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Contents
Futures Contracts
A futures contract is an agreement between two parties to buy
or to sell an asset at a certain time in the future for a certain
price. But they are standardized and traded on an
exchange.The two parties to the contract do not necessarily
know each other. The clearing office guarantees that the
contract will honored.
A very wide range of commodities and financial assets form the
underlying assets in the various contracts. The commodities
include sugar, wool, copper, gold and the financial assets
include stock indices, currencies and Treasury bonds. Futures
prices are regularly reported in the financial press.
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At T0
Sell
Buy
Borrow
Buy
Total
At T1 whatever the price of the share S*, the result is known with certainty:
C
P
S
S
+C
-P
+S
-S
CP
At T1
Reimbursement of the loan - S
Interest payments
-S(1+ r)
Share sale
+K
Total
K S(1+ r)
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uS
Cu=Max (0, uS-K)
S
C
dS
Cd=Max (0, dS-K)
U,d (percentage amount of moving up and down for the prices),
K Option strike price
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U>r>d
uS = 125
S=100
Cu = 25
C
dS = 80
Cd = 0
p =(1.025 - 0.8)/ (1.25 - 0.8) =0.5
1 - p =0.5
C =(1/1.025)[0.5x25 + 0.5X0]= 12.195
H = (Cu - Cd)/S(u - d) = (25 - 0) /100(1.25 0.8) =0.5555
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ARBITRAGE
Sell a call
Buy 0.5555 stock
Borrow
12.195
-55.55
43.355
If stock price = 80
Sell stock
+ 44.44
(80x0.5555)
Reimbursement
- 44.44
buy a call
0
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HuS + Pu
HS + P
HdS + Pd
We select H to meet this equality: HuS + Pu = HdS + Pd
H = (Pd Pu) / S(u - d)
This riskless portfolio, must only earn the riskless interest rate,
then: HS + P =(HuS + Pu)/r
Substituting H by its value, it comes:
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u^2S
uS
S
udS
C
dS
d^2S
Cuu=Max(0, u^2S - K)
Cu
Cud=Max(0, udS - K)
Cd
Cdd=Max(0, d^2S - K)
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Example
S=K=100, u=1.25,d=0.8, r=1.025, n=2
u^2S = 156.25
Cuu= 56.25
uS = 125
Cu
S = 100
udS = 100
C
Cud = 0
dS = 80
Cd
d^2S = 64
Cdd = 0
p=(1.025-08)/(1.25- 0.8) = 0.5
C =(1/1.025^2)[0.5^2x56.25x1] = 13.385
Cu=27.44 ; Cu =(1/1.025)[0.5x56.25 +0.5x0 ], Cd =0, C= 13.385
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Generalization
C =(1/r^n)[ (n!)/(n- j)!j!]p^j(1- p)^(n- j)Max (0, u^jd^(n- j)S - K)
P =(1/r^n)[ (n!)/(n- j)!j!]p^j(1- p)^(n- j)Max (0, K - u^jd^(n- j)S)
Where the value of (n!)/ j!(n- j)! is given by the Pascal Triangle, j
representing the number of stock price moves up among the n
binomial periods, and (n - j) the number of down movements.
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u S+Br = Cu
S+B
d S+Br= Cd
Then, B = (Cu - uS)/r and substituting B by its value in
the other equation, we get: dS + Cu - uS = Cd
Hence = (Cu Cd) / S(u - d)
Similarly B = (uCd dCu) / (u - d)r
Rearranging, the option price is :
C = [(Cu Cd) / (u - d)] + (uCd dCu) / (u - d)r
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190.3125
u^2S=156.25 4 = 152.25
uS=125
121.8
S=100
udS=100 4 = 96
120
dS=80
76.8
d^2S= 64 -4 = 60
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At the beginning of period 3, three sub-binomial trees appear,
and no more correspondence exists between the different
nodes of the 3 sub-trees . We can still apply the iterative
procedure to valuate options. For n =3 without dividend, C is
priced 19.769, with a dividend its price is 17.656.
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Hedgers use derivatives to reduce the risk that they face from
potential future movements in a market variable.
There is a fundamental difference between the use of forward
contracts and options for hedging. Forward contracts are
designed to neutralize risk by fixing the price that the hedger
will pay or receive for the underlying asset.
Option contracts, by contrast, provide insurance. They offer a
way for investors to protect themselves against adverse price
movements in the future while still allowing them to benefit
from favorable price movements.Unlike forwards, options
involve the payment of an up-front fee.
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i=1,n
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Convenience Yield
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Delivery Options
Whereas a forward contract normally specifies that delivery is
to take place on a particular day, a futures contract often allows
the party with the short position to choose to deliver at any
time during a certain period.
