Last Revised: 08/14/2023

2024 Level 2 - Derivatives

Learning Modules Page

Pricing and Valuation of Forward Commitments 2

Valuation of Contingent Claims 20

Review 44

M.M138463888.

This document should be used in conjunction with the corresponding learning modules in the 2024 Level 2 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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 Last Revised: 08/14/2023

Pricing and Valuation of Forward Commitments

a. describe the carry arbitrage model without underlying cashflows and with
underlying cashflows

b. describe how equity forwards and futures are priced, and calculate and interpret
their no-arbitrage value

c. describe how interest rate forwards and futures are priced, and calculate and
interpret their no-arbitrage value

d. describe how fixed-income forwards and futures are priced, and calculate and
interpret their no-arbitrage value

e. describe how interest rate swaps are priced, and calculate and interpret their no-
arbitrage value

f. describe how currency swaps are priced, and calculate and interpret their no-
arbitrage value

g. describe how equity swaps are priced, and calculate and interpret their no-
arbitrage value

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

M.M138463888.

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 Last Revised: 08/14/2023

Forwards/Futures Prices
Page 1
⇒ Arbitrage-free pricing & valuation LOS a, b
- describe
assumptions/ replicating instruments are identifiable
- compare
and investable - calculate
market frictions are nil - interpret
short selling is allowed with full use of proceeds
borrowing & lending are available at a known risk-
free rate
Notation: S – underlying
F – forward V – value of forward
f – futures v – value of futures

V0 = 0
- at contract initiation, the value of a futures/forward
contract = 0 (i.e. no money changes hands)
- at expiration, FT = fT = ST (called convergence)

VT = FT – F0 = ST – F0 (long) VT = F0 - FT = F0 – ST (short)

Page 2
- futures/ vt = ft – ft-1 futures are marked- LOS a, b
(before) to-market daily - describe
vt = 0 (after) - compare
- calculate
1/ no underlying cash flows F0 = S0erT - cont. comp. - interpret
or/ F0 = S0(1 + r)T - periodic comp.

e.g./ S0 = 100 Step #1. Borrow $100 for one year

rf = 5% Step #2. Buy S0
T = 1 yr. Step #3. Sell F0
Step #4. Payback loan of S0erT at time T
M.M138463888.

F0 = S0e = 100e
rT
= 105.127
.05(1)

F0 = S0(1 + r) = 100(1.05)1 = 105

T

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 Last Revised: 08/14/2023

Page 3
e.g./ S0 = 100
F0 = S0erT = 100e.05(1) = 105.127 LOS a, b
rf = 5% - describe
or/ F0 = S0(1 + r)T = 100(1.05)1 = 105
T = 1 yr. - compare
general rule : buy low, sell high - calculate
- interpret
Case 1: F0 = 110 Case 2: F0 = 90
- sell F0 (i.e. short) - Sell S0 for $100, invest @ 5%
- borrow $100, buy S0 - Buy F0 (i.e. long)
- at T, deliver S0 for $110 - at T, take delivery of S for $90, cover
- pay back $105 short position
- at time 0, borrow - profit = $15
reverse
5/1.05 = 4.762 - at time 0, borrow
carry carry
(get paid today) 15/1.05 = 14.286
arbitrage arbitrage
(get paid today)

Page 4
An Australian stock paying no dividends is trading in LOS a, b
Australian dollars for A$63.31, and the annual Australian - describe
interest rate is 2.75% with annual compounding. Based on - compare
the current stock price and the no-arbitrage approach, what - calculate
is the equilibrium three-month forward price? - interpret

S0 = 63.31 F0 = S0(1 + r)T

rf = 2.75% = 63.31(1.0275).25 = 63.74
T = .25

If the interest rate immediately falls 50 bps to 2.25%,

the three-month forward price will: ↓
63.31(1.0225).25 = 63.66
M.M138463888.

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 Last Revised: 08/14/2023

Page 5
1/ no underlying cash flows Key point: the LOS a, b
quoted forward price does not directly - describe
reflect expectations of future underlying prices - compare
- calculate
long
⇒ Value × × F0 = S0(1 + r)T - interpret
–

–
0 𝒕 short T
Ft = St(1 + r)T-t
𝐒𝐭
𝐅𝐭 − 𝐅𝟎 𝐅
𝐕𝐭 = 𝐨𝐫/ 𝐕𝐭 = 𝐒𝐭 − 𝟎>
(𝟏 + 𝐫)𝐓,𝐭 (𝟏 + 𝐫)𝐓,𝐭

× F0 = 105
e.g./ F0 = 105 V0 = 0
–

–
0 St = 110 T
T = 1 yr.
𝐅𝐭 = 𝐒𝐭 (𝟏 + 𝐫)𝐓&𝐭 = 𝟏𝟏𝟎(𝟏. 𝟎𝟓).𝟐𝟓
St = 110
𝟏𝟏𝟎 − 𝟏𝟎𝟓5 = 111.3499
𝒕 = 9 mos. (𝟏. 𝟎𝟓).𝟐𝟓
(𝟏𝟏𝟏. 𝟑𝟒𝟗𝟗 − 𝟏𝟎𝟓)
= 𝟔. 𝟐𝟕𝟐𝟗 𝐕𝐭 = = 𝟔. 𝟐𝟕𝟐𝟗
rf = 5% (𝟏. 𝟎𝟓).𝟐𝟓

Page 6
2/ Underlying with cash flows LOS a, b
𝛄 – gamma ⇒ benefits - describe
𝛉 – theta ⇒ costs 𝐅𝟎 = [𝐒𝟎 + 𝐏𝐕(𝛉) − 𝐏𝐕(𝛄)](𝟏 + 𝐫)𝐓 - compare
- calculate
increase decrease F0
- interpret
F0
e.g./ S0 = 100
𝟐. 𝟗𝟐𝟕𝟕
rf = 5% 𝐅𝟎 = %𝟏𝟎𝟎 + 𝟎 − 1 (𝟏. 𝟎𝟓)𝟏
(𝟏. 𝟎𝟓).𝟓
T = 1
= 102
CF = 2.9277 @ t = .5
𝟐.𝟗𝟐𝟕𝟕
- 3 mos. later St = 105 𝐅𝐭 = 3𝟏𝟎𝟓 + 𝟎 − (𝟏.𝟎𝟓).𝟐𝟓 6 (𝟏. 𝟎𝟓).𝟕𝟓 = 𝟏𝟎𝟓. 𝟗𝟏𝟑𝟒
(𝟏𝟎𝟓. 𝟗𝟏𝟑𝟒 − 𝟏𝟎𝟐)
𝐕𝐭 = >(𝟏. = 𝟑. 𝟕𝟕𝟐𝟖
𝟎𝟓).𝟕𝟓
𝟐. 𝟗𝟐𝟕𝟕 M.M138463888.
𝟏𝟎𝟐
B𝟏𝟎𝟓 − C− D(𝟏. 𝟎𝟓).𝟕𝟓 = 𝟑. 𝟕𝟕𝟐𝟖
(𝟏. 𝟎𝟓).𝟐𝟓

5
 Last Revised: 08/14/2023

Page 7
2/ Underlying with known yield LOS a, b
- describe
assumed to be continuous
- compare
𝐅𝟎 = 𝐒𝟎 𝐞(𝐫 𝐜 .𝛉,𝛄)𝐓 𝐫𝐜 - calculate
𝛉 all continuous rates - interpret
𝛄
Recall/ (𝟏 + 𝐫)𝐓 = 𝐞𝐫𝐜 𝐓 ⇒ 𝐥𝐧[(𝟏 + 𝐫)𝐓 ] = 𝐫𝐜 𝐓
𝐓 𝐥𝐧(𝟏.𝐫)
𝐓
= 𝐫𝐜

𝐫𝐜 = 𝐥𝐧 (𝟏 + 𝐫)
e.g./ rf = 5% annual

rc = ln (1.05) = 4.897% & e.04897 = 1.05

Page 8
A. Equities/ LOS a, b
- describe
The continuously compounded dividend yield on the EURO
- compare
STOXX 50 is 3%, and the current stock index level is 3,500.
- calculate
The continuously compounded annual interest rate is 0.15%.
- interpret
Based on the carry arbitrage model, the three-month futures
price will be closest to:
𝛄 = 3% rc = .15% 𝐅𝟎 = 𝐒𝟎 𝐞(𝐫𝐜 ,𝛄)𝐓
S0 = 3500 T = .25 = 𝟑𝟓𝟎𝟎𝐞(.𝟎𝟎𝟏𝟓,.𝟎𝟑).𝟐𝟓 = 𝟑𝟒𝟕𝟓. 𝟏𝟓

Suppose Nestlé common stock is trading for CHF70 and pays

a CHF2.20 dividend in one month. Further, assume the Swiss
one-month risk-free rate is 1.0%, quoted on an annual 𝐅𝟎 = (𝐒𝟎 − 𝐏𝐕(𝛄))
compounding basis. Assume that the stock goes ex-dividend (𝟏 + 𝒓)𝑻
the same day the single stock forward contract expires. Thus,
M.M138463888.
the single stock forward contract expires in one month.
𝟏5
𝐅𝟎 = 𝐒𝟎 (𝟏 + 𝐫)𝐓 − 𝛄 = 𝟕𝟎(𝟏. 𝟎𝟏) 𝟏𝟐 − 𝟐. 𝟐𝟎 = 𝟔𝟕, 𝟖𝟓𝟖
𝟏
(𝐒𝟎 − 𝐏𝐕(𝛄))(𝟏. 𝟎𝟏) 5𝟏𝟐

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 Last Revised: 08/14/2023

Page 9
Suppose we bought a one-year forward contract at 102 LOS a, b
and there are now three months to expiration. The underlying - describe
is currently trading for 110, and interest rates are 5% on an - compare
annual compounding basis. If there are no other carry cash - calculate
flows, the forward value of the existing contract will be closest to: - interpret

9 F0 = 102
𝐅𝐭 = 𝟏𝟏𝟎(𝟏. 𝟎𝟓).𝟐𝟓 = 𝟏𝟏𝟏. 𝟑𝟒𝟗𝟗
–

–
0 𝒕 T −𝟏𝟎𝟐
St = 110
𝟗. 𝟑𝟒𝟗𝟗
𝟏𝟏𝟎 − 𝟏𝟎𝟐D 𝟗. 𝟑𝟒𝟗𝟗9
(𝟏. 𝟎𝟓).𝟐𝟓 = 𝟗. 𝟐𝟑𝟔𝟓 (𝟏. 𝟎𝟓).𝟐𝟓 = 𝟗. 𝟐𝟑𝟔𝟓

If a dividend payment is announced between the forward’s valuation

and expiration dates, assuming the news announcement does not
change the current underlying price, the forward value will most likely:
↓ [𝐒𝟎 + 𝐏𝐕(𝛉) = 𝐏𝐕(𝛄)] decrease

Page 10
B. Interest Rates LOS a, b
forward rate agreement (OTC) - describe
- underlying is an interest rate on a deposit - compare
- calculate
long = floating rate receiver (pays fixed) - interpret
short = fixed rate receiver (pays floating)

- no exchange of notional amount

- FRA price is the fixed interest rate that eliminates arbitrage

3x9 FRA – the rate on a deposit that begins in 3

months and lasts for 6 months

L(90) f(3,6) = FRA fixed rate

–

M.M138463888.
0 3 9 K𝟑𝟎D𝟑𝟔𝟎L
L(270)

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 Last Revised: 08/14/2023

Page 11
B. Interest Rates LOS a, b
- describe
- compare
L(90) f(3,3) - calculate

–
FRA expires FRA payoff - interpret
L(180)
discounted back advanced
advanced set, advanced settled set, settled
(FRAs) in arrears
swaps
- receive floating interest
𝐝𝐚𝐲𝐬D
𝐍𝐀(𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 − 𝐟𝐢𝐱𝐞𝐝 𝐫𝐚𝐭𝐞) 3 𝟑𝟔𝟎6 rate options
𝐝𝐚𝐲𝐬D
X𝟏 + 𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 3 𝟑𝟔𝟎6Y
- receive fixed
𝐝𝐚𝐲𝐬D
𝐍𝐀(𝐟𝐢𝐱𝐞𝐝 𝐫𝐚𝐭𝐞 − 𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞) 3 𝟑𝟔𝟎6
𝐝𝐚𝐲𝐬D
X𝟏 + 𝐟𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 3 𝟑𝟔𝟎6Y

Page 12
B. Interest Rates LOS a, b
In 30 days, a UK company expects to make a bank deposit of - describe
£10,000,000 for a period of 90 days at 90-day Libor set 30 days - compare
from today. The company is concerned about a possible decrease - calculate
in interest rates. Its financial adviser suggests that it negotiates today, - interpret
at Time 0, a 1 × 4 FRA, an instrument that expires in 30 days and is
based on 90-day Libor. The company enters into a £10,000,000 notional
amount 1 × 4 receive-fixed FRA that is advanced set, advanced settled.
The appropriate discount rate for the FRA settlement cash flows is 0.40%.
After 30 days, 90-day Libor in British pounds is 0.55%. rec. fx. = fl.
L(30)
f(1,3)
M.M138463888.
–

0 30 120
L(120) L(90) = .55%

The interest actually paid at maturity on the UK company’s bank deposit will
be closest to:
𝟏𝟎𝐌 3. 𝟎𝟎𝟓𝟓K𝟗𝟎D𝟑𝟔𝟎L6 = 𝟏𝟑, 𝟕𝟓𝟎

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Page 13
B. Interest Rates LOS a, b
L(30) f(1,3) - describe
- compare

–
0 30 120
L(120) - calculate
L(90) = .55%
- interpret
If the FRA was initially priced at 0.60%, the payment
received to settle it will be closest to:
rec. fx. - pay fl.

𝐍𝐀(𝐟𝐱. 𝐫𝐚𝐭𝐞 − 𝐟𝐥. 𝐫𝐚𝐭𝐞)K𝟗𝟎D𝟑𝟔𝟎L 𝟏𝟎𝐌(. 𝟎𝟎𝟔 − . 𝟎𝟎𝟓𝟓)K𝟗𝟎D𝟑𝟔𝟎L

=
𝟏 + . 𝟎𝟎𝟒 K𝟗𝟎D𝟑𝟔𝟎L 𝟏 + . 𝟎𝟎𝟒 K𝟗𝟎D𝟑𝟔𝟎L
= 𝟏𝟐𝟒𝟖. 𝟕𝟓
If the FRA was initially priced at 0.50%, the payment
received to settle it will be closest to:
𝟏𝟎𝐌(. 𝟎𝟎𝟓 − . 𝟎𝟎𝟓𝟓)K𝟗𝟎D𝟑𝟔𝟎L −𝟏𝟐𝟓𝟎
= = −𝟏𝟐𝟒𝟖. 𝟕𝟓
𝟏 + . 𝟎𝟎𝟒 K𝟗𝟎D𝟑𝟔𝟎L 𝟏. 𝟎𝟎𝟏

Page 14
B. Interest Rates LOS a, b
L(180) = 1.5% - describe
?
!𝟑𝟎%𝟑𝟔𝟎& - compare
–

L(270) = 1.75% - calculate

- interpret
6 x 9 FRA fixed rate = ?

