Unit 3: Basics of Futures and Op ons

A financial security is a legal claim to some future benefit. Bonds, bank deposits, common
stocks, and the like are all examples of financial securi es. In contrast, a general financial
contract links nominally two (or more) par es. Such a contract specifies condi ons under
which payments or payoffs are to be made between the par es. The main example is
deriva ve contracts whose payoff depends on the value of another financial variable such as
price of a stock, price of a bond, market index, or exchange rate called underlying assets.
Examples include forward contracts, futures, swaps, and op ons.
We have discussed various types of financial assets and investments, such as bank accounts,
bonds, annui es, mortgages, and other types of loans. They all have one thing in common. It
is the assump on that all future payments are guaranteed. However, in any investment
por olio, where a certain amount is invested today and future cash flows are returned over
me, there is always the possibility that not all future payments will actually be received or
the amount of future payments is not certain.
For most investments, future cash flows are con ngent upon the financial posi on of the
company issuing the investment. On the other hand, there are many financial assets (or
securi es), such as stocks, foreign currencies, or commodi es, whose future market values
are unpredictable, because they depend on the choices and decisions made by a great
number of agents ac ng under condi ons of uncertainty. Such assets can be viewed as
“risky” assets in comparison with “risk-free” assets with certain future cash flows. There are
several types of risk involved in the purchase and sale of financial assets. These include
economic risk, interest rate sensi vity, the possibility of company failure, company
management problems, compe on with other companies, and governmental rulings that
may nega vely affect the company. It is reasonable to assume that future prices of risky
assets depend on random factors.

A corpora on that needs funds for its development or expansion may issue stock to
investors. Stock represents ownership of a corpora on. Owners of common stock have
vo ng rights and are en tled to the earnings of the company a er all obliga ons are paid. If
an investor purchases shares of stock in the company, then such an investor assumes a large
amount of risk in return for the possibility of growth of the company and a corresponding
increase in the value of the shares. It is important to realize that the corpora on receives its
money when the stock shares are issued. Any trading a er that point takes place between
the shareholders and the people wishing to purchase the stock, and does not directly
represent a profit or loss to the company. Investors who purchase stock may receive
dividends periodically (usually quarterly).
Thus, the investor may profit by either an increase in the value of the stock or by receipt of
dividends. The price that an investor is willing to pay for a share of common stock is based
upon the investor’s expecta ons regarding dividends and the future price of the stock.

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In order to buy or sell shares of stocks, the investor uses an investment firm registered with
the appropriate governmental agencies. The fee or commission charged for the transac on
is an important considera on. The person actually making the transac ons for the firm is
called a broker. If an investor believes that a stock is going to decrease in value, then the
investor may borrow shares from the broker (if such a transac on is possible), and then sell
the stock. Such a financial opera on is called short selling. If the stock decreases in value,
then the investor may purchase an equivalent number of shares at the lower price and use
those shares to repay the loan. Stock market indices are used to compute an “average” price
for groups of stocks. A stock market index a empts to mirror the performance of the group
of stocks it represents through the use of one number, the index. Indices may represent the
performance of all stocks in an exchange or a smaller group of stocks, such as an industrial
or technological sector of the market. In addi on, there are foreign and interna onal
indices. Examples are Dow Jones, Standard and Poor’s, and NASDAQ indices. The most well-
known example of a deriva ves is an op on contract.

Defini on:
An op on is a contract that gives its buyer the right, but not the obliga on, to buy (for a call
op on) or to sell (for a put op on) a specified asset at a specified price (called the exercise
price or strike price) on or before a specified date (called the expiry date or maturity date).

An op on is an example of a deriva ve financial contract, whose value is derived from the

values of other underlying assets. Op ons can be wri en for numerous products, such as
gold, wheat, tulip bulbs, foreign exchange, movie scripts, stocks, etc. The purchase price of
an op on is called the premium. An op on is said to be in the money if exercising the op on
yields a profit, excluding the premium. It is out of the money if exercising the op on is
unprofitable. If the purchase price of the underlying asset is equal to the exercise price, then
the op on is said to be at the money.

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Basic Assump ons for Asset Price Models:
Not moving the market: In prac ce, financial mathema cians generally make the following
assump ons when dealing with asset price models. Not moving the market. Our ac ons do
not affect the market prices. In other words, we can buy or sell any amount of assets
without affec ng their prices. Clearly, this is not true for a free market, since an increasing
demand moves market prices up. Not moving the market.

Liquidity: At any me we can buy or sell as much as we wish at the market price without
being forced to wait un l a counter-party can be found. A liquid asset can be sold rapidly,
any me within market hours. Cash is the most liquid asset. A market is liquid when there
are ready and willing buyers and sellers at all mes.

Shor ng: We can have a nega ve amount of an asset by selling assets we do not hold. In this
case we say that a short posi on is taken or that the asset is shorted. A short posi on in
bonds means that the investor borrows cash and the interest rate is determined by the bond
prices. A short posi on in stock means that the investor borrows the stock, sells it, and uses
the proceeds to make other investments. The opposite of going “short,” i.e., holding an
asset, is some mes called being “long” in the asset.

Frac onal quan es: We are able to purchase frac onal quan es of any asset. It is a
reasonable assump on when the size of a typical financial transac on is sufficiently larger
than the smallest unit one can hold.

