P1.T3.

Financial Markets & Products

Chapter 1 – Banks

Bionic Turtle FRM Study Notes

Chapter 1: Banks

IDENTIFY THE MAJOR RISKS FACED BY A BANK, AND EXPLAIN WAYS IN WHICH THESE RISKS CAN
ARISE. ................................................................................................................................ 4
DISTINGUISH BETWEEN ECONOMIC CAPITAL AND REGULATORY CAPITAL.................................. 7
SUMMARIZE BASEL COMMITTEE REGULATIONS FOR REGULATORY CAPITAL AND THEIR
MOTIVATIONS. ..................................................................................................................... 9
EXPLAIN HOW DEPOSIT INSURANCE GIVES RISE TO A MORAL HAZARD PROBLEM..................... 10
DESCRIBE INVESTMENT BANKING FINANCING ARRANGEMENTS INCLUDING PRIVATE PLACEMENT,
PUBLIC OFFERING, BEST EFFORTS, FIRM COMMITMENT, AND DUTCH AUCTION APPROACHES... 11
DESCRIBE THE POTENTIAL CONFLICTS OF INTEREST AMONG COMMERCIAL BANKING, SECURITIES
SERVICES, AND INVESTMENT BANKING DIVISIONS OF A BANK AND RECOMMEND SOLUTIONS TO
THE CONFLICT OF INTEREST PROBLEMS. ............................................................................. 16
DESCRIBE THE DISTINCTIONS BETWEEN THE “BANKING BOOK” AND THE “TRADING BOOK” OF A
BANK ................................................................................................................................ 18
EXPLAIN THE ORIGINATE-TO-DISTRIBUTE MODEL OF A BANK AND DISCUSS ITS BENEFITS AND
DRAWBACKS. .................................................................................................................... 19

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Chapter 1: Banks
 Identify the major risks faced by a bank, and explain ways in which these risks can
arise.
 Distinguish between economic capital and regulatory capital.
 Summarize Basel Committee regulations for regulatory capital and their
motivations.
 Explain how deposit insurance gives rise to a moral hazard problem.
 Describe investment banking financing arrangements including private placement,
public offering, best efforts, firm commitment, and Dutch auction approaches.
 Describe the potential conflicts of interest among commercial banking, securities
services, and investment banking divisions of a bank and recommend solutions to
the conflict of interest problems.
 Describe the distinctions between the “banking book” and the “trading book” of a
bank
 Explain the originate-to-distribute model of a bank and discuss its benefits and
drawbacks.

Selected key concepts:

 The three major risks faced by a bank are credit, market, and operational risk. But
these are not the only risks!
 Regulatory capital is externally imposed, somewhat formulaic (and comparable
across banks) with the objective of maintaining solvency and minimizing systemic
risk. Economic capital is internal to each bank and therefore varies in practice.
Economic capital is also the bank’s risk capital such that it has multiple purposes
beyond solvency (e.g., risk-adjusted return on capital, RAROC) and often covers
more risk types.
 Moral hazard is when an actor is encouraged (or permitted) counter-intuitively to
assume more risk because the actor does not bear the full consequence of incurring
the risk. For example, if the existence of insurance motivates the insured to disregard
risk, knowing somebody else will pay the consequence, this is a moral hazard.
 The trading book included assets/liabilities (generally held in the short-run) that are
marked to market (MTM) daily and subject to regulatory market risk capital
calculations. The banking book (generally held for the longer-run) includes loans,
often held to maturity, that are subject to credit risk capital calculations.
 The originate-to-distribute model

Benefits include: securitized loans removed from the balance sheet which liberates
capital to fund additional loans; bank earns an origination fee (and perhaps a
subsequent servicing fee); in theory, ought to distribute risk among several entities.

Drawbacks include: prepayment risk transferred from bank to investors so that

banks are motivated to generate as much volume as possible without regard to credit
risk; for loans guaranteed by Federal agencies, credit risk ultimately borne by US
taxpayers.

3
Identify the major risks faced by a bank, and explain ways in which
these risks can arise.
Banks are in the business of risk, but their failure can be a threat to the financial system.
Consequently, regulators require banks to hold a threshold amount of capital to maintain a
low possibility of failure. The three major types of risk faced by a bank are credit risk, market
risk, and operational risk.
Credit Risk
Credit risk is the possibility that the bank’s
counterparties to loan deals and derivatives
Credit Market
transactions will default. risk risk
For instance, from 2008 the central
government in Greece was continuously in Operational
negotiations with the European Union and risk
creditors on renegotiating its debt (see image
below). Why? Because Greece’s massive
amount of debt was unsustainable and was on
the brink of default. If Greece were to default, what would happen to the banks holding
Greece’s debt? Well, some banks were heavily exposed to Greek debt, as shown in the
following map by country. Unsurprisingly, the largest exposed country to Greek government
debt as of 2011 was Greek banks at almost €56 billion. Also heavily exposed were German
banks at almost €8 billion and France at over €9 billion. Banks opted to take on this
counterparty credit risk and would have had to live with a real downside risk had the
European Union not renegotiated Greece’s debt picture. This issue of poorly managed
European government finances is one that will be a persistent issue in the 2020s.

More generally, banks are designed to allocate credit and assume credit risk. Unlike
operational risk, the assumption of credit risk is intrinsic to a bank’s business model. A bank
does not seek to eliminate credit risk, but instead seeks to profit from credit risk. Different
banks often specialize as the primary source of financing to different sectors or geographies;
in some cases, governments deliberately encourage (or incentivize) banks to allocate credit
to specific populations/sectors1. Credit risk attaches to credit allocation and ample credit
allocation is an essential feature of a modern economy.

Bank exposure to Greek debt by Country, M Euros2

1
The Federal Farm Credit Banks Funding Corporation provides loans to rural communities and U.S.
agriculture
2 Guardian (2015), available at Source: https://www.theguardian.com/news/datablog/2011/jun/17/greece-

debt-crisis-bank-exposed

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For banks to cover potential losses from their loans, banks:
 Estimate collateral on their loans so that they have an idea of the real amount of
unrecoverable loss at risk.
 Build potential losses into the interest rate they charge on loans. For instance, if a
bank’s cost of funds is 2% and it can loan money out at 5%, then the bank’s net
interest margin is 3%. If the bank anticipates a loss rate of 2% on its loans, then the
bank will have 1% left to cover operational costs and contributions to profits. Banks
are also well aware that the loss rate varies significantly from year to year. Should
the economy sour, the loss rate could jump to say 6%, in which case the bank would
be in a net loss position. Currently, regulators require banks to hold enough capital to
cover potential losses that may occur once every thousand years. Banks often
account for potential losses when loans are initiated. An accounting rule, IFRS 9,
requires lending institutions to estimated expected losses at the onset of a loan and
back that amount out of their balance sheet. Banks also account for potential losses
on credit derivatives through a credit value adjustment (CVA). The CVA captures the
potential losses stemming from counterparty default. Interestingly, although the
losses must have occurred, the theoretical losses are booked against income.
= −
Regulators use a time horizon of one year to cover potential losses from credit risk.

Market Risk

Market risk captures risks a bank faces when market factors move in an unfavorable
manner. The list of market factors (or more commonly known as risk factors) is broad, and
includes, among others:

 Commodity prices;
 Interest rates;
 Exchange rates; and
 Equity prices.

Most of a bank’s market risk stems from trading activities. In the U.S. (because proprietary
trading is discouraged), most of the market risk stems from the services and products a bank
will offer corporate clients and institutional investors.

Recent examples of market risk include the United Kingdom opting to leave the European
Union in favor of self-governance. Initially, this was associated with a decline in the value of
the British pound. Banks are also often exposed to corporate clients that work in the
commodity space. Should commodity prices collapse, banks could be left without a
repayment stream on some of its loans connected with commodity prices. The list of market
variables that affect banks’ balance sheets is virtually endless. Regulators typically use a
time horizon shorter than one year for addressing market risk.

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Operational Risk
Regulators define operational risk as:

“The risk of loss resulting from inadequate or failed internal processes, people, and systems
or from external events.3”

Operational risk is much more difficult to predict. Why? Generally, because operational risk
comes from low probability, high-consequence events. What are these events? Some
potential loss causing events include robbery, improper trading, forgery, natural disaster and
a host of other issues. For instance, when the Morgan Stanley trader known as the London
Whale lost more than $6 billion in 2012, could Morgan Stanley have predicted the loss?
Further, could Morgan Stanley have predicted that two former traders would face criminal
charges and the bank would be faced to pay more than $1 billion in fines because of the
issue? Perhaps, but probably not given that the predictability of such outcomes is nearly
impossible. Regulators use a one-year horizon for covering operational risk.

Regulators categorize operational risk into seven

general categories, listed below.
 Internal Fraud: Banks may have rogue traders
that misrepresent their positions or employees
that steal or create fictitious loans.
 External fraud: Cyberattacks, robberies, forgery
and check kiting.
 Employment practices and workplace safety:
Workers hurt on the job, discrimination claims, and other human capital-related
litigation.
 Clients, products, and business practices: Clients involved in money laundering
and other illegal activity that could put the bank at risk.
 Damage to physical assets: Natural disasters, such as flood or tornados, or man-
caused damage through terrorism or vandalism.
 Business disruption and systematic failures: Computer problems, network
outages, and similar risks.
 Execution, delivery, and process management: Employee errors ranging from
data entry to spreadsheet miscalculations to collateral management to inadequate
legal documentation.

In general, operational risk is considered riskier for banks than the risks banks plan for –
market risk and credit risk. From 2008 to 2017, European and North American-
headquartered banks have incurred more than $300 billion in fines for operational risk
violations. It is important to note that these three main areas of risk for a bank – credit,
market, and operational risk – are not independent of each other. Credit risk losses often
occur when market risk rises. Operational risk also has a business cycle associated with it
that aligns generally with market risk. Banks, obviously, must be well-aware of the joint
probability of losses happen simultaneously.

3 John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New Jersey: John

Wiley & Sons, 2018).

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Distinguish between economic capital and regulatory capital.
Regulatory capital is the capital required to be held by banks as imposed by the
central banks or other regulators. The objective of regulatory capital is solvency – keeping
the total capital of a bank adequately high enough so that the chance of a bank failure is low.
Banks keep enough regulatory capital to cover a loss that would occur once every thousand
years.

Economic capital is the capital that a bank thinks it needs, in addition to regulatory
capital. The amount of economic capital depends on a bank’s own models rather than
those prescribed by regulators. Although banks decide how much regulatory capital to
hold, regulators are involved in defining what types of assets count as economic capital.
Economic capital is allocated to a bank’s business unit so that the capital can be compared
using a return on an allocated economic capital metric.

The Figure4 below depicts economic capital. It should be noted that, according to the authors
(the Federal Deposit Insurance Corporation (FDIC)), economic capital is a measure of risk,
not of capital held.

The expected loss is the anticipated loss over a specified period. Expected losses are
captured in operating income. The confidence level is chosen by the bank’s board of
directors and represents, among other things, the risk of insolvency over the period the bank
anticipates operating.

In this framework, economic capital contributes to a comprehensive pricing system, assists

in the evaluation of the adequacy of capital, develops risk-adjusted performance measures,
and improves risk management by providing for a common currency measurement of risk.

Economic capital may be less or more than regulatory capital. Interestingly, although
not surprising, economic capital may be smaller or larger than regulatory capital. In cases
when economic capital is smaller, this might stem from banks preferring to put assets into
activities that provide a higher return than more stable capital forms.

4 Federal Deposit Insurance Corporation, Supervisory Insights, Economic Capital and the Assessment

of Capital Adequacy, available at

https://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/economic_capital.html

7
With that said, banks are well-aware that they should maintain their capital levels adequately
above the regulatory minimum so that they avoid needing to raise capital on short notice
when required.

For instance, when banks faced huge losses during the credit crisis in 2007-08, they had to
raise new capital in a short time period. Particularly during that time, sovereign wealth funds
(investment funds controlled by the government of a country) provided some relief by
rendering capital to banks that faced heavy losses.

In the Figure6 below, the FDIC provides an example of minimum regulatory capital compared
with economic capital. As shown, the minimum regulatory capital comprises 3 blocks (market
risk, operational risk, and credit risk). In contrast, the bank’s internal economic capital
models have seven blocks, including liquidity risk, business risk, interest rate risk, market
risk, operational risk, credit risk, and diversification benefit. What the different blocks
represent is shown in the blue text to the right of each block. In this example, economic
capital is much larger than regulatory capital. This is not always the case.

6
Federal Deposit Insurance Corporation, Supervisory Insights, Economic Capital and the
Assessment of Capital Adequacy, available at
https://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/economic_capital.html

8
Summarize Basel Committee regulations for regulatory capital and
their motivations.

1974: 1998: 2007:

Basel Basel I Basel II 2027:
Founded Revised Final Basel III

1988: 1999: 2007-

Basel I Basel II 2009:
Basel II
too weak

1974: The Basel Committee is founded. From 1974 to 1988 (and, of course, the years
before 1974), bank regulation and enforcement varied widely from country to country.

1988: In 1988, the story changed with the international agreement known as Basel I. Basel I
required regulators in all countries that took part in the agreement to calculate capital
requirements in the same way. The first round of Basel I dealt mostly with covering
losses stemming from loan defaults and derivative contracts.

1998: Over the ensuing decade after the 1988 Basel I agreement, trading activity by banks
grew quickly. The Basel Committee decided that banks should hold capital not only for
credit risk but also for market risk. The modification was known as the Market Risk
Assessment.

2007: The finalized 2007 change had its beginnings in 1999 (yes, it takes that long for
changes to work through banking committees). The Basel Committee revised its agreement
on the calculation of credit risk capital and finalized procedures for operational risk. The
Basel II was the sum of three capital requirements: credit risk + market risk +
operational risk.

2008-2009: Just when Basel II was finalized, the global financial crisis hit the world stage.
Global regulators saw what happened in the financial world and concluded that the
market risk capital requirements were too weak. The revised rules were known as Basel
II.5.

2027: After adjusting the market risk capital, the Basel Committee concluded that equity
capital requirements needed review. To be implemented in 2027, Basel III requires a large
increase in the amount of equity capital.

9
Explain how deposit insurance gives rise to a moral hazard
problem.
In theory, deposit insurance might give rise to moral hazard. What is moral hazard? Moral
hazard refers to the idea that insurance or other risk-sharing policies encourage imprudent
(unduly risky) behavior. For instance, a person with bicycle insurance may be less likely to
lock up their bicycle if they know that they are covered in the event the bicycle is stolen.

Deposit insurance affects the behavior of banking customers. Like the bicycle example,
some analysts believe that banking customers are less likely to be vigilant about the
condition of their banking services with the knowledge that the Federal Deposit Insurance
Corporation (FDIC) will cover any potential losses up to $250,000. Why would a customer
put effort into ensuring the financial conditions of one’s bank when one knows that in the
event of bankruptcy, the FDIC will pay them back?

Deposit insurance might also affect the behavior of banking managers. The presence
of deposit insurance may encourage bank managers to offer riskier loans. How so? Without
insurance, the bank’s customers are more likely to withdraw their money if the bank offers
too many unduly risky loans. With deposit insurance, a bank may be willing to offer slightly
higher average interest rates to depositors and use that funding to make risky loans at
above-market interest rates. If customers are not monitoring the bank’s activities, managers
might be motivated—outside of regulatory risk—to engage in potentially risky lending
practices. The bank’s managers do not bear the consequences if the bank goes bankrupt.

Risk-based deposit insurance premiums are a way to counter moral hazard. Banking
regulators are well-aware of the moral hazard problem of deposit insurance. To counter the
risk, today’s banking system (at least in the U.S.) requires risk-based insurance premiums,
which impose higher premiums on riskier banks.

The size of the risk premium has been debated for decades. For instance, banks failed at
very high rates during the Great Recession from 1929 to 1930, with nearly 10,000 banks
failing. In response, Congress created the FDIC to guarantee depositors and ensure
confidence in the system. Initially, the maximum level of protection was $2,500. The
protection amount has increased substantially since, reaching $250,000 per depositor per
bank in October 2008. The system worked well from the aftermath of the Great Depression
to the early 1980s. Things changed in the 1980s. From 1980 to 1990, bank failures
surpassed 1,000 (by comparison, this was more than all the failures from 1933 to 1979).
Amongst various other reasons cited for this failure, moral hazard was top of the list.

During the problem period, FDIC balances reached the lowest base levels and eventually
had to borrow $30.0 billion from the U.S. Treasury. To address the issue, Congress passed
the FDIC Improvement Act in 1991 to prevent any possibility of the fund becoming insolvent
in the future. From then until 2006, bank failures were rare, but the funds held by FDIC
depleted again when banks failed during the 2007-08 global financial crisis (GFC).
Since 2007, the required premium paid by banks has depended on the bank's capital and its
safety as perceived by regulators. For well-capitalized banks, the premium might be less
than 0.1% of the insured amount; for under-capitalized banks, it could exceed 0.35% of the
insured amount insured.

Outside of the U.S., countries with many small banks are also susceptible to bank runs and
the resultant panic created due to bank failures. Generally following the lead of the U.S.,
many countries’ regulators insure a certain amount of deposits and banks generally pay an
insurance premium for customers’ guarantees.

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Describe investment banking financing arrangements including
private placement, public offering, best efforts, firm commitment,
and Dutch auction approaches.
Investment banks raise money for corporations or governments, in the form of debt,
equity, or hybrid instruments such as convertible debt. This includes activities, such as:
 Originating securities;
 Underwriting securities; and
 Placing the securities with investors.

Origination of securities involves comprehensive legal documentation listing the rights of the
securities holders. Investment bankers also help firms planning to sell securities with
prospectuses. Prospectuses provide information on the company's past performance, future
prospects and the major risks (such as lawsuits) faced by the company. The investment
bank and company management market the securities to potential investors, which typically
includes large fund managers and other money managers. The event is commonly referred
to as the “roadshow”. The securities price is set and agreed upon by the investment bank
and the issuing company. Typically, the bank then takes responsibility for the sale of the
securities to potential investors and the initial public offering to the market.

There are two types of financing arrangements that an investment bank offers an issuing
corporation – a private placement and a public offering.

Private placement: The investment bank sells securities of the issuing

corporation to a small number of usually large institutional investors, such
as pension funds, mutual funds, and life insurance companies. The
investment bank earns a fee for this service.

Public Offering: The securities of the issuing corporation are offered to

the general public through the investment bank. The two ways in which the
public offering takes place are distinguished based on a best effort or firm
commitment basis.
 In a best efforts public offering, the investment bank does the best it can to place
the securities with investors. Based mostly on its success, the bank receives a fee.
 In a firm commitment public offering (aka, bought deal), the investment bank
buys the securities from the issuer at a particular price and sells the securities to
investors at (typically) slightly higher prices. The difference between the price at
which it sells the securities and the price it pays the issuer is its profit. In the case
that the investment bank is unable to sell the securities to investors, the investment
bank will usually hold the securities on its own books. An investment bank is taking
on more risk in the case of a bought deal compared to a best efforts arrangement.

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Examples of the two types of public offerings.
Suppose an investment bank has agreed to underwrite an issue of 50.0 million shares by
Bionic Corporation. After negotiations, the target selling price per share is $30. For the
$
corporation, this $30 per share will raise $1.5 billion ( ∙ 50. 0 ℎ = $1. 5 .
After arriving at the raise amount, the bank can either offer the client a best efforts
arrangement where it charges a fee of say $0.30 per share, or it can offer a firm commitment
where it agrees to buy the shares from ABC Corporation for $30 per share.

Consideration of risk by the investment bank. Which option should the bank propose?
Choosing is akin to walking a tightrope. The risks swing both ways, and the more profitable
option is knowable only ex-post. The answer to the question depends upon:
 The bank’s confidence in its ability to market the shares or keep them on their books;
 How confident the bank is in the value (or share price target) of the company.
Suppose the bank is confident that it will be able to sell the shares but is uncertain about the
price. As part of its procedures for assessing risk, it considers two alternative scenarios.
Under the first scenario, it can obtain a price of $32 per share; under the second scenario, it
is able to obtain only $29 per share.
 In a best-efforts deal, assuming all shares are sold, the investment bank obtains a
total fee of $15 million ($0.3 per share × 50 million shares) under both the best efforts
and firm commitment scenarios (see Figure above).
 In contrast to the best efforts deal, in a firm commitment deal, the profit depends on
the price at which it can sell to the investors.
o If the bank thinks it can make a profit above the $30 per share, then it may buy all
the shares and take on the risk of either selling or owning all the shares. If the
bank is able to sell all 50 million shares at $32 per share, then the bank makes a
profit of $100 million (($32 per share − $30 per share) × 50 million shares).
o If the bank takes the risk but sells the shares for only $29 per share, it loses $50
million (($29 per share - $30 per share) × 50 million shares) because it purchased
the shares at $30 per share. The decision to take on the risk depends on the
bank’s subjective probabilities of the final selling price. The decision to opt for the
firm commitments option is referred to as the bank’s “risk appetite”.

12
This example illustrates the importance of risk in investment banking. If the bank evaluates
its risk optimally, it will earn much more profit under a firm commitment scenario compared
to a best efforts scenario. Taking on the risk, though, also comes with the chance that the
investment bank will lose (significant) money.
Public Offerings
When a business opts to go public, there are two general offerings, initial public offerings
(IPOs) and secondary offerings.

Initial Public Offering: When a private company wishes to issue shares for the first time,
the share issue is known as an IPO. Generally, the share issues are made on a best effort
basis. The key question mark in an IPO is the offering price.
 If the company sells its shares lower than what the market values the company at,
then the issuing company is leaving money on the table, which not only means the
company could have raised more money, but for the advice they received from the
investment bankers. If the share price is too far off, then the investment bankers
develop a bad reputation for the advice they give potential issuers.
 In contrast, if the company attempts to sell the shares at a price that is more than
what the market will value the company, then the company will generate poor press
and generally not be in good graces with investors. This was the case when Uber,
the ride-sharing company, went public in 2019. The stock went public at $45 per
share, only to see its share price drop by 7% on its first day of trading. The market
found Uber’s private valuations completely off, dropping from a potential value of
$120 billion to $82 billion at the IPO. In the Uber example, the advising investment
bankers’ assessment of the company's value divided by the number of shares
currently outstanding was way off (the company itself was also responsible for this
mistake as well).

Usually, companies and investment bankers will attempt to set the offering price just below
what it believes the market price will be, thus increasing the likelihood of being able to sell
the shares. If done on a best efforts basis, the investment bank’s fee per share sold would
still be the same regardless of the offering price.

Generally, many investors consider IPOs attractive buys because of the possibility of earning
substantial increases in price after the stock goes public, sometimes more than 40%. In
recent years, though, the “IPO pop” has become riskier, with many instances of the price of
a given IPO dropping after going public. Even with the risk, IPOs are usually in high demand.
With the hopes of increasing business, investment banks often offer IPOs to the fund
managers and other large investors that are their best customers. Investment bankers may
also place pre-IPO stock with senior executives of large companies to increase exposure to
the issuing business. This is referred to as “spinning” and is generally looked down upon by
regulators.

Secondary offerings: The headline gathering news is when a company initially goes public
(the initial IPO). Although not as flashy, companies often issue stocks a second time, and
many numerous times, over the course of their operating existence. When the company has
already issued publicly traded equities, then additional offerings are referred to as secondary
offerings. Generally, investment banks will use the market price as the guide for the issuing
price, typically looking at where the company's shares were trading a few days before the
issue is to be sold to the market. Usually, new shares are issued at target prices slightly
below the current price.

13
When new shares are issued, the stock price of the company will usually fall. Why? Because
there are more shares trading for the same value of the company. For instance, suppose the
company’s value prior to a new share issuance is $1.5 billion and the number of shares
outstanding is 35 million. The company’s stock price will be $42.86 per share, as shown
below.

$1,500,000,000
= $42.86 ℎ
35,000,000

Suppose the company plans to issue new shares – also known as diluting – by issuing
another 5,000,000 shares, and in the process raising $213,750,000 by selling the 5,000,000
shares at $42.75 per share. If the market assumes that the new shares do not increase the
market value of the company, then the value of each share will drop from $42.86 to $37.50
per share.

$1,500,000,000
= $37.50 ℎ
35,000,000 + 5,000,000

If this story plays out, the existing stockholders see a loss of 12.5%. It is also possible for the
market to see the share issuance as a “good” signal, perhaps indicating that the company’s
growth prospects are bright. If this situation plays out, the market may add the $213,750,000
to the initial company value of $1,500,000,000, resulting in a share price of $42.84, or almost
no change from the initial stock price.

$1,500,000,000 + $213,750,000
= $42.84 ℎ
35,000,000 + 5,000,000

The bottom line is that the final trading price post-new share issuance depends upon how
the market reads the reasons for the share issuance. As already mentioned, the market
typically views new share issuances poorly, as it not only lowers the notional value of each
stock but also lowers the notional value of earnings per share.

Dutch Auction Process

An increasingly popular option for “going public” (IPO) is through the Dutch auction process.
In a Dutch auction process, companies issue a prospectus and do the typical roadshow like
the regular IPO process. The difference is in how investors receive shares. In a Dutch
auction process, investors bid for the number of shares they would like to purchase at a
particular price. Shares are then allocated to investors in a rank order. The highest bidders
get the first block of shares. The next highest bidder gets the next block of shares. The
process continues until all are sold. The price paid by all successful bidders is the lowest bid
that leads to a share allocation.

14
An example of the Dutch auction process

The table7 to the right has an example of a company that

wants to sell one million shares in an IPO through the Dutch
auction process. The first column from the left has the
Bidder identifier. The middle column has the number of
shares. The far-right column has the price. Based upon a
highest to the lowest bid allocation strategy, shares will be
allocated to C, F, E, H, and A, which had bids of $33,
$31.50, $30.50, $30.25, and $30.00 per share. The
allocation occurs in that order. After these 800,000 shares
have been allocated, the next highest bidder is D, who bid for 300,000 shares. Since only
200,000 shares are available, D's order is only filled up to 200,000 shares. The price paid by
all investors, from A, C, D, E, F, and H is equal to the bid by the lowest bidder D ($29.00). In
this example, the company raises $29,000,000 (1,000,000 shares x $29 per share).

Google’s public offering

One of the most famous public offerings in recent memory
is Google (now known as Alphabet). When Google went
public in 2004, the company opted for a little different
Dutch IPO than the traditional Dutch auction. The company
reserved the right to change the number of shares and the
percentage of the request amount allocated to each bidder.
Surprisingly, when the founders – Sergei Brin and Larry
Page – finally decided on the number of shares to be sold, they offered 19,605,052 at a price
of $85 per share. In the process, they raised $1.67 billion. This was surprising to the
investment banks because most companies that would have offered all available shares at
$85 per share, raising $2.25 billion. Google’s founders opted to leave $580 million on the
table. Why? Although no one really knows, one speculation is that Messrs. Brin and Page
expected the shares to jump following the IPO. The founders would then be able to sell more
of their shares later at higher prices. Sergei and Larry turned out to be right. After the first
day of trading, Google’s stock soared 18% above its offer price. On the second day, the
stock added another 7%. Google’s founders appeared to have made the right move,
although some investment bankers have noted that although Google’s value appeared to be
underpriced, the stock did not jump as much as other technology company IPOs that used
the traditional IPO method. By using the Dutch IPO method, Google saved 1.2% in fees (it
paid 2.8% to the investment banks compared with 4% for the typical IPO). Google did raise
another $4.18 billion about a year later by issuing another 14,159,265 shares at $295 per
share. Why such an odd number of shares? Google’s love of mathematics – they wanted the
number of shares to be like the mathematical constant π, which is 3.14159265.
The advantages of Dutch auctions
Dutch auctions have two advantages over that of a traditional IPO.
 First, the price that clears the market ($29.00 in the previous example) becomes the
market price in the bidding process.
 Second, because it is an auction process, any potential investor can obtain shares. In
traditional IPOs, favored clients of investment bankers typically get first dibs on
shares.

7
John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New Jersey: John
Wiley & Sons, 2018). Table from Hull’s Example 2.2.

15
Describe the potential conflicts of interest among commercial
banking, securities services, and investment banking divisions of a
bank and recommend solutions to the conflict of interest problems.
Banks often offer services in:
 Commercial banking;
 Retail banking;
 Securities services; and
 Investment banking.

When a bank performs these services under the umbrella of a single

corporate entity, potential conflicts of interest may arise.
 Suppose a bank’s investment banking division is trying to sell
securities of a company that wants to go public but is having
a hard time finding buyers. Presuming the bank also has a retail investment advisory
business, the bank may be tempted to have its financial advisers promote the
securities of the investment bank. This non-disclosed conflict of interest can be a
problem for customers and clients.
 Suppose a bank acts as the fiduciary on an investment account. When deciding
which securities to buy for its client, the bank may be tempted to allocate the difficult
to sell securities into its customer’s account. Again, a clear conflict of interest.
 Banks hold confidential information. Suppose a bank was an advisor to a large
company seeking an acquisition of a smaller, but potentially very profitable company.
Suppose further that the commercial banking division is the key provider of banking
services to the smaller company. The mergers and acquisitions division of the bank
may be tempted to use confidential of the commercial banking division in its
acquisition advice. This is another clear example of a conflict of interest.
 Suppose the research arm of the securities division in a bank is enticed to rate a
company's share as a “buy” to please the company's management and get more
investment banking business. In this case, the conflict of interest is between the
research division and the investment banking business.
 Consider a case where a commercial bank no longer wants to hold a loan it has
offered to a company on its books based on confidential information that there is an
increased chance of bankruptcy. In such a situation, its investment banking division
may be forced to organize a bond issue for the company, whose proceeds will be
used to pay off the loan. This action of replacing the loan of the company which is
about to go bankrupt with a loan made by investors who have less information about
the bankruptcy may make the bank safer but puts the investors at risk. Taking
advantage of this type of asymmetric information is a clear example of a conflict of
interest.

16
Possible solutions to handle potential conflicts of interest
If the conflicts of interest are never

FIREWALL
CHINESE
discovered, they may simply lead to a
more profitable corporate bank. On the Commercial Investment
other hand, actual or perceived conflicts banking banking
of interest, when discovered, may result
in the degradation of a bank’s reputation
and may lead to fines and lawsuits.

One of the most common ways these types of conflicts of interest can be addressed
is by separating the commercial banking division from investment banking, often
referred to as Chinese walls. The commercial banking division is prohibited from
transferring information to the investment banking division when the information is not in the
best interests of the customer.

The initial separation of investment banking activities from commercial banking activities
occurred when the U.S. Congress passed the Glass-Steagall Act of 1933. The bill limited the
ability of commercial banks and investment banks to engage in each other's activities, such
as public offerings. Additionally, investment banks were not allowed to take deposits and
make commercial loans.

For many years, the Chinese firewall was strict even though there was a slow shift towards
more communication between the two banking divisions over time. The relaxation of the
firewall was further relaxed in 1987 when the Federal Reserve allowed banks to establish
holding companies with subsidies in commercial banking and investment banking.

The rules were relaxed further over time, and in 1999, under the Financial Services
Modernization Act, all restrictions on the operations of banks, insurance companies, and
securities firms were effectively eliminated.

The situation changed in the aftermath of the global financial crisis of 2008 and 2009. In
2007, there were five large investment banks in the U.S. – Goldman Sachs, Morgan Stanley,
Merrill Lynch, Bear Stearns, and Lehman Brothers. In global crisis led to a Lehman Brothers
bankruptcy, a takeover of Bear Stearns by JPMorgan Chase, and Bank of America taking
over control of Merrill Lynch. The remaining two large entities – Goldman Sachs and Morgan
Stanley – became bank holding companies with commercial and investment banking
interests.

Today, although investment banks and commercial banks may be held by the same entity,
banks are required to keep the financial transactions of their commercial banking activities
separate so that they are not affected by losses in investment banking.

17
Describe the distinctions between the “banking book” and the
“trading book” of a bank
The activities of banks are separated into two “accounting books” – the trading book and the
banking book.
Trading book
 The trading book includes all the assets and
liabilities the bank has as a result of its trading
operations.
 Items in the trading book are subject to
regulatory market risk capital calculations.
 The values of these assets and liabilities are
marked to market daily.
o The daily marked to market means that the value of the book is adjusted daily to
reflect changes in market prices. For example, if a bank buys an asset for $100
on one day and the price falls to $60 the next day, it records an immediate loss of
$40, even though it may not be selling the asset in the immediate future.
o Sometimes it becomes difficult to estimate the value of a security or contract
when market prices of comparable transactions may not be available. Even
during these circumstances, often a model must be assumed by the bank. The
process of coming up with a “market price” is known as marking to model.
Banking book
As one might expect, the banking book is quite different
from the trading book.
 The banking book includes loans made to
corporations and individuals. The assets and
liabilities that are held to maturity are part of the
banking book.
 Items in the banking book are subject to credit
risk capital calculations.
 Items in the banking book (loans) were traditionally not subject to marked to market.
This is changing with the introduction of International Accounting Standards Board
IFRS 9 and similar accounting updates from the Financial Accounting Standards
Board in the U.S.
o When a borrower makes principal and interest payments of a loan on time, the
loan is recorded in the bank's books at the principal amount owed plus accrued
interest.
o If payments due from the borrower are more than 90 days past due, the loan is
usually classified as a non-performing loan. In this case, the bank does not
accrue interest on the loan when calculating its profit.
o When it becomes likely that the principal of the loan will not be repaid, the loan is
classified as a loan loss.

18
  Actual loan losses are charged against reserves and show up as charges against the
income statement of a bank. What gets entered on the income statement is an
estimate of the loan losses that will be incurred.
o To deal with actual or probable loan losses, the bank may increase or decrease
its reserve over time.
o A bank can also smooth out its income from one year to the next by
overestimating reserves in good years and underestimating them in bad years.
o Sometimes, banks may resort to tactics such as debt rescheduling to avoid the
recognition of loan losses. In debt rescheduling, more money is lent to the
borrower so that the payments on the old loans can be kept up to date. It allows
interest on the loans to be accrued and defers the recognition of likely loan
losses. Banks must, of course, be careful with the debt rescheduling strategy as it
can lead to even larger losses down the road.

Explain the originate-to-distribute model of a bank and discuss its

benefits and drawbacks.
The traditional view of a bank is that it operates by accepting deposits and using those
deposits to finance loans. The loans are reflected in their accounting books.

An alternative approach to the traditional originate-to-hold model of banking is the originate-

to-distribute model. In an originate-to-distribute model, the bank originates the loans
but does not keep the loans in its books. Instead, portfolios of loans are packaged
into tranches and sold to investors. The originate-to-distribute model is also referred to as
securitization because securities are created from cash flow streams originated by the bank.
The originate-to-distribute model has been around for many years and has been used for
various types of bank lending, including:
 Student loans;
Student
 Commercial loans
loans;
Car Commercial
 Commercial loans loans
mortgages;
Securitized
 Residential loans
mortgages;
Credit Commercial
 Credit card receivables mortgages
receivables; and
Residentia
 Car loans. l
mortgages

Many private-sector
brokers exist to support the originate-to-distribute model. There are also three government-
sponsored entities in the U.S. to facilitate this originate-to-distribute model for mortgages.
They are
 Government National Mortgage Association (GNMA) or “Ginnie Mae,”
 Federal National Mortgage Association (FNMA) or “Fannie Mae,” and
 the Federal Home Loan Mortgage Corporation (FHLMC) or “Freddie Mac.”

19
These government-sponsored
enterprises buy pools of mortgages
from banks and other mortgage
originators, guarantee the timely
repayment of interest and principal,
and then package the cash flow
streams and sell them to investors.
Purchasers of securities offered by
GNMA, FNMA, and FHLMC accept
prepayment risk – the risk that
interest rates will drop, and
mortgages will be paid sooner than
expected – but accept no default or
credit risk because the mortgages are
guaranteed by the U.S. government.
The existence of these government-sponsored enterprises explains the rapid rise in the
percentage of consumer debt owned by the Federal government, as shown in the figure to
the right. The percentage of consumer debt owned by the Federal government is now
approaching one-third of all debt.

Up until 1999, the government-sponsored agencies only purchased mortgages with low
default risks. This changed in 1999 when the entities began accepting subprime mortgages,
which are mortgages with higher chances of default.
Securitization
The process of securitization works as follows.
 The bank’s first step is to sell a loan portfolio to a special purpose vehicle (SPV). In
the example depicted in the figure below, the total principal is $100 million.
 The bank arranges the SPV to have three tranches – senior, mezzanine and equity
tranches with funds of 70% (senior), 25% (mezzanine) and 5% (equity), respectively.
If returns reported in the far-right boxes are the returns if no losses occur. In the
example below, the returns for each tranche are 5% for senior tranche, 8% for
mezzanine and 25% for equity tranche.
 Why different returns for the different tranches? The answer lies in the risk each
tranche takes. Repayment of the principal first flows to the senior tranche. Because
the senior tranche receives the first repayment stream, it has the lowest risk and the
lowest return.
 Once the senior tranche has been repaid, repayment streams flow to the mezzanine
tranche.
 Once the mezzanine tranche has been repaid, any remaining repayment streams go
to the equity tranche.
 Interest payments flow in the same manner as principal payments. The first cash flow
payments go to senior tranche holders until they have received the promised return
of 5%.
 After the senior holders have received their interest payments, the mezzanine
tranche receives its payments until they receive the promised 8% return.
 The last group to receive payments is the equity tranche.
 If the securitized asset experiences losses, the equity tranche bears the first loss until
5% of the total has been repaid. The mezzanine then bears the next 25% of losses
and the senior tranche bears all the losses in excess of 30%.

20
The Figure8 below gives a description of securitization:

Benefits
The originate-to-distribute model is considered attractive for the following reasons.
 By securitizing loans, banks can keep them off their balance sheet. This frees up
funds to make more loans.
 Securitization also frees up capital that can be used to cover risks elsewhere in the
bank. This is particularly attractive if the bank feels that the capital required by
regulators for a loan is too high.
 A bank earns a fee for originating a loan and another fee if it services the loan after it
has been sold.
 On a societal level, the originate-to-distribute model distributes risk among a broader
group of entities, which is generally thought to be good for financial markets.
Drawbacks
The originate-to-distribute model also has drawbacks.
 When loans are packaged and sold, the prepayment risk is transferred from the bank
to the investors. With no risk, banks have the incentive to generate as many loans as
possible with whatever credit risk the eventual purchasers will accept.
 For loans that are guaranteed by federal agencies, the credit risk is borne by U.S.
taxpayers with the profits going to banks and investors.

8
Hull, J. (2018). Risk Management and Financial Institution. Hoboken, NJ: John Wiley & Sons, Inc.

21
The originate-to-distribute models grew quickly leading up to the global financial crisis of
2008 and 2009, partly because of relaxes credit standards and partly because of the
incredible activity of securitizing assets. Often, securitized assets would be securitized again,
and again. When the global financial crisis hit, the market froze as banks and investors lost
confidence in the securities created. The market has since recovered and is growing again,
as shown in the Figure below.

22
P1.T3. Financial Markets & Products

Chapter 2. Insurance Companies and Pension Plans

Bionic Turtle FRM Study Notes

Chapter 2. Insurance Companies and Pension Plans

DESCRIBE THE KEY FEATURES OF THE VARIOUS CATEGORIES OF INSURANCE COMPANIES AND
IDENTIFY THE RISKS FACING INSURANCE COMPANIES. ............................................................ 3
DESCRIBE THE USE OF MORTALITY TABLE AND CALCULATE PREMIUM PAYMENT FOR A POLICY
HOLDER............................................................................................................................ 11
DISTINGUISH BETWEEN MORTALITY RISK AND LONGEVITY RISK AND DESCRIBE HOW TO HEDGE
THESE RISKS. ................................................................................................................... 15
DESCRIBE A DEFINED BENEFIT PLAN AND A DEFINED CONTRIBUTION PLAN FOR A PENSION FUND
AND EXPLAIN THE DIFFERENCES BETWEEN THEM. ................................................................ 16
CALCULATE AND INTERPRET LOSS RATIO, EXPENSE RATIO, COMBINED RATIO, AND OPERATING
RATIO FOR A PROPERTY CASUALTY INSURANCE COMPANY. .................................................. 17
DESCRIBE MORAL HAZARD AND ADVERSE SELECTION RISKS FACING INSURANCE COMPANIES,
PROVIDE EXAMPLES OF EACH, AND DESCRIBE HOW TO OVERCOME THE PROBLEMS. .............. 19
EVALUATE THE CAPITAL REQUIREMENTS FOR LIFE INSURANCE AND PROPERTY-CASUALTY
INSURANCE COMPANIES. ................................................................................................... 20
COMPARE THE GUARANTY SYSTEM AND THE REGULATORY REQUIREMENTS FOR INSURANCE
COMPANIES WITH THOSE FOR BANKS. ................................................................................. 22

2
Chapter 2. Insurance Companies and Pension Plans
 Describe the key features of the various categories of insurance companies and
identify the risks facing insurance companies.
 Describe the use of mortality table and calculate premium payment for a policy
holder.
 Distinguish between mortality risk and longevity risk and describe how to hedge
these risks.
 Describe a defined benefit plan and a defined contribution plan for a pension fund
and explain the differences between them.
 Calculate and interpret loss ratio, expense ratio, combined ratio, and operating
ratio for a property casualty insurance company.
 Describe moral hazard and adverse selection risks facing insurance companies,
provide examples of each, and describe how to overcome the problems.
 Evaluate the capital requirements for life insurance and property-casualty
insurance companies.
 Compare the guaranty system and the regulatory requirements for insurance
companies with those for banks.

Describe the key features of the various categories of insurance

companies and identify the risks facing insurance companies.
Insurance companies can be classified into four broad categories. They are life insurance,
property-casualty insurance (non-life), health insurance, and pension plans. Regardless of
the type of insurance offered, all insurance companies operate in a common way: they
accept payments (premiums) from policyholders with the promise of receiving contingent
payout(s) when the contractual terms are triggered.

Property-Casualty Health Pension

Life Insurance Insurance (Non-life) Insurance Plans
Term Life Insurance Property (accidents,
fire, theft, water)
Whole Life Insurance Casualty (legal
liability)
Variable life insurance
Universal life insurance
Variable-Universal life
insurance
Endowment life insurance
Group life insurance
Annuity contracts

3
Life insurance companies
Life insurance companies offer products that pay off when the life
of a policyholder ends. Typically, life insurance contracts are long
term. Life insurance contracts may take the following forms:
 Term life insurance, also known as temporary life
insurance: a term life insurance contract only pays off
when the policyholder dies during the period covered by the
contract. Term life insurance policies usually have a constant or declining face value
over time. When a premium is not constant over the years of the contract, the policy
is referred to as an annual renewable term policy. In an annual renewable term
policy, the policyholder renews the policy at the rate that reflects the age of the
policymaker regardless of the policymaker’s health. Typical 2020 term rates are
shown in the following table.

4
  Whole life insurance: a whole life insurance contract
provides the policyholder protection for the life of the
policyholder – meaning the contract pays off upon the
death of the insured. The insurance company uses
the portion of the premium not required to meet
expected payouts in the early years of the policy and
invests it with the intent to cover the expected
payouts in later years. One of the main advantages of
whole life insurance is its tax benefits, where the present value of the tax paid may
be less than it would be if the investor had chosen to invest funds directly rather than
through the insurance company. As an example, consider the following figure1 below.
Suppose a man purchases a $1 million whole life insurance policy at age 40 that
costs $20,000 per year. The probability of a male dying from age 40 to 41 is 0.00209.
When one multiplies this 0.00209 by $1 million, a “fair premium” would be $2,090.
The man actually paid $20,000, meaning the contract had a $17,910 premium that
the insurance company invests. The contract eventually becomes an expected
positive for the policyholder when the expected value is greater than the amount
paid. In this example, this occurs when the man reaches 70 with a probability of
death of 0.02353. The man pays $20,000, while the expected payment is $23,530.

 Variable Life Insurance: a variation of whole life insurance is variable life insurance.
The distinction between variable life insurance and whole life insurance is that the
surplus premiums shown in the figure above are invested in a fund chosen by the
policyholder. The policyholder could opt to invest the surplus premiums in equity,
bond, or money market funds, among others. Usually, the policy will detail a
minimum guaranteed payout on death with the potential for a larger payout if the
investments outperform. Variable life insurance policies allow for shifting among
investment funds.

1
Hull, John C. (2018), Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken New Jersey

5
 Universal Life: another variation on whole life insurance is when the premium trends
down over time to a specified minimum without a lapse in coverage. The insurance
company invests the surplus premiums in safe fixed-income investments such as
mortgages, money market instruments, and bonds. After guaranteeing a minimum
return of say 3%, the policymaker is given the option on what to do with the policy
upon the policyholder’s death. The policyholder can opt for a fixed benefit upon death
or the policyholder can choose a fixed benefit for their beneficiaries plus an amount
above the fixed benefit if the investment return is greater than a contractual
minimum. Obviously, because the second option has a richer benefit structure, the
second option has higher premiums compared to the first.
 Variable-Universal Life Insurance: a variable-universal life insurance policy
combines features of variable life insurance and universal life insurance contracts.
The policyholder decides on final death benefits, as well as the investment of surplus
premiums. Each policy can differ slightly, with the only constant being that the
insurance company guarantees a minimum death benefit. The investment of surplus
premiums and the structure of premium payments are decided upon by the
policyholder.
 Endowment Life Insurance: an endowment life insurance policy is different from the
other types of policies mentioned up to this point in that the policy has a defined
period and pays off either at the end of the period or when the policyholder dies. The
amount that is paid out is negotiated in advance and is independent regardless of
whether the end period is met or the policyholder dies. Sometimes policies include a
provision for payout if the policyholder develops a critical illness. Some types of
endowment life insurance policies include:
o With-profits endowment policy, where the insurance company announces
periodic bonuses depending upon the performance of the investments. The
bonuses are reinvested and are paid out at the end of the life of the policy.
o Unit-linked endowment is completely dependent upon the performance of the
fund over the period leading up to the maturity of the endowment life
insurance policy.
o Pure endowment policy only pays out if the policymaker survives to the end of
the policy.
 Group Life Insurance: a group life insurance policy covers groups of people under a
single policy. A policy is often purchased by a company for its employees. There are
two main types of group life insurance policies:
o Contributory, where the employer and the employee contribute to the
premium payments; or
o Noncontributory, where the employer covers the entire cost of the policy.
Insurance companies and employers generally find economies of scale in group life
insurance contracts. Additionally, group life insurance contracts generally do not
require medical tests when purchasing life insurance policies, in contrast to individual
policies.

6
Annuity contract
Annuity contracts are typically the opposite of life insurance contracts. Instead of making
monthly payments in exchange for a lump sum payment at the end of the specified period
(or upon death), an annuity contract offers payments in exchange for an upfront lump-sum
payment. Typically, an annuity provides the policyholder with an income stream beginning
from a future date for the rest of the policyholder’s life. In some instances, the annuity starts
immediately right after the lump-sum payment by the policyholder. More typically, though,
the lump-sum payment is made by the policyholder years in advance of expected payments.
This deferred annuity structure allows the insurance company to invest the funds and build
up larger balances in anticipation of payments.

Annuity contracts are often used for their tax advantages because taxes are typically
deferred until the annuity income is received. Annuity values often grow over time, and this
growth in value is referred to as the accumulation value. Generally, annuity funds can be
withdrawn early, but the surrender value is typically lower than the accumulation value
because the insurer has administrative costs to cover. Also, increasingly popular are
penalty-free withdrawals where the policyholder can withdraw a certain portion of their
accumulation value without penalty. Usually, if a policyholder dies before annuity payments
begin, the full accumulation value can be withdrawn penalty-free.

In recent years, annuity contracts that track certain well-known stock indices, such as the
S&P 500, have become popular. Very popular annuity contracts have provisions that offer
minimum and maximum returns, such as 2% and 8%. The insurance company guarantees
that the return on the annuity will be at least 2% even if the market returns -25%. Of course,
the upside is also limited. If the market gains 30% in a year, the maximum return the
policyholder will earn is 8%. These types of annuities are attractive to investors wanting
some exposure to the higher return the market can provide but do not want the risk of losing
money.
Property-casualty insurance companies
Property-casualty insurance companies can be subdivided
based on their concentration of activities in either property
insurance or casualty insurance.

 Property insurance provides protection against loss

of or damage to property from accidents, fire, theft,
water damage, and other adverse events on a property.
 Casualty insurance provides protection to individuals
and companies against legal liability due to actions of
the insured, such as a child breaking a bone while
playing on an insured party’s property.

Property-casualty insurance contracts usually last for a year and are typically renewed every
year. The premiums collected by property-casualty insurance companies may increase or
decrease each year depending upon the expected payouts, profit margins, and competition,
among other factors.

7
Risks associated with property and casualty insurance contracts can be divided into two
main risk groups.

 Easy to predict payouts. Payouts that have a history

of occurrence and a wealth of historical data can give
rise to models that can fairly accurately predict
potential payouts. Easy to predict payouts include, for
instance, payouts for car accidents and property
damage. For instance, suppose an insurance
company insures 1 million car owners, that 15% of
drivers make a claim each year, and that the average
claim payout is $5,000. In this company’s scenario, the expected dollar volume of
claims is:
1,000,000 ∙ 0.15 ∙ $5,000 = $750,000,000.
This $750 million will vary somewhat from year-to-year, but because the claim events
are independent of each other, the payout amounts will typically be around what the
models predict.
 Difficult to predict payouts. Contract payouts that
are more difficult to predict are single events that
may trigger many individual claims, such as a
hurricane, flood, or earthquake. These are referred
to as high consequence, low probability events, or
catastrophic risks. Catastrophic claims typically are
not independent of each other – either an
earthquake happens, or it does not (all-or-nothing
risks). Because of these potentially large claims, a property-casualty insurance
company must typically keep more equity capital as a percent of total assets
compared to a life insurance company. For instance, suppose the same insurance
company as above insures 1 million homes against hurricane damage. Suppose the
chance of an earthquake hitting the area covered by all 1 million homes is 0.5% each
year (once every 200 years) and that the average damage to the homes that the
insurance company would be liable for is $220,000 per home. In this case, the
insurance company has an expected payout each year of $1.1 billion.
1,000,000 ∙ 0.005 ∙ $220,000 = $1,100,000,000.
The large numbers and potentially damaging effects a catastrophic event can have
on an insurance company is the reason that insurance companies often employ
professional modeling experts to ensure the company is covered in the event of a
catastrophic event.
Health insurance companies
According to the World Health Organization2, $7.3 trillion
was spent globally on health insurance. Obviously, health
insurance is another important function of the insurance
market. Paying and control of health care can generally be
divided into two systems: (1) one in which the government
covers all or most of the costs and controls the system to a
large degree and (2) one in which private insurance markets allocate care and costs.

2
World Health Organization (2015), available at:
https://apps.who.int/iris/bitstream/handle/10665/259632/WHO-HIS-HGF-HFWorkingPaper-17.10-
eng.pdf

8
Government-controlled health insurance. In some countries, the government provides for
and controls the health insurance markets to a large degree. For instance, in Canada,
virtually all health care activities are paid for by a publicly funded, government-controlled
system. The government in Canada goes even further and generally prohibits doctors from
offering most services privately. In the United Kingdom, health care is also funded by the
government, but individuals can purchase private health insurance should they want access
to a parallel-running private system. Individuals purchase private health insurance in the
United Kingdom when they want shorter wait times for such things a routine elective surgery.

Private health insurance markets. In the U.S., most of the cost of health care is covered
through employer and employee premiums in the insurance market. Most individuals receive
health insurance through their employers. In 2010, President Obama signed the Patient
Protection and Affordable Care Act (commonly known as “Obamacare”) which expanded
Medicaid coverage (health insurance coverage for low-income and needy
individuals/families), prevented insurers from discriminating against individuals that had pre-
existing conditions, and imposed penalties and taxes on individuals and businesses for
either not having health insurance or for some other reason (in 2017, the individual mandate
to have health insurance has since been muted by the elimination of the tax for not having
health insurance). In a privately-run healthcare system, policymakers make regular premium
payments and payouts occur when services are provided. Health insurance premiums
resemble life insurance premiums because changes to the company’s assessment of the
risk of a payout do not lead to an increase in premiums. For instance, when the health of the
policyholder deteriorates, the health insurance premiums do not change. Health insurance
can also resemble property-casualty insurance because the premiums of a health insurance
company may increase when the overall costs of providing health care increase.
Pension plans
Companies often offer their employees pension plans. Pension plans are payments to
former employees once retirement commences. Pension plans are like annuity contracts,
where employers and employees make tax-deductible contributions for use later in life. The
design of each pension plan can be slightly different. There are two major types of pension
plans – defined contribution plans and defined benefit plans.

Defined contribution plans are the less risky of the two types of plans because the
employer is only guaranteeing payments to an account owned by an employee, such as a
401(k). Employees may also contribute to their accounts and often have control over the
allocation of assets.

Defined benefit plans. In contrast to defined contribution plans, defined benefit plans pool
contributions to a plan. The sponsor of the plan takes the risk of guaranteeing payments. For
instance, a common defined benefit plan offers employees future payments equal to the
average of the final three years of salary multiplied by the number of years of service and
2%. For a person having 30 years of service at the company and $75,000 in salary, the
payment would be $45,000.

=. ∙ ∙$ , =$ ,

9
 Defined contribution plans Defined benefit plans
(1) Funds are typically contributed by the (1) Funds are typically contributed by
employer and the employee the employer and the employee
(2) Contributions are not pooled, but rather (2) Contributions are pooled
owned by the individual in, for example, a
401(k) plan
(3) Employees choose the allocation of (3) There is a common formula for
assets calculating the pension payments after
employment separation
(4) The risk of having enough money for (4) Riskier than contribution plans
retirement lies with the employee. The because the company is guaranteeing
employee contributes to an account, and pension payments in a certain way.
that is the end of their risk.
(5) Each year, actuaries assess the
pension plan’s obligations and assets
and arrive at a funded ratio.
(6) Important assumptions in planning
for costs associated with defined
benefit plans are the discount rate and
the assumed rate of return.
(7) At the end of the day, shareholders
bear the risk of defined plans.

Risks facing insurance companies

Given the range of activities insurance companies are involved in, it likely comes as no
surprise that insurance companies face a host of risks.

Reserves may fall short. A common concern among all insurance firms is that the reserves
held by insurance companies may fall short of needed payouts.

The investments to cover projected costs. Another risk insurance companies face is their
investment choices. Insurance companies often invest in corporate bonds. When defaults on
corporate bonds increase, it can cause an inordinate amount of drop-in profitability of the
insurance company.

Liquidity risks. Insurance companies also face the possibility that their investments may not
have a readily liquid market when the funds are needed. For instance, insurance companies
may place a higher percentage of their funds in illiquid bonds because illiquid bonds have
higher yields but typically cannot be readily converted into cash.

Credit risk. Since insurance companies enter transactions with banks and reinsurance
companies, they are also exposed to credit risk.

Operational and business risk. As with most any other industry, insurance companies are
also exposed to operational risks and business risks, such as an employee making an
investment mistake or a competitor entering the market and stealing market share.

Misprice their risk. Insurance companies operate on risk models. If their economists and
statisticians misestimate their expected costs due to, for example, an unexpected natural
disaster, the result could be bankruptcy.

10
Describe the use of mortality table and calculate premium payment
for a policy holder.
How do insurers know how much to charge individuals and companies for their policies? The
answer is mortality tables. Mortality tables are used to value life insurance contracts. The
table below contains an example mortality table of mortality rates for the U.S. as estimated
by the Social Security Administration for 2013 (https://www.ssa.gov/oact/). The interpretation
of the table is as follows for a person aged 6 (the first blue row):
 The first column shows the Exact age assumed for the calculations in the other
columns. We will refer to the first row that is highlighted in blue: Exact age = 6.
 The second column gives the single-year probability of a male aged 6 dying within
the next year. The probability is 0.000146 or 0.0146% (or a 1 in 6,849 chance).
 The third column is the probability of this male surviving to age 6. In this case, the
probability is 0.992193 or 99.219%.
 The fourth column shows the remaining life expectancy. For the 6-year old, the
remaining life is 70.88 years. On average, this male lived to age 76.88 (ie., the
current age of 6 plus 70.88 years). The same figure is given for a female in the far
right columns. A 6-year old female, on average, can expect to live another 75.57
years (far right column) to the ripe age of 81.57 years (6 years plus 75.57 years). The
probability of a 6-year old female dying within one year is 0.000109 (0.0109%) and
the probability of that female surviving to age 6 is 0.993615 (99.361%).
If you follow the remaining blue highlighted rows, you will see that the probability of death in
the following year decreases with age up to 10 years of life and then begins to increase.

As a second example, the table3 also shows the probability of death for older individuals.
Consider, the two highlighted green rows for individuals aged 90, 91, 100, and 110.
 For a 90-year old man, the probability of death is 16.7291%, while for a 100-year
old man the death probability is 35.35% and for a 110-year old man, it is 57.59%.
 For women, the probabilities of death for women aged 90, 100, and 110 in the next
year are 13.22%, 30.47%, and 54.56%, respectively.
The figures show that women generally live longer than men. Also, as one can (hopefully)
easily see, some numbers in the table can be deduced from others. The third column shows
that the (cumulative) probability of a man surviving up to age 90 is 0.177348 or 17.73%. The
probability of a man surviving up to age 91 is 14.77%. The unconditional probability of a
man dying between his 90th and 91st birthday is the difference between the two. In this case,
the unconditional probability is 0.177348 − 0.147679 = 0.029669 = 2.97%.

What about the probability that a 90-year old man will die during his 90th year? The
conditional one-year death probability is simply the one-year unconditional death probability
(0.029669) divided by the cumulative survival probability (0.177348), as shown below.

0.029669
= 0.167291
0.177348

A related calculation is the cumulative probability of a man surviving to aged 91 given that he
survived to age 90. The answer to this is 14.77% (0.177348 x (1-0.167291) = 0.147679.

3 Adapted from the U.S. Social Security Administration’s Office of the Chief Actuary, available at

https://www.ssa.gov/oact/.

11
Periodic Life Table (2013)4

4
Inspired by Table 3.1 Hull, John C. (2018), Risk Management and Financial Institutions, John Wiley
& Sons, Inc., Hoboken New Jersey, but spreadsheet hand constructed by David Harper using source
data at https://www.ssa.gov/OACT/STATS/table4c6_2013.html

12
Calculating the premium payment and expected payout for a policyholder
For example5: Suppose the yield curve (interest rates) is flat (all maturities) at 4.0% per year
with semiannual compounding. Suppose also that premiums are paid once a year at the
beginning of the year. In this scenario, what is an insurance company's break-even premium
for $100,000 of term life insurance for a man of average health aged 90?

The calculation is known as the expected payout. It is given by the probability of death
multiplied by the insurance coverage. Using the previous mortality table, the probability of
the man dying from the time the policy is purchased until the man turns 91 is 16.7291%. One
then takes the total potential payout if this situation occurs and multiplies this by the
probability of death to arrive at the expected payout of $16,729.

0.167291 × $100,000 = $16, 729

What about the present value of the expected payout? If we assume the payout occurs at
the middle point of the year, the present value of the payout is $16,404, as shown below.

=( )∙( )
=$ , ∙( ) .
=$ ,
.

The two-year calculation. What if the term insurance lasts longer than one year? If we
suppose the term insurance lasts two years, the expected payout in the first year is still
$16,729. The probability that the policyholder dies during the second year is (1 −
0.167291) × 0.184520 = 0.153651. The expected payout in the second year is then $15,365
and is calculated as 0.153651 × $100,000 = 15,365. If we assume the payout occurs in the
middle of the second year, the present value of the payout is $14,487, as calculated below.

$15,365 ∙ 0.942866= $14,487

To calculate the total present value of payouts, one sums the two years. In this two-year
case, the present value of the expected payouts is $30,891 ($16,404 + $14,487 = $30,891).
Premium payments
Up to this point, the calculations have been on the nominal and present value of expected
payouts should death occur. What about premium payment? The insurance company has to
cover the expected payouts. In the example above, it is known that the first premium has no
risk. The second payment depends upon whether the individual lives to age 91. This
probability is the change that the person does not die during the first year. In this example,
the probability is 83.27% ((1 − 0.167291) = 0.832709).

If the premium is dollars per year, the present value of the premium payments is given by:

1
+ 0.832709 ∙ ∙ = 1.800682
(1 + 0.04)

With the above equation, the calculation of the break-even annual premium is found simply
by equating the present value of the expected premium payments to the present value of the
expected payout. In this case, the equation (below) and associated answer is $17,155.

$30,891
1.800682∙ = $30,891 ⇒ = = $17,155
1.800682

5
Hull, John C. (2018), Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken New Jersey. Chapter 3 and Example 3.1.

13
The Mortality Table employs conditional and cumulative probabilities (such that
unconditional probabilities can be inferred)
In response to a question about how to interpret the mortality table, David gave the following
response6:

“Hi @Flashback We recently discussed this here @ https://www.bionicturtle.com/forum/...ts-and-

mortality-tables-hull.10259/post-70531 in reference to Hull's (RM & FI Chapter 3) Mortality Tables,
see below.

 The default probability analog is: The Joint (aka, Unconditional) Prob [Default during Year T
and Survives thru end of Year T-1] = Cumulative Prob[Survive thru end of Year T-1] *
Conditional Prob [Default during Year T | Survive thru end of Year T-1] = Cumulative
Prob[Default, end of Year T] - Cumulative Prob[Default, end of Year T];
 In Hull's Mortality Table (below), the "Death w/n one year" is a Conditional Death Probability
while the "Survival" column is a Cumulative Survival Probability. Consequently, the
Conditional prob of death during the first year after the 80th birthday, Conditional Pr(death
over the next year | Survival up to 80th birthday) = Unconditional (aka, joint) Prob (death
during 80th year) / Cumulative Pr(survival up to 80th birthday) = (0.5062880 -
0.4762130)/(0.5062880) = 0.059403.

For me, the key relationship is the simple Conditional Pr(A | B) = Joint Pr(A, B) / Cumulative Pr(B);
which is the same as more familiar Conditional Pr(A | B) = Joint Pr(A, B) / Unconditional Pr(B)
because the Cumulative Pr(survive up to end of year T-1) is also an Unconditional probability. So the
potentially confusing part is ...

 The cumulative probability of survival up to (eg) the end of the 80th year is an unconditional
probability because it is from the perspective of time zero (age zero),
 But the Joint Prob (survive to 80th birthday and die during 80th year) is also an unconditional
probability because it is also from the perspective of time zero (age zero).”

6
See https://www.bionicturtle.com/forum/threads/general-question.21096/post-70875

14
Distinguish between mortality risk and longevity risk and describe
how to hedge these risks.
Mortality risk
Mortality risk is the chance that events will happen to make
individuals die sooner than what the insurance models predict.
Triggers for mortality risk include, for instance, wards, pandemics
(such as the coronavirus), epidemics (such as AIDS), massive
earthquakes, large-scale floods, and other adverse events.
 It likely goes without saying that mortality events adversely
impact not only human life but the life insurance industry. On
the flip side, mortality events could increase the profitability of
annuities because the present value of expected payments
drops.
Of importance, actuaries consider the age group demographics of
the particular policies when considering the impact of large-scale,
adverse mortality events.
Longevity risk
Longevity risk is the chance that people will live longer than
expected. Reasons for this might be a healthier lifestyle, modern
medicine, and other life choices.
 For life insurance, an increase in longevity increases the
profitability of the contracts (assuming, for the moment, no
competition for the term insurance business) because
potential payouts are either delayed or never happen at all.
 For annuity contracts, an increase in longevity may lower the profitability of the
contracts because the payouts may last for longer than what the insurance company
expected.
Insurance companies are, of course, aware that life expectancy is increasing across most of
the world. This longevity increase gets built into insurance rates.
Hedging mortality and longevity risk
Reinsurance. Insurance companies consider the effects of longevity and mortality risks
when they offer policies. When the net exposure is larger than what an insurance company
is comfortable with, the insurance company may turn to reinsurance. When an insurance
company purchases reinsurance, it is hedging a risk against adverse events. The risk is
transferred to the reinsurance company.

Derivative contracts. Another hedging option is for insurance companies to enter longevity
derivative contracts (often referred to as longevity bonds or survivor bond). These derivative
contracts provide payoffs favorable to the insurance company should the risk associated
with longevity exposure materialize. Longevity bonds are fairly straight-forward. A population
group is defined and the coupon on the bond at any given time is defined as being
proportional to the number of individuals in the population that are still alive. Financial
speculators sell these types of bonds to the insurance companies assuming that the upside
risks of payment from the insurance company is worth the potential risk should people live
longer than expected. Another reason speculators may take on the risk associated with
longevity bonds is that the bond payments are largely uncorrelated with the performance of
the stock market – thus, they diversify away some risk.

15
Describe a defined benefit plan and a defined contribution plan for
a pension fund and explain the differences between them.
Pension plans are a way for an employee and an
employer to ensure some form of income post-
employment. Generally, pension plans are paid for partly
by an employee and partly by an employer. The split
between the two depends on the company, employee,
and plan choice. Contributors to a pension plan typically
make regular contributions while the employee is
working. There are two main types of pension plans,
described below.

Defined benefit plan

In a defined benefit plan, regular contributions are required up to a certain age and then
lifetime pensions are provided. In a defined benefit plan, the pension received by the
employee after retirement is defined by a plan. That is, the amount of the pension is
typically calculated by a defined formula. The formula for the pension amount depends on
the company, but typical plans take the number of years of employment and the employee's
average salary for their final three years of employment. For instance, the pension of a
retired employee per year might equal to 2% (known as the multiplier) of the average of the
employee's final three years of salary multiplied by the number of years of employment. If
the employee worked say 35 years and the average of his three years of working was
$100,000, then the pension for this employee would be $70,000.

=. ∙ ∙$ , =$ ,

Spouses. Depending upon the structure of the pension plan, the employee's spouse may
also continue to receive a pension if the employee dies earlier than the spouse. The pension
check may be the same or less than what the pensioner received.

Death. Pension plans may also have death payments. For instance, some plans may
stipulate that when an employee dies while still employed, a lump sum may be paid to
dependents and a monthly income may be payable to a spouse or dependent children.

Adjusting for inflation. In a process known as indexation, the defined benefit plans may
also be adjusted for inflation (virtually every plan has the benefit adjusted for inflation). For
instance, a defined benefit plan may require an indexation equal to 75% of the increase in
the consumer price index.
Defined contribution plan
In a defined contribution plan, the contributions to the plan are defined, and the employer
and employee contributions are invested on behalf of the employee. When employees retire,
the final value of the contributions invested can be converted to a lifetime annuity or received
as a lump sum.

Taxes. Contributions to both defined benefit and defined contribution plans are tax-
deferred, meaning no taxes are payable on money contributed to the plan by the employee
and contributions made by the company are deductible. Taxes are subsequently due when
pension income is received. Depending upon the situation of the employee, this tax deferral
may result in a much lower overall tax burden over their lifetime.

16
Differences between a defined benefit and a defined contribution plan
 Benefits defined vs. contributions defined. The key difference between the two
types of pensions is in the name. In a defined benefit plan, the final benefits received
by the employee are defined. In a defined contribution plan, the monthly contributions
made by the employees and employers to the pension plan are defined.
 Pooled assets vs. individual assets. In a defined benefit plan, the contributions to
the pension fund are all pooled and payments to retirees are made from the pool. For
instance, the largest pension plan in the U.S., Social Security, is a defined benefit
plan. Employers and employees contribute to the pool of funds and distributions from
the account are made according to statute. In contrast, a defined contribution plan
places contributions into individual accounts owned by the individual employees. The
most common example of a defined contribution plan in the U.S. is a 401(k) plan.
 Risk. Perhaps the most important distinction between the two plans is risk. In a
defined benefit world, the employer takes on the risk of ensuring promised benefit
payments are made. In contrast, in a defined contribution world, the risk of having
enough money in retirement largely falls on the shoulders of the employee.

Calculate and interpret loss ratio, expense ratio, combined ratio,

and operating ratio for a property casualty insurance company.
Four ratios are addressed here: the loss ratio, the expense ratio,
the combined ratio, and the operating ratio. What’s the
difference between the four?
Loss ratio
The loss ratio is the ratio of payouts to premium revenue. It is
calculated on an annual basis. In the U.S., loss ratios are
generally in the 60% to 80% range and depend on the business
cycle, insurance companies’ models, and other factors. For instance, suppose an insurance
company earned $250 million in premium revenue and paid out $220 million in claims. This
insurance company’s loss ratio would be 88%. With the 12% not paid out for claims, the
insurance company would need to cover selling expenses, administrative expenses such as
overhead for determining the validity of a claim (commonly referred to as loss adjustment
expenses), and potentially profit for shareholders.

$
= = = .
$
Expense ratio
The expense ratio for an insurance company is the ratio of expenses to premiums earned in
a year. Typically, expense ratios in the U.S. are in the 25% to 30% range. For instance, if an
insurance company’s premium revenue was $250 million and it had $25 million in expenses,
then the company’s expense ratio would be 10%. Overall, there appears to be a general
trend to lower the expense ratio over time.

$
= = = .
$

17
Usually, the two major sources of expenses are:
 Loss adjustment expenses, which are expenses related to assessing the validity of a
claim and deciding how much the policyholder should be paid in the event of a claim.
 Selling expenses, which include the commissions paid to brokers and other
marketing expenses related to the acquisition of a new business.
Combined ratio
The combined ratio is the loss ratio plus the expense ratio. For instance, if we sum the
previous two examples, the combined ratio would be 88% + 10% = 98%.

= + = %+ %= %
Combined ratio after dividends
Often, insurance companies will make dividend payments to policyholders. The combined
ratio after dividends adds the dividend payment from the combined ratio. For instance, if the
dividend payment was 1%, then the combined ratio after dividends would be 99%.

= +
= . + .
Operating ratio
In most cases, premiums paid by policyholders to insurance companies are made at the
beginning of the year or at the beginning of a six-month period. Payouts on claims are made
continuously throughout the year, or after the end of the year. The timing of payments and
expenses leaves room for the insurance company to earn investment income from the
interest on the premiums. This investment income is subtracted from the combined ratio
after dividends to arrive at the operating ratio of an insurance company. Building on the
previous example, the operating ratio would be the 0.99 combined ratio plus investment
income. If investment income is 2%, then the operating ratio becomes 0.97 or 97%.

= +
= . − . = .
Example
The following table presents the four ratios discussed in this section.

1 Premium rev enue $250,000,000

2 Claims $220,000,000
3 Loss ratio (row 2 / row 1 ) 88%
4 Ex penses $25,000,000
5 Ex pense ratio (row 4 / row 1 ) 1 0%
6 Combined ratio (row 3 + row 5) 98%
7 Div idends 1%
8 Combined ratio after div idends (row 6 + row 7 ) 99%
9 Inv estment income 2%
10 Operating ratio (row 8 - row 9) 97 %

18
Describe moral hazard and adverse selection risks facing
insurance companies, provide examples of each, and describe how
to overcome the problems.
Insurance companies face a multitude of risks. Two of the most
prominent risks are moral hazard risk and adverse selection risk.

Moral Hazard
Moral hazard is the risk that the availability of insurance
would cause policyholders to behave differently than they would without the
insurance. This difference in behavior increases the risks and the expected payouts
of the insurance company.

Examples of moral hazard include:

 A car owner buys insurance to protect against the car being stolen. As a result of the
insurance, the owner becomes less likely to lock the car.
 An individual purchases health insurance. As a result of the insurance policy, the
policyholder goes to the doctor more often, thus incurring more costs.
 An individual buys home insurance. As a result, the individual is less likely to install
alarm systems.
 As a result of a government-sponsored deposit insurance plan, a bank takes more
risks because it knows that it is less likely to lose depositors because of this strategy.
Insurance companies attempt to align their interests with those of the policyholders.
A better alignment can be achieved by using:
 Deductibles: The policyholder is responsible for bearing the first part of any loss.
 Co-insurance provision: The insurance company pays a predetermined percentage
(less than 100%) of losses in excess of the deductible.
 Policy limit: An insurance company places an upper limit to the payout.
In these three scenarios, the risk of moral hazard is somewhat minimized by requiring the
insured to have “skin-in-the-game,” meaning that any losses also impact the insured as well
as the insurance company.
Adverse Selection
Adverse selection refers to a situation when high-risk individuals are more likely to
purchase insurance than the general population. Insurance companies generally cannot
distinguish between good and bad risks. As a result, the insurance company offers the same
price to everyone, and thereby attracts bad risks at a higher rate. Adverse selection is simply
a problem of self-selection bias. Examples for adverse selection include:
 If an insurance company is not able to distinguish good drivers from bad drivers and
offers the same auto insurance premium to both, it is likely to attract drivers that are
more likely to get into accidents.

 If an insurance company is unable to distinguish healthy from unhealthy people, the

insurance company may offer the same life insurance premiums to both individuals.
In the process, the insurance company may attract a higher share of individuals that
are unhealthy.

19
To reduce the risk associated with adverse selection, an insurance company often attempts
to gather as much information about the policyholder before offering an insurance contract.
 For example, before offering life insurance, the insurance company may require the
potential policyholder to undergo a physical examination by an approved physician.
 As a second example, an insurance company will gather as much information as
possible about a potential policyholder’s driving record and behavior before offering
auto insurance to the driver.
It should be noted that although insurance companies generally attempt to address moral
hazard and adverse selection, it is impossible to completely overcome these risks without
perfect information.

Evaluate the capital requirements for life insurance and property-

casualty insurance companies.
Life insurance and property-casualty insurance companies take risks. If the downside of
taking risks materializes, the insurance company needs to be prepared. Part of planning for
potentially poor economic and business conditions is having enough capital to withstand the
“bad times”. Thus, the push from regulators for capital requirements.
Life insurance capital requirements
The table below depicts an abbreviated example balance sheet summary for a life insurance
company. In contrast to a bank, a life insurance company has exposure on both sides of the
balance sheet – the liability side and the asset side.

On the asset side of the balance sheet, a life insurance company’s investments are often
invested in corporate bonds, which may have higher default rates than say Treasury bonds.
As with banks, a life insurer attempts to match the maturity of its assets with the maturity of
its liabilities. By attempting to align maturities, the insurance company takes on credit risk
because of the higher default rate on corporate bonds.

The policy reserves of a life insurance company are often relatively conservative estimates
of the present value of payouts on the written policies. In the example of the table below, the
policy reserves are 80% of the assets.

If policyholders die earlier than expected (money gets paid out sooner) or the annuity
contract holders live longer than expected (more payments over a longer life), then actual
payouts would likely be higher than estimated. In cases when payouts are greater than
expected, 10% equity capital (in the table, this amount to $55 million) provides the safety
net.

Abbreviated Balance Sheet for Life Insurance Company7

7
Adapted from John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New
Jersey: John Wiley & Sons, 2018).

20
Property-casualty insurance capital requirements
The following table is an example balance sheet for a property-casualty insurance company.
The property-casualty business is more uncertain than the life insurance business, and as
such, generally requires higher equity capital. This is shown in the property-casualty table
below where the equity capital is $165 million compared to the $55 million for the life insurer
in the life insurance table above. The uncertainty stems from potential claims for large
disasters, such as hurricanes, floods, or earthquakes. The higher equity capital safety net
comes from somewhere. In the case of the table below, the higher equity capital equates to
lower policy reserves. As shown, the policy reserves of the property-casualty insurance
company are $248 million compared to $440 million for the life insurance company in the life
insurance table on the previous page.

Abbreviated Balance Sheet for Property-casualty Company8

Other differences. The different policy reserves and equity capital of life insurers compared
to property-casualty insurers are not the only differences. A property-casualty insurance
company has no unearned premiums whereas the life insurer has premiums yet to be
received. Also, although not shown in the table, property-casualty insurance companies
typically invest their assets in liquid bonds with shorter maturities compared to the bonds of
life insurance companies. This practice stems from attempts to match payouts with bond
maturities.

8
Adapted from John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New
Jersey: John Wiley & Sons, 2018).

21
Compare the guaranty system and the regulatory requirements for
insurance companies with those for banks.
Guaranty system
In the United States, policyholders are protected against insurance company
insolvency (i.e. unable to make payouts on claims) by insurance guaranty
associations. What is an insurance guaranty association? An insurance
guaranty association is a group of insurance companies that pay into a fund to cover
potential insolvencies of members. To operate an insurance company in the U.S., an
insurer must be a member of a guaranty association in the state where the insurance
company is conducting business. The amount an insurance company contributes to the
insolvency fund depends on the state, type of business, and the premiums the company
collects from business in the state. The fund pays out to policyholders of the insolvent
insurance company.

There may also be a cap on the amount the insurance company must contribute to the state
guaranty fund in a year. Because of this cap, and the general nature of the system,
policyholders may have to wait several years before the guaranty fund is in a position to
make a full payout on claims against it. In the case of life insurance, where policies last for
years, the policyholders of insolvent companies are usually taken over by other insurance
companies. During the takeover process, the acquiring life insurance company may make
some changes to the terms of the policy so that the policyholder may be less generous than
the acquired life insurer.
Guaranty system is different than banks
The guaranty system for insurance companies in the United States is different than the
system for banks. Banks pay into a permanent fund created from premiums paid by banks to
the Federal Deposit Insurance Corporation to protect depositors. In contrast, insurance
companies pay into no permanent fund. Insurance companies make contributions after
an insolvency has occurred as opposed to banks' pre-funded failures. There are, of
course, exceptions to this general observation. For instance, property-casualty companies in
New York pay into a permanent fund.
Regulatory requirements
In the U.S., insurance companies are regulated at the state level rather than at the
federal level. This was confirmed by the McCarran-Ferguson Act of 1945. This differs
from banking, where banks are regulated at many levels, including the federal level.
The state-level regulators are involved with issues such as the solvency of insurance
companies, their ability to satisfy policyholders' claims, and their business conduct (such as
contract terms, the setting of premiums, advertising, and the licensing of insurance agents
and brokers).

Insurance companies file detailed annual financial statements with regulators at the state
level. Regulators often conduct unannounced on-site reviews to ensure the insurance
company is complying with state law. Capital requirements are determined by state
regulators using risk-based capital standards determined by the National Association of
Insurance Commissioners (NAIC). The NAIC is an organization consisting of the chief
insurance regulatory officials from all 50 states.

22
Given the dispersed nature of insurance regulation, some observers have mentioned
potential shortcomings of the current system, such as the issues addressed below.
 Regulations tend to vary across different states, which may be a good or bad thing
depending upon one’s perspective. Larger insurance companies may prefer to
operate with one regulator as opposed to having multiple regulatory authorities.
Some large insurance companies think a national regulatory body would be more
efficient. Other researchers on this issue disagree.
 The regulations for insurance companies are different than for banks. For instance,
some insurance companies trade derivatives in the same way as banks but are not
subject to the same regulations as banks. This was a major political issue in 2008
when the world’s largest insurer – American International Group (AIG) – was bailed
out by the American taxpayer when they confirmed that without a bailout, they would
file for bankruptcy.
The U.S. federal government has responded to the concern that a state-level regulatory
framework is insufficient. In 2010, Congress passed the Dodd–Frank Act, which resulted in
the formation of the Federal Insurance Office (FIO). The FIO monitors the insurance industry
and identifies potential gaps in regulation. The push for federal control from some was
confirmed with a 2013 report to Congress by the FIO. The report argued that to improve
regulation of the insurance industry, Congress consider one of two options: (1) move to a
system where regulations are determined federally and administered at the state level or (2)
move to a system where regulations are set federally and administered federally. Neither of
these suggestions have been implemented.

In contrast to the U.S., the European Union regulates insurance companies centrally. The
framework is known as Solvency I. Solvency I requires that an insurance company hold
capital equal to 4% of the policy provisions, which implies that life insurance companies have
a 95% chance of surviving. One criticism of Solvency I was that it did not consider
investment risks. To answer this potential weakness, the European Union developed
Solvency II. Solvency II assigns capital for a wider set of risks. It was implemented in 2016.

23
P1.T3. Financial Markets & Products

Chapter 3. Fund Management

Bionic Turtle FRM Study Notes

Chapter 3. Fund Management

DIFFERENTIATE AMONG OPEN-END MUTUAL FUNDS, CLOSED-END MUTUAL FUNDS, AND

EXCHANGE-TRADED FUNDS (ETFS). ..................................................................................... 3
IDENTIFY AND DESCRIBE POTENTIAL UNDESIRABLE TRADING BEHAVIORS AT MUTUAL FUNDS. ... 8
CALCULATE THE NET ASSET VALUE (NAV) OF AN OPEN-ENDED MUTUAL FUND. ........................ 9
EXPLAIN THE KEY DIFFERENCES BETWEEN HEDGE FUNDS AND MUTUAL FUNDS. .................... 10
CALCULATE THE RETURN ON A HEDGE FUND INVESTMENT AND EXPLAIN THE INCENTIVE FEE
STRUCTURE OF A HEDGE FUND INCLUDING THE TERMS HURDLE RATE, HIGH-WATER MARK, AND
CLAWBACK. ...................................................................................................................... 12
DESCRIBE VARIOUS HEDGE FUND STRATEGIES, INCLUDING LONG/SHORT EQUITY, DEDICATED
SHORT, DISTRESSED SECURITIES, MERGER ARBITRAGE, CONVERTIBLE ARBITRAGE, FIXED
INCOME ARBITRAGE, EMERGING MARKETS, GLOBAL MACRO, AND MANAGED FUTURES, AND
IDENTIFY THE RISKS FACED BY HEDGE FUNDS. .................................................................... 17
DESCRIBE CHARACTERISTICS OF MUTUAL FUND AND HEDGE FUND PERFORMANCE AND EXPLAIN
THE EFFECT OF MEASUREMENT BIASES ON PERFORMANCE MEASUREMENT. .......................... 22

2
Chapter 3. Fund Management
 Differentiate among open-end mutual funds, closed-end mutual funds, and
exchange-traded funds (ETFs).

 Identify and describe potential undesirable trading behaviors at mutual funds.

 Calculate the net asset value (NAV) of an open-end mutual fund.

 Explain the key differences between hedge funds and mutual funds.

 Calculate the return on a hedge fund investment and explain the incentive fee
structure of a hedge fund including the terms hurdle rate, high-water mark, and
clawback.

 Describe various hedge fund strategies, including long/short equity, dedicated

short, distressed securities, merger arbitrage, convertible arbitrage, fixed income
arbitrage, emerging markets, global macro, and managed futures, and identify the
risks faced by hedge funds.

 Describe characteristics of mutual fund and hedge fund performance and explain
the effect of measurement biases on performance measurement.

Differentiate among open-end mutual funds, closed-end mutual

funds, and exchange-traded funds (ETFs).
Mutual funds and exchange-traded funds (ETFs) are managed
by professional money managers. Although all three types of
funds are managed, there are key distinctions between the three,
including fees to get in and out of the funds, intended holding
periods, operating costs, and investor targets, among other
differences. Investors typically opt to put money in mutual funds
and ETFs for many reasons, including:
 A desire to have investment expertise rather than put the time and effort into the
investment process themselves.
 The general rule that transaction costs are lower for large trades than for small
trades (and by pooling money in mutual funds or ETFs, investors can lower their
costs to buy stock or bond assets).
 Diversification. Investors wanting access to a broad range of assets would have to
buy each stock or bond individually to ensure diversification. For instance, if an
investor wanted to own each stock within the Standard and Poor’s 500 (S&P 500)
equity index, an investor would need to purchase every 500 stocks by himself. The
investor would also have to keep up with which stocks are in and out of the S&P 500
index at any given moment. Instead of purchasing all 500 stocks, an investor could
simply purchase an S&P 500 index fund and be diversified to all stocks in the S&P
500 with just one purchase.

3
 • Number of • Number of • Track and
Open-End Mutual Funds

Exchange-Traded Funds
Closed-End Mutual Funds
shares shares is index of
increase or fixed stocks, such
decrease • Trade like a as the S&P
• NAV is stock 500
calculated at • Usually have • Can be
4 p.m. each a market bought and
day value that is sold at any
• Actively and less than the time and can
passively NAV of the be shorted
managed underlying
assets

Open-End Mutual Funds

The key distinguishing feature of open-ended mutual funds is that the number of shares
outstanding increases or decreases each day as investors opt to put more money into the
fund or decide to redeem their shares. Shares in the fund can be bought from the fund or
sold back to the fund at any time. Some important aspects of open-ended mutual funds
include:
 The funds are valued once a day at 4 p.m. When an investor issues instruction to buy
or sell shares, the value calculated at the end of the day is applied to the transaction
made before that time during that day.
 The value of each share is calculated and referred to as the net asset value (NAV)
of the fund. The NAV is simply the total value of the fund’s assets divided by the
number of shares outstanding. To arrive at the NAV of the fund, the fund manager
sums up all the market values of the assets in the portfolio at the 4 p.m. cutoff.
∑
( )= =
ℎ ℎ

Mutual fund companies and other providers of open-ended funds offer many types of open-
ended funds, such as:
 Money Market funds, which invest in fixed income securities with maturities of less
than one year. Most money market funds attempt to keep a NAV of $1. When the
fund drops below $1 NAV, it is referred to as breaking the buck. Breaking the buck
occurs very infrequently. The most recent popularized breaking of the buck occurred
in September 2008 to Reserve Primary Fund. The buck broke because the Reserve
Primary Fund held commercial paper issued by now-bankrupt Lehman Brothers. In
response to the situation, governments stepped in to guarantee money market funds.
 Bond funds, which invest in fixed income securities with maturities of more than one
year.
 Equity funds, which invest in stocks of publicly traded funds (typically).
 Hybrid funds, which invest in more than one type of security (multi-asset fund).

4
The most well-known and used open-ended mutual funds are equity funds. Equity funds can
be divided into two general groups:
 Actively managed fund. An actively managed fund relies on stock selection and
timing skills of the fund manager, such as funds that invest in equities with high
dividend ratios.
o Actively managed funds usually have a higher expense ratio than a passively
managed fund, where the expense ratio is defined as total expenses divided
by total assets.

 Index or passively managed fund. An index or passively managed fund is

designed to track an index, such as the S&P 500 or FTSE 100. The fund buys all the
shares in the index in an amount representative of the index’s weight and generally
accomplishes this goal.
o Although index funds attempt to perfectly track the index of stocks, tracking is
not perfect, as every index fund has tracking error. The average tracking error
of passively managed funds may be around -0.48%. The negative in front of
the 0.48% means that passively managed index funds usually underperform
their associated index by 0.48%1.
o Index funds typically have lower expense ratios compared to actively
managed funds. This is because actively managed funds typically require
fees for their expertise and administrative/trading activities.
The return of closed-end funds can also be affected by front-end and back-end load fees.
 Front-end load fees. A mutual fund charging front-end load fees is imposing a fee
for purchasing into the fund. The fee often goes to the brokers that sell the fund to
investors.
 Back-end load fees. A mutual fund charging back-end load fees is imposing a fee
when the investor redeems shares in the mutual fund. Back-end load fees are
generally an attempt to prevent investors from moving quickly in and out of the
mutual fund, which increases the expense ratio of the fund. Often, back-end load
fees are for a specified period, such as 6-months or 1-year. Once the investor has
met the holding period requirements, back-end load fees typically go away.
Investor interest in open-ended mutual funds has grown quickly in recent years. In 2008,
open-ended mutual funds had $21.7 trillion in total net assets under management (AUM).
That figure has more than doubled since then, ending 2017 at $49.3 trillion. Of the AUM in
open-ended funds, the largest portion is held in equity funds (44% as of the end of 2017).

In terms of AUM with actively managed mutual funds compared with passively managed
mutual funds, actively managed funds have grown from $1.5 trillion in 1993 to $12.5 trillion in
2017. Over the same period, passively managed funds have gone from $28 billion to $3.3
trillion. The growth in passively managed funds has been much stronger because of
investors’ concerns that actively managed funds do not produce better returns than the
market as a whole, while simultaneously imposing higher fees2.

1
A. Khorana, H. Servaes, and P. Tufano, “Mutual fund fees around the world,” Review of Financial
Studies, 22 (March 2009): 1279-1310.
2
See, as an example, S. Ross, “Neoclassical finance, alternative finance, and the closed-end puzzle,”
European Financial Management, 8(2002): 129-137.

5
Total Net Assets of Worldwide Regulated Open-End Funds3

Closed-End Mutual Funds

In contrast to open-ended mutual funds, closed-end mutual funds have a constant number of
shares (unless new shares are issued). Closed-end mutual funds are essentially a regular
company with the purpose of investing in other companies. When an investor buys shares in
a closed-end mutual fund, they are buying a share in the investing company. The price of the
company reflects changes in expected profit and overall supply and demand.

Net asset value. For closed-end funds, two NAVs are calculated.
 The first NAV is the price at which the shares of the fund are trading.
 The second is the fair market value, which is the market value of the fund’s portfolio
divided by the number of shares outstanding. Usually, a closed-end fund’s share
price is less than its fair market value. One would think that if the NAV was higher
than the trading value of a closed-end fund, that arbitragers would bid this
discrepancy away. Research has generally argued that the reason for the persistent
discrepancy is the fees paid to fund managers4.

3
The Investment Company Factbook, 2018, The Investment Company, 2018. Available at
https://www.ici.org/pdf/2018_factbook.pdf
4
See, as an example, S. Ross, “Neoclassical finance, alternative finance, and the closed-end puzzle,”
European Financial Management, 8(2002): 129-137.

6
 o The persistent difference between the market value of closed-end funds and the
NAV can also be explained with an example. Assume that an investor is
considering buying into a closed-end fund for five years. The fund is assumed to
pay no dividend and the fund’s return on assets is assumed to be 10%. Without
considering other factors, the fund’s expected value in five years is $161.05.
= $100∙ (1 + 0.10) = $161.05
Now, suppose that the closed-end fund charges a management fee of 1% of
AUM. Implied from this 1% is that the fund’s value will grow at 9% instead of
10%. The expected value after five years is then $153.86, or 4.5% less than the
value of the underlying assets.
% = $100∙ (1 + 0.09) = $153.86
Thus, one should expect the value of closed-end funds to be less than the value
of their underlying assets.

Exchange-Traded Funds
Exchange-traded funds (ETFs), also known as index funds
or passively managed funds, are funds whose design is to
track an index, such as the S&P 500 or the Dow Jones
Industrial Average. Originally introduced in the U.S. in
1993 and in Europe in 1999, ETFs have fundamentally
altered the way investors invest and money managers
allocate investments.

An ETF is similar to a stock, where some or all of the shares in the ETF are traded on a
stock exchange. This feature makes ETFs more like a closed-end mutual fund. However, a
key difference between ETFs and closed-end mutual funds is that the value of the assets
underlying the ETF is virtually identical to the market price of the ETF, whereas the market
price of closed-end mutual funds is typically priced below their NAV. This equally stems from
the requirement that ETFs be easily exchangeable on the market. If there was even a
noticeable difference between the value of the assets within the ETF and its market price,
this discrepancy would be arbitraged away quickly.

Because ETFs generally have the same characteristics as stocks, it likely comes as no
surprise that ETFs can be bought and sold at any time of the day, unlike open-ended mutual
funds. Exchange-traded funds can also be shorted, just like stocks. Twice each day ETF
holdings are disclosed, providing investors with more information about the assets
underlying the fund. This is quite different than mutual funds, which disclose their holdings
infrequently.

How are ETFs able to achieve much lower expense ratios compared to most mutual funds?
When an investor redeems shares in a mutual fund, managers sell the stocks in which the
fund has invested. They sell the stocks to raise the cash that is paid to the investor. With
ETFs, this is not necessary because another investor is purchasing the shares from the
seller. Generally, the ETF provider does not need to sell the shares. Thus, ETFs achieve
lower transaction costs and by extension lower expense ratios.

