Outline

Interest Calculation Basics

Session 2 Types of Interest Rates
Simple interest, Discrete Compounding, Continuous Compounding
Forward Rates
Forward Rate Agreements
Nadima El-Hassan
Forwards and Futures
Preliminaries
School of Finance and Economics Uses
University of Technology, Payoffs
Trading Strategies
Sydney.
Forward/Futures Prices
Valuation
March 2010 Hedging

Reference. Hul.J.C.l, Futures, Options and other Derivatives. Chapter 2, 3, 4, 5

1 2

Interest Rates Interest Rates

Interest is a payment given by the borrower of funds to the lender as a fee

Interest: defined as the time value of money
in financial market, it is the price for credit determined by demand
and supply of credit
A factor in the valuation of virtually all derivatives
Summarizes the returns over the different time periods
Useful comparing investments and scales the initial amount
Different markets use different measures in terms of year, month,
week, day.
for the use of funds, and to compensate for factors such as:
Economic Risk: inflation, economic or political shock
Credit Risk: risk of default.
Market Risk: capital gains/losses when interest rates fluctuate.
The interest is usually quoted as a percentage of the principal, and the
market convention is to annualise all interest rates.
The interest rates for most fixed income instruments are either quoted as
simple interest rates or as compound interest rates.

Compound interest rates can be discretely compounded (which is usually the

case in practice) or continuously compounded (which is a useful
mathematical idealisation).
3 4
 Types of Interest Rates Types of Interest Rates: Treasury Rates

Treasury rates Treasury Rates:

LIBOR rates interest rates applied to Treasury bills and Treasury bonds;
Repo rates usually assumed to be (credit) risk-free (no chance Government will
default on an obligation in its own currency);
Not market risk-free;
Investor in Treasury bills or Treasury bonds is certain to receive the
promised coupon and principal;
Used to price Treasury bonds;
Not always used by traders as risk-free rates LIBOR used instead.
See http://www.rba.gov.au/statistics/tables/xls/f16.xls

5 6

Types of Interest Rates: Bond Yields Types of Interest Rates: Bond Yields

Australian long-term bond yields

Australian yield spread

Spread between 10-year bond yield and monetary policy rate.

7 8
 Types of Interest Rates: LIBOR Types of Interest Rates: LIBOR

Example of LIBOR rates (as of 12/3/2010) for some currencies.

LIBOR: London Interbank Offer Rate
interest rates at which financial institutions (FI) are willing to lend funds to USD EUR GBP JPY CHF CAD AUD NZD
other FI; O/N LIBOR 0.18656 0.27875 0.53500 0.11625 0.04833 0.25000 3.97250 2.65750
The FI borrowing at LIBOR must have AA credit rating; 1 Week
0.21000 0.30625 0.53188 0.13000 0.06000 0.26833 4.02250 2.70250
LIBOR
Quoted in all major currencies for maturities upto 12months; 2 Week
0.22000 0.32625 0.53250 0.14000 0.07000 0.28833 4.05000 2.72250
LIBOR
Used as short-term risk-free rate by traders in FI. Typically regarded as the 1 Month
0.23000 0.37625 0.54250 0.15625 0.09167 0.30000 4.09500 2.75750
opportunity cost of capital by traders. LIBOR
2 Month
0.24138 0.45938 0.57250 0.19250 0.16500 0.35000 4.20375 2.80000
More accurate as a proxy short-term borrowing rate of a AA-rated company LIBOR
3 Month
but not totally risk-free. (Treasury rates considered too low). LIBOR
0.25719 0.59438 0.64438 0.24813 0.25000 0.39833 4.29750 2.85000
4 Month
0.29231 0.70313 0.71563 0.33000 0.27167 0.49833 4.38500 2.90000
LIBOR
5 Month
0.33250 0.79625 0.79188 0.38375 0.29833 0.59833 4.48250 2.95000
LIBOR
6 Month
0.39781 0.90688 0.86938 0.45000 0.33417 0.70000 4.60750 3.03750
LIBOR

9 10

Types of Interest Rates: REPO Rate Types of Interest Rates: Zero Rate

REPO: interest rate associated with a repurchase agreement Zero Rate: the interest rate associated with zero coupon bonds.
Also know as a spot rate or pure discount rate;
A repurchase agreements is a contract where an investment dealer
who owns securities agrees to sell them to another company now It is the interest rate applicable on an instrument which pays no coupon
and details the exchange of a cash flow today for another (larger) cash
(Psell) and buys them back at a slightly higher price (Pbuy) .
flow at a future date.
Need to preserve compounding convention when pricing with zero.
Interest earned is (Psell Pbuy) Zero bonds are issued by the US Treasury STRIPS (Separate Trading of
registered Interest and Principal Securities ).
Rate at which central banks repurchase Government securities from
commercial banks. Maturity Zero Rate
(years) (% cont comp)
0.5 5.0
Overnight repo, term repos 1.0 5.8
1.5 6.4
2.0 6.8
11 12
 Types of Interest Rates: Discount Factor
Coupon versus zero-coupon bonds
Discount Factor = dt = present value of $1 to be received at time t.
A hypothetical two-year 12% coupon bond, and a hypothetical two-year
zero coupon bond:
1
dt
1 rt
t 0.5 1 1.5 2

Coupon Bond: 6 6 6 106

Zero Coupon Bond 100
Any interest rate convention can be applied (continuous, annual, semi-
annual).
Discount Factors can be used to compute the present value of any cash
A coupon bond is a portfolio of zero coupon bonds. flow.
Use the notation (c1; t1); (c2; t2); . . . ; (cN; tN) to denote a bond with N
cashflows

13 14

Types of Interest Rates: Yield-

Yield-to-
to-Maturity Treasury Rates:
Indicative Mid-Rates of Commonwealth Government Securities
Yield to maturity (or simply, yield) on an investment is defined as
the constant rate of interest that makes the present value of its Coupon Maturity 16-Mar-2010 19-Feb-2010
cash flows equal to its market price. 5.25% 15-Aug-10 4.235% 4.085%
5.75% 15-Jun-11 4.445% 4.300%
For securities with multiple cash flows, this implies that the same 5.75% 15-Apr-12 4.850% 4.660%
rate is applied to discount all the cash flows. 4.75% 15-Nov-12 5.035% 4.835%
6.50% 15-May-13 5.095% 4.930%
For discount instruments such as bills, the yield is the actual rate of 6.25% 15-Jun-14 5.285% 5.150%
return they provide. This is not necessarily the same as the quoted 6.25% 15-Apr-15 5.370% 5.250%
rate (e.g., US bills). As we will see, however, this is not necessarily 6.00% 15-Feb-17 5.500% 5.440%
the case for coupon instruments. 5.25% 15-Mar-19 5.580% 5.560%
4.50% 15-Apr-20 5.630% 5.625%
5.75% 15-May-21 5.660% 5.670%

15 16
 Types of Interest Rates: Par Yield Types of Interest Rates: Forward Rate

Par Yield: this interest rate that causes the prices on a coupon paying The forward rate: is the future zero rate implied by todays zero or spot
security to equal its face value. rates (or the term structure of interest rates).