No transac ons costs: We can buy and sell assets without paying any addi onal fees. In the
market, one of the typical ways to collect transac on costs is that buy and sell prices differ
slightly. Such a difference in prices is called a bid–ask spread. The size of the bid–ask spread
is closely related to liquidity. For a very liquid asset, the bid–ask spread will be quite small.

Stochas c prices: The future prices of financial assets are uncertain. Thus, we deal with
stochas c asset price models. All factors that can affect the outcome of an economy are
commonly called risk factors. We assume that all prices are equilibrium prices. We are not
concerned with modelling the mechanism by which prices equilibrate.

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 Deriva ves and Securi es
A deriva ve is a financial contract whose value depends on (or derives from) the values of
other basis variables such as stock prices, bond values, interest rates, exchange rates,
commodity prices, market indices, etc. Such basis variables are called underlyings. There are
three broad categories of traders interested in trading deriva ves contracts:
hedgers who use deriva ves to reduce the risk that they face from poten al future
movements in market variables;
speculators who use deriva ves to bet on the future direc ons of market variables;
arbitrageurs who take offse ng posi ons in two or more instruments to lock in a risk-free
profit.

Forward Contracts:
A forward contract is an agreement to buy or to sell an asset for a fixed price on a fixed
future date, all specified in advance. The fixed price paid for the asset is called the forward
price; the fixed date is called the delivery me. A forward contract is a direct agreement
between two par es. Both par es are obliged to fulfil the contract. The party to the contract
who agrees to sell the asset is said to enter into a short forward posi on. The other party
who has to buy the asset is said to take a long forward posi on.
The exchange flows between two par es:

Let 𝐹(𝑡, 𝑇) with 𝑡 < 𝑇 denote the delivery price for a forward contract, which is agreed
upon at me t, and whose delivery me is 𝑇. Let 𝑆(𝑡) denote the me-𝑡 price of the
underlying asset on which the forward contract is wri en. The payoff of the long forward
contract is 𝑆(𝑇) − 𝐹(𝑡, 𝑇) and the payoff is 𝐹(𝑡, 𝑇) − 𝑆(𝑇) for the short forward contract.
At the delivery me T there are two possibili es:
1. If 𝐹(𝑡, 𝑇) < 𝑆(𝑇), then the party taking a long forward posi on benefits from a
posi ve payoff. The instant profit is 𝑆(𝑇) − 𝐹(𝑡, 𝑇) since the asset bought (at me
𝑇) at the forward price 𝐹(𝑡, 𝑇) can be immediately sold for 𝑆(𝑇). The party with a
short posi on has nega ve payoff 𝐹(𝑡, 𝑇) − 𝑆(𝑇) by selling the asset below the
market price 𝑆(𝑇); this represents a loss in the amount of 𝑆(𝑇) − 𝐹(𝑡, 𝑇).
2. . If 𝐹(𝑡, 𝑇) > 𝑆(𝑇), the situa on is exactly reversed. The party taking a short
forward posi on benefits from a posi ve payoff since the asset is sold at price

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 𝐹(𝑡, 𝑇) which is above its market price 𝑆(𝑇). The payoff to the party taking a long
posi on is nega ve, represen ng a loss in the amount of 𝐹(𝑡, 𝑇) − 𝑆(𝑇).
Payoff diagram for a long posi on (forward contract):

Payoff diagram for a short posi on (forward contract):

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6
No-Arbitrage evalua on of Forward Contracts:

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Value of a Forward Contract:

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 Basic Op ons Theory
The concept of an Op on Contract:
The holder of a forward contract is obliged to trade at the maturity of the contract. Unless
the posi on is closed before the delivery date (i.e., the contract is sold to another party), the
holder of a long forward must take possession of the asset regardless of whether the asset
has risen or fallen (or pay the difference in prices).

An op on contract gives the holder the right, not the obliga on, to trade in the future at a
previously agreed price. A European call op on is a contract giving the holder the right (not
the obliga on) to buy an underlying asset for a price K fixed in advance, called the exercise
price or strike price, at a specified future me T, called the exercise me, or expiry me, or
maturity me. A European put op on is a contract giving the holder the right to sell an
underlying asset for an agreed exercise price K at an expiry me T. Since the holder of a
European call (put) op on can only exercise his or her right and sell (buy) the asset at the
me T when the op on is expiring, there is no difference between the exercise me and
expiry me for a European-type deriva ve. There is a difference between these two me
moments for American op ons, which can be exercised at a me prior to the expiry
(maturity) date.
At the delivery me there are two possible scenarios for the holder of a standard European
op on:
𝑆(𝑇) ≥ 𝐾: The holder of a call op on will exercise the op on. The payoff at me 𝑇 is 𝑆(𝑇) −
𝐾. The holder of a put op on will not exercise the op on. The payoff is zero.

𝑆(𝑇) ≤ 𝐾: The holder of a put op on will exercise the op on. The payoff at me T is 𝐾 −
𝑆(𝑇). The holder of a call op on will not exercise the op on so the payoff is zero.

where(𝑥 ) ≔ max(𝑥, 0).

It costs a trader nothing to enter into a forward contract (with the no-arbitrage delivery
price), whereas the purchase of an op on requires an up-front payment which is the op on
value at incep on. Indeed, if no premium is paid, the op on holder will lose no money and
would make a posi ve profit (with some posi ve probability) whenever the op on is in the

9
money. According to the no-arbitrage principle, the price paid for an op on has to be
nonnega ve, although the op on price is strictly posi ve in most cases.

