Rates FO Training-Session V Products) 20 May 2010

Rates FO Training
Session IV (Products)
April 15, 2010
© COPYRIGHT 2010 SAPIENT CORPORATION | CONFIDENTIAL 1

About the training
This training will cover
Products and markets (Session I)
What are interest rates, really ? (Session IV, V)
How are they set, and in which markets are they traded? (Session II, III)
What are the key products used for trading and hedging rates? (Session IV, V)
Processes
What is the ‘front to back’ process used to trade rates?
What do FO, MO and BO do? What tools and techniques do they use?
What tools and techniques do they use in UBS?
We will emphasize FO concepts, and operations, but cover some MO and BO
What role can, might I play in the process?
Mathematics underlying rates trading
Introduction to rates analytics/mathematics (A flavor!)
Valuation and risk management (forward curves, discount curves, and those pesky greeks!)
Typical IT projects, assignments, challenges in FO, and possible solutions (Optional)
So where will it get me?
You will not become an expert, but you will be
Able to talk to a trader, and understand his needs
Able to talk to a BA, and understand his needs
Able to ‘talk’ rates FO - in weeks, and hopefully, start ‘walking the walk’ – a journey of years!
Where do you want to go?
Assumptions?
For ‘101’ sessions, we don’t assume much and start from the basics (‘time value of money’)
For ‘201’ sessions- we will use slightly advance maths– not necessary, but very helpful
Account Plan Topics
Bond basics
What are bonds
Bond valuation
Yield Curve and Term structure of interest rates
Interest Rate products and Risk Management
Futures and Forwards
Swaps
Options
Advanced topics?

Overview of Bonds
Link between FI and Rates

The rates business is rooted in the fixed income business
We will take a quick pass through the bonds and bond valuation to understand what
interest rates are and how are they set in the markets. (There is a macroeconomic
angle as well, which discusses how interest rates are influenced and determined by
an interaction of the monetary policy in an economy-typically set by the Fed, and the
fiscal policy, typically managed by the federal government. This will be covered in a
201 session)
This will build the foundation for an understanding of various rates products and their
purpose

What is a Bond?
In its broadest sense, a bond is any debt instrument that promises a fixed income stream to the holder
Fixed income securities are often classified according to maturity, as follows:
Less than one year – Bills or “Paper”
1 year < Maturity < 7 years – Notes
< 7 years – Bonds
A typical bond has the following characteristics:
A fixed face or par value, paid to the holder of the bond, at maturity
A fixed coupon, which specifies the interest payable over the life of the bond
Coupons are usually paid either annually or semi-annually
A fixed maturity date
Note:
The coupon rate, the maturity date, par value are all set (fixed) at the time the bond was originally sold The coupon rate will reflect the
required rates of interest at the time of bond issue.
After issue, interest rates, and required rates of return will change. Because everything is fixed except the required rate of return and
the bond price, as rates change, so too will bond prices!

Bond Valuation: Time Value of Money
Revisiting the time value of money
Future value of an investment at an annual rate r, compounded m times a year is for T years is
Conversely
Setting FV to 1, provides the present value of 1 dollar in the future, and is called the discount factor
Discount factors are of critical importance to finance-it is possible to determine the value of any investment
by applying the appropriate discount factors. For an FI security consisting of known cash flows (Ci), at
various times (Ti)
We will understand its use an application in the relatively simple case (nevertheless important one) of bond
valuation

Bond Valuation: Present Value and Yield to Maturity (YTM)
Bond Valuation
A Coupon Bond’s Present Value (PV)/price has Two Components:
Present Value of the Coupon Interest Payments
Present Value of the Future Redemption Value
For a bond with annualized coupon C, m times a year, with N=txM payments due, the value is
The standard bond pricing formula assumes a ‘flat yield’, i.e. a single interest rate applicable to
all cash flows. With this assumption
This is the so called ‘Price-Yield’ Formula

Bond Valuation: Yield to Maturity
Yield To Maturity (YTM)- rate of return anticipated on a bond if it is held until the maturity date. Or alternatively
put – it’s the IRR (internal rate of return) on a bond
YTM takes into account the current market price, par value, coupon rate and time to maturity. It is also assumed
that all coupons are reinvested at the same rate
When bond investors speak of ‘yield’, they are referring to Yield to maturity
Note that when coupon rate equals the yield the price becomes ‘Par’

Bond Valuation: Yield to Maturity
When the coupon rate is higher than the yield, the bond is ‘at discount’, and in reverse ‘at a premium’
As the bond approaches maturity, the bond gets closer to par as you’d expect. This is called ‘pulling to par effect’
Clean vs. Dirty Price

Dirty price is the price you’d expect to pay in the market place and takes into account the accrued coupon at
dates between coupon payments. This introduces ‘raggedness’ in the bond pricing-to get a smoother
measure bond traders prefer to use a different measure
Clean price = dirty price-accrued interest

Factors Affecting Bond Prices
As the price-yield formula suggests
There are three factors that affect the price volatility of a bond
Yield to maturity
Time to maturity
Size of coupon
We will look at each of these in turn.

