similar to credit default swaps. Note that this option type is always
structure as a put option.
b. Effects of dividends and stock splits
a. In general, options are not adjusted for cash dividends- which has option pricing
consequences. To be incorporated into valuation model
b. Options are adjusted for stock splits. For example, if stoch as a 2-for-1 stock split.
Then the strike price will be reduced by one-half and the number of shares underlying
the asset double.
c. If stock exhibits a B for A stock split. Strike price = (A/B)*K (strike price)
d. No of shares in underlying are multiplied (B/A)*no.ofshares
e. **(research) E.g. stock dividends are dealt with in same manner if stock pays a 25%
dividend. Treated as a 5-for-4 stock split.
c. Position and Exercise Limits
a. Number of options a trader can have on one stock is limited by the exchange. This is
a position limit.
b. Exercise limit equals the position limit and specifies the maximum number of
options contracts that can be exercised by an individual over any 5 consecutive
business days.
6. Motivations for Long Short Positions on Calls ad Puts

a.

Long Call is a bullish or accumulative position. You expect the stock to go up. You may want
to own a call for the purpose of exercising the call and buying the stock at the strike price,
when the price in the market is higher than the strike price. Or you may want to own the call
simply as a trader - you expect it to be worth more sometime before expiration than it is
now, and you intend to sell the option when you have a profit.

b. Short Call is a bearish or neutral position, or a way to sell stock at a target price. As a
trader, you expect the stock to either go down, or not go up. If the stock goes down after
you sell a call, the call will be worth less, and you can buy it back at a profit.
a. A short call can also be used as a way to sell stock at a target price. For instance, if
you bought stock at $30, you may think that $35 is a fair price for selling your stock,
so you could sell a 35 strike call. If the stock is not over $35 at expiration, you keep
both the premium received and the stock. If the stock is over $35 at expiration, you
will keep the premium, and sell your stock for $35 a share. This particular strategy is
called the "Covered Call" or "buy-write".
c. Long Put is a bearish or protective position. You either expect the stock to go down, or you
want to protect stock you currently own in the event the stock does go down. You may trade
the put. If the stock goes down after you buy a put, the put will be worth more, and you can
sell it for a gain. You may exercise the put if you own the stock and the stock drops, since
your long put gives you the right to sell your stock at a higher price than the current market.
d. Short Put is a bullish, neutral, or accumulative position. You either expect the stock to go
up, or not go down, or you are interested in buying the stock at a lower price than the
current market. You can trade the short put. If you sell a put, and the stock goes up, the put
will be worth less than what you sold it for, and you can buy it back for a gain. You can also
hold the short put until expiration. If the stock price stays over the strike price of the put, the
put will expire worthless and you will keep the entire premium received, without further

obligation. You can also sell a put with the intention of buying stock at less than the current
market value.
7. Describe basic options trading
a. General Options are quoted relative to one underlying stock. To get total cost- you must
multiply times no of shares per contract.
a. Quote will also include the strike, expiration month, volume, and the option class.
b. Market makers will quote bid and offer(or ask) prices whenever necessary.
c. They profit on bid-offer spreads and add liquidity to the market.
d. Floor brokers represent a particular firm and execute trades for the general public.
e. Order book official enters Limit orders relayed from the floor broker. An offsetting
trade takes place when a long (short) option position is offset with a sale (purchase)
of the same option.
f. If trade is not an offsetting trade, then open interest increases by one contract.
b. What are the various commission
a. Vary based on trade size and broker type (discount vs. full service)
b. Typical structure commission rates as a fixed amount plus a percentage of the trade
amount.
c. 1% of trade amount for stock. Depending on option trade amount, fixed fee + x% of
trade amount. Some also have a max charge per contract.
d. $10 option price*100shares = $1000 contract, now commissionis= $30 fee+ .
8%(1000) = $38 dollars
c. Margin requirements.
a. Options with maturities of 9 months of fewer cannot be purchased on margin.
Leverage would become too high. For options with long maturities, investors can
borrow a maximum of 25% of option value.
b. Margin for option writers depends on the amount and position of contracts written.
c. Naked Options (or Uncovered Options) options in which the writer does not also
own a position in the underlying asset. The size of the initial and maintenance margin
for nake option writing is equal to the option premium plus a percentage of the
underlying share price. Very speculative.
d. Covered calls Writing Covered Calls (selling a call option on a stock that is owned
by the seller of the option) is far less risky than naked call writing
d. Options Clearing Corporation guarantees that buyers and sellers in the exchange traded
opions market will honor their obligations and records al option positions. Exchange traded
options have no default risk because of the OCC, while OTC options posses default risk.
a. All trades cleared by one of its clearing members.
b. Members must met net capital requirements and help finance an emergency fund
that is utilized in the event of a member default.
c. Writers Must post margin and buyers deposite required funds by the morning of the
business day immediately following the day the option is purchased.
e. Exercising an Option
a. When investor exercises an option prior to contract expiration, her broker contacts
assigned OCC member responsible for clearing that brokers trades.
b. OCC member then submits an exercise order to the OCC which matches it with a
clearing member who identifies an investor who has written a stock option.
c. Assigned investor must sell(if a call option) or buy (if a put option) the underlying at
the specified strike price on the third business day after the order to exercise is
received.
d. Unexercised options expiring in the money after accounting for transaction costs will
be exercised by brokers.
f. Other Option-Like Securities
a. Warrants often issued by a company to make a bond issue more attractive and will
typically trade separately from the bond at some point. Warrants are like call options
except that, upon exercise, the company receives the strike price and may issue new
shares to deliver.
b. Same distinction applies to employee stock options, which are issued as an incentive
to company employees and provide a benefit if the stock price rises above the
exercise price. When an employee exercises incentive stock options, any shares
issued by the company wil increase the number of shares outstanding.

c. Convertible bonds contain a provision that gives the bondholder the option of
exchanging the bond for a specified number of shares of the companys common
stock. At exercise, the newly issued shares increase the number of shares
outstanding and debt is retired based on the amount of bonds exchanged for the
shares.
There is a potential for dilution pf the firms common shares from newly issued shares
with warrants , employee stock options, and convertible bonds that does not exist for
exchange traded options.

