is above the upper limit or below the lower limit, trades cannot take place.

Some
exchanges have circuit breakers; in this case, when a futures price reaches a limit
price, trading is suspended for a short period.

MODULE QUIZ 69.1

1. Which type of contract always requires daily marking to market of gains and
losses?
A. Futures contracts only.
B. Forward contracts only.
C. Both futures and forward contracts.
2. Compared to a futures contract, an otherwise identical forward contract most likely
has greater:
A. liquidity.
B. transparency.
C. counterparty risk.

MODULE 69.2: SWAPS AND OPTIONS

Swaps
 has greater:
A. liquidity.
B. transparency.
C. counterparty risk.

MODULE 69.2: SWAPS AND OPTIONS

Swaps
Swaps are agreements to exchange a series of payments on multiple Video covering
settlement dates over a speci ied time period (e.g., quarterly this content is
available online.
payments for two years). At each settlement date, the two payments
are netted so that only one net payment is made. The party with the greater liability
at each settlement date pays the net difference to the other party.
Swaps trade in a dealer market and the parties are exposed to counterparty credit
risk, unless the market has a central counterparty structure to reduce counterparty
risk. In this case, margin deposits and mark-to-market payments may also be
required to further reduce counterparty risk.
We can illustrate the basics of a swap with a simple ixed-for- loating interest rate
swap for two years with quarterly interest payments based on a notional principal
amount of $10 million. In such a swap, one party makes quarterly payments at a
ixed rate of interest (the swap rate) and the other makes quarterly payments based
on a loating market reference rate.
The swap rate is set so that the swap has zero value to each party at its inception. As
expectations of future values of the market reference rate change over time, the
value of the swap can become positive for one party and negative for the other party.
We can illustrate the basics of a swap with a simple ixed-for- loating interest rate
swap for two years with quarterly interest payments based on a notional principal
amount of $10 million. In such a swap, one party makes quarterly payments at a
ixed rate of interest (the swap rate) and the other makes quarterly payments based
on a loating market reference rate.
The swap rate is set so that the swap has zero value to each party at its inception. As
expectations of future values of the market reference rate change over time, the
value of the swap can become positive for one party and negative for the other party.
Consider an interest rate swap with a notional principal amount of $10 million, a
ixed rate of 2%, and a loating rate of the 90-day secured overnight inancing rate
(SOFR). At each settlement date, the ixed-rate payment will be $10 million × 0.02/4
= $50,000. The loating-rate payment at the end of the irst quarter will be based on
90-day SOFR at the initiation of the swap, so that both payments are known at the
inception of the swap.
If, at the end of the irst quarter, 90-day SOFR is 1.6%, the loating-rate payment at
the second quarterly settlement date will be $10 million × 0.016 / 4 = $40,000. The
ixed-rate payment is again $50,000, so at the end of the second quarter the ixed-
rate payer will pay the net amount of $10,000 to the other party.
A company with 2-year loating-rate quarterly-pay note outstanding could enter
such a swap as the ixed-rate payer, converting its loating-rate liability into a ixed-
rate liability. It now makes ixed interest rate payments and can use the loating-rate
payments from the counterparty to make the payments on its loating-rate debt. By
entering into the swap, the company can hedge the interest rate risk (uncertainty
about future quarterly rates) of their existing loating-rate liability.
As we will see in our reading on swap valuation, a swap can be constructed from a
series of forward contracts in which the underlying is a loating rate and the forward
price is a ixed rate. Each forward settles on one of the settlement dates of the swap.
At each settlement date, the difference between the ixed and the loating rates
would result in a net payment, just as with a swap. Often, interest rate forwards
settle at the beginning of the quarter rather than the end; the cash lows are the
present value equivalents of the end-of-quarter swap payments.

Credit Swaps
One type of swap that is structured a bit differently is a credit default swap (CDS).
With a CDS, the protection buyer makes ixed payments on the settlement dates and
the protection seller pays only if the underlying (a reference security) has a credit
would result in a net payment, just as with a swap. Often, interest rate forwards
settle at the beginning of the quarter rather than the end; the cash lows are the
present value equivalents of the end-of-quarter swap payments.

Credit Swaps
One type of swap that is structured a bit differently is a credit default swap (CDS).
With a CDS, the protection buyer makes ixed payments on the settlement dates and
the protection seller pays only if the underlying (a reference security) has a credit
event. This could be a bond default, a corporate bankruptcy, or an involuntary
restructuring.
When a credit event occurs, the protection seller must pay an amount that offsets
the loss in value of the reference security. The ixed payments represent the yield
premium on the reference bonds that compensates bondholders for the expected
loss from default, the probability of default times the expected loss in the event of
default (or other credit event). The protection buyer is essentially paying the yield
premium on the reference security for insurance against default.
The holder of a risky bond can hedge its default risk by entering a CDS as the
protection buyer. The protection seller receives the default risk premium (credit
spread) and takes on the risk of default, resulting in risk exposure similar to that of
holding the reference bond.

Options
The two types of options of interest to us here are put options and call options on
an underlying asset. We introduce them using option contracts for 100 shares of a
stock as the underlying asset.
The holder of a risky bond can hedge its default risk by entering a CDS as the
protection buyer. The protection seller receives the default risk premium (credit
spread) and takes on the risk of default, resulting in risk exposure similar to that of
holding the reference bond.

Options
The two types of options of interest to us here are put options and call options on
an underlying asset. We introduce them using option contracts for 100 shares of a
stock as the underlying asset.
A put option gives the buyer the right (but not the obligation) to sell 100 shares at a
speci ied price (the exercise price, also referred to as the strike price) for speci ied
period of time, the time to expiration. The put seller (also called the writer of the
option) takes on the obligation to purchase the 100 shares at the price speci ied in
the option, if the put buyer exercises the option.
Note the “one-way” nature of options. If the exercise price of the puts is $25 at the
expiration of the option, and the shares are trading at or above $25, the put holder
will not exercise the option. There is no reason to exercise the put and sell shares at
$25 when they can be sold for more than $25 in the market. This is the outcome for
any stock price greater than or equal to $25. Regardless of whether the stock price
at option expiration is $25 or $1,000, the put buyer lets the option expire, and the
put seller keeps the proceeds from the sale.
If the stock price is below $25, the put buyer will exercise the option and the put
seller must purchase 100 shares for $25 from the put buyer. On net, the put buyer
essentially receives the difference between the stock price at expiration and $25
(times 100 shares).
A call option gives the buyer the right (but not the obligation) to buy 100 shares at a
speci ied price (the exercise price) for a speci ied period of time. The call seller
(writer) takes on the obligation to sell the 100 shares at the exercise price, if the call
buyer exercises the option.

LOS 69.b: Determine the value at expiration and pro it from a long or a short
position in a call or put option.

Unlike forwards, futures, and swaps, options are sold at a price (they do not have
zero value at initiation). The price of an option is also referred to as the option
premium.
buyer exercises the option.

LOS 69.b: Determine the value at expiration and pro it from a long or a short
position in a call or put option.

Unlike forwards, futures, and swaps, options are sold at a price (they do not have
zero value at initiation). The price of an option is also referred to as the option
premium.
At expiration the payoff (value) of a call option to the owner is Max (0, S - X), where
S is the price of the underlying at expiration and X is the exercise price of the call
option. The Max ( ) function tells us that if S < X at expiration, the option value is
zero, that is, it expires worthless and will not be exercised.
At expiration the payoff (value) of a put option to the owner is Max (0, X - S), where
S is the price of the underlying at expiration and X is the exercise price of the put
option. A put has a zero value at expiration unless X - S is positive.
For the buyer of a put or call option, the pro it at expiration is simply the difference
between the value (payoff) of the option at expiration and the premium the investor
paid for the option.
Because the seller (writer) of an option receives the option premium, the pro it to
the option seller at expiration is the amount of the premium received minus the
option payoff at expiration. The writer loses the payoff at expiration and will have a
loss on the option if the payoff is greater than the premium received.
Note the risk exposures of call and put buyers and writers. The buyer of a put or call
has no further obligation, so the maximum loss to the buyer is simply the amount
For the buyer of a put or call option, the pro it at expiration is simply the difference
between the value (payoff) of the option at expiration and the premium the investor
paid for the option.
Because the seller (writer) of an option receives the option premium, the pro it to
the option seller at expiration is the amount of the premium received minus the
option payoff at expiration. The writer loses the payoff at expiration and will have a
loss on the option if the payoff is greater than the premium received.
Note the risk exposures of call and put buyers and writers. The buyer of a put or call
has no further obligation, so the maximum loss to the buyer is simply the amount
they paid for the option. The writer of a call option has exposure to an unlimited
loss because the maximum price of the underlying, S, is (theoretically) unlimited, so
that the payoff S - X is unlimited. The payoff on a put option is X - S, so if the lower
limit on S is zero, the maximum payoff on a put option is the exercise price, X.