Factors Affecting Bond Prices: Yield
Inverse Relationship Between Bond Prices and Yields

Price
to Maturity ($)
When interest rates (required rate of return on the
bond) increase, bond prices fall.
The relationship between the coupon rate and the

bond’s yield-to-maturity (YTM) determines if the
bond will sell at a premium, at a discount or at par
Market Yield
(%)
If Then Bond Sells at a:

Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium

Factors Affecting Bond Prices: Yield
Yield to maturity (investor’s required return)

Bond prices go down when the YTM goes up
Bond prices go up when the YTM goes down
The graph below shows how the price of a 25 year, 10% coupon bond changes as the
bond’s YTM varies from 1% to 30%
Note that the graph is not linear – instead it is said to be convex to the origin
P rice /Y ie ld R e lationship
350
300
Price per $100 of Face
250
200
Value
150
100
50
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
P e rce nt YT M
Other Factors Affecting Bond Prices: Term to Maturity
Long bonds have greater price volatility than short bonds

The longer the bond, the longer the period for which the cash flows are fixed
More distant cash flows are affected more in the discounting process (remember the
exponential nature of compounding…and that discounting is the inverse of compounding)
The most distant cash flow from a bond investment is the most important (it is the face value
of the bond) and this cash flow is affected the greatest in the discounting process.

Other Factors Affecting Bond Prices: Coupon
Low coupon bonds have greater price volatility than high coupon bonds
High coupons act like a stabilizing device, since a greater proportion of the
bond’s total cash flows occur closer to today & are therefore less affected by a
change in YTM
The greatest price volatility is found with stripped bonds (no coupon payments)

Change in Interest Rates with Time
Why practically homogeneous bonds of different maturities have different interest rates?
This question is of great significance to both borrowers and lenders.
Should a lender invest in short-term bonds and have to worry about the rates at which to
reinvest when short-term bond matures? Or should the lender buy long-term bonds and run
the risk of an uncertain liquidating value if selling is necessary before maturity?
Borrowers are faced with the choice of whether to borrow short-term or long-term. Short-
term borrowing runs the risk that refinancing may be at higher rates. Long-term financing
runs the risk that a high rate may be locked in.
A study of the yield-curve and term-structure of interest rates can help borrowers and
lenders in making the right decision.

What is a Yield Curve?
A graphical depiction of the relationship between the yield on bonds of the same credit quality, but different
maturities is known as the yield curve.
Term structure of interest rates may be defined as the relation between yield to maturity of zero coupon
securities of the same credit quality and maturities of those zero-coupon securities.
Yield-to-maturity on zero-coupon securities for different maturities is also the spot rate for that maturity.
Therefore, term structure of interest rate may also be defined as the pattern of spot rates for different
maturities.
The yield on Treasury securities is a benchmark for determining the yield curve on non-Treasury
securities. Consequently, all market participants are interested in the relationship between yield and
maturity for Treasury securities.

Term Structure of Interest Rates
The graphical depiction of the relationship between the yield on Treasury securities
for different maturities is known as the yield curve. While a yield curve is typically
constructed on the basis of observed yields and maturities, the term structure of
interest rates is the relationship between the yield on zero-coupon Treasury securities
and their maturities.
Therefore, to construct term structure of interest rates, we need the yield on zero-
coupon Treasury securities for different maturities.
Zero-coupon Treasuries are issued with maturities of six-months and one-year, but
there are no zero-coupon Treasury securities with maturity more than one-year.
Thus, we cannot construct such term structure solely from market observed yields.
Rather, it is essential to construct term structure from theoretical consideration applied
to yields of actually traded Treasury debt securities.
Such a curve is called “Theoretical Spot Rate Curve”

More risky bonds (e.g. rated Corporate Bonds) will have their own yield curve and it will plot at higher YTM
at every term to maturity because of the default risk that they carry
The difference between the YTM on a 10-year corporate bond (say BBB)and a 10-year US Govt bond is
called a yield spread and represents a default-risk premium investors demand for investing in more risky
securities.
Side bar: All publicly traded bonds are assigned a “risk rating” by a rating agency, such as Dominion Bond
Rating Service (DBRS), Standard & Poors (S&P), Moodys, Fitch, etc.
Bonds are categorized as:
Investment grade – top four rating categories (AAA, AA, A & BBB)
Junk or high yield – everything below investment grade (BB, B, CCC, CC, D, Suspended)
Spreads will increase when pessimism increases in the economy