CH 11 Properties of Stock Options - Hull Options Futures and Other Derivatives

9Ed.
1. 6 Factors that affect Option prices
a. Current stock price
i. As S increases, call increases
ii. As S decreases, put increases
iii. As option becomes closer to in-the-money, it value increases.
b. Strike price of the option
i. Effect of strike prices on option will be exactly opposite.
ii. As X increases, Call decreases
iii. As X Increase, Put Increases
iv. Option value will increase as it becomes closer to or more in-the-money.
c. Time to expiration (maturity)
i. For American Options increasing, T, expiration, will increase option value.
ii. T increases, likelihood of in-the-money increases.
iii. European Options not generally the same. if a dividend is expected in 2 months. A 1
month option would be worth more than a 3 month option. (3 month option price will
fall when dividend is paid in 2 months)
d. r short term risk free interest rate over T
i. As risk free rate increases, the value of call will increase. (because value of stock will
increase. S_0e^rT . higher r (opportunity costs/rate of return) makes a higher S_T and
option value will increase. to insure no arbitrage.
e. D present value of the dividend of the underlying stock.
i. Option owner does not have access to cash flow of the underlying stock, and the
stock price decreases when a dividend is paid. Thus, as the dividend increases, the
value of the call (put) will decrease (increase).
f.

expected volatility of stock prices over T.

i. As volatility increases, option value increases. This is due to assymetric payoff of

options.
ii. Long options have a maximum loss equal to premium. Incr volatility only increases
changes of expiring in the money.
iii. Volatility is considered most important factor in option valuation.
When evaluating a change in any one of the factors, hold the other factors constant. E.g.

C C C C

S r t
FACTOR

ECall

E Put

A Call

A Put

S0

X
T

?depends
+

+
?depends
+

+
+

+
+
+

r
D

+
-

+
-

2. Upper Pricing Bounds for European and American Options

UPPER BOUNDS

a. Call options
underlying
b. Put Options

C E S 0 , C A S0
PE X , P A X

if this does not exist you could sell option and buy
if this does not exist, you could sell put and invest proceeds at

rf
c. Euro Put Options, since cannot exercise early, it can never be worth more than present value

PE X erT

of strike price -

3. LOWER BOUNDS European Call Option

a. Consider 2 portfolios
i. Portfolio P1 : 01 Euro Call, c, with exercise price X plus a zero-Coupon risk free bond
that pays X at T.
ii. Portfolio P2: one share of the underlying stock.
b. At T, Portfolio P1 will always be the greater of X(when the optio expires out of the money) or

ST

(when portfolio expires in the money.

ST

c. At T, Portfolio P2 will be worth

d. P1 is always worth as much as P2. If we know at T,

P1 P 2 , it always has to be true

otherwise, arbitrage would be possible. Thereore we can state.

i.

rT

CE+ X e

S
max ( 0X erT , 0 )
CE

S 0 and

4. LOWER Bound on European Put Prices on non dividend paying stock.

a. Consider portfolio P1, a put,

PE , and one share of the underlying stock.

b. Consider a portfolio P2, a zero-coupon risk free bond that pays X at T.

c. At T, portfolio P1 will always be more than P2, otherwise arbitrage.

PE + S T X erT PE + S 0 X erT so , PE max ( X erT S 0 ,0 )

d. So,

5. Put Call Parity

a. Put call parity is based on two portfolio combinations : a fiduciary call and a protective put.
b. Fiduciary call is a combination of a pure-discount(i.e. zero-coupon), riskless bond that
pays X at maturity and a call with exercise X. bond pays for strike at T.

C E + X erT

i. Payoff is X if out-of-the money and X+(S-X)=S if in-the-money.

c. Protective Put - Share of stock together with a put option. (hold stock to deliver) at T, pay
off is

S T if out-of-the money or X- S T + ST = X

if in-the-money.

PE + S 0

d. NOTE: on same strike X, when put is in the money, call is out of the money, and both
portfolios pay X at maturity. Similarly, when put is out of the money, and call is in the
money, both portfolios pay S at expiration. (loser pays, winner receives)
e. PUT-CALL PARITY holds that portfolios with identical payoffs

i.
f.

rT

PE + S 0=C E + X e

Equivalencies of Put-Call Parity

i.

S 0=C E P E +X erT

ii.

PE =C E S 0 +X erT

iii.

C E=S 0X erT + P0

iv.

X erT =P E + S0C E

v. Pay off on a long stock can be synthetically created with a long call , a short put,
and a long position in a risk free discount bond.

vi. Must have same strike and maturity for equality constraints to hold.
6. Explain early exercise on American Call and Put Options
a. For Call Options, since Americans can be exercised early, American Options can always be
used to replicate their corresponding European options. If exercise at day one, payoff is S_0
rT

S 0 X e

X, which is never larger than

, which is at least the price of a European call

option, therefore, it is never optimal to exercise early. If he exercised early, he will pay X,
which is more than its present value and he could have held that cash and invested it at risk
free rate.
b. Never optimal to exercise early in American Option (theoretically, but always exist
possibility of huge price swing)
i.

S
max ( 0X erT , 0 )
C A C E

c. Put Option same argument for calls.

i.

P A P E max ( X erT S 0 , 0 )

ii. American Puts are optimally exercises early if sufficiently in the money. In extreme
case, when

Xe

rT

S 0 is close to zero, the future value of the exercised cash value

is always worth more than later exercise X. we place an even stronger bound

since it can always be exercised early.

iii.

P A max ( XS 0 , 0 ) bc X is larger than PV. More likelihood of early drop and early

exercise possibility. So we need a stronger bound.