If the futures price is an increasing function of the time to
maturity, it can be optimal for the party with the short position
to deliver as early as possible, because the interests earned on
the cash received outweighs the benefits of holding the asset
( c > y). Conversely if c < y the short position will deliver as late
as possible.
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t =0
Buy Stocks
- P0
Borrow
+ P0
Sell a futures contract
0
Total = 0
t=T
Sell Stocks
PT + P0e^(dT)
Reimbursement
- P0- P0e^(rT)
Buy a futures contract
F0 - IT
Total = F0 - IT + PT- P0e^[(r d)T]
If the portfolio replicates the stock index, we have P0 =I0, PT = IT, and the AOA
condition becomes :
F0 =I0e^[(r d)T]
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Basis Risk
The hedges considered before have been almost too good to
be true. The hedger was able to identify the precise date in the
future when an asset would be bought or sold. The hedger was
then able to use futures contracts to remove almost all the risk
arising from the price of the asset on that date. Hedging is
often not quite as straightforward.
The basis in a hedging situation is as follows B0 = S0 F0
An alternative definition holds when the underlying asset is a
bond or a financial asset B0 = F0 - S0.
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Example
June 18, a company knows that it will need to purchase 20.000
barrels of crude oil at some time in november or december. It
buys 20 contracts on the NYMEX for december with a futures
price of 150 us$ per barrel. The purchase is done on the 25th of
November, and the strategy is closed out at that time.
Suppose the spot price is 160 us$ and that futures price is 157
us$. The gain on the futures market: 157 -150 = 7 us$ per barrel.
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Cross Hedging
Previously, the asset underlying the futures contract has been
the same as the asset whose price is being hedged. Cross
hedging occurs when the two assets are different. Before we
got:
S2 + F1 - F2 = B2 + F1
But in this case : F1 + B2 = F1 + (S2* - F2) + (S2 S2*)
The first term depicts the basis which could be observed if the
contract had the right underlying asset.
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EC = h*2 (2F / 2S )
The parameters p, 2S, 2F are usually estimated from historical
data on S against F and equals p^2 or EC.
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Bond Yield
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Par Yield
The par yield for a certain bond maturity is the coupon rate that
causes the bond price to equal its par value. Taking again in
consideration the previous example, one can compute C so as
to obtain a four year price equal to 100.
Cxe^(-0.027x1) + Cxe^(-0.029x2) + Cxe^(-0.031x3) + (100 +C)xe^(0.032x4) = 100
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Bond price
97.7
94.7
89.6
95.5
97
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Forward Rates
Forward interest rates are the rates of interest implied by
current zero rates for periods of time in the future. Suppose a
particular set of zero rates from 1 year to 5 years: (5%, 5.5%,
6%, 6.3%, 6.4%).
The continuous interest rate is supposed to be 5% and 100
invested at this interest rate gives 100xe^(0.05x1) = 105.127
The same investment on two years gives 100e^(0.055x2)
=111.627
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e^ (RF) = 0.06183
e^ (RF) = 0.072508
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Define:
Rf the forward LIBOR rate for period between T1, T2
Rk the rate of interest agreed to in the FRA between T1, T2
R The actual Libor rate observed in the market at time T1 for the
period between T1 and T2
M the principal underlying the contract;
V = M(Rk - Rf) (T2 - T1)e^(- R2T2) with Rk received
V = M(Rf - Rk) (T2 - T1)e^(- R2T2) with Rk paid
Example:
Suppose that the 3-months, and 6-months LIBOR continuous
rates are 5% and 5.5%.
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This means:
LnST LnS0 ~ [( - ^2/2)T, T ]
Or LnST ~ [LnS0 + ( - ^2/2)T, T ]
This equation shows that lnST is normally distributed.
A variable has a lognormal distribution if the natural logarithm
of the variable is normally distributed.
The model of stock price developped therefore implies that a
stocks price at time T, given its price today, is lognormally
distributed.
The standard deviation of the logarithm of the stock price is
T. It is proportional to the square root of how far ahead we
are looking.
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Greek Letters
The first derivatives of C with respect to S, E, 2, r et (T t) =
are:
1 Cs = N(d1) >0 ( coefficient)
2 CK = - e^(- rT)N(d2) <0
3 C2 = Ke^(-rT)Z(d2)[T / 2 ] >0 ( vega coefficient)
4 Cr = Ke^(-rT)N(d2) >0 (rh coefficient)
5 C = e^(-rT)[Z(d2)(/2T) + rN(d2)] >0
= - C option sensibility with respect to time
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i=1,n
Portfolio Delta neutrality gives protection against a modest
adverse variation of the asset price, between two adjustments.
Gamma neutrality allows a protection against adverse jumps in
price.
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