Spreads will narrow during times of economic expansion (confidence)
Corporate Bond Risk Premium and Flight to

Quality
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Corporate bonds, monthly data Baa-Rate
10-year maturity Treasury bonds, monthly data

Types of Yield Curve
There is no single yield curve describing the cost of money for everybody. The most important
factor in determining a yield curve is the currency in which the securities are denominated. The
economic position of the countries and companies using each currency is a primary factor in
determining the yield curve.
Different institutions borrow money at different rates, depending on their creditworthiness. The
yield curves corresponding to the bonds issued by governments in their own currency are called
the government bond yield curve (government curve).
Banks with high credit ratings (Aa/AA or above) borrow money from each other at the LIBOR
rates. These yield curves are typically a little higher than government curves. They are the most
important and widely used in the financial markets, and are known variously as the LIBOR curve
or the swap curve.
LIBOR rates are widely used as a reference rate for :-
Forward rate agreements
Short term interest rate futures contracts
Interest rate swaps
Floating rate notes
Syndicated loans
Besides the government curve and the LIBOR curve, there are corporate (company) curves.
These are constructed from the yields of bonds issued by corporations.

Uses of Yield Curve
Shape of government Yield Curve is a key of economic conditions
Inverted Yield Curve –indicates recessions
Article from USA Today Feb 2007
“Inverted yield curve may no longer be sign of recession”
http://www.usatoday.com/money/economy/2007-02-13-curve-usat_x.htm
Steep Yield Curve –predicts end of recessions
Benchmark for pricing many other fixed-income securities (Typically LIBOR)

Construction of Yield Curve
Typically market yield curve used

in I banks (so called LIBOR yield
curve) is constructed from
different instruments at differing
maturities
201 session
This is the yield curve that
underlies pricing for various
products-appropriately adjusted
for various premiums (risk, cost of
funds etc.)

Spot Market
A market in which commodities are bought and sold for cash and immediate
delivery.
The spot market refers to instruments that are traded and settle within two
business days* of the transaction.
The spot rate refers to the current market rate
Also called the cash market or physical market

Forwards
A forward contract
Delivery of a security/ commodity at some future date
Delivery price is determined at the time of contract
It is defined such that it has no initial monetary value
Define the grade and quantity of goods to be delivered
Time and place of delivery are also defined

Evolution of the forwards/ futures market
17th Century “To Arrive” 18th Century

Japan Contracts U.S
“Forward Agreements” Shipping “Organized grain
Silk and Rice Industry markets”
COM
FUTURES
1840 1848
1898
Chicago (center of CBOT CBOT
Chicago Butter
rail road network) Member based Standardized
and Egg Board
Natural trading hub org contracts
1919
Start of Modern Spot and Future trading
FIN Futures Market Converted to CME
forward trading
FUTURES
1971 IMM 1976 Euro Dollar 1982
Currency no established. 90 day US T-Bill future Stock
longer Currency future contract contracts Index
Pegged to Futures Most actively traded Cash Future on
Gold launched future Settlement S&P 500

Futures
Definition: A futures contract is a type of derivative instrument, or financial

contract, in which two parties agree to transact a set of financial instruments
or physical commodities for future delivery at a particular price.
Buyers and sellers in the futures market primarily enter into futures contracts
to hedge risk or speculate rather than exchange physical goods (which is the
primary activity of the cash/spot market).
Buy = Long Position, Sell = Short Position

Forwards and Futures Contracts
Futures Forward
Amount Standardized Negotiated
Delivery Date Standardized Negotiated
Counter-party Clearinghouse Bank
Collateral Margin Acct. Negotiated
Market Auction Market Dealer Market
Costs Brokerage and Bid-ask spread
exchange fees
Liquidity Very liquid Highly illiquid
Regulation Government Self-regulated
Location Central exchange Worldwide

Need for futures
Hedging – need for price certainty in the future.