7. FIGURE OF BOUNDS FOR Option Classes
Option
Minimum Value
Euro Call
S
rT

c max ( 0X e

Maximum Value

S0

, 0)

Euro Put

p max ( X erT S0 , 0 )

Amer Call

S
c max ( 0X erT , 0)
C

S0

Amer Put

P max ( XS0 , 0 )

rT

Xe

8. Impact of Dividends on Pricing Bounds

a. Stock options have expiration of less than a year. Dividends can be estimated quite
accurately.
b. To prevent arbitrage, stock price value must decrease by the amount of the dividend.
c. Increase value of put and decrease value of call.
d. Lower bounds on Calls
e. Lower bounds on Put

c S0 DX erT
p X erT S 0+ D

9. Put-Call Parity with Dividents

a.

rT

PE + S 0=C E + X e

+D

D is the PV of Dividend.

CH 12** Trading Strategies Involving Options - Hull Options Futures and Other
Derivatives 9Ed.
1. Covered Calls a. sell a call option on a stock that is owned by the option writer.

b. By writing out of the money call option, the combined position caps the upside potential at
the strike price. In return for potential gain in stock price beyond strike price, write receives
the option premium.
c. Strategy is used to generate cash on a stock that is not expected to increase above the
exercise price over the life of the option.
2. Protective Puts
a. at the money long put position is combined with the underlying stock. (also called portfolio
insurance or a hedged portfolio)
b. Holding a long position in underlying and buying a put option.
c. Use to put limit on downside risk at the cost of the put premium.
d. Benefits from stock price increases, but will be lower by amount paid for put.
e. See pg 179 for payoff diagram. Essential becomes a long call payoff.
3. Bull Call Spread
a. Buyer of the spread purchase a call option with lower k, and subsidizes it by selling a call
with higher K.
b. Expects stock price to rise and finish in-the-money for purchased call, but not for written call
with higher K. (out-of-the money) written call.

4. Bear Call Spread

a. is the sale of a bull spread. Bear spread trader, will purchase the call with higher exercise
price and sell the call with lower exercise price.
b. Designed to profit from falling stock prices. (bear strategy)
c. As stock price falls, investor keeps premium from written call (lower K), net the long calls
cost (higher K)
d. Purpose of long call is to protect from large increases in stock price. (higher K)

5. Put Spread can be used to replicate Call spreads as well.

a. Bull Put Spread long put with low strike and a short put with high strike.

i. Best implemented in a bullish market. You sell a short put which means you are
obligated to buy.
ii. But you feel stock will go up., so you reap the proceeds from the short put at high K.
iii. Meanwhile you go long a put at low k (less likely to fall in the money, but cheaper to
curb losses and protect against short put. Investment is less than required to buy the
stock.
iv. You would enter a Bull put spread if you feel stock will end up at or above short put.
v. Less financing for margin requirements as well.
b. Bear Put Spread investor buys a put with higher exercise K, and sells a put with lower K.

6. Butterfly Spreads involved the purchase or sale of three different call/put options.
7.
a. Butterfly Call Spreads
i. Buys one call with lower exercise, K
ii. Buys another with higher exercise, K
iii. Sells two calls with an exercise in between.
iv. Essentially betting that the stock price will stay near the strike price of the written
calls.
v. Loss that the butterfly spread buyer sustains if the stock price strays from this level is
limited.

b. Butterfly Put Spreads - buy low and high strike put options and sell two puts with an
intermediate strike price.
c.

8. Calendar Spreads transacting in two options that have the same strike price but different
expirations.
a. Neutral Calendar Spread if strike price is close to the current price
b. Bullish Calendar Spread has strike price above the current price
c. Bearish Calendar Spread ha strike price below the current stock price
d. Reverse Calendar Spread produces a payoff that is opposite of the graph in fig 6. Instead
of selling a short-date option and buying a long-date option, the investor of a reverse
calendar will buy a short-date option and sell a long-date option. The investor will profit
when the stock is well above or below the strike and will siffer loss if the stock is near the
strike price. (bets on high volatility) good for times of high volatility.
9. Diagonal Spreads Similar to calendar spread except that instead of using options with the same
strike price and different expirations, the options in a diagonal spread can have different strike
prices in addition to different expirations.
10. Box Spreads - a combination of a bull call spread and bear put spread on the same asset
11. Long Straddle(bottom straddle or straddle purchase) purchasing a call and a put with same strike
price and expiration.
a. End up with a V profit diagram, losses near strike
b. Strategy profits with high volatility, and stock moves strongly In either direction.
12. Short Straddle (top straddle) sells both options and bets on little movement in the stock. Short
straddle on the same thing as the butterfly spread or calendar spread, except losses are limited.
a. Bet that profits more if correct and lose more if incorrect. Straddles are sym,etric around the
strike price.
13. Long Strangle - similar to straddle, but options purchased are slightly out of the money, so cheaper
to implement than a straddle. Payoff similar to a straddle except for a flat section between the
strike prices. Bc it is cheaper, stock will have to move more relative to a straddle before strangle
pays off. Also symmetric around strikes.
14. Short Strangle similar to a short straddle.
15. Strips involves purchasing two puts and one call with same strike and expiration. Assymetric
payoff. A strip is betting on volatility but is more bearish since it pays off more on the downside.
16. Straps purchasing two calls and one put with same strike pric and expiration. Strap bets on
volatility but is more bullish since it pays off more on the upside.
17. Collar combination of a protective put and a covered call. The usual gal is for the owner of the
underying asset to buy a protective put and then sell a call to pay for the put.
18. Zero-Cost Collar if premiums of two are same (prot put and cov call), then it is a zero cost collar.
19. Interest Rate Caps an agreement which one party agrees to pay the other at regular intervals over
a certain period of time when the benchmark interest rate(LIBOR) exceeds the strike specified in
the contract.
a. Strike rate is cap rate
b. E.g. seller of a cap might agree to pay the buyer at the end of any quarter over the next two
yrs if LIBOR is greater than a cap rate of 6%. Called Cap because payer does not pay over
the rate (a cap)
c. Cap buyer pays a premium to the seller and execises the cap if the market rate of intrest
rises above the cap strike.
20. Caplets when interest rate cap is multi-period agreement, a cap is actually a portfolio of call
options on LIBOR called caplets. For e.g. 2 yr cap is actually a portfolio of weight interest rate
options with different maturity dates.
21. Interest Rate Floors agreement in which one party agrees to pay the other at regular intervals
over a certain period when the benchmark interest rate (e.g. LIBOR) falls below the strike rate
specified in the contract. Strike rate is the floor rate.
a. Buyer of the floor benefits from an interest rate decrease. As if he buys a put option.
b.
22. Floorlets portfolio of put options on LIBOR
23. Long Cap equivalent to a portfolio of long put options on fixed-income securitiy prices. (option to
sell bonds if price falls, which means interest rate rose, but you sell for at least strike, which means
you pay at most the cap rate)
24. Long Floor equivalent to a portfolio of call options on fixed-income security. (if price of bond goes
up, you will exercise at bond price, which means rates went down, but you will receive at least Floor
rate when you execute the call option to buy the ixed income security)
25. Options on Rate vs. Options on Prices pretty straight forward.