[𝟏 + . 𝟎𝟏𝟕𝟓K𝟐𝟕𝟎D𝟑𝟔𝟎L\ = [𝟏 + . 𝟎𝟏𝟓K𝟏𝟖𝟎D𝟑𝟔𝟎L\[𝟏 + 𝐱K𝟗𝟎D𝟑𝟔𝟎L\

𝟏 + . 𝟎𝟏𝟕𝟓K𝟐𝟕𝟎D𝟑𝟔𝟎L
= 𝟏 + 𝐱K𝟗𝟎D𝟑𝟔𝟎L
𝟏 + . 𝟎𝟏𝟓K𝟏𝟖𝟎D𝟑𝟔𝟎L

𝟏. 𝟎𝟎𝟓𝟓𝟖𝟑𝟏𝟐𝟕 = 𝟏 + 𝐱K𝟗𝟎D𝟑𝟔𝟎L
M.M138463888.

𝐱 = 𝟐. 𝟐𝟑𝟑%

9
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Page 15
B. Interest Rates LOS a, b
Suppose we entered a receive-floating 6 x 9 FRA at a rate of 0.86%, - describe
with notional amount of C$10,000,000 at Time 0. The six-month spot - compare
Canadian dollar (C$) Libor was 0.628%, and the nine-month C$ Libor - calculate
was 0.712%. Also, assume the 6 x 9 FRA rate is quoted in the market - interpret
at 0.86%. After 90 days have passed, the three-month C$ Libor is 1.25%
and the six-month C$ Libor is 1.35%.
Assuming the appropriate discount rate is C$ Libor, the value of the
original receive-floating 6 x 9 FRA will be closes to: NA(fl. - fx.)
L(180) = .628%
↓
L(270) = .712% x 𝟏 + . 𝟎𝟏𝟑𝟓!𝟏𝟖𝟎%𝟑𝟔𝟎&
.86%
' − 𝟏1 × 𝟒
-

-
0 L(90) = 1.25% T 𝟏 + . 𝟎𝟏𝟐𝟓!𝟗𝟎%𝟑𝟔𝟎&
6x9
L(180) = 1.35% =. 𝟎𝟏𝟒𝟒𝟓

(rec. fl., pay fx.) (pay fl., rec fx.) 𝟏𝟎𝐌(. 𝟎𝟏𝟒𝟓 − . 𝟎𝟎𝟖𝟔) 𝟗𝟎%𝟑𝟔𝟎
= 𝟏𝟒, 𝟔𝟓𝟏. 𝟏𝟎
-.86% +1.45% 𝟏 + . 𝟎𝟏𝟑𝟓 !𝟏𝟖𝟎%𝟑𝟔𝟎&

Page 16
C. Fixed Income Forwards LOS a, b
1. Full price = Clean Price + Accrued Interest - describe
(quoted price) - compare
- calculate
2. Fixed Income futures contracts are based on a
- interpret
generic bond i.e. Treasury Bond Futures – one contract involves
the delivery of $100,000 face value, 6% semi-annual
coupon
∴ underlying ≠ deliverable – short position decides what to deliver
e.g./ T-Bond futures ⇒ any gov’t. bond > 15 yrs. to
maturity as of Day 1 of the delivery period

∴ need a conversion factor – quoted price a bond would have

on the first day of the delivery period on the
M.M138463888.

assumption that the interest rate for all maturities = 6%

(Quoted futures price × CF) + AI defines the price to

be paid to the short
T-bond quote
side on delivery

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Page 17
C. Fixed Income Forwards LOS a, b
3. Cheapest-to-Deliver (CTD) – since the short - describe
side decides which bond to deliver, they - compare
- calculate
will choose the CTD
- interpret
- on Day T: cost to purchase deliverable bond = 𝐒𝐓 + 𝐀𝐈
Short side receives (𝐅𝐓 × 𝐂𝐅) + 𝐀𝐈
Cheapest-to-Deliver 𝐒𝐓 − (𝐅𝐓 × 𝐂𝐅)

e.g./ FT = 93.25

Bond PV CF Cost-to-Deliver
1 99.50 1.0382 99.50 – (93.25 × 1.0382) = 2.69
2 143.50 1.5188 143.50 – (93.25 × 1.5188) = 1.87
3 119.75 1.2615 119.75 – (93.25 × 1.2615) = 2.12

Page 18
C. Fixed Income Forwards LOS a, b
- describe
borrow I
- compare
–

0 T - calculate
buy bond S0 - interpret
· pay AI AI
X𝐒𝟎 + 𝐀𝐈 − 𝐈D(𝟏 + 𝐫)𝐭 Y (𝟏 + 𝐫)𝐓 owe X(𝐒𝟎 + 𝐀𝐈) − 𝐈D(𝟏 + 𝐫)𝐭 Y (𝟏 + 𝐫)𝐓
· sell ST = ?
· get AI (known amt.)
𝐅𝟎 = X(𝐒𝟎 + 𝐀𝐈) − 𝐈D(𝟏 + 𝐫)𝐭 Y (𝟏 + 𝐫)𝐓 − 𝐀𝐈

F0 = QF0 × CF
M.M138463888.
QF0 = F0/CF

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Page 19
C. Fixed Income Forwards LOS a, b
- describe
I 60d 122d I 148d 35d I
r = 10% - compare

–
0 T - calculate
CTD
- interpret
12%
270 days
PV = 120
CF = 1.4 𝐅𝟎 = X(𝐒𝟎 + 𝐀𝐈) − 𝐈D(𝟏 + 𝐫)𝐭 Y (𝟏 + 𝐫)𝐓 − 𝐀𝐈
𝟐𝟕𝟎*
:;𝟏𝟐𝟎 + 𝟔<𝟔𝟎9𝟏𝟖𝟐>? − 𝟔@ 𝟏𝟐𝟐 A (𝟏. 𝟏) 𝟑𝟔𝟓 = 𝟏𝟐𝟒. 𝟔𝟓𝟏𝟖𝟖𝟓
(𝟏. 𝟏) *𝟑𝟔𝟓
− 𝟔<𝟏𝟒𝟖9𝟏𝟖𝟑>
𝟏𝟏𝟗. 𝟕𝟗𝟗𝟒𝟐𝟔
𝐅𝟎D
𝐐𝐅𝟎 = 𝐂𝐅
= 𝟏𝟏𝟗. 𝟕𝟗𝟗𝟒𝟐𝟔D𝟏. 𝟒 = 𝟖𝟓. 𝟓𝟕𝟏

Page 20
C. Fixed Income Forwards LOS a, b
(1) I (1) - describe
CTD ½ month - compare
–

(2% semi) 0 T - calculate

CF = .729535 - interpret
1 month
S0 = 108 r = .1%
AI = 0.083

X(𝐒𝟎 + 𝐀𝐈) − 𝐈D( Y (𝟏 + 𝐫)𝐓 − 𝐀𝐈

𝐅𝟎D 𝟏 + 𝐫)𝐓
3𝐐𝐅𝟎 = 𝐐𝐅𝟎 =
𝐂𝐅6 𝐂𝐅
𝟏5
[(𝟏𝟎𝟖 + . 𝟎𝟖𝟑) − 𝟎](𝟏. 𝟎𝟎𝟏) 𝟏𝟐 − 𝟏3𝟏. 𝟓D𝟔6
=
. 𝟕𝟐𝟗𝟓𝟑𝟓
= 𝟏𝟎𝟕. 𝟖𝟒𝟐D. 𝟕𝟐𝟗𝟓𝟑𝟓 = 𝟏𝟒𝟕. 𝟖𝟐
M.M138463888.

𝐅𝟎 = 𝐐𝐅𝟎 × 𝐂𝐅 = 𝟏𝟒𝟕. 𝟖𝟐 × . 𝟕𝟐𝟗𝟓𝟑𝟓 = 𝟏𝟎𝟕. 𝟖𝟒𝟐

12
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Page 21
C. Fixed Income Forwards LOS a, b
- describe
1 month - compare
- calculate
r = .1% - interpret
–

–
0 𝒕 T

2 months
F0 = 145
long 5 forwards
Ft = 148 Ft = 148
F0 = 145
(underlying = $100,000) (148 - 145)
(𝟏𝟒𝟖 − 𝟏𝟒𝟓)
𝐕𝐭 = > 𝟏
(𝟏. 𝟎𝟎𝟏) 5𝟏𝟐
= 𝟐. 𝟗𝟗𝟗𝟕 /100 of par value

𝟏𝟎𝟎, 𝟎𝟎𝟎
𝐓𝐨𝐭𝐚𝐥 𝐕𝐚𝐥𝐮𝐞𝐭 = 𝟓 × × 𝟐. 𝟗𝟗𝟗𝟕 = 𝟏𝟒, 𝟗𝟗𝟖. 𝟓𝟎
𝟏𝟎𝟎

Page 22
D. Currency Forwards/Futures currencies can LOS a, b
rf – foreign risk-free rate be seen as - describe
r – domestic risk-free rate having a known - compare
yield - calculate
(𝟏 + 𝐫𝐟 )𝐓 (𝟏 + 𝐫) 𝐓
- interpret
𝐅𝐟5 = 𝐒𝐟5 𝐨𝐫 𝐅𝐝5 = 𝐒𝐝5
𝐝 𝐝 (𝟏 + 𝐫)𝐓 𝐟 𝐟 (𝟏 + 𝐫𝐟 )𝐓

𝐨𝐫/ 𝐅𝐟5 = 𝐒𝐟5 𝐞(𝐫𝐟 ,𝐫)𝐓 𝐅𝐝5 = 𝐒𝐝5 𝐞(𝐫,𝐫𝐟 )𝐓 Note: 𝐟9𝐝 or 𝐝9𝐟
𝐝 𝐝 𝐟 𝐟
does not matter
e.g./ USD/AUD = .6200 rAUD = 5% rUSD = 7% T = 2 years if rf = r
then F0 = S0
(𝟏 + 𝐫𝐔𝐒𝐃 )𝟐 𝐅𝐔𝐒𝐃M.M138463888.
= 𝐒𝐔𝐒𝐃5 𝐞(𝐫𝐔𝐒𝐃 ,𝐫𝐀𝐔𝐃)
𝐓

𝐅𝐔𝐒𝐃5 = 𝐒𝐔𝐒𝐃5 5 𝐀𝐔𝐃 𝐀𝐔𝐃 if rf > r

𝐀𝐔𝐃 𝐀𝐔𝐃 (𝟏 + 𝐫𝐀𝐔𝐃 )𝟐
= . 𝟔𝟐𝟎𝟎𝐞 (.𝟎𝟕,.𝟎𝟓)𝟐 then 𝐅𝐟* > 𝐒𝐟*
(𝟏. 𝟎𝟕)𝟐 𝐝 𝐝
= . 𝟔𝟐𝟎𝟎 = . 𝟔𝟒𝟓𝟑 & 𝐅𝐝* < 𝐒𝐝*
(𝟏. 𝟎𝟓)𝟐 𝐟 𝐟

= . 𝟔𝟒𝟑𝟖

13
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Page 23
D. Currency Forwards/Futures LOS a, b
e.g./ SGBP/EUR = 0.7920 rGBP = 1% rEUR = .3% T = 1 yr. - describe
- compare
(𝟏 + 𝐫𝐆𝐁𝐏 )𝟏 (𝟏. 𝟎𝟏) - calculate
𝐅𝐆𝐁𝐏5 = 𝐒𝐆𝐁𝐏5 = . 𝟕𝟗𝟐𝟎
𝐄𝐔𝐑 𝐄𝐔𝐑 (𝟏 + 𝐫𝐄𝐔𝐑 )𝟏 (𝟏. 𝟎𝟎𝟑) - interpret

= . 𝟕𝟗𝟕𝟓 (.798)

e.g./ A corporation sold €10,000,000 against a British pound forward at a forward

rate of £0.8000 for €1 at Time 0. The current spot market at Time t is such
that €1 is worth £0.7500, and the annually compounded risk-free rates are
0.80% for the British pound and 0.40% for the euro. Assume at Time t there
are three months until the forward contract expiration.
FGBP/EUR = .8000 3 mos. .8000
–

–
0 𝒕 T
𝐒𝐆𝐁𝐏5 = . 𝟕𝟓
𝐄𝐔𝐑
𝟑5
(. 𝟖𝟎𝟎𝟎 − . 𝟕𝟓𝟎𝟕)𝟏𝟎𝐌 (𝟏. 𝟎𝟎𝟖) 𝟏𝟐
𝟑*
= 𝟒𝟗𝟐, 𝟎𝟏𝟖. 𝟗𝟎 𝐅𝐆𝐁𝐏5 = . 𝟕𝟓𝟎𝟎 = . 𝟕𝟓𝟎𝟕
𝟑5
(𝟏. 𝟎𝟎𝟖) 𝟏𝟐 𝐄𝐔𝐑
(𝟏. 𝟎𝟎𝟒) 𝟏𝟐

Swaps
Page 24
A. Interest Rate Swaps/ LOS c, d
fixed fixed - describe
Company Dealer Company
- compare
A B - calculate
Libor Libor
- interpret
swap rate
bid spread spread ask
- the fixed rate a - the fixed rate a
dealer is willing dealer is willing
swap
to pay for Libor to accept for
rate
M.M138463888.
Libor

rate at which Vswap = 0 @ T = 0

Company A/ receive fixed, pay floating the swap rate is

lent - long a fixed rate bond the fixed rate
equiva
to: - short a floating rate bond such that
Bfx = Bfl

