The n-year zero-coupond interest rate is the rate of interest earned on an investment that starts today and lasts for n years. The investment provides payoff only at the end of year n.
e.g. a 5-year zero rate with continuous compounding quoted as 5% per annum
It is also called n-year spot rate, n-year zero rate, and n-year zero.
Most of the interest rate we observe directly in the market are not pure zero rate.
e.g. a 5-year government bond that provide 6% coupond
Bond Pricing
The idea: To calculate the cash price of a bond we discount each cash flow at the appropriate zero rate.
The Pricing Formula B={∑t=1T(1+Rt)tCt+(1+RT)TF∑t=1TCte−Rtt+Fe−RTT(simple interest)(continuously compounded) Example: A 2-year Treasure bond with a principal if $100 provides coupon at the rate of 6% per annum semiannually. The zero rates are quoted with continuous pompounding.
Bond yield is the single discount rate that, when applied to all cash flows, gives a bond price equal to its market price. B=t=1∑TCte−ty+Fe−Ty
Example: Suppose the market price of the bond is $98.39, please determine the yield to maturity.
3e−y×0.5+3e−y×1.0+3e−y×1.5+103e−y×2.0=98.39
Solving y, we have y=6.76%.
(Macaulay's) Duration
Duration is a measure of how long on average the holder of the bond has to wait before receiving cash payments.
If the bond is priced as B=∑t=1Tcte−yt (cT is the sum of the last coupond and the face value), the duration is defined as D=B∑t=1Ttcte−yt=i=1∑Tt[Bcte−yt]
Linear approximation: BΔB≈B1dydBΔy=−DΔy
Duration measures the sensitivity of bond price to the interest (discount) rate
DB is called the Dollar Duration, DVBP=0.0001×DB is the Dollar Value of a Basis Point
Modified Duration
Modified Duration is defined as D∗=1+y/mD. It allows us to simplify ΔB.
Generally, if y is expressed with a compounding frequency of m times per year, then
ΔB=−1+y/mBDΔy=−BD∗Δy
Bond Portfolios
The duration for a bond portfolio is the weighted average duration of the bonds in the portfolio with weights proportional to prices
The key duration relationship for a bond portfolio describes the effect of small parallel shifts in the yield curve
What exposures remain if duration of a portfolio of assets equals the duration of a portfolio of liabilities?
Convexity
A measure of convexity is C=B1dy2d2B=B∑i=1nciti2e−yti
Approximate ΔB with the first two oder derivatives of the interest rate. BΔB=−DΔy+21C(Δy)2
When used for bond portfolios it allows larger shifts in the yield curve to be considered, but the shifts still have to be parallel
Equities
Gordon Growth Model
Assumptions
A firm pays out a dividend of D over the next year
Dividends are expected to grow at the constant rate of g
Systematic risk is risk that cannot be avoided and is inherent in the overall market.
It is also known as non-diversifiable or market risk
It is not diversifiable.
Examples of factors that constitute systematic risk include interest rates, inflation, economic cycles, political uncertainty, and widespread natural disasters.
Nonsystematic risk is risk that is local or limited to a particular asset or industry
that need not affect assets outside of that asset class.
It is also known as company-specific, industryspecific, diversifiable, or idiosyncratic risk.
It can be diversified.
Examples of nonsystematic risk could include the failure of a drug trial, major oil discoveries, or an airliner crash.
How two manage these two classes of risks? (hedging / diversification)
Pricing the risk (Systematic & Nonsystematic)
Measuring Systematic Risk: Beta
The Market Model:Ri=αi+βiRm+ei. We have, Cov(Ri,Rm)====Cov(αi+βiRm+ei,Rm)Cov(Rf(1−βi)+βiRm+ei,Rm)βiCov(Rm,Rm)+βiCov(ei,Rm)βiσm2
So, theoretically the beta can be calculated as below. βi=σm2σi,m2=σmσiρi,m
Beta captures an asset's systematic risk, or the portion of an asset's risk that cannot be eliminated by diversification.
What is the possible range of β?
