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Assignment Unit 2
School of Management
ASSIGNMENT UNIT 2
Table of Contents
Introduction......................................................................................................................................4
PART A............................................................................................................................................5
Describe the major features of valuing Futures, Forwards and Swaps............................................5
What is Net Cost of Carry? What role does it play?....................................................................6
What are the major return risk concerns?........................................................................................8
What is hedging? How do we perform hedging of different types of risk?...................................11
Price risk minimizing hedge......................................................................................................13
Revenue risk minimizing hedge.................................................................................................14
Margin risk minimizing hedge...................................................................................................15
Portfolio value risk minimizing hedge.......................................................................................15
Multiple sources of risk minimizing hedge................................................................................15
PART B..........................................................................................................................................16
What is an ARBITRAGE? Why options are considered non-arbitrage price relations?...............16
Describe different kinds of non-arbitrage relations. What are their major features and
differences?....................................................................................................................................16
Continuous rate..........................................................................................................................17
Discrete flow..............................................................................................................................19
No-arbitrage intermarket relations.............................................................................................21
What is the European-Style option? What are the different kinds of OPTIONS TRADED in
European-Style way?.....................................................................................................................22
Reference.......................................................................................................................................23
List of Abbreviations
CAPM. Capital Asset Pricing Market
CML.. Capital Market Line
OTC.... over- the-counter
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List of Figures
Figure 1 Relation between expected return and risk for portfolio consisting of one unit of asset
and nF futures contracts.................................................................................................................11
List of Tables
Table 1 Carry costs/ benefits and net carry cost modelling assumptions........................................5
Table 2 Summary of no-arbitrage price relations for European-style and American-style options
where the underlying asset has a continuous ne carry rate............................................................17
Table 3 Summary of no-arbitrage price relations for European-style and American-style options
on assets where the underlying asset pays a discrete cash dividend..............................................19
ASSIGNMENT UNIT 2
Introduction
This short essay is divided into two parts:
Part A answers the following questions.
a.
b.
c.
d.
ASSIGNMENT UNIT 2
PART A
Describe the major features of valuing Futures,
Forwards and Swaps
(Whaley, 2007) defines a derivative as a contract to execute an exchange at some future date and
its value derives from the price of an underlying asset such as a stock, bond, currency, or
commodity and the key feature of the transaction specified in a derivative contract is that it will
be executed in the future than today. (Drake & Fabozzi, 2010) distinguish two sources of
derivative value; a) the value derived from the underlying asset, and b) the value derived from
the features of the derivative itself.
Valuation is a process of determining the value of financial or real asset (Damodaran, 2002).
According to (Whaley, 2014), the value of a financial asset can be determined using three
factors, namely: risk, return, and timing of cash flows.
Futures, forward and swaps contracts are all viewed as derivative contracts because they derive
their value from an underlying asset although they have differences in their market mechanics
(Damodaran, 2002).The major features of valuing Futures, Forwards and SWAPS contracts are;
a) valuation assumes that derivatives contracts are traded in markets with no arbitrage, b)
valuation uses replication and perfect substitutes to value contracts with the same risk, return,
and timing of cash flows, and c) valuation uses net cost of carrying relations.
Valuation assumes that derivatives contracts are traded in markets with no arbitrage
According to (Whaley, 2014), the fundamental assumption in valuation is that in the absence of
costless arbitrage opportunities, if two investments (perfect substitutes) are identified whose risk,
return, and timing of cash flow properties are exactly the same they must have the same price in
the marketplace. Otherwise, market participants can make free money by simultaneously selling
the more expensive one and buying the cheaper one.
Valuation uses replication and perfect substitutes to value contracts with the same risk,
return, and timing of cash flows
The pricing of forward contracts, futures contract and swaps or the pricing of all derivatives is
based on replication, that is, the price or the value 1 of a derivative should be the cost of creating
the same outcome by using other securities assuming no arbitrage, that is, that markets do not
permit the creation of something out of nothing (Sundaram & Das, 2013).