Price of raw materials
Price of produce goods
Speculation
Making profit by being on the right side of the price move. i.e. if the price is
expected to increase then buy the instrument else short it.
As the prices of commodities and fin instruments change frequently there are a
lot of opportunities
Day traders, Position traders, Arbitragers

Contract Terms
Ticker symbol: Initials that identify the contract
Contract size: The cost per unit of the commodity multiplied by the number
of units specified in the contract
Tick size: Minimum price increment permitted in the trading process
Delivery/expiration months
Sample quote: The terms and format used in reporting price quotes
Trading hours: Hours during which a contract may be traded; may differ for
open outcry and electronic trading
Price limits: Amount of change in price permitted in one day; in cases when
limits are reached in a day, limits are usually expanded the next day
Position limits and accountability: Maximum number of contracts a single
entity can hold; explanations required when holding large numbers of a
single contract
Last trading day: Final day and time after which the contract cannot be
traded
Final settlement rule: Day on which final contract value is determined and
settlement made
Trading venue: Where and how the contract is traded: via open outcry,
electronic trading, or both

Margin
Margins (also called Performance Bonds)

Different from stocks
Instead of borrowed money it is good faith money
Initial Margin
Maintenance Margin
Margin Call
Leverage – double edged sword

T – Bill Futures
Defining features
$ one million face
Delivery of a T-bill maturing in 3 months
Price is quoted as the 100 – expected discount rate on the 3 month T-bill on
maturity
Invoice price on delivery
$1,000,000 [ 1 – (settlement discount on last trading day) X (days to maturity /360)]

Eurodollars Futures
Defining features
One million principal value
3 month maturity
Price quoted in terms of IMM index for 3-month EDs (100.00 – yield)
Cash Settled
Price of ED based on random selection of 20 banks from a predetermined list

US Treasury Bond and Note Futures Contract
Defining features
The contract requires delivery of $100,000 face value of bonds with at least 15
years to call (i.e. if the bonds are callable) or 15 years to maturity
Future price is quoted as a percentage of the face with a tick of 1/32
Invoice Price on delivery = Future Price * 100,000 * Conversion Factor + AI
Position day: notice of delivery by short, 2 days prior to delivery date
Intention day: short must state precisely which bond will be used for delivery, 1
day before delivery

US Treasury Bond and Note Futures Contract (cont…)
Defining features (cont…)

Delivery day: short must transfer bonds to long and long must pay for it.
No trade done on last 7 biz days
Note Contracts and their acceptable maturities
2 year 1 year 9 months to 2 years
5 year 4 years 3 months to 5 year 3 months
10 year 6.5 years to 10 years
Several deliverable bonds

Identify the cheapest to deliver

Principles of Futures Prices
Parallelism
Futures and Cash markets highly correlated. Similar factors influence each
market
Example: The imminent war in Iraq causes both current and future prices to
increase
Or like monsoon in India
Convergence
Futures and Cash prices tend to converge at the expiration of the futures contract
Due to the fact that carrying costs decrease as the futures contract draws closer
to expiration

Spread Trading
Buy two related futures contracts, one short and one long
Consists of both a long and short position in different contracts of the same or
related commodities
Takes advantage of the relative movements between two (or more) underlying
contracts
Eliminates sensitivity to absolute price changes
Assumption: The two contracts are highly correlated. (i.e. price increases affect
both commodities)

Swaps
All swaps involve exchange of a series of periodic payments between two parties, usually through an
intermediary which is normally a large international financial institution which runs a “swap book”
The two major types are interest rate swaps (also known as coupon swaps) and currency swaps.
The two are combined to give a cross-currency interest rate swap
Other less common structures are equity swaps, commodity swaps
Liability swaps exchange one kind of liability for another
Asset swaps exchange incomes from two different types of assets
Why would a firm want to exchange one kind of liability or asset for another?
Capital market imperfection or factors like differences in investor attitudes, informational
asymmetries, differing financial norms, peculiarities of national regulatory and tax structures and
so forth explain why investors and borrowers use swaps.
Swaps enable users to exploit these imperfections to reduce funding costs or increase return
while obtaining a preferred structure in terms of currency, interest rate basis etc.

Interest Rate Swaps
A standard fixed-to-floating interest rate swap, known in the market jargon as a plain vanilla
coupon swap (also referred to as "exchange of borrowings") is an agreement between two parties
in which each contracts to make payments to the other on particular dates in the future till a specified
termination date
One party, known as the fixed rate payer, makes fixed payments all of which are determined at the
outset
The other party known as the floating rate payer will make payments the size of which depends
upon the future evolution of a specified interest rate index
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key features of an interest rate swap
The Notional Principal; The Fixed Rate; Floating Rate Trade Date, Effective
Date, Reset Dates and Payment Dates (each floating rate payment has three
dates associated with it as shown below
The setting/reset date is the date on which the floating rate applicable for the
next payment is set
Accrual date is the date from which the next floating payment starts to accrue
Settle date is the date on which the payment is due