26. Interest Rate Collar - simultaneous position in a florr and a cap on the same benchmark rate over
the same period with the same settlement dates.
a. First strategy is to purchase a cap and sell a floor.
b. Second strategy is to purchase a floor and sell a cap

CH 26 Exotic Options - Hull Options Futures and Other Derivatives 9Ed.

1. Define and Exotic Derivative and difference from plain vanilla

2. Factors that cause their development of exotic products

3. Explain how derivative can be converted into zero-cost product

4. Transforming Standard American Options into non- standard American Options

5. Types of Exotic Options

6. Gap Options

7. Gap Call option

8. Gap put option

9. Forward Start Options

10. Compound Options

a. Call on Call -

b. Call on put -

c. Put on a call -

d. Put on a put -

11. Chooser Options

12. Barrier Options
a. Down-and-out call (put) -

b. Down-and-in call (put) -

c. Up-and-out call (put) -

d. Up-and-in Call (put)

13. Binary Options -

a. Cash-or-nothing call

b. Asset-or-nothing call

14. Lookback Options -

a. Floating Lookback call

b. Floating lookback put -

c. Fixed lookback call

d. Fixed lookback put

15. Shout Options -

16. Asian Options

a. Average price calls and puts

b. Average strike calls

17. Exchange Options

a. Option to exchange

18. Basket Options

a. Rainbow options

19. Volatility swaps -

20. Variance swaps -

21. Premise of static option replication how can it be applied to hedging exotic options.

a. Dynamic options replication

b. Static options replication -

CH6 Commodity Forwards and Futures McDonald Derivatives 3 rd Ed

1. Commodity arbitrage

2. Reverse cash and carry arbitrage

3. Lease rates and no arbitrage for commodity forwards and futures

4. Contango and Bakwardation

5. Carry Markets and impacts of storage, convenience on commodity forwards and futures

6. Forward price of a commodity with storage costs

7. Fwd Price with convenience yield

8. Compare lease rates with convenience yield

9. Different types of commodity characteristics

10. Basis Risk how can it occur when hedging commodity price exposure

11. Strip Hedge

12. Stack Hedge

13. Cross Hedging

CH 13 Foreign Exchange Risk

1. Financial institutions overall foreign exchange exposure

a. Net position exposure a banks actual exposure to a given currency.

b. Positive net exposure (net long) hold more assets than liabilities in a given currency.
Institution faces risk that the foreign currency will fall in value against the domestic currency.
(Foreign Assets will fall in Value)
c. Negative net exposure (net short) hold more liabilities than assets in a foreign currency.
Institution faces the isk that foreign currency will rise in value against domestic currency.
(more expensive to pay liabilities when converting domestic to Foreign)
d.

Net Exposure=( EU RassetsEU R Liabiities ) + ( EU Rbought EU R Sold )

2. How financial institutions could alter its net position exposure to reduce foreign exchange risk
a. It is important for Financial institutions to balance their position n a currency where
asset(purchases) are exactly offset by liabilities (sales) , the institution will be exposed to
variations in the foreign exchange rate of that currency against the domestic currency.
b. The more volatile the FX rate, the more potential impact a net exposure (either Long or
short) will have on the value of a banks foreign currency portfolio.
3. Potential dollar gain or loss exposure to particular currency
4. Types of Foreign exchange Trading
a. Customers to participate in international commercial business transactions
b. Customers take positions in real or financial foreign investments. Financial institution may
also do so for itself and its portfolio.
c. Offsetting exposure in a given currency for hedging purposes. Helps to reduce FX exposure.
d. Speculating on foreign currencies in search of prfit by forecasting and/or anticipating futures
FX rate movements. Relates to open positions that are taken for speculative purposes and
represent an unhedged position in a given currency. Usually trades made directly with other
financial institutions or arranged with an FX specialist broker. Currency spot trades most
frequent speculative trades.
e. When bank trades, buys and sells FX for its customers (receives a fee) it also does not
assume FX risk itself.
5. Source of gains and losses on Foreign exchange trading.
a. Mismatched foreign asset and liability positions
b. Returns from banks portfolio are derived from differences between income and costs.
however, foreign investment provides additional dynamic of having profits and losses
affected by changes in foreign exchange rates.
c. TWO METHODS to control the scale of FX exposurei. On-balance-sheet Hedging - achieved when company has a matched maturity and
currency foreign asset-liability book.
ii. By directly matching foreign assets and liabilities, we can lock in a positive return or
profit spread if exchange rates move in either direction over the investment period.
iii. Off-balance Sheet Hedging rather than matching foreign assets and liabilities, we
can lock in a positive return or profit spread if exchange rates move in either
direction over the investment period.
1. Using a forward foreign exchange agreements. which involves an exchange
of foreign currency at some point in the future that is determined today.
2. E.g. if you have CHF and want USD. You can sell forward the expected
principal and interest of CHF on the loan at the current known rate USD/CHF,
with delivery of Swiss Francs (CHF) to the buyer of the forward contract taking
place at the end of the investment horizon.
3. Effectively removing foreign exchange rate uncertainty.
6. No arbitrage assumptions in foreign exchange markets leads to interest rate parity theorem.
a. Interest Rate Parity the discounted spread spread between domestic and foreign
interest rates equals the percentage spread between forward and spot exchange rates.
i. In other words, the hedged dollar return on foreign investments should be equal to
the return on domestic investments.
ii. IRP implies that in a competitive market, a firm should not be able to make excess
profits from foreign investments. (i.e. a higher domestic currency return from lending
in a foreign currency and locking in the forward rate of exchange)
iii.

