Forward (no premium):

Position Payoff/Profit Max. Gain Max. Loss Strategy

Long Spot price – Forward price Unlimited – Forward Price Guaranteed purchase price
Short Forward price – Spot price Forward Price Unlimited Guaranteed sale price
Forward + Bond = Spot price at expiration
Options (with premium):
Position Payoff Profit Max. Gain Max. Loss Strategy
Long Call Max [0, Spot – Strike] Payoff – FV Premium Unlimited – FV Premium Insures against high price
Short Call – Max [0, Spot – Strike] Payoff + FV Premium FV Premium Unlimited Seller of insurance
Long Put Max [0, Strike – Spot] Payoff – FV Premium Strike – FV Premium – FV Premium Insures against low price
Short Put – Max [0, Strike – Spot] Payoff + FV Premium FV Premium FV Premium – Strike Seller of insurance
Spot – Strike – FV Premium = 0 à Break-even price = Strike + FV Premium
Put call parity à Call – Put + PV Strike = PV Forward Price

Insurance, collars, spreads:

Positions Combination Looks like Strategy
Insured Assets (Floor) Long Index + Long Put Long Call + Bond Guarantee min. sale price for index
Insured Short (Cap) Long Call + Short Index Long Put - Bond Against higher price of repurchasing index
Covered Call Long Index + Short Call Short Put + Bond Neutral – Index unlikely to move
Covered Put Short Index + Short Put Short Call - Bond Neutral to slightly bearish
Bull Spread Long Call/Put + Short Call/Put at higher strike Flat – Upward – Flat Believe stock price will go up a little
Bear Spread Short Call + Long Call at higher strike + Bond Flat – Downward – Flat Believe stock price will go down
Long (Short) Put + Short (Long) Call at higher
Collar Downward – Flat – Downward Bearish
strike
Straddle Long/Short Call & Put at same strike price V shape (long); ^ (short) Believe price will be volatile (long)/ steady (short)
Long/Short Put + Long/Short Call at higher
Strangle Inverted Trapezoid (no lid) Lower Premium than Straddle
strike price
Butterfly Long Strangle + Short Straddle --^-- Against losses on Straddle (low volatility)
Long Stock + Collar = Bull Spread

Sellers: Inherent Long Position (LONG STOCK)

Positions Payoff Looks like Strategy
Short Forward Stock – Forward Long Bond Lock the revenue/Constant revenue
Long Put Stock + Put Long Call + Bond Protected downside + unlimited upside (but expensive)
Buy Collars Stock + Collar Bull spread + Bond Trade upside potential for downside protection (cheaper)
Short Call Stock – Call Short Put + Bond (Covered Call) Reduce losses by receiving premium
Reasons to hedge: bankruptcy and distress costs; costly external financing; taxes; preservation of (increase) debt capacity; managerial risk aversion
Reasons not to hedge: transaction costs; costly expertise; cost of monitoring; complications (tax & accounting); potential collateral requirements
Buyers: Inherent Short Position (SHORT STOCK)
Positions Payoff Looks like Strategy
Long Forward Forward – Stock Short Bond Lock the cost/Constant cost
Long Call Call – Stock Put – Bond (Cap) Higher profit when price is low; protect against high cost
Short Collars – Collar – Stock Bear Spread – Bond Trade potential low cost to protect high cost
Short Put – Put – Stock Short Call – Bond (Covered Put) Reduce cost by receiving premium