Let 𝐶 ≥ 0 and 𝑃 ≥ 0 denote the price paid by a buyer of a European call and put op on,
respec vely. For convenience, suppose that the op on is wri en at me 0. By taking into
account the me value of the price, we have the following formulae for the overall gain
(profit) of an op on buyer at me T:

We assume that the interest is compounded con nuously at a risk-free rate r.

Similarly to a forward contract, there are two par es to every op on contract: the buyer of
an op on, who has the right to exercise the op on, and the writer, who is obliged to deliver
the underlying asset if the op on will be exercised at maturity. The buyer takes the long
posi on; the writer takes the short posi on.
The writer receives a cash premium up front but has poten al liabili es later. The writer’s
profit or loss is the reverse of that for the purchaser (the holder) of the op on.

Example:
Find the expected value of the gain for a holder of a European put op on with strike price K
= $100 and exercise date T = 0.5 years, if the risk-free con nuously compounded rate is r =
10%, the current price of the underlying security is S(0) = $95, the op on is bought for $7,
and the price S(0.5) may take one of four values: $80, $90, $100, $110, with equal
probability.
Solu on:
The expected value of the gain (or loss) to the op on holder is the difference between the
expected payoff and the appreciated value of the op on price paid. The op on is in the
money only when S(0.5) = $80 or S(0.5) = $90. The respec ve payoffs are

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 Proper es of European Op ons:
The op on price depends on a number of variables such as
variables describing the contract: the strike price K and expiry me T;
variables describing the underlying: the ini al price S(0) and dividend yield q;
market variables: the interest rate r.

One can derive various proper es of the prices 𝐶 and 𝑃 solely based on the no-arbitrage
principle. Such proper es are general and independent of the pricing model. For example,
one can obtain bounds on the op on price (as a func on of S(0) and K), prove monotonicity
of the op on price (as a func on of S(0), K, and T), and prove convexity of the op on price
(as a func on of S(0) and K).

Theorem:
(Upper and lower bounds on European op ons prices). The no-arbitrage prices of the
European call, 𝐶 , and European put, 𝑃 , sa sfy

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 Early Exercise and American Op ons:
An American call op on is a contract giving the holder the right (not the obliga on) to buy
an underlying asset for a strike price K (fixed in advance) at any me between now and the
expiry me T. An American put op on is a contract giving the holder the right (not the
obliga on) to sell an underlying asset for an agreed strike price K at any me between now
and the expiry me T. The main difference between a European-style deriva ve and an
American-style deriva ve is that the la er can be exercised at any me up to and including
the expiry me, whereas the former can only be exercised at the expiry me. American
op ons are similar to callable bonds that can be redeemed at some point before the date of
maturity.

Rela on to European Op on Prices:

Consider European and American op ons with the same strike price K and expiry me T.
Since the American op on gives at least the same rights as the corresponding European
counterpart, we have

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 Some Non-Standard European Op ons
Standard European op ons can be used as building blocks to create more sophis cated
financial instruments. An investor with specific views on the future behaviour of stock prices
may be interested in deriva ves with payoff profiles that are different from those of the
standard European call and put op ons. In principle, any con nuous piecewise payoff
func on can be manufactured from European call and put payoffs with different strikes. So
being given a specific payoff, we can design a por olio of securi es with the same payoff
func on.

A spread strategy involves taking a posi on in two or more op ons of the same type. An
investor who expects the stock price to rise may form the following por olio: Buy a call
op on with strike price K1 and then, to reduce the premium paid for the call op on, write
and sell another call op on with the same exercise date but with the strike price K2 > K1.
The resul ng por olio is called a bull spread.

A bear spread would sa sfy an investor who believes that the stock price will decline. The
bear spread is equivalent to a por olio that has one long put op on with strike price 𝐾 and
one short put op on with strike 𝐾 < 𝐾 . Both op ons have the same exercise date. The
payoffs are described in the table below.

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An investor who expects that the future stock price will change insignificantly and stay in an
interval [K1, K3] may choose a bu erfly spread that is constructed from three op ons of the
same kind expiring on the same date with strike prices Ki , i = 1, 2, 3, so that 𝐾 < 𝐾 <
𝐾 . One way to construct a bu erfly spread is to combine one long call with strike 𝐾 , two
short calls with strike 𝐾 , and one long call with strike 𝐾 .

A combina on is an op on por olio that involves taking a posi on in both calls and puts on
the same underlying security. Some examples are as follows.
Straddle combines one put and one call with the same strike and expiry date.
Strip combines one long call and two long puts with the same strike and expiry date. Strap
combines two long calls and one long put with the same strike and expiry date.
Strangle is a combina on of a put and a call with the same expiry date but different strike
prices.

Example:

Consider a pharmaceu cal company awai ng FDA approval for a new drug. Its stock price
may fluctuate drama cally post-announcement.
A straddle op ons strategy works similarly to how the name suggests. A straddle involves
purchasing both a call and put op on at the same strike price and expira on date
to straddle the strike price in an cipa ng a significant price change. For example, you
purchase a call and put at a $50 strike price and expiry date of April 9, for $3 each. This
strategy an cipates significant vola lity regardless of direc on. The cost of the straddle is
the combined price of the put and call, which would be $6. Given the premium paid ($6), the
stock would need to rise or fall by approximately 12% to poten ally profit from this. To
determine the required movement for profitability, you typically consider the premium paid
rela ve to the current stock price, rather than the strike price.