[ ]

1+r DC
forward FX price=spot FX price
1+r FC

r DC =domestic currency rate

1.

r FC =foreign currency rate

Forward=Spot e (

iv. Continuously compounded

r DC r FC ) T

7. Use theorem to calculate forward foreign exchange rates

a. Take 1000 pounds invest it at foreign currency and sell it forward,
b. Invest 1000 pounds and exchange is at spot rate to USD at

F0 ,

r DC . at time T , we must

have:
c. 1000
d.

rf T

L e F0 =1000 S 0 e

F0 =S 0 e(

rdc rf ) T

F0 =$ / L

rdc T

S 0=

$
L

8. Diversification in multi-currency asset liability positions can reduce portfolio risk.

a.
9. Relationship between nominal and real interest rates
a. Each domestic and foreign interest rate consists of two components- First component is:
b. Real interest rate reflects a given currencys real demand and supply for its funds.
Differences in real interest rates will cause capital to flow into countries with the highest
available real rates of interest. Therefore, there will be an increased demand for those
currencies
c. Expected inflation rate amount of compensation required by investors to offset the
expected erosion of real value over time due to inflation.
i. Differences in inflation rates will cause residents of the country with the highest
inflation rate to demand more imported (cheaper) goods. For e.g., if prices in US are
rising twice as fast as Australia, citizens will increae their demand for Australian
goods (aussie goods are now cheaper relative to domestic goods)
d. Nominal interest rate ,r, the compounded sum of real interest rate, real r, and the expected
rate of inflation, E(i), over an estimation horizon.
i. Exact methodology:
ii.

1 ( 1+ r real ) =

( 1+r nominal )=( 1+ r real ) ( 1+ E ( i ) )

1+r nominal
1+ E ( i )

CH 12 Corporate Bonds Fabozzi Handbook of Fixed Income Securities 2012

1. Bond indenture a document that sets forth the obligation of the issuer (payer) and the rights of
the investors in the bonds (i.e. the bondholders) Detailed document filled with legal language.
2. Corporate trustee is to interpret this language and represent the interests of the bondholders.
Banks or trust companies most often serve as corporate trustees. Position requires they act in a
fiduciary capacity on behalf the bonholders.
a. Authenticate the issue, which includes keeping track of the amount of bonds issued and
making sure the number does not exceed the limit specified in the indenture.
b. Monitors corporations to ensure they abid by the indentures covenants and keep key ratios
below a given level. Etc.
3. Trust Indenture Act specifies that all bond offerings over $5 million and sold in interstate
commerce must have a corporate trustee. The corporate trustees must be competent and
financially responsible and should aslo not have any conflicts of interest (being a creditor of the
issuer). The indenture would also specify how the trustee would make reports to bondholders and
what to do if the issuer fails to pay interest and principal. role is to protect the rights of
bondholders.
4. Bond maturity and impact on bond retirements
a. Maturity when the bond issuers obligations are fulfilled. At maturity, the issuer pays the
principal and any accrued interest or premium.
i. The bond issuer may retire bond early if set forth in the bond indenture.
ii. Longer the maturity the more time a company has t retire the bond issue.
5. Interest Payment Classifications interest rate on a bond often called the Coupon.

