553.

444/644 Introduction to Financial

Where we are
Derivatives
• Previously: Swaps, Options Analysis, Binomial Tree
Midterm 2 Review Model, Risk-Neutral Analysis, the Stochastic Process,
& Ito’s Lemma (Chapter 7, 10-11,13-14 OFOD)
• Now: Review for Midterm 2 (November 15th )
• Next: Black-Scholes-Merton Model for Options plus
Applications (Chapter 15, 17–18, OFOD)

1.1 10.2

Where we are Schedule

• Mid Term 2: November 14th, Wednesday Date 2018
Monday, October 08, 2018
Module
Swaps (M6)
Due Comments
Hull: 7

• Fall Break: November 19th – 23rd Wednesday, October 10, 2018

Monday, October 15, 2018
Swaps (M6)
Options (M7) HW 6 Hull: 10 ‐ 11
Wednesday, October 17, 2018 Options (M7)
• Last Day of Classes: Friday, December 7th Monday, October 22, 2018 Binomial (M8) HW 7 Hull: 13
Wednesday, October 24, 2018 Binomial (M8)
• Final Exam: Friday, December 14th, 9am - Noon Monday, October 29, 2018
Wednesday, October 31, 2018
Stoch Process (M9)
Stoch Process (M9)
HW 8 Hull: 14

Monday, November 05, 2018 BSM Models (M10) HW 9 Hull: 15, 17 – 18

Wednesday, November 07, 2018 Midterm 2 Review Hull: 7, 10  ‐ 14  (X12)
Friday, November 09, 2018 Section: HW Problem Review All HW Returned (NLT)
Monday, November 12, 2018 Midterm Sample Q
Wednesday, November 14, 2018 Midterm 2 Exam M6 – M9
Friday, November 16, 2018 Midterm 2 Exam Return
11/19 ‐ 11/23/2018 Thanksgiving Break

1.3 1.4

1

Date 2018
11/19 ‐ 11/23/2018
Monday, November 26, 2018
Wednesday, November 28, 2018
Monday, December 03, 2018
Wednesday, December 05, 2018
Friday, December 07, 2018
Friday, December 14, 2018
9am ‐12Noon
Schedule Assignment
Module
Thanksgiving Break
Due Comments • For November 5th, 26th & 28th
BSM Models (M10)
BSM Models (M10) • Read: Hull Chapter 15 (Black-Scholes-Merton)
Greeks (M11) HW10 Hull:
Greeks (M11); Fin Rev HW 11 Hull: 15, 17‐18,  • Read: Hull Chapter 17-18 (Options on Indices &
HW Problem Review All HW Returned (NLT)
Currencies + Futures Options)
Final Exam M9 – M11
• Homework 10: Problems (Due December 3rd)
o Chapter 15 (15, 9e; 14, 8e; 13, 7e): 4, 5, 11, 13, 15, 17; 28
o Chapter 17 (17, 9e; 16, 8e; 15, 7e): 4, 22; 23*
o Chapter 18 (18, 9e; 17, 8e; 16, 7e): 7, 8, 15; 22

11.6
1.5

Assignment Midterm Review

• For December 5th
Know how to apply the two approaches to
• Read: Hull Chapter 19 (The Greeks)
valuing interest rate and currency swap
• Homework 11: Problems (Due December 7th) contracts; Know how to use swap rates to
o Chapter 19 (18, 8e; 17, 7e): 2, 10, 18; 24 bootstrap the LIBOR/Swap curve; Be able to
explain/analyze the principle of comparative
advantage for both the interest rate and
currency swap

11.7
7.8

2
 Valuation of an Interest Rate Swap that is Valuation of Currency Swaps
NOT New • Like interest rate swaps, currency swaps can be valued either as the
• Interest Rate Swap can be valued as the difference between the value difference between 2 bonds or as a portfolio of forward contracts
of a fixed-rate bond and a floating-rate bond VSwap=BFIX - BFLOAT • Let the Swap be where USD is received and foreign currency is paid
• Alternatively, they can be valued as a portfolio of forward rate VSWAP  B D  S 0 B F
agreements (FRAs)
o S0 is the spot exchange rate as number of US$ per unit of currency
o where Fi = Forward rate, i>0 n
t t  • Similarly, for a portfolio of forward FX contracts where USD is received
o F0 = Current/Last LIBOR 
VSwap  L(C  Fi 1 ) i i 1 e  Ri ti
 360  VSWAP   USD(Ti )  FC (Ti ) S0 e
 R  R T   e R T
i i
f
i
o C = Swap Rate (fixed side) i 1
i i