14
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Page 25
A. Interest Rate Swaps/ LOS c, d
- since Bfl = 100 at a reset date, solve for - describe
PMT to find the fixed rate - compare
- calculate
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏 - interpret
𝟏= + + ⋯ + notional = $1
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝐧 )𝐧

zero rates for maturities t1, t2 … tn

Since 𝟏&(𝟏 + 𝐫)𝐭 = 𝐃𝐅𝐭

𝟏 = 𝐏𝐌𝐓 ⋅ 𝐃𝐅𝟏 + 𝐏𝐌𝐓 ⋅ 𝐃𝐅𝟐 + ⋯ + 𝐏𝐌𝐓 ⋅ 𝐃𝐅𝐧 + 𝐃𝐅𝐧

𝐧

𝟏 = 𝐏𝐌𝐓 JK 𝐃𝐅L + 𝐃𝐅𝐧

𝐢0𝟏

𝐏𝐌𝐓 ⋅ ∑𝐃𝐅 = 𝟏 − 𝐃𝐅𝐧

𝟏 − 𝐃𝐅𝐧
𝐏𝐌𝐓 =
∑𝐃𝐅

Page 26
A. Interest Rate Swaps/ LOS c, d
e.g./ 5 yr. Libor-based interest rate swap with - describe
annual resets - compare
Maturity DF swap rate: - calculate
- interpret
1 .99099 𝟏 − 𝐃𝐅𝐧 𝟏 − . 𝟗𝟑𝟕𝟒𝟔𝟕
𝐫𝐟𝐢𝐱 = =
∑𝐃𝐅 𝟒. 𝟖𝟐𝟐𝟏𝟎𝟕
2 .977876
= . 𝟎𝟏𝟐𝟗𝟔𝟖
3 .965136
~ 𝟏. 𝟐𝟗𝟔𝟖%
4 .951529

5 .937467

4.822107
M.M138463888.

Valuation: 𝐕𝐬𝐰𝐚𝐩 = K𝐫𝐟𝐢𝐱 𝟎 − 𝐫𝐟𝐢𝐱 𝐭 L∑𝐃𝐅 𝐍𝐀 rec. fx., pay fl. T=0
(given current Libor) rec fl., pay fx. T=𝒕
𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐟𝐢𝐱𝟎 − 𝐕𝐟𝐢𝐱𝐭
= (𝐏𝐌𝐓𝟎 ⋅ 𝐃𝐅𝟏 + 𝐏𝐌𝐓𝟎 ⋅ 𝐃𝐅𝟐 + ⋯ + 𝐏𝐌𝐓𝟎 ⋅ 𝐃𝐅𝐧 + 𝐃𝐅𝐧 )
= (𝐏𝐌𝐓𝐭 ⋅ 𝐃𝐅𝟏 + 𝐏𝐌𝐓𝐭 ⋅ 𝐃𝐅𝟐 + ⋯ + 𝐏𝐌𝐓𝐭 ⋅ 𝐃𝐅𝐧 + 𝐃𝐅𝐧 )
= 𝐏𝐌𝐓𝟎 (∑𝐃𝐅) + 𝐃𝐅𝐧 − 𝐏𝐌𝐓𝐭 (∑𝐃𝐅) − 𝐃𝐅𝐧 = (𝐏𝐌𝐓𝟎 − 𝐏𝐌𝐓𝐭 )∑𝐃𝐅

15
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Page 27
A. Interest Rate Swaps/ 2 yrs. ago we entered into LOS c, d
a swap for €100M, 7-yr. rec. fx., pay Libor - describe
with annual resets, swap rate was 2% - compare
- calculate
Maturity DF
- interpret
1 .99099 - at T2: swap rate = 1.2968

2 .977876 rec. fx., pay. fl. T=0

- pay. fx., rec. fl. T=2
3 .965136
K𝐫𝐟𝐱𝟎 − 𝐫𝐟𝐱𝐭 L∑𝐃𝐅 ⋅ 𝐍𝐀
4 .951529

5 .937467

4.822107

∴ Vswap = (.02 - .012968)4.822107 100M

= 3,390,905 𝟑, 𝟑𝟕𝟓, 𝟎𝟎𝟎
3 6
𝟏. 𝟑%

Page 28
B. Currency Swaps/ LOS c, d
£10M - describe
- compare
Domestic 6% in USD Foreign - calculate
$14M £10M
Company Company - interpret
@ 6% 5% in £ @ 5%
(wants GBP) (wants USD)
$14M USD
- fixed-for-fixed

Pricing/ we can view the swap as a pair of fixed rate bonds

value of a currency swap = 0 when first negotiated

Vswap = VD – S0VF V – value of domestic bond

D
M.M138463888.

- the price of the swap VF – value of foreign bond

is the set of fixed rates S0 = Sd/f
that result in VD = Sd/f ⋅ VF

16
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B. Currency Swaps/ Page 29

e.g./ US Company wants $100M AUD for 1 yr. LOS c, d
- describe
use 1 yr. currency swap with quarterly resets
- compare
AUD/USD = 1.1400 (f/d) (30/360)
- calculate
Rate AUD DF - interpret
L(90) 2.50 𝟏 = . 𝟗𝟗𝟑𝟕𝟖𝟗
:6𝟏 + . 𝟎𝟐𝟓7𝟗𝟎5 89
𝟑𝟔𝟎 𝐫𝐟𝐱.𝐀𝐔𝐃 = 𝟏 − . 𝟗𝟕𝟐𝟕𝟔𝟑
L(180) 2.60 𝟏 = . 𝟗𝟖𝟕𝟏𝟔𝟕
:6𝟏 + . 𝟎𝟐𝟔7𝟏𝟖𝟎5 𝟑. 𝟗𝟑𝟑𝟖𝟕
𝟑𝟔𝟎89
𝟏 = . 𝟎𝟎𝟔𝟗𝟐𝟑𝟖𝟏
L(270) 2.70 :6𝟏 + . 𝟎𝟐𝟕7𝟐𝟕𝟎5 = . 𝟗𝟖𝟎𝟏𝟓𝟐
𝟑𝟔𝟎89
× 𝟒 = 𝟐. 𝟕𝟔𝟗𝟓%
L(360) 2.80 𝟏 = . 𝟗𝟕𝟐𝟕𝟔𝟑
:6𝟏 + . 𝟎𝟐𝟖7𝟑𝟔𝟎5
𝟑𝟔𝟎89
𝟑. 𝟗𝟑𝟑𝟖𝟕
USD DF
L(90) .10 𝟏 = . 𝟗𝟗𝟗𝟕𝟓𝟎
:6𝟏 + . 𝟎𝟎𝟏7𝟗𝟎5
𝟑𝟔𝟎89 𝐫𝐟𝐱.𝐔𝐒𝐃 = 𝟏 − . 𝟗𝟗𝟕𝟓𝟎𝟔
L(180) .15 𝟏 = . 𝟗𝟗𝟗𝟐𝟓𝟏
:6𝟏 + . 𝟎𝟎𝟏𝟓7𝟏𝟖𝟎5 𝟑. 𝟗𝟗𝟓𝟎𝟎𝟗
𝟑𝟔𝟎89
𝟏 = . 𝟎𝟎𝟎𝟔𝟐𝟒𝟐𝟐
L(270) .20 :6𝟏 + . 𝟎𝟎𝟐7𝟐𝟕𝟎5 = . 𝟗𝟗𝟖𝟓𝟎𝟐
𝟑𝟔𝟎89
× 𝟒 = . 𝟐𝟒𝟗𝟕%
L(360) .25 𝟏 = . 𝟗𝟗𝟕𝟓𝟎𝟔
:6𝟏 + . 𝟎𝟎𝟐𝟓7𝟑𝟔𝟎5 89
𝟑𝟔𝟎
𝟑. 𝟗𝟗𝟓𝟎𝟎𝟗

Page 30
B. Currency Swaps/
LOS c, d
e.g./ US Company wants $100M AUD for 1 yr.
- describe
use 1 yr. currency swap with quarterly resets
- compare
AUD/USD = 1.1400 (f/d) (30/360) - calculate
- interpret
87,719,298.25 USD
𝟏𝟎𝟎𝐌
% 1
𝟏. 𝟏𝟒
long VD 54,758.77 USD/q
US Company AUD Company
692,250 AUD/q
short VF
. 𝟎𝟐𝟕𝟔𝟗(𝟏𝟎𝟎𝐌) $100M AUD . 𝟎𝟎𝟐𝟒𝟗𝟕(𝟖𝟕, 𝟕𝟏𝟗, 𝟐𝟗𝟖. 𝟐𝟓)
𝟒 M.M138463888.
𝟒
Valuation/

𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐃 − 𝐒𝐭 𝐕𝐅 = 𝐍𝐀<𝐫𝐟𝐱𝐝 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 >

(𝐢𝐧 𝐝) 𝐒𝐭 = 𝐝9 − 𝐒𝐭 ⋅ 𝐍𝐀<𝐫𝐟𝐱𝐟 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 >
𝐟
𝐨𝐫 𝐕𝐬𝐰𝐚𝐩 = 𝐒𝐭 𝐕𝐃 − 𝐕𝐅
(𝐢𝐧 𝐟) 𝐒𝐭 = 𝐟9𝐝
𝐕𝐬𝐰𝐚𝐩 = 𝐏𝐚𝐲𝐦𝐞𝐧𝐭𝐬 𝐭𝐨 𝐛𝐞 𝐫𝐞𝐜𝐞𝐢𝐯𝐞𝐝 − 𝐏𝐚𝐲𝐦𝐞𝐧𝐭𝐬 𝐭𝐨 𝐛𝐞 𝐦𝐚𝐝𝐞

17
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Page 31
B. Currency Swaps/ 𝟏𝟎𝟎𝐌 LOS c, d
87,719,298.25 USD % 1
𝟏. 𝟏𝟒 - describe
54,758.77 USD/q - compare
US Company AUD Company - calculate
692,250 AUD/q
. 𝟎𝟐𝟕𝟔𝟗(𝟏𝟎𝟎𝐌) - interpret
$100M AUD
𝟒 . 𝟎𝟎𝟐𝟒𝟗𝟕(𝟖𝟕, 𝟕𝟏𝟗, 𝟐𝟗𝟖. 𝟐𝟓)
𝟒

60 days have passed (300 days left) 𝐒𝐀𝐔𝐃5 = 𝟏. 𝟏𝟑𝟎𝟎

𝐔𝐒𝐃
AUD DF
𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐃 − 𝐒𝐭 𝐕𝐅 = 𝐍𝐀(𝐫𝐔𝐒𝐃 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 )
L(30) 2.00 .998336 (USD) − 𝐒𝐝* ⋅ 𝐍𝐀(𝐫𝐀𝐔𝐃 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 )
𝐔𝐒𝐃5
L(120) 1.90 .993703 𝐀𝐔𝐃
𝐟
. 𝟎𝟎𝟐𝟒𝟗𝟕
L(210) 1.80 .989609 = 𝟖𝟕, 𝟕𝟏𝟗, 𝟐𝟗𝟖. 𝟐𝟓 % ⋅ 𝟑. 𝟗𝟗𝟒𝟖𝟒𝟏 + . 𝟗𝟗𝟖𝟑𝟑𝟔1
𝟒
L(300) 1.70 .986031 . 𝟎𝟐𝟕𝟔𝟗
3.967863 − 𝟏9𝟏. 𝟏𝟑 ⋅ 𝟏𝟎𝟎𝐌 % ⋅ 𝟑. 𝟗𝟔𝟕𝟖𝟔𝟑 + . 𝟗𝟖𝟔𝟎𝟑𝟏1
𝟒
USD DF = 𝟖𝟕, 𝟕𝟗𝟐, 𝟎𝟖𝟓. 𝟗𝟐 − 𝟖𝟗, 𝟔𝟗𝟎, 𝟏𝟑𝟓. 𝟓𝟒 = −𝟏, 𝟖𝟗𝟖, 𝟎𝟒𝟗. 𝟔𝟐
.50 .999584 = 𝟗𝟗, 𝟐𝟎𝟓, 𝟎𝟓𝟕. 𝟎𝟗 − 𝟏𝟎𝟏, 𝟑𝟒𝟗, 𝟖𝟓𝟑. 𝟐𝟎 = −𝟐, 𝟏𝟒𝟒, 𝟎𝟒𝟗. 𝟔𝟐
.40 .998668 (−𝟐, 𝟏𝟒𝟓, 𝟐𝟎𝟎)
.30 .998253
.20 .998336
3.994841

Page 32
C. Equity Swap/ LOS c, d
- describe
OTC contract ➞ one party pays a variable series
- compare
determined by an equity - calculate
➞ the other pays ➀ a variable rate - interpret
series determined by another equity or rate
➁ a fixed series
floating M.M138463888.
floating
a) receive equity, pay fixed
b) pay equity, receive fixed
equity equity
stock
⇒ Underlying for the equity leg index
custom portfolio

⇒ Equity leg cash flow can be with or without dividends

18
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Page 33
C. Equity Swap/ LOS c, d
Receive equity return, pay fixed NA(equity r – fixed r) - describe
pay floating NA(equity r – floating r) - compare
pay equity NA(equitya r – equityb r) - calculate
- interpret
e.g./ receive equity, pay fixed, quarterly resets (30/360)
NA = $5M (@ 1.6%/a)
equity index return = 4% for Q1
NA(equity – fixed r) = 5M(.04 - .004) = 180,000
equity index return = -6% for Q2
5M(-.06 - .004) = -320,000

⇒ Valuation/ Vswap = Vfx – Ve - receive fixed, pay equity

or Vswap = Ve – Vfx - receive equity, pay fixed

& fixed rate = 𝟏 − 𝐃𝐅𝐧

∑ 𝐃𝐅

Page 34
C. Equity Swap/ LOS c, d
150k 150k 150k 150k 150k + Pr
- describe
-

0 1 2 3 4 5 - compare
- calculate
receive fixed
6 months later - interpret
pay equity
rfx = 1.2% (all maturities = 1.2%
5 yr., annual resets (30/360)
rfx = 1.5% St = 105 - flat term structure)
S0 = 100
NA = $10M 𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐟𝐱 − 𝐕𝐞
Term DF = 𝐍𝐀(𝐫𝐟𝐱 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 )
.5 𝟏 = . 𝟗𝟗𝟒𝟎𝟑𝟔 𝐒
;6𝟏 + . 𝟎𝟏𝟐8𝟏𝟖𝟎& − 𝐍𝐀 ; 𝐭9𝐒 ?
𝟑𝟔𝟎9: 𝟎
1.5 𝟏 = . 𝟗𝟖𝟐𝟑𝟏𝟖
; = 𝟏𝟎𝐌(. 𝟎𝟏𝟓 ⋅ 𝟒. 𝟖𝟓𝟓𝟔𝟔𝟖 + . 𝟗𝟒𝟖𝟕𝟔𝟕)
<𝟏 + . 𝟎𝟏𝟐6𝟓𝟒𝟎&𝟑𝟔𝟎:= M.M138463888.