Major Types of Swap Structures
A zero-coupon swap has only one fixed payment at maturity

A basis swap involves an exchange of two floating payments, each tied to a different market index
In a callable swap the fixed rate payer has the option to terminate the agreement prior to scheduled maturity while
in a puttable swap the fixed rate receiver has such an option
In an extendable swap, one of the parties has the option to extend the swap beyond the scheduled termination date
In a forward start swap, the effective date is several months even years after the trade date so that a borrower with
a future funding need can take advantage of prevailing favourable swap rates to lock in the terms of a swap to be
entered into at a later date
An indexed principal swap is a variant in which the principal is not fixed for the life of the swap but tied to the level
of interest rates - as rates decline, the notional principal rises according to some formula
A Callable Coupon Swap is a coupon swap in which the fixed rate payer has the option to terminate the swap at a
specified point in time before maturity and a Puttable Swap can be terminated by the fixed rate receiver
Application of callable swap
Transforming Callable Debt into Straight Debt
Swaptions, as the name indicates are options to enter into a swap at a specified future date, the terms of the swap
being fixed at the time the swaption is transacted

Swap Valuation
One can view interest rate swaps as:

Long position in bond with a short position in another bond or as a portfolio of forward
contracts.
The value of the swap (for the institution paying floating and receiving fixed), denoted V, is
(assume that the financial institution receives fixed payments of C dollars at times s and make
floating payments at the same times):
V ( t ) = b ( t ) – b*(t)
b( t ): value of fixed-rate bond underlying swap.
b*( t ): value of floating-rate bond underlying swap.
The discount rates used in the valuation reflect the riskiness of the cash flows. Note that: [r(n) is
the discount rate at date n]:
b = Σ C × e-r(s) s + Q × e-r(T) T
where Q is the notional principal underlying the interest rate swap, C is the fixed payment and
the summation goes from s=1 to s=T the termination date of the swap
b* = C* × e-r(t1) t1 + Q × e-r(t1) t1
where the floating rate bond, b* must have, after the payment at time t1 value equal to the
notional principal , Q , and C* is the floating rate payment due at time t1

Swap Valuation- Example
Example: Financial institution pays 6-month LIBOR and receives 8% per annum (with semiannual
compounding) on a notional principal of $100 Million. The swap has a remaining life of 1.25 years. The
relevant discount rates are 10%, 10.5%, and 11% for 3 months, 9 months, and 15 months. The 6
month LIBOR rate at the last payment date was 10.2% (and the reset frequency is 3 months).
Note For s= 3/12 = 0.25; r = 0.10 For s = 9/12 = 0.75; r=0.105 For s = 1.25; r = 0.11
t1 = 3 months = 0.25
r ( t1 = 1) = 0.10 [reset frequency discount rate]
C = ½ × 0.08 × 100 = 4 Million [coupon for fixed]
C* = ½ × 0.102 × 100 = 5.1 Million [coupon for floating].

b = 4 (e-0.25 × 0.1 + e-0.75 × 0.105) + 104 (e-1.25 × 0.1) = 98.24 million
b* = 5.1 (e-0.25 × 0.10) + 100 e-0.25 × 0.10 = 102.51
The value of the swap to the fixed rate receiver is
98.24 – 102.51 = -4.27 million.
The value to the fixed rate payer is obviously + 4.27million

What are Options?
An option is a contract giving the

investor the right, but not the obligation,
to buy or sell an underlying asset (a
stock or index) at a specific price on or
before a specific date
The choice has a price – Option price

or premium the buyer pays to the seller
for acquiring the “right”
Like other securities, options are listed

and traded with buyers and sellers
making bids and offers
Source: http://www.cboe.com
Buyer acquires no ownership rights in

the underlying asset

Types of Options – Call
You are interested in buying a house priced at $100,000. However, you do
not have sufficient funds to close the deal and need a month to arrange the
funds. As a result, you negotiate a deal with the seller to hold the house for
you for a period of one month in return for a holding fee of $3,000
At the end of the one month period you could:

Walk away from the deal as you realize the house is not worth the price
Pay the seller $100,000 and transfer the house in your name
Sell your right to buy the house in turn for the increase in the price of the house
e.g. say the house is now priced at $130,000. You can give up your right and in
return get $30,000
Call Option – right to BUY the underlying asset at a specific price called as strike
price on or before the specified date called as expiration date for a price the option
premium or option price

Types of Options – Put
You want to protect the value of your new car against any damages. Hence
you buy an insurance for a fixed period and in return pay a premium to the
insurance provider for protecting the value of your new car e.g. for a $25,000
car you pay $1500 for a year
At the end of the year you could:

Regain the insured value from the insurance provider if the car is damaged
during the insurance period
No payments to you as the car is not damaged. Insurance provider keeps the
premium
Put Option – right to SELL the underlying asset at a specific price called as strike
price on or before the specified date called as expiration date for a price, the option
premium or option price

Writers and Holders
Writers = Sellers of the option contract. They have obligations

Holders = Buyers of the option contract. They have rights
Buyer (Holder) Seller (Writer)
Call Right to buy Obligation to sell
Put Right to sell Obligation to buy
Long = Buy, Short = Sell Long Call = Buy Call
What is a Long Call? Short Call = Sell Call

Long Put = Buy Put
Short Put = Sell Put

Option Value – In, At and Out of Money
XYZ $75 Call XYZ $75 Put

In the Money
Out of Money
$90
Share Price
$75 At the Money
$60

Long Call – Buy a Call
Profit ($) Buy $60 Call at $5

30
20
10
30 40 50 60 65 Share price ($)
0
-5 70 80 90
Risk: Premium
Reward: Unlimited
Break Even: Strike Price + Premium
Motivation: When share prices are expected to rise (Bullish)

Short Call – Sell a Call
Profit ($)
5 65 70 80 90
0
30 40 50 60 Share price ($)
-10
-20
Sell $60 Call at $5
-30
Risk: Unlimited
Reward: Premium
Break Even: Strike Price + Premium
Motivation: When share prices are expected to remain flat (neutral
outlook)
Long Put – Buy a Put
30 Profit ($)
Buy $60 Put at $7
20
10
53 Share price ($)
0
30 40 50 60 70 80 90
-7
Risk: Premium
Reward: Limited (Strike price – Share price) Insurance policy
Break Even: Strike Price - Premium
Motivation: When share prices are expected to fall (bearish) or want to use
it has a protective strategy in bearish markets

Short Put – Sell a Put
Profit ($) Sell $60 Put at $7

7
30 40 50 Share price ($)
0
60 700 80 90
53
-10
-20
-30
Risk: Limited (Strike price – Share price)
Reward: Premium
Break Even: Strike Price - Premium
Motivation: Share price are expected to remain flat/bullish or purchase at
a pre-determined price lower than the market price
Covered Calls
Sell a call and buy underlying stock

Short Call and Long Stock
Profit
Short Call
Strike Price
Share Price
Stock Purchase Price
Long stock

Covered Calls - Motivation (continued)
Expect market to remain flat

Collect premiums and reduce the
Short Call
cost of holding
Hedge to limit the downside risk
Long stock

Protective Puts
Buy underlying stock and buy put

Long Stock and Long Put
Profit
Long Put
Strike Price Share Price
Stock Purchase Price

Long stock
Motivation: Insurance policy on the long stock

Option Value – Intrinsic Value (IV) versus Time Value (TV)
XYZ Corp. Share price = $75
$80 TV
IV = In the money amount

Strike Price
TV
TV
TV = Opportunity value that
$75 option may become more
valuable in future
IV
$70
$70 Call at $7 $75 Call at $4 $80 Call at $1

Factors affecting option prices
Non Quantifiable
Liquidity
Market sentiment
Corporate Actions
Market news
Supply and demand
Quantifiable
Underlying price
Strike Price
Expiration Date
Volatility
Risk Free Interest Rate
Dividends

Strike and share price
Consider two call options which only differ only by strike prices. Which call
would have an higher premium, the one with a lower strike price or higher?
E.g. would XYZ $100 May Call be more valued that XYZ $120 May Call?
Further, what is the impact of the underlying share price on the option price?
Call Put
Strike Price – +
Share Price + –
Payoff for call = share price – strike price
Payoff for put = strike price – share price
Expiration Date
Consider two options which differ only by the expiration date? Which option would
be more valuable? The one maturing earlier or later? E.g. would XYZ $100 May
Call be more valued that XYZ $100 June Call?
Call Put
Expiration
Date + +
Option Decay
European Options: exercise only at expiration date

American Options: exercise any time up-to the expiration date

Volatility
Measures the un-certainty of future stock price movements

Historical Volatility
The volatility of an asset is the standard deviation of the continuously
compounded rate of return in 1 year e.g. it is the standard deviation of the return
provided by the stock in one year using continuous compounding
Is the unknown variable in the factors affecting the option prices
Expressed as a percentage e.g. XYZ is at $60 with an annualized volatility at
30%. Therefore 1 std dev = .3 * $60 = $18
68.3% prices would fluctuate between $42 and $78

Implied Volatility
Implied by the current market option prices

Volatility that would lead to the current option market price and it derived
from the option pricing model by providing all inputs except the volatility
Can monitor the market’s current opinion
Traders calculate implied volatility from active options and apply it to the less
active options

Volatility
Consider two options XYZ.com and ABC. XYZ has a lot of fluctuations in its
share price compared to ABC. All factors similar which option would be more
priced? XYZ.com or ABC
Call Put
Share Price + +

Interest rates
What happens to option prices when the interest rates go up?
Call Put
Interest rates + –
Only true if other factors remain constant especially the share prices
Interest rate increases normally would be followed by decrease in share
prices causing call option prices to reduce

Dividends
XYZ company declares a cash dividend of 50% with an ex-date in May.