• EXAMPLE: Consider the • EXAMPLE   

o SWAP o SWAP (legacy): 3-year tenor, annual pay
o Pay 6M LIBOR; Receive 8% PA on $100mm o Pay: USD at 8%PA on $10 million
o 15-months to go o Receive: YEN at 5%PA on Y1,200 million
o Market o Market:
o LIBOR (cc): 3M=10%; 9M=10.5%; 15M=11% o LIBOR/Swap Curve: flat in US (at 9%PA) & Japan (at 4%PA)
o 6M LIBOR 3M ago: 10.2% o FX spot market has Y110 = $1
o First Bonds then FRAs …
7.9 7.10

Using Swap Rates to Bootstrap the The Comparative Advantage

LIBOR/Swap Zero Curve • AAACorp wants to borrow $10 million for 5-years
• Suppose the 6-, 12-, and 18-month Libor/Swap zero rates have been
o Has a Comparative Advantage in Fixed Market
determined as 4%, 4.5%, and 4.8% (continuous compounding)
o 120bps better than BBBCorp
• And the 2-year swap rate (for semiannual payments) is 5%
• BBBCorp wants to borrow $10 million for 5-years
• The 5% swap rate means o Has a Comparative Advantage in Floating Market
o A bond with $100 principal and a semiannual coupon of 5% per o “Only” 70bps worse than AAACorp
annum sells for Par
o If R4 is the 2-year zero rate, then
4
1 Fixed Floating
BFIX   Ci e  Riti   5e  Riti  100e R4t4  100
i 1 2 AAACorp 4.0% 6-month LIBOR – 0.10%
 2.5e 0.040.5  2.5e 0.0451.0  2.5e0.0481.5  102.5e  R4 2.0  100
BBBCorp 5.20% 6-month LIBOR + 0.60%
 R4  4.953%
A=120bps B=70bps
• And if we have the Libor/Swap zero curve, then we can determine the One can always structure swap so the pick-up is:
successive Swap Rates (vice versa) A - B = 50bps
7.11 7.12

3
 Comparative Advantage Arguments for
Final Review
Currency Swaps
• GE wants to borrow 20 million in AUD for 5-years
o Has a Comparative Advantage in USD • Know the properties of stock options;
o 200bps better than Quantas
• Qantas wants to borrow 15 million in USD for 5-years • be able to explain/develop (prove?) the
o Has a Comparative Advantage in AUD “bounding” conditions for European-style
o Only 40bps worse than GE
• Implied FX is 1.33 AUD per USD or .75 USD per AUD
option value and the condition of put-call
• Borrowing Rates for each parity;
5-year rates USD AUD • explain the considerations when
General Electric 5.0% 7.6% expanding this analysis to American-style
Quantas 7.0% 8.0% options and for dividend-paying stocks
A = 200 B = 40
Can always structure swap pick-up as A-B = 160 bps

7.13 7.14

Lower Bound for European Call Option Lower Bound for European Call Option
Price (No Dividends) Price (No Dividends)

c  max S0  Ke  rT , 0  • PF A is worth max (ST , K) at expiration
• Consider the two portfolios • PF B at expiration is worth ST
Portfolio A: One European Call option plus cash = Ke –rT • At expiration, PF A has value of at least PF B
Portfolio B: One Share • In the absence of arbitrage, this must also be
• For PF A at expiration, T true today (Discuss)
o If the cash is invested, it will grow to K at T • Hence c + Ke -rT  S0 or c  S0 – Ke -rT
o If ST > K, then the option is exercised; PF A is worth ST
o We pay for the share with the cash and have a share worth ST
• Finally, at worst the call will expire worthless, so
o If ST < K, then the option is worthless; PF A is worth K
o Hence PF A is worth max (ST , K)

c  max S0  Ke  rT , 0 
1.15 1.16

4
 Final Review Generalization of the Binomial Model
• Consider the portfolio that is
• Be prepared to construct a binomial tree to
o Long  shares and
evaluate an option on a given underlying o Short 1 option S0u– ƒu
asset. S0– ƒ
• Understand the relationship of the
S0d– ƒd
probability for an up/down movement to
volatility u / d  exp   /   t   • The portfolio is riskless when S0u– ƒu = S0d– ƒd or
 