1 value is what one beliefs that the contract is worth while the price results from supply and
demand of contracts in the market (Whaley, 2007)
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(Sundaram & Das, 2013) qualifies the no-arbitrage assumption by pointing out that arbitrage
opportunities do arise but they do not persist, that is, as soon as the investors start taking
advantage of arbitrage opportunity, immediately, the prices adjust to eliminate the arbitrage.
Valuation uses net cost of carrying relations
The key to understanding of forward/futures valuing lies on identifying the net cost of carrying
or net cost of buying and holding an asset and in the process of identifying the costs of buying
and holding an asset continuous rates and discrete cash flows assumptions do apply (Whaley,
2007).
( 1)
For a financial asset or security the benefit is income (yield) paid as dividend for stock and
coupon for bond. Thus, (Equation 2) computes the net carry cost for a security.
Net carry cost = Cost of funds Income
( 2)
The carry costs/benefits and net carry cost rate are modelled using either continuous rates or
discrete cash flows (Table 1).
Table 1 Carry costs/ benefits and net carry cost modelling assumptions2
Carry costs/benefits
Modelling assumptions
Continuous rates
Discrete cash flows
Costs of funds (risk-free interest rate) Warehouse rent, quarterly cash
Dividend yield on stock portfolio, dividend, semiannual coupon
interest income on a foreign currency receipts
deposit, lease rate on gold
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denotes the price of the asset at future time T, where tilde means that the future
asset price is uncertain.
r denotes the opportunity cost of funds, that is, the risk-free interest rate and is
assumed to be constant, continuous rate.
denotes what will be owed at time T, if the funds are borrowed to buy the asset
today.
i denotes a constant, continuous rate called yield to maturity rate used for discounting
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The net cost of carry rate of this stock index portfolio is equal to the difference between
the risk-free rate of interest r and the dividend yield rate i. So the total cost of carry paid
at time T is
( 3)
Estimating net carry cots rate using continuous rate
Stocks with quarterly cash dividends and bonds with semiannual coupon payments,
noninterest carry costs/benefits are best modelled as discrete flows (Whaley, 2007). Lets
assume a stock that can pay n cash dividends in the amount I i at time ti, with i=1,.,n
from toady to a future time T. If one borrows S to buy the stock and reinvest all cash
dividends as they are received at risk-free rate of interest, the terminal value of the stock
will be
( 4)
With
( 5)
The role of Net Cost of Carry is to find out how much is going to cost to buy an asset and hold
it until future time T taking into account the nature of the asset.
ASSIGNMENT UNIT 2
widespread default in other markets, there first must be large defaults in derivative markets
(Hentschel & Smith Jr, 1995, p. 17).
Counterparty risk, credit risk or default risk (Hentschel & Smith Jr, 1995) refers to the
likelihood that one of the parties involved in a derivatives trade, such as the buyer, seller or
dealer, defaults on the contract. The derivatives traded in OTC markets have a much higher risk
than ones traded in exchange markets. In the exchange markets both the buyer and seller are
required to deposit good-faith collateral designed to show that they can fulfill the terms of the
contract (Whaley, 2007) and in OTC the management of the counterparty risk depends on the
dealer trustworthiness.
Settlement risk, Herstatt risk refer to defaults that occur at a specific point in the life of the
contract: the date of settlement. (Hentschel & Smith Jr, 1995).
Liquidity Risk arises when investors plan to liquidate positions to meet funding requirements
(Jorion, 2009).
Operational risks such as price risk, revenue risk, gross margin refers to the risk of loss
arising resulting from failed or inadequate organizational processes or resources (Jorion, 2009).
Basis risk refers to the fact that the futures price movements and asset price movements are not
perfectly correlated (Whaley, 2007) and is defined by two factors.
Base risk = Time basis risk + Grade basis risk
Meaning of Time basis risk
When the markets are assumed to be frictionless and the risk-free rate of interest, r, and the
income rate on the asset, i, are constant through time, the net cost of carry relation are constant at
all points in time and the time basis risk is said to be zeo. Because arbitrage opportunities due
happen, the futures price movements and asset price movements in these circunstances do not
correlate perfectly except when the hedge time horizon is equal to time to expeiration of the
futures and there is guantee that futures and asset prices will be the same (Whaley, 2007).