What impact would it have on the XYZ May Call?
Call Put
Dividends – +

Summary of factors affecting option prices
Call Put
Strike Price – +
Share Price + –
Volatility + +
Expiration + +
Dividend – +
Interest rate + –

Advanced strategies
Spread – Strategy involves taking a position in two or more options of the

same type (call or put) on the same stock but varying strike prices or
expiration dates
Bull
Bear
Butterfly
Calendar
Combinations – Strategy involves taking position in both calls and puts on
the same stock
Straddle
Strips
Straps
Strangles

Summary
Bear
Bull
S2 = Buy Call
S1 = Buy Call
S1 = Sell Call
S2 = Sell Call
S2 = Sell Call Calendar

Sell call
Butterfly
S1 = Buy Call
S3 = Buy Call Strike
Buy call with higher maturity

Summary
Bottom straddle Top straddle
S = Buy Call and Put
S = Short Call and Put
Strip Strap
Strangle
S2 = Buy Call
S1 = Buy Put

Option Prices Sensitivities - Greeks
Underlying Price Delta Gamma
Volatility Vega
Strike Price Option Sensitivities or Greeks
Expiration Date Theta
Interest Rates Rho
Dividends

Delta
How much does an option premium change in value as the underlying stock
price changes?
Delta (∆ ): The rate of change of the option price with respect to the
underlying stock price i.e. ratio of change in option price to change in stock
price
Indicator of the option’s sensitivity to

the change in the underlying stock
price
Option
XYZ June 60 Call price
At T1, XYZ = 59.5, Option = 5.5
At T2, XYZ = 60.5, Option = 6.0 B Slope = ∆
Delta = 6.0 – 5.5 / 60.5 – 59.5
Delta = 0.5 or 50% or 50
A Stock price

Delta – Calls, Puts and Stock
Long Short
Call Positive Delta Negative Delta
Put Negative Delta Positive Delta
Delta for underlying stock = 1

Delta Hedging
Delta hedging entails “continuously re-balancing” the portfolio by maintaining

a delta neutral for the position
Position/portfolio with delta = 0 is delta neutral
For the above call option, assume, delta = 0.6 which means for every $1
share price change the option price changes by $0.6
To maintain a delta neutral position, XYZ can hedge by buying 0.6 (delta) *
1000 (contracts) * 100 (lot size) = 60,000 shares
60,000 shares would lead to a gain of $60,000 for $1 price increase
1000 contracts would lead to a loss of $60,000 for $.6 price increase
Net delta = 0
If stock price increases causing delta to increase by 0.05 then we buy 0.05 (delta
change) * 1000 (contracts) * 100 (lot size) = 5000 shares

Gamma
How does the options delta change in value as the underlying stock price
changes?
Gamma: The rate of change of the option delta with respect to the
underlying share price
6
δ
5 Gamma=
Value
U
4
3
Second derivate
2 of the portfolio
value with respect
20 21 22 23 24 25 26
to the underlyer
Underlying
price
Gamma neutral
Underlying stock gamma = 0

Asset price is linear to the underlying price
How would we make a portfolio gamma neutral?
Use derivative since price is non-linear with the underlying asset price
Gamma of portfolio = (Γ P), Gamma of hedge option = (Γ H)
New Gamma = Contracts hedge * (Γ H) + (Γ P)
To make portfolio Gamma neutral we need to add position of option hedge =
- (Γ P) / (Γ H)
Adding new option position causes the delta of the portfolio to change and
hence make it delta neutral to changing position of the underlying stock
Since Gamma is not constant, re-balance the portfolio to maintain gamma
neutrality. This is called as gamma trading

Gamma Trading
If we buy options, (calls or puts) then we are said to have POSITIVE

GAMMA. This works in our favour because
The Gamma makes our portfolio longer in a rising market and shorter in a falling
market
If we are gamma trading, this forces us to Sell High and Buy Low to remain Delta
Neutral
If we sell options, (calls or puts) then we are said to have NEGATIVE
GAMMA. This works against us because
The Gamma makes our portfolio shorter in a rising market and longer in a falling
market
If we are gamma trading, this forces us to Sell Low and Buy High to remain Delta
Neutral