2.5 𝟏 = . 𝟗𝟕𝟎𝟖𝟕𝟒
− 𝟏𝟎𝐌;𝟏𝟎𝟓9𝟏𝟎𝟎?
;6𝟏 + . 𝟎𝟏𝟐8𝟗𝟎𝟎& 9:
𝟑𝟔𝟎 = 𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟐𝟎. 𝟐𝟎 − 𝟏𝟎, 𝟓𝟎𝟎, 𝟎𝟎𝟎
3.5 𝟏 = . 𝟗𝟓𝟗𝟔𝟗𝟑
;6𝟏 + . 𝟎𝟏𝟐8𝟏𝟐𝟔𝟎& 9: = −𝟐𝟖𝟑, 𝟗𝟕𝟗. 𝟖𝟎
𝟑𝟔𝟎
4.5 𝟏 = . 𝟗𝟒𝟖𝟕𝟔𝟕
;6𝟏 + . 𝟎𝟏𝟐8𝟏𝟔𝟐𝟎& 9:
𝟑𝟔𝟎
𝟒. 𝟖𝟓𝟓𝟔𝟔𝟖

19
 Last Revised: 08/14/2023

Valuation of Contingent Claims

a. describe and interpret the binomial option valuation model and its component
terms

b. calculate the no-arbitrage values of European and American options using a two-
period binomial model

c. identify an arbitrage opportunity involving options and describe the related

arbitrage

d. calculate and interpret the value of an interest rate option using a two-period
binomial model

e. describe how the value of a European option can be analyzed as the present value
of the option’s expected payoff at expiration

f. identify assumptions of the Black-Scholes-Merton option valuation model

g. interpret the components of the Black-Scholes-Merton model as applied to call

options in terms of a leveraged position in the underlying

h. describe how the Black-Scholes-Merton model is used to value European options

on equities and currencies

i. describe how the Black model is used to value European options on futures

j. describe how the Black model is used to value European interest rate options and
European swaptions

k. interpret each of the option Greeks

l. describe how a delta hedge is executed

M.M138463888.
m. describe the role of gamma risk in options trading

n. define implied volatility and explain how it is used in options trading

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

20
 Last Revised: 08/14/2023

Valuation of Contingent Claims

Page 1/
Contingent claim - provides the owner a right (not an obligation)
to a payoff determined by an underlying asset or rate
options ➞ valuation models (Binomial, BSM) based on the
principle of no arbitrage - no price risk
- no investment of personal
- valuation involves the following assumptions funds
1/ replicating instruments are identifiable/investable
2/ no market frictions
3/ short selling allowed with full use of proceeds
4/ underlying follows a known statistical distribution
5/ borrow or lend at 𝐫𝐟

Note: LOS 1-5 will be done as one block since they don’t separate
well

Page 2/
Binomial Model (one and two periods) LOS 1-5

L1 Review
/ 𝐮 and 𝐝 are based on the volatility
𝐮 = 𝐒 5𝐒
𝐭 𝐒𝐓. of the underlying
long stock 𝐜𝐓.
Short call 𝐒𝐭 𝐜 = 𝐦𝐚𝐱(𝟎, 𝐒𝐓 − 𝐗)
−𝐜𝟎
𝐝 = 𝐒 5𝐒
& 𝐒𝐓,
𝐭 𝐜𝐓,
Step 1/ find a hedge ratio (𝐡) to create a risk-free portfolio
such that 𝐡𝐒 . − 𝐜 . = 𝐡𝐒 , − 𝐜 ,
𝐡𝐒 . − 𝐡𝐒 ,
= −𝐜 , + 𝐜 .
M.M138463888.
➞ (𝐜 . − 𝐜 , )
𝐡(𝐒 . − 𝐒 , ) = 𝐜 . − 𝐜 ,
𝐜= − 𝐜>
𝐡=
𝐒= − 𝐒>

21
 Last Revised: 08/14/2023

Page 3/
Step 2: determine a risk-neutral probability (𝛑) LOS 1-5
(𝟏 + 𝐫) − 𝐝 𝐮
𝛑= 𝟏−𝛑
𝐮−𝐝 𝐒𝐭 𝛑 + (𝟏 − 𝛑) = 𝟏
(1 + r)
𝛑 or 100%
Step 3: Calculate 𝐜𝟎 (or 𝐩𝟎 ) 𝐝
.
𝛑 𝐜
𝛑𝐜 . + (𝟏 − p)𝐜 , 𝛑𝐩. + (𝟏 − p)𝐩,
𝐜𝟎 = 𝐩𝟎 =
𝐜 (𝟏 + 𝐫) (𝟏 + 𝐫)
𝟎

(𝟏 − 𝛑) 𝐜,
135 𝐡 = (𝟑𝟓 − 𝟎)/(𝟏𝟑𝟓 − 𝟕𝟒) = . 𝟓𝟕𝟑𝟕𝟕
35 𝟏. 𝟎𝟓𝟏𝟓 − . 𝟕𝟒 . 𝟑𝟏𝟏𝟓
e.g./ 𝐒𝐭 = 100
𝛑= = 9. 𝟔𝟏 = . 𝟓𝟏𝟎𝟔𝟓𝟔
𝐱 = 100 𝟏. 𝟑𝟓 − . 𝟕𝟒
𝐮 = 1.35 74 . 𝟓𝟏𝟎𝟔𝟓𝟔(𝟑𝟓)
𝐝 = .74 ∅
𝐜𝟎 = = 𝟏𝟔. 𝟗𝟗𝟖
𝟏. 𝟎𝟓𝟏𝟓
𝐫𝐟 = 5.15%

Page 4/
135 𝐡 = . 𝟓𝟕𝟑𝟕𝟕 LOS 1-5
e.g./ 𝐒𝐭 = 100 35 𝛑 = . 𝟓𝟏𝟎𝟔𝟓𝟔
𝐱 = 100 𝐜𝟎 = 𝟏𝟔. 𝟗𝟗𝟖
𝐮 = 1.35 74
𝐝 = .74 ∅
𝐫𝐟 = 5.15% risk-free portfolio = long .57377 shares
short 1 call option
𝐮: .57377(100)(1.35) = 77.45895
- 35
42.45895
𝐝: .57377(100)(.74) = 42.45898

or/ put-call parity

(𝟏 − . 𝟓𝟏𝟎𝟔𝟓𝟔)𝟐𝟔 M.M138463888.
𝐒𝟎 + 𝐩 = 𝐜 + 𝐏𝐕(𝐱)
𝐩𝟎 = 𝐩 = 𝐜 + 𝐏𝐕(𝐱) − 𝐒𝟎
𝟏. 𝟎𝟓𝟏𝟓
= 𝟏𝟐. 𝟎𝟗𝟗𝟖 = 𝟏𝟔. 𝟗𝟗𝟖 + 𝟏𝟎𝟎%𝟏. 𝟎𝟓𝟏𝟓 − 𝟏𝟎𝟎
= 𝟏𝟐. 𝟏𝟎

22
 Last Revised: 08/14/2023

Binomial Option Valuation Model

Page 5/

𝐒 .. 𝐌𝐚𝐱(𝟎, 𝐒 .. − 𝐱)
𝐜 .. = 𝐌𝐚𝐱(𝟎, 𝐮𝟐 𝐒 − 𝐱)
𝐮 𝐒.
𝐜.
𝐒 𝐒 ., 𝐌𝐚𝐱(𝟎, 𝐒 ., − 𝐱)
𝐜 𝐜 ., = 𝐌𝐚𝐱(𝟎, 𝐮𝐝𝐒 − 𝐱)
𝐝 𝐒,
𝐜,
𝐒 ,, 𝐌𝐚𝐱(𝟎, 𝐒 ,, − 𝐱)
𝐜 ,, = 𝐌𝐚𝐱(𝟎, 𝐝𝟐 𝐒 − 𝐱)
recombining lattice 𝐜 .. − 𝐜 .,
𝚫. = ..
𝐒 − 𝐒 .,
work backwards
𝐜 ., − 𝐜 ,,
𝚫, =
𝐒 ., − 𝐒 ,,

Page 6/

132.389
c = 57.389 𝟓𝟕. 𝟑𝟖𝟗 − 𝟎
𝐮 = 1.356 97.632 𝚫= =
𝟏𝟑𝟐. 𝟑𝟖𝟗 − 𝟓𝟐. 𝟖𝟏𝟗𝟏
c = 33.43
𝐒 = 72 52.8191 = . 𝟕𝟐𝟏𝟐𝟒
c = 19.474 0
38.952
𝟎−𝟎
𝐝 = 0.541 𝚫> = =𝟎
X = 75 c= 0 𝐒 =>
− 𝐒 >>
𝐫 = 3%/a 21.07303 𝟏. 𝟎𝟑 − . 𝟓𝟒𝟏
𝟑𝟑. 𝟒𝟑 − 𝟎 0 𝛑= = . 𝟔𝟎
𝚫= = . 𝟓𝟔𝟗𝟕 𝟏. 𝟑𝟓𝟔 − . 𝟓𝟒𝟏
𝟗𝟕. 𝟔𝟑𝟐 − 𝟑𝟖. 𝟗𝟓𝟐
. 𝟔(𝟓𝟕. 𝟑𝟖𝟗) + . 𝟒(𝟎)
. 𝟔(𝟑𝟑. 𝟒𝟑) + . 𝟒(𝟎) 𝐜= =
𝐜= = 𝟏𝟗. 𝟒𝟕𝟒 𝟏. 𝟎𝟑
𝟏. 𝟎𝟑 M.M138463888.

= 𝟑𝟑. 𝟒𝟑

23
 Last Revised: 08/14/2023

Page 7/
𝟐 .. ., 𝟐 ,,
𝛑 𝐜 + 𝟐𝛑(𝟏 − 𝛑)𝐜 + (𝟏 − 𝛑) 𝐜
𝐜=
(𝟏 + 𝐫)𝟐

91.94 𝟏. 𝟎𝟓 − . 𝟕𝟒𝟒
𝐮 = 1.356 𝐜 ""
= 41.94
𝛑= = .𝟓
67.80 𝟏. 𝟑𝟓𝟔 − . 𝟕𝟒𝟒

𝐒 = 50 50.4432
𝐜 "# = .4432
X = 50 37.20
𝐝 = .744
𝐫 = 5% 27.6768 and/
0 𝐗
𝐒+𝐩= +𝐜
(𝟏 + 𝐫)𝟐
. 𝟓𝟐 (𝟒𝟏. 𝟗𝟒) + 𝟐(. 𝟓)(. 𝟓). 𝟒𝟒𝟑𝟐 + (. 𝟓)𝟐 (𝟎)
𝐜= 𝟓𝟎 + 𝐩 = 𝟓𝟎9( + 𝟗. 𝟕𝟏𝟏𝟐
(𝟏. 𝟎𝟓)𝟐 𝟏. 𝟎𝟓)𝟐
𝟏𝟎. 𝟒𝟖𝟓 + . 𝟐𝟐𝟏𝟔 𝐩 = 𝟒𝟓. 𝟑𝟓𝟏𝟒𝟕𝟑 + 𝟗. 𝟕𝟏𝟏𝟐 − 𝟓𝟎
= = 𝟗. 𝟕𝟏𝟏𝟐
𝟏. 𝟎𝟓𝟐 = 𝟓. 𝟎𝟔𝟐𝟔

Page 8/
⇒ American Style Options/
Calls ⇒ early exercise results in loss of time
value
∴ better to sell than exercise
- no change in valuing 𝐜 between European & American
Puts ⇒ early exercise results in a premium over European
style options
e.g./ 132.389
𝐩=0 𝐈𝐕 = 𝐗 − 𝐒𝐭 = 𝟕𝟓 − 𝟑𝟖. 𝟗𝟓𝟐
97.632
𝐩 = 8.61401 52.81891 = 𝟑𝟔. 𝟎𝟒𝟖
𝐒 = 72
𝐩 = 18.16876 𝐩 = 22.18109
vs. 𝟑𝟑. 𝟖𝟔𝟑𝟓𝟑
38.952
𝐫 = 3%/a 𝐩 = 33.86353 21.07303
M.M138463888. - early exercise
X = 75 𝐩 = 53.92697
premium = 2.18447

24
 Last Revised: 08/14/2023

Page 9/
e.g./ 𝐒𝟎 = 26, X = 25, 𝐮 = 1.466, 𝐝 = 0.656 , 𝐫 = 2.05%

- find exercise premium of put over European

put price assuming a 2-period model
𝟏. 𝟎𝟐𝟎𝟓 − . 𝟔𝟓𝟔
𝛑=
55.87806 𝟏. 𝟒𝟔𝟔 − . 𝟔𝟓𝟔
𝐮 = 1.466
𝐩= 0 = 𝟎. 𝟒𝟓
38.116
𝐩=0 . 𝟒𝟓(𝟎) + . 𝟓𝟓(𝟏𝟑. 𝟖𝟏𝟏𝟐𝟔)
25.0041 𝐩=
26 𝟏. 𝟎𝟐𝟎𝟓
𝐩=0
17.056 = 𝟕. 𝟒𝟒𝟑𝟔
𝐝 = 0.656 𝐩 = 7.944 . 𝟒𝟓(𝟎) + . 𝟓𝟓(𝟕. 𝟒𝟒𝟑𝟔)
11.18874
𝐩=
𝐩 = 13.81126 𝟏. 𝟎𝟐𝟎𝟓
. 𝟒𝟓(𝟎) + . 𝟓𝟓(𝟕. 𝟗𝟒𝟒)
𝐩=
𝟏. 𝟎𝟐𝟎𝟓
= 𝟒. 𝟐𝟖𝟏𝟒𝟑 premium = 𝟒. 𝟎𝟏𝟏𝟕𝟑𝟗
= .26969

Page 10/
- Adjusting for dividends/
8𝟏𝟎𝟎 − 𝟑&𝟏. 𝟎𝟏9 × 𝟏. 𝟐𝟐𝟒
𝐮 = 1.224 145.3676
𝐜 = 50.3676 . 𝟓(𝟓𝟎. 𝟑𝟔𝟕𝟔)
118.7644 𝐜. =
𝟏. 𝟎𝟏
𝐜 = 26.7644
𝐒𝟎 = 100 = 𝟐𝟒. 𝟗𝟑𝟒
94.5364
X = 95 𝐜=0
𝐫 = 1% 77.2356
𝐝 = .796 Am. Style allows
𝐃𝟏 = $3 𝐜=0
61.4796 exercise before
𝐜=0 ex-div.
𝟏. 𝟎𝟏 − . 𝟕𝟗𝟔
𝛑= = . 𝟓𝟎 𝐜 = 𝐌𝐚𝐱(𝟎, 𝐒𝐓 − 𝐗)
𝟏. 𝟐𝟐𝟒 − . 𝟕𝟗𝟔
= 𝐌𝐚𝐱(𝟎, 𝟏𝟏𝟖. 𝟕𝟔𝟒𝟒 + 𝟑 − 𝟗𝟓)
M.M138463888.
= 𝟐𝟔. 𝟕𝟔𝟒𝟒