7
Identify and describe potential undesirable trading behaviors at
mutual funds.
In the U.S., Europe, and many other countries or political unions, mutual funds and ETFs are
heavily regulated. In the U.S., the regulatory authority is the Securities and Exchange
Commission (SEC). Regulators work to prevent conflict of interest between mutual fund
managers and the assets they purchase on behalf of the funds’ investors. Additionally,
regulators require very detailed financial reporting to prospective investors. Despite being
heavily regulated, mutual fund managers may take part in undesirable trading behaviors that
lower the actual returns of investors.

Late trading
In the U.S., all buy and sell orders in an open-ended mutual fund
end at 4 p.m. Thus, all trade instructions should be with a broker
before 4 p.m. Theoretically for administrative reasons, however,
the pre-4 p.m. trades may not make it to the mutual fund until
after 4 p.m. If there are market developments soon after 4 p.m.,
a trader might call the broker to cancel a trade that was
previously scheduled to be carried out at the price it would have
gone for at the 4 p.m. cutoff. A trader may also call after the 4
p.m. deadline and request that the broker put through a new
trade at that price. Additionally, some brokers have been known
to (dishonestly) accept orders after 4 p.m. This activity is known
as late trading and, although it happens, it is illegal. Regulators
look for this type of activity and attempt to prosecute violations in
an effort to make the financial system fair for all investors.
Market Timing
Although most assets of an open-ended mutual fund trade
actively, not all do. Because of this, the prices employed to
calculate the fund’s NAV may not reflect the most recent
information. Additionally, prices of securities that trade on
overseas markets may also be stale because of time zone
differences. For instance, suppose that it is 3:45 p.m. and
markets have been performing well over the past few hours,
generally up. With the knowledge that some of the prices of the assets are stale, a trader
could probably guess that the value of the mutual fund shares are probably worth (slightly)
more than what the NAV would indicate. The trader could act on this knowledge and
purchase shares in the mutual fund before 4 p.m. Likewise, in down markets, a trader may
wish to sell at 4 p.m. if the trader believes that the NAV slightly overstates the value of the
assets in the fund. This type of market timing is perfectly legal but may need to be very large
to make it worth the trader’s time. Should this activity occur too often, the size of the fund
may be more volatile than it otherwise would be. This type of trading could also lead to costs
for all investors as the fund may have to keep additional cash on hand to accommodate
redemptions. Lastly, regulators may become concerned if special trading privileges are
offered to market timers.

8
Front Running
Front running refers to the practice that individuals with insider knowledge make trading
moves before the knowledge becomes public. For instance, suppose a trader working for a
mutual fund knows that the fund he works for will execute a large trade that may move
markets. The trader will be tempted to trade on his or her own account immediately before
putting through the fund’s trade. For instance, if a fund is going to buy 20 million shares of a
large company stock, the trader might buy 100,000 for his own account before the 20 million
shares are purchased for the fund. The trader could go even further than trading on his own
accounts before the fund trades and pass on this knowledge to preferred customers or other
fund employees. It likely comes as no surprise that front running (also known as tailgating) is
illegal for employees in the fund management industry.
Directed Brokerage
A directed brokerage agreement is an informal arrangement between a mutual fund and a
brokerage house that the mutual fund will use for its trades if the brokerage house
recommends the mutual fund to its clients. This type of quid-pro-quo behavior is generally
not in the clients’ best interest.

Calculate the net asset value (NAV) of an open-ended mutual fund.

Calculating the net asset value (NAV) of an open-ended mutual fund is a three-step process.
First, the managers calculate the market value of each asset in the fund.

= { , …, , }

In the above set, the fund managers calculate the market value for asset i through asset N.

After calculating all the market values, the fund managers sum up all the market values to
arrive at a total market value for the fund.

The third step to derive the daily NAV is to divide the total market value by the number of
shares outstanding.
∑
( )= =
ℎ ℎ

For instance, if the total value of the assets in the fund was $1 billion and if the number of
outstanding shares is 2 million, then the NAV is $500 per share.

$1,000,000,000 $500
( )= = =
ℎ 2,000,000 ℎ

9
Taxes

In an open-ended mutual fund, the investor is responsible for

any taxes as though he owned the securities in the fund.
Likewise, when the fund receives a dividend, an investor is
responsible for his share of the dividend, even if the dividend is
reinvested in the fund. When the fund sells securities, the
investor is responsible for any capital gain or loss, even if the
fund has not sold any of the investor’s shares in the fund.

Adjustments for capital gains and losses

Fund managers and investors must ensure that no double counting occurs. To ensure this,
the purchase price of the shares gets adjusted to reflect any capital gains and losses
accrued to the investor. For instance, suppose an investor purchases shares in a fund at
$100. After the first year, the capital gains are +$20 and after the second year, the capital
loss is -$25. In this instance, if an investor sold shares in the fund during the second year,
the purchase price for tax purposes would be assumed to be $120. Similarly, if the investor
sold his shares in the fund during the third year, the purchase price would be assumed to be
$95 for tax purposes.

Explain the key differences between hedge funds and mutual

funds.
Hedge funds (also known as alternative investments) and
mutual funds differ from each other in a number of
aspects.
Size of the investable assets of an investor
Hedge funds typically use strategies that carry more risk for the average investor. Because
of this, hedge fund investors usually need to be accredited investors. What are accredited
investors? Accredited investors are high-net-worth individuals, banks, financial institutions,
and corporations with the assets and sophistication to accept the risk associated with hedge
funds. Requirements to be an accredited investor differ across the world. In the U.S., an
accredited investor is an individual or entity with at least $2.5 million in investable assets
and/or $250,000 in income over the prior two years.

Mutual funds, on the other hand, generally accept investment money from all types of
investors, including small investors with just a few hundred dollars to large corporations with
hundreds of millions to invest. Often, mutual funds will offer different classes of the mutual
fund shares (such as Class A shares, Class B shares, and so forth) with different investment
requirements and fee structures. For instance, a mutual fund may offer Class A shares to
only institutions that invest $100 million or more in the fund.
Regulations
Hedge funds and mutual funds are subject to different sets of regulations. It is generally
thought that hedge funds are subject to fewer regulations than mutual funds because hedge
funds cater to financially sophisticated (or theoretically sophisticated) individuals. This is not
to say that hedge funds do not have regulations on how they market their products, what
their strategies may be, what their legal liabilities are, and a host of other regulations. With
this acknowledged, mutual funds differ from hedge funds in the following ways.

10
  Redemption: mutual funds or ETFs allow investors to redeem or sell their shares on
any given day. Mutual funds may charge a fee for short-term trading or a back-end
load fee. In contrast, hedge funds often have long lock-up periods. During lock-up
periods, investors cannot withdraw their money.
 Reporting of fund value: mutual funds are required to report their NAV at least once
per day. In contrast, hedge funds have more flexibility in reporting returns monthly,
quarterly, or at some other interval.
 Disclose of investment strategy: while mutual funds must be generally transparent
with their investment strategy, hedge funds generally keep their investment strategy
proprietary, as they consider this a competitive advantage. Hedge funds must
disclose the general nature of their investment activities but keep proprietary
components proprietary. Additionally, as long as it is disclosed, hedge funds may
switch between investment strategies depending upon management’s view of the
economic situation.
 Leverage: mutual funds are generally prohibited from using leverage. In contrast,
many hedge funds may use leverage to increase their potential return.
Fees
Another important distinguishing point between hedge funds and mutual funds is the fees.
Both mutual funds and hedge funds must be completely transparent on fees, although their
fee structures are usually widely different.
 Mutual fund fees. Mutual funds always charge an
expense ratio fee to cover operating expenses. Mutual
funds may also impose:
o Sales charges (front-loaded fee)
o A redemption fee (back-loaded fee when shares
are sold)
o Short-term trading fees for shares that are held less than say 30 to 90 days
o Ongoing service fees, known as 12(b)1 fees, marketing, or other costs.
 Hedge fund fees. Hedge funds may impose a fee of 1% to 3% of assets under
management and some percentage of profits above a hurdle rate. That hurdle rate
might be something like the return on the S&P 500 or the return on the 10-year
Treasury Note. A typical hedge fund fee might be expressed as “2 plus 20%”, which
means that the fund charges 2% per year of assets under management and 20% of
net profit above some hurdle rate. In addition to the fees imposed, hedge funds also
require a lock-up period of typically at least one year. There is considerable debate
about whether the fees imposed by hedge funds are worth it. Certainly, some hedge
funds have done spectacularly well, returning an average of 35% per year over a 20-
year period5, while others have provided returns that were far less spectacular.

5
Renaissance Technologies, founded by mathematics professor Jim Simons, is the hedge fund
referred to here.

11
 Differences Between Hedge Funds and Mutual Funds
Hedge Fund Mutual Fund
Size of investor Typically, hedge fund Mutual funds may cater to
investors must be small or large investors, and
accredited investors (in the typically have different
U.S., >$2.5 million in classes of shares depending
investable assets and/or upon the size of the investor
>$250,000 in income for the
past two years)
Strategies Hedge funds have more Can invest in various asset
leeway in their strategies classes, including equities,
and, as long as it is bonds, commodities, and
disclosed, can change other investment options.
investment strategies on a One strategy that is
dime. Hedge funds can also prohibited is the use of
employ leverage, shorting, leverage. Additionally, the
and other riskier financial strategy is fixed by the
maneuvers. prospectus
Risk Can range from very risky to The risk is dependent upon
completely hedged. Hedge the allowable investment
funds are generally options stated in the
considered riskier than prospectus
mutual funds because of the
investment strategies
employed
Regulation Lighter regulation Heavily regulated
Fees Usually higher fees that, Usually has management
including base fees and fees fees as a percentage of
linked to performance of the assets under management
fund and potentially front-end
and/or back-end loaded fees
Length of investment Typically has a lock-up Generally required to allow
period investors to redeem their
shares at any moment, but
can charge a short-term
trading fee or a back-end
load fee

Calculate the return on a hedge fund investment and explain the

incentive fee structure of a hedge fund including the terms hurdle
rate, high-water mark, and clawback.
Return on a hedge fund investment
The net return on a hedge fund investment depends upon the fee structure paid by the
investors. Suppose an investor places $5 million in Hedge Fund A and Hedge Fund B.
Further suppose that both funds charge a “2 plus 20” fee, meaning that the hedge fund
imposes a fee of 2% of assets under management (AUM) and 20% of realized profits. Lastly,
assume that both funds have no hurdle rates to achieve before the incentive fee is paid out.

12
Scenario 1. Suppose in the first year of investment, Fund A earns a gross return of 20% and
Fund B earns a gross return of –10%. Before any fees, the investor’s return on the
investment is 5%.

= 0.5 ∙ 20% + 0.5 ∙ (−10%) = 5%

Now let’s consider the fees paid to the managers of the funds. The fees paid by the investor
to Fund A and Fund B are 5.6% and 2%, respectively, as shown below.

= 2% + 0.2 ∙ (20% − 2%) = 5.6%

= 2% + 0.2 ∙ {−10% − 2%, 0} = 2.0%

. % %
On average, the fee paid by the hedge fund investor is 3.8% (which is ). Net of fees,
the investor’s return is 1.2% (5% - 3.8% = 1.2%).

In the previous example, the fees were calculated separately. What if the 2% plus 20% fee
structure were applied to the overall return of 5% instead of the two investments separately?
The investor would have paid a fee of 2.6% (which is 2% + 0.2 (5% -2%) = 2.6%). In this
instance, the investor’s return is double that of the original return at 2.4% (which is 5% -
2.6% = 2.4%).

In this example, the hedge funds were imposing fee structures of “2 plus 20”. Fees imposed
by hedge funds have been under pressure in recent years, and as such, they are coming
down. Many hedge funds now offer “1.5 plus 15” or even more competitive fee structures.

Fund of funds. In addition to investing directly in hedge funds, an investor may opt to invest
in a fund of funds. What is a fund of funds? Fund of funds is a way for an investor to diversify
across hedge funds by allowing investors to place money in the fund of funds. The fund of
funds then places the investment into multiple hedge funds. Fund of funds managers charge
a fee for this service. A fund of funds hedge fund may charge a fee of 1% of assets under
management plus 10% of the net profits above some hurdle rate. The hurdle rate may
include the management and incentive fees of the hedge funds invested in.

An example of a fund of hedge funds. Consider an example where a fund of hedge funds
divides its money equally between 10 hedge funds. Assume all hedge funds charge a 2 plus
20% fee structure and the fund of hedge funds charges a 1 plus 10% fee structure. At first
glance, one might think the investor would be paying a 3 plus 30% fee structure. In reality,
the actual fees can be higher. Consider the following scenario in the table below where five
of the hedge funds lose 40% before fees and the other five make 40% before fees.

In this scenario, the profitable hedge funds would impose an incentive fee of 20% on the
profit, equating to 38% (which is 0.2 × (40% – 2%) = 7.6 %). The average incentive fee
across all 10 funds is 3.8% (which is (7.6% × 5)/10 = 3.8%).

The 3.8% average incentive fee is not the end of the story. In addition to the incentive fee,
the investor will need to pay the management fee to each of the hedge funds (through the
fund of funds) and the 1% management fee to the fund of funds. In this scenario, the net
return of the investor is –6.8% (which is 3% + 3.8%).

13
Incentives of Hedge Fund Managers
A major difference between hedge fund managers and mutual
fund managers is incentive pay. Outside of losing assets to
manage for poor performance, mutual fund managers generally
have no incentive to perform better than the market, at least
from an investor’s perspective (the company employing the
mutual fund manager may have an incentive pay structure,
though). In contrast to the mutual fund manager, a hedge fund manager has a fee structure
that gives him an incentive to make a profit above some hurdle rate. Essentially, the hedge
fund manager has a call option on the assets of the fund. In practice, this means that hedge
fund managers can increase the value of their option by taking risks that increase the
volatility of the fund’s assets and (hopefully) increase the return of the fund.

14
An example of a hedge fund manager’s incentive. As an example of the incentive
structure of a hedge fund manager, consider this example. Suppose there is a 40%
probability of a 60% profit and a 60% probability of a 60% loss for a hedge fund that charges
the theoretical industry-standard fee of “2 plus 20%.”

In this example, the expected return on the investment is -12%.

= 0.4 ∙ 60% + 0.6 ∙ (−60%) = −12%

Interestingly, although the return is negative, the hedge fund manager still earns a fee from
managing the money (as is the case with mutual fund managers and most other financial
mangers). In this example, the fee income is 13.6% of the assets under management for the
case when the fund earns a 60% profit and 2% if the -60% materializes. The probability-
weighted fee (expected value) is 6.64%, made up of the 2% management fee and the 4.64%
incentive fee. Of course, a mutual fund manager would have also been paid regardless of
the return of the fund.
 60% profit example: the hedge fund’s fee is 2% + 0.2 × 58% = 13.6%.
 60% loss example: the hedge fund’s fee is 2% + 0.2 x 0% = 2%.
 The expected (or probability weighted average) fee to the hedge fund is 0.4 × 13.6%
+ 0.6 × 2% = 6.64%.

The expected return for the hedge fund investors, after accounting for the fees, is -18.64%,
as shown in the table below.

0.4 ∙ (60% − 0.2 ∙ (60% − 2%) − 2%) + 0.6 ∙ (−60% − 2%) = −18.64%

An Example of a High-Risk Investment with a "2 + 20" Fee Structure

Returns 60% -60%
Probability 40% 60%
Expected return to hedge fund 6.64%
Expected return to investors -18.64%
Overall expected return -12.00%

The above table should make one point clear. The fee structure for hedge funds provides an
incentive for hedge fund managers to take high risks, perhaps even when expected returns
are negative. For instance, if one changes the probabilities in the table (see below) to be a
10% chance of a gain of 60% and a 90% chance of a 60% loss, the expected returns for the
investors and the hedge fund managers are -51% and +3%, respectively. The hedge fund
manager’s expected return only drops by a little more than 3% even though his investors’
expected return drops from about -19% to about -51%.

An Example of a High-Risk Investment with a "2 + 20" Fee Structure

Returns 60% -60%
Probability 10% 90%
Expected return to hedge fund 3.16%
Expected return to investors -51.16%
Overall expected return -48.00%

15
Arrangements (or clauses) offered by hedge funds to make high fees more palatable
Since the incentive fee structure and the associated risk of the hedge fund is high relative to
a mutual fund manager with no incentive structure, hedge funds and their clients may agree
to arrangements that include certain clauses to better align incentives. These include,
among others:
 Hurdle rate: Investors may demand that, in order for the hedge fund to earn their
high fees, it must perform better than a specified minimum return. Generally,
investors push for hurdle rates that are as high as possible, sometimes even as high
as the return on the S&P 500. In contrast, hedge funds generally attempt to keep the
hurdle rates low, such as the yield of the 10-year Treasury Note.
 Clawback clause: Clawback clauses are what the name implies – an investor can
“clawback” something. What the “something” is depends on the contract. For
instance, a clawback clause may allow investors to apply for part or all of the
previous incentive fees against current losses. In this case, a portion of the incentive
fees paid by the investor each year is then retained in a recovery account and used
to compensate investors for a percentage of any future losses.
 High-water mark clause: A high-water mark clause requires the hedge fund to
recoup any previous losses before an incentive fee applies. The high-water mark
clause is investor specific, meaning that the hedge fund and each investor will need
to keep track of what the provisions are. For instance, if an investor places $100
million with a hedge fund and the fund loses $10 million, then the managers of the
hedge fund must make $10 million before incentives kick back in.
 Proportional adjustment clause: A proportional adjustment clause states that if
funds are withdrawn by investors, the amount of previous losses that have to be
recouped is adjusted proportionally. In the example used above, if the investor
withdraws $5 million before the hedge fund makes up the losses, the hedge fund
may only need to make up $5 million before the incentive fees apply again.

16
Describe various hedge fund strategies, including long/short
equity, dedicated short, distressed securities, merger arbitrage,
convertible arbitrage, fixed income arbitrage, emerging markets,
global macro, and managed futures, and identify the risks faced by
hedge funds.
Hedge funds use a variety of strategies catered to different
types of investors. Hedge funds may also change strategies
depending upon the belief of the manager.
Long/Short Equity
Perhaps the most popular hedge fund strategy is a long/short
equity strategy. Managers using a long/short strategy take
long positions in a group of perceived undervalued stocks and
a short position in a group of stocks considered overvalued by
the market. In theory, this strategy could provide strong
returns regardless of whether general market conditions are
in bull and bear markets if the stocks are picked up after
being well researched. The long and short positions need not
be of equal size. Often, the hedge fund manager has a net
long bias, meaning that the hedge fund’s long stock
ownership is larger than the shorts. The flip can also be true
should the hedge fund manager have such as bias.

Referring to a fund as long/short captures the broad picture.

There are many different styles underneath this umbrella,
including:
 An equity-market-neutral strategy, which matches
long positions with short positions in some way.
 A dollar-neutral strategy, which takes an
approximately neutral strategy where the amount of the long position equals the
amount of the short position.
 A beta-neutral strategy, which is an equity-market-neutral fund where the weighted
average beta of the shares in the long portfolio equals the weighted average beta of
the shares in the short portfolio. Done correctly, the overall beta of the portfolio is
zero or totally insensitive to market movements. (As a reminder, the beta of a
portfolio is how correlated the returns of a fund are with the overall market.)
 A sector neutrality strategy, where long and short positions are balanced across
industry sectors.
 A factor neutrality strategy, where funds maintain neutral exposure to such factors
as:
o The price of oil,
o The level of interest rates, or
o The rate of inflation.

17
Dedicated Short
Dedicated short strategies are strategies in which the hedge fund managers select stocks
they consider overvalued and sell them short. Hedge fund managers may use this strategy
to take advantage of nuances in the marketplace, including:
 Brokers and analysts are generally less than excited to issue sell recommendations.
If the hedge fund managers think they can trade based upon this incented behavior,
they may generate reasonable returns.
 Shorting companies with weak financial measures, such as market value to book
value, earnings growth, or other financial measures.
 Shorting companies that change their auditors regularly.
 Shorting companies that delay filing reports with the U.S. Securities and Exchange
Commission.
 Shorting companies in industries with perceived overcapacity, which may lead to
profit pressure.
 Shorting companies attempting to silence their short sellers.
This list of potential reasons hedge fund managers may short a company is not intended to
be exhaustive, but rather an indication of some of the reasons hedge fund managers make
the investment decisions they make.
Distressed Securities
Bonds with a rating of BB or lower are referred to as “non-
investment grade” or “junk” bonds. Bonds with a credit rating
of CCC are known as “distressed”. Bonds with a D rating are
in default. There are important points to consider when
thinking about distressed security investing, addressed below.
 Distressed debt cannot be shorted. The nature of
distressed debt is that there are no takers for potential
shorting. This means that hedge fund managers
cannot bet on the debt dropping further. Instead of
shorting, hedge fund managers usually look for debt
that the managers consider undervalued by the
market.
 Bankruptcy laws must be known. When dealing with
distressed debt, one has to know that any investment is one step away from
bankruptcy. Because of this, distressed debt hedge fund managers must be well
versed with bankruptcy proceedings, including reorganization, liquidation, recovery
rates, prioritization, and other factors that would determine whether the hedge fund,
as an owner of bond debt, would get paid in the event of a bankruptcy.
 Passive managers take one type of risk. Passive hedge fund managers buy
distressed debt when managers think the price is below its fair value and generally
hold it. The advantage of a passive approach, compared to an active approach, is
that the fund generally places smaller bets on the distressed company.
 Active managers take another type of risk. Active managers, in contrast to
passive managers, may buy a large position in outstanding debt so that they can
influence any potential reorganization proposal. The risk with this is that the hedge
fund is placing more assets at risk for greater control of the assets in case
bankruptcy occurs.

18
Merger Arbitrage
A merger is when one company combines with another company. Mergers can be friendly or
contested. Typically, when a potential merger is announced, there is uncertainty about
whether the merger will go through. Some roadblocks might be shareholder resistance,
regulatory concerns, and anti-trust considerations. Merger arbitrage is when an investment
manager makes “bets” on whether a merger will go through after it has been announced. In
terms of returns, merger-arbitrage hedge funds generally produce reasonable, but not
massive, returns.

Mergers arbitrage can be divided into two main types of deals:

 Cash deal. Consider a cash deal in which Company Gamma announces that it plans
to acquire all shares of Company Epsilon for $50 per share. Prior to the
announcement, suppose the shares Company Epsilon were trading at $42 and
immediately after the announcement the price jumps to $48 per share. Why did the
price not rise all the way to $50 per share? Well, there is uncertainty about whether
the deal will go through. It may also take time to factor into market prices. Merger-
arbitrage hedge funds buy the shares in company Epsilon for $48 and wait. If the
merger happens at $50 per share or higher, the fund makes a profit of at least $2 per
share. There is, of course, the risk that the deal will not go through. If the merger is
blocked by say, the U.S. Justice Department, the hedge fund may take a loss if the
target company’s share price drops back to $42 per share.
 Share-for-share exchange. Consider a share-for-share exchange in which
Company Gamma is willing to exchange one of its shares for four of Company
Epsilon’s shares. What would happen to the price of Company Epsilon? Well,
assume that Company Epsilon’s shares were at 15% of the price of Company
Gamma, say $15 and $100, respectively. Post-announcement, Company Epsilon’s
share price might rise to what a 4:1 exchange would mean. In this case, prior to the
announcement, four of Company Epsilon’s shares would have been $60 per share.
Post-announcement, the notional value of each share of Company Epsilon would be
$25 per share (4 shares of Epsilon would be $100), a gain of 67%. A merger
arbitrage hedge fund would buy a certain amount of Company Epsilon’s stock and
simultaneously short a quarter as much of Company Gamma’s stock. If things go as
planned, the deal generates handsome profits.

Convertible Arbitrage
Convertible bonds are bonds that can be converted into the
equity of the bond issuer at specified times and prices in the
future. The price of the convertible bond depends upon:
 The price of the underlying equity.
 The volatility of the equity.
 Interest rates.
 Default probability.
Hedge fund managers involved in convertible arbitrage typically have complex models for
valuing convertible bonds. Many convertible bonds trade at undervalued prices compared to
their presumed fair market value. Some hedge fund managers with this strategy will buy the
convertible bonds and hedge their risks by shorting the underlying stock.

19
Fixed Income Arbitrage
A common hedge fund strategy related to fixed-income (bonds) is fixed-income arbitrage.
Underneath the fixed-income arbitrage umbrella are the details of each strategy, including
relative value, market neutral, and directional strategies.
 Relative value strategy. Hedge fund managers employing a relative value strategy
buy bonds where the zero-coupon yield curve indicates the bonds may be
undervalued by the market, and sell bonds along the same yield curve that it thinks
are overvalued.
 Market-neutral strategy. Hedge fund managers involved in market-
neutral strategies are using the same general tools as managers
using the relative value strategy, with the difference being that the
fund has no exposure to interest rate movements.
 Directional strategy. Some fixed-income hedge fund managers follow
directional strategies, where managers take positions based upon
expectations that certain interest rate spreads, or interest rates
themselves, will move in a direction favorable to their investment. It is
common for directional strategy funds to use leverage and must post
collateral with their prime brokers. This strategy generally has more short-term risk
than long-term risk because interest rate movements on orders of magnitude may be
relatively predictable, but in the short-term markets often move unpredictably.
Emerging Markets
Another common hedge fund strategy is to invest in emerging markets (sometimes referred
to as developing countries). Hedge funds investing in emerging markets may make equity,
debt, or some other type of investment.
 Equities. When managers make equity investments, managers invest in securities
trading on the local exchange, or through American Depository Receipts (ADRs). In
the case of ADRs, the certificates are backed by shares of a foreign company issued
in the U.S. The ADRs trade on U.S. exchanges. Why would hedge fund managers
invest in ADRs as opposed to owning the stock in its local currency? There are two
main reasons. First, ADRs may have better liquidity, and second, ADRs may have
lower transactions costs than the underlying foreign shares. Although snapped up
quickly, sometimes there are price discrepancies between ADRs and the underlying
shares that arbitragers may exploit.
 Debt. Typically, when managers invest in emerging
market debt, they are investing in Eurobonds or local
currency bonds.
o Eurobonds are bonds issued by the country
and denominated in a hard currency such as
the U.S. dollar or the euro.
o Local currency bonds are bonds
denominated in the local currency. Generally, local currency bonds are
thought to be riskier than Eurobonds because countries can print money (the
bonds are in their own currency) to pay off the bonds. In recent years, there
have been several incidents in emerging market debt, including defaults by
Argentina, Russia, Brazil, and Venezuela, to name a few.

20
Global Macro
Global macro strategies are perhaps the most flexible of investment strategies. Hedge fund
managers involved in global macro trade based upon expected global macroeconomic
trends. Essentially, global macro managers attempt to spot situations where markets have
moved “too far away” from equilibrium. After finding such situations, managers invest funds
in the direction of the markets towards equilibrium. Many global macro funds make
investment decisions based upon exchange rates and interest rates, among other factors.

Global macro funds may be further sub-divided into systematic (computer-driven algorithms)
or classic discretionary investing. Within these broad classifications are further sub-divisions,
such as funds that focus on:
 Types of trades, such as directional versus relative value.
 Geographic focus, such as emerging markets or developed countries.
 Asset class specialization, such as commodities, currencies, or volatility.
Examples. One potential macro strategy could be for the U.S. dollar to depreciate because
of the large balance of payments trade deficit. Perhaps the most famous global macro hedge
fund example is George Soros’s Quantum Fund. Mr. Soros bet heavily in 1992 that the
British pound would depreciate because of policy moves by the Bank of England and the
British government. His move would later be called “the man who broke the Bank of
England.”

Global macro funds possess many risks. Of the risks, and perhaps the most transparent, is
that managers do not really know where or when the equilibrium will be restored. Global
markets can be in disequilibrium for long periods of time.
Managed Futures
Hedge funds that employ a managed futures strategy are attempting to predict the future
movements in commodity prices.

When making investment decisions on the future of commodity prices, managers of

managed futures funds may use, among other techniques:
 Technical analysis. When managers employ technical analysis techniques, they
use historical price performance and other external forces to predict future price
movements.
o Technical analysis typically comprises back-testing, out-of-sample testing,
and other data mining techniques. These advanced modeling techniques are
different from the rules of fundamental analysis.
o Some data mining professionals will point out that out of the many thousands
of possible trading techniques, a few will perform well on historical data even
though there is no guarantee that they will perform well in the future.
Technical analysts are well aware of this critique.
 Fundamental analysis. When managers employ fundamental analysis techniques,
they are attempting to derive a fair value for the commodity based upon so-called
fundamental factors. Fundamental factors might include:
o Market conditions in which the fund is investing.
o The economy.
o Weather conditions, including projected weather conditions.
o Supply and demand forces.
o Cross-competition from other commodities

21
Describe characteristics of mutual fund and hedge fund
performance and explain the effect of measurement biases on
performance measurement.
Mutual Funds
Suppose you are a potential mutual fund investor. In addition to potentially investing in a
mutual fund, you can also invest in hedge funds, index funds, individual stocks,
commodities, and a host of other investment options. When considering investing in a
mutual fund, what questions might you ask? Some relevant questions might be:
 Will an investment in an actively managed mutual fund outperform the market (i.e.
should an investor pay a professional investor for their expertise)?
 If an investment in an actively managed fund outperforms the market in one year, will
it continue to outperform the market in subsequent years?
The answer to both questions, according to research begun in the 1960s by finance
professor Michael Jensen, is no6. Actively managed mutual funds generally do not beat the
market after one considers expenses associated with ownership of the funds.

The first question was answered simply with historical return data. Mr. Jensen answered the
second question by calculating the probability that a mutual fund that has beaten the market
for one or more years will do so again the following year (testing for persistence). He found
that only 50% of mutual funds that beat the market in one year accomplish the same feat in
the following year. Mutual funds that beat the market two years in a row also had a roughly
50% probability of beating the market in the following year. Similar results were obtained for
mutual funds that had beaten the market for three, four, five, and six years. While there may
be some mutual funds that can consistently beat the market, Jensen’s research (which has
been confirmed by other researchers many times over in recent years) indicates that the
chance of an actively managed fund consistently beating the market is less than 50%. There
is, of course, considerable debate on this topic.

One of the consequences of the research against putting money with an active manager has
been more investors placing money with index funds and other passively managed funds.
Index funds usually impose lower fees and may, on average, produce better returns, partially
because of the fees imposed by active managers.

Advertising of mutual fund returns. Jensen’s research may seem to contradict impressive
returns advertised by many mutual funds. The returns advertised by mutual funds are
probably accurate but may or may not hide important information. Usually, mutual funds offer
multiple funds to potential investors. Jensen’s research would suggest that a fund has a 50%
probability of beating the market in one year and that the probability that the specific fund will
beat the market every year for four years is 6.25% (( ) = .0625). If a company has 16
different funds, there is a high chance that one of its funds will have beaten the market every
year for the past four years. The mutual fund company may choose to advertise that fund as
opposed to the others.

6
See M. C. Jensen, “Risk, the pricing of capital assets, and the evaluation of investment portfolios,”
Journal of Business, 42 (April 1969): 167–247.

22
Hedge Funds
Measuring and comparing the returns of hedge funds is more difficult because of different
reporting requirements. As of today (and likely forever), there is no database with all return
information from inception to death. Some hedge funds do not report their results. It would
be pure speculation – although consistent with behavioral theory – that funds that incur
losses are less than excited about reporting to information accumulating databases. Hedge
funds that close also do not report their returns. This speculated tendency would result in an
upward bias in average reported return.

One possible source to compare hedge fund returns is the Credit Suisse Hedge Fund Index,
which is an asset-weighted index of hedge fund returns net of fees. Although it has non-
reporting bias, the database is an often-used source for hedge fund returns. The following
table compares the hedge funds returns with the S&P 500 (with dividends reinvested).

Although hedge funds performed very well before 2008, as did the S&P 500, in the same
year when the S&P 500 lost 37%, the Credit Suisse Hedge Fund Index reports that hedge
funds lost about 16%, on average. As one might expect, when the S&P 500 performed
poorly, the Hedge Fund Index performed quite well. The opposite story is true from 2009 to
2013, over which the S&P 500 beat the return of the average hedge fund every year.

Performance of Hedge funds7

Measurement Bias
Hedge funds may have a “winning streak” bias. Although not average, it is not at all
uncommon to see hedge funds report good returns for a few years and then to have some
poor performing years and the poor performing years lead to fund closure. Some critics of
hedge funds sometimes portray hedge funds with the phrase:

“Hedge fund returns are like the returns from writing out-of-the-money options: the options
cost nothing, but occasionally they become very expensive.8”

Other hedge fund tracking databases have the same non-reporting bias. For instance, the
Tass hedge funds database only includes hedge funds that report voluntarily. Small hedge
funds and those with poor track records usually do not report their returns. Also, the reported
returns may not be accurate, with Tass usually backfilling with the fund’s prior returns. The
reporting bias makes for comparing hedge fund returns with other asset classes less than
desirable. Overall, suffice it to say that there is considerable debate about the returns of
hedge funds compared with other asset classes.

7
Hull John, C. (2018). Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken, New Jersey, page 94
8
Hull John, C. (2018). Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken, New Jersey, page 93

23
P1.T3. Financial Markets & Products

Chapter 4. Introduction to Derivatives

Bionic Turtle FRM Study Notes

CHAPTER 4. INTRODUCTION TO DERIVATIVES .............................................................. 3
DEFINE DERIVATIVES, DESCRIBE FEATURES AND USES OF DERIVATIVES, AND COMPARE LINEAR
AND NON-LINEAR DERIVATIVES. ................................................................................................ 3
DESCRIBE THE OVER-THE-COUNTER MARKET, DISTINGUISH IT FROM TRADING ON AN EXCHANGE,
AND EVALUATE ITS ADVANTAGES AND DISADVANTAGES. ............................................................ 5
DIFFERENTIATE BETWEEN OPTIONS, FORWARDS, AND FUTURES CONTRACTS .............................. 6
IDENTIFY AND CALCULATE OPTION AND FORWARD CONTRACT PAYOFFS. ..................................... 7
DIFFERENTIATE AMONG THE BROAD CATEGORIES OF TRADERS: HEDGERS, SPECULATORS, AND
ARBITRAGEURS. ...................................................................................................................... 9
CALCULATE AND COMPARE THE PAYOFFS FROM HEDGING STRATEGIES INVOLVING FORWARD
CONTRACTS AND OPTIONS. .................................................................................................... 10
CALCULATE AND COMPARE THE PAYOFFS FROM SPECULATIVE STRATEGIES INVOLVING FUTURES
AND OPTIONS........................................................................................................................ 11
CALCULATE AN ARBITRAGE PAYOFF AND DESCRIBE HOW ARBITRAGE OPPORTUNITIES ARE
TEMPORARY. ........................................................................................................................ 13
DESCRIBE SOME OF THE RISKS THAT CAN ARISE FROM THE USE OF DERIVATIVES. ..................... 15
CHAPTER SUMMARY ............................................................................................................. 16
QUESTIONS & ANSWERS: ...................................................................................................... 17

2
Chapter 4. Introduction to Derivatives
 Define derivatives, describe features and uses of derivatives, and compare linear
and non-linear derivatives.

 Describe the over-the-counter market, distinguish it from trading on an exchange,

and evaluate its advantages and disadvantages.

 Differentiate between options, forwards, and futures contracts.

 Identify and calculate option and forward contract payoffs.

 Differentiate among the broad categories of traders: hedgers, speculators, and

arbitrageurs.

 Calculate and compare the payoffs from hedging strategies involving forward
contracts and options.

 Calculate and compare the payoffs from speculative strategies involving futures
and options.

 Calculate an arbitrage payoff and describe how arbitrage opportunities are

temporary.

 Describe some of the risks that can arise from the use of derivatives.

Define derivatives, describe features and uses of derivatives, and

compare linear and non-linear derivatives.

Derivatives are contracts whose values depend on (or derive from) the values of one or
more financial variables (e.g., equity prices, exchange rates, and interest rates). These
variables are referred to as underlyings.

The value of the underlying is central to valuation of derivatives along with other variables
(e.g. interest rates and volatilities).

Derivatives have many features; they allow the risks to be transferred from one party to
another in ways that benefit both the sides.

 Corporate treasurers can manage exchange rate risk, interest rate risk, and
commodity price risk in ways that would otherwise not be possible
 Fund managers can diversify their exposures using derivatives
 Ski slope operators can avoid being forced out of business due to a single
unreasonably warm winter

Derivatives are used in several ways:

 Derivatives are used by companies to manage interest rate risk, foreign exchange
risk, and the risk arising from commodity price changes, etc.
 Derivatives are sometimes added to corporate bond issuances. They can give bond
issuers the right to repay bonds early, or give bond holders the right to demand early

3
 repayment. Sometimes, bond holders have the right to convert a bond into equity of
the issuing company.
 Employee compensation plans sometimes give employees options to buy shares
from the company at future times for a predetermined price.
 Capital investment opportunities often have embedded options. For example, a
company embarking on an investment may be able to abandon it if things go badly or
expand if things go well. These are referred to as real options because they involve
physical assets (rather than financial assets). It is now a common practice to
consider real options when valuing of capital investment opportunities.
 Homeowners sometimes have derivatives embedded in their mortgages. If interest
rates decline, for example, a homeowner can have the right to repay the mortgage
early and refinance at a lower rate

Derivatives can be used for either hedging or speculation. If a trader has an exposure in an
asset class, a derivatives trade can reduce that exposure. If the trader has no exposure,
however, that same trade is speculative.

Derivatives can be categorized into:

 Linear Derivatives: Linear derivatives provide a payoff that is linearly related to the
value of the underlying asset(s). For example: Forward contracts are linear
derivatives; they are agreements between two parties to buy or sell an asset at a
specified price at a future time
 Non-Linear Derivatives: Non-linear derivatives are those where the payoff is a non-
linear function of the value of the underlying asset. For example, Options - These are
the contracts where the holder has the right (but not the obligation) to buy or sell an
asset for a specified price at a future time. The payoff for an option is a non-linear
function of the value of its underlying(s).

4
Describe the over-the-counter market, distinguish it from trading on
an exchange, and evaluate its advantages and disadvantages.
A derivatives exchange is a central marketplace where participants can trade standardized
contracts. The over-the-counter (OTC) market is an alternative to exchanges where trades
take place between two counterparties directly or through a network of dealers linked by
recorded phone conversations and computers. The key differences include the following:

Exchange Traded Markets Over-The-Counter Markets

Trading takes place in an exchange or Trading takes place over-the-counter via
electronically through a centralized marketplace interdealer brokers or directly through phone or
email
Contracts are standardized and defined by the Contracts may be customized and there is more
exchange negotiating flexibility with respect to features
Exchange clearing house assumes credit risk Trades may be cleared bilaterally or through a
CCP which assumes the credit risk

Subject to regulations Largely unregulated prior to crisis but now new

regulations are affecting their operations

Though number of derivatives contracts traded Trades are typically larger and total value the
per year are larger, the average size of market is “much larger” than trades in the
transactions is smaller than OTC markets exchange

Other than large financial institutions, the Banks, other large financial institutions, fund
participants include retail investors managers, and corporations are the main
participants
A trader can easily close out his position prior to Traders can attempt to negotiate an early
maturity by acquiring exactly offsetting positions termination of a particular contract, but it is may
with any market participant. be more difficult to find a counterparty with
exactly offsetting positions.

Advantage of OTC
 Customization (a.k.a., “tailored” exposure): The terms of a contract do not have to be
those specified by an exchange.
 Market participants are free to negotiate any mutually attractive deal for any type of
security.
 The OTP markets for derivatives are huge and thus may provide ample liquidity for
trading in certain instruments.
Disadvantage of OTC
 Counterparty risk may be high when trades do not take place through a central
counterparty (CCP).
 Since trades can be highly customized, for certain securities, active trading may not
take place due to liquidity issues.

5
Differentiate between options, forwards, and futures contracts
A forward contract is an obligation (agreement) to buy or sell an asset at a certain
future time for a certain price and is traded over-the-counter.
 For example, an oil producer promises to sell 10 million barrels of oil next December
at a pre-agreed price of $110.00 per barrel.
A futures contract is similar to a forward, but trades on an exchange. The exchange
(clearinghouse) is effectively the counterparty.

An option gives holder the right (but not the obligation) to buy/sell at a certain price.
Options are traded both on exchanges and in the over-the-counter markets. Whereas it
costs nothing to enter into a forward or futures contract, there is a cost (option premium) to
acquiring an option.
 For example, an executive has the right (but not the obligation) to buy 10,000 shares
of her company’s stock next December, at the pre-agreed (strike or exercise) price of
$35 per share. Unlike a long forward position, she is not obligated to purchase.
Instead she has the option to either exercise or not exercise this right.

6
Identify and calculate option and forward contract payoffs.
Forward Payoff:
If is the delivery price and is the spot price of the asset at maturity of the contract:
 Payoff for a long position in forward contract is −
 Payoff for a short position in forward contract is −
Since the forward has no initial cost, its profit plot is identical to its payoff plot.

Option Payoff:
 Payoff for a call option buyer (long) is ( − , 0). The payoff to the call
seller(short) is the negative of this value.
 Payoff for a put option buyer (long) is ( − , 0). The payoff to the put
seller(short) is the negative of this value.
Since an option has an initial cost (the option premium), option charts plot the option
profit as payoff minus the premium cost of the option.

= − .

Note the difference between an option payoff and an option profit:

 Premium: Initial cost (or initial investment or up-front cost)
 Payoff: Gain or loss on exercise (i.e., intrinsic value at exercise)
 Profit: Payoff of the option less its initial cost.
o To the long who buys the option: ( ) = – .
o To the short who sells (writes) the option: ( ) = – .

Below is the payoff plot for the forwards. As mentioned, the profit plot and payoff plot for
the forwards are the same.

7
Below is the payoff and profit plot for the options.

Long call, K = $20.00 Long put, K = $20.00

$6 Profit Payoff $6 Profit Payoff
$4 $4
$2
$2
$0
($2) $0
($4) ($2)
$15 $17 $19 $21 $23 $25 $15 $17 $19 $21 $23 $25

1. Question: If the price (premium) is $4.00 for a call option with a strike (exercise) of
$30.00, what are the payoff and profit on a long position (option buyer), if the option
expires when the stock is $38.50?

2. Answer: Payoff on a long call = MAX[0, S(t) – K] = MAX[0, 38.50 – 30.00] = $8.50
Profit on the long call = payoff – premium = $8.50 – 4.00 = $4.50.

3. Question: If the price (premium) is $3.80 for a put option with a strike (exercise) of
$20.00, what are the payoff and profit on a short position (option writer), if the option
expires when the stock is $13.00?

4. Answer: Payoff on a short put = -MAX[0, K – S(t)] = -MAX[0, 20 - 13] = -$7.00

Profit on the short put = premium – payoff = 3.80 - $7.00 = -$3.20.

8
Differentiate among the broad categories of traders: hedgers,
speculators, and arbitrageurs.
The derivatives market has been a huge success mainly because it has attracted different
types of traders and provided a great deal of liquidity.

Traders can be divided into three broad categories:

- Hedgers: Hedgers use derivatives to reduce risk that they may face due from
potential future movements in a market variable. Hedgers avoid taking exposure to
adverse price movements of an asset. Their main purpose is to reduce risk; there is
no guarantee that the future outcome will be better with hedging than without
hedging.

- Speculators: Speculators use derivatives positions to bet on the future direction of

market variable. Speculators wish to take a position in the market. They bet on the
movement of the asset. They either bet that the price of the asset will go up or they
bet that the price of the asset will go down.

- Arbitrageurs: Arbitrage involves locking in riskless profit by simultaneously entering

into transactions in two or more markets.

9
Calculate and compare the payoffs from hedging strategies
involving forward contracts and options.
Both forwards and options can be used to hedge but there are key differences.
 The forward does not require an upfront investment or a premium while an option
requires a premium.
 Forward contracts are designed to neutralize risk by fixing the price that the hedger
will pay or receive for the underlying asset. However, the contract can produce a loss
as well as a profit. Options, in 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.
 While the forward contract is an obligation, an option does not have to be exercised,
and can be left to expire worthless if conditions are unfavorable. Thus, unlike the
forward contract, the payoff structure for the option is asymmetric.

Example: Hedging strategies using options

Consider an investor who owns 1,000 shares of a particular at a share price of $28.00 per
share. The investor is concerned about a possible share price decline in the next 2 months
and wants protection. The investor could buy put option contracts expiring in 2 months on
the company’s stock with a strike price of $27.50. The quoted option price is $1.00 per
option contract.

Each option contract would cost 100 * $1.00 = $100.00 and the total cost of the hedging
strategy would be 10 *$100.00 = $1,000.00

The strategy costs $1,000.00 but guarantees that the shares can be sold for at least $27.50
per share during the life of the option.
 If the market price of the stock falls below $27.50, the options will be exercised, so
that $27,500.00 is realized for the entire holding. When the cost of the options is
taken into account, the amount realized is $26,500.00
 If the market price stays above $27.50, the options are not exercised and expire
worthless. However, in this case the value of the holding is always above $27,500.00
(or above $26,500.00 when the cost of the options is taken into account).

10
The figure below (Hull Fig 1.4) shows the net value of the portfolio (after taking the cost of
the options into account) as a function of the stock price in 2 months.

Calculate and compare the payoffs from speculative strategies

involving futures and options.
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.
Example: Speculations using options
Suppose a speculator considers that a stock is likely to increase in value over the next 2
months. The stock price is currently $20.00, and a 2-month call option with a $22.50 strike
price is currently selling for $1.00

The table below illustrates two possible alternatives, assuming that the speculator is willing
to invest $2,000.00. One alternative is to purchase 100 shares. The other involves the
purchase of 2,000 call options (i.e., 20 call option contracts).

11
Example: Hull Table 1.5

Scenario 1: If stock price rises to $27.00 in 2 months

 The first alternative of buying the stock yields a profit of $700.00 [=100*(27-20)].
 A call option on the stock with a strike price of $22.50 gives a payoff of $4.50,
because it enables something worth $27 to be bought for $22.50. The total payoff
from the 2,000 options that are purchased is $9,000.00 (4.50*2,000). Subtracting the
original cost of the options ($2,000.00) yields a net profit of $7,000.00
The options strategy in this example is seen to be 10 times more profitable than directly
buying the stock.

Scenario 2: If stock price falls to $15.00 in 2 months

 The first alternative of buying stock yields a loss of $500.00 [=100 *(15-20)].
 Since the call options expire without being exercised, the options strategy would lead
to a loss of $2,000.00 (the original amount paid for the options).
Options like futures provide a form of leverage. For a given investment, the use of options
magnifies the financial consequences. Good outcomes become very good, while bad
outcomes result in the whole initial investment being lost.

12
The figure below (Hull Fig 1.5) shows the profit or loss from the two strategies as a function
of the stock price in 2 months.

Calculate an arbitrage payoff and describe how arbitrage

opportunities are temporary.
Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in
two or more markets. For instance, when futures price of an asset is getting out of line with
its cash or spot price which is forwarded at the risk-free rate of interest, offsetting positions
can be taken in the two markets to lock in a profit.

Consider the following assumptions:

 The spot price of gold, is $900.00
 The risk-free interest rate, is 10.0%
 Assume no transaction costs1, zero storage cost, zero convenience yield, and no
lease rate.

These assumptions add a sense of reality to our cost of carry model, however; our carry
model is simple so we do not expect accuracy. Our cost of carry model returns a “model
futures price” of $990; i.e., our model “predicts” a futures price, , of $990 [=900*(1+10%)]

1
The learning spreadsheet allows for transaction costs; if we enter a non-zero transaction cost the model forward price
becomes, instead, a model forward interval with a lower and upper bound. Here, as we assume zero transaction costs, the
lower and upper bound give the same value

13
Then we simulate two different scenarios:
1. The observed one-year futures price, , is $1,000. Here the futures is “trading rich”
as the observed [trading] price of $1,000 is greater than the model price of $990.
2. The observed one-year futures price, , is $980.00. The futures is “trading cheap”
as the observed [trading] price of $980 is less than the model price of $990.

In the first scenario, because the futures price “trades rich”—i.e., observed , price
exceeds the model’s predicted , price—the correct arbitrage is a cash and carry: short
the futures, and borrow to buy the spot.

In the second scenario, the futures price “trades cheap” and the arbitrageur should conduct
a reverse cash and carry trade: long futures and lend the cash received from shorting the
spot.

Therefore,
 if the futures price is “trading rich,” the arbitrage trade is cash and carry:
borrow to buy the spot asset (buy the cheap thing) and short the futures (sell the
expensive thing).
 if the futures price is “trading cheap,” the arbitrage trade is reverse cash and
carry: sell short the spot asset & lend the cash (sell the expensive thing) and go long
the futures (buy the cheap thing).

However, arbitrage opportunities such as these do not usually last for long. As traders tend
to exploit this arbitrage opportunity, that is buy(sell) the cheaper asset and sell(buy) the
expensive asset, very quickly, the futures price would converge to our “predicted” model
price. In other words, the possibility of earning riskless profit over and above that of the risk-
free interest rate keeps decreasing until the arbitrage opportunity is completely eliminated.
In general, the very existence of arbitrageurs means that in practice only very small arbitrage
opportunities are observed in the prices that are quoted in most financial markets.

14
Describe some of the risks that can arise from the use of
derivatives.
The very versatile nature of derivatives by which they can be used for activities like hedging,
speculation, and arbitrage can cause problems.

One of the risks faced by a company that trades derivatives is that an employee who has a
mandate to hedge or to look for arbitrage opportunities may become a speculator
(consciously or unconsciously). The results can be disastrous. Few examples of rogue trader
losses prior to 2008 include:
 An employee of Société General whose job was to trade arbitrage opportunities
turned into speculation activities since 2005. While giving the appearance of
arbitraging, he took big positions on European equity indices and created fictitious
trades to make it appear that he was hedged. In reality, he had large bets on the
direction in which the indices would move and the size of his unhedged position grew
over time to tens of billions of euros. Finally, in 2008, when the bank found this
happening, it unwound his position for a loss of 4.9 billion euros. This is one among
the biggest losses created by fraudulent activity in the history of finance.
 For another trader who worked at Barings Bank, his job was to arbitrage between
Nikkei 225 futures quotes in Singapore and Osaka. Instead he found a way to make
big bets on the direction of the Nikkei 225 using futures and options, losing $1 billion
and destroying the 200-year old bank in the process.
 In 2002, it was found that an employee at Allied Irish Bank had lost $700 million from
unauthorized foreign exchange trading.
The lessons from these losses are that it is important to define unambiguous risk limits for
traders and then to monitor what they do very carefully to make sure that the limits are
adhered to. Both financial and nonfinancial corporations must set up controls to make sure
that derivatives are being used for their intended purpose.

Unfortunately, even when traders follow the risk limits that have been specified, big mistakes
can happen. Some of the activities of traders in the derivatives market during the period
leading up to the start of the credit crisis in July 2007 proved to be much riskier than they
were thought to be by the financial institutions they worked for.
 The house prices in the United States had been rising fast and most people thought
that the increases would continue, or, at worst, that house prices would simply level
off. Very few were prepared for the steep decline that actually happened.
 Furthermore, very few were prepared for the high correlation between mortgage
default rates in different parts of the country.
 Some risk managers did express reservations about the exposures of the companies
for which they worked to the US real estate market. But, when times are good (or
appear to be good), there is an unfortunate tendency to ignore risk managers and
this is what happened at many financial institutions during the 2006–2007 period.

The key lesson from the credit crisis is that financial institutions should always be
asking ‘‘What can go wrong?’’, and they should follow that up with the question ‘‘If it
does go wrong, how much will we lose?’’

15
Chapter Summary
 In an open outcry system, traders physically meet on exchange floor, they shout,
they use hand signals.
 In an electronic trading system, trades are executed at almost light-speed from
banks, hedge funds and traders around the world by use of computers.

Two different markets exist: the OTC market and the Exchange-traded market.
 In terms of size, the OTC market is significantly larger than the Exchange-traded
market measured in terms of volume of trading.
 The size of the two markets is difficult to measure, and it is likely that the Exchange-
Traded market will grow at a much faster pace than the OTC market in years to come
as the Dodd-Frank regulations forces certain financial institutions to have their trades
on an exchange or to go through a clearinghouse. The regulations have yet to be
finalized so the outcome over the next few years will be interesting, and will have a
huge impact on those working in risk management and the financial sector.

Forward contracts and futures contracts are similar in form, in that they both involve
an agreement to buy or sell some asset in the future, but at a predetermined price.
 However, whereas forwards are transacted in the OTC market, futures are highly
standardized contract that trade on an exchange.
 Forwards can be customized in a way that futures cannot, however, they also carry
with them credit and counterparty risk - risk that a futures contract is not nearly as
exposed to.
 Futures contracts, while generally being less exposed to credit and counterparty risk,
forces the owner of the futures to post margin at the end of each trading day. We say
that futures are marked-to-market. It is this mechanism that reduces the counterparty
risk. It does not however, reduce the market or liquidity risk, and forces the company
to typically have a larger liquidity pool tied up for margining purposes – capital that
could have been employed elsewhere.

Whereas forwards and futures contracts involve an obligation to buy or to sell an asset at a
predetermined price in the future, options gives you the right, but not the obligation to
buy or sell the asset in the future at a predetermined price.
 Call options give you the right but not the obligation to buy an asset in the future,
whereas put options give you the right but not the obligation to sell an asset in the
future.
 A distinguishing feature of options as opposed to forwards and futures is the fact that
options require an initial outlay of money, whereas forwards and futures do not.

The reading distinguishes between three broad categories of traders:

1. Speculators: take a view on the market, and will often use leverage
2. Hedgers: wish to use derivatives as insurance, or to minimize market risk
3. Arbitrageurs: seek out ephemeral pricing discrepancies in the market

16
Questions & Answers:
1. Which of the following is LEAST likely to trade in an open outcry system?
a) Futures contract on investment commodity
b) Futures contract on consumption commodity
c) Exchange-traded call option on publicly traded stock
d) Over-the-counter (OTC) forward contract on consumption commodity

2. What is the chief advantage of a derivatives trade that intends to hedge an exposure on
the OTC market over a similar trade on an exchange?
a) Greater liquidity
b) Lower counterparty risk
c) Lower basis risk
d) Ability to trade an option instead of a futures contract

3. A US-based importer knows it will need to pay EUR 10 million (Euros) to a European
supplier in exactly three months. To hedge, the importer buys Euros in the three-month
currency forward market. Which of the following is TRUE?
a) The hedged outcome must be better than the un-hedged outcome
b) The hedged outcome could be worse than the un-hedged outcome
c) The payoff with currency forwards is identical to the payoff with currency options
d) If markets are efficient, there is no logical reason to use the forward contract

4. A long (plain vanilla) call option and a long futures position, both on the same underlying
publicly traded stock, are similar in EACH of the following ways EXCEPT for:
a) Both can be priced analytically
b) Both have unlimited upside but a limited downside capped by the initial investment
c) Both forgo interim dividends
d) Both are leveraged relative to the corresponding cash (spot) position

5. Which BEST summarizes Hull’s explanation for the ephemeral (short-lived) existence of
arbitrage opportunities?
a) Efficient markets
b) Arbitrageurs conducting arbitrage
c) Transaction costs
d) Information technology

17
Answers

1. D. Open outcry occurs on the floor of an exchange; OTC markets are not
standardized and do not utilize open outcry

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-134-open-outcry-

versus-electronic-trading.4332/

2. C. Lower basis risk

Lower basis risk is the key hedging advantage afforded to the CUSTOMIZATION (or
“tailoring”) of the instrument to the underlying exposure; the exchange-traded instrument is
standardized.

In regard to (A) and (B), please note these are decidedly false: an exchange-traded market
generally offers superior liquidity and lower counterparty risk.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-135-over-the-

counter-otc-versus-exchange-traded-markets.4336/#post-24956

3. B. The hedged outcome could be worse than the un-hedged outcome

If the Euro depreciates in the next three months, the un-hedged cost will be less: locking in
forward cost cuts in both directions (Hull: “the purpose of hedging is to reduce risk. There is
no guarantee that the outcome with hedging will be better than the outcome without
hedging.”)
 In regard to (C), this is false: the option incurs a premium cost, and limits the
downside, but unlike the forward allows the buyer to enjoy upside. Insurance has a
totally different profile!
 In regard to (D), this is false: the forward minimizes forex risk, even if the expected
returns are identical.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-138-forward-

hedges.4353/#post-11256

4. B. The long futures contract has payoff = S(t) - K, such that while not uncapped on
the downside, potential loss is (K). But as worst, the long option holder losses the
premium.

In regard to (A), (C), and (D), please note these are TRUE of both options and futures.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-136-options-

forwards-futures.4339/#post-11209

18
5. B. Arbitrageurs conducting arbitrage

In regard to (A), this is tempting and an argument can be made. But EMH asserts the prices
impound (incorporate) information; Hull makes a narrower argument that does not require
EMH! He only requires the practice of arbitrage and supply/demand. Please notice this is
related to the CAPM, which requires several restrictive assumptions, and the APT, which is
less restrictive because it depends on no-arbitrage conditions.

Hull: “Arbitrage opportunities such as the one just described cannot last for long. As
arbitrageurs buy the stock in New York, the forces of supply and demand will cause
the dollar price to rise. Similarly, as they sell the stock in London, the sterling price will
be driven down. Very quickly the two prices will become equivalent at the current
exchange rate. Indeed, the existence of profit-hungry arbitrageurs makes it unlikely
that a major disparity between the sterling price and the dollar price could ever exist in
the first place. Generalizing from this example, we can say that the very existence of
arbitrageurs means that in practice only very small arbitrage opportunities are
observed in the prices that are quoted in most financial markets. In this book
most of the arguments concerning futures prices, forward prices, and the values of
option contracts will be based on the assumption that no arbitrage opportunities exist.”

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-139-arbitrage-

payoff.4355/#post-11258

19
P1.T3. Financial Markets & Products

Chapter 5. Exchanges and OTC Markets

Bionic Turtle FRM Study Notes

CHAPTER 5. EXCHANGES AND OTC MARKETS .............................................................. 3

DESCRIBE HOW EXCHANGES CAN BE USED TO ALLEVIATE COUNTERPARTY RISK. DESCRIBE

NETTING AND DESCRIBE A NETTING PROCESS ....................................................................... 3
EXPLAIN THE DEVELOPMENTS IN CLEARING THAT REDUCE RISK. ............................................. 5
DESCRIBE THE IMPLEMENTATION OF A MARGINING PROCESS AND EXPLAIN THE DETERMINANTS
OF INITIAL AND VARIATION MARGIN REQUIREMENTS. ............................................................ 10
COMPARE EXCHANGE-TRADED & OTC MARKETS AND DESCRIBE THEIR USES. ....................... 11
IDENTIFY THE CLASSES OF DERIVATIVES SECURITIES AND EXPLAIN THE RISK ASSOCIATED WITH
THEM. .............................................................................................................................. 15
IDENTIFY RISKS ASSOCIATED WITH OTC MARKETS AND EXPLAIN HOW THESE RISKS CAN BE
MITIGATED. ....................................................................................................................... 20
DESCRIBE THE ROLE OF COLLATERALIZATION IN THE OVER-THE-COUNTER MARKET AND
COMPARE IT TO THE MARGINING SYSTEM. ........................................................................... 22
EXPLAIN THE USE OF SPECIAL PURPOSE VEHICLES (SPVS) IN THE OTC DERIVATIVES MARKET.
........................................................................................................................................ 23

2
Chapter 5. Exchanges and OTC Markets
 Describe how exchanges can be used to alleviate counterparty risk.

 Explain the developments in clearing that reduce risk.

 Describe netting and describe a netting process.

 Describe the implementation of a margining process and explain the determinants

of initial and variation margin requirements.

 Compare exchange-traded and OTC markets and describe their uses.

 Identify the classes of derivatives securities & explain the risk associated with
them.

 Identify risks associated with OTC markets & explain how risks can be mitigated.

 Describe the role of collateralization in the over-the-counter market and compare it

to the margining system.

 Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market.

Describe how exchanges can be used to alleviate counterparty risk.

Describe netting and describe a netting process.
Exchanges perform useful functions to expand
economic activity. Originally, exchanges were simply
forums for entities to trade. The modern exchange has
standardized contracts, settlement support, and
counterparty risk management. Among the list of
activities exchanges facilitate are:
 Product standardization. In modern
exchanges, such as the Chicago Board of
Options Exchange (CBOE) or the New York
Stock Exchange (NYSE), contracts are standardized. For instance, a buyer
purchases one share of Ford Motor Company stock and the seller is selling exactly
one share of Ford Motor Company. There is no debate about what a share means.
Similarly, the CBOE standardizes option contracts by ensuring each option has a
clearly stated preset price and date. By standardizing products, exchanges make it
easier for trading to occur. Typical standardized items include:
o Quotation price minimum increments.
o Maturity dates.
o Delivery location.
o The method or mechanism for delivery.
o The grade, form, or physical features of
the underlying asset to be delivered.

3
  Trading venue. Exchanges offer a central location through which trading can occur.
Although typically a physical location, such as the NYSE, the trading venue does not
necessarily need to be physically located in a specific geographic location. Trading
venues are increasingly turning to electronic exchange business. By requirement,
exchanges do some due diligence and limit access to the exchange to approved
entities that will honor the rules of the exchange.
 Price discovery. One of the most important aspects of exchanges is that they offer
price discovery. Price discovery is the process of entities finding out what their
product is worth.
 Liquidity. Another important aspect of exchanges is liquidity. Liquidity refers to the
ability to buy and sell an asset quickly at a reasonable bid-ask spread.
 Reporting services: Exchanges offer buyers, sellers, data vendors, and data
subscribers to information on price discovery and other reported information.

Counterparty Risk

Exchanges are intermediaries, facilitating a place

where members can trade with each other. In each
exchange, both parties are taking on counterparty risk.
Counterparty risk is the possibility that counterparties
to a transaction could potentially renege on agreed-
upon transactions. How do exchanges help with
counterparty risk? There are two main avenues
through which exchanges help minimize counterparty risk.
 The first way exchanges address counterparty risk is through margin requirements.
Imposing margin requirements is when assets are transferred from one trader to
another through an intermediary (the exchange). The presence of the intermediary
minimizes counterparty default risk.
o For instance, suppose Trader Alpha
buys 25,000 bushels of corn from
Trader Beta in October for 500 cents
per bushel. Further, suppose that the
price of corn drops to 400 cents per
bushel the day after the trade was
made. Trade Alpha would want to
renege on his purchase if possible.
What could prevent Trader Alpha from
reneging? One way is through a margin requirement. In this example, Trader
Beta may request that Trader Alpha deposit 100 cents per bushel with the
exchange ($25,000). If Trader Alpha tries to renege, he may lose the margin
amount with nothing in return.
 The second way exchanges address counterparty risk is by providing methods for
improving clearing and thereby minimizing counterparty risk. Clearing refers to
reconciling and resolving contracts between parties to a transaction. The clearing
process occurs between trade execution and trade settlement.

4
Netting

Netting refers to offsetting transactions, or “netting” short and long positions. For instance,
suppose Trader Alpha purchases 10,000 bushels of corn for $1 per bushel from Trader Beta
and Trader Beta purchases 10,000 bushels of corn for $1.30 per bushel from Trader Alpha.
Presuming both have the same delivery date, rather than each entity delivering the items,
Trader Beta could simply pay Trader Alpha $3,000 and be done with the transaction. In this
case, Trader Alpha and Trader Beta are netting the two transactions against each other.

Overall, there are three broad categories of netting – direct clearing, ring clearing, and
complete clearing – addressed in the following section.

Explain the developments in clearing that reduce risk.

Trade
Clearing Settlement
execution

Clearing is the process of reconciling contracts between counterparties. In terms of timing,

the clearing process begins when buyers and sellers agree on a price and when the actual
settlement of the trade execution takes place (after all legal obligations are met).

How do buyers and sellers ensure that a trade execution results in a final settlement? Such
a situation may occur when there is a large change in price from the trade execution date
and when the final settlement is to take place. Exchanges have developed two methods to
reduce non-settlement risk – margining and netting.
 Margining refers to exchange members putting up cash or other assets to cover
potential gains and/or losses in the respective positions. There are two types of
margining – variation margin and initial margin.
o Variation margin allows for the margin amounts to vary.
o Initial margin allows for extra coverage against losses in case parties
default.
 Netting involves the offsetting of contracts, or “netting” short and long positions in a
position. which reduces the exposure of counterparties and the underlying network to
which they are exposed. It reduces the costs of maintaining open positions such as
via the margins needing to be posted. Netting can be seen in all of the three forms of
clearing that have developed, namely direct clearing, ring clearing, and complete
clearing.

5
Direct clearing

Direct clearing is the simplest and oldest of the clearing processes. It involves a mutual, two-
party agreement on the reconciliation of commitments. In a direct clearing arrangement, one
counterparty delivers the asset(s) to the other counterparty, who delivers the cash in
exchange for the asset. This is a direct clearing arrangement and is what most people that
have ever traded baseball cards or been involved in basic trading are used to.

Direct clearing can also refer to offsetting trades if counterparties have offsetting trades,
depicted in the following figure.

Direct clearing with offsetting trades

In the example here, counterparties Alpha and Beta have offsetting positions with each other
in the same contracts:
 Alpha has an agreement to buy 100
contracts from Beta for $110 at a
specified future date.
 Beta has a reverse position with Alpha
but at a lower price of $107.
 This offsetting direct clearing is
possible with standardized contracts
that make contracts fungible.
 To improve the transaction, rather than
Alpha and Beta physically exchanging
100 contracts with associated
payments of $10,700 and $11,000 to
one another, the parties could use a
“payment of difference”
arrangement. In this case, Beta would
pay Alpha $300. Payment of
difference, rather than delivery, which
became common in futures markets to
reduce problems associated with
creditworthiness. Of course, this type
of arrangement requires some form of
connection between the parties to the
transaction.
 In this example, the payment of difference could occur on the settlement date or any
time before that date. In the OTC derivatives market, this “payment of
difference” form of direct clearing is netting.
Of note, in this example of direct clearing, the original counterparties are still exposed to
each other. The exposure, though, is minimized by using a payment of differences
arrangement. It is also important to note that although exchanges facilitate these types of
transactions by defining standard contractual terms, exchanges have a limited additional role
to play in such a structure. They would generally play the role similar to a mediator should a
dispute materialize.

6
Clearing rings

A direct clearing process is the oldest and most common type of clearing arrangement.
Another option is clearing rings. Clearing rings arrangements are possible because of the
fungibility created by standardization. They allow for clearing to be extended to more than
two counterparties. As with direct rings, clearing rings utilize standardized aspects of
contracts, such as closing out positions, to enhance liquidity and improve overall market
trading conditions.

How do clearing rings work? The figure below provides an example of clearing rings. The left
portion of the graphic has four trading entities – A, B, C, and D. The areas represent trades
between parties. For instance, A and B have equal, direct trades with each other, as do A
and C. The story changes with Trader C, which has purchased an item from Trader D for
100. Trader D has also purchased an asset, in this case from Trader B for 100. Now, Trader
C could simply pay Trader D, and Trader D could simply pay Trader B. Another option would
be to bypass Trader D and have Trader C pay Trader B. This is the essence of the multi-
party connection.

Clearing Rings1

A B A B

100

C 100 D C

Advantages of clearings are:

 They reduce counterparty risk. For instance, in the second figure, D is removed from
the counterparty risk possibility, reducing the number of bilateral risk exposure
positions by one.
 They simplify the dependencies of traders’ open positions and allow them to easily
settle contracts.
 By making the settlement process easier, clearing rings increase liquidity.
 They require consensus, meaning that members of the ring must agree to a price for
settling contracts, and the process is efficiently handled through an exchange.

It is important to note that exchanges and courts have upheld contractual features of ringing.
For instance, if a counterparty had their original counterparty replaced with a different
counterparty and the replacement counterparty defaulted, then the counterparty that was
defaulted upon could not challenge the clearing ring reassignment that led to this.

1
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for
OTC Derivatives (New York: John Wiley & Sons, 2014)

7
It likely also goes without saying that not all counterparties see a decrease in counterparty
risk. For instance, although Trader D can offset the transactions with Trader C and Trader B,
Trader A is indifferent to the formation of the ring because its positions are unchanged. The
only difference for Trader B and Trader C is the replacement counterparty they have been
assigned. If the new counterparty has stronger credit quality, then the ring has improved
counterparty risk. The opposite also holds – if the replacement counterparty has weaker
credit, then the clearing ring may have increased certain traders’ counterparty risks. This
example leads to an important point – a clearing ring may offer collective benefits but
may not be beneficial to all participants. A trader at the ‘end of a ring’ with only a long or
short position may see no benefit to the ring at all.

A couple of important notes on ring clearing:

 Prior to the adoption of “complete clearing” (addressed below) at the Chicago Board
of Trade, groups of three or more traders would “ring out” offsetting positions.
Clearing rings were an informal means of reducing the exposure of three or more
market members.
 To achieve the benefits of “ringing,” participants in the ring had to be willing to accept
substitutes to their original counterparties. Participation in rings was voluntary,
although once a ring was joined, exchange rules bound participants to the ensuing
settlements. The potential benefits and risks of rings led some traders to forgo joining
rings, while other traders joined multiple rings. In a clearing ring, exchange members
formally agree to accept other traders’ contracts and to allow counterparties to be
interchanged.

Complete clearing

Clearing rings distribute risk across a broader system

(the exchange), which reduces but does not eliminate
counterparty risk. There are still idiosyncratic risks of
contracts, including the continued presence of
counterparty failure. Additionally, contract ringing
potentially leads to greater systematic risk, where a few
contract failures can lead to a cascading string of
seemingly unrelated counterparties defaulting.
 An example of this cascading is the 1902 bankruptcy of George Phillips2. When
George Phillips went bankrupt, almost half of the Chicago Board of Trade’s (CBOT)
members were affected. The CBOT responded to the defaults in 1903 by requiring
damages from defaulted contracts to be paid through the exchange’s clearinghouse.
To remedy potential cascading of distributed counterparty risk, the final stage in the
settlement clearing is complete clearing. Central counterparty clearing (CCP) refers to the
idea that the “clearinghouse” becomes the counterparty to all transactions. When
counterparties to a derivative trade engage each other, the counterparties agree to specific
requirements with each other. By putting itself between the two counterparties (both of which
are clearing members) a CCP takes upon itself all contractual rights and responsibilities.
This is shown in the figure below.

2
Millo, Y., Muniesa, F., Panourgias, N. S., & Scott, S. V. (2005). Organized detachment:
Clearinghouse mechanisms in financial markets. Information and Organization, 15(3), 229-246.

8
Complete Clearing3

A 50 B A B
75 50

50 100 CCP

C 100 D 25
C D
In complete clearing, traders need not worry about the counterparty risk of offsetting
transactions, nor the counterparty risk of a member’s credit quality because the CCP takes
on all counterparty risk.

Given that CCPs accept counterparty risk, CCPs needed a way to limit their own exposure.
Central counterparty clearinghouses attempt to minimize their exposure using pre-existing
margining rules, including:
 Initial margin, which covers close-out costs if a member defaults.
 Variation margin, which is a dynamic mechanism to enforce the daily settlement of
profits and losses using daily mark-to-market valuation.
 In addition to initial and variation margin, CCPs also developed loss-sharing
models. Loss sharing requires all clearing members to purchase shares, which
allows them to be members of the exchange. In the event of a clearing member
failure, the defaulting clearing members are at risk of losing their equity investment.
Today, it is this equity investment risk that acts as the basis of what CCPs define as
default funds.
All exchange-traded contracts are currently subject to central clearing. The CCP
function need not necessarily be provided by the exchange itself. An exchange may offer the
CCP function or may purchase that service from an independent company. All derivatives
exchanges have some form of a CCP, and CCP was the standard practice for derivatives
markets clearing until the arrival of the over-the-counter (OTC) derivatives market. The OTC
market took the lead in the last quarter of the 20th century.

3
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for
OTC Derivatives (New York: John Wiley & Sons, 2014)

9
Describe the implementation of a margining process and explain
the determinants of initial and variation margin requirements.
One might think that a contract is settled at the settlement date. In the case of a futures
contract, the contract is not settled at maturity. Instead, a futures contract is settled day-by-
day in the march to maturity.

Consider a trader who has purchased 10 December

cattle contracts (long) and the December futures price
is $100 per cattle contract at the close of trading Day 1.
Next, suppose that the future price for each cattle
drops to $95 on Day 2. In this case, the trader has a
notional loss of $50 (10 cattle X $5 cattle = $50).
Because of the notional loss, the exchange requires
the trader to cover the $50 loss to the CCP. If the
December cattle price jumps to $105 per cattle at the close of Day 3, the trader is up $50
from his original position (10 X $5 = $50). In this case, the exchange owes the trader $50.

Every day, the CCP receives from traders or pays traders:

 Traders who have lost money pay their loss to the exchange CCP.
 Traders who have made money receive a payment from the exchange CCP.
Payments made to traders are known as variation margin. The payments are
typically made once per day. The one-day rule is a general rule rather than hard-and-
fast, as variation margin may be paid more often during highly volatile markets.
When a futures price for a contract increases from the close of trading on one day to the
close of trading on the next day, funds flow through the CCP from members who have net
short positions to members who have net long positions. This is shown in the following
figure.

Central Counterparty Clearing, Futures Price Increase

In contrast to the figure above, the figure below shows the situation when a futures price for
a contract decreases from the close of trading one day to the close of trading the next day.
In this case, funds flow through the CCP from members who have net long positions to
members who have net short positions.

Central Counterparty Clearing, Futures Price Decrease

It is important to remember that the number of long positions is, by definition, equal to the
number of short positions, which results in no net cash inflow or cash outflow for the CCP.
Daily settlement has another important advantage: It makes closing out futures contracts
much simpler. A trader does not need to worry about when the contract was entered or what
the futures price was at that time. The exchange has standardized this aspect for him.

10
Initial Margin: Initial margin is the funds or marketable securities that must be deposited
with the CCP. These are in addition to variation margin. Initial margin is required to prevent
the loss of default on variation margin by a member of the exchange.

Who controls the initial margin amount? The initial margin amount is set by the
exchange. In theory, the exchange considers the volatility of futures prices when setting the
initial margin. Generally, the exchange will reserve the right to change the initial margin at
any time when market conditions change.

Does the CCP pay interest? With money exchanging hands each day, one might think that
the CCP should pay interest on funds held. The answer is yes and no.
 CCPs do not pay interest on variation margin payments because futures contracts
are settled daily rather than at maturity.
 CCPs do pay interest on the initial margin because the funds belong to the
members that contributed it.
Some members may be unhappy with the interest rate paid by the CCP. In this case, a
member may post securities, such as Treasury bills, instead of cash. In this instance, the
CCP would find the cash margin equivalence of the Treasury securities. The resulting
reduction is referred to as a haircut. Generally, the haircut will increase when the asset’s
price becomes more volatile.

Multiple contracts. When a trader holds multiple contracts, the CCP will typically consider
both in deriving variation and initial margin requirements. For instance, suppose a trader has
one long October corn contract and one short December corn contract. If the price of the
corn drops for the October contract, the short December corn contract is likely also affected.
The trader will pay a netting of the variation margin across contracts. Additionally,
exchanges also consider multiple contracts when deriving the total initial margin for the
October and December contracts. When considering the two contracts together, the initial
margin is usually lower than what the initial margin would be for the two contracts separately.

Compare exchange-traded & OTC markets and describe their uses.

Exchange-traded derivatives

Exchange-traded derivatives are standardized contracts that are actively traded in

secondary markets. Liquidity is near perfect generally, with each market participant having
the ability to buy a contract and sell the equivalent contract to close the position. Prices are
transparent and accessible to market participants.

OTC derivatives

In contrast to the transparency and liquidity of exchange-traded derivatives, over-the-counter

(OTC) derivatives are privately negotiated and traded directly between two parties without an
exchange or other intermediary. Prices are not transparent, may have large bid-ask spreads,
and negotiation over price is typically a bilateral process. OTC derivatives have traditionally
been negotiated between a dealer and an end-user or between two dealers. Historically,
OTC markets have not reported their trades. Instead, trades can occur privately, outside the
eyes of exchange participants. Documentation is also bilaterally negotiated between the two
parties, although some general standards have been developed. In bilateral OTC markets,
each party takes counterparty risk and must manage this risk themselves.

11
Comparison between exchange-traded and OTC derivatives4

With the advantages of liquidity, transparency, and standardization of exchange-

traded derivatives, why do traders sometimes prefer OTC derivatives? The answer is
that OTC products offer traders the ability to customize contracts to the clients’ needs. By
their very nature of standardization, exchange-traded products do not offer this type of
customization. Key players in the OTC market include banks, investment funds, and other
sophisticated parties, such as hedge funds and wealthy individuals. Additionally, inter-dealer
brokers also play a role in intermediating OTC derivatives transactions. Before regulatory
action changed the OTC market in the aftermath of the global financial crisis of 2008 to
2009, the OTC was largely unregulated. The OTC market is still the largest market in the
world for derivatives.

Customized Versus Exotic OTC Derivatives

Classifying all OTC derivatives into one group is somewhat misleading because there are
important differences between customized and exotic OTC derivatives.
 Suppose a client wants to hedge his position in a specific asset. The clients might
want to do this to protect the price he will get for the production of his crop at a
specific date, as an example. The producer might prefer a customized OTC
derivative as opposed to an exchange derivative for several reasons, including that
the customized derivative may not be available on an exchange (because exchanges
try to standardize contracts, such as the maturity month). This example of a
customized OTC derivative might be more useful for risk management than an
exchange-traded derivative because the customized derivatives give rise to
additional basis risk (such as, in this example, the mismatch of maturity dates).
Disadvantages of OTC derivatives. With the advantages of OTC derivatives addressed,
what are the disadvantages? The disadvantages of OTC derivatives include:
 For clients wishing to unwind an OTC transaction, the client must do it with the
original counterparty. This puts the client at an immediate disadvantage, and the
client may have to unwind the position on unfavorable terms.
 Clients wanting to unload an OTC transaction may not be able to even assign or
novate the transaction to another counterparty without the permission of the original
counterparty. Stickiness in fungibility can be a major problem in OTC transactions.
 Additionally, some customized OTC derivatives are employed as a means to conduct
regulatory arbitrage, perhaps even to “distract” a client. These types of OTC
derivatives can be classified as exotic OTC derivatives and generate considerable
criticism.

4
Adapted from Gregory, J. (2014). Central counterparties: mandatory central clearing and initial
margin requirements for OTC derivatives. John Wiley & Sons.

12
The growth in the OTC derivatives market. Derivatives – be they are classified as
exchange-traded or OTC – have grown considerably in recent decades. Part of this growth
has been due to regulation in other markets or a desire for unrelated market trading. Other
sources of demand that have led to the explosive growth are liquidity and counterparty risk
control for exchange-traded derivatives. Additionally, financial engineering and technology
evolution, combined with competent non-regulation has contributed to the continued growth
of the industry.

Why have OTC derivatives grown much faster than exchange-traded derivatives? One
explanation is that OTC derivatives allow for “exotic” contracts and new markets, such as
credit derivatives. The notional value difference is still quite large. Additionally, another
important aspect is that OTC derivatives are heavily concentrated with a few commercial
banks (known as dealers). For instance, the four largest commercial banks in the U.S.
account for 90% of the notional value of OTC derivatives.

The following two graphics, based upon data from the Bank for International Settlement,
capture the relative notional values of OTC derivates by type of OTC derivative and the
notional value of exchange-traded derivatives. The first figure shows the notional amount of
OTC derivatives in trillions of U.S. dollars. The largest OTC portion is interest rate OTC
derivatives, summing to over $500 trillion at the end of 2019. Overall, OTC derivatives’
notional value just recently surpassed $600 trillion again, a value not seen since 2014.

The figures contain information on the OTC market. The first is the notional value of
exchange-traded derivatives from 1993 to 2019. Exchange-traded interest rate derivatives
are much larger than exchange-traded foreign exchanges. The magnitude of difference
between OTC derivatives and exchange-traded derivatives is also quite stark, with the OTC
derivative market about $500 trillion larger than the exchange-traded derivative market.

13
Notional amount of OTC derivatives in trillions of U.S. dollars5

Exchange-traded Derivatives6
Exchange-traded Derivatives, Trillions of U.S. Dollars
$140
Trillions

$120

$100

$80

$60

$40

$20

$0
1993-Q1
1993-Q4
1994-Q3
1995-Q2
1996-Q1
1996-Q4
1997-Q3
1998-Q2
1999-Q1
1999-Q4
2000-Q3
2001-Q2
2002-Q1
2002-Q4
2003-Q3
2004-Q2
2005-Q1
2005-Q4
2006-Q3
2007-Q2
2008-Q1
2008-Q4
2009-Q3
2010-Q2
2011-Q1
2011-Q4
2012-Q3
2013-Q2
2014-Q1
2014-Q4
2015-Q3
2016-Q2
2017-Q1
2017-Q4
2018-Q3
2019-Q2

Foreign exchange Interest rate

5
As of March 2020 from the Bank for International Settlements,
https://stats.bis.org/statx/srs/tseries/OTC_DERIV/
6 Developed from data provided by the Bank for International Settlements, accessible here:

https://www.bis.org/statistics/full_data_sets.htm

14
Identify the classes of derivatives securities and explain the risk
associated with them.
OTC derivatives include the following five broad
classes of derivative securities – interest rate
derivatives, foreign exchange derivatives, equity
derivatives, commodity derivatives, and credit
derivatives.
1. Interest rate derivatives: Interest rate
derivatives are securities in which one party to
the transaction exchanges an interest rate
payment for a different interest rate payment at
a future, specified date.
a. Interest rate swap: The most common type of interest rate derivative is an
interest rate swap, where a party accepts floating interest rate payments for
fixed interest rate payments in a negotiated currency (typically dollars or
euros). The market is dominated by large, global banks.
b. Interest rate future: The most common
types of interest rate futures include
trading on T-bill, T-bond, and Eurodollar
futures. At its core, a futures contract is
used to hedge against changes to
interest rates by taking advantage of the
inverse relationship between interest
rates and bond prices (i.e. when interest
rates rise, existing bond prices drop). For
instance, suppose a borrower thinks that interest rates could rise in the near-
term future. To hedge against this risk, the borrower could sell a future
contract today. If interest rates do rise, then the seller of the future could
make a profit when the interest rate future is sold (because the seller would
be selling a future at a price that is above the current value).
2. Foreign exchange derivatives: Foreign exchange derivatives (FX derivatives) are
agreements to buy and sell currencies at a future date. FX derivatives typically show
up as forward contracts, futures contracts, or options. The differences between the
three types are captured in the table on the next page.
a. Forward contracts: Forward contracts are agreements between two
counterparties to trade currencies at some time in the future. Forward
contracts have no standardization, generally do not trade openly, may be
negotiated at an arbitrary future date, generally are not used by speculators,
and may be used by large, multi-national corporations (MNCs).
b. Futures contracts: Futures contracts negotiate a price of a currency that a
party will exchange with another counterparty at some future date. The
important distinction is that the price is set in advance. Futures contracts are
standardized, trade openly on exchanges such as CME Group, GLOBEX, or
OTC, specify a fixed future date for true-up, and are used by speculators and
MNCs alike.

15
 c. Options: A foreign currency option gives the owner the right to buy (call) or
sell (put) a currency at an agreed-upon exchange rate on a specific date in
the future. Foreign currency options are standardized, trade openly on
exchanges such as CME Group, GLOBEX, ISE, and OTC, generally have a
specified future date of expiration attached (although this can be avoided with
a premium) and are used by speculators and MNCs.

Issue Forward Future Options

Contracts Contracts
Currency No Yes Yes
standardization
Traded openly No CME Group CME Group
GLOBEX GLOBEX
OTC ISE
OTC
Specified future date Yes Yes No, but with a
premium
Used by speculators No Yes Yes
Used by MNCs Yes Yes Yes

3. Equity derivatives: Equity derivatives have their value in price movements of the
underlying security, in this case, equities. The most common types of equity
derivatives are often referred to as puts or calls, which derive their value from a
change in the price of the underlying stock. Equity derivatives are often used to
leverage the potential return from a stock price change, to hedge against undesired
movements in the price of a stock, or speculate on future stock price movements.
a. Puts: A person that owns an equity put has the right, but not the obligation, to
sell a stock at a specified price in the future. The other side of the transaction
must buy the security at the specified price from the owner or default.
i. For instance, if a trader thought that the price of Ford stock would go
from $10 per share to $4 per share in three months from purchase of
the put, then the person may want to buy a put. Assuming a strike
price of $10 per share, when the stock price drops to $4 per share, the
trader can sell the shares to the other side of the transaction for $10
per share even though it was only worth $4 per share.
b. Calls: A person that owns an equity call has the right, but not the obligation,
to buy a stock at a specified price in the future. The other side of the
transaction must sell the security at the specified price or default.
i. For instance, if a trader through the price of Ford stock would go from
$10 per share to $20 per share in three months from purchase of the
call, then the person may want to buy a call. Assuming a strike price of
$10 per share, when the stock price rises to $20 per share, the trader
can buy the shares from the other side of the transaction for $10 per
share even though it was worth $20 per share.

16
4. Commodity derivatives: Commodity
derivatives also come in different flavors,
including commodity forwards, commodity
futures, and commodity options.
a. Forward: A forward commodity
derivative is an agreement between two
parties to exchange an asset at an
agreed-upon price at a specified future
time. For instance, in March 2020 a
trader could enter a forward contract to deliver 50 tons of steel for $500 per
ton in June 2020.
b. Future: A commodity futures contract is like a commodity forward contract,
with the distinction being that futures contracts trade on an exchange and the
buyers are referred to as long position holders, while sellers are known as
short position holders. Futures contracts often require a percentage margin to
be deposited with the exchange.
c. Option: As with equity options, a commodities option gives the holder the
right, but not the obligation to either buy or sell an asset at a specified date
and a specified price.
5. Credit derivatives: Credit derivatives are contracts in which the risk associated with
a credit asset – be it a debt security or fixed-income instrument – is transferred from
seller to buyer of the credit derivative. Credit derivatives are often used by banks as a
form of insurance policy against default. The derivatives are also a way for banks to
diversify their credit portfolios. For instance, if a bank typically deals in industrial
sector debt and a different bank typically focuses on credit to the farm sector, a bank
may want to swap some of each other’s income streams.
a. Credit swaps: A credit swap is when two parties agree to swap income
streams from credit securities. Credit swaps can be standardized or
customized. For instance, a bank may trade corporate bond income streams
for income streams from government securities. Parties to a credit swap may
also agree to a total return swap, in which counterparties agree to swapping a
credit portfolio for a pre-determined fixed rate. The pre-determined rate may
also be indexed to a benchmark interest rate.
b. Credit options: Credit options are like equity options. They give the holder
either the right, but not the obligation, to buy a credit security or sell a credit
security for a specified price at a specified future date.
c. Credit default swap: A credit default swap occurs when a buyer pays a
premium for protection against a “credit event”, which may include payment
default or some other credit event.
d. Credit-linked notes: A credit-linked note is a tradeable instrument in which a
buyer is purchasing an income stream, while simultaneously accepted the risk
associated with a credit event. The protection buyer is the seller of the credit-
linked note. Investors buying the securities will see a delay or reduction in
payment if a legally defined credit event occurs.

17
The notional amount of volume outstanding for these five areas is by no means equal. The
split of OTC derivatives by product type is shown in the figure below. Through the first half of
the calendar year 2019, most OTC derivatives were interest rate derivatives, with a notional
value of $524 trillion. In second and third place were foreign exchange derivatives at $98.7
trillion and credit default swaps at $7.8 trillion. It should be noted that, although, when
measured by notional value, interest rate derivatives are the largest, the other security types
are integrally important for a well-functioning derivatives market.

Notional Amount of OTC Derivatives, First Half of 20197

The key component of derivatives is their limited exposure. Derivatives have no

principal risk since the transaction is a trade-in cash flow.

An example. Consider an interest rate swap, where the two parties are simply swapping
interest payments, typically floating interest payments for fixed coupons. In this case, the
trade has no principal risk, only cashflow risk. The entire amount of the cash flow is not even
at risk because on coupon dates (when coupon payments are made), only the difference
between the fixed and floating coupons are exchanged. This is referred to as the
net payment.

If a counterparty fails to make a payment, then the other party to the transaction has no
obligation to continue to make coupon payments. In a default situation, the trade gets
unwound based on independent quotations of the current market value. If the swap’s value
is below zero, then the owner may stand to lose nothing when their counterparty fails to
make payment.

7
Developed from data provided by the Bank for International Settlements, accessible here:
https://www.bis.org/statistics/full_data_sets.htm

18
Notional vs. Market Value

Beginning financial professionals are sometimes amazed at the size of the notional value of
the OTC derivative market. It is important to remember, though, that the actual market value
of derivatives is much less than the notional value, as shown in the following graphic. For
example, the total market value of interest rate contracts is only 1.5% of the total notional
outstanding as of the second half of 2018.

Comparison of Total Notional Outstanding and the Market Value of OTC Derivatives
by Asset Type, as of the Second Half of 20188

Risks

 Interest rate derivatives risks: The two main risks associated with interest rate
derivatives are interest rate risk and credit risk. Interest rate risk is the possibility that
interest rates move in a direction that is opposite of the trade a bank has made.
Credit risk is the possibility that the counterparty to the transaction may default.
 Foreign exchange derivatives risks: Foreign exchange derivatives carry exchange
rate risk, which is the chance that foreign exchange rates will move in a direction
different than what was expected. Additionally, although most foreign exchange rates
are short-dated, the long-dated nature of cross-currency swaps can mean significant
counterparty risk.
 Equity derivatives risks: The underlying asset of an equity derivative is a stock.
Depending upon whether one owns a put or a call, the movement of the underlying
stock price can create profit or loss. In formal terms, this is called price risk.

8
Developed from data provided by the Bank for International Settlements, accessible here:
https://www.bis.org/statistics/full_data_sets.htm

19
  Commodity derivatives risks: As with equity derivatives, commodity derivatives
have price risk. Should the underlying commodity’s price move in an undesirable
direction, a commodity derivatives investor could experience a loss.
 Credit derivatives risks: The main risk associated with credit risk is the possibility
that the opposite side of the transaction won’t pay the money back.
A summary of the risks contained in the five areas is summarized in the following table. If the
asset class is exposed to the risk area, the cell notes this by a “Yes”. In addition to the
detailed risks, all these derivatives have market or systemic risk. Lastly, derivatives with
counterparty risk also have wrong-way risk, which captures the observation that when
counterparty risk rises – meaning a firm may be unable to repay obligations – their credit
may also suffer.

Risks associated with derivatives

Area Interest Counterparty Exchange Price Market Risk

Rate Risk Credit Risk Rate Risk Risk (Systemic Risk)
Interest rate Yes Yes Yes
derivatives
Foreign exchange Yes Yes Yes
derivatives
Equity derivatives Yes Yes
Commodity Yes
derivatives
Credit derivatives Yes Yes

Identify risks associated with OTC markets and explain how these
risks can be mitigated.
Individual transactions on OTC markets carry risks. Not to be forgotten is that OTC markets
as a whole carry risks. These risks can be mitigated to one degree or another. The market-
wide OTC risks include decentralization, lower transparency, heterogeneous transactions,
lower liquidity, and counterparty risk.
 Decentralized: By definition, OTC markets are decentralized compared to exchange-
traded equivalents. This decentralization can carry with it a higher level of risk should
problems arise with the counterparty or the nature of the contract itself.
 Heterogeneous: OTC markets enable customization of transactions. With that
customization comes the risk that heterogeneous transactions may be done legally
incorrect or some other unique problem will materialize that could affect the entire
economy, such as what happened leading up to the global financial crisis.
 Transparency: OTC markets are less transparent than their exchange-traded
competitors. This lower level of transparency is often desired by OTC market
participants but comes with greater systemic risk should economy-wide problems
materialize. Again, this lack of transparency was a problem during the global financial
crisis.
 Liquidity: OTC markets carry the risk of lower liquidity. This lower level of liquidity
can be a level of systemic risk for the entire financial system should liquidity dry up
and affect other areas of the financial system.
 Counterparty risk: Perhaps the highest level of concern among OTC market
participants is counterparty risk and the potential for chain reactions from the initial
spark.