Example: if Company X's current price is $50, a trader would purchase both a call and put at
$50 with the same expira on date.

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 Long straddle vs short straddle
 A long straddle is when a trader buys a put and a call with the same strike price and
expira on date.
 A short straddle is when a trader sells both a put and a call at the same strike price and
expira on date.

Alterna vely, a strangle would entail buying a call and a put at two different strike prices.
A strangle involves selling both a call and a put op on with different strike prices. In this
scenario, the poten al gain is limited due to the premiums received from selling the op ons.
However, the poten al loss is theore cally unlimited because of the sale of the call op on,
which could lead to substan al losses if the stock price rises significantly.
Using the above scenario, an example would be an investor buying a $55 call and $45 op on
for $2 each. To poten ally profit at expira on, the stock price will need to move above or
below these amounts, by more than $4. Like straddles, they are considered direc onally
neutral, however, strangles allow investors who think a stock will move in a par cular
direc on to add a direc onal bias to the strangle.

When selling a strangle, it's termed a short strangle and has a dis nct theore cal maximum
loss/gain.

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 Basics of Op ons Pricing:
Consider a European-style deriva ve D on an asset S, whose payoff Λ is a func on of the
asset price only at maturity me T. Examples include:

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 Op on Pricing in the Log-Normal Model: The Black–Scholes–
Merton Formula
Let 𝑆(𝑇) denote the log-normal price, which is defined by

Recall that 𝑆 is the ini al asset price, r is the risk-free interest rate compounded
con nuously, T is the maturity me (in years), and σ is the (annual) vola lity of the asset
price.

The Black–Scholes price of the European call op on as a func on of the ini al stock price S.
The parameters used are: K = $100, T = 5, σ = 30%, r = 5%. The upper bound is S; the lower
bound is (𝑆 − 𝐾𝑒 ) .

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The Black–Scholes price of the European put op on as a func on of the ini al stock price S.
The parameters used are K = $100, T = 5, σ = 30%, r = 5%. The upper bound is Ke −rT ; the
lower bound is (𝐾𝑒 − 𝑆) .

Where

Typical plots of Black Scholes prices of European call and put op ons along with upper
and lower bounds can be seen in the previous two figures.

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Note that we generally start/make the contract at 𝑡 = 0.

Solved Examples:
Imagine you are considering buying a European call op on on XYZ Corpora on. The current
stock price (S) is $100, the strike price (K) is $110, the me to expira on (T) is 90 days, the
vola lity (σ) is 0.20 (or 20%), and the risk-free interest rate (r) is 5%.
Using the Black-Scholes Model, you can calculate the theore cal value of this call op on.
Plugging the values into the formula, you get:
. ∗ .
𝐶 = 100 ∗ 𝑁 (𝑑 ) − 110 ∗ 𝑒 ∗ 𝑁(𝑑 )
Here,
100 (0.20)
ln + 0.05 + ∗ 0.25
110 2
𝑑 = = −0.778
0.20 ∗ √0.25
100 (0.20)
ln + 0.05 − ∗ 0.25
110 2
𝑑 = = −1.128
0.20 ∗ √0.25
Moreover, (Using a Normal Table)
𝑁(𝑑 ) = 𝑁(−0.778) = 0.21770.
𝑁(𝑑 ) = 𝑁(−1.128) = 0.13350.
Therefore,

𝐶 = 100 ∗ 0.21770 − 110 ∗ 0.8825 ∗ 0.1335 = 21.770 − 12.9595 = 8.8105.

Therefore the op on should be priced at Rs. 8.8105.

Ques on: Why exactly this price? What happens if the op on is priced above/below the
above men oned price?
Example: Imagine you are considering buying a European call op on on XYZ Corpora on.
The current stock price (S) is $100, the strike price (K) is $110, the me to expira on (T) is 1
year, the vola lity (σ) is 0.20 (or 20%), and the risk-free interest rate (r) is 5%.

100 (0.20)
ln + 0.05 +
110 2
𝑑 = = −0.239
0.20 ∗ √0.25
100 (0.20)
ln + 0.05 −
110 2
𝑑 = = −0.0339
0.20 ∗ √0.25
𝑁(𝑑 ) = 0.61026

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 𝑁(𝑑 ) = 0.45620
Therefore,

𝐶 = 100 ∗ 0.61026 − 110 ∗ 0.9876 ∗ 0.45620 = 61.026 − 49.5597 = 11.4662.

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 Hedging of Op ons:
The writer of a European op on receives a cash premium upfront but has poten al liabili es
later on the op on exercise date. The writer’s profit or loss is the reverse of that for the
purchaser of the op on and is given by
𝐶 𝑒 − (𝑆 (𝑇 ) − 𝐾 )
where 𝐶 is the premium received from the purchaser of the op on. The writer can invest
the premium in risk-free bonds. If the op on will end up deep in the money when S(T) > K,
the writer of the op on will be exposed to the risk of a large loss. Theore cally, the loss of
the writer may be unlimited. For a European put op on, the writer’s loss is limited:

𝑃 𝑒 − 𝐾 − 𝑆(𝑇) ≥𝑃 𝑒 −𝐾

but it s ll may be very large compared to the premium 𝑃 . The writer of an op on may
reduce this risk over a small me interval by forming a suitable por olio in the underlying
security called a hedge or a hedging por olio. For a binomial model, such a por olio is
constructed by replica ng the op on payoff. In reality, it is impossible to hedge in a perfect
way by designing a single (sta c) por olio to be held for the whole period. The hedge has to
be rebalanced dynamically to adapt it to changes in risk factors that affect the op on value.
This leads to a hedging strategy.

