Prof.

Izabela Pruchnicka-Grabias, Financial engineering

Arbitrage

Arbitrage means conducting transactions on two or more markets at the

same time to generate risk-free profits higher than the risk-free interest
rate available to this investor.

Two types of arbitrage transactions:

• Risk-free arbitrage
• Risky arbitrage

The core of an arbitrage with the use of futures contracts is taking

advantage of the difference between the value of a derivative and its
underlying asset.

The two values must be equal at the end of the futures contract’s life.
This difference is called a basis.

Apart from the basis, the important element of the arbitrage

transaction is the theoretical value which is calculated as follows:

T =(S-D)ert/360

Where:
T – theoretical value of a futures contract
S – price of the underlying instrument
r – risk-free interest rate (continuous capitalization)
t – number of days that are left until the day of the end of a contract’s
life,
D – present value of dividends generated by an underlying asset

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering

If the price of a futures contract (F) is higher than the theoretical value
calculated according to the above given formula, the investor can
engage in an arbitrage strategy, taking a short position in a contract and
a long position in an underlying instrument.

This methodology can be applied only by investors who use their own
financial means and want to generate higher profits than thanks to other
safe methods of investing. If an investor wants to use foreign capital, r
is not a risk-free rate but the real cost of capital.

Besides, the above-presented formula does not take transaction costs

into consideration. If one considers them, the formula is:

zmT = (S-D)ert/360 + %k×S + C

where:
%k – transaction costs presented as a percent of the initial capital
zmT – modified theoretical value
C – commission on futures

Example 1
On 14.08.2001r. the WIG20 index value was 1124 points, and the
futures contract on the index was 1151 points. Though the basis was
equal to 27 points. In order to calculate the theoretical value, please
assume that:
• Risk free rate is 16%
• Commision on the stock trade – 0,02%
• Commision on the futures contract 10PLN per one contract
• The contract expiry date is: 30.09.2001

The theoretical value is:

………………………….

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering

The investor takes this opportunity to buy the basket of stocks creating
the index and to sell a futures contract. The investor hopes for the basis
to be zero earlier than at the day of the end of futures contract’s life. It
would make his investment more effective.

The basis was zero on 20 August, when futures contracts were valued
at a small discount in comparison to the underlying instrument. The
nominal value of the profit is the same, however the annual rate of
return looks better.

Open Close
Date Security Price Date Price Profit/Loss
14.08.2001

Total result:

Example 2
BRE Bank decided to pay the dividend equal to 10 PLN per share. After
tax deductions he received 8,5 PLN. On the 7th of June the contract
FBREU2 was worth 121,4PLN, whereas stocks were worth 125 PLN.
Let’s assume the overall commission of 0,625 PLN. The contract expiry
date was 20 September. The risk free interest rate was 9%. Should the
investor get into the arbitrage strategy??

zmT = ……………………………………..

If the futures contract price is lower than its theoretical value, can we
engage in the arbitrage transaction and buy a futures contract while
selling the underlying asset? Is it true?

Example 3 (theoretical)
On 14.09.2018 the WIG20 index value was 1420 points, and the futures
contract on the index was 1504 points. Please assess arbitrage
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Prof. Izabela Pruchnicka-Grabias, Financial engineering

opportunities.
In order to calculate the theoretical value, please assume that:

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Prof. Izabela Pruchnicka-Grabias, Financial engineering

• