Bonds and Derivatives

Derivative Markets and Bonds
Contents
Organized and OTC markets 3 - 22

Option pricing with binomial trees 23 - 40
Mechanics of futures Markets 41 - 50
Determination of forward et futures prices 51 - 80
Hedging strategies using forward and futures
contracts 81 - 102
Interest rates markets 103 - 118
The Black- Scholes- Merton Model 119 - 147
Concluding comments 148 - 149
1

Rfrences
Options, Futures et and other derivatives John Hull 7th
Edition, 2008, Pearson.
J. Cox, M. Rubinstein, Options Market, 1985, Prentice Hall
D. Brigo, F. Mercurio Interest rate Models: Theory and
Practice, 2007, 2nd ed, Springer Finance
H. Gman Commodities and Commodity Derivatives, 2005,
Wiley Finance.
P. Ritchken, Derivative Markets : Theory, Strategy and
Applications Harper Collins College Publishers, 1996.
P. Navatte, Marchs et instruments financiers: Limportance
des produits drivs, 2ime dition, 2010, ditions EMS
2

Organized and OTC Markets
A derivative exchange is a market where individuals trade
standardized contracts. Exchanges are increasingly replacing
the open outcry by electronic trading.
Not all trading is done on exchanges. OTC (Over The Counter)
Markets are an important alternative. Measured in terms of total
volume of trading, they have become much larger than
exchange-traded markets. They are telephone- and computerlinked networks of dealers. Financial institutions often act as
market makers. They are ready to quote both a bid price (to
buy), and an offer price to sell : (bid ask spread).
Telephone conversations in an OTC market are usually taped.
One key advantage of OTC market is that market participants
are free to negociate any deal, but there is a counterparty risk.
3

For most futures contracts, daily price movement limits are
specified by the exchange. Position limits are the maximum
number of contracts that a speculator may hold.
A futures contract is referred to by its delivery month. As the
delivery period is approached, the futures price converges to
the spot price of the underlying asset.
A clearinghouse acts an intermediary in futures transactions. It
guarantees the performance of the parties to each transaction.
The clearinghouse has a number of members, who must post
funds with the exchange. Brokers who are not members
themselves must channel their business through a member.
A deposit is required to enter the futures market, and each day
a margin account will be settled as if it was maturity (marking to
the market). Most contracts involve a cash settlement, but
delivery is also possible.
4

Future and Forward contracts on foreign exchange are very
popular. They can be used to hedge foreign currency risk.
Forward Contracts (OTC Markets)

It is an agreement to buy or to sell an asset at a certain future
time for a certain price. It can be contrasted with a spot
contract, which is an agreement to buy or to sell a contract
today.
One of the parties to a forward contract assumes a long
position and agrees to buy the underlying security on a certain
specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on
the same date for the same price.
5

Consider a forward currency contract : We buy dollar (USD) Euro (EUR) for a 6 months delivery 1.4565- 1.4569. Quotation
gives number of US$ per EUR. Then 1.4565 is the exchange
rate for which banks agree to buy , and 1.4569 is the price they
want to sell .
Forward contracts allow companies to hedge exchange risk. If
we are compelled to pay 6 months later 1 million whereas our
cash inflows are in US$, we can buy now 1 million deliverable
in six months for 1.4565 US$ per EUR, in order to fix the cost,
whatever the exchange rate in six months (import of a US
company).
6

The following stages are:
1) no cash ouflow or inflow, but signature of the contract
2) At maturity,if 6 months later the USD/ exchange rate moves
up to 1.50 (spot) a profit is made (1.50-1.4565)* 1 million , or
43500 uS$
3) At maturity, if 6 months later the USD /$ spot rate is equal
to1.40, a loss of (1.40 1.4565)* 1 million , or 56500 uS$ is
registered. Nevertheless the hedge was perfect in the sense
that from the beginning, no uncertainty was prevailing
concerning the hedging cost.
As a matter of fact, the payoff of a forward contract is (ST K),
where ST is the spot price of the underlying security at maturity,
and K the forward price at the beginning of the game.

The payoff of a short position on a forward contract is (K- ST),
where ST is the spot price of the underlying asset at maturity,
and K the forward price considered at the inception of the
position. (example: export payed in whereas the
corresponding charges are to be paid in , then we sell forward
contracts on )
Relationship between spot et forward prices: Consider that the
gold spot price is 800 USD and the riskless interest rate for one
year is equal to 5%. We hypothesize no storage cost, and no
revenue distribution. What is the price of this gold ounce in
one year? A trader can undertake the following strategy:
1) borrow 800 USD at an interest rate of 5% during one year

2) Buy a gold ounce
3) Take a short position (sell) on the forward contract
At maturity, for every price higher than 840 US$, this strategy is
profitable.
Conversely, an investor who holds a gold ounce can
1) sell it at the spot price of 800 us$
2) invest the money at the riskless interest rate (5%)
3) Take a long position on the forward contract
At the end of the year, he gets 840 US$. For any price less than
840 US$, he makes a profit.

Then, with all these pressures (up and down),the equilibrium
price must be 840 US$.
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.
10

Options
Options are traded both on exchanges and in the OTC markets.
There are two types of options.
A call option gives the holder the right to buy the underlying
asset by a certain date for a certain price. A put option gives
the holder the right to sell the underlying security by a certain
date for a certain price. A premium has to be paid at the
beginning of both contracts.
The price in the contract is known as the exercise price or the
strike price. The expiration date is called maturity.
American options can be exercised at any time up to the
expiration date. European options can be exercised only on the
expiration date itself.
11

It should be emphasized that an option gives the holder the
right to do something. The holder does not have to exercise
this right. It is a striking difference with forward and futures
contracts, where the holder is compelled to buy or sell the
underlying asset.
Consider an investor who buys european calls on Air Liquide
stock with a strike price equal to 80 for a 3 months maturity.
The corresponding premium is 4.
1) If at maturity, the underlying asset price is equal to 100 (3
months later), he gets the following amont of money (100 - 80)
4 (if we neglect the interval of time and the appropriate
discount of cash-flows) = 16.In fact,exercising the call option
at 80, he can sell the stock immediately at 100 on the market.
2) If at maturity, the underlying asset price is equal to 70, he
gives up the option, and loses all his initial stake.
12

All the call options deserve to be exercised as soon as the
price of the underlying security is a bit higher than the strike
price.
A buyer of a call option hope that the price of the underlying
security will go up : Max (ST K;0); Conversely, a buyer of put
option bets on the decrease of the share price: Max (K ST;0).
Suppose an investor buys a put for a premium of 3 concerning
the Accor stock with a strike price of 50 and a maturity of
three months.
1) If three months later, the stock price has decreased to 40,
one can exercise the put at 50, but at the same moment buy a
stock at 40 on the market, 3 being the initial stake.
2) If the stock price is rising, the investor gives up the put
option and loses its premium.
13

The payoff corresponding to the sale of a call option is - Max
(ST K;0) = Min (K ST;0)
The payoff resulting from the sale of a put option is - Max (K ST;0) = Min (ST - K;0).Selling naked options is a very risky
strategy. If an investor doesnt own the underlying asset, to be
able to deliver it, he must be compelled to buy it on the market
at defavourable price for him.
Factors affecting option prices

There are six factors affecting the price of a stock option: The
current stock price S, the strike price K, time to expiration T,
The volatility of the stock price , the risk-free interest rate r,
the dividends if any expected during the life of the option.
14

The total option value can be split between intrinsic value and
time value
Intrinsic value (ST K, 0) for a call option represents its value if
immediate exercise takes place. Its value is positive or equal to
zero.
When intrinsic value of a call or a put option is null, the option
is considered as out of the money .
In the specific case where the price of the underlying security
is equal to the strike price, the option is considered as at the
money .
When the intrinsic value is positive, the call or put options are
said in the money .
15

An american option which can be exercised at every moment
until maturity, has for lower bound for its price its intrinsic
value.
Time value is weak when S<<K, then increases, and becomes
maximum when the option is at the money, and then decreases
when S>>K.
Option price is a positive function of the volatility of the
underlying asset. Roughly speaking, the volatility of a stock
price is a measure of how uncertain we are about future stock
price movements.
Dividends have the effect of reducing the stock price on the exdividend date. This is bad news for the value of call options and
good news for the value of put options.
16

It is never optimal to exercise an american call on a nondividend paying stock before the expiration date. This is not
always true if some dividends take place during the life of the
option.
The buyer of an american call option may exercise optimally
before a dividend payment if the intrinsic value of the call is
higher than the ex-total value of the option after the payment
It can be optimal to exercise an american put option even on a
non-dividend-paying stock early. Because they are some
circumstances when it is desirable to exercise an american put
option early, it follows that an american put option is always
worth more than the corresponding European put option.
17

Concerning interest rate, buying a call option requires less
capital than acquiring the stock. The remaining capital could be
then invested in the riskless asset.The advantage is more
important as soon as the interest rates increase. Investors are
then ready to pay more for a call option if interest rates are
high.
Time value of options grows with maturity. Both put and call
options become more valuable as time to expiration increases.
A call option becomes more valuable as the stock price
increases and less valuable as the strike price increases. Put
options behave in the opposite way.
The slope of the premium curve concerning a call option is not
only increasing in the spot price of the stock but, also as soon
as the strike price is lower. This slope coefficient is named
hedge ratio and could be written as follows: H = (dC/dS).
18
Actifs Drivs et Obligataires

The option leverage represents the elasticity of the option price
with respect to the stock price. It could be defined as the option
instantaneous return divided into the stock instantaneous
return. If we call L, the leverage, it comes :
L= (dC/C) / (dS /S) = (dC/dS)*(S/C) = H*(S/C)
PUT-CALL parity relationship

An arbitrage may be undertaken, if the european option price
seems to be to high compared with the corresponding put price
(same underlying asset, same strike price and maturity). In this
settings, we sell C, and we buy P the corresponding put
option.
The arbitrageur borrows the amount S to buy the stock.
19
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)
If S* > K, C is exercised by his buyer and we sell the share for K

- If S* = K, no option is exercised, and we sell the share at a price equal to K
- If S* < K, P is exercised and we sell the share at a price equal to K
20

As the portfolio is riskless (no uncertainty concerning the
results), its rate of return when the market is in equilibrium
must be equal to the risk free rate r.
Following, the net cash-flows when discounted at the risk free
rate r(discontinuous rate) must be equal to zero:
C P + K/(1+ r) S = 0
Then C- P = S K/(1+r)
From another point of view, we must keep in mind that the
value of a call option C is always situated between these two
lower and upper bounds:
0 <= C <=S
with <= (less or equal to)
21

Similarly, the price of a put option on a stock must always be
worth less that the options strike price.
A european call option on a non-dividend-paying stock must be
worth more than Max (S - Ke^(- rT), 0).
For a dividend paying stock, the put-call parity relationship is
the following:
C + D+ Ke^(- rT) = P+ S
It is possible to derive some results for american option prices.
It can be shown that when there are no dividend, we have the
following call- put relationship:
S - K <=C- P<= S - Ke^(- rT)
22

Option Pricing with Binomial Trees
We suppose market efficiency, and the following prevailing
conditions on the markets: no transaction costs, the
opportunity to buy or to short-sell stocks, and we suppose that
the price evolution of a stock S is governed by a multiplicative
binomial process like presented below during only one time
period:
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
23
U>r>d
with r=1+ r the discontinuous risk free interest rate per

binomial period. This constraint ensures that the market can be
considered as being in equilibrium and that no asset is
dominated.
To price options, one can build an arbitrage portfolio including
the following assets:
Buy H stocks (long position)
Sell one call option (short position)
H must be selected in order to make sure that the resulting
portfolio is riskless. H has to conform to the following
equalities:
HuS-Cu
HS-C
Hds-Cd
24

HuS - Cu = HdS Cd
Then H = (Cu - Cd) / S(u - d)
In this context, as the portfolio is riskless, it must not earn
anything else, but the relevant riskless interest rate, if a market
equilibrium prevails.
.
HS - C = [HuS - Cu]/r = [HdS - Cd]/r
Taking into account the first equality, it comes:
C = [rHS HuS + Cu]/r = (1/r)[HS(r- u) + Cu]
Then substituting H by its value, it comes:
C = (1/r){[(Cu - Cd) / S(u - d) ](r- u) + Cu}
C = (1/r)[p Cu +(1- p) Cd]
With p = (r- d)/(u - d) et 1- p = (u - r)/(u - d)
25

Example
S = K = 100, u = 1.25, d = 1/u = 0.8, r= 1.025 (discontinuous
riskless interest rate per period), n = 1. Compute the price of
this call option.
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
26
ARBITRAGE
Sell a call
Buy 0.5555 stock
Borrow
If stock price =125

Sell stock
+ 69.44
(125x.5555)
Reimbursement - 44.44
Buy a call
- 25
12.195
-55.55
43.355
If stock price = 80
Sell stock
+ 44.44
(80x0.5555)
Reimbursement
- 44.44
buy a call
0
27

For put option, we use a similar approach. We build an
arbitrage portfolio including H stocks and a put option (long
position).
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:
28
P = (1/r)[p Pu + (1- p)Pd]

Where p= (r- d) / (u - d)
Example
S = K = 100, u = 1.25, d = 1/u = 0.8, r= 1.025 (riskless interest
rate per period), n = 1. Compute the corresponding put price.
uS = 125
Pu = 0
S=100
C
dS = 80
Pd = 20
p =(1.025 - 0.8)/ (1.25 - 0.8) =0.5
1 - p =0.5
P =(1/1.025)[0.5x0 + 0.5X20]= 9.7560
29

Check C - P = S - K/(1+ r) and then :
C= P + S K/(1+r) =9.756 + 100 100/1.025 = 12.195
Two step binomial Trees
Trees are the following:
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)
30

We can extend the analysis to a two-step binomial tree. This
can be done by repeatedly applying the principles established
earlier. We need to compute Cu, et Cd before C.
Cu = (1/r)[pCuu +(1 - p) Cud]
Cd = (1/r)[pCud +(1 - p) Cdd]
Then C = (1/r)[pCu +(1 - p) Cd]
It is also possible to get the same result directly, without
intermediate calculations. But we will not be able to compute
greek letters in that case.
C=(1/r^2)[p^2Cuu + 2(1- p)pCud + (1- p)^2Cdd]
31
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
32
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.
Management parameters (Greeks)

coefficient of a call option is defined as the rate of change of
the option price with respect to the price of the underlying
asset. It is the slope of the curve that relates the option price to
the underlying asset price.
33

c = (Cu Cd) / S(u - d)
p = (Pd - Pu ) / S(u - d)
Coefficient (gamma) is the rate of change of the options delta
with respect to the price of the underlying asset. It is the
second partial derivative of the option price with respect to
asset price: = (u - d) / S(u - d)
Its value is the same for C and P (put option)
coefficient indicates the rate of change of the option value
with respect to the passage of time with all else remaining the
same. Theta is sometimes referred to as the time decay of the
option.
c= n(Cud - C)/2
P= n(Pud - P)/2
Where represents a calendar period to be transformed into
binomial periods.
34

Example
S=K=100, u=1.25, d=0.8, r=1.025, n=2, =6 months
c= (27.439 - 0)/100(1.25 - 0.8) = 0.60975
= (1 - 0)/100(1.25 0.8) = 0.0222
We compute u =(Cuu-Cud)/uS(u - d) =(56.25-0)/125(1.25-0.8)=1
As is 0.5 year, a binomial period represents 3 months, or 0.25
year.
c= (0 - 0.133849)/2x0.25 =-26.7698 (on a yearly basis)
For a week, the time decay of the option price implies that
C=13.3848 (26.7696/52) = 12.87
35

Option Replication
One can build a portfolio equivalent to an option if this
asset is not quoted on the market.
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
36
C= (1/r)[ rCu rCd + uCd - dCu]/[u - d]

C= (1/r)[pCu +(1 - p)Cd]
Where p = (r- d)/(u - d)
Example
S=K=100, u =1.25, d = 0.80, r=1.025, n=2
c = 0.60975
B = uCd- dCu/(u - d)r= (1.25x0 - 0.8x27.439)/ (1.25 - 0.8)1.025=47.59
Then to replicate a call option, we must buy 0.60975 stock
priced 100 and borrow 47,59 to finance partially this
investment. Finally the amount invested is just equal to the
premium value (60.975 47.59 = 13.384).
37

At the end of period 1, two scenarii may happen:
- If the stock price is 125 et u is 1 (Cuu - Cud) / uS(u- d)=
56.25/56.25 =1
We must buy some additional stock (1-0.60975=0.39025), and
borrow a little bit more (97.5617= 47.59*1.025 + 48.78). Then we
get Cu =27.438 or (125 - 97.5617).
- If the stock price is 80, we have to sell on the spot all the
stocks held, d is null. We get (0.60975x80= 48.78), and we are
able to reimburse the loan (47.5907x1.025= 48.78). But all the
initial stake (the premium) is lost.
Then, the option replication is costly since it is necessary to
rebalance periodically the position.
38

Stocks paying dividends
Options contracts are not adjusted in case of dividends
distributed during the option life . This benefits to the buyer of
a put option and implies drawbacks for the buyer of a call
option.
We suppose that the reduction of the share price at the exdividend date is just equal to the dividend amount. Moreover
we suppose that the date and the amount distributed are
known. To get the option price under these circonstances, we
have to create new independent sub-binomial trees.
Example
S = K= 100, u = 1.25, d = 0.80, r = 1.025, n= 3, D = 4 (distribution
at the end of the second binomial period), p=0.5.
39
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
75
48
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.
40

The american call option does not have a higher value that its
european counterpart since, no early exercise seems profitable
at period 1: Cu = 31.436, Cd = 4.7590. In fact, the intrinsic value
of the option (25, 0) in these two contexts is not more important
that the total value of the option ex dividend.
If we consider american put options, early exercise is possible
at every moment, even if there is no dividend distribution.
Mechanics of Futures Markets

Derivatives markets have been outstandingly successful. The
main reason is that they have attracted many different types of
traders and have a great deal of liquidity. Three broad
categories of traders can be identified: hedgers, speculators
and arbitrageurs.
41

Hedgers
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.
42

Speculators
Whereas hedgers want to avoid exposure to adverse
movements in the price of an asset, speculators wish to take a
position in the market. Either they are betting that the price of
the asset will go up or they are betting that it will go down.
Futures and options are similar instruments for speculators in
that they both provide a way in which a type of leverage can be
obtained. However, there is an important difference between
the two. When a speculator uses futures, the potential loss as
well as the potential gain is very large.
When options are used (When they buy options), no matter
how bad things get, the speculators loss is limited to the
amount paid for the options.
43

Arbitrageurs
Arbitrage involves locking in a riskless profit by simultaneously
entering into transactions in two or more markets. Suppose, a
stock is quoted 105 in Paris and 160 US$ New-York (spot
exchange rate 1.45 US$ for 1). Buying 100 stocks in Paris at
105 (152.25 US$), and selling them immediately at a price of
160 US$ in New-York results in a profit (without taking into
account transaction costs) of (160 105*1.45) = 7.75 US$ per
stock.
Arbitrage opportunities such as the one described cannot last
long. As arbitrageurs buy the stock in Paris, the forces of
supply and demand will cause the euro price to rise. Similarly,
as they sell the stock in New-York the dollar price will be driven
down. Very quickly the two prices will become equivalent at the
current exchange rate.
44

Dangers.
Derivatives are very versatile instruments. Sometimes traders
who have a mandate to hedge risks or follow an arbitrage
strategy become (consciously or unconsciously) speculators.
The results can be disastrous (Barings Bank, Lehman Brothers
case,). To avoid the sort of problems lehman Brothers
encountered, it is very important for both financial and non
financial corporations to set up controls to ensure that
derivatives are being used for their intended purposes. Risk
limits should be set and the activities of traders should be
monitored daily to ensure that these risk limits are adhered to.
45

Futures Markets
The two largest exchanges in Europe are Nyse-Euronext and
Eurex. In the United States The CME (Chicago Mercantile
Exchange) group operates the largest futures exchanges.
The vast majority of futures contracts do not lead to delivery.
The reason is that most traders choose to close out their
positions prior to the delivery period specified in the contract.
Closing out a position means entering into the opposite trade
to the original one.
Delivery is so unusual that traders sometimes forget how the
delivery process works. Nevertheless the delivery arrangement
is important, because it is the possibility of final delivery that
ties the futures price to the spot price.
46

When the asset is a commodity, there may be quite a variation
in the quality of what is available on the marketplace. When the
asset is specified, it is therefore important that the exchange
stipulates the grades of the commodity that are acceptable.
The contract size specifies the amount of the asset that has to
be delivered under one contract. For example, under the
treasury bond futures contract traded on the CBOT (CME
group), instruments with a face value of $100.000 are delivered.
The margin requirements are the same on short futures
positions as they are on long futures positions. Many
newspapers carry futures prices (opening prices, the highest
(lowest) prices achieved in trading during the day, the closing
price or settlement price).
47

Settlement prices are used for calculating daily gains and
losses and margin requirements.
The open interest is the total number of contracts
outstanding.It is the number of long positions or equivalently,
the number of short positions.
Futures prices can show a number of different patterns. Gold,
crude oil all have settlement prices that increase with the
maturity of the contract (normal market). Conversely the orange
juice futures price was a decreasing function of maturity in
2007. This is known as an inverted market.
Market order is a request that a trade be carried out
immediately at the best price available in the market. There are
many types of orders (limit order, stop order, fill or kill order)
Commission brokers are following the instructions of their
clients and charge a commission for doing so, locals are
trading on their own account.
48

Trading irregularities
Most of the time futures markets operate efficiently and in the
public interest. However, from time to time, trading
irregularities do come to light. One type of trading irregularity
occurs when an investor group tries to corner the market .
The investor group takes a huge long futures position, and also
tries to exercise some control over the supply of the underlying
commodity. As the maturity of the futures contracts is
approached, the investor group does not close out its position,
so that the number of outstanding futures contracts may
exceed the amount of the commodity available for delivery.
49

The holders of short positions realize that they will find it
difficult to deliver and become desperate to close out their
positions.The result is a large rise in both futures and spot
prices.
Regulators usually deal with this type of abuse of the market by
increasing margin requirements or imposing stricter position
limits or prohibiting trades that increase a speculators open
position or requiring market participants to close out their
positions.
Under the US tax rules, two key issues are the nature of a
taxable gain or loss (capital gains or ordinary income) and the
timing (short or long term) of the recognition of the gain or
loss.
50

Determination of forward and futures Prices
When considering forward and futures contracts, it is important
to distinguish between investment and consumption assets.
An investment asset is held for investment purposes by
significant numbers of investors. Stocks and bonds are clearly
investment assets. Gold and silver are also examples of these
assets, even if silver has industrial uses. A consumption asset
is an asset that is held primarily for consumption. Examples are
commodities such as copper, and oil.
We can use arbitrage arguments to determine the forward and
futures prices of an investment asset, but we cannot do the
same for consumption assets.
51

Interest rate are important to determine futures prices, Yearly
compounding for a capital A of 100 and r = 5% :
100x1.05=105
For n years: A(1 + r) ^n
If the compounding frequency is semi-annualy, we have:
100x1.025x1.025 = 105.0625 at the end of the year.
For a monthly compounding, we have:
100[1+ (0.05/12)]^12 = 105.116
For n years, with a compounding frequency of m times per
annum, it comes: A[1+(r/m)]^mn
When m tends to infinity, we switch to a continuous
compounding; for n years, it comes Ae^rn where e is the
exponential function : 100e^(0.05x1) = 105.127
52

Discounting an amount A for n years at a continuously
compounded rate for n years involves multiplying by e^(- rn).
Suppose that rc is a rate with continuous compounding and rm
is the equivalent rate compounding m times per annum, we get
the following equalities:
Ae^(nrc) = A[1 + (rm/m)]^(mn)
Then rc = mxln[1 + (rm/m)]
And rm = m[e^(rc/m) -1]
These equations can be used to convert a rate with a
compounding frequency of m times per annum to a
continuously compounded rate and vice versa.
Consider an interest rate that is quoted 5% per annum with
semiannual compounding, the equivalent rate with continuous
compounding is:
53

2ln [1+ (0.05/2) ] = 0.049385
Suppose that a lender quotes the interest rate on loans as 5%
per annum with continuous compounding, and that interest is
actually paid quaterly, then the equivalent rate rm with quaterly
compounding is : 4[e^(0.05/4)-1 ]= 0.0503138
This means that on a 1000 loan, interest payments of 12.578
would be required each quater.
Assumptions and Notation

- There are no transaction cost when a trade takes place.
- The market participants can borrow money at the same riskfree rate of interest as they can lend money.
- The market participants take advantage of arbitrage
opportunities as they occur
54

The following notation will be used throughout this chapter:
T: Time until delivery date in a forward or futures contract;
S0: Price of the asset underlying the forward or futures contract
today (time 0);
F0: Forward or futures price today;
R: risk-free rate of interest per annum, expressed with
continuous compounding, for an investment maturing at the
delivery date(i.e in T years);
In fact F0 et S0 are tied by the following relationship if the
underlying asset provides the holder with no income:
F0 = S0 e^(rT)
If F0 > S0 e^(rT) arbitrageurs borrow, buy the asset and sell the
forward contract.
55

If F0 < S0 e^(rT) arbitrageurs short sell the asset and buy the
forward contract.
Consider the following case: S0 = 100, r = 0.05, T = 3 months, it
comes:
F0 = 100e (0.05x0.25) = 101.2578
If F0 is quoted 102 an arbitrageur immediately sells the forward
contract and buy the underlying asset with a loan: 102- 100e^
(0.05x0.25) = 0.7421 (gain F0 S0e^rt)
If F0 is quoted 100, an arbitrageur buys the forward contract
and short sell the underlying asset, then invests the proceeds
at the riskless interest rate r: - 100 + 100 + 1.2578 = 1.2578
(gain S0e^rt - F0).
When market equilibrium prevails, F0 must be quoted for a
price of 101.2578.
56

Example:
Consider a 4-month forward contract to buy a zero-coupon

bond that will mature 1 year from today . The current price of
ZC is 0.93 (This means that the bond will have 8 months to go
when the forward contract matures). We assume that the 4month risk free rate of interest is 5% per annum.
F0 is given by :0.93e^(0.05X0.25) =0.94169, It is the delivery
price.
Known Income
If we consider a forward contract on an investment asset that
will provide a perfectly predictable cash income to the holder,
with a present value I , we get : F0 = (S0- I)e^rt
57

If we consider a one year forward contract on a coupon-bearing
bond quoted today 0.9, with a maturity of 5 years, we will have
to take into account two coupon payments of 0.04 expected in
6 months and in 12 months just before the forward contract
maturity. We assume that the risk-free interest rates are
respectively equal to 7% et 8% per annum for 6 and 12 month
maturities.
I= 0.04xe^(-0.07x0.5) + 0.04xe^(-0.08x1) = 0.038624 + 0.036924
F0 = (0.9 - 0.075548)e^( 0.08x1) = 0.8931
If F0 > (S0 I)e^rT, arbitrageur buys the bond with a loan and
sell the forward contract.
If F0 < (S0 I)e^rT, arbitrageur buys the forward contract, sell
the bond, and invests the money at the risk-free rate.
58

Known Yield
We now consider the situation where the asset underlying a
forward contract provides a known yield q rather than a known
cash income.
F0 = S0e^(r - q)T
If S0 = 30 , r = 0.05, T= 0.25, q =0.03 (discontinuous time) [ln
(1.03) = 1.029558]
F0 =30e^[(0.05 - 0.02955)x0.25] = 30.1537
Consider a 3 month futures contract on CAC40, and assume
that the stocks included in the index pay a dividend of 2% on a
yearly basis, the index quoting 4500 (S0) today.
59

If r =0.05 and T = 0.25 then it comes:
F0 = 4500e^(0.05 0.02)0.25 = 4533.87
Q must be adjusted to take into account the fact that
companies usally pay dividends between May and August.
Several exchanges trade options on stock indices. Some of the
indices track the movement of the market as a whole. Others
are based on the performance of a particular sector. The most
wellknown futures contracts on stock indices are: DAX-30,
FTSE-100, Standard & Poors 500, Dow Jones
Valuing Forward contracts

The value of a forward contract at the time it is first entered into
is zero. At a later stage i, it may prove to have a positive or
negative value: f = (Fi K) e^(-r*T-i) with K the delivery price (long
position). At time 0, F0 = K et f = 0
60

Similarly, the value of a short forward contract with delivery
price K is :
f = [K- S0]e^(-rT)
Are forward prices and futures prices equal?

