MATH 4210 Financial Mathematics
Course Notes
Part I : Some Basic Option Theory
( I.2. interest rates, forwards& features)
Instructor: Shieh Narn-Rueih
Spring 2015
Interest rates, continuously compound mode
I Per annum (p.a) interest rate 100r % means, if one deposits
M0 dollars in the bank account then he/she receives
M0 (1 + r ) dollars after 1 year period of time.
I If the interest payment is m 2 times one year (in m equal
time-horizons), then after 1 year, one will receive
r m
M0 (1 + )
m
dollars.
I Proof: Induction on m.
Contd
I Let m , i.e. we consider continuously compound
mode, then, after 1 year, the money returned is
M(1) = M0 e r ,
and more generally, after T > 0 time-horizon,
M(T ) = M0 e rT .
Contd
I Assume that the interest rate is time-dependent r = r (t),
then using O.D.E.
I
dM
= r (t)dt,
M
I we have, for 0 s < t,
Rt
r (u)du
M(t) = M(s)e s .
I This is in consistency with the constant r case:
M(t) = M(s)e r (ts) .
Present value
I Given a value M(T ) at the T , its present value, or say the
discounted value at the time t, t < T , is
I RT
M(t) = M(T )e t r (u)du
.
I For M(T ) = K and the constant r , the present value of K is
then
M(t) = Ke r (T t) .
I We assume that the market has a risk-free (riekless) interest
rate; in practice, the LIBOR is assumed to be such a risk-free
interest rate.
Spot rate and bond yield
I The above interest rate is the spot rate, in the sense that, if
5% p.a. then one will receive 5 years later, upon deposit $100
at now, $100 e 0.055 = $128.4
I The notion of discounted value is applied to the bonds as
follows: assume that a bond with face value $1 is issued with
maturity T years and with interest rate 100r % p.a. what is its
current value V ? That is, what is the value V to pay to the
issuer if one wants to buy this bond ?
I Assume that this bond is a zero-coupon (it does not pay any
coupon during the time-horizon), then it has to be
Ve rT = 1.
I It can be used to infer the rate r , called zero rate, from the
value V (the value is known from the market data), by
ln V
r = r (T ) = .
T
Contd
I For the coupon-paying bond, the price and the rate must be
calculated in accordance with the coupon payment. We give
an example.
I A bond with face value $100 is issued; the coupon payments
are semi-annually, according to the 0.50, 1.00, 1.50, 2.00
years-to-maturity, 0,0,4,6 dollars respectively. Suppose that
the market data show that the prices for the 0.25, 0.50, 1.00,
1.50, 2.00 years-to-maturity are, respectively, $ 97.5, 94.9,
90.0, 96.0, 101.6. Calculate the corresponding zero rates.
I The first three rates can be calculated by directly using the
above formula, since it does not pay coupons for these three
cases. The calculated rates are 10.127, 10.469, 10.536 %
respectively.
Contd
I for the 1.5 years-to-maturity, since a coupon $4 is paid at the
end of the 6 months and also the 1 year, and moreover the
maturity payment is $ 104, the corresponding zero rate should
be the R = r (1.5) such that
4e 0.104690.5 + 4e 0.105361.0 + 104e R1.5 = 96.0
The R = 0.10681 = 10.681%.
I for the 2.0 years-to-maturity, it is then, with R = r (2),
6e 0.104690.5 +6e 0.105361.0 +6e 0.106811.5 +106e R2.0 = 101.6
The R = 0.10808 = 10.808%.
I The procedure in the above is called bootstrapping.
I The above procedure also shows that, for a 2-year
zero-coupon bond, then, at the issuing, it should be priced at
V = 100 e 0.108082 = 80.56
I we may plot a t r (t) curve, and form a term structure.
Contd
I In the above example, the yield-to-maturity rate is the R
such that
6e R0.5 + 6e R1.0 + 6e R1.5 + 106e R2.0 = 101.6
This is solved numerically (since the equation is non-linear) as
R = 0.1079 = 10.79%.
I There is another interest rate, the forward rate, which we
shall not discuss at here.
Forward and its price
I A forward is an OTC (over-the-counter) contract, for the two
parties enter the contract at time t = 0 and one delivers a
specified asset (say a stock) S with a specified price K at the
maturity time t = T . The two parties need no premium at
the engagement.
I The value of this forward at time t [0, T ] is formulated by
static hedging as follows.
I The writer of this forward, at the engagement t = 0, to buy
one asset with the price S0 and keep it until the maturity T ,
for which the delivery price is K .
I at the engagement t = 0, it has
f (0) = S(0) e rT K = 0,
moreover, the payoff f (T ) = S(T ) K . Thus, since the
market has no arbitrage, the value of this forward at any
t [0, T ] is
f (t) = f (t, S(t)) = S(t) e r (T t) K .
Futures
I A future is also a contract to deliver a specified asset with a
specified price from the writer to the buyer at the maturity, it
has several additional requirements
I The contract is engaged at an institute, so-called cleaning
house; The CME Group is one famous institute.
I The buyer and the seller must keep a margin account and
proceed the daily settlements, to avoid the default.
I Suppose that Mr. Smith longs a future contract of 5000
bushels of corns. The margin account is maintained at $700
and the initial deposit at $945. Assume at the next day of the
engagement the corn price drops from $3.682/bushel to
$3.652. Then the broker deducts $0.03 5000 = $150 from
Mr Smiths margin account, and $945-$150=$795 is left. If
the next next day, the price drops again to $3.552/bushel,
then a further $500 must be deduced. The margin account of
Mr. Smith is then only $295. He must either deposit at least
$405 to maintain his account, or his position will be closed
out.