a. Straight-coupon bond called fixed rate bonds, have fixed interest rate set for the entire life
of the issue.
i. In US, they typically pay semiannual interest.
ii. In Europe and other countries, they pay annual interest rate payments.
b. Participating Bonds pay at least the specified interest rate but may pay more if the
companys profits increase.
c. Income bonds pay at most the specified interest, but they may pay less if the companys
income is not sufficient.
In case of Participating and Income Bonds, the specifications for paying more or less is set
out in the indenture.
d. Zero-coupon bonds pay the Face Value or Principal at Maturity. There is not a cash Interest
payment; instead the bond holder ears a return by purchasing the bond at a discount to
faceValue and receiving he full Face Value at Maturity.
i. Deferred-interest bond variation of ZCB, will not pay cash interest for some number
of years early in the life of the bond. That period is the deferred-interest period, cash
interest accrues and is then paid semiannually until maturity or when redeemed.
ii. Payment-in-kind bond (PIK) a variation of ZCB, pay interest with additional bonds for
the initial period, and then cash interest after that period ends.
iii. Most zero coupons issued today share a host of other features such as being
convertible, callable, and putable. A Zero-coupon bond interest rate is determined by
the original-issue discount(OID):
1. Original-issue discount=face value-Offering Price
2. Value of bond grows very year, and thus pays implicit interest, which is a
function of the OID and the term to maturity.
3. Zero-coupon bonds have zero reinvestment risk. The bondholder does not
have to make an effort to reinvest cash interest payments or worry about the
available rates at which to reinvest them.
4. Disadvantage is that the bondholder must pay taxes each year on the accrued
interest even though no cash is received from the bond issuer.
e. Floating-rate bonds known as variable bonds- interest paid is generally linked to some
widely used reference rate such as LIBOR or the Federal Funds Rate.
Corporate Bonds can have a security, such as real property, underlying the issue. Those who own
mortgage bonds have a first mortgage lien on the properties of the issuer.
Debentures are unsecured bonds.
6. Bond Types
a. Mortgage Bonds can be issued in a series in a blanket arrangement. In this case, one group
of bonds is issued under the mortgage.
b. Collateral Trust Bonds are backed by stocks, notes, bonds or other similar obligations that
the company owns. Underlying assets are called collateral or personal property.
i. Trustee holds the collateral for benefit of the bond holders. The issuer retains voting
rights for stock used as collateral, so they retain control over their subsidiaries.
ii. Provisions are also set in place if value of collateral falls below the value of the loan.
Issuer may have to contribute additional securities to back the bonds.
iii. Issuer can also withdraw collateral if value rises in order to exceed loan value.
c. Equipment Trust Certificates are variations of a mortgage bond where particular equipment
underlies the bond. The usual arrangement is that the borrower does not actually purchase
the equipment. Instead the trustee purchases the equipment and leases it to the effective
borrower who pays rent. Rent is then passed on to the holders of the ETC.
i. More security than a mortgage bond. Esp attractive if equipment is standardized. E.g.
railroad cars, which provides for easy sale or lease of te equipment in the case of the
user equipment defaults.
d. Debentures undecured bonds that do not have asset underlying the issue. Most Corporate
Bonds are Debentures and usually pay higher interest rate for that reason. If company is
highly rated and has not issued any secured bonds, then debentures are almost equivalent
to mortgage bonds in that they have a claim on all the assets of the issuer along with the
general creditors.
i. If the issuer has issued secured debt along with debentures, the debenture holders
have a claim on the assets that are not backing the secured debt.
ii. Typically Issuer is restricted to one issue of debentures if there is already secured
debt.

iii. Subordinated Debenture Bonds have a claim that is at the bottom of the list of
creditors if the issuer goes into default. They are bonds that are unsecured and have
another unsecured bond with a higher claim above them.
iv. Convertible Debentures which give the bondholder the right to convert the bond
into common stock. This feature will lower the interest rate paid.
1. The cost to the issuer, however, is the possibility of increased dilution of the
stock.
v. Exchangeable debentures convert into common stock of a corporation other than
that of the issuer.
vi. Guaranteed bonds Bonds issued by one company may also be guaranteed by other
companies. GSEs, etc. private label securitizations type companies. Guarantee does
not ensure the issue will be free of default risk since the risk will depend on the ability
of the guarantor(s) to satisfy all obligations.
7. Methods for Retiring Bonds variety of methods, and most included in bonds indenture while
others are not included.
8. Indenture includes call provisions, refunding provisions, sinking funds provision, maintenance and
replacement funds, and redemption through sale of assets. Indenture would not include fixedspread tender offers.
a. Call provisions essentially call options on the bonds that the issuer owns and give the ssuer
the right to purchase at a fixed price either in whole or in part prior to maturity.
i. Fixed-Price call the firm can call back the bonds at specific prices that can vary over
the life of the bonds as specified in the indenture. They generally start out high and
decline toward par. As for most bonds, they are not callable during the first few years
of the issues life.
ii. Make-whole Call- In this case, market rates determine the call price, which is the
present value of the bonds remaining cash flows subject to a floor price equal to par
value.
1. A discount rate based on the yield of comparable-maturity Treasury
securities(usually the rate plus a premium)
2. The redemption price is the greater of that present value or the par value plus
accrued interest.
b. Sinking fund provisions the issuing firm retires a specified portion of the debt each year as
outline in the indenture. A lottery can be used where the owners of the selected bonds must
redeem them, or the bonds are purchased in the open market.
i. Purchase of equipment in excess value of the amount of the bonds to be retired is
another action that may satisfy a sinking fund provision.
ii. First, retirement of bonds improves the financial health of the firm. Second, the
redemption price may exceed the market price, however the indenture may give the
issuer flexibility as to how much of the bonds to call back each period.
iii. Accelerated Sinking funds Provisions which allows the firm to call back more bonds
in early years, which the firm would do if interest rates fall in those early years.
c. Maintenance and replacement fund same goal as a sinking fund provision, which is to
maintain the credibility of the property backing the bonds. REQUIRES valuation formulas for
the underlying assets. Provision specifies that the fund must keep up the value of the
underlying assets much like a home mortgage specifies the home buyer must keep up the
value of the home.
i. One way is to acquire sufficient cash to maintain the health of the firm/equipment
etc. underlying the asset. That cash can also be used to help retire the fund.
d. Tender Offers - means for retring debt for most firms.
i. Firm openly indicates an intrest in buying back a certain dollar amount of bonds, or ,
more often, all of the bonds at a set price.
ii. Goal is to eliminate restrictive covenants or to use excess cash.
iii. If first tender offer does not get sufficient interest, the firm can increase its offer
price.
iv. Firms can also announce it will buy back bonds determined by a certain market
interest rate. (this lowers interest rate risk for both the bondholders and the bond
issuer.
9. Credit Risk includes credit default risk and credit spread risk
a. Credit default risk - is the uncertainty the issuer making timely payments of interest and
principal as prescribed by the bonds indenture.