An arbitrage argument can be used to show that when the riskfree interest rate is constant, and the same for all maturities,
the forward and the futures prices for a certain delivery date are
the same.
When interest rates vary unpredictably, forward and futures
prices are no longer the same. If the price of the underlying
asset is strongly positively correlated with interest rates, when
S increases, r increases, and the gain (margin account) is
invested at a higher rate.
61

When S decreases, the investor will incur an immediate loss.
But this loss will tend to be financed at a lower interest rate.
Then the future price should be higher than the forward price.
Conversely, if an asset price S is strongly negatively correlated
with the risk-free interest rate, the forward price should be
higher than the future price.
Despite these points, when maturities are not too far, it is
reasonable to assume that forward and futures prices are the
same.
Proof that forward and futures prices are

equal when interest rates are constant
Suppose that a futures contract lasts for n days and that Fi is
the futures price at the end of day i ( 0 <i < n)
62

Define r as the risk-free rate per day (assumed constant).
Consider the following strategy:
Take a long futures position of e^r at the end of day 0, then
increase long position to e^2r at the end of day 1then
increase long position at the end of day i to hold eîr contracts.
Then the (profit/loss) from the position on day i is:
eîr (Fi Fi-1), Assume that the profit is compounded at the
risk-free rate until the end of the day n. Its value is: eîr x e^r(n
- i)(Fi Fi-1) = (Fi Fi-1)e^nr
The value at the end of day n of the entire investment strategy
is therefore:
Z (Fi Fi-1)e^nr = (Fn F0)e^nr
i=1,n
Because Fn is the same as the terminal asset spot price Sn , the

terminal value of the strategy can be written (Sn F0)e^nr
63

An investment F0 in the risk-free bond combined with the
strategy involving futures just given yields at time n: F0e^rn +
(Sn F0)e^rn = Sn e^rn
No investment is required for all the long futures positions
described. It follows that an amount F0 can be invested to give
an amount Sn e^rn at time n.
Suppose next that the forward price at the end of day 0 is G0.
Investing G0 in a riskless bond and taking a long forward
position of e^nr forward contract also guarantees Sne^nr at
time n
Thus, there are two strategies- one requiring an initial outlay of
F0 , and the other requiring an initial outlay of G0- both of
which yield Sne^nr at time n .
It follows that, in the absence of arbitrage opportunities F0 = G0
. In other words, the futures price and the forward price are
identical.
64

Futures et Forward contracts on currencies
The underlying asset is one unit of foreign currency. S0 is the
current spot price in dollars(1.40) of one unit of foreign
currency (), and F0 is the corresponding forward price.
We note rd the domestic interest rate and rf the foreign riskless
interest rate. The forward price can be written as follows;
F0 = S0e^(rd - rf)T
This comes from the well - known interest rate parity
relationship from international finance.
Suppose that one-year interest rate in the US is 3%, that oneyear interest rate in France is 5%, It follows: F0 = 1.40e^(0.03 0.05)1 = 1.372278 us$ /
65

Assume that the forward exchange rate is 1.35.
1)An arbitrageur can borrow 1000 at an interest rate of 5% for
one year, and this implies a reimbursement of 1000*e^.0.05 =
1051.271, He can convert them in 1400 us $ and invest the
lump sum at 3%, which yields 1400e^0.03 = 1442.636$
2)An arbitrageur can also take a long position on the forward
contract for 1051.271 taking into account the exchange rate of
1.35 = 1419.215 us$
The resulting strategy profit is: 1442.636 1419.215 = 23.4201$
Conversely, if the forward exchange rate is 1.39, an arbitrageur
would have to sell the forward contract and borrow some $.
66

Futures on Commodities.
Storage costs can be treated as negative income. If U is the
present value of all the storage cost, net of income, during the
life of a forward contract, it follows that: F0 = (S0 + U)e^rT
Consider a 1-year futures contract on an investment asset that
provides no income. It costs 2$ per unit to store the asset, with
the payment been made at the end of the year. Assume that the
spot price is $900 per unit and the risk-free rate is 5% per
annum for all maturities. It comes: U = 2e^(-0.05)x1 = 1.90245
us$, and then
F0 = (900 + 1.90245)e^(0.05x1) = 948.1439 us$
If the storage costs, net of income incurred at any time are
proportional to the price of the commodity, they can be treated
as negative yield and: F0 = S0e^(r + u)T
67

Consumption Commodities
For commodity assets arbitrage arguments cannot be used as
extensively as before. Individuals and companies who own a
consumption commodity usally plan to use it in some way.
They are reluctant to sell the commodity in the spot market and
buy forward or futures contracts, because they cannot be
consumed. Therefore F0 <= (S0 + U) e^(rT) or if storage costs U
are expressed as a proportion u of the spot price,the equivalent
result is:
F0 < = S0e^(r + u)T
Convenience Yield
Users of a consumption commodity may feel that ownership of

the physical commodity provide benefits that are not obtained
by holders of futures contracts.
68

For example, an oil refiner is unlikely to regard a futures
contract on crude oil in the same way as crude oil held in
inventory. The crude oil in inventory can be an input to the
refining process, whereas a futures contract cannot be used for
this purpose. Ownership of the physical asset enables a
manufacturer to keep a production process running and
perhaps profit from temporary local shortages.
The benefits from holding the physical asset are sometimes
refferred to as the convenience yield y provided by the
commodity. If the present value of the storage cost is U, y is
defined such that F0e^yT = (S0 + U)e^rT or F0e^yT = (S0)e^(r +
u)T or F0 = S0 e^(r+ u - y)T
In fact, if ( r + u y) < 0 then, quotations of futures prices are
decreasing with maturity.
69

Y reflects the markets expectations concerning the future
availability of the commodity. The greater the probability that
shortages will occur, the higher the convenience yield. If users
of the commodity have high inventories, there is little chance of
shortages in a near future, and the convenience yield y tend to
be low, or near zero.
The cost of carry

The relationship between futures prices and spot prices can be
summarized in terms of the cost of carry, c. This measures the
storage cost plus the interest that is paid to finance the asset
less the income earned on the asset. For a non-dividend-paying
stock, the cost of carry is c = r, for a stock index, it is c = r q
(dividends), for a commodity, it is c = r q + u (storage cost).
70

For an investment asset, the futures price is : F0 = S0e^cT
and for a consumption asset it is, F0 = S0e^(c- y)T where y is
the convenience yield.
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.
71

Options on stock indices
The CAC40 Index was created by SBF in June 1988. At 31/12/87
this index was quoting 1000. It is composed of 40 stocks
belonging to different sectors of activities. Periodically some
newcomers are added, and some others stocks are delisted.
The Cac40 index is quoted every thirty seconds. The CAC40
index futures contract could used to benefit from the arbitrage
cash and carry opportunity. Futures price in equilibrium is
equal to:
F = Ie^(r d)T
with I : spot value of the stock index, d: the amount of
dividends distribution rate until T
72

(F- I)/I = e^(r - d)T
This relationship prevails, because a portfolio including:
1) a long position in stocks replicating the index, financed by a
loan with an interest rate r and
2) the sale of a futures contract,
has a riskless payoff at maturity T. In fact the related cashflows
are presented in the following table.
We are selling the futures contract because its price is
supposed here to be higher than its price under market
equilibrium. In the opposite case, a reverse cash and carry
arbitrage would have been undertaken. This implies to short
sell the stocks, to invest the money in the riskless rate, and buy
a futures contract.
73
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]
74

EXAMPLE: We buy a basket of stocks equivalent to 4250 basis
points or a multiple. The yearly interest rate is supposed to be
5%, the divident pay-out of 2%.
We sell a futures contract quoted 4287 points, dividends
accounting for (0.02x4250x0.25 = 21.25) during a three months
period. Then, it comes:
(4287 4250 + 21.25) / 4250 = 0.0137058 thus on a yearly
continuous basis: RC = mxLn (1 +Rm / m) = 4Ln (1 + 0.01371) =
0.05446%
This rate is higher than 5%. We can then look for the equibrium
price F*such that there will be no arbitrage opportunity, either
cash and carry or reverse cash and carry .
75

Example (Equilibrium price computation)
I0 = 4250; r =5%; d = 2%, T = 3 months

Then it comes for the equilibrium price F :
F = 4250e^[ 0.05 0.02]0.25 = 4281.99
Then basis at time 0 equals 4281.99 4250 = 31.99 and the
adjusted basis is (F I0) / I0 = (0.05 - 0.02)*0.25 = 0.075%
If interest rates and dividends remain constants, then basis
value is reduced linearly towards 0 at maturity (31.99 0).
One can check (4282 4250 + 21.25) / 4250 = 0.012529412 or in
a continuous time on a yearly basis that the implicit interest
rate to the futures contract is equal to the interest rate
prevailing on the spot market t: RC = mxLn (1 +Rm / m) = 4Ln (1 +
0.012529412) ~ 0.05
76

Futures Prices and expected Future Spot Prices
Is the futures price F0 equal to the expected spot price of the
underlying asset at maturity?
For Keynes et Hicks, if hedgers tend to hold short positions
and speculators tend to hold long positions, the futures price
of an asset will be below the expected spot price (the reverse is
true).This is because speculators require compensation for the
risks they are bearing. hedgers will lose money on average, but
they are prepared to accept this because the futures contract
reduces their risks.
When the futures price is below the expected future spot price,
the situation is known as normal backwardation, and when the
futures price is above the expected future spot price, the
situation is known as contango.
77

If hedgers tend to hold long positions while speculators hold
short positions Keynes argues that the futures price will be
above the expected spot price for a similar reason.
The modern approach to explaining the relationship between
futures prices and expected spot prices is based the CAPM risk
return relationship. An investor requires a higher expected
return bor bearing higher systematic risk. It arises from a
correlation between returns from the investment and returns
from the whole market. An investor can accept a lower
expected return that the risk-free rate when the systematic risk
in an investment is negative.
Lets us consider a speculator who takes a long position in a
futures contract that lasts for T years in the hope that the spot
price of the asset will be above the futures price at the end of
the life of the futures contract.
78