It is the rate which is applicable on a loan commencing its term in the future
but which is agreed upon today.

17 18

Simple Interest
Future Values and Present Value Calculations

Future Value - Amount to which an investment will grow after
earning interest.
Compound Interest - Interest earned on interest.
The interest rates quoted on most pure discount instruments and short
term borrowing and lending are simple interest rates.
A simple interest rate expresses the interest amount paid at the maturity of
an investment as a percentage of the principal, per annum.

Simple Interest - Interest earned only on the original investment. F

F = P(1+rt) P=
(1+rt)
Interest Calculation: Notation
P = the principal;
r = interest rate (annualised); F -1

P 1 F-P
t = the maturity in years;
r= =
F = the face value of the investment at time t t t P

19 20
 Future Values: Simple Interest
Simple Interest : Exercise
Example
Interest earned at a rate of 6% for five years on a principal balance of
$100. Consider a 3 month Treasury bill with face value $100,000.
a. This bill is trading at $98,704.50, then what will be the quoted rate in
Today Future Years the market?
1 2 3 4 5 b. Now assume that the bill matured in 2 months time rather than in 3
months. Determine the quoted rate.
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130
(Note: Treasury bills are priced using simple interest convention).

Value at the end of Year 5 = $130

Ft 1 P(1 r1 ) at t 1 If the rate of interest is constant

Ft 2 P(1 r1 r2 ) at t 2 every period, the amount of interest
earned on the investment is the same
very period. 21 22

Compound Interest
Simple Interest : Exercise 1
Consider a 3 month Treasury bill with face value $100,000. This bill is The interest rates quoted on most long term fixed income instruments are
trading at $98,704.50, then what will be the quoted rate in the market? compound interest rates.
(Note: Treasury bills are priced using simple interest convention). Compound interest rates usually apply to investments where there are
periodic interest payments and each interest payment is reinvested at the
1 F P same rate until maturity.
r
t P
1 100000 98704.50
5.25%p.a Notation:
(3/12) 98704.50 F is the future value or sum;
P is the present value or price;
So the 3 month treasury bill rate will be quoted as 5:25% (per annum). r is the interest rate per annum;
If the bill matured in 2 months time rather than in 3 months, then the k is the number of compounds per year;
t is investment horizon in years.
quoted rate would be
1 100000 98704.50
r 7.875% p.a
(2 /12) 98704.50

23 24
 Compound Interest: Discrete Compounding Compounding Frequency

kt Compounding frequency defines the units in which an interest rate is

r Compounding
F P 1 measured.
k
Possible to convert a rate with one compounding frequency into another
compounding frequency.
kt Annual: k=1
F r
P kt
F 1 Discounting Semiannual: k=2
r k
1 Quarterly : k=4
k
Daily: k =365

1

F kt
r 1 k
P Return (or interest rate)

25 26

Future Value
Multiple Cashflows
Example
Determine the future value of a $1000 investment for three years at an Suppose there are cashflows (c1; t1); , (cN; tN). Assume constant interest rate
interest rate of 15% p.a. with monthly compounding. across all maturities , r, the:
y = 0.15, T = 3, m =12, n = 36
N k (T ti )
Ci N
r
P kt F Ci 1
0.15
36
i1 ri i1 k
FV 1000 1

$1563.94
12 1
k
Discounting Compounding

Interest Paid Monthly Quarterly Semi-annual Annual BUT we have an entire yield curve, with different r for different t. Not accurate to
m discount all future cashflows at the same rate.

N
Ci
Future Value 1563.94 1555.45 1543.30 1520.88
P
($) kti
i 1 ri
1
k
27 28
 Compound Interest : Future Value
Compound Interest: Example
Example - Compound Interest Consider a term deposit of $10, 000 with maturity 1 year. If the deposit
Interest earned at a rate of 6% for five years on the previous years earns quarterly compounded interest at 5.00% per annum, and the
balance. interest payments are rolled over until maturity, then what will be the
total value of the deposit at maturity?

Today Future Year

The compounding period =0.25 years and there are n = 4 periods. So,
1 2 3 4 5 the total value of the deposit at maturity will be
Interest Earned 6.00 6.36 6.74 7.15 7.57 41
0.05
Value 100 106.00 112.36 119.10 126.25 133.82 F 100001 $10,549.45
4

Value at the end of Year 5 = $133.82

The interest accrued over the year is $509.45.

29 30

Compound Interest: Exercise Compound Interest: Exercise

Now consider a term deposit of $10, 000 but with maturity of 2 years. If Now consider a term deposit of $10, 000 but with maturity of 2 years. If
the deposit earns quarterly compounded interest at 5.00% per annum, the deposit earns quarterly compounded interest at 5.00% per annum, and
and the interest payments are rolled over until maturity, then what will the interest payments are rolled over until maturity, then what will be the
be the total value of the deposit at maturity? total value of the deposit at maturity?

The compounding period =0.25 years and there are n = 8 periods. So, the
total value of the deposit at maturity will be
42
0.05
F 100001 $11,044.86
4
Note that the accrued interest over two years is $1018.90 which is more
than twice the interest accrued over one year. (WHY?)