fu  f d

S 0u  S 0 d

7.17 9.18

Generalization of the Binomial Model One Last Detail e t  d

p* 
f  fd ud
• Substituting for where   u • So the variance of the stock price return is
S 0u  S 0 d
p *u 2  (1  p * )d 2  [ p *u  (1  p * )d ] 2   2 t
• We obtain • Substituting for p* from above, we get
ƒ = [ pƒu + (1 – p)ƒd ]e–rT e t (u  d )  ud  e 2 t   2 t
• Where we define p as and one solution for u and d is: u  e t

 t
d e
e rT  d
p where  is the volatility and t is the length of the time
ud
step (and when terms in Δt2 and higher powers of Δt are
x2
• This is the Generalized Binomial Model of Option Value ignored) and as t gets small (use e x  1  x   ... )
2!
• This is the approach used by Cox, Ross, and Rubinstein
• Standard practice for constructing the lattice
9.19 9.20

5
 Final Review Ito’s Lemma for a Stock Price Process
• When the stock price process is an Ito Process
• Know the form for the Ito Process of a stock price
for a non dividend paying stock d S   S dt   S d z
• Know Ito’s Lemma and be able to apply to form a
• Then for a function G of S and t Ito’s Lemma gives that
process model for a function of an underlying
process  G G  2G 2 2  G
dG   S  ½  S  dt   S dz
  S  t  S 2
 S
• Know the distribution for the mean and variance
• Let’s look at how this is so …
of the state of this Ito Process and what it means
for it to be a Log-Normal Process (i.e., (14.18)-
(14.19) and/or (15.2)-(15.3))

7.21 11.22

Applications of Ito’s Lemma The Stock Price Assumption

• Let F0  S0e  F ( S , 0) be the forward price of term T on a
rT
• Consider a stock whose price is S and (as we have seen)
non-dividend paying stock follows the Ito Process,
• Or more generally for any t   0, T  : F ( S , t )  Ser (T t ) dS   S dt   S dz
• We can use Ito’s Lemma to determine the process for F where  is expected return and  is volatility (per year)
where the process for S is d S   S dt   S d z • In a short period of time of length t, the return on the
F r (T t ) 2F F
and we find S  e ;  0;   rSe r (T t ) stock can be characterized as
S 2 t
• So dF  e r (T t )  S  rSer (T t )  dt  e r (T t ) Sdz S   S t   S t
 (   r ) F dt   F dz with  ~  (0,1), the standardized normal distribution
• Like S, the forward price process F follows an Ito Process, • So it follows that ΔS/S is normally distributed as well
but has growth rate μ – r rather than μ S
o The growth rate of F is the excess return of S over the risk-free rate S

~  t ,  2 t 
11.23 11.24

6
 Lognormal Property of Stock Prices The Expected Returns and −
• From Ito’s Lemma, letting G = ln S, gives G 1  2G
 ;
1
 2
 2  S S S 2 S • Suppose we have daily data for a period of several
dG      dt   dz G t  0
 2  months
• So the change in ln S between 0 and some future T is o {S0, S1 , S2 , …}
normally distributed with mean (µ - σ2/2)T and variance σ2T
• is the average of the returns in each day [=E(S/S)]
• Which we can express as 2
    • −is the expected return over the whole period
ln ST  ln S0 ~     T ,  T 
2

2 covered by the data measured with continuous

  
or compounding (or daily compounding, which is almost the
  2  
ln ST ~   ln S0     T ,  T 
2
same)
  2  
• Since ln ST is normal, ST is lognormally distributed
• And ST  2  
ln ~    
2
T ,  T 
S0  2  
11.25 11.26

The Expected Returns and −

• Consider the two representations
E ( ST )  S0 e T (from slide 11.43)
  2  
ln ST ~  ln S0     T ,  T 
2

  2  
• We can show ln[ E ( ST )]  E[ln( ST )]  0 as in Jenson’s
Inequality and as expected by the nonlinearity of ln ( . )
ln[ E ( ST )]  ln( S0 )  T
 2 
E[ln( ST )]  ln( S0 )     T
 2 
• So
  2   2
ln[ E ( ST )]  E[ln( ST )]  ln( S0 )  T  ln( S0 )     T   T 0
  2   2
11.27