We suppose that the speculator puts the present value of the
futures price into a risk-free investment while simultaneously
taking a long futures position. The proceeds of the risk-free
investment are used to buy the asset on the delivery date. The
asset is then immediately sold for its market price. The cashflows to the speculator are as follows:
At time 0 we have F0e^(-rT)
and in T price ST.
The present value in 0 of the investment could be written:
F0e^(- rT) + E(ST)e^(- kT)
Where k is the risk adjusted discounting rate for this
investment. If the market is in equilibrium, we can assume that
all investments in securities markets are priced so that they
have zero net present value. This means :
79

F0e^(- rT) + E(ST)e^(- kT)= 0 Then,
F0 = E(ST)e^(r k)T
As we have just discussed, the returns, investors require on an
investment depend on its systematic risk. If the returns from
this asset are uncorrelated with the stock market, the correct
discount rate to use is the risk-free rate r, so we should set k = r
and we get F0 = E(ST). If the return from the asset is positively
correlated with the stock market, k > r, and then F0 < E(ST).
If the return from the asset is negatively correlated with the
stock market, k < r, and then F0 > E(ST). Thus, the futures price
overstates the expected future spot price.
The equality F0 = E(ST) just holds when the underlying asset is
uncorrelated with the stock market.
80

Hedging Strategies Using Futures
Many of the participants in futures markets are hedgers. Their
aim is to use futures markets to reduce a particular risk they
face. This risk might relate to fluctuations in the price of oil, a
foreign exchange rate, or the level of the stock market.
At this stage, we restrict our attention to what might be termed
hedge-and-forget strategies. We assume that no attempt is
made to adjust the hedge once it has been put in place. Static
hedging instead of dynamic hedging is considered.
We neglect the differences between forward and futures
contracts.
In these settings, Hedging is considered to be perfect if all
uncertainty is completely eradicated.
81

Short hedges
A short hedge is appropriate when the hedger already owns an
asset and expects to sell it at some time in the future.
A short hedge can also be used when an asset is not owned
right now but will be owned at some time in the future.
Assume an oil producer has just negotiated on the 15th of May
(spot price $150 per barrel, forward price $145 end of August)
to sell one million of barrels of crude oil at the end of August
on the NYMEX (New York Mercantile Exchange). The oil
producer is therefore in the position to lock in a price of $145
whatever the evolution of the price at the end of August.
82

To illustrate what might happen, consider the two following
situations:
1) At maturity, suppose ST is $140. The profit of the strategy is
the following: (145-140)x 1000 contracts i.e 5 millions $. This
gain counterbalance the loss encountered on the spot market
and makes sure that each barrel is sold 140 +5 = 145 us$.
2) At maturity, suppose ST is 155 us$. A loss appears on the
future market (155-145)x 1000 contracts, but is counterbalanced
by the sales done on the spot market. In fact each barrel is sold
(155 - 10 = 145us$).
As there is no uncertainty concerning the outcome at the end
of August, the hedge can be considered as perfect, even if in
the second case (ST = 155), it would have been better not to
hedge It is always advisable to speak with the CEO or his
staff before taking a huge hedging position.
83

Long Hedges
A long hedge is appropriate when a company knows it will have
to purchase a certain asset in the future and wants to lock in a
price now.
Suppose we are now January 15, A copper fabricator knows it
will require 100.000 pounds of copper on May 15 to meet a
certain contract. The spot price is now 1.40 us$ per pound, the
futures price for May 15 is 1.2us$ per pound on the COMEX.
Each contract is for the delivery of 25.000 pounds of copper.
Then we need to buy 4 contracts.
Doing this, the buying price is definitevely fixed at 1.20 us$ per
pound at May 15. Long hedges can also be used to manage an
existing short position.
84

To illustrate what might happen, consider the two following
situations:
1) At maturity, the spot price of copper reachs 1.30 us$. We pay
130.000 us$, but we make a profit on the future market, selling
the contracts : 4x25000x(1.3 1.2) = 10000 $, the total cost is
then 120.000 us$.
2) At maturity, the spot price of copper 1.10 us$, a loss is done
on the futures market (1.2 1.1)x25000x4 = 10000$, then the
total cost is equal to 120.000 us$.
We have assumed that there is no daily settlement. In practice,
daily settlement does have a small effect on the performance of
the hedge. Note that usually, hedgers with long positions avoid
any possibility of having to take delivery by closing their
positions before the delivery period.
85

Hedging and shareholders
Most companies have no particular skills or expertise in
predicting variables such as interest rates, exchange rates, and
commodity prices. It makes sense for them to hedge the risks
associated with these variables as they arise.
The companies can then focus on their main activities for
which they do have particular skills and expertise. In pratice
many risks are left unhedged.
Although some think that shareholders can, if they wish, do the
hedging themselves, they have not as much information about
the risks faced by a company as does the companys
management. In most instances this is not the case. But a
shareholder can diversify his stock portfolio among different
firms. If hedging is not the norm in a certain industry, it may not
make sense for one particular company to choose to be
different from all others.
86

A company that does not hedge can expect its profit margins to
be roughly constant, however a company that does hedge can
expect its profit margins to fluctuate!
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.
87

If the asset to be hedged and the asset underlying the futures
contract are the same, the basis should be zero at the
expiration of the futures contract. Prior to expiration, the basis
may be positive or negative. As time passes, the spot price and
the futures price do not necessarily change by the same
amount. As a result, the basis changes.
For a lot of commodities, basis is positive: B0 > 0 and then S0
> F0
For gold or silver or a currency with a low interest rate, the
basis will be negative: B0 < 0 and then S0 < F0
The basis value skrinks when time elapses and when contract
maturity happens. for t=T, basis value is null FT = ST.
Suppose a hedge is initiated in t1 closed out in t2 before the
maturity of the futures contract. The spot and forward prices,
for a maturity T are 30 $ and 27$ in t1 . B1= 3$.
88

At t2, the spot price and the forward price of maturity T are 25$
and 24$, then B2 = 1$.
Consider a hedger, who sells forward contracts in t1, because
he will have to sell the underlying asset in t2 . The spot price of
the asset will be S2 and his gain/loss on the forward market will
be equal to (F1 - F2). Then (F1 - F2) + S2 = B2 + F1
The result is 28$, the value F1 is known since the beginning of
the game, but the level of the basis is on the contrary only
known at the end of the strategy. This is known as the basis
risk.
Note that basis risk can lead to an improvement or a worsening
of a hedgers position. Consider a short hedge. If the basis
increases unexpectedly, the hedgers position improves, if the
basis decreases, the hedgers position worsens.
89

For a consumption asset, The basis risk may be increased by
an absence of equilibrium between the supply and demand
sides, combined with storage difficulties.
For an investment asset (gold, silver, currency) basis risk
stems from the uncertainty concerning the evolution of the
interest rate.
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.
90

At maturity, basis value is 160 - 157 = 3 us$. The price paid per
barrel could be written as the initial futures price plus the basis
value (150 +3 = 153 us$) or as the difference between the spot
price and the profit made on futures contracts [160 (157-150)]
= 153
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.
91

The second term (S2 S2*) describes the correlation risk
existing between the two assets.
We must select a type of contract for which futures prices are
very correlated with the evolution of the prices of the other spot
commodity.
In case of a short position, the profit is higher when basis
broadens, and lower, when basis skrinks
The minimum Variance Hedge ratio

The hegde ratio is the ratio of the size of the position taken in
futures contracts to the size of the exposure. When the asset
underlying the futures contract is the same as the asset being
hedged, it is natural to use a hedge ratio of 1.0.
92

When cross hedging is used, setting the hedge ratio equal to
1.0 is not always optimal. The hedger should choose a value for
the hedge ratio that minimizes the variance of the value of the
hedged position.
We will use the following notation:
S Change in the spot price, S, during a period of time equal to
the life the hedge;
F Change in futures price F, during a period of time equal to
the life of the hedge;
S Standard deviation of S ;
F Standard deviation of F;
P coefficient of correlation between S et F
H* Hedge ratio that minimizes the variance of the hedgers
position.
93

When a hedger possesses a long position on the spot market
and a short position on the futures markets, changes of
strategy value during the hedging period is given by:S HF
for each unit of asset.
For a short spot position and a long hedging position on the
futures markets, it comes: HF - S
In both cases, variance v of the opened position is equal to :
2S + h22F 2hpS F
In order to find the minimum value, we have: v/h = 2h2F
2pS F = 0
Then h2F = pSF and h = p (S / F)
This value minimizes the variance of the strategy, because the
second derivative is positive.
94

The optimal hedge ratio is the product of the coefficient of
correlation between S and F and the ratio of the standard
deviation of S to the standard deviation of F.
When the correlation is perfect (p = 1) This result is expected
when the futures price mirrors the spot price. The optimal
hedge ratio h* is the slope of the best-fit line when S is
regressed against F. If F=2 S and p = 1 the hedge ratio h* is
0.5. This result is expected because the futures price changes
by twice as much as the spot price.
The hedge effectiveness (EC) can be defined as the proportion
of the variance that is eliminated by hedging:
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.
95

Revised number of contracts
Define variables as follows:

Na, Size of position being hedged ( units);
QF , size of one futures contract ( units);
N* revised number of futures contracts for hedging.
The futures contracts should be on h*Na units of the asset. The
number of futures contracts required is therefore given by:
N* = [h*Na / QF]
Example:
An Airline expects to purchase 2 million gallons of jet fuel in a
month and decides to use heating oil futures for hedging. With
the help of historical data we find F=0.0343 and S =0.0290,
and P = (cov(F, S)/ S* F)
96