Meaning of Grade basis risk
Second factor, grade basis risk, happen when futures contracts are not written directly to the
assets being hedged because there are not futures contrats for such assets so they use close
related assets. However, the price of the close substitute asset and the price of the asset being
managed may change over time criating price uncertainity called grade basis risk (Whaley,
Markets, Valuation, and Risk Management, 2007).
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10
In summary, the major return risk concerns that corporate managers focus more of their attention
are price risk, revenue risk, margin risk, portfolio value risk and multiple sources of risk
(Whaley, 2007). Therefore, hedging will concentrate on these risks.
Before introducing risk hedging using derivative contracts, a brief explanation of how to express
the expected return of derivate contracts using CAPM model is next presented.
The CAPM model, among its several applications can be used to analyze the relationship
between return and risk. In the assignment one, it has been shown that CML does compensate
investors only for specific risk but not for systematic risk. Systematic risk is compensated by
CML that includes the beta factor.
According to (Whaley, 2007), the key to understand the relationship between return and risk of
derivatives contracts hinges on the relationship between the rate of price change of the financial
contract and the rate of return of the underlying asset. (Whaley, 2007) showed that the only
income arising from holding a futures contract is the price change of futures contract and that the
rate of return from investment in the underlying asset is the sum of two components the
continuous rate of price appreciation and the income rate.
(6)
, is
( 7)
(Equation 7) expresses the return relations between the financial contract and the underlying
asset.
CAPM model is defined as
ki RF ( ERM RF ) i
(8)
Now, the return of the forward contract (Equation 7) will be expressed in terms of (Equation 8).
ASSIGNMENT UNIT 2
11
CAPM estimates expected returns, so, the (Equation 7) will be expressed in terms of expected
return of futures and expected return of the underlying asset.
EF = ES r
(9)
The specific risk of the expected returns of futures contract as measured by return variance and
the market risk as measured beta of are:
Variance
(10)
Beta
(11)
Substituting (Equation 9) and (Equation 11) into (Equation 8), the expected return of future has
the following relation.
(12)
So, (Equation 12) says that in buying the asset one expect to get two rewards; a) the rate of return
on the risk-free asset, r, and b) the risk premium associated with holding the asset, (E M- r)S. An
in buying the future, one has only one reward, the risk premium, (EM- r) F.
Whithin the framework of net cost of carry, being long the asset means one expects to receive
the rate of return ES and being short the futures means one expects to receive the rate of return EF.
Thus, the net return of the portfolio from be in long the asset and short the futures is the risk-free
rate of interest (Equation 13).
(13)
The conclusion is that the risk premium associated with buying the asset is exactly offset by the
risk premium associated with selling futures (Whaley, 2007).
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(Whaley, 2007) points out that hedging opportunities can be identified by exploring the
relationships between the underlying asset and futures contract and be done in a two steps
process:
a) The expected returns of the portfolio made up of the underlying asset and future contracts
are.
(14)
b) (Equation 15) is used to find the total risk of the portfolio made up of one unit of the asset
and nf futures contract.
(15)
(Equation 14) means that to manage expected return and risk of the portfolio one has to find the
of nF. For instance, using a portfolio made up of an underlying asset with 10% of expected
return, 20% of total risk, and 4% of risk-free rate of interest, and a futures contract of 8% of
expected return and 20% of risk, a number of opportunities (defined by n F) can be identified
(Figure 1). When nF=0, the investor has only the 12% of return and 20% of total risk, that is the
portfolio is not hedged. When nF= -0.5, meaning that investor is selling one futures contract for
every two units of the asset he holds. The risk level of the portfolio, which is 10%, is less than
the risk of the underlying asset, which is 20%), meaning that the underlying asset is being
hedged. In (Figure 1), when nF= -1, the hedge portfolio has an expected return of 4% and no
risk. This portfolio with the lowest risk level possible is called the risk-minimizing hedge and
can be computed by (Equation 18) (Whaley, 2007) .