Prepaid Forward Price: Forward Price: Bond: compensation for time value of money only
Without Dividend: $
𝐹!,#
𝑆! = $
𝐹!,# = 𝐹!,# × 𝑒 '# = 𝑆! 𝑒 ('%&)# Stock: compensation for time value of money + risk
$ %&# Forward: compensation for risk only
Dividend: 𝐹!,# = 𝑆! 𝑒
Discrete: Discrete: 1. Synthetic Forward
$
𝐹!,# = 𝑆! − 𝑃𝑉 𝑜𝑓 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝐹!,# = 𝑆! − 𝐹𝑉𝑜𝑓 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 2. Synthetic Stock
3. Synthetic Bond
Synthetic Forward = Stock – Bond *ST unknown
Cash Flows
Transaction t=0 t=T
Buy 𝑒 %&# units of index − 𝑆! 𝑒 "#$ + 𝑆$
Borrow 𝑆! 𝑒 %&# + 𝑆! 𝑒 "#$ − 𝑆! 𝑒 (&"#)$
Total 0 𝑺𝑻 − 𝑺𝟎 𝒆(𝒓"𝜹)𝑻
Long One Forward 0 𝑆$ − 𝐹!,$ → 𝑁𝐴 𝐿𝑜𝑤𝑒𝑟 𝐵𝑜𝑢𝑛𝑑
Lend 𝑆! 𝑒 %&# − 𝑆! 𝑒 "#$ + 𝑆! 𝑒 (&"#)$
Total − 𝑺𝟎 𝒆"𝜹𝑻 𝑺𝑻
Buy 𝑒 %&# units of index − 𝑆! 𝑒 "#$ + 𝑆$
Short One Forward 0 (𝐴𝑐𝑡𝑢𝑎𝑙) 𝐹!,$ − 𝑆$ → 𝑁𝐴 𝑈𝑝𝑝𝑒𝑟 𝐵𝑜𝑢𝑛𝑑
Total − 𝑺𝟎 𝒆"𝜹𝑻 𝑭𝟎,𝑻
Short Stock 𝑆! 𝑒 %&# + 𝑆! 𝑒 "#$ − 𝑆$
*Transaction cost Forward: NA upper bound = F < A overpriced C&C (short forward + long stock + borrow); F > A NA lower bound (long forward + short stock + lend)
-(. &' /&01
(𝑆!"#$ &' ()&'* − 2𝑘)𝑒 '!"#$+ ≤ 𝐹!,+ ≤ (𝑆! + 2𝑘)𝑒 '%&''&(+ (2k = transaction cost; if in %, S0*(1+%) + S0*% + forward cost or S0*(1-%) - S0*% - forward cost)
Futures: exchanged-traded forwards; standardized; liquid (settled daily); structured to minimize credit risk
Forwards: OTC – customized; cannot predict future prices; forward price is calculated based on risk-free interest rate, expected stock price is calculated based on
expected stock return, which should be larger than risk-free interest rate; therefore, forward price will be lower than the stock price; forward premium = F0,T/S0;
2 3),+
annualized = + , 𝑙𝑛 + , = 𝑟 − 𝛿; forward price = spot + interest to carry – asset lease rate
+ 4)

Currency Forwards:
5) (27')+
Non-exponential: 𝐹!,+ = Exponential: 𝐹!,+ = 𝑥! 𝑒 9':',#$"'!-.#/;+
(27',#$"'!-.#/ )+

Carry trade: borrow low-rate currency and lend high-rate currency; 𝑥! = 4.7𝐻𝐾𝐷/𝐴𝑈𝐷; 1 year expire; 𝑟<=> = 2%; 𝑟?@> = 4%; underlying = AUD; foreign = HKD
Position T=0 T=1
HKD AUD HKD AUD
Borrow 1000 HKD at T0 for –1000*(1+ 𝑟*+, )
1000 0 0
1 year = –1020
1000/𝑥!
Convert HKD to AUD at T0 -1000 0 0
= 212.77
212.77*(1+ 𝑟-., )
Lend AUD at T0 for 1 year 0 -212.77 0
= 221.28
Convert AUD to HKD at T1 0 0 221.28 𝑥# –221.28
TOTAL 0 0 221.28 𝒙𝑻 – 1020 0
*Exchange rate risk – carry trade is a bet on the high-rate currency will not depreciate too much
A.C (2.!D)
Suppose 𝑥+ = 𝐹!,+ = 4.7 (random walk), 𝐹!,+ = (2.!A)
= 4.0696, 𝑟𝑒𝑡𝑢𝑟𝑛 = 221.28 × 4.6096 − 1020 = 0

2!.H (2.!I)
Arbitrage: 𝑥! = 10.5 𝐻𝐾𝐷/𝐺𝐵𝑃; 𝑥2 = 10 𝐻𝐾𝐷/𝐺𝐵𝑃; 𝑟<=> = 6%; 𝑟EFG = 3%; underlying = GBP; 𝐹!,2 = = 10.806 > 10; 𝐴𝑟𝑏𝑖𝑡𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 = 0.806;
(2.!J)
Underpriced (Fair > Actual) = reverse cash & carry (long forward + short/borrow underlying + convert underlying to foreign + lend foreign); Overpriced (Fair < Actual)
= cash & carry (short forward + long/lend underlying + convert foreign to underlying + borrow foreign)
Position T=0 T=1
HKD GBP HKD GBP
Long Forward (short
0 0 -10 1
forward reverse signs)
1/1.03
Short GBP Bonds
0 = 0.9708 (if c.c. then 0 -1
(Borrow GBP)
𝑒 %'!"## )
Convert GBP to HKD at 0.9708*10.5
-0.9708 0 0
T0 = 10.914
10.914*1.06
Lend HKD -10.914 0 0
= 10.806 (if c.c. then 𝑒 '$%&# )
TOTAL 0 0 0.806 0