F(est) = 0.0343 ; S(est) = 0.0290, p = 0.941 then ratio h has for
value 0.941x(0.0290 /0.0343) = 0.79559
Each heating oil contract traded on NYMEX is on 42000 gallons
of heating oil, the revised number of contracts is :
(0.79559x2000000) / 42000 = 37.89 or 38 contracts.
Stock Index Futures

We now move on to consider stock index futures and how they
are used to hedge or manage exposures to equity prices.
If the portfolio P mirrors the index, the optimal hedge ratio h*
equals 1, and if F is the current value of one futures contract,
the number of futures contracts that should be shorted is:
N* = (P / F).
97

Example
Consider a portfolio worth 4.5 million which replicates the
CAC40 index. The index futures price quoted on EURONEXT is
10 times the index. If future stock index value F is 4500 points,
we get P = 4500000 et F = 10x 4500, We have to sell 100
contracts to hedge the position.
But if the portfolio doest not replicate the index, we can take
advantage of its coefficient (CAPM) to find the optimal
hedging strategy. The optimal number of contracts is then
equal to N* = (P/F). This, for sure, doestnt take into account
the basis risk and the marking to maket. Moreover we suppose
that the strategy is closed out at the end of the future contract.
98

Example
The spot price of the CAC40 index is 4500;

Portfolio value is 2 million to hedge during 3 months;
The risk-free rate of interest is 5% per annum;
The proportional pay-out of dividends is 2%;
Portfolio coefficient is 1.5;
The futures contract used to hedge the position is CAC40
futures with a life of 4 months;
The futures contract price is: 4500e^(0.05-0.02)x(4/12) =
4545.18. The number of contracts to sell is 1.5x(2000000 /
4545.2 = 66 contracts.
Suppose the index goes down to 4000 three months later
99

The futures contract becomes : 4000e^(0.05-0.02)x (1/ 12) =
4010.012
Hedging profit is then: 66x(4545.18 4010.012)x10 = 35321.1
The loss on the index is 11.11%, and the pay-out of 2% per
year, means 0.5% during three months. Return is then equal to
-0.1061. Moreover the riskless interest rate is 5% on a yearly
basis, i.e 1.25% for a quater. CAPM relationship could be
written:
E(R) = Rf + (stock indice Rf) i.e 1.25 + 1.5(-10.61 -1.25) =16.54%
The expected value of the portfolio is 2 x(1 - 0.1654) = 1.6692
million , and the terminal value is:1.6692 + 0.35321 = 2.02241
100

The terminal value of the portfolio is then nearly the same that
what would have given by a 3 month investment at the riskless
interest rate. Hedging implies taking no risk, then the return is
the risk-free rate is ~ 2e^(0.05/4) = 2.025millions .
Hedging a stock portfolio could mean try to obtain a
coefficient equal to zero to immunize it for a short period of
time. But as the maturity of the investment is more important
than three months, hedging is only temporary.
Sometimes futures contracts are used to modify portfolio in
order to reduce or increase exposure. In the previous example,
one could sell only 33 contracts to reduce coefficient to 0.75
or buy 66 contracts to reach a = 3.
101

Some exchanges do trade futures contracts on selected
individual stocks, but in most cases a position in an individual
stock can only be hedged using a stock index futures
contract.The number of index futures contracts that the hedger
should short is given by P/F. Note that the hedge provides
protection only against the risk arising from market movements
(systematic risk) and not against non systematic risk.
Sometimes the expiration date of the hedge is later than the
delivery dates of all the futures contracts than can be used. The
hedger must then roll the hedge forward by closing out one
futures contract and taking the same position in a futures
contract with a later delivery date.
This strategy, on n periods, involve N basis risks. (Recall
Metallgesellschaft losses of $1.33 billion).
102

Interest Rate markets
An interest rate in a particular situation defines the amount of
money a borrower promises to pay to the lender. For any given
currency, many different types of interest rates are regularly
quoted.
The interest rate applicable in a situation depends on the credit
risk. The higher the credit risk, the higher the interest rate.
Treasury rates are the rates an investor earns on treasury bills
or Bonds. AA rated Banks buy money at LIBID (London
Interbank Bid Rate) and sell money at LIBOR (London Interbank
Offered Rate).
To be consistent with the normal practice in derivatives
markets, the term risk-free rate should be interpreted as the
LIBOR rate.
103

Interest rates for corporate bonds include some default risk
spreads. Companies rating is important to compute spreads.
Standard & Poors, Moodys use different rating categories :
(AAA, AA, A, BBB, BB, B, C).
Zero Coupon rates

The n-year zero-coupon interest rate is the rate of interest
earned on an investment that starts today and lasts for n years.
All the interest and principal is realized at the end of n years
There no intermediate payment. If the zero coupon rate at 4
years with continuous compounding is 5%, this means that an
investment of 100 will give at the end of the 4th year:
100xe^(0.05x4) = 122,14
104

Bond Pricing
Most bonds pay coupons to the holder periodically. The bonds
principal is paid at the end of its life. We can consider a bond
of 4 years which can be split into a sum of 4 zero coupons
(principal 100, yearly coupon payments 3%).If the zero-coupon
rates are the following (2.7%, 2.9%, 3.1%, 3.2%) we have:
B= 3e^(- 0.027x1) + 3e^(- 0.029x2) + 3e^(- 0.031x3) + 103e^(0.032x4) = 2.9200 + 2.8309 + 2.7335 +90.6248 = 99.109
Bond Yield
A bonds yield is the single discount rate that, when applied to

all cash flows, gives a bond price equal to its market price.
105

Suppose That the theoretical price of the bond we have been
considering, 99.11, is also its market value. If y is the yield on
the bond expressed with continuous compounding, it must be
true that:
3xe^(-yx1) + 3xe^(-yx2) + 3xe^(-yx3) + 103xe^(-yx4) = 99.11
y = 3.28%? (iterative procedure)
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
106

0.97336C + 0.94364C + 0.91119C + 0.87985C +87.985 = 100, then
3.70804 C = 12.015
We get C = 3.2402%, It is the par yield.
More generally, if d is the present value of 1 at maturity of the
bond, A is the value of an annuity that pays one on each
coupon payment date and m is the number of coupon
payments per year, then the par yield C must satisfy:
100 = A [C/m] +100d
So that C = [ m/A]100 (1-d)
In our example, we have: m=1, d = e^(- 0.032x4) = 0.879853 and
A = e^(-0.027x1) + e^(-0.029x2) + e^(-0.031x3) + e^(-0.032x4) =
0.97336 + 0.94364 + 0.91119 + 0.87985 = 3.7080412
107

The formula confirms that the par yield is :
C= [1/3.7080412]x100(1-0.879853) = 3.2402%
Determining Treasury Zero-Rates

One way of determining Treasury zero rates is to observe the
yields on strips. Another way to determine zero rates is from
treasury bills or coupon-bearing bonds. It is the bootstrap
method. Consider the following prices:
Principal maturity annual coupon*

100
0.25
0
100
0.50
0
100
1
0
100
1.50
8
100
2
12
(*coupons paid each semester)
Bond price
97.7
94.7
89.6
95.5
97
108

Because the first three bonds pay no coupon, the zero rates
corresponding to the maturities of these bonds can easily be
calculated. The 3-month bond value is 97.7 , and we get 100
three months later. With quaterly compounding, the 3-month
rate ZC is (2.3x4)/97.7 = 0.09416 par an. The continuous
corresponding rate is equal to:
4ln[1 + (0.09416/4)] = 0.093068
For the 6-month-ZC rate we get, (2x5.3)/94.7 = 0.11193 and
2ln[1 + (0.11193/2)] = 0.10891
For the 1-year-ZC rate, (1x10.4)/89.6 = 0.116071 and
Ln[1+0.116071] = 0.109814
For the next bond, the cash flows are the following: 4 in six
months, 4 in one year, 104 in 18 months.
109

We already know the two first rates for 6 months and 12
months:
4xe^(-0.10891x0.5) + 4xe^(-0.109814 x1) + 104xe^(-Rx1.5)=95.5
104xe^(-Rx1.5) = 95.5 - 3.7880 - 3.5840 =88.128
e^(-Rx1.5) =(88.128 / 104) = 0.847384
R = - ln (0.847384) /1.5 = 0.11040
The same methodology can be applied for the two years bond:
6xe^(-0.10891x0.5) + 6xe^(-0.109814 x1) + 6xe^(-0.11040 x1.5) +
106xe^(-Rx2) = 97
97 - 5.68200 - 5.376004 - 5.00569 = 106xe^(-Rx2) =80.9363
e^(-Rx2) = (80.9363 / 106) = 0.76355
R = - ln (0.76355) / 2 = 0.134888
110

The approach often used by analysts is to interpolate between
the bond price data before it is used to calculate the zero curve.
For example the 9-month ZC rate may be estimated like that :
(0.10891x0.5 + 0.109814 x0.5) = 0.109362
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
111

The forward rate in one year for one year is such that:
e^(0.05x1) x e^(RF) = e^(0.055x 2), do e^(RF) = e ^(0.055x2-0.05)
e^ (RF) = 0.06183
The corresponding continuous rate is: ln (1.06183) = 0.06

the forward interest rate in two years, for one year is:
e^(0.055x2) x e^(RF) = e^(0.06x 3), do e^(RF) = e ^(0.06x3 - 0.055X2)
e^ (RF) = 0.072508
The corresponding continuous rate is: ln (1.072508) = 0.07

In general, if R1 et R2 are the zero coupon rates for maturities T1
and T2, respectively, the forward interest rate RF for the period
of time between T1 et T2 can be written like that:
112