Delta Hedging:
Delta hedging is the process of reducing the risk associated with price changes in the
underlying security by keeping the delta of the por olio as close to zero as possible. This can
be achieved by offse ng long and short posi ons. For example, a short call posi on may be
delta-hedged by a long posi on in the underlying security. Such a por olio is called delta-
neutral.

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 Swaps
A swap is a deriva ve contract through which two par es exchange the cash flows or
liabili es from two different financial instruments. Most swaps involve cash flows based on
a no onal principal amount related to a loan or bond, although the security can be almost
anything. Usually, the principal does not change hands.
Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the
other is variable and based on a benchmark interest rate, floa ng currency exchange rate, or
index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on typical
exchanges, and generally, retail investors do not engage in them. Rather, swaps are
transacted over the counter (OTC) or on security-based Swap Execu on Facili es (SEFs). They
occur primarily between businesses or financial ins tu ons.
In an interest rate swap, the par es to the contract exchange cash flows based on a no onal
principal amount of an underlying security. The amount of the principal is not actually
exchanged. But the cash flows related to the interest rates are. Also, the swap can be an
amor zing swap, where the underlying principal of a loan will decrease over me.
Par es undertake swaps in order to hedge (protect against) interest rate risk or to speculate.
For example, imagine that ABC Co. has just issued $1 million in five-year bonds with a
variable annual interest rate defined as the Secured Overnight Financing Rate (SOFR) plus
1.3% (or 130 basis points). Also, assume that the SOFR is at 2.5% and ABC’s management is
anxious about an interest rate rise.
The management team finds another company, XYZ Inc., that is willing to pay ABC an annual
rate of the SOFR plus 1.3% on a no onal principal amount of $1 million for five years. In
other words, XYZ will fund ABC’s interest payments on its latest bond issue.
In exchange, ABC agrees to pay XYZ a fixed annual rate of 5% on a no onal value of $1
million for five years. ABC will benefit from the swap if rates rise significantly over the next
five years. XYZ will benefit if rates fall, stay flat, or rise only gradually.

Addi onal Factors

This example does not account for the other benefits ABC might have received by engaging
in the swap. For example, perhaps the company needed another loan, but lenders were
unwilling to extend one unless the interest obliga ons on its other bonds were fixed.
In most cases, the two par es would act through a bank or other intermediary, which would
take a cut of the swap. Whether it is advantageous for two en es to enter into an interest
rate swap depends on their compara ve advantage in fixed- or floa ng-rate lending markets.

Other Swaps

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Swaps involve more than interest rate payments. In fact, there are many types of swaps.
However, rela vely common arrangements include commodity swaps, currency swaps, debt
swaps, and total return swaps.

Commodity Swaps
Commodity swaps involve the exchange of a floa ng commodity price, such as the Brent
Crude oil spot price, for a set price over an agreed-upon period.7 Commodity swaps most
commonly involve crude oil.

Currency Swaps
In a currency swap, the par es exchange interest and principal payments on debt
denominated in different currencies. Cash flows are based on a fixed rate and a variable rate
(which is based on the floa ng currency exchange rate). Unlike with an interest rate swap,
the principal is not a no onal amount, but it is exchanged along with interest obliga ons.

Currency swaps can take place between countries. For example, China has used swaps with
Argen na, helping the la er stabilize its foreign reserves. The U.S. Federal Reserve engaged
in an aggressive swap strategy with European central banks during the 2010 European
financial crisis to stabilize the euro, which was falling in value due to the Greek debt crisis.10

Debt-Equity Swaps
A debt-equity swap involves the exchange of debt for equity. In the case of a publicly traded
company, this would mean bonds for stocks. It is a way for companies to refinance their debt
or reallocate their capital structure.

Total Return Swaps

In a total return swap, the total return from an asset is exchanged for a fixed interest rate.
This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an
index.11 For example, an investor could pay a fixed rate to one party in return for the capital
apprecia on plus dividend payments of a pool of stocks.

Credit Default Swap (CDS)

A credit default swap (CDS) consists of an agreement by one party to pay the lost principal
and interest of a loan to the CDS buyer if a borrower defaults on a loan. Excessive leverage

23
and poor risk management in the CDS market were contribu ng causes of the 2008/2009
financial crisis.