25
 Last Revised: 08/14/2023

Page 11/
e.g./ 𝐒𝟎 = $7.35 X = 8.00 put/calls ⇒ 2 yrs.
𝐫 = 4.35% 𝐮 = 1.445 𝐝 = 0.715
1) 𝐩 & 𝐜 @ 𝐓𝟎 & 𝐓𝟏 ⇒ European
𝐓𝟏
𝐜 .. = 𝐌𝐚𝐱(𝟎, 𝐮𝟐 𝐒 − 𝐗) 𝐩.. = 𝐌𝐚𝐱(𝟎, 𝐗 − 𝐮𝟐 𝐒)
= 𝐌𝐚𝐱(𝟎, 𝟏. 𝟒𝟒𝟓𝟐 𝟕. 𝟑𝟓 − 𝟖) = 𝐌𝐚𝐱(𝟎, 𝟖 − 𝟏. 𝟒𝟒𝟓𝟐 𝟕. 𝟑𝟓)
= 𝟕. 𝟑𝟒𝟕 =𝟎
𝐜 ., = 𝐌𝐚𝐱(𝟎, 𝐮𝐝𝐒 − 𝐗) 𝐩., = 𝐌𝐚𝐱(𝟎, 𝐗 − 𝐒𝐮𝐝)
= 𝐌𝐚𝐱(𝟎, 𝟏. 𝟒𝟒𝟓(. 𝟕𝟏𝟓)(𝟕. 𝟑𝟓) − 𝟖) = 𝐌𝐚𝐱(𝟎, 𝟖 − 𝟕. 𝟑𝟓(𝟏. 𝟒𝟒𝟓)(. 𝟕𝟏𝟓))
=𝟎 = . 𝟒𝟎𝟔
𝐜 ,, = 𝐌𝐚𝐱(𝟎, 𝐝𝟐 𝐒 − 𝐗) 𝐩,, = 𝐌𝐚𝐱(𝟎, 𝐗 − 𝐒𝐝𝟐 )
= 𝐌𝐚𝐱(𝟎, . 𝟕𝟏𝟓𝟐 𝟕. 𝟑𝟓 − 𝟖) = 𝐌𝐚𝐱(𝟎, 𝟖 − 𝟕. 𝟑𝟓(. 𝟕𝟏𝟓)𝟐 )
=𝟎 = 𝟒. 𝟐𝟒

Page 12/
e.g./ 𝐒𝟎 = $7.35 X = 8.00 put/calls ⇒ 2 yrs.
𝐫 = 4.35% 𝐮 = 1.445 𝐝 = 0.715
1) 𝐩 & 𝐜 @ 𝐓𝟎 & 𝐓𝟏 ⇒ European 𝟏. 𝟎𝟒𝟑𝟓 − . 𝟕𝟏𝟓
𝛑= = 𝟎. 𝟒𝟓
𝐜 .. = 7.347 𝐩.. = 0 𝟏. 𝟒𝟒𝟓 − . 𝟕𝟏𝟓
𝐜 ., = 0 𝐩., = .406 . 𝟒𝟓(𝟎) + . 𝟓𝟓(. 𝟒𝟎𝟔)
𝐩. = = . 𝟐𝟏𝟒
𝐜 ,, = 0 𝐩,, = 4.24 𝟏. 𝟎𝟒𝟑𝟓
. 𝟒𝟓(𝟕. 𝟑𝟒𝟕) . 𝟒𝟓(. 𝟒𝟎𝟔) + . 𝟓𝟓(𝟒. 𝟐𝟒)
𝐜= = = 𝟑. 𝟏𝟔𝟖 𝐩, = = 𝟐. 𝟒𝟏
𝟏. 𝟎𝟒𝟑𝟓 𝟏. 𝟎𝟒𝟑𝟓
𝐜, = 𝟎
(. 𝟒𝟓)𝟐 (𝟕. 𝟑𝟒𝟕) + 𝟐(. 𝟒𝟓)(. 𝟓𝟓)(𝟎) + (. 𝟓𝟓)M.M138463888.
𝟐
𝟎 (. 𝟒𝟓)𝟐 𝟎 + 𝟐(. 𝟒𝟓)(. 𝟓𝟓)(. 𝟒𝟎𝟔) + (. 𝟓𝟓)𝟐 𝟒. 𝟐𝟒
𝐜= 𝐩=
(𝟏. 𝟎𝟒𝟑𝟓) 𝟐
(𝟏. 𝟎𝟒𝟑𝟓)𝟐
= 𝟏. 𝟒𝟖𝟖&(𝟏. = 𝟏. 𝟑𝟕 = 𝟏. 𝟒𝟖𝟒&(𝟏. = 𝟏. 𝟑𝟔
𝟎𝟒𝟑𝟓)𝟐 𝟎𝟒𝟑𝟓)𝟐

26
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Page 13/
e.g./ 𝐒𝟎 = $7.35 X = 8.00 put/calls ⇒ 2 yrs.
𝐫 = 4.35% 𝐮 = 1.445 𝐝 = 0.715
2) ∆ @ 𝐓𝟏 & 𝐓𝟎 = European
𝐒 .. = 𝟕. 𝟑𝟓(𝟏. 𝟒𝟒𝟓)𝟐 = 𝟏𝟓. 𝟑𝟒𝟕
𝐜 = 7.347
..
𝐩 =0
..
𝐒 ., = 𝟕. 𝟑𝟓(𝟏. 𝟒𝟒𝟓)(. 𝟕𝟏𝟓) = 𝟕. 𝟓𝟗𝟒
𝐜 ., = 0 𝐩., = .406
𝐜 ,, = 0 𝐩,, = 4.24 𝐒 ,, = 𝟕. 𝟑𝟓(. 𝟕𝟏𝟓)𝟐 = 𝟑. 𝟕𝟓𝟖
𝐜 .. − 𝐜 ., 𝟕. 𝟑𝟒𝟕 − 𝟎 𝐩.. − 𝐩., 𝟎 − . 𝟒𝟎𝟔
𝐡.
𝐜 = .. = 𝐡.
𝐩 = .. =
𝐒 − 𝐒 ., 𝟏𝟓. 𝟑𝟒𝟕 − 𝟕. 𝟓𝟗𝟒 𝐒 − 𝐒 ., 𝟏𝟓. 𝟑𝟒𝟕 − 𝟕. 𝟓𝟗𝟒
= . 𝟗𝟒𝟕𝟔 = −. 𝟎𝟓𝟐𝟑
𝐜 ., − 𝐜 ,, 𝟎 𝐩., − 𝐩,, . 𝟒𝟎𝟔 − 𝟒. 𝟐𝟒
𝐡,
𝐜 = ., = =𝟎 𝐡,
𝐩 = ., = = −𝟏
𝐒 − 𝐒 ,, 𝐒 .. − 𝐒 ,, 𝐒 − 𝐒 ,, 𝟕. 𝟓𝟗𝟒 − 𝟑. 𝟕𝟓𝟖

Page 14/
e.g./ 𝐒𝟎 = $7.35 , X = 8.00 put/call ⇒ 2 yrs.
𝐫 = 4.35% 𝐮 = 1.445 𝐝 = 0.715
2) ∆ @ 𝐓𝟏 & 𝐓𝟎 ⇒ European

𝐜. − 𝐜, 𝐩. − 𝐩,
𝐡𝐜 = . 𝐡𝐩 =
𝐒 − 𝐒, 𝐒. − 𝐒,
𝟑. 𝟏𝟔𝟖𝟑𝟐 − 𝟎 . 𝟐𝟏𝟒𝟎 − 𝟐. 𝟒𝟏
= =
𝟏𝟎. 𝟔𝟐𝟎𝟕 − 𝟓. 𝟐𝟓𝟓𝟑 𝟏𝟎. 𝟔𝟐𝟎𝟕 − 𝟓. 𝟐𝟓𝟓𝟑
= . 𝟓𝟗𝟎𝟓 = −. 𝟒𝟎𝟗𝟐𝟗

M.M138463888.

27
 Last Revised: 08/14/2023

Page 15/
Puts/
Ⓐ 15.347
𝚫 = -.05237 Ⓐ Buy a put for
10.6207 0
𝚫 = -.40929 .214
.214 = Sell .05237
Ⓒ 7.35 7.594
1.36
shares @ $10.6207
.406
= .5562
Buy a put @ $1.36 5.2553 (Lend 0.77022)
= Sell .40929 shares 2.41 3.758
@ 7.35 = 3.0083
(Lend 4.3683) 𝚫 = -1.0 Ⓑ 4.24
Buy a put @ $2.41
= Sell 1 share @ $5.2553
(Lend $7.6653)

Page 16/
Calls/
Ⓐ 15.347
𝚫 = .9476
7.347 Ⓐ Buy a call @
10.6207
𝚫 = .5905 3.1683
3.1683
Ⓒ 7.35 7.594 = Buy .9476 shares
1.37 0 @ 10.6207 = $10.064
Buy call @ $1.37 5.2553 (Borrow $6.8958)
= Buy .5905 shares 0
3.758
@ 7.35 = $4.34
(Borrow $2.97)
𝚫 =0 Ⓑ 0
Buy a Call @ $0
= Buy 0 shares for $0
(Borrow/lend $0)
M.M138463888.

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Interest Rate Options

Page 17/
e.g./ NA = $1M

X = 3.25% 3.9706%
.96180
𝛑 = 0.50 3.9084% 𝐜 .. = .007206
.962386 𝐜 ., = .000042
3.0454% 3.2542% 𝐜 ,, = 0
DF = .970446 .968484
𝐩.. = 0
2.6034% 𝐩., = 0
.974627 2.2593% 𝐩,, = .009907
⇒ find 𝐩 & 𝐜 .977906
. 𝟓(. 𝟎𝟎𝟕𝟐𝟎𝟔) + . 𝟓(. 𝟎𝟎𝟎𝟎𝟒𝟐)
𝐜= = 𝐩= = 𝟎%𝟏. 𝟎𝟑𝟗𝟎𝟖𝟒 = 𝟎
𝟏. 𝟎𝟑𝟗𝟎𝟖𝟒
= . 𝟎𝟎𝟑𝟒𝟖𝟖
. 𝟓(𝟎) + . 𝟓(. 𝟎𝟎𝟗𝟗𝟎𝟕)
>
. 𝟓(. 𝟎𝟎𝟎𝟎𝟒𝟐) 𝐩> =
𝐜 = 𝟏. 𝟎𝟐𝟔𝟎𝟑𝟒
𝟏. 𝟎𝟐𝟔𝟎𝟑𝟒
= . 𝟎𝟎𝟒𝟖𝟐𝟖

Page 18/
e.g./ NA = $1M

X = 3.25% 3.9706%
.96180
𝛑 = 0.50 3.9084% 𝐜 .. = .007206
.962386 𝐜 ., = .000042
3.0454% 3.2542%
𝐜 ,, = 0
DF = .970446 .968484
𝐩.. = 0
2.6034%
𝐩., = 0
.974627 2.2593% 𝐩,, = .009907
⇒ find 𝐩 & 𝐜 .977906
. 𝟓(. 𝟎𝟎𝟑𝟒𝟖𝟖) + . 𝟓(. 𝟎𝟎𝟎𝟎𝟐)M.M138463888. 𝐜 . = .003488
𝐜= = . 𝟎𝟎𝟏𝟕𝟎𝟐𝟏𝟔
𝟏. 𝟎𝟑𝟎𝟒𝟓𝟒 𝐜 , = .00002

. 𝟓(𝟎) + . 𝟓(. 𝟎𝟎𝟒𝟖𝟐𝟖) 𝐩. = 0

𝐩= = . 𝟎𝟎𝟐𝟑𝟒𝟐𝟔𝟔
𝟏. 𝟎𝟑𝟎𝟒𝟓𝟒 𝐩, = .004828

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BSM Assumptions
Page 19/
⇒ percentage changes in stock prices in
a short period of time are
approximately normally distributed
- changes in successive time periods are independent
∴ stock price itself has lognormal distribution

0 lognormal dist. normal dist.

bounded by ∴ 𝐥𝐧 𝐒𝐓 is normal So,

𝟐 𝐄(𝐒𝐓 ) = 𝐒𝟎 𝐞𝛍𝐓
zero 𝐦𝐞𝐚𝐧 = 𝐥𝐧 𝐒𝟎 + 3𝛍 − 𝛔 D𝟐6 𝐓
𝐬. 𝐝. = 𝛔 √𝐓

Page 20/
e.g./ 𝐒 = $40 , 𝐄(𝐑) = 16%/annum
𝟎
volatility = 20%/annum

- What is the prob. dist. of 𝐒𝐓 in 6 mos.?

𝟐
𝐥𝐧 𝐒𝐓 ~ 𝐍 3𝐥𝐧 𝐒𝟎 + X𝛍 − 𝛔 D𝟐Y 𝐓, 𝛔√𝐓6
𝟐
B𝐥𝐧 𝟒𝟎 + X. 𝟏𝟔 − . 𝟐 D𝟐Y . 𝟓, K. 𝟐√. 𝟓LC
𝐥𝐧 𝐒𝐓 ~ 𝐍(𝟑. 𝟕𝟓𝟗, 𝟎. 𝟏𝟒𝟏)
95% CI/
M.M138463888.
𝟑. 𝟕𝟓𝟗 − (𝟏. 𝟗𝟔 × 𝟎. 𝟏𝟒𝟏) < 𝐥𝐧 𝐒𝐓 < 𝟑. 𝟕𝟓𝟗 + (𝟏. 𝟗𝟔 × 𝟎. 𝟏𝟒𝟏)
𝐞𝟑.𝟕𝟓𝟗 , (𝟏.𝟗𝟔 × 𝟎.𝟏𝟒𝟏) < 𝐒𝐓 < 𝐞𝟑.𝟕𝟓𝟗 . (𝟏.𝟗𝟔 × .𝟏𝟒𝟏)

𝟑𝟐. 𝟓𝟓 < 𝐒𝐓 < 𝟓𝟔. 𝟓𝟔

30
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Page 21/
Assumptions/
1. Stock prices are lognormally distributed
2. No transaction costs
3. No arbitrage opportunities
4. Trading is continuous
5. borrowing/lending at 𝐫𝐟 , and 𝐫𝐟 is constant
6. European options
7. Constant & known volatility of the underlying
8. Liquid underlying, divisible
9. Short selling with full use of proceeds
10. GBM describes price movements – continuous & smooth

BSM Model
Page 22/
𝐜 = 𝐒 𝐍(𝐝𝟏 ) − 𝐞,𝐫𝐓 𝐗 𝐍(𝐝𝟐 ) 𝐍( )
(𝐒 − 𝐗𝐞 ,𝐫𝐓 ) - standard normal cumulative
distribution
𝐩 = 𝐞,𝐫𝐓 𝐗 𝐍(−𝐝𝟐 ) − 𝐒 𝐍(−𝐝𝟏 )
𝟐
𝐥𝐧!𝐒%𝐗& + J𝐫 + 𝛔 %𝟐M 𝐓
(𝐗𝐞,𝐫𝐓 − 𝐒) 𝐝𝟏 =
𝛔√𝐓
- since the BSM is a 𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓
cdf
continuous time model,
𝐫 here is a continuously
compounded rate
- 𝐍(𝐗) ➞ represents risk-neutral
probabilities M.M138463888.

𝐫 = 𝐫𝐟 𝐗 = -1.645
then 𝐍(𝐗) = .05

31
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Page 23/
𝐜 = 𝐒 𝐍(𝐝𝟏 ) − 𝐞,𝐫𝐓 𝐗 𝐍(𝐝𝟐 ) 𝐩 = 𝐞,𝐫𝐓 𝐗 𝐍(−𝐝𝟐 ) − 𝐒 𝐍(−𝐝𝟏 )
⇒ BSM can be seen as having 2 components
Calls/ stock component 𝐒 𝐍(𝐝𝟏 )
bond component 𝐞,𝐫𝐓 𝐗 𝐍(𝐝𝟐 ) or 𝐗𝐞,𝐫𝐓
𝐜 = stock component – bond component
𝐒−𝐁 - goal is to replicate option payoffs
𝐒 𝐍(𝐝𝟏 ) 𝐗𝐞 ,𝐫𝐓
𝐍(𝐝𝟐 ) with stocks & zero coupon bonds
Puts/ stock component 𝐒 𝐍(−𝐝𝟏 )
bond component 𝐗𝐞,𝐫𝐓 𝐍(−𝐝𝟐 )
𝐩 = bond component – stock component
𝐁−𝐒
𝐗𝐞,𝐫𝐓 𝐍(−𝐝𝟐 ) 𝐒 𝐍(−𝐝𝟏 )

Page 24/
- cost of stock + bond portfolio = 𝐜 or 𝐩
Calls/ cost 𝐧𝐒 𝐒 + 𝐧𝐁 𝐁

𝐍(𝐝𝟏 ) = 𝐧𝐒 > 𝟎 −𝐍(𝐝𝟐 ) = 𝐧𝐁 < 𝟎

buy stock sell bonds

replicate payoff of a long call

- as 𝐒 rises, 𝐍(𝐝𝟏 ) rises, as 𝐒 drops, 𝐍(𝐝𝟏 ) drops
∴
must hedge by buying more stock in rising
markets and sell stock in falling markets
- cumulative losses of buying high & selling low = 𝐜
∴ by ‘Law of One Price’, total cost of stock + bond
portfolio = 𝐜 M.M138463888.

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Page 25/
e.g./ 𝐒 = 100 𝐗 = 100 𝐫 = 5% 𝐓 = 1.0 𝛔 = 30%
𝟐 𝟐
𝐥𝐧K𝐒D𝐗L + 3𝐫 + 𝛔 D𝟐6 𝐓 𝐥𝐧(𝟏) + 3. 𝟎𝟓 + . 𝟑 D𝟐6 𝟏. 𝟎
𝐝𝟏 = =
𝛔√𝐓 . 𝟑√𝟏
𝟎 + . 𝟎𝟗𝟓
𝐝𝟐 = . 𝟑𝟏𝟔𝟕 − . 𝟑 = . 𝟎𝟏𝟔𝟕 = = . 𝟑𝟏𝟔𝟕
.𝟑
𝐍(𝐝𝟏 ) = 𝐍(.3167) = .624 [𝐍 ~ (0,1)]
𝐍(𝐝𝟐 ) = 𝐍(.0167) = .507 - prob. that call option expires ITM
𝐍(−𝐝𝟏 ) = 𝐍(-.3167) = 1 - .624 = .376 𝐏(𝐒𝐓 > 𝐗)

𝐍(−𝐝𝟐 ) = 𝐍(-.0167) = 1 - .507 = .493 - prob. that put option expires

ITM
𝐜 = 𝐒 𝐍(𝐝𝟏 ) − 𝐗𝐞>𝐫𝐓 𝐍(𝐝𝟐 ) = 𝟏𝟎𝟎(. 𝟔𝟐𝟒) − 𝟏𝟎𝟎𝐞>.𝟎𝟓 (. 𝟓𝟎𝟕) = 𝟏𝟒. 𝟏𝟕
(buy shares) (sell bonds)
𝐩 = 𝐗𝐞>𝐫𝐓 𝐍(−𝐝𝟐 ) − 𝐒 𝐍(−𝐝𝟏 ) = 𝟏𝟎𝟎𝐞>.𝟎𝟓 (. 𝟒𝟗𝟑) − 𝟏𝟎𝟎(. 𝟑𝟕𝟔) = 𝟗. 𝟐𝟗
(buy bonds) (short shares)

Page 26/
Buy a Call Sell a Call
Replicate - buy 𝐍(𝐝𝟏 ) 𝐒𝐓 - sell 𝐍(𝐝𝟏 ) shares −𝐒𝐓
shares
- sell 𝐍(𝐝𝟐 )% - buy 𝐍(𝐝𝟐 )% of
−𝐗 +𝐗
of a zero a zero
𝐒 𝐍(𝐝𝟏 ) − 𝐗𝐞>𝐫𝐓 𝐍(𝐝𝟐 ) 𝐒 − 𝐍(𝐝𝟏 ) − 𝐗𝐞>𝐫𝐓 − 𝐍(𝐝𝟐 )

Buy a Put Sell a Put

- buy 𝐍(−𝐝𝟐 )% 𝐗 - sell 𝐍(−𝐝𝟐 )% −𝐗
of a zero of a bond
- sell 𝐍(−𝐝𝟏 ) shares −𝐒𝐓 - buy 𝐍(−𝐝𝟏 ) +𝐒𝐓
shares
𝐗𝐞>𝐫𝐓 )
𝐍(−𝐝𝟐 − 𝐒 𝐍(−𝐝𝟏 ) 𝐗𝐞
M.M138463888. >𝐫𝐓
− 𝐍(−𝐝𝟐 ) − 𝐒 − 𝐍(−𝐝𝟏 )

33
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Page 27/
⇒ modifications for carry benefits/
𝐜 = 𝐒𝐞,𝛄𝐓 𝐍(𝐝𝟏 ) − 𝐗𝐞,𝐫𝐓 𝐍(𝐝𝟐 )
𝛄 – carry benefits
𝐩 = 𝐗𝐞,𝐫𝐓 𝐍(−𝐝𝟐 ) − 𝐒𝐞,𝛄𝐓 𝐍(−𝐝𝟏 ) expressed as a
𝟐 continuous yield
𝐥𝐧K𝐗D𝐒L + 3𝐫 − 𝛄 + 𝛔 D𝟐6 𝐓
𝐝𝟏 = 𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓
𝛔√𝐓
lowers 𝐝𝟏
Note: carry benefits
∴ lowers 𝐝𝟐 – the prob. (𝐒𝐓 − 𝐗 > 𝟎)
lower the value of
- the prob. of the call being ITM drops the underlying
as 𝛄 rises - reduces value of calls
⇒ using put-call parity/ - increases value of puts

𝐒𝐞,𝛄𝐓 + 𝐩 = 𝐗𝐞,𝐫𝐓 + 𝐜

Page 28/
⇒ modifications for carry benefits/
BSM applied to equities (𝛄 = 𝛅)
𝐜 = 𝐒𝐞,𝛅𝐓 𝐍(𝐝𝟏 ) − 𝐗𝐞,𝐫𝐓 𝐍(𝐝𝟐 )
𝐩 = 𝐗𝐞,𝐫𝐓 𝐍(−𝐝𝟐 ) − 𝐒𝐞,𝛅𝐓 𝐍(−𝐝𝟏 )

BSM applied to currencies K𝛄 = 𝐫 𝐟 L

𝐜 = 𝐒𝐞,𝐫𝐟 𝐓 𝐍(𝐝𝟏 ) − 𝐗𝐞,𝐫𝐓 𝐍(𝐝𝟐 )
𝐩 = 𝐗𝐞,𝐫𝐓 𝐍(−𝐝𝟐 ) − 𝐒𝐞,𝐫𝐟 𝐓 𝐍(−𝐝𝟏 )

M.M138463888.

34
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Black Model
Page 29/
𝐜 = [𝐅𝟎 (𝐓) 𝐍(𝐝𝟏 ) − 𝐗 𝐍(𝐝𝟐 )]𝐞,𝐫𝐓
𝐅𝟎 (𝐓)9 𝛔𝟐
𝐅𝐓 − 𝐗 𝐥𝐧 ; 𝐗? + ; 9𝟐? 𝐓
𝐝𝟏 =
𝛔√𝐓
𝐩 = [𝐗 𝐍(−𝐝𝟐 ) − 𝐅𝟎 𝐍(−𝐝𝟏 )]𝐞,𝐫𝐓
𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓
𝐗 − 𝐅𝟎
CL - NOV. 17 - $50 (1000)
e.g./ Calls Puts call $55 cheap/ (𝐗)
𝐍(𝐝𝟏 ) = .491 𝐍(−𝐝𝟏 ) = .509
Call = 𝐏𝐕(. 𝟒𝟗𝟏 × 𝐅𝟎 (𝐓) − . 𝟒𝟔𝟏 × 𝐗)
𝐍(𝐝𝟐 ) = .461 𝐍(−𝐝𝟐 ) = .539
Put = 𝐏𝐕!. 𝟓𝟑𝟗 × 𝐗 − . 𝟓𝟎𝟗 × 𝐅𝟎 (𝐓)&
𝐜 = $51.41 𝐩 = $59.76

Page 30/

𝐍(𝐝𝟐 )
𝐗
- the further out of the
money the strike, the
lower the probability of
𝐅𝟎 exercise
(i.e. ⇒ lower 𝐍(𝐝𝟐 ))

𝐍(𝐝𝟐 ) - in the money call,

M.M138463888.
higher probability of
𝐅𝟎
exercise
𝐗

35
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Black Model - Interest Rates

𝐑 𝐓𝟏,𝐓𝟐 = 𝐑 𝐅 Page 31/
𝐓𝟏 𝐓𝟐

𝐅𝐑𝐀(𝐑 𝐤 )

- interest rate call option

⇒ underlying = FRA
⇒ underlying = Libor rate
𝐓𝟐
𝐜 = 𝐀𝐏 [𝐅𝐑𝐀 𝐍(𝐝𝟏 ) − 𝐗 𝐑 𝐍(𝐝𝟐 )]𝐞,𝐫𝐓

𝐅𝐑𝐀𝐓𝟏 ,𝐓𝟐 exercise accrual period of option

rate 𝐅𝐑𝐀𝐓𝟏,𝐓𝟐 𝟐
𝐥𝐧 T V𝐗 W + J𝛔 %𝟐M 𝐓
𝐑
𝐝𝟏 =
𝐩 = 𝐀𝐏 [𝐗 𝐑 𝐍(−𝐝𝟐 ) − 𝐅𝐑𝐀 𝐍(−𝐝𝟏 )]𝐞,𝐫𝐓 𝛔√𝐓
𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓

Page 32/
⇒ if 𝐗 𝐑 = 𝐅𝐑𝐀𝟎
long FRA = borrower
gets 𝐑 𝐦
long call receive floating
+ short put pay fixed
𝐗 pays 𝐗 long put receive fixed
+ short call pay floating

⇒ Caps/
get

pay pay pay

.5yr 1yr 1.5yr M.M138463888.

caplet + caplet + caplet = Cap

36
 Last Revised: 08/14/2023

Page 33/
⇒ Caps/
6.915%
e.g./
6.004%
NA = $100
5.54% 5.437%
𝐗 = 5.75%
(up - up)
4.721% (semi)

4.275
Time 0 1 2
At T = 0, 𝐫 = 5.54% , 𝐗 𝐑 ⇒ OTM Company receives $0
pays $2.77
At T = 1, 𝐫 = 6.004%, 𝐗 𝐑 ⇒ ITM Company receives 0.127
pays 3.002
net $ 2.875
At T = 2, 𝐫 = 6.915%, 𝐗 𝐑 ⇒ ITM Company receives .5825
pays 3.4575
net $ 2.875

Page 34/
⇒ Floors/ puts
receive
- a floating rate
receive receive investment with a
floor

.5yrs 10yrs 15yrs

floorlet + floorlet + floorlet = Floor

⇒ long a floor – receive fixed

fixed for floating swap
short a cap – pay floating M.M138463888.

⇒ if 𝐗 𝐑 = swap rate , 𝐕𝐜𝐚𝐩 = 𝐕𝐟𝐥𝐨𝐨𝐫 ∴ cost = $0

37
 Last Revised: 08/14/2023

Page 35/
⇒ Swaptions/ - option on a swap
- holder ⇒ right to enter a swap at a
pre-agreed swap rate (fixed)
- if swap rate increases
Payer swaption – pay fx., get fl.
before expiration, buyer
fixed
enters into a pay fx. @ 𝐗 𝐑
Receiver swaption – get fx., pay fl. get fl.
⇒ can enter an offsetting
𝐧
receive fixed-pay floating
𝐏𝐕𝐀 = {(𝐫𝐟𝐢𝐱 − 𝐗 𝐑 ) 𝐍𝐀
swap
𝐣O𝟏
- floating legs offset
- annuity = fixed rate – 𝐗 𝐑

Page 36/

𝐏𝐚𝐲𝐬𝐰𝐧 = [𝐑 𝐟𝐢𝐱 𝐍(𝐝𝟏 ) − 𝐗 𝐑 𝐍(𝐝𝟐 )] 𝐏𝐕𝐀

𝐑 𝐟𝐢𝐱D 𝛔𝟐D 6 𝐓
𝐥𝐧 3 𝐗𝐑 6 + 3 𝟐
𝐑𝐞𝐜𝐬𝐰𝐧 = [𝐗 𝐑 𝐍(−𝐝𝟐 ) − 𝐑 𝐟𝐢𝐱 𝐍(−𝐝𝟏 )] 𝐏𝐕𝐀 𝐝𝟏 =
𝛔√𝐓

𝐞,𝐫𝐓 ? where is the discount factor? 𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓

When
- since the payment is a series swaption
of payments, the 𝐏𝐕𝐀 embeds the expires
discount factor

M.M138463888.