20
To address the systemic risks that can materialize
with OTC markets, OTC market participants have
focused on the following:
 Netting agreements: Netting implies
offsetting transactions, or “netting” short and
long positions.
o For instance, suppose Trader A buys
10,000 bushels of corn for $1 per
bushel from Trader B and Trader B
purchases 10,000 bushels of corn for $1.30 per bushel from Trader A.
Presuming both have the same delivery date, rather than each entity
delivering the items, Trader B could simply pay Trader A $3,000 and be done
with the transaction.
 Margin requirements: Imposing margin requirements is when assets are transferred
from one trader to another through an intermediary (the exchange). The presence of
the intermediary minimizes counterparty default risk.
o For instance, suppose Trader A buys 25,000 bushels of corn from Trader B in
October for 500 cents per bushel. Further, suppose that the price of corn
drops to 400 cents per bushel the day after the trade was made. Trade A
would want to renege on his purchase if possible. What could prevent Trader
A from reneging? One way is through a margin requirement.
 Periodic cash resettlements: Contracts are evaluated at some specified frequency
and cash payments are made periodically to the counterparties to the transaction.
 Collateral management: By using collateral management techniques, the OTC
markets may minimize potential system-wide downside risk by ensuring there is
enough collateral to cover some contagion should some contracts default.
 Special purpose vehicles (SPVs): SPVs are legal entities that legally separate a
firm from financial risk. Theoretically, by setting up SPVs, banks can prevent the
potential contagion risk to the financial market by preventing the risk to flow up to the
banks creating the SPVs.
 Derivative product companies: Generally triple-A rated entities established by one
or more financial companies (usually banks) as a bankruptcy-remote subsidiary of a
major dealer. These structures are intended to prevent contagion from defaults in the
OTC market.
 Monolines: Monolines are insurance companies created as financial guarantors, like
derivative product companies.
 Credit default swaps: A credit default swap occurs when a buyer pays a premium
for protection against a “credit event”, which may include payment default or some
other credit event.
There is also considerable debate about the effect each of these factors can have on the
systemic risks of OTC markets. Some professional investors have noted that an initial spark
of counterparty default can lead to a chain reaction and eventually an explosion in the
financial markets, something that these options may exacerbate rather than minimize.
Famed investor Warren Buffet once called the derivatives market support the OTC market
as “financial weapons of mass destruction.9”

9
Berkshire Hathaway annual letter to shareholders in 2002.

21
Describe the role of collateralization in the over-the-counter market
and compare it to the margining system.
As previously addressed, the OTC market contains
risks with bilateral and multi-lateral contracts, among
them, credit risk. For many years, bilaterally
negotiated contracts in the OTC market have used
collateral as the means to control credit risk. Within
the “managing credit risk” umbrella is the credit
support annex (CSA) of a master agreement. The
CSA:
 Details how collateral is calculated; and
 What securities will be posted
It is commonplace for outstanding derivatives to be priced every day and the net change in
value to be used to determine any extra collateral that must be posted. Although collateral is
the common man’s term for hedging credit risk in the OTC market, the terminology of
exchange-traded markets is sometimes used, where the term collateral is replaced with
margin or margining.

Collateral versus margining

Although often synonymous, collateral in the OTC market can be different from margining in
the exchange-traded markets. In the exchange-traded markets, exchanges have developed
two methods to reduce non-settlement risk – margining and netting.
 Margining refers to exchange members putting up cash or other assets to cover
potential gains and/or losses in the respective positions. Within the margining
umbrella, there are two types of margining – variation margin and initial margin.
o Variation margin allows for the margin amounts to vary.
o Initial margin allows for extra coverage against losses in case parties
default.
Traditional collateral, where assets are encumbered against credit risk, is in some sense,
different.

An example. As an example, consider companies Alpha and Beta. The two companies are
counterparties to a derivatives transaction. Suppose that on a given day, the net value of
outstanding transactions rises by $1 million to the favor of Company Beta. By extension, the
net value has decreased by $1 million for Company Alpha. If the CSA requires the company
with a net decline in value to post collateral for the difference, then Company Alpha would
need to post another $1 million of collateral to Company Beta.

22
Explain the use of special purpose vehicles (SPVs) in the OTC
derivatives market.
A Special Purpose Vehicle (SPV) or Special
Purpose Entity (SPE) is a legal entity created to
legally separate a firm from financial risk. In the OTC
derivatives environment, SPVs are employed to
protect an entity from credit risk. SPVs and SPEs are
often set up to separate the risk associated with a
large project from the corporate entity itself. In some
legal jurisdictions, the jurisdiction may prohibit an
SPV to be owned by the entity creating the SPV. To
effectuate an SPV, a corporate entity often transfers
assets to the SPV for management separate of the corporate entity itself. There are many
important points to note on SPVs.
 Part of the purpose of SPVs is to change the
order in which entities receive their
invested money in the event of a
bankruptcy. SPVs attempt to move clients
closer to the front of the bankruptcy payment
order. Essentially, should a counterparty to a
derivative transaction become insolvent, a
client may still be able to receive their full
investment prior to any other claims being
paid out, at least that is the legal strategy.
SPVs are often employed in structured notes, where the investor uses this
mechanism to guarantee the counterparty risk on the principal of the note. Often, the
guarantee carries more creditworthiness than the issuer itself. Of course, the
creditworthiness of the SPV is done independently by rating agencies.
 An SPV transforms counterparty risk into legal risk. This distinction is important.
SPVs may not eliminate risk, but rather shift the level and type of risk to legal risk.
The main risk underneath the legal risk umbrella is consolidation. Consolidation
refers to the power of a bankruptcy court to combine the SPV assets with those of
the originator. The legal argument behind consolidation is that the SPV is the same
entity as the originator. In such a case, the setting up of the SPV as a separate legal
entity becomes irrelevant. Consolidation law depends on many factors, including
geography. For instance, courts in the U.S. may be more apt to require consolidation
than say U.K. courts.
 SPVs also come with the added issue of legal documentation evolving through
experience. Because the field has unsettled issues in the enforceability of the SPV
legal structure, entities setting up SPVs may be surprised when final legal decisions
are made. For instance, leading up to the 2008 downturn, now-defunct Lehman
Brothers used SPVs to shield investors in complex transactions, such as
Collateralized Debt Obligations (CDOs), from Lehman’s own counterparty risk.
o The key provision in Lehman’s SPVs was known as the ‘flip’ provision, which
basically said that if Lehman went bankrupt, then investors would be first in
line as creditors. In the U.S. bankruptcy courts, the courts found the flip
clauses unenforceable, whereas the U.K. courts found the opposite. Many flip
clauses have subsequently been settled out of court.

23
Derivatives product companies

Derivatives product companies (DPCs) are generally triple-A rated entities established
by one or more financial companies (usually banks) as a bankruptcy-remote
subsidiary of a major dealer.
 DPCs differ from SPVs in that DPCs are separately capitalized to obtain a triple-A
credit rating. This separate capitalization minimizes consolidation risk.
 The DPC structure also offers external counterparties with a degree of protection
against counterparty risk by implementing protection should the DPC parent fail.
Essentially, a DPC structure is an attempt to offer investors some of the benefits of
the exchange-based system while simultaneously preserving the flexibility and
decentralization of the OTC market.
 Early innovators of DPC products include Lehman Brothers Financial Products,
Merrill Lynch Derivative Products, Morgan Stanley Derivative Products, and Salomon
Swapco.
 Improvements in risk management modeling and the introduction of credit rating
agencies allowed sponsors to create their “mini derivatives exchange” using a DPC.
To maintain their triple-A rating, DPCs:
o Maintain adequate capital
o Control margin
o Implement activity restrictions.
 Rather than use the corporate creator’s quantitative risk assessment model to
quantify their credit risk, DPCs, as separately capitalized and legally distinct, employ
their own credit risk models. DPCs benchmark their conditions against triple-A rated
entities to ensure they maintain their triple-A rated status. The model deployed by
DPCs falls within the category of dynamic capital allocation to monitor their triple-A
credit risk requirements.
Although it depends on the rating agency, a DPC’s triple-A credit rating usually
depends on:
 How well the DPC minimizes market risk. In terms of market risk, DPCs can
attempt to be close to market-neutral via trading offsetting contracts. Ideally, they
would be on both sides of every trade, as these ‘mirror trades’ lead to an overall
matched book. Normally the mirror trade exists with the DPC parent.
 How much support a DPC receives from a parent. The DPC is a so-called
bankruptcy-remote entity created by its parent. If the parent goes south, then
ownership of the DPC would pass to another entity and that could change its rating.
Potential outcomes for the DPC include being transferred to a well-capitalized
financial institution or termination. The trades would then settle at mid-market.
 How well defined the DPC’s credit risk management and operational guidelines
appear to the ratings agencies. Does the DPC impose position limits? Does the
DPC detail guidelines on the use of margin terms? Restrictions may be viewed by the
ratings agencies as positive signals for a triple-A credit rating, including restrictions
on external counterparty credit quality and the just-mentioned activities such as
position limits and use of margin. One additional important component of managing
counterparty risk is having daily mark-to-market and margin posting.

24
DPCs also aim for enhanced security by detailing an orderly workout process. The
workout process has two broad steps:
1. What events trigger its own failure, and
2. How the triggered workout process would work.
Pre-planning for a potential bankruptcy (a “pre-packaged bankruptcy”) is viewed by ratings
agencies and others as simpler than the often-messy standard bankruptcy of an OTC
derivative counterparty. Overall, there are two general bankruptcy approaches:
 A continuation structure, which is a continuation of the relationship, but in a different
form.
 A termination structure, which is when the relationship is terminated.
 In both cases, the manager is responsible for managing and hedging existing
positions.
A brief history lesson. In the early days of the OTC derivative market, DPCs were created
to facilitate the trading of long-dated derivatives by counterparties with credit quality of less
than triple-A. The DPC market grew steadily until the mid-1990s until the use of margin
became more popular. The existence of alternative triple-A entities also led to slower
demand for DPCs.

Monolines and CDPCs

As just mentioned, the growth in the demand for

DPCs stemmed largely from the demand for quality
counterparties in the OTC derivatives market. The
market exploded higher from around 1998 and
afterward. The first credit derivative was a credit
default swap (CDS), which contained some unique
challenges, chief among them, the credit spread risk
from mark-to-market accounting and wrong-way risk.
These two risks created a need for a “default remote entity”.

In response to this need, financial firms created

monoline insurance companies10. Monoline
insurance companies are financial guarantee
companies with high credit ratings that are used as
“credit wraps”, or in other words, to create financial
guarantees. Monoline insurance companies
(monolines) began offering credit wraps for other
areas, but after seeing the potential for diversification
and higher returns, they also entered the single-name
CDS and structured finance arena.

10
Companies such as AIG would also fall under the group of firms offering monolines and CDPCs.

25
Another extension of the DPCs was the credit derivative product company (CDPC). The
business models of CDPCs were quite similar to monoline insurance companies, including
the following notes.
 To achieve good ratings, monolines and CDPCs had capital requirements that were
driven by the potential losses on the structures they protected.
 In addition to the capital requirements being connected to potential losses, the capital
requirements were dynamically connected to the portfolio of assets that the
monolines and CDPCs wrapped, like DPCs.
 An important component of monolines and CDPCs is that they do not have to post
margin (at least usually) when the mark-to-market value of their assets drops. This
beneficial aspect stems from their triple-A credit rating.
The good times of monolines and CDPCs met an abrupt end when companies such as XL
Financial Assurance Ltd, AMBAC Insurance Corporation, and MBIA Insurance Corporation
went under beginning in November 2007. The dire situation came to a head when AIG
publicly announced that they would go bankrupt unless they received support from the
federal government to the tune of $182 billion. Fearing a global financial meltdown,
policymakers offered AIG the requested “bailout” money.

What caused the failures? Multiple forces

contributed to the financial problems of banks,
CDPCs, DPCs, and monolines, including ratings
downgrades, a deterioration of the underlying assets,
imposed margin postings, and mark-to-market losses.
The downward spiral caused many banks to find
themselves heavily exposed to monolines. CDPCs
had a similar outcome to monolines because of their
inability to post margin and being highly leveraged.
CDPCs generally fared better than the monolines
initially, not because of their stronger financial position, but because most CDPCs were not
fully operational until after July 2007. This late start meant that CDPCs generally missed the
first wave of losses incurred by parties selling credit protection.

26
P1.T3. Financial Markets & Products

Chapter 6. Central Clearing

Bionic Turtle FRM Study Notes

CHAPTER 6. CENTRAL CLEARING

PROVIDE EXAMPLES OF THE MECHANICS OF A CENTRAL COUNTERPARTY (CCP). .................... 3

DESCRIBE THE ROLE OF CCPS AND DISTINGUISH BETWEEN BILATERAL AND CENTRALIZED
CLEARING. .......................................................................................................................... 9
DESCRIBE ADVANTAGES AND DISADVANTAGES OF CENTRAL CLEARING OF OTC DERIVATIVES. 12
EXPLAIN REGULATORY INITIATIVES FOR THE OTC DERIVATIVES MARKET AND THEIR IMPACT ON
CENTRAL CLEARING........................................................................................................... 15
COMPARE MARGIN REQUIREMENTS IN CENTRALLY CLEARED AND BILATERAL MARKETS AND
EXPLAIN HOW MARGIN CAN MITIGATE RISK. ......................................................................... 17
COMPARE AND CONTRAST BILATERAL MARKETS TO NOVATION AND NETTING ......................... 19
ASSESS THE IMPACT OF CENTRAL CLEARING ON THE BROADER FINANCIAL MARKETS. ............ 20
IDENTIFY AND EXPLAIN THE TYPES OF RISKS FACED BY CCPS. ............................................. 21
IDENTIFY AND DISTINGUISH BETWEEN THE RISKS TO CLEARING MEMBERS AS WELL AS NON-
MEMBERS. ........................................................................................................................ 25

2
Chapter 6. Central Clearing
 Provide examples of the mechanics of a central counterparty (CCP).

 Describe the role of CCPs and distinguish between bilateral and centralized
clearing.

 Describe advantages and disadvantages of central clearing of OTC derivatives.

 Explain regulatory initiatives for the OTC derivatives market and their impact on
central clearing.

 Compare margin requirements in centrally cleared and bilateral markets and

explain how margin can mitigate risk.

 Compare and contrast bilateral markets to the use of novation and netting.

 Assess the impact of central clearing on the broader financial markets.

 Identify and explain the types of risks faced by CCPs.

 Identify and distinguish between the risks to clearing members as well as non-
members.

Provide examples of the mechanics of a central counterparty

(CCP).
According to GARP1, three of the largest central counterparties that clear over the counter
(OTC) derivatives are:
 SwapClear (https://www.lch.com/services/swapclear) is part of LCH who clears a
range of OTC and listed asset classes, including swaps, fixed income, FX, CDS,
equities, and commodities.
 CME ClearPort (https://www.cmegroup.com/clearport.html) is part of CME Group
who is the world’s largest derivates exchange and a key resource on commodities.
 ICE Clear (https://www.theice.com/clear-us ) who is part of Intercontinental Exchange
https://www.theice.com/index

Major CCP Functions

1
2020 Financial Risk Management Part I: Financial Markets and Products, 10th Edition. Chapter 6.

3
Exchange-traded markets. The role of central counterparty clearing differs depending upon
the market in which the clearing occurs. In the central clearing non-OTC market, the primary
role of the CCP is:
 To standardize contracts; and
 To simplify operational processes.

OTC markets. In contrast to the exchange-traded CCPs, OTC CCPs play a much more
significant role in managing counterparty risk. This stems from:
 The longer maturities and
 The relative illiquidity of OTC derivatives.

As illustrated (see diagram on previous page), the three broad functions of the CCP are:
 Execution. The first step is the execution, which represents when a buyer and seller
legally agree to an underlying transaction.
 Clearing. Following the execution step is the clearing step. This is the middle step
that occurs after execution and before settlement. Clearing encompasses any
margining, cashflow payments, collateral, and other pre-settlement steps.
 Settlement. The third step is the settlement step. This final step captures the final
exchange of securities or cash. All obligations are settled after this step.

CCP definition. What exactly is a CCP? In a nutshell, a CCP captures the set of rules and
operational arrangements that help to allocate, manage, and reduce counterparty risk to a
bilateral market. A visual depiction of the CCP topology for financial markets is shown in the
following figure. Rather than multiples lines between parties, the CCP inserts itself into the
processes by handling all the clearing and settlement portions of the transaction between
buyers and sellers.

Visual depiction of bilateral markets (left) and markets using central clearing (right)2

2
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC
Derivatives (New York: John Wiley & Sons, 2014). Inspired by Gregory but rendered in MS Visio.

4
Important notes on CCPs and financial markets topology
The above figure has six Ds. For the moment, assume these six entities are large global
banks known as dealers. There are at least two clear advantages from this simple depiction:
 First, in theory, a CCP may reduce the interconnectedness among participants in
financial markets, which may lower the potential contagion effect is a member
becomes insolvent. This issue is debated.
 Second, by using a CCP, members are accepting greater transparency in their own
transactions and other market participants.

Novation
Contract novation is the legal process of positioning the CCP between buyers and sellers.
Depicted in the figure above is the novation process. On the left side of the graph are the
bilateral trades between parties. If one counts the arrows, there are 15 arrows, representing
one transaction between each of the counterparties. The figure on the right changes the
nature of the exchange to just five arrows, with each party accepting the CCP as the central
entity in negotiating the various transactions. This is novation. Novation replaces one
contract with one or more other contracts. With novation, the CCP acts as the middleman
and places itself as an insurer of counterparty risk for both counterparties.
 Important to a well-functioning novation process are:
o First, new contracts must be legally enforceable.
o Second, a guarantee that the original parties to the transaction are no
longer connected with each other.
o Once these two conditions are met, the original parties to the transaction
no longer have a bilateral contract. The bilateral contract ceases to exist,
and counterparty risk is minimized, transferring this risk to the CCP.
 The CCP accepts the counterparty risk by putting itself between buyers and sellers.
In this way, the CCP takes on a “matched book”. By having a matched holding, the
CCP itself has no net market risk. The market risk stays with the parties to the
original transaction.
 How do CCPs minimize their own counterparty should one party to a transaction
default? CCPs address this by requiring transacting parties to commit some financial
capital as a form of an “insurance fund” should members default on their
commitment. The amount of financial capital is set so as to cover any expected
losses in the course of business.

5
Multilateral offset
Perhaps surprisingly to people new to central counterparty clearing, the proliferation of
bilateral clearing leads to overlapping and potentially redundant contracts. Why? Because
parties to a contract may enter offsetting trades instead of canceling the original contract.
This redundancy leads to a more interconnected financial system and potentially increases
counterparty risk. The issue is even more complex for dealers because it may need to hedge
very similar, but distinct contracts.

This leads to the first real advantage of central clearing – multilateral offset, as depicted
in the following figure. The offset can cover multiple items, including cashflow or margin
requirements.

Explaining the figure below

 The left pane of the figure has traders A, C, and D in a bilateral market. In this setup,
Trader A owes Trader C 60, Trader D owes Trader A 90, and Trader C owes Trader
D 30. Total liability for the market is 180. The counterparty exposure is clear. For
instance, Trader A is exposed to Trader C by 90 and if D defaults, Trader A may be
unable to make payments to Trader C.
 The middle pane switches the view from a bilateral market to a novation structure.
Each trader places their transaction with the CCP, and the CCP manages the
exchange. For instance, Trader A places 60 with the CCP and receives 90 from the
CCP. With this central clearing structure, all assets and liabilities associated with the
transactions run through the CCP. The CCP can then offset the transaction.
 The far-right pane shows this netting. By using a central clearing entity, the total
systemic risk is reduced, with overall credit dropping from 180 to 120. In this case,
should Trader D default, the risk to the other parties is lower and the presence of the
CCP may minimize any potential contagion.

Depiction of multilateral offsetting3

3
Adapted from John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for
OTC Derivatives (New York: John Wiley & Sons, 2014). Rendered in MS Visio.

6
Margining
What would happen if the New York Stock Exchange went down? What about the Chicago
Board of Trade? Likely, market trading would drop significantly combined with the ensuing
financial market panic. Similarly, in modern markets, CCPs sit at the center of activity. If they
fail at employing risk control measures and have inadequate resources, market trading could
collapse. This leads to the obvious conclusion:

It is critically important that CCPs have effective risk control and sufficient financial
resources.

To ensure risk control and adequate financial resources, CCPs charge a premium to cover
the market risk associated with the trades it covers. For CCPs, margin comes in two forms:
 Initial margin: Charged at the trade’s inception, initial margin is intended to cover
close-out costs should the worst-case scenario materialize. The actual costs to find
replacement transactions in the event of default are the initial margin.
 Variation margin: Covers any potential downside to the member’s position. It is
measured as the net change in market value.

An example. Suppose a bank has $100 billion that it plans on trading in the OTC market,
and that the CCP thinks the replacement costs on the transaction would be 0.1%. Further,
assume that the potential net change in market value is 5%. In this hypothetical example, the
initial margin would be $100 million, and the variation margin would be $5 billion.

CCPs are much stricter on their margin requirements than the bilateral derivative
markets.
 Variation margin must generally be posted daily (sometimes even intra-daily). Cash
is usually the form in which payment must be made.
 Initial margin is usually not fixed and changes with market conditions. Payments are
typically made in cash or liquid assets.
 When one combines the effect initial margins and increased required liquidity of
margin, one notices that margin requirements have come with much higher costs
than has traditionally been the case.

7
In addition to the points on risk control, having enough financial resources, and the strict
margin requirements on bilateral derivatives markets, another important point is that CCPs
usually derive margin requirements based upon the risks associated with each
member’s portfolio. That is, the initial margin requirements are at most only marginally
related to the credit of the posting institution. This might be surprising to some – the most
creditworthy institutions will be faced with the same initial margins on the same
portfolio of securities even if the default risk for the two institutions is materially
different.

Auctions
What do CCPs have to do with auctions? It has to do
with what happens when a party defaults. As
background, remember that, in theory, when a default
occurs with a CCP, the CCP acts as a “shock
absorber”, theoretically preventing contagion to the
broader market. Once a default becomes certain, the
CCP swiftly acts by terminating quickly all financial
relations with that counterparty so that any potential
losses are minimized.

How does the CCP close out the defaulting members contracts? The CCP does this
through the CCP auctioning system. Other members of the CCP bid on the defaulted
counterparty’s contracts.

Generally, other members of the CCP have strong incentives to participate in the auction.
Why do members have strong incentives to participate in auctions? The answer is that if the
CCP auction fails, the CCP is within its powers to attempt other methods of loss allocation,
and those methods may be more harmful to CCP members than through the auction system.
Essentially, the CCP generally achieves better pricing of the defaulted entity’s assets
through the auction/unwinding/novating process than through a bilaterally cleared market.

Loss mutualization
In a world that placed blame on the entity causing the problem, CCP members would take a
“defaulter pays” approach, meaning that every member would cover their own potential
default. In practice, this is not implemented because it would require higher financial
contributions from each member, leading to unprofitable “dry powder”. Instead, what
members cover are losses that have a high degree of confidence in scenarios where a
default does occur. This “slimmed” approach to covering potential defaults means that there
are small chances of losses occurring that do not follow a defaulter pays approach.

This leads to loss mutualization. Loss mutualization refers to the idea that losses not
covered by a defaulter’s own resources are “mutualized” or shared among CCP members.

Default fund. The way CCP members share losses not covered by the defaulter is through
a default fund. A default fund takes contributions from CCP members and distributes funds
in the event of a default. Payments from the default fund are only made should the
defaulter’s own funds be insufficient to cover losses, thus “socializing” or a mutualization of
the losses.

8
Members can incur losses even if the member
never traded with the defaulting member. An
important note on loss mutualization is that in a CCP
environment, mutualized default losses are not
directly connected to the non-defaulting member’s
transactions. Essentially, members can suffer losses
even if they never traded with the defaulted party.
This is true even if the member has no net position
with the CCP or has a net position directionally the
same as the defaulter.

This background leads to the obvious conclusion that loss mutualization is a form of
insurance. Of course, this insurance, or risk pooling, has potential benefits for the market as
a whole.

By risk pooling potential extreme losses, more participants can enter the market. The benefit
of loss mutualization comes with downside issues as well, among them incentive and
informational problems, more commonly known as moral hazard and adverse selection.

Describe the role of CCPs and distinguish between bilateral and

centralized clearing.
At their core, CCPs are essentially facilitators. In derivatives
transactions, they act not as a matchmaker but as a
counterparty to all transactions made by members. In this role:
 CCPs have developed rules for margin (initial and
variation).
 Derived required contributions to the default fund.
 Offer independent trade valuations.
 Value collateral options.
 Monitor members’ creditworthiness.
 Manage other trading issues to efficiently handle credit
risks.
In its oversight role, CCPs typically require variation margin to be paid daily (sometimes
intra-day) based on the change in the value of each member’s portfolio of transactions with
the CCP. When a default does not occur, the variation margin received and paid out should
be equal. This stems from the CCP’s matched book nature and implies that the CCP, in
theory, bears no market risk4. When a default does occur, market risk shows up, and the
CCP closes out the positions of the defaulting member as quickly as possible.

4
Should the global economy collapse, this statement would be untrue, but outside of extreme black swan events,
CCPs bear no market risk.

9
When CCP equity becomes at risk. CCPs operate under
the assumption of 99% confidence. What this means is that
the amount that is deposited from initial margin is set so
that the CCP is 99% confident that the loss will not be
greater than estimated. What happens if the loss is greater
than the estimated 99th confidence level? Should the
defaulting member’s initial margin be insufficient to cover
their losses, the default fund chips in, with the first
contributions used stemming from the defaulting member. If this still leaves the CCP short,
the contributions from other members are used. If this is still insufficient, then the CCP’s
equity is at risk.

Coordinating an auction. A member default in the CCP world is a big deal. CCPs must act
quickly to address the issue. The most common method to resolve a member default is by
inviting members to an auction. At the auction, members bid for the transactions that offset
the defaulting member’s transactions.

Why do members participate in the auction? At issue is an evaluation of potential outcomes.

 One outcome for a member is to participate in the auction and potentially purchase
positions at desirable prices.
 Another potential outcome is for a member to participate in the auction but end up
with no positions.
 In both cases, the auction solved the issue with
the defaulting member.
 What happens if no members bid on the positions
at auction or the CCP finds the bids
unacceptable?
 Should the auction fail, the CCP has the right to:
o Allocate losses to members with recent
gains.
o Tear up the transactions. In this scenario, non-defaulting members take
losses because the transactions are closed at prices that allocate losses
among CCP members.
 The risk of what might happen should the auction fail provides a sizeable incentive
for members to cooperate with the CCP. As such, the CCP performs duties similar to
a judge.

Differences between bilateral and central clearing

Is there much of a difference between bilateral and central clearing? The answer is yes –
very stark differences. As a note, both markets are still vitally important, as shown below. As
of writing, CCPs accounted for 54% of the derivatives market.

10
Derivatives by counterparty according to the Bank for International Settlement5

Bilateral transactions. Key distinguishing points of bilateral transactions include:

 Bilaterally cleared transactions are transactions with two parties.
 Transactions can be non-standard and can be customized as the parties see fit.
 Should the parties desire, they offer a way to avoid regulation.
 All the aspects of the trade are agreed between the two trading parties.
CCP transactions. Key distinguishing points of centrally cleared transactions include:

 The legal aspects of the transaction/product must fit market standards.

 The economic aspects of the transaction/product must fit market standards.
 Models used to value the product must be generally accepted by the CCP. This
stems from the requirement that the CCP determines variation margin at least once
per day.
 The products must be liquid, meaning they must be actively traded. Illiquid trades
make it difficult to unwind a member’s position should margin fail to be posted. Illiquid
products are also difficult to value frequently and accurately. This is not to say CCPs
may not move in this direction, but currently, illiquid products are generally excluded
from CCP trading.
 Products traded with CCPs generally have reasonable historical data on the price of
the product to enable calculation of margin requirements.
 Products must be non-complex (or non-exotic) to enable the CCP to support
transactions.
 CCPs offer reporting services.

5
Bank for International Settlements, accessed in April 2020 from this link.

11
Table of comparison

Bilateral CCP
Between two entities The CCP is the middleman and accepts
virtually all of the counterparty risk
Transactions can be non-standard, Legal and economic aspects of the contract
including a high degree of customization must be standardized
Avoids regulation Highly regulated
Requires bilateral agreement Requires that the CCP accept the
transaction
Valuations can be non-standard Valuations must be generally acceptable to
the CCP
May be illiquid Generally required to be liquid
Collateral covers counterparty risk Initial/variation margin and default funds
cover the CCP’s risk
Price history of trades may be long or non- Price history is generally well-known
existent
Products can be simple to completely Products can generally only be simple,
complex (exotic) plain vanilla
Reporting is done by the parties Offer reporting services

Describe advantages and disadvantages of central clearing of OTC

derivatives.
Before addressing the advantages and disadvantages of OTC derivatives’ central
clearing, it is important to keep in mind important points, including:
 Sometimes it is perceived that a CCP will solve all
problems in the OTC market. Although CCPs can
“cure” some issues in the OTC market, CCPs are not
a cure-all for all potential problems in the OTC
derivatives market. In fact, in some models, CCPs
exacerbate the potential financial market systemic
risk, potentially burning a hole in the global financial
system.
 Counterparty risk does not disappear with a CCP. Instead, it transforms the nature of
counterparty risk from a bilateral nature to an entity that centralizes the risk and
converts it into different forms, such as operational and liquidity risk.
 Although it may seem that CCPs have advantages that come with no disadvantage,
that is generally not true. Generally, every considered advantage also has a
connected disadvantage.
o For instance, CCPs may lower overall systemic risk but can
also increase systemic risk. CCPs lower overall systemic risk by, for example,
offering auctions in the case of default, while potentially increasing overall
systemic risk by, for example, changing margin requirements when market
volatility increases.
 The functions provided by CCPs are not new. For many years, bilateral markets
accomplished the functions provided by CCPs using other mechanisms. Depending
upon one’s perspective, CCPs may or may not execute redundant functions more
efficiently and with less risk.

12
  The potential benefits of central clearing are not equally distributed. Some markets
may benefit from central clearing more than other markets.
 It is yet to be seen whether the potential unintended consequences of the expanded
use of CCPs will prove to have been economy-wide beneficial or detrimental.
 As with other financial institutions, CCPs can fail. A potential failure of a large CCP
could be disastrous, although there are historical CCP insolvencies analysts can
learn from.

Advantages of CCPs
 Transparency: CCPs know the positions of their market participants. With this
knowledge, CCPs can provide confidence that could disappear in times of panic in
bilaterally traded markets. Additionally, with this transparent knowledge of each
member’s positions, the CCP is in a position to point out extreme exposure and to act
on this by limiting trading.
 Offsetting: The presence of CCPs enables offsetting. Offsetting refers to the practice
of netting positive and negative transactions by a trading entity to arrive at a net
position. By creating the possibility for offsetting or netting, the CCP creates greater
flexibility for new transactions, greater ability to terminate existing transactions, and in
the process, reduce operational costs.
 Loss mutualization: In a bilateral trade, all counterparty risk is held by the trading
party. In contrast to this setup, a CCP mutualizes that risk across members. This
dispersion of risk lowers the potential adverse effects of idiosyncratic risk and may
also lower the risk of systemic problems.
 Legal and operational efficiency: With a CCP, the legal and operational aspects of
trading can potentially be done more efficiently. This is because the CCP
standardizes the margining, netting, and settlement functions in an effort to reduce
costs. The legal advantage stems from the CCP offering centralized rules and
mechanisms for normal trading operations.
 Liquidity: With a CCP, markets may become more liquid and the presence of
multilateral netting may further the advantage of CCPs. Additionally, CCPs may
increase market entry by offering firms the ability to trade anonymously while
simultaneously mitigating counterparty risk. Liquidity may be furthered by the practice
of daily margining, which may produce product valuations more transparently and
accurately.
 Default management: By being a de facto default manager, a well-managed central
auction may produce smaller price disruptions than the uncoordinated replacement of
positions when a crisis period associated with the default of a clearing member hits.
 Ease of transaction: Perhaps one way to sum up the advantage points so far is that
CCPs offer “easier” transaction management.

13
Disadvantages of CCPs
 Moral hazard: This problem is synonymous with the insurance industry. Moral
hazard refers to the idea that people or entities with “insurance” behave in a less than
completely prudential manner because they have insurance. Similarly, with the
presence of a CCP, parties may not have the incentive to patrol good counterparty
risk management practices by CCP members because the CCP has accepted all
counterparty risk. This lack of an incentive to monitor other members’ credit quality
may lead to greater systemic risk should the CCP fall into financial problems.
 Adverse selection: CCPs are susceptible to adverse selection. This happens when
CCP members are more informed about the underlying nature of the derivatives
products than the CCP themselves. With this information asymmetry, members may
selectively pass riskier products to CCPs because the CCPs may be underpricing the
risks. This information asymmetry is quite common given that many large banks
specialize in OTC derivatives and their frequent use of derivatives may give them
superior informational advantage over the CCP.
 Bifurcations: Another disadvantage of CCPs is that they require products to be
standardized. This standardization requirement may end up creating bifurcations
between cleared and non-cleared trades. This setup can result in highly volatile
customer cashflows and mismatches for “presumed” hedged positions.
 Procyclicality: Perhaps the most insidious disadvantage of CCPs is their
procyclicality. Valuations of the derivatives traded on the CCP move in the same
direction as the economy. For instance, when market volatility increases, CCPs may
increase margins, which is not desirable during periods of market crisis. CCPs also
require greater frequency and liquidity to meet margin requirements compared to
more customizable and flexible margin practices in the bilateral OTC markets. The
CCP could exacerbate an already terrible problem with its procyclical policies.

Comparison table of OTC, CCP, and exchanges6

Item OTC CCP Exchange
Trading Bilateral Bilateral Centralized
Counterparty Original CCP CCP
Products All Must be standard Must be standard
Participants All Clearing members are Clearing members
usually large dealers. are usually large
Other margin posting dealers.
entities can clear Other margin
through clearing posting entities can
members. clear through
clearing members.
Margining Bilateral, bespoke Full margining, Full margining, incl.
arrangements open to including initial margin initial margin
disputes enforced by the CCP enforced by CCP
Loss buffers Regulatory capital and Initial margins, default Initial margins,
margin (where provided) funds and CCP own default funds and
capital CCP own capital

6
Adapted from John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for
OTC Derivatives (New York: John Wiley & Sons, 2014)

14
Explain regulatory initiatives for the OTC derivatives market and
their impact on central clearing.
In the aftermath of the global financial recession,
regulators began a new push to regulate the OTC market.
One result was an increased use of CCPs in the OTC
derivatives market. The initial effort for regulation came to
a head in September 2009 when G-20 leaders met in
Pittsburgh to discuss the potential systemic risk associated
with the OTC derivatives market. After seeing what
happened leading up to and in the aftermath of the global
financial crisis, regulators were concerned that a default by
one derivatives dealer could have cascading effects, potentially leading to losses by other
derivatives dealers and, in the worst-case scenarios, sharp economic declines and a
collapse of the global financial system.

The G-20 meeting concluded with four “new” major regulations for CCPs.
1. All standardized OTC derivatives should be cleared through CCPs
First, the group proposed that all standardized OTC derivatives be cleared through
CCPs. Standardized derivatives include:
o Plain vanilla interest rate swaps (the majority of traded OTC derivatives) and
o Credit default swaps on indices.
This requirement intended to minimize bilateral credit exposure among
counterparties. Theoretically, this would reduce interconnectedness and the
associated systemic risk.
2. All standardized OTC derivatives should be traded on exchanges or electric
platforms
Second, the leaders suggested that standardized OTC derivatives be traded on
exchanges or electronic platforms. The intent of this move was to improve price
transparency. With an electronic platform that matches buyers and sellers, products’
prices are completely transparent to all market participants. The platforms are the
swap execution facilities (SEFs) and the organized trading facilities (OTFs)
(U.S./Europe).
In practice, standardized products are passed automatically to a CCP once the
trades have taken place on the platforms.
3. Reporting of OTC derivatives to trade repositories
Third, the G-20 group suggested that all trades in the OTC market be reported to a
central trade repository. By requiring OTC derivatives report to trade repositories,
market regulators gain information on participants’ risks in the OTC market.

15
 4. Higher capital requirements for OTC derivatives that are not centrally cleared
To address the potential risks in the non-centrally cleared OTC derivatives market,
regulators suggested higher capital requirements.
The first two of these regulations are applied only to transactions that fall under the
following two situations:
o First, between two financial institutions; or
o Second, between a financial institution and a non-financial company deemed
systemically important due to the volume of its OTC derivatives trading.
The implication from these two points is that derivatives dealers can avoid using
electronic platforms and/or CCPs when trading standardized contracts with most of
their non-financial end users. Additionally, one of the many outcomes of the new
regulations was a large increase in standard interdealer transactions (interest rate
swaps) using CCPs.
Objections
The Pittsburg proposals met significant criticism that can generally be placed into two
groups. The first group focused on potentially prohibitive implementation costs of central
clearing and the second group questioned whether central clearing would have any effect on
the long-term safety of financial markets.
 Prohibitive costs. The calls for “universal” central clearing were met with early
estimates of up to $2 trillion in extra margin costs7.
Other studies on implementation costs suggested that the 3% OTC derivative margin
requirement would cost the economy 100,000 to 120,000 jobs.
 Long-term stability of financial markets. A key argument in favor of standardized
OTC derivative markets was that they would make the financial markets more stable.
Some of the most common counterarguments made on the topic are:
Standardization and margin changes would eliminate the hedge aspect of OTC
derivatives. Hedge funds, corporates, pension funds, and other end-user entities use
derivative contracts for hedging. A more standardized OTC market would make the
OTC derivatives market less useful for hedging and provide no benefit to the long-
term stability of financial markets.
CCPs may reduce the long-term stability of financial markets.
o First, having multiple CCPs for a single asset class may reduce netting
efficiency and lead to increased exposure should a default occur.
o Second, a concentration of large, systemically important banks with
distributed liability may increase, rather than decrease, the long-term stability
of financial markets.
o Third, the long-term stability of financial markets may be harmed when CCPs
need to close out large OTC derivative portfolios.
o Fourth, mismanagement of initial and variation margin requirements may
reduce the long-term stability of financial markets.

7
Singh, M., 2010, ‘Collateral, netting and systemic risk in the OTC derivatives market’, November, IMF Working
Papers.

16
Formal responses
The Pittsburgh meeting led to formal responses by governments. In the U.S., new
requirements showed up in the Dodd-Frank Act and the European Union's new requirements
were formally adopted with the passage of the European Market Infrastructures Regulation
(EMIR). In addition, the gradual implementation of Basel III is implementing many of the
formal legal adjustments adopted in the U.S. and the E.U., as well as adding new additions
to the regulatory environment, as is the International Organization for Securities Commission
(IOSCO). The following table highlights which entities or acts in the U.S. and the E.U. have
led to new clearing requirements, margin requirements, and capital requirements.

Comparison of clearing and other requirements in the U.S. and Europe8

US Europe
Clearing requirements Dodd-Frank EMIR
Margin requirements BCBS/IOSCO Basel III/IOSCO
Capital requirements (bilateral/CCP trades) Basel III

The details of the regulatory requirements are addressed in other sections of these notes. It
should be noted that the details are important, including the many exemptions. For instance,
the following table compares the clearing requirements in the U.S. and Europe by trading
entity type. For non-financials in the U.S., entities can obtain an exemption for transactions
hedging commercial risk, whereas in Europe, only entities above certain thresholds to which
certain hedges do not apply.

Comparison of clearing requirements in the U.S. and Europe by entity8

U.S. Europe
Dealers/banks Yes Yes
Other Yes Yes (pension funds 3-year
financials exemption)
Non-financials Can obtain exemption for Only above certain thresholds (to
transactions hedging commercial which certain hedges don’t
risk contribute)

Compare margin requirements in centrally cleared and bilateral

markets and explain how margin can mitigate risk.
The following table compares OTC markets with CCP and exchange-based markets. When
it comes to margin requirements, the difference between centrally cleared and bilateral
markets is:
 CCPs: CCPs require full margining, including an enforced CCP initial margin and
daily variation margin posting. CCPs also include a third layer of default risk
protection through a default fund. Generally, CCP margin requirements are much
stricter than the bilateral derivative markets.
 Bilateral OTCs: Bilateral OTC allows for negotiation on margins, including bespoke
arrangements that depend on the credit quality.

8
Adapted from John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for
OTC Derivatives (New York: John Wiley & Sons, 2014)

17
Comparison table of OTC, CCP, and exchanges9

Item OTC CCP Exchange

Trading Bilateral Bilateral Centralized
Counterparty Original CCP CCP
Products All Must be standard Must be standard
Participants All Clearing members Clearing members
are usually large are usually large
dealers. dealers.
Other margin Other margin
posting entities posting entities can
can clear through clear through
clearing members. clearing members.
Margining Bilateral, bespoke Full margining, Full margining,
arrangements including initial including initial
dependent on credit margin enforced margin enforced by
quality and open to by the CCP the CCP
disputes
Loss buffers Regulatory capital and Initial margins, Initial margins,
margin (where default funds and default funds and
provided) CCP own capital CCP own capital

Learning from past failures: How margin can mitigate risk

Given what happened during the global financial crisis, exchanges and CCPs have learned
from the failures and near-failures of CCPs in the past and are now considered to be
extremely safe under most market conditions.
 For instance, initial margin requirements are adjusted more frequently now to reflect
changing market conditions.
 Additionally, initial and variation margin payments may be required from members
intraday as well as at the end of a day. This occurs even when asset prices are
abnormally volatile.
 This shift towards more frequent margin postings is important given that a member
typically has only one or two hours to meet a margin call. If a margin call is not met,
the member’s position is closed out.
 CCPs monitor the positions of members carefully and may require members to
reduce their exposures in some circumstances.
 The combination of these steps is generally considered to have mitigated some
potential risk in the derivatives market.

9
Adapted from John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for
OTC Derivatives (New York: John Wiley & Sons, 2014)

18
Compare and contrast bilateral markets to novation and netting
In bilaterally traded markets, entities involved in OTC transactions trade as shown to the
right. Trader A simply exchanges their asset or cash for what Trader B has promised to
provide. The trades, in this case, Trade 1 and Trade 2, are independent of each other. The
potential inefficiency of the above depiction is that Trader A and Trader B could combine the
transactions to simplify the accounting. This is what netting offers. When netting is not
performed, the two transactions between Trader A and Trader B are over-complex and
present risks for the following two reasons – cash flows and close out.
 Cash flows: When Trader A and
Trader B are exchanging cash
flows on a periodic basis, such as
shown with Trade 1 and Trade 2,
issues generally do not pop up.
However, should the cash flows happen on the same day, the situation gives rise to
settlement risk in the exchanging of gross amounts.
 Close out: Should Trader A or Trader B default, the surviving trader may suffer from
an inability to close out other transactions. For instance, if Trader A defaults and
Trader B was planning on using the proceeds of that position to pay for another
transaction, Trader B’s other position may be in jeopardy. Additionally, traders may
need to close out two transactions even if one offsets some or all of the other
position.

Bilateral derivatives netting

Historically, bilateral derivatives markets developed two types of netting methods – payment
and close-out netting.
 Payment netting occurs when institutions net cashflows occurring on the same day,
even if the payments are in
different currencies. This type of
netting carries settlement risk. A CCP B
 Close-out netting refers to the
practice of allowing the termination of all contracts between the insolvent and a
solvent counterparty, together with the offsetting of all transaction values. The
offsetting may include positions that are both in the solvent counterparty’s favor and
those against it. This type of transaction is related to counterparty risk.

Novation
Novation replaces the original contract between Trader A and Trader B with two contracts:
 A contract between Trader A and the CCP, and
 A contract between Trader B and the CCP.
All trades are executed through the CCP. Because the CCP is a facilitator rather than having
an opinion on the direction prices will go regarding certain assets, the CCP is known as
having a “matched book”. As such, the CCP does not bear market risk but does bear a
significant amount of “conditional market risk”. The reason the CCP is said to have
conditional market risk is that in the event of a member default, the CCP will no longer have
a matched book.

19
Assess the impact of central clearing on the broader financial
markets.
Has central clearing affected the broader financial markets? Unsurprisingly, the overall
impact depends upon the issue of discussion.
Positive impacts on the broader financial markets
 One often mentioned benefit of CCPs is that they reduce
systemic risk. CCPs, in theory, reduce systemic risk by:
o Offering greater transparency to all market
participants.
o Offsetting positions (netting against bilateral
positions).
o Efficiently and effectively handle large defaults.
 In a general sense, CCPs may not so much reduce
counterparty risk but rather distribute it. This distribution
of risk is really a conversion of risk into other forms, such
as liquidity, operational, and legal risks. A distributed risk
framework leads to a more stable financial system10.

Negative impacts on the broader financial markets

 It is often claimed that CCPs lower systemic risk in the broader financial system. This
may be the case, but then again, it might not be the case. The development and
continued use of CCPs could potentially increase systemic risk by, for instance,
increasing margins in periods of market instability.
 CCPs concentrate risk in a single entity that in turn attempts to distribute the risk it
takes on. In theory, this method of distributing risk would improve the overall financial
system, but that conclusion is not ensured. The concentration of risk with CCPs could
result in magnifying the potential risk of, for example, defaults.

OTC derivative clearing is fundamentally different from the clearing of other financial
transactions.
 OTC derivative contracts remain outstanding for potentially years or even decades
before being settled. It is not completely obvious that CCPs are as effective in risk
mitigation for these longer-dated, more complex, and illiquid products.
 Central clearing for non-standard and/or exotic OTC derivatives may not be feasible.
OTC markets have proven over the years that they are a good source of financial
innovation and can continue to offer cost-effective and well-tailored risk reduction
products. They are also likely to remain important in the future at providing incentives
for innovation. There is a risk that mandatory central clearing has a negative impact
on the positive role that OTC derivatives play.
 Even if CCPs make OTC derivatives safer, this does not necessarily translate into
more stable financial markets in general. Mechanisms such as netting and margining,
protect OTC derivative counterparties at the expense of other creditors.

10
This presumption is heavily debated among financial professionals.

20
Identify and explain the types of risks faced by CCPs.
CCPs
CCPs face risks associated with defaults and non-defaults.
Default loss events
CCPs face risks associated with the default of clearing
members. Usually, CCPs are structured in such a way to
ensure that the CCPs would be just fine if one or a small
number of clearing members simultaneously defaulted. The
larger risk occurs when contagion hits. Contagion is when a default of one clearing member
leads to defaults or serious financial problems with other clearing members. CCPs can
handle selected defaults but will fail if the entire system around them becomes prone to
default. With this background, CCPs face the following default risks:
 Default or distress of other clearing members: It turns out, unsurprisingly, that
when one member defaults, other members in the OTC derivatives market are also
likely to experience defaults.
 Failed auctions: CCPs often turn to auctions for resolving member defaults. If the
auction fails because the CCP did not receive reasonable economic bids, then it
faces imposing other loss allocation methods. These might include rights of
assessment and/or alternative loss allocation methods, addressed in the next
section.
 Resignations: If members become too unsatisfied with the CCP, they may opt to
resign. In this situation, CCPs would face:
o The loss of the member’s initial margins and default funds, a real hit to the
fund’s balance sheet.
o It should be noted that if a member opts to leave a CCP, the action would
happen after the member had flattened their cleared portfolio and provided a
pre-defined notice to the CCP that they planned to leave (the period covering
the notice, which is like a two-week notice for a company employee, lasts
perhaps one month). A member can never leave a CCP immediately.
 Reputational: When a member defaults or resigns, the CCP faces the possibility of
losing its reputation. CCPs can lose reputation in the process because of the
methods the CCP may need to employ to remedy a default, including potentially
using extreme loss allocation methods.
o Even if the loss allocation methods are successful from a financial point of
view – ensuring the viability and continuation of the CCP – the methodology
for assigning losses may leave some clearing members and their clients
feeling dissatisfied. The negativity could have a cascading effect on loss
allocation and lead to (further) resignations.

21
Non-default loss events
Losses associated with defaults are not the only way a CCP may experience losses. CCPs
may also experience loss from fraud, operational, legal, and investment problems.
 Fraud: CCPs must contend with the possibility of internal or external fraud. This
might include an employee siphoning off funds or a member misrepresenting their
assets.
 Operational: A CCP is a system that enables trading among members. If the CCP’s
systems fail or experience other problems, operational losses could arise.
 Legal: CCPs impose generally strict rules on their members. A CCP could
experience losses if litigation or other legal claims ensue, such as if the rules of the
CCP are inconsistent with the law in the jurisdiction.
For instance, margining and netting terms are complex, and regional laws may not
respect these contractual arrangements of the CCP.
 Investment: CCPs hold significant assets and they invest these assets. By holding
investment assets, CCPs face the non-default risk of losses from:
o Investments held in cash and securities (from margin contributions and other
financial resources) that were invested within the investment guidelines of the
CCP but the returns on the investments simply went south.
o CCPs may experience losses stemming from a deviation of its own
investment policy, such as from losses incurred because of a rogue trader.
Correlation risk
In addition to default and non-default risk, CCPs also face correlation risk. Correlation risk
is the likelihood that default and non-default losses may hit the CCP concurrently.
 The concurrence problem stems from the fact that when defaults become more
prominent among CCP members, the market disturbance also shows up as
operational and investment problems for the CCP itself.
 In an environment with concurrent default, operational, and investment problems, the
large spread of potential winners and losers in a default scenario also increases the
chance of legal challenges and fraudulent activity.
Model risk
CCPs have significant exposure to model risk through the approach they take on
margining. In contrast to exchange-traded products, the prices of OTC derivatives often
require modeling that cannot be directly, transparently observed through market
transactions.
 CCPs value assets using models because of the variation margin requirement that
assets be valued mark-to-market.
 When performing mark-to-market valuation modeling, the approaches for marking-to-
market must be standard and robust across all potential market scenarios.
o If the mark-to-market valuations cannot be done in a timely manner, then the
margin calls may be compromised.
o CCPs use models for their initial margin calculations. Models make
assumptions that may be wrong (sometimes referred to as misspecification),
including: Volatility assumptions, Tail risk, Complex dependencies, and
Wrong-way risk

22
  As an example, an adverse correlation across market and credit risks could mean
that a CCP is faced with liquidating positions in a situation where there are significant
market moves.
In reviewing prior CCP failures, it is important to note that members update their
initial margin methodologies as the market shifts, but that shift should be incremental
and not excessive to avoid procyclicality with market movements (i.e. exacerbating
problems in time of stress).
Models generally impose linearity. Another very important feature of the models used for
valuing OTC assets is that they generally impose linearity. Why is linearity important?
 Suppose that a CCP calculates that the initial margin requirement for a $1 billion
position is 1%, or $10 million.
 When assuming linearity, if the position increases to $100 billion, the initial margin
requirement stays at 1% and the amount increases to $1 billion.
 Is it reasonable to assume that a $100 billion position poses the same default risk for
the CCP as a $1 billion position (meaning a constant 1%)?
 The answer, at least according to a majority of thinkers on the subject, is no. The
larger position poses a greater risk to the CCP than the initial 1%.
 CCPs deal with larger and more concentrated positions by imposing margin
multipliers and penalties to ensure that risks are adequately covered. These
adjustments are sometimes referred to as qualitative adjustments to quantitative
models.
Liquidity risk
CCPs process billions in cash flow stemming from variation margin payments and other
payments. When CCPs hold liquid assets, they attempt to optimize the investment of their
financial resources without taking excessive credit and liquidity risk. The potential liquidity
risk occurs when a CCP member defaults. In such a case, the CCP must continue to fulfill its
obligations to surviving members in a reasonable amount of time.

In the short term, CCPs invest cautiously, just as any prudent individual investor would if
they needed the money to be available over the course of a day or week. Danger surfaces
when the underlying investments that were intended to be held for longer than short term
must be sold and converted into cash. The rub shows up when CCPs with enormous initial
margin holdings attempt to secure prearranged and highly reliable funding arrangements.
Potential funders are often hesitant.
 For instance, a typical credit facility at a bank may extend single-digit billions to
potential borrowers, while many large CCPs may hold tens of billions in initial
margins. If a central bank does not offer liquidity support to the CCP, the potential
liquidity risk could turn into a dangerous lack of funding situation.
CPSS-IOSCO (2012). The potential for a liquidity problem is not lost
on regulators and CCP members. The CPSS-IOSCO (2012) principals
required a CCP to have enough liquid resources to meet obligations if
one or two of its largest clearing members collapse.
 Within the umbrella of this guidance, bonds may only be used
towards a CCP’s liquidity resources if backed with committed
funding arrangements. This includes government bonds. This
requirement ensures that the bonds can be immediately
converted into cash.

23
Leverage ratio requirements. Another issue that falls within the liquidity risk or liquidity
pressure umbrella is the Basel III leverage ratio requirement. This rule requires entities to
have a leverage ratio of at least 3% of the entity’s Tier 1 capital divided by its exposure. The
rule intends to limit what some may perceive as excessive risk-taking.
 Exposure comprises the gross notional amount of centrally cleared OTC derivative
transactions.

Operational and legal risk

One of the advantages of CCPs is that they centralize various functions within a CCP, which
in theory increases the efficiency of the overall market. The downside to this centralization is
that market participants are exposed to new forms of risks concentrated at the CCP. Among
these centralized risks are operational risks and legal risks, such as systems failures and
fraud.

Other risks
In addition to default risks, non-default risks, model risk, liquidity risk, operational risk, and
legal risk, CCPs are also faced with various other risks, detailed in the list below.
 Settlement and payment: CCPs use banks as intermediaries for cash settlements.
Should the bank be unwilling or unable to provide those services, the CCP is faced
with settlement risk.
 FX risk: CCPs facilitate deals in multiple currencies. Although the CCPs require
variation margin payments in cash and in the currency of the transaction, there could
be a potential mismatch between margin payments and cashflows in various
currencies.
 Custody risk: CCPs use financial entities as custodians for member funds. Should a
custodian fail, the CCP would have to deal with the ensuing problems.
 Concentration risk: CCPs face the risk of having clearing members and/or margins
exposed to a single region.
 Sovereign risk: Related to concentration risk is sovereign risk. This risk captures the
potential contagion that a sovereign failure or a devaluation of sovereign bonds held
as margin would have on the CCPs.
 Wrong-way risk: There is a strong correlation between the value of margin held and
the creditworthiness of clearing members.

24
Identify and distinguish between the risks to clearing members as
well as non-members.
Risks for clearing members
Clearing members face various risks, some of them if the CCP defaults and others if a CCP
member defaults, depicted below by the CCP default waterfall chart. The first three bars are
instances when the defaulter pays (initial margin, default margin, and CCP equity). The
remaining orange bars are when the survivors pay (default fund for surviving members,
rights of assessment, remaining CCP capital, liquidity support, and other loss allocation
methods).

Defaulter pays risks

 Initial margins failure: The first line of defense against the contagion of a default is
the initial margin. Because members place their own money to cover initial margins,
members directly risk losing this money.
 Default fund contributions: CCP members contribute to the default fund. Any use
of the default fund contributions is a direct usage of members’ money.
 CCP equity: CCP equity is the ownership portion members have with the CCP. The
third rung of the “defaulters pay” section is the equity that defaulting members give
up when the financial impact of their default moves beyond initial margins and default
fund contributions.

25
Survivors pay risks. In addition to the direct risks associated with defaulter pays scenarios,
clearing members can experience CCP-related losses through various other mechanisms
where the survivors cover the costs of default:
 Auction costs: It was mentioned earlier that members may be generally better off by
participating in auctions of a defaulting member’s positions than dealing with the
consequences of the positions being unwound unilaterally. Participating in an
auction, of course, comes with the risk that a member takes on a portfolio that cannot
be easily hedged, and eventually leads to further losses.
 Variation margins gains haircutting (VMGH): Variation margins go up and down
based upon the positions of a member. Should the CCP be in material danger of
financial insolvency, the members of the CCP with margin gains may be at risk of
seeing a cut in the variation margins gains.
o VMGH is a “popular” alternative loss allocation procedure, probably the most
common method used.
o In a VMGH, the accumulated gains of the trading “winners” since the start of
the default may be trimmed, while the members owing money to the CCP
may be required to pay the entire amount. It is common for a cap to be placed
on a VMGH.
 Rights of assessment: A right of assessment (or more commonly referred to as
capital calls) is when the CCP issues an obligation to members for additional
contributions to the default fund. In accountant speak, this is an unfunded obligation.
o Usually, rights of assessment are invoked when the default fund experiences
a loss of 25% or more and needs immediate recapitalization. Rights of
assessment are limited, otherwise, CCPs would never fail because they could
pull on an unlimited right of assessment. Rights of assessment are limited to
minimize moral hazard and unlimited exposure for CCP members.
 Tear-up: When a CCP member defaults, the CCP is left with unmatched positions. If
the auction process fails, the CCP may opt for a tear-up. A tear-up occurs when the
CCP terminates the other side of the defaulter’s trades.
The main difference between a tear-up and a VMGH is that in a tear-up, the CCP is
not exposed to any risk premium with the auctioned transactions because usually the
CCP only pays the current mid-market value of the transaction.
Tear-ups come with disadvantages, including:
o Unlimited liability: Non-defaulting members possess potentially unlimited
liability.
o Replacement impact: When members hedge their risk of tear-up by finding
replacement hedges.
o Portfolio bifurcation: Partial tear-ups can affect surviving members’
portfolios, including leading to a bifurcation of their portfolios, which may lead
to additional initial margin requirements and a less diversified portfolio.

26
 When performing tear-ups, CCPs have options on how they perform the tear-up, and
which trades to tear-up, including:
o Voluntary basis tear-ups: Members voluntarily tear-up their positions with
the defaulting member.
o Original counterparties: The original counterparties to the defaulting
members are identified. This option is a direct mimicking of bilaterally traded
markets.
o By bidder: Bids received at auction affect how the default process
progresses.
o Other: The CCP could use arbitrary methods to deal with the default,
including randomly assigning offsetting positions.
 Forced allocation occurs when the CCP obliges members to accept portfolios at
specified prices.
 Other loss allocation methods: Other potential loss allocation methods may
include:
o Initial margin haircutting
o The CCP attempting to novate trades to a separate CCP
o Playing a reverse clearing function and returning trades to bilateral
 CCP failure: It goes without saying that if the CCP fails, all members of the entity will
likely experience some form of financial loss in addition to potentially the global
financial system.

Members’ considerations of the nature of the CCP

In order to assess the risks faced by being a member of a CCP, a clearing member would
naturally attempt to make a detailed evaluation of the risk management framework of the
CCP, covering aspects such as:
 Membership criteria
 The number of other clearing members and their creditworthiness
 Initial margin and default fund requirements and their expected coverage
 Capital requirements (this depends on regulatory recognition of the CCP)
 External liquidity access
 Investment policies
 Flexibility of the CCP to listen to policy changes suggested by clearing members
 Operational capacity (important in default scenarios)
 Default management process
 Loss waterfall and recovery and resolution mechanisms

27
Risks for non-clearing members
Non-clearing members who clear indirectly through a clearing member face different risks
but may also have additional protection.
 In the event of the failure of the CCP, clients may be protected as long as their
clearing member is solvent.
 In the event of default of their clearing member, the CCP may provide protection and
ensure continuity through margin segregation and portability.
 Since clients do not contribute to default funds, they do not have this direct exposure
to CCPs that exists for clearing members.

28
P1.T3. Financial Markets & Products

Chapter 7. Futures Markets

Bionic Turtle FRM Study Notes

CHAPTER 7. FUTURES MARKETS .................................................................................... 3
DEFINE AND DESCRIBE THE KEY FEATURES OF A FUTURES CONTRACT INCLUDING THE UNDERLYING
ASSET, THE CONTRACT PRICE AND SIZE, TRADING VOLUME, OPEN INTEREST, DELIVERY, AND
LIMITS. ................................................................................................................................... 3
EXPLAIN THE CONVERGENCE OF FUTURES AND SPOT PRICES..................................................... 6
DESCRIBE THE RATIONALE FOR MARGIN REQUIREMENTS AND EXPLAIN HOW THEY WORK. ............ 7
DESCRIBE THE ROLE OF AN EXCHANGE IN FUTURES AND OVER-THE-COUNTER MARKET
TRANSACTIONS. .................................................................................................................... 10
IDENTIFY THE DIFFERENCES BETWEEN A NORMAL AND INVERTED FUTURES MARKET. ................. 12
EXPLAIN THE DIFFERENT MARKET QUOTES. ............................................................................ 13
DESCRIBE THE MECHANICS OF THE DELIVERY PROCESS AND CONTRAST IT WITH CASH
SETTLEMENT ........................................................................................................................ 14
EVALUATE THE IMPACT OF DIFFERENT TRADING ORDER TYPES................................................. 15
COMPARE AND CONTRAST FORWARD AND FUTURES CONTRACTS ............................................. 16
CHAPTER SUMMARY ............................................................................................................. 18
QUESTIONS & ANSWERS: ...................................................................................................... 19

2
Chapter 7. Futures Markets
 Define and describe the key features of a futures contract including the underlying
asset, the contract price and size, trading volume, open interest, delivery, and
limits.
 Explain the convergence of futures and spot prices.

 Describe the rationale for margin requirements and explain how they work.

 Describe the role of an exchange in futures and over-the-counter market

transactions.

 Identify the differences between a normal and inverted futures market.

 Explain the different market quotes.

 Describe the mechanics of the delivery process and contrast it with cash
settlement.

 Evaluate the impact of different trading order types.

 Describe the application of marking to market and hedge accounting for futures.

 Compare and contrast forward and futures contracts.

Define and describe the key features of a futures contract including

the underlying asset, the contract price and size, trading volume,
open interest, delivery, and limits.
A futures contract is a standardized contract that trades on a futures exchange and is
an agreement to buy or to sell an underlying asset at a delivery date at some pre-set
futures price. The specifications of a futures contract include, but are not limited to:

 Asset  Delivery Months

 Contract Size  Price Quotes
 Delivery  Price Limits and Position
Arrangement Limits
Asset
When the asset is a commodity (e.g., cotton, orange juice), the exchange specifies a grade
(quality). Financial assets are generally well defined. For example, consider the underlying
asset in the case of a Treasury bond/note:
 A Treasury bond futures contract is made on the underlying U.S. Treasury with
maturity of at least 15 years and not callable within 15 years (T bond  15 years).
 A Treasury note futures contract is made on the underlying U.S. Treasury with
maturity of at least 6.5 years but not greater than 10 years (6.5 ≤ T note ≤ 10 years).

3
Contract Size
Contract size specifies the quantity of the asset that has to be delivered under one contract.
It varies by the type of futures contract.
 Treasury bond futures contract size is a face value of $100,000
 S&P 500 futures contract is index  $250 (multiplier of 250X)
 NASDAQ futures contract is index  $100 (multiplier of 100X)
 “Mini-contracts” also exist that have multipliers of 50X for the S&P and 20X for the
NASDAQ; each contract is one-fifth of normal in order to attract smaller investors.
A common test question involves S&P 500 Index futures contract. Please note the multiple
for the S&P 500 contract is $250; e.g., if the index value is 1400, then one contract is worth
$350,000.
Delivery Arrangement
The exchange specifies delivery location. When alternative delivery locations are specified,
the price received by short is adjusted according to the location chosen.
Delivery Months
The exchange must specify the precise period during the month when delivery can be made.
The delivery period may be the whole month or a sub-period of the month.
Price Quotes
The exchange defines how prices are quoted. For e.g., crude oil futures is quoted in dollars
and cents.
Price limits and Position Limits
For most contracts, daily price limits are specified by the exchange. A limit move is a move
in either direction (limit up or limit down) equal to the daily price limit. Normally, if the limit is
breached, trading stops for the day. Position limits are the maximum number of contracts
that a speculator may hold (the purpose is to prevent speculators from an undue influence
on the overall market).

Example I: Futures Contract on Light Sweet Crude Oil

Asset Light, Sweet, Crude Oil
Contract Size 1,000 barrels (42K gallons)
Delivery Arrangement FOB Seller’s Facility
Delivery Months Ratable over month
Price Quotes U.S. dollars & cents per barrel
Any one-month - 10,000 net futures; all months - 20,000 net
Price limits and position
futures; but not to exceed 3,000 contracts in the last three
limits
days of trading in the spot month.

Example II: Corn Futures

Asset Corn (No. 2 Yellow.. )
Contract Size 5000 bushels
Delivery Arrangement Toledo, St. Louis
Delivery Months Dec, Mar, May, Jul, Sep
Price Quotes cents/bushel

4
 Daily Price Limit: $0.25 per bushel ($1,250/contract)
Price limits and position limits above or below the previous day's settlement price. No
limit in the spot month

Example III: S&P 500 Index Futures

Asset S&P 500 Index
Contract Size $250 x S&P 500 Index
Delivery Arrangement Cash settlement
Delivery Months Mar, Jun, Sep, Dec
Price Quotes 0.10 index points=$25
Price limits and position limits 20,000 net long or short in all contract months combined

Mini contracts tend to be 1/5th the size

 As the S&P 500 Futures contract is index  $250 (multiplier of 250X),
the S&P 500 “mini” = $50 x S&P Index
 As the NASDAQ Futures contract is index  $100 (multiplier of 100X),
the NASDAQ “mini” = $20 x NASDQ
Long versus Short Positions:
A long position agrees to buy in the future and a short position agrees to sell in the future.
The price mechanism maintains a balance between buyers and sellers. For example, if there
are more buyers than sellers, the price increases until new sellers enter the futures market.

Most futures contracts do not lead to delivery, because most trades “close out” their
positions before delivery. Closing out a position means entering into the opposite type of
trade from the original.

Open Interest

The number of contracts in existence at any time is referred to as the open interest. This is
the number of net long contracts held by members and it is equivalent to the number of net
short contracts held by members (because the number of long positions must always equal
the number of short positions). A trade of a futures contract between two members has one
of the following effects on the open interest of that contract.

 when both members are taking new positions, the open interest increases by one.
 when one member is closing out a position while the other member is taking a
new position, the open interest remains the same.
 when both members are closing out their respective positions, the open interest
decreases by one.

Trading Volume

The number of contracts traded in a day is referred to as the trading volume. The trading
volume can be greater than the open interest at the end of the day if many traders are
closing out their positions (which tends to occur towards the end of the life of a contract). It
can also happen if there is a large amount of day trading, which is when trades are entered
into and closed out on the same day.

5
Explain the convergence of futures and spot prices
At the futures contract approaches maturity, the spot price should converge with the
futures price (at least to a so-called “zone of convergence”). Put another way, the basis
(the difference between the spot and futures price) should converge toward zero as the
futures contract approaches maturity.

In an (unrealistic) world where there is no risk premium, we can view this as the forward
price representing an estimate of the expected future spot price, on the assumption that, as
the maturity of its contract tends toward (shrinks) to zero, the forward price will converge on
the spot price as:

= ( )→ =

6
Describe the rationale for margin requirements and explain how
they work.
Margin is one kind of credit risk mitigation (CRM)

Other CRM methods include:

 Netting
 Guarantees
 Credit Derivatives

A margin is cash or marketable securities deposited by an investor with his or her

broker. Whereas a forward contract is settled at the end of its life, a futures contract is
settled daily by marking to market. That is, at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss. Margins thus minimize the possibility
of a loss through a default on a contract because of the daily settlement.

How margin requires work

The example below shows the operation of the maintenance margin. A common test
question would be to ask you to “Compute the variation margin.”

When an investor enters into a futures contract, the broker requires an initial margin
deposit into the margin account. At the end of each trading day, the margin account is
marked-to-market.

If the account balance falls below the maintenance margin (i.e., typically lower than the
initial margin), a margin call requires the investors to “top up” the account back to the initial
margin amount.

Key terms are:

 Margin account: Broker requires deposit.
 Initial margin: Must be deposited when contract is initiated.
 Mark-to-market: At the end of each trading day, margin account is adjusted to reflect
gains or losses.
 Maintenance margin: Investor can withdraw funds in the margin account in excess
of the initial margin. A maintenance margin guarantees that the balance in the margin
account never gets negative (the maintenance margin is lower than the initial
margin).
 Margin call: When the balance in the margin account falls below the maintenance
margin, the broker executes a margin call. The next day, the investor needs to “top
up” the margin account back to the initial margin level.
 Variation margin: Extra funds deposited by the investor after receiving a margin call.
There is only a variation margin if and when there is a margin call.
Variation margin = Initial margin – Margin account balance

7
Example: To illustrate how margin accounts work, consider an investor who buys two gold
futures contracts whose current futures price is $1,450 per ounce. The assumptions are:

 The contract size is 100 ounces, and the investor has bought 2 contracts or a total of
200 ounces at the given futures price.
 The initial margin required is $6,000 per contract or $12,000 in total for 2 contracts.
 The maintenance margin required is $4,500 per contract or $9,000 for 2 contracts.
Note:
 The exchange sets minimum levels for initial and maintenance margins. The margin
account is volatile: cash in excess of margin can be withdrawn. This daily market-to-
market creates convexity bias vis-à-vis forward contracts
 Breach of maintenance margin triggers a margin call, in which case, variation margin
is required to “top up” to the level of the initial margin.
Simulated daily futures price movements and margin calculations are illustrated below.

Hull Table 2.1- Example: Operation of margin account

8
  From the table, we see that the contract is entered into on Day 1 at $1,450.00 and
closed out on Day 16 at $1,426.90. As the futures prices fluctuate, that is, as they
decrease/increase, the initial margin levels decrease/increase and the margin
balance varies accordingly.
 On Day 7, the margin balance falls below the maintenance margin level of $9,000 to
$7,980. This triggers a margin call and the investor has to replenish the balance up to
the initial margin levels by adding $4,020 (=12000-7980) by the ending of Day 8. This
is the variation margin required during a margin call.
 On Day 11, again the balance falls to $8,220, which is below the maintenance
margin level. So, a margin call for $3,780 (=12000-8220) is sent out to the investor
for restoring the margin balance up to the initial margin level. This amount is the also
the variation margin and the margin call should be fulfilled by the end of the next
trading day, i.e., Day 12.
 On the final trading day when the futures price is $1,426.90, the investor has a
cumulative loss of $4,620.00 [=200* (1450 -1426.9)].
 The ending margin balance is $15,860 (=12000 + 4020 + 3780 - 4620) which tallies
the initial margin levels plus the variation margins provided during the two margin
calls less the cumulative loss.
IMPORTANT CONCEPT: The maintenance margin is a trigger level—once triggered,
the investor must “top up” to the initial margin level rather than just to the
maintenance margin level.

9
NOTE: THE WORDING IN THIS LO CHANGED FROM “ROLE OF
CLEARINGHOUSE FUTURES” TO “ROLL OF AN EXCHANGE IN FUTURES”.
CONTENT SHOULD BE THE SAME BUT CHANGE WORDING ACCORDINGLY

Note from David: “It deserves an asterisk, i happen to know of a subtle

difference but I’m sure they meant them as synonyms. I can add value to that
interesting synonym.”

Kept the content same but added few lines to provide a connection between
the LO and the previous content (hope this works). The curriculum considers
the role of exchange and exchange’s CCP in futures market.

Describe the role of an exchange in futures and over-the-counter

market transactions.
Futures contracts are popular exchange traded-products which are actively traded all over
the world. Standard futures contracts are defined by an exchange. An exchange’s
CCP/clearinghouse becomes the counterparty to all the members of the exchange when
they trade.
Role of clearinghouse in futures markets
An exchange’s clearinghouse function is critical because its performance guarantee
basically overcomes counterparty risk.
 The clearinghouse acts as an intermediary in futures transactions and it guarantees
performance of the parties to each transaction. Thus, it ensures that the obligations
of all trades are met.
 The main job of the clearinghouse is to keep track of transactions, and calculate the
net position of each member daily.
The exchange clearinghouse is often a division of the exchange (e.g., the CME Clearing
House is a division of the Chicago Mercantile Exchange) or an independent company.
Brokers maintain margin accounts with the clearinghouse.
 Just as an investor is required to maintain a margin account with a broker, the broker
or a clearing house member is required to maintain initial margin (“clearing margin”)
with the clearinghouse.
 Brokers who are not members themselves also must maintain a margin account with
another clearinghouse member.
 The margin accounts for clearinghouse members are adjusted for gains and losses
at the end of each trading day in the same way as are the margin accounts of
investors.

However, some ways in which a broker’s margin account differs from that of an investor’s
margin account are:
 Every day the account balance for each contract must be maintained at an amount
equal to the original margin times the number of contracts outstanding as there is
only initial margin and no maintenance margin in case of a broker’s margin account.
 Also in case of brokers, in determining the initial margin, the number of contracts
outstanding is usually calculated on a net basis. This means that short positions the

10
 clearing house member is handling for clients are offset against clients’ long
positions.
 Moreover, clearing house members are required to contribute to a guaranty fund.
This may be used by the clearing house in the event that a member fails to provide
variation margin when required to do so, and there are losses when the member’s
positions are closed out.

11
Identify the differences between a normal and inverted futures
market.
If the forward price is higher than the spot price (or the distant forward price is higher
than the near forward price) the futures curve is said to be normal, or in contango.
That is, in a normal market, futures price increase with the maturity of the contract.
If the forward price is less than the spot price (or the distant forward price is less than
the near forward price), the futures curve is said to be inverted, or in
backwardation. That is, in an inverted market, futures price decline with maturity.

12
Explain the different market quotes.
Futures quotes are available from the exchange. The below table shows the quotes
provided by CME group for different commodities.

Price: The first three columns show

the opening price, the highest price in
trading so far and the lowest price in
trading so far.

Settlement Price: The settlement

price is the price used for calculating
the daily gains and losses and margin
requirements. It is usually calculated
as the price at which the contract
traded immediately before the end of
a day’s trading session. The fourth
column in the above table shows the
settlement price for previous day. The
fifth column shows the most recent
trading price and the sixth column
shows the price change from the
previous day’s settlement price.

Trading Volume and Open Interest:

The final column in the table shows
the trading volume. The trading
volume is the number of contracts
traded in a day. It can be contrasted
with open interest, which is the
number of contracts outstanding, that
is, number of long positions or
equivalently number of short
positions.

If there is a large amount of trading by

day traders (i.e. traders who enter into
a position and close it out on the
same day) the volume of trading in a
day can be greater than either the
beginning-of-day or end-of-day open
interest.

13
Describe the mechanics of the delivery process and contrast it with
cash settlement
Mechanics of the delivery process
 If the futures contract is not closed out before maturity, it is usually settled by
delivering the asset underlying the contract.
 The exchange decides the delivery specifications which vary by contract
 When there are alternatives about what is delivered, where it is delivered, and when
it is delivered, the party with the short position chooses.
 In case of commodities, taking delivery usually means accepting a warehouse receipt
in return for immediate payment. In the case of financial futures (e.g., those on stock
indices and Eurodollar futures), delivery is usually made by wire transfer.
 The most recent settlement price is used for delivery and this price is adjusted for
grade, location of delivery, and so on.
 The whole delivery procedure from the issuance of the notice of intention to deliver to
the delivery itself generally takes about two to three days, which includes three
critical days, namely first notice day, last notice day and last trading day.

Cash settlement
 Some financial futures, such as those on stock indices are settled in cash because it
is inconvenient or impossible to deliver the underlying asset. For example, in case of
the futures contract on the S&P 500, delivering the underlying asset would involve
delivering a portfolio of 500 stocks and so it is more convenient to settle it in cash.
 When a contract is settled in cash, all outstanding contracts are declared closed on a
predetermined day. The final settlement price is set equal to the spot price of the
underlying asset at either the open or close of trading on that day.

14
Evaluate the impact of different trading order types.
Market order (guarantees the transaction, but not the price): The market order is a
simple (the simplest) request to execute the trade immediately at the best available price.

Limit order (guarantees price, but not the transaction): A limit order specifies a particular
price. The order can be executed only at this price or at one more favorable to the investor.
 For example: If the limit price is $30 for an investor wanting to buy, the order will be
executed only at a price of $30 or less. There is no guarantee that the order will be
executed at all, because the limit price may never be reached.
Stop-loss order (if an asset reaches a specified price, it, in effect, becomes a market order):
The order is executed at the best available price once a bid or offer is made at that particular
price or a less-favorable price.
 For example: Suppose a stop-loss order to sell at $30 is issued when the market
price is $35. It becomes an order to sell if and when the price falls to $30. The
purpose of a stop order is usually to close out a position if unfavorable price
movements take place. It limits the loss that can be incurred.
Stop-limit order (combination of stop and limit: as soon as stop is breached, limit order
applies): The order becomes a limit order as soon as a bid or offer is made at a price equal
to or less favorable than the stop price. Two prices must be specified in a stop-limit order:
the stop price and the limit price. If the stop price and the limit price are the same, the order
is sometimes called a stop-and-limit order.
 For example: Suppose when the market price is $35, a stop-limit order to buy is
issued with a stop price of $40 and a limit price of $41. As soon as there is a bid or
offer at $40, the stop-limit becomes a limit order at $41.
Market-if-touched order (a.k.a., board order): A market-if-touched (MIT)-order is executed
at the best available price after a trade occurs at a specified price or at a price more
favorable than the specified price. In effect, an MIT becomes a market order once the
specified price has been hit. It enables investors to take profits when favorable price
movements occur.

Discretionary order (a.k.a., market-not-held order): A market order except that execution
may be delayed at the broker's discretion in an attempt to get a better price

Time-of-day order: Specifies a particular period of time during the day when the order can
be executed.

Open order (a.k.a., good-till-cancelled order): It is in effect until executed or end of trading
in the particular contract

Fill-or-kill order: This order must be executed immediately on receipt or not at all.

15
Describe the application of marking to market and hedge
accounting for futures.
Normal accounting rules call for gains and losses from futures to be accounted for as they
occur.

Futures are settled daily so that the cash corresponding to the profits is realized in the years
in which the profits are accounted for. The valuation process is referred to as marking to
market.

Realizing and accounting for gains and losses year-by-year when hedging could lead to an
increase in reported earnings volatility, rather than a reduction in volatility as would be
expected when performing hedging activities.

If the gold company is hedging gold that it expects to produce in two years, however, the
contracts it has entered may qualify for hedge accounting. This provides an exception to the
general rule and allows the gain (or loss) from hedging transactions to be recognized at the
same time as the loss (or gain) on the items being hedged. The Financial Accounting
Standard Board (FASB) has issued FAS 133 and ASC 815 to explain when hedge
accounting can and cannot be used by companies in the United States. The International
Accounting Standards Board (IASB) has similarly issued IAS 39 and IFRS 9.

The rules concerning the use of hedge accounting are strict. The hedge must be fully
documented, for example, with the hedged item and the hedging instrument being clearly
identified. The hedge must also be classified as effective, which means that an economic
relationship that is not dominated by the effect of credit risk must exist between the hedging
instrument and the hedged item. The effectiveness of a hedge must be tested periodically.

Taxation raises similar issues for futures trading. In many jurisdictions, futures contracts are
normally treated for tax purposes as though they are closed out at the end of the tax year.
While hedging transactions in the United States are exempt from this rule, the definition of a
hedging transaction for tax purposes is different from the definition used for accounting
purposes. For tax purposes, a transaction is a hedging transaction if it is entered in the
normal course of business primarily to reduce risk exposures. Given the different criteria, it is
possible for a transaction to qualify as a hedge for tax purposes but not for accounting
purposes.

16
Compare and contrast forward and futures contracts
Key differences between a forward and futures contract:

Forward Futures
Traded over-the-counter (OTC) Traded on an exchange
Not standardized Standardized contracts
One specified delivery date Range of delivery dates
Settled at contract’s end Settled daily
Delivery or final cash settlement usually Contract usually closed out prior to
occurs maturity
Reduces basis risk due to tailored High liquidity due to standardized
specifications but less liquid specifications but more basis risk

17
Chapter Summary
The most important specifications of a futures contract include: the asset, the contract
size, the delivery arrangement, the delivery months, how prices are quoted as well as price
and position limits.
 As the futures get closer and closer to the delivery period, the futures price tends to
converge to the spot price. This must be the case, since arbitrageurs would take
advantage of this discrepancy by buying the futures or spot, depending on which is
more expensive, and selling the opposite, depending on which is cheaper. As
discussed in Chapter 1, arbitrageurs make sure such opportunities are ephemeral.
The rationale for margin requirements is to avoid non-performance, or default on, e.g.,
a futures contract.
 This is achieved by having the exchange acting as a financial intermediary.
 At inception, there is an initial margin paid to the exchange as security.
 At the end of each trading day, the position is marked-to-market and the investor
must provide additional funds if his position has lost money.
 In the event that the position falls below the maintenance margin, the investor must
top-up the account to the initial margin level (note: not just to the maintenance
margin level).

A clearinghouse functions as a financial intermediary through which members post

margin, just as individual investors post margin with their brokers.
 On exchanges, non-members must transact through members and post margin with
them. The role of the clearinghouse is to reduce the credit risk.
 In the OTC market when there is no central clearinghouse function and trades are
cleared bilaterally, participants rely on collateral. When central clearing is used, a
central counterparty (CCP) stands between the two sides.
If the forward price is higher than the spot price the futures curve is said to be normal, or in
contango.

If the forward price is less than the spot price the futures curve is said to be inverted, or in
backwardation.

Futures contracts are traded on exchanges and the counterparty to any deal may
change at any time, whereas for a forward transaction one cannot close out the
position by passing it on to a third party since it is between two defined
counterparties and collateral is posted.
 For futures, collateral is not needed due to the margining mechanism employed by
the clearinghouses. However, futures contract do not allow for the kind of
customization that forward contracts do.
 Moreover, whereas futures contracts are often closed out prior to delivery, forward
contracts usually do lead to delivery – and the delivery is for a specific date, rather
than a range of days which is typical for a future.
 Although some interest is paid on the margin account, this is typically much lower
than the return a company could earn elsewhere, thus futures also require a liquidity
buffer of idle capital.

18
Questions & Answers:
1. Which is a feature of a futures contract?
a) Range of delivery dates
b) Usually one specified delivery date
c) Significant counterparty risk
d) Settled at end of contract

2. The roll return is the return due to the change in the price of the futures contract. If the
commodity forward curve is in contango, and the spot price will be constant over time, what
is the roll return on a short position in a futures contract on the commodity?
a) Negative roll return (a.k.a., roll yield)
b) Approximately zero roll return
c) Positive roll return
d) Need more information

3. Assume a long position in a gold futures contract has the exact same terms as a long
position in a gold forward contract; e.g., asset quality, quantity, size and delivery exactly the
same. Is there any theoretical difference in the price of the future and forward contract?
a) No, cost of carry is same
b) No, both lack a convenience yield
c) Yes, if gold has a storage cost
d) Yes, if interest rates vary unpredictably

4. Which of the following is TRUE about a normal/inverted futures market?

a) A futures market is either normal or inverted but cannot be a mixture
b) The roll return (roll yield) is profitable during an inverted futures market
c) A falling futures price necessarily implies backwardation
d) Gold must always be a normal market (assuming positive interest rates) because it
has storage cost but does not pay a dividend

5. Yesterday, there were 1,000 open long positions in a futures contracts for a certain
consumption commodity, and also 1,000 open short positions. Today, 100 contracts were
physically delivered. What is today’s open interest?
a) 800
b) 900
c) 1,800
d) 1,900

19
Answers

1. A. Range of delivery dates

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-142-key-features-

of-a-futures-contract.4370/#post-11281

2. C. Positive roll return

In contango, F(T) > S(0), such that basis convergence implies F(T) decreases as maturity
decreases. A long futures position profits (loses) on the roll return in a backwardation
(contango); a short futures position profits on the roll return in a contango.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-143-convergence-

of-futures-and-spot-prices.4373/#post-29142

3.D. Yes, if interest rates vary unpredictably

If interest rates are constant and flat, the prices should be the same. But if interest rates
vary, the DAILY SETTLEMENT (mark to market) creates interim cash flow volatility with
uncertain reinvestment risk: this impacts the futures position.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-144-futures-

margin-requirements.4377/#post-11292

4. B. The roll return (roll yield) is profitable during an inverted (backwardation) futures
market; i.e., the futures are rolled into higher prices as the futures price increases while
maturity shortens.
 In regard to (A), this is FALSE: commodities are often in alternating
contango/backwardation; e.g., natural gas, corn due to seasonality in
demand/production.
 In regard to (C), this is tempting but FALSE: in the Metallgesellschaft, a
backwardation experienced falling futures price yet went into contango because the
SPOT price dropped more.
 In regard to (D), this is FALSE for two reasons: 1. It omits the lease rate and
convenience yield; and 2. It omits technical factors; supply/demand could
conceivably create backwardation.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-147-normal-
versus-inverted-futures-market.4396/#post-29067

5. B. 900. An open contract has a long and a short, by definition. Yesterday, there was
an open interest of 1,000 contracts. Today, it was reduced by the settlement of 100.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l1-t3-150-definitions-

futures-contracts.4411/#post-12883

20
P1.T3. Financial Markets & Products

Chapter 8. Using Futures for Hedging

Bionic Turtle FRM Study Notes

CHAPTER 8. USING FUTURES FOR HEDGING ................................................................. 3
DEFINE AND DIFFERENTIATE BETWEEN SHORT AND LONG HEDGES AND IDENTIFY THEIR
APPROPRIATE USE. ................................................................................................................. 3
DESCRIBE THE ARGUMENTS FOR AND AGAINST HEDGING AND THE POTENTIAL IMPACT OF HEDGING
ON FIRM PROFITABILITY ........................................................................................................... 4
DEFINE THE BASIS AND THE VARIOUS SOURCES OF BASIS RISK, AND EXPLAIN HOW BASIS RISKS
ARISE WHEN HEDGING WITH FUTURES. ..................................................................................... 5
DEFINE CROSS HEDGING, AND COMPUTE AND INTERPRET THE MINIMUM VARIANCE HEDGE RATIO
AND HEDGE EFFECTIVENESS .................................................................................................... 8
COMPUTE THE OPTIMAL NUMBER OF FUTURES CONTRACTS NEEDED TO HEDGE AN EXPOSURE, AND
EXPLAIN AND CALCULATE THE “TAILING THE HEDGE” ADJUSTMENT. ........................................... 11
EXPLAIN HOW TO USE STOCK INDEX FUTURES CONTRACTS TO CHANGE A STOCK PORTFOLIO’S
BETA .................................................................................................................................... 11
EXPLAIN HOW TO USE STOCK INDEX FUTURES CONTRACTS TO LOCK IN THE BENEFIT OF A STOCK
SELECTION. .......................................................................................................................... 13
EXPLAIN HOW TO CREATE A LONG-TERM HEDGE USING A “STACK AND ROLL” STRATEGY AND
DESCRIBE SOME OF THE RISKS THAT ARISE FROM THIS STRATEGY. ........................................... 14
CHAPTER SUMMARY ............................................................................................................. 15
PRACTICE QUESTIONS & ANSWERS: ...................................................................................... 16

2
Chapter 8. Using Futures for Hedging
 Define and differentiate between short and long hedges and identify their
appropriate use.

 Describe the arguments for and against hedging and the potential impact of
hedging on firm profitability.

 Define the basis and the various sources of basis risk and explain how basis risks
arise when hedging with Futures.

 Define cross hedging, and compute and interpret the minimum variance hedge
ratio and hedge effectiveness.

 Compute the optimal number of futures contracts needed to hedge an exposure

and explain and calculate the “tailing the hedge” adjustment.

 Explain how to use stock index Futures contracts to change a stock portfolio’s
beta.

 Explain how to create a long-term hedge using a “stack and roll” strategy and
describe some of the risks that arise from this strategy.

Define and differentiate between short and long hedges and

identify their appropriate use.
Short hedge
A short forward or futures hedge is an agreement to sell in the future and is
appropriate when the hedger already owns the asset.

The classic example is a farmer who wants to lock in a sales price for her crop of, e.g. corn,
and therefore protect herself against a price decline. By owning the corn crop, she effectively
has a long position in corn. To offset this long position, she needs to enter into a
corresponding short position, which is exactly what a short hedge accomplishes.
Long Hedge
A long forward or futures hedge is an agreement to buy in the future and is
appropriate when the hedger does not currently own the asset but expects to
purchase it in the future.

An example is an airline, which depends on jet fuel and enters into a forward or futures
contract (a long hedge) in order to protect itself from exposure to high oil prices.

A long forward (or futures) hedge is an A short forward (or futures) hedge is
agreement to buy in the future an agreement to sell in the future
Hedger does not currently own the asset. Hedger already owns the asset.
Expects to purchase it in future.
For example, an airline depending on jet For example, farmer wants to lock in a
fuel enters into futures contract (a long sales price for his crop to protect
hedge) to protect from exposure to rising against a price decline.
oil prices.

3
A key difference: is the future price predetermined?
Consider a coffee producer who plans to sell 100 pounds of coffee on a future date under
two different scenarios:
1. To a key customer, the coffee producer promises to sell 100 pounds, on a date one
year in the future, at $3.00 per pound.
2. To a key customer, the coffee producer promises to sell 100 pounds, on a date one
year in the future, at the future spot price (which is obviously unknown today)
If the coffee producer wants to hedge with coffee futures, the hedge differs depending on the
scenario:
1. In the first scenario, the producer is exposed to a future spot price increase, such that
the appropriate hedge is a long position in coffee futures contracts. Because the
sales price of $3.00 is predetermined, the underlying exposure is effectively a short
position, such that the hedge instrument is a long position to offset.
2. In the second scenario, the producer is exposed to a future spot price decrease, such
that the appropriate hedge is a short position in coffee futures contracts. In this
case as the future sale price is not predetermined, the underlying exposure is
effectively a long position such that the hedge instrument is a short position.

Describe the arguments for and against hedging and the potential
impact of hedging on firm profitability
Arguments in favor of hedging:
Hedging is a way of reducing risk. Rather than focus on market forces, over which a firm has
no control, and financial instruments, over which they have little knowledge, companies
should focus on their primary business, where they do have specialized knowledge.
Accordingly, the firm should take steps to minimize risks arising from market variables such
as interest rates, exchange rates and other prices by hedging them.
Arguments against hedging:
 In theory, there is no reason for the firm to try to minimize risk by hedging since
shareholders can make their portfolios well diversified and can make their own
hedging decisions (this is the classic argument by Stulz). Although in practice owning
the market portfolio has frictions and transaction costs.
 Hedging may increase risks when competitors do not hedge. For example, if you are
an airline and you hedge your exposure to jet fuel while your competitors do not and
the price of jet fuel drops, you are stuck with “overpaying” for the jet fuel.
 In some industries margins stay roughly the same because the cost of inputs can be
passed on directly to consumers in the form of higher prices.
o In this case, the firm’s margins can either get squeezed, or conversely, the
margins may expand. This sort of hedging may be perceived as more akin to
price speculation than actual hedging.
 The person responsible for hedging may be reluctant to enter into a hedge in case
prices do not move in their favor. It is likely that questions will be asked as to why the
company entered into the hedge when there is a loss. However, if there is a gain, this
might not be recognized. This informational asymmetry will tend to lead to principal-
agent problems, whereby management may choose the safer option of not hedging,
even though it may actually be optimal for the firm to hedge.