(16)
When n*F is greater than -1 the risk increases while the expected return reduces until no longer
hedging is possible and speculation takes over.
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Figure 1 Relation between expected return and risk for portfolio consisting of one unit of
asset and nF futures contracts
Source: (Whaley, 2007, p. 148)
(Whaley, 2007) says that to find opportunities as suggested by (Figure 1) it is not an easy task
because the basis risk introduces price risk. Instead, (Whaley, 2007) presents a more elaborated
framework for hedging risks that comprehends four steps: (1) identifying appropriate derivative
contract, (2) collecting historical prices, (3) estimating standard deviation and correlation
parameters, and (4) computing the risk-minimizing hedge.
Next, these steps are applied to hedge risk price, revenue risk, margin risk, portfolio risk, and
multiple sources of risk.
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(17)
Step three3
To estimate standard deviation and correlation parameters (Equations 18 and 19) are respectively
used for historical data.
(18)
Where Var(ST) and Var(FT) are the variances of the asset and futures prices, respectively, and
is the covariance of the asset and futures prices.
(19)
Step four
To compute the price risk-minimizing hedge it is necessary to find the number of futures
contracts,
Where
prices.
, calculated by (Equation 19), is the correlation between the asset and futures
In summary, the effectiveness of the hedge will depend upon the correlation between the asset
and futures prices. There are three scenarios for the effectiveness of the correlation; a) with
=+1, the hedge is said to be perfect, and the optimal hedge is to sell on futures contract, b) with
= -1, the hedge is also said to be perfect but the optimal hedge is to buy on futures contract, and
with in between minus one and one, -1 <<+1, the hedge will not be fully effective. The
effectiveness will decrease with the correlation approaching to 0. With p = 0, the asset and future
prices are independent and futures position cannot be taken (Whaley, 2007),
3 Instead of calculating individual standard deviation and correlation parameters, it can be use
OLS tool to generate these parameters,
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Where
V and F are the standard deviation of the continuously compounded returns of the
portfolio and the futures, and V,F is the correlation between the rates of return of the portfolio
and the futures (Whaley, 2007).
= - 1.
(25)
1= - 1.
n= - n.
(26)
Where all futures contracts whose returns are thought to influence the value of the portfolio are
used.
PART B
What is an ARBITRAGE? Why options are considered
non-arbitrage price relations?
Arbitrage is a zero-risk, zero-net investment strategy that still generates profits (Jorion, 2007,
p. 111). Risk-free arbitrage opportunity arises when an investment is identified that requires no
initial outlays yet guarantees nonnegative payoffs in the future. Such opportunities do not last
long, as astute investors soon alter the demand and supply factors, causing prices to adjust so that
these opportunities are closed off (Ritchken, 2006, p. 1)
ASSIGNMENT UNIT 2
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Options are contracts that gives its owner the right, but not the obligation, to buy or sell a
specified asset at a stipulated price, called the strike price. Contracts that give owners the right to
buy are referred to as call options and contracts that give the owner the right to sell are called put
options. (Sill, 1997). The price at which the underlying asset is bought or sold is called the
exercise price or strike price of the option (Whaley, 2007).
Options are considered non-arbitrage price relations because they assume that they are no
costless arbitrage and all arbitrage opportunities in the market have been taken out, consequently
the market in in equilibrium (Whaley, 2007).
Continuous rate
Under the continuous rate assumption the interest carry cost rate, r, and the noninterest carry
benefit/cost rate, i, are modelled as continuous rates. The income rate is positive, that is, i>0, if
the asset holder receives income from holding the asset. It is negative, that is, i<0, if the asset
holder pays costs such as storage costs in addition to interest rate (Whaley, 2007).
Lower Price Bound of European Style Call
Assuming continuous rate, the lower price bound of an European-style call option (Equation 27)
is positive or zero because the investor does not to be paid to take on a privilege (Whaley, 2007).
(27)
Where c is the call price, Se-iT denotes the asset price and -Xe-iT denotes the strike price.