2 509.45 $1018.90

31 32
 Simple versus Compound Interest Rates Converting between discrete compounding frequencies:

Linear growth and Geometric growth The k-times compounded rate, rk, can be converted to the equivalent m-
times compounded rate, rm , by rearranging the equation
1200

1000
k m
rk rm
800 1 1
k m
Value

600

400 k

rk m
rm 1 1 m
200
k
0
0 2 4 6 8 10 12 14 16 18 20
Years
Simple Interest
Compound Interest

33 34

Converting between discrete compounding frequencies: Continuous Compounding:

Exercise

For the quarterly compounded 5% term deposit in the previous Value of $10,000 after one year at 5% Equivalent Interest rates
exercise, what are the equivalent monthly and daily compound rates 10514.00 5.02%

that give the same value at the end of the year 10512.00 5.00%

Equivalent interest rate

10510.00 4.98%

Final value
10508.00 4.96%
k m
rk rm 4.94%

1 1
10506.00

10504.00 4.92%

k m 10502.00 4.90%

10500.00 4.88%

10498.00 4.86%
0 100 200 300 400 0 100 200 300 400
Compounding frequency Compounding frequency

As the frequency of compounding increases toward infinity, the limiting

rate, rcc as is called the continuously compounded rate.

35 36
 Continuous Compounding: Converting between discrete and continuous compounding

kt
Denote
r
Using: lim 1 e rt
rcc : the continuously compounded rate
k
k

rk: same rate with compounding k times per year

Under continuous compounding, the principal and future values are To determine the equivalent discretely compounded interest rate for a
related by: given continuously compounded rate use the following idea: $1
invested at either rate, for a give horizon, should yield the same future
value
F Pe rt
P F e rt

F
ln
r
P For practical purposes: continuous

e = 2.71828
t compounding can be thought of as
equivalent to daily compounding.

37 38

Converting between discrete and continuous compounding

Compound Interest: Example
Denote
rcc : the continuously compounded rate For the quarterly compounded 5% term deposit in the previous
rk: same rate with compounding k times per year exercise, what is the equivalent continuously compounded rate?

IDEA: If rcc is equivalent to rk , then $1 invested with discrete compounding

4
should give the same future value as $1 invested with continuous 0.05 0.05
rcc ln1 4 ln1 4.96901%
compounding. Assume t = 1. 4 4

k
r
P 1 k Pe rcc
k
1
rcc
rk ( e rcc ) k 1 k e k 1 k

k
r r
rcc ln 1 k k ln 1 k
k k
39 40
Present and Future Values: Summary
Forward Rates

F
Simple Interest: F P 1 rt ; P DEFINITION: the interest rate today that will be paid on funds to
1 rt
be
borrowed at some specific future date and
kt
r F
Discrete Compounding: F P 1 ;
to be repaid at a specific more distant future date
P kt
k 1 r

k

Continuous Compounding: F Pe ; rt
P Fe rt

41 42

Forward Rates
Let t < T. Then the t to T forward rate, ft,T is the interest rate that applies
over the interval [t, T], usually given as a simple interest rate. However,
can be calculated with any compounding frequency.
In general, ft,T will be referred to as the discrete forward rates, or simply
forward rates.
An example of discrete forward rates are the LIBORs.
The length of time, T-t, over which the forward rate ft,T applies is called
the tenor of the forward rate, and ft,T is often referred to as the (T t)-
forward rate, eg. 90-day forward rate, 180-day forward rate, etc.
Breakeven principle: forward rates must be arbitrage-free, giving the same
holding period return from fixed rate / reinvestment strategies
Forward Rates
1. Zero coupon rates (or the spot curve) contains explicit information about
the expected level of rates in the future.
1. Thus, the expectation in the spot yield curve can be used to derive the
forward rates that give rise to equilibrium between the supply and demand
for different securities.
2. Deriving forward rates from spot rates involves an underlying assumption
that securities with the same risk class are perfect substitutes for each
other.
3. This method can be used to find the forward interest rate for any maturity,
though care must be taken in the compounding convention used. The only
rates required are the short and long term maturity zero-coupon rates
bracketing the forward rate.

43 44
 Forward Rates Forward Rates
Example If the 90-to-120 day forward rate is quoted as 4.20%and the yield on a
90-day bill is 4.15%, then what is the price of a 120-day bill with face value $100, Notation:
000. Assume that the rates and the bills are for the Australian market.
rT = the spot rate applicable on an investment maturing in T years
(as a decimal per annum);
The 90 to 120 day forward rate allows us to discount the bill back t = 90/365 and
the yield on the 90 day bill allows us to discount over the remaining interval. f T1 ,T 2 = the forward rate applicable on an investment starting in T years from now and
1
maturing in T years from now.; ie the forward rate over the period [T 1,T]

rT

rT2

90 days 120 days

0
4.15% 4.20% T1 T2
0

rT1 f T1 ,T 2

45 46

Calculation of Forward Rates

Calculation of Forward Rates

For continuously compounded interest rates:

Zero Rate for 1-yr Forward Rate
r T f T2 -T1
Year (n) maturity n -year.
(% p.a.)
for n th year.
(% p.a.)
e rTT2 =e T1 1 e T1 ,T2
r T +fT1 ,T2 T2 -T1
1 10.0 e rTT2 =e T1 1 Using Laws of Exponent
2 10.5 11.0
3 11.8 14.4 Taking natural logs across the equation gives:
4 11.0 8.6
5 11.1 11.5 rT2 T2 =rT1 T1 +f T1 ,T2 T2 -T1

Assume: continuous compounding rT2 T2 -rT1 T1

Hence: f T1 ,T2 =
T2 -T1

47 48
 Calculation of Forward Rates
Calculation of Forward Rates
Suppose that the spot rate of interest on a one-year instrument is 6.00% and
For discretely compounded interest rates with k compounding rates.: the spot rate of interest on a two year instrument is 7.50%. If we were to
contract to purchase a one-year instrument one year from now, what rate of
kT kT kT2 T1
rT2
2
rT1 fT1,T2
1
interest should we expect for this instrument?
1
k k 1 k
1
This rate should render the investor indifferent between purchasing a two
year instrument today and holding a it to maturity; or purchasing a one-year
1
instrument today and entering into a forward contract to purchase a one-
1 rT2 k T2 T1
kT2

year instrument one-year from now.
k
fT1 ,T2 1 k
Hence: kT1

1 rT1
k

Need use the discrete compounding method when you calculate

forward rates for money market instruments like LIBOR term
deposits
49 50

Forward Rate Agreements

Forward Rate Agreements
A forward rate agreement, or FRA, is an agreement to pay or receive interest on a
A forward rate agreement (FRA) is an agreement that a certain rate will certain principal, P, at a certain rate, rX, over a specified future time period [T1, T2].
apply to a certain principal during a given future time period.