4
Define the basis and the various sources of basis risk, and explain
how basis risks arise when hedging with futures.
Define the basis
Remember that the basis itself converges to zero over time, as the spot price
converges toward the futures price. We can represent the basis as,

= –
= −
Financial commodities often express basis risk in the reverse: Future price – Spot Price. The
direction of your subtraction is not critical: the basis is the difference in price.

As the basis is the difference between the spot price and the futures price, the basis can
change due to changes to either the spot or the futures price, or both. For example, knowing
the spot price increases by itself does not tell us whether the basis increased or decreased.

The following specific terms are specifically defined by Hull:

 An increase in the basis is called a strengthening of the basis.
 A decrease in the basis is called a weakening of the basis.
For example, assume today the spot price is $4.00 and the futures price is $3.80. The
current basis is $4.00 - $3.80 = $0 20. Consider three scenarios as we imagine going
forward in time by some interval such as one month (illustrated below, left to right):
1. The spot price increases to $4.20 and the futures price increases to $4.00, over the
next month (below left). The basis is unchanged from $0.20 to $0.20.
2. The spot price decreases to $3.90 and the futures price remains at $3.80, over the
next month (below middle). The basis weakens from $0.20 to $0.10.
3. The spot price increases to $4.40 and the futures price increases to $4.10, over the
next month (below right). The basis strengthens from $0.20 to $0.30.

5
Basis change illustrated
Consider a company that in March 2017 plans to buy 25,000 pounds (lbs.) of copper in
December 2017 (end of year). The company employs a long hedge; i.e., long position in a
futures contract. The March spot and December futures prices are $2.50 and $2.70,
respectively. In March 2017, therefore, the basis is -$0.20. The company hedges by taking
a long position in one copper futures contract.
 In the exhibit below, observe the implication of three different scenarios, each
illustrating a possible state in December.
 In all three scenarios, the basis strengthens (increases) from -$0.20 to zero.
 The key point is that the hedge is effective under each scenario. Specifically, the net
cost is the same $67,500, where net cost includes both the un-hedged cost of buying
the copper and the futures gain/loss.
Contract (pounds) 25,000 Contract specs http://trtl.bz/cme-copper
Number of contracts 1

December 2017 Scenarios

March Future converges --> spot such that Basis unexpectedly
2017 basis converges to zero as expected Weakens Strengthens
Spot $2.50 $2.55 $2.70 $2.85 $2.70 $2.70
Futures $2.70 $2.55 $2.70 $2.85 $2.76 $2.64
Basis ($0.20) $0.00 $0.00 $0.00 ($0.06) $0.06

Unhedged Cost (this illustrates the price risk)

Cost ($63,750) ($67,500) ($71,250) ($67,500) ($67,500)

Unexpected basis Δ -->

Long Hedge hedger better/worse
Futures gain, per pound ($0.15) $0.00 $0.15 $0.06 ($0.06)
Futures gain, position ($3,750) $0 $3,750 $1,500 ($1,500)
Net cost ($67,500) ($67,500) ($67,500) ($66,000) ($69,000)
↑ ↑
long hedge long hedge
better worse

In the same exhibit above, as seen on the right side, consider two different scenarios in
which the basis does not converge to zero.
 These scenarios show how the intended hedge, via unexpected basis weakening or
strengthening, can contribute to a profit or loss.
 If the expectation is basis convergence and the expectation is realized (as in the
case of the three scenarios above), the hedge works perfectly. However,
unexpected basis weakening or strengthening introduces variability in the net cost.
 In this case, when the basis weakens, the net cost is lesser at $66,000 compared to
when the basis converges, and is favorable to the long hedge. However, when the
basis strengthens, the net cost increases to $69,000 which worsens the long hedge’s
position relative to the scenario in which basis converges.

6
Overall, unexpected basis change can be either favorable or unfavorable to the
hedger. Consider the following, but please keep in mind to focus on the impact of the
unexpected change):
 When the spot price increases by more than the futures price, the basis
increases and this is said to be a, “strengthening of the basis.”
o When the strengthening is unexpected, this strengthening is favorable for a
short hedge and unfavorable for a long hedge.
o In our example of the farmer, we can see how this is favorable: the farmer can
close out the futures contract and sell in the spot market. She will lose on the
futures contract since it has risen. However, since the spot price has risen even
more, the difference, the basis, is her gain.
 When the futures price increases by more than the spot price, the basis declines
and this is said to be a, “weakening of the basis.”
o When the weakening is unexpected, this weakening is favorable for a long
hedge and unfavorable for a short hedge.
o In the example of the farmer who employed a short hedge, we see that an
unexpected weakening of the basis is unfavorable

Sources of basis risk

Choice of the contract: It is the key factor affecting basis risk and has two components:
 The choice of the asset underlying the futures contract: If the asset being
hedged does not exactly match an asset underlying a futures contract, it is necessary
to carry out a careful analysis to determine which of the available futures contracts
has futures prices that are most closely correlated with the price of the asset being
hedged.
 The choice of the delivery month: In general, basis risk increases as the time
difference between the hedge expiration and the delivery month increases.
Therefore, it is good to choose a delivery month that is as close as possible to, but
later than, the expiration of the hedge.
The choice of the delivery month is likely to be influenced by several factors.
o When the expiration of the hedge corresponds to a delivery month, the contract
with that delivery month can be chosen.
o In fact, a contact with later delivery months are usually chosen as futures prices
are quite erratic during the delivery month. Moreover, a long hedger runs the risk
of having to take delivery of the physical asset if the contract is held during the
delivery month which can be expensive and inconvenient.
o However, as liquidity tends to be greatest in short-maturity futures contracts, the
hedger may be inclined to use short- maturity contracts and roll them forward.

7
Basis risk arises when hedging with futures
Basis risk arises because the characteristics of the futures contract often differ from the
underlying position. In particular, basis risk is ensured if the asset to be hedged is not exactly
the same as the asset underlying the futures contract. This can be due to these factors:
 Contract is standardized (e.g., WTI oil Futures)
 Commodities are not exactly the same (they have different qualities or grades)
 Uncertain timing: The hedger may be uncertain as to the exact date when the asset
will be bought or sold.
 Timing uncertainty vis-a-vis futures contract: The hedger may require the futures
contract to be closed out before its delivery month.
Basis risk may be sub-classified in various ways.
 For example, time-varying changes in the cost of carry model may induce basis risk.
 There is an inherent trade-off between liquidity and basis risk: to reduce basis risk is
to require a tailored hedge.

Define cross hedging, and compute and interpret the minimum

variance hedge ratio and hedge effectiveness
A cross hedge is hedge wherein the asset underlying the hedge is different from the
asset being hedged.
 A classic cross-hedge example is that of an airline hedging the cost of jet fuel with
futures contracts. Cross-hedges are necessary in this case because futures are
standardized contracts for commodities. Although jet fuel futures are indeed traded
on the CME, however, the open interest and volume is so limited, to the extent that
airlines resort to cross-hedging by using highly correlated heating oil futures instead.

Compute and interpret the minimum variance hedge ratio and hedge effectiveness
When the asset underlying the futures contract is the same as the asset being hedged, that
is, if the spot and future positions are perfectly correlated, then a 1:1 hedge ratio results in a
perfect hedge. However, this is rarely the case and indeed, with cross-hedging the optimal
hedge ratio need not equal 1.0. Rather the optimal hedge ratio is the ratio that minimizes the
variance of our hedge. This is the minimum variance hedge ratio (MVR), and is given by:

∗ ,
= , ,( = . . . )

where is the standard deviation of the changes in the spot price(∆ ) of the asset we are
hedging, is the standard deviation of the changes in the futures prices(∆ ), and , is the
coefficient of correlation between the two price changes.

8
Note that the MVR is equal to 1.0 when , = 0.5 and = 2 , for example. As a corollary,
while a perfect hedge implies a correlation equal to 1:1, in our example the correlation , ≠
1.0, yet the hedge is still optimal because it is the minimum variance ratio. There is a subtle
difference between a perfect hedge that implies a correlation of 1, and an optimal hedge,
which is the MVR and is the optimality criteria that the hedge typically wants to satisfy.

IMPORTANT CONCEPT: The minimum variance ratio is the slope of the regression
line of ∆ against ∆ and is the optimal hedge ratio. Note that the correlation can take
on a range of different values and does not need to equal 1 in order for the hedge to
be optimal.

The hedge effectiveness, that is, just how good our hedge is, is defined as the proportion
of the variance that is eliminated by hedging. It can be measured by a regression of the
change in spot prices against the change in futures prices, typically using historical, non-
overlapping data1. The resulting = , tells us how good our hedge is.
Example of minimum variance (optimal) hedge ratio
If the volatility of the spot price is 20%, the volatility of the futures price is 10%, and their
correlation is 0.40, then the optimal hedge ratio, h*, is given by:

20%
ℎ∗ = (0.4) = 0.8
10%
∗
And the optimal number of futures contracts is given by when is the size of the position
being hedged and is the size of one futures contract.
∗
∗ ℎ
=

1FASB 133 accounting rules regarding Cash-Flow hedging requires that you regress 36 months of
price changes of your hedging instrument against the asset you wish to hedge, and that the beta-
coefficient be between 0.85 and 1.2. You may choose the time interval (days, weeks, months)
however, once chosen it cannot be changed. This hedge effectiveness testing must be done both on
a retrospective (historical) and prospective (future expected) basis every month.

9
Hull’s example 3.3: Cross-hedge
In Hull’s example, an airline intends to purchase 2.0 million gallons of jet fuel in the future (at
the future spot price which is currently unknowable) and decides to use heating oil futures
for hedging. The appropriate hedge is therefore a long hedge. Each heating oil contract
traded by the CME Group is on 42,000 gallons of heating oil.

The historical change in spot price (jet fuel) is regressed against the change in futures price
(heating oil futures).

Note: the slope of the regression line equals the optimal hedge ratio.

Hull’s Example: 3.3 and Fig 3.2: Cross-hedging

The minimum variance hedge (MVH) ratio is 0.78. Using this MVH ratio and from =
2,000,000 and =42,000, the optimal number of futures contracts is 37.

10
Compute the optimal number of futures contracts needed to hedge
an exposure, and explain and calculate the “tailing the hedge”
adjustment.
When futures are used, a small adjustment, known as tailing the hedge allows for the
impact of daily settlement. The only difference here is to replace the units with values.

Instead of using quantities, that is the size of the position being hedged ( ) and size of one
futures contract( ) used in finding the optimal number of futures contracts as:
∗
∗ ℎ
=

we use the dollar value of the position being hedged ( ) and the dollar value of one futures
contract ( ), as in:
∗
∗ ℎ
=

The dollar values are obtained by multiplying the original ratio of quantities by the ratio of
/ (spot price/futures price).

Explain how to use stock index futures contracts to change a stock

portfolio’s beta
Given a portfolio beta ( ), the current value of the portfolio ( ), and the value of stocks
underlying one futures contract ( ), the number of stock index futures contracts (i.e., which
minimizes the portfolio variance) to be hedged is given by:

∗
=

We saw that the hedge ratio ℎ∗ is the slope of the best-fit line when percentage one-day
changes in the portfolio are regressed against percentage one-day changes in the futures
price of the index. Beta ( ) is the slope of the best-fit line when the return from the portfolio
is regressed against the return for the index.

∗
And now, by extension, when the goal is to shift portfolio beta from ( ) to a target beta ( ),
the number of stock index futures contracts required is given by:

∗ ∗
=( − )

11
For example: hedging an equity portfolio
Assume a $10 million equity portfolio has a beta of 1.20. The S&P 500 futures price is 1500
(one futures contract is for delivery of $250 multiplied by the index).

The optimal number of contracts is given by:

∗ 10,000,000
= = 1.2 (1500)(250) = 32

The hedge trade is short 32 futures contracts. The above essentially changes the beta to
zero so that the hedger’s expected return is almost independent of the performance of the
index.

Now assume that, instead of hedging the net beta to zero, we want to change the beta of the
portfolio to 2.0. In this case:

∗ ∗ 10,000,000
=( − ) = (2.0 − 1.2) = 21.33
1500 250

The hedge trade here is to enter into a long position on 21.33 futures contracts.

Note we could have used (beta minus target beta) in which case the result would be
negative (-) 21.33. But in either case, we must buy (go long) futures contracts because we
are increasing the beta. If we are reducing the beta, then we short futures.
For example: Hedging an equity portfolio
Suppose our $10 million portfolio has a beta of 1.5, and we want to reduce the beta to 1.2. If
our assumptions are: value of portfolio is $10 million; S&P 500 Futures Price = 1240;
Portfolio beta () is 1.5; Contract = $250 × Index (per specifications); and our target beta is
1.2. The number of contracts is given by:

∗ ∗ 10,000,000
=( − ) = (1.2 − 1.5) 1240 250 = −9.68

Therefore, we should short about 10 futures contracts.

12
Explain how to use stock index futures contracts to lock in the
benefit of a stock selection.
A smart investor considers who owns a small portfolio of stocks that is confident of
performing better than the market should short index futures contracts where β is the
beta of the portfolio, VA is the total value of the portfolio and VF is the current value of one
index futures contract. If the investors’ portfolio performs better than a well-diversified
portfolio with the same beta then he will make money by shorting the futures contract.

Consider an investor who, in April, holds 20,000 shares of a company, each worth $100. The
investor feels that the market will be very volatile over the next three months but that the
Company has a good chance of outperforming the market. The investor decides to use the
August futures contract on the Mini S&P 500 to hedge the market’s return during the three-
month period. The of the company’s stock is estimated at 1.1. Suppose that the current
futures price for the August contract on the Mini S&P 500 is 2,100. Each contract
is for delivery of $ 50 times the index. In this case, VA = 20,000 X 100 = 2,000,000 and
VF = 2,100 X 50 = 105,000. The number of contracts that should be shorted is therefore

2,000,000
1.1 = 20.95
105,000

Rounding to the nearest integer, the investor shorts 21 contracts, closing out the position
in July. Suppose the company’s stock price falls to $90 and the futures price of the Mini S&P
500 falls to 1,850. The investor loses 20,000 ($100 - $90) = $200,000 on the stock, while
gaining 21 X 50 X (2,100 - 1,850) = $ 262,500 on the futures contracts.

The overall gain to the investor in this case is $62,500 because the company’s stock price
did not go down by as much as a well-diversified portfolio with a of 1.1. If the market had
gone up and the company’s stock price went up by more than a portfolio with a of 1.1 (as
expected by the investor), then a profit would be made in this case as well.

13
NOTE: THIS LO HAS SOME WORDING THAT CHANGED. MAKE SURE THE WORDING
IN THIS CONTENT IS THE SAME AND CHANGE IF NECESSARY (Previous LO
wording: Explain the term “rolling the hedge forward” and describe some of the risks
that arise from this strategy.)
Explain how to create a long-term hedge using a “stack and roll”
strategy and describe some of the risks that arise from this
strategy.
When the delivery date of the futures contract occurs prior to the expiration date of the
hedge, or there is little liquidity but in the spot and prompt month, the hedger can roll forward
the hedge, that is close out a futures contract and take the same position on a new futures
contract with a later delivery date. This is also known as a stack and roll strategy.
Risks arising from a stack and roll strategy
Rolling the hedge forward exposes the company or hedger to basis risk on the
original hedge.
 It exposes the hedger to basis risk on each new hedge; a.k.a., rollover basis risk. If
the price of the asset we are long declines, such that there are margin calls, or at
least cash-outflows in the near-term, the firm might experience a liquidity squeeze.
 With insufficient liquidity this can cause major problems. This is largely due to
unfortunate timing: in the short-run we have cash outflows due to the loss on the
futures contract. However, since the firm employs the stack and roll strategy every
month, it can readily expect to buy futures, and thus hedge its cost in the following
months at a lower price.
For example (see below): Suppose that in April 2017 a company plans to sell 100,000
barrels of oil in June 2018 and decides to hedge its risk with a hedge ratio of 1.0. The current
spot price is $49.00. Although futures contracts are traded with maturities stretching several
years into the future, only the first six delivery months have sufficient liquidity. The company
therefore shorts 100 October 2017 contracts. In September 2017, it rolls the hedge forward
into the March 2018 contract. In February 2018, it rolls the hedge forward again into the July
2018 contract.

Date April 2017 Sep 2017 Feb 2018 June 2018

Oct 2017 futures price $48.20 $47.40
Mar 2018 futures price $47.00 $46.50
July 2018 futures price $46.30 $45.90
Spot price $49.00 $46.00

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Chapter Summary
A short hedge is an agreement to sell in the future and is appropriate when the hedger
already owns the asset.

A long hedge is an agreement to buy in the future and is appropriate when the hedger does
not currently own the asset but expects to purchase it in the future.

Hedging is a way of reducing risk.

 Rather than focus on market forces over which a firm has no control, and financial
instruments, over which they have little knowledge, companies should focus on the
main business they are in; where they do have specialized knowledge.
 In theory, there is no reason for the firm to try to minimize risk by hedging since
shareholders can make their portfolios well diversified and can make their own
hedging decisions.
 In practice this can be questioned due to frictions and transaction costs associated
with owning the market portfolio.
= – = − .

Hull states that, “basis arises from uncertainty as to what the basis will be at maturity
of the hedge.”
 This is not entirely satisfactory however, as it begs the question as to what drives this
uncertainty in the first place.
 A more precise answer is that basis risk reduces to one key fact: the asset being
hedged is typically not identical to the commodity underlying the futures contract.
There is an inherent trade-off between liquidity and basis risk: to reduce basis risk is
to require a tailored hedge, which is why basis risk is not an issue when hedging
using forwards.
A cross hedge is a hedge wherein the asset underlying the hedge is different from the
asset being hedged. The hedge ratio is the futures position taken over the total exposure. A
correlation of 1 implies a perfect hedge. However, the criteria for optimality may be to
minimize the variance of the hedge, in which case the optimal hedge is the beta of a
regression of price changes of the spot against price changes of the futures. This is the
minimum variance hedge ratio. The effectiveness of the hedge is measured by the
aforementioned regression’s .

When futures are used, a small adjustment, known as “tailing the hedge” can be made
to allow for the impact of daily settlement. The only difference here is to replace the units
with values. Instead of using quantities, we use the dollar value of the position being hedged
and the dollar value of one futures contract. The effect is to multiply the original ratio by the
ratio of spot price/futures price.

Stock index futures may be used to change a stock portfolio’s beta by going long or short
stock index futures in order to reduce or increase the portfolio’s beta.

When the delivery date of the futures contract occurs prior to the expiration date of the
hedge, or there is little liquidity but in the spot and prompt month, the hedger can roll
forward the hedge by closing out the futures contract and take the same position on a new
futures contract with a later delivery date.

15
Practice Questions & Answers:
1. In theory, futures contract can hedge commodity price risk. According to Hull, however,
EACH of the following is a valid reason for a company to AVOID such a commodity price
hedge EXCEPT for:
a) Hedge may be unnecessary if shareholders are well diversified
b) Hedge may be counterproductive if hedging is not the norm and commodity prices
changes ripple from raw material to wholesale and retail
c) Treasurer may incur career risk if senior management (and Board of Directors) does
not under fully understand the nature of the hedge
d) Hedge may be inappropriate if shareholders are focused on gross margins and the
cost of hedging would reduce margins to an unacceptable level

2. EACH of the following is a source of basis risk EXCEPT:

a) The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.
b) The hedger cannot be 100% certain that the counterparty in the forward contract will
meet their obligation (even the exchange-traded futures contract has a similar but
smaller risk)
c) The hedger may be uncertain as to the exact date when the asset will be bought or
sold.
d) The hedge may require the futures contract to be closed out before its delivery
month.

3. Assume the volatility (standard deviation) of the change in prices for the spot price of oil
and the futures price, respectively, are 20% and 32%. The (coefficient of) correlation
between changes in the two prices is 0.80. What is the variance of the basis?
a) 0.04
b) 0.08
c) 0.12
d) 0.16

4. A wheat farmer hedged her future sale of 100,000 bushels of wheat by selling forward 10
contracts (each for 5,000 bushels). The standard deviation of monthly changes in the spot
and futures price of wheat is, respectively, $0.60 and $0.90. What was her correlation
assumption?
a) 0.67
b) 0.75
c) 0.80
d) 0.90

5. An oil producer has negotiated a contract to sell one million barrels of crude oil in six
months. Which is the best hedge against changes in the spot price of oil?
a) Short 1,000 futures contracts
b) Short 1,000,000 futures contracts
c) Long 1,000 futures contracts
d) Long 1,000,000 futures contracts

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Answers
1. D. Hedge may be inappropriate if shareholders are focused on gross margins and
the cost of hedging would reduce margins to an unacceptable level

Commodity futures are considered to have very low transaction costs; and unlike options, no
up-front premium is incurred.

In regard to (A), (B) and (C), these are the three practical reasons Hull gives for the
tendency of many companies to avoid hedges.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-151-long-and-

short-hedges.4417/#post-15497

2. B. The hedger cannot be 100% certain that the counterparty in the forward contract
will meet their obligation (even the exchange-traded futures contract has a similar but
smaller risk)

This is counterparty credit risk, not basis risk. Basis risk is a market (price differential) risk.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-152-basis-

risk.4424/#post-24309

3. A. 0.04

Since basis = S-F, variance of basis = Variance(S-F) = variance(S) + variance(F) -

2*volatility(S)*volatility(F)*correlation(S,F);
Same as: Variance(S-F) = variance(S) + variance(F) - 2*covariance(S,F).
In this case, variance of basis = 20%^2 + 32%^2 - 2*20%*32%*0.8 = 0.04.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-153-minimum-

variance-hedge.4432/#post-13012

4. B. 0.75

The optimal hedge ratio = correlation * spot standard deviation / futures standard deviation.
The optimal # of contracts = optimal hedge ratio * quantity being hedged / quantity of
contract.
Correlation = (optimal # of contracts * quantity of contract / quantity being hedged) * futures
standard deviation / spot standard deviation.
In this case, correlation = (10 * 5,000 / 100,000) * 0.90 / 0.60 = 0.75.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-154-optimal-

futures-contracts-to-hedge.4442/#post-11460

5. A. Short 1,000 futures contracts

Each contract is for 1,000 barrels; e.g., http://www.cmegroup.com/trading/energy/crude-

oil/light-sweet-crude_contract_specifications.html
Since the oil producer will be selling in the future, a SHORT HEDGE is required.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-151-long-and-

short-hedges.4417/#post-11400

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.

P1.T3. Financial Markets & Products

Chapter 9. Foreign Exchange Markets

Bionic Turtle FRM Study Notes

.

CHAPTER 9. FOREIGN EXCHANGE MARKETS .............................................................. 3

EXPLAIN AND DESCRIBE THE MECHANICS OF SPOT QUOTES, FORWARD QUOTES, AND FUTURES
QUOTES IN THE FOREIGN EXCHANGE MARKETS, AND DISTINGUISH BETWEEN BID AND ASK
EXCHANGE RATES .................................................................................................................. 4
CALCULATE BID-ASK SPREAD AND EXPLAIN WHY THE BID-ASK SPREAD FOR SPOT QUOTES MAY
BE DIFFERENT FROM THE BID-ASK SPREAD FOR FORWARD QUOTES. ........................................ 8
COMPARE OUTRIGHT (FORWARD) AND SWAP TRANSACTIONS .................................................. 9
DEFINE, COMPARE, AND CONTRAST TRANSACTION RISK, TRANSLATION RISK, AND ECONOMIC
RISK .................................................................................................................................... 10
DESCRIBE EXAMPLES OF TRANSACTION, TRANSLATION, AND ECONOMIC RISKS, AND EXPLAIN
HOW TO HEDGE THESE RISKS ............................................................................................... 13
DESCRIBE THE RATIONALE FOR MULTI-CURRENCY HEDGING USING OPTIONS .......................... 14
IDENTIFY AND EXPLAIN THE FACTORS THAT DETERMINE EXCHANGE RATES. ............................ 15
CALCULATE AND EXPLAIN THE EFFECT OF AN APPRECIATION/DEPRECIATION OF A CURRENCY
RELATIVE TO A FOREIGN CURRENCY ..................................................................................... 17
EXPLAIN THE PURCHASING POWER PARITY THEOREM AND USE THIS THEOREM TO CALCULATE
THE APPRECIATION OR DEPRECIATION OF A FOREIGN CURRENCY. ......................................... 18
DESCRIBE THE RELATIONSHIP BETWEEN NOMINAL AND REAL INTEREST RATES ....................... 20
DESCRIBE HOW A NON
‐ARBITRAGE ASSUMPTION IN THE FOREIGN EXCHANGE MARKETS LEADS
TO THE INTEREST RATE PARITY THEOREM; USE THIS THEOREM TO CALCULATE FORWARD
FOREIGN EXCHANGE RATES ................................................................................................ 20
DISTINGUISH BETWEEN COVERED AND UNCOVERED INTEREST RATE PARITY CONDITIONS ....... 22
QUESTIONS & ANSWERS: .................................................................................................... 26
HULL, CHAPTER 3 END OF CHAPTER QUESTIONS & ANSWERS ............................ 32
QUESTION 13.1 .................................................................................................................. 32
QUESTION 13.2 .................................................................................................................. 32
QUESTION 13.3 .................................................................................................................. 33
QUESTION 13.4 .................................................................................................................. 34
QUESTION 13.5 .................................................................................................................. 34
QUESTION 13.6 .................................................................................................................. 34
QUESTION 13.7 .................................................................................................................. 34
QUESTION 13.8 .................................................................................................................. 35
QUESTION 13.9 .................................................................................................................. 36
QUESTION 13.10 ................................................................................................................ 36
QUESTION 13.11 ................................................................................................................ 37
QUESTION 13.12 ................................................................................................................ 38
QUESTION 13.13 ................................................................................................................ 38
QUESTION 13.14 ............................................................................................................... 39
QUESTION 13.15 ................................................................................................................ 40
QUESTION 13.16 ................................................................................................................ 41
QUESTION 13.17 ................................................................................................................ 44
QUESTION 13.18 ................................................................................................................ 45
QUESTION 13.19 ................................................................................................................ 46
QUESTION 13.20 ................................................................................................................ 48

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Chapter 9. Foreign Exchange Markets

 Explain and describe the mechanics of spot quotes, forward quotes, and futures
quotes in the foreign exchange markets, and distinguish between bid and ask
exchange rates.

 Calculate bid-ask spread and explain why the bid-ask spread for spot quotes may
be different from the bid-ask spread for forward quotes.

 Compare outright (forward) and swap transactions.

 Define, compare, and contrast transaction risk, translation risk, and economic
risk.

 Describe examples of transaction, translation, and economic risks, and explain

how to hedge these risks.

 Describe the rationale for multi-currency hedging using options.

 Identify and explain the factors that determine exchange rates.

 Calculate and explain the effect of an appreciation/depreciation of a currency

relative to a foreign currency.

 Explain the purchasing power parity theorem and use this theorem to calculate the
appreciation or depreciation of a foreign currency.

 Describe the relationship between nominal and real interest rates.

 Describe how a non-arbitrage assumption in the foreign exchange markets leads

to the interest rate parity theorem; use this theorem to calculate forward foreign
exchange rates.

 Distinguish between covered and uncovered interest rate parity conditions.

Foreign Exchange Rates

A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can be
exchanged for another currency (e.g., the Swiss franc). According to Saunders, foreign
exchange rates are listed in two ways, direct or indirect. A direct quote gives U.S. dollars
received for one (1.0) unit of foreign currency exchanged. An indirect quote gives units of
foreign currency received for one U.S. dollar. For example:

Direct quote (aka, US$ Equivalent)

 For example, on July 4, 2012, the exchange rate of U.S. dollars for Canadian dollars
was $0.9870 or USD 0.9870 per one Canadian dollar.
Indirect quote (Currency per US$)
 Conversely, the exchange rate of Canadian dollars for each U.S. dollar was CAD
1.0131 per one U.S. dollar, which of course is approximately equal to 1/0.987.

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However, it is perhaps more important to understand the common market convention for
quoting currency pairs. In the market, the currency pair is quoted as “base/quote” where
the first currency is the base currency and the second currency is the quote currency.
The exchange rate, then, gives the number of units of the quote currency per one unit of the
base currency. For example, in the currency pair EUR/USD 1.23 or EURUSD 1.23, EUR is
the base currency (it is first) and U.S. dollars is the quote currency (it appears second). So,
this refers to $1.23 U.S. dollars per one EUR. Note this can be confusing because the “/”
does not denote a ratio, and is often omitted.

Explain and describe the mechanics of spot quotes, forward

quotes, and futures quotes in the foreign exchange markets, and
distinguish between bid and ask exchange rates.
Calculate bid-ask spread and explain why the bid-ask spread for
spot quotes may be different from the bid-ask spread for forward
quotes.
When an exchange rate is quoted, there is a base currency and a quote currency. Currency
pairs are typically indicated as XXXYYY or XXX/YYY (with XXX as the base currency and
YYY as the quote currency). The exchange rate shows how much of the quote currency is
needed to buy one unit of the base currency. For example, a EURUSD quote of 1.2345
indicates that 1.2345 U.S. dollars are needed to buy one euro. A USDSEK quote of 8.7654
would indicate that 8.7654 Swedish Kronor are needed to buy one U.S. dollar.

The most common exchange rate quotes are between USD and another currency. Other
quotes (e.g., between GBP and EUR) are known as cross-currency quotes. Currency traders
have conventions about which currency is the base currency when exchange rates are
quoted. In the case of the exchange rate between the U.S. dollar and the British pound, for
example, the U.S. dollar is the quote currency. This is also the case when the U.S. dollar is
quoted with the euro, the Australian dollar, and the New Zealand dollar. In most other cases,
however, the U.S. dollar is the base currency and the other currency is the quote currency.
The quote for the Canadian dollar, for example, is USDCAD, and it indicates the number of
Canadian dollars that are equivalent to one U.S. dollar.

Spot exchange rates are typically quoted with four decimal places. The bid-ask spread
faced by corporations when they trade large amounts of a currency is quite small. On July
6, 2018, for example, EURUSD was quoted as bid 1.1744 and ask 1.1746. (For the small
currency exchanges necessary when traveling, however, bid-ask spreads are much larger.)

Forward exchange rates are quoted with the same base currency as spot exchange rates.
They are usually shown as points that are multiplied by 1/10,000 and then added to (or
subtracted from) the spot quote.

As an example, consider the EURUSD three-month forward quote (from the below table)
with bid 80.87 and ask 82.07. Because the spot rate was bid 1.1744 and ask 1.1746, this
means that the three-month forward bid quote is

1.1744 + 0.008087 = 1.182487

Meanwhile, the three-month forward ask quote is

1.1746 + 0.008207 = 1.182807

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.

The bid-ask spread for the points is 1.20. This increases the bid-ask spread for the three-
month forwards by 0.00012 relative to the bid-ask spread for spot trades and makes it so
that the bid-ask spread for the forward quote is 0.00032 (=0.0002 + 0.00012).

EURUSD Forward Quotes

Maturity Bid Ask
1 week 5.74 5.90
2 weeks 11.67 11.75
3 weeks 17.55 17.65
1 Month 26.10 27.20
2 Months 52.87 53.87
3 Months 80.87 82.07
4 Months 112.58 113.89
5 Months 138.06 139.46
6 Months 172.70 174.70
7 Months 203.89 206.39
8 Months 231.79 234.29
9 Months 263.36 265.86
10 Months 294.45 296.95
11 Months 326.60 329.10
1 Year 359.50 362.00
15 Months 460.01 461.77
21 Months 662.53 665.83
2 Years 754.50 759.45
3 Years 1,119.70 1,135.70
4 Years 1,452.40 1,472.40
5 Years 1,754.80 1,778.80
6 Years 2,031.00 2,063.00
7 Years 2,284.00 2,324.00
8 Years 2,516.00 2,556.00
9 Years 2,729.00 2,768.00
10 Years 2,929.00 2,969.00
12 Years 2,731.00 2,806.00
15 Years 3,139.00 3,239.00
20 Years 3,834.00 3,984.00
30 Years 5,259.00 5,227.40

The bid-ask spread increases as the maturity of the forward contract increases.For example,
20-year forward rate bid:

1.1744 + 0.3834 = 1.5578

and ask:

1.1746 + 0.3984 = 1.5730

for a bid-ask spread of 0.0152.

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.

The quotes indicate that EUR, when purchased with USD, is more expensive in the forward
market than in the spot market.

Consider another example of USDCAD forward rates (quotes in the below table). The spot
exchange rate is bid 1.3082, ask 1.3083. In this case, the points are negative so that the
forward exchange rate is less than the spot exchange rate. Note that the magnitude of
negative ask points is always less than the magnitude of negative bid points. This is
consistent with the bid-ask spread for forward quotes being greater than the bid-ask spread
for spot quotes. The ten-year forward bid quote is

USDCAD Forward Quotes

Maturity Bid Ask
1 week -2.21 -1.81
2 weeks -3.98 -3.48
3 weeks -5.85 -5.25
1 Month -8.29 -7.67
2 Months -15.20 -14.29
3 Months -22.10 -20.91
4 Months -28.91 -27.42
5 Months -35.90 -33.95
6 Months -43.60 -41.08
7 Months -53.84 -49.84
8 Months -57.88 -55.08
9 Months -63.00 -60.00
10 Months -71.27 -68.07
11 Months -76.00 -72.40
1 Year -82.15 -78.15
15 Months -104.00 -94.00
21 Months -146.06 -131.38
2 Years -162.70 -142.70
3 Years -214.00 -183.00
4 Years -285.70 -205.70
5 Years -290.10 -270.10
6 Years -385.00 -265.00
7 Years -441.00 -241.00
8 Years -498.00 -218.00
9 Years -521.00 -241.00
10 Years -521.00 -241.00

1.3082 − 0.0521 = 1.2561

Meanwhile, the ten-year forward ask quote is

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1.3083 – 0.0241 = 1.2842

The bid-ask spread is therefore 0.0281. However, note that the bid-ask spread for ten-year
forwards on EURUSD is a much lower 0.0042. One reason for the difference is that long-
dated forward contracts on EURUSD are more actively traded than those on USDCAD.

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Compare outright (forward) and swap transactions.

Outrights and swaps

A forward foreign exchange transaction, where two parties agree on an exchange at some
future date, is termed an outright transaction or a forward outright transaction. It can be
contrasted with an FX swap transaction, where currency is exchanged on two different
dates. Typically, an FX swap involves a foreign currency being bought (sold) in the spot
market and then sold (bought) in the forward market. An FX swap is a way of funding an
asset denominated in a foreign currency by paying interest in the domestic currency.

For example, a U.S. company can fund its European operations by borrowing in USD and
buying one million EUR today while at the same time agreeing to sell one million EUR for
USD in one month. This has the effect of funding the European operation in the domestic
currency. If the bid quote for one-month forward EUR is 26.1 points, this is the amount by
which EUR is more valuable in the forward market. In this case, the points reduce the net
funding cost in USD because more USD are going to be received for EUR in one month
compared to the amount that could have been received today.

Futures Quote

Forex futures trade actively on exchanges throughout the world. The CME Group in the
United States trades many different futures contracts on exchange rates between the U.S.
dollar and other currencies. These are always quoted with USD as the base currency. This
is because (from the perspective of the exchange) a foreign currency is treated like any
other asset and is valued in U.S. dollars. For example, a six-month forward quote for the
USDCAD of 1.3000 corresponds to a six-month futures quote of 0.7692 (= 1/1.3000) USD
per CAD.
Popular contracts traded by the CME Group are on 100,000 AUD; 62,500 GBP; 100,000
CAD; 125,0000 EUR; 12.5 million JPY; and 125,000 CHF. The maturity months available on
a given date include the following three months along with March, June, September, and
December for the next 20 months. The CME Group also trades contracts on several cross
rates.

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.

Define, compare, and contrast transaction risk, translation risk, and

economic risk.
Describe examples of transaction, translation, and economic risks,
and explain how to hedge these risks.
Firms need to quantify their exposures to exchange rates at different times in the future.
Once this is done, they must then decide whether their exposures are acceptable or whether
some hedging is necessary.

There are three categories of risk:

 Transaction risk,
 Translation risk, and
 Economic risk

Transaction Risk

Transaction risk is the risk related to receivables and payables. For example, consider a
British company that imports goods from South Africa and pays for the goods in South
African rand. It is therefore exposed to GBPZAR (i.e., the number of rand per British pound)
risk. If ZAR strengthens relative to GBP, the company will find that its profits suffer when it
must buy ZAR to pay its suppliers.
Suppose further that the British company sells goods in Portugal and prices its goods in
euros. In this case, it is exposed to EURGBP risk. If EUR weakens relative to GBP, the
company will find that its profits suffer when it exchanges its EUR revenues to GBP.
Transaction risk can be hedged with outright forward transactions. For the company in the
previous example, buying ZAR forward would lock in the exchange rate paid to South
African suppliers, while selling EUR forward would lock in the exchange rate applicable to
EUR revenues.
An FX swap is useful when a company owns foreign currency that will be used for purchases
at a future time and yet wants to earn interest in its domestic currency. The swap would
enable the company to sell the foreign currency in exchange for its domestic currency in the
spot market and buy it back at a future time in the forward market.

Translation Risk

Translation risk arises from assets and liabilities denominated in a foreign currency. These
must be valued in a firm’s domestic currency when financial statements are produced. This
can lead to foreign exchange gains or losses.

For example, suppose that a U.S. company has a manufacturing facility in the U.K. At the
end of Year 1, the facility is valued at GBP 10 million and the GBPUSD exchange rate is
1.3500. At the end of Year 2, the value of the facility in GBP has not changed and it is still
valued at GBP 10 million. However, the GBPUSD exchange rate is now 1.25. The company
will record a foreign exchange loss (in USD) of:

(1.3500 − 1.2500) × 10,000,000 = 1,000,000

Borrowings in a foreign currency can also lead to foreign exchange gains and losses. To see
how this is the case, suppose that a U.S. company has a loan of 20 million euros that will be
paid back in five years. Interest is paid in euros, and thus the firm is exposed to transaction

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risk. However, the loan principal to be paid back also gives rise to translation risk, which can
be much greater.

Suppose that the EURUSD exchange rate at the end of Year 1 is 1.2000 and that at the end
of Year 2 it is 1.1500. The loan will be valued in USD at the end of Year 1 as:

20,000,000 × 1.2000 = 24,000,000

The value of the loan at the end of Year 2 is

20,000,000 × 1.1500 = 23,000,000

The company has a foreign exchange gain of USD 1 million because the euro has
weakened. If the euro had strengthened during the year, the company would have incurred a
foreign exchange loss.

Translation risk is fundamentally different from transaction risk. Whereas transaction risk
directly affects a company’s cash flows, translation risk does not. However, it can have a big
effect on its reported earnings.

It is sometimes recommended that translation risk be netted against transaction risk, but this
is not appropriate. Forward contracts are very useful for hedging transaction risk.
Transaction risk exposures should be estimated month by month, and each month’s
exposure can be hedged separately. However, it only makes sense to hedge translation
exposure on one future date. For example, it would be over hedging to hedge the FX
exposure to the value of the assets in one and in two years because the price increase (or
decrease) over the first year is then considered twice.

Hedging translation risk with forward contracts on a reporting date makes accounting profits
less volatile on that reporting date. However, it is questionable whether this is a good idea
unless there is a plan to sell foreign currency assets or retire foreign currency liabilities at a
particular time in the future. This is because hedging replaces accounting risk with cash flow
risk (because forward contracts do affect future cash flows). While translation risk is
reduced, the transaction risk relating to the cash flows from the forward contracts is
increased.

A better way of avoiding translation risk is to finance the assets in a country with borrowings
in that country. In that case, gains (losses) on assets are offset by losses (gains) on
liabilities.

Consider again the U.S. company with a GBP 10 million manufacturing facility in the U.K. If
the translation risk is considered unacceptable, the facility can be financed by GBP 10
million of borrowings. There will then be no net translation gain or loss.

Economic Risk

Economic risk is the risk that a company’s future cash flows will be affected by exchange
rate movements. For example, a U.S. firm that sells software in Brazil and denominates
the price of the software in USD has no transaction risk. However, the firm does have
economic risk. If the real (BRL) declines in value relative to the USD, the company’s
customers in Brazil will find its software more expensive. As a result, either the demand
for the software will decrease or the firm will find it necessary to reduce the USD price of
the software when it is sold in Brazil.

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Sometimes exchange rate movements can affect a firm’s competitive position in its
domestic market. Consider a U.K. firm with no production or sales overseas. Exchange
rate movements might make it more profitable for a foreign competitor to increase its
activities in the U.K. in a way that adversely affects the firm.

Economic risk is more difficult to quantify than transaction or translation risk, but possible
exchange rate movements should be considered when key strategic decisions are being
made. For example, foreign exchange considerations might play a role in a decision to
move production overseas.

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13
.

Describe the rationale for multi-currency hedging using options.

Multinational companies have exposures to many different currencies. These exposures can
lower FX risk because exchange rate movements across different currencies are not
perfectly correlated. In general, the volatility for an investment portfolio with multiple
stocks is less than that of one with a single investment. In the same way, volatility arising
from exposures to many different currencies is usually less than that arising from an
exposure to a single currency.
Treasurers often prefer options to forward contracts when hedging. This is because options
provide downside protection against adverse exchange rate movements while still allowing a
firm to benefit from favourable movements. One FX hedging strategy is to buy options on
individual currencies to cover each possible adverse exchange rate movement. A less
expensive alternative, however, is for a firm to identify the portfolio of currencies to which it is
exposed and buy an option on that portfolio in the over-the-counter market.

For example, a corporation could buy an option on a portfolio consisting of:

 A long position in 100,000 units of currency A,

 A long position in 200,000 units of currency B, and
 A short position in 75,000 units of currency C.
This type of option is known as a basket option. Multinational firms usually have exposures
to an exchange rate in every month of the year. One way to limit this exposure is to trade
options with monthly maturities. A less expensive alternative is to trade options on the
average exchange rate during the year. These options are known as Asian options.

14
.

Identify and explain the factors that determine exchange rates.

Exchange rates are determined by many interrelated factors. Exchange rates however, are
ultimately determined by supply and demand, which are in turn influenced by many factors.
The most important economic variables that influence exchange rates are:

Balance of Payments and Trade Flows

The balance of payments between two countries measures the difference between the value
of exports and the value of imports. For example, suppose exports from country A to country
B increase. When exporters exchange their foreign currency-denominated revenues for their
domestic currency, it will increase the demand for country A’s currency and strengthen it
relative to country B’s currency. If imports from country A to country B increase, however,
country A’s currency will weaken relative to that of country B (because importers would have
to buy country B’s currency to pay for the goods they are importing).

There are some equilibrating forces at work here. As country A increases its exports to
country B, its currency strengthens. This causes its exports to become more expensive for
customers in country B. As a result, there is lower demand for those exported goods in
Country B. Similarly, country A imports increase as its currency weakens. As a result, goods
imported from Country B become more expensive, and this in turn reduces the demand for
goods imported from Country B.

An example of USDCAD is that since, Canada is an oil exporting nation, the value of the
Canadian dollar is influenced by the price of oil. For example, the Canadian dollar was worth
more than the U.S. dollar from 2011–2014, when the price of crude oil was high. When the
price of oil declined, so did the Canadian dollar.

Inflation

If USDCAD is 1.2500, we would expect the CAD price of goods in Canada to be 25% higher
than the USD price of goods in the United States. If this is not the case, there is a theoretical
arbitrage opportunity.

For example, suppose that a product costs USD 100 and CAD 130. An arbitrageur can buy
the product in the United States and sell it in Canada for a profit of CAD 5 per unit. Similarly,
if the product costs USD 100 and CAD 120, the arbitrageur can buy the product in Canada
and sell it in the United States for a similar profit. These arbitrage opportunities may not exist
in practice due to several costs that the arbitrageur may incur (e.g., transportation costs and
possibly tariffs). However, this relationship is the basis of what is known as purchasing
power parity.

For example, the inflation is 3% per year in the United States and 1% per year in
Switzerland. The cost of a representative basket of goods in the United States measured in
USD increases at 3% per year, while the cost of the same basket of goods in Switzerland
increases at 1% per year. Suppose further that the initial USDCHF exchange rate is 1.05. If
purchasing power parity holds, the cost of a basket of goods worth 100 USD is now worth
105 CHF. After one year, the same basket of goods will be worth USD 103 (= 100 × 1.03)
and CHF 106 (= 105 × 1.01). Purchasing power parity suggests that the exchange rate
should become

106.5
= 1.0296
103

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.

This is an (approximate) 2% strengthening of CHF relative to USD. The general

(approximate) purchasing power parity formula is

Percent Strengthening of Domestic Spot Rate = Foreign Inflation Rate – Domestic Inflation
Rate

In our example, the foreign (CHF) inflation rate minus the domestic (USD) inflation rate is
−2%, and thus the domestic spot rate weakens by about 2%.

Monetary Policy

The value of a country’s currency is also influenced by the monetary policy of its central
bank. If country A increases its money supply by 25% while country B keeps its money
supply unchanged, the value of country A’s currency will tend to decline by 25% relative to
country B’s currency (with all else being equal). This is because 25% more of country A’s
currency is being used to purchase the same amount of goods.

16
.

Calculate and explain the effect of an appreciation/depreciation of a

currency relative to a foreign currency.
Effect of appreciation/depreciation of currency relative to a foreign currency

 The appreciation of a country’s currency (or a rise in its value relative to other
currencies) means that the country’s goods are more expensive for foreign buyers
and that foreign goods are cheaper for foreign sellers (all else constant). Thus, when
a country’s currency appreciates, domestic manufacturers find it harder to sell their
goods abroad and foreign manufacturers find it easier to sell their goods to domestic
purchasers.
 Depreciation of a country’s currency (or a fall in its value relative to other currencies)
means the country’s goods become cheaper for foreign buyers and foreign goods
become more expensive for foreign sellers.
 Appreciation/Depreciation impacts the amount transferred to one’s bank on
conversion from one currency to another:
A U.S. investor wanting to buy British pounds through a local bank on July 4, 2012,
essentially has the dollars transferred from his or her bank account to the dollar account of a
pound seller at a rate of $1 per 0.6414 pound (or $1.5591 per pound). Simultaneously,
pounds are transferred from the seller’s account into an account designated by the U.S.
investor.

 If the dollar depreciates in value relative to the pound (e.g., $1 per 0.6360 pound or
$1.5723 per pound), the value of the pound investment, if converted back into U.S.
dollars, increases.
 If the dollar appreciates in value relative to the pound (e.g., $1 per 0.6433 pound or
$1.5545 per pound), the value of the pound investment, if converted back into U.S.
dollars, decreases.

17
.

Explain the purchasing power parity theorem and use this theorem
to calculate the appreciation or depreciation of a foreign currency.
As global financial markets have become increasingly interlinked, interest rates, inflation,
and foreign exchange rates have as well. For example, higher domestic interest rates may
attract foreign financial investment and impact the value of the domestic currency.

The effect of inflation in one country impacts the foreign currency exchange rates and it is
called as purchasing power parity.

One factor affecting a country’s foreign currency exchange rate with another country is the
relative inflation rate in each country (which, as shown below, is directly related to the
relative interest rates in these countries). Specifically:

rUS = iUS + rrUS

and

rS = iS + rrS
where

rUS = Interest rates in United States

rS = interest rates in Switzerland (or any other foreign country)
iUS = Inflation rate in United States
iS = Inflation rate in Switzerland (or any other foreign country)
rrUS = real rate of interest in the United States
rrS = Real rate of interest in Switzerland (or another foreign country)

Assuming real rates of interest (or rates of time preference) are equal across countries:

rrUS = rrS

Then
rUS - rS = iUS - iS

The (nominal) interest rate spread between the United States and Switzerland reflects the
difference in inflation rates between the two countries.

As relative inflation rates (and interest rates) change, foreign currency exchange rates that
are not constrained by government regulation should also adjust to account for relative
differences in the price levels (inflation rates) between the two countries. One theory that
explains how this adjustment takes place is the theory of purchasing power parity (PPP).

According to PPP, foreign currency exchange rates between two countries adjust to reflect
changes in each country’s price levels (or inflation rates and, implicitly, interest rates) as
consumers and importers switch their demands for goods from relatively high inflation
(interest) rate countries to low inflation (interest) rate countries.

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.

Specifically, the PPP theorem states that the change in the exchange rate between two
countries’ currencies is proportional to the difference in the inflation rates in the two
countries. That is:

iDomestic - iForeign = ΔSDomestic/Foreign/SDomestic/Foreign

where

SDomestic/Foreign= Spot exchange rate of the domestic currency for the foreign currency (e.g.,
U.S. dollars for Swiss francs)

ΔSDomestic/Foreign = Change in the one-period spot foreign exchange rate

Thus, according to PPP, the most important factor determining exchange rates is the fact
that in open economies, differences in prices (and, by implication, price level changes with
inflation) drive trade flows and thus demand for and supplies of currencies.

Saunders Example 13-4: An application of Purchasing Power Parity Theorem

Suppose that the current spot exchange rate of U.S. dollars for Russian rubles, SUS/R, is 0.17
(i.e., 0.17 dollar, or 17 cents, can be received for 1 ruble). The price of Russian-produced
goods increases by 10 percent (i.e., inflation in Russia, iR, is 10 percent), and the U.S. price
index increases by 4 percent (i.e., inflation in the United States, iUS, is 4 percent). According
to PPP, the 10 percent rise in the price of Russian goods relative to the 4 percent rise in the
price of U.S. goods results in a depreciation of the Russian ruble (by 6 percent). Specifically,
the exchange rate of Russian rubles to U.S. dollars should fall, so that:

. .
U.S. Inflation rate - Russian inflation rate = . .

Or iUS - iR = ΔSUS/R/SUS/R

Plugging in the inflation and exchange rates, we get:

0.04 - 0.10 = ΔSUS/R/SUS/R = ΔSUS/R/0.17

or
-0.06 = SUS/R/0.17
and
ΔSUS/R = -0.06 X 0.17 = -0.0102

Thus, it costs 1.02 cents less to receive a ruble (i.e.,1 ruble costs 15.98 cents: 17 cents
_1.02 cents), or 0.1598 of $1 can be received for 1 ruble. The Russian ruble depreciates in
value by 6 percent against the U.S. dollar as a result of its higher inflation rate.

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.

Describe the relationship between nominal and real interest rates

Theoretically speaking, the one-period nominal interest rate ( ) on fixed income securities in
any particular country has two major components.
 First, the real interest rate reflects underlying real sector demand and supply for
funds in that currency.
 Second, the expected inflation rate reflects an extra amount of interest lenders
demand from borrowers to compensate the lenders for the erosion in the principal (or
real) value of the funds they lend due to inflation in goods prices expected over the
period of the loan.

= +
= Nominal interest rate in country i
= real interest rate in country i
= expected one-period

Nominal interest rate ≅ real interest rate + [expected] inflation rate.

This can also be defined slightly more mathematically precise as so,

Nominal interest rate = [(1 + real interest rate) x (1 + expected inflation)] -1.

Describe how a non‐arbitrage assumption in the foreign exchange

markets leads to the interest rate parity theorem; use this theorem
to calculate forward foreign exchange rates
In general, spot rates and forward rates for a given currency differ. The forward exchange
rate is determined by the spot exchange rate and the interest rate differential between the
two countries. The specific relationship that links spot exchange rates, interest rates, and
forward exchange rates is described as the interest rate parity theorem (IRPT).

Intuitively, the IRPT implies that by hedging in the forward exchange rate market, an investor
realizes the same returns whether investing domestically or in a foreign country. This is a so-
called no-arbitrage relationship in the sense that the investor cannot make a risk-free return
by taking offsetting positions in the domestic and foreign markets. That is, the hedged dollar
return on foreign investments just equals the return on domestic investments. The eventual
equality between the cost of domestic funds and the hedged return on foreign assets, or the
IRPT, can be expressed as:

1
1+ = × [1 + ]×

Rate on U.S. investment = Hedged return on foreign (U.K.) investment

1+ = 1 plus interest rate on US CDs for the FI at time t

= $/£ spot exchange rate at time t

1+ = 1 plus interest rate on UK CDs at time t

= $/£ forward exchange at time t

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.

Thus, the IRPT is motivated by arbitrage arguments: if interest rates are higher in, say the
UK, than in the US, it is attractive for investors to invest in UK assets, earning a higher rate
of return. Indeed, investors would borrow cheaply in the US and invest in the UK and make a
profit on the interest rate differential.

However, as you have probably already figured, such arbitrage opportunities cannot persist.
If US investors borrow USD to buy Pound Sterling denominated CDs, the cost of Pound
Sterling in terms of USD appreciates (becomes more expensive). As the spot price
increases, the forward exchange rate simultaneously decreases. Thus, it becomes less
attractive to but Pound Sterling denominated CDs as you get fewer Pounds per USD, and
you know that the exchange rate one year from now will be lower (you will receive less for
your Pound Sterling). These forces will ensure that Covered Interest Rate Parity holds, with
any deviation quickly being seized upon by arbitrageurs.

Saunders Example 13-5: An application of Interest Rate Parity Theorem

Suppose = 8% and = 11%, as in our preceding example. As the FI moves into

more British CDs, suppose the spot exchange rate for buying pounds rises from $1.60/£1 to
$1.63/£1. In equilibrium, the forward exchange rate would have to fall to $1.5859/£1 to
eliminate completely the attractiveness of British investments to the U.S. FI manager.

That is:
(1.08) = (1/ 1.63) [1.11] (1.5859)

This is a no-arbitrage relationship in the sense that the hedged dollar return on foreign
investments just equals the FI’s dollar cost of domestic CDs. Rearranging, the IRPT can be
expressed as:

− −
=
[1 + ]

0.08 − 0.11 1.5859 − 1.63

≈
1.11 1.63
−0.0270 ≈ −0.0270

That is, the discounted spread between domestic and foreign interest rates is approximately
equal to the percentage spread between forward and spot exchange rates.

21
.

Distinguish between covered and uncovered interest rate parity

conditions.
Covered Interest parity

Suppose a U.S. trader starts with 100 GBP and wants to end up with USD in T years. There
are two ways to do this:
 The trader can invest the funds at the GBP risk-free rate (RGBP) so that they grow to
100(1 + RGBP)T at time T. At the same time, the trader can enter into a forward
contract to exchange 100(1 + RGBP)T for USD at time T. This leads to
100(1 + RGBP)TF where F is the T-year forward GBPUSD exchange rate.
 The trader can exchange the funds immediately for USD and then invest the USD
funds at the USD risk-free rate. The 100 GBP first becomes 100S USD, where S is
the current GBPUSD spot rate. At time T, this becomes
100S(1 + RUSD)T
where RUSD is the annual USD risk-free rate.
There is no uncertainty about the amount of USD that will be obtained at time T for either
scenario. In the absence of arbitrage opportunities, they must therefore give the same
result:

100(1 + RGBP)T F = 100S(1 + RUSD)T

so that

= (1 + )
(1 + )

This is known as covered interest parity. If F is less than the exchange rate given by the
above equation:

< (1 + )
(1 + )

An arbitrageur can

 Borrow 100 GBP for T years at RGBP

 Convert the funds to 100S USD
 Invert the USD at RUSD for T years to obtain 100S(1+RUSD)T USD at time T and
 Enter into forward contract to convert this to 100S(1+RUSD)T/F GBP at time T
Thus, the trader would have more GBP than required to repay the funds borrowed in GBP.

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.

If F is greater than the interest rate given by covered interest rate parity principle then:

> (1 + )
(1 + )

an arbitrageur can:
 Borrow 100S USD for T years at RGBP
 Convert the funds to 100 GBP
 Invert the USD at RGBP for T years to obtain 100(1+RGBP)T USD at time T and
 Enter into forward contract to convert this to 100(1+RGBP)TF USD at time T
From the above inequality:
100 (1 + ) > 100 (1 + )
Thus, the trader has more USD than required to repay the funds borrowed in USD.
This analysis assumes that the trader can borrow and lend at the same interest rate (i.e.,
that the borrowing and lending risk-free interest rates in the United States are the same and
equal to RUSD). For a large bank, this is close to true. If we take the bank’s spread between
borrowing and lending rates into account, however, we would obtain a narrow range of
possible values of F (instead of just one value).
In general, for an exchange rate of XXXYYY,

= (1 + )
(1 + )
If the risk-free rate for currency XXX is higher than that for currency YYY, XXX is weaker in
the forward market than in the spot market (i.e., it takes less units of YYY to buy one unit of
XXX in the forward market than it does in the spot market). If the risk-free rate for currency
XXX is lower than that for currency YYY, XXX is stronger in the forward market than in the
spot market (i.e., it takes more units of YYY to buy one unit of XXX in the forward market
than it does in the spot market).

From the table on EUR USD exchange rates when USD is exchanged for EUR; USD was
weaker in the forward market than in the spot market. For example, the mid-market spot
exchange rate is USD 1.1745 (= (1.1744 + 1.1746)/2), while the mid-market point for a 12-
month forward is 360.75 (= (359.5 + 362)/2) and therefore the mid-market forward rate is
USD 1.2106 (= 1.1745 + 360.75/10000):

1+
1.2106 = 1.1745
1+

which reduces to

= 1.0307

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.

This indicates that the one-year USD interest rate was about 3% higher than the euro
interest rates. Indeed, this was the case: The one-year interbank borrowing rate was about
2.8% in USD and −0.2% in EUR.

Interpretation of Points

From the covered interest rate parity principle

= (1 + )
(1 + )

If T<1 then the equation can be approximated to:

1+
=
1+
This can be written as:

1+
−1= −1
1+
or
− 1+ −1−
=
1+
so that

− −
=
1+
Or approximately as

−
=( − )

This provides an interpretation of the forward rate points. The term F-S is the points divided
by 10,000 and (when expressed as a percentage of the spot rate) is approximately equal to
the interest rate differential applied to time T.

Uncovered Interest Rate Parity

Covered interest parity concerns forward exchange rates and can be expected to hold well
because it depends on arbitrage arguments. Uncovered interest parity is an argument
concerned with exchange rates themselves and is just one of the many interacting factors
that determine how exchange rates move. It argues that investors should earn the same
interest rate in all currencies when expected exchange rate movements are considered.

Consider currencies X and Y with risk-free rates of 2% and 6% (respectively). In equilibrium,

the two currencies should be equally attractive. According to uncovered interest rate parity,
this means that the investor should expect the value of currency Y to weaken by about 4%
relative to the value of currency X.

Arguably, there are many potential violations of uncovered interest parity. In 2018, the
interest rate in USD was much higher than the interest rate in EUR. However, the U.S.
economy was generally considered to be much stronger than many European economies.
Furthermore, many market participants did not consider the interest rate differential to be
indicative of a stronger euro in the future. If both covered and uncovered interest rate parity
held, the forward exchange rate would equal the expected future spot exchange rate.

24
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25
.

Questions & Answers:

500.3. The following are the foreign currency positions of a U.S. bank, expressed in the
foreign currency:

The spot exchange rates are currently as follows (all given in base/quote format): USD/CHF
0.980, GPD/USD $1.56, and USD/JPY ¥125.0

If the Japanese yen appreciates by 2.0%, what is the bank's expected gain or loss (note: this
is variation on Saunder's Question #8) in US dollar terms?

a) Loss
b) Loss of about $61.0 dollars
c) Gain of about
d) Gain

501.2. A bank has the following currency positions in the Brazilian real, expressed in
 Brazilian real ($R):
 Assets = R$ 125,000
 Liabilities = R$ 78,000
 FX Bought = R$ 27,000
 FX Sold = R$ 5,000
The spot exchange rate USDBRL is $R 3.497 (i.e., USD is the base currency). If the
Brazilian real depreciates by 3.0%, approximately what is the gain (loss) on the currency
position expressed in US dollars?

a) Loss of $3,365
b) Loss of $592
c) Gain of $1,270
d) Gain of $4,822

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502.3. Suppose the U.S. financial institution has $600.0 million in assets, at the start of the
year, which are funded by US certificates of deposit (CDs) with a promised one-year of
3.0%. The institution invests $400.0 million domestically in U.S. loans that yield 5.0% and
the remaining $200.0 million are invested abroad in euro-denominated loans that yield 8.0%:

Rather than match foreign asset position with liabilities (i.e., on balance sheet hedging), the
institution uses the forward FX market to employ an off-balance-sheet hedge. The exchange
rate of dollars for euros at the beginning of the year is $1.15/€1. The current forward one-
year exchange rate between dollars and euros is $1.12/€1; that is, the forward trades at a
$0.03 discount to the spot FX rate. Which is nearest to the implied net interest margin?
(note: variation on Saunders' Question #16)

a) 1.52%
b) 2.06%
c) 3.00%
d) 4.17%

503.1. A bank purchases a six-month, $1.0 million Eurodollar deposit at an interest rate of
2.5% per annum with semiannual compounding. It invests the funds in a six-month Swedish
krone AA-rated bond paying 3.5% per annum. The current SEKUSD spot rate is $0.1140 per
1.0 krona (kr, https://en.wikipedia.org/wiki/Swedish_krona). The six-month forward rate on
the Swedish krone is being quoted at SEKUSD $0.1210. If the bank covers its foreign
exchange exposure using the FX forward market, which is nearest to the net spread earned
on this investment per annum with semiannual compounding? (note: variation on Saunders'
Question #22)

a) 2.38%
b) 4.75%
c) 7.93%
d) 13.50%

191.5. A US bank has the following pound sterling exposures: GBP 10.0 billion in assets,
GBP 7.0 billion in liabilities, GBP 5.0 billion bought, GBP 6.0 billion sold. The bank is
concerned that the pound sterling will fall in value relative to the US dollar. Which of the
following will reduce the bank’s exposure to pound sterling depreciation?

a) Nothing, its net exposure implies a benefit if GBP depreciates

b) Add +2 billion in assets to the balance sheet that are denominated in pound sterlings
c) Add +2 billion in liabilities to the balance sheet that are denominated in pound
sterlings
d) Add + 2 billion in long forward exposure to the pound sterling; i.e., promises to buy
GBP in the future

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192.3. According to Saunders, which of the four trading activities most contributes to foreign
exchange (FX) risk exposure?

a) Open positions in a currency

b) Purchase and sale of currencies for hedging purposes
c) Purchase and sale of currencies to complete international transactions.
d) Facilitating positions in foreign real and financial investments

193.3. Which of the following is TRUE about the use of an ON-BALANCE-SHEET HEDGE to
control a bank’s foreign exchange (FX) exposure?

a) The hedge will lock-in (guarantee) a specific, predetermined net return

b) The hedge can ensure a positive, but nevertheless volatile, net return
c) The hedge cannot ensure a positive net return
d) By employing a forward foreign currency contract, the on-balance-sheet hedge can
ensure a positive return that is also not volatile

194.1. A US bank raises USD $10 million (liabilities) and invests this amount into a Russian
project denominated in Russian rubles (asset) with an expected foreign rate of return of
12%. The bank remains unhedged with respect to this currency risk. If there is an sudden
increase in the Russian inflation rate, without any corresponding impact on the project’s
nominal, foreign 12% return on the project, according to purchasing power parity (PPP),
what is the impact on the bank?

a) No impact
b) Ruble should appreciate, translating into a gain for the bank
c) Ruble should depreciate, translating into a gain for the bank
d) Ruble should depreciate, translating into a loss for the bank

191.1. The spot foreign currency exchange rate is EUR/USD $1.4296/$1.4304. Each of the
following is true about this quote EXCEPT:

a) The spread is 8 pips

b) If the domestic currency is the US dollar (USD), as from the perspective of an
American trader, as EUR is the base currency and the USD is the quoted currency,
this is direct quote
c) We can buy one Euro for $1.4304 and sell one Euro for $1.4296
d) If the spot rate changes to EUR/USD $1.4416/$1.4424, then the EUR has weakened
and the USD has strengthened

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Answers

500.3. B. Loss of about $61.0 dollars

The net yen exposure = (500,000 - 300,000) + (100,000 - 680,000) = -¥380,000; i.e., net
short the currency such that if the currency appreciates, the position loses.
¥-380,000 * 2.0% / 125 = -$60.80.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-500-foreign-

exchange-fx-exposures-saunders.8788/

501.2. B. Loss of $592

(R$ 125,000 - R$ 78,000) + (R$ 27,000 - R$ 5,000) = +R$ 69,000 which is a long position in
the Brazilian real. This long position will gain if the Brazilian real appreciates and lose if the
Brazilian real depreciates against the dollar. A 3.0% depreciation implies a 3.0% * R$ 69,000
= R$ 2,070 loss, which is R$ 2,070/3.497 = $591.94.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-501-foreign-

exchange-fx-gain-and-loss-saunders.8795/

502.3. B. 2.06%
The U.S. FI sells $200 million for euros at the spot exchange rate (today) and receives $200
million/1.15 = €173.91 million. The FI then immediately lends the €173.91 million to a
German customer at 8.0% for one year. The FI also sells the expected principal and interest
proceeds from the euro loan forward for dollars at today’s forward rate for one-year delivery.

This means that the forward buyer of euros promises to pay: €173.91 million * 1.08 *
$1.12/€1 = €187.83 million x $1.12/€1 = $210.37 million to the FI (the forward seller) in one
year when the FI delivers the €187.83 million proceeds of the loan to the forward buyer.

In one year, the German borrower repays the loan to the FI plus interest in euros (€187.83
million). The FI delivers the €187.83 million to the buyer of the one-year forward contract and
receives the promised $210.37 million.
 The FI knows from the very beginning of the investment period that it has locked in a
guaranteed return on the German loan of: ($210.37m - $200m)/$200 = 5.1826%.
 Given this return on British loans, the overall expected return on the FI’s asset
portfolio is: (400m/600m)(0.050) + (200m/600m)(.051826) = 5.061%.
 Net return = average return on assets - average cost of funds = 5.061% - 3.0% =
2.061%.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-502-foreign-

exchange-fx-hedges-saunders.8809/

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503.1. D. 13.50%
 Interest plus principal expense on six-month CD = $1m x (1 + 0.025/2) =
$1,012,500.00.
 Principal of Swedish bond = $1,000,000/0.1140 = kr 8,771,929.82.
 Interest and principle = kr 8,771,929.82 * (1 + 0.035/2) = kr 8,925,438.60.
 Interest and principle in dollars if hedged: kr 8,925,438.60 * $0.1210 =
$1,079,978.07.
 Spread = $1,012,500.00 - $1,079,978.07 = $67,478.07 / $1.0 million = .06748 for six
months, or 13.4956% annually
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-503-interest-rate-
parity-saunders.8815/

191.5. C. Add +2 billion in liabilities to the balance sheet that are denominated in
pound sterling. The net exposure = (10 - 7) + (5 - 6) = +2 GBP; i.e., the bank is net long
pound sterling and faces the risk of GBP depreciation.

Each of answers (A), (B) and (D), increase the net long exposure to a greater net long
exposure.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l1-t3-191-foreign-

exchange-exposure.4680/#post-12342

192.3. A. Open positions in a currency

In regard to (C) and (D), please note Saunders says here, “the bank [FI] normally acts as
an agent of its customers for a fee but does not assume the FX risk itself.”

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l1-t3-192-foreign-

exchange-fx-exposure.4692

193.3. B. The hedge can ensure a positive, but nevertheless volatile, net return
As illustrated by the examples, the hedge ensures directional protection and the net return
will tend to cluster near the net return earned under a scenario of: un-hedged with no
currency changes. However, due to the spread differentials, volatility will remain.

Please note (D) is nonsensical.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l1-t3-193-on-and-off-

balance-sheet-foreign-exchange-fx-risk-hedges.4696

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194.1. D. Ruble should depreciate, translating into a loss for the bank
As the bank is net invested in ruble-denominated assets, the bank is long the Russian ruble.
Per PPP, inflation in Russia should lead to depreciation of the Russian ruble, which will
create a loss on the long currency position.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l1-t3-194-interest-rate-

parity.4701

191.1. D. To go from able to buy one Euro for $1.4304 to able to buy one Euro for
$1.4424, we need more dollars to buy one Euro, so the dollar has weakened (similarly,
one Euro gets us more dollars than before).

In regard to (A), (B) and (C), each is true.

Please note EUR/USD refers to base/quoted currency, such that EUR/USD $1.4296 means
$1.4296 dollars [ie, the quoted currency] per 1 Euro [ie, the base currency].

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l1-t3-191-foreign-

exchange-exposure.4680

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Hull, Chapter 3 End of Chapter Questions & Answers

Question 13.1
What are four FX risks faced by FIs?

Answer:

Four risks include (1) trading in foreign securities, (2) making foreign currency loans, (3)
issuing foreign currency-denominated debt, and (4) buying foreign currency-issued
securities.

Question 13.2
What is the spot market for FX? What is the forward market for FX? What is the position of
being net long in a currency?

Answer:

The spot market for foreign exchange involves transactions for immediate delivery of a
currency, while the forward market involves agreements to deliver a currency at a later time
for a price or exchange rate that is determined at the time the agreement is reached. The net
exposure of a foreign currency is the net foreign asset position plus the net foreign currency
position. Net long in a currency means that the amount of foreign assets exceeds the
amount of foreign liabilities.

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Refer to Table 13-1 to answer questions 13.3, 13.4 and 13.5

Question 13.3
 What was the spot exchange rate of Canadian dollars for U.S. dollars on July 4,
2012?
 What was the six-month forward exchange rate of Japanese yen for U.S. dollars on
July 4, 2012?
 What was the three-month forward exchange rate of U.S. dollars for Swiss francs on
July 4, 2012?

Answers:
 The spot exchange rate of Canadian dollars for U.S. dollars was 1.0131 on July 4,
2012.
 The six-month forward exchange rate of Japanese yen for U.S. dollars was 79.66 on
July 4, 2012.
 The three-month forward exchange rate of U.S. dollars for Swiss francs was 1.0455
on July 4, 2012.

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Question 13.4
 On June 4, 2012, you purchased a British pound-denominated CD by converting $1
million to pounds at a rate of 0.6435 pounds for U.S. dollars. It is now July 4, 2012.
Has the U.S. dollar appreciated or depreciated in value relative to the pound?
 Using the information in part (a), what is your gain or loss on the investment in the
CD? Assume no interest was been paid on the CD.
Answers:
 The exchange rate of British pounds for U.S. dollars on July 4, 2012 was 0.6414. The
U.S. dollar has depreciated in value relative to the pound.
 Initial investment was $1 million x 0.6435 = 643,500 pounds. Exchanging the funds
back to dollars on July 4, 2012 you will have 643,500 pounds / 0.6414 = $1,047,875.
Your gain is $1,047,875 - $1,000,000 = $47,875.

Question 13.5
On July 4, 2012, you convert $500,000 U.S. dollars to Japanese yen in the spot foreign
exchange market and purchase a one-month forward contract to convert yen into dollars.
How much will you receive in U.S. dollars at the end of the month? Use Table 13-1 for this
problem.

Answer:

At the beginning of the month you convert $500,000 to yen at a rate of 79.87 yen per dollar,
or you will have 500,000 x 79.87 = ¥39,935,000.

The one-month forward rate for the U.S. dollar for Japanese yen on July 4, 2012 was
0.012524. So, at the end of the month you will convert ¥39,935,000 to dollars at $0.012524
per ¥ or you will have ¥39,935,000 x 0.012524 = $500,145.94

Question 13.6
X-IM Bank has ¥14 million in assets and ¥23 million in liabilities and has sold ¥8 million in
foreign currency trading. What is the net exposure for X-IM? For what type of exchange rate
movement does this exposure put the bank at risk?

Answer:

The net exposure would be ¥14 million – ¥23 million – ¥8 million = - ¥17 million. This
negative exposure puts the bank at risk of an appreciation of the yen against the dollar. A
stronger yen means that repayment of the net position would require more dollars.

Question 13.7
What two factors directly affect the profitability of an FI’s position in a foreign currency?

Answer:

The profitability is a function of the size of the net exposure and the volatility of the foreign
exchange rate.

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Question 13.8
The following are the foreign currency positions of an FI, expressed in the foreign currency.

The exchange rate of dollars per SFs is 0.9301, of dollars per British pounds is 1.6400, and
of dollars per yen is 0.010600.

The following are the foreign currency positions converted to dollars.

 What is the FI’s net exposure in Swiss francs stated in SF and in $s?
 What is the FI’s net exposure in British pounds stated in £ and in $s?
 What is the FI’s net exposure in Japanese yen stated in ¥s and in $s?
 What is the expected loss or gain if the SF exchange rate appreciates by 1 percent?
State you answer in SFs and $s.
 What is the expected loss or gain if the £ exchange rate appreciates by 1 percent?
State you answer in £s and $s.
 What is the expected loss or gain if the ¥ exchange rate appreciates by 2 percent?
State you answer in ¥s and $s.

Answer:
 Net exposure in stated in SFs = SF134,394 - SF53,758 + SF10,752 -
SF16,127=SF75,261
Net exposure in stated in $s = $125,000 - $50,000 + $10,000 - $15,000 = $70,000
 Net exposure in £ = £30,488 - £13,415 + £9,146 - £12,195= £14,024
Net exposure in $ = $50,000 - $22,001 + $15,000 - $20,000 = $22,999
 Net exposure in ¥ = ¥7,075,472 - ¥2,830,189 + ¥1,132,075 - ¥8,301,887= -
¥2,924,529
Net exposure in $ = $75,000 - $30,000 + $12,000 - $88,000 = -$31,000
 If assets are greater than liabilities, then an appreciation of the foreign exchange
rates will generate a gain = SF75,261 x 0.01 = SF7,261, or $70,000 x 0.01 = $7,000.
 Gain = £14,024 x 0.01 = $140, or $22,999 x 0.01 = $230
 Loss = - ¥2,924,529 x 0.02 = -$58,491 or -$31,000 x 0.02 = -$620

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Question 13.9
What are the four FX trading activities undertaken by FIs? How do FIs profit from these
activities?

Answer:

The four areas of FX activity undertaken by FIs are either for their customer’s accounts or for
their own proprietary trading accounts. They involve the purchase and sale of FX in order to
(a) complete international commercial transactions, (b) invest abroad in direct or portfolio
investments, (c) hedge outstanding currency exposures, and (d) speculate against
movements in currencies. Most FIs earn commissions on transactions made on behalf of
their customers. If the FIs are market makers in currencies, they make their profits on the
bid-ask spread.

Question 13.10
City Bank issued $200 million of one-year CDs in the United States at a rate of 6.50 percent.
It invested part of this money, $100 million, in the purchase of a one-year bond issued by a
U.S. firm at an annual rate of 7 percent. The remaining $100 million was invested in a one-
year Brazilian government bond paying an annual interest rate of 8 percent. The exchange
rate at the time of the transaction was Brazilian real 0.50/$1.

 What will be the net return on this $200 million investment in bonds if the exchange
rate between the Brazilian real and the U.S. dollar remains the same?
 What will be the net return on this $200 million investment if the exchange rate
changes to real 0.4167/$1?
 What will be the net return on this $200 million investment if the exchange rate
changes to real 0.625/$1?

Answers:
Brazilian bonds issued in reals = $100m/0.50 = Real 200m
Cost of funds= 0.065 x $200 million = $13,000,000
Return on U.S. loan= 0.07 x $100 million= $7,000,000
Return on Brazilian bond =(0.08 x Real 200m) x 0.50 = $8,000,000
Total interest earned= $15,000,000
Net return on investment = ($15 million - $13 million)/$200 million = 1.00 percent.

Cost of funds = 0.065 x $200 million = $13,000,000

Return on U.S. loan = 0.07 x $100 million= $7,000,000
Return on Brazilian bond = (0.08 x Real 200m) x 0.4167= $6,667,200
Total interest earned= $13,667,200
Net return on investment = $13,666,667 - $13,000,000/$200,000,000 = 0.33 percent.

Consideration should be given to the fact that the Brazilian bond was for Real 200 million.
Thus, at maturity the bond will be paid back for Real200 million x 0.4167 = $83,340,000.
Therefore, the strengthening dollar will have caused a loss in capital ($16,660,000) that far
exceeds the interest earned on the Brazilian bond. Including this capital loss, the net return
on investment is:
Net return on investment = ($13,666,667 - $13,000,000 -$16,666,667))/$200,000,000 = -8%

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Cost of funds =0.065 x $200 million = $13,000,000

Return on U.S. loan = 0.07 x $100 million= $7,000,000
Return on Brazilian bond = (0.08 x Real 200m) x 0.625= $10,000,000
Total interest earned= $17,000,000
Net return on investment = $17,000,000 - $13,000,000/$200,000,000 = 2.00 percent.

Consideration should be given to the fact that the Brazilian bond was for Real200 million.
Thus, at maturity the bond will be paid back for Real200 million x 0.625 = $125,000,000.
Therefore, the strengthening real will have caused a gain in capital of $25,000,000 in
addition to the interest earned on the Brazilian bond. Including this capital loss, the net return
on investment is:

Net return on investment = ($17,000,000 - $13,000,000 + $25,000,000)/$200,000,000 =

14.50%

Question 13.11
Sun Bank USA purchased a 16 million one-year euro loan that pays 12 percent interest
annually. The spot rate of U.S. dollars per euro is 1.25. Sun Bank has funded this loan by
accepting a British pound-denominated deposit for the equivalent amount and maturity at an
annual rate of 10 percent. The current spot rate of U.S. dollars per British pound is 1.60.

 What is the net interest income earned in dollars on this one-year transaction if the
spot rates of U.S. dollars per euro and U.S. dollars per British pound at the end of the
year are 1.35 and 1.70?
 What should be the spot rate of U.S. dollars per British pound at the end of the year
in order for the bank to earn a net interest margin of 4 percent?
 Does your answer to part (b) imply that the dollar should appreciate or depreciate
against the pound?
 What is the total effect on net interest income and principal of this transaction given
the end-of-year spot rates in part (a)?

Answers:

Loan amount = €16 million x 1.25 = $20.0 million

Deposit amount = $20.0m/1.60 = £12,500,000
Interest income at the end of the year = €16m x 0.12 = €1.92m x 1.35 = $2,592,000
Interest expense at the end of the year = £12,500,000 x 0.10 = £1,250,000 x 1.70 =
$2,125,000
Net interest income = $2,592,000 - $2,125,000 = $290,000

A net interest margin of 4 percent would imply $20,000,000 x 0.04 = $800,000.

The net cost of deposits should be $2,592,000 - 800,000 = $1,792,000.
Pound rate = $1,792,000/£1,250,000 = $1.4336/£1.
Thus, the pound should be selling at $1.4336/£1 in order for the bank to earn 4 percent.

The dollar should depreciate against the pound. Each pound gives fewer dollars.

Interest income and loan principal at year-end = (€16m x 1.12) x 1.35 = $24,192,000
Interest expense and deposit principal at year-end = (£12.5m x 1.10) x 1.70 = $23,375,000
Total income = $24,192,000 - $23,375,000 = $817,000

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Question 13.12
Bank USA just made a one-year $10 million loan that pays 10 percent interest annually. The
loan was funded with a Swiss franc-denominated one-year deposit at an annual rate of 6
percent. The current spot rate is SF1.05/$1.

 What will be the net interest income in dollars on the one-year loan if the spot rate at
the end of the year is SF1.03/$1?
 What will be the net interest return on assets?
 What is the total effect on net interest income and principal of this transaction given
the end-of-year spot rates in part (a)?
 How far can the SF/$ appreciate before the transaction will result in a loss for Bank
USA?

Answers:

Swiss deposit account issued in SF = $10m x 1.05 = SF10.5m

Interest income at year-end = $10m x 0.10 = $1,000,000
Interest expense at year-end = (SF10,500,000 x 0.06)/1.03 = SF630,000/1.03 = $611,650.49
Net interest income = $1,000,000 - $611,650.49 = $388,349.51

Net interest return on assets = $388,349.51/$10,000,000 = 0.0388 or 3.88 percent.

Interest income and loan principal at year-end = $10m x 1.10 = $11,000,000.

Interest expense and deposit principal at year-end = (SF10,500,000 x 1.06)/1.03
= SF11,130,000/1.03 = $10,805,825.24
Total income = $11,000,000 - $10,805,825.24 = $194,173.76

Interest expense and deposit principal at year-end = (SF10,500,000 x 1.06)/SF/$

$11,000,000 => SF/$ = SF11,130,000/11,000,000 = 1.01182

Question 13.13
What motivates FIs to hedge foreign currency exposures? What are the limitations to
hedging foreign currency exposures?

Answer:

FIs hedge to manage their exposure to currency risks, not to eliminate it. As in the case of
interest rate risk exposure, it is not necessarily an optimal strategy to completely hedge
away all currency risk exposure. By its very definition, hedging reduces the FI's risk by
reducing the volatility of possible future returns. This narrowing of the probability distribution
of returns reduces possible losses, but also reduces possible gains (i.e., it shortens both tails
of the distribution). A hedge would be undesirable, therefore, if the FI wants to take a
speculative position in a currency in order to benefit from some information about future
currency rate movements. The hedge would reduce possible gains from the speculative
position.

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Question 13.14
What are the two primary methods of hedging FX risk for an FI? What two conditions are
necessary to achieve a perfect hedge through on-balance-sheet hedging? What are the
advantages and disadvantages of off-balance-sheet hedging in comparison to on-balance-
sheet hedging?

Answer:

The manager of an FI can hedge using on-balance-sheet techniques or off-balance-sheet

techniques. On-balance-sheet hedging requires matching currency positions and durations
of assets and liabilities. If the duration of foreign-currency-denominated fixed rate assets is
greater than similar currency denominated fixed rate liabilities, the market value of the
assets could decline more than the liabilities when market rates rise and therefore the hedge
will not be perfect. Thus, in matching foreign currency assets and liabilities, not only do they
have to be of the same currency, but also of the same duration in order to have a perfect
hedge.

Advantages of off-balance-sheet FX hedging:

The use of off-balance-sheet hedging devices, such as forward contracts, enables an FI to
reduce or eliminate its FX risk exposure without forfeiting potentially lucrative transactions.
On-balance-sheet transactions result in immediate cash flows, whereas off balance-sheet
transactions result in contingent future cash flows. Therefore, the up-front cost of hedging
using off-balance-sheet instruments is lower than the cost of on-balance-sheet transactions.
Moreover, since on-balance-sheet transactions are fully reflected in financial statements,
there may be additional disclosure costs to hedging on the balance sheet.

Off-balance-sheet hedging instruments have been developed for many types of risk
exposures. For currency risk, forward contracts are available for the majority of currencies at
a variety of delivery dates. Moreover, since the forward contract is negotiated over the
counter, the counterparties have maximum flexibility to set terms and conditions.

Disadvantages of off-balance-sheet FX Hedging:

There is some credit risk associated with off-balance-sheet hedging instruments since there
is some possibility that the counterparty will default on its obligations. This credit risk
exposure is exacerbated in negotiated markets such as the forward market, but mitigated for
exchange-traded hedging instruments such as futures contracts.

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Question 13.15
Suppose that a U.S. FI has the following assets and liabilities:

The promised one-year U.S. CD rate is 5 percent, to be paid in dollars at the end of the year;
the one-year, default risk–free loans in the United States are yielding 6 percent; and default
risk–free one-year loans are yielding 12 percent in the United Kingdom. The exchange rate
of dollars for pounds at the beginning of the year is $1.6/£1.

 Calculate the dollar proceeds from the UK investment at the end of the year, the
return on the FI’s investment portfolio, and the net interest margin for the FI if the
spot foreign exchange rate has not changed over the year.
 Calculate the dollar proceeds from the UK investment at the end of the year, the
return on the FI’s investment portfolio, and the net interest margin for the FI if the
spot foreign exchange rate falls to $1.45/£1 over the year.
 Calculate the dollar proceeds from the UK investment at the end of the year, the
return on the FI’s investment portfolio, and the net interest margin for the FI if the
spot foreign exchange rate rises to $1.70/£1 over the year.

Answers:

At the beginning of the year, the FI sells $100 million for pounds on the spot currency
markets at an exchange rate of $1.60 to £ => $100 million/1.60 = £62.5 million.

At the end of the year, pound revenue from these loans will be £62.5(1.12) = £70 million.

Then the dollar proceeds from the U.K. investment are:

£70 million x $1.60/£1 = $112 million or as a return

$112 million − $100 million

= $12.00%
$100 million

Given this, the weighted return on the FI’s portfolio of investments would be:

(0.5)(0.06) + (0.5)(0.12) = 0.09, or 9%

This exceeds the cost of the FI’s CDs by 4 percent (9% - 5%).

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At the end of the year, pound revenue from these loans will be £62.5(1.12) = £70 million.

Then the dollar proceeds from the U.K. investment are:

£70 million x $1.45/£1 = $101.5 million or as a return

$101.5 million − $100 million

= 1.50%
$100 million

Given this, the weighted return on the FI’s portfolio of investments would be:

(0.5)(0.06) + (0.5)(0.0150) = 0.0375, 3.75%

In this case, the FI actually has a loss or a negative interest margin (3.75% - 5% = -1.25%)
on its balance sheet investments.

At the end of the year, pound revenue from the loans will be £62.5(1.12) = £70 million.

Then the dollar proceeds from the U.K. investment are:

£70 million x $1.70/£1 = $119 million or as a return

$119 million − $100 million

= 19.00%
$100 million

Given this, the weighted return on the FI’s portfolio of investments would be:

(0.5)(0.06) + (0.5)(0.19) = 0.1250, or 12.50%

This exceeds the cost of the FI’s CDs by 7.5 percent (12.5% - 5%).

Question 13.16
Suppose that instead of funding the $100 million investment in 12 percent British loans with
U.S. CDs, the FI manager in problem 15 funds the British loans with $100 million equivalent
one-year pound CDs at a rate of 8 percent. Now the balance sheet of the FI would be as
follows:

 Calculate the return on the FI’s investment portfolio, the average cost of funds, and
the net interest margin for the FI if the spot foreign exchange rate falls to $1.45/£1
over the year.
 Calculate the return on the FI’s investment portfolio, the average cost of funds, and
the net interest margin for the FI if the spot foreign exchange rate rises to $1.70/£1
over the year.

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Answers:

As in part b in question 15, when the pound falls in value to $1.45/£1 at the end of the year,
pound revenue from the British loans is be £62.5(1.12) = £70 million.

Then the dollar proceeds from the U.K. investment are:

£70 million x $1.45/£1 = $101.5 million or as a return

$101.5 million − $100 million

= 1.50%
$100 million

and the weighted return on the FI’s portfolio of investments would be:

(0.5)(0.06) + (0.5)(0.0150) = 0.0375, 3.75%

On the liability side of the balance sheet, at the beginning of the year, the FI borrows $100
million equivalent in pound CDs for one year at a promised interest rate of 11 percent. At an
exchange rate of $1.60/£1, this is a pound equivalent amount of borrowing of $100
million/1.6 = £62.5 million.

At the end of the year, the FI must pay the pound CD holders their principal and interest,
£62.5 million (1.08) = £67.50 million.

If the pound falls to $1.45/£1 over the year, the repayment in dollar terms would be

£67.50 million x $1.45/£1 = $97.875 million or as a return

$97.875 million − $100 million

= −2.125%
$100 million

Thus, at the end of the year,

Average cost of funds:

(0.5)(0.05) + (0.5)(−0.02125) = 0.014375 = 1.4375%

Net return:

Average return on assets - Average cost of funds

3.75% − 1.4375% = 2.3125%

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As in part c in question 15, when the pound rises in value to $1.70/£1 at the end of the year,
pound revenue from the British loans is be £62.5(1.12) = £70 million.

Then the dollar proceeds from the U.K. investment are:

£70 million x $1.70/£1 = $119 million or as a return

$119 million − $100 million

= 19.00%
$100 million

and the weighted return on the FI’s portfolio of investments would be:

(0.5)(0.06) + (0.5)(0.19) = 0.1250, 12.50%

On the liability side of the balance sheet, at the beginning of the year, the FI borrows $100
million equivalent in pound CDs for one year at a promised interest rate of 11 percent. At an
exchange rate of $1.60/£1, this is a pound equivalent amount of borrowing of $100
million/1.6 = £62.5 million.

At the end of the year, the FI must pay the pound CD holders their principal and interest,
£62.5 million (1.08) = £67.50 million.

If the pound increases to $1.70/£1 over the year, the repayment in dollar terms would be

£67.50 million x $1.70/£1 = $114.75 million or as a return

$114.75 million − $100 million

= 14.75%
$100 million

Thus, at the end of the year,

Average cost of funds:

(0.5)(0.05) + (0.5)(0.1475) = 0.09875 = 9.875%

Net return:

Average return on assets - Average cost of funds

12.50% − 9.875% = 2.625%

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Question 13.17
Suppose that instead of funding the $100 million investment in 12 percent British loans with
CDs issued in the United Kingdom, the FI manager in problem 16 hedges the foreign
exchange risk on the British loans by immediately selling its expected one-year pound loan
proceeds in the forward FX market. The current forward one-year exchange rate between
dollars and pounds is $1.53/£1.

 Calculate the return on the FI’s investment portfolio (including the hedge) and the net
interest margin for the FI over the year.
 Will the net return be affected by changes in the dollar for pound spot foreign
exchange rate at the end of the year?

Answers:

The U.S. FI sells $100 million for pounds at the spot exchange rate today and receives $100
million/1.6 = £62.5 million. The FI then immediately lends the £62.5 million to a British
customer at 12 percent for one year.

The FI also sells the expected principal and interest proceeds from the pound loan forward
for dollars at today’s forward rate for one-year delivery.

This means that the forward buyer of pounds promises to pay:

£62.5 million (1.12) x $1.53/£1 = £70 million x $1.53/£1 = $107.1 million

to the FI (the forward seller) in one year when the FI delivers the £70 million proceeds of the
loan to the forward buyer.

In one year, the British borrower repays the loan to the FI plus interest in pounds (£70
million).

The FI delivers the £70 million to the buyer of the one-year forward contract and receives the
promised $107.1 million.

The FI knows from the very beginning of the investment period that it has locked in a
guaranteed return on the British loan of:

$107.10m − $100m
= 0.0710 = 7.10%
$100m

Given this return on British loans, the overall expected return on the FI’s asset portfolio is:
(0.5)(0.06) + (0.5)(0.0710) = 0.0655, 6.55%

Net return:
Average return on assets - Average cost of funds
6.55% − 5.00% = 1.55%

The net return is fully hedged against any dollar/pound exchange rate changes over the one-
year holding period of the loan investment. By selling the expected proceeds on the pound
loan forward, at a known (forward FX) exchange rate today, the FI removes the future spot
exchange rate uncertainty and thus, the uncertainty relating to investment returns on the
British loan.

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Question 13.18
Suppose that a U.S. FI has the following assets and liabilities:

The promised one-year U.S. CD rate is 4 percent, to be paid in dollars at the end of the year;
the one-year, default risk–free loans in the United States are yielding 6 percent; and default
risk–free one-year loans are yielding 10 percent in Germany. The exchange rate of dollars
for euros at the beginning of the year is $1.25/€1.

 Calculate the dollar proceeds from the German loan at the end of the year, the return
on the FI’s investment portfolio, and the net interest margin for the FI if the spot
foreign exchange rate has not changed over the year.
 Calculate the dollar proceeds from the German loan at the end of the year, the return
on the FI’s investment portfolio, and the net interest margin for the FI if the spot
foreign exchange rate falls to $1.15/€1 over the year.
 Calculate the dollar proceeds from the German loan at the end of the year, the return
on the FI’s investment portfolio, and the net interest margin for the FI if the spot
foreign exchange rate rises to $1.35/€1 over the year.

Answers:

At the beginning of the year, the FI sells $200 million for euros on the spot currency markets
at an exchange rate of $1.25 to € => $200 million/1.25 = €160 million.

At the end of the year, euro revenue from these loans will be €160(1.10) = €176 million.