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The lower price bound of an option is called intrinsic value and the difference between the
options market value (price) and its intrinsic value (price) 4 is called its time value. So, a
European-style call has an intrinsic value of max(0, Se-iT -Xe-iT) and a time value of c - max(0, SeiT
-Xe-iT) (Whaley, 2007).
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(Equations 30 and 31) is the added factor X-S to reflect the fact that the American Style put
may be exercised at any time. If P<X-S it is said that an investor can earn a costless arbitrage
profit of X-S-P by buying the put, exercising it and buying the asset at same time.
(31)
The sequence of trading simultaneously the call, put and asset is called conversion if it is buy the
asset, buy the put, sell the call, and sell risk-free. If the sequence is reversed, that is, sell the
asset, sell the put, buy the call and buy risk-free bonds it is called a reverse conversion (Whaley,
2007).
Put-call parity price for American-style options
The Put-call parity price for American-style options is defined by (Equations 33 and 34) because
of early exercise possibility of American-style options (Whaley, 2007).
(33)
(34)
(Table 2) from (Whaley, 2007, p. 188) summarizes the no-arbitrage price relations for Europeanstyle and American-style on assets with a continuous net carry cost.
Table 2 Summary of no-arbitrage price relations for European-style and American-style options
where the underlying asset has a continuous ne carry rate
ASSIGNMENT UNIT 2
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Discrete flow
Under discrete flow assumption the interest carry cost rate, r, is modelled as continuous rate but
the noninterest carry benefit/cost rate, i, is modelled as discrete cash flows.
Lower Price bound for European Style Call
(Whaley, 2007) defines the Lower Price bound for European Style Call, c, call price (Equation
35) on an asset that makes a single, discrete cash dividend payment during the options life.
(35)
Where
t<T.
, and the
. The two expressions
(36)
ASSIGNMENT UNIT 2
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(38)
Where
denotes the present value of the exercise proceeds if the put is
exercised just after the dividend payment and X-S are the exercise proceeds if the put is
exercised immediately. If P<X-S a costless arbitrage profit can be earned by buying the put and
the asset, and then exercising the put. Finally, the an arbitrage profit is X S P >0 (Whaley,
2007).
Put-Call Parity for European Style Options
(Whaley, 2007) gives the following put-call parity for European-style options on assets with
discrete noninterest cash flows (Equation 39).
(39)
Put-Call Parity for American Style Options
The (Equation 40) defind by (Whaley, 2007) describes the put-call parity for American-style
options on assets with discrete cash dividends.
(40)
(Table 3) from (Whaley, 2007, p. 197) summarizes the no-arbitrage price relations for Europeanstyle and American-style on assets with a discrete cash dividend.
ASSIGNMENT UNIT 2
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(Whaley, 2007) observed that very often, asset options and futures options are traded
concurrently and he concluded that if assuming that the futures and options expire
simultaneously and that the exercise prices of the asset and futures options are the same a
number of intermarket arbitrage price relations may be derived for European-style and
American-style options.
Intermarket arbitrage price relations for European Options
According to (Whaley, 2007), the price of a European-style asset option is equal to the price of
the corresponding futures option, that is,
(41)
(42)
The reason why the (Equations 41 and 42) are equal is because at expiration the payoffs of the
asset option and the futures option are identical.
Intermarket arbitrage price relations for American Options
(Whaley, 2007) states that the relation between the price of an American-style asset option and
the price of the corresponding futures option depends on whether the futures price is greater than
the asset price or not. If F>S,
(43)
(44)
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1. Financial Options have financial assets, such as an interest rate or a currency, as their
underlying assets. There are several types of financial options, such as:
Index Option such as S&P 100 Index Options, DAX 30 Index Options, FTSE 100
Index Options
Bond Option
Currency Option
2. Options on Futures
3. Commodity Options - These are options in which the underlying asset is a commodity
such as wheat, gold, oil and soybeans.
4. Other Options such as options whose underlying assets such as the weather
ASSIGNMENT UNIT 2
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