RF = (R2T2 - R1T1) / (T2 T1)
If the zero curve is upward sloping between t1 and t2, then the
forward rate RF> R2, as it is shown below:
RF = R2+ (R2 - R1)[ T1 / (T2 T1)]
Similarly, if the zero curve is downward sloping with R2<R1,
then, we have RF<R2
Derivatives traders tend to use LIBOR rates as a proxies for
risk-free rates when valuing derivatives. One way of extending
the Libor zero curve beyond 12 months is to use Eurodollar
futures. These data are used to produce a Libor zero curve out
to 2 years- and sometimes out as far as 5 years.
The resulting zero curve is sometimes referred to as the LIBOR
zero curve or the swap zero curve.
113

Ri+1 = Fi [(Ti+1 Ti) + Ri Ti] /(Ti+1)
Example: The 360 days ZC continuous Libor rate has been
estimated 4.5%, and with the help of futures contracts, the
forward 90 days rate beginning in 360 days is computed at 5%.
We can then compute the 450 days rate as follows: (0.05x90 +
0.045x360)/450 =0.046
Taking limits as T2 approaches T1, and letting the common
value of the two be T, we obtain : RF = R +T(R/T ) where R is
the zero rate for a maturity of T. This is the forward rate that is
applicable to a very short future time period that begins at time
T. It is the instantaneous forward rate for a maturity of T. Define
P(0,T) as the price of a zero-coupon bond maturing at time T.
Because P(0,T) = e^(-RT) the equation of the instantaneous
forward rate can also be written as: RF=-(/ T)lnP(0,T)
114

Forward Rate Agreements (FRA)
A forward rate agreement is an over-the counter agreement that
a certain interest rate will apply to either borrowing or lending a
certain principal during a specified future period of time.
We will depart from the usual assumption of continuous
compounding and assume that the rates Rk, RF and Rm are all
measured with a compouding frequency reflecting the length of
the period to which they apply.
This means that if T2-T1= 0.5, they are expressed with
semiannual compounding.
115
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%.
116

Let us consider a FRA stating that we receive a rate of 6.5%
(with a quaterly compounding) during three months for the next
three months on a principal of one million .
The forward interest rate is equal to : (0.055x0.5 0.05x0.25)
/0.25 = 0.06 that means with a quaterly compounding 4x( e^[
(0.06/4)]-1) =0.060452
The FRA value is equal to 1000000x(0.0650 - 0.060452)
x0.25xe^(-0.055x0.5) = 1106.158
Day Count Issues, Quotations

The day count defines the way in which interest accrues over
time. The day count convention is usally expressed as X/Y.
117

X: Number of days between dates;
Y: Number of days in reference period
Conventions are (actual / actual), (30/360), (actual / 360) in the
US. The (actual/actual) day count is used for treasury bonds.
The 30/360 day count is used for corporate and municipal
bonds. The actual/360 day count is used for money market
instruments.
Conventions vary from country to country.
The price of money market instruments are sometimes quoted
using a discount rate. This is the interest earned as a
percentage of the final face value rather than as a percentage of
the initial price paid for the instrument.
For bonds, the quoted price, which traders refer to as the clean
price, is not the same as the cash price paid by the purchaser
of the bond, which traders refer to as the dirty price.
118

The Black-Scholes-Merton model
Any variable whose value change over time in an uncertain way
is said to follow a stochastic process.
Learning about the continuous time stochastic process for
stock prices is the first step to understanding the pricing of
options and other derivatives.
A markov process is a particular type of stochastic process
where only the present value of a variable is relevant for
predicting the future.
A wiener process is a particular type of markov stochastic
process .
119

A generalized Wiener process for a variable x can be defined
as: dx =adt +bdz where a and b are constants.
The adt term implies that x has an expected drift rate of a per
unit of time. The bdz term can be regarded as adding noise or
variability to the path followed by x.
The amount of this noise or variability is b times a Wiener
process. In a small time interval t, the change x in the value
of x is given by: x = a t + b t
Where as before has a standard normal distribution. Thus x
has a normal distribution with :
Mean of x: a t, standard deviation x: b t
Thus the general Wiener process given has an expected drift
rate of a and a variance rate of b^2.
120

ITO PROCESS
A further type of stochastic process, known as an Ito process,
can be defined. This is a generalized Wiener process in which
the parameters a and b are functions of the value of the
underlying variable x and time t.
An Ito process can be written as follows:
dx = a (x, t)dt + b(x, t)dz
Both the expected drift rate and variance rate of an It process
are liable to change over time. In a small time interval between t
and t + t, the variable changes from x to x + x where:
x = a (x, t) t + b(x,t) t
121

THE PROCESS FOR A STOCK PRICE
It is tempting to suggest that a stock price follows a
generalized Wiener process, that it has a constant expected
drift rate and a constant variance.
However, this model fails to capture a key aspect of stock
prices. This is that the expected percentage return required by
investors from a stock is independent of the stocks price.
Clearly, the assumption of constant expected drift rate is
inappropriate and needs to be replaced by the assumption that
the expected return (expected drift divided by the stock price)
is constant.
122

If S is the stock price at time t, then the expected drift rate in S
should be assumed to be S for some constant parameter .
This means that in a short interval of time, t, the expected
increase in S is St. If the volatility of the stock price is always
zero, then this model implies that S = St
In the limit as t goes to 0, dS = Sdt or dS/S = dt, then
integrating between time 0 and time T, we get:
ST = S0e^(T)
When the variance is zero, the stock price grows at a
continuously compounded rate of per unit of time.
123

In practice, a stock price does exhibit volatility. A reasonable
assumption is that the variability of the percentage return in a
short period of time, t, is the same regardless of the stock
price.
This suggests that the standard deviation of the change in a
short period of time t should be proportional to the stock
price and leads to the model:
dS = Sdt + Sdz
Or (dS/S) = dt + dz
This equation is the most widely used model of stock price
behavior.
124

ITS LEMMA
The price of a stock option is a function of the underlying
stocks price and time. More generally, we can say that the
price of any derivative is a function of the stochastic variables
underlying the derivative and time.
Suppose that the value of a variable x follows the It process:
dx = a(x,t)dt + b(x, t)dz
Where dz a Wiener process and a and b are functions of x and
t. The variable x has a drift rate of a and a variance of b^2. It
lemma shows that a function G of x and t follows the process:
dG = [(G/x)a + (G/t) + 1/2(2G/x2)b^2 ]dt + (G/x)bdz
125

THE LOGNORMAL PROPERTY
We now use its lemma to derive the process followed by G =
lnS when S follows the process: dS = Sdt + Sdz
G/ S = 1/S ; 2G/ S^2 = - (1/S2) : G / t = 0
It follows that dG = [ - ^2 /2]dt + dz
Since and are constant, this equation indicates that G =lnS
follows a generalized Wiener process. It has a constant drift
rate ( - ^2/2) and constant variance ^2.
The change in lnS between time 0 and some future time T is
therefore normally distributed with mean ( - ^2/2)T and
variance ^2T.
126
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.
127

Derivation of the BSM differential equation
The stock price process we are assuming is this one:
dS = Sdt + Sdz
Suppose that f is the price of a call option on other derivative
contingent on S. The variable f must be some function of S and
t. Hence:
df = [(f/ S) S + (f/ t) + (2f/ S2)^2S^2 ]dt + f/ Sdz
It follows that, by choosing a portfolio including the stock and
the derivative, the Wiener process can be eliminated. The
appropriate portfolio is: - 1(derivative), f/ S shares.
The holder of this portfolio is short one derivative and long an
amount f/ S of shares. Define as the value of the portfolio.
128

Substituting, we obtain:
[ (f/ t) + (2f/ S2)^2S^2 ] t = r(f- (f/ t)S] t (*)
So that
[ (f/ t) + rS(f/ S) + (2f/ S2)^2S^2 ]= rf
This is the Black-Scholes-Merton differential equation. This
particular derivative that is obtained when the equation is
solved depends on the boundary conditions that are used. In
the case of a european call option, the key boundary condition
is: f = max (S K, 0) when t = T ; in case of a european put
option, it is: f = max (K S, 0) when t = T
f = S Ke^[-r(T-t)] for a call option price
Any function f(S,t) that is a solution of equation (*) is the
theoretical price of a derivative that could be traded.
129

RISK-NEUTRAL VALUATION
It is without doubt the single most important tool for the
analysis of derivatives. This property is that the equation does
not involve any variables that are affected by the risk
preferences of investors.
The solutions that are obtained are valid in all worlds, not just
those where investors are risk neutral. When we move from a
risk neutral world to a risk-averse world, two things happen.
The expected growth rate in the stock price changes and the
discount rate that must be used for any payoffs from the
derivative changes. It happens that these two changes always
offset each other exactly.
130

BLACK-SCHOLES PRICING FORMULAS
The B&S formulas for the prices at time 0 of a European call or
put option on a non-dividend-paying stock are:
c = S0 N(D1) Ke^(-rT)N(D2)
And
P = Ke^(-rT)N(- D2) - S0 N(- D1)
Where D1 = [ ln(S0/K) + (r + ^2/2)T] / t
D2 = D1 - t
The function N(x) is the cumulative probability distribution
function for a standardized normal distribution. In other words,
it is the probability that a variable with standard normal
distribution (0,1), will be less than x.
131

Where denotes the expected value in a risk-neutral world.
Then c = e^( - rT) [max (ST K, 0) ]
Another way of deriving the Black and Scholes formulas, is to
use risk-neutral valuation. Consider a european call option. The
expected value of the option at maturity in a risk-neutral world
is: [max (ST K, 0) ]
It can then be written:
c = e^( - rT) [ (S0N(D1)e^(rT) KN(D2) ]
The expression N(D2) is the probability that the option will be
exercised in a risk neutral world, so that KN(D2) is the strike
price times the probability that the strike price will be paid. The
expression S0N(D1)e^(rT) is the expected value of a variable
that is equal to ST if ST > K, and to 0 otherwise.
Cumulative normal Distribution Function
132
N(d) = [ 1 N(d)*(a1k + a2k^2 + a3k^3 + a4k^4 + a5k^5)]