Then the dollar proceeds from the German loan are:

€176 million x $1.25/€1 = $220 million or as a return
$220 million − $200 million
= 10%
$200million

Given this, the weighted return on the FI’s portfolio of investments would be:
(300m/500m)(0.06) + (200m/500m)(0.10) = 0.076, or 7.60%

This exceeds the cost of the FI’s CDs by 3.6 percent (7.6% - 4%).

At the end of the year, euro revenue from these loans will be €160(1.10) = €176 million.

Then the dollar proceeds from the German loan are:

€176 million x $1.15/€1 = $202.4 million or as a return

$202.4 million − $200 million

= 1.20%
$200million

45
.

Given this, the weighted return on the FI’s portfolio of investments would be:
(300m/500m)(0.06) + (200m/500m)(0.0120) = 0.0408, or 4.08%

This exceeds the cost of the FI’s CDs by 0.08 percent (4.08% - 4% = 0.08%).

At the end of the year, euro revenue from the loans will be €160(1.10) = €176 million.

Then the dollar proceeds from the German loan are:

€176 million x $1.35/€1 = $237.6 million or as a return
$237.6 million − $200 million
= 18.8%
$200 million

Given this, the weighted return on the FI’s portfolio of investments would be:
(300m/500m)(0.06) + (200m/500m)(0.188) = 0.1112, or 11.12%

This exceeds the cost of the FI’s CDs by 7.12 percent (11.12% - 4%).

Question 13.19
Suppose that instead of funding the $200 million investment in 10 percent German loans
with U.S. CDs, the FI manager in problem 18 funds the German loans with $200 million
equivalent one-year euro CDs at a rate of 7 percent. Now the balance sheet of the FI would
be as follows:

Calculate the return on the FI’s investment portfolio, the average cost of funds, and the net
interest margin for the FI if the spot foreign exchange rate falls to $1.15/€1 over the year.

As in part b in question 18, when the euro falls in value to $1.15/€1 at the end of the year,
euro revenue from the German loans is be €160(1.10) = €176 million.

Then the dollar proceeds from the German loan are:

€176 million x $1.15/€1 = $202.4 million or as a return
$202.4 million − $200 million
= 1.20%
$200 million

and the weighted return on the FI’s portfolio of investments would be:
(300m/500m)(0.06) + (200m/500m)(0.0120) = 0.0408, or 4.08%

On the liability side of the balance sheet, at the beginning of the year, the FI borrows $200
million equivalent in euro CDs for one year at a promised interest rate of 7 percent. At an
exchange rate of $1.25/€1, this is a euro equivalent amount of borrowing of $200 million/1.25
= €160 million.

At the end of the year, the FI must pay the pound CD holders their principal and interest,
€160 million (1.07) = €171.20 million.

46
.

If the euro falls to $1.15/€1 over the year, the repayment in dollar terms would be

€171.20 million x $1.15/€1 = $196.88 million or as a return

$196.88 million − $200 million
= 1.56%
$200 million

Thus, at the end of the year,

Average cost of funds:
(300m/500m)(0.04) + (200m/500m)(−0.0156) = 0.01776, or 1.776%

Net return:
Average return on assets - Average cost of funds
4.08% − 1.776% = 2.304%

As in part c in question 18, when the euro rises in value to $1.35/€1 at the end of the year,
euro revenue from the German loans is be €160(1.10) = €176 million.

Then the dollar proceeds from the German loan are:

€176 million x $1.35/€1 = $237.6 million or as a return

$237.6 million − $200 million
18.80%
$200 million

and the weighted return on the FI’s portfolio of investments would be:
(300m/500m)(0.06) + (200m/500m)(0.188) = 0.112, or 11.20%

On the liability side of the balance sheet, at the beginning of the year, the FI borrows $200
million equivalent in euro CDs for one year at a promised interest rate of 7 percent. At an
exchange rate of $1.25/€1, this is a euro equivalent amount of borrowing of $200 million/1.25
= €160 million.

At the end of the year, the FI must pay the pound CD holders their principal and interest,
€160 million (1.07) = €171.20 million.

If the euro increases to $1.35/€1 over the year, the repayment in dollar terms would be
€171.20 million x $1.35/€1 = $231.12 million or as a return

$231.12 million − $200 million

= 15.56%
$200 million
Thus, at the end of the year,
Average cost of funds:

(300m/500m)(0.04) + (200m/500m)(0.1556) = 0.08624, or 8.624%

Net return:
Average return on assets - Average cost of funds

11.2% − 8.624% = 2.576%

47
.

Question 13.20
Suppose that instead of funding the $200 million investment in 10 percent German loans
with CDs issued in Germany, the FI manager in problem 19 hedges the foreign exchange
risk on the German loans by immediately selling its expected one-year euro loan proceeds in
the forward FX market. The current forward one-year exchange rate between dollars and
euros is $1.20/€1.

 Calculate the return on the FI’s investment portfolio (including the hedge) and the net
interest margin for the FI over the year.

 Will the net return be affected by changes in the dollar for euro spot foreign exchange
rate at the end of the year?

Answers:

The U.S. FI sells $200 million for pounds at the spot exchange rate today and receives $200
million/1.25 = €160 million. The FI then immediately lends the €160 million to a German
customer at 10 percent for one year.

The FI also sells the expected principal and interest proceeds from the euro loan forward for
dollars at today’s forward rate for one-year delivery.

This means that the forward buyer of euros promises to pay:

€160 million (1.10) x $1.20/€1 = €176 million x $1.20/€1 = $211.2 million

to the FI (the forward seller) in one year when the FI delivers the €176 million proceeds of
the loan to the forward buyer.

In one year, the German borrower repays the loan to the FI plus interest in euros (€176
million).

The FI delivers the €176 million to the buyer of the one-year forward contract and receives
the promised $211.2 million.

The FI knows from the very beginning of the investment period that it has locked in a
guaranteed return on the German loan of:
$211.20m − $200m
== 0.0560 = 5.60%
$200m

Given this return on British loans, the overall expected return on the FI’s asset portfolio is:
(300m/500m)(0.06) + (200m/500m)(0.0560) = 0.0584, or 5.84%

Net return:
Average return on assets - Average cost of funds
5.84% − 4.00% = 1.84%

The net return is fully hedged against any dollar/euro exchange rate changes over the one-
year holding period of the loan investment. By selling the expected proceeds on the euro
loan forward, at a known (forward FX) exchange rate today, the FI removes the future spot
exchange rate uncertainty and thus, the uncertainty relating to investment returns on the
German loan.

48
.

P1.T3. Financial Markets & Products

Chapter 10. Pricing Financial Forwards and Futures

Bionic Turtle FRM Study Notes

.

CHAPTER 10. PRICING FINANCIAL FORWARDS AND FUTURES .................................... 3

DIFFERENTIATE BETWEEN INVESTMENT AND CONSUMPTION ASSETS ........................................... 3
DEFINE SHORT‐SELLING AND CALCULATE THE NET PROFIT OF A SHORT SALE OF A DIVIDEND-PAYING
STOCK ....................................................................................................................................... 4
DESCRIBE THE DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS AND EXPLAIN THE
RELATIONSHIP BETWEEN FORWARD AND SPOT PRICES ................................................................ 4
CALCULATE THE FORWARD PRICE GIVEN THE UNDERLYING ASSET’S SPOT PRICE AND DESCRIBE AN
ARBITRAGE ARGUMENT BETWEEN SPOT AND FORWARD PRICES .................................................... 8
DISTINGUISH BETWEEN THE FORWARD PRICE AND THE VALUE OF A FORWARD CONTRACT. .......... 10
CALCULATE THE VALUE OF A FORWARD CONTRACT ON A FINANCIAL ASSET THAT DOES OR DOES
NOT PROVIDE INCOME OR YIELD ................................................................................................ 12
EXPLAIN THE RELATIONSHIP BETWEEN FORWARD AND FUTURES PRICES .................................... 13
CALCULATE A FORWARD FOREIGN EXCHANGE RATE USING THE INTEREST RATE PARITY
RELATIONSHIP. ........................................................................................................................ 14
CALCULATE THE VALUE OF A STOCK INDEX FUTURES CONTRACT AND EXPLAIN THE CONCEPT OF
INDEX ARBITRAGE. .................................................................................................................. 16
CHAPTER SUMMARY ............................................................................................................... 18
QUESTIONS & ANSWERS: ....................................................................................................... 19

2
.

Chapter 10. Pricing Financial Forwards and Futures

 Differentiate between investment and consumption assets.

 Define short-selling and calculate the net profit of a short sale of a dividend-paying
stock.

 Describe the differences between forward and futures contracts and explain the
relationship between forward and spot prices.

 Calculate the forward price given the underlying asset’s spot price and describe
an arbitrage argument between spot and forward prices.

 Distinguish between the forward price and the value of a forward contract.

 Calculate the value of a forward contract on a financial asset that does or does not
provide income or yield.

 Explain the relationship between forward and futures prices.

 Calculate a forward foreign exchange rate using the interest rate parity
relationship.

 Calculate the value of a stock index futures contract and explain the concept of
index arbitrage.

Differentiate between investment and consumption assets

An investment asset is held for investment purposes by a significant number of
investors; e.g., stocks, bonds, gold, silver, ETFs. Further, it’s convenience yield must be
zero.

A consumption asset is held primarily for consumption and it tends to confer a

convenience yield; e.g., copper, oil, pork bellies, gold, silver. Gold and silver, which are
both used for industrial applications as well as a store of value are examples of commodities
that are both investment and consumption assets.

Investment Assets Consumption Assets

[Theory] No-arbitrage implies that the Because of convenience yield, storage
forward price is a function of the spot cost and the lease rate, the forward price
price and any dividends paid. is not a simple function of spot.

3
.

Define short‐selling and calculate the net profit of a short sale of a

dividend-paying stock.
In a short sale, the investor wants to profit from a decline in the price of the security.
 Shorting involves selling an asset that is not owned. So, the short-seller borrows
shares of stock from the broker in order to sell the shares.
 An investor with a short position must pay to the broker any income, such as
dividends or interest, that would normally be received on the securities that have
been shorted.
 Subsequently, the short-seller purchases the shares in order to replace the borrowed
shares. This is known as covering the short position and it effectively cancels out the
short position with the stocks bought.
 However, the short-seller can experience what is known as a short squeeze. In a
short-squeeze, the contract is open, the broker runs out of shares to borrow, and the
investor is forced to cover, i.e., close out the position.
Example: Consider an investor who shorts 500 shares when the price per share is $120.
Suppose that a dividend of $1 per share is paid in a month’s time after the short sale. The
position is closed by buying back the shares in 2 months when the price per share is $100.
The net profit calculation is shown in the table below.

Time Short sale Calculation Cash Flow

0 Borrow shares, Sell shares + (500 * 120) + 60,000
1 Pay dividend - (500 * 1) - 500
2 Buy shares to close short position - (500 * 100) - 50,000
Net Profit + 9,500

Describe the differences between forward and futures contracts

and explain the relationship between forward and spot prices
Differences between forward and futures contracts
While both forwards and futures are agreements to buy or sell an asset in the future (at a
pre-determined price), a forward contract is traded over-the-counter (OTC) and is not
standardized.

The futures contract is traded on an exchange, and has standardized contract

specifications. The futures position is also often closed out before maturity, rather than
physically delivered.

Forward Futures
Trades over-the-counter Trades on an exchange
Not standardized Standardized contracts
One specified delivery date Range of delivery dates
Settled at the end of a contract Settled daily
Delivery or final cash settlement Contract usually closed prior to
usually occurs maturity

4
.

The relationship between forward and spot prices

Notation: The following notations apply to forward contracts:

Time until delivery date in a forward/futures contract (in years)

Price of the underlying asset (spot price)
Today’s forward or futures price
Forward value of a contract
Delivery price
Risk-free rate—annual rate but expressed with continuous compounding
Foreign risk-free interest rate
Present value of income received from asset (in dollar terms)
Dividend yield rate (in percentage terms; e.g., 2% dividend yield)
, Storage cost. = dollar cost and = cost in % terms
Convenience yield

Forward price given by the Cost of Carry Model

The cost-of-carry model sets the futures price as a function of the spot price. The
futures price ( ) equals the spot price ( ) compounded at the cost of carry ( ).

The cost of carry is the interest rate ( , required to finance the asset) plus the storage cost
( / ) of the asset less any income ( / ) earned on the asset, less any convenience yield ( )
gained by the asset.
 For a non-dividend-paying investment asset (when asset has no storage cost)
the futures price is essentially similar to forward prices. The generalized forward price
( ) is either case (futures or forwards) is given as:
=
 If the investment asset provides income (e.g., a stock that pays dividends) in the
form of interim cash flows, where which equals the present value of the cash flows
received, or in the form of dividend yields expressed as a constant percentage of the
spot price ( ), then
=( − ) or = −

 A foreign currency can be regarded as an investment asset paying a known yield,

which is the foreign risk-free interest rate of and is priced as follow. This is known
as interest rate parity (IRP) such that IRP is a version of the cost of carry model:
( − )
=
 For consumption assets, which have a storage cost and produces a
convenience yield: if is the convenience yield shown as a constant percentage of
the spot price, and is the storage cost given as a constant percentage or is the
lump-sum dollar storage cost, then:
=( + U− ) or = + −

5
.

As the chart below shows:

 Storage costs increase the value of the forward contract and is offset by any
convenience yield.
 Risk-free rate is the cost of financing and increases the value of the forward contract;
it works in the opposite direction income (or dividends for a financial asset).

In summary, the cost of carry links the spot price to the forward price:

6
.

So far, we saw the relationship between the spot prices and the initial forward price at the
time the contract is entered. Now let us see how the forward contract’s value changes as
time passes.

Value of a forward contract

When a forward contract is first entered into, it has no value1 because when first negotiated,
the delivery price, , equals the forward price . Only as time passes and when the forward
price change does the forward contract gain or lose value.
 A long forward contract provides a payoff at time of − with present value of:
= ( − )
 As = , the value of a long forward contract for an asset with no income is:
= −
 This equation is extended to give the value of long forward contract with income as:
= − − or = −

Examples:
 A stock’s price today is $50.00. The stock will pay a $1.00 dividend (2%) in six
months. The risk-free rate is 5.0% for all maturities. What is the price of a (long)
forward contract, , to purchase the stock in one year?
Answer:
=( − )
= [50 − (1) (− 0.05)(6/12) ] (0.05)(1) = $51.538
 A long forward contract on a non-dividend-paying stock has three months left to
maturity. The delivery price is $8 and the stock price is $10. Also, the risk-free rate is
5%. Find the price of the forward contract and its value at maturity.
The forward price (because t = 0.25 or one-fourth of a year) is given by:
= = 10 (5% )(0.25) = 10.126
And the value of the forward contract is given by:
= (10.126− 8 ) (− 5% )(0.25) = 2.10

1
Strictly speaking, we are here referring to the objective value using risk-neutral, or objective, probabilities. Using subjective
probabilities, this contract does have value to both parties, or it would not have been entered into: both parties expect some
benefit. This is a subtle but important general concept.

7
.

Calculate the forward price given the underlying asset’s spot price
and describe an arbitrage argument between spot and forward
prices.
Calculate the forward price given the spot price
The following exhibit locates several cost-of-carry examples together into the same template
(one textbook example per column).

IMPORTANT CONCEPT:

Each of the “four forces” are represented. Interest rate and storage costs increase the
price of the forward; dividend and convenience decrease the price of the forward.

Table: Calculation of forward prices given the underlying spot prices

From the spot forward relationship equations discussed in the previous section, the forward
prices as shown in the above table are calculated as:

Sec 5.4: Asset with no income = 40 (5% ∗0.25) = $40.50

Ex 5.1: Zero coupon bond = 930 (6% ∗0.
3 3) = $948.79
Ex 5.2: Stock paying income =( − ) (50− 2.16 2) (8% ∗0. 83 ) = $51.14
Ex 5.3: Asset with yield income = − 25 (10% − 3.96% )∗0. 5 = $25.77
Ex 5.4: Forward value of stock = − 25 10% ∗0. 5 = $26.28
Ex 5.5: Index with dividend yield = − 1300 (5%− 1% 25
)∗0. = $1313.77
Ex 5.6: Currency forward − 0.98 (1%− 3% )∗2 = $0.94
=
Ex 5.8: Asset with storage costs = ( + U) (450 + 1.865) (7% ∗1 )= $484.63

8
.

Arbitrage argument between spot and forward prices

Consider a long forward contract to purchase a non-dividend-paying stock in 3 months. If the
stock price is $40 and risk-free interest rate is 5% per annum, then its forward price
according to the cost of carry model is 40 (5% ∗3/12) = $40. 50 .

If the forward prices vary from this value, then arbitrage opportunities arise, which can be
exploited to earn a riskless profit as shown in the two scenarios below.

Table: Arbitrage opportunities for asset providing no income

Forward Price = $43 Forward Price = $39

Action now: Action now:
 Borrow $40 at 5% for 3 months to  Short 1 unit of asset to realize $40
buy one unit of asset and invest it at 5% for 3 months
 Enter into forward contract to sell  Enter into a forward contract to buy
asset in 3 months for $43 asset in 3 months for $39
Action in 3 months: Action in 3 months:
 Sell asset for $43  Buy asset for $39 to cover short
position
 Use $40.50 to repay loan with
interest  Receive $40.50 from investment
Profit realized = $1.50 Profit realized = $1.50

9
.

Distinguish between the forward price and the value of a forward

contract.
Calculate the value of a forward contract on a financial asset that
does or does not provide income or yield.
When a forward contract on a financial asset is first entered, its forward price is calculated
as:

F = (S – I) (1 +R)T

where I is the present value of the Income from the asset.

However, the value of the forward contract itself is zero (or very close to zero). If this were
not so, one party would require a payment from the other at the outset (akin to the premium
paid for options). Forward contracts are normally structured so that there is no such
payment. As time passes, however, the asset price changes and the value of the forward
contract may become positive or negative. While the value of the contract changes, the price
at which the asset will be eventually bought or sold continues to equal the original forward
price.

Suppose that we are valuing a long forward contract to buy an asset for price K. We assume
this is not a new contract, but rather one entered some time ago. The value of the contract
depends on movements in the price of the underlying asset and can be positive or negative.
We can value the contract by comparing it with a similar contract that could be entered
today. Define K as the forward price at the time the contract was originally entered, F as
the current forward price for the contract, and T as the contract’s current time to
maturity.

The two different forward contracts we consider are:

 A forward contract to buy the asset for price K at time T (the contract we are
interested in valuing), and
 A forward contract to buy the asset for price F at time T (a contract that could be
entered today).

The only difference between these two contracts lies in the price paid at time T. The value of
the second contract minus the value of the first contract is the present value of F – K (which
can be positive or negative.) However, the second contract is worth zero because it is
entered at the current forward price. Therefore, the first contract is worth the present value of
F – K. Specifically:

Value of Long Forward Contract = ( )

Similarly,

Value of Short Forward Contract = - ( )

=( )

These equations are true for all the forward contracts on all assets (not just the financial
assets).

In case of financial assets, for an asset providing no income, F can be substituted for

10
.

( )
Value of Long Forward Contract = ( )
= −( )

When an income with a present value of I is to be paid during the remaining life of the
forward contract:

( )( )
Value of Long Forward Contract = ( )
= − −( )

When a yield at rate Q is provided

( )
( )
Value of Long Forward contract = ( )
=( )
−( )

Example: Let the asset price be 70 USD, there is no income, and the one-year interest rate
is 5%. The current no-arbitrage forward price is USD 73.50. Some time ago a long forward
contract was entered to buy the asset at USD 78.

Now, the value of contract = 70 − .

= − 4.
286

11
.

12
.

Explain the relationship between forward and futures prices

If the risk-free rate, , is constant across all maturities, then the forward price should
equal the futures price (forward = futures price). When asset price increases, an investor
who holds a long futures position makes an immediate gain because of the daily settlement
procedure. Also, if the interest rates are higher, the gain will tend to be invested at a higher
than average rate of interest. Therefore, when there is a correlation between the underlying
asset (S) and interest rates,
 If the correlation is strongly positive: futures > forward:
 If the correlation is strongly negative: futures < forward
The other factor relates to contract life:
 For short contracts, price differences should be negligible
 For long contracts (e.g., 10 year Eurodollar futures), the price difference can be
significant

13
.

Calculate a forward foreign exchange rate using the interest rate

parity relationship.
Consider a forward foreign currency contract from the perspective of a US investor. The
underlying asset is one unit of the foreign currency. Let be the current spot price in dollars
of one unit of the foreign currency and the forward or futures price in dollars of one unit of
the foreign currency. A foreign currency has the property that the holder of the currency can
earn interest at the risk-free interest rate ( ) prevailing in the foreign country, while the dollar
risk-free rate is . As illustrated below, if an individual starts with 1,000 units of foreign
currency, there are two ways it can be converted to dollars at future time :
 One is by investing it for years at and entering into a forward contract to sell the
proceeds for dollars at time . This generates 1,000 dollars.
 The other is by exchanging the foreign currency for dollars in the spot market and
investing the proceeds for years at rate . This generates 1,000 dollars.
Figure 5.1: Two ways of converting 1,000 units of a foreign currency to dollars at time T.

In the absence of arbitrage opportunities, the two strategies must give the same result.

, = ,
−
Such that the interest rate parity relationship is implied: =

Hull Example 5.6: Suppose that the 2-year interest rates in Australia and the US are 5.0%
and 7.0%, respectively, and the spot exchange rate between the Australian dollar (AUD) and
the US dollar (USD) is 0.980 USD per AUD.

According to the interest rate parity(IRP) relationship, the forward exchange rate should be:

− ( . − . )×
= = . = .

14
.

In the absence of arbitrage opportunities, the two strategies must be equal

1,000 = 1,000 
. × . ×
1000 × 9416
0. = 1000 × 0.
98  $999.80= $999.80

In case forward exchange rate rates vary from 0.9416, arbitrage opportunities arise. If the 2-
year forward exchange rate is less than this, say 0.9300 to illustrate, an arbitrageur can
 Borrow 1,000 AUD at 3% per annum for 2 years, convert it to $980(1000 × 0.98) and
invest it at 1%. It grows to $999.80 (= 980 . × 2 ) in 2 years.
 Out of this amount, to repay principal and interest on the 1,000 AUD that is borrowed
. ×2
(1,061.84= 1000 ), $987.51 is used to enter in to a forward contract to buy
1,061.84 AUD ($987.51= 1,061.84 × 0. 93). The strategy generates a riskless profit
of $12.29 (=999.80− 987.51 ).
Instead, if the 2-year forward exchange rate is greater than this, say 0.9600, she can:
 Borrow $1,000 at 1% per annum for 2 years, convert it to 1020.41 AUD (1000/ 0.98 )
and invest it at 3%. It grows to 1083.51 AUD (= 1020.41 . × 2 ) in 2 years.
 To repay principal and interest on the borrowed $1,000 (1,020.20= 1000 . ×2
),
enter into forward contract to sell 1083.51 AUD for $1040.17 (1,083.51 × 0. 96). The
strategy gives rise to a riskless profit of $19.97 (=1040.17− 1,020.20 ).

15
.

Calculate the value of a stock index futures contract and explain

the concept of index arbitrage.

Stock Indices

A stock index tracks the value of a hypothetical stock portfolio (i.e., if the value of the
hypothetical portfolio increases by X%, the index also increases by X%). The CME Group
offers exchange trading platforms for futures on several different stock indices. Among these
are the S&P 500 (a portfolio of 500 stocks), the Nasdaq-100 (a portfolio of 100 stocks traded
on the Nasdaq Stock Market), and the Dow Jones Index (a portfolio of 30 large stocks).

The weight of a stock in a portfolio is the percentage of the portfolio invested in the stock. In
the case of the S&P 500 and the Nasdaq-100, the weight of a stock is proportional to its
market capitalization (i.e., its share price multiplied by the number of shares outstanding). In
the case of the Dow Jones Index, the weight is proportional to the share price. The two S&P
500 futures contracts traded on the CME are on USD 50 and USD 250 multiplied by the
index. The two CME futures contracts on the Nasdaq are on USD 20 and USD 100
multiplied by the index. The two CME futures contracts on the Dow Jones are on USD 5 and
USD 10 multiplied by the index. All contracts are settled in cash (rather than by delivering
the portfolio). For example, final settlement of the S&P 500 contract is the opening price of
the S&P 500 on the third Friday of the delivery month.

Similar futures contracts trade actively in other countries. For example, futures on the CSI
300 Index (a market-capitalization weighted portfolio of 300 Chinese stocks) trades on the
China Financial Futures Exchange (CFFEX).

A stock index can be regarded as a financial asset that pays dividends. Because the asset is
the portfolio of stocks underlying the index, the dividends are the dividends received by an
investor holding the portfolio. It is therefore possible to go through the stocks in the portfolio
and estimate the dividend on each to produce the total estimated cash income on the index.

Example: Consider an index that is 2,500 in a situation when the risk-free rate is 5% per
year and the dividend yield is 3% per year (both are assumed to be the same for all
maturities). The futures price for a contract where the final settlement will be in six
months is

.
1.0 5
2500× = 2,52 4
1.03

Index Arbitrage
If F0 > S0e(r-q)T , profits can be made by buying the stocks underlying the index at the spot
price (i.e. for immediate delivery) and shorting futures contracts. If F0 < S0e(r-q)T, profits can
be made by doing the reverse – that is shorting or selling the stocks underlying the index
and taking a long position in the futures contracts. These strategies are known as index
arbitrage.

When F0 < S0e(r-q)T, index arbitrage is often done by a pension fund that owns an indexed
portfolio of stocks. When F0 > S0e(r-q)T, it might be done by a bank or a corporation holding
short-term money market investments. For indices involving many stocks, index arbitrage is

16
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sometimes accomplished by trading a relatively small representative sample of stocks

whose movements closely mirror those of the index. Usually index arbitrage is implemented
through program trading. This involves using a computer system to generate the trades.

17
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Chapter Summary
We distinguish between investment assets and consumption assets.
 The former is held for purposes of investment whereas the latter is held primarily for
consumption.
 Gold and silver are examples of assets that can be thought of as both investment
and consumption assets.
An investor engaged in short selling is hoping to profit from a decline in the price of
the security.
 The short-seller borrows shares of stock from the broker in order to sell the shares.
 The investor then covers his short position by buying the shares in the market to
close out his position.
Forwards and Futures are agreements to buy or sell an asset in the future at a
predetermined price.
 However, a forward contract is traded over-the-counter (OTC) while a futures
contract is standardized and traded on an exchange.
 The forward position will typically take delivery of the underlying while futures are
often closed out before the delivery period.
 The forward and futures prices are the same only if the risk-free interest rate is
constant and the rate curve is flat and if the counterparty (credit) risk on the forward
contract is virtually zero.
The cost-of-carry model sets a futures price as a function of the spot price. Note that
the “four forces” are represented in the general cost-of-carry model.
 Interest rate and storage costs increase the price of the forward.
 Dividends and convenience yield decrease the price of the forward.
 There is also a fifth factor that is sometimes lumped together with convenience
yield: the lease rate. It is important to be clear about the reason a lease payment is
required for a commodity and not for a financial asset.
The value of a forward contract with time to maturity T, risk-free rate r, and dividend
yield q is given by either equation below:

= ( − )

= −

These are equivalent because the second equation replaces the forward price, , with a
spot price that is continuously compounded “forward in time.”
 Normal contango refers to a forward price that is greater than the expected
future spot price:
> [ ]
 Normal backwardation refers to a forward price that is less than the expected
future spot price:
< [ ].

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Questions & Answers:

1. Under what condition should the price of a FORWARD contract equal the price of a
FUTURE contract, if the commodity and specifics of the contracts (e.g., maturity) are
otherwise identical? (Best answer)
a) If the financing cost (r), storage cost (u), income (q) and convenience yield (y) are
identical
b) If the counterparty (credit) risk on the forward contract is virtually zero
c) If the risk-free interest rate is constant and the rate curve is flat
d) If the risk-free interest rate is constant and the rate curve is flat; and if the
counterparty (credit) risk on the forward contract is virtually zero

2. Each of the following is TRUE about the cost of carry approach (model) to pricing
commodity forwards EXCEPT:
a) If the storage cost of a consumption commodity exceeds the risk-free rate, the
forward curve must exhibit contango
b) Forward curve backwardation implies a convenience yield that is greater than the
cost of carry (y > c)
c) The convenience yield is economically like a dividend and therefore like a negative
storage cost
d) A non-dividend-paying stock has a cost of carry equal to the risk-free rate

3. If currency futures are quoted in US dollars per unit of foreign currency, and if foreign
exchange futures prices are increasing with maturity, what does interest rate parity (IRP)
imply?
a) US risk interest rates are greater than foreign interest rates (r > rf)
b) Foreign interest rates and greater than US risk interest rates (rf > r)
c) Spot exchange rates are greater than foreign interest rates
d) Foreign interest rates are greater than spot exchange rates

4. Assume that corn has the following properties: positive storage cost, no convenience
yield, and positive systematic risk (i.e., beta > 0). According to Hull, which is most likely with
respect to, respectively, the observed forward curve (contango = normal; backwardation =
inverted) and the relationship between the futures price, F(0,X), and the expected future spot
price, E[S(X)]?
a) Contango and normal contango
b) Contango and normal backwardation
c) Backwardation and normal contango
d) Backwardation and normal backwardation

5. How many of the following five commodities are INVESTMENT commodities: Oil; Gold;
Copper, Foreign currency (e.g., EUR/USD Futures contract); and S&P 500 Index?
a) One
b) Two
c) Three
d) Four

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Answers

1. D. If the risk-free interest rate is constant and the rate curve is flat; and if the
counterparty (credit) risk on the forward contract is virtually zero
 (C) is a fine answer and faithful to the text: the key theoretical pricing difference,
immaterial at short maturities, is the marginal cash flow volatility implied by the daily
(mark to market) settlement of the futures contract; this difference is a function of the
interest rates at which the marginal cash flows are borrowed/reinvested.
 (D) is better because counterparty risk is another key difference between the
forward and the futures contract.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-164-futures-
contracts-on-investment-consumption-commodities.4534/#post-11864

2. A. Finance cost plus storage (r + u) alone implies contango but convenience yield
might be large enough to induce backwardation; i.e., unclear with convenience yield.

In regard to (B), (C), and (D), each are TRUE.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-165-commodity-

cost-of-carry.4540/#post-29612

3. A. US risk interest rates are greater than foreign interest rates (r > rf).

In regard to (C) and (D), these are meaningless comparison.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-166-interest-rate-

parity-irp.4544/#post-29352

4. B. Contango and normal backwardation

 With respect to the forward curve, per the cost of carry, we observe F(X) =
S(0)*EXP(r + u); i.e., contango.
 With respect to the expected future spot price, positive systematic risk implies normal
backwardation, F(x) < E[S(x)]; i.e., speculators expect a profit as compensation for
assuming the systematic risk
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-167-cost-of-carry-
and-normal-backwardation.4547/#post-26287

5. C. Three (gold, FX, S&P 500). Two are consumption commodities (oil and copper).
oil = consumption; gold = investment; copper = consumption; FX = investment; S&P 500 =
investment

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-164-futures-

contracts-on-investment-consumption-commodities.4534/

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P1.T3. Financial Markets & Products

Chapter 11. Commodity Forwards and Futures

Bionic Turtle FRM Study Notes

.

CHAPTER 11. COMMODITY FORWARDS AND FUTURES .............................................. 3

EXPLAIN THE KEY DIFFERENCES BETWEEN COMMODITIES AND FINANCIAL ASSETS. ................... 3
DEFINE AND APPLY COMMODITY CONCEPTS SUCH AS STORAGE COSTS, CARRY MARKETS, LEASE
RATE, AND CONVENIENCE YIELD ............................................................................................ 5
UPDATED LO: IDENTIFY FACTORS THAT IMPACT PRICES ON AGRICULTURAL COMMODITIES,
METALS, ENERGY, AND WEATHER DERIVATIVES. ..................................................................... 7
PREVIOUS LO: IDENTIFY FACTORS THAT IMPACT GOLD, CORN, ELECTRICITY, NATURAL GAS, AND
OIL FORWARD PRICES ........................................................................................................... 7
EXPLAIN THE BASIC EQUILIBRIUM FORMULA FOR PRICING COMMODITY FORWARDS. ................ 11
DESCRIBE AN ARBITRAGE TRANSACTION IN COMMODITY FORWARDS, AND COMPUTE THE
POTENTIAL ARBITRAGE PROFIT ............................................................................................. 12
DEFINE THE LEASE RATE AND EXPLAIN HOW IT DETERMINES THE NO‐ARBITRAGE VALUES FOR
COMMODITY FORWARDS AND FUTURES. CALCULATE A CONTINUOUS LEASE RATE FOR A
COMMODITY ASSET. ............................................................................................................ 13
DESCRIBE THE COST OF CARRY MODEL AND ILLUSTRATE THE IMPACT OF STORAGE COSTS AND
CONVENIENCE YIELDS ON COMMODITY FORWARD PRICES AND NO-ARBITRAGE BOUNDS.
COMPUTE THE FORWARD PRICE OF A COMMODITY WITH STORAGE COSTS .............................. 14
COMPARE THE LEASE RATE WITH THE CONVENIENCE YIELD. ................................................. 17
EXPLAIN HOW TO CREATE A SYNTHETIC COMMODITY POSITION AND USE IT TO EXPLAIN THE
RELATIONSHIP BETWEEN THE FORWARD PRICE AND THE EXPECTED FUTURE SPOT PRICE ....... 18
EXPLAIN THE RELATIONSHIP BETWEEN CURRENT FUTURES PRICES AND EXPECTED FUTURE
SPOT PRICES, INCLUDING IMPACT OF SYSTEMATIC AND NONSYSTEMATIC RISK........................ 19
DEFINE AND INTERPRET CONTANGO AND BACKWARDATION ................................................... 20
CHAPTER SUMMARY ........................................................................................................... 22
END OF CHAPTER QUESTIONS & ANSWERS .............................................................. 23
QUESTION 6.1 .................................................................................................................... 23
QUESTION 6.2 .................................................................................................................... 24
QUESTION 6.3 .................................................................................................................... 24
QUESTION 6.4 .................................................................................................................... 25
QUESTION 6.5 .................................................................................................................... 26
QUESTION 6.6 .................................................................................................................... 27
QUESTION 6.7 .................................................................................................................... 29
QUESTION 6.8 .................................................................................................................... 30
QUESTION 6.9 .................................................................................................................... 31
QUESTION 6.10 .................................................................................................................. 32
QUESTION 6.11 .................................................................................................................. 32
QUESTION 6.12 .................................................................................................................. 33

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Chapter 11. Commodity Forwards and Futures

 Explain the key differences between commodities and financial assets.

 Define and apply commodity concepts such as storage costs, carry markets, lease
rate, and convenience yield.

 Identify factors that impact prices on agricultural commodities, metals, energy,

and weather derivatives.

 Explain the basic equilibrium formula for pricing commodity forwards.

 Describe an arbitrage transaction in commodity forwards, and compute the

potential arbitrage profit.

 Define the lease rate and explain how it determines the no-arbitrage values for
commodity forwards and futures.

 Describe the cost of carry model and illustrate the impact of storage costs and
convenience yields on commodity forward prices and no-arbitrage bounds.

 Compute the forward price of a commodity with storage costs.

 Compare the lease rate with the convenience yield.

 Explain how to create a synthetic commodity position and use it to explain the
relationship between the forward price and the expected future spot price.

 Explain the relationship between current futures prices and expected future spot
prices, including the impact of systematic and nonsystematic risk.

 Define and interpret normal backwardation and contango.

Explain the key differences between commodities and financial

assets.
There are several important differences between commodities and financial assets. Some
differences are:

 The storage costs associated with financial assets (e.g., stocks and bonds) are
negligible. The storage costs for commodities, however, can be quite substantial.
These costs include insurance, which can vary over time. Some commodities
deteriorate with time and require special (i.e., costly) care in storage. Assets such as
corn and natural gas are frequently stored for use at a particular time of the year.
Other assets, such as oil and copper, are consumed throughout the year.
 Commodities can be costly to transport and thus their prices can depend on their
location. By contrast, financial assets are usually transported electronically at virtually
no cost.
 A commodity held for investment purposes (e.g., gold or silver) can be borrowed for
shorting. However, the borrower must pay what is called a lease rate. This lease rate
can exceed the fees charged when financial assets are borrowed for shorting.

3
.

 A financial asset provides investors with an expected financial return that reflects its
risk. Most commodities do not have this property. Indeed, it can be argued that the
prices of most commodities are mean reverting. This means that although the price
of a commodity can be quite volatile, it tends to get pulled back toward some central
value. When the price of a commodity is relatively high, its production will become
attractive and its supply will therefore tend to increase. At the same time, users of the
commodity may search for less expensive alternatives. Combined, these actions will
tend to reduce the price of the commodity. If the price is at a relatively low level, on
the other hand, the production of the commodity will become less attractive, while its
use will tend to increase. As a result, its price will tend to rise.
As a result of these distinctions, the futures prices of commodities can behave quite
differently from those of financial assets

4
.

NOTE: MAKE SURE THAT THIS LO COVERS BOTH DEFINE AND APPLY (NOT
JUST DEFINE)

Define and apply commodity concepts such as storage costs, carry

markets, lease rate, and convenience yield.
Storage Costs
Investment assets such as securities do not have any physical storage costs associated with
them, however assets that are both investment assets and consumption assets, such as
gold and silver, do have a storage cost associated with them, such as the cost of storing the
commodity in a vault. Consumption assets in general do have storage costs associated with
them, e.g. one can think of the cost of storing corn in a silo. Moreover, certain consumption
assets such as, e.g. coal deteriorate over time, so there is a real cost to not utilizing it
immediately.
Carry Markets
The cost of carry for an asset reflects the impact of:

 Storage costs
 Financing costs, and
 Income earned on the asset
A commodity for which the forward price compensates a commodity owner for costs
of storage is called a carry market. Above, we mentioned that there is no physical storage
cost for pure investment assets. One does, however, “store” financial assets although it
might only be stored electronically in an exchange’s database. The old adage, “time is
money,” is nevertheless true: the owner of a forward or a Futures contract expects to be
compensated for this time-value of money. Thus investment assets are always compensated
for their “storage cost,” which is reflected in a higher price for the asset. This phenomenon
– that the forward or Futures price reflect the costs of storage is called a carry market.

In the case of a financial asset, if the financing cost is R and the yield is Q (both expressed
with annual compounding), the cost of carry per year is

1+
−1
1+

which is often simply approximated as R – Q.

Consider, a foreign currency. If the domestic interest rate is 4% and the foreign interest rate
is 3%, the cost of carry is approximately 1%. If the foreign interest rate were 6%, the cost of
carry would be around -2% (this is referred to as negative carry).

Analogously, markets for consumption commodities, such as corn, where the owner incurs
storage costs are also carry markets. Electricity, on the other hand, which cannot be easily
stored, is not a carry market. Later in this chapter we will explore the financial implications of
storage costs and carry markets on the forward and Futures price.
Lease rate
The lease rate is to commodities what the dividend is to financial assets: it is the rate
received by the owner of a consumption asset from the investor for borrowing the
asset. In short selling of financial assets, the short-seller compensates the owner of the
asset with dividend payments or other payments accruing to the asset, similarly, in case of
consumption assets the borrower has to pay a lease rate to the owner of the asset.

5
.

Lease rate payment is clearly a benefit to the owner of the asset. Accordingly, it has the
effect of lowering forward price. To see this, just imagine that the forward price was not
impacted by the lease rate. The owner of the commodity could exploit this by leasing his
commodity to a short seller, and turn around in the market and sell the forward at the higher
price, thus earning a risk-free payment equal to the present value of the lease rate.

“It is important to be clear about the reason a lease payment is required for a
commodity and not for a financial asset” (McDonald)

Let L be the lease rate, then the relationship between Forward price and Spot price is given
by: =

1+
=
1+

The Lease rate using the equation is:

= (1 + ) − 1

Example: Assume that the spot price of gold is USD 1,240, the six-month futures price is
USD 1,250, and the six-month risk-free rate is 4% (with annual compounding). The implied
lease rate is:

1240 .
× 1.04 − 1 = 0.023
1250
or 2.3%.
The lease rate of gold varies with the supply of gold that can be borrowed along with the
demand to borrow gold. Recall that when gold producers hedge future production, the banks
on the other side of the transaction borrow gold. As gold producers hedge more (less), the
demand for borrowed gold will increase (decrease) and the lease rate will rise (fall).
Similarly, as asset owners become more (less) willing to lend gold, the lease rate will tend to
fall (rise). Occasionally the lease rate is negative and may therefore allow arbitrageurs to buy
the metal and sell it forward for a profit.

Convenience yield
Convenience yield also affects the pricing relation for a forward or a Futures contract. Think
of a commodity, such as oil, where the owner of the oil can derive immediate benefits by
using it in production for example. This certainly has some value, and in fact, it serves to
reduce the cost of storing the oil. The forward price will thus decrease in the case when
there is a convenience yield. Convenience yield thus refers to the nonmonetary benefits
received by the owner of the consumption asset from physical possession of the commodity.
With respect to the cost of carry model (as explained in the Hull reading), convenience yield
is typically not an objectively observed input like the risk-free rate, storage cost, or dividend
yield. Rather, we typical infer the convenience yield from the forward curve (i.e., the forward
price). In this way, convenience yield is the “plug variables” that reconciles the other inputs
with the observed forward price.

6
.

If Y is convenience yield and U be the storage cost, then the forward price is given by:

1+
=( + )
1+
Such that, = (1 + ) − 1

The convenience yield measures the benefits to the asset holder of having it in their
inventory as a protection against future shortages or delivery delays.

Suppose there is expected to be a plentiful supply of the asset during the life of a futures
contract. This means it can be ordered at any time for almost immediate delivery. In this
case, the convenience yield is likely to be close to zero and = ( + )(1 + )T might be
a reasonable approximation. If inventory levels of the asset are low and there are
concerns about shortages, however, the convenience yield will likely be quite high. In that
case, F is likely to be less than ( + )(1 + )T .

Example: Consider that the spot price of the oil is USD 69 per barrel, and the six-month
futures price is USD 65 per barrel. The cost of storing oil for six months has a present value
of USD 1 barrel, and the risk-free rate is 2% per year. The convenience yield satisfies

1.02 /
65 = (69+ 1)( )
1+
So that

70
= 1.02 − 1 = 0.183
65

That is, the convenience yield is 18.3%

18.3% can be viewed as the cost of borrowing oil (if that were possible). Because physical
oil provides benefits to the holder at the rate of 18.3% per year, this is arguably the rate that
would be charged to borrow it.

In the example, it appears that the market was expecting the price of oil to decline over the
six-month period. Under such circumstances, holding oil as an investment makes no sense.
(Indeed, if oil were an investment asset, its price would reflect market sentiment.) The only
reason someone would hold oil is to use it. An expectation that the price of an asset will
decline sharply is therefore consistent with the physical asset having a high convenience
yield.

OLD LO SHOULD COVER NEW LO BUT REVIEW AND MAKE SURE

(Previously it included factors for different commodities now it includes a
more generic content). Updated accordingly.
Identify factors that impact prices on agricultural commodities,
metals, energy, and weather derivatives.

Agricultural Commodities: Agricultural commodities with futures contracts include products

that are grown (e.g., corn, wheat, soybeans, cocoa, and sugar) as well as livestock (e.g.,
cattle and hogs). It is expensive to store agricultural commodities; even under optimal
conditions, some products can only be stored for a limited period of time. There is also an

7
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interdependence among various agricultural commodities. For example, the cost of feeding
livestock can depend on the prices of grown agricultural commodities (e.g., corn).

The prices of agricultural commodities can be seasonal. For example, consider the prices of
corn and soybeans. At harvesting time (October to November), their prices tend to be
relatively low. Outside of this period, however, their prices may be higher as farmers and
other distributors incur storage costs. This seasonality is sometimes reflected in futures
prices, causing them to display a mixture of normal and inverted pricing patterns.

There are also other factors that may affect the market’s view on the future price of a
commodity. If there has been (or if there is expected to be) a good (or bad) harvest, market
participants will expect prices to be relatively low (or relatively high). Political considerations
can also affect futures prices. Weather is also an important consideration for many
agricultural commodities. Bad weather in Florida, for example, can increase the futures price
of frozen orange juice. Meanwhile, frosts in Brazil are liable to drastically reduce Brazilian
coffee production and increase coffee futures prices.

Metals:

Commodity metals include gold, silver, platinum, palladium, copper, tin, lead, zinc, nickel,
and aluminium. Their properties are quite different from those of agricultural products.
For example, metal prices are not affected by the weather and are not seasonal (because
they are extracted from the ground). Additionally, their storage costs are typically lower
than those of agricultural products.

Some metals are held purely for investment purposes. This means that their futures price
can be more easily obtained from observable variables. For someone looking to hold a metal
for investment, owning a futures contract can be an acceptable alternative to owning the
physical asset itself.

As in the case of agricultural commodities, inventory levels are important in determining

prices. Most metals are extracted in one country and consumed in another. As a result,
exchange rates may affect prices. Other crucial factors include the scope of a metal’s
industrial application and the rate at which new sources are found. Changes in extraction
methods, actions by governments (and/or cartels), and environmental regulations can
also impact metal prices. Sometimes metal prices can even be affected by recycling
processes. For example, a metal used in a production process one-year can be recycled
and re-enter the market many years later.

Energy

Energy products are another important category of commodities. There are futures contracts
on crude oil and crude oil extracts (e.g., petroleum and heating oil). Futures also trade on
natural gas and electricity. The crude oil market is the largest commodity market in the world
and global demand is estimated to be nearly 100 million barrels per day. There are many
grades of crude oil reflecting variations in gravity (density) and sulfur content. Two important
benchmarks are Brent crude oil (which is sourced from the North Sea) and West Texas
Intermediate (WTI) crude oil.

Natural gas is used for heating and generating electricity. It can be stored (either above
ground or underground) for indefinite periods, but its storage costs are quite high. Natural
gas is also expensive to transport, and hence the price of natural gas can vary regionally.

8
.

CME Group offers a futures contract on 10,000 million British thermal units (BTUs) of
natural gas. The contract requires delivery to be made at a roughly uniform rate to a hub
in Louisiana. Intercontinental Exchange (ICE) also offers a futures contract on natural gas.
The demand for natural gas is high in the winter (for heating purposes) and to a lesser
extent the summer (to produce electricity for air conditioning). This creates seasonality in
the futures prices as illustrated in the below Figure.

Electricity is an unusual commodity because it is almost impossible to store. The maximum

supply of electricity in a region is determined by the capacity of all electricity generating
plants in that region. In the United States, there are 140 such regions and the wholesale
price of electricity is determined by the price charged in each of them. The non-storability of
electricity can lead to huge price swings. For example, heat waves in the summer can drive
up the demand for air conditioning and have been known to increase the cost of electricity by
as much as 1,000%. Once the heat wave is over, however, the price quickly returns to
normal levels.
Futures contracts on electricity do exist, but they are less actively traded than futures
contracts on natural gas and crude oil. Electricity futures contracts also trade in the over the
counter market. A typical contract allows one side to receive a specified number of megawatt
hours for a specified price at a specified location during a particular month. In a 5 × 8
contract, power is received during the off-peak period (11 p.m. to 7 a.m.) from Monday to
Friday. In a 5 × 16 contract, power is received during the on-peak period (7 a.m. to 11 p.m.)
from Monday to Friday for the specified month. In a 7 × 24 contract, power is received 24
hours a day, seven days a week for the specified month. Prices are highly seasonal,
reflecting increased demand in the summer.

Weather

Derivative contracts on weather are available in both the exchange-traded and over the
counter markets. The most popular contracts are those with payoffs contingent on
temperature (which are used by energy companies as hedges).

Two important weather derivative variables are heating degree days (HDDs) and cooling
degree days (CDDs). The HDD and CDD for a day are (respectively) defined as:

HDD = max(0, 65 − A)

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and

CDD = max(0, A − 65)

where A is the average of the highest and lowest temperature during a given day at a
specified weather station (as measured in degrees Fahrenheit). For example, if the
minimum temperature during a day (midnight to midnight) is 40 degrees Fahrenheit and
the maximum is 60 degrees Fahrenheit, A = (60 + 40)/2 = 50. The daily CDD is therefore
zero, and the daily HDD is 15. Contracts are usually defined in terms of the cumulative
HDD and CDD for all the days in a given month.

10
.

Explain the basic equilibrium formula for pricing commodity

forwards.
The prepaid forward price for a commodity is the price today to receive the unit of the
commodity in the future date. The prepaid forward price is therefore, the present value of
the commodity on the future date. Prepaid forward price is:

, = [ ]

Where α is the discount rate for the commodity,

[ ] is the spot price of S at time T, as expected at time 0.

The forward price is the future value of the prepaid forward price, with the future value
computed using the risk-free rate:
, = ,

From the above two equations, commodity forward price is the expected spot price,
discounted at the risk premium. The discount rate is a function of the risk premium on the
commodity: the risk premium is the difference between the discount rate on the commodity
and the risk-free rate.
( )
, = ( )

or
, = ( )

The time – T forward price discounted at risk free rate is the present value of a unit of
commodity received at time T. This equation implies that for example, an industrial producer
who buys oil can calculate the present value of future oil costs by discounting oil forward
prices at the risk-free rate.

11
.

Describe an arbitrage transaction in commodity forwards, and

compute the potential arbitrage profit
Consider a copper forward with current price and 1-year forward price both equal to $ 3.00.
The effective annual interest rate is 10%. If copper forward behaves similar to financial asset
the forward price should be 1.10 × 3 = $ 3.30, the future value of the current copper price.

Thus, the $ 3.00 forward price would create an arbitrage opportunity. If the forward price is
$3.00 the trader could buy copper forward and short sell copper today. The table below
shows the cash flows in the mentioned reverse cash and carry arbitrage.

Reverse Cash and Carry (buy cheap forward and sell expensive commodity)
Apparent reverse cash-and-carry arbitrage for copper if the copper forward price is F0,1
< $3.30. This demonstrates that there is an arbitrage opportunity if the copper forward
price is below $3.30. S1 is the spot price of copper in 1 year, and F0,1 is the copper
forward price. There is a logical error in the table (see below).

Cash Flows
Transaction Time 0 Time 1
Long forward @ F0,1 0 S1 – F0,1
Short-sell copper +$3.00 -S1
Lend short-sell proceeds @ 10% -$3.00 $ 3.30
Total 0 $ 3.30 – F0,1

The results in the above table show that there is an arbitrage opportunity for any copper
forward price below $3.30. If the copper forward price is $3.00, it seems that the trader will
make a profit of $0.30 per pound of copper.

The above numbers in the table seem to have a problem. The arbitrage assumes that
the trader can short-sell copper by borrowing it today and returning it in the year. However,
in order for the trader to short-sell for a year, an investor must be willing to lend copper for
the period of one year. The lender must be holding the asset and willing to give up the
physical possession for the period of short-sale.

From the perspective of the lender, the trade looks like he has spent $ 3.00 for copper and it
will be returned after a period of one year which will sell at $3.00. Thus, the lender will not
earn any interest for his investment. However, from the perspective of the trader, short-
selling is like an interest free loan of $3.00. Clearly, the investor loses and the
trader/borrower benefits. Thus, no investor will lend copper without charging additional fees.

Summarizing, the copper futures is not mispriced, the issue is that leasing rate of copper is
equal to the interest free loan and it happens to show an arbitrage profit.

12
.

Define the lease rate and explain how it determines the no‐arbitrage
values for commodity forwards and Futures. Calculate a
continuous lease rate for a commodity asset.
The lease rate is the rate received by the owner of a consumption asset from the
investor for borrowing the asset. The short-seller of an item may have to compensate the
owner of the item for lending.

In the above example, the lease rate was equal to the risk-free rate. The copper lender had
invested $3.00 in copper and must expect to earn a satisfactory return on that investment.
The copper lender will require the short seller to make a lease payment so that the
commodity loan is a fair deal. The actual payment the lender requires will depend on the
forward price. The lender will recognize that it is possible to use the forward market to lock in
a selling price for the copper in 1 year, and will reason that copper bought for $3.00 today
can be sold for F0,1 in 1 year. A copper borrower must be prepared to make an extra
payment – a lease payment of

= 1.1× $3.00− ,

The table below incorporates the lease payment and shows that the apparent arbitrage
vanishes.

Lease payment inclusion

Reverse cash-and-carry arbitrage for copper. This table demonstrates that there is no
arbitrage opportunity if the commodity lender requires an appropriate lease payment
Cash Flows
Transaction Time 0 Time 1
Long forward @ F0,1 0 S1 – F0,1
Short-sell copper + $ 3.00 -S1
Lease payment 0 -($ 3.30 -F0,1)
Lend short-sell proceeds
- $ 3.00 $ 3.30
@ 10%
Total 0 0

Lease payment can also be interpreted in terms of discounted cash flow. Let α denote
the equilibrium discount rate for an asset with the same risk as the commodity. The lender is
buying the commodity for S0. One unit returned at time T is worth ST, with a present value of
E0(ST )e-αT . If there is a proportional continuous lease payment of δL, the NPV of buying the
commodity and lending it is

= ( ) −

The lease rate that makes NPV zero is then

1
δ = α −
ln ( )

13
.

The lease rate is the difference between the discount rate for the commodity and the
expected price appreciation. From substituting equation e−rTF0,T = E0(ST ) e-αT into this
expression, the continuous lease rate is

1 ,
δ = r − ln

For example, assume the spot price, , is $9.8 and the forward price in six months (T=0.5)
is $10 , . . Given further a risk-free rate of 6%, the implicit lease rate is about 2%:

1 , 1 10
= − ln = 6% − ln ≅ 2%
0.5 9.8

It is important to be clear about the reason a lease payment is required for a

commodity and not for a financial asset.
 For a non-dividend-paying financial asset, the price is the present value of the future
price, so that S0 = E(ST )e-αT . This implies that the lease payment is zero.
 For most commodities, the current price is not the present value of the expected
future price, so there is no presumption that the lease rate would be zero.

Describe the cost of carry model and illustrate the impact of

storage costs and convenience yields on commodity forward
prices and no-arbitrage bounds. Compute the forward price of a
commodity with storage costs.
Carry markets
A commodity for which the forward price compensates a commodity owner for costs
of storage is called a carry market. A commodity that is stored is in a carry market.
Storage is carry. Storage permits consumption throughout the year. In such a market, the
return on a cash and carry, net of all costs, is the risk-free rate. Thus, a user who buys and
stores a commodity in a carry market will be compensated for interest and physical storage
costs less a convenience yield. Hence, the forward price is given as:

( )
, =

where, r is the risk-free rate

is the physical storage cost
C is the convenience yield
Impact of storage costs and convenience yields on commodity forward prices and no-
arbitrage bounds
Effects of Storage Cost
Storage is not always feasible (e.g. fresh strawberries are perishable) but when the storage
is feasible it is costly. If the commodity is optimal to store, then the forward price must be
high enough so that the returns on a cash-and-carry compensate for both financing and
storage costs.

14
.

Cash and Cary Arbitrage:

A commodity merchant who owns a unit of commodity can either sell it today for S0 or store
till time T and can guarantee the price of the commodity by selling the forward at F0,T

The merchant will store the commodity only if the present value of selling at time T is at least
as great as that of selling today. Denote the future value of storage costs for one unit of the
commodity from time 0 to T as λ(0, T ) . The table below summarizes the cash flows for a
cash and carry with storage costs:

Cash and Carry Arbitrage – Storage Cost Impact

Cash-and-carry for copper for 1 year, assuming that there is a 1-year storage cost of
λ(0, 1) payable at time 1, and an effective interest rate of R.
Cash Flows
Transaction Time 0 Time 1
Buy Copper -S0 S1
Pay Storage Cost 0 -λ(0,1)
Short Forward 0 F0,1 – S1
Borrow @ R + S0 -(1+R)S0
Total 0 F0,1 – [(1+R)S0 + λ(0,1)]

The table shows that the cash and carry arbitrage is not profitable if

F0,1 < (1 + R)S0 + λ(0,1)

If the above inequality is violated, storage will occur because the forward premium is great
enough that sale proceeds in the future compensate for the financial costs of storage (RS0)
and the physical costs of storage (λ(0, 1)). If there is to be both storage and no arbitrage,
then equation holds with equality. An implication of the equation is that when costly storage
occurs, the forward curve can rise faster than the interest rate.

Storage costs can be viewed as a negative dividend: Instead of receiving cash flow for
holding the asset, the investor has to pay to hold the asset. If there is storage, storage costs
increase the upper bound for the forward price. Storage costs can include depreciation of the
commodity, which is less a problem for metals such as copper than for commodities such as
strawberries and electricity.

In the special case where continuous storage costs of λ are paid continuously and are
proportional to the value of the commodity, storage cost is like a continuous negative
dividend. If storage occurs and there is no arbitrage, the forward price in a carry market,
where the commodity is stored will be:
( )
=

15
.

Example1: Suppose that the November price of corn is $2.50/bushel, the effective monthly
interest rate is 1%, and storage costs per bushel are $0.05/month. Assuming that corn is
stored from November to February, the February forward price must compensate owners for
interest and storage.

The future value of storage costs is:

$0.05+ ($0.05× 1.01)+ ($0.05

× 1.012) = ($0.05/.01)
× [(1+ 0.01)3– 1]= $0.1515

Thus, the February forward price will be

2.50 (1.
01)3 + 0.1515 = $ 2.7273

Reverse Cash and Carry Arbitrage: An arbitrageur buys the commodity forward and short-
sells it. The commodity lender will require a lease payment which will be equal to (1+R)S0 –
F0,1. The transaction is shown in the below table:

Reverse Cash and Carry – Impact of Storage Cost

Reverse cash-and-carry for copper for 1 year, assuming that the commodity lender
requires a lease payment of L.
Cash Flows
Transaction Time 0 Time 1
Short-sell copper S0 -S1
Lease payment 0 -L
Long forward 0 S1 – F0,1
Invest @ R -S0 (1+R)S0
Total 0 [(1+R)S0 – F0,1] - L

The storage cost does not affect profit because neither the arbitrageur nor the lender is
actually storing the commodity. The reverse cash-and-carry is profitable if the lender
requires a lease payment below (1+ R)S0 − F0,1. Otherwise, arbitrage is not profitable. If the
commodity lender uses the forward price to determine the lease rate, then the resulting
circularity guarantees that profit is zero. The profit is zero if L = (1+ R)S0 − F0,1

The important implication of this result is the ability to engage in a reverse cash-and-
carry arbitrage does not put a lower bound on the forward price. A forward price that is
too high can give rise to arbitrage, but a forward price that is too low need not.

However, due to other economic pressures, the forward price reaches the “correct” level.
 If the forward price is too low, there will be an incentive for arbitrageurs to buy the
commodity forward.
 If the forward price is too high, there is an incentive for traders to sell the
commodity, whether or not arbitrage is feasible.
Leasing and storage costs complicate arbitrage, however.

16
.

Effects of Convenience yields

Consider a food producer for which corn is an essential input in the end food product. The
food producer will hold corn in the inventory. If he holds too much corn than required, he can
sell the excess. However, if the inventory is less, he will end up halting the production and
idling the workers and machines. Thus, physical corn has a value for the food producer. It is
a nonmonetary value but provides an insurance that he can keep producing even in case the
corn supply is disrupted. This extra nonmonetary return to the food producer is called
convenience yield.

The convenience yield is only relevant when the commodity is stored. In order to store
the commodity, the owner will require that the forward price compensate for the financial and
physical costs of storing, but the owner will accept a lower forward price to the extent there is
a convenience yield. If the continuously compounded convenience yield is c, proportional to
the value of the commodity, the owner will earn an acceptable return from storage if the
forward price is

( )
, ≥

For no arbitrage pricing the forward price of the commodity in this case should be:

( )
, =
 It explains patterns in storage—for example, why a commercial user might store a
commodity when the average investor will not.
 It provides an additional parameter to better explain the forward curve.
Now, given the convenience yield is c and storage cost is λ, the no arbitrage price range is
given by

( ) ( )
≤ , ≤

Compare the lease rate with the convenience yield.

If the lease rate is given by , then the forward price is given by:

F , = S e( )

Forward price of a commodity with λ as storage cost and c as convenience yield is given by

F , = S e( )

When the above two equations are equated,

δ =c− λ

Intuitively, an owner of a commodity who has given it for lease to the arbitrageur, loses
convenience yield, c and saves the storage costs λ. Hence, in order to compensate the
lender for the convenience yield less storage costs the borrower has to pay the
leasing rate =c - .

17
.

Explain how to create a synthetic commodity position and use it to

explain the relationship between the forward price and the
expected future spot price
Eo(ST) Spot price of S at time T, as expected at time o
Fo,T Forward price
R Risk-free rate
α Discount rate for commodity S

Consider the following investment strategy: enter into a long forward contract plus a zero
coupon bond that pays F(0,T) at time T. Since the forward contract is costless, the cost of
this investment strategy at time 0 is just the cost of the bond: the discounted price of the face
value of the bond = e-rT*F(0,T). Again, the idea is to lend at the risk-free rate in order to
receive back, at future time T, the exact amount need to meet the long forward obligation. At
time T, this strategy (long forward on the commodity plus invest in zero coupon bond) has
the same payoff as the future spot price. By using the forward, the unfunded position is
synthetic but otherwise equivalent to buying the commodity on the cash market:

( − , )+ , =

Where − , is the forward contract payoff

, is the bond payoff

Here is the key step: we equate the price paid for the synthetic strategy (i.e., the amount we
need to invest at the riskless rate in order to receive future proceeds to meet the long
forward obligation) with the price we should be willing to pay for the commodity today. That
price is the expected future spot price, discounted to today using the discount rate (α):

, = ( )
Then we solve for the forward price:

, = ( )

And end up with the essential formula that links the forward price to the expected future spot
price:

( )
, = ( )
And, as McDonald says, the forward price [F0] is a biased estimate of expected spot price
[E(St)], where the bias is due to the risk premium on the commodity (risk premium = α – r).

It is generally preferable to invest in synthetic commodities rather than physical

commodities. Comparing the returns of owning the physical commodity with the returns of
owning the synthetic commodity will prove the hypothesis.

Let λ (0,T) denote the future value of the storage costs.

To invest in the physical commodity for 1 year, we can buy the commodity and prepay the
storage costs. This costs S0 + λ (0,1)/(1+R) initially and one period later pays S1 + λ (0,1) - λ
(0,1) = S1

18
.

An investment in the synthetic commodity costs the present value of the forward price,
F0,1/(1+R), and pays S1. The synthetic investment will be preferable if

0,1/(1+ ) < 0 + (0,1)/(1+ )

or 0,1 < 0(1+ )+ (0,1) .

Suppose, however, that F0,1>S0 (1+ R) + λ (0, 1). This is an arbitrage opportunity exploitable
by buying the commodity, storing it, paying storage costs, and selling it forward. Thus, if
there is no arbitrage, we expect that F0,1 ≤ S0(1+R) + λ (0, 1) and the synthetic commodity
will be the less expensive way to obtain the commodity return. Moreover, there will be
equality only in a carry market. So, investors will be indifferent between physical and
synthetic commodities in a carry market and will prefer synthetic commodities at all other
times.

Explain the relationship between current futures prices and

expected future spot prices, including impact of systematic and
nonsystematic risk.
“Normal backwardation” and “normal contango” refer to an unobserved relationship
between the current forward/futures price, F(0,T), and the expected future spot price,
E[S(T)].

 In normal contango, the forward/futures price is greater than the expected future
spot price: > [ ] (note the curve may or may not be inverted!).
 In normal backwardation, the forward/futures price is less than the expected future
spot price: < [ ]. (again, the curve may or may not be inverted!).

A classic model would predict a normal backwardation (i.e., compensation to the long
forward position) during contango (i.e., positive cost of carry).

Theory of Normal Backwardation

The theory of normal backwardation assumes that hedgers tend to be net short and
speculators tend to be net long.
 If hedgers are net short, the futures price will fall below the expected future spot
price. Normal backwardation is expected under this theory because the long forward
position (the speculator) expects more than a zero profit, so the long must expect
[ ] > , . The expected positive non-zero profit, [ ] − , , is the compensation
for bearing systematic risk.
 If, instead, hedgers are net long and speculators are net short, futures prices will be
greater than expected future spot prices and this is known as contango.

19
.

The impact of systematic and non-systematic risk

The futures price today is a function of the expected spot price at the end of the contract:

= ( ) r−k

where k is the expected or required return: = + ∗

Relationship of
Relationship of expected futures price to
Underlying asset return to risk-free rate expected future spot price
No systematic risk k=r = ( )
Positive systematic risk k>r < ( )
Negative systematic risk k<r > ( )

If the investment has positive systematic risk, the future price should be less than the
expected future spot price: the long position expects compensation for the assumption of
systematic risk!

Tip: This learning objective refers to systematic risk (aka, non-diversifiable or market risk)
which is the risk assumed in the capital asset pricing model (CAPM). It is different than
systemic risk which is the risk that default by one institution will lead to defaults by other
financial institutions.

Define and interpret contango and backwardation

Contango
Contango refers to an upward-sloping (“normal”) forward curve: long-term forward prices are
greater than near-term forward prices (and the spot price).

20
.

Backwardation
Backwardation refers to an inverted forward curve: long-term forward prices are less than
near-term forward prices (and the spot price).
Relationship between commodity futures and spot prices, and how it relates to the
cost of carry model
 Contango and backwardation describe the shape of an observed forward curve. As
the shape is a function of spot and forward prices, these are not model-driven but
simply observed in the pricing term structure.
 Backwardation (an inverted forward curve) may occur when convenience yield is
greater than the interest rate (or greater than the interest rate plus the storage costs):

21
.

Chapter Summary
This chapter re-visits several themes previously seen in Hull’s chapter 5 Determination of
Forward and Futures prices, thus a lot of the concepts should already be familiar. One
important thing to note is the difference in notation between Hull and McDonald, e.g. Hull
uses u for storage costs and y for convenience yield, whereas McDonald uses lambda and
c, respectively for the same. The underlying theory remains the same though.

What is new and important in this reading is how the theory is applied specifically to
commodities. One of the key concepts encountered is that of a carry market, that is, when
commodities are, e.g., stored, the forward or Futures price must reflect the fact that the
investor must bear both financing costs as well as storage cost (a so-called cash-and-carry).
More succinctly, a commodity that is stored is in a carry market. Storage is carry.

In addition to our usual terms of the risk-free rate, storage costs the notion of a lease-rate
and convenience yield are introduced. The lease-rate can be thought of as the commodity
market equivalent of a financial dividend yield. In particular, the owner of a commodity
expects to be compensated in order to lend, e.g., a short seller the commodity. On the other
hand, the convenience yield reflects the fact that holders of a given commodity may derive
some benefit from having physical ownership over the commodity. Both the convenience
yield and lease rate are benefits to the owner, and thus will reduce the price of the forward.

One thing to note is that it can often be difficult to ascertain what the convenience yield for a
commodity is. This gives us arbitrage bounds for the forward price, where we effectively
solve for the lease rate, but the lease rate depends on both the storage cost and the
convenience yield. You should be comfortable with the derivation of the following inequality:

S0 e( r   c )T  F0  S0 e(r   )T

When taking, e.g., a long position in one commodity that is an input factor for another
commodity that is an [final] output, then we can take a short position in the output commodity
and the difference is the commodity spread.

As we saw in Hull’s chapter 3 on Hedging Strategies using Futures, the basis is the
difference between the price of the Futures contract and the spot price of the underlying
asset. Basis risk is the risk (to the hedger) created by the uncertainty in the basis. We
elaborated slightly on the concept (page 44).

The forward curves of various commodities exhibit patterns that are often idiosyncratic to
that commodity. We can often infer these factors from the forward curve and what we know
about the commodity. McDonald says, the forward price [F0] is a biased estimate of
expected spot price [E(St)], where the bias is due to the risk premium on the commodity (risk
premium = α – r).

Synthetic commodities can be constructed using default-free bonds and commodity Futures,
and will always be preferred over their physical equivalent, except for in a carry-market
where the investor will be indifferent between the two.

22
.

End of Chapter Questions & Answers

Question 6.1
The spot price of a widget is $70.00 per unit. Forward prices for 3, 6, 9, and 12 months are
$70.70, $71.41, $72.13, and $72.86. Assuming a 5% continuously compounded annual risk-
free rate, what are the annualized lease rates for each maturity? Is this an example of
contango or backwardation?

Answer:

The spot price of a widget is $70.00. With a continuously compounded annual risk-free rate
of 5%, we can calculate the annualized lease rates according to the formula:

( )×
, = ×

, ( )×
⟺ =

,
⟺ =( − )×

1 ,
⟺ = −

Time to expiration Forward price Annualized lease rate

3 months $70.70 0.0101987
6 months $71.41 0.0101147
9 months $72.13 0.0100336
12 months $72.86 0.0099555

The lease rate is less than the risk-free interest rate. The forward curve is upward sloping,
thus the prices of exercise 6.1 are an example of contango.

23
.

Question 6.2
The current price of oil is $32.00 per barrel. Forward prices for 3, 6, 9, and 12 months are
$31.37, $30.75, $30.14, and $29.54. Assuming a 2% continuously compounded annual risk-
free rate, what is the annualized lease rate for each maturity? Is this an example of contango
or backwardation?

Answer:

The spot price of oil is $32.00 per barrel. With a continuously compounded annual risk-free
rate of 2%, we can again calculate the lease rate according to the formula:

1 ,
= −

Time to expiration Forward price Annualized lease rate

3 months $31.37 0.0995355
6 months $30.75 0.0996918
9 months $30.14 0.0998436
12 months $29.54 0.0999906

The lease rate is higher than the risk-free interest rate. The forward curve is downward
sloping, thus the prices of exercise 6.2 are an example of backwardation.

Question 6.3
Given a continuously compounded risk-free rate of 3% annually, at what lease rate will
forward prices equal the current commodity price? (Recall the copper example in Section
6.3.) If the lease rate were 3.5%, would there be contango or backwardation?

Answer:

The question asks us to find the lease rate such that F , = S . We take our pricing formula,
, = × ( )×
, and immediately see that the sought equality is established if
( )×
= 1, which is guaranteed for any T > 0 if and only if = . If the lease rate were
3.5%, the lease rate would be higher than the risk-free interest rate. Therefore, a graph of
Therefore, a graph of forward prices would be downward sloping, and thus there would be
backwardation.

24
.

Question 6.4
Suppose that copper costs $3.00 today and the continuously compounded lease rate for
copper is 5%. The continuously compounded interest rate is 10%. The copper price in 1 year
is uncertain and copper can be stored costlessly.
a) If you short-sell a pound of copper for 1 year, what payment do you have to make
to the copper lender? Would it make sense for a financial investor to store copper
in equilibrium?
b) Show that the equilibrium forward price is $3.154.
c) In what sense is $3.316 (= 3 × e0.10) a maximum possible forward price?
d) Explain the circumstances in which any price below $3.316 could be the
observed forward price, without giving rise to arbitrage. (Be sure to consider the
possibility that the lease rate may not be 5%.)
Answers:
a) As we need to borrow a pound of copper to sell it short, we must pay the lender
the lease rate for the time we borrow the asset, i.e., until expiration of the contract
in one year. After one year, we have to pay back one pound of copper, which will
cost us, the uncertain future pound of copper price, plus the leasing costs:
Total payment = + × . −1= .
= 1.0 5127 ×

It does not make sense to store a pound of copper in equilibrium, because even if
we have an active lease market for pounds of copper, the lease rate is smaller
than the risk-free interest rate. Lending money at 10 percent is more profitable
than lending pounds of copper at 5 percent.

b) The equilibrium forward price is calculated according to our pricing formula:

( )× ( . . )×
, = × = $3.00 × = $3.00× 1.051 27 = $3.1538

which is the price given in the exercise.

c) Copper need not be stored because there is a constant supply of copper. If the
forward price was greater than 3.316, then a copper producer will find it profitable
to sell forward production.

d) As the textbook points out, the reverse cash-and-carry arbitrage does not put a
lower bound on the forward price. The lender will require a lease payment and
can use the forward price to determine the lease rate.

25
.

Question 6.5
Suppose the gold spot price is $300/oz, the 1-year forward price is 310.686, and the
continuously compounded risk-free rate is 5%.
a) What is the lease rate?
b) What is the return on a cash-and-carry in which gold is not loaned?
c) What is the return on a cash-and-carry in which gold is loaned, earning the lease
rate?
Answers:
a) The spot price of gold is $300.00 per ounce. With a continuously compounded
annual risk-free rate of 5 percent, and at a one-year forward price of 310.686, we
can calculate the lease rate according to the formula:

1 , 310.686
= − = 0.05 − = 0.015
300

b) Suppose gold cannot be loaned. Then our cash and carry “arbitrage” is:

Transaction Time 0 Time T=1

Short forward 0 310.686 - ST
Buy gold -$300 ST
Borrow @ 0.05 $300 −$315.38
Total 0 −4.6953
The forward price bears an implicit lease rate. Therefore, if we try to engage in a
cash and carry arbitrage but we do not have access to the gold loan market and
thus to the additional revenue on our long gold position, it is not possible for us to
replicate the forward price. We incur a loss.

c) If gold can be loaned, we engage in the following cash and carry arbitrage:

Transaction Time 0 Time T=1

Short forward 0 310.686 - ST
Buy tailed gold position, −$295.5336 ST
lend @ 0.015
Borrow @ 0.05 $295.5336 −$310.686
Total 0 0

26
.

For the next three problems, assume that the continuously compounded interest rate is
6%and the storage cost of widgets is $0.03 quarterly (payable at the end of the quarter).
Here is the forward price curve for widgets:

Year 0 Year 1 Year 2

Dec Mar June Sept. Dec Mar. June
3.000 3.075 3.152 2.750 2.822 2.894 2.968

Question 6.6
a) What are some possible explanations for the shape of this forward curve?
b) What annualized rate of return do you earn on a cash-and-carry entered into in
December of Year 0 and closed in March of Year 1? Is your answer sensible?
c) What annualized rate of return do you earn on a cash-and-carry entered into in
December of Year 0 and closed in September of Year 1? Is your answer
sensible?
Answers:
a) The forward prices reflect a market for widgets in which seasonality is important.
Let us look at two examples, one with constant demand and seasonal supply,
and another one with constant supply and seasonal demand.

One possible explanation might be that widgets are extremely difficult to produce
and that they need one key ingredient that is only available during July/August.
However, the demand for the widget is constant throughout the year. In order to
be able to sell the widgets throughout the year, widgets must be stored after
production in August. The forward curve reflects the ever increasing storage
costs of widgets until the next production cycle arrives. Once produced, widget
prices fall again to the spot price.

Another story that is consistent with the observed prices of widgets is that
widgets are in particularly high demand during the summer months. The storage
of widgets may be costly, which means that widget producers are reluctant to
build up inventory long before the summer. Storage occurs slowly over the winter
months and inventories build up sharply just before the highest demand during
the summer months. The forward prices reflect those storage cycle costs.

- continued -

27
.

b) Let us take the December Year 0 forward price as a proxy for the spot price in
December Year 0. We can then calculate with our cash and carry arbitrage
tableau:
Transaction Time 0 Time T=3/12
Short March forward 0 3.075 - ST
Buy December Forward -3.00 ST
(= Buy spot)
Pay storage cost −0.03
Total −3.00 3.045
We can calculate the annualized rate of return as:
( )×
3.045 =
3.00
3.045
⟺ = × 3.12
3.00

= 0.05955

which is the prevailing risk-free interest rate of 0.06. This result seems to make
sense.

c) Let us again take the December Year 0 forward price as a proxy for the spot price
in December Year 0. We can then calculate with our cash and carry arbitrage
tableau:
Transaction Time 0 Time T=9/12
Short Sep forward 0 2.75 - ST
Buy spot −0.300 ST
Pay storage cost Sep −0.03
FV(Storage Jun) −0.0305
V(Storage Mar) −0.0309
Total −0.300 2.6586
We can calculate the annualized rate of return as:

2.6586 ( )×
2.6586
= ⟺ = × 9/12
3.00 3.00

= −0.1610 8

This result does not seem to make sense. We would earn a negative annualized
return of 16 percent on such a cash and carry arbitrage. Therefore, it is likely that
our naive calculations do not capture an important fact about the widget market.
In particular, we will buy and hold the widget through a time where the forward
curve indicates that there is a significant convenience yield attached to widgets.

It is tempting, although premature, to conclude that a reverse cash and carry

arbitrage may make a positive 16 percent annualized return. Question 6.7 deals
with this aspect.

28
.

Question 6.7
a) Suppose that you want to borrow a widget beginning in December of Year 0 and
ending in March of Year 1. What payment will be required to make the
transaction fair to both parties?
b) Suppose that you want to borrow a widget beginning in December of Year 0 and
ending in September of Year 1. What payment will be required to make the
transaction fair to both parties?
Answers:
a) Let us take the December Year 0 forward price as a proxy for the spot price in
December Year 0. We can then calculate a reverse cash and carry arbitrage
tableau:

Transaction Time 0 Time T=3/12

Long March forward 0 ST − 3.075
Short widget +3.00 −ST
Lend money −3.00 +3.045
Total 0 −0.03

We need to receive 0.03 as a compensation from the lender of the widget. This
cost reflects the storage cost of the widget that the lender does not need to pay.
The lease rate is negative.

b) Let us take the December Year 0 forward price as a proxy for the spot price in
December Year 0. We can then calculate a reverse cash and carry arbitrage
tableau:
Transaction Time 0 Time T=9/12
Long Sept forward 0 ST – 3.075
Short widget +3.00 −ST
Lend money −3.00 +3.13808
Total 0 0.06308
Although we free the lender of the widget of the burden to pay three times
storage costs, we still need to pay him 0.06308. This reflects the fact that we hold
the widget through the period in which widgets are valuable (as reflected by the
forward contracts) and are returning it at a time it is worth less. The lender is only
willing to do so if we compensate him for the opportunity cost.

29
.

Question 6.8
a) Suppose the March Year 1 forward price were $3.10. Describe two different
transactions you could use to undertake arbitrage.
b) Suppose the September Year 1 forward price fell to $2.70 and subsequent
forward prices fell in such a way that there is no arbitrage from September Year 1
and going forward. Is there an arbitrage you could undertake using forward
contracts from June Year 1 and earlier? Why or why not?
Answers:
a) The first possibility is a simple cash and carry arbitrage:
Transaction Time 0 Time T = 3/12
Short March forward 0 3.10 −ST
Buy December −3.00 ST
forward (= Buy spot)r
Borrow @ 6% +3.00 −3.045
Pay storage cost −0.03
Total 0 +0.025
The second possibility involves using the June futures contract. It is a forward
cash-and-carry strategy:
Transaction Time T(1) = 3/12 Time T = 6/12
Short March forward 3.10 − ST −ST(2)
Buy June forward 0 −ST(2) −3.152
Lend @ 6% −3.10 3.1469
Receive storage cost +0.03
Total 0 +0.02485
We can use the June futures in our calculations and claim to receive storage
costs because it is easy to show that the value of it is reflecting the negative
lease rate of the storage costs.

b) It is not possible to undertake an arbitrage with the futures contracts that expire
prior to September Year 1. A decrease in the September futures value means
that we would need to buy the September futures contract, and any arbitrage
strategy would need some short position in the widget. However, the drop in the
futures price in September indicates that there is a significant convenience yield
factored into the futures price over the period June–September. As we have no
information about it, it is not possible for us to guarantee that we will find a lender
of widgets at a favorable lease rate to follow through our arbitrage trading
program. The decrease in the September futures may in fact reflect an increase
in the opportunity costs of widget owners.

30
.

Question 6.9
Consider Example 6.1. Suppose the February forward price had been $2.80. What would the
arbitrage be? Suppose it had been $2.65. What would the arbitrage be? In each case,
specify the transactions and resulting cash flows in both November and February. What are
you assuming about the convenience yield?

Answer:

If the February corn forward price is $2.80, the observed forward price is too expensive
relative to our theoretical price of $2.7273. We will therefore sell the February contract short,
and create a synthetic long position, engaging in cash and carry arbitrage:

Transaction Nov Dec Jan Feb

Short Feb forward 0 2.80 − ST
Buy spot −2.50 ST
Borrow purchasing cost +2.50 −2.57575
Pay storage cost Dec, −0.05 −0.051005
borrow storage cost 0 +0.05
Pay storage cost Jan, −0.05 −0.0505
borrow storage cost +0.05
Pay storage cost Feb −0.05
Total 0 0 0 0.072745

We made an arbitrage profit of 0.07 dollar. If the February corn forward price is $2.65, the
observed forward price is too low relative to our theoretical price of $2.7273. We will,
therefore, buy the February contract and create a synthetic short position, engaging in
reverse cash and carry arbitrage:

Transaction Nov Dec Jan Feb

Long Feb forward 0 ST − 2.65
Sell spot 2.50 −ST
Lend short sale −2.50 +2.57575
Proceeds
Receive storage cost +0.05 +0.051005
Dec, lend them −0.05
Receive storage cost +0.05 +0.0505
Jan, lend them −0.05
Receive cost Feb +0.05
Total 0 0 0 0.077255

We made an arbitrage profit of $0.08. It is important to keep in mind that we ignored any
convenience yield that there may exist to holding the corn. We assumed the convenience
yield is zero.

31
.

Question 6.10
Using Table 6.6, what is your best guess about the current price of gold per ounce?

Table 6.6
Gold forward and prepaid forward prices on 1 day for gold delivered at 1-year intervals, out
to 6 years. The continuously compounded interest rate is 6% and the lease rate is assumed
to be a constant 1.5%.

Expiration Year Forward Price ($) Prepaid Forward Price ($)

1 313.81 295.53
2 328.25 291.13
3 343.36 286.80
4 359.17 282.53
5 375.70 278.32
6 392.99 274.18

Answer:

Our best bet for the current spot price is the first available forward price, properly discounted
by taking the interest rate and the lease rate into account, and by ignoring any storage cost
and convenience yield (because we do not have any information on it):

( )×
, = ×

( )×
⟺ × , ×

( . . )×
⟺ = 313.81 × = 313.81× 0.956= 300.001 6

Question 6.11
Consider production ratios of 2:1:1, 3:2:1, and 5:3:2 for oil, gasoline, and heating oil. Assume
that other costs are the same per gallon of processed oil.
a) Which ratio maximizes the per-gallon profit if oil costs $80/barrel, gasoline is
$2/gallon, and heating oil is $1.80/gallon?
b) Suppose gasoline costs $1.80/gallon and heating oil $2.10/gallon. Which ratio
maximizes profit?
c) Which spread would you expect to be most profitable during the summer? Which
during the winter?

32
.

Answers:

There are 42 gallons of oil in one barrel. For each of these production ratios, we have to buy
oil and sell gasoline and heating oil.

We calculate for the

2:1:1 split: Profit = $2/gallon × 1 gallon + $1.80/gallon × 1 gallon – 2 × $80/42 = –0.0095

3:2:1 split: Profit = $2/gallon × 2 gallons + $1.80/gallon × 1 gallon – 3 × $80/42 = 0.0857
5:3:2 split: Profit = $2/gallon × 3 gallons + $1.80/gallon × 2 gallons – 5 × $80/42 = 0.07619
The 3:2:1 split maximizes profits

With these prices, we calculate for the

2:1:1 split: Profit = $1.80/gallon × 1 gallon + $2.10/gallon × 1 gallon – 2 × $80/42 = 0.0905

3:2:1 split: Profit = $1.80/gallon × 2 gallons + $2.10/gallon × 1 gallon – 3 × $80/42 = –0.0143
5:3:2 split: Profit = $1.80/gallon × 3 gallons+ $2.10/gallon × 2 gallons – 5 × $80/42 = 0.0762
Now, the 2:1:1 split maximizes profit.

You would expect the heating oil to be the most expensive in winter, and hence the 2:1:1
split to be most profitable in winter. People drive more and need less heating oil during the
summer, so then you would choose a split with the highest fraction of gasoline, the 3:2:1.

Question 6.12
Suppose you know nothing about widgets. You are going to approach a widget merchant to
borrow one in order to short-sell it. (That is, you will take physical possession of the widget,
sell it, and return a widget at time T.) Before you ring the doorbell, you want to make a
judgment about what you think is a reasonable lease rate for the widget. Think about the
following possible scenarios.
a) Suppose that widgets do not deteriorate over time, are costless to store, and are
always produced, although production quantity can be varied. Demand is
constant over time. Knowing nothing else, what lease rate might you face?
b) Suppose everything is the same as in (a) except that demand for widgets varies
seasonally.
c) Suppose everything is the same as in (a) except that demand for widgets varies
seasonally and the rate of production cannot be adjusted. Consider how
seasonality and the horizon of your short-sale interact with the lease rate.
d) Suppose everything is the same as in (a) except that demand is constant over
time and production is seasonal. Consider how production seasonality and the
horizon of your short-sale interact with the lease rate.
e) Suppose that widgets cannot be stored. How does this affect your answers to the
previous questions?

33
.

Answers:
a) Widgets do not deteriorate over time and are costless to store; therefore, the
lender does not save anything by lending me the widget. On the other hand,
there is a constant demand and flexible production—there is no seasonality.
Therefore, we should expect that the convenience yield is very close to the
riskfree rate, merely compensating the lender for the opportunity cost.

b) Demand varies seasonally, but the production process is flexible. Therefore, we

would expect that producers anticipate the seasonality in demand and adjust
production accordingly. Again, the lease rate should not be much higher than the
risk-free rate.

c) Now we have the problem that the demand for widgets will spike up without an
appropriate adjustment of production. Let us suppose that widget demand is high
in June, July, and August. Then, we will face a substantial lease rate if we were
to borrow the widget in May and return it in September: We would deprive the
merchant of the widget when he would need it most (and could probably earn a
significant amount of money on it), and we would return it when the season is
over. We most likely pay a substantial lease rate.

On the other hand, suppose we want to borrow the widget in January and return
it in June. Now we return the widget precisely when the merchant needs it and
have it over a time where demand is low, and he is not likely to sell it. The lease
rate is likely to be very small.

However, those stylized facts are weakened by the fact that the merchant can
costlessly store widgets, so the smart merchant has a larger inventory when
demand is high, offsetting the above effects at a substantial amount.

d) Suppose that production is very low during June, July, and August. Let us think
about borrowing the widget in May and returning it in September. We do again
deprive the merchant of the widget when he needs it most, because with a
constant demand, less production means widgets become a comparably scarce
resource and increase in price. Therefore, we pay a higher lease rate. The
opposite effects can be observed for a widget borrowing from January to June

Again, these stylized facts are offset by the above mentioned inventory
considerations.

e) If widgets cannot be stored, the seasonality problems become very severe,

leading to larger swings in the lease rate due to the impossibility of managing
inventory.

34
P1.T3. Financial Markets & Products

Chapter 12. Options Markets

Bionic Turtle FRM Study Notes

CHAPTER 12. OPTIONS MARKETS ..................................................................................... 3
DESCRIBE THE TYPES, POSITION VARIATIONS, PAYOFFS AND PROFITS, AND TYPICAL UNDERLYING
ASSETS OF OPTIONS. ................................................................................................................ 3
EXPLAIN THE SPECIFICATION OF EXCHANGE-TRADED STOCK OPTION CONTRACTS, INCLUDING THAT
OF NONSTANDARD PRODUCTS. ................................................................................................. 9
EXPLAIN HOW DIVIDENDS AND STOCK SPLITS CAN IMPACT THE TERMS OF A STOCK OPTION ......... 13
DESCRIBE HOW TRADING, COMMISSIONS, MARGIN REQUIREMENTS, AND EXERCISE TYPICALLY
WORK FOR EXCHANGE-TRADED OPTIONS.................................................................................. 14
DEFINE AND DESCRIBE WARRANTS, CONVERTIBLE BONDS, AND EMPLOYEE STOCK OPTIONS. ..... 18
CHAPTER SUMMARY ............................................................................................................... 19

2
Chapter 12. Options Markets
 Describe the types, position variations, payoffs and profits, and typical underlying
assets of options.

 Explain the specification of exchange-traded stock option contracts, including that

of nonstandard products.

 Explain how dividends and stock splits can impact the terms of a stock option.

 Describe how trading, commissions, margin requirements, and exercise typically

work for exchange-traded options.

 Define and describe warrants, convertible bonds, and employee stock options.

NOTE THIS LO HAS ADDITIONAL WORDING ADDED “Payoffs and profits”.

The earlier content discusses about the payoffs and profits.

Describe the types, position variations, payoffs and profits, and

typical underlying assets of options.
Types of options
There are two basic types of options.
 A call option gives the holder of the option the right to buy an asset by a certain date
for a certain price.
 A put option gives the holder the right to sell an asset by a certain date for a certain
price.
The date specified in the contract is known as the expiration date or the maturity date. The
price specified in the contract is known as the exercise price or the strike price.

Options can be either American or European, a distinction that has nothing to do with
geographical location.
 American options can be exercised at any time up to the expiration date.
 European options can be exercised only on the expiration date itself.
Most of the options that are traded on exchanges are American. However, European options
are generally easier to analyze than American options, and some of the properties of an
American option are frequently deduced from those of its European counterpart.

Call Option: Consider the situation of an investor who buys a European call option with a
strike price of $100 to purchase 100 shares of a certain stock. Suppose that the current
stock price is $98, the expiration date of the option is in 4 months, and the price of an option
to purchase one share is $5.
 The initial investment is $500. Because the option is European, the investor can
exercise only on the expiration date. If the stock price on this date is less than $100,
the investor will clearly choose not to exercise. In these circumstances, the investor
loses the whole of the initial investment of $500.
 If the stock price is above $100 on the expiration date, the option will be exercised.
Suppose that the stock price is $115. By exercising the option, the investor is able to
buy 100 shares for $100 per share. If the shares are sold immediately, the investor

3
makes a gain of $15 per share, or $1,500, ignoring transactions costs. When the
initial cost of the option is taken into account, the net profit to the investor is $1,000.

4
It is important to realize that an investor sometimes exercises an option and makes a
loss overall.
 Suppose that, the stock price is $102 at the expiration of the option: The investor
would exercise the option contract for a gain of 100 x ($102 - $100) = $200 and
realize a loss overall of $300 when the initial cost of the option is taken into account.
Not exercising would lead to an overall loss of $500, which is worse than the $300
loss when the investor exercises.
 In general, call options should always be exercised at the expiration date if the stock
price is above the strike price.
The figure below shows how the investor's net profit or loss on a call option to purchase
one share varies with the final stock price in the example.

Hull Fig 10.1: Profit from a long European call

Long call, K = $100, c=$5

$30
$20
$10
$0
($10)
$100

$110

$120

$130
$70

$80

$90

Put Options: Consider an investor who buys a European put option with a strike price of
$70 to sell 100 shares of a certain stock. Suppose that the current stock price is $65, the
expiration date of the option is in 3 months, and the price of an option to sell one share is $7.
 The initial investment is $700. Because the option is European, it will be exercised
only if the stock price is below $70 on the expiration date. If the final stock price is
above $70, the put option expires worthless, and the investor loses $700.
 Suppose that the stock price is $55 on expiration date. The investor can buy 100
shares for $55 per share and, under the terms of the put option, sell the same shares
for $70 to realize a gain of $15 per share, or $1,500. When the $700 initial cost of the
option is taken into account, the investor's net profit is $800.

5
The figure below shows the way in which the investor's profit or loss on a put option to sell
one share varies with the terminal stock price in this example.

Hull Fig 10.2: Profit from a long European put

Long put, K = $70, p=$7

$30
$20
$10
$0
($10)

$100
$40

$50

$60

$70

$80

$90
Option Positions: There are two sides to every option contract.
 One counterparty is the investor who has the long position (she bought the option).
 The other counterparty has taken a short position (he sold or “wrote” the option).
o The writer of an option receives cash up front, but has potential liabilities later.
o The writer's profit or loss is the reverse of that for the purchaser of the option.