38
 Last Revised: 08/14/2023

Option Greeks
Page 37/
Delta/ - change in the value of the option
for a change in the price of the
underlying
underlying itself has delta = 1

𝐃𝐞𝐥𝐭𝐚𝐜 = 𝐞,𝛅𝐓 𝐍(𝐝𝟏 ) - for a given 𝐗, 𝐝𝐞𝐥𝐭𝐚𝐜 + 𝐝𝐞𝐥𝐭𝐚𝐩 = 1.0

,𝛅𝐓
𝐃𝐞𝐥𝐭𝐚𝐩 = 𝐞 𝐍(−𝐝𝟏 )
∴ long call, short put at some 𝐗
= 𝐞>𝛅𝐓 𝐍(𝐝𝟏 ) + −𝐞>𝛅𝐓 𝐍(−𝐝𝟏 )
= 𝐞>(𝛅𝐓>𝛅𝐓) !𝐍(𝐝𝟏 ) + 𝐍(−𝐝𝟏 )&
= 𝐞𝟎 (𝟏)
=𝟏×𝟏 =𝟏
➞ a 𝐓 ➞ 0 , 𝐝𝐞𝐥𝐭𝐚 ➞ 0 or 1 (OTM vs. ITM)

Page 38/
Delta/ Call

Call (delta)

for small changes in 𝐒, option

delta is fairly accurate

- for larger changes, delta loses accuracy

- delta hedging ⇒ taking an offsetting delta position
so as to be delta neutral

e.g./ long 100 shares = long 100 deltas protects from

M.M138463888. small moves
sell 2 ATM calls = short (50 x 2) deltas up/down in
𝐒.

39
 Last Revised: 08/14/2023

Page 39/
- delta hedging/
- delta neutral implies
(portfolio delta + 𝐍𝐇 𝐃𝐞𝐥𝐭𝐚𝐇 ) = 0

e.g. 100 + -2 (50) = 0

−𝐩𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐝𝐞𝐥𝐭𝐚 −𝟏𝟎𝟎
𝐍𝐇 = = 9𝟓𝟎 = −𝟐
𝐃𝐞𝐥𝐭𝐚𝐇

e.g./ 𝐒 = 100 𝐗 = 100 𝐫 = 5% 𝐓 = 1.0 𝛔 = 30% 𝛅 = 5%

position: short puts on 10,000 shares

𝐃𝐞𝐥𝐭𝐚𝐜 = 0.532 delta hedge = short 4,190 shares

𝐃𝐞𝐥𝐭𝐚𝐩 = -0.419 or
delta hedge = −𝟒𝟏𝟗𝟎9. 𝟓𝟑𝟐 = −𝟕, 𝟖𝟕𝟔 calls

Page 40/
Gamma/ - the change in an option’s delta
for a change in 𝐒𝟎
e.g./ 𝐒𝟎 = 50 , 𝐗 = 50 delta = .50 gamma = .03
as 𝐒𝟎 ➞ 51, 𝐜 ↑ .50 , but as 𝐒𝟎 ➞ 52, 𝐜 ↑ .53
- a measure of the curvature in option price vs. the
stock price
𝐞,𝛅𝐓
𝐠𝐚𝐦𝐦𝐚𝐜 = 𝐠𝐚𝐦𝐦𝐚𝐩 = 𝐧(𝐝𝟏 ) ⇒ 𝐩𝐝𝐟, 𝐧𝐨𝐭 𝐜𝐝𝐟.
𝐒 𝛔√𝐓
i.e. at 𝐒 & 𝐗 , 𝐝𝐞𝐥𝐭𝐚𝐜 + 𝐝𝐞𝐥𝐭𝐚𝐩 = 1.0 let 𝐠 = change in delta

at 𝐒 + 𝐆 & 𝐗 , 𝐝𝐞𝐥𝐭𝐚𝐜.𝐠 + 𝐝𝐞𝐥𝐭𝐚𝐩,𝐠 = 1.0 𝐆 = change in 𝐒

- gamma of underlying = 0, since delta is constant at 1

(the underlying will always move
M.M138463888. 1-for-1 with itself)

40
 Last Revised: 08/14/2023

Page 41/
Gamma/ - gamma is always non-negative
& is largest ATM
- gamma very small when deep ITM/OTM
- gamma measures the risk that remains once a portfolio
is delta neutral
- gamma risk can be managed to a specific
level but never eliminated
e.g./ long 100 shares = 100 deltas

a) sell 2 ATM calls = short 100 deltas

highest gamma Sell 2 calls
Buy 60 shares
b) sell deep ITM calls/ e.g. - 𝐝𝐞𝐥𝐭𝐚𝐜 = .80
Sell 1 call
lowest gamma
Sell 20 shares

Page 42/
Gamma/
𝐠𝐚𝐦𝐦𝐚𝐜
𝐜𝐧𝐞𝐰 − 𝐜𝐨𝐥𝐝 ≈ (𝐒𝐧𝐞𝐰 − 𝐒𝐨𝐥𝐝 )𝐝𝐞𝐥𝐭𝐚𝐜 + (𝐒𝐧𝐞𝐰 − 𝐒𝐨𝐥𝐝 )𝟐
𝟐
𝐠𝐚𝐦𝐦𝐚𝐩
𝐩𝐧𝐞𝐰 − 𝐩𝐨𝐥𝐝 ≈ (𝐒𝐧𝐞𝐰 − 𝐒𝐨𝐥𝐝 )𝐝𝐞𝐥𝐭𝐚𝐩 + (𝐒𝐧𝐞𝐰 − 𝐒𝐨𝐥𝐝 )𝟐
𝟐
Call
(delta + Call
gamma)

Call(delta)

M.M138463888.

41
 Last Revised: 08/14/2023

Page 43/
⇒ Theta/ - a change in 𝐜 & 𝐩 for a change
in time to expiration
long options = negative theta (time is your enemy)
short options = positive theta (time is your friend)

- theta = rate of option decay

𝐜
- theta cannot be adjusted by
positions in the
𝐩 underlying
-

30d 60d 90d 120d

Page 44/
⇒ Vega/ - change in 𝐜 & 𝐩 for a change
in volatility
long options = positive vega (long volatility)
short options = negative vega (short volatility)
- vega is based on future volatility (unobservable)
- option value is very sensitive to vega
$𝐜
$𝐩 call value

put value

M.M138463888.
-
-
-
-
-
-

5 10 15 20 25 30

42
 Last Revised: 08/14/2023

Page 45/
⇒ Rho/ - a change in 𝐜 & 𝐩 for a change in
the risk-free rate
calls - positive rho (𝐒𝟎 𝐞𝐫𝐓 ) – raises cost of carry as 𝐫𝐟 ↑
puts – negative rho (𝐗𝐞,𝐫𝐓 ) – lowers 𝐏𝐕 as 𝐫𝐟 ↑
$𝐜
$𝐩
call value

put value
𝐫𝐟
-
-
-
-
-

5 10 15 20 25

Implied Volatility
Page 46/
⇒ volatility can be estimated from historical data
- in BSM, vol. is ‘future volatility’
- volatility can be inferred from prices ⇒ implied volatility
- common to see different implied vols. for different
➞ exercise prices
- volatility smile/skew
➞ times to expiration
- term structure of volatility
➞ positions with the same terms (puts & calls)
- options are sometimes quoted in volatilities Belief
e.g./ 3-mos. ATM call @ 19% IV on an index 25%
1-mos. ITM put @ 24% IV on a component 20%
Action: Buy index Call, sell component put
M.M138463888.

(long vol.) (short vol.)

43
 Last Revised: 08/14/2023

REVIEW

M.M138463888.

44
 Last Revised: 08/14/2023

Pricing & Valuation of Forward Commitments

Review - 1
- general:
1) no underlying cash flows: F0 = S0(1 + r)T F0 = S0erT
Vt = Ft – F0 Vt = (Ft – F0)e-r(T-t)
(1 + r)T-t

2) underlying cash flows: 𝐅𝟎 = [𝐒𝟎 + 𝐏𝐕(𝛉) − 𝐏𝐕(𝛄)](𝟏 + 𝐫)𝐓

$ $
3) underlying with known yield 𝐅𝟎 = 𝐒𝟎 𝐞 (𝐫 . 𝛉 , 𝛄)𝐓

%
A/ Equities ➞ all equations above

B/ Interest Rates ➞ Forward Rate Agreement

- advanced set
6x9 FRA advanced settled
–

–
0 6 9
expires payoff

discounted back

Review - 2
B/ Interest Rates ➞ Forward Rate Agreement
- rec. fl. - rec. fx.
𝐝𝐚𝐲𝐬D 𝐝𝐚𝐲𝐬D
𝐍𝐀(𝐟𝐥. 𝐫𝐚𝐭𝐞 − 𝐟𝐱. 𝐫𝐚𝐭𝐞) 3 𝟑𝟔𝟎6 𝐍𝐀(𝐟𝐱. 𝐫𝐚𝐭𝐞 − 𝐟𝐥. 𝐫𝐚𝐭𝐞) 3 𝟑𝟔𝟎6
𝐝𝐚𝐲𝐬D 𝐝𝐚𝐲𝐬D
X𝟏 + 𝐟𝐥. 𝐫𝐚𝐭𝐞 3 𝟑𝟔𝟎6Y X𝟏 + 𝐟𝐥. 𝐫𝐚𝐭𝐞 3 𝟑𝟔𝟎6Y

C/ Fixed Income
𝐅𝟎D
Quoted Futures Price (QF0) 𝐐𝐅𝟎 = 𝐂𝐅

- generic bond
M.M138463888.

deliverable bonds
CTD

𝐅𝟎 = X(𝐒𝟎 + 𝐀𝐈) − 𝐈𝐧𝐭.D(𝟏 + 𝐫)𝐭 Y (𝟏 + 𝐫)𝐓 − 𝐀𝐈 F0 = QF0 × CF

45
 Last Revised: 08/14/2023

Review - 3
D. Currency Forwards rf – foreign int. rate
r – domestic int. rate
(𝟏 + 𝐫𝐟 )𝐓 (𝟏 + 𝐫)𝐓
𝐅𝐟5 = 𝐒𝐟5 𝐨𝐫 𝐅𝐝5 = 𝐒𝐝5
𝐝 𝐝 (𝟏 + 𝐫)𝐓 𝐟 𝐟 (𝟏 + 𝐫𝐟 )𝐓

𝐨𝐫 𝐅𝐟5 = 𝐒𝐟5 𝐞(𝐫𝐟 ,𝐫)𝐓 𝐅𝐝5 = 𝐒𝐝5 𝐞(𝐫,𝐫𝐟)𝐓

𝐝 𝐝 𝐟 𝐟

(𝐅𝟎 − 𝐅𝐓 )𝐍𝐀 (𝐅𝐭 − 𝐅𝟎 )𝐍𝐀

𝐕𝐭 = (short) 𝐕𝐭 = (long)
(𝟏 + 𝐫)𝐓,𝐭 (𝟏 + 𝐫)𝐓,𝐭

1. Interest Rate Swaps fixed rate = 𝟏 − 𝐃𝐅𝐧

∑ 𝐃𝐅
𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐟𝐱𝟎 − 𝐕𝐟𝐱𝐭
= 𝐍𝐀K𝐫𝐟𝐱𝟎 − 𝐫𝐟𝐱𝐭 L∑𝐃𝐅

Review - 4
2. Currency Swaps - 2 fixed rates
𝟏 − 𝐃𝐅𝐧 𝟏 − 𝐃𝐅𝐧
𝐫𝐝𝐨𝐦 = 𝐫𝐟𝐨𝐫 =
∑𝐃𝐅 ∑𝐃𝐅

𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐃 − 𝐒𝐝5 𝐕𝐅 - in domestic currency

𝐟
= 𝐍𝐀K𝐫𝐟𝐱𝐝 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 L − 𝐒𝐭 ⋅ 𝐍𝐀K𝐫𝐟𝐱𝐟 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 L

𝐕𝐬𝐰𝐚𝐩 = 𝐒𝐟5 ⋅ 𝐕𝐃 − 𝐕𝐅 – in foreign currency

𝐝
= 𝐒𝐭 ⋅ 𝐍𝐀K𝐫𝐟𝐱𝐝 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 L − 𝐍𝐀K𝐫𝐟𝐱𝐟 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 L

3. Equity Swaps NA (equity r – fixed r) - rec. equity, pay fx.

𝐒
𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐞 − 𝐕𝐟 = 𝐍𝐀 3 𝐭D𝐒 6 − 𝐍𝐀(𝐫𝐟𝐱 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 )
𝟎
or
𝐒
𝐕𝐬𝐰𝐚𝐩 = 𝐕𝐟 − 𝐕𝐞 = 𝐍𝐀(𝐫𝐟𝐱 ⋅ ∑𝐃𝐅 + 𝐃𝐅𝐧 ) − 𝐍𝐀 3 𝐭D𝐒 6
M.M138463888.
𝟎
(rec. fx., pay equity)

46
 Last Revised: 08/14/2023

Valuation of Contingent Claims

Review - 1
⇒ Binomial Option Valuation Model/ no-arbitrage

r = 5.15% 𝐜. − 𝐜, 𝟑𝟓 − 𝟎
(S+)
𝚫= . ,
= = . 𝟓𝟕𝟑𝟕𝟕𝟎𝟓
135 𝐒 −𝐒 𝟏𝟑𝟓 − 𝟕𝟒
u = 1.35
c = 35
+

𝐩 = 𝚫𝐒 + 𝐏𝐕(−𝚫𝐒 . + 𝐩. )
S = 100
c = ? (S-)
𝐜 = 𝚫𝐒 + 𝐏𝐕(−𝚫𝐒 . + 𝐜 . )
d = .74
74 (−. 𝟓𝟕𝟑𝟕𝟕𝟎𝟓(𝟏𝟑𝟓) + 𝟑𝟓)
c- = 0 = . 𝟓𝟕𝟑𝟕𝟕𝟎𝟓(𝟏𝟎𝟎) +
𝟏. 𝟎𝟓𝟏𝟓
= 𝟏𝟔. 𝟗𝟗𝟕𝟓
= Alternative/
(𝟏 + 𝐫) − 𝐝 𝟏. 𝟎𝟓𝟏𝟓 − . 𝟕𝟒
𝛑= = = . 𝟓𝟏𝟎𝟔𝟓𝟔
𝐮−𝐝 𝟏. 𝟑𝟓 − . 𝟕𝟒
. 𝟓𝟏𝟎𝟔𝟓𝟔(𝟑𝟓) + (𝟏 − . 𝟓𝟏𝟎𝟔𝟓𝟔)𝟎
𝐜 = 𝐏𝐕[𝛑𝐜 . + (𝟏 − 𝛑)𝐜 , ] = = 𝟏𝟔. 𝟗𝟗𝟕𝟓
𝟏. 𝟎𝟓𝟏𝟓
. 𝟓𝟏𝟎𝟔𝟓𝟔(𝟎) + (𝟏 − . 𝟓𝟏𝟎𝟔𝟓𝟔)(𝟐𝟔)
𝐩 = 𝐏𝐕[𝛑𝐩. + (𝟏 − 𝛑)𝐩, ] = = 𝟏𝟐. 𝟏𝟎
𝟏. 𝟎𝟓𝟏𝟓
𝐱 𝟏𝟎𝟎
⇒ Put-Call Parity/ 𝐒 + 𝐩 = + 𝐜 / 𝟏𝟎𝟎 + 𝐩 = 𝟏.𝟎𝟓𝟏𝟓 + 𝟏𝟔. 𝟗𝟗𝟕𝟓 / 𝐩 = 𝟏𝟐. 𝟏𝟎
(𝟏 . 𝐫)

Review - 2
⇒ 2-period/ 91.94
𝟏. 𝟎𝟓 − . 𝟕𝟒𝟒
c = 41.94
++
𝛑= = . 𝟓𝟎
𝟏. 𝟑𝟓𝟔 − . 𝟕𝟒𝟒

u = 1.356 67.80 𝛑𝟐 𝐜 == + 𝟐𝛑(𝟏 − 𝛑)𝐜 => + (𝟏 − 𝛑)𝟐 𝐜 >>

𝐜=
50.443 (𝟏 + 𝐫)𝟐
S = 50 c = .4432
+-
. 𝟓𝟐 (𝟒𝟏. 𝟗𝟒) + 𝟐(. 𝟓)(. 𝟓)(. 𝟒𝟒𝟑𝟐) + (. 𝟓)𝟐 (𝟎)
=
X = 50 (𝟏. 𝟎𝟓)𝟐
d = .744 37.20
r = 5% = 𝟗. 𝟕𝟏𝟏𝟐
27.678
𝐗
c-- = M.M138463888.
0 𝐒+𝐩= +𝐜
⇒ American style options/ (𝟏 + 𝐫)𝟐
- call ⇒ no change 𝟓𝟎
𝟓𝟎 + 𝐩 = + 𝟗. 𝟕𝟏𝟏𝟐 = 𝟓. 𝟎𝟔𝟐𝟔
- always better to sell than (𝟏. 𝟎𝟓)𝟐
to exercise early
- put ⇒ early exercise results
in a premium over European
puts.