An FRA is equivalent to an agreement where interest at a predetermined

rate, rK is exchanged for interest at the market rate.

An FRA can be valued by assuming that the forward interest rate is

certain to be realized.
A FRA is essentially a forward contract on an interest rate, and provides another
way for locking in a rate for forward deposit or loan.
Forward rate agreement (FRA): OTC contract that allows the user to
"lock in" the current forward rate. As with other forward contracts, the FRA rate is set so that it does not advantage
either party when the contract is initiated.

51 52
 Forward Rate Agreements Forward Rate Agreements
Assume: f T1 ,T2 = forward rate over the period [T1, T2], given as a simple
The FRA rate is the T1-to-T2 forward rate according to the current market
interest rate.
conditions, ignoring the margins imposed by financial institutions etc.

Note then that according to the current market conditions, f T1 ,T2 is the rate at
Market convention is to quote the FRA rate, rX, as a simple interest rate. which a forward deposit or loan can be locked in over the period [T1, T2].

FRAs are cash settled, so that only the difference between the interest Now, as with other forward contracts, the value of a FRA is the defined to be
computed at the FRA rate and the (T2 T1)-maturity rate at time T1 is paid or the present value of the payoff resulting from closing out the position.
received on the settlement date.

FRAs may be settled at the beginning of the interval [T1, T2] (in advance), or
the end (in arrears).

If a FRA is settled in advance, then the interest difference is discounted to

time, T1 using the (T2 T1)- maturity rate at time T1.

53 54

Forward Rate Agreements: Valuation Forward Rate Agreements: Valuation

Consider an FRA that is settled in ADVANCE. Then the payoff occurs at time
Consider firstly a FRA that is settled in ARREARS. Then the payoff occurs at
T1, and the payoff for the party that has agreed to receive at the FRA rate is
time T2, and the payoff for the party that has agreed to receive at the FRA rate is

Payoff T2 Prx T2 -T1 -Pf T1 ,T2 T2 -T1 Prx T2 T1 P fT1 ,T2 T2 T1

Payoff T1
1 fT1 ,T2 T2 T1
=P rx -f T1 ,T2 T2 -T1
P rx fT1 ,T2 T2 T1

1 fT1 ,T2 T2 T1
If r2 is the continuously compounded T2-maturity rate, then discounting this
payoff gives the value of the FRA, settled in arrears, as

If r1 is the continuously compounded T1-maturity rate, then the value of the

V0 =e-r2T2 P rx -f T1 ,T2 T2 -T1 FRA, settled in advance, is

P rx fT1 ,T2 T2 T1
V0 e r1T1
1 fT1 ,T2 T2 T1
55 56
 FRA: Example 1 FRA: Example 1
Example Suppose an investor wishes to make a 30-to-60 day forward deposit of The total amount for deposit in 30 days time is hence
$1,000,000.
If the current 30-to-60 day FRA rate is 4.25%, then explain how the investor can
achieve the required forward deposit at the rate 4.25%.

Assume that the FRA is settled in advance.

Investing this amount at the market rate, r30d,60d, over the 30-to-60 day period gives
Since the investor requires a forward deposit, the investor should enter the FRA the final value
contract at time t = 0 to receive at the FRA rate.

Since the FRA is settled in advance, the payoff from the FRA for the investor in 30 which is the value of $1, 000, 000 invested at 4.25% over this interval.
days time is
It should be noted that this value is independent of the market rate r30d,60d.
Note that if r30d,60d < 4.25%, then I* > 0 and the FRA payoff compensates for the lower
interest rate.
Conversely, if r30d,60d > 4.25%, then I* < 0 and the investor would have been better off
without the FRA position. However, as with other hedge positions, the aim is to lock in
a future value of an investment rather than to make profit

57 58

FRA: Example 2 FRA: Example 2

Example: Suppose an investor has entered into a 30-to-60 day FRA on the notional Since the value of the FRA is the discounted payoff
principal of $1, 000, 000 to receive rX = 4.25% in advance. If after 15 days, the 15-
day bill rate is 4.20% and the 45-day bill rate is 4.35%, then what is the value of the
FRA at this time?

We must first compute the 15-to-45 day rate. The forward rate is

and so the FRA represents a loss of $136.84.

59 60
 Why use forwards/futures

Forwards and Futures To hedge risks

To speculate (take a view on the future direction of the market)
Preliminaries To lock in an arbitrage profit
Forwards : definition, cashflows, payoffs To change the nature of an investment without incurring the costs of
Futures selling one portfolio and buying another
Forwards vs Futures

61 62

Forward Contracts Forward Contracts

A forward contract is an OTC agreement which specifies a future delivery of A Contract whereby parties are committed:
a financial asset in the future on a known date for a price contracted today. to buy (sell)
Its not an option: both parties are expected to transact under the agreement. an underlying asset
at some future date (maturity)
It can be contrasted with a spot contract which is an agreement to buy or sell at a delivery price (forward price) set in advance
immediately
Buying forward = LONG position
The forward price for a contract is the delivery price that would be Selling forward = SHORT position
applicable to the contract if it were negotiated today (i.e., it is the When contract initiated: No cash flow
delivery price that would make the contract worth exactly zero) Obligation to transact

The forward price may be different for contracts of different maturities

63 64
 Forward Contracts: Example Forward Contracts: Cash Flows

A Underlying asset: Gold Assume the following notation:

Spot price: $980 / troy ounce
Maturity: 6-month ST = Price of underlying asset at maturity
Size of contract: 100 troy ounces (2,835 grams) Ft = Forward price (delivery price) set at time t<T
Forward price: $1000 / troy ounce
Initiation Maturity

Profit/Loass at Maturity
Long 0 ST Ft
Spot Price 960 980 1000 1020 1040 Short 0 Ft S T
Buyer (Long) -4000 -2000 0 2000 4000
Seller (Short) 4000 2000 0 -2000 -4000
Initial cash flow = 0 :delivery price equals forward price.
Credit risk during the whole life of forward contract.

65 66

Profit from a long Forward Position

Profit from a Short Forward Position

Profit
Profit

K Price of Underlying at Maturity, ST

K Price of Underlying at Maturity, ST

67 68
Forward contract: Locking in the result before maturity Futures contract: Definition

Standardized forward contract with daily settlement of gains and losses.

Enter a new forward contract in opposite direction. Forward contract
Eg: at time t1 : long forward at forward price F1 Buy : LONG
At time t2 (<T): short forward at new forward price F2 Sell : SHORT

Gain/loss at maturity :
Standardized:
Maturity, Face value of contract
(ST - F1) + (F2 - ST ) = F2 - F1 no remaining uncertainty Example: Gold future: Trading unit: 100 troy ounces (2,835 grams)
Traded on an organized exchange
Clearing house
Daily settlement of gains and losses: (Marked to market)

69 70

Example of ASX Futures Contracts Futures: Daily settlement and the clearing house

ASX SPI 200 Index Futures In a forward contract:

30 Day Interbank Cash Rate Futures Buyer and seller face each other during the life of the contract
3 Year Commonwealth Treasury Bond Futures Gains and losses are realized when the contract expires
10 Year Commonwealth Treasury Bond Futures Credit risk: BUYER <> SELLER

3 Year Interest Rate Swap Futures

In a futures contract
10 Year Interest Rate Swap Futures
Gains and losses are realized daily (Marking to market)
d-cypha SFE Base Load, Peak Period and Strip Electricity
The clearing house (CH) guarantees contract performance:
Fine Wool Futures steps in to take a position opposite each party.
Greasy Wool Futures
Broad Wool Futures BUYER <> CH <> SELLER
MLA/SFE Cattle Futures

71 72
 Trading Strategies
Futures: Margin requirements
Speculation -
INITIAL MARGIN : deposited into a margin account short - believe price will fall
MAINTENANCE MARGIN : minimum level of the margin account long - believe price will rise
MARKING TO MARKET : balance in margin account adjusted daily
Hedging -
LONG (buyer): + {Size of contract * (Ft+1 -Ft)} A long futures hedge is appropriate when you know you will purchase
SHORT (seller): {Size of contract * (Ft+1 -Ft)} an asset in the future and want to lock in the price
long hedge - protecting against a rise in price

Equivalent to writing a new futures contract every day at new futures price
(Remember how to close position on a forward) A short futures hedge is appropriate when you know you will sell an
asset in the future and want to lock in the price
Note: timing of cash flows different
short hedge - protecting against a fall in price

Long position: benefit from a rise in the price of the underlying asset.
Short position: benefit from a fall in the price of the underlying asset.
73 74

Issues with Hedging using futures Basis and Basis Risk

Basis in a hedging situation is:
Perfect hedging may be difficult because: Spot price of asset to be hedged Futures price of contract to be used
The asset underlying the futures may be different to the asset whose price over time the basis will likely change and will eventually converge
is be hedged.
The hedger may not be certain of the exact date that the asset will be Basis Risk - the variability in the basis that will affect profits and/or hedging
performance
bought or sold.
The hedge may require the hedge to be closed out before its deliver
Basis risk arises because of the uncertainty about the basis when the hedge is
month.
closed out.

These problems result in BASIS RISK. Basis risk exists for those contracts where you must exit the contract before
its expiration (where Basis is not zero). This is more likely to happen in
futures contracts that offer only quarterly rather than monthly contracts.

Basis risk increases as the time difference between the hedge expiration and
the delivery month increases. A good rule of thumb is therefore to choose a
delivery that is as close as possible to, but later than, the expiration of the
hedge.

75 76
 Long Hedge
Basis risk
Notation
Basis = Spot price of asset Futures prices (S-F)
F1 : Initial Futures Price
t1 t2 F2 : Final Futures Price
S2 : Final Asset Price
Spot price S1 S2
Futures price F1 F2
Hedge the future purchase of an asset by entering into a long futures
Basis b1= S1 F1 b2 = S2 F2 contract.

Cash flow at time t2:

Cost of Asset = S2 + (F1 F2) or S2 (F2 F1) = F1 + Basis
Long hedge: -S2 + (F2 F1) = F1 b2 ie realised price for asset is S2 and loss on hedge is (F1 F2)
Short hedge: +S2 + (F1 F2) = + F1 + b2

Assume: hedge closed out at t2 known at

time t1
77 78

Short Hedge Convergence of Futures to Spot

Again we define
F1 : Initial Futures Price
F2 : Final Futures Price Futures
Price Spot Price
S2 : Final Asset Price
Spot Price Futures
Price
Hedge the future sale of an asset by entering into a short futures
contract .
Time Time

Price Realized = S2+ (F1 F2) = F1 + Basis (a) (b)

At maturity, it must be the case that the futures price converges to the then-
prevailing spot price.
If not, an arbitrage occurs.
79 80
80
 Choice of Contract
Forward Contracts vs Futures Contracts

Choose a delivery month that is as close as possible to, but later

FORWARDS FUTURES
than, the end of the life of the hedge
Private contract between 2 parties Exchange traded
When there is no futures contract on the asset being hedged, choose Non-standard contract Standard contract
the contract whose futures price is most highly correlated with the
asset price. This is known as cross hedging. Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash settlement Contract usually closed

usually occurs out prior to maturity
Some credit risk Virtually no credit risk

81 82
81 82

Hedging and Speculating Example

You speculate that copper will go up in price, so you go long 10 copper
contracts for delivery in 3 months. A contract is 25,000 pounds in cents
per pound and is at $0.70 per pound or $17,500 per contract. Determination of Forward and Futures
Prices
If futures prices rise by 5 cents, you will gain:
Gain = 25,000 .05 10 = $12,500
Valuing forward contracts
If prices decrease by 5 cents, your loss is:
Stock index futures
Loss = 25,000 -.05 10 = -$12,500
Forward and futures contracts on currencies
Futures on commodities
Cost of carry

83 84
 Investment Assets vs. Consumption Assets Assumptions and notation
Investment assets are assets held by significant numbers of people
purely for investment purposes (Examples: gold, silver)
Assumptions:
No no transactions costs
Homogeneous tax rates on net trading profits
Consumption assets are assets held primarily for consumption
(Examples: copper, oil) Everyone can borrow and lend at the same risk-free rate
Market participants can take advantage of arbitrage opportunities.
Use arbitrage arguments to determine the forward and futures prices
of an investment asset from its spot price and other observable market
variables. Notation
Not for consumption assets.
S0: Spot price today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate per annum, expressed with continuous
compounding, for maturity T
85 86