The figures below show the variation of the profit or loss with the final stock price for writers
of the options considered in Hull Figures 10.1 and 10.2.

Hull Fig 10.3: Profit from Hull Fig 10.4: Profit from
a short European call option a short European put option

Short call, K = $100, c=$5 Short put, K = $70, p=$7

$10 $10
$0 $0
($10) ($10)
($20) ($20)
($30)
($30)
$100

$110

$120

$130
$70

$80

$90

$100
$40

$50

$60

$70

$80

$90

6
Thus, there are four types of basic option positions:
1. A long position in a call option
2. A long position in a put option
3. A short position in a call option
4. A short position in a put option
Payoffs from positions
It is often useful to characterize a European option in terms of its payoff to the purchaser of
the option. The initial cost of the option is then not included in the calculation. If is the
strike price and is the final price of the underlying asset, the payoffs are:

Long position in a European call option: ( − , 0)

Short position in a European call option: − ( − , 0) = ( − , 0)
Long position in a European put option: ( − , 0)
Short position in a European put option: − ( − , 0) = ( − , 0)

The figure below illustrates these payoffs for the examples discussed earlier.

Hull Fig 10.5: Payoffs from positions in European options

Long call, K = $100 Long put, K = $70

$40 $40
$30 $30
$20 $20
$10 $10
$0 $0
$100

$110

$120

$130

$100
$70

$80

$90

$40

$50

$60

$70

$80

$90

Short call, K = $100 Short put, K = $70

$0 $0
($10) ($10)
($20) ($20)
($30) ($30)
($40) ($40)
$40

$50

$60

$70

$80

$90

$100
$100

$110

$120

$130
$70

$80

$90

7
Underlying Assets
There are options on underlying assets such as stocks, currencies, stock indices, and
futures. These are traded on the exchanges or over-the-counter.

Stock Options: Most trading in stock options is on exchanges. Options trade on more than
thousand different stocks. One contract gives the holder the right to buy or sell 100 shares at
the specified strike price. This contract size is convenient because the shares themselves
are normally traded in lots of 100.

Foreign Currency Options: Most currency options trading is now in the over-the-counter
market, but there is some exchange trading. The major exchange for trading foreign
currency options in the United States is the Philadelphia Stock Exchange. It offers both
European and American contracts on a variety of different currencies.
The size of one contract depends on the currency. For example, in the case of the British
pound, one contract gives the holder the right to buy or sell £31,250; in the case of the
Japanese yen, one contract gives the holder the right to buy or sell 6.25 million yen.

Index Options: Many different index options currently trade throughout the world in both the
over-the-counter market and the exchange-traded market.
 The most popular exchange-traded contracts in the United States are those on the
S&P 500 Index (SPX), the S&P 100 Index (OEX), the Nasdaq 100 Index (NDX), and
the Dow Jones Industrial Index (DJX). All of these trade on the Chicago Board
Options Exchange.
 Most of these contracts are European. An exception is the OEX contract on the S&P
100, which is American. One contract is usually to buy or sell 100 times the index at
the specified strike price. Settlement is always in cash, rather than by delivering the
portfolio underlying the index.
o Consider, for example, one call contract on the S&P 100 with a strike price of
980. If it is exercised when the value of the index is 992, the writer of the
contract pays the holder (992 - 980) x 100 = $1,200. This cash payment is
based on the index value at the end of the day on which exercise instructions
are issued.
Futures Options: When an exchange trades a particular futures contract it often also trades
options on that futures contract.
 A futures option normally matures just before the delivery period in the futures
contract.
 When a call option is exercised, the holder acquires from the writer a long position in
the underlying futures contract plus a cash amount equal to the excess of the futures
price over the strike price.
 When a put option is exercised, the holder acquires a short position in the underlying
futures contract plus a cash amount equal to the excess of the strike price over the
futures price.

8
Explain the specification of exchange-traded stock option
contracts, including that of nonstandard products.
Specifications on standard stock options
A standard exchange-traded stock option in the United States is an American-style option
contract to buy or sell 100 shares of the stock. Details of the contract like the expiration date,
the strike price, what happens when dividends are declared, how large a position investors
can hold, and so on-are specified by the exchange.
Expiration Dates
One of the items used to describe a stock option is the month in which the expiration date
occurs.
 Stock options in US are on a January, February, or March cycle.
o The January cycle consists of the months of January, April, July, and
October.
o The February cycle consists of the months of February, May, August, and
November.
o The March cycle consists of the months of March, June, September, and
December.
 If the expiration date for the current month has not yet been reached, options
trade with expiration dates in the current month, the following month, and the next
two months in the cycle.
 If the expiration date of the current month has passed, options trade with
expiration dates in the next month, the next-but-one month, and the next two months
of the expiration cycle.
 When one option reaches expiration, trading in another is started. Longer-term
options, known as LEAPS (long-term equity anticipation securities), also trade on
about 500 stocks in the United States. These have expiration dates up to 39 months
into the future. The expiration dates for LEAPS on stocks are always in January.
For example:
 A January call trading on IBM is a call option on IBM with an expiration date in
January. The last day on which options trade is the third Friday of the expiration
month. The precise expiration date is the Saturday immediately following the third
Friday of the expiration month.
 IBM is on a January cycle.
o At the beginning of January, options are traded with expiration dates in January,
February, April, and July; at the end of January, they are traded with expiration
dates in February, March, April, and July; at the beginning of May, they are
traded with expiration dates in May, June, July, and October; and so on.

9
Strike Prices
The exchange normally chooses the strike prices at which options can be written.
 These strikes are spaced $2.50, $5, or $10 apart. Typically, the spacing is:
o $2.50 when the stock price is between $5 and $25,
o $5 when the stock price is between $25 and $200,
o $10 for stock prices above $200.
 Stock splits and stock dividends can lead to nonstandard strike prices.
 When a new expiration date is introduced, the two or three strike prices closest to the
current stock price are usually selected by the exchange.
 If the stock price moves outside the range defined by the highest and lowest strike
price, trading is usually introduced in an option with a new strike price. To illustrate'
these rules,
o Suppose that the stock price is $84 when trading begins, call and put options
would probably first be offered with strike prices of $80, $85, and $90.
o If the stock price rise above $90, it is likely that a strike price of $95 would be
offered; if it falls below $80, it is likely that a strike price of $75 would be offered;
and so on.
Terminology
For any given asset at any given time, many different option contracts may be trading.
 Option class refer to all options of the same type (calls or puts) on a stock. For
example, IBM calls are one class, whereas IBM puts are another class.
 An option series consists of all the options of a given class with the same expiration
date and strike price. In other words, it refers to a particular contract that is traded.
For example, IBM 200 October 2014 calls would constitute an option series.
 Options are referred to as in the money, at the money, or out of the money. An
option will be exercised only when it is in the money. In the absence of transactions
costs, an in-the-money option will always be exercised on the expiration date if it has
not been exercised previously. If is the stock price and is the strike price:
Option In the money At the money Out of money
Call > = <
Put < = >
 The intrinsic value of an option is defined as the maximum of zero and the value the
option would have if it were exercised immediately.
o The intrinsic value for a call option is ( − , 0); put option is ( − , 0).
o An in-the-money American option must be worth at least as much as its intrinsic
value because the holder can realize the intrinsic value by exercising
immediately. Often it is optimal for the holder of an in-the-money American option
to wait rather than exercise immediately.
 An option's time value is equal to its premium (the cost of the option) less its
intrinsic value.
 The total value of an option can be thought of as the sum of its intrinsic value and
its time value.

10
Non-standard products
FLEX Options: These are flexible options where the traders on the floor of the exchange
agree to nonstandard terms.
 The Chicago Board Options Exchange offers FLEX options on equities and equity
indices.
 These nonstandard terms can involve a strike price or an expiration date that is
different from what is usually offered by the exchange. It can also involve the option
being European rather than American.
 The exchange specifies a minimum size (e.g., 100 contracts) for FLEX option trades.
 FLEX options are an attempt by option exchanges to regain business from the over-
the-counter markets.
In addition to flex options, the CBOE trades a number of other nonstandard products. They
are:
 Options on exchange-traded funds
 Weeklys: These are options that are created on a Thursday and expire on Friday of
the following week.
 Binary options: These are options that provide a fixed payoff of $100 if the strike
price is reached. For example
o a binary call with a strike price of $50 provides a payoff of $100 if the price of the
underlying stock exceeds $50 on the expiry date.
o a binary put with a strike price of $50 provides a payoff of $100 if the price of the
stock is below $50 on the expiry date.
 Credit event binary options (CEBOs): These are options that provide a fixed payoff
if a particular company (known as the reference entity) suffers a ‘‘credit event’’ by the
maturity date.
o A CEBO is a type of credit default swap.
o Credit events are defined as bankruptcy, failure to pay interest or principal on
debt, and a restructuring of debt.
o Maturity dates are in December of a particular year and payoffs, if any, are made
on the maturity date.
 DOOM options: These are deep-out-of-the-money put options.
o They have a low strike price and so they cost very little.
o They provide a payoff only if the price of the underlying asset plunges.
o DOOM options provide the same sort of protection as credit default swaps.

Dividends and Stock Splits

Exchange-traded options are not usually adjusted for cash dividends.
 If a company declared a cash dividend, the strike price for options on the company's
stock is not reduced on the ex-dividend day by the amount of the dividend.
 An exception is sometimes made for large cash dividends.

11
Exchange-traded options are adjusted for stock splits.
 A stock split occurs when the existing shares are "split" into more shares and the
terms of option contracts are adjusted to reflect expected changes in a stock price
arising from a stock split.
 In general, an n-for-m stock split should cause the stock and strike price to go down
to m/n of its previous value
o For example, the 2-for-1 stock split should cause the price to go down to one-half
of its previous value.
 Also, an n-for-m stock split causes the number of shares covered by one contract to
increase to n/m of its previous value. If the stock price declines in the way expected,
the positions of both the writer and the purchaser of a contract remain unchanged.
o For example, if there is a call option to buy 100 shares of a company for $30 per
share and if the company makes a 2-for-1 stock split, then terms of the option
contract are then changed so that it gives the holder the right to purchase 200
shares for $15 per share.
Exchange-traded stock options are adjusted for stock dividends.
 A stock dividend is when a company issues more shares to its existing shareholders.
 A stock dividend, like a stock split, has no effect on either the assets or the earning
power of a company.
 The stock price can be expected to go down as a result of a stock dividend.
 The terms of an option are adjusted to reflect the expected price decline arising from
a stock dividend in the same way as they are for that arising from a stock split.
o For example, a 20% stock dividend means that investors receive one new share
for each five already owned. The 20% stock dividend referred to is essentially the
same as a 6-for-5 stock split. All else being equal, it should cause the stock price
to decline to 5/6 of its previous value.
Consider a put option to sell 100 shares of a company for $15 per share.
Suppose the company declares a 25% stock dividend. This is equivalent to a 5-
for-4 stock split. The terms of the option contract are changed so that it gives the
holder the right to sell 125 shares for $12.
Position Limits and Exercise Limits
Position limits and exercise limits are designed to prevent the market from being unduly
influenced by the activities of an individual investor or group of investors.

Position limit defines the maximum number of option contracts that an investor can hold on
one side of the market.
 For this purpose, long calls and short puts are considered to be on the same side of
the market. Also, considered to be on the same side are short calls and long puts.
 Options on the largest and most frequently traded stocks have positions limits of
250,000 contracts. Smaller capitalization stocks have position limits of 200,000,
75,000, 50,000, or 25,000 contracts.
The exercise limit defines the maximum number of contracts that can be exercised by any
individual (or group of individuals acting together) in any period of five consecutive business
days.
 It usually equals the position limit.

12
Explain how dividends and stock splits can impact the terms of a
stock option.
Cash dividends usually do not affect the terms of a stock option. However, exceptions
are sometimes made when the cash dividend is unusually large. Specifically, if the cash
dividend is more than 10% of the stock price, the Options Clearing Corporation forms a
committee to determine whether adjustments should be made.

In contrast, stock splits do lead to strike price adjustments. For example, if a company
announces a 5-to-1 stock split (i.e., each share is replaced by five new shares), the strike
price will be reduced to one fifth of the original price and the number of options is
multiplied by five.

Similarly, stock dividends also lead to strike price adjustments. A 10% stock
dividend means shareholders receive one new share for each ten shares owned (this is
identical to an 11-to-10 stock split). Using the stock split rule, the strike price will be
reduced to ten-elevenths of its original level and the number of options is multiplied by
11/10. All these adjustments are designed to keep the positions of buyers and sellers
unchanged by incidents of stock splits or stock dividends.

13
Describe how trading, commissions, margin requirements, and
exercise typically work for exchange-traded options.
Trading
Traditionally, exchanges have had to provide a large open area for individuals to meet and
trade options, but this has changed. Many derivatives exchanges are fully electronic, so
traders do not have to physically meet.

Market makers: Most options exchanges use market makers to facilitate trading.
 A market maker will quote both a bid and an offer price on the option. The bid is the
price at which the market maker is prepared to buy, and the offer or asked is the
price at which the market maker is prepared to sell.
 The offer is always higher than the bid, exceeding it by an amount referred to as the
bid-offer spread. The exchange sets upper limits for the bid-offer spread.
o For example, it might specify that the spread be no more than $0.25 for options
priced at less than $0.50, $0.50 for options priced between$0.50 and $10, $0.75
for options priced between $10 and $20, and $1 for options priced over $20.
 The existence of the market maker ensures that buy and sell orders can always be
executed at some price without any delays and therefore add liquidity to the market.
The market makers themselves make their profits from the bid-offer spread.
Offsetting order: An investor who has purchased options can close out the position by
issuing an offsetting order to sell the same number of options. Similarly, an investor who has
written an option can close out the position by issuing an offsetting order to buy the same
option. When an option contract is traded,
 if, neither investor is closing an existing position, the open interest increases by one
contract.
 if one investor is closing an existing position and the other is not, the open interest
stays the same.
 if both investors are closing existing positions, the open interest goes down by one
contract.
Commissions
The types of orders that can be placed with a broker for options trading are similar to those
for futures trading.
 A market order is executed immediately, a limit order specifies the least favorable
price at which the order can be executed, and so on.
 For a retail investor, commissions vary significantly from broker to broker. Discount
brokers generally charge lower commissions than full-service brokers.

14
  The actual amount charged is often calculated as a fixed cost plus a proportion of the
dollar amount of the trade.
 If an option position is closed out by entering into an offsetting trade, the commission
must be paid again.
 If the option is exercised, the commission is the same as it would be if the investor
placed an order to buy or sell the underlying stock. This could be as much as 1% to
2% of the stock's value.
The table below shows the sort of schedule that might be offered by a discount broker.

Hull Table 10.1: Sample commission schedule for a discount broker

Dollar amount of trade Commission*

< $2,500 $20 + 2% of dollar amount
$2,500 to $10,000 $45 + 1% of dollar amount
> $10,000 $120 + 0.25% of dollar amount
*Maximum commission is $30 per contract for the first five contracts plus $20 per
contract for each additional contract. Minimum commission is $30 per contract
for the first contract plus $2 per contract for each additional contract.

From the table, the purchase of eight contracts when the option price is $3 would cost:

Cost in dollar amount: 8 x 100 x 3= $2400

Cost in commissions: $20 + (0.02 x $2400) = $68

Example: Consider an investor who buys one call contract with a strike price of $50 when
the stock price is $49. The option price is $4.50. Suppose that the stock price rises and the
option is exercised when the stock reaches $60.
 The cost of the contract is $450 (=4.5 x 100)
 Under the schedule in Table 10.1, the purchase or sale of one contract always costs
$30 (both the maximum and minimum, commission is $30 for the first contract).
Assuming that the investor pays 0.75% commission to exercise the option and a
further 0.75% commission to sell the stock, there is an additional cost of $90(= 2 x
0.0075 x 60 x 100). The total commission paid is $120 (= 90+30)
 The net profit to the investor is: (60-50) x 100 – 450 – 120 =$430
 Note that selling the option for $10 instead of exercising it would save the
investor $60 in -commissions. (The commission payable when an option is sold is
only $30 in our example.) In general, the commission system tends to push retail
investors in the direction of selling options rather than exercising them.
A hidden cost in option trading (and in stock trading) is the market maker's bid-offer
spread.
 Suppose that, in the example just considered, the bid price was $4.00 and the offer
price was $4.50 at the time the option was purchased. We can reasonably assume
that a "fair" price for the option is halfway between the bid and the offer price, or
$4.25.
 The cost to the buyer and to the seller of the market maker system is the difference
between the fair price and the price paid. This is $0.25 per option, or $25 per
contract.

15
Margin requirements
When shares are purchased in the United States, an investor can borrow up to 50% of the
price from the broker. This is known as buying on margin.
 If the share price declines so that the loan is substantially more than 50% of the
stock's current value, there is a "margin call", where the broker requests that cash
be deposited by the investor. If the margin call is not met, the broker sells the stock.
 When call and put options with maturities less than 9 months are purchased, the
option price must be paid in full. Investors are not allowed to buy these options on
margin because options already contain substantial leverage and buying on margin
would raise this leverage to an unacceptable level.
 For options with maturities greater than 9 months, investors can buy on margin,
borrowing up to 25% of the option value.
 A trader who writes options is required to maintain funds in a margin account so that
the trader will not default if the option is exercised. The amount of margin required
depends on the trader's position.

A naked option is an option that is not combined with an offsetting position in the underlying
stock. The initial margin required
 For a written naked call option is the greater of the following two calculations:
a) A total of 100% of the proceeds of the sale plus 20% of the underlying share
price less the amount, if any, by which the option is out of the money
b) A total of 100% of the option proceeds plus 10% of the underlying share price
 For a written naked put option, it is the greater of
a) A total of 100% of the proceeds of the sale plus 20% of the underlying share
price less the amount, if any, by which the option is out of the money
b) A total of 100% of the option proceeds plus 10% of the exercise price
 The 20% in these calculations is replaced by 15% for options on a broadly based
stock index because a stock index is usually less volatile than the price of an
individual stock.
 A calculation similar to the initial margin calculation (but with the current market price
of the contract replacing the proceeds of sale) is repeated every day.
 Funds can be withdrawn from the margin account when the calculation indicates that
the margin required is less than the current balance in the margin account. When the
calculation indicates that a greater margin is required, a margin call will be made.
Hull Example 10.3: An investor writes four naked call option contracts on a stock priced
$38. The option price is $5, the strike price is $40. The option is $2 out of the money.
 The initial margin required for this naked call is $4,240 which is calculated as:
[ 400 (5 + 0.2 × 38 – 2), 400 (5 + 0.1 × 38)] = [$4240, $3520]
 Note that, if the option had been a put, it would be $2 in the money and the initial
margin requirement would be $5040 which is calculated as:
[ 400 (5 + 0.2 × 38 ), 400 (5 + 0.1 × 38) ] = [$5040, $3520]
 In both cases, the proceeds of the sale can be used to form part of the margin
account.

16
For option trading strategies such as covered calls, protective puts, spreads, combinations,
straddles, and strangles exchanges have special rules for determining the margin
requirements.

Exercising an Option
The Options Clearing Corporation (OCC) performs much the same function for
options markets as the clearinghouse does for futures markets.
 The OCC has a number of members, and all option trades must be cleared through a
member. If a broker is not itself a member of an exchange's OCC, it must arrange to
clear its trades with a member.
 Members are required to have a certain minimum amount of capital and to contribute
to a special fund that can be used if any member defaults on an option obligation.
 When purchasing an option, the buyer must pay for it in full by the morning of the
next business day. The funds are deposited with the OCC.
 The writer of the option maintains a margin account with a broker.
 The OCC guarantees that options writers will fulfill their obligations under the terms
of contracts and keeps a record of all long and short positions.
When an investor notifies a broker to exercise an option, the broker in turn notifies
the OCC member that clears its trades.
 This member then places an exercise order with the OCC. The OCC randomly
selects a member with an outstanding short position in the same option.
 The member, using a procedure established in advance, selects a particular investor
who has written the option. The investor is said to be assigned.
 If the option is a call, this investor is required to sell stock at the strike price. If it is a
put, the investor is required to buy stock at the strike price.
 When an option is exercised, the open interest goes down by one.
 At the expiration of the option, all in-the-money options should be exercised unless
the transactions costs are so high as to wipe out the payoff from the option.

17
Define and describe warrants, convertible bonds, and employee
stock options.
Warrants

Warrants are options issued by a corporation. They are usually call options on the
corporation’s own stock, but they can also be the options to buy or sell another asset (e.g.,
Gold). Once issued, they are often traded on the exchange.

To exercise a warrant, the holder needs to contact the issuer. When a call warrant on the
issuing company’s stock is exercised, the firm issues more of its stock. Once that happens,
the warrant holders can then buy the stock at the strike price.

Warrants can be used by firms to make debt issuances more attractive to investors. For
example, suppose a company’s stock price is currently USD 40 and the firm is planning a
debt issue. It might choose to add two warrants to each USD 1,000 bond; each warrant
would give the holder the right to buy one share at USD 45 on the expiration date. The
bondholders would then have a stake in the fortunes of the company beyond the desire
to see it avoid a default.

Convertible Bonds

A convertible bond (also referred to as a convertible) is similar to a warrant. Specifically, a

convertible is a bond that can be converted into equity using a pre-determined exchange
ratio. For example, suppose a company’s current share price is USD 40. It might choose to
issue ten-year bonds, each with a USD 1,000 par value, that can be converted into 20
shares at any time after four years. When an investor chooses to convert, the company
simply issues more of its stock to be exchanged for the bonds. Like warrants, convertible
bonds are often traded on exchanges.

Employee Stock Options

Employee stock options are call options granted by a company to its employees. They
differ from exchange-traded options in several ways.
 There is usually a vesting period during which options cannot be exercised. These
periods can last up to four years.
 Employees may forfeit their options if they leave their jobs (voluntarily or
involuntarily) during the vesting period.
 When employees leave after the vesting period, they usually forfeit options that are
out-of-the-money. They may also have to exercise their in-the-money options
immediately.
 Employees are not permitted to sell their stock options to a third party.
Because the employee options cannot be sold, they are usually exercised earlier than
their exchange-traded counterparts. It is debatable whether employee stock options align
with the interests of shareholders and managers. If the stock price does well, both
shareholders and managers will gain. If the stock price declines, however, the shareholders
typically suffer more than managers. Thus, granting managers shares (rather than stock
options) can create a better alignment of interests. Employee stock options are commonly
used by start-up companies that cannot afford to pay a competitive salary.

18
Chapter Summary
There are two types of options
 A call option gives the holder the right to buy the underlying asset for a certain price
by a certain date.
 A put option gives the holder the right to sell the underlying asset by a certain date
for a certain price.
There are four possible positions in options markets. Taking a short position in an option is
known as writing it.
o a long position in a call
o a short position in a call
o a long position in a put
o a short position in a put
Options are currently traded on underlying assets such as stocks, stock indices, foreign
currencies, futures contracts, etc.

An exchange must specify the terms of the option contracts it trades.

 It must specify the size of the contract, the precise expiration time, and the strike
price.
 In the US, one stock option contract gives the holder the right to buy or sell 100
shares.
 The expiration of a stock option contract is 10:59 p.m. Central Time on the Saturday
immediately following the third Friday of the expiration month.
 Options with several different expiration months trade at any given time.
 Strike prices are at $21, $5, or $10 intervals, depending on the stock price. The strike
price is generally fairly close to the stock price when trading in an option begins.
 The terms of a stock option are not normally adjusted for cash dividends. However,
they are adjusted for stock dividends, stock splits, and rights issues. The aim of the
adjustment is to keep the positions of both the writer and the buyer of a contract
unchanged.
Most option exchanges use market makers to facilitate trading.
 A market maker quotes both a bid price (at which he or she is prepared to buy) and
an offer price (at which he or she is prepared to sell). They themselves make a profit
from bid-offer spread. The exchange has rules specifying upper limits for the bid-offer
spread.
 They improve the liquidity of the market and ensure that there is never any delay in
executing market orders.
Writers of options have potential liabilities and are required to maintain margins with their
brokers. If it is not a member of the OCC, the broker will maintain a margin account with a
firm that is a member. This firm will in turn maintain a margin account with the OCC.

The OCC is responsible for keeping a record of all outstanding contracts, handling exercise
orders, and so on.

Apart from exchanges, options are also traded in the OTC market. They can be tailored by a
financial institution to meet the particular needs of a corporate treasurer or fund manager.

19
P1.T3. Financial Markets & Products

Chapter 13. Properties of Options

Bionic Turtle FRM Study Notes

CHAPTER 13. PROPERTIES OF OPTIONS .......................................................................... 3
IDENTIFY THE SIX FACTORS THAT AFFECT AN OPTION'S PRICE ..................................................... 3
IDENTIFY AND COMPUTE UPPER AND LOWER BOUNDS FOR OPTION PRICES ON NON-DIVIDEND AND
DIVIDEND PAYING STOCKS. ........................................................................................................ 5
EXPLAIN PUT-CALL PARITY AND APPLY IT TO THE VALUATION OF EUROPEAN AND AMERICAN STOCK
OPTIONS WITH DIVIDENDS AND WITHOUT DIVIDENDS AND EXPRESS IT IN TERMS OF FORWARD
PRICES ...................................................................................................................................... 6
EXPLAIN AND ASSESS POTENTIAL RATIONALES FOR USING THE EARLY EXERCISE FEATURES OF
AMERICAN CALL AND PUT OPTIONS. ............................................................................................ 8
CHAPTER SUMMARY ............................................................................................................... 11
QUESTIONS & ANSWERS: ....................................................................................................... 12

2
Chapter 13. Properties of Options
 Identify the six factors that affect an option’s price.

 Identify and compute upper and lower bounds for option prices on non-dividend
and dividend paying stocks.

 Explain put-call parity and apply it to the valuation of European and American
stock options with dividends and without dividends, and express it in terms of
forward prices.

 Explain the early exercise features of American call and put options.

Identify the six factors that affect an option's price

In the chart below, we show the directional impact of each input on the value of a call
or put option, while all the other factors remain fixed.

Directional Impact of Each Input on Call or Put

Factor Symbol Call Put
Stock price () + -
Strike price () - +
+ (American) + (American)
Time to expiration ()
? (European) ? (European)
Volatility () s + +
Risk-free rate () + -
Div. yield () - +

With respect to each factor:

 Stock price: For a call option, a higher stock price implies greater intrinsic value
 Strike price: For a call option, a higher strike price implies less intrinsic value
 Time to expiration: For an American option (call or put), option value is an
increasing function with greater time to expiration. For a European option, while value
will typically increase with greater time to expiration, the timing of dividends makes
the relationship ambiguous (on dividend payout, the stock tends to drop).
 Volatility: Greater volatility increases the value of both a call and a put option
 Risk-free rate: The minimum value of a European call option is the stock price minus
the discounted strike price. A higher risk-free rate implies a lower discounted strike
price and therefore, in turn, implies an increase in the value of the call option.
 Dividend yield: As dividends have the effect of reducing the stock price on the ex-
dividend date, a higher dividend reduces the call option’s value.
Please note that stock price, strike price, riskless rate and time to expiration are easily seen
in the Black-Scholes-Merton Volatility is contained in the and :

= ( )− ( )

3
The charts below illustrate the effect of changes in stock price, strike price, expiration date,
volatility and risk-free interest rate when = 50, = 50, =5%, s = 30%, and = 1.

Figure: Effect of input factors on option prices

4
Identify and compute upper and lower bounds for option prices on
non-dividend and dividend paying stocks.
For options on non-dividend paying stocks, the boundaries are:
Upper Bound:
 An American or European call option gives the holder the right to buy one share of
a stock for a certain price. No matter what happens, the option can never be worth
more than the stock ( ≤ )
 An American put option gives the holder the right to sell one share of a stock for
K. No matter how low the stock price becomes, the option can never be worth
more
than K. ( ≤ )
 For European put options, at maturity, the option cannot be worth more than K. It
follows that it cannot be worth more than the present value of K today( ≤ ).
Lower Bound:
 A lower bound for the price of a European call option on a non-dividend-paying
stock is the stock price minus discounted strike price. This is the price the Black-
Scholes gives if the volatility input is equal to zero. Since the option can at worst
expire ≥ ( − , 0).
worthless, it’s value cannot negative, so lower bound is
 For a European put option on a non-dividend-paying stock, lower bound is maximum
of zero or discounted strike price minus the stock price ≥ ( − ,0 ).
For options on dividend paying stocks, if denotes the present value of the dividends
during the life of the option, then the lower boundaries show a change from that of options
on non-dividend paying stocks to incorporate the effect of dividends.

The results are summarized in the table below. (Note the use of small ‘c’ and small ‘p’ for
European options and capital ‘C’ and ‘P’ for American options).

Upper Bound European Call American Call European Put American Put
Div / Non-div stock ≤ ≤ ≤ ≤
Lower Bound European Call European Put
Non-div stock ≥ ( − , 0) ≥ max ( − , 0)
Div stock ≥ ( − − , 0) ≥ max ( + − , 0)

Hull Example 11.1: Consider a European call option on a non-dividend-paying stock where
= $51, the = $50, = 6 months (0.5), and =12% per annum.
 The upper bound on the call option is $51: why would you pay more for an
option than you could pay for the stock?
 The lower bound is the (51 − 50 %× .
, 0) = $3.91. This is its so-called
minimum value.
Hull Example 11.2: Consider a European put option on a non-dividend-paying stock when
= $38, = $40, = 3 months (0.25), and = 10% per annum.
 As a put option cannot be worth more than its strike price at maturity, its upper bound
%× .
is the present value of its strike price, 40 = $39.01.
 The lower bound is the 40 %× .
− 38, 0 = $1.01. You would be willing to
pay at least $1.01.

5
Explain put-call parity and apply it to the valuation of European and
American stock options with dividends and without dividends and
express it in terms of forward prices.
Put–call parity is based on a no-arbitrage argument; it can be shown that arbitrage
opportunities exist if put–call parity does not hold. Put-call parity for non-dividend paying
stocks is given by:

+ = +

For a European call with the same certain exercise price and exercise date as the European
put, put–call parity shows that the value of the call combined with a bond which matures to
yield the strike price of the option is equivalent to the value of a put plus a share of the stock.

Please be ready to re-arrange put-call parity; e.g., here are three re-arrangements:

= + − = + − − = −

Note: Put-call parity only holds for European options. However, it is possible to derive
some results for American option prices. It can be shown that, in case of American
options, when there are no dividends,

− ≤ − ≤ −

Typical question: A typical application is to solve for the price of a call or put given the
other variables. For example, assume we know that a one-year European put ( ) is valued
at $2. If the risk-free rate is 4%, what is the value of the corresponding European call (i.e.,
one-year term) if the strike price is $10 ( )and the stock price is $11 ( )?

%×
= + − ⟹ 2 + 11 − 10 = $3.39

Put-Call parity for European options

The table below shows two examples (Hull Ex 11.1 and Hull Ex 11.2) that apply put-call
parity. To illustrate put-call parity for the European call option (Hull Ex 11.1), assume two
portfolios:
 The first portfolio is a call option combined with a $50 par bond
 The second portfolio is a put along with a share of stock priced at $51 (i.e., a
protective put).
Now consider the payoff of each portfolio if the stock increases to $60.
 The payoff on the first portfolio is $60: call gain of $10(=60-50) plus $50 bond
 The payoff on second portfolio is $60, the stock’s price, as the put expires worthless.
Now consider the payoff of each portfolio if the stock drops to $40.
 The payoff on the first portfolio is the $50 bond, and the call expires worthless.
 The payoff on the second portfolio is $50: put gain of $10(=50-40) plus $40 stock.
Thus, the portfolios have the same payoff regardless of the stock price at maturity! Similarly,
the put-call parity can be proved for the European put (Hull Ex 11.2).

6
Illustration of put-call parity for European options

Since the portfolios have identical values (or put-call

parity) at maturity, they must have identical values
today.
 The first portfolio consists of a long position
in a call option plus a bond that provides a
payoff equal to strike price of the option at
maturity. The value of the present value of
that bond is $47.09(= 50 − 12% × 0.5). The
current value of the call option from Black-
Scholes model(BSM) is $5.15. So, the total
value of this portfolio is $ 52.24
 A protective put consists of a long position in
a put option plus one share of the underlying
stock. Current value of the put option as per
BSM is $1.24 and the value of the stock is
$51. So, the total value of this portfolio adds
up to $ 52.24 which is same as the value of
the covered call, thereby proving the put-call
parity.

Put-Call parity for American options

Hull Ex 11.3: An American call option on a non-dividend-paying stock with strike price
$20.00 and maturity in 5 months is worth $1.50. Suppose that the current stock price is
$19.00 and the risk-free interest rate is 10% per annum. For American options,

− ≤ − ≤ −
%× /
19 − 20 ≤ − ≤ 19 −20

From this equation and with = $1.50, the upper and lower bounds for an American put with
the same strike price and expiration date as the American call are $2.50 and $1.68.

Put call parity for Dividend paying stocks

When the stock is dividend paying, the put-call parity equation for European Options
becomes:

+ + = +

With dividend paying stocks the put call parity equation for American options is modified as:

− − ≤ − ≤ −

7
Put call parity using Forward prices

The put call parity results can be generalized to other underlying assets besides stocks. This
can be done considering forward contracts and no income from the assets. The put-call
parity equation becomes:

+ = +

where F is the Forward price

The lower bound for a European call option can be written as:

≥ −

Similarly, lower bound of the European put option is:

≥ −

Analysts use the above expressions of forward prices observed in the market to obtain
forward prices for the desired option maturity.

Explain and assess potential rationales for using the early exercise
features of American call and put options.
An American-style option can be exercised prior to expiration (i.e., can be exercised
early). A European option can only be exercised on the expiration date itself.

All other things being equal, the value of an American style option must be at least as great
as a European option with the same features:

[ ] ³ [ ]
 Strictly speaking, the put–call parity relationship applies only to European options
 An American call on a non-dividend paying stock must be worth at least its
European analogue.
The difference between an American call and an American put (C–P) is bounded by
the following:

− ≤ − ≤ − −

From a mathematical standpoint, it is never optimal to execute an early exercise on an

American call option on a non-dividend paying stock. Optionality (i.e., the choice provided by
the option) gives the option holder insurance against the value of the stock falling below the
strike price. As soon as the option is exercised, this optionality is lost.

Consider an American call option where the strike price is USD 30 and the stock price is
USD 50. Suppose further that the underlying asset pays no dividends and there are two
months until maturity. In this case, it is tempting for an investor to exercise the call and sell
the stock. The investor could buy the stock for USD 30, sell it for USD 50, and thus receive a
profit of USD 20. Considering each options contract is for the right to buy 100 shares, the
potential gain is USD 2,000 per contract.

8
Despite this profit, however, the option should not be exercised before maturity if interest
rates are positive. To understand why this is so, note that the option owner is in one of two
situations.

Situation 1: The investor wants to have a position in the stock

Situation 2: The investor does not want to have a position in the stock

In Situation 1, the option holder will not sell the stock after exercising the option (because
they want to have a position in the stock). Thus, he or she is better off holding the option
until expiry. To understand this, consider two outcomes for Situation 1.

Outcome 1: The stock price is greater than USD 30 on the expiry date.

Outcome 2: The stock price is less than USD 30 on the expiry date.

Under Outcome 1, there is no benefit to exercising the option early because the strike price
(USD 30) will be paid regardless of when the option is exercised. In contrast, holding the
option until expiry would allow the investor to earn additional interest by investing the strike
price at the risk-free rate for two months.

Now consider Outcome 2. By exercising early, the investor incurs a loss of USD 30 – S
(where S is the stock price at expiry). If the investor waits until maturity, the option is not
exercised and thus, the investor does not incur this loss.

Now suppose that the investor is in Situation 2 and does not want a position in the stock.
Exercising the option immediately would yield a profit equal to intrinsic value of the option
(which in this case is USD 20). However, selling the option yields a profit of the intrinsic
value plus what is called the time value. The time value is the value of the optionality given
by the option and is equal to the premium that would be paid if the option were at-the-
money.

However, it can be optimal to execute an early exercise on an American put. In general, we

can say that for an American put, the early exercise becomes more attractive as:
 Stock price ( ) decreases,
 Risk-free ( ) rate increases, and/or
 Volatility (s) decreases.

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10
Chapter Summary
In this chapter, we explored the factors that affect the price of European and American call
and put options. These factors, along with the boundary conditions that were established for
the prices of the respective options should become second nature to you, as it has high-
testability. Furthermore, understanding how these factors affect options prices is
fundamental to understanding this and the following chapters.

The factors that affect the prices of an options were presented earlier in this chapter
in this table, however, they are so important that it is repeated here. You should know
and understand these by heart (not memorize).

Factor Symbol Call Put

Stock price () + -
Strike price () - +
+ (American) + (American)
Time to expire ()
? (European) ? (European)
Volatility () s + +
Risk-free rate () + -
Div. yield () - +

A option is an option but not an obligation to purchase the underlying instrument at a

predetermined price. It should therefore not be surprising that the price of the option can
never exceed that of the underlying. This is the upper bound for both American and
European call options. Analogously, the most one may gain from a put option is the strike
price, K. This is the upper bound for the American put option; for the European equivalent, it
is K discounted to the present value.

Put-call parity allows us to combine the stock price, strike price, and risk-free rate,
along with, say the put option price in order to uniquely solve for the call price. The
same applies for solving for any of the other variables. This is a strict equality, which hold
whether there are dividends involved or not. It is given as: + = +

For American options, the early exercise feature complicates the matter slightly. That
is, we cannot create a strict equality but rather a set of inequalities that bounds the price of
our put and call options. When there is no dividend being paid on an American call option,
we can show by arbitrage arguments that it is never optimal to exercise early.

For an American call option with dividends, it can be optimal to exercise immediately
before the ex-dividend date if the dividend is sufficiently large. For dividend and non-
dividend paying American put options it can be optimal to exercise early. The maximum we
can ever hope to gain is ( – , 0) , thus when the stock price is zero it is clearly optimal
to exercise.

You should be comfortable with solving and re-arranging the following equation:
− ≤ − ≤ − − which bounds the American Call and Put option.

11
Questions & Answers:
1. EACH of the following is true about option volatility EXCEPT:
a) The lower bound for a European call option is equal to the Black-Scholes-Merton
option value where the volatility input is zero
b) The historical volatility, as in input into Black-Scholes-Merton, tends to converge on
implied volatility as the option is nearer to being “at the money” (ATM)
c) Option value is an increasing function with volatility for an American or European
CALL on a both a dividend- or non-dividend-paying stock
d) Option value is an increasing function with volatility for an American or European
PUT on a both a dividend- or non-dividend-paying stock

2. What is the lower bound for the price of a nine (9)-month American PUT option on a non-
dividend-paying stock when the stock price is $14.00, the strike price is $20.00, and the risk-
free interest rate is 4.0% per annum?
a) zero (0)
b) $5.22
c) $5.41
d) $6.00

3. The price of a non-dividend-paying stock is $14.00 and the price of a three (3)-month
European put option on the stock with a strike price of $15.00 is $1.85. The risk free rate is
4.0% per annum. What is the price of a three (3)-month European call option with a strike
price of $15.00?
a) $0.65
b) $1.00
c) $1.15
d) $1.88

4. Each of the following statements is true EXCEPT for (which is the false statement?):
a) In the case of American options on a dividend-paying stock, put-call parity holds (can
incorporate dividends)
b) In the case of European options on a dividend-paying stock, put-call parity holds (can
incorporate dividends)
c) While it is never optimal to exercise early an American option on a NON-dividend-
paying stock, it can be optimal to exercise early an American option on a dividend-
paying stock
d) In the case of a dividend-paying stock, we can obtain upper and lower bounds for the
difference between the price of an American call and an American put (i.e., C - P)

12
Answers

1. B. Historical volatility is backward-looking and does not necessarily correspond to

forward-looking implied volatility for OTM/ATM/ITM options (the skew/smile of implied
volatility is a different issue).
 In regard to (A), this is true: BSM option value (if volatility = 0) gives same value as
minimum value (lower bound).
 In regard to (C) and (D), option value is always an increasing function of volatility.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-179-six-factors-

that-impact-option-price.4601/#post-12163

2. D. $6.00
 For a European put, the lower bound is p >= K*exp(-rT) - S(0), but
 For an American put, the lower bound is P >= K - S(0). In this case, P >= 20 - 14 =
$6.00
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-179-six-factors-
that-impact-option-price.4601/#post-12163

3. B. $1.00
c = p + S(0) - K*exp(-rT) = 1.85 + 14 - 15*exp(-4%*0.25) = $1.00

4. A. In the case of American options on a dividend-paying stock, put-call parity does

not hold

In regard to (B), (C) and (D), EACH are TRUE.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-182-impact-of-

early-exercise-and-dividends-on-put-call-parity.4616/#post-12194

13
P1.T3. Financial Markets & Products

Chapter 14. Trading Strategies

Bionic Turtle FRM Study Notes

CHAPTER 14. TRADING STRATEGIES ................................................................................ 3
EXPLAIN THE MOTIVATION TO INITIATE A COVERED CALL OR A PROTECTIVE PUT STRATEGY AND
CALCULATE THE PAYOFF FUNCTIONS OF THE RESPECTIVE STRATEGIES. ...................................... 3
DESCRIBE PRINCIPAL PROTECTED NOTES (PPNS) AND EXPLAIN NECESSARY CONDITIONS TO
CREATE A PPN. ........................................................................................................................ 5
DESCRIBE THE USE AND CALCULATE THE PAYOFFS OF VARIOUS SPREAD STRATEGIES. ................. 6
DESCRIBE THE USE AND EXPLAIN THE PAYOFF FUNCTIONS OF COMBINATION STRATEGIES. ......... 11
CHAPTER SUMMARY ............................................................................................................... 14
QUESTIONS & ANSWERS: ....................................................................................................... 15

2
Chapter 14. Trading Strategies
Explain the motivation to initiate a covered call or a protective put strategy.

Describe principal protected notes (PPNs) and explain necessary conditions to create
a PPN.

Describe the use and calculate the payoffs of various spread strategies.

Describe the use and explain the payoff functions of combination strategies.

Explain the motivation to initiate a covered call or a protective put

strategy and calculate the payoff functions of the respective
strategies.
Covered Call
To “write a covered call” is to combine a long stock position with a short position in a
call option.

Writing a covered call = long stock + short call option = −

The rationale of the covered call is either:

 To cover the cost of the potential short call payoff with the stock: The long stock
position ‘‘covers’’ or protects the investor from the payoff on the short call that
becomes necessary if there is a sharp rise in the stock price.
 To generate income via the sale of the short call: Writing a covered call is an
income strategy.
This trade reflects a neutral to bullish outlook.
 If the stock price increases modestly (assuming the strike exceeds the current price),
the covered call writer enjoys the interim capital appreciation supplemented by the
option premium. If the stock price hovers or rises modestly, this strategy can be
rolled over (e.g., buy to close original options and sell new options at higher
price/later expiration), generating a stream of income.
 If the stock increases significantly, the strike price will be breached and the written
call option will be exercised such that the trade forfeits further profits. This strategy
enhances income but limits the upside.
 On the other hand, if the stock price decreases then the option will not be exercised,
and the collected option premium provides a modest hedge to the stock's capital
depreciation. As Hull notes, put-call parity shows that the price exposure from writing
a covered call is the same as the exposure from writing a naked put.
IMPORTANT CONCEPT:
If the payoff strategy for a covered call looks like a short put option, that’s because it
is! Remember the put-call parity − = − . We can infer from this that going
long the stock and short a call is the same as going short a put with the PV of the
strike price in the bank. By knowing the intuition behind the put-call parity you can
often reason your way to the answer!

The reverse of writing a covered call is a short position in a stock combined with a long
position in a call option. Its payoff resembles a long put. (Think about the payoff profile in
terms of the put-call parity).

3
Protective Put
A protective put can be thought of as a form of insurance. The investment strategy
involves buying a European put option on a stock and the stock itself. Looking at the strategy
and the payoff, it looks like we have created a synthetic long call option! Again, the concept
of put-call parity comes in handy.

It is tempting to think that having protective puts on your portfolio and rolling them over at
maturity is a great way to benefit from the potential increase in the stock price while having
our losses capped. However, the premium paid and transaction costs incurred dilute the
profits from such a strategy, just like in the case of the covered call.

We can generalize this concept further by noting that, after adjusting for risk, there is no one
strategy that offers an easy way to make money in a [weak form] efficient market. There is
no such thing as a free lunch.

Important Concept: While a covered call generates income (the short call option
premium) when the (long) stockholder does not expect further price appreciation on
the long position, the protective put forfeits some income (the long put option
premium) in exchange for downside protection.

The reverse of a protective put is a short position in a put option combined with a short
position in the stock. Its payoff is similar to a short call. (Remember put-call parity!). The
graph below illustrates the profit for the above strategies. The assumptions are: Stock price
= $20, strike price of options = $20, call premium = $1.99, put premium = $1.20

Figure: Profit patterns for trading strategies involving an option and a stock

4
Describe principal protected notes (PPNs) and explain necessary
conditions to create a PPN.
A principal protected note (PPN) is a security created from a single option such that the
investor benefits from any gain in the value of a specified portfolio without the risk of losses.
Suppose a three- year interest rate is 7% (compounded annually). The present value of USD
10,000 is

10,000
= 8,162.98
1.07
Suppose that portfolio A consists of:
 A three-year zero-coupon bond that will pay USD 10,000 in three years; and
 A three-year call option on Portfolio B, which is currently worth USD 10,000 with a
strike price of USD 10,000
The holder of portfolio A will benefit from any increase in the value of portfolio B without
incurring any loss of principal if its value declines. This feature is likely to be attractive to risk-
averse investors.

Note that the first item in Portfolio A costs USD 8,162.98. If the option can be purchased for
less than USD 1,837.02 (= USD 10,000 – USD 8,162.98), then the portfolio will cost less
than USD 10,000 and can be profitably offered to investors. PPNs are possible because of
the following:

 The investor is giving up three years of interest on the USD 10,000 investment.
 The investor does not receive any income that the owners of Portfolio B would
receive during the next three years
PPNs are only possible for portfolios that provide an income. From put call parity

p + S = c + PV(K)

Because the call is currently at the money (so that K = S), put-call parity gives

c = p + S – PV(S)

The above equation implies:

c > S – PV(S)

This shows that the call always costs more than the funds available to pay for it. In the above
example the call will always cost > 1,837.02 USD. However, portfolio B’s income reduces
the value of the call. If the income is sufficiently high, a PPN can be created.

5
Describe the use and calculate the payoffs of various spread
strategies.
A spread strategy is a position with two or more options of the same type, i.e., two or
more calls; or, two or more puts.
Bull spread (type of vertical spread)
A bull spread can be created by buying a European call option on a stock with a lower
strike price and selling a European call option on the same stock with a higher strike price.
Bull spreads can also be created by buying a European put with a low strike price and selling
a European put with a high strike price.
 In case of both call and put bull spreads, we are bullish, as the name implies, and
thus expect the price of the underlying to increase.
 Because a call price always decreases as the strike price increases, the value of the
option sold is always less than the value of the option bought. A bull spread, when
created from calls, therefore requires an initial investment or a cash outflow.
Conversely, when creating a bull spread using put options there is always a cash
inflow.
 The bull spread strategy limits the investor’s upside as well as downside risk. For eg.
consider an investor who has a call option with a lower strike price and has chosen to
give up some upside potential by selling a call option with higher strike price. In
return for giving up the upside potential, the investor gets the price of the option with
a higher strike price.
Payoff: For a call bull spread, if ( ) is the strike price of the long call option and ( ) is the
strike price of call option sold where > , and is the stock price at option expiration,
then:
 If is greater than the higher strike price( ), the payoff is the difference between
the two strike prices, −
 If lies between the two strike prices, the payoff is −
 If is below the lower strike price ( ), the payoff is zero.
Unlike bull spreads created from calls, those created from puts have a payoff that is either
negative or zero.

Hull Ex 12.2: An investor buys for $3 a 3-month European call with a strike price of $30 and
sells for $1 a 3-month European call with a strike price of $35.
 The payoff from this bull spread strategy is $5 if the stock price is above $35, and
zero if it is below $30.
 If the stock price is between $30 and $35, the payoff is the amount by which the
stock price exceeds $30.
 The cost of the strategy is $2(=3-1). So, the profit is the payoff less this cost.
The graphs below illustrate profits from bull spreads with call and puts. Assumptions are:
 Bull spread with calls: Here the long call has a strike ( 1 ) = $18, with a premium =
$3.21 while short call has a higher strike( 2 ) = $22, with a premium = $1.13 on the
same stock priced at $20, with the same time to expiration of 1 year.

6
  Bull spread with puts: Here the long put has a strike ( 1 ) = $19, with a premium =
$0.81 while short put has a higher strike ( 2 ) = $22, with a premium = $2.27 on the
same stock priced at $20, with the same time to expiration of 1 year.

Bear spread (type of vertical spread)

A bear spread can be created by buying a European put with a higher strike price and
selling a European put with a lower strike price on the same underlying stock. (This is in
contrast to a bull spread, where the strike price of the option purchased is always less than
the strike price of the option sold.) It is important to note that we can create a bear spread
using call options also.
 An investor who enters into a bull spread is hoping that the stock price will increase.
By contrast, in case of either a put or call bear spread, we are bearish as the name
implies and thus expect the underlying stock price to decline.
 A bear spread created from puts involves an initial cash outflow because the price of
the put sold is less than the price of the put purchased whereas when creating a bear
spread with calls we have a cash inflow.
 Like bull spreads, bear spreads limit both the upside profit potential and the downside
risk. For eg. in a put bear spread, the investor has bought a put with a higher strike
price and chosen to give up some of the profit potential by selling a put with a lower
strike price. In return for the profit given up, the investor gets the price of the option
sold.
Payoff: For a put bull spread, if ( ) is the strike price of the long put option and ( ) is the
strike price of short put option where ( < ), and is the stock price at option
expiration, then
 If is greater than , the payoff is zero.
 If is less than , the payoff is −
 If the stock price is between and , the payoff is − .
Hull Ex 12.3: An investor buys for $3 a 3-month European put with a strike price of $35 and
sells for $1 a 3-month European put with a strike price of $30.
 The payoff from this bear spread strategy is zero if the stock price is above $35, and
$5 if it is below $30.
 If the stock price is between $30 and $35, the payoff is 35 − .

7
  The options cost $2(=3-1) up front. The profit is calculated by subtracting this initial
cost from the payoff.
The graphs below illustrate profits from bear spreads with puts and calls. Assumptions are:
 Bear spread with puts: Here the long put has a strike ( 1 ) = $22, with a premium =
$2.27 while short put has a higher strike ( 2 ) = $19, with a premium = $0.81 on the
same stock priced at $20, with the same time to expiration of 1 year.
 Bear spread with calls: Here the long call has a strike ( 1 ) = $22, with a premium =
$1.13 while short call has a higher strike( 2 ) = $18, with a premium = $3.21 on the
same stock priced at $20, with the same time to expiration of 1 year.
As the graph below shows, we have a range of possible payoff scenarios, however; our loss
is capped at $0 (excluding the premium), while our gain is capped at − (excluding the
premium).

Box Spreads
A box spread is a combination of a bull call spread with strike prices and and a bear
put spread with the same two strike prices.
 The payoff from a box spread is always − .
 The value of a box spread is therefore always the present value of this payoff or
( − ) . A value different from this would give rise to an arbitrage opportunity.
CONCEPT: “A box spread arbitrage only works with European options” (Hull)

Butterfly spread (sideways strategy)

A butterfly spread involves positions in options with three different strike prices. It can be
created using either call or put options.
 For eg. it involves buying a European call option at a relatively low strike price ,
buying a European call option with higher strike price , and selling two European
call options at strike price halfway between and . Generally, is close to
the current stock price.
 This strategy leads to a profit if the stock price stays close to , but gives rise to a
small loss if there is a significant stock price move in either direction. It is therefore
appropriate for an investor who feels that large stock price moves are unlikely. It
requires a small investment initially.

8
Payoff: The payoff is illustrated with an example here. Suppose that a certain stock is
currently worth $61. Consider an investor who feels that a significant price move in the next
6 months is unlikely and so creates a butterfly spread by buying one call priced $10 with a
$55 strike price, buying one call priced $7 with a $65 strike price, and selling two calls priced
$5 with a $60 strike price.
 It costs 10 + $5 – (2 × 5) =$1 to create the spread.
 If the stock price in 6 months is greater than $65 or less than $55, the total payoff is
zero, and the investor incurs a net loss of $1.
 If the stock price is between $56 and $64, a profit is made. The maximum profit, $4,
occurs when the stock price in 6 months is $60.
In this graph below depicting the butterfly spread the assumptions are: Long call with
strike =$18, premium = $3.21, long call with strike =$22, premium = $1.13 short two
calls with strike =$20, premium = $1.99. Why the butterfly? The investor expects low
volatility (range-bound), and wants to cap the risk.

Calendar spread

In a calendar spread, the options have the same strike price but different expiration dates.
The calendar spread can be created with calls or puts.
 It can be created from:
o Two calls: The investor sells a call option with a certain strike price and buys a
call option with same strike price but with a longer term to maturity.
o Two puts: The investor sells a short-maturity put option and buys a long-maturity
put option with the same strike price.
 The longer the maturity of an option, the more expensive it usually is. A calendar
spread therefore usually requires an initial investment.
 In a neutral calendar spread, a strike price close to the current stock price is chosen.
A bullish calendar spread involves a higher strike price, whereas a bearish calendar
spread involves a lower strike price.

9
  The profit pattern for a calendar spread is similar to the profit from the butterfly
spread in the sense that the investor makes a profit if the stock price at the expiration
of the short-maturity option is close to the strike price of the short-maturity option.
However, a loss is incurred when the stock price is significantly above or significantly
below this strike price.
 A reverse calendar spread is the opposite where the investor buys a short-maturity
option and sells a long-maturity option. A small profit arises if the stock price at the
expiration of the short-maturity option is well above or well below the strike price of
the short-maturity option. However, a loss results if it is close to the strike price.

Payoff: The payoff for a calendar spread is as outlined below.

 If the stock price at expiration ( ) is very low the short-maturity option expires
worthless and the value of the long-maturity option is close to zero. The investor
therefore incurs a loss that is close to the cost of setting up the spread initially.
 When is very high, both the short and long- maturity options are worth close to
− , if is the strike price of the options. Again, the investor makes a net loss
that is close to the cost of setting up the spread initially.
 If is close to , the short-maturity option costs the investor either a small amount
or nothing at all. However, the long-maturity option is still quite valuable. In this case,
a significant net profit can be made.
We illustrate calendar spread in this graph below. Assumptions are:
 Short call with 1year maturity, premium = $1.99 and Long call with 1.25 year
maturity, premium = $2.27 and both with a strike price of $20.
 Short put with 1year maturity, premium = $1.20 + Long put with 1.25 year maturity,
premium = $1.29 and both with a strike price of $20.

Diagonal spread
In a diagonal spread, both the expiration date and the strike price of the calls are different.
This increases the range of profit patterns that are possible.

10
Describe the use and explain the payoff functions of combination
strategies.
A combination strategy involves taking a position in both call(s) and put(s) on the
same stock.
Straddle
To straddle is to buy or sell a call and a put on the same stock with same strike price and
expiration date. In what is called as a straddle purchase (bottom straddle), the investor
buys a call and put with the same strike price and expiration date. A straddle write (top
straddle) is the reverse of this position which is created by selling a call and a put with the
same exercise price and expiration date.
 Why the bottom straddle? This is appropriate when an investor is expecting a large
move in a stock price but does not know in which direction the move will be. The
worst-case scenario is that the stock settles at the strike price: the investor has paid
two premiums but does not receive any payoffs.
 Why the top straddle? The investor is highly confident that the stock will not stray
from the strike price in either direction. If the stock price equals the strike price, the
investor has collected two premiums for profit. This is a very risky strategy however,
because the potential loss from a large move is unlimited. A top straddle is also a
direction neutral volatility strategy; however, unlike with the bottom straddle, we want
little to no movement in the underlying.
Payoff: The payoff is explained with an example here. Consider a stock currently priced at
$69 whose price is expected to increase in future. An investor creates a straddle by buying
both a put and a call with a strike price of $70 and an expiration date in 3 months. Suppose
the call costs $4 and the put costs $3 and so an up-front investment of $7 is required (=4+3).
 If the stock price stays close to the strike, the loss is limited. For eg. if the stock
remains at $69 during expiration, this strategy costs the investor $6 as the call
expires worthless, and the put expires worth $1. If the stock price moves to $70, a
loss of $7 is experienced. This is the worst that can happen.
 A large move in either direction leads to profits. For eg. if the stock price jumps up to
$90, a profit of $13 is made; if the stock moves down to $55, a profit of $8 is made.

11
The figure above illustrates:
 a bottom straddle consisting of a long call with a premium = $1.99 and a long put with
a premium = $1.20, both with a strike price of $20.
 a top straddle consisting of a short call with a premium = $1.99 and a short put with a
premium =$1.20, both with a strike price of $20.

IMPORTANT CONCEPT:

A straddle is a direction neutral volatility strategy: we don't mind which way the
underlying moves. In case of a bottom straddle as long as the price moves
sufficiently, we are invariant to which way it moves. Conversely, for a top straddle, we
want the price to deviate from the strike as little as possible.

Strips and Straps

Strip consists of a long position in one call and two puts with same strike price and
expiration date. Strap consists of a long position in two calls and one put with same strike
price and expiration date.
 Why the strip? The investor bets on a large stock price move but considers a
decrease more likely than an increase.
 Why the strap? Like the strip, the investor bets on a large stock price movement, but
instead considers an increase more likely. In this regard, a strap is also similar to a
straddle, but in this case, we are biased upwards.
This illustrated strip consists of a long call with a premium = $1.99 plus two long puts priced
at $1.20, all with a strike price of $20 and time to expiration of one year.

The graph related to the strap consists of two long calls, priced at $1.99 plus a long put with
a premium of $1.20, all with a strike price of $20, and time to expiration of one year.

Strangle
In a strangle, (also called a bottom vertical combination), an investor buys a put and a
call with the same expiration date and different strike prices. The call strike price is higher
than the put strike price. The sale of a strangle where an investor sells a put and a call with
the same expiration date and different strike prices is also referred to as a top vertical
combination.

12
  Why the strangle? The investor is betting on a large price movement but is
uncertain whether it will be an increase or a decrease. A strangle is similar to a
straddle but cheaper to install, however this comes at the cost of requiring more
extreme price movements than with the straddle. Consequently, this is a strategy that
is bullish on volatility.
 Why write a strangle? Strangle writing can be appropriate for an investor who feels
that large stock price moves are unlikely. Just as with sale of a straddle, this is a risky
strategy involving unlimited potential loss to the investor.
Payoff: The profit pattern obtained with a strangle depends on how close together the strike
prices are. If strike prices are far apart, the less the downside risk and the farther the stock
price has to move for a profit to be realized.

The illustrated graphs show a:

 strangle consists of a long call with strike = $18, premium = $3.21 plus a long put
with strike =$22, premium = $2.27.
 strangle write consisting of a short call with strike = $18, premium=3.21$ plus a short
out with strike =$22, premium = $2.27

Collar and costless collar

A collar (sometimes also referred to as a fence) is a combination strategy where we own the
underlying, sell a call option with a strike price greater than the current price of the
underlying ( > ), and buy a put option with a strike price less than the current price of
the underlying ( < ). This strategy gives us a range of profit or losses.

When the premium collected from writing the call exactly matches the premium paid for the
put, we have what is called a zero cost, or costless collar.

13
Chapter Summary
The options strategies we have seen are but a few of the many that are used on a daily
basis. However, they form the basis of many such strategies.
 That is, a combination of the strategies we have reviewed can be used to construct
any options strategy - your imagination (and wallet) is the limit.
 It is important to note that, while several of the strategies seem to lock in a
guaranteed profit, or have a seemingly high probability of making money, this is
largely an illusion due to the transaction costs involved - and the spread between the
bid and the ask price actually observed in the market.
 We can generalize this further: typically, only when your expectations differ from that
of the market will there be a genuine moneymaking opportunity. However, going
against the market can pose a significant risk as options enable you to leverage your
positions in a way that regular stocks and bonds do not. That being said, there are
many scenarios in which putting on any of the aforementioned options strategies
would makes sense.
 The primary reason why we would want to do this is to hedge our risk, and the
secondary reason is that we simply hold a different view than the market and are
making an informed bet. Investment banks are typically more than willing to act as
market makers as, on average, they end up with a net profit due to this sort of market
making.
To “write a covered call” is to combine a long stock position with a short position in a call
option. A protective put is buying a put option on a stock along with buying the stock itself.

To summarize spreads: It is a position with two or more options of the same type, i.e., two
or more calls; or, two or more puts.
 In the case of bull and bear spreads, the options have the same expiration date but
different strike prices. Box spread combines a bull call with a bear put.
 In the case of calendar spreads, the options have the same strike price but different
expiration dates.
 In the case of diagonal spreads, both the expiration date and the strike price of the
options can vary.
To summarize combinations: It involves taking a position in both calls and puts on the
same stock.
 In a straddle, the strategy is to buy or sell a call and a put on the same stock with
same strike price and expiration date
 Strip involves a long position in one call and two puts with same strike price and
expiration date. Strap involves a long position in two calls and one put with same
strike price and expiration date.
 In a strangle, the strategy is to buy or sell a call and a put with the same expiration
date and different strike prices.
After reading this chapter (and completing the accompanying exercises in the separate PDF)
you should be able to define and calculate the payoff of a covered call, protective put,
spread and combination strategies. You should also be able to specify under what
circumstances each of these strategies would be appropriate to put on, and you should know
which strategies are direction neutral with respect to a risk factor, and which ones are not.

14
Questions & Answers:
1. What are some of the benefits of “options strategies” over a single call or put option
investment?

2. You believe volatility is about to drop. What is the appropriate strategy?

3. Of the following options strategies, which one is the MOST risky?

a) Buying a bull spread
b) Buying a bear spread
c) Writing (selling) naked put options
d) Writing (selling) naked call options

4. An asset manager tells you he wants to go long a straddle because he has a bullish view
on volatility (and the movement of the stock price). The asset manager tells you that this
strategy is always superior to a strangle, since you need less of a price movement in order to
be net In-the-Money. Is the asset manager right? Why or why not?

5. An investor wants to hedge her bond portfolio. Being sensitive to interest rate the investor
decides to sell a call option with ≥ to finance entirely the cost of going long a put
option where ≤ which hedges against an increase in interest rate (remember the
value of a portfolio of bonds decreases when the payments are discounted more heavily).
Which option strategy is the investor employing?
a) Butterfly
b) Costless collar
c) Strangle
d) Box spread

15
Answers:
1. One of the primary goals of the various options strategies is to hedge against
exposure from different risk factors. The different options strategies also enable investors
to take a view on risk factors other than those associated with just the underlying stock.
Indeed, we have seen that there are a number of ways to take advantage of a view on e.g.,
volatility.

2. When volatility is about to drop, you want to enter into a direction neutral volatility
strategy, hoping that the underlying will barely move. In this case the appropriate
strategy is a top straddle.

3. Both a, b and c have bounded losses, whereas the potential loss from d is
unbounded (limitless). Thus, writing naked call options is the most risky strategy.

4. The asset manager is wrong. While it is true that the straddle requires less of an uptick
in volatility (and movement in the stock price in either direction) to make money than with a
strangle, this comes at the cost of higher risk downside risk if the stock is OTM at expiration.

5. The investor is employing a costless-collar. Notice that in a costless collar, the

premium from selling the call option exactly matches the cost of the put option. The investor
accordingly locks in a range of profit and losses since the investor is already long the
underlying, buys a [protective] put and sells a call.

16
P1.T3. Financial Markets & Products

Chapter 15. Exotic Options

Bionic Turtle FRM Study Notes

CHAPTER 15. EXOTIC OPTIONS........................................................................................ 3
DEFINE AND CONTRAST EXOTIC DERIVATIVES AND PLAIN VANILLA DERIVATIVES. .......................... 3
DESCRIBE SOME OF THE FACTORS THAT DRIVE THE DEVELOPMENT OF EXOTIC PRODUCTS........... 3
EXPLAIN HOW ANY DERIVATIVE CAN BE CONVERTED INTO A ZERO-COST PRODUCT. ..................... 4
DESCRIBE HOW STANDARD AMERICAN OPTIONS CAN BE TRANSFORMED INTO NONSTANDARD
AMERICAN OPTIONS. ............................................................................................................... 4
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: GAP OPTIONS..... 5
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: FORWARD START
OPTIONS ................................................................................................................................ 8
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: COMPOUND
OPTIONS ................................................................................................................................ 9
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF CHOOSER OPTIONS
........................................................................................................................................... 10
IDENTIFY AND DESCRIBE CHARACTERISTICS AND PAY-OFF STRUCTURE OF BARRIER OPTIONS .... 11
IDENTIFY AND DESCRIBE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: BINARY OPTIONS ..... 13
IDENTIFY AND DESCRIBE CHARACTERISTICS & PAY-OFF STRUCTURE OF: LOOKBACK OPTIONS .... 14
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: SHOUT OPTIONS 17
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: ASIAN OPTIONS . 18
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: EXCHANGE
OPTIONS .............................................................................................................................. 19
IDENTIFY AND DESCRIBE THE CHARACTERISTICS AND PAY-OFF STRUCTURE OF: BASKET OPTIONS
........................................................................................................................................... 20
DESCRIBE AND CONTRAST VOLATILITY AND VARIANCE SWAPS. ................................................. 20
EXPLAIN THE BASIC PREMISE OF STATIC OPTION REPLICATION AND HOW IT CAN BE APPLIED TO
HEDGING EXOTIC OPTIONS. .................................................................................................... 21
CHAPTER SUMMARY ............................................................................................................. 24
PRACTICE QUESTIONS & ANSWERS: ...................................................................................... 25

2
Chapter 15. Exotic Options
 Define and contrast exotic derivatives and plain vanilla derivatives.

 Describe some of the factors that drive the development of exotic products.

 Explain how any derivative can be converted into a zero-cost product.

 Describe how standard American options can be transformed into nonstandard

American options.

 Identify and describe the characteristics and pay-off structure of the following
exotic options: gap, forward start, compound, chooser, barrier, binary, lookback,
shout, Asian, exchange, and basket options.

 Describe and contrast volatility and variance swaps.

 Explain the basic premise of static option replication and how it can be applied to
hedging exotic options.

Define and contrast exotic derivatives and plain vanilla derivatives.

Plain Vanilla Derivatives are the standard European and American call and put
options traded on the exchanges.
 They have standard well-defined properties and trade actively.
 Their prices or implied volatilities are quoted by exchanges or by brokers on a regular
basis.

Exotic Derivatives or simply exotics are non-standard options that are mostly traded
over-the-counter.
 They include a number of nonstandard products that have been created by financial
engineers.
 Although they are usually a relatively small part of its portfolio, these exotics are
important to a derivatives dealer because they are generally much more profitable
than plain vanilla products.

Describe some of the factors that drive the development of exotic

products.
Exotic products are developed for a number of reasons.
 Sometimes they meet a genuine hedging need in the market;
 sometimes there are tax, accounting, legal, or regulatory reasons why corporate
treasurers, fund managers, and financial institutions find exotic products attractive;
 sometimes the products are designed to reflect a view on potential future movements
in particular market variables;
 occasionally an exotic product is designed by an investment bank to appear more
attractive than it is to an unwary corporate treasurer or fund manager.

3
Explain how any derivative can be converted into a zero-cost
product.
A package is a portfolio consisting of standard European calls, standard European puts,
forward contracts, cash, and the underlying asset itself. Often a package is structured by
traders so that it has zero cost initially.
 For eg. a range forward contract consists of a long call and a short put or a short call
and a long put. The call strike price is greater than the put strike price and the strike
prices are chosen so that the value of the call equals the value of the put.
It is worth noting that any derivative can be converted into a zero-cost product by
deferring payment until maturity. For a European call option:
 cost of the option when payment is made at time zero =
 cost when payment is made at maturity of the option ( ) = =
 Payoff: ( − , 0) − or ( – − , − ).
 When the strike price, , equals the forward price, deferred payment options are also
known as break forward, Boston option, forward with optional exit, and cancelable
forward.

Describe how standard American options can be transformed into

nonstandard American options.
In a standard American option, exercise can take place at any time during the life of the
option and the exercise price is always the same.

Such standard American options can be converted into nonstandard American options like
those which are traded in the over-the-counter market by
 Restricting early exercise to certain dates. The instrument is known as a Bermudan
option. (Bermuda is between Europe and America!)
 Allowing early exercise during only part of the life of the option. For example, there
may be an initial "lock out" period with no early exercise.
 Changing the strike price during the life of the option.
The warrants issued by corporations on their own stock often have some or all of these
features.
 For example, in a 7-year warrant, exercise might be possible on particular dates
during years 3 to 7, with the strike price being $30 during years 3 and 4, $32 during
the next 2 years, and $33 during the final year.
Such nonstandard American options can usually be valued using a binomial tree. At
each node, the test (if any) for early exercise is adjusted to reflect the terms of the option.

4
Identify and describe the characteristics and pay-off structure of:
Gap Options
A gap option is one which has a strike price of (which determines the payoff), and a
trigger price of (which determines whether and where the option makes the payoff). The
strike price may be greater than or less than the trigger price. If the trigger price is less than
the strike price, then presumably the holder is required to exercise.
 For a given strike price, the trigger price that produces the maximum gap option price
is the strike price.
o When the strike price equals the trigger price, the gap option is the same as an
ordinary option.
o Increasing the trigger price above the strike price causes the value of the gap
option to fall
o Decreasing the trigger price below the strike price also causes the value of the
gap option to fall.
 The trigger price determines whether or not the gap option will have a nonzero
payoff. The strike price determines the amount of the nonzero payoff.
o When the final stock price exceeds the trigger price, gap call option has a
nonzero payoff (which may be positive or negative): − when >
o A gap put option has a nonzero payoff if the final stock price is less than the
trigger price: − when <
 Gap options can be valued with a small modification to BSM (non-dividend stock):
o The price for gap options are greater than the price given by the BSM for a
regular call option (with strike price )by: − − ( 2)
o
Gap option Regular option

Call ( )− ( ) ( )− ( )

Put (− )− (− ) (− )− (− )

ln ( 0 / 2)+( − + 2/2)
o For gap options: = ; = − √

Hull Ex 26.1: An asset is currently worth $500,000 ( ). Over the next year, it is expected to
have a volatility of 20%. The risk-free rate is 5%, and no income is expected. Suppose an
insurance company has provided a regular put option where the policyholder has the right
to sell the asset for $400,000 ( )in one year if asset value has fallen below that level. This is
a regular put option.

Suppose the cost of transferring the asset is $50,000 and this is borne by the policyholder.
The option is then exercised only if the value of the asset is less than $350,000( 2 -trigger
price). Here the strike price is still $400,000 but the trigger price, , is $350.000. This is
a gap put option.

5
 Gap put options
(compared to regular put)

As shown in the table:

The value of the regular put option is $3,436 which is calculated from:
 (− )− (− )
The value of the gap put option is $1,896 which is calculated from:
ln ( 0 / 2)+( − + 2/2)
 (− )− (− ) where =

If we graph the payoff of a gap call option as a function of its final stock price, then we can
see that there is a gap where ST = K2. In the graph below, there are no negative payoffs
because the trigger price is greater than the strike price:

6
If the trigger price is less than the strike price for a gap call option, then negative payoffs
are possible as shown below:

7
Identify and describe the characteristics and pay-off structure of:
Forward start options
Forward start options start at some time in the future. For eg. employee stock options,
can be viewed as forward start options as the company commits (implicitly or explicitly) to
granting at-the-money options to employees in the future.

The value of an at-the-money call option on an asset is proportional to the asset price. So,
for an at-the-money forward start option, starting at time and maturing at time :

 Its value at time is: 1

0

 Its value today at is given by today’s value of the ATM option: where is
the dividend yield and is the value, at time zero, of an ATM option with a life of
( − ).

For a non-dividend-paying stock, = 0 and the value of the forward start option is exactly the
same as the value of a regular at-the-money option with the same life as the forward start
option. For example, if the option value (as a percentage) is 20% of the stock price, and
today’s stock price is $20, then the value of the forward start ATM option is 20% * $20 =
$4.00.

8
Identify and describe the characteristics and pay-off structure of:
Compound options
Compound options are options on options. Compound options have two strike prices and
two exercise dates. The four types are:
 Call on a call: option to pay at , and receive a long option with strike at
 Call on a put: option to pay at , and receive a long put with strike at
 Put on a call: option to sell (put) at , a call option with strike at ; i.e., if
exercised at , holder will be short a call option
 Put on a put: option to sell (put) at ,, a put option with strike at ; i.e., if
exercised at , holder will be short a put option

Compound options have two strikes (K1, K2) and two exercise dates (T1, T2):

9
Identify and describe the characteristics and pay-off structure of
chooser options
A chooser option (aka, “as you like it” options) gives the holder, after a specified
period of time, the right to choose whether the option is a call or put. The value of the
chooser option at this point is ( , ).

Note: If the options underlying the chooser option are both European and have the same
strike price, put–call parity can be used to provide a valuation formula. In this case, the
chooser option is a package consisting of:
 A call option with strike price and maturity

 − ( 2− 1 ) put options with strike price −( − )( 2 − 1 ) and maturity

We can compare a chooser to a straddle (long call + long put):

 Both believe that a stock is about to go through a volatile period but are unsure about
the direction of the stock price.
 But investor in a chooser option is confident that the direction is revealed within a
certain time frame and is therefore willing to choose between a put and a call after
this time frame. As a result, the investor pays less for the chooser option than he
would have paid for the equivalent straddle.

10
Identify and describe characteristics and pay-off structure of
barrier options
A barrier option has a strike price (K) but additionally has a barrier price (H). The
barrier causes the option to be cheaper than the equivalent option without a barrier.
 Knock-in barrier option: if barrier breached, option comes into existence.
 Knock-out barrier option: if barrier breached, option ceases to exist.
 Down: Barrier (H) is less than initial asset price: <
 Up: Barrier (H) is greater than initial asset price: >
Combining these four concepts, we have down and in, down and out, up and in, up and out
barrier options.

11
Properties of barrier options:
 The value of a regular options equals the value of a call (or put) down-and-in (up-
and-in) plus the value of a call (or put) down-and-out (up-and-out) options:
= + = + = + = +

From this relation, the value of the barrier options can be derived.
 Note: In particular, when is less than or equal to strike price , the value of the up-
and-out call, is zero and so, the value of the up-and-in call, = .
 As we increase the frequency with which we observe the asset price in determining
whether the barrier has been crossed, the value of knock-out option goes down but
the value of knock-in option goes up.
 Vega of barrier option can be negative (!). For eg. in case of an up-and-out call option
whose asset price is close to the barrier level, when volatility increases, the
probability that the barrier will be hit increases. Consequently, the barrier option’s
price decreases.
 One disadvantage of the barrier options that a ‘‘spike’’ in the asset price can cause
the option to be knocked in or out. An alternative structure is a Parisian option,
where the asset price has to be above or below the barrier for a period of time (say,
for eg. 50 days) for the option to be knocked in or out. However, parisian options are
more difficult to value than regular barrier options.

12
Identify and describe characteristics and pay-off structure of:
Binary options
Binary options have discontinuous payoff. There are two kinds of binary options:

 Cash-or-nothing: if “in the money,” pays fixed (Q) or else nothing.

 Asset-or-nothing: if “in the money”, pays asset price or else nothing.

Value of: Call Put

Cash-or-nothing Q ( ) Q (− )

Asset-or-nothing ( ) (− )

A binary option is similar to (but not the same as) a (bull) spread

Consider a binary call option with strike price of $35 either paying $5 or zero (“all or
nothing”). Compare to bull spread: Long call option with strike @ $30 plus short call option
with strike @ $35. Payoffs if stock prices at expiration is:

 From $30 to $35: Binary payoff = $0 and bull spread payoff = $1 to $5

 $35 and above: both their payoffs = $5

13
  European call option = long asset-or-nothing call + short cash-or-nothing call
 European put option = long cash-or-nothing put + short asset-or-nothing put

Note: cash payoff for cash-or-nothing (call or put) options = strike price

“A regular European call option is equivalent to a long position in an asset-or-nothing

call and a short position in a cash-or-nothing call where the cash payoff in the cash-
or-nothing call equals the strike price. Similarly, a regular European put option is
equivalent to a long position in a cash-or-nothing put and a short position in an asset-
or-nothing put where the cash payoff on the cash-or-nothing put equals the strike
price.” – Hull

Identify and describe characteristics & pay-off structure of:

Lookback options
The payoffs from lookback options depend on the maximum or minimum asset price reached
during the life of the option.

Lookback call options (floating and fixed):

 A floating lookback call does not have a fixed strike price: Its payoff is the
amount that final asset price exceeds the minimum asset price achieved during the
life of the option.
Floating (“floating strike”) lookback payoff = − ( )

Because this payoff is always positive, it can be argued that the floating lookback is
not really an option.
 A fixed lookback call, on the other hand, does have a fixed strike price: Its
payoff is the same as a regular European call option except that the final asset price
is replaced by the maximum asset price achieved during the life of the option.
Fixed (“fixed strike”) lookback call payoff = ( ) −
To illustrate, consider a stock with initial price of $10 such that = $10 which fluctuates up
to = $13, down to = $7, and finally up to = $11.

14
  The payoff of the floating lookback call is $4, the difference between the final price
($11) and the minimum price ($7).
 In the case of the fixed lookback call, if the strike price = $10, the payoff is the
maximum ($13) minus the strike price ($10).

Lookback put options (floating and fixed):

 A floating lookback put does not have a fixed strike price: its payoff is the
amount by which the maximum asset price achieved during the life of the option
exceeds the final asset price.
Floating lookback put payoff: ( ) −
 A fixed lookback put, on the other hand, does have a fixed strike price: Its
payoff is the same as a regular European put option except that the final asset price
is replaced by the minimum asset price achieved during the life of the option.
Fixed lookback put payoff = − ( )

15
Continuing with the same example,
 The payoff of the floating lookback put is $2, the difference between the maximum
price ($13) and the final price ($11).

 In the case of the fixed lookback put, payoff is $3, the difference between the strike
price = $10 and the minimum price ($7).

Properties:
 Lookbacks are appealing to investors, but very expensive when compared with
regular options.
 As with barrier options, the value of a lookback option is liable to be sensitive to the
frequency with which the asset price is observed for the purposes of computing the
maximum or minimum.

“[Lookback options] are probably the most discussed and least used of the standard
exotic options. The problem is that on the one hand they have immense intuitive
appeal and pricing presents some interesting intellectual challenges but on the other
hand they are so expensive that no-one wants to buy them.” –Peter James, Option
Theory

16
Identify and describe the characteristics and pay-off structure of:
Shout options
Shout option is a European option where holder can “shout” to the writer at one point
during its life; the intrinsic value at that point is the minimum payoff.

That is, the end of the life of the option, the option holder receives the GREATER OF:
 The usual payoff from a European option, or
 The intrinsic value at the time of the shout
For example, assume the strike price is $50 and the holder of a call shouts when the price
of the underlying asset is $60. If the final asset price is less than $60, the holder receives a
payoff of $10. If it is greater than $60, the holder receives the excess of the asset price over
$50.
Features:
 A shout option has some of the same features as a lookback option, but is
considerably less expensive.
 If the holder shouts at a time when the asset price is the payoff from the option
is (0, − )+( − )

17
Identify and describe the characteristics and pay-off structure of:
Asian options
Asian options have a payoff that depends on the average price ( ) of the underlying
asset during the life of the option.

 Average price call payoff: [ 0, – ]

 Average price put payoff: [ 0, – ]

Another type of Asian options is an average strike option.

 Average strike call payoff: [ 0, – ]
 Average strike put payoff: [ 0, – ]

18
Features:
 Average price options are less expensive than regular options. Average price options
are also more appropriate than regular options for meeting certain needs of
investors. For eg. a treasurer expecting to receive a cash flow in a foreign currency
spread evenly over the next year will look for an option that guarantees that the
average exchange rate realized during the year is above some level.
 Average strike options can guarantee that the average price paid for an asset in
frequent trading over a period of time is not greater than the final price (or average
price received is not less than the final price)

Identify and describe the characteristics and pay-off structure of:

Exchange options
Exchange options are options to exchange one asset for another. They arise in various
contexts. For example,
 An option to buy yen with Australian dollars is, from the point of view of a US
investor, an option to exchange one foreign currency asset for another foreign
currency asset.
 A stock tender offer is an option to exchange shares in one stock for shares in
another stock.
Consider a European option to give up an asset worth at time and receive in return an
asset worth . The payoff from this exchange option is:
 ( − , 0)

19
An exchange option can be valued with Black-Scholes variation called Margrabe.

 Suppose that the asset prices, , , both follow geometric Brownian motion with
volatilities and . Suppose further that the instantaneous correlation between
and is , and the yields provided are and , respectively. and are the
values of and at times zero. The value of the option at time zero is:

( )− ( )
1 ( 0 / 0 )+ − + 2 /2)
where = , = − √
√

= + −2

 This option price is the same as the price of European call options on an asset
worth / when the strike price is 1.0, the risk-free interest rate is , and the
dividend yield on the asset is .
An option to obtain better or worse of two assets can be regarded as a position in one of the
assets combined with an option to exchange it for the other asset:
 ( , )= − ( − , 0)
 ( , )= + ( − , 0)

Identify and describe the characteristics and pay-off structure of:

Basket Options
The option involving several assets is a basket option.
 This is an option where the payoff is dependent on the value of a portfolio (or basket)
of assets.
 The assets are usually either individual stocks or stock indices or currencies.
 A European basket option can be valued with Monte Carlo simulation, by assuming
that the assets follow correlated geometric Brownian motion processes.

Describe and contrast volatility and variance swaps.

Volatility swap is an agreement to exchange the realized volatility of an asset between time
0 and time T for a pre-specified volatility.
 Suppose that there are n daily observations on the asset price during the period
between time 0 and time T. The realized volatility is

252 +1
=
−2

where Si is the ith observation on the asset price.

20
  The payoff from the volatility swap at time to the payer of the fixed volatility is
( − ), where is the notional principal and is the fixed volatility.
 Whereas an option provides a complex exposure to the asset price and volatility, a
volatility swap is simpler in that it has exposure only to volatility.
Variance swap is an agreement to exchange the realized variance rate of an asset between
time 0 and time T for a pre-specified variance.
2
 The variance rate is the square of the volatility =
 Variance swaps are easier to value because the variance rate can be replicated
using a portfolio of puts and calls.
 The payoff from a variance swap at time T to the payer of the fixed variant rate is
( − ), where Lvar is the notional principal and VK is the fixed variance rate.
 Often the notional principal for a variance swap is expressed in terms of the
corresponding notional principal for a volatility swap using = /(2 ).

Explain the basic premise of static option replication and how it

can be applied to hedging exotic options.
Static option replication involves searching for a portfolio of actively traded options
that approximately replicates the exotic option. Shorting this position provides the
hedge.

The basic principle underlying static options replication is as follows:

 If two portfolios are worth the same on a certain boundary, they are also worth the
same at all interior points of the boundary.
 We can approach the hedging of exotic options by creating a delta neutral position;
and rebalancing frequently to maintain delta neutrality.
Some exotic options are easier to hedge than plain vanilla options and some are more
difficult.
 An example of an exotic option that is relatively easy to hedge is an average price
option where the averaging period is the whole life of the option.
o As time passes, we observe more of the asset prices that will be used in
calculating the final average. This means that our uncertainty about the payoff
decreases with the passage of time. As a result, the option becomes
progressively easier to hedge.

o In-the final few days, the delta of the option always approaches zero because
price movements during this time have very little impact on the payoff.
 By contrast barrier options are relatively difficult to hedge.
o Consider a down-and out call option on a currency when the exchange rate is
0.0005 above the barrier.
o If the barrier is hit, the option is worth nothing. If the barrier is not hit, the option
may prove to be quite valuable.
o The delta of the option is discontinuous at the barrier, which makes conventional
hedging very difficult.

21
Example: Consider a 9-month up-and-out call option on a non-dividend-paying stock where
the stock price is 50, the strike price is 50, the barrier is 60, the risk-free interest rate is 10%
per annum, and the volatility is 30% per annum.

Suppose that ( , ) is the value of the option at time for a stock price of . Any boundary
in ( , ) space can be used for the purposes of producing the replicating portfolio.

As seen from the figure above, the replicating portfolio chosen is defined by = 60 and =
0.75. The boundary values of the up-and-out option are:

( , 0.75) = max( − 50, 0) when < 60

(60, ) = 0 when 0 ≤ ≤ 0.75

There are many ways that these boundary values can be approximately matched using
regular options.
 The natural option to match the first boundary is a 9-month European call with a
strike price of 50. The first component of the replicating portfolio is therefore one unit
of this option. (We refer to this option as option A.)
One way of matching the (60, ) boundary is to proceed as follows:
 Divide the life of the option into steps of length
 Choose a European call option with a strike price of 60 and maturity at time (=9
months) to match the boundary at the {60, ( − 1) } point.
 Choose a European call option with strike of 60 and maturity at time ( − 1) to
match the boundary at the {60, ( − 2) } point and so on.

22
  Note that the options are chosen in sequence so that they have zero value on the
parts of the boundary matched by earlier options.
 The option with a strike price of 60 that matures in 9 months has zero value on the
vertical boundary that is matched by option A.
 The option maturing at time has zero value at the point {60, } that is matched
by the option maturing at time ( + 1)∆ for 1 ≤ ≤ − 1.
Suppose that Δ = 0.25. In addition to option A, the replicating portfolio consists of positions
in European options with strike price 60 that mature in 9, 6, and 3 months. We will refer to
these as options B, C, and D, respectively.
 Given our assumptions about volatility and interest rates, option B is worth 4.33 at
the {60, 0.5} point. Option A is worth 11.54 at this point. The position in option B
necessary to match the boundary at the {60, 0.51} point is: -11.54/4.33 = -2.66.
 Option C is worth 4.33 at the {60, 0.25} point. The position taken in options A and B
is worth -4.21 at this point. The position in option C necessary to match the boundary
at the {60, 0.25} point is: 4.21/4.33 = 0.97.
 Similar calculations show that the position in option D necessary to match the
boundary at the {60, 0} point is 0.28. The portfolio chosen is summarized in the table
below.
Option Strike Maturity Position Initial
Price (years) Value
A 50 0.75 1 6.99
B 60 0.75 -2.66 -8.21
C 60 0.50 0.97 1.78
D 60 0.50 0.28 0.17
Sum 0.73

 The portfolio is worth 0.73 initially (i.e., at time zero when the stock price is 50). This
compares with 0.31 given by the analytic formula for the up-and-out call.
 The replicating portfolio is not exactly the same as the up-and-out option because it
matches the latter at only three points on the second boundary. If 18 points are
matched the value reduces to 0.38 and if 100 points are matched, the value reduces
further to 0.32.
 To hedge a derivative, the portfolio that replicates its boundary conditions must be
shorted. The portfolio must be unwound when any part of the boundary is reached.
 Static options replication has the advantage over delta hedging that it does not
require frequent rebalancing. It can be used for a wide range of derivatives. The
user has a great deal of flexibility in choosing the boundary that is to be matched and
the options that are to be used.

23
Chapter Summary
Exotic options are options with rules governing the payoff that are more complicated
than standard options.
 We discussed different types of exotic options: packages, nonstandard American
options, gap options, forward start options, compound options, chooser options,
barrier options, binary options, lookback options, shout options, Asian options,
options to exchange one asset for another, and options involving several assets.
 We discussed how these can be valued using the same assumptions as those used
to derive the Black-Scholes model.
 Some can be valued analytically, but using much more complicated formulas than
those for regular European calls and puts.
 Some exotic options are easier to hedge than the corresponding regular options;
others are more difficult.
o In general, Asian options are easier to hedge because the payoff becomes
progressively more certain as we approach maturity.
o Barrier options can be more difficult to hedge because delta is discontinuous
at the barrier.
 One approach to hedging an exotic option, known as static options replication, is
to find a portfolio of regular options whose value matches the value of the exotic
option on some boundary. The exotic option is hedged by shorting this portfolio.

24
Practice Questions & Answers:
1. In comparison to a plain vanilla derivative, each of the following is true of an EXOTIC
derivative EXCEPT for (most likely answer):
a) BETTER hedge effectiveness
b) BETTER liquidity
c) LOWER basis risk
d) HIGHER (more) counterparty risk

2. Assume the current price of a non-dividend-paying stock is $20 (S=20) with volatility of
30%. The riskfree rate is 4%. If option terms are one year (T=1), what is the same strike
price required for two European options that creates a range forward contract; i.e., a
package consisting of a long (short) call and a short (long) put with zero initial cost?
a) $18.82
b) $19.52
c) $20.82
d) $22.52

3. For each of the following, is the answer true or false?

(i) True or false: Nonstandard American-style options ought to be valued with a

variant of Black-Scholes-Merton
(ii) True or false: A Parisian option can be exercised before expiration but only on
certain restricted dates
(iii) True or false: A nonstandard American option with an initial lockout (“vesting
restrictions”) ought to be worth less than its European style analog
(iv) True or false: An executive stock option (ESO), with a four (4) year vesting
restriction and seven (7) year term, where the strike price is indexed to the S&P
500 could be called a nonstandard American option and could be valued with
Margrabe which is a variant of BSM
(v) True or false : A compound option must be valued with a binomial “simulation”
(numerical) method rather than an analytical-type method.

4. The BSM value of a ATM three-month call option on a non-dividend paying stock is $1.35
(assumptions: S= 30, K=30, sigma = 20%, RF rate = 4%, q = 0%, T = 0.25.). Assume the
same parameters except this is changed into a FORWARD START option that starts in three
months and expires three months after it starts; i.e., start in T0 + 0.25 year and expire in T0
+ 0.5. What is the (present) value of this forward start call option?

25
Answers:

1. B. BETTER liquidity
The benefit of nonstandard terms is a better hedge but the price is typically less liquidity. The
essential difference between vanilla and exotic is similar to the difference between forward
and futures: a vanilla derivative has standard terms which enables exchange trading; the
exotic has non-standard terms which often requires OTC. As such, the primary (typical)
trade-off is between liquidity and basis risk. A vanilla instrument will tend to have higher
liquidity due to standardized terms but the exotic can be customized to LOWER basis risk
(and thus giving BETTER hedge effectiveness).

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l2-t5-09-exotic-versus-

vanilla.3393/#post-9239

2. C. $20.82
Volatility is not required, we can use put-call parity.
Since c + K*EXP(-rT) = p + S, c - p = S - K*EXP(-rT)
We want c - p = 0, so that: S - K*EXP(-rT) = 0, and S = K*EXP(-rT), or K = S*EXP(rT).
In this case, K = 20*EXP(4%*1) = $20.82
... and we can check with BSM:
call[S=20, K = 20.82, sigma = 0.3, rho=4%, T=1] = $2.385
put[S=20, K = 20.82, sigma = 0.3, rho=4%, T=1] = $2.385

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l2-t5-10-range-forward-

contract.3394/#post-9240

3. True or False

I. False: American-style options are well-suited to the BINOMIAL rather than the
closed-form (analytical) BSM. This is especially true of nonstandard American-
style options in order to test the early exercise at nodes prior to expiration.
II. False. A Parisian option is barrier option with Asian-style path-dependence (e.g.,
knocked-out if asset price stays below strike price for a consecutive amount of
time). A BERMUDAN option is an can be early exercised on restricted dates, so
the BERMUDAN is a nonstandard American option.
III. False: this nonstandard American option still has some additional option value
(the option to early exercise). It should still be worth more than its European
counterpart
IV. True. Technically, the indexed ESO an exchange option (exchange indexed
strike for asset price) but the indexed strike price meets Hull’s third criteria for a
nonstandard American option (“3. The strike price may change during the life of
the option.”). The vesting restriction is a modification of the American style. And
the Magrabe formula, a direct variation on BSM, can be used.
V. False. Hull shows the analytical formula for a European style compound option
(although if you answered TRUE because you recognized that the formula
requires a bivariate normal distribution, you get credit!)