Interest Swaps
When borrowing money, the borrower pays interest to the lender to compensate for the use
of the money. The interest rate that is charged on the loan may be a fixed interest rate or a
variable interest rate. A fixed interest rate is a rate that is determined at the me of the loan
and will not change during the term of the loan even if interest rates in the market change.
This means that the borrower and the lender can agree to a repayment schedule that will
not change over the term of the loan. For example, ABC Life Insurance Company borrows 10
million that will be repaid at the end of five years. ABC will pay 6% interest at the end of
each year. In this example, the interest rate is a fixed interest rate of 6% and the annual
interest payment is 600,000.
For other loans, the interest rate on the loan will be variable. A variable interest rate is
adjusted periodically, upward or downward, to reflect the level of market interest rates at
the me of the adjustment. The procedure for adjus ng the interest rate will be specified in
the loan agreement. A variable interest rate is o en referred to as a floa ng interest rate,
which is a synonymous term.
For example, DEF Life Insurance Company borrows 10 million that will be repaid at the end
of five years. DEF will pay interest on the loan at the end of each year. The interest rate on
the loan will be adjusted each year. The interest rate to be paid will be the one-year spot
interest rate1 at the beginning of the year. Thus, the annual interest payment on the loan
could change each year.
Unlike the loan to ABC where the interest rate is known for all five years at the me that the
loan is ini ated, the interest rate on the loan to DEF is known for only the first year at the
me that the loan is ini ated. Therefore, the interest rate that DEF will pay in years two
through five may be greater than or less than the interest rate in the first year.

LIBOR (London Inter-Bank Offered Rate)

Most bank loans to corpora ons or businesses, as well as some home mortgage loans,
contain a variable interest rate. Most of the me, the interest rate to be charged is linked to
an outside index. The most common indexes used are the London Inter-Bank Offered Rate
(LIBOR) and the prime interest rate.
LIBOR is the interest rate es mated by leading banks in London that the average leading
bank would be charged if borrowing from other banks. LIBOR rates are calculated for five
currencies and seven borrowing periods ranging from overnight to one year. The prime
interest rate is the rate at which banks in the U.S. will lend money to their most favoured
costumers and is a func on of the overnight rate that the Federal Reserve will charge banks.

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The Wall Street Journal surveys the 10 largest banks in the U.S. and daily publishes the prime
interest rate.
The variable interest rates charged on the loans are typically one of the above indexes plus a
spread. For example, the variable interest rate may be LIBOR plus 2.5%. This is typically
expressed in term of basis points or bps. A basis point is 1/100 of 1%. Therefore, the above
rate would be LIBOR plus 250 bps. The spread is nego ated between the borrower and the
lender. The spread is a func on of several factors, such as the credit worthiness of the
borrower. The spread will be larger if the credit risk associated with the borrower is greater.
In the loan to DEF above, the interest rate can change annually. The period of me between
adjustments of the interest rate does not need to be a one-year period. It could be reset
more frequently, such as every 90 days.
A loan with a variable interest rate adds a level of uncertainty (and poten ally risk) to the
loan that a borrower may want to avoid. An interest rate swap can be used to remove this
uncertainty. However, a party that has income based on the current level of interest rates,
may prefer to have a variable interest rate. This would result in a be er matching of income
with the expected loan payments, which would reduce the risk for the party. In that case, if
the party has a fixed rate loan, they may enter into a swap to change the fixed rate into a
variable rate.

Some Defini ons

An interest rate swap is an agreement between two par es in which each party makes
periodic interest payments to the other party based on a specified principal amount. One
party pays interest on a variable rate while the other party pays interest on a fixed rate.2
The fixed interest rate is known as the swap rate.3 We will use the symbol R to represent
the swap rate. The swap rate will be determined at the start of the swap and will remain
constant for each payment. In contrast, while the variable interest rate will be defined at
the start of the swap (e.g., equal to LIBOR plus 100 bps), the rate will likely change each me
a payment is determined.
The two par es in the agreement are known as counterpar es. The counterparty who
agrees to pay the swap rate is called the payer. The counterparty who agrees to pay the
variable rate, and thus receive the swap rate, is called the receiver.
The specified principal amount is called the no onal principal amount or just no onal
amount. The word “no onal” means in name only. The no onal principal amount under an
interest rate swap is never paid by either counterparty. Thereby, it is principal in name only.
However, the no onal amount is the basis upon which the exchange of payments is
determined. One counterparty will owe a payment determined by mul plying the swap rate
by the no onal amount. The other counterparty will owe a payment determined by
mul plying the variable interest rate by the no onal amount.
The specified period of the swap is known as the swap term or swap tenor.
An interest rate swap will specify dates during the swap term when the exchange of
payments is to occur. These dates are known as se lement dates. The me between
se lement dates is known as the se lement period. Se lement periods are typically evenly
spaced. For example, se lement periods could be daily, weekly, monthly, quarterly, annually,

25
or any other agreed upon frequency. The first se lement period normally begins
immediately with the first payment at the end of the se lement period. For example, if the
se lement period is every three months, then the first swap payment is made at the end of
three months.
An interest rate swap can be used to change the variable rate into a fixed rate. In this case the
borrower would enter into an interest rate swap with a third party. Entering into a swap does
not change the terms of the original loan. A swap is a deriva ve instrument that is used to
exchange variable rate payments for fixed rate payments.

