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Derivatives 01 Introduction |2
Discount factors and interest rates
Derivatives 01 Introduction |3
Forward contract valuation : No income on
underlying asset
• Example: Gold (provides no income + no storage cost)
• Current spot price S0 = $1,340/oz
• Interest rate (with continuous compounding) r = 3%
• Time until delivery (maturity of forward contract) T = 1
• Forward price F0 ? t=0 t=1
Strategy 1: buy forward
0 ST –F0
Strategy 2: buy spot and borrow
Should
Buy spot -1,340 + ST be
equal
Borrow +1,340 -1,381
0 ST -1,381
Derivatives 01 Introduction |4
Forward price and value of forward contract
rT
• Forward price: F0 = S 0 e
• Remember: the forward price is the delivery price which sets the value of a
forward contract equal to zero.
Derivatives 01 Introduction |5
Arbitrage
• If F0 ≠ S0 e rT : arbitrage opportunity
Derivatives 01 Introduction |6
Arbitrage: examples
Derivatives 01 Introduction |7
Repurchase agreement (repo)
Time t
buy bond at Pt deliver bond
Time T
sell bond at PT get bond
Deposit
(overnight)
Financial Institutional
institution investors
Non financial firms
Collateral
(No checking
Market value
account insured by
+ haircut
FDIC)
Huge repo market – exact size unknown
• Consider a:
• 6- month forward contract
• on a 1- year zero-coupon with face value A = 100
• Current interest rates (with continuous compounding)
– 6-month spot rate: 4.00%
– 1-year spot rate: 4.30%
• Step 1: Calculate current price of the 1-year zero-coupon
• I use 1-year spot rate
• S0 = 100 e –(0.043)(1) = 95.79
• Step 2: Forward price = future value of current price
• I use 6-month spot rate
• F0 = 95.79 e(0.04)(0.50) = 97.73
• At time T* :
• Difference between the interest paid RS and the interest on a loan made at
the spot interest rate at time T : rs
M [ rs- Rs ] τ
• At time T:
• ΠT = [M ( rs- Rs ) τ ] / (1+rSτ)
T=0,25 T*=0,75
S0 ST Receive
underlying asset
f0 = 0
0 t T
rT
S0 F0 = S0 e Pay forward
price
Derivatives |21
Review Long forward on zero-coupon
(1) Face value of zero-
coupon given
* *
−r T A = F0 e Rτ
S0 = Ae ST
(3) Calculate
forward
interest rate
f0 = 0
0 t T T *
τ
rT (2) Calculate forward
S0 F0 = S0 e price which set the
initial value of the
contract equal to 0.
ft = St − F0e − rT = ( Ft − F0 )e − rT
Derivatives |22
Review Forward investment=buy forward zero-
coupon (2) Calculate face value of zero-
coupon which set the value of
the contract equal to 0
* * A = M (1 + RSτ ) = F0 e Rτ
S0 = Ae− r T ST
f0 = 0
*
0 T τ T
M (1 + RSτ ) M ( RS − rs )τ
fT = ST − M = −M =
1 + rsτ 1 + rsτ
Derivatives |23
Review Forward borrowing=sell forward zero-
coupon
S0
F0 = M
f0 = 0
*
0 T τ T
ST A = M (1 + RSτ ) = F0 e Rτ
− r *T *
S0 = Ae
M (1 + RSτ ) M (rs − RS )τ
fT = M − ST = M − =
1 + rsτ 1 + rsτ
Derivatives |24
Review Long Forward Rate Agreement
Mrsτ
S0
1 + rsτ
f0 = 0
*
0 T τ T
MR fraτ
1 + rsτ
* *
S0 = Ae− r T
M (rs − R fra )τ
fT =
1 + rsτ
Derivatives |25
To lock in future interest rate
Derivatives |26
Valuing a FRA
Mrsτ M
+ =M
1 + rsτ 1 + rsτ
*
0 t T τ T
MR fraτ + M
⇔ M (1 + R fraτ )
1 + rsτ 1 + rsτ
ft = M × d (T − t ) − M (1 + R fraτ ) × d (T * − t )
Derivatives |27
Basis: definition
T time
F0 = (S0 – I )erT
where I is the present value of the income
S0 = 110.76 C=6
I = 6 e –(0.05)(0.25) = 5.85
• Examples:
• Forward contract on a Stock Index
r = interest rate
q = dividend yield
• Foreign exchange forward contract:
r = domestic interest rate (continuously compounded)
q = foreign interest rate (continuously compounded)
r$T
€ F0e F0e r$T
= S0er€T
( r€ − r$ )T
r€T
F0 = S0e
Spot exchange €S0 € S0 e
rate €/$
€0.70 €0.70 × e4%×0.50 = 0.7141
Time 0 r€: domestic interest rate (4%) Time T
Derivatives |31
Commodities
No income − rT
f = S − Ke F = Se rT
Known income
I =PV(Income)
f = (S − I ) − Ke − rT F=(S – I)erT
Known yield q
f =S e-qT – K e-rT F = S e(r-q)T
Commodities
f=Se(u-y)T- Ke-rT F=Se(r+u-y)T
• If the interest rate is non stochastic, futures prices and forward prices are
identical
• NOT INTUITIVELY OBVIOUS:
– èTotal gain or loss equal for forward and futures
– èbut timing is different
• Forward : at maturity
• Futures : daily
• If k = r F = E(ST) CAPM:
• If k > r F < E(ST)
k = r + β (kMarket − r)
• If k < r F > E(ST)
E0 (S1 ) − F0 = S0 [ E(R) − rF ]
Risk premium on
Forward price bias =
underlying asset
This is also the expected cash flow on the derivative