Try to calculate the beta for market portfolio & risk-free asset
CAPM: The Security Market Line (SML)
E[Ri]−Rf=βi(E[Rm]−Rf)
Arbitrage Pricing Theory (APT)}
CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark
An alternative pricing theory with fewer assumptions was developed: Arbitrage Pricing Theory (APT)
Three Major Assumptions of Arbitrage Pricing Theory
Capital markets are perfectly competitive
Investors always prefer more wealth to less wealth with certainty
The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or indexes
APT does not assume
A market portfolio that contains all risky assets, and is mean-variance efficient
Normally distributed security returns
Quadratic utility function
In application of the theory, the factors are not identified
Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio
APT assumes that, in equilibrium, the return on a zero-investment, zero-systematic-risk portfolio is zero when the unique effects are diversified away
The expected return on any asset i (E[Ri]) can be expressed as: E[Ri]=λ0+λ1bi1+λ1bi2+⋯++λ1bik (APT)
λ0: the expected return on an asset with zero systematic risk
λj: the risk premium related to the jth common risk factor
bij: the pricing relationship between the risk premium and the asset; that is; how responsive asset i is to the jth common factor. (These are called factor betas or factor loadings.)
Understanding APT
Arbitrage
No initial investment: ∑i=1nωi=0 (in vector form ω′1=0)
Risk-free: ∑i=1nωiβij=0 for j=1,2,…,k (in vector form ω′βj=0)
Positive profit: ∑i=1nωiE[ri]>0
No-arbitrage: If (a)+(b)⟹∑i=1nωiE[ri]=0 (in vector form ω′E[r]=0), then E[ri]=λ0+j=1∑kλjβi,j,∀i=1,2,…,n
A little math
Geometry: Normal and hyperplane
Riesz representation theorem
Forwards and Futures
Forward Contract: A contract that obligates the holder to buy or sell an asset for a predetermined delivery price at a predetermined future time
Forward Price: The delivery price in a forward contract that causes the contract to be worth zero
Futures Contract: A contract that obligates the holder to buy or sell an asset for a predetermined delivery price during a specified future time period. The contract is settled daily.
Futures Price: The delivery price currently applicable to a futures contract
Forwards vs. Futures
FORWARDS
FUTURES
Private contracts between 2 parties
Traded on an exchange
Not standardized
Standardized contracts
Usually on specified delivery date
Range of delivery dates
Settled at end of contracts
Settled daily
Delivery or final cash settlement usually takes place
Contracts usually closed out prior to maturity
Some credit risk
Virtually no credit risk
Pricing: No-arbitrage Argument}
The Big Idea: No arbitrage opportunity exists in an equilibium
If a forward contract is underpriced, an investor can
Arbitrage by buying forward and selling spot
Her profit will be S0erT−F
If a forward contract is overpriced, an investor can
Arbitrage by buying spot and selling forward
Her profit will be F−S0erT
No (positive) profit is allowed, so we have {S0erT−F≤0F−S0erT≤0⟹F=S0erT
Option
An option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date.
A call option is an option to buy a certain asset by a certain date for a certain price, i.e. the strike price
A put option is an option to sell a certain asset by a certain date for a certain price, i.e. the strike price
European vs. American
A European option can be exercised only at maturity
An American option can be exercised at any time during its life
Excercise Price (Strike Price) & Expiration Date (Maturity Date)
Options vs. Futures / Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price
An option gives the holder the right to buy or sell at a certain price
Payoff (Diagram)
call
put
long
max(ST−K,0)
max(K−ST,0)
short
−max(ST−K,0)
−max(K−ST,0)
Option Pricing: The Black-Scholes Formula
Geometric Brownian Motion SdS=μdt+σdZ
The Black-Scholes-Merton Differential Equation is ∂t∂f+rS∂S∂f+21S2∂S2∂2f=rf
Price of European call and put c=S0N(d1)−Ke−rτN(d2) p=Ke−rτN(−d2)−S0N(d1)
where d1=στln(S0/K)+(r+σ2/2)τ d2=στln(S0/K)+(r−σ2/2)τ=d1−στ
Understanding Black-Scholes
The formula c=e−rTN(d2)(S0erTN(d1)/N(d2)−K)
- e−rT: Discount factor
- N(d2): Probability of exercise
- erTN(d1)/N(d2): Expected percentage increase in stock price if option is exercised
- K: Strike price paid if option is exercised
Introduction to Financial Risk Mamagement
Managing Linar Risk
Hedge}
Perfect hedging: the one that completely eliminates the risk
A long futures hedge (involves a long position in future contract) is appropriate when you know you will purchase an asset in the future and want to lock in the price
A short futures hedge (involves a short position in future contract) is appropriate when you know you will sell an asset in the future and want to lock in the price
Hedge Horizon and Contract Maturity
Basis Risk
Problems give rise to what is termed basis risk
The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract
The hedger may be uncertain as to the exact date when the asset will be bought or sold
The hedge may require the futures contract to be closed out before its delivery month
Basis is the difference between the spot and futures price
Basis risk arises because of the uncertainty about the basis when the hedge is closed out
Long Hedge
We define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price
If you hedge the future purchase of an asset by entering into a long futures contract then Cost of Asset=S2−(F2−F1)=F1+Basis
Short Hedge
We define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price
If you hedge the future sale of an asset by entering into a short futures contract then Price Realized=S2+(F1−F2)=F1+Basis
Choice of Contract
Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge
When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross hedging.