However, two par es can enter into an interest rate swap without any loan being involved.
One reason for doing this is specula on. One counterparty is “be ng” that the variable
rates are going to increase from current expecta ons while the other counterparty is be ng
that the variable rates are going to decrease. Other reasons include managing the dura on
of a por olio or to swap a series of cash flows linked to interest rates, but where the cash
flows are not from a loan.
At the me that each exchange of payments is to occur, the two payments are ne ed and
only one payment is made. For example, Tyler and Graham enter into an interest rate swap.
Based on this swap, at the end of one year, Tyler owes Graham 32,000 and Graham owes
Tyler 27,000. Rather than each counterparty making a payment, the two payments would be
ne ed and Tyler would pay Graham 5,000. This is known as the net swap payment.
The vast majority of interest rate swaps have a level no onal amount over the swap term.
However, this is not always the case. For example, a swap could have a no onal amount that
follows the outstanding balance of an amor za on loan. Such a swap is known as an
amor zing swap as the no onal amount is decreasing over the term of the swap. Similarly, a
swap could have a no onal amount that increases over me. This is known as an accre ng
swap.
A swap typically has the first se lement period beginning at me zero. However, a swap
could be a deferred swap. For deferred swaps, the exchange of payments does not start
un l a later date. An example is a swap where se lements occur quarterly over a three year
period, but the first se lement period does not start for two years. This means that the first
exchange of payments will be at the end of two years and three months because se lement
occurs at the end of the se lement period that starts at me 2 and ends at me 2.25. With a
deferred swap, the swap rate R is determined at the me that the swap is ini ated even
though the first payment will not occur un l a er the deferral period. The swap term or
swap tenor for a deferred swap includes the deferral period. For the example in this
paragraph, the swap term would be five years.
There is no cost to either counterparty to enter into an interest rate swap. This is because
the swap rate is determined such that the expected future payments for each counterparty
has the same present value. This will be our basis for determining the swap rate, R. Since the
actual payments are ne ed as noted above, this results in the present value of the net
payments that each counterparty is expected to receive in the future being equal to zero.

26
It should be noted that in prac ce customized swaps may not have a value of zero at
incep on, in which case a premium would be paid by one counterparty to the other
counterparty. However, for the purpose of this course, we assume the present value of the
swap is always zero at incep on.

Example:
Jordan Corpora on has borrowed 500,000 for the next two years at a variable interest rate.
Under this loan, Jordan will pay interest at the end of year one and at the end of year two.
The interest that Jordan will need to pay at the end of the first year is based on the one-year
spot interest rate at the start of year one ( me zero). The interest to be paid at the end of
the second year will be based on the one-year spot interest rate at the beginning of the
second year ( me one). As men oned above, the one-year spot interest rate that Jordan
Corpora on will have to pay will likely be related to LIBOR or the prime rate. These
nego ated or agreed upon rates would be used in our calcula on. However, for simplicity of
language throughout this study note, we will use the term spot interest rate without
worrying about how it would be specifically defined in the swap or loan agreement.
The current spot interest rates are an annual effec ve interest rate of 5% for a one-year
period and an annual effec ve interest rate of 6% for a two-year period. These spot interest
rates will be used to calculate present values. From this we know that the interest rate for
the first year of the loan is 5%. However, we do not know what the interest rate will be
during the second year of the loan because it will be whatever the one-year spot interest
rate is at the beginning of the second year. Based on the spot interest rates today, we can
calculate the implied one-year spot interest rate that will be in effect during the second year.
This is also known as the forward interest rate for the period from me one to me two. We
will refer to this rate as the one-year forward rate (since it covers a period of one year from
me one to me two), deferred one year (since it comes into effect one year in the future).
The implied rate for the second year is 7.01%.
.
Note that the implied rate is calculated as − 1 = 0.07010 = 7.01%.
.

However, under this loan, the interest rate for the second year could be higher or lower than
7.01% depending on the interest rates in one year.
Jordan Corpora on is not comfortable with the uncertainty of the second year interest rate
so it wants to enter into an interest rate swap that will fix the interest rate for the two years.
Using our defined terms from above, the swap term or tenor is two years. The se lement
periods are one year with se lement dates at the end of one year and at the end of two
years. Jordan Corpora on is one of the counterpar es. The other counterparty is not
specifically known in this example. Under the swap, Jordan will pay a fixed interest rate of R
during both years of the loan. To find the swap rate R, we set the present values of the
interest to be paid under each loan equal to each other and solve for R. In other words:
The Present Value of interest on the variable rate loan
=
The Present Value of interest on the fixed rate loan.

27
Under the variable loan interest rate, the interest to be paid in the first year is 500,000(0.05).
Further, based on today’s interest rates, the interest to be paid at the end of the second year is
expected to be 500,000(0.07010). For the fixed rate loan, the interest to be paid at the end of
the first year and at the end of the second year is 500,000(R). Se ng the present value (using
the current spot rates) of each of these interest streams equal to each other, we get:
500000(0.05) 500000(0.07010) 500000(𝑅) 500000(𝑅)
+ = + .
1.05 1.06 1.05 1.06
Solving gives R = 0.05971. Therefore, if Jordan Corpora on entered into a swap, the fixed
interest rate that Jordan would pay is 5.971% for the tenor of the swap.

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 Specula on
Specula on, or specula ve trading, refers to the act of conduc ng a financial transac on
that has substan al risk of losing value but also holds the expecta on of a significant gain or
other major value. With specula on, the risk of loss is more than offset by the possibility of
a substan al gain or other recompense.
An investor who purchases a specula ve investment is likely focused on price fluctua ons.
While the risk associated with the investment is high, the investor is typically more
concerned about genera ng a profit based on market value changes for that investment
than on long-term inves ng. When specula ve inves ng involves the purchase of a foreign
currency, it is known as currency specula on. In this scenario, an investor buys a currency in
an effort to later sell that currency at an appreciated rate, as opposed to an investor who
buys a currency in order to pay for an import or to finance a foreign investment.
Without the prospect of substan al gains, there would be li le mo va on to engage in
specula on. It may some mes be difficult to dis nguish between specula on and simple
investment, forcing the market player to consider whether specula on or investment
depends on factors that measure the nature of the asset, expected dura on of the holding
period and/or amount of leverage applied to the exposure.
How Does Specula on Work?