Forward contract valuation : No income on underlying asset

Valuing forward contracts: Key ideas
Example: Gold (provides no income + no storage cost)
Two different ways to own a unit of the underlying asset at maturity:
1. Borrow and buy spot (SPOT PRICE: S0) Current spot price S0 = $980/oz.
=> Interest and inventory costs Interest rate (with continuous compounding) r = 5% p.a.
Time until delivery (maturity of forward contract) T = 1
2. Buy forward (AT FORWARD PRICE F0)
Forward Price?
t=0 t=1
VALUATION PRINCIPLE: NO ARBITRAGE Strategy 1: buy forward 0 ST F 0 ******
In perfect markets, no free lunch: the 2 methods should cost the same.
Strategy 2: buy spot and borrow

Buy Spot -980 +ST

Borrow +980 -1030.25 (= -980e0.05(1))
Strat 2: Total 0 ST -1030.25 ******

87
ST F0 = ST S0erT 88
 Forward price and value of forward contract
Forward Contracts: Valuation

Forward Price: F0 S0e rT Assumption so far is that r is compounded continuously

F0 = S0erT

The forward price is the delivery price (K) which sets the value of a If ra is compounded annually then:
forward contract equal to zero.
F0 = S0(1 + ra )T

Value of forward contract with delivery price K:

f S0 Ke rT

You can check that f = 0 for K = S0erT

89 90

Arbitrage Arbitrage: examples

If spot-futures parity is not observed, then arbitrage is possible
Gold: S0 = $980, r = 5%, T = 1; S0erT= $1030.25

If F0 <> S0 erT : arbitrage opportunity 0 T

Cash and carry arbitrage: if F0 > S0 erT

Borrow S0, buy spot and sell forward at forward price F0
If the futures price is too high, short the futures and acquire the stock by S0 S0erT
borrowing the money at the riskfree rate

If F0 $1030.25 there will be an arbitrage opportunity.

Cash and carry arbitrage: if F0 < S0 erT

Short asset, invest and buy forward at forward price F0
If the futures price is too low, go long futures, short the stock and invest the
proceeds at the riskfree rate

91 92
 Arbitrage: examples (ctd) Arbitrage: examples (ctd)

Assume :Gold: S0 = $980, r = 5%, T = 1; S0erT= $1030.25 Assume :Gold: S0 = $980, r = 5%, T = 1; S0erT= $1030.25
If forward price = $1100: F0 > S0erT If forward price = $950: F0 < S0erT

0 T 0 T

Borrow +$980 Repay $980 load: - $1030.25 Sell (spot) one ounce of gold +$980 -ST
+ST Invest +$1030.25
Buy one ounce of gold -$980 -$980
Sell 1ounce of gold for $1100.0 -ST Buy forward contract 0 ST - $950
Short a forward contract on one
under forward contract TOTAL: + $80.25
ounce of gold $0 TOTAL: $0
TOTAL: $0 TOTAL: + $ 69.75

93 94

Forward Contract on Asset with Known Income Forward Contract on Asset with Known Dividend Yield

Forward Price: F0 S0 I e
rT
where I is the present value of the
income. Asset provides a known yield rather than cash income.
Income is known when expressed as a % of assets price at the time the
Application: stocks paying known dividends and coupon-bearing bonds. income is paid.
Let q = dividend yield per annum. paid continuously.
Example: Consider a 10-month forward contract on a stock when the
price is $50. ie S0 = $50. Assume: Forward Price: F0 S0e r q T
r = 8% p.a. continuously compounded. where q is the average yield during the life of the contract (expressed with
Dividends of $0.75 per share are expected after 3, 6 and 9 months. continuous compounding)
Determine: I, F0
The PV of the dividends, I, is given by: Examples:
Forward contract on a Stock Index:
I 0.75 e 0.080.25 0.75 e 0.080.50 0.75 e 0.080.75 2.162
r = interest rate, q = dividend yield
Using F0 S0 I e => F0 50 2.162 e
0.08(10 / 12 )

rT
$51.14 Foreign exchange forward contract:
r = domestic interest rate (continuously compounded), q =rf = foreign interest
If F0 < $51.14: arbitrage by shorting the stock and buy the forward contract. rate (continuously compounded)
If F0 > $51.14: arbitrage by buy the stock and short the forward contract. 95 96
 Forward Contract on Asset with Known Dividend Yield
Example: Consider a 6-month forward contract on an asset that is
expected to provide an income equal to 2% of the asset price once
during the six-month period. The current asset price is $25.ie S0 = $25.
Assume:
r = 10% p.a. continuously compounded.
Valuing Forward Contracts
Value of a forward contract when entered into is ZERO. It may have a
negative or positive value later.
Let :
K = delivery price in a forward contract (agreed upon at initiation of contract;
F0 = forward price that would apply to the contract today

Here, the dividend yield is 4% per annum with semiannual compounding.

General result:
This is equivalent to 3.96% p.a. continuous compounding. Ie q=3.96%
The value of a long forward contract is f = (F0 K )erT
The value of a short forward contract is f = (K F0 )erT
Determine: F0

Using F0 S0er q T => F0 50e 0.100.0396 0.5 $25.77

97 98

Valuing a Forward Contract : Example

Valuing Forward Contracts

The value of a long forward contract is f = (F0 K )erT Consider a long forward contract on a non-dividend paying stock that
was entered into sometime ago.
This shows that we can value a long forward contract on an asset by
assuming ST = F0 Assume:
Contract currently has 6 months to maturity.
r = 10% p.a. continuously compounded.
Under this assumption, the payoff from a long forward position at
The current stock price is $25
time T would be: F0 K
The delivery price is $24
ie: T=0.5, r= 10%, S0=25, K=24
This has a PV of erT(F0 K ) which is equal to value of
The 6-month forward price is F0 is : F0 S0e rT 25e 0.10.5 $26.28
f = (F0 K )erT

Note: K is the delivery price agreed upon at initiation of forward The value of forward is f = (F0 K )erT = (26.28 25)e0.1(0.5) = $2.17
contract. F0 is the current forward price.