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 Last Revised: 08/14/2023

Binomial Option Valuation Model

132.389
c = 57.389
𝐜 == 𝟓𝟕. 𝟑𝟖𝟗 − 𝟎
𝚫= =
97.632 𝟏𝟑𝟐. 𝟑𝟖𝟗 − 𝟓𝟐. 𝟖𝟏𝟗𝟏
u = 1.356
c = 33.43 = . 𝟕𝟐𝟏𝟐𝟒
52.8191
S = 72 0 𝟎−𝟎
C = 19.474 𝚫> = =𝟎
𝐒=>− 𝐒>>
d = 0.541 38.952
X = 75 c = 0
r = 3%/a 21.07303 𝟏. 𝟎𝟑 − . 𝟓𝟒𝟏
𝛑= = . 𝟔𝟎
0 𝟏. 𝟑𝟓𝟔 − . 𝟓𝟒𝟏
𝟑𝟑. 𝟒𝟑 − 𝟎
𝚫= = . 𝟓𝟔𝟗𝟕 . 𝟔(𝟓𝟕. 𝟑𝟖𝟗) + . 𝟒(𝟎)
𝟗𝟕. 𝟔𝟑𝟐 − 𝟑𝟖. 𝟗𝟓𝟐 𝐜= =
𝟏. 𝟎𝟑
. 𝟔(𝟑𝟑. 𝟒𝟑) + . 𝟒(𝟎) = 𝟑𝟑. 𝟒𝟑
𝐜= = 𝟏𝟗. 𝟒𝟕𝟒
𝟏. 𝟎𝟑

Valuation of Contingent Claims

Review - 3
Puts/
Ⓐ
𝚫 = -0.05237 15.347
x = 8.00
10.6207 0
.214
Ⓐ Buy put for
𝚫 = -.40929
0.214
Ⓒ 7.35 7.594
Sell .05237
1.36 .406
shares @ $10.6207
5.2553
= .5562
Buy put @ $1.36 2.41
3.758 (Lend 0.77022)
Sell .40929 shares 𝚫 = -1.0
@ 7.35 = 3.0083 4.24
Ⓑ M.M138463888.

(Lend 4.3683) Buy put @ $2.41

Sell 1 shares @ $5.2553
(Lend 7.6653)

48
 Last Revised: 08/14/2023

Review - 4

Ⓐ
𝚫 = .9476 15.347
10.6207 7.347
𝚫 = .5905 3.1683 Ⓐ Buy Call @
Ⓒ 7.35 7.594 $3.1683
1.37 0 Buy .9476 shares
5.2553
Buy Call @ 1.37 0 @ 10.6207 = $10.064
3.758 (Borrow $6.8958)
Buy .5905 shares 𝚫= 0
0
@ 7.35 = 4.34 Ⓑ
(Borrow $2.97) Buy Call @ 0
Buy 0 shares for $0
Borrow/lend $0

1. A stock price is currently $50. Over each of the next

two three-month periods it is expected to go up by 6% or
down by 5%. The risk-free interest rate is 5% per annum
with continuous compounding. What is the value of a six-
month European call option with a strike price of $51. (𝟏 + 𝐫) − 𝐝
𝐮−𝐝

56.18 𝐞.𝟎𝟓(.𝟐𝟓) − . 𝟗𝟓
c++ = 5.18 𝛑= = . 𝟓𝟔𝟖𝟗
𝟏. 𝟎𝟔 − . 𝟗𝟓

53
1.06 . 𝟓𝟔𝟖𝟗(𝟓. 𝟏𝟖)
c+ = 2.9103 𝐜= = = 𝟐. 𝟗𝟏𝟎𝟑
50.35 𝐞.𝟎𝟓(.𝟐𝟓)
50 c+- = 0
(𝛑𝐜 = + (𝟏 − 𝛑)𝐜 > )
c = ?
.95 47.50 . 𝟓𝟔𝟖𝟗(𝟐. 𝟗𝟏𝟎𝟑)
X = 51 𝐜= = 𝟏. 𝟔𝟑𝟓𝟏
c- = 0
M.M138463888.
𝐞.𝟎𝟓(.𝟐𝟓)
45.125
c-- = 0

49
 Last Revised: 08/14/2023

2. A stock price is currently $50. Over each of the next

two three-month periods it is expected to go up by 6% or
down by 5%. The risk-free interest rate is 5% per annum
with continuous compounding. What is the value of a six-
month American put option with a strike price of $49.

X = 49 𝐞.𝟎𝟓(.𝟐𝟓) − . 𝟗𝟓
56.18 𝛑= = . 𝟓𝟔𝟖𝟗
p++ = 0 𝟏. 𝟎𝟔 − . 𝟗𝟓

53 𝐩= = 𝟎
p = 0
+

50.35
50 p+- = 0 . 𝟓𝟔𝟖𝟗(𝟎) + . 𝟒𝟑𝟏𝟏(𝟑. 𝟖𝟕𝟓)
𝐩> =
𝐞.𝟎𝟓(.𝟐𝟓)
p = .7022
47.50 = 𝟏. 𝟔𝟒𝟗𝟖
p- = 1.6498
45.125
. 𝟒𝟑𝟏𝟏(𝟏. 𝟔𝟒𝟗𝟖) p-- = 3.875
𝐩= 1.31
𝐞.𝟎𝟓(.𝟐𝟓)
1.50
= . 𝟕𝟎𝟐𝟐

Review - 7
⇒ BSM/ - from discrete time (binomial) to continuous time
𝐜 = 𝐒 𝐍(𝐝𝟏 ) − 𝐞,𝐫𝐓 𝐗 𝐍(𝐝𝟐 ) 𝐍(⋅) - standard normal cumulative
distribution
𝐒 − 𝐗𝐞,𝐫𝐓
𝟐
𝐩 = 𝐞,𝐫𝐓 𝐗 𝐍(−𝐝𝟐 ) − 𝐒 𝐍(−𝐝𝟏 ) 𝐥𝐧K𝐒D𝐗L + 3𝐫 + 𝛔 D𝟐6 𝐓 risk-free
𝐝𝟏 = rate
𝛔√𝐓
𝐗𝐞,𝐫𝐓 − 𝐒 {d1,d2}
𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓
risk neutral
e.g./ S = 100, X = 100, r = 5% T = 1.0 σ = 30% probabilities
𝟐
𝐥𝐧(𝟏) + 3. 𝟎𝟓 + . 𝟑 D𝟐6 𝟏. 𝟎
𝐝𝟏 = = . 𝟑𝟏𝟔𝟕 𝐝𝟐 = . 𝟑𝟏𝟔𝟕 − . 𝟑√𝟏 = 𝟎. 𝟎𝟏𝟔𝟕
. 𝟑√𝟏
N(d1) = N(.3167) = .624
M.M138463888.

N(d2) = N(.0167) = .507 - prob. that c expires ITM

N(-d1) = N(-.3167) = 1 - .624 = .376 𝐩 = 𝟏𝟎𝟎𝐞.𝟎𝟓 (. 𝟒𝟗𝟑) − 𝟏𝟎𝟎(. 𝟑𝟕𝟔)
N(-d2) = N(-.0167) = 1 - .507 = .493 buy bonds sell
= 𝟗. 𝟐𝟗 shares
𝐜 = 𝟏𝟎𝟎(. 𝟔𝟐𝟒) − 𝟏𝟎𝟎𝐞,.𝟎𝟓 (. 𝟓𝟎𝟕) = 𝟏𝟒. 𝟏𝟕
buy shares sell bonds

50
 Last Revised: 08/14/2023

Review - 8
Buy a Call Sell a Call
Replicate - buy N(d1) ST - sell N(d1) shares -ST
Shares
- sell N(d2)% -X - buy N(d2)% +X
of a zero of a zero
c = 𝐒 ⋅ 𝐍(𝐝𝟏 ) − 𝐗𝐞,𝐫𝐓 𝐍(𝐝𝟐 ) 𝐒 − 𝐍(𝐝𝟏 ) − 𝐗𝐞,𝐫𝐓 − 𝐍(𝐝𝟐 )
Buy a Put Sell a Put
- buy N(-d2)% X - sell N(-d2)% -X
of a bond of a bond
- sell N(-d1) -ST - buy N(-d1) ST
shares shares
p = 𝐗𝐞 ,𝐫𝐓
𝐍(−𝐝𝟐 ) − 𝐒 𝐍(−𝐝𝟏 ) 𝐗𝐞,𝐫𝐓 − 𝐍(−𝐝𝟐 ) − 𝐒 ⋅ −𝐍(−𝐝𝟏 )

⇒ modification for carry benefits/ 𝛄 – carry benefits (continuous comp.)

(dividends 𝛄 = 𝛅) 𝟐
𝐥𝐧<𝐒9𝐗> + ;𝐫 − 𝛄 + 𝛔 9𝟐? 𝐓
𝐜 = 𝐒𝐞>𝛄𝐓 𝐍(𝐝𝟏 ) − 𝐗𝐞>𝐫𝐓 (𝐝𝟐 )
(currencies 𝛄 = 𝐫𝐟 ) 𝐝𝟏 =
𝛔√𝐓

Review - 9
⇒ Black Model/ 𝐜 = [𝐅𝟎 (𝐓) ⋅ 𝐍(𝐝𝟏 ) − 𝐗 ⋅ 𝐍(𝐝𝟐 )]𝐞,𝐫𝐓
- underlying is
F0 ⇒ futures 𝐩 = [𝐗 ⋅ 𝐍(−𝐝𝟐 ) − 𝐅𝟎 ⋅ 𝐍(−𝐝𝟏 )]𝐞,𝐫𝐓 costless to
contract 𝐅 𝛔𝟐
𝐥𝐧 3 𝐗𝟎 6 + B 𝟐 C 𝐓 carry
𝐝𝟏 = 𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐓
𝛔√𝟐

FRA – forward 𝐜 = 𝐀𝐏[𝐅𝐑𝐀 ⋅ 𝐍(𝐝𝟏 ) − 𝐗 𝐑 ⋅ 𝐍(𝐝𝟐 )]𝐞,𝐫𝐓 ~ T2

rate agreement
𝐅𝐑𝐀𝐓𝟏 ,𝐓𝟐 exercise rate of the call

,𝐫𝐓
𝐩 = 𝐀𝐏[𝐗 𝐑 𝐍(−𝐝M.M138463888.
𝟐 ) − 𝐅𝐑𝐀 ⋅ 𝐍(−𝐝𝟏 )]𝐞

AP – accrual 𝐅𝐑𝐀𝐓𝟏 ,𝐓𝟐 𝛔𝟐

𝐥𝐧 B C + B C 𝐓𝟏
period 𝐗𝐑 𝟐
𝐝𝟏 = 𝐝𝟐 = 𝐝𝟏 − 𝛔•𝐓𝟏
scaling 𝛔•𝐓𝟏
variable

51
 Last Revised: 08/14/2023

Review - 10
⇒ Black Model/
FRA/ Caps Floors

long a floor
+ fixed for
& if XR = swap rate, Vcap = Vfloor
short a cap floating
∴ cost = 0

⇒ Swaptions/ payer swaption – pay fx., get fl.

- option on receiver swaption – pay fl., get fx.
a swap

Review - 11
⇒ Option Greeks/
delta – change in the value of the option
for a change in the price of the underlying
- for a given X, |𝐝𝐞𝐥𝐭𝐚𝐜 | + •𝐝𝐞𝐥𝐭𝐚𝐩 • = 𝟏. 𝟎
- on expiration date, delta = 1 or 0
(ITM) (OTM)
delta hedging/ S = 100 X = 100
Deltac = .532 Deltap = -.419
position: short puts on 10,000 shares

➀ short 4,190 shares

,𝟒𝟏𝟗𝟎
➁ short = −𝟕, 𝟖𝟕𝟔 calls
.𝟓𝟑𝟐

gamma/ change in delta for a change in underlying

M.M138463888.

gammac = gammap

52
 Last Revised: 08/14/2023

Review - 12
⇒ Option Greeks/
gamma/ - measures the risk that remains once a
portfolio is delta neutral
- gamma risk can be managed to a specific
level, but never eliminated

c theta - a change in c or p for a change in time

to expiration (rate of option decay)
p long options - negative theta
short options - positive theta
-

60d 120d

vega – change in c & p for a change in volatility

$
c long options – positive vega
p short options – negative vega

vol.

Review - 13
⇒ Option Greeks/
rho - a change in c & p for a change rf
calls – pos. rho S0erT
c
puts – neg. rho Xe-rT

⇒ Implied Volatility/ - future volatility

- common to see different implied vols. for
different exercise prices
- volatility smile/skew
M.M138463888.

53