Bond:
3K G(!,+)
𝑟! (𝑡, 𝑇) = 𝑍𝐶𝐵 𝑌𝑖𝑒𝑙𝑑, ZCB Bond Price: 𝑃! (𝑡, 𝑇) = = 𝑒 :'+ 𝑃! (𝑡, 𝑇) =
[27')(*,+)]+ G(!,*)

[27') (!,+)]+ G)(!,*) [27')(!,D)]1 G)(!,2)

One-year Implied Forward Rate: 1 + 𝑟! (𝑡, 𝑇) = [27') (!,*)]0
= 𝑒. 𝑔. 1 + 𝑟!(1,2) = =
G)(!,+) 27')(!,2) G)(!,D)
→ [1 + 𝑂𝑛𝑒 𝑦𝑒𝑎𝑟 𝑖𝑚𝑝𝑙𝑖𝑒𝑑 𝐹𝑅 (1,2)] × 1𝑠𝑡 𝑦𝑒𝑎𝑟 𝑍𝐶𝐵 𝑦𝑖𝑒𝑙𝑑 = [1 + 𝑟!(0,2)]D
𝑂𝑛𝑒 𝑦𝑒𝑎𝑟 𝑖𝑚𝑝𝑙𝑖𝑒𝑑 𝐹𝑅 (0,1) = 𝑟! (0,1) = 1𝑠𝑡 𝑦𝑒𝑎𝑟 𝑍𝐶𝐵 𝑌𝑖𝑒𝑙𝑑 𝑎𝑛𝑑 𝑃𝑎𝑟 𝐶𝑜𝑢𝑝𝑜𝑛
G) (!,*) G) (!,2)
Ø More than one-year implied FR: [1 + 𝑟! (𝑡, 𝑇)]+:* = 𝑒. 𝑔. [1 + 𝑟! (1,3)]J:2 =
G) (!,+) G) (!,J)
N N 3K7N
Bond Price: 𝐵! (0, 𝑇, 𝑐, 𝑛) = + + ⋯ + [27' = 𝑐𝑃! (0,1) + 𝑐𝑃! (0,2) + (𝐹𝑉 + 𝑐)𝑃! (0, 𝑇)
[27')(!,2)] [27')(!,D)]1 ) (!,+)]
+

𝟕 𝟕 𝟏𝟎𝟕
e.g. 1st year ZCB yield = 6%, One-year Implied FR (1,2) = 6.5%, Coupon rate = 7%, FV = 100, find YTM à 𝟏𝟎𝟎 = + + → 𝒓 = 𝒀𝑻𝑴
𝟏.𝟎𝟔 𝟏.𝟎𝟔×𝟏.𝟎𝟔𝟓 (𝟏7𝒓)𝟑
One-year Implied FR (0,1) = 2%, Coupon rate = 3%, FV = 1000, find 𝑃! (1,2)
2!!! J! J!72!!! 2!!!
𝑃! (1,2) = , 1000 = + (2,D)]
, 𝑟! (1,2) = 4.0404%, 𝑃!(1,2) = = 961.1650
27') (2,D) 2.!D 2.!D×[27') 27A.!A!A%

2:G) (!,+) 2:G) (!,+) 2:G) (2,J)

Par Coupon Rate: 𝑐 = ∑# = ; 𝑐2 = ; When the bond is priced at par, 𝑐 = 𝑌𝑇𝑀
.34 G) (!,*. ) G) (!,2)7G)(!,D)7⋯7G) (!,+) G)(2,D)7G) (2,J)

Use ZCB Price as interest rate to calculate PV/discount back to the present: 𝑃𝑉 = 𝑐 × 𝑃! (0, 𝑇)
Continuously Compounded Zero Yield: 𝑙𝑛 (1 + 𝑍𝐶𝐵 𝑌𝑖𝑒𝑙𝑑)

Equity-Linked CD:
e.g. S0 = 1300, initial investment = $10000; if ST < 1300, CD returns $10000; if ST > 1300, investor receives principal plus 70% of the gain
4+
i.e. the CD pays 10000 × [1 + 0.7 × max +0, − 1,] à long call + bond
2J!!
2!!!!
Suppose that the effective annual interest rate is 6%; after 5.5 years, the buyer has lost interest with a PV of 10000 − (𝑃𝑉 𝑜𝑓 𝐵𝑜𝑛𝑑) = $2742
2.!I5.5
à Imbedded option premium = $2742