Cross Hedging
Cross hedging occurs when the two assets are different
Hedge ratio is the size of position taken in futures contracts to the size of the exposure
If we hedge the risk of one unit of the exposure with h futures, the total change in the value of the portfolio is ΔV=ΔS+hΔF
The total variance is σΔV2=σΔS2+h2σΔF2+2hσΔSσΔF
Minimum variance hedge ratio h∗=−ρσΔFσΔS ρ is the coefficient of correlation between ΔS and ΔF.
Tailing the Hedge}
Two way of determining the number of contracts to use for hedging are
Compare the exposure to be hedged with the value of the assets underlying one futures contract N∗=QFh∗QA
Compare the exposure to be hedged with the value of one futures contract (=futures price time size of futures contract N∗=VFh∗VA
The second approach incorporates an adjustment for the daily settlement of futures
Example
An airline knows that it will need to purchase 10,000 metric tons of jet fuel in three months. It wants some protection against an upturn in prices using futures contracts.
The company can hedge using heating oil futures contracts traded on NYMEX. The notional for one contract is 42,000 gallons. As there is no futures contract on jet fuel, the risk manager wants to check if heating oil could provide an efficient hedge instead. The current price of jet fuel is $277/metric ton. The futures price of heating oil is $0.6903/gallon. The standard deviation of the rate of Change in jet fuel prices over three months is 21.17%, that of futures is 18.59%, and the correlation is 0.8243.
Compute:
The notional and standard deviation of the unhedged fuel cost in dollars
The optimal number of futures contract to buy/sell, rounded to the closest integer
Solution:
The position notional is QS=$2,770,000. The standard deviation in dollars is σ(Δs/s)sQ=0.2117×$277×10,000=$586,409
For reference, that of one futures contract is σ(Δf/f)fQf=0.1859×$0.6903×42,000=$5,389.72
with a future notional of Qf=$0.6903×42,000=$28,992.60.
The cash position corresponds to a payment, or liability. Hence, the company will have to buy futures as protction. First, we compute the optimal hedge ration: h∗=ρS,FσΔFσΔS=0.8243×0.18590.2117=0.9387
Then the number of furtures contract required is N∗=VFh∗VA=42,000×$0.690.9387×10,000×$277=89.7≈90
Hedging Using Index Futures
To hedge the risk in a portfolio the number of contracts that should be shorted is
N∗=βFP
where P is the value of the portfolio, β is its beta, and F is the value of one futures contract
Changing β
Perfect hedge: β is reduced to zero. (the hedger's expected return is independent with the performance of index)
Change the beta of portfolio from β to β∗, where β>β∗, a short position of (β−β∗)FP is required.
Change the beta of portfolio from β to β∗, where β<β∗, a long position of (β∗−β)FP is required.
Example
A portfolio manager holds a stock portfolio worth $10 million with a beta of 1.5 relative to the S&P 500. The current futures price is 1,400, with a multiplier of $250.
Compute:
The notional of the futures contract
The number of contracts to sell short for optimal protection
Solution:
The notional amount of the futures contract is $250×1,400=$350,000.
The optimal number of contracts to short is, N∗=βFP=1.5×$350,000$10,000,000=42.9≈43
Nonlinear (Option) Risk Models
Option Sensitivities
Taylor Expansion df=∂S∂fdS+21∂S2∂2fdS2+∂r∂fdr+∂r∗∂fdr∗+∂σ∂fdσ+∂τ∂fdτ+…