With N(d) = [ 1/ 2 ]e^(-d^2/2)
k = (1/(1+ d)) avec = 0.2316419
a1 = 0.31938153; a2 = - 0.3565637; a3 = 1.7814779;
a4 = -1.821255978; a5 = 1.3302744
EXAMPLE
Suppose a call with a maturity of 7 months: S0 = 40, K = 40, t =
7 months or 0.5833 year, (yearly) = 0.4, with a discontinuous
rate r = ln (1.05) = 0.04879, then we obtain:
d1 = [ln (40/40) + (0.04879 + 0.4 ^2 / 2 )0.5833] / 0.4 0.5833
d2 = = d1 0.4 0.5833
133

d1 = 0.245913
d2 = - 0.059592
This polynomial approximation is correct when - 0.5 <d< 2.95.
With d1, it comes the following numbers k = 0.946106 et N(d1) =
0.597125
With d2, k = 1.014095 and N(d2) =0.476240;then we compute the
call value C = 40x0.597125 40e^(-0.04879x(7/12))*0.476240 =
5.37
For P (Put), we get N(- d1) = 1 N(d1) = 1 0.597125 = 0.402875

N(- d2) = 1 N(d2) = 1 N(d2) = 1 0.476240 = 0.523760
P = - 40x0.402875 + 40e^(-0.04879x0.04879)x 0.523760
P = 4.25
134

The call put parity relationship is the following, : P = C S +
Ke^(-rT)
Then we can check ours previous results P = 5.37 40 + 40e^(0.04879x0.5833) = 4.25
In the B-S-M formula, only one parameter cannot be observed
directly: The stocks volatility. We can infer the implicit volatility
from other market prices by inverting the B-S-M formula or
computing iteratively. The computations are done using
liquid options at the money . A smile effect could be
observed for in the money and out of the money calls.
This smile effect is the consequence of non lognormal
probability distributions of asset prices. Traders allow the
volatility used to price an option to depend on its strike price
and time to maturity.
135

The volatility smile for equity options has been studied by
Rubinstein (1994). The volatility decreases as the strike price
increases.
It comes from the probability distribution of an equity price
which has heavier left tail and less heavy right tail than the
lognormal distribution.
It is called volatility skew . One possible explanation for the
skew in equity options concerns leverage. As a companys
equity declines in value, the companys leverage increases. The
equity then becomes more risky and its volatility increases.
As a companys equity increases in value, leverage decreases.
The equity becomes less risky and its volatility decreases.
This argument shows that we can expect the volatility of equity
to be a decreasing function of price. Another explanation is
crashphobia.
136

For foreign currency options, the volatility smile is U-shaped.
When volatility smiles and volatility term structures are
combined, they produce a volatility surface.
In addition to a volatility smile, traders use a volatility term
structure when pricing options. This means that the volatility
used to price an-at-the-money option depends on the maturity
of the option.
Volatility tends to be an increasing function of maturity when
short-dated volatilities are historically low. This is because
there is then an expectation that volatilities will increase.
Similarly, volatility tends to be an decreasing function of
maturity, when short-dated volatilities are historically high. This
is because there is then an expectation that volatilities will
decrease.
137

Dividends
We assume that the amount and timing of the dividend during
the life of an option can be predicted with certainty. The date on
which the dividend is paid should be considered to be the exdividend date.On this date the stock price declines by the
amount of the dividend.
Consider an european call on a stock quoted 40. Its strike
price K is 40, its maturity 9 months (0.75 year), the riskless
interest rate 0.04879 and the standard deviation 0.4 on a yearly
basis. A 5 dividend will be paid at the end of the third month:
S = 40 5e^(-0.04879x(3/12)) =35.06
Inserting this value in the B&S formula , we obtain C = 3.50.
Without any dividend, the option value would have been 6.15.
The value of the call (put) option is then reduced (increased).
138

Put option P price with a dividend reaches 7 and without any
dividend is 4.71.
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
139

We must note that the derivative of N(d) with respect to x could
be written : [N(d)]/ x = Z(d)[d/x] and that the gamma
coefficient is: Cs / S = Z(d1)x[ 1/ ST ]. It is the change rate of
the delta coefficient .
A call option price is then an increasing function of S, , r, T,
and a decreasing value of its strike price.
For a put option P, it comes:
1 Ps = Cs 1 < 0 (coefficient )
2 PE = CE +e^(- rT) > 0
3 P = C >0
4 Pr = Cr TKe^(- rT) <0
5 PT = CT rKe^(rT) ><0
140

A put option price is then an increasing function of K, , T, and
a decreasing value of S and r.
Hedging with options
Coefficient (Cs = N(d1) >0) is important for hedging. Some
traders manage their portfolios in disturbed periods with a
neutral position. The delta() of a stock is one. A position
combining short and long position is said to be delta neutral. If
=0 for only a short period of time, the hedge is perfect. But the
hedge has to be adjusted periodically. This is known as
rebalancing. So we can have dynamic hedging scheme, or
static hedging schemes if the hedge is set up initially and never
adjusted.
(put) =N(D1) -1, Delta is negative, which means that a long
position in a put should be hedged with a long position in the
underlying stock.
141

For european call options written on an asset paying some
dividend or coupon q, we obtain: = e^(- qT) N(d1)
For a put option, it comes = e^(- qT) [ N(d1) -1]
To achieve a delta neutral position, the delta coefficient of a
forward contract e^(r-q)T is to be multiplied by HA, where HA is
the required position in asset for delta hedging
Delta coefficient of a plain vanilla forward contract which
value is (S0 Ke^(- rT)) is always equal to one. This means that
a short position on a forward contract could be covered by the
purchase of a stock.
Note that marking to market makes the deltas of futures and
forward contracts slightly different.
142

Delta coefficient () of an option portfolio (P/ S) could be
estimated with the help of each individual delta coefficient of
every option included in the portfolio.
If a portfolio is built with n different options, option i
representing proportion i of the total amount invested, with i
(1 < i < n), global portfolio delta could be estlmated as follows:
= i i
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.
143

Portfolio insurance
A portfolio manager is often interested in acquiring a put option
on his portfolio. This provides protection against market
declines while preserving the potential for a gain if the market
does well.
Creating an option synthetically involves maintaining a position
in the undelying asset so that the delta of the position is equal
to the delta of the required option. The position necessary to
create an option synthetically is the reverse of that necessary
to hedge it.
It may be more attractive for the portfolio manager to create the
required put option synthetically, because first options markets
do not have always the liquidity to absorb the trades required
by managers, second, fund managers may require strike prices
and exercise dates that are different from those available in
exchange-traded markets.
144

The synthetic option can be created from trading the portfolio,
or from trading in index futures contracts. The portfolio
manager is going to sell a fraction of the portfolio: e^(qT)[N(d1)-1], and invest it immediately at the riskless interest
rate. If the stock value increases, riskless assets will be sold,
and some more stocks purchased. Hedging costs stem from
successive purchases and sales.
EXAMPLE
A portfolio is worth 90 millions. To protect against market
downturns the manager of the portfolio,requires a 6-month
European put option with a strike price of 87 million . The
risk-free rate is 9% per annum, the dividend yield is 3% and
volatility 25% per annum. The S&P500 index stands at 900.
145

As the portfolio is considered to mimic the S&P500, one
alternative is to buy 1000 put option contracts on the S&P500
with a strike price of 870. Another alternative is to create the
required option synthetically. In this case S0 = $90 million, K =
87 million r = 0.09, q = 0.03, = 0.25 et T = 0.5, then:
d1 = [ln (90/87) + (0.09 - 0.03 +0.25 ^2 / 2 )0.5] / 0.25 0.5 =0.4499
And the delta of the required option is:
= e^(- qT [ N(d1) -1] =-0.3215
This shows that 32.15% of the portfolio should be sold initially
to match the delta coefficient of the required option. The
amount of the portfolio sold must be monitored frequently. For
example, if the value of the portfolio reduces to $88 million, the
of the required option changes to -0.3679 and a further 4.64%
of the original portfolio should be sold.
146

If the value of the portfolio increases to $92 million, the delta of
the required option change to -0.2787, and 4.28% of the
original portfolio should be repurchased.
Using index futures to create options synthetically can be
preferable to using the underlying stocks because the
transaction costs associated with trades in index futures are
generally lower than those associated with the corresponding
trades in the underlying stocks.
Portfolio insurance strategies have the potential effect to
increase volatility. When the market declines, they cause the
portfolios managers, either to sell stock or to sell index futures
contracts. Either action may accentuate the decline. When the
market rises, portfolio insurance strategies cause the manager
either to buy stock or to buy futures contracts. This may
accentuate the rise and volatility.
147

Concluding comments
The derivatives market is a vast multitrillion dollar market that
by most measures has been outstandingly successful and has
served the needs of its users well. Nevertheless, some huge
losses at Daiwa, Shell, Sumitomo, Barings, Socit Generale
happened, but were often the result of the activities of a single
individual.
The losses should not be viewed as an indictment on the whole
derivatives industry. But it is essential that all companies
define in a clear and unambiguous way , limits to the financials
risks than can be taken. They should set up procedures for
ensuring that the limits are obeyed. Ideally overall risk limits
should be set at board level.
148

Daily reports should indicate the gain or loss that will be
experienced for particular movements in market variables. It is
tempting to ignore risk violations of risk limits when profits
result. However, this is shortsighted. The classic example here
is Orange county!!!
The key lesson to be learned from the losses is the importance
of internal controls. Management should issue a clear an
unambiguous policy statement about how derivatives are to be
used and the extent to which it is permissible for employees to
take positions on movements on market variables.
Management should then institute controls to ensure that the
policy is carried out.
149

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Actifs Drivs et Obligataires

PUT-CALL parity relationship

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Mechanics of Futures Markets

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