For example, real estate can blur the line between investment and specula on when buying
property with the inten on of ren ng it out. While this would qualify as inves ng, buying
mul ple condominiums with minimal down payments for the purpose of reselling them
quickly at a profit would undoubtedly be regarded as specula on. Buying real esate for the
purpose of ren ng it out is considered inves ng but buying several apartments with the
inten on of earning a quick profit by reselling them a er a short dura on. Specula on
traders provide market liquidity and can narrow the difference between the bid price and
the asking price for an asset in the market. Specula ve trading not only keeps the rampant
bullishness in check but also prevents the risk of the forma on of asset price bubbles
through be ng on successful outcomes.

Speculators and their types

A speculator is an individual or en ty that a empts to gain profit from small fluctua ons in
the prices of financial assets over a short me. Speculators can range from individuals from
the household sector to en es from corporate and foreign sectors as well as banks.
Speculators use their own money (or some mes, borrowed money) and invest it in bonds,
equity, money market, foreign exchange and other financial instruments for a short period of
me. Some people might confuse specula on with gambling but there's a huge difference
between them. Speculators take on risks in order to earn a risk premium but gamblers risk

29
even without a risk premium making specula on trading less risky than good old gambling.
Now that you know who speculators are, it's me to know what type of speculators you
might come across in the market.

Bull: In simple words, a bull is an op mist speculator. He/She is the kind of speculator who
gains profits when the prices of the bought assets increase. A bullish speculator buys
undervalued stocks and waits for their value to rise, so they can be resold for a profit. Bullish
specula ons are typical of buy and hold investments that's why bullish posi ons are also
known as long posi ons. For example, the stock is $10 in value, a bullish speculator would
buy it when its value has fallen down to $8 and would hold it un l the stock reaches $11
thus earning him a profit of $3.
Bear: A bear is a pessimist speculator, he/she gains profit when there's a fall in the value of
that asset. Bearish posi ons are called short posi ons. In this, the speculator borrows
securi es and sells them to an available buyer in the hopes of buying them back at a price
lower than what the securi es were originally sold for. This way, the speculator can return
the securi es back to the borrower while also earning a profit for himself/herself. For
example, a speculator expects the value of a par cular share to fall from $10 to $8. So,
he/she will borrow some shares and sell them at the current price of $10 and when the
prices go down to $8 he will buy them back at $8 earning him a profit.
Stag: A stag is a type of cau ous speculator who only deals with new shares of a company
with the intent of selling them for a profit at a later date. Instead of an cipa ng the market
trend on their own, they use thorough technical analysis and tape readings to predict the
market trend and make purchases accordingly thus giving them the name cau ous
speculators.
Lame Duck: Lame Duck is a type of speculator who is on the verge of going bankrupt
because of his/her bad trades. In most cases, a lame duck is a bear speculator who is unable
to get the borrowed securi es at a lower price and the person is said to be struggling like a
lame duck.

Types of specula ve transac ons

There are a number of transac ons that facilitate specula ve dealing which can be classified
into the following types:

Op on Dealings: Op on dealing is an arrangement of the right to buy or sell a specific

number of securi es within a prescribed me at a price determined earlier. Op ons dealing
is a highly risky transac on in securi es as their prices change very frequently and very
heavily. Op on dealings can be further classified into Call, Put and Call & Put op on dealings.

30
Margin Trading: In margin trading, the client opens an account with the broker by deposi ng
a certain amount of securi es or cash. The client purchases securi es with the funds that he
borrowed from the broker and then the price difference is credited or debited to or from the
client's account.
Blank Transfer: This is a transfer method in which securi es are transferred without
men oning the name of the transferee. With this process, shares can be transferred any
number of mes and finally the transferee who wanted the shares can get them registered
under his/her name saving stamp duty that is charged during transfers.
Arbitrage: In Arbitrage, speculators earn profit out of the differences in prices of a security in
two different markets. This process is known to level the pricing of that security in those two
markets. It is a highly specialized specula ve ac vity that requires skills.
Wash Sales: Wash sales are used to create ar ficial demand in the market which will lead to
a rise in prices. This is done by selling securi es and then buying the same securi es at a
higher price. Wash sales are some mes also called fic ous transac ons as the only purpose
of these transac ons is to jack up the prices.
Carry Over Transac ons: Carry over transac ons are usually done when the prices of a
par cular financial instrument move against what the speculator expected. This happens in
the case of forward delivery contracts, the contract is se led on the next se lement date
only if both par es agree to it.
Cornering: A corner refers to the condi on of the market in which the en re supply of a
par cular security is controlled by an individual or a group of individuals. The speculators
enter such a market and make purchasing contracts with the bears un l they have a
substan al amount of the securi es available in the market thus making them go out of the
market. In these cases, bears will struggle to make the delivery on the fixed date. This
process turns a bear into a lame duck.
Rigging the Market: Rigging as the name suggests means forcing the price of a security in
the market to go up. This process is generally carried out by the Bulls in the market. When
the security reaches the desired prices they sell their securi es and earn a substan al profit.

31