Introduction to Options and Futures
Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
FX forwards and futures
Play with interest rates
Work with int. rate forwards and futures
Objective: Build a “bridge” to swaps
Refresh basic
Currency swaps exchange rate
Main use: Hedge FX risk;
two parties have claims relations
denominated in different
Swaps currencies
Refresh basic
Interest rate swaps maths of
Hedge interest rate risk; turn a
floating rate liability into a fixed interest rates
rate one and vice versa and bonds
Later (time
Credit default swaps permitting)
1. Exchange rates
No income, no storage costs:
𝐹0 = 𝑆0 𝑒 𝑟𝑇
Known income with present value 𝐼:
𝐹0 = 𝑆0 − 𝐼 𝑒 𝑟𝑇
Known income yield 𝑞:
𝑟−𝑞 𝑇
𝐹0 = 𝑆0 𝑒
Forward on foreign currencies
Foreign currency = same as a security
providing a yield equal to the foreign risk-free
interest rate 𝑟𝑓
𝑟−𝑟𝑓 𝑇
𝐹0 = 𝑆0 𝑒
𝑆0 = $/£ spot exchange rate; 𝐹0,𝑇 = forward
exchange rate with maturity 𝑇; 𝑟 = $ risk-free
rate; 𝑟𝑓 = £ risk-free rate.
Today you have £1,000. You can invest in two
ways:
A. Deposit £ and hedge by shorting £ forward for $;
B. Sell £ now, and deposit in $.
How much can we get on £1,000?
𝒕=𝟎 𝒕=𝑻
Deposit £ and −£1𝐾 £1𝐾 × 𝐹0,𝑇 × 𝑒 𝑟£𝑇
short £ fwd
Sell £ now and −£1𝐾 × 𝑆0 £1𝐾 × 𝑆0 × 𝑒 𝑟$𝑇
deposit in $
You start from £1,000 either way! No
arbitrage ⇒ Can’t make more money one way
than the other
Must be: 𝑒 𝑟𝑓 𝑇 𝐹0 = 𝑒 𝑟𝑇 𝑆0 (both: $ amounts)
𝑟−𝑟𝑓 𝑇
𝐹0 = 𝑆0 𝑒
As before: Fwd price 𝐹0 is spot price 𝑆0 plus
net cost to hold to maturity 𝑟 − 𝑟𝑓
𝑆0 = £0.67/$; 𝑟$ = 5%; 𝑟£ = 10%
𝐹0 = …
Exchange rates
𝑆0 = (Spot) price of foreign currency in terms of local currency
E.g.: 𝑆0 = $1.50/£ →You need $1.50 to buy £1
Can treat $, £ etc. just like numbers!
E.g., 1/𝑆0 = £0.67/$ → You need £0.67 to buy $1
E.g., 𝑆0 $/£ × 𝑆0 £/¥ = 𝑆0 $/¥
What do FX forward payoff profiles look like?
Long £ Short £
𝑆𝑇 $/£ 𝑆𝑇 £/$
Short £ Long £
2. Interest rates
What do we usually assume is the risk-free
rate 𝑟? …
In practice:
A. LIBOR rate – Close to risk-free in normal market
conditions
B. Overnight Indexed Swap (OIS) rate – swap rate
(more on this soon!) for overnight lending
between large institutions; closer to risk-free
C. T-Bill – arguably risk-free
What do we usually assume is the risk-free
rate 𝑟? …
Thus, two measures of “pure” credit risk:
▪ LIBOR – OIS spread = 3-month LIBOR – OIS
▪ TED spread = 3-month LIBOR – 3-month T-Bill
5
LIBOR-OIS 3M Spread
TED Spread
4
Credit risk
peaks in
3
2008Q4
0
Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10
Source: Datastream; St. Louis Fed
Zero-coupon bonds The yield curve is the
set of zero rates, for
𝐹𝑉
different maturities
−𝑃0
𝑃0 = 𝐹𝑉 exp −𝑟0,𝑇 𝑇
Zero rate
6
2
Oct-01
1 Aug-06
Nov-15
0
0 5 10 15 20 25 30
Maturity (years)
Source: St. Louis Fed
Zero-coupon bonds Coupon bonds
𝐹𝑉 +
𝐹𝑉 Coupon
Coupons
−𝑃0 −𝑃0
𝑃0 = 𝐹𝑉 exp −𝑟0,𝑇 𝑇 𝑃0
= 𝑐𝑒 −𝑟0,𝑡𝑡 + 𝐹𝑉𝑒 −𝑟0,𝑇𝑇
Zero rate 𝑡
Bond yield: Discount rate equating market price of the
bond to PV of future cash flows
Date Cash flow E.g.: Price = 98.39
0 Yield 𝑦 solves:
0.5 3
3𝑒 −0.5𝑦 + 3𝑒 −1.0𝑦 + 3𝑒 −1.5𝑦
1.0 3 + 103𝑒 −2.0𝑦 = 98.39
1.5 3
𝑦 =…
2.0 100 + 3
Par yield: Coupon that makes the value of the bond
equal its par value
1
Semiannual coupon: 𝑐
Date Zero rate 2
0 Par yield 𝑐 solves:
0.5 5.0% 𝑐 −0.5×5%
൫𝑒 + 𝑒 −1.0×5.8%
1.0 5.8% 2
1.5 6.4% + 𝑒 −1.5×6.4% ൯
𝑐 −2.0×6.8%
2.0 6.8% + 100 + 𝑒 = 100
2
𝑐 =…
You may not have ZCB for all maturities; how
do you determine the zero curve?
Use information from coupon
bonds
Compute implied zero rates,
such that coupon bonds are
priced correctly
A.k.a. “bootstrapping”
Principal Maturity Annual Bond price (Implied)
($) (years) coupon ($) ($) zero rate
100 0.25 0 97.50 10.13%
100 0.50 0 94.90
100 1.00 0 90.00
100 1.50 8 96.00
100 2.00 12 101.60
For maturities 0.25, 0.50, and 1.00 we have
ZCB
𝑃 = 100𝑒 −Maturity×𝑟0.25
𝑟0.25 = ⋯
Principal Maturity Annual Bond price (Implied)
($) (years) coupon ($) ($) zero rate
100 0.25 0 97.50 10.13%
100 0.50 0 94.90 10.47%
100 1.00 0 90.00 10.54%
Semiannual coupon =
100 1.50 8 96.00 8/2 = 4
100 2.00 12 101.60
Maturity 1.5 years?
4𝑒 −0.5×10.47% + 4𝑒 −1×10.54% + 104𝑒 −1.5×𝑟1.5
= 96.00
𝑟1.5 = ⋯
Principal Maturity Annual Bond price (Implied)
($) (years) coupon ($) ($) zero rate
100 0.25 0 97.50 10.13%
100 0.50 0 94.90 10.47%
100 1.00 0 90.00 10.54%
100 1.50 8 96.00 10.68%
100 2.00 12 101.60 10.81%
Maturity 1.5 years?
Maturity 2.0 years?
6 × 𝑒 −0.5×10.47% + 𝑒 −1×10.54% + 𝑒 −1.5×10.68%
+ 106𝑒 −2×𝑟2 = 101.60
Company wants to fund a project that pays
back in 9 months
A. Take a 6-month loan and roll over
𝑟0,6 𝑟6,9
0 6 9
𝑟0,9
B. Take a 9-month loan
What difference between options A and B?
Implied forward rate: future zero rate implied
by today’s zero interest rates
𝑟0,6 𝐹6,9 = ?
0 6 9
𝑟0,9
What pricing approach are we (implicitly)
following?
For short-term investments (maturity shorter
than one year), one convention is to use
simple compounding
$1 invested today yields $ 1 + 𝑟𝜏 𝜏 dollars,
where 𝜏 = maturity and 𝑟𝜏 = zero rate
associated with maturity 𝜏
Implied forward rate: future zero rate implied
by today’s zero interest rates
1 + 𝑟0,9 × 0.75
= 1 + 𝑟0,6 × 0.50 × 1 + 𝐹6,9 × 0.25
𝐹6,9 = ⋯
1 1 + 𝑟0,𝑇2 × 𝑇2
𝐹𝑇1,𝑇2 = × −1
𝑇2 − 𝑇1 1 + 𝑟0,𝑇1 × 𝑇1
Suppose 𝑟0,3 = 10% and 𝑟0,7 = 15%. What is
𝐹3,7 ?
Suppose 𝑟0,6 = 12% and 𝐹2,6 = 14%. What is
𝑟0,2 ?
1 1 + 𝑟0,𝑇2 × 𝑇2
𝐹𝑇1,𝑇2 = × −1
𝑇2 − 𝑇1 1 + 𝑟0,𝑇1 × 𝑇1
Now longer maturity: Company wants to
fund a project that pays back in 2 years
A. Take a 1-yr loan and roll over
𝑟0,1 𝑟1,2
0 1 2
𝑟0,2
B. Take a 2-yr loan
What difference between options A and B?
Implied forward rate: future zero rate implied
by today’s zero interest rates
𝑟0,1 𝐹1,2 = ?
0 1 2
𝑟0,2
What pricing approach are we (implicitly)
following?
Implied forward rate: future zero rate implied
by today’s zero interest rates
𝑟0,1 𝐹1,2 = ?
0 1 2
𝑟0,2
2
1 + 𝑟0,2 = 1 + 𝑟0,1 × 1 + 𝐹1,2
2
𝐹1,2 = 1 + 𝑟0,2 / 1 + 𝑟0,1 − 1
What if we use continuous compounding?
𝑟0,1 𝐹1,2 = ?
0 1 2
𝑟0,2
𝐹1,2 = …
Forward 2 years at 4%:
n-year
rate for
Year n Zero rate exp 2 × 4% = 1.0833
n-th year
(%)
(%) 1 year at 3%:
1 3.0 exp 1 × 3% = 1.0305
2 4.0 5.0
3 4.6 5.8 𝐹1,2
4 5.0 6.2 exp 2 × 4%
= ln
5 5.3 6.5 exp 1 × 3%
Hull, Table 4.5
= 5%
How about 𝐹1,3 ?
A. Invest 3 years at 4.6% exp 3 × 4.6%
B. Invest 1 year at 3%, then two more years at 𝐹1,3
exp 1 × 3.0% exp 2 × 𝐹1,3
1 exp 3 × 4.6% 3 × 𝑟3 − 1 × 𝑟1
𝐹1,3 = × ln =
2 exp 1 × 3.0% 3−1
General case (fwd between dates 𝑇1 and 𝑇2 ):
𝑇2 𝑟2 − 𝑇1 𝑟1
𝐹𝑇1,𝑇2 =
𝑇2 − 𝑇1
Taking limits as 𝑇1 → 𝑇2 : Where does
𝜕𝑟 this come
𝐹 =𝑟+𝑇 from?
𝜕𝑇
A.k.a. instantaneous forward rate
3. Basic interest
rate derivatives
Forward Rate Agreement (FRA): Contract to set the
interest rate that applies during a given future time
period
FRA 𝑟𝐹𝑅𝐴 FRA
borrower Ref. rate lender
Borrower is paid if reference rate > FRA rate;
Lender is paid if reference rate < FRA rate
In 6 months, you will need to borrow $100m
for 3 months
Today 6m 9m
– $101.5m
𝑟6,9 = 1.5%
Risk + $100m
exposure? 𝑟6,9 = 2.0%
– $102m
Enter FRA today, setting 𝑟𝐹𝑅𝐴 = 1.8%
Payment (at 𝑡 = 6m): 𝑟6,9 − 𝑟𝐹𝑅𝐴 × $100𝑚
Today 6m 9m
If 𝑟6,9 = 1.5%: −$0.3𝑚
If 𝑟6,9 = 2.0%: +$0.2𝑚
Overall payment, either way: −$101.8𝑚
How should we set 𝑟𝐹𝑅𝐴 ?
𝑇0 𝑇1 𝑇2
Replicating portfolio approach:
▪ Invest PV(1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1 ) with maturity 𝑇2
▪ Borrow PV(1) with maturity 𝑇1
▪ At 𝑇1 , borrow 1
How should we set 𝑟𝐹𝑅𝐴 ?
𝑇0 𝑇1 𝑇2
1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1
− 1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1
1 + 𝑟𝑇2 𝑇2
1
+ −1
1 + 𝑟𝑇1 𝑇1
+1 − 1 + 𝑟𝑀 𝑇2 − 𝑇1
How should we set 𝑟𝐹𝑅𝐴 ?
𝑇0 𝑇1 𝑇2
1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1
𝑟𝐹𝑅𝐴 − 𝑟𝑀 × 𝑇2 − 𝑇1
= FRA payoff
− 1 + 𝑟𝑀 𝑇2 − 𝑇1
How should we set 𝑟𝐹𝑅𝐴 ?
𝑇0 𝑇1 𝑇2
1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1
−
1 + 𝑟𝑇2 𝑇2
1
+
1 + 𝑟𝑇1 𝑇1 1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1 1
− +
1 + 𝑟𝑇2 𝑇2 1 + 𝑟𝑇1 𝑇1
= Value of the FRA at 𝑇0
Set 𝑇0 value of the FRA to 0 (sound familiar?)
1 + 𝑟𝐹𝑅𝐴 𝑇2 − 𝑇1 1
− + =0
1 + 𝑟𝑇2 𝑇2 1 + 𝑟𝑇1 𝑇1
1 1 + 𝑟2 𝑇2
𝑟𝐹𝑅𝐴 = − 1 = 𝐹𝑇1,𝑇2
𝑇2 − 𝑇1 1 + 𝑟1 𝑇1
Value of FRA at date 𝑡 later than 𝑇0 ?
Compare two FRAs:
1. FRA rate = 𝑟𝐹𝑅𝐴
2. FRA rate = 𝐹𝑇1 ,𝑇2 , the forward rate at 𝑡
Difference in value must be:
𝑟𝐹𝑅𝐴 − 𝐹𝑇1,𝑇2 × 𝑇2 − 𝑇1
1 + 𝑟𝑇2 𝑇2
Value of the “𝐹𝑇1,𝑇2 -FRA” must be 0, so the
value of the “𝑟𝐹𝑅𝐴 -FRA” is also:
𝑟𝐹𝑅𝐴 − 𝐹𝑇1,𝑇2 × 𝑇2 − 𝑇1
1 + 𝑟𝑇2 𝑇2
Compare to payoff: 𝑟𝐹𝑅𝐴 − 𝑟𝑀 × 𝑇2 − 𝑇1
To price FRA: (i) assume that future spot rates will
be equal to today’s forward rates, and (ii) discount
(remember this when we discuss swap pricing!)
n-year In an FRA, you receive
Year n Zero rate
(%) 𝑟𝐹𝑅𝐴 = 6% and pay LIBOR
1 3.0
on $100m between end of
2 4.0
year 1 and end of year 2.
From: Hull, Table 4.5
What is the FRA value?
𝑇2 𝑟2 − 𝑇1 𝑟1 2 × 4% − 1 × 3%
𝐹1,2 = = = 5%
𝑇2 − 𝑇1 2−1
n-year In an FRA, you receive
Year n Zero rate
(%) 𝑟𝐹𝑅𝐴 = 6% and pay LIBOR
1 3.0
on $100m between end of
2 4.0
year 1 and end of year 2.
From: Hull, Table 4.5
What is the FRA value?
𝑉𝐹𝑅𝐴 = $100𝑚 × 6% − 5% 𝑒 −2×4%
= $923,116.34
Eurodollar: $1 deposited in a bank outside the
US
Eurodollar futures: futures on the 3m
Eurodollar deposit rate (= 3m LIBOR), to
apply on a $1m principal
At expiry, settlement price = 100 – current 3m deposit
rate
1 bps change in quote 𝑄 ⇒ $25 contract price change (=
$1𝑚 × 3/12 × 0.01%)
Contract price is defined as:
10,000 × 100 − 0.25 × 100 − 𝑄
Thus, settlement price 𝑄 = 99.31 implies a contract
price of $998,275
In June, you know you will receive interest on
a $100m principal, starting from September,
for a 3m period; current Eurodollar futures
quote is 96.50
Can thus lock in 100 – 96.5 = 3.5% interest
▪ Desired return = 3.5% × $100m = $875,000
Risk: You lose if interest rates .
Hedge by going long Eurodollar futures
▪ Suppose in Sept. Eurodollar rate is 2.6%
▪ Interest return = 2.6% × $100m = $650,000
▪ Gain on futures position = 100 × 25 × ሺ9,740 −
9,650ሻ = $225,000
▪ Total = $650,000 + $225,000 = $875,000
Eurodollar futures similar to FRA
▪ Can lock in a given interest rate for a future period
in both cases
Important differences:
1. Futures: Daily settlement; FRA: settlement only
once
2. Futures: Settlement at beginning of underlying
3m period; FRA: Settlement at the end
In practice
▪ For short maturities (≤ 1 year) Eurodollar futures
interest rate ≈ forward interest rate
▪ Longer maturities: differences can be important