i. Most widely used indicators are bond ratings that major agencies perform credit
analysis. The rating can be interpreted as a probability of default within some time
period.
b. Credit spread risk focuses on the differene between a corporate bonds yield and the yield
on a comparable-maturity benchmark Treasury security. Difference is known as the credit
spread. Embedded options and liquidity factors can affect the spread.
i. Other factors affecting credit spreads are: macroeconomic factors, treasury yield
curve, business cycle, issue specific factors (corporations financial position) futures
prospects of the firm.
10. Event Risk addresses the adverse consequences from possible events such as mergers,
recapitalizations, restructurings, acquisitions, leveraged buyouts, and share repurchases, which
may escape being included in the indenture.
a. Such events can drastically affect firms capital structure and reduced the creditworthiness
of the bonds and their value.
b. A company may include in the indenture a poison put, which can require the company to
repurchase debt at or above par value.
c. The prupose of this feature is to protect bondholders, but its effectiveness toward this goal
can be misleading in that the acquiring firm may offer a higher price for the stock which will
then turn it into a friendly turnover.
11. Discuss types of High Yield Bonds, payment features, issuers a. High Yield Bonds are those bonds created below investment grade by ratings agencies.
b. Businessmans risk refers to bonds with a rating at the bottom rung of the investmentgrade category (BBB, Baa) or at the top end of the speculative grade category (Ba or BB)
c. Some companies who issue bonds with a non-investment grade rating. Usually young and
growing companies.
d. Firms can issue bonds to raise venture capital and their prospectus are tied to a particular
project- so they call them Story Bonds.
e. Fallen Angels another type of high yield bond. They are bonds that were issued with an
investment-grade rating, but then events led to the ratings agencies lowering the rating to
below investment grade.
i. If issues are or near bankruptcy, they are often called special situations, which could
payoff if the company recovers or lead to big losses.
f. Restructurings and Leveraged Buyouts may increase the credit risk of a company to the
point where the bonds become non-investment grade.
i. The new management may pay high dividends, deplete the acquired firms cash, and
lower the rating of th existing bonds.
g. High yield bonds have several types of coupon structures
i. Reset bonds- where designated investment banks periodically reset coupon to reflect
market rates and the creditworthiness of the issuer.
ii. Deferred-coupon structures- three types
1. Deferred-interest bonds sell at a deep discount and do not pay interest in
the early years of the issue.
2. Step-up bonds pay a low coupon in early years and then a higher coupon in
later years.
3. Payment-in-kind bonds allow issuer to pay interest in form of additional
bonds over the initial period.
12. Default A Default occurs if there are any missed or delayed disbursements of interest and/ or
principal.
a. Proven that lower credit ratings indicate a higher probability of default, but there are two
ways to measure default: by the raw number of issuers that defaulted r the dollar amount of
issues that defaulted.
13. Default rate and dollar default rate
a. Issuer Default Rate number of issuers that defaulted over a year divided by the total
number of issuers at the beginning of the year.
b. Dollar Default Rate the par value of all bonds that defaulted in a given calendar year
divided by the total par value of all bonds outstanding during the year.
14. Recovery Rate the amount received as a proportion of the total obligation after a bond defaults.
Measuring can be complicated because the value of the total obligation requires computing the
present value of the remaining cashflows at the time of the default.
a. Some of the amount that the investor recovers may be in the form of securities.
b. Bonds with higher seniority will have higher recovery rates.

CH 20 Mortgages and Mortgage-Backed Securities , Handbook of Fixed Income

Securities 2012
1. Mortgage a loan that s collaterized with a specific piece of real property.
a. Primary Market first market where banks issue loans and collected pmts from borrowers.
b. Secndary Market Mortgage lenders sold to this market through securitization.
2. Mortgage backed security (MBS)- when mortgages are pooled together and packaged to investors
in this form.
3. Securitization - when mortgages are packaged and sold on secondary market. Usually must be
securitized by a GSE or private label securitizations.
4. Pass-through structure- pmts of the MBS are passed from the borrower to the banks and end up
with the MBS investor. This includes interest and principal.
5. Lien Status - refers to the ability of the person to recover the balance owed in the event of a
default. There are First Lien, Second Lien, Subsequent Lien. First Lien would give the lender the first
right to recover proceeds on liquidation.
6. Original Loan Term usually mortgages issued for 10 to 30 years. However medium term in the 1020 years are starting to become more common.
7. Credit Classifications Prime and subprime
a. Prime (Agrade)- constitute most of the outstanding loans.
i. Low rates o delinquency and default as a result of low loan-to-value ratios (far less
than 95%)
ii. Loan-to-value ratio of a loan to the value of the asset purchased.
iii. Borrowers with stable and sufficient income(front income ratio of no more than
28% of monthly income to service pmts relaing to home and back income ratio of
36% for those pmts plus other debt pmts)
b. Subprime (B-grade) Loans have higher raes of delinquency and default compared to prime
loans. They could be associated with high LTV ratios.
i. Borrowers with lower income levels, and borrowers with marginal or poor credit
histories(FICO score below 660)
c. Alternative-A loans le in between Prime and SubPrime. Essentially prime loans, they are a
little riskier than A.
i. Loan value may be unusually high or LTV ration may behigh or less documentation for
income verification or down payment source.
8. Front end Debt-to-income ratio calculates how much of a persons gross income is going towards
housing costs (mortgae, mortgage insurance) divided by gross income.
9. Back end debt-to-income ratio percentage of gross income towards other types of debt like credit
card or car loans. Includes mortgage costs.
10. Interest Rate Types fixed rate , Adjustable rate
a. Fixed rate remains constant throughout term of mortgage
b. Adjustable Rate rates change throughout the term.
i. Based on a base rate (prime rate, LIBOR) + a spread.
ii. Depending on agreement, it can be monthly, quarterly, semiannual or annual.
11. Prepayment and Prepayment penalties reasons include:
a. Home is sold, which requires balance to be paid off.
b. Refinanciing due to lower rates or more attractive loan features elsewhere.
c. Partial prepayments by the borrower during the term.
d. Contracts usually contain prepayment penalities as a result. There are SOFT penalties that
may be waived on sale or HARD penalties that may not be waived.
12. Credit Guarantees for:
a. Government loans backed by federal government agencies(Gov National Mortgae
Association or GNMA)
b. Conventional Loans could be securitized by Government Sponsored Enterprises(GSEs)
i. FHLMC-Fedral Home Loan Mortgage Corporation
ii. FNMA Federal National Mortgage Association
iii. They place a guarantee on loans with a guaranty fee which means they will pay the
outstanding balance to the investors in the event of default.
c. Private label securitizations non-agency (or non-conforming) MBSs securitized by private
label market willing to take on risks in nonconventional loans jumbo loans(principal over
the limit and/or loans with high LTV)