Call Option Profits and Losses

Consider a call option with a premium of $5 and an exercise price of $50. This
means the buyer pays $5 to the writer. At expiration, if the price of the stock is less
than or equal to the $50 exercise price, the option has zero value, the buyer of the
option is out $5, and the writer of the option is ahead $5. When the stock’s price
exceeds $50, the option starts to gain (breakeven will come at $55, when the value of
the stock equals the exercise price plus the option premium. Conversely, as the price
of the stock moves upward, the seller of the option starts to lose (negative igures
will start at $55, when the value of the stock equals the exercise price plus the
option premium).
An illustration of the pro it or loss at expiration for the buyer (long) and writer
(short) of this call option, as a function of the stock price, is presented in Figure 69.1.
This pro it/loss diagram indicates the following:
The maximum loss for the buyer of a call is the $5 premium (at any S ≤ $50).
The breakeven point for the buyer and seller is the exercise price plus the
premium (at S = $55).
The pro it potential to the buyer of the option is unlimited, and, conversely, the
potential loss to the writer of the call option is unlimited.
The call holder will exercise the option whenever the stock’s price exceeds the
exercise price at the expiration date.
The greatest pro it the writer can make is the $5 premium (at any S ≤ $50).
The sum of the pro its between the buyer and seller of the call option is always
 The breakeven point for the buyer and seller is the exercise price plus the
premium (at S = $55).
The pro it potential to the buyer of the option is unlimited, and, conversely, the
potential loss to the writer of the call option is unlimited.
The call holder will exercise the option whenever the stock’s price exceeds the
exercise price at the expiration date.
The greatest pro it the writer can make is the $5 premium (at any S ≤ $50).
The sum of the pro its between the buyer and seller of the call option is always
zero; thus, trading options is a zero-sum game. One party’s pro its equal the other
party’s losses.
Figure 69.1: Profit/Loss Diagram for a Call Option
Put Option Profits and Losses
To examine the pro its and losses associated with trading put options, consider a put
option with a $5 premium and a $50 exercise price. The buyer pays $5 to the writer.
When the price of the stock at expiration is greater than or equal to the $50 exercise
price, the put has zero value. The buyer of the option has a loss of $5 and the writer
of the option has a gain of $5. When the stock price is less than $50, the put option
has a positive payoff. Breakeven will come at $45, when the value of the stock equals
the exercise price less the option premium. At a stock price below $45, the put seller
will have a loss.
Figure 69.2 shows the pro it/loss diagram for the buyer (long) and seller (short) of
the put option that we have been discussing. This pro it/loss diagram illustrates
that:
The maximum loss for the buyer of the put is the $5 premium (at any S ≥ $50).
The maximum gain to the buyer of the put is limited to the exercise price less the
premium ($50 - $5 = $45). The potential loss to the writer of the put is the same
amount.
The breakeven price for the put buyer (seller) is the exercise price minus the
option premium ($50 - $5 = $45).
The maximum pro it for the writer is the $5 premium (S ≥ $50).
The pro it (loss) of the put buyer will always equal the loss (pro it) of the put
writer.
Figure 69.2: Profit/Loss Diagram for a Put Option
 The breakeven price for the put buyer (seller) is the exercise price minus the
option premium ($50 - $5 = $45).
The maximum pro it for the writer is the $5 premium (S ≥ $50).
The pro it (loss) of the put buyer will always equal the loss (pro it) of the put
writer.
Figure 69.2: Profit/Loss Diagram for a Put Option

EXAMPLE: Option pro it calculations

EXAMPLE: Option pro it calculations
Suppose that both a call option and a put option have been written on a stock with
an exercise price of $40. The current stock price is $42, and the call and put
premiums are $3 and $0.75, respectively.
Calculate the pro it to the long and short positions for both the put and the call
with an expiration day stock price of $35 and with a price at expiration of $43.
Answer:
Pro it will be computed as ending option value - initial option cost.
Stock at $35:
 Long call: $0 - $3 = -$3. The option has no value, so the buyer loses the premium
paid.
Short call: $3 - $0 = $3. Because the option has no value, the call writer’s gain
equals the premium received.
Long put: $5 - $0.75 = $4.25. The buyer paid $0.75 for an option that is now
worth $5.
Short put: $0.75 - $5 = -$4.25. The seller received $0.75 for writing the option,
but the option will be exercised so the seller will lose $5 at expiration.
Stock at $43:
Long call: -$3 + $3 = $0. The buyer paid $3 for the option, and it is now in the
money by $3. Hence, the net pro it is zero.
Short call: $3 - $3 = $0. The seller received $3 for writing the option and now
faces a -$3 valuation because the buyer will exercise the option, for a net pro it
of zero.
Long put: -$0.75 - $0 = -$0.75. The buyer paid $0.75 for the put option and the
option now has no value.
Short put: $0.75 - $0 = $0.75. The seller received $0.75 for writing the option and
 Long call: -$3 + $3 = $0. The buyer paid $3 for the option, and it is now in the
money by $3. Hence, the net pro it is zero.
Short call: $3 - $3 = $0. The seller received $3 for writing the option and now
faces a -$3 valuation because the buyer will exercise the option, for a net pro it
of zero.
Long put: -$0.75 - $0 = -$0.75. The buyer paid $0.75 for the put option and the
option now has no value.
Short put: $0.75 - $0 = $0.75. The seller received $0.75 for writing the option and
it has zero value at expiration.

A buyer of puts or a seller of calls has short exposure to the underlying (will pro it
when the price of the underlying asset decreases). A buyer of calls or a seller of puts
has long exposure to the underlying (will pro it when the price of the underlying
asset increases).

LOS 69.c: Contrast forward commitments with contingent claims.

A forward commitment is a legally binding promise to perform some action in the

future. Forward commitments include forward contracts, futures contracts, and
most swaps.
A contingent claim is a claim (to a payoff) that depends on a particular event.
Options are contingent claims; the event is the price of the underlying being above
or below the exercise price. Credit default swaps are also considered contingent
claims because the payment by the protection seller depends on a credit event
occurring.
A forward commitment is a legally binding promise to perform some action in the
future. Forward commitments include forward contracts, futures contracts, and
most swaps.
A contingent claim is a claim (to a payoff) that depends on a particular event.
Options are contingent claims; the event is the price of the underlying being above
or below the exercise price. Credit default swaps are also considered contingent
claims because the payment by the protection seller depends on a credit event
occurring.

MODULE QUIZ 69.2

1. Interest rate swaps are:
A. highly regulated.
B. equivalent to a series of forward contracts.
C. contracts to exchange one asset for another.
2. A call option is:
A. the right to sell at a specific price.
B. the right to buy at a specific price.
C. an obligation to buy at a certain price.
 3. At expiration, the exercise value of a put option is:
A. positive if the underlying asset price is less than the exercise price.
B. zero only if the underlying asset price is equal to the exercise price.
C. negative if the underlying asset price is greater than the exercise price.
4. At expiration, the exercise value of a call option is the:
A. underlying asset price minus the exercise price.
B. greater of zero or the exercise price minus the underlying asset price.
C. greater of zero or the underlying asset price minus the exercise price.
5. An investor writes a put option with an exercise price of $40 when the stock price
is $42. The option premium is $1. At expiration the stock price is $37. The investor
will realize a:
A. loss of $2.
B. loss of $3.
C. profit of $1.
6. Which of the following derivatives is a forward commitment?
A. Stock option.
B. Interest rate swap.
C. Credit default swap.

KEY CONCEPTS
 B. loss of $3.
C. profit of $1.
6. Which of the following derivatives is a forward commitment?
A. Stock option.
B. Interest rate swap.
C. Credit default swap.

KEY CONCEPTS

LOS 69.a
Forward contracts obligate one party to buy, and another to sell, a speci ic asset at a
speci ic price at a speci ic time in the future.
Futures contracts are much like forward contracts, but are exchange-traded, liquid,
and require daily settlement of any gains or losses.
A call option gives the holder the right, but not the obligation, to buy an asset at a
speci ic price at some time in the future.
A put option gives the holder the right, but not the obligation, to sell an asset at a
speci ic price at some time in the future.
In an interest rate swap, one party pays a ixed rate and the other party pays a
loating rate, on a given amount of notional principal. Swaps are equivalent to a
series of forward contracts based on a loating rate of interest.
A credit default swap is a contract in which the protection seller provides a payment
if a speci ied credit event occurs.

LOS 69.b
A put option gives the holder the right, but not the obligation, to sell an asset at a
speci ic price at some time in the future.
In an interest rate swap, one party pays a ixed rate and the other party pays a
loating rate, on a given amount of notional principal. Swaps are equivalent to a
series of forward contracts based on a loating rate of interest.
A credit default swap is a contract in which the protection seller provides a payment
if a speci ied credit event occurs.

LOS 69.b
Call option value at expiration is Max(0, underlying price minus exercise price) and
pro it or loss is Max(0, underlying price minus exercise price) minus the option cost
(premium paid).
Put value at expiration is Max(0, exercise price minus underlying price) and pro it or
loss is Max(0, exercise price minus underlying price) minus the option cost.
A call buyer (call seller) bene its from an increase (decrease) in the value of the
underlying asset.
A put buyer (put seller) bene its from a decrease (increase) in the value of the
underlying asset.
LOS 69.c
A forward commitment is an obligation to buy or sell an asset or make a payment in
the future. Forward contracts, futures contracts, and most swaps are forward
commitments.
A contingent claim is a derivative that has a future payoff only if some future event
takes place (e.g., asset price is greater than a speci ied price). Options and credit
derivatives are contingent claims.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 69.1

1. A Futures contracts are marked to market daily. Forward contracts typically are
not, but could be if there is central clearing party. (LOS 69.a)
2. C Forward contracts involve counterparty risk; futures contracts trade through a
clearinghouse. Because futures contracts trade on organized exchanges, they
have greater liquidity and transparency than forward contracts. (LOS 69.a)

Module Quiz 69.2

Module Quiz 69.1
1. A Futures contracts are marked to market daily. Forward contracts typically are
not, but could be if there is central clearing party. (LOS 69.a)
2. C Forward contracts involve counterparty risk; futures contracts trade through a
clearinghouse. Because futures contracts trade on organized exchanges, they
have greater liquidity and transparency than forward contracts. (LOS 69.a)

Module Quiz 69.2

1. B A swap is an agreement to buy or sell an underlying asset periodically over the
life of the swap contract. It is equivalent to a series of forward contracts. (LOS
69.a)
2. B A call gives the owner the right to call an asset away (buy it) from the seller.
(LOS 69.a)
3. A The exercise value of a put option is positive at expiration if the underlying
asset price is less than the exercise price. Its exercise value is zero if the
underlying asset price is greater than or equal to the exercise price. The
exercise value of an option cannot be negative because the holder can allow it
to expire unexercised. (LOS 69.b)
4. C If the underlying asset price is greater than the exercise price of a call option,
the value of the option is equal to the difference. If the underlying asset price
is less than the exercise price, a call option expires with a value of zero. (LOS
69.b)
5. A Because the stock price at expiration is less than the exercise price, the buyer
 underlying asset price is greater than or equal to the exercise price. The
exercise value of an option cannot be negative because the holder can allow it
to expire unexercised. (LOS 69.b)
4. C If the underlying asset price is greater than the exercise price of a call option,
the value of the option is equal to the difference. If the underlying asset price
is less than the exercise price, a call option expires with a value of zero. (LOS
69.b)
5. A Because the stock price at expiration is less than the exercise price, the buyer
of the put option will exercise it against the writer. The writer will have to pay
$40 for the stock and can only sell it for $37 in the market. However, the put
writer collected the $1 premium for writing the option, which reduces the net
loss to $2. (LOS 69.b)
6. B This type of custom contract is a forward commitment. (LOS 69.c)
READING 70

DERIVATIVE BENEFITS, RISKS,

AND ISSUER AND INVESTOR USES

MODULE 70.1: USES, BENEFITS, AND RISKS OF

DERIVATIVES

LOS 70.a: Describe bene its and risks of derivative instruments.

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MODULE 70.1: USES, BENEFITS, AND RISKS OF
DERIVATIVES

LOS 70.a: Describe bene its and risks of derivative instruments.

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Advantages of Derivatives
Derivative instruments offer several potential advantages over cash market
transactions, including the following:

Ability to Change Risk Allocation, Transfer Risk, and Manage Risk

We have discussed these bene its in our introduction to derivative contracts. Some
examples of ways that risk exposures can be altered using derivatives, without any
cash market securities transactions, are:
A portfolio manager can increase or decrease exposure to the risk and return of a
market index.
A manufacturer can hedge the exchange rate risk of anticipated receipts or
payments.
The issuer of a loating-rate note can change that exposure to a ixed-rate
obligation.
Derivative instruments can be used to create risk exposures that are not available in
cash markets. Consider the following examples of changing an existing risk pro ile:
 A portfolio manager can increase or decrease exposure to the risk and return of a
market index.
A manufacturer can hedge the exchange rate risk of anticipated receipts or
payments.
The issuer of a loating-rate note can change that exposure to a ixed-rate
obligation.
Derivative instruments can be used to create risk exposures that are not available in
cash markets. Consider the following examples of changing an existing risk pro ile:
The owner of common stock can buy puts that act as a loor on the sale price of
their shares, reducing the downside risk of the stock by paying the cost of the
puts.
An investor can acquire the upside potential of an asset without taking on its
downside risk by buying call options.

Information Discovery
Derivatives prices and trading provide information that cash market transactions do
not.
 Options prices depend on many things we can observe (interest rates, price of the
underlying, time to expiration, and exercise price) and one we cannot, the
expected future price volatility of the underlying. We can use values of the
observable variables, together with current market prices of derivatives, to
estimate the future price volatility of the underlying that market participants
expect.
Futures and forwards can be used to estimate expected prices of their underlying
assets.
Interest rate futures across maturities can be used to infer expected future
interest rates and even the number of central bank interest rate changes over a
future period.

Operational Advantages
Compared to cash markets, derivatives markets have several operational advantages.
Operational advantages of derivatives include greater ease of short selling, lower
transaction costs, greater potential leverage, and greater liquidity.
Ease of short sales. Taking a short position in an asset by selling a forward or a
futures contract may be easy to do. Dif iculty in borrowing an asset and
 future period.

Operational Advantages
Compared to cash markets, derivatives markets have several operational advantages.
Operational advantages of derivatives include greater ease of short selling, lower
transaction costs, greater potential leverage, and greater liquidity.
Ease of short sales. Taking a short position in an asset by selling a forward or a
futures contract may be easy to do. Dif iculty in borrowing an asset and
restrictions on short sales may make short positions in underlying assets
problematic or more expensive.
Lower transaction costs. Transaction costs can be signi icantly lower with
commodities derivatives, where transportation, storage, and insurance add costs
to transactions in physical commodities. Entering a ixed-for- loating swap to
change a loating-rate exposure to ixed rate is clearly less costly than retiring a
loating-rate note and issuing a ixed-rate note.
Greater leverage. The cash required to take a position in derivatives is typically
much less than for an equivalent exposure in the cash markets.
Greater liquidity. The low cash requirement for derivatives transactions makes
very large transactions easier to handle.

Improved Market Efficiency

Low transaction costs, greater liquidity and leverage, and ease of short sales all
make it less costly to exploit securities mispricing through derivatives transactions
and improve the ef iciency of market prices.
 Greater liquidity. The low cash requirement for derivatives transactions makes
very large transactions easier to handle.

Improved Market Efficiency

Low transaction costs, greater liquidity and leverage, and ease of short sales all
make it less costly to exploit securities mispricing through derivatives transactions
and improve the ef iciency of market prices.

Risks of Derivatives

Implicit Leverage
The implicit leverage in derivatives contracts gives them much more risk than their
cash market equivalents. Just as we have shown regarding the leverage of an equity
investment on margin, a lower cash requirement to enter a trade increases leverage.
Futures margins, according to the CME Group, are typically in the 3% to 12% range,
indicating leverage of 8:1 to 33:1. With required cash margin of 4%, a 1% decrease
in the futures price decreases the cash margin by 25%.
A lack of transparency in derivatives contracts and securities that combine
derivative and cash market exposures (structured securities) may lead to situations
in which the purchasers do not well understand the risks of derivatives or securities
with embedded derivatives.

Basis Risk
Basis risk arises when the underlying of a derivative differs from a position being
hedged with the derivative. For a manager with a portfolio of 50 large-cap U.S.
stocks, selling a forward with the S&P 500 Index as the underlying (in an amount
equal to the portfolio value) would hedge portfolio risk, but would not eliminate it
because of the possibility that returns on the portfolio and returns on the index may
differ over the life of the forward. Basis risk also arises in a situation where an
investor’s horizon and the settlement date of the hedging derivative differ, such as
hedging the value of a corn harvest that will occur on September 15 by selling corn
futures that settle on October 1. Again the hedge may be effective but will not be
perfect, and the corn producer is said to have basis risk.

Liquidity Risk
Derivative instruments have a special type of liquidity risk when the cash lows
because of the possibility that returns on the portfolio and returns on the index may
differ over the life of the forward. Basis risk also arises in a situation where an
investor’s horizon and the settlement date of the hedging derivative differ, such as
hedging the value of a corn harvest that will occur on September 15 by selling corn
futures that settle on October 1. Again the hedge may be effective but will not be
perfect, and the corn producer is said to have basis risk.

Liquidity Risk
Derivative instruments have a special type of liquidity risk when the cash lows
from a derivatives hedge do not match the cash lows of the investor positions. As an
example, consider a farmer who sells wheat futures to hedge the value of her wheat
harvest. If the future price of wheat increases, losses on the short position
essentially offset the extra income from the higher price that will come at harvest
(as intended with a hedge), but these losses may also cause the farmer to get margin
calls during the life of the contract. If the farmer does not have the cash (liquidity)
to meet the margin calls, the position will be closed out and the value of the hedge
will be lost.

Counterparty Credit Risk

We have discussed counterparty credit risk previously. Here we note additionally
that different derivatives and positions have important differences in the existence
or amount of counterparty risk. The seller of an option faces no counterparty credit
risk; once the seller receives the option premium there is no circumstance in which
the seller will be owed more at settlement. On the other hand, the buyer of an option
will be owed money at settlement if the option is in the money; thus, the buyer faces
counterparty credit risk. In contrast, both the buyer and seller of a forward on an
Counterparty Credit Risk
We have discussed counterparty credit risk previously. Here we note additionally
that different derivatives and positions have important differences in the existence
or amount of counterparty risk. The seller of an option faces no counterparty credit
risk; once the seller receives the option premium there is no circumstance in which
the seller will be owed more at settlement. On the other hand, the buyer of an option
will be owed money at settlement if the option is in the money; thus, the buyer faces
counterparty credit risk. In contrast, both the buyer and seller of a forward on an
underlying asset may face counterparty credit risk.
In futures markets the deposit of initial margin, the daily mark-to-market, and the
guarantee of the central clearinghouse all reduce counterparty risk. With forwards
there may be no guarantees, or the terms of the forward contract may specify
margin deposits, a periodic mark-to-market, and a central clearing party to mitigate
credit risk.

Systemic Risk
Widespread impact on inancial markets and institutions may arise from excessive
speculation using derivative instruments. Market regulators attempt to reduce
systemic risk though regulation, for example the central clearing requirement for
swap markets to reduce counterparty credit risk.

LOS 70.b: Compare the use of derivatives among issuers and investors.

Derivatives Use by Issuers

Corporate users of derivative instruments are considered issuers of derivatives. A
non- inancial corporation may have risks associated with changes in asset and
liability values as well as earnings volatility from changes in various underlying
securities or interest rates. Some examples are:
A corporation may have income in a foreign currency and hedge the exchange
rate risk with forwards to smooth earnings reported in their domestic currency.
A corporation may use fair value reporting for its ixed-rate debt, and that value
changes as interest rates change. By entering an interest rate swap as the loating-
rate payer, the corporation has essentially converted the ixed-rate liability to a
loating-rate liability that has much lower duration so that its balance sheet value
is less sensitive to changes in interest rates.
liability values as well as earnings volatility from changes in various underlying
securities or interest rates. Some examples are:
A corporation may have income in a foreign currency and hedge the exchange
rate risk with forwards to smooth earnings reported in their domestic currency.
A corporation may use fair value reporting for its ixed-rate debt, and that value
changes as interest rates change. By entering an interest rate swap as the loating-
rate payer, the corporation has essentially converted the ixed-rate liability to a
loating-rate liability that has much lower duration so that its balance sheet value
is less sensitive to changes in interest rates.
A corporation with a commodity-like product may carry its inventory at fair
market value, leading to luctuations in the value reported on the balance sheet
over time as the market price of their product changes. By selling forward
contracts on an underlying that matches well with their product, the irm will
have gains or losses on the forwards that offset decreases or increases in reported
inventory value. With the market value of the forward position also reported on
the balance sheet, total assets will have less variation from changes in the market
price of their product.
Accounting rules may permit hedge accounting. Hedge accounting allows irms to
recognize the gains and losses of qualifying derivative hedges at the same time they
recognize the corresponding changes in the values of assets or liabilities being
hedged. Issuer hedges against the effects of a changing price or value of a
derivative’s underlying are classi ied by their purpose.
A hedge of the domestic currency value of future receipts in a foreign currency
using forwards is termed a cash low hedge. A swap that converts a loating-rate
liability to a ixed-rate liability is also considered a cash low hedge (cash lows
for interest payments are more certain).
Accounting rules may permit hedge accounting. Hedge accounting allows irms to
recognize the gains and losses of qualifying derivative hedges at the same time they
recognize the corresponding changes in the values of assets or liabilities being
hedged. Issuer hedges against the effects of a changing price or value of a
derivative’s underlying are classi ied by their purpose.
A hedge of the domestic currency value of future receipts in a foreign currency
using forwards is termed a cash low hedge. A swap that converts a loating-rate
liability to a ixed-rate liability is also considered a cash low hedge (cash lows
for interest payments are more certain).
A fair value hedge is one that reduces (offsets) changes in the values of the irm’s
assets or liabilities. Our examples of a irm that uses derivatives to hedge against
changes in the balance sheet value of its inventory, and a irm that uses an interest
rate swap to decrease the volatility of debt values on its balance sheet, are
considered fair value hedges.
A net investment hedge is one that reduces the volatility of the value of the
equity of a company’s foreign subsidiary reported on its balance sheet. Foreign
currency forwards or futures can be used to hedge changes in the reported value
of the subsidiary’s equity due to changes in exchange rates.
Derivatives Use by Investors
As we have seen, investors can hedge, modify, or increase their exposure to the risk
of an underlying asset or interest rate with derivatives positions, either forward
commitments or contingent claims. Some examples are:
An investor can buy silver forwards to gain exposure to the price of silver, with no
or low funds initially required.
An investor can increase the duration of their bond portfolio by entering an
interest rate swap as the loating-rate payer/ ixed-rate receiver, which is similar
to issuing loating-rate debt and buying a ixed-rate bond with the proceeds.
An equity portfolio manager can modify their market risk exposure temporarily
at low cost, increasing it by buying equity index futures or decreasing it by selling
equity index futures. Alternatively, the portfolio manager could decrease
downside risk and preserve upside potential by buying puts on an equity index.

MODULE QUIZ 70.1

1. Which of the following most accurately describes a risk of derivative instruments?
A. Derivatives make it easier for market participants to take short positions.
B. The underlying of a derivative might not fully match a position being hedged.
 An equity portfolio manager can modify their market risk exposure temporarily
at low cost, increasing it by buying equity index futures or decreasing it by selling
equity index futures. Alternatively, the portfolio manager could decrease
downside risk and preserve upside potential by buying puts on an equity index.

MODULE QUIZ 70.1

1. Which of the following most accurately describes a risk of derivative instruments?
A. Derivatives make it easier for market participants to take short positions.
B. The underlying of a derivative might not fully match a position being hedged.
C. Volatility in underlying asset prices is implied by the prices of options on those
assets.
2. Uses of derivatives by investors most likely include:
A. hedging against price risk for inventory held.
B. modifying the risk exposure of a securities portfolio.
C. stabilizing the balance sheet value of a foreign subsidiary.

KEY CONCEPTS

LOS 70.a
Advantages of derivatives include the ability to change or transfer risk; information
discovery about the expected prices or volatility of underlying assets or interest
rates; operational advantages such as ease of short sales, low transaction costs, and
greater leverage and liquidity; and improved market ef iciency.
Risks of derivatives include implicit leverage, basis risk from inexact hedges,
liquidity risk from required cash lows, counterparty credit risk, and systemic risk
for inancial markets.
LOS 70.a
Advantages of derivatives include the ability to change or transfer risk; information
discovery about the expected prices or volatility of underlying assets or interest
rates; operational advantages such as ease of short sales, low transaction costs, and
greater leverage and liquidity; and improved market ef iciency.
Risks of derivatives include implicit leverage, basis risk from inexact hedges,
liquidity risk from required cash lows, counterparty credit risk, and systemic risk
for inancial markets.

LOS 70.b
Derivatives uses by issuers include managing risks associated with changes in asset
and liability values as well as earnings volatility from changes in various underlying
securities or interest rates.
Derivatives uses by investors include hedging, modifying, or increasing their
exposure to the risk of an underlying asset or interest rate.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 70.1

1. B Basis risk arises when the underlying of a derivative differs from a position
being hedged. Ease of taking short positions with derivatives compared to
their underlying assets, and the information about implied volatility that is
revealed by option prices, are two of the advantages of derivative instruments.
(LOS 70.a)
2. B Modifying the risk exposure of a securities portfolio is an example of
derivatives use by investors. Hedging against price risk for inventory and
stabilizing the balance sheet value of a foreign subsidiary are examples of
derivatives use by issuers. (LOS 70.b)
READING 71

ARBITRAGE, REPLICATION, AND

THE COST OF CARRY IN PRICING
DERIVATIVES

MODULE 71.1: ARBITRAGE, REPLICATION, AND

CARRYING COSTS

LOS 71.a: Explain how the concepts of arbitrage and replication

MODULE 71.1: ARBITRAGE, REPLICATION, AND
CARRYING COSTS

LOS 71.a: Explain how the concepts of arbitrage and replication

are used in pricing derivatives. Video covering
this content is
available online.
In contrast to valuing risky assets as the (risk-adjusted) present
value of expected future cash lows, the valuation of derivative securities is based on
a no-arbitrage condition. Arbitrage refers to a transaction in which an investor
purchases one asset or portfolio of assets at one price and simultaneously sells an
asset or portfolio of assets that has the same future payoffs, regardless of future
events, at a higher price, realizing a risk-free gain on the transaction.
While arbitrage opportunities may be rare, the reasoning is that when they do exist,
they will be exploited rapidly. Therefore, we can use a no-arbitrage condition to
determine the current value of a derivative, based on the known value of a portfolio
of assets that has the same future payoffs as the derivative, regardless of future
events. Because there are transaction costs of exploiting an arbitrage opportunity,
small differences in price may persist when the arbitrage gain is less than the
transaction costs of exploiting it.
We can illustrate no-arbitrage pricing with a 1-year forward contract, with a
forward price of F0(1), on an Acme share that pays no dividends and is trading at a
they will be exploited rapidly. Therefore, we can use a no-arbitrage condition to
determine the current value of a derivative, based on the known value of a portfolio
of assets that has the same future payoffs as the derivative, regardless of future
events. Because there are transaction costs of exploiting an arbitrage opportunity,
small differences in price may persist when the arbitrage gain is less than the
transaction costs of exploiting it.
We can illustrate no-arbitrage pricing with a 1-year forward contract, with a
forward price of F0(1), on an Acme share that pays no dividends and is trading at a
current price, S0, of $30.

Consider two strategies to own an Acme share at t =1:

Portfolio 1: Buy a pure discount bond with a yield of 5% that pays F0(1) at t = 1.
The current cost of the bond is F0(1)/1.05. Additionally, enter a forward contract
on one Acme share at F0(1) as the buyer. The forward has a zero cost, so the cost
of Portfolio 1 is F0(1)/1.05.
At t = 1 the bond pays F0(1), which will buy an Acme share at the forward price,
so that the payoff on Portfolio 1 is the value of one share at t = 1, S1.
 Portfolio 2: Buy a share of Acme at S0 = 30 and hold it for one year. Cost at t = 0 is
$30.
At t = 1 the value of the Acme share is S1, and this is the payoff for Portfolio 2.

The no-arbitrage condition (law of one price) requires that two portfolios with the
same payoff in the future for any future value of Acme have the same cost today.
Because our two portfolios have a payoff of S1, they must have the same cost at t = 0
to prevent arbitrage. That is, F0(1)/1.05 = $30, so we can solve for the no-arbitrage
forward price as F0(1) = 30(1.05) = 31.50.

To better understand the no-arbitrage condition, we will consider two situations in

which the forward price is not at its no-arbitrage value: F0(1) > 31.50 and F0(1) <
31.50.
If the forward contract price is 32 (F0(1) > 31.50), the pro itable arbitrage is to
sell the forward (because the forward price is “too high”) and buy a share of stock.
At t = 1, deliver the share under the forward contract and receive 32, for a return
of 32/30 - 1 = 6.67%, which is higher than the risk-free rate.
We can also view this transaction as borrowing 30 at the risk-free rate (5%) to
buy the Acme share at t = 0, and at t = 1 paying 31.50 to settle the loan. The share
To better understand the no-arbitrage condition, we will consider two situations in
which the forward price is not at its no-arbitrage value: F0(1) > 31.50 and F0(1) <
31.50.
If the forward contract price is 32 (F0(1) > 31.50), the pro itable arbitrage is to
sell the forward (because the forward price is “too high”) and buy a share of stock.
At t = 1, deliver the share under the forward contract and receive 32, for a return
of 32/30 - 1 = 6.67%, which is higher than the risk-free rate.
We can also view this transaction as borrowing 30 at the risk-free rate (5%) to
buy the Acme share at t = 0, and at t = 1 paying 31.50 to settle the loan. The share
delivered under the forward has a contract price of 32, so the arbitrageur has an
arbitrage pro it of 32 - 31.50 = 0.50 with no risk and no initial cost.
If the forward contract price is 31 (F0(1) < 31.50), the pro itable arbitrage is to
buy the forward and sell short an Acme share at t = 0. The proceeds of the short
sale, 30, can be invested at the risk-free rate to produce 30(1.05) = 31.50 at t = 1.
The forward contract requires the purchase of a share of Acme for 31, which the
investor can return to close out the short position. The pro it to an arbitrageur is
31.50 - 31 = 0.50. With no cash investment at t = 0, the investor receives an
arbitrage pro it of 0.50 at t = 1.
When the forward price is “too high,” the arbitrage is to sell the forward and buy the
underlying asset. When the forward price is “too low,” the arbitrage is to buy the
forward and sell (short) the underlying asset. In either case, the actions of
arbitrageurs will move the forward price toward its no-arbitrage level until
arbitrage pro its are no longer possible.
Replication refers to creating a portfolio with cash market transactions that has the
same payoffs as a derivative for all possible future values of the underlying.
When the forward price is “too high,” the arbitrage is to sell the forward and buy the
underlying asset. When the forward price is “too low,” the arbitrage is to buy the
forward and sell (short) the underlying asset. In either case, the actions of
arbitrageurs will move the forward price toward its no-arbitrage level until
arbitrage pro its are no longer possible.
Replication refers to creating a portfolio with cash market transactions that has the
same payoffs as a derivative for all possible future values of the underlying.
Our arbitrage example for Acme forwards will serve to illustrate replication.
A long forward on an Acme share can be replicated by borrowing 30 at 5% to
purchase an Acme share, and repaying the loan on the settlement date of the
forward. At settlement (t = 1), the payoff on the replication is S1 - 30(1.05) = S1 -
31.50 (value of one share minus the repayment of the loan), the same as the payoff
on a long forward at 31.50, for any value of Acme shares at settlement.
A short forward on an Acme share can be replicated by shorting an Acme share and
investing the proceeds of 30 at 5%. At settlement the investor receives 31.50 from
the investment of short sale proceeds, and must buy a share of Acme for S1. The
payoff on the replicating portfolio is 31.50 - S1, the same as the payoff on a short
forward at 31.50, for any value of Acme shares at settlement.
These replications allow us to calculate the no-arbitrage forward price of an asset,
just as we did in our example using Acme shares. Because our replicating portfolio
for a long forward has the same payoff as a long forward at time = T, the payoff at
settlement on a portfolio that is long the replicating portfolio and short the forward
must be zero to prevent arbitrage. For this strategy, when the forward is priced at its
no-arbitrage value the payoff at time = T is:
ST - S0(1 + Rf)T - [ST - F0(T)] = 0

so that S0(1 + Rf)T + F0(T) = 0 and F0(T) = S0(1 + Rf)T.

For a portfolio that is short the replicating portfolio and long the forward, the payoff
at time T is:
S0(1 + Rf)T- ST + [ST - F0(T)] = 0

so that S0(1 + Rf)T - F0(T) = 0 and F0(T) = S0(1 + Rf)T.

The forward price that will prevent arbitrage is S0(1 + Rf)T, just as we found in our
example of a forward contract on an Acme share.
 so that S0(1 + Rf)T + F0(T) = 0 and F0(T) = S0(1 + Rf)T.

For a portfolio that is short the replicating portfolio and long the forward, the payoff
at time T is:
S0(1 + Rf)T- ST + [ST - F0(T)] = 0

so that S0(1 + Rf)T - F0(T) = 0 and F0(T) = S0(1 + Rf)T.

The forward price that will prevent arbitrage is S0(1 + Rf)T, just as we found in our
example of a forward contract on an Acme share.

LOS 71.b: Explain the difference between the spot and expected future price
of an underlying and the cost of carry associated with holding the underlying
asset.

When we derived the no-arbitrage forward price for an asset as F0(T) = S0(1 + Rf)T,
we assumed there were no bene its of holding the asset and no costs of holding the
asset, other than the opportunity cost of the funds to purchase the asset (the risk-
free rate of interest).
Any additional costs or bene its of holding the underlying asset must be accounted
for in calculating the no-arbitrage forward price. There may be additional costs of
owning an asset, especially with commodities, such as storage and insurance costs.
For inancial assets, these costs are very low and not signi icant.
There may also be monetary bene its to holding an asset, such as dividend payments
for equities and interest payments for debt instruments. Holding commodities may
have non-monetary bene its, referred to as convenience yield. If an asset is dif icult
free rate of interest).
Any additional costs or bene its of holding the underlying asset must be accounted
for in calculating the no-arbitrage forward price. There may be additional costs of
owning an asset, especially with commodities, such as storage and insurance costs.
For inancial assets, these costs are very low and not signi icant.
There may also be monetary bene its to holding an asset, such as dividend payments
for equities and interest payments for debt instruments. Holding commodities may
have non-monetary bene its, referred to as convenience yield. If an asset is dif icult
to sell short in the market, owning it may convey bene its in circumstances where
selling the asset is advantageous. For example, a shortage of the asset may drive
prices up temporarily, making sale of the asset in the short term pro itable.
We denote the present value of any costs of holding the asset from time 0 to
settlement at time T (e.g., storage, insurance, spoilage) as PV0(cost), and the present
value of any cash lows from the asset or convenience yield over the holding period
as PV0(bene it).
Consider irst a case where there are storage costs of holding the asset, but no
bene its. For an asset with no costs or bene its of holding the asset, we established
the no-arbitrage forward price as S0(1 + Rf)T, the cost of buying and holding the
underlying asset until time T. When there are storage costs to hold the asset until
time T, an arbitrageur must both buy the asset and pay the present value of storage
costs at t = 0. This increases the no-arbitrage price of a 1-year forward to [S0+
PV0(cost)](1 + Rf)T. Here we see that costs of holding an asset increase its no-
arbitrage forward price.
Next consider a case where holding the asset has bene its, but no costs. Returning to
our example of a 1-year forward on a share of Acme stock trading at 30, now
consider the costs of buying and holding an Acme share that pays a dividend of $1
during the life of the forward contract. In this case, an arbitrageur can now borrow
the present value of the dividend (discounted at Rf), and repay that loan when the
dividend is received. The cost to buy and hold Acme stock with an annual dividend
of $1 is [30 - PV0(1)](1.05) = 30(1.05) - 1. This illustrates that bene its of holding an
asset decrease its no-arbitrage forward price.
The no-arbitrage price of a forward on an asset that has both costs and bene its of
holding the asset is simply [S0 + PV0 (costs) - PV0(bene it)](1 + Rf)T.
We can also describe these relationships when costs and bene its are expressed as
during the life of the forward contract. In this case, an arbitrageur can now borrow
the present value of the dividend (discounted at Rf), and repay that loan when the
dividend is received. The cost to buy and hold Acme stock with an annual dividend
of $1 is [30 - PV0(1)](1.05) = 30(1.05) - 1. This illustrates that bene its of holding an
asset decrease its no-arbitrage forward price.
The no-arbitrage price of a forward on an asset that has both costs and bene its of
holding the asset is simply [S0 + PV0 (costs) - PV0(bene it)](1 + Rf)T.
We can also describe these relationships when costs and bene its are expressed as
continuously compounded rates of return. Recall from Quantitative Methods that
given a stated annual rate of r with continuous compounding, the effective annual
return is er - 1, and the relationships between present and future values of S for a 1-
year period are FV = Ser and PV = Se-r. For a period of T years, FV = SerT and PV = Se-
rT . With continuous compounding the following relationships hold:

With no costs or bene its of holding the underlying asset, the no-arbitrage price of
a forward that settles at time T is S0erT, where r is the stated annual risk-free rate
with continuous compounding.
With storage costs at a continuously compounded annual rate of c, the no-
arbitrage forward price until time T is S0e(r+c)T.
With bene its, such as a dividend yield, expressed at a continuously compounded
annual rate of b, the no-arbitrage forward price is until time T is S0e(r+c-b)T.

EXAMPLE: No-arbitrage price with continuous compounding

Consider a stock index trading at 1,550 with a dividend yield of 1.3%
(continuously compounded rate) when the risk-free rate is 3% (continuously
 With storage costs at a continuously compounded annual rate of c, the no-
arbitrage forward price until time T is S0e(r+c)T.
With bene its, such as a dividend yield, expressed at a continuously compounded
annual rate of b, the no-arbitrage forward price is until time T is S0e(r+c-b)T.

EXAMPLE: No-arbitrage price with continuous compounding

Consider a stock index trading at 1,550 with a dividend yield of 1.3%
(continuously compounded rate) when the risk-free rate is 3% (continuously
compounded rate). Calculate the no-arbitrage 6-month forward price of the stock
index.
Answer:
The no-arbitrage price of a long 6-month forward is 1,550 × e(0.03 - 0.013)(0.5) =
1,563.23.

Forward Contracts on Currencies

Recall from Economics that we de ined the no-arbitrage price of a forward on a
currency as the forward price that satis ies the equality:
We can use this no-arbitrage forward rate to examine how an arbitrage pro it can be
made when the exchange rate in a forward contract is greater or less than the no-
arbitrage forward exchange rate. The forward exchange rate depends on the spot
exchange rate and the difference between the interest rates on the base and price
currencies.
Consider a situation at t = 0 where the risk-free rate in euros is 3%, the risk-free rate
in U.S. dollars is 2%, and the current USD/EUR exchange rate is 1.10. We will
examine the arbitrage transactions that establish this relationship by looking at the
trades for an investor based in the United States that seeks to pro it from the higher
interest rate on euros. The investor borrows 100 USD for one year at 2%, exchanges
the USD for euros, invests the euros for one year at 3%, and then exchanges the
resulting euros for USD. At the end of one year the arbitrageur will have 100/1.10 ×
1.03 = 93.64 euros and owe 100(1.02) = 102 USD.
As these transactions have no net cost, there should be no gain from this transaction
relative to simply investing the USD for one year at 2%. If this is the case, the 93.64
euros should equal 102 USD. This is the case if the exchange rate at the end of the
trades for an investor based in the United States that seeks to pro it from the higher
interest rate on euros. The investor borrows 100 USD for one year at 2%, exchanges
the USD for euros, invests the euros for one year at 3%, and then exchanges the
resulting euros for USD. At the end of one year the arbitrageur will have 100/1.10 ×
1.03 = 93.64 euros and owe 100(1.02) = 102 USD.
As these transactions have no net cost, there should be no gain from this transaction
relative to simply investing the USD for one year at 2%. If this is the case, the 93.64
euros should equal 102 USD. This is the case if the exchange rate at the end of the
year is 102/93.64, which equals a USD/EUR exchange rate of 1.0893. This is the no-
arbitrage forward rate. From the formula we saw in Economics we can arrive at the
same solution by 1.10 × (1.02/1.03) = 1.0893.
If the arbitrageur has a forward contract to buy USD with a price of 1/1.0893 =
0.9180 euros, he can exchange the 93.64 euros for 93.64/0.9180 = 102 USD, which is
the amount owed on the original loan of 100 USD. The depreciation of the euro in
the forward price just offsets the higher euro interest, and the arbitrage transaction
returns zero. With a forward exchange rate greater than 1.0893, the arbitrage would
have a pro it, and with a forward exchange rate less than 1.0893, an arbitrageur
could pro it from the opposite transactions.
If we convert the effective annual rates to equivalent stated annual rates with
continuous compounding, we get RUSD = ln 1.02 = 1.98% and REUR = ln 1.03 = 2.96%.
In this case we can say: forward exchange rate = 1.10 × e (0.0198-0.0296) = 1.0893.

MODULE QUIZ 71.1

1. Derivatives pricing models use the risk-free rate to discount future cash flows
because these models:
could pro it from the opposite transactions.
If we convert the effective annual rates to equivalent stated annual rates with
continuous compounding, we get RUSD = ln 1.02 = 1.98% and REUR = ln 1.03 = 2.96%.
In this case we can say: forward exchange rate = 1.10 × e (0.0198-0.0296) = 1.0893.

MODULE QUIZ 71.1

1. Derivatives pricing models use the risk-free rate to discount future cash flows
because these models:
A. are based on portfolios with certain payoffs.
B. assume that derivatives investors are risk-neutral.
C. assume that risk can be eliminated by diversification.
2. Arbitrage prevents:
A. market efficiency.
B. earning returns higher than the risk-free rate of return.
C. two assets with identical payoffs from selling at different prices.
3. The underlying asset of a derivative is most likely to have a convenience yield
when the asset:
A. is difficult to sell short.
B. pays interest or dividends.
C. must be stored and insured.
 4. An investor can replicate a forward on a stock that pays no dividends by:
A. selling the underlying short and investing the proceeds at the risk-free rate.
B. buying the underlying in the spot market and holding it.
C. borrowing at the risk-free rate to buy the underlying.
5. The forward price of a commodity will most likely be equal to the current spot price
if the:
A. convenience yield equals the storage costs as a percentage.
B. convenience yield is equal to the risk-free rate plus storage costs as a
percentage.
C. risk-free rate equals the storage costs as a percentage minus the convenience
yield.

KEY CONCEPTS

LOS 71.a
Valuation of derivative securities is based on a no-arbitrage condition. When the
forward price is too high, the arbitrage is to sell the forward and buy the underlying
asset. When the forward price is too low, the arbitrage is to buy the forward and sell
short the underlying asset. Arbitrage will move the forward price toward its no-
arbitrage level.
KEY CONCEPTS

LOS 71.a
Valuation of derivative securities is based on a no-arbitrage condition. When the
forward price is too high, the arbitrage is to sell the forward and buy the underlying
asset. When the forward price is too low, the arbitrage is to buy the forward and sell
short the underlying asset. Arbitrage will move the forward price toward its no-
arbitrage level.
Replication refers to creating a portfolio with cash market transactions that has the
same payoffs as a derivative for all possible future values of the underlying.
Replication allows us to calculate the no-arbitrage forward price of an asset.

LOS 71.b
Assuming no costs or bene its of holding the underlying asset, the forward price that
will prevent arbitrage is the spot price compounded at the risk-free rate over the
time until expiration.
The cost of carry is the bene its of holding the asset minus the costs of holding the
asset.
Greater costs of holding an asset increase its no-arbitrage forward price.
Greater bene its of holding an asset decrease its no-arbitrage forward price.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 71.1

The cost of carry is the bene its of holding the asset minus the costs of holding the
asset.
Greater costs of holding an asset increase its no-arbitrage forward price.
Greater bene its of holding an asset decrease its no-arbitrage forward price.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 71.1

1. A Derivatives pricing models use the risk-free rate to discount future cash lows
because they are based on arbitrage relationships that are theoretically
riskless. (LOS 71.a)
2. C Arbitrage forces two assets with the same expected future value to sell for the
same current price. (LOS 71.a)
3. A Convenience yield refers to nonmonetary bene its from holding an asset. One
example of convenience yield is the advantage of owning an asset that is
dif icult to sell short when it is perceived to be overvalued. Interest and
 dividends are monetary bene its. Storage and insurance are carrying costs.
(LOS 71.b)
4. C Borrowing S0 at Rf to buy the underlying asset at S0 has a zero cost and pays
the spot price of the underlying asset minus the loan repayment of at time = T
of S0(1 + Rf)T, which is the same payoff as a long forward at F0 = S0(1 + Rf)T,
the no-arbitrage forward price. (LOS 71.a)
5. B When the opportunity cost of funds (Rf) and storage costs just offset the
bene its of holding the commodity, the no-arbitrage forward price is equal to
the current spot price of the underlying commodity. (LOS 71.b)
READING 72

PRICING AND VALUATION OF

FORWARD CONTRACTS AND FOR
AN UNDERLYING WITH VARYING
MATURITIES

MODULE 72.1: FORWARD CONTRACT VALUATION

LOS 72.a: Explain how the value and price of a forward contract
MATURITIES

MODULE 72.1: FORWARD CONTRACT VALUATION

LOS 72.a: Explain how the value and price of a forward contract
are determined at initiation, during the life of the contract, and Video covering
at expiration. this content is
available online.

Consider a forward contract that is initially priced at its no-arbitrage value of F0(T)
= S0(1 + Rf)T. At initiation, the value of such a forward is: V0(T) = S0 - F0(T) (1 + Rf)-T
= 0.
At any time during its life, the value of the forward contract to the buyer will be
Vt(T) = St - F0(T) (1 + Rf)-(T-t). This is simply the current spot price of the asset minus
the present value of the forward contract price.
This value can be realized by selling the asset short at St and investing F0(T) (1 + Rf)-
(T-t) in a pure discount bond at Rf. These transactions end any exposure to the

forward; at settlement, the proceeds of the bond will cover the cost of the asset at
the forward price, and the asset can be delivered to cover the short position.
At expiration, time T, the value of a forward to the buyer is = ST - F0(T)(1 + Rf)-(T-T) =
ST - F0(T). The long buys an asset valued at ST for the forward contract price of
 t t 0
the present value of the forward contract price.
This value can be realized by selling the asset short at St and investing F0(T) (1 + Rf)-
(T-t) in a pure discount bond at Rf. These transactions end any exposure to the

forward; at settlement, the proceeds of the bond will cover the cost of the asset at
the forward price, and the asset can be delivered to cover the short position.
At expiration, time T, the value of a forward to the buyer is = ST - F0(T)(1 + Rf)-(T-T) =
ST - F0(T). The long buys an asset valued at ST for the forward contract price of
F0(T), gaining if ST > F0(T), losing if ST < F0(T). If the forward buyer has a gain, the
forward seller has an equal loss, and vice versa.
In the more general case, when there are costs and bene its of holding the underlying
asset, the value of a forward to the buyer at time = t < T is:
Vt(T) = [St+ PVt (costs) - PVt(bene it)] - F0(T) (1 + Rf)-(T-t)

LOS 72.b: Explain how forward rates are determined for interest rate forward
contracts and describe the uses of these forward rates.
Forward rates are yields for future periods. The rate of interest on a 1-year loan to
be made two years from today is a forward rate.
The notation for forward rates must identify both the length of the loan period and
how far in the future the money will be loaned (or borrowed). 1y1y or F1,1 is the
rate for a 1-year loan one year from now; 2y1y or F2,1 is the rate for a 1-year loan to
be made two years from now; the 2-year forward rate three years from today is
3y2y or F3,2; and so on.

Figure 72.1: Forward Rates

For money market rates the notation is similar, with 3m6m denoting a 6-month rate
three months in the future.
For money market rates the notation is similar, with 3m6m denoting a 6-month rate
three months in the future.
Recall that spot rates are zero-coupon rates. We will denote the YTM (with annual
compounding) on a zero-coupon bond maturing in n years as Zn.
An implied forward rate is the forward rate for which the following two strategies
have the same yield over the total period:
Investing from t = 0 to the forward date, and rolling over the proceeds for the
period of the forward.
Investing from t = 0 until the end of the forward period.
As an example, lending for two years at Z2 would produce the same ending value as
lending for one year at Z1 and, at t = 1, lending the proceeds of that loan for one year
at F1,1. That is, (1 + Z2)2 = (1 + Z1)(1 + F1,1 ). When this condition holds, F1,1 is the
implied (no-arbitrage) forward rate.

EXAMPLE: Implied forward rate

Consider two zero-coupon bonds, one that matures in two years and one that
matures in three years, when Z2 = 2% and Z3 = 3%. Calculate the implied 1-year
As an example, lending for two years at Z2 would produce the same ending value as
lending for one year at Z1 and, at t = 1, lending the proceeds of that loan for one year
at F1,1. That is, (1 + Z2)2 = (1 + Z1)(1 + F1,1 ). When this condition holds, F1,1 is the
implied (no-arbitrage) forward rate.

EXAMPLE: Implied forward rate

Consider two zero-coupon bonds, one that matures in two years and one that
matures in three years, when Z2 = 2% and Z3 = 3%. Calculate the implied 1-year
forward rate two years from now, F2,1.
Answer:
As illustrated in Figure 72.2, lending for three years at Z3 should be equivalent to
lending for two years at Z2 and then for the third year at F2,1.

Figure 72.2: Implied Forward Rate

 Lending $100 for two years at Z2 (2%) results in a payment of $100(1.02)2 =
$104.04 at t = 2, while lending $100 for three years at Z3 (3%) results in a payment
of $100(1.03)3 = $109.27. The forward interest rate F2,1 must be 109.27/104.04 - 1
= 5.03%, the implied forward rate from t = 2 to t = 3.

An example of an interest rate derivative is a forward rate agreement (FRA), in

which the ixed-rate payer (long) will pay the forward rate on a notional amount of
principal at a future date, and the loating-rate payer will pay a future reference rate
times that same amount of principal. In practice, only the net amount is exchanged.
Consider a 3-month forward on a 6-month MRR (F3m6m) with a notional principal of
$1 million. At settlement in three months, the buyer receives (or pays) the present
 = 5.03%, the implied forward rate from t = 2 to t = 3.

An example of an interest rate derivative is a forward rate agreement (FRA), in

which the ixed-rate payer (long) will pay the forward rate on a notional amount of
principal at a future date, and the loating-rate payer will pay a future reference rate
times that same amount of principal. In practice, only the net amount is exchanged.
Consider a 3-month forward on a 6-month MRR (F3m6m) with a notional principal of
$1 million. At settlement in three months, the buyer receives (or pays) the present
value of (realized 6-month MRR - 1%)/2 × $1 million.
We divide by 2 because MRRs are typically annualized rates. We take the present
value of the difference in interest because the settlement payment is at the
beginning of the 6-month period, whereas the interest savings would be at the end of
the period.
Assume that the current 3-month MRR is 1.0% and 9-month MRR is 1.2%. Adjusting
for periodicity, the no-arbitrage condition for the value of F3m6m is:

The implied forward rate, F3m6m, as an annualized rate, is:

Now let’s examine the payoff to the ixed-rate payer in an F3m6m FRA with a notional
principal of $1 million when the 6-month MRR three months from now is 1.5%.
The implied forward rate, F3m6m, as an annualized rate, is:

Now let’s examine the payoff to the ixed-rate payer in an F3m6m FRA with a notional
principal of $1 million when the 6-month MRR three months from now is 1.5%.
Because the realized 6-month MRR is greater than the forward rate, the ixed-rate
payer ( loating-rate receiver) will have a gain.
The payment to the ixed-rate payer is the present value (discounted at 6-month
MRR) of the interest differential between two 6-month loans, one at 1.3% and one at
1.5% (both annualized rates). The ixed-rate payer in the FRA receives:

FRAs are used primarily by inancial institutions to manage the volatility of their
interest-sensitive assets and liabilities. FRAs are also the building blocks of interest
rate swaps over multiple periods. An FRA is equivalent to a single-period swap.
Multiple-period swaps are used primarily by investors and issuers to manage
interest rate risk.

MODULE QUIZ 72.1

1. Two parties agree to a forward contract to exchange 100 shares of a stock one year
from now for $72 per share. Immediately after they initiate the contract, the price
of the underlying stock increases to $74 per share. This share price increase
represents a gain for:
A. the buyer.
B. the seller.
C. neither the buyer nor the seller.
2. The forward rate F2,3 represents the interest rate on a loan for the period from:
A. Year 2 to Year 3.
B. Year 2 to Year 5.
C. Year 3 to Year 5.
3. Given zero-coupon bond yields for 1, 2, and 3 years, an analyst can least likely
derive an implied:
A. 1-year forward 1-year rate.
B. 2-year forward 1-year rate.
C. 2-year forward 2-year rate.
 2. The forward rate F2,3 represents the interest rate on a loan for the period from:
A. Year 2 to Year 3.
B. Year 2 to Year 5.
C. Year 3 to Year 5.
3. Given zero-coupon bond yields for 1, 2, and 3 years, an analyst can least likely
derive an implied:
A. 1-year forward 1-year rate.
B. 2-year forward 1-year rate.
C. 2-year forward 2-year rate.

KEY CONCEPTS

LOS 72.a
The value of a forward contract at initiation is zero.
During its life, the value of a forward contract to the buyer is the spot price of the
asset minus the present value of the forward contract price, and the value to the
seller is the present value of the forward contract price minus the spot price of the
asset.
At expiration, the value of a forward contract to the buyer is the spot price of the
asset minus the forward contract price, and the value to the seller is the forward
contract price minus the spot price of the asset.

LOS 72.b
An implied forward rate is the forward rate for which the following two strategies
have the same yield over the total period:
Investing from t = 0 to the forward date, and rolling over the proceeds for the
At expiration, the value of a forward contract to the buyer is the spot price of the
asset minus the forward contract price, and the value to the seller is the forward
contract price minus the spot price of the asset.

LOS 72.b
An implied forward rate is the forward rate for which the following two strategies
have the same yield over the total period:
Investing from t = 0 to the forward date, and rolling over the proceeds for the
period of the forward.
Investing from t = 0 until the end of the forward period.
In a forward rate agreement (FRA), the ixed-rate payer (long) will pay the forward
rate on a notional amount of principal at a future date, and the loating-rate payer
will pay a future reference rate times that same amount of principal. FRAs are used
primarily by inancial institutions to manage the volatility of their interest-sensitive
assets and liabilities.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 72.1
1. A If the value of the underlying is greater than the forward price, this increases
the value of the forward contract, which represents a gain for the buyer and a
loss for the seller. (LOS 72.a)
2. B F2,3 is the 2-year forward 3-year rate, covering a period that begins two years
from now and extends for three years after that. (LOS 72.b)
3. C The forward rate F2,2 extends four years into the future and cannot be derived
using zero-coupon yields that only extend three years. From zero-coupon bond
yields for 1, 2, and 3 years, we can derive implied forward rates F1,1, F1,2, and
F2,1. (LOS 72.b)
 1,1 1,2
F2,1. (LOS 72.b)
READING 73

PRICING AND VALUATION OF

FUTURES CONTRACTS

MODULE 73.1: FUTURES VALUATION

LOS 73.a: Compare the value and price of forward and futures
contracts. Video covering
this content is
available online.
While the price of a forward contract is constant over its life when
MODULE 73.1: FUTURES VALUATION

LOS 73.a: Compare the value and price of forward and futures
contracts. Video covering
this content is
available online.
While the price of a forward contract is constant over its life when
no mark-to-market gains or losses are paid, its value will luctuate with changes in
the value of the underlying. The payment at settlement of the forward re lects the
difference between the (unchanged) forward price and the spot price of the
underlying.
The price and value of a futures contract both change when daily mark-to-market
gains and losses are settled. Consider a futures contract on 100 ounces of gold at
$1,870 purchased on Day 0. The following illustrates the changes in contract price
and value with daily mark-to-market payments.
The change in the futures price to the settlement price each day returns its value to
zero. Prices of forward contracts for which mark-to-market gains and losses are
settled daily will also be adjusted to the settlement price.
Interest rate futures contracts are available on many market reference rates. We
may view these as exchange-traded equivalents to forward rate agreements. One key
difference is that interest rate futures are quoted on a price basis. For a market
reference rate from time A to time B, an interest rate futures price is stated as
follows:
futures price = 100 – (100 × MRRA, B–A)
For example, if the futures price for a 6-month rate six months from now is 97, then
MRR6m, 6m = 3%.

Like other futures contracts, interest rate futures are subject to daily mark-to-
market. The basis point value (BPV) of an interest rate futures contract is de ined
as:
BPV = notional principal × period × 0.01%

If the contract in our example is based on notional principal of €1,000,000, its BPV is
€1,000,000 × (0.0001 / 2) = €50. This means a one basis point change in the MRR
will change the futures contract value by €50.

LOS 73.b: Explain why forward and futures prices differ.

For pricing, the most important distinction between futures and forwards is that
with futures, mark-to market gains and losses are paid each day. Gains above initial
margin can be withdrawn from a futures account and losses that reduce margin
deposits below their maintenance level require payments into the account.
Forwards most often have no mark-to-market cash lows, with gains or losses
LOS 73.b: Explain why forward and futures prices differ.

For pricing, the most important distinction between futures and forwards is that
with futures, mark-to market gains and losses are paid each day. Gains above initial
margin can be withdrawn from a futures account and losses that reduce margin
deposits below their maintenance level require payments into the account.
Forwards most often have no mark-to-market cash lows, with gains or losses
settled at contract expiration. Forwards typically do not require or provide funds in
response to luctuations in value during their lives.
If interest rates are constant or uncorrelated with futures prices over time, the
prices of futures and forwards are the same. A positive correlation between interest
rates and the futures price means that (for a long position) daily settlement provides
funds (excess margin) when rates are high and they can earn more interest, and
requires funds (margin deposits) when rates are low and opportunity cost of
deposited funds is less. Because of this, futures are theoretically more attractive than
forwards when interest rates and futures prices are positively correlated, and less
attractive than forwards when interest rates and futures prices are negatively
correlated.
Because of the short maturity of most forwards and the availability of funds at near
risk-free rates, differences between equivalent forwards and futures are not
observed in practice. Additionally, derivative dealers in some markets with central
clearing are required to post margin and may require derivative investors to post
mark-to-market margin payments as well.
A separate issue arises for interest rate forwards and futures settlement payments.
attractive than forwards when interest rates and futures prices are negatively
correlated.
Because of the short maturity of most forwards and the availability of funds at near
risk-free rates, differences between equivalent forwards and futures are not
observed in practice. Additionally, derivative dealers in some markets with central
clearing are required to post margin and may require derivative investors to post
mark-to-market margin payments as well.
A separate issue arises for interest rate forwards and futures settlement payments.
Recall that the payoff on an interest rate forward is the present value (at the
beginning of the forward period) of any interest savings (at the end of the forward
period) from the difference between the realized MRR and the forward MRR.
Because the realized MRR is the discount rate for calculating the payment for a
given amount of future interest savings, the payment for an increase in the MRR will
be less than the payment for an equal decrease in the MRR, as the following example
will illustrate.
Consider a $1 million interest rate future on a 6-month MRR priced at 97.50 (an
MRR of 2.5%) that settles six months from now. Each basis point change in the
(annualized) MRR will change the value of the contract by 0.0001 × 6/12 × $1
million = $50. If the MRR at settlement is either 2.51% or 2.49%, the payoff on the
future at the end of one year is either $50 higher or $50 lower than when the MRR
at settlement is 2.5%.
Compare this result with the payoffs for an otherwise equivalent forward, F6m6m,
priced at 2.5%.
If the MRR at settlement is 2.51%, the long receives 50/(1 + 0.0251/2) = $49.3803.
If the MRR at settlement is 2.49%, the long must pay 50/(1 + 0.0249/2) = $49.3852.
The value of the forwards exhibit convexity. An increase in rates decreases the
forward’s value by less than a decrease in the interest rate increases the forward’s
value, just as we saw with bonds. Also just as with bonds, the convexity effect for the
value of forwards increases for longer periods. The convexity of forwards is termed
convexity bias and forwards and futures prices can be signi icantly different for
longer-term interest rates.

MODULE QUIZ 73.1

1. For a forward contract on an asset that has no costs or benefits from holding it to
have zero value at initiation, the arbitrage-free forward price must equal the:
A. expected future spot price.
forward’s value by less than a decrease in the interest rate increases the forward’s
value, just as we saw with bonds. Also just as with bonds, the convexity effect for the
value of forwards increases for longer periods. The convexity of forwards is termed
convexity bias and forwards and futures prices can be signi icantly different for
longer-term interest rates.

MODULE QUIZ 73.1

1. For a forward contract on an asset that has no costs or benefits from holding it to
have zero value at initiation, the arbitrage-free forward price must equal the:
A. expected future spot price.
B. future value of the current spot price.
C. present value of the expected future spot price.
2. For a futures contract to be more attractive than an otherwise equivalent forward
contract, interest rates must be:
A. uncorrelated with futures prices.
B. positively correlated with futures prices.
C. negatively correlated with futures prices.

KEY CONCEPTS

LOS 73.a
For a forward contract on which no mark-to-market gains or losses are paid, the
forward price is constant over its life, but the contract’s value will luctuate with
changes in the value of the underlying.
For a futures contract, the price and value both change when daily mark-to-market
gains and losses are settled. The change in the futures price to the settlement price
each day returns its value to zero.
LOS 73.a
For a forward contract on which no mark-to-market gains or losses are paid, the
forward price is constant over its life, but the contract’s value will luctuate with
changes in the value of the underlying.
For a futures contract, the price and value both change when daily mark-to-market
gains and losses are settled. The change in the futures price to the settlement price
each day returns its value to zero.
Unlike forward rate agreements, interest rate futures are quoted on a price basis:
futures price = 100 - (100 × MRRA, B–A)

LOS 73.b
Because gains and losses on futures contracts are settled daily, prices of forwards
and futures that have the same terms may be different if interest rates are correlated
with futures prices. Futures are more valuable than forwards when interest rates and
futures prices are positively correlated and less valuable when they are negatively
correlated. If interest rates are constant or uncorrelated with futures prices, the
prices of futures and forwards are the same.