Vega
How does the option value change as the underlying stock becomes more or
less volatile?
Vega: The rate of change of the option price with respect to the underlying
stock’s volatility
Indicator of the option’s sensitivity to underlying volatility
5
P
Value
4 Vega =
V
3
2
5% 10% 15% 20% 25% 30% 35%
Implied Volatility
Vega characteristics
Option premium rises with increasing volatility and falls with decreasing
volatility
Positive Vega for buyers and negative Vega for writers
High Vega indicates higher changes to portfolio value for small changes in
underlying volatility
Vega for underlying stock = 0
Vega neutral by adding option position = –V Portfolio / V Hedge
Represented as dollar amount the option is expected to change for a 1%
increase in volatility e.g. $$$/1% an option with a Vega of 0.2 would gain
(lose) $0.20 in value for each 1% increase (decrease) in volatility

Theta and Rho
Theta
How much does the passage of time affect the option value?
Theta: The rate of change of the option price with respect to the time
Indicator of the option’s sensitivity to passage of time
As expiration approaches, time value of option decreases. Theta measure
this option time decay
Rho
Rho is the rate of change of the value of the option with respect to the
interest rate

Greek Summary
Instrument Delta Gamma Vega Theta
Long Call Positive Positive Positive Negative
Short Call Negative Negative Negative Positive
Long Put Negative Positive Positive Negative
Short Put Positive Negative Negative Positive

What are Exotics?
Exotic options are non-standard products whose pay-off is dependant on the path
realized by the underlying asset
All Exotic options are customized as per client requirements (also called structured
products) and hence are always OTC products
Carries significant credit risk apart from the usual market risk that any options portfolio
shall always carry

Example of Exotics
Binary (Digital) Options
Cash-or-nothing Call – here, the payoff is zero if the price of the underlying asset
ends up below the strike price at time T (maturity time) and pays a fixed amount
Q if it ends up above the strike price.
Cash-or-nothing Put – here, the payoff is Q if the underlying price ends up below
the strike price at maturity and zero if it is above the strike price at maturity.
Similarly, Asset-or-nothing options can be set up –the only difference is that the
payoff in this case is the value of the underlying price at maturity
Barrier Options
Barrier option will knock in or knock out depending on whether the barrier has
been hit during the life of the option and the type of the option.
A knock-out option ceases to exist when the price reaches a certain barrier
A knock-in option comes into existence only when the underlying price reaches a
certain barrier

Example of Exotics
Lookback Options
Payoff from Floating Strike Lookback options depend on the maximum or
minimum price reached during the life of the option
The payoff from a Floating Strike European style Lookback Call is the amount that
the final price exceeds the minimum price during the life of the option
The payoff from a Floating Strike European style Lookback Put is the amount by
which the maximum price achieved during the life of the option exceeds the final
price.
Barrier Options
Payoff depends on the average price of the underlying asset during at least some
part of the life of the option
Now, the average can be looked at in two respects:
Fixed Strike, Average Price:
Payoff from an average price Call option is max (0, Save – X)
Payoff from an average price Put option is max (0, X – Save ),
Average Strike:
Payoff from an average strike Call is max (0, ST – Save )
Payoff from an average strike Put is max (0, Save - ST)

Rates FO Training-Session V Products) 20 May 2010

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Link between FI and Rates

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This is the so called ‘Price-Yield’ Formula

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Clean vs. Dirty Price

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As the price-yield formula suggests

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Inverse Relationship Between Bond Prices and Yields

The relationship between the coupon rate and the

If Then Bond Sells at a:

Coupon = YTM Market = Face Par

Coupon > YTM Market > Face Premium

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Yield to maturity (investor’s required return)

Long bonds have greater price volatility than short bonds

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This question is of great significance to both borrowers and lenders.

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Spreads will increase when pessimism increases in the economy

Corporate Bond Risk Premium and Flight to

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Steep Yield Curve –predicts end of recessions

Benchmark for pricing many other fixed-income securities (Typically LIBOR)

Typically market yield curve used

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17th Century “To Arrive” 18th Century

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Definition: A futures contract is a type of derivative instrument, or financial

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Hedging – need for price certainty in the future.

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Margins (also called Performance Bonds)

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Defining features (cont…)

Several deliverable bonds

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Asset swaps exchange incomes from two different types of assets

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Settle date is the date on which the payment is due

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A zero-coupon swap has only one fixed payment at maturity