13. Conventional mortgage most common residential mortgage. Loan based on creditworthiness of
borrower and collateralized by residential real estate that is used to purchase.
14. Amortized mortgage loans (fixed rate, level pmt) mortgage that requires equal payments(usu
monthly) over the life of the mortgage. Each pmt consists of an interest component and a principal
component.
a. Features include- amt of principal increases as time passes. Intrest decreases as time
passes. Servicing fee also declines as time passes.
b. Ability of borrow to repay results in prepayment risk.
15. Prepayment risk - prepayments curtail amount of interest the lender receives over the life of the
mortgage and cause the principal to be repaid sooner.
16. Amortization schedule 17. Mortgage prepayment option and factors that influence prepayments
a. Seasonality summer time! Popular time for individuals to move(and mortgages must be
paid out prior to sale of home.
b. Age of Mortgage pool lower age of pool, less likely. Prepayment usually comes several
years into the mortgage.
c. Personal marital breakdown, loss of employment, family emergencies, and destruction o
property. Difficult to assess this type of prepayment risk.
d. Housing Prices property value increases may spur prepayments as borrowers wanting to
take advantage of increased equity for personal use. Property value decreases reduce the
value of collateral, reduce the ability to refinance, and therefore, decrease the risk pf
prepayment.
e. Refinancing burnout if there is significant prepayment or refinance activity in the mortgage
pool in the past, the risk of prepayment in the future decreases.
18. Securitization to reduce risk of potentially undiversified portfolio of mortgage loans, a number of
financial insitutitions wil work together to pol residential mortgage loans with similar characteristics
into a more diversified portfolio.
a. They wil then sell the loans to a separate entitity, called a Special Purpose Vehicle., in
exchange for cash.
b. An issuer will purchase those mortgage assets in the special purpose vehicle, and then use
the SPV to issue MBSs o investors.
c. The lack of securitization market for mortgages would lead to the downfall of mortgage
lending because of financial institutions would not want to retain the risks.
19. Mortgage pass-through security represents a claim against a pool of portgages. Any number of
mortgages may be used to form the pool and any mortgagage included in the pool is referred to as
a securitized mortgage.
20. Securitized mortgage a mortgage in a pool of mortages under a mortgage pass-through security.
21. Weighted average mortgage maturity the weighted average of all the mortgage ages in thepool,
each weighted by the relative outstanding balance to the value of the entire pool.
22. Weighted average mortgage coupon the weighted average of the mortgage rates in the pool.
23. Pass-through rates (the coupon rate on the pass-through) less servicing and guarranty/insurance
fee.
a. Note: More than one kind of pass-through securities may be issued against a pool.
24. Measuring prepayment speeds it is necessary to make specific assumptions about the rate at
which prepayment of the pooled mortgages occurs when valuing pass-through securities.
a. Two conventions used: see below:
25. Conditional prepayment rate (CPR) - is the annual rate at which a mortgage pool balance is
assumed to be prepaid during the life of the pool. For e.g a pool of mortgages with CPR of 8% would
indicate that for each period,(annual), 8% of the pools remaining principal outstanding will be paid
off.
a.

CPR=1( 1SMM )12

26. Public Securities Association (PSA)

27. Single monthly mortality rate (SMM) constant maturity mortality
a.

Prepaymen t t
Principal Pm t t Schedule pm t t

SMM =1( 1CPR ) 12

b. SMM of 10% impies 10% of pools beginning of month outstanding balance, less schedule
payments, will be prepaid during the month.
c. Now that Bob paid of this mortgage, he wont be making any mre payments, the schedule
monthly payment on the MBS will decline by, you guessed it, 10%.

d. Called mortality because analysts were actuaries and called it the slow death of the
mortgage pool.
28. Specified pools market identifies the number and balances of the pools prior to a trade
29. TBA Market To Be announced Market where you can trade MBSs in the forward market. More
liquid than specified pools. Involves establishing the price in a forward market. Pool Allocation,
however, is not revealed to seller until immediately before settlement.
30. Dollar roll transaction occurs when an MBS market maker buys positions for one settlement
month, and at the same, time, sells those same positions for another month. (essentially to buy it
back cheaper in next month- accounting for coupon payments, principal pmts, reinvested interest),
but he can reinvest the cash and have it grow. This might be useful for duration matching, risk
reduction in a given month, The fall in price is known as the Drop.
31. Valuing a dollar roll transaction a. Securitys coupon, age, WAC b. Holding period(period btw settlement dates) c. Assumed prepayment speed
d. Funding cost in the repo market
32. Factors causing a dollar roll to trade Special
a. When the price difference/drop is large enough to result in financing at less than the
implied costs of the funds, then the dollar roll is trading special.
b. Caused by: a decrease in backmonth price ( incr sale/settelements transactions on back
month-incr demand, incr supply, price drops)
c. Incr in front month price(dur to incr demand in front month for deal collateral)
d. Shortages of certain securities in market that cause dealer to
33. Collateralized Mortgage Obligations

34. Planned Amortization Class Tranches

35. Strips

36. Prepayment Modeling

37. Refinancing a mortgage

38. Dynamic Valuation Models

39. Option Adjusted Spread

CH 6 The Ratings Agencies - Managing Credit Risk 2nd Ed

1. Role of credit ratings agencies SEE THE BOOK VERY QUICK

2. Interpreting Credit Ratings

3. Rating scale

4. Unsolicited ratings

5. Investment grade

6. Speculative grade

7. Ratings Process

8. Ratings and Regulation