99 100
 Valuing a Forward Contract: A Summary
Forward/Future Price
Asset
Provides no income
Provides known income
with PV = I
Are forward prices and futures prices equal?
Forward and futures prices are usually assumed to be the same. When
interest rates are uncertain they are, in theory, slightly different.
Value of long forward
F0
Contract with delivery A strong positive correlation between interest rates and the asset price
price K
implies the futures price is slightly higher than the forward price.
S 0er T S 0 Ke rT A strong negative correlation implies the reverse.
S0 I er T S0 I Ke rT

In practice, we also must consider the probability of counterparty default,

Provides known yield, q S0e r q T taxes, transactions costs, and the treatment of margins.
S0 e qT Ke rT
For long-lived contracts with maturities as long as ten years (eg.
Eurodollar futures), it would be dangerous to ignore the differences.

101 102

Stock index futures Futures and Forwards on Currencies

A stock index can be viewed as an investment asset paying a dividend yield A foreign currency is analogous to a security providing a dividend yield

The futures price and spot price relationship is therefore The continuous dividend yield = foreign risk-free interest rate

F0 = S0 e(rq )T It follows that if rf is the foreign risk-free interest rate

where q is the dividend yield on the portfolio represented by the index ( r rf )T

F0 S0 e

For the formula to be true it is important that the index represent an

investment asset. Futures exchange rates are quoted as the number of USD per unit of the foreign
currency
Forward exchange rates are quoted in the same way as spot exchange rates. This
In other words, changes in the index must correspond to changes in the value means that GBP, EUR, AUD, and NZD are quoted as USD per unit of foreign
of a tradable portfolio currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign
currency per USD.

103 104
 Futures and Forwards on Currencies
Futures and Forwards on Currencies
If you are going to owe foreign currency in the future, agree to buy the
foreign currency now by entering into long position in a forward contract. This equilibrium condition is perhaps more widely known as interest
rate parity IRP).
If you are going to receive foreign currency in the future, agree to sell the
foreign currency now by entering into short position in a forward IRP is an arbitrage condition.
contract.
If IRP did not hold, then it would be possible for an astute trader to
make unlimited amounts of money exploiting the arbitrage opportunity.

Since we dont typically observe persistent arbitrage conditions, we can

safely assume that IRP holds.

105 106

Futures and Forwards on Currencies IRP and Covered Interest Arbitrage

2 ways of converting 1,000 units of Consider the following set of foreign and domestic interest rates and spot and forward
foreign currency to dollars at time T. exchange rates.
1000 units of
foreign currency
( r rf ) T
at time zero Spot exchange rate S($USD/$AUD) = $USD0.80/$AUD F0 S0e

S0 = spot FX rate. 360-day forward rate F360($USD/$AUD) = $USD0.7842/$AUD

F0 = forward FX rate.
U.S. interest rate (r) r$ = 5.00%
rf T AUSTRATLIA r$AUD = 7.00%
1000 e 1000S0 dollars interest rate (rf)
units of foreign at time zero
currency at time T
A trader with $USD1,000 to invest could invest in the U.S. for one year and the
investment will be worth $USD1,051.27 (= $1,000e.05) and covert back to AUD at F360.
The final amount would be: $AUD1340.64
rf T
1000 F0e 1000S0e rT
dollars at time T Alternatively, this trader could exchange $USD1,000 for $AUD1250 at the prevailing spot
dollars at time T rate, and invest this at iAUD = 7% for one year to achieve $AUD1340.64.

107 108
 IRP and Covered Interest Arbitrage
Arbitrage Strategy I
According to IRP only one 360-day forward rate, F360($USD/$AUD), can Case 1: Forward rate is greater than $USD0.7842/$AUD
exist. It must be 0.7842
Assume: F360($USD/$AUD) = $USD0.8/$AUD (> $USD0.7842/$AUD)
Why?
Borrow $USD1,000 at t = 0 at i$(USD) = 5.0% for 1 yr.
If F360($USD/$AUD) $USD0.7842/$AUD, an astute trader could make money
with one of the following strategies:
Convert $1,000 for $AUD1250 at the prevailing spot rate, invest $AUD1250 at
(i$(AUD)) for one year to achieve $AUD1340.64

Enter into forward contract to sell $AUD1340.64 for $USD 1072.51 (=$1340.64 *
0.8). This will be more than enough to repay your dollar obligation of $1051.27 (
=1000e0.05).

Riskless profit of $1072.51 $1051.27=$AUD21.24

109 110

Futures on commodities: Storage Costs

Arbitrage Strategy II
Case 2: Forward rate is less than $USD0.7842/$AUD
Consider commodities which are investment assets, such as gold and silver.

Assume: F360($USD/$AUD) = $USD0.77/$AUD (< $USD0.7842/$AUD) Storage Costs: Treated as a negative income (-I).
U = the present value of all storage costs during the life of the forward contract:
Borrow $AUD1,000 at t = 0 at i$(AUD) = 7.0% for 1 yr. Need to pay back F0 (S0+U )erT
$AUD1072.51
If storage costs incurred at any time are proportional to the price of the
Convert $AUD1,000 for $USD800 at the prevailing spot rate, invest at 7.00% for commodity, then
one year to achieve $USD858
u = the storage cost per annum as a percent of the spot price, net of any yield
earned on the asset.
Enter into forward contract to buy $AUD1072.51for 1072.51*0.77 = $USD825.83.
F0 S0 e(r+u )T

Riskless profit of $858 $825.83 = $USD32.17

111 112
Futures on commodities: Convenience Yield Futures on commodities: Cost of Carry
Consider commodities which are investment assets, such as gold and silver. Cost of Carry: summarizes the relationship between futures prices and
spot prices.
Convenience Yields: The benefits from holding the physical assets. Cost of Carry = c =
Let U = the present value of all storage costs during the life of the forward contract. The storage costs + interest paid to finance asset income earned on asset
convenience yield, y, is defined such that:

F0 eyT (S0+U )erT Non-dividend paying stock: c = r

Index: c = r q
If storage costs incurred per unit are a constant proportion, u, then the convenience Currency: c = r rf
yield, y, is defined such that : Commodity that provides income at rate q and requires storage at rate u, c =
u = the storage cost per annum as a percent of the spot price, net of any yield earned on r q + u.
the asset.
F0 eyT S0 e(r+u )T or
In general: Let c = cost of carry:
F0 S0 e(r+u-y )T INEVSTMENT asset: F0 S0ecT
CONSUMPTION asset: F0 S0e(c-y)T
The Convenience Yield reflects the markets expectation about the future
availability of the commodity. The greater the possibility of shortage, the higher the
convenience yield. 113 114