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l2-t5-11-nonstandard-

american-options.3398/#post-9247

4. $1.35 (same as value of similar call with a three month term). The value of the forward call
= c * EXP(-qT) such that if q=0, forward call = c due to discounting

Discuss here in forum: https://www.bionicturtle.com/forum/threads/l2-t5-12-forward-start-

option.3401/#post-9251

26
P1.T3. Financial Markets & Products

Chapter 16. Properties of Interest Rates

Bionic Turtle FRM Study Notes

CHAPTER 16. PROPERTIES OF INTEREST RATES ............................................................ 3
DESCRIBE TREASURY RATES, LIBOR, SECURED OVERNIGHT FINANCING RATE (SOFR), REPO
RATES AND WHAT IS MEANT BY THE RISK-FREE RATE. .................................................................. 3
CALCULATE THE VALUE OF AN INVESTMENT USING DIFFERENT COMPOUNDING FREQUENCIES ........ 5
CONVERT INTEREST RATES BASED ON DIFFERENT COMPOUNDING FREQUENCIES.......................... 6
CALCULATE THE THEORETICAL PRICE OF A BOND USING SPOT RATES. ......................................... 7
CALCULATE THE DURATION, MODIFIED DURATION AND DOLLAR DURATION OF A BOND. ................ 11
EVALUATE THE LIMITATIONS OF DURATION AND EXPLAIN HOW CONVEXITY ADDRESSES SOME OF
THEM. ..................................................................................................................................... 15
CALCULATE THE CHANGE IN A BOND’S PRICE GIVEN DURATION, CONVEXITY, AND A CHANGE IN
INTEREST RATES ..................................................................................................................... 16
DERIVE FORWARD INTEREST RATES FROM A SET OF SPOT RATES ............................................... 18
DERIVE THE VALUE OF CASH FLOWS FROM A FORWARD RATE AGREEMENT (FRA) ...................... 19
CALCULATE ZERO-COUPON RATES USING THE BOOTSTRAP METHOD .......................................... 21
COMPARE AND CONTRAST THE MAJOR THEORIES OF THE TERM STRUCTURE OF INTEREST RATES.
............................................................................................................................................... 22
CHAPTER SUMMARY ............................................................................................................... 23
QUESTIONS & ANSWERS: ....................................................................................................... 24

2
Chapter 16. Properties of Interest Rates
 Describe Treasury rates, LIBOR, Secured Overnight Financing Rate (SOFR), repo
rates and what is meant by the risk-free rate.

 Calculate the value of an investment using different compounding frequencies.

 Convert interest rates based on different compounding frequencies

 Calculate the theoretical price of a bond using spot rates.

 Calculate the duration, modified duration and dollar duration of a bond.

 Evaluate the limitations of duration and explain how convexity addresses some of
them.

 Calculate the change in a bond’s price given duration, convexity, and a change in
interest rates.

 Derive forward interest rates from a set of spot rates.

 Derive the value of the cash flows from a forward rate agreement (FRA).

 Calculate zero-coupon rates using the bootstrap method.

 Compare and contrast the major theories of the term structure of interest rates.

NOTE: THIS LO HAS CHANGES “SECURED OVERNIGHT FINANCING RATE (SOFR)”

REPLACED “overnight indexed swap (OIS) rates”. PLEASE CHANGE CONTENT
ACCORDINGLY.

Describe Treasury rates, LIBOR, Secured Overnight Financing Rate

(SOFR), repo rates and what is meant by the risk-free rate.
Treasury rates are the rates an investor earns on Treasury bills and Treasury bonds;
i.e., the instruments used by a government to borrow in its own currency.
 For example, Japanese Treasury rates are the rates at which the Japanese
government borrows in yen; US Treasury rates are the rates at which the US
government borrows in US dollars.
 It is often, but not always, assumed that there is virtually no chance that a
government will default on an obligation denominated in its own currency.
 Treasury rates are therefore totally risk-free rates in the sense that an investor
who buys a Treasury bill or Treasury bond is certain that interest and principal
payments will be made as promised.
LIBOR (London Interbank Offered Rate) and SECURED OVERNIGHT FUNDING RATE
(SOFR)
A LIBOR quote by a particular bank is the rate of interest at which the bank is
prepared to make an unsecured large wholesale deposit with other banks.

3
  Large banks and other financial institutions quote LIBOR in all major currencies for
maturities up to 12 months: 1-month LIBOR is the rate at which 1-month deposits are
offered, 3-month LIBOR is the rate at which 3-month deposits are offered, and so on.
Banks have been accused of trying to manipulate Libor rates by providing overly high or low
estimates of their borrowing rates. A bank might have an incentive to do this when the payoff
from a derivative it has entered depends on a specific libor fixing for that day. Another
scenario would be a bank that reports extensively lower rates in order to appear more
creditworthy.

The underlying problem is that there is not enough Libor borrowing for estimates to be based
on actual transactions. As a result, the person providing the estimates has to use quite a bit
of judgement.

There are plans to begin phasing out Libor in 2021 and replace it with a rate based on actual
transactions (rather than estimates). There are two main candidates for this replacement
benchmark rate: the repo overnight rate and the overnight interbank borrowing rate.

The United States has proposed the use of the repo-based Secured Overnight Financing
Rate (SOFR). Meanwhile, the United Kingdom has proposed the use of the Sterling
Overnight Index Average (SONIA), which is based on interbank borrowing. Both are one-day
rates. Swaps are necessary to create a complete interest rate term structure from these
rates.
Repo rates
Sometimes, trading activities are funded with a repo or repurchase agreement: a
contract where a dealer (who owns securities) agrees to sell them to another
company now and buy them back later at a slightly higher price.
 The other company is lending a collateralized (secured) loan.
 The difference between selling price (today) and the repurchased price (tomorrow or
later) is the interest paid in obtaining a loan and this interest rate is called repo rate.
 If structured carefully, the loan involves very little credit risk.
 If the borrower does not honor the agreement, the lending company simply keeps the
securities.
 The most common type of repo is an overnight repo, in which the agreement is
renegotiated each day. However, longer-term arrangements, known as term repos,
are sometimes used.

Risk-Free Rate
Derivative traders have typically used LIBOR rates as short-term risk-free rates. For a AA-
rated financial institution, LIBOR is the short-term opportunity cost of capital.

Traders argue that Treasury rates are too low to be used as risk-free rates because:
 Market demand: Financial institutions, to fulfill a variety of regulatory requirements
must purchase Treasury bills/bonds. This increases demand for these Treasury
instruments driving the price up and their yield down.

4
  Regulatory relief: The amount of (regulatory) capital required to support an
investment in Treasury bills/bonds is substantially smaller than the capital required to
support a similar investment in other instruments.
 Tax treatment: In the United States, Treasury instruments are given a favorable tax
treatment because they are not taxed at the state level.
Due to the global financial crisis (GFC), many dealers have switched to using the overnight
indexed swap (OIS) rate as a proxy for the risk-free rate.

Calculate the value of an investment using different compounding

frequencies.
If we assume that is the amount invested, is the rate of interest with continuous
compounding, is the equivalent rate of interest with discrete compounding ( times per
annum), and is the number of years, then by equivalence:

= 1+ → = 1+

And therefore:
⁄
 We can translate from a continuous to discrete rate with: = −
 We can translate from a discrete to a continuous rate with: = +

In the table below, we see the effect of the compounding frequency on the value of $100 at
the end of 1 year when the interest rate is 10% per annum.

Hull Table 4.1: Calculating investment value using different compounding frequencies

5
Convert interest rates based on different compounding
frequencies.
The present value is discretely discounted at (m) periods per year (e.g., m = 2 for semi-
annual compounding) over (n) years by using the formula on the left. The continuous
equivalent is the right. When the future value is $1.00, the PV is the discount factor (DF).

Discrete Continuous
= =

$ =$
=

Discount Factor (DF), Discount Factor,

10 years @ 8% semi-annual 10 years @ 8% continuous

%∗
( )=$ ∗ = . ( )=$ = .
%
+

We also must be able to convert from a discrete rate into a continuous rate, and vice-versa:

Semi-annual equivalent of 8% Continuous equivalent of 8.162%

continuous: semi-annual:

= ( / − ) = +

= ( %/ − ) . %
= +
= . %
= %

The following snippet (from the learning spreadsheet) shows, in the left panel, the translation
of a discrete rate of 8.0% per annum into its continuous equivalents depending on the
discrete compound frequency; and, in the right panel, the translation of a continuous rate of
8.0% per annum into various discrete rates:

6
Calculate the theoretical price of a bond using spot rates.
Most bonds pay coupons to the holder periodically. The bond’s principal (par value or face
value) is paid at the end of its life. The theoretical price of a bond can be calculated as the
present value of all the cash flows that will be received by the owner of the bond.

To calculate the price of a coupon-paying bond, each cash flow is discounted by the
appropriate discount factor (or, equivalently, by using the corresponding spot rate).

Example: To illustrate this, consider the situation where Treasury zero rates, measured with
continuous compounding, are as shown in the table below. Suppose that a 2-year Treasury
bond with a principal of $100.00 provides semi-annual coupons at the rate of 6.0% per
annum.

Hull Table 4.2: Treasury zero rates

 Coupon rate is always per annum; eg. 6.0% semi-annual (s.a.) coupon pays 3.0%
every six months
 Given the zero rate curve, for eg. the 6 month zero rate is 5.0%. "CC" refers to
continuously compounded zero rate. Under continuous compounding, the present
value (PV) of the coupon cash flow of $3.00 is $2.93 = $3.00 * EXP(-0.050*0.5).
 Likewise, each cash flow is discounted by its respective zero rate. The theoretical
model price ($98.39) is the sum of the present values (PVs) of these cash flows.

Although the accurate approach in bond pricing is to use a different zero or spot rate for
each cash flow as shown above, sometimes bond traders use the same discount rate for all
the cash flows underlying a bond to arrive at the market price of the bond. In this context, we
take a look at the bond yield. In case of a par yield, though different spot discount rates are
used, a coupon rate is found which makes the bond price equal to its principal or par value.

7
Bond Yield (yield to maturity, YTM)
A bond’s yield (YTM) is the single rate that discounts the bond's cash flows to match
its market price. Unlike the zero-rate curve (which it averages), it is effectively a flat line.

Suppose $98.39 is the observed market price of the bond. We can us an iterative (‘‘trial and
error’’) procedure to retrieve the single discount rate that, when applied to all cash flows,
returns a bond price equal to this market price. The single rate that discounts (then sums) all
cash flows to a price of $98.39 is found to be 6.76%, as shown in the table below.

Hull sec 4.4: Bond Yield Example

Importantly, we can solve for yield with the calculator if we have the other four time value of
money (TVM) inputs. Below, we can find the semi-annual yield of 4.944% with: N = 4, PV
= -101.988, PMT = 3, FV = 100 and CPT [I/Y] = 2.47 * 2 = 4.94.

8
Par Yield
The par yield for a bond is the coupon rate that causes the bond price to equal its principal
or par value. The par yield discounts cash flows at the various zero rates, but finds the
coupon rate that discounts the present value (model price) to its par value (i.e,
$100.00 or $1,000.00)
Hull sec 4.4: Par Yield Example

Using the same zero rates in Table 4.2, the value of the bond is equal to its par value of 100
when by iteration we find the coupon rate or the 2-year par yield is 6.87% per annum in case
of semiannual compounding.

It is possible to derive the par yield

analytically, as illustrated to the right. The
par yield is given by

c = [(1 – df(2.0)]*m/A, where

df(2.0) is the discount factor associated

with the final cash flow,
(m) is the number of periods per year,
and
(A) is the sum of the discount factors.

Determining Treasury Spot rates

Now that we have seen the calculation of bond rates and par yields, let’s calculate Treasury
zero rates like those in Hull Table 4.2 which are used to obtain the theoretical price of a
bond. The most popular approach to determine them is known as the bootstrap method.

9
Example: To illustrate the bootstrap, consider the data below on the prices of five bonds.

Hull Table 4.3 & 4.4: Determining Treasury Zero rates; aka, bootstrap

 Since the first three bonds pay no coupons, the zero rates corresponding to the
maturities of these bonds can easily be calculated. For example, the 3-month bond
has the effect of turning an investment of $97.50 into $100.00 in 3 months such that:
100 = 97.5 ∗ . . So, the continuously compounded 3-month spot rate is
calculated as: l n(100/97.5)
× (1/0.25)
= 10.127% .
 The other two spot rate can be calculated as follows. The fourth bond has two
payments of $4.00 coupon, one in six months and another in one year. In 1.5 years,
it gets the final principal payment of $100.00 along with the $4.00 coupon payment.
From the earlier calculations (hence the bootstrap), we know the discount rate for the
payment at the end of six months is 10.469% and the discount rate for the payment
at the end of 1 year is 10.536%. We also know that the bond’s price, $96.00, must
equal the present value of all the payments received by the bondholder such that:
. ∗ . . ∗ ∗ . ∗ .
= + +  = .
Therefore, =− ( . )/ . = . %

Solving this, the 1.5-year spot is

calculated to be 10.681%.
Likewise, the 2-year spot rate is
calculated as 10.808%.
The treasury zero rates
determined by this bootstrap
method are plotted at the right.

10
Calculate the duration, modified duration and dollar duration of a
bond.
Modified duration is a measure of price sensitivity: it is the approximate percentage
change in bond price given a 1.0% change in the yield. For example, if the (modified)
duration is 3.5 years, then the bond’s price will increase approximately 3.5% if the yield
drops by 1.0%.

= −(∆ / )/∆
The related duration measure is Macaulay Duration. Macaulay duration is the weighted-
average maturity of the bond, where the weight is the present value of the cash flow as a
proportion of the bond’s price. For a bond with price and cash flows at time giving a
continuously compounded yield of , it is calculated as:

−
=∑=
Hull also explains that bond duration is a measure of how long on average the
holder of the bond has to wait before receiving cash payments. This is the “break-even”
interpretation of Macaulay duration.

Calculation of Macaulay Duration

Example: Consider a 3-year 10% coupon bond with a face value of $100.00 and a yield of
12.0% per annum with continuous compounding. Coupon payments of $5.00 are made
semiannually. The table below shows the calculations necessary to determine the bond’s
duration.

Hull Table 4.6: Calculation of Macaulay Duration

11
  The present values (PV) of the bond’s cash flows, using yield as the discount rate,
. ∗ .
are shown under PV. For example, the PV of the first cash flow is $5.00 =
$4.71. This also equals the $5.00 cash flow multiplied by the 0.9420 discount factor.
 The sum of the PV of all the bond’s cash flows returns the bond’s price of $94.213.
 The weights are calculated as proportion of the present value of cash flow at each
time period divided by the bond price of $94.213. For example, the final cash flow of
$105.00 has a present value (PV) of $73.26 = $105.00*EXP(-0.12*3.0). The cash
flow, in present value terms, constitutes 0.778 or 77.8% of the bond’s price (which is
the sum of the present value of all cash flows, by definition). As this cash flow occurs
in year 3.0, its contribution to duration is given by 3.0 years * 0.778 = 2.333 years
(shown in the final column). The sum of these weighted-maturities is the Macaulay
duration, which is 2.6530 years.
 These weights are then applied to each time period and summed up to give the bond
duration of 2.653 years (the units of both modified and Macaulay duration are years)

Application of duration (Hull Example 4.5): For the bond in Table 4.6 with a price of
$94.213 and duration of 2.653 years, suppose the yield increases by 10 basis points
(0.10%). Let us check if the actual bond price due to this yield shock is same as that
predicted by the duration relationship. This new bond price obtained by both methods can be
verified by the calculation in the table below.

Hull Example 4.5

 From the definition of duration, we can calculate the change in bond price as
∆ =− × ∆ × = 2.653 × 0.001 × 94.21= −0.2499
So, due to the yield shock of 0.10%, the bond price goes down to 93.96307
(=94.21-0.2499). This is the new bond price as predicted by the duration relationship.
 Valuing the bond in terms of its yield in the usual way (like that shown in table 4.6),
we find that, when the bond yield increases by 10 bps to 12.1%, the actual bond
price declines to 93.96343 from $94.213 (shown as Exact bond price in the table).
 The difference between the actual bond price and the one predicted by the duration
relationship is negligible as they both are similar up to three decimal places.

Thus, for very small changes in yield we can see that the Macaulay duration is a quick way
to calculate the approximate change in a bond's value.

12
Calculation of Modified Duration
The calculation of Macaulay duration we saw above is based on the assumption that the
yield is continuously compounded. Instead, if the yield is compounded with a compounding
frequency of m times per year, then the duration relationship is modified to:

− × ∆ ×
∆ = + /
This change in the duration (which accounts for discrete) compounding of yield is called
Modified duration, D*, and its relationship to Macaulay duration is given by:

∗
=
+ /
∗
such that the duration relationship becomes ∆ = − × ∆ ×

Hull Example 4.6: For the same bond in Table 4.6 with a price of 94.213 and a duration of
2.653, if the yield expressed with semiannual compounding is 12.3673%, then the modified
duration is calculated as:

∗ 2.65 3
=
1+ /
= 1+12.3673%/2 = 2.50

∗
So, ∆ = − × ∆ × = −2.5 0 × 0.001 × 94.21= −0.2 35

This means that the new bond price as predicted by the Modified Duration relationship for a
change in yield of 0.1% is $93.978 (= 94.213 -0.235).

An exact calculation similar to that in Hull example 4.5 shows that, when the semiannually
compounded bond yield increases by 0.10% to 12.4673%, the bond price becomes $93.978.
We can see the modified duration is very accurate for small yield changes.

Calculation of Dollar Duration

Dollar duration, D$, is the modified duration, D*, multiplied by the bond’s current price:

∗
$ = ×

Such that the duration relationship becomes ∆ = − $ × ∆

Example: For the same bond in Table 4.6 with a price of $94.213 and a modified duration of
2.50 years, the dollar duration is calculated as:
∗
$ = × B = 50
2. × 94.213= $235.8 0

Effective Duration
Along with all the above duration measures, we have another one called effective duration
which not only considers the discounting that occurs at different interest rates but also takes
in to account the way in which changes in yield will affect the expected cash flows. It is
generally used for measuring bonds with embedded options.

13
Effective Duration (ED) is the approximate percentage change in bond prices for a
percentage change in yield and calculated as:

ℎ − ℎ
=
2× ℎ × ∆

Example: Now let us look at another example where the all the duration measures are
compared. Consider a 3-year, 10.0% coupon bond with a face value of $100.00. It gives a
yield of 12.00% per annum with semiannual compounding. Coupon payments of $5.00 are
made semiannually. Now suppose that the yield changes by 50 basis points (0.5%). The
duration measures and the new bond prices as a result of yield shock are calculated in the
table on the next page.

Example: Comparison of Duration measures

Macaulay duration is weighted average maturity of the bond; i.e., the sum of (T*W) in the
final column, where (W) is the ratio of the present value of the cash flows to the bond price.
The sum of each [maturity * weight] gives the Macaulay duration of 2.6548 years
The modified duration is obtained by adjusting the Macaulay duration for semiannual
compounding and calculated as:

2.6548
∗
=
1+ /
= 1+12% /2
= 2.50 46years

14
The dollar duration is the modified duration times the bond price and is calculated as:
∗
$ = × B = 2.5046 × 95.083= $238.145

Finally, the effective duration is calculated as:

– . .
D = × × ∆
=
× . × .
= 2.5047 years

We see that the effective duration does a good job of approximating modified duration, which
is less than Macaulay duration (it cannot be greater than Macaulay duration!). Keep in mind
that all three of these duration measures are merely linear approximations and therefore
valid for (very) small parallel shifts in the yield curve; they cannot predict bond prices
when yield curve shifts are either large and/or non-parallel.

Evaluate the limitations of duration and explain how convexity

addresses some of them.
Limitations of duration
By hedging a portfolio to achieve a net duration of zero, exposure is eliminated only with
respect to small parallel shifts in the yield curve. If a portfolio is hedged with respect to
duration, it still remains exposed to shifts that are large in magnitude and/or non-parallel.

How convexity can help alleviate the

problem
 Convexity, as a function of the
second derivative, adjusts for some
but not all of the “gap” between
duration and the actual price
change.
 It does however help address the
issue of non-parallel shifts and
larger changes by more effectively
hedging our position against non-
linearity.
It is important to note that even with the convexity adjustment, this remains a single-
factor model, i.e., the yield to maturity is the single factor, with limitations:
 Duration is a first-order linear approximation
 Duration is only accurate for small, parallel shifts in the yield curve (i.e., unrealistic)
 Convexity adds a term to adjust for the curvature in the price/yield curve
 Convexity is still imprecise
Both utilize the Taylor Series approximation: duration is a function of the first term and
convexity is a function of the second term.

15
Calculate the change in a bond’s price given duration, convexity,
and a change in interest rates
Using the duration, convexity and change in interest rates, we illustrate the calculation of
change in bond’s price with the help of an example. Example: Consider a 3-year, 10.0%
coupon bond with a face value of $100. It gives a continuously compounded yield of
12.0% per annum. Coupon payments of $5 are made semiannually. Now suppose that the
yield changes by 10 basis points (0.10%).

This bond is similar to the one shown in Hull Table 4.6. We have already seen how to
calculate the duration measures. In addition, we calculate convexity here and evaluate how
given a yield shock, the bond prices change. The results are presented in the table below.

Example: Change in a bond’s price given duration, convexity, and a change in yield

 Like we saw earlier in the duration section, from the table, the sum of the PV of all
the bond’s cash flows give an initial bond price of 94.213 and a bond duration
(Macaulay duration) of 2.653 years.

16
 Now we need to convert the Macaulay duration ( ) into modified duration ( ∗ ). Note
that modified duration can be less than or equal to Macaulay duration, but never
greater than! In the special case of continuous compounding, the relationship,
∗ ∗
=
1+ /
reduces to = .

Thus, the modified duration will be equal to the Macaulay duration of 2.653 years.
 While the duration relationship can be applied for small changes in yields, convexity
measures the curvature in the yield curve for large yield changes. It is the time
squared weighted average of ratio of the present value of the cash flows to the bond
price. It is calculated as the sum of times the weights and found to be 7.57.
 Now, given the yield shock of 10 basis points (0.1%), the change in bond price as
given by the duration ( ) and convexity ( ) relationship is:

∆ = − ∆ + (∆ )
1
= 94.21 −2.653 ∗ 0.
001 + 57 ∗ (0.001 )2 = −$ 0.2496
∗ 7.
2
 The change in bond price is added to the initial bond price to obtain the new bond
price of $96.96343 (= 94.21 - 0.2496) as predicted by the duration and convexity
relationship.
 An exact calculation of the bond, shows that when the bond yield increases by 10
bps to 12.1%, the actual bond price declines to $93.96343 from $94.213.
 As we see, the new bond price and the exact bond price match very closely (up to
five decimal places) and so their differences can be considered negligible.
 Thus, adding convexity in to the duration relationship to predict the change in bond
prices seems to eliminate the error due to linearity.

17
Derive forward interest rates from a set of spot rates.
Hull assumes a continuous compounding/discounting frequency. The forward (continuously
compounded) rate, , is given by:

−
=
−

For example, assume the following zero rate curve and the implied one-year forward rates:

The one-year forward rate for year two: The one-year forward rate for year four:

[4% × 2 - 3% × 1] [5% × 4 - 4. 6%× 3]

= 5. 0% = 6. 2%
[2 - 1] [4 - 3]

In the following table, 6-month forward rates are extracted from the spot rate curve.

It is good practice to extract these forward rates. For example, given the same zero rate
curve, what is the six-month continuous forward rate starting in 1.5 years, . , ?

[2. 5%× 2 – 2. 25%× 1. 5]

= 3. 25%
[2 – 1. 5]

Try another. What is the six-month semi-annual forward rate starting in 1.5 years, . , ?

2∗2
( 1+2. 5%/ 2)
1.5∗2 − 1 = 3. 252%
( 1+2. 25%/ 2)

18
Derive the value of cash flows from a forward rate agreement (FRA)
A forward rate agreement (FRA) is an agreement that a fixed interest rate will apply to
either borrowing or lending a certain principal during a specified future time period.
 An FRA is equivalent to an agreement where interest at a predetermined rate, is
exchanged for interest at the market rate (LIBOR).
 An FRA can be valued by assuming the forward interest rate will be realized.
The value of a forward rate agreement (FRA) where a fixed rate, , will be received on a
principal (L) between times and ,if is the forward rate for the period and is the
spot/zero rate for maturity is given by:

, = ( − )( − )

The value of FRA where a fixed rate , is paid is

, = ( − )( − )

Hull departs from continuous compounding and assumes compound frequency equal to
period; e.g., quarterly where – = 3 months or 0.25 years. FRAs are usually settled at
time rather than . So, the payoff must then be discounted from time to as:

( )( ) ( )

Example of FRA cash flows (Hull 4.3), a company enters an FRA to receive 4.0% (“selling
the FRA”) on $100.0 MM principal for a three-month period, three years forward. The
company will receive the fixed rate (4.0%) and pay the floating rate, LIBOR. The notation to
specify this FRA is either FRA36,39 = 4.0% or FRA3.0,3.25 = 4.0% or 36 × 39 4.0%.
 If LIBOR is 4.5% in 3 years, company ends up paying to the counterparty who is the
buyer receiving the payment at a future value of time t = 3.25 years of $125,000.
100,000,000× (4% − 4.5%)× 0.
25 = −$125,000
,
Discounting this to the present value at year 3, we get = −123,60 9.
( .% × . )
Hull Example 4.3: Forward Rate Agreement (FRA) cash flows

19
Valuation of an FRA
Here we assume an FRA’s with a fixed rate of 5.80% for a six-month period starting in 18
months; i.e., FRA18,24 = 5.8%, or FRA1.5,2.0 = 5.8%, or 18 × 24 4.0%. The semi-annual zero
rates are s(1.5) = 3.72% and s(2.0) = 4.0%, deliberately chosen to imply a round forward
rate, f(1.5,2.0) = 5.0%. The expected future payoff is $400,000 (see blue cells) such that the
FRA’s present value equals about $369,247 (see green cells).

Example of a Valuation of Forward Rate Agreement (FRA)

20
Calculate zero-coupon rates using the bootstrap method.
Analysts determine zero-coupon interest rates from the market prices of traded instruments.
Money market instruments which have a life of less than one year provide the entire return at
the end of their term. Thus, they provide zero-coupon interest rates in a direct way.
However, instruments lasting longer than one year usually make regular payments prior to
maturity. It is then necessary to calculate the zero-coupon rates implied by these
instruments. One way of doing this is by working forward and fitting the zero-coupon rates to
progressively longer maturity instruments. This is called the bootstrap method.

Consider the zero-coupon interest rates (semi-annually compounded) for maturities of 0.5,
1.0, and 1.5 years in the below table has already been determined. A two-year bond with a
par value of USD 10 has a market value of USD 102.7 when it pays a semi-annual coupon
at the rate of 4% per year.

Maturity Zero-coupon interest rates

(Years) Semi-Annually Compounded
0.5 2.0%
1 2.3%
1.5 2.5%

If the two-year zero-coupon interest rate is R, the equation that equates the value of the
bond to USD 102.7 is

2 2 2 2
+ + + = 102.7
0.02 0.02 0.02 0.02
1+ 2 (1+ 2 ) (1+ 2 ) (1+ 2 )

This can be solved to give R = 0.0261. Thus, the two-year rate with semi-annual compounding
is therefore 2.61%.

A zero curve defines the relationship between zero-coupon interest rates and their
maturities. The zero-coupon interest rates in a zero curve are usually assumed to be
constant until the first maturity for which data is available. They are also usually assumed
to be constant beyond the longest maturity for which data is available.

21
Compare and contrast the major theories of the term structure of
interest rates.
A number of theories have been proposed to explain the shape of the zero (spot rate)
curve, including the following three:
1. Expectations Theory: This is the simplest (but unrealistic) theory that long-term
interest rates should reflect only expected future short-term interest rates. More
exactly, a forward interest rate corresponding to a certain future period is equal to the
expected future zero interest rate for that period.
2. Market Segmentation Theory: The theory that short, medium & long rates are
independent of each other: “There need be no relationship between short-, medium-,
and long-term interest rates. Under the theory, a major investor such as a large
pension fund invests in bonds of certain maturity and does not readily switch from
one maturity to another. The short-term interest rate is determined by supply and
demand in the short-term bond market; medium-term interest rates are determined
by supply and demand in the medium-term bond market; and so on.”
3. Liquidity Preference: The Liquidity Preference theory holds that forward rates are
higher than expected future zero rates. This theory is very appealing. Investors
prefer to preserve their liquidity and invest funds for short periods of time. Borrowers,
on the other hand, usually prefer to borrow at fixed rates for long periods of time.
Liquidity preference theory leads to a situation in which forward rates are greater
than expected future zero rates. It is also consistent with the empirical result that
yield curves tend to be upward sloping more often than they are downward sloping.

22
Chapter Summary
Important interest rates include the Treasury rates, the LIBOR rates, the Repo Rates
and the OIS rate.
 The risk-free rate is an important part of both financial theory and practice.
 Traditionally the LIBOR rate has been seen as a proxy for the risk-free rate, however;
the OIS rate is increasingly being used as a proxy for the risk-free rate.
Interest rates may be compounded at a variety of frequencies, of which quarterly,
semi-annual, annual and continuous are the most important.
 It is imperative that you are able to quickly convert a rate from one compounding
frequency to another. This is frequently a requirement in order to solve questions on
the FRM exam.
The theoretical price of a coupon-paying bond can be calculated using spot rates, by
discounting the nth cash flow with the corresponding nth year spot rate, n years back in time.
This is also known as the nth year zero-rate.

Treasury rates and zero rates can be determined by using a technique known as
bootstrapping.
 Forward interest rates can easily be inferred from a set of spot or zero-rates. The
forward interest rate is the rate implied for the period of time between the end of the
nth and (nth-1) period of zero rates, e.g. the rate between the end of the 5th and the
4th zero rate.
A forward rate agreement (FRA) is an agreement, in which an investor will pay or
receive a pre-determined rate in the future on a given principal, for a given period.
 An FRA is equivalent to an agreement where interest at a predetermined rate, 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 and by discounting the resulting payoff
Simple duration is the weighted-average time to receipt of cash flows.
 Duration hedging (slope) helps protect the portfolio against small parallel shifts in the
yield curve. We are however still exposed to shifts that are either large in magnitude,
non-parallel or both.
 Convexity, as a function of the second derivative (curvature), adjusts for some
shortcomings of duration only hedging. However, hedging using both duration and
convexity still implies that the yield to maturity remains the single factor in our model.
Duration typically comes in three forms: Macaulay Duration, Effective Duration and
Dollar Duration. Changes in a bond’s price can be calculated given duration, convexity and
a change in interest rates using the following formula:

∆ 1
=− ∆ + (∆ )2 .
2

The main theories of the term structure of interest rates are the expectations theory,
the market segmentation theory, and the liquidity preference theory of which the last is
described as, “the most appealing.”

23
Questions & Answers:
1. Suppose a lender quotes the interest rate on a $1,000 loan as 9.0% per annum with
continuous compounding but the interest is actually paid monthly. What are the monthly
interest payments?
a) $7.47
b) $7.50
c) $7.53
d) $7.59

2. Assume the following theoretical continuously compounded spot rates: 2.0% at 0.5 years;
3.0% at 1.0 year; 4.0% at 1.5 years; and 5.0% at 2.0 years. What is the two-year PAR
YIELD with continuous compounding?
a) 4.88%
b) 4.94%
c) 5.00%
d) 5.04%

3. Which of the following is TRUE about a forward rate agreement (FRA)?

a) It is an exchange-traded instrument
b) It can be cash or physically settled
c) A borrower who intends to borrow cash at LIBOR in the future will hedge by receiving
the fixed interest rate, R(k), in an FRA
d) A bank that intends to lend cash at LIBOR in the future will hedge by receiving the
fixed interest rate, R(k), in an FRA

4. Each of the following is TRUE with respect to duration and convexity EXCEPT:
a) Both modified and Macaulay duration are denoted in units of “years”
b) To estimate bond price change with both duration and convexity, per two-term Taylor
series, is still to employ a single-factor measure of sensitivity that assumes a parallel
shift in the yield curve
c) With respect to a plain vanilla bond (without embedded options), bond convexity
increases with maturity, decreases with coupon rate and decreases with yield
d) At low yields, a callable bond exhibits negative convexity and therefore negative
duration

5. Under discounting continuously (i.e., discounting at a continuously compounded rate) the

current price of a $1,000 par 20-year zero-coupon bond is $204. What is the bond’s implied
continuous yield?
a) 7.95%
b) 7.98%
c) 8.00%
d) 8.02%

24
Answers

1. C. $7.53
The equivalent monthly rate = 12 * . ⁄ - 1 = 9.0338%.
Each interest payment = $1,000 * 9.0338%/12 = $7.53

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-157-rate-

compounding-frequency.4472/#post-29357

2. B. 4.94%
A 5.0% semiannual coupon rate is the solution that prices that bond exactly at par, given this
theoretical spot rate curve.
The continuous par yield is therefore = 2*LN(1+5%/2) = 4.94%

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-158-bond-price-

using-spot-rates.4481/#post-20394

3.D. A bank that intends to lend cash at LIBOR in the future will hedge by receiving
the fixed interest rate, R(k), in an FRA

In the future, the bank’s cash flows will be:

(+) receive LIBOR on the lent cash
(+) receive fixed rate on the FRA
(-) pay LIBOR on the FRA
= net (+) receive fixed rate on the FRA
 In regard to (A), FRA is OTC.
 In regard to (B), FRA is cash settled.
 In regard to (C), to hedge the future LIBOR, the borrower wants to pay fixed and
receive LIBOR (i.e., the gain/loss on LIBOR in the FRA offsets the future borrowing).

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-160-valuation-of-

forward-rate-agreement-fra.4510/

25
4. D. At low yields, a callable bond exhibits negative convexity but this does not imply
negative duration; rather, it implies only that duration is increasing rather than
decreasing (more specifically, as low yields increase, negative convexity implies the
dollar duration [the slope of the tangent line] is decreasing from negative to more
negative. As the negative convexity gives over to “regular” convexity, the dollar duration [the
slope] continues to be negative but increasing to less negative. Regardless, even with the
negative convexity, the duration is always positive (i.e., the slope of the tangent is always
negative)

In regard to (A), (B) and (C), each of these are true.

 In regard to (B), please note that although two terms are involved (duration +
convexity), the model is still a single- or one-factor model, as the single factor
remains the yield (yield to maturity). For example, a two-factor model might introduce
a short- versus a long-term yield or interest rate.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-161-bond-
duration-convexity.4522/

5. A. 7.95%
Since $204*EXP(20*y) = $1,000,
y = 1/20*LN(1000/204) ~= 7.95%

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-157-rate-

compounding-frequency.4472/#post-29357

26
P1.T3.Financial Markets & Products

Chapter 17. Corporate Bonds

Bionic Turtle FRM Study Notes

CHAPTER 17. CORPORATE BONDS ............................................................................... 3
DESCRIBE FEATURES OF BOND TRADING AND EXPLAIN THE BEHAVIOR OF BOND YIELD. ............ 3
DESCRIBE A BOND INDENTURE AND EXPLAIN THE ROLE OF THE CORPORATE TRUSTEE .............. 6
DEFINE HIGH-YIELD BONDS AND DESCRIBE TYPES OF HIGH-YIELD BOND ISSUERS AND SOME OF
THE PAYMENT FEATURES UNIQUE TO HIGH YIELD BONDS. ......................................................... 7
DIFFERENTIATE BETWEEN CREDIT DEFAULT RISK AND CREDIT-SPREAD RISK ............................ 8
DESCRIBE EVENT RISK AND EXPLAIN WHAT MAY CAUSE IT IN CORPORATE BONDS. .................... 8
DESCRIBE THE DIFFERENT CLASSIFICATIONS OF BONDS CHARACTERIZED BY ISSUER, MATURITY,
INTEREST RATE, AND COLLATERAL. ........................................................................................ 9
DESCRIBE THE MECHANISMS BY WHICH CORPORATE BONDS CAN BE RETIRED BEFORE MATURITY
........................................................................................................................................... 12
DEFINE RECOVERY RATE AND DEFAULT RATE, DIFFERENTIATE BETWEEN AN ISSUE DEFAULT
RATE AND A DOLLAR DEFAULT RATE, AND DESCRIBE THE RELATIONSHIP BETWEEN RECOVERY
RATES AND SENIORITY. ........................................................................................................ 14
EVALUATE THE EXPECTED RETURN FROM A BOND INVESTMENT AND IDENTIFY THE COMPONENTS
OF THE BOND’S EXPECTED RETURN ...................................................................................... 15
CHAPTER SUMMARY ........................................................................................................... 17
QUESTIONS & ANSWERS: .................................................................................................... 18

2
Chapter 17. Corporate Bonds
 Describe features of bond trading and explain the behavior of bond yield.

 Describe a bond indenture and explain the role of the corporate trustee in a bond
indenture.

 Define high-yield bonds and describe types of high-yield bond issuers and some
of the payment features unique to high yield bonds.

 Differentiate between credit default risk and credit spread risk.

 Describe event risk and explain what may cause it in corporate bonds.

 Describe the different classifications of bonds characterized by issuer, maturity,

interest rate, and collateral.

 Describe the mechanisms by which corporate bonds can be retired before

maturity.

 Define recovery rates and describe the relationship between recovery rates and
seniority.

 Evaluate the expected return from a bond investment and identify the components
of the bond’s expected return.

Describe features of bond trading and explain the behavior of bond

yield.
Bonds issued via private placements are often not traded. Instead, they are held by the
original purchasers until maturity. Bonds issued in a public offering, on the other hand, are
typically traded in the over-the-counter market. This is in contrast to stocks, which are
typically traded on exchanges.

There is a network of dealers who buy and sell bonds, either for their own portfolios or for
their clients. Dealers aim to make a profit from the difference between the prices at which
they buy and the prices at which they sell. Bond prices (like those of any other financial
security) are determined by supply and demand. If more investors want to buy a bond than
want to sell it, the price increases. If the reverse is true, the price decreases.

Bond yield can be thought of as the return earned on a bond over its life assuming that all
interest and principal payments are paid as promised. As indicated in below Figure, the yield
is composed of a risk-free return (which is the return that would be earned on a similar risk-
free instrument) and a credit spread (which is the extra return to compensate the investor for
the possibility of a default). As the maturity of the bond increases, the credit spread for a
bond with a good credit rating tends to increase. This is because the chance that the issuer
will experience financial difficulties increases with the passage of time.

3
If the price of a bond increases, its yield declines (and vice versa). When it is considered
likely that interest rates will increase, investors will demand higher yields. This will lead to
selling pressure in the bond market, and the prices of all bonds should decline. When it is
considered likely that interest rates will decline, the yields required by investors will also
decline and the prices of all bonds will increase. News about the financial health of a bond
issuer may cause the market to adjust the required credit spread. This can also increase
or decrease the price of a bond.
Bond dealers are market makers who quote bid and ask prices for bonds on request as well
as maintain inventory to facilitate trading. If risk-free interest rates and/or credit spreads
increase, bond prices can decrease and dealers may lose money on their inventories.

Liquidity is an important issue in bond trading. It can be defined as the ability to turn an asset
into cash within a reasonable time period at a reasonable price. Markets where the trading
volume is high tend to be highly liquid and have low bid-ask spreads. Markets where the
trading volume is low are usually less liquid and have higher bid-ask spreads. Liquidity in the
bond market varies from bond to bond. Some bonds trade only a few times a year, while
others trade several times a day. Part of the yield on a bond is compensation for its liquidity
risk (or lack thereof). As a bond’s liquidity declines, investors require a greater yield. The
Volcker rule (part of the Dodd–Frank legislation in the United States) now restricts the extent
to which banks can trade bonds (or other securities) for their own account. Some banks in
the United States have had concerns that the Volcker rule is reducing bond liquidity because
it restricts their ability to keep bonds in their inventories for market-making purposes.

The price quoted for a bond is referred to as the clean price. The cash price for a bond is
called the dirty price and is the clean price combined with accrued interest (i.e., the interest
earned by the seller since the last coupon payment date). For corporate bonds in the United
States, this interest is calculated with a 30/360-day convention (where it is assumed that
there are 30 days in a month and 360 days in a year).

Suppose that the coupon rate is 8% per year, today is June 4, and the last coupon payment
date was February 15. The number of days between February 15 and June 4 using the
30/360-day convention is 109 (= 15 + 30 + 30 + 30 + 4). The accrued interest on June 4 is
therefore:

4
 109
× 8% = 2.422%
360

If a dealer quotes the price of the bond as USD 96.00, the price that would be paid for a
bond with principal of USD 1,000 is

960 + 24.22 = 984.22

Day count conventions can vary across countries.

5
Describe a bond indenture and explain the role of the corporate
trustee
Bond indenture
Bond Indenture is the contract that contains corporate bond issuer promises and investors’
rights. The indenture is made out to corporate trustee, who represents bondholders’
interests.
Corporate trustee
The corporate trustee is a third party to the contract. The trustee acts in a fiduciary (legal)
capacity on behalf of the investors. Typically, the trustee is a bank or trust company with a
corporate trust department and officers who are experts in performing trustee functions.

The corporate trustee’s responsibilities include authenticating the bonds issued. Acting on
behalf of the bondholders, the trustee must ensure that the bond issuer is in compliance with
the covenants of the indenture at all times. These covenants are often many and technical,
and they must be watched during the entire period that a bond issue is outstanding.

The indenture must include adequate requirements for performance of the trustee's duties
on behalf of bondholders; there must be no conflict between the trustee's interest as a
trustee and any other interest it may have, especially if it is also a creditor of the issuer; and
there must be provision for reports by the trustee to bondholders. If a corporate issuer has
breached an indenture promise, such as not to borrow additional secured debt, or fails to
pay interest or principal, the trustee may declare a default and take such action as may be
necessary to protect the rights of bondholders.

The trustee is paid by the debt issuer and can only do what the indenture provides. The
indenture may contain a clause stating that the trustee undertakes to perform such duties
and only such duties that are set forth in the indenture, and no implied covenants or
obligations shall be read into the indenture against the trustee. Trustees often are not
required to take actions such as monitoring corporate balance sheets to determine issuer
covenant compliance, and in fact, indentures often allow a trustee to rely upon certifications
and opinions from the issuer and its attorneys. The trustee is not bound to make
investigations into the facts surrounding documents delivered to it, but it may do so if it sees
fit. Also, the trustee is under no obligation to exercise the rights or powers under the
indenture at the request of bondholders unless it has been offered security or indemnity.

The terms of bond issues set forth in bond indentures are always a compromise between the
interests of the bond issuer and those of investors who buy bonds. The issuer always wants
to pay the lowest possible rate of interest and wants its actions bound as little as possible
with legal covenants. Bondholders want the highest possible interest rate, the best security,
and a variety of covenants to restrict the issuer in one way or another.

Corporate Bonds
The five broad categories of corporate bonds sold in the United States based on the type of
issuer are:
1. Public utilities,
2. Transportations,
3. Industrials,
4. Banks and finance companies; and
5. International or Yankee issues.

6
Define high-yield bonds and describe types of high-yield bond
issuers and some of the payment features unique to high yield
bonds.
High-yield bonds are those rated below investment grade by the ratings agencies, these
issues are also known as junk bonds. Despite the negative connotation of the term junk, not
all bonds in the high-yield sector are on the verge of default or bankruptcy. Many of these
issues are on the fringe of the investment grade sector.
Types of high-yield bond issuers
 Original Issuers: Original issuers include young, growing concerns lacking the
stronger balance sheet and income statement profile of many established
corporations but often with lots of promise. Also called venture-capital situations or
growth or emerging market companies, the debt is often sold with a story projecting
future financial strength. There are also the established operating firms with
financials neither measuring up to the strengths of investment grade corporations nor
possessing the weaknesses of companies on the verge of bankruptcy. Subordinated
debt of investment-grade issuers may be included.
 Fallen Angels: "Fallen angels" are companies with investment-grade-rated debt that
have come on hard times with a deteriorating balance sheet and income statement
financial parameters. They may be in default or near bankruptcy. In these cases,
investors are interested in the workout value of the debt in a reorganization or
liquidation whether within or outside the bankruptcy courts. Over the years, they have
fallen on hard times; some have recovered, and others have not.
 Restructurings and Leverage Buyouts: These are companies that have
deliberately increased their debt burden with a view toward maximizing shareholder
value. The shareholders may be the existing public group to which the company pays
a special extraordinary dividend, with the funds coming from borrowings and the sale
of assets. Cash is paid out, net worth decreased, and leverage increased, and
ratings drop on existing debt. Newly issued debt gets junk-bond status because of
the company's weakened financial condition. In a leveraged buyout (LBO), a new
and private shareholder group owns and manages the company. The debt issue's
purpose may be to retire other debt from commercial and investment banks and
institutional investors incurred to finance the LBO. The debt to be retired is called
bridge financing because it provides a bridge between the initial LBO activity and the
more permanent financing.
Payment features peculiar to high-yield bonds (deferred-coupon structures)
 Deferred-interest bonds: Deferred-interest bonds are the most common type of
deferred-coupon structure. These bonds sell at a deep discount and do not pay
interest for an initial period, typically from three to seven years.
 Step-up bonds: Step-up bonds pay coupon interest in the initial period, but the
coupon rate is low for an initial period and then increases ("steps up") to a higher
coupon rate.
Payment-in-kind bonds: These bonds give the issuers an option to pay cash at a coupon
payment date or give the bondholder a similar bond (i.e., a bond with the same coupon rate
and a par value equal to the amount of the coupon payment that would have been paid). The
period during which the issuer can make this choice varies from five to ten years.

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Differentiate between credit default risk and credit-spread risk
Credit default risk
Any bond investment carries with it the uncertainty as to whether the issuer will make timely
payments of interest and principal as prescribed by the bond’s indenture. Credit default risk
is the risk that a bond issuer will be unable to meet its financial obligations.
Credit-spread risk
The credit spread is the difference between a corporate bond’s yield and the yield on a
comparable-maturity benchmark Treasury security.

What explains the difference?

The difference in yields is due primarily to the corporate bond’s exposure to credit risk, but
not exclusively. The risk profile of corporate bonds differs from Treasuries on other
dimensions; corporate bonds are less liquid and may have embedded options. Credit-spread
risk is the risk of financial loss resulting from changes in the level of credit spreads used in
the marking-to-market of a fixed income product. Credit spreads driven by: Macroeconomic
forces include such things as the level and slope of the Treasury yield curve, the business
cycle, and consumer confidence. Issue-specific factors include the corporation’s financial
position and the future prospects of the firm and its industry.

Describe event risk and explain what may cause it in corporate

bonds.
Event risk is the risk that a transaction (or corporate event) will devalue the bondholder’s
position. Restructurings, recapitalizations, mergers, acquisition, leveraged buyouts, and
share repurchase often cause substantial changes in a corporation’s capital structure,
greatly increased leverage and decreased equity. Event risk has caused some companies to
include other special debt- retirement features in their indentures. An example is the
maintenance of net worth clause included in the indentures of some lower-rated bond
issues.

8
Describe the different classifications of bonds characterized by
issuer, maturity, interest rate, and collateral.
Issuer

There are five broad categories of issuers:

1. Utilities: Examples include electric, gas, water and communications companies,

2. Transportation companies: Examples include airlines, railroads, and trucking companies,

3. Industrials: Examples include manufacturing, retailing, mining, and service companies,

4. Financial institutions: Examples include banks, insurance companies, brokerage firms,

and asset management firms, and

5. Internationals: Examples include supranational organizations such as European

Investment Bank, foreign governments, and other non-domestic entities. The bonds that they
issue are referred to as Yankee bonds in the United States.

Maturity

Corporate bonds have an original maturity of at least one year. (Instruments with an original
maturity of less than one year are referred to as commercial paper.) Bonds with maturity of
up to five years are usually referred to as short-term notes, those with maturities between
five and 12 years are referred to as medium term notes, and those with maturities of greater
than 12 years are referred to as long-term bonds. There are instances when all (or part) of
the bond principal is repaid prior to maturity.

Interest rates

Bonds can also be categorized by how they structure their interest rates.

Fixed-rate bonds pay the same rate of interest throughout their lives. Occasionally, the
interest is payable in a foreign currency. For example, entities outside the United States
sometimes issue bonds in U.S dollars.

Floating rate bonds, also known as floating-rate notes (FRNs) or variable rate bonds, are
bonds where the coupon equals a floating reference rate (e.g., Libor) plus a spread.

Consider a bond that pays a coupon every six months with interest equal to the six-month
Libor plus 20 basis points. Thus, the Libor rate at the beginning of the six-month period
would determine the size of the coupon paid at the end of the six-month period, with the 20-
point spread remaining fixed. Some floating-rate bonds specify maximum or minimum (or
both) levels for their coupons. A floating-rate bond can be created from a fixed-rate bond and
an interest rate swap.

Zero-coupon bonds (as their name implies) pay no coupons to the holder. Instead, they sell
at a discount to the principal amount. For example, consider a five-year, zero-coupon bond
that sells for USD 80. This means that an investor could pay USD 800 at the outset and get
USD 1,000 in five years. The interest rate with annual compounding would be

100
( ) − 1 = 0.0456
80
or 4.56%.

9
The holder of a coupon-bearing bond in the United States can usually hold a claim on the
principal in the event of a bankruptcy. In contrast, the holder of a zero-coupon bond can hold
a claim on the original price paid plus accrued interest.

One of the attractions of zero-coupon bonds is that they can turn one form of income int
another under certain tax regimes. If the USD 200 difference between the price at which the
bond in the previous example is bought and the final repayment of its par value is treated as
a capital gain, the investor will have essentially converted what would normally be interest
income into capital gain income. This is advantageous if capital gains are taxed at a lower
rate.

Another advantage of zero-coupon bonds is that there is no reinvestment risk. With a

coupon-bearing bond, however, the coupons received must be reinvested. If interest rates
decline (increase), investors will be forced to reinvest at a relatively low (high) interest rate
and thus a coupon bearing bond will lead to a worse (better) result than a zero-coupon bond.

Collateral

Bonds can also be classified by the collateral provided, which becomes important if a
Company defaults on its debt payments. As previously mentioned, a default leads to either a
reorganization or an asset liquidation. In either situation, a bondholder with collateral should
fare better than one without collateral. In the case of a liquidation, bonds with collateral will
be paid first from the proceeds of the sale of the collateral; in the case of a reorganization,
bonds with collateral will be in a stronger negotiating position than bonds without collateral.

A mortgage bond provides specific assets (e.g., homes and commercial property) as
collateral. In the event of a default, the bondholders have the right to sell the assets to satisfy
unpaid obligations (although it is usually necessary to get permission of the courts first). The
mortgage bondholder usually wants to ensure that its position will not be worsened by future
bond issues. It may therefore impose conditions concerning future bond issues and the
extent to which assets acquired in the future can be used as collateral for future bond issues.

Sometimes there is an after-acquired clause that requires property acquired after the bonds
are issued to be used as collateral for the bonds. This effectively prevents the collateral from
being used for other mortgage bond issues. A collateral trust bond is a bond where shares,
bonds, or other securities issued by another company are pledged as collateral. Usually, the
other Company is a subsidiary of the issuer. A Company that has pledged shares of a
subsidiary as collateral would like to be able to vote the shares when key decisions are
made at shareholder meetings. As a result, the issuer has the right to vote shares in the
subsidiary if there has not been a default. But if there has been a default, the corporate bond
trustee votes the shares. Note that the corporate bond trustee will act in the best interests of
the bondholders (which may not always be in the best interest of the Company’s
shareholders). Sometimes, there are provisions requiring additional collateral to be provided
if the appraised value of the collateral falls below a certain level.

An equipment trust certificate (ETC) is a debt instrument used to finance the purchase of
an asset. (They are commonly used to fund aircraft purchases.) The title to the property
vests with the trustee, who then leases it to the borrower for an amount sufficient to provide
the lenders with the return they have been promised. When the debt is fully repaid, the
borrower obtains the title to the asset. An advantage of ETC to the lender is that the asset is
already owned by the trustee. Thus, legal proceedings are not necessary to take possession
of the asset in the event of a default. Instead, the trustee (acting in the interest of the
investors) can simply lease the asset to another company.

10
Debentures are unsecured bonds (i.e., bonds where no collateral has been posted by the
issuer). They rank below mortgage bonds and collateral trust bonds and are likely to pay a
higher interest rate. Often, a debenture bond’s indenture will include provisions that limit the
extent to which the issuing company can issue more debentures in the future. These
provisions are needed because a new debenture issue weakens the position of existing
debenture holders.

For example, debenture holders might get 30 cents on the dollar (i.e., an amount equal to
30% of their principal) in the event of a default or liquidation. If the company had been
allowed to issue twice as many debentures (and if there are no other significant general
creditors), the 30 cents on the dollar would become 15 cents on the dollar. Debentures
sometimes include a negative pledge clause preventing the issuer from pledging assets as
security for new bond issues if doing so weakens the debenture holder’s position. A
subordinated debenture, as its name implies, ranks below other debentures and other
general creditors in the event of a bankruptcy (which means that other debentures get paid
first from available funds). Subordinated debentures require a higher rate of interest than
unsubordinated debentures to compensate the holders for their inferior standing in the event
of a default by the issuer. Sometimes a bond issued by one Company is guaranteed by
another company (e.g., the Company’s parent). The bondholder should then receive the
promised interest and principal (unless both the issuer and the guarantor default). The value
of the guarantee depends on the correlation between the financial performance of the issuer
and the guarantor. As the correlation increases, the guarantee becomes less valuable.

11
Describe the mechanisms by which corporate bonds can be retired
before maturity.
Retiring bonds before maturity
Frequently, bonds are retired early, before maturity. There are several mechanisms by which
a corporation may go about retiring their debt. Included below are some of the most
important and commonly used retirement mechanisms. The mechanisms with a star (*) are
particularly important.
 Call and refunding provisions*
 Fixed-price call provision
 Make-whole call provision
 Sinking-fund provision*
 Maintenance and replacement funds*
 Redemption through sale of assets
 Tender offers*

Call provision
Corporate bonds with a call provision given contain an embedded option that gives the
issuer the right to buy the bonds back at a fixed price prior to maturity, either in whole or in
part. The ability to retire debt before its scheduled maturity date is a valuable option for
which bondholders will demand compensation ex-ante.

Ceteris paribus, bondholders will pay a lower price for a callable bond than an otherwise
identical option-free (i.e., straight) bond. The difference between the price of an option-
free bond and the callable bond is the value of the embedded call option.

Fixed price
The bond issuer has the option to buy back some or all of the bond issue prior to maturity at
a fixed price (“call price”). Call prices start at a substantial premium over par and decline
toward par over time; in the final years of a bond’s life, the call price is usually par.

In some corporate issues, bondholders are afforded some protection against a call in the
early years of a bond's life. This protection usually takes one of two forms.
 First, some callable bonds possess a feature that prohibits a bond call for a certain
number of years.
 Second, some callable bonds prohibit the bond from being refunded for a certain
number of years.
Make-whole
Call price is calculated as the present value of the bond’s remaining cash flows subject to a
floor price equal to par value. The discount rate used to determine the present value is the
yield on a comparable maturity Treasury security plus a contractually specified make whole
call premium.

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  For example, in November 2010, Coca-Cola sold $1 billion of 3.15% Notes due
November 15, 2020. These notes are redeemable at any time either in whole or in
part at the issuer's option. The redemption price is the greater of (1) 100% of the
principal amount plus accrued interest or (2) the make whole redemption price, which
is equal to the sum of the present value of the remaining coupon and principal
payments discounted at the Treasury rate plus 10 basis points. The spread of 10
basis points is the make-whole call premium. Thus, the make-whole call price is
essentially a floating call price that moves inversely with the level of interest rates.
Sinking‐fund provisions
Money applied periodically to redemption of bonds before maturity. Corporate bond
indentures require the issuer to retire a specified portion of an issue each year.

There are two advantages from the bondholder’s perspective:

 Default risk is reduced because of the orderly retirement of the issue before maturity
 If bond prices decline as a result of an increase in interest rates, the issuer or its
fiscal agent may provide price support because it must enter the market on the buy
side in order to satisfy the sinking-fund requirement.
A disadvantage is that the bonds may be called at the special sinking-fund call price at a
time when interest rates are lower than rates prevailing at time of issuance.
Maintenance and replacement funds
Maintenance and replacement fund (M&R) provisions first appeared in bond indentures of
electric utilities subject to regulation by the Securities and Exchange Commission (SEC)
under the Public Holding Company Act of 1940. It remained in the indentures even when
most of the utilities were no longer subject to regulation under the act. The original
motivation for their inclusion is straightforward. Property is subject to economic depreciation,
and the replacement fund helps to maintain the integrity of the property securing the bonds.
An M&R differs from a sinking fund in that the M&R only helps to maintain the value of the
security backing the debt, whereas a sinking fund is designed to improve the security
backing the debt. Although it is more complex, it is similar in spirit to a provision in a home
mortgage requiring the homeowner to maintain the home in good repair.
Tender offers
At any time, a firm may execute a tender offer and announce its desire to buy back specified
debt issues. Firms employ tender offers to eliminate restrictive covenants or to refund debt.
Usually the tender offer is for “any and all” of the targeted issue, but it also can be for a fixed
dollar amount that is less than the outstanding face value. An offering circular is sent to the
bondholders of record stating the price the firm is willing to pay and the window of time
during which bondholders can sell their bonds back to the firm.

13
Define recovery rate and default rate, differentiate between an issue
default rate and a dollar default rate, and describe the relationship
between recovery rates and seniority.
Issuer default rate
Issuer default rate is defined as the number of issuers that default divided by total number of
issuers at the beginning of the year. It gives no recognition to the amount defaulted nor the
amount of issuance. The rationale for ignoring dollar amounts is that the credit decision of an
investor does not increase with the size of the issuer.
Dollar default rate
Dollar default rate is defined as the Par value of all defaulted bonds divided by total par
value of bonds outstanding during the year (Altman uses this method).

Average annual default rate

The average annual default rate is measured as:

Cumulative $ value of all defaulted bonds

Cumulative $ value of all issuance X weighted avg. no. of years outstanding

Cumulate annual dollar default rate.

Cummulative $ value of all defaulted bonds

Cummulative $ value of all issuance

Recovery Rate

Measuring the amount recovered is non-trivial. The final distribution to claimants may consist
of cash and securities. However, it can often be difficult to track what was received and then
determine the present value of any noncash payments received. Moody’s use the trading
price at the time of default as a proxy for the amount recovered. The recovery rate is thus
the trading price at that time divided by the par value.
 Moody’s found that the recovery rate was 38% for all bonds.
 While default rates are the same regardless of the level of seniority, recovery rates
differ.
 The study found that the higher the level of seniority, the greater the recovery rate.
 The distribution of recovery rates is bimodal
 Recovery rates are unrelated to the size of the bond issuance
 Default rates and recovery rates are inversely correlated
 Recovery rate is lower in an economic downturn and in a distressed industry
 Tangible asset incentive industries have recovery rates.

14
Evaluate the expected return from a bond investment and identify
the components of the bond’s expected return.
The expected return from a bond is:

Risk-free rate + Credit Spread – Expected Loss rate

It might be thought that a bond with a credit spread of 100 basis points (i.e. 1%) would have
an expected loss rate of 1% (and therefore the expected return on the bond is the risk-free
rate). However, this is not usually the case, the expected loss rate is lower than the credit
spread.

Table below shows some results from Hull (2018) showing that the excess of the spread
over the loss rate tends to increase as the credit quality of the issuer decreases. (An
exception that Ba issuers tend to have an excess greater than that of B issuers).

Rating Spread over Loss rate (%) Excess of Spread

treasuries (%) over Loss rate (%)
Aaa 0.78 0.02 0.76
Aa 0.86 0.05 0.81
A 1.11 0.12 0.99
Baa 1.69 0.25 1.44
Ba 3.22 1.30 1.92
B 5.23 3.40 1.83
Caa 11.46 7.50 3.96

15
It can be argued that while the Treasury rate is used as a risk-free benchmark by bond
traders, it is not the right reference point for corporate bond yields. Rather, research
suggests that a higher risk-free benchmark (e.g., the inter-bank borrowing rate) should be
used instead. However, changing the risk-free benchmark does not change the nature of
the results: bond traders still have an expected return greater than the risk-free rate and
the credit spread they earn is always greater than their expected loss from defaults.
The poor liquidity of corporate bonds is one explanation for the results shown in the above
Table. However, while bond traders do require some compensation for the illiquidity of
bonds, research shows that the compensation provided by the market for bond illiquidity
does not account for the results.

The main explanation for these results is that bonds do not default independently of one
another. When the economy is doing well, the default rate on bonds tends to be low.
However, the default increases when there is a recession. This means that bonds have
systematic risk (i.e., risk related to the overall performance of the market) that cannot be
diversified away. Thus, bond traders require compensation for taking systematic risk. It is
also worth noting that the non-systematic (i.e., idiosyncratic) risk of bonds can (in theory) be
diversified away. But in practice, a very large portfolio is necessary to eliminate non-
systematic risk because the return from a bond includes only a small probability of a default.

16
Chapter Summary
The bond’s indenture is the contract that contains corporate bond issuer promises and
investors’ rights.

The corporate trustee is a third party to the contract and acts in a fiduciary (legal) capacity
for, or on behalf of, investors. It is the role of the trustee to certify that the bond issuer is in
compliance with the covenants set forth in the bond’s indenture.

The maturity date of the bond is the date on which the issuer’s obligation to satisfy the terms
of the indenture are fulfilled. Moreover, the principal must be repaid along with any premium
and accrued interest.

The 3 main interest payment classifications of domestically (US) issued corporate bonds are:
 Straight-coupon bonds (sometimes also referred to as plain-vanilla bonds),
 Zero-coupon bonds, and
 Floating-rate, or variable-rate, bonds.

Zero-coupon bonds are bonds without coupons or interest rate payments. They are issued at
discounts to par; the difference is the return to the bondholder. Furthermore, zero-coupon
rates play an important role in the construction of a discount curve: it informs the rate of
return for the date at which it matures since there is no re-investment risk. The difference
between the face amount and the offering price when first issued is called the original-issue
discount (OID).

The security types relevant for corporate bonds include mortgage bonds, collateral trust
bonds, equipment trust certificates, debenture bonds, including subordinated and convertible
bonds, and guaranteed bonds.

Firms often retire their bonds before maturity. The mechanisms by which they do this
includes: call and refunding provisions, fixed-price call provision, make-whole call
provision, sinking-fund provision, maintenance and replacement funds, redemption
through sale of assets and tender offers.

Credit default risk is the risk that a bond issuer will be unable to meet its financial obligations.
The credit spread is the difference between a corporate bond’s yield and the yield on a
comparable-maturity benchmark Treasury security. Credit-spread risk is the risk of financial
loss resulting from changes in the level of credit spreads used in the MTM of a fixed income
product.

The issuer default rate is the number of issuers that default divided by total number of
issuers at the beginning of the year. The dollar default rate is the par value of all defaulted
bonds divided by total par value of bonds outstanding during the year.

17
Questions & Answers:
504.3. On Jan 1st, 2010, Acme Corporation (a U.S. corporation) issued a zero-coupon bond
with an original maturity of ten (10) years on Jan 1st, 2020. The original yield to maturity
(YTM, yield) was 6.0% with semi-annual compounding. In 2015, Amce filed for bankruptcy
with a bankruptcy filing date of September 1st, 2015 (which becomes the settlement date).
The bankruptcy court determines that the original yield is a valid market yield assumption for
purposes of unpaid interest. Which of the following represents the bondholder's claim at
settlement?
a) $55.37 (day count is not relevant)
b) $77.40 based on 30/360 day count
c) $83.81 based on act/act day count
d) $100.00 (day count is not relevant)

505.2. Three months ago, a US corporation issued a floating-rate note (FRN) that pays its
first coupon in three months and matures in five years. The index (aka, reference rate; eg,
six-month LIBOR) was 1.20% at the time of issuance but has dropped to its current level of
0.50%. The index is quoted per annum with semiannual compounding. The quoted margin
on the note is 200 basis points, such that the first coupon pays 3.20% = 1.20% reference +
2.00% margin. Assume three months equals 0.25 years and assume the quoted margin
equals the required margin; i.e., the margin is appropriate compensation for credit risk.
Which is nearest to the note's current value?
a) $97.35
b) $99.13
c) $100.00
d) $100.97

506.1. In 2014, General Products Incorporated issues a mortgage bond to investor John
Smith. The bond's indenture authorized the issuance of an additional bonds, in the future,
with the same mortgage lien as already issued to John Smith. In 2015, General Products
issued a subordinated debenture to Investor Sally Miller. In regard to John Smith's mortgage
bond, which of the following is the LEAST plausible?
a) John Smith was granted a security interest in real property
b) The bond issued to Sally Miller carries a higher coupon rate than Investor ABC's
mortgage bond
c) John Smith's indenture imposed conditions in an after-acquired clause
d) The bond issued to Sally Miller was a violation of the after-acquired clause in John
Smith's indenture

507.1. On a single day the price of a corporate bond with a modified duration of 4.52 years
drops from $87.20 to $85.65. If the benchmark yield increases by 10 basis points during the
day, which is nearest to the approximate change in the bond's credit spread?
a) Increase of 29 bps
b) Increase of 19 bps
c) Approximately unchanged
d) Decrease of 15 bps

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507.3. Keedsler Motors issued a bond five years ago which is currently a high-yield bond.
Each of the following is not necessarily true, except which of the following MUST be true
about this bond?
a) It is not investment-grade
b) It was never investment-grade
c) It is subordinated and/or unsecured
a) It has a yield at least 100 basis points above the benchmark and offers more interest
rate risk than credit risk commerce

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Answers
504.3. B. $77.40 based on 30/360 day count; the 30/360 is not essential, it is really
included as a reminder than US corporate bonds use a 30/360 day count convention.

Fabozzi: "In bankruptcy, a zero-coupon bond creditor can claim the original offering price
plus the accretion that represents accrued and unpaid interest to the date of the bankruptcy
filing, but not the principal amount of $1,000."

In this case, under a 30/360 day count convention, settlement on 9/1/2015 with original
issuance maturity on 1/1/2010 represents 5.6677 years since issuance and 4.3333 years
until maturity. Assuming 6.0% yield, the current value of the bond = -PV(6%/2, 4.333 * 2, 0,
100) = $77.40.

We can retrieve the same value with the calculator by pricing the bond as of 7/1/2015
(because that is exactly 4.5 years until maturity, such that 9.0 semesters is an integer).
Specifically, on 7/1/2015, the bond's value was 9 N, 3 I/Y, 0 PMT, 100 FV and CPT PV =
$76.64167 then compound the value forward at the 6.0% yield such that $76.64167 *
1.03^(2/12*2) = $77.40.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-504-bond-

indenture-and-interest-payments-fabozzi.8831/

505.2. D. $100.97

The key assumption is that, given the quoted margin equals the required margin (a fine
default assumption in any case), the floating-rate note prices exactly to par immediately after
(upon) each coupon payment. Therefore, we only need to value a single cash flow. In this
case, as the coupon equals $1.60 = $3.20%/2 * $100.00, the cash flow is $101.60 in three
months.

Therefore, the current value equals $101.160*(1+0.0250/2)^-(0.25*2) = $100.97089. The

assumption given ("Assume three months equals 0.25 years") was to avoid confusions due
to day count convention; while fixed-rate US corporate bonds always use 30/360, floating-
rate notes (FRN) tend to use act/act or act/360.

Also, intuitively, the floating rate note was priced at par (i.e., $100.00) immediately at
issuance, just like it prices to par immediately after each coupon. The floating rate
subsequently dropped such that the note's price shifts above par, pricing at a premium; if the
floating rate had increased, the note would subsequently price at a discount.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-505-bond-

interest-payments-and-zero-coupon-bonds-fabozzi.8837/

506.1. D. False: An after-acquired clause provides that any additional property acquired by
the borrower after the mortgage or security agreement is signed will be additional collateral
for the obligation. Further, the subordinated debenture is unsecured, it does not impact the
collateral pledged to John Smith.
 In regard to (A), (B) and (C), each is plausible or likely.
 In regard to true (C), see https://en.wikipedia.org/wiki/Negative_pledge
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-506-bond-
security-and-rank-fabozzi.8848/

20
507.1. A. Increase of 29 bps
The linear estimate of price change (in percentage terms) equals (-1) multiplied by modified
duration (D) multiplied by yield change: %ΔP ~= -%Δy*D.

Therefore, Δy ~= -%ΔP/D ~= (85.65/87.20 - 1)/4.52 = 0.00393257 = 39.326 basis points. If

the benchmark index increased by 10 basis points, then the credit spread increased by
about 39.326 - 10.0 = 29.326 bps.

507.3. A. It is not investment grade. "High-yield" is a ratings-based distinction. Bonds are

either investment grade or high-yield (aka, speculative, junk); see
https://en.wikipedia.org/wiki/High-yield_debt

Fabozzi: "High-yield bonds are those rated below investment grade by the ratings agencies.
These issues are also known as junk bonds. Despite the negative connotation of the term
junk, not all bonds in the high-yield sector are on the verge of default or bankruptcy. Many of
these issues are on the fringe of the investment-grade sector."

Discuss the two questions above here in forum:

https://www.bionicturtle.com/forum/threads/p1-t3-507-high-yield-corporate-bonds-
fabozzi.8854/

21
P1.T3. Financial Markets & Products

Chapter 18. Mortgages and Mortgage-Backed

Securities

Bionic Turtle FRM Study Notes

By David Harper, CFA FRM CIPM
www.bionicturtle.com
Chapter 18. Mortgages and Mortgage-Backed Securities

DESCRIBE THE VARIOUS TYPES OF RESIDENTIAL MORTGAGE PRODUCTS................................. 3

CALCULATE A FIXED RATE MORTGAGE PAYMENT, AND ITS PRINCIPAL AND INTEREST
COMPONENTS. .................................................................................................................... 5
DESCRIBE THE MORTGAGE PREPAYMENT OPTION AND THE FACTORS THAT INFLUENCE
PREPAYMENTS. ................................................................................................................... 8
SUMMARIZE THE SECURITIZATION PROCESS OF MORTGAGE BACKED SECURITIES (MBS),
PARTICULARLY FORMATION OF MORTGAGE POOLS INCLUDING SPECIFIC POOLS AND TBAS. ... 10
CALCULATE WEIGHTED AVERAGE COUPON, WEIGHTED AVERAGE MATURITY, SINGLE MONTHLY
MORTALITY RATE (SMM), AND CONDITIONAL PREPAYMENT RATE (CPR) FOR A MORTGAGE
POOL................................................................................................................................ 13
DESCRIBE THE PROCESS OF TRADING OF PASS-THROUGH AGENCY MBS. ............................. 16
EXPLAIN THE MECHANICS OF DIFFERENT TYPES OF AGENCY MBS PRODUCTS, INCLUDING
COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS), INTEREST-ONLY SECURITIES (IOS), AND
PRINCIPAL-ONLY SECURITIES (POS). .................................................................................. 18
DESCRIBE A DOLLAR ROLL TRANSACTION AND HOW TO VALUE A DOLLAR ROLL. ..................... 20
EXPLAIN PREPAYMENT MODELING AND ITS FOUR COMPONENTS: REFINANCING, TURNOVER,
DEFAULTS, AND CURTAILMENTS. ........................................................................................ 22
DESCRIBE THE STEPS IN VALUING AN MBS USING MONTE CARLO SIMULATION. .................... 24
DEFINE OPTION ADJUST SPREAD (OAS), AND EXPLAIN ITS CHALLENGES AND ITS USES. ........ 25

2
Chapter 18. Mortgages and Mortgage-Backed Securities
Describe the various types of residential mortgage products.
Calculate a fixed rate mortgage payment, and its principal and interest components.
Describe the mortgage prepayment option and the factors that influence
prepayments.
Summarize the securitization process of mortgage backed securities (MBS),
particularly formation of mortgage pools including specific pools and TBAs.
Calculate weighted average coupon, weighted average maturity, single monthly
mortality rate (SMM), and conditional prepayment rate (CPR) for a mortgage pool.
Describe the process of trading of pass-through agency MBS.
Explain the mechanics of different types of agency MBS products, including
collateralized mortgage obligations (CMOs), interest-only securities (IOs), and
principal-only securities (POs).
Describe a dollar roll transaction and how to value a dollar roll.
Explain prepayment modeling and its four components: refinancing, turnover,
defaults, and curtailments.
Describe the steps in valuing an MBS using Monte Carlo Simulation.
Define Option Adjust Spread (OAS), and explain its challenges and its uses.

Describe the various types of residential mortgage products.

Lenders offer many types of mortgage loan products. Below is a simplified, non-exhaustive
typology. Notice there is a difference between conventional and conforming loans.

3
Types of Residential Mortgages

The typical (~ 70 to 80%) residential mortgage loan has a maturity of 30 years but is paid off
earlier. The 15-year fixed-rate mortgage accounts for about 10.0% and is popular as a
refinance product1. Adjustable-rate mortgages (ARMs) surged in popularity (up to 40%)
prior to the global financial crisis (GFC) but currently account for less than 5.0% of loans.

Conventional loans are either agency (aka, conforming) or non-conforming.

 Agency or conforming loans meet the eligibility standards of Federal National
Mortgage Association (FNMA; aka, Fannie Mae), Federal Home Loan Mortgage
Corporation (FHLMC; aka, Freddie Mac), or Government National Mortgage
Association (GNMA; aka, Ginnie Mae). Fannie Mae and Freddie Mac are housing-
related government-sponsored enterprises (GSEs); as opposed to education GSE
(Sallie Mae) of farming GSE. Most lenders—after they originate the loan—sell or
securitize the loan; they can sell conforming loans to Fannie Mae or Freddie Mac.

Although the loan size limit is the most well-known criteria, conforming loans must
meet several standards:
o Loan limits. In 2020, the maximum (“baseline”) loan amount in the
(contiguous) United States was $510,400, For high-cost areas, the maximum
can be up to 150% of this baseline, or up to $765,600. See FHFA2
o Loan-to-value (LTV) ratio; e.g., at least 80.0%
o Debt-to-income ratio
o Credit score; and documentation requirements
 Non-agency or Non-Conforming Loans do not meet all of the conforming loan
criteria; i.e., if a loan does not meet all criteria, it is non-conforming. Because they do
not “conform” with the standards, they are not necessarily eligible to be purchased by
the housing GSEs. Instead, they are funded by an ample pool of private lenders
(including hard money lenders) and sold into the private-label securitization market.

Non-conforming loans might simply exceed the limit (aka, Jumbo); or the borrower
may not meet the credit quality standards of the conforming loan (and would
traditionally be considered higher risk). Interest rates will be higher than conforming
products, although Jumbos have sometimes been lower. Types include:
1. Jumbos: These are above conforming loan size limit; often, this is the only
variation from conforming loan.
2. Alt-A: These are almost conforming but failed to meet one requirement.
Consequently, the interest rate is higher than the prime lending rate but lower
than the subprime lending rate
3. Subprime: These fail to qualify against multiple criteria such that borrowers
represent significantly greater credit risk (aka, poor creditworthiness). Subprime
loans are disproportionally adjustable-rate mortgages (ARMs) and the interest
rates, after the teaser, are higher.

1
Urban Institute’s Housing Finance at a Glance (April 2020):
https://www.urban.org/research/publication/housing-finance-glance-monthly-chartbook-april-2020/view/full_report
2
Specifics available at the Federal Housing Finance Agency (FHFA)
https://www.fhfa.gov/DataTools/Downloads/Pages/Conforming-Loan-Limits.aspx

4
Calculate a fixed rate mortgage payment, and its principal and
interest components.
A fixed-rate mortgage has a constant interest rate over the life of the loan. Further, the
payments are level and the principal balance amortizes such that the final principal balance
is zero. Unlike a bond, the borrower does not repay a balloon-type amount at the end: the
principal decreases over time and the final installment expires the principal. The original loan
amount, B(0), must equal the present value of the stream of monthly payments, discounted
at the constant mortgage rate (which is expressed in per annum terms with monthly
compound frequency):
1
(0) = ℎ ( )×
1 + 12

where, (0) is the original loan amount, is the annual rate of interest, and denotes the
tenure of the loan in years.

For example: Calculate fixed-rate mortgage payment with the following parameters:
 Original loan (principal) amount, (0) = $100,000
 Mortgage interest rate, y = 5.0% per annum with monthly compounding
 Loan maturity, T = 30 Years
On the next page, we show the amortization schedule. The monthly payment is $536.82
which implies the following:

1
$100,000 = $ . ×
0.050
1+
12

The fixed monthly payment of $536.82 includes two components: interest and principal.

 The interest component equals the periodic mortgage rate, y/12, multiplied by the
outstanding principal amount at the beginning of that period. If B(n) is the outstanding
principal amount (i.e., original principal less principal repaid) after the payment on
y
date (n), the interest component of the payment on date (n+1) is B(n) ×
12
.
 The principal component is the remainder of the monthly payment after subtracting
the interest component. Therefore, it is given by − ( ) ×
12
In this example where the original balance is $100,000:
 At the first month’s end, the mortgage interest of 5.0% per annum on the original
balance amounts to $100,000 × 0.050/12 or $416.67. The remainder of the total
monthly payment, $536.82 − $416.67 = $120.15 is the (scheduled) re-payment of
principal. This principal payment reduces the outstanding balance from the original
$100,000 to $100,000 − $120.15 = $99,879.85 at the end of the first month.
 At the second month’s end, the interest is (5.0%/12) × $99,879.85 = $416.17.
 At the third month’s end, the interest is (5.0%/12) × $99,759.19 = $415.66.

5
 Continuing in this way produces an amortization table, as shown below:

Using the calculator to retrieve the mortgage payment

Using the time value of money keys, we can

solve for the PMT. In this case,

N = 360,
I/Y = 5 ÷ 12 = 0.4167
PV = -100,000
FV = 0, and then
[CPT] [PMT] returns 536.82

Notice that we need to specify that future value

(FV) equal zero because the principal amortizes.

6
Mortgage payment factor

We can also retrieve the monthly payment by using the mortgage payment factor which is
given by:
interest_rate(1+interest_rate)loan_term
=
(1 + interest_rate)loan_term − 1

0.004167(1 + 0.004167)
= = .0053682
(1 + 0.004167) − 1

The monthly payment is given by the mortgage payment factor multiplied by the original
balance. In this case, the monthly payment is given by 0.0053682 × $100,000 original
balance = $536.82.

The plot below parses each month’s payment (i.e., $536.82 which is constant over the life)
into its interest and principal components. The total height is the full monthly payment of
$536.8. The blue columns represent the interest component, and the green columns
represent the principal component.

Early in the life of the loan, payments are composed mostly of interest (ie, more than
$400.00) and less principal is repaid (ie., less than about $130.00 per month during the first
nineteen months). But as the principal balance reduces, more interest can be paid and, in
turn, this accelerates the return of principal while reducing the interest required.

7
Describe the mortgage prepayment option and the factors that
influence prepayments.
We continue with the prior example: original balance was $100,000 for a 30-year mortgage
loan with a fixed rate of 5.0% per annum (with semi-annual compounding) such that each
month’s (principal plus interest; aka, P&I) payment is $536.82. The outstanding balance at
the end of five years or 60 months is given by:

1 12 1
$536.82 × = $536.82 1− = $ ,
0.050 0.050 0.050
1 + 12 1 + 12

We can also retrieve this outstanding balance (after 60 months) with the calculator. After
entering the TVM keystrokes (N = 360, I/Y = 5 ÷ 12 = 0.4167, PV = -100,000, FV = 0, and
then [CPT] [PMT] returns 536.82) we can use:

[2nd] [Amort] ; display reads P1 = 1.00

[Enter] ; to accept P1 = 1.00 so that the schedule starts with the first payment
[↓] 60 [Enter] ; to indicate P2 = 60 as the last payment in our range
[↓] ; displays BAL = -91,828 as the outstanding balance
[↓] ; displays PRN = 8,171 as the total principal paid in the first 60 months
[↓] ; displays INT = 24,038 as the total interest paid in the first 60 months

Per the amortization schedule, at each month the outstanding principal balance is reduced.
For example, given this mortgage loan:
 At the end of the 60th month (aka, five years), the principal balance is ~ $91,828
 At the end of the 61st month, the principal balance is ~ $91,675
There is an important, additional feature to a mortgage loan: the borrower has the option to
prepay the balance. This is the borrower’s prepayment option; it is equivalent to an
embedded call option where the option’s exercise price is the amount of outstanding
loan principal.

After origination, higher interest rates imply that the present value of the remaining stream of
mortgage payments will be reduced. In this scenario of higher interest rates, the borrower is
not motivated to prepay. However, lower interest rates imply the present value of the
remaining stream of mortgage payments is greater. In this scenario of lower interest rates, it
is profitable for the borrower to prepay. Specifically, consider at the end of five years, the
borrower is facing an obligation to make the monthly payment of $536.82 for 300 months:
 If the interest rate has (subsequent to origination) increased (from 5.0%) to 6.0%,
then the present value (PV) of the obligation stream equals = -PV(0.060/12, 300,
536.82, 0) = $83,318.40. It does not make financial sense to exercise the
prepayment option.
 If the interest rate has (subsequent to origination) decreased (from 5.0%) to 4.0%,
then the present value (PV) of the obligation stream equals = -PV(0.040/12, 300,
536.82, 0) = $101,702.19. It is profitable to re-finance or prepay because the gain is
$101,702.19 - $91.828.73 = $9,873.46 (If we assume zero transaction costs. In
practice, the gain must overcome transactions fees and costs.)

8
Factors that influence prepayment

According to GARP3, there are four “reasons” for prepayment: refinancing, turnover,
defaults, and curtailments (i.e., partial prepayments). In practice, it is common to distinguish
between two major categories:

 Refinancing, or
 Turnover

Refinancing activity increases when interest rates decrease as borrowers take advantage of
the opportunity to lower their monthly payments. This is called a rate-and-term refinance. An
interesting feature of rate-and-term financing is that borrowers do not necessarily optimize
their opportunity to refinance. A cash-out refinance, which may not depend on lower rates,
refers to borrowers liquidating some portion of their equity, for example, to remodel or
upgrade their house. Factors that influence refinancing include:

 Level of the interest rate.

 Change in borrower’s profile. For example, the borrower’s credit rating improves, and
this avails him/her of a lower rate.
 Increase in property value. This decreases the loan-to-value (LTV)
 Age of the mortgage pool. As we know, the monthly mortgage payments have two
components: principal and interest. In its early years, the payments in the mortgage
have a large interest component and a small principal component. So, by prepaying,
borrowers can save on the interest amount. However, in the early years of the
mortgage, prepayments due to this reason are low because refinancing is expensive.
 Housing prices (note that house prices are also a factor with respect to refinancing. If
house prices increase, homeowners are more likely to take out their equity).
 Burnout effect. This is the tendency of an “old” mortgage pool to become somewhat
insensitive to lower interest rates simply because borrowers have already
(previously) refinanced in the recent past. In the pool, the borrowers who already
refinanced may perceive little incremental advantage in refinancing for a second (or
third?) time. On the other hand, the pool may contain some borrowers who never
take advantage of refinancing, setting a lower bound on refinance activity in the pool.

Turnover refers to the acceleration of the loan principal due to the triggering of the due-on-
sale clause when the homeowner sells their house. Because homeowners have many
reasons for selling their house, we can say there are many factors that influence prepayment
to the extent they cause turnover. Factors that influence turnover include, but are not limited
to, the following:

 Seasonality. Mobility increases in the spring and summer; e.g., families moving to a
new area ahead of the school year
 Family circumstances such as job transfer, divorce (where a sale of the house is
highly likely to divide the assets), death in the family.

3
2020 FRM Part I: Financial Markets and Products, 10th Edition. 18.4. Modeling Prepayment Behavior

9
Summarize the securitization process of mortgage backed
securities (MBS), particularly formation of mortgage pools
including specific pools and TBAs.
Fifty years ago, banks held to maturity their mortgage loans. The primary market is where
borrowers obtain their mortgage loan directly from the lender. The first mortgage-based
securitization (MBS) was a $70.0 million offering by Ginnie Mae in 19704. Subsequently, the
MBS market exploded and was a $6.0 trillion market by 20005. Although there exist many
variations and details, the essence of securitization is:
 Mortgages (credit-sensitive assets) are pooled. Pooling provides diversification.
 Claims (i.e., note, bonds) are sold to investors. This is the transfer of credit risk.
Many consider securitization to be one of the culprits of the global financial crisis (GFC).
Specifically, securitization enabled banks to shift their business models from holding loans
on their balance sheet to the so-called originate-to-distribute (OTD) model. Nevertheless, in
theory and practice, securitization provides material benefits to the originator (e.g., liquidity),
borrowers (e.g., funds), and investors (e.g., specific risk/return preferences).

Securitization of Mortgage-Backed Securities (MBS)

The essential steps (several details here are omitted) in an MBS securitization include:
 The originator (and/or arranger) collects the mortgage loans into a pool. Typically, the
loans share similar features; e.g., sub-prime
 The mortgage pool is sold to a bankruptcy-remote special purpose vehicle (SPV).
Purchase by the SPV removes the loans from the originator’s balance sheet.
 The SPV issues tranches of securities (aka, notes) to investors that represent
interest(s) in the mortgage pool. The different tranches have different risk profiles.
 As borrowers make their principal and interest (P&I) payments, the cash flow
“waterfall” mechanics determine the flow of funds: after promised coupons are paid to
the debt (note) holders, the remainder (aka, excess spread) funds the over-
collateralization (O/C) account and the residual flows to the equity investors.

4
McConnell, and Buser, The Origins and Evolution of the Market for Mortgage-Backed Securities. Annual
Reviews (December 5, 2011)
5
According to Investopedia https://www.investopedia.com/ask/answers/052015/what-are-some-historical-
examples-debt-securitization.asp

10
There are several players involved in an MBS securitization6:
 The borrower (aka, mortgagor) applies for a mortgage in order to purchase a
property or to refinance an existing mortgage
 The originator, possibly via a broker, underwrites the loan.
 The arranger buys the pool of mortgage loans and probably arranges funding from a
third-party lender. The arranger is responsible for funding the mortgage loans until
the details of the deal are finalized. (When the arranger is a depository institution, this
can be done easily with internal funds. However, mono-line arrangers typically
require funding from a third-party lender for loans kept in the “warehouse” until they
can be sold.)
 The pool of mortgage loans is sold by the arranger to a bankruptcy-remote trust: the
special-purpose vehicle (SPV). The bankruptcy-remote feature is essential: it
protects investors from bankruptcy of the originator or arranger.
 The SPV issues the debt (note) securities to investors. The securities are
collateralized by mortgage loans. The investors, of course, provide the cash funds for
the purchase of the mortgage-backed security.
 The mortgage guarantor7 (if such an entity exists for the securitization) guarantees
to investors the payment of interest and principal against borrower defaults. This
requires a fee. If the borrower defaults, the guarantor compensates the pool with a
lump sum payment and then, through the servicer, pursues the borrower and the
underlying property to recover as much of the amount paid as possible.
 The trust employs a servicer who is responsible for collection and remittance of loan
payments, making advances of unpaid interest by borrowers to the trust, accounting
for principal and interest, customer service to the mortgagors, holding escrow or
impounding funds related to payment of taxes and insurance, contacting delinquent
borrowers, and supervising foreclosures and property dispositions.
 Securities are sold to an asset manager (who is an agent for investors).

There are two basic versions of an MBS.

1. Pass-through or participation certificates (PCs) represent a direct claim on the

pool of mortgage loans.
2. Collateralized mortgage obligation (CMOs) or real estate mortgage investment
conduits (REMICs) are more complicated. These securities essentially take the
interest and principal payments from several MBS and create additional
securities with varying maturities and coupons.

6
Adam Ashcraft and Til Schuermann, “Understanding the Securitization of Subprime Mortgage Credit,” Federal
Reserve Bank of New York Staff Reports, No. 318 (March 2008). This is an FRM Part 2, Topic 6 reading
7
Are Mortgage-backed Securities Backed by Any Guarantees? (Investopedia.com)
https://www.investopedia.com/ask/answers/07/mbs-guarantee.asp

11
Investors in the MBS

For investors, an MBS is much like a bond. Most offer semi-annual or monthly income, and
this payment frequency enhances the compounding effects of reinvestment. Prepayment risk
is a large concern for MBS investors.
 When people move, for example, they sell their houses, pay off their mortgages with
the proceeds, and buy new houses with new mortgages. When interest rates fall,
many homeowners refinance their mortgages, meaning they obtain new, lower-rate
mortgages and pay off their higher-rate mortgages with the proceeds.
 Like bonds, changes in interest rates affect MBS prices, but the change is
exacerbated by the fact that MBS investors are more likely to get their principal back
early. They might have to reinvest that principal at rates below what their MBS were
yielding.

Agency pools trade in either specified pools or To Be Announced (TBA) market

Due to their government affiliation and implicit guarantee8, agency bonds (i.e., Fannie Mae,
Freddie Mac, and Ginnie Mae) are very secure. The government agency mortgage
pools/bonds trade in two forms: Specified Pools and TBAs (To Be Announced).

Specified Pools: In this market, buyers and sellers agree to trade specific loan pools: the
characteristics of the underlying loans are already “specified.” Trading prices, therefore,
reflect the features of the specified pool.

To Be Announced (TBAs): This is a forward market where sellers have a cheapest-to-

deliver (CTD) option, much like the CTD option in the U.S. Treasury bond market. This
secondary market is highly liquid and much larger than the Specified Pools market.

8
For more see “2. Explicit and Implicit Guarantees” in GSE Guarantees, Financial Stability, and Home Equity
Accumulation Volume 24, Number 3 December 2018 (The Federal Reserve Bank of New York) at
https://www.newyorkfed.org/research/epr/2018/epr_2018_gse-guarantees_passmore.html

12
Calculate weighted average coupon, weighted average maturity,
single monthly mortality rate (SMM), and conditional prepayment
rate (CPR) for a mortgage pool.
Weighted Average Coupon (WAC)

The weighted average coupon (WAC) is the weighted average (mortgage) loan rate paid by
the borrowers. This is not the coupon received by the MBS investors: the term “coupon” is
a misnomer because WAC refers to the cash inflows (paid by borrowers) to the
securitization. The coupon rate paid to investors will be less than (cannot be greater than)
the WAC because the difference between the higher received WAC and the lower-paid
investor coupons is the fees paid to the servicer and guarantor.

Weighted Average Maturity (WAM)

The weighted average maturity (WAM) is the weighted average of the maturities of the
underlying loans of the pool. The WAM is more simple than, and different from, either the
weighted average life (WAL) or Macaulay duration. The Macaulay is the weighted average
maturity but the weight is the proportion of the present value of cash flows; the WAL weight
maturities by the prepayments.

The single monthly mortality rate (SMM) and the conditional prepayment rate (CPR)

Investors in an MBS—who generally do not want to be prematurely repaid principal—incur

prepayment risk. During each month of the life of an MBS, some loans will prepay
completely and others may curtail (i.e., partially prepay). Determining the most likely
prepayment scenario is critical to making an investment decision with a reasonable
expectation about a security’s life, which, in turn, affects the likely returns for the investors.

For valuation and modeling purposes, prepayments are divided into the scheduled
prepayments (the prepayments that amortize the principal per the original schedule) and the
unscheduled prepayments (prepayments due to borrows opportunistically exercising their
prepayment option). We measure the principal amount prepaying as a percentage of the
total principal outstanding.

The Single Monthly Mortality (SMM) rate at month n, denoted as SMM , is the percentage
of principal outstanding at the beginning of month n that is prepaid during month n, where
these prepayments exclude scheduled (i.e., amortizing) principal amounts. The SMM is
annualized to the Conditional Prepayment Rate (CPR).

If a pool prepays at a constant rate equal to then it follows:

 (1 − ) of the principal remains at the end of one month
 (1 − ) of the principal remains at the end of the year (12 months), and
 1 − (1 − ) the principal is prepaid during the year (over the 12 months).

The CPR is an annualized rate (although it adjusts monthly). The SMM is a monthly rate. We
can translate back and forth between the CPR and the SMM as follows:

= −( − ) or = −( − )( / )

13
For example: if a pool prepaid 0.5% of its principal above its amortizing principal in a given
month, it would be prepaying that month at a CPR of about 5.8% as shown. This means that
approximately 5.8% of the outstanding mortgage balance at the beginning of the year is
expected to be prepaid by the end of the year.

= −( − . ) = . %

Note that CPR of a pool is computed every month even though CPR is an annualized rate.

Public Securities Association (PSA) prepayment benchmark

In the US, prepayment rates are described in terms of a prepayment benchmark over the life
of a mortgage pool called the Public Securities Association (PSA) prepayment benchmark
expressed as a monthly series of CPRs. Slower or faster prepayment rates referenced as
some percentage of PSA. The benchmark is 100 PSA. PSA assumption greater than 100
PSA means that prepayments are assumed to be faster than the benchmark. PSA
assumption lower than 100 PSA means that prepayments are assumed to be slower than
the benchmark. The 100 PSA standard assumes a CPR of 6.0% such that:
 From month 1 to month 29, 100 PSA = no. of months / 30 × 6% CPR × 1
 From month 30 onwards, 100 PSA = 6% CPR × 1

The table here shows the calculation of CPR and SMM describing the assumed prepayment
for a pool of mortgage loans with the given PSA assumptions for up to 5 months.

From the table, for eg. for the 1st month,

 CPR for 50 PSA is calculated as 0.10% = 1/30 × 6% × 50/100)
 CPR for 100 PSA is calculated as 0.20% = 1/30 × 6% ×100/100)
 CPR for 150 PSA is calculated as 0.30% =1/30 × 6% ×150/100)
 SMM for 50 PSA is calculated as 0.008% = 1 − (1 − 0.10%)( / )

 SMM for 100 PSA is calculated as 0.017% = 1 − (1 − 0.20%)( / )

 SMM for 150 PSA is calculated as 0.025% = 1 − (1 − 0.30%)( / )

14
Below are graphs showing the annual CPR and monthly SMM for the assumed prepayment
of a pool of mortgage loans with the given PSA assumptions for up to 60 months. Note that
after 30 months the CPR is assumed to be constant at 6% for 100 PSA.

15
Describe the process of trading of pass-through agency MBS.
In a pass-through structure, all investors collect their ratable share of all principal and
interest payments made on the pool of loan assets. These investors are equally exposed to
prepayment risk. As GARP explains9, the features of pass-through securities include the
issuer, the coupon rate, and the maturity. GARP’s example is a single pass-through security
referred to as “GNMA 30-year 4% pool,” because the original lives were 30 years.

As discussed, pass-through agency securities can trade in either the specified pools or the
to-be-announced (TBAs) market. The TBA is a forward market and it is much larger. In
GARP’s example, the trade involves a FNMA 30-year 4.5% pool; in this case, FNMA is the
issuer, 30 years is the original maturity, and 4.5% is the per annum coupon rate. Perhaps
the seller must deliver in August (i.e., August is the delivery month10). The seller has a
cheapest-to-deliver (CTD) option: she can choose to deliver securities from any FNMA 30-
year pool where the coupon is 4.5% subject to qualifications; e.g., for a 30-year TBA, the
remaining maturity must be between 15 and 30 years. The seller must announce the
“chosen” pool two days prior to settlement day. On settlement day, the seller receives the
agreed price plus accrued interest (assuming a 30-day month) from the month’s beginning.

On the next page, we illustrate the cash-flows of a pass-through mortgage-backed security

(MBS). Specific, illustrative calculations are shown below the exhibit, but conceptually the
model starts with assumptions (highlighted in yellow) and then divides the monthly coupon:

 The original mortgage original principal balance is $600.00. If the weighted average
coupon (WAC) is 6.50%, then the first month’s coupon, C(1) =PMT(6.50%/12, 360, -
600, 0) = $3.792 million. Because unscheduled prepayments reduce this principal
balance (in addition to the scheduled, amortizing principal), this coupon reduces over
time. As this is paid by borrowers, from the perspective of the securitization, this
coupon is the cash inflow.
 This Coupon, C(t), includes two components: Mortgage Interest, I(t), and Scheduled
Principal, Pay(t, Sch). Like a single mortgage loan, the Scheduled Principal is the
component that remains after the I(t) is paid. In the first month, I(1) = $600.0 *
6.50%/12 = $3.250 million such that the Scheduled Principal, Pay(1, Sch) =
C(1) - I(1) = $3.792 - 3.250 = 0.542 million.
 Prepaid Principal, Pay(t, Pre) is a function of the SMM; e.g., Pay(1, Pre) =
$600.0 * 0.0334% = $0.200 million
 The Pass-Thru Interest, I(t, PT), is paid to the investors; e.g., I(1, PT) =
$600.0 * 6.00%/12 = $3.0 million because r(PT,12) = 6.0% is paid to investors.
 Total Cash Flows, CF(t), is the sum of (Scheduled + Unscheduled Principal) and the
Pass-Thru Interests; CF(t) = Pay(t, Sch) + Pay(t, Pre) + I(t, PT). In the first month,
$0.542 + 0.200 + 3.00 = $3.74 million.
 The Present Value Cash Flow ($634.81 million) discounts these Total Cash Flows.

9
2020 FRM Part I: Financial Markets and Products, 10th Edition. Chapter 18
10
The settlement dates within the settlement month for TBAs are provided by the Securities Industry and
Financial Markets Association (SIFMA).

16
 Per Column 2 this model assumes 200% PSA.
 Column 3 is the SMM implied by the CPR; eg, because this is a 200% PSA model,
the initial CPR is 200% * 0.20% = 0.40% per annum such that SMM = 1 - (1-
0.40%)^(1/12) = 0.0334%
 Column 4 is the coupon paid by the mortgage pool: C(t+1) = (1-p)*C(t); C(1) is a
function of the 6.50% WAC
 Column 5 is the Mortgage Interest: I(t) = WAC/12 * Principal Balance; eg,
I(2) = 6.50%/12 * $599.26 = $3.246
 Column 6 is Scheduled Principal: Pay(t, Sch) = Coupon C(t) – Mortgage Interest I(t);
e.g., Pay(2, Sch) = 3.790 - $3.246 = $0.544
 Column 7 is Prepaid Principal: Pay(t, Pre) = SMM (p) * Principal Balance; eg,
Pay(2, Pre) = 0.0669% * $599.26 = $0.401
 Column 8 is Pass-through interest: I(t, PT) = r(Pt,12)/12 * Principal Balance; eg,
I(2, PT)(2) = 6.0%/12 * $599.26 = $2.9963 or about 3.00
 Column 9 is the Total Cash Flow CFt(t) = Pay(t, Sch) + Pay(t, Pre) + I(t, PT); eg,
CF(2) = $0.5439 + $0.4010 + $2.9963 = $3.941 or about $3.94
 Column 10 is the Principal L(t+1) = L(t) - Pay(t, Sch) - Pay(t, Pre); e.g., Principal (2)
= $599.26 - $0.5439 - $0.4010 = $598.312
 Column 11 is the discount factor, Z(0,T), continuously at yield

17
Explain the mechanics of different types of agency MBS products,
including collateralized mortgage obligations (CMOs), interest-only
securities (IOs), and principal-only securities (POs).
The previously mentioned pass-through security is the simplest type of MBS. The other type
of MBS is called a collateralized mortgage obligation (CMO) but CMOs are a class of MBS
with several variations. CMO structures are more complex than pass-through securities
because they offer investors different levels of prepayment risk; this variety is achieved with
tranches in the capital structure.

In a pass-through, all investors proportionately (pro-rate) receive the net cash flows from the
mortgage collateral. In a CMO, the principal and interest payment streams are distributed to
the different tranches of the CMO. Each tranche bears a different level of prepayment risk.
Consequently, each tranche has a different duration. These tranches are designed to have
different risk-return profiles that suit the needs of different investors. In a CMO, an investor
can select the security (based on tranches) that suits her requirements. The collateral in a
CMO can be the mortgages, and it can also be the mortgage pass-through securities.

CMOs can be structured in many ways. The two popular structures are sequential pay and
planned amortization class (PAC). In addition, there exist interest-only (IO) and principal-only
(PO) securities. These involve stripping the total cash flow from a pass-through security into
two securities: interest only (IO), and principal only (PO).

CMO Type: Sequential Pay Structure

In a sequential pay structure, the entire collateral pool is divided into three to four (A, B, C,
D, and so on) tranches that receive payments sequentially. All of the tranches receive the
interest payments; however, the principal payment is first received only by the first tranche
(Tranche A). Once Tranche A is fully paid, then Tranche B starts receiving the principal, and
so on. Sometimes, a Tranche Z is added, which is like a zero-coupon bond. It doesn’t
receive any cash flow; instead, the coupon is accrued over time to the principal amount.
Once all the other tranches have been paid, the principal is paid to Tranche Z. The Z class
acts like a buffer and protects the other classes from the effects of prepayments.

Specifically, in a CMO sequential pay structure, the tranches receive cash flows as follows:

1. A fixed coupon rate payment, in percentage of the tranche principal,

3. Sequentially, all of the principal payments, scheduled or prepaid, up to the point
where the whole principal of the tranche is paid out.

Imagine a sequential pay structure with four tranches:

Tranches Principal
Tranche A 200 Receives both principal and interest until fully redeemed. Until
then, other tranches (B, C, and D) only receive interest.
Tranche B 150 Only receives interest until Tranche A is fully paid off (redeemed).
At that point, receives principal and interest.
Tranche C 100 Only receives interest until both Tranches A and B are redeemed.
At that point, receives principal and interest.
Tranche D 50 Only receives principal after Tranches A, B, and C are redeemed.
Total 500

18
CMO Type: Planned Amortization Class (PAC)

The PAC securities also have tranches such as A, B, C plus a companion tranche. The main
difference is that PAC tranches offer a fixed principal redemption schedule. It achieves this
by specifying a fixed prepayment schedule for each tranche according to the PSA standard.
By keeping the prepayment amount fixed, a fixed principal payment schedule is followed.
Because the actual prepayments can be low or high, the difference is absorbed by the
companion tranche. The companion tranche is therefore highly sensitive to prepayment.

IO and PO Strips

The interest only (IO) strip receives all the interest payments from the underlying collateral
pool. It does not receive anything from the principal. If interest rates decline, borrowers will
prepay their debt. This will lower the cash flow for this strip as fewer interest payments will
be received on the reduced principal.

The principal only (PO) strip receives all the principal payments from the underlying
collateral pool. It does not receive anything from the interest. In this case, if the borrowers
prepay, all the prepayment amount goes to this strip. This increases the cash flow in the
near future.

Key observations about IO and PO strips:

 The effective duration of interest-only (IO) strips is negative.
 The effective duration of principal-only (PO) stripes is large and positive; i.e., the
duration will typically exceed the average maturity of the underlying pool.
 According to GARP11, “as prepayments increase, a PO becomes more valuable
because cash flows are received earlier than expected. By contrast, IOs become less
valuable because fewer interest payments are made overall. As prepayments
decrease, the reverse happens.”

11
2020 FRM Part I: Financial Markets and Products, 10th Edition. Chapter 18

19
Describe a dollar roll transaction and how to value a dollar roll.
A dollar roll is conducted in the TBA market and bears a resemblance to a repurchase
agreement (repo). Recall that a repo a short-term, secured loan: today the borrower raises
cash by selling securities (aka, asset collateral) to the lender (who conducts the reverse
repo), with the promise to repurchase the collateral tomorrow12 or shortly afterward at a
slightly higher price (in order to pay interest to the lender).

In a dollar roll transaction, the “buyer of the roll” sells a TBA for near- or front-month
settlement at a specified price and simultaneously buys the same TBA for future- or back-
month settlement at a lower price. As GARP explains13, the dollar roll transaction has two
differences from a repo:
 Because sellers in TBA market have a cheapest-to-deliver (CTD) option, the security
that is repurchased in the back-month is not necessarily the same as the security
sold in the front-month (although it can be), and
 Interest is not added to the repurchase price such that the borrower effectively
misses one month of interest payments from the pool, while the counterparty gains
one month of interest.
The difference between a spot and the forward price is called the forward drop. In the TBA
market, typically the forward price is lower than the spot price. The value of the dollar roll is
the difference in proceeds between two trades: (i) buying the roll, versus (ii) holding the pool
over the one-month period. If the two trades—by way of comparison—generate equivalent
proceeds (i.e., if the value of the roll is zero), then the roll trades at breakeven. If the value of
the roll is positive (i.e., if the forward drop is sufficiently large such that buying the roll is
more profitable than holding the pool), then the roll trades above carry. If the value of the roll
is negative, the roll trades below carry.

For further detail on the dollar roll, here are two forum discussions:
 Here is David’s step-by-step explanation of the dollar roll and the factors that
influence the drop: https://www.bionicturtle.com/forum/threads/p2-t5-111-mbs-dollar-
roll-fabozzi.5356/post-14990
 Here is some detail on the day count conventions assumed in the following Dollar
Roll example https://www.bionicturtle.com/forum/threads/p1-t3-510-dollar-roll-
tuckman.8495/post-51974

12
Most of the US repo market is overnight (~70%). See SIFMA’s helpful fact sheet (2020) at
https://www.sifma.org/resources/research/us-repo-market-fact-sheet/
13
2020 FRM Part I: Financial Markets and Products, 10th Edition. Chapter 18

20
For example (value of a dollar roll): Tuckman’s example14 assumes that the TBA price of
the Fannie Mae 5% for July (the “front-month”) 12th settlement is $102.50 and the price for
August (the “back-month”) 12th settlement is $102.15. The scheduled (aka, expected) total
principal pay down plus prepayments is 2.0% of an outstanding balance of $10 million. The
short-term interest rate is 1.0%

To compute the proceeds of buying the roll:

 As the coupon rate is 5.0% per annum, the accrued interest as of the 12th day is
$100.00 × 5.0%/12 × (12/30) = $0.167, which is added to each settlement price.
 The investor (who “rolls a balance” of $10.0 million) sells the July TBA and collects
proceeds of $$10,266,666.67. These proceeds earn interest of $8,840.74 (at the
short-term interest rate of 1.0%) over the next month
 The cost to purchase the August TBA (after 2.0% of its principal pay down) is
$10,027,033.33. Therefore, the net proceeds from the roll is $248,474.07.
In comparison, the proceeds earned from holding the roll:
 Holding the roll simply collects the coupon (5.0%/12 × $10.0 million = $41,666.67)
plus the 2.0% principal pay down (20% of $10.0 million) for a total of $241,667.
Therefore, the value of the roll is the difference between “buying the roll” and “holding the
roll,” which is $6,807.41. As the value is positive, this roll is said to be trading above carry.

14
Tuckman, Bruce and Angel Serrat. Fixed Income Securities: Tools for Today’s Markets. Wiley 2012. This
illustrates Tuckman’s “Dollar Rolls” example from Chapter 20

21
Explain prepayment modeling and its four components:
refinancing, turnover, defaults, and curtailments.
Previously we considered the several factors that influence prepayments. Many of these
factors can be categorized into the two buckets that inform classical prepayment models:
rate-driven refinancing and turnover. Turnover is a major cause of repayment because
conventional loans contain a due-on-sale15 clause; the due-on-sale clause accelerates the
loan and forces prepayment. The due-on-sale is effectively the lender’s put option, just as
the borrower effectively can exercise their call option to prepay.

It is inherently difficult to model (and anticipate) prepayments which can be voluntary (e.g.,
cashout refinance) or involuntary (e.g., default). Although we can quantify financial optimal
behavior regarding a refinance, actual borrower behavior is not financially optimal because
additional non-financial factors play a role, and the factors vary by household.

Refinancing

A common model is based on borrowers’ incentive to refinance and utilizes an incentive

function that quantifies the key prepayment factors. There exist various possible incentive
function models. The FRM reviews a common but simple incentive function that mostly aims
to quantify borrowers’ incentive to perform rate-driven refinances. This simply incentive
function16 is given by:

=( − )× × − ; where

I is the estimated Incentive;

WAC is the weighted average coupon of the pool;
R is the current mortgage borrowing rate available for the borrowers;
ALS is the Weighted Average Loan Size of the pool; A is an annuity factor
that gives the present value of an annual dollar payment from the average
loan (from a loan with a remaining maturity equal to the average maturity of
the loans being modeled), and
K is the estimated (fixed) cost of refinancing.

This incentive function estimates the present value of the gain due to refinancing. A greater
spread between the coupon paid by borrowers (WAC) and the current rate (R) implies a
greater incentive to refinance, but higher fees (K) imply a lower incentive to refinance. This
incentive function, I, can assist in modeling prepayments as an input into the conditional
prepayment rate, CPR; for example:

( )= + ⁄ + ; where

I is the incentive function value;

T captures turnover;
a and b are empirically calibrated parameters

15
See Due-on-sale clause at https://en.wikipedia.org/wiki/Due-on-sale_clause
16
2020 FRM Part I: Financial Markets and Products, 10th Edition. Chapter 18

22
The Incentive Function informs
the Prepayments (see to the plot
to the right: S-curve Prepayments
as a Function of the Incentive).
This is just an illustration with
arbitrary parameters.

This S-curve happens to assume

a turnover, T = 5.0%. When the
Incentive Function is quite
negative (e.g., -200), there is no
refinancing. As the Incentive
Function increases, the CPR
increases above 5.0%. Part of
the reason the CPR flattens as
the Incentive becomes high is the
assumption of the burnout effect.

Turnover

Turnover drives prepayments due to change in the situation/condition of the

borrowers such as relocation leading to the sale of houses by borrowers, changing needs of
borrowers to opt for a bigger or smaller house (due to divorce or addition of family
members), or any other personal circumstances.
 One of the factors that go into turnover models is the seasonality of relocations. A
turnover model for a particular group of loans begins with a base rate that is adjusted
to account for this seasonality, e.g., higher in summer, lower in winter. Also,
borrowers who took the mortgage loan recently are less likely to relocate. Typically,
the probability of borrowers to relocate starts increasing steeply 30 months after the
origination of the loan starting from zero at the time of origination.
 Another factor is the early prepayments made by less creditworthy borrowers in the
expectation of improving their creditworthiness.
 Although turnover does not contain reasons related to change in interest rates, yet,
there is found to be a linkage as borrowers are less likely to move if they enjoy a
below-market mortgage rate, or, put another way, if they would have to pay a higher
rate on a new mortgage after selling their homes and moving. This behavior is known
as the lock-in effect.

Defaults

If the borrower defaults, the mortgage guarantor (if there exists a guarantor for the MBS) is
expected to pay the outstanding principal (and outstanding interest).

Curtailments

Curtailments are partial prepayments of the loan balance. These tend to occur when
balances are old and low.

23
Describe the steps in valuing an MBS using Monte Carlo
Simulation.
Because mortgages contain the prepayment option, mortgage-backed securities (MBS) are
not well-suited to analytical valuation. Instead, Monte Carlo simulation (MCS) is preferred.
MCS generates paths and securities with embedded options are path-dependent. For
example, the paths associated with lower interest rates can model prepayment, while paths
associated with higher interest rates can assume the borrower’s option is not exercised.

Valuation of MBS using Monte Carlo simulation (MCS) entails simulating many mortgage
rate paths and computing the implied cash flows. The following are the stylized steps17:

Step 1: Simulate short-term interest rate paths

 The MCS engine employs a random number generator but also requires several
assumptions including
o The interest rate term structure model. This choice, of course, has a big
impact on the results. Any MCS is highly dependent on the selected model
which is the “engine.”
o Basis-point volatility (volatility of the interest rate in basis points)
o Relationship between the refinancing rate and the short-term interest rate
 Over the security’s remaining life (or 30 years in the case of fresh origination), the
interest rate is simulated. One simulation is a single potential, random future path;
this path is also called a trial. Typically, each step is one month such that the path
steps over (T) months.
 Many paths or trials (i.e., N paths or N trials) are generated.

Step 2: Generated cash flow vectors implied by interest rate paths

 Each month’s cash flow is the sum of the scheduled principal, prepayments (i.e.,
unscheduled principal), and net interest. While the scheduled principal and interest
(P&I) is easy to compute because it follows the original amortization schedule,
prepayments dependent on the selected prepayment model.
 As the interest rate path implies a cash flow vector (a series of future cash flows over
time), the full simulation produces a cash flow matrix. Just as the interest rate term
structure model is important, the selection of the prepayment model is also
consequential to the output.

Step 3: Compute the present value of each (cash flow) path

From each cash flow vector (i.e., series of future cash flows), we can compute the present
value. The discount rate can be the spot rate associated with the horizon of each cash flow,
and of course, the spot rates can be a function of the forward rate curve:

z (n) = {[1 + f (n)][1 + f (n)] ⋯ [1 + f (n)]} −1

Where ( ) is the spot rate for month (T) on path (n); given ( ) as the future one-month
forward rate.

17
Fabozzi, Bhattacharya, and Berliner. Mortgage-backed Securities; Pricing, Structuring and Analytical
Techniques. John Wiley & Sons (2007). Chapter 10 (Techniques for Valuing MBS)

24
For each path (n), the cash flow present value (PV) is the future simulated cash flow
discounted at the simulated spot rate (if we are computing the option-adjusted spread, OAS,
we can add a spread equal to K. Indeed, this is probably the reason we are using the MCS!):

C (n)
PV[C (n)] =
[1 + z (n) + K]

And the sum of this vector is the present value of the full path:

PV[Path(n)] = PV[C (n) + C (n) + ⋯ + C (n)]

Step 4: Estimate value of security as average of each path’s present value

Where (n) is the number of paths, the average of each path’s present value estimates the
value of the mortgage security:

PV[Path(1)] + PV[Path(2)] + ⋯ + PV[Path(N)]

Value =
N
Considerations in the MBS using MCS

On the one hand, we prefer that the MCS model generates many trials (paths). On the other
hand, given the time step is one month and the mortgages contain an embedded option, this
can become computationally cumbersome. Many models employ variance reduction
techniques. Another effective approach employs principal component analysis (PCA). PCA
enables accurate results with few paths.

Define Option Adjust Spread (OAS), and explain its challenges and
its uses.
Z-spread; aka, zero-volatility spread, static spread

The Z-spread (aka, zero-volatility spread, static spread) is the spread that reconciles a
theoretical model price with the observed market price. We must assume an interest rate
term structure; typically, the term structure is presumed to be the Treasury spot rate curve.
Let this term structure be the vector of riskless spot rates, S[riskless] = {S0, S1, …S(n)}. If
we use this spot rate curve (i.e., sequence of spot rates) to discount the MBS security’s cash
flows, then our present value reflects the value of a riskless instrument (and this value
should be higher than any market price).

If we observe (or assume) a market price for the security, then we can solve for the spread
(let’s denote with K) that can be added to the risk-free spot rates. Let this risky term structure
be the vector of spot rates: S[risky] = {S0 + K, S1 + K, S2 + K, …, S(n) + K}. Notice that each
spot rate on the term structure is different; e.g., in the case of a typical upward-sloping term
structure, we can expect S(0) < S(1) < S(n). However, the value of (K), which is here the Z-
spread or static spread, is a constant: the same spread is added to each spot rate (we can
visualize the risky term structure as parallel, but not necessarily linear), to the riskless term
structure, given the spread is constant). In this way, we solve for the Z-spread, denoted here
by K, that matches the discounted present value (aka, the model price) to the market price. If
we solve for a Z-spread, then the market price suddenly drops, the revised Z-spread is
higher.

25
Option-adjusted spread (OAS)

The options-adjusted spread (OAS) is similar to the Z-spread: it is also a spread that
reconciles the DCF-based model price with the market price. The Z-spread, however, does
not model the prepayment option because it assumes a single cash flow vector; therefore,
the Z-spread effectively assumes zero interest volatility (or, if you like, fails to incorporate
interest rate volatility and therefore does not model cash flow changes as a function of
interest rate volatility). The OAS spread recruits the Monte Carlo Simulation in order to
compute a spread that reconciles the DCF-based model price with the market price but
additionally accounts for the embedded option (due to various paths that are a function of
interest rate volatility).
The key relationship is given by:

 Z-spread = OAS plus (+) Option Cost … or solving for Option Cost:
 Option Cost = Z-spread minus (-) OAS

Uses of—and challenges to—the option-adjusted spread (OAS)

As a relative value measure, it is natural to use the OAS to identify mispriced securities and
spot trading opportunities. For example, a security might belong to a category that has
exhibited a long-run average OAS of 130 basis points, but the current OAS is 190 basis
points. If the trader perceives the OAS will revert to its long-term mean (aka, mean
reversion), then she can trade the view.

The challenges of the OAS begin with its inherent and considerable model risk. The Monte
Carlo simulation (MCS) that generates paths must assume an interest rate term model (and
there are many choices here!) that, in turn, assumes an interest rate volatility parameter (at a
minimum: additional parameters may be required). A deeper challenge concerns the
difficulty of distinguishing between a security that is truly mispriced, as opposed to a security
that is not really mispriced but instead trades at a premium/discount along with its peers in a
segment or sub-segment of the market. In this latter case, certain segments can persist in
what seems like a discounted or premium situation, but (in truth) other factors are
contributing. This is largely a challenge of making the correct comparisons in the relative
value determination, but also the challenge of understanding the relevant market dynamics
in a segment of the market.

26
P1.T3. Financial Markets & Products

Chapter 19. Interest Rate Futures

Bionic Turtle FRM Study Notes

CHAPTER 19. INTEREST RATE FUTURES .......................................................................... 3
IDENTIFY THE MOST COMMONLY USED DAY COUNT CONVENTIONS, DESCRIBE THE MARKETS THAT
EACH ONE IS TYPICALLY USED IN, AND APPLY EACH TO AN INTEREST CALCULATION ....................... 3
CALCULATE THE CONVERSION OF A DISCOUNT RATE TO A PRICE FOR A U.S. TREASURY BILL. ....... 4
DIFFERENTIATE BETWEEN THE CLEAN AND DIRTY PRICE FOR A US TREASURY BOND; CALCULATE
THE ACCRUED INTEREST AND DIRTY PRICE ON A US TREASURY BOND. ........................................ 5
EXPLAIN AND CALCULATE A US T-BOND FUTURES CONVERSION FACTOR ..................................... 6
CALCULATE THE COST OF DELIVERING A BOND INTO A TREASURY BOND FUTURES CONTRACT ....... 7
DESCRIBE THE IMPACT OF THE LEVEL AND SHAPE OF THE YIELD CURVE ON THE CHEAPEST‐TO‐
DELIVER TREASURY BOND DECISION ......................................................................................... 8
CALCULATE THE THEORETICAL FUTURES PRICE FOR A TREASURY BOND FUTURES CONTRACT ..... 9
CALCULATE THE FINAL CONTRACT PRICE ON A EURODOLLAR FUTURES CONTRACT AND COMPARE
EURODOLLAR FUTURES TO FRAS. ........................................................................................... 11
DESCRIBE AND COMPUTE THE EURODOLLAR FUTURES CONTRACT CONVEXITY ADJUSTMENT ....... 11
EXPLAIN HOW EURODOLLAR FUTURES CAN BE USED TO EXTEND THE LIBOR ZERO CURVE ......... 14
CALCULATE THE DURATION‐BASED HEDGE RATIO AND DESCRIBE A DURATION‐BASED HEDGING
STRATEGY USING INTEREST RATE FUTURES ............................................................................. 15
EXPLAIN THE LIMITATIONS OF A DURATION BASED HEDGING STRATEGY ...................................... 15
CHAPTER SUMMARY ............................................................................................................... 16
QUESTIONS & ANSWERS: ....................................................................................................... 17

2
Chapter 19. Interest Rate Futures
 Identify the most commonly used day count conventions, describe the markets
that each one is typically used in, and apply each to an interest calculation.

 Calculate the conversion of a discount rate to a price for a U.S. Treasury bill.

 Differentiate between the clean and dirty price for a US Treasury bond; calculate
the accrued interest and dirty price on a US Treasury bond.

 Explain and calculate a US Treasury bond futures contract conversion factor.

 Calculate the cost of delivering a bond into a Treasury bond Futures contract.

 Describe the impact of the level and shape of the yield curve on the cheapest‐to‐
deliver Treasury bond decision.

 Calculate the theoretical futures price for a Treasury bond futures contract.

 Calculate the final contract price on a Eurodollar futures contract and compare
Eurodollar futures to FRAs.

 Describe and compute the Eurodollar Futures contract convexity adjustment.

 Explain how Eurodollar futures can be used to extend the LIBOR zero curve.

 Calculate the duration‐based hedge ratio and describe a duration‐based hedging

strategy using interest rate futures.

 Explain the limitations of using a duration‐based hedging strategy

Identify the most commonly used day count conventions, describe

the markets that each one is typically used in, and apply each to an
interest calculation.
Money Market instruments include: Capital Market Instruments include:
 Short-term financial instruments  Long-term securities
 Treasury bill (government)  US Treasury notes (1-10 yrs) and
bonds (> 10 yrs)
 Certificate of deposit (bank)
 Domestic and Eurobonds (issued
 Commercial paper (CP)
internationally)
 Repurchase agreement (repo)
 Euro bond (denominated in Euros)

Day count conventions are used for computing accrued interest. The interest earned
between two dates can be expressed as:

3
Commonly used day conventions are:
 Actual/actual: U.S. Treasury bonds
 30/360: U.S. corporate and municipal bonds
 Actual/360: U.S. Treasury bills and other money market instruments
For example, a bond pays a coupon of $4.00 every six months. If coupons are paid on
March 1st and September 1st, and we wish to calculate the accrued interest earned between
March 1 and July 3, then the following illustrates three different day count conventions
applied to the accrued interest (AI) on this bond:
 Actual/actual computes based on actual days between March 1st and July 3rd and
actual days between March 1st and September 1st: 124 /184 * $4.00 = $2.696
 30/360 assumes 30 days per month and 360 days per year. In this case, it is 122
days between March 1st and July 3rd and 180 days between March 1st and
September 1st: 122/180 * $4.00 = $2.711
 Actual/360 computes actual days between Mar 1 and Jul 3 and 180 days between
Mar 1 and Sep 1(assuming 30 days per month): 124 /180 * $4.00 = $2.756

Calculate the conversion of a discount rate to a price for a U.S.

Treasury bill.
A US Treasury bill is a discount instrument: the discount rate is expressed as a
percentage of the face value. Consequently, the discount rate is not a true yield.

Consider the following example. The face value of the Treasury bill is $100.00 and the cash
price is $98.00. As the T-bill matures in 90 days, the discount rate as a percentage of face
value is 2.0% (= 100 − 98) per quarter. This translates in to a discount rate of
8.0% [= 360⁄90 ∗ (100 − 98)] per annum. In other words, 8.0% is the annualized (2.0% ∗ 4)
interest as a percentage of the face ([$2 ∗ 4]/$100). Therefore, it is not the true yield.

Money market instruments tend to be quoted using a discount rate. In general, the
relationship between quoted price and cash price of a Treasury bill (if is the remaining life
of the T bill in days) can be given as:

= ∗( − )

4
The “true yield” for this example is illustrated:

The true yield is 8.16%

100∗8%
= 98 . This is the
quarterly compounded
rate such that we can
confirm that $98 ∗ (1 +
8.1633% ∗
4
) = $100, for n
= 0.25 = 90/360.

Differentiate between the clean and dirty price for a US Treasury

bond; calculate the accrued interest and dirty price on a US
Treasury bond.
Clean Price
The clean price (aka, quoted price or flat price or simply “price”) does not reflect the cash
price if interest has accrued.
Dirty Price
The dirty price (aka, full or invoice or cash price) adds accrued interest to the clean price.
 Cash Price = Quoted Price + Accrued Interest since last coupon date.
The illustration below computes the dirty price by adding the accrued interest (which
depends on the day count convention) to the quoted (clean) price. In the case, the quoted
price of the 11.0% coupon bond is $95.50 on the settlement date of March 5, 2015
(3/5/2015). 54 days have elapsed since the last coupon and, because we happen to be
adopting an actual/actual day count, there are 181 actual days between coupons. The
accrued interest is therefore $100.00 * 11.0%/2 * 54/181 = $1.64. The dirty (aka, invoice or
full) price of the bond is $95.50 + $1.64 = $97.14.

5
  When the accrued interest of a bond is zero (i.e., when the settlement date is a
coupon payment date) the flat and full prices of the bond are equal.
 When accrued interest is not zero, the amount paid/received for a bond (i.e., its full
price) should equal the present value of its cash flows.

If P is a bond’s flat price, and AI is the accrued interest, then the full price is the present
value (PV) which is given by:

( ℎ )= +

AI is the accrued interest (we saw it earlier under day count conventions) and is given as:

.
= × .

To summarize, the full price of the bond equals the flat price plus accrued interest (if
any). The invoice price is the amount paid by the buyer and received by the seller; therefore,
it is the face amount multiplied by the full price.

Explain and calculate a US T-bond futures conversion factor

The Treasury bond futures contract allows the party with the short position to deliver any
bond with a maturity of more than 15 years and that is not callable within 15 years. The short
here has flexibility in delivery! When the chosen bond is delivered, the conversion factor
(CF) defines the price received by the party with the short position.

Cash Received by short = Settlement Price  Conversion factor + Accrued interest

The conversion factor for a bond is set equal to the quoted price of the bond per dollar of
principal on the first day of the delivery month with the assumption that the interest rate
for all maturities equals 6% per annum (with semiannual compounding). The bond’s
maturity and time-to-coupon-payment dates are rounded down to the nearest 3 months:
 If, after rounding, the bond lasts for an exact number of 6-month periods, the first
coupon is assumed to be paid in 6 months.
 If, after rounding, the bond does not last for an exact number of 6-month periods (i.e.,
there are an extra 3 months), the first coupon is assumed to be paid after 3
months and accrued interest is subtracted.

6
Calculation of Conversion Factor
1. Consider a 10% coupon bond with 20 years and 2 months to maturity ($100 face)
2. Consider another: 8% coupon with 18 years and 4 months to maturity ($100 face)
For calculation of conversion factor, a discount rate of 6% per annum with semiannual
compounding (or 3% per 6 months) is assumed. For the purposes of calculating the
conversion factor, the first bond is assumed to have exactly 20 years to maturity while the
second bond is assumed to have exactly 18 years and 3 months to maturity.

 The value of the first bond is the present value of all its cash flows and is found to be
$146.23. The conversion factor is the quoted price per dollar and is got by dividing
this bond price by the face value to give 1.4623 (=146.23/100)
 For the second bond, the first coupon is assumed to be paid after 3 months and the
accrued interest is subtracted to obtain the price of the bond, which is $123.99. So,
the conversion factor is 1.2199 (= [123.99 – 2]/100)

Calculate the cost of delivering a bond into a Treasury bond futures

contract
During the delivery month, many bonds (with varying coupon and maturity) can be delivered
in the Treasury bond futures contract. The party with the short position can choose which of
the available bonds is ‘‘cheapest’’ to deliver.

The cost to deliver by the short position is the dirty price, which is the quoted bond
price plus accrued interest (AI). The short position will receive the settlement price times
conversion factor plus accrued interest (AI) from the long.

The cheapest to deliver (CTD) bond is the one which minimizes the difference between the
cost paid and the cash received by the short. In other words, CTD bond is the bond that
either:
 minimizes  MIN: Quoted Bond Price - (Settlement Price  CF) or
 maximizes  MAX: (Settlement Price  CF) - Quoted Bond Price

7
Hull Example 6.1: The party with the short position has decided to deliver and is trying to
choose between the three bonds in the table below. Assume the most recent settlement
price is or 93.25. From the table below,
 For eg. the cost to deliver the second bond is 143.5 – (93.25  1.5188) = $1.87.
 Since the second bond’s cost is relatively lower than the other two bonds, it is
considered as the cheapest to deliver bond.
Cost of delivering a Treasury bond and CTD bond

Describe the impact of the level and shape of the yield curve on the
cheapest‐to‐deliver Treasury bond decision
Several factors determine the cheapest-to-deliver (CTD) bond, including whether
1. yields are above or below the 6.0% level
2. the slope of the yield curve.

The CTD bond depends on the yield levels. Because the cheapest-to-deliver (CTD) is
based on standardizing the yields at 6%:
 If bond yields are less than 6%, delivery of high-coupon, short-maturity bonds; i.e.,
bonds with lower durations are favored.
 If bond yields are greater than 6%, delivery of low-coupon, long-maturity bonds; i.e.,
bonds with higher durations are favored.

The CTD bond depends on the slope of the yield curve.

 An upward-sloping yield curve favors long time-to-maturity bonds,
 A downward-sloping yield curve favors short time-to-maturity bonds.

In brief, long-term maturity bonds will be favored if the yield is high and/or the yield curve is
upward sloping.

8
Calculate the theoretical futures price for a Treasury bond Futures
contract
The futures contract on a Treasury bond provides the holder with known income assuming
that both the cheapest-to-deliver bond and the delivery date are known. Its futures price is
given by:

=( − )

Hull example 6.2: Cheapest to deliver bond is a 12.0% coupon bond with a conversion
factor of 1.60 and delivery in 270 days. Coupons pay $6.00 semi-annually and the last
coupon was paid 60 days ago, the next coupon pays in 122 days, and the coupon thereafter
is in 305 days. The term-structure is flat with interest rate at 10% per annum.

Theoretical Price of Treasury Bond Futures Contract

9
  The cash price is quoted bond price plus the proportion of the next coupon payment
that accrues to the holder. Cash price = Quoted bond price + AI
60
Cash price = 115 + × 6 = 115 + 1.978 = $116.978
60+122
 PV of $6 coupon to be received after 122 days is:
PV of coupon = 6 −10% × (122/365) = 5.803
 Cash futures price, if the contract were written on the 12% bond, for delivery in 270
days is:
Cash futures price = (116.978 – 5.803) × 10% × (270/365) = $119.711
 At delivery, there are 148 (=270 -122) days of accrued interest. The days remaining
at delivery is 35(=305 - 270). The quoted futures price for the 12% bond is obtained
by subtracting this AI from the cash futures price.
148
Quoted futures price = 119.711 − 148+35 × 6 = $114.859

 From the definition of the conversion factor, 1.6 standard bonds are considered
equivalent to each 12% bond. The quoted futures price should therefore be
Quoted Futures price (CTD) = 114.859 / 1.6 = 71.79

Also, we can directly calculate the cash futures price based on the cost of carry model as:
=( − ) = (116.978 – 5.803) × 10% × (270/365) = $119.711

From this dirty price, we subtract the AI and standardize (divide by CF) to get the clean or
119.711 148
×6
148+35
quoted futures price: 1.6
= 71.79

10
Calculate the final contract price on a Eurodollar futures contract
and compare Eurodollar futures to FRAs.
If R is the LIBOR interest rate, the Eurodollar futures price is quoted at 100–R.

The contract is designed so that a one-basis-point (.01%) move in the futures quote
corresponds to a gain or loss of $25 per contract. A one-basis-point change in the futures
quote corresponds to a 0.01% change in the underlying interest rate such that:

1,000,000  0.0001 0.25 = 25

The contract price is defined as: 10,000  [100 – 0.25  (100 – Quote)]

Example: In May 2013, an investor buys a Eurodollar contract at quote of 99.725 (implied
LIBOR = 100 – 99.725 = 0.275%). Going forward to June, when contract settles, LIBOR is
0.385%, so quote is 99.615 (100 – 0.385 = 99.615). The difference between the quotes is
0.11(99.615 - 99.725).

May contract price = 10,000  [100 – 0.25  (100 – 99.725)] = $999,312.5

June (settlement) contract price = 10,000  [100 – 0.25  (100 – 99.615)] = $990,037.5

The difference between this initial and final contract price is the loss of $275 on this long
position: 990,037.5 – 999,312.5 = – $275

This loss is consistent with “$25 per basis point move” rule: – 0.11 x $25 x 100 = - $275

IMPORTANT CONCEPT:

If the Eurodollar Futures quote increases by one (1) basis point, long position gains
$25 and short position loses $25.

If the Eurodollar Futures quote decreases by one (1) basis point, long position loses
$25 and short position gains $25.
Difference between Eurodollar Futures and Forward rate Agreements (FRAs)

11
There is an important difference between Eurodollar futures and FRAs in the timing of the
interest payments.

Let the Libor interest rate on October 15, 2019 (two days before the third Wednesday of the
month) is 2.3%. Then, the interest for three months on USD 1,000,000 would be

0.25 x 0.023 x USD 1,000,000 = USD 5,750

In an FRA, this interest is paid at the end of the three-month period (i.e., mid-January 2020).
However, the Eurodollar futures contract provides a settlement at the beginning of the three-
month period (i.e., mid-October 2019).

Another difference between Eurodollar futures and FRAs is that Eurodollar futures are
(like all futures contracts) settled daily, whereas FRAs are settled only once at the end.

An FRA (by construction) provides a correct estimate of the forward rate. In order to estimate
the forward rate from Eurodollar futures quotes, analysts make what is referred to as a
convexity adjustment. The adjustment is very small for contracts lasting only one or two
years, but it becomes too large to ignore as for longer maturities.

This adjustment depends on the interest rate model that is assumed. An adjustment based
on the Ho and Lee interest rate model involves reducing the futures rate estimate (when
expressed in decimal form) by 0.5σ2T(T + 0.25) to get a forward rate of:

10 Futures rate – 0.5 σ2T(T + 0.25)

where σ is the standard deviation of changes in the short-term interest rate over one year, T
is the maturity of the Eurodollar futures as measured in years (so that the underlying rate
lasts from T years to T + 0.25 years), and the futures rate is 100 ─ Q (where Q is the futures
quote). When this formula is applied, both the forward rate and futures rate should be
expressed using the actual/actual convention with continuous compounding.

For example, suppose the Eurodollar futures quote is USD 96.200, the standard deviation of
the change in the one-month rate (a proxy for the short rate) in one year is estimated as
1.1%, and the time to maturity is four years. Then Q = 96.2, σ = 0.011, and T = 4. The
futures rate using actual/360 with quarterly compounding is USD 3.8% (= 100 − 96.2). This
is equal to 3.853% (= (365/360) × 3.8%) on an actual/actual basis with quarterly
compounding. Converting it to continuous compounding, the rate becomes
4 × ( 1 + 0.03853/4) = 0.03834

The forward rate with continuous compounding is therefore:

0.03834 ─ 0.5 × 0.0112 × 4 × 4.25 = 0.0373 or 3.73%.

12
Describe and compute the Eurodollar futures contract convexity
adjustment
The convexity adjustment assumes continuous compounding.
 Given that (s) is the standard deviation of the change in the short-term interest rate in
one year, is the time to maturity of the futures contract and is the time to
1
maturity of the rate underlying the futures contract, convexity adjustment is: s2 1 2
2
 Under the Hull-Lee model, the forward rate is less than the futures rate as a
function of variance:
1
= − s
2
The primary difference is due to daily settlement of futures contracts: as they settle
daily, it leads to interim cash flows (i.e., margin calls or excess margin).

Hull Example 6.4: Consider the assumptions given in the table below for an 8-year
Eurodollar futures whose price quote is 94.

Convexity Adjustment

From the table:

 The convexity adjustment is: s2 1 2 =0.475%

 The futures rate is 6.00% per annum on an actual/360 basis with quarterly
compounding.
 This corresponds to 1.50% per quarter or an annual rate 6.038% with continuous
compounding and an actual/365 day count.
 The forward rate after adjusting the futures rate for convexity is 5.563% per
annum with continuous compounding.

13
Explain how Eurodollar futures can be used to extend the LIBOR
zero curve
The bootstrap procedure can be used to extend the LIBOR zero curve. We know that
the forward interest rate is:

+1 +1 −
= ;
+1 −

(Note: This forward rate is of the same form as defined in an earlier chapter)

From this forward rate, the zero rate can be obtained as:

+1 − +
=
+1 .

Hull Example 6.5: The 400-day LIBOR zero rate has been calculated as 4.80% with
continuous compounding and, from Eurodollar futures quotes, the forward rate for a 90-day
period beginning in 400 days, 491 days and 589 days has been calculated as 5.30%, 5.50%
and 5.60% respectively, with continuous compounding, as given in the table below. From
these forward rates, the 491 and 589-day zero rates can be obtained.

 For eg: The 491-day zero rate is obtained using the forward rate of 5.3% as:
5.3% × (491 − 400) + 4.8% × 400
= 4.893%
491
 Similarly, the 589-day zero rate of 4.994% is obtained using the forward rate of 5.5%
 Likewise, the next forward rate of 5.6% can be used to determine the zero curve out
to the maturity of the next Eurodollar futures contract.
Note: Even though the rate underlying the Eurodollar futures contract is a 90-day rate, it is
assumed to apply to the 91 or 98 days elapsing between Eurodollar contract maturities.

14
Calculate the duration‐based hedge ratio and describe a duration‐
based hedging strategy using interest rate futures
The number of contracts required to hedge against an uncertain change in the
yield(y) is the duration-based hedge ratio and is given by:

∗
=

: contract price for the interest rate futures contract.

: duration of asset underlying futures contract at maturity.
: forward value of the portfolio being hedged at the maturity of the hedge (typically
assumed to be today’s portfolio value).
: duration of portfolio at maturity of the hedge.

Hull Example 6.6: Assume a portfolio value of $10 million invested in government bonds.
The manager hedges with T-bond futures (each contract delivers $100,000) with a current
price of $93.0625. The duration of the portfolio at hedge maturity will be 6.8 and the duration
of futures contract will be 9.2. How many futures contracts should be shorted?

∗ (10,000,000)(6.8)
= = = 79.42
(93,062.5)(9.2)
So, the manager should short 79 contracts to hedge the bond portfolio.
Duration‐based hedging strategy using interest rate futures
Financial institutions may hedge themselves against interest rate risk by ensuring that the
average duration of their assets equals the average duration of their liabilities. The liabilities
can be regarded as short positions in bonds. This strategy is known as duration matching or
portfolio immunization.

When implemented, it ensures that a small parallel shift in interest rates will have little effect
on the value of the portfolio of assets and liabilities. The gain (loss) on the assets should
offset the loss (gain) on the liabilities.

Explain the limitations of a duration based hedging strategy

Although matching the durations of assets and liabilities is sometimes a first step in asset–
liability management (ALM) to monitor exposure to interest rates, this does not protect a
bank against non-parallel shifts in the yield curve. This is a weakness of the duration based
hedging approach.
 In practice, short-term rates are usually more volatile than, and are not perfectly
correlated with, long-term rates.
 Sometimes it even happens that short- and long-term rates move in opposite
directions to each other.
Therefore, additional tools are required to manage interest rate exposure. Tools such as
swaps, FRAs, bond futures, Eurodollar futures, and other interest rate derivatives can be
used for this purpose.

15
Chapter Summary

Different day-count conventions apply to U.S. Treasury bonds, U.S. corporate and
municipal bonds, and U.S. Treasury bills and other money market instruments.
 Knowing which day count convention applies to each instrument is important in
order to correctly calculate their respective prices.
 As we have seen US Treasury bill is a discount instrument: the discount rate is
expressed as a percentage of the face value, and consequently we need to employ
some simple calculations in order to obtain the true yield.

Market conventions and participants tend to differentiate between the clean price and
the dirty price of an instrument.
 The cash price = quoted price + accrued interest since last coupon date.
 The dirty price (the cash price) adds the accrued interest to the clean price.
 A Treasury bond Futures contract allows the party with the short position to deliver
any bond with a maturity of more than 15 years and that is not callable within 15
years. This flexibility leads to the futures contract being less valuable.

The cheapest to deliver (CTD) Treasury bond Futures contract is:

 The bond that minimizes  MIN: Quoted Bond Price - (Settlement  CF), or similarly
 The bond that maximizes  MAX: (Settlement  CF) - Quoted Bond Price

It is important to understand how to calculate the theoretical futures price for a

Treasury bond futures contract.
 The Eurodollar Futures contract is important in building interest rate curves, and
knowing how to price a Eurodollar futures contract is imperative.
 Generally speaking, the price of a contract is 100 – LIBOR. By design, each contract
pays $25 per basis point.
 We have seen how to calculate a convexity adjustment to a Eurodollar Futures
contract, using the Hull-Lee model, that explains and enables us to compute the
difference between a forward and a futures contract:
1
Convexity Adjustment: = − s
2
 The primary difference between the forward and futures rate is due to the daily
settlement process of futures contracts.
 The bootstrap procedure that was mentioned in previous chapters was highlighted
again in the context of extending the LIBOR zero curve using the Eurodollar futures
contracts.
Hedging small parallel shifts in the yield curve with duration hedging was once again
explored, along with sensitivity analysis and the number of contracts necessary to hedge our
exposure to such parallel shifts.

As discussed in earlier chapters, duration based hedging is not a panacea as it fails to take
into account issues such as non-linearity. Since short term rates are often more volatile than
longer term rates, the assumption of parallel shifts is unlikely to hold up in actual markets.

16
Questions & Answers:
1. If French money market instrument pays in Euros with an interest rate of 5.0% per annum
with (discrete) annual compounding and under an actual/360 day count (ACT/360)
convention, what is the equivalent rate under continuous compounding under an actual/365
day count?
a) 4.879%
b) 4.947%
c) 5.000%
d) 5.069%

2. Interest rates (bond yields) are currently below 6.0%. Which of the following bonds will the
short position in U.S. Treasury bond futures contract be most likely to deliver; i.e., which will
be CTD?
a) Short-maturity with low coupon
b) Short-maturity with high coupon
c) Long-maturity with low coupon
d) Long-maturity with high coupon

3. Each of the following is TRUE about the Eurodollar futures contract EXCEPT:
a) A Eurodollar is a dollar denominated deposit in a bank that is not located in the
United States
b) The long position in a Eurodollar future contract promises to borrow $1,000,000 at
maturity and repay this principal three months later
c) The notional value of a single Eurodollar futures contract is $1,000,000 with delivery
months of March, June, September and December
d) The short position in a Eurodollar futures contract gains when the LIBOR interest rate
increases

4. If a bond portfolio with a duration of 9.0 years is hedged with futures contracts in which the
underlying asset has a duration of only 3.0 years, but the volatility of the 3-year interest rate
is greater than the volatility of the 9-year interest rate, what is the likely impact on a duration-
based hedge?
a) The portfolio is likely to be over-hedged
b) The portfolio is likely to be under-hedged
c) The portfolio will be correctly hedged: volatility does not impact the duration hedge
d) The portfolio will be correctly hedged because more hedge contracts (~ 3X) will
simply equate the value (dollar) durations of the portfolio and the hedging
instruments

5. A United States (U.S.) Treasury bond pays an 8.0% semi-annual coupon on January 1st
and July 1st. If an investor owns $1 million in face value of the Treasury bond, what is the
accrued (coupon) interest as of August 5th, 2010?
a) $7,391
b) $7,556
c) $7,609
d) $7,778

17
Answers

1. B. 4.947%
365/360*LN (1+5%) = 4.947%

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-168-day-count-

conventions.4553/#post-11926

2. B. Short-maturity with high coupon

 If yields are low (< 6%), favors low duration bonds;
 If yields are high (>6%), favors high duration bonds;
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-171-conversion-
factors-cf-and-the-cheapest-to-deliver-ctd-in-us-treasury-bond-futures-contract.4564/#post-
11950

3. B. The $1 MM is a notional reference with the contract settling at maturity; the long
does not actually borrow the $1 MM.

In regard to (A), (C) and (D), EACH is TRUE

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-172-eurodollar-

futures-pricing-and-convexity.4566/#post-29039

4. A. The portfolio is likely to be over-hedged

In regard to (D), it is true that the hedge will equate the dollar durations and this would be
correct under the naive assumption of SMALL, PARALLEL shifts in the yield curve. But the
higher volatility of the short-rate is a realistic violation of the assumption and will imply over-
hedging.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-173-eurodollar-

futures-and-duration-based-hedges.4570/#post-11963

5. C. $7,609
Actual days between July 1st and August 5th = 31 + 4 = 35
Actual days between July 1st and January 1st = 184
US Treasury bonds use an actual/actual (ACT/ACT) day count convention, such that:
per $100, coupon = 8%*100/2*35/184 = $0.760870, and
for $1 million face value, accrued coupon = $0.760870 * $1,000,000/$100 = $7,608.70

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-168-day-count-

conventions.4553/#post-11926

18
P1.T3. Financial Markets & Products

Chapter 20. Swaps

Bionic Turtle FRM Study Notes

CHAPTER 20. SWAPS ............................................................................................................ 3
EXPLAIN THE MECHANICS OF A PLAIN VANILLA INTEREST RATE SWAP AND COMPUTE ITS CASH
FLOWS ...................................................................................................................................... 3
EXPLAIN HOW A PLAIN VANILLA INTEREST RATE SWAP CAN BE USED TO TRANSFORM AN ASSET OR A
LIABILITY AND CALCULATE THE RESULTING CASH FLOWS ............................................................. 5
EXPLAIN THE ROLE OF FINANCIAL INTERMEDIARIES IN THE SWAPS MARKET .................................. 6
DESCRIBE THE ROLE OF THE CONFIRMATION IN A SWAP TRANSACTION ........................................ 6
DESCRIBE THE COMPARATIVE ADVANTAGE ARGUMENT FOR THE EXISTENCE OF INTEREST RATE
SWAPS AND EVALUATE SOME OF THE CRITICISMS OF THIS ARGUMENT .......................................... 7
EXPLAIN HOW THE DISCOUNT RATES IN A PLAIN VANILLA INTEREST RATE SWAP ARE COMPUTED . 10
CALCULATE THE VALUE OF A PLAIN VANILLA INTEREST RATE SWAP BASED ON TWO SIMULTANEOUS
BOND POSITIONS ..................................................................................................................... 11
CALCULATE THE VALUE OF A PLAIN VANILLA INTEREST RATE SWAP FROM A SEQUENCE OF
FORWARD RATE AGREEMENTS (FRAS) ..................................................................................... 13
EXPLAIN THE MECHANICS OF A CURRENCY SWAP AND COMPUTE ITS CASH FLOWS ...................... 14
EXPLAIN HOW A CURRENCY SWAP CAN BE USED TO TRANSFORM AN ASSET OR LIABILITY AND
CALCULATE THE RESULTING CASH FLOWS ................................................................................. 16
CALCULATE THE VALUE OF A CURRENCY SWAP BASED ON TWO SIMULTANEOUS BOND POSITIONS16
CALCULATE THE VALUE OF A CURRENCY SWAP BASED ON A SEQUENCE OF FRAS ..................... 18
IDENTIFY AND DESCRIBE OTHER TYPES OF SWAPS, INCLUDING COMMODITY, VOLATILITY, CREDIT
DEFAULT, AND EXOTIC SWAPS .................................................................................................. 19
DESCRIBE THE CREDIT RISK EXPOSURE IN A SWAP POSITION. ................................................... 20
CHAPTER SUMMARY ............................................................................................................... 21
QUESTIONS & ANSWERS: ....................................................................................................... 22

2
Chapter 20. Swaps
 Explain the mechanics of a plain vanilla interest rate swap and compute its cash
flows.

 Explain how a plain vanilla interest rate swap can be used to transform an asset or
a liability and calculate the resulting cash flows.

 Explain the role of financial intermediaries in the swaps market.

 Describe the role of the confirmation in a swap transaction.

 Describe the comparative advantage argument for the existence of interest rate
swaps and evaluate some of the criticisms of this argument.

 Explain how the discount rates in a plain vanilla interest rate swap are computed.

 Calculate the value of a plain vanilla interest rate swap based on two simultaneous
bond positions.

 Calculate the value of a plain vanilla interest rate swap from a sequence of forward
rate agreements (FRAs).

 Explain the mechanics of a currency swap and compute its cash flows.

 Explain how a currency swap can be used to transform an asset or liability and
calculate the resulting cash flows.

 Calculate the value of a currency swap based on two simultaneous bond

positions.

 Calculate the value of a currency swap based on a sequence of foreign exchange

rates

 Identify and describe other types of swaps, including commodity, volatility, credit
default and exotic swaps.

 Describe the credit risk exposure in a swap position.

Explain the mechanics of a plain vanilla interest rate swap and

compute its cash flows
In a plain-vanilla interest-rate swap, one company pays a predetermined fixed interest rate
and receives a variable interest rate (pay-fixed and receive-floating), and their counterparty
pays a variable rate and receives a fixed interest rate (pay-floating and receive-fixed).
 The counterparty who pays the fixed rate is called the swap payer. This
counterparty profits from an increase in interest rates (and by convention this
counterparty is long the swap, although because some use this term differently,
long/short terms are discouraged in the swap context).
 The counterparty who pays the floating rate is called the swap receiver. This
counterparty profits from a decrease in interest rates (and by convention, this
counterparty is short the swap).

3
Here is an illustration given the following assumptions:
 Notional principal: $100 million. It is called notional principal because in the vanilla
version of the swap principal is not exchanged.
 Swap agreement: Pay fixed rate of 5.0% and receive 6-month LIBOR rate
 Term (aka, tenor): 3 years with payments every six months

Hull Table 7.1: Cash flows (in millions of $) in an interest rate swap

The notional is not exchanged in the plain vanilla interest rate swap (keep this in mind
for the exam). Also, the first floating rate payment is known at inception because the
floating rate that applies is the rate that prevails at the start of the six-month swap interval
though it is paid at the end of the period. In general, the floating rate is determined at the
beginning of each period and paid at the end of each period.
A note on discounting in wake of the LIBOR scandal and financial crisis
Throughout the assigned readings and in the examples presented in these notes, the LIBOR
rate is used both to infer the future cash flows, as well as the risk-free rate to discount the
future cash flows. In practice this is not the way the market operates.
 In wake of the LIBOR scandal, Governmental agencies tasked with overseeing
financial markets have investigated banks, and several banks have admitted to
sending in artificially high or low LIBOR rates to the BBA during the financial crisis.
In order to appear more creditworthy, the LIBOR rate has received a lot of negative
attention. Moreover, it shed light on shoddy practices by banks, as well as the
vulnerability of the LIBOR rate to be manipulated.
Banks and financial institutions today do not use LIBOR as the risk-free rate at which they
discount cash flows. Rather they use the Overnight Indexed Swap rate (OIS).
 The OIS rate is perceived to be nearly risk-free, and the spread between LIBOR –
OIS is closely monitored in markets to gauge banks’ willingness to lend to one
another, as well as overall liquidity and financial conditions.
 As Hull states in the assigned reading, “In normal market conditions, it [the LIBOR –
OIS spread] is about 10 basis points.” However, during and in the wake of the
financial crisis the spread experienced unprecedented volatility, as well as spikes as
high as several hundred basis points. Clearly, LIBOR rate is not risk-free by any
means, as the risk-free rate is supposed to be fairly constant.

4
  The OIS rate on the other hand did remain fairly constant compared to LIBOR. As a
result, banks today discount cash flows at the OIS rate. This has led to a
phenomenon called dual-curve stripping.
 Dual curve stripping arises from the fact that, while the LIBOR ± any spread is used
to infer the future cash flows on the floating leg of, e.g. a swap, the rate which is used
to discount the future cash flows is the OIS rate, hence the name dual-curve
stripping. As a consequence, at inception, the value of a swap may not equal zero,
although it is likely to be fairly close.
 There is however a logical fallacy in Hull’s statement. Although the historical average
has been a LIBOR-OIS spread of roughly 10 basis points that does not imply that this
will continue in the future. Moreover, the notion of, “normal market conditions” is at
best highly stylized; it presupposes that there is such a thing as normal market
conditions, AND that we as observers are able to infer what is and what is not
normal. That is a bold assumption indeed.

Explain how a plain vanilla interest rate swap can be used to

transform an asset or a liability and calculate the resulting cash
flows
Using swap to transform a liability: A company could use a swap to transform a floating-
rate loan into a fixed-rate loan. Suppose Microsoft (MSFT) can borrow $100.0 million in the
floating-rate market at LIBOR plus 10 basis points. Assume Microsoft prefers to borrow
instead at fixed rates. Microsoft enters the swap (illustrated below) such that:
 MSFT pays LIBOR plus 0.10% to its lenders.
 Under the terms of the swap, MSFT pays 5.015% fixed
 Under the terms of the swap, MSFT receives LIBOR
Thus, the swap effectively transforms borrowings at a floating rate of LIBOR plus 0.1% into
borrowings at a net fixed rate of 5.115%; i.e., LIBOR cancels and MSFT pays 5.015% plus
10 basis points. Suppose Intel (INTC) is the swap counterparty. Intel borrows 5.20 in fixed
rate markets but prefers to pay a floating rate. After Intel enters into the swap:
 Intel pays 5.20% to its lenders.
 Intel pays LIBOR under the terms of the swap.
 Intel receives 4.985% under the terms of the swap.
This transforms Intel’s borrowing to a net floating rate of LIBOR + 215 basis point.

5
Explain the role of financial intermediaries in the swaps market
Usually two non-financial swap counterparties do not deal with each other directly. They deal
through a financial institution. The financial intermediary may earn about 3 or 4 basis points
(0.03% or 0.04%) on a pair of offsetting transactions of a “plain vanilla” LIBOR-for-fixed
swaps. The spread earned is partly to compensate it for the risk that one of the two
companies will default on the swap payments.

The potential uses of a swap for the same two companies discussed in the previous section
is illustrated in the figure below. Here a financial intermediary(FI) enters into two offsetting
swap transactions with both Intel and Microsoft.
 Assuming that both companies honor their obligations, the financial institution is
certain to make a profit of $30,000 per year (0.03% times notional principal of $100
million).
 Microsoft ends up borrowing at 5.115% (instead of 5.1%), and Intel ends up
borrowing at LIBOR plus 21.5 basis points (instead of at LIBOR plus 20 basis points)
if they transact through an intermediary instead of directly entering into a swap with
each other as explained in the previous section.

In practice, intermediary is prepared to enter a swap even without having offsetting swap,
thereby acting as market makers (known as warehousing swaps).

Describe the role of the confirmation in a swap transaction

Confirmation is a legal agreement underlying a swap and is signed by representatives
of the two parties. Drafting of confirmations is facilitated by the ISDA.
 ISDA has produced a number of master agreements and the so-called credit support
annexes that include well-defined clauses.
 In the US, it is commonplace for companies to require an ISDA master agreement be
entered into before entering into a swap transaction. This is then supplemented with
a credit support annex, which stipulates further terms specific to the transaction.
 An ISDA agreement can include description of the terms of the swap contracts
including netting arrangements, collateral and non-performance clauses. It would be
highly unusual for a firm to enter into a swap transaction in the OTC market without
some form of agreement with the ISDA.

6
Describe the comparative advantage argument for the existence of
interest rate swaps and evaluate some of the criticisms of this
argument
The comparative-advantage argument is used to explain the popularity (or utility) of
swaps. Consider two companies: AAACorp has a higher credit rating than BBBCorp. Their
respective borrowing rates are given below:

Fixed Floating
AAACorp 4.0% LIBOR - 0.1%
BBBCorp 5.2% LIBOR + 0.6%

Notice that AAACorp has an advantage in both the fixed and floating markets.
 When one company has an advantage in a market, it is called an absolute
advantage.
 Despite the absolute advantage of AAACorp in both markets, the fact that BBBCorp
enjoys a comparative advantage in floating-rate markets implies they can achieve
mutual gain!
 BBBCorp is said to have a comparative advantage in the floating-rate market
(because BBBCorp borrows at only +0.70% more in floating rate markets, compared
to 1.2% more in fixed rate markets). AAACorp is said to have a comparative
advantage in fixed rate markets.
 The total advantage is given by the difference between the respective rate
differentials. Specifically, in this case, the fixed rate differential equals 1.20% (=
5.20% - 4.00%) and the floating-rate differential equals 0.70% (= 0.60% + 0.10%).
The total gain equals 0.70% = 1.20% - 0.70%.
 To generalize, we can say that a comparative advantage exists when two companies
face different interest rate markets: the difference in fixed rate markets (i.e., between
the companies; call this “ ”) is greater than the difference in floating rate markets
(call this “ ”). Under these circumstances, a swap arrangement can produce a
total gain, that is, to both parties, before any transaction costs, equal to: – .

If AAACorp and BBBCorp want to share the advantage equally, they would swap as follows:

7
In this arrangement, AAACorp’s cash flows, ignoring transaction costs are:
 It pays 4.00% per annum to outside lenders.
 It receives 4.35% per annum from BBBCorp.
 It pays LIBOR to BBBCorp.
BBBCorp’s cash flows, ignoring transaction costs are:
 It pays LIBOR + 0.6% per annum to outside lenders.
 It receives LIBOR from AAACorp.
 It pays 4.35 % per annum to AAACorp.

Under this swap, notice that both have improved their cost of capital as they effectively pay:
 AAACorp pays LIBOR - 0.35%: 0.25% less than its “competitive” floating rate,
 BBBCorp pays 4.95% fixed: 0.25% less than its “competitive” fixed rate
In this swap arrangement, the total gain – should be 1.2- 0.7 = 0.5%. As we have seen
above, the net gain of 0.25% on each side sums up so that the total gain is 0.5%.

IMPORTANT CONCEPT:

A comparative advantage exists when [two] companies face different interest rates in
the market. Both companies benefit from entering into a swap, even if one company
has an absolute advantage in both the fixed and the floating market. This is a
common test question so be sure you know the difference, and how to calculate the
gain to each party.

Inserting a financial intermediary into the swap

We can add an assumption that the two counterparties do not deal directly with each other
but instead use a financial intermediary. In this case, we continue to follow Hull’s example
and assume the intermediary charges four basis point (0.04%). The reduces the total shared
net advantage from 50 basis points to 46 basis points. The resulting swap is illustrated
below, and on the next page (with our dynamic learning spreadsheet that solves for the
swap given an assumption about the relative advantage share; in this case, we continue to
assume the total gain is shared 50/50 between the counterparties).

8
Spreadsheet illustration of swap with financial intermediary:

Criticism of the comparative advantage argument

The contrary view concerns arbitrage: if markets were efficient, we would expect the
differentials that allow for the comparative advantage in the first place, to erode. The
reason that spread differentials appear to exist is due to the nature of the contracts available
to companies in fixed and floating markets.
 The floating rate is typically LIBOR + a spread, and is adjusted, or reset, every six
months. Thus, if the borrower’s creditworthiness has declined, the lender has the
option of increasing the spread over LIBOR that is charged. This is not possible for
fixed rate loans as they are set for a longer period of time.
 Also, in the short term, there is very little chance that either of the firms will default
but as we look further ahead, the probability of a default by a company with a
relatively low credit rating is liable to increase faster than the probability of a default
by a company with a relatively high credit rating. So, the spread between the 5-year
rates is greater than the spread between the 6-month rates.
The comparative advantage argument assumes floating rates will not adjust and converge,
an assumption, which in practice does not hold up. A floating rate loan might seem to have
transformed in to a fixed rate loan at which the swap is entered in to but it may not be fixed
in the sense that it depends on the spread above LIBOR the company borrows at in the
future.

9
Explain how the discount rates in a plain vanilla interest rate swap
are computed
LIBOR rates are observable only for shorter periods, typically one day to one year.
 For longer durations such as one to three years, Eurodollar futures are used, and
then from year 3 to year 30, the “swap curve” is used.
 The reason multiple curves are used has to do with the liquidity of the instrument at
the different time-horizons.
 We can bootstrap the discount rate for the LIBOR/swap zero curve
For example:
Assume that LIBOR/swap zero rates are given: six-month = 4%, one-year = 4.5%, and
eighteen months = 4.8%; and the 2-year swap rate is 5.0%, which implies that a $100.00
face value bond with a semiannual coupon of 5% will sell exactly at par (why? Because the
5% coupons are discounted at 5%)

We can solve for the two-year zero rate (R) which is the unknown as follows:
 2.5 ( % ∗ . )+ 2.5 ( . % ∗) + 2.5 ( . %∗ . ) + 102.5 ( ∗ ) = 100
 2.45 + 2.39 + 2.33 + 102.5 ( ∗ ) = 100 → 102.5 ( ∗ ) = 92.83
 ( ∗ )
= 92.83/102.5 → = −ln (92.83/102.5)/2= 4.953%

10
Calculate the value of a plain vanilla interest rate swap based on
two simultaneous bond positions
Interpretation of Swap
 If two companies enter into an interest rate swap arrangement, then one of the
companies has a swap position that is equivalent to a long position in floating-rate
bond and a short position in a fixed-rate bond: = −
 The counterparty to the same swap has the equivalent of a long position in a fixed-
rate bond and a short position in a floating-rate bond: = −

For a fixed-rate payer (who therefore receives floating), the value of an interest rate swap is
the present value of receive-floating cash flow stream minus the present value of the pay-
fixed cash flow stream: = −

Here is the notation: Symbol

Time until payments are exchanged:
Notional principal in swap agreement:
Fixed payment made on each payment date:
The next floating-rate payment to be made on the next payment date: ∗

The value of the fixed rate cash flows requires the discounting of each coupon and the
final payment: =∑ +

A floating-rate bond is worth the notional principal immediately after a payment because at
this time the bond is a ‘‘fair deal’’ where the borrower pays LIBOR for each subsequent
accrual period: = . It follows that immediately before the payment, the value of the
floating rate bond is the notional principal plus the floating payment ∗ that will be made at
time (which was determined at the last payment date): = + ∗

So, valuing the floating-rate stream is easier! We only need to discount the sum of the
∗
notional principal ( ) and the next floating-rate payment ( ): = ( + ∗)

Hull Example 7.2: On a notional principal of $100 million, a swap is arrangement is made so
as to receive 6-month LIBOR and pay 3% per annum (with semiannual compounding). The
swap has a remaining life of 1.25 years. The LIBOR rates with continuous compounding for
3-month, 9-month, and 15- month maturities are 2.8%, 3.2%, and 3.4%, respectively. The 6-
month LIBOR rate at the last payment date was 2.9% (with semiannual compounding).
These assumptions are shown below.

11
 Hull Ex. 7.2: Valuing a swap in terms of bonds ($ millions).

 The swap rate is 3% per annum and hence the semiannual coupon payments are
$1.5(=100 x 3%/2). So, the fixed-rate bond will have cash flows of 1.5, 1.5, and 101.5
in 3, 9 and 15 months respectively. The discount factors for these cash flows are
. %∗ .
calculated (for eg. the 3-month factor is =0.9930) and multiplied with their
respective cash flows. This gives us present value of the (received or incoming)
fixed cash flow stream which is $100.23 million.
 For the present value of the floating-rate cash flow stream, we only need to value
one cash flow at three months: the next floating payment of $1.45 ( ∗ ) to be made in
6 months, (because it’s a semi-annual payment on 2.9%, it is the rate of 1.45% times
the notional) plus the notional ( =$100) which equals $101.45. That’s the future
value in three months, so we discount it with the 3-month factor (0.9930) to get its
present value of $100.74 million.
 The value of the swap, to our fixed rate payer, is the difference between the present
value of the floating rate stream they are receiving (100.74) and the present value of
the fixed cash flow stream they are paying (100.23), which is $0.5117 million.

We only need to value one cash flow on the floating-rate side because, when
the next coupon pays, the floating-rate bond must be priced at par!

12
Calculate the value of a plain vanilla interest rate swap from a
sequence of forward rate agreements (FRAs)
A swap can be valued as a sequence of forward rate agreements (FRAs), in an essentially
similar procedure by making the assumption that forward interest rates are realized:
 Use the LIBOR/swap zero curve to calculate forward rates for each of the LIBOR
rates that will determine swap cash flows.
 Calculate swap cash flows by assuming LIBOR rates will equal the forward rates.
 Discount the net cash flows (at LIBOR/swap zero rates) to obtain the swap value.
Hull Ex. 7.3: Valuing a swap in terms of FRAs ($ millions)

The key difference here is that we calculate the forward rate in 3 months and in 9 months;
specifically, we want to calculate the 3 x 9 (6-month rate when contract expires in three
months) and the 9 x 15 (6-month rate when contract expires in 9 months).
 For eg. the 3 x 9 forward rate in continuous terms is given by:
− 3.2% × 0.75 − 2.8% × 0.5
= = 3.4%
− 0.75 − 0.25
This is converted to a semiannual basis as:
. %/
2× − 1 = 3.43%
 Similarly, the 9 x 15 forward rate on a semiannual basis is calculated as 3.73%.

13
From the table, the cash flows exchanged in 3 months are:

 The fixed rate of 3% (semiannual rate of 1.5%) will lead to a cash outflow of =$1.5
million (=100 x 3%/2)
 The floating rate of 2.9% (that set 3 months ago) will lead to a cash inflow of $1.45
million (=100 x 2.9%/2).

The cash flows exchanged in 9 months assuming that forward rates are realized are
 The cash outflow is $1.5 million as before.
 The cash inflow using 3 x 9 forward rate of 3.43% is 1.71 million (=100 x 3.43%/2)

Similarly, the cash flows that will be exchanged in 15 months assuming that forward rates
are realized are: cash outflow of $1.5 million and a cash inflow of $1.87 million.

The differences between the inflows and outflows of the 3, 9 and 15-month cash flows gives
us the net cash flows. These when discounted by their discount factors (0.9930, 0.9763 and
0.9584, respectively) gives us the present value of the net cash flows which is equal to
$0.5117 million.

This value of the swap calculated as a series of FRA’s is in agreement with the value
calculated in the previous section by decomposing the swap into bonds.

Explain the mechanics of a currency swap and compute its cash

flows
A currency swap exchanges principal and interest in one currency for principal and
interest in another currency.
 A currency swap agreement requires the principal to be specified in each of the two
currencies. The principal amounts are usually exchanged at the beginning and at the
end of the life of the swap.
 For a party paying interest in the foreign currency, the foreign principal is received,
and the domestic principal is paid at the beginning of the swap’s life. At the end of the
swap’s life, the foreign principal is paid, and the domestic principal is received.
 Usually the principal amounts are chosen to be approximately equivalent using the
exchange rate at the swap’s initiation. When they are exchanged at the end of the life
of the swap, their values may be quite different.

14
Each of the three types of currency swaps mentioned below would involve an initial
exchange of principal in the opposite direction to the interest payments and a final exchange
of principal in the same direction as the interest payments at the end of the swap’s life.
 A fixed-for-fixed currency swap involves exchanging principal and interest
payments at a fixed rate in one currency for principal and interest payments at a fixed
rate in another currency.
 Fixed-for-floating currency swap is where a floating interest rate in one currency is
exchanged for a fixed interest rate in another currency. A fixed-for-floating swap can
be regarded as a portfolio consisting of a fixed-for-fixed currency swap and a fixed-
for-floating interest rate swap.
 Floating-for-floating currency swap is where a floating interest rate in one
currency is exchanged for a floating interest rate in another currency. A floating-for-
floating swap can be regarded as a portfolio consisting of a fixed-for-fixed currency
swap and two interest rate swaps, one in each currency.
For example:
Consider a 5-year currency swap with a company paying a fixed rate of interest of 5.0% in
sterling and receiving a fixed rate of interest of 6.0% in dollars from its counterparty. Interest
rate payments are made once a year and the principal amounts exchanged are $15 million
and £10 million.
Cash flows in a currency swap

This is a fixed-for-fixed currency swap because the interest rate in each currency is at a fixed
rate.
 At the outset of the swap, our company pays $15 million and receives £10 million.
Each year during the life of the swap contract, it receives $0.90 million (=6% x $15)
and pays £0.50 million (=5% x £10). At the end of the life of the swap, it pays a
principal of £10 million and receives a principal of $15 million.

15
Explain how a currency swap can be used to transform an asset or
liability and calculate the resulting cash flows
A currency swap can be used to transform borrowings(liability) in one currency to borrowings
in another.
 Continuing with the previous example, a company issues $15 million of US- dollar-
denominated bonds at 6% interest. The swap has the effect of transforming this
transaction into one where it has borrowed £10 million at 5% interest. The initial
exchange of principal converts the proceeds of the bond issue from US dollars to
sterling. The subsequent exchanges in the swap have the effect of swapping the
interest and principal payments from dollars to sterling. The resulting cash flows are
as shown in the previous section.

The swap can also be used to transform the nature of assets.

 Suppose if the same company can invest £10 million in the UK to yield 5% per
annum for the next 5 years, but feels that the US dollar will strengthen against
sterling and prefers a US-dollar-denominated investment. The swap has the effect of
transforming the UK investment into a $15 million investment in the US yielding 6%.

Calculate the value of a currency swap based on two simultaneous

bond positions
A currency swap exchanges principal and interest in one currency for principal and
interest in another currency. The valuation of currency swap is given by:

= −
= −

So, in the first case, the valuation of a swap that pays in foreign currency and receives US
dollars involves subtracting the foreign bond after translating its value based on the spot
exchange rate (expressed as number of dollars per unit of foreign currency). In effect, the
exchange rate allows you to “standardize” on US dollars and take the difference in values.

The second one shows the value of a swap where the foreign currency is received, and
dollars are paid. The value of a swap can therefore be determined from interest rates in the
two currencies and the spot exchange rate.

Hull Example 7.4: Consider a company that has entered into a currency swap in which it
receives 5% per annum in yen and pays 8% per annum in dollars once a year. The
principals in the two currencies are $10 million and 1,200 million yen.

16
The term structure of interest rates is flat in both Japan and the United States at 4% and 9%
per annum respectively (both with continuous compounding). The swap will last for another 3
years, and the current exchange rate is 110 yen = $1.

These assumptions are tabulated below.

The calculations are shown in the table below.

Hull Ex 7.4: Valuation of currency swap in terms of bonds ($ millions)

 The cash flows from the dollar bond underlying the swap are $0.80 million (=$10 x
8%) each year. In addition, the dollar principal of $10 million is paid in year 3. The
present value of these cash flows paid using the dollar discount rate of 9% sum up
to $9.64 million.
 Likewise, the cash flows from the yen bond underlying the swap are ¥60 million (=
¥1200 x 5%) each year. In addition, the yen principal of ¥1200 million is received in
year 3. The present value of the cash flows received using the yen discount rate of
4% sum up to ¥1230.55 million.
 The value of the swap (that pays in dollars and receives in yen) in dollar terms is
therefore calculated as:
= − = ¥1230.55 / ¥11 0 − $9.64 → $11.19 − $9.64 = $1.543

17
Calculate the value of a currency swap based on a sequence of
FRAs
Each exchange of payments in a fixed-for-fixed currency swap is a forward foreign exchange
contract. These contracts are valued by assuming that forward exchange rates are realized.
For this example, (Hull 7.5), consider the same assumptions as in Hull Example 7.4

Hull Ex 7.5: Valuation of currency swap as a portfolio of forward contracts ($ millions)

The cash flows paid are $0.80 million each year plus the additional dollar principal of $10.0
million paid in year 3. The cash flows received are ¥60.0 million each year plus the additional
yen principal of ¥1200.0 in year 3. The current spot rate is 0.009091 dollar per yen. From
= 9% and = 4%, the forward rates for 3 years are calculated.
−
 For eg. 1-year forward rate is calculated as: = = 0.009091 ×
(9% −4%)×1
= 0.009557
Assuming that these forward rates are realized, the swap can be valued.
For example, if the 1-year forward rate is realized, the yen cash flow in year 1 is
worth: $0.57 million (=60 x 0.009557).
 The net cash flow at the end of year 1 is $0. 23 million ( − = 0.57 - 0.8). This has a
present value of $0.21 million (0.23 × −9% ×1).
 The values of the other forward contracts are calculated similarly and summed up
to obtain the total value of the swap which is $1.5430 million. Thus, the total value
of the swap calculated as a series of currency forward contracts agrees with the
value of the swap calculated by decomposing it into bonds.

18
Identify and describe other types of swaps, including commodity,
volatility, credit default, and exotic swaps
 Variations of standard fixed for floating interest rate (or plain vanilla) swaps:
o Instead of the common floating reference rate LIBOR, commercial paper rates
may be used
o tenor (payment frequency) can vary from the normal 6 month LIBOR to 1 month,
3 months, and 12 month LIBOR
o the tenor on the floating side does not have to match the tenor on fixed side.
 Principal can vary throughout the swap term:
o Amortizing Swap: Principal reduces in a predetermined way to correspond to
the amortization schedule on a loan
o Step-up swap: Principal increases in a predetermined way
o Deferred (forward) swap: the parties do not begin exchange until some future
period. Sometimes the principal to which the fixed payments are applied is
different from the principal to which the floating payments are applied.
 Constant maturity swap (CMS swap): an agreement to exchange a LIBOR rate for
a swap rate.
 Constant maturity Treasury swap (CMT swap): the counterparties agree to swap a
LIBOR rate for a Treasury rate.
 Compounding swap: Interest on one or both sides is compounded forward to the
end of the swap’s life.
 Credit Default Swap: A credit default swap (CDS) provides insurance against a
default by a Company. The buyer of this protection makes fixed periodic payments to
the seller of protection for an agreed period of time. If the Company that is the
subject of the protection (known as reference entity) defaults, there is a payment
from the seller of protection to the buyer of protection. Otherwise, the seller of
protection does not have to make any payments. In an index credit default swap, the
single reference entity is replaced by the portfolio of companies. In return for regular
payments, the buyer of protection is compensated for defaults by any of the
companies in the portfolio.
 LIBOR-in arrears swap: The LIBOR rate observed on a payment date is used to
calculate the payment on that date (In a standard deal, the LIBOR rate observed on
one payment date is used to determine the payment on the next payment date.)
 Accrual swap: Interest on one side of a swap accrues only if floating rate is within a
certain range.
 Diff swap or Quanto: A rate observed in one currency is applied to a principal
amount in another currency.
 Equity swaps: Agreement to exchange total return (gains plus dividends) realized
on an equity index in exchange for LIBOR (both on the same principal).
 Options embedded in swaps like
o Extendable swap - one counterparty has the option to extend the life of the swap
o Puttable - one party has the option to terminate early
o Swaptions - options on swaps.

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  Commodity swaps: A series of forward contracts on a commodity with different
maturity dates and the same delivery prices.
 Volatility swaps: In a series of time periods, at the end of each period, one side
pays a preagreed volatility, while the other side pays the historical volatility realized
during the period. Both volatilities are multiplied by the same notional principal in
calculating payments.
 Exotic swaps: Swaps are limited only by the imagination of financial engineers and
the desire of corporate treasurers and fund managers for exotic structures.
o E.g. A 5/30 swap entered into between Procter and Gamble and Bankers Trust,
where payments depend in a complex way on the 30-day commercial paper
rate, a 30-year Treasury bond price, and the yield on a 5-year Treasury bond.

Describe the credit risk exposure in a swap position.

Because a swap involves offsetting position, there is no credit risk when the swap
has negative value. Credit risk only exists when the swap has positive value. A financial
institution is liable to lose money if one of the counterparties defaults when it has positive
value in its swap because it still has to honor its swap agreement with the other
counterparty.

For an interest rate swap, because principal is not exchanged at the end of the life of an
interest rate swap, the potential default losses are much less than those on an equivalent
loan.

On the other hand, in a currency swap, the risk is greater because currencies are exchanged
at the end of the swap. It can be shown that, when interest rates in two currencies are
significantly different:
 the payer of the currency with the high interest rate is in the position where the
forward contracts corresponding to the early exchanges of cash flows have negative
values, and the forward contract corresponding to final exchange of principals has a
positive value.
 the payer of the currency with the low interest rate is in the opposite position where
the forward contracts corresponding to the early exchanges of cash flows have
positive values, while that corresponding to the final exchange has a negative value.
These results are important when the credit risk in the swap is being evaluated.

Note the distinction between credit risk and market risk.

 In the case of a swap, credit risk includes the risk the counterparty defaults; market
risk includes the risk that interest rates and/or currency exchanges rates vary
unfavorably.
 Market risks can be hedged relatively easily by entering into offsetting contracts;
credit risks are less easy to hedge

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Chapter Summary
Swaps are instruments entered into by two or more parties in order to swap one cash
flow for another. In theory, we discount the cash flows from the swaps by the respective
LIBOR rates, but in practice, the OIS (Overnight Indexed Swap) rate is used as the risk-free
rate, while LIBOR is used as the index for one of the swaps’ legs to infer the future cash
flows, which leads to what is called dual-curve stripping.

The most common forms of swaps by far are interest rate swaps and currency swaps.
In an interest rate swap a company swaps a cash flow based on either a fixed or floating
rate, in exchange for a cash flow based on another rate or index, which can be either fixed or
floating. The most common form of interest rate swap is the fixed-float swap; however, fixed-
fixed and float-float swaps are also common. In a currency swap it is more common [than for
an interest rate swap] that both legs are floating, based on their respective currencies LIBOR
rate.

We explored why companies might enter into a swap in the first place, and discussed the
theory of comparative advantage in which both parties can benefit from exchange, even
though one party may have an absolute advantage in both fixed and floating rates. This is a
powerful economic theory, which applies universally to all forms of exchange, and is, in
particular a key argument for the benefits of trade [between nations]. We saw that for swaps
in particular, the theory of comparative advantage was questionable as applied to plain
vanilla swaps, however, firms may derive real tax advantages from using currency swaps.

The bootstrap method for calculating interest rates was used to explain how we might
compute the discount rates in a plain vanilla interest rate swap.

Two techniques may be employed in order to value vanilla interest swaps, as well as a
currency swaps. These include:
1. Calculating the value of the swap based on two simultaneous bond positions (long
one bond and short another)
2. Calculating the value of the swap from a sequence of Forward Rate Agreements
(FRAs).

Swaps can be traded both on an exchange or OTC.

 The OTC volume by far exceeds the exchange-traded volume, albeit recently
introduced legislation might shift the balance by forcing such as sell-side firms to use
an exchange/clearinghouse for their transactions.
 When traded OTC, financial intermediation is typically performed by brokers or banks
so as to reduce the credit risk and match the parties involved in the transaction. This
means that the financial intermediary takes on credit risk as it guarantees payment,
even in the event of non-performance by one of the parties.

A currency swap is valued just like a plain vanilla swap, only with an exchange rate
component attached to it.

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Questions & Answers:
1. Company A can borrow at 7.0% in fixed rate markets and LIBOR plus 100 basis points in
floating rate markets. If Company B, which is riskier, can borrow at 7.8% in fixed markets, at
which borrowing rate in the floating rate market would any comparative borrowing advantage
be neutralized such that NEITHER company has a comparative advantage in the fixed nor
floating rate market?
a) LIBOR plus 20 basis points
b) LIBOR plus 80 basis points
c) LIBOR plus 120 basis points
d) LIBOR plus 180 basis points

2. Consider four statements about the 5-year swap rate:

1. The 5-year swap rate is the average of the bid and offer fixed rates that a market
maker is prepared to exchange for LIBOR in a standard plain vanilla 5-year swap
2. The 5-year (par) swap rate is the 5-year LIBOR/swap par yield; i.e., the fixed rate that
makes the value of the swap equal to zero
3. The 5-year swap rate should be greater than the 5-year AA-rated borrowing (lending)
rate
4. The 5-year swap rate is a pure risk-free (riskless) rate
Which is (are) TRUE?
a) I. only
b) I. and II. only
c) II., III. and IV
d) I., II., III. and IV.

3. Consider two companies. Company A can borrow euros (EUR) at 5.0% or dollars (USD)
at 4.0%. Riskier Company B can borrow EUR at 6.5% or USD at 6.0%. EACH of the
following is TRUE EXCEPT:
a) Company A has an absolute advantage in both markets
b) Company A has a comparative advantage borrowing dollars (USD)
c) Company B has a comparative advantage borrowing euros (EUR)
d) Company B has a comparative advantage in NEITHER market

4. With respect to a generic commodity swap, EACH of the following is true EXCEPT:
a) A commodity swap is effectively a series of forward contracts on a commodity with
different maturity dates and the same delivery prices
b) A Commodity swap is financially settled and does not involve any physical delivery
c) Like a vanilla interest rate swap, notional is not exchanged
d) Unlike a vanilla interest rate swap, exchanged payments are NOT netted

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5. An interest rate swap with a notional of $100 million has a remaining life of nine (9)
months. Under the swap, 6-month LIBOR is exchanged for 3.0% per annum (compounded
semiannually). Three months ago (t - 0.25 years) the 6-month LIBOR rate was 2.0%.
Currently, the swap rate curve is flat at 1.0% for all maturities; e.g., the three- and nine-
month LIBOR rates are 1.0% per annum (compounded continuously). What is the current
value of the swap to the counterparty who is paying fixed?
a) negative (-) $2.99 million
b) negative (-) $1.49 million
c) + $2.99 million
d) + $1.49 million

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Answers

1. D. LIBOR plus 180 basis points

Comparative advantage is possible only when the difference between the rate differentials is
zero. If a = fixed rate differential and b = floating-rate differential, then:
 total gain = a - b, or
 if a - b = 0 then neither company enjoys a comparative advantage
In this case, the fixed differential = 7.8% fixed - 7.0% fixed = 80 basis points, and
There is no comparative advantage if (80 bps - b) = 0, or if b = 80 bps; i.e.,
[L + X] - [L + 100 bps] = 80 bps,
X - 100bps = 80,
X = 180 bps

In this case, to summarize:

 Fixed rate differential = a = 7.8% - 7.0% = 80 bps;
 Floating rate differential = b = [L+180 bps] - [L+100 bps] = 80 bps;
 Total gain in swap = a - b = 80 bps - 80 bps
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-174-interest-rate-
swap-mechanics.4577/#post-28520

2. b. I. and II. only

Both (I.) and (II.) are true but:
in regard to (III.) the X-year swap rate should be LESS THAN the X-year lending/borrowing
rate; in regard to (IV.), like LIBOR, the swap rate is NOT riskless as there is some
counterparty (default) risk. They are “near riskless.”

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-175-interest-rate-

swap-valuation-swap-rate.4581/#post-12116

3. D. As (C) is true, (D) must be false.

If the differential in differentials is non-zero, both must have a comparative advantage. The
differential in differentials, in this case, is:
(USD 6.0% - USD 4.0%) - (EUR 6.5% - EUR 5.0%) = 2.0% - 1.5% = 0.5%.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-176-currency-

swap-valuation.4587/#post-12136

4. D. Payments are netted: the generic commodity swap is just like an interest rates swap,
the only difference is that the underlying good is a commodity rather than cash such that the
reference is a spot price rather than an interest rate.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-178-non-vanilla-

swaps.4596/#post-12154

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5. B. negative (-) $1.49 million
Spreadsheet @ https://www.dropbox.com/s/ymof7y3quzd64ou/T3.175.1_irate_swap_v1.xlsx
 The value of the fixed-rate bond position = $1.5 MM * EXP(-1%*0.25) + $101.5 MM *
EXP(-1% * 0.75) = $102.23785
 The value of the floating-rate bond position = $101 MM * EXP(-1% * 0.25) =
$100.747815; i.e.,
the next coupon = 0.5*2% LIBOR at last coupon * $100 MM, and the floating-rate
bond will have par value ($100 MM) at next coupon.
 Value to pay fixed = $100.747815 MM - $102.23785 MM = -$1,490,037

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t3-175-interest-rate-

swap-valuation-swap-rate.4581/#post-12116

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