Summary
Most of the time, the futures price of a contract with a certain delivery
date can be considered to be the same as the forward price for a HEDGING WITH FORWARDS and
contract with the same delivery date. FUTURES CONTRACTS
It is convenient to divide futures contracts into two categories
Those written on investment assets
Basic principles of hedging with futures
Those written on consumption assets
Minimum variance hedge ratio
In the case of investment assets, we considered three situations Stock index futures
The underlying asset provides no income
The asset provides a known dollar income
The asset provides a known yield

115 116
 Identifying the exposure
Setting up the hedge
Exposure: position to be hedged
Cash flow(s) Futures position:
Future income eg: oil/gold producer Number of contracts n (n>0 long hedge; n<0 short hedge)
Future expense eg: user of commodity Size of one contract N
Value Futures price F
Asset eg: asset manager
Liability eg: financial intermediary Hedge = n N F

General formulation: Perfect hedge: choose n so that value of hedged position does not change if S
changes

Exposure = M S V M S n N F 0
with: M = quantity, size (M > 0 asset, income M < 0 liability, expense)
S = market price
Value of hedged portfolio: V M S nN F

117 118

Hedge Ratio (HR) Perfect hedge

Change in value of hedged portfolio: V M S n N F 0 Assume F and S are perfectly correlated:

M S If M >0 : n <0 short hedge

S F
To achieve V = 0 n
N F If M<0 : n>0 long hedge

M
then: HR = - and n
nN
N
Hedge ratio: HR
M

S
To achieve V = 0 HR
F

119 120
Minimum variance hedge Some math

Real life more complex: Var (V ) M 2Var (S ) n N Var (F ) 2MnN cov(S , F )

1. asset to be hedged might differ from underlying the futures
contract Take derivative and set it equal to 0:
2. basis (S F) might vary randomly
2nN Var (F ) 2 MN cov(S , F ) 0
More general specification:
Solve for n:
M cov(S , F )
n
S F N Var ( F )

cov(S , F )
Choose n to minimize the variance of V Note : s
Var ( F ) F

Notation: S is the standard deviation of S; F is the standard deviation of F

121 is the correlation between S and F 122

SFE SPI 200 Stock Index Futures

Hedging Using Index Futures

Stock index futures: futures on hypothetical portfolio tracked by Four delivery months: March/June/September/December up to six
index. quarter months ahead.
Size = Index Value of 1 index point
Min. price movement = 25 points
Example: SPI Futures - $25 index
Cash settled
To hedge the risk in a portfolio the number of contracts that Underlying : S&P/ASX 200 Index
should be shorted is
P
n
A
where P = the value of the portfolio;
= portfolio beta;
A = value of the assets underlying one futures contract

123 124
 Marking to Market Hedging with Stock Index Futures
The smallest allowed price change (the tick) is 1 point, which
equals $25. The primary purpose of SPI futures contract is to facilitate risk
transfer from one who bears undesired risk to someone else willing to
bear the risk
Thus, if the ASX SPI 200 Index futures price falls from 5100 to 5098,
the face value of the futures contract declines $50. That is: SPI Index futures are used by most large commercial banks and
by many pension funds as foundations to hedge
(5100)(25) = $127,500
(5098)(25) = $127,450

This two tick decrease in the futures price creates a mark to market Consider
profit of $25 for an individual who is short one contract. Systematic and unsystematic risk
The need to hedge
The hedge ratio

125 126

Hedging with Stock Index Futures Hedging with Stock Index Futures
You are the manager of a $100 million equity portfolio. You are bullish To determine the hedge ratio, you need:
in the long term, but anticipate a temporary market decline.
The value of the chosen futures contract
How can you use futures contracts to hedge your stock portfolio? The dollar value of the portfolio to be hedged
The beta of the portfolio
To construct a proper hedge, you must realize that portfolios are of
Different sizes
Different risk levels

The hedge ratio incorporates the relative value of the stock and futures,
and accounts for the relative riskiness of the two portfolios

127 128
 Determining the Factors for A Hedge
The Market Falls
Suppose the manager of a $5 million stock portfolio (with a beta of 0.91)wants to hedge
using the June SPI futures contract
Using the Hedge in A Falling Market
On the previous day, the S&P/ASX 200 Index closed at 4900, and the June 10 SPI futures
closed at 4950.
Assume the S&P/ASX 200 index falls 5%, from 4900 to 4655 after
three months.
The value of the futures contract is $25 * 4950 =$123,750

The Hedge Ratio is: HR Dollar Value of Portfolio Given beta, the portfolio should have fallen by 5.0% * 0.91 = 4.55%,
Dollar Value of SPI Futures which translates to $227,500.

5000000
= 0.91 36.77 37 contracts If you sold 37 contracts short at 4950, your account will benefit by
123750
(4950 4655) * $25 * 37 = $272,875
Hedge by SELLING 37 SPI futures contracts.
The hedged portfolio gained 272,875 227,500 = $45375 in a falling market.

129 130

Summary Summary
There are a variety of ways a firm can hedge exposure to the price of an asset
using futures. Stock index futures can be used to hedge the systematic risk in an
equity portfolio.
The number of futures required is the of the
An important concept in hedging is basis risk.
The basis is the difference between the spot price of an asset and the futures price.
Basis risk is created by a hedgers uncertainty as to what the basis will be at Dollar value of portfolio
maturity or the hedge. portfolio
Dollar value of 1 forward
The Hedge ratio is the ratio of the size of the position taken in futures
contracts to the size of the exposure.
A hedge ratio of 1.0 is not always optimal.
Stock index futures can also be used to change the beta of a
A hedge ratio different from 1 may offer a reduction in the variance. portfolio without changing the stocks comprising the portfolio
The optimal hedge ratio is the slope of the best fit line when changes in the spot
price are regressed against changes in the futures price.

131 132
APPENDIX

Important properties of the exponential function:

e x e y e x y

The natural logarithm function is the inverse of the exponential function.

If y e x , then x ln( y )

ln( XY ) ln( X ) ln(Y )

ln( X / Y ) ln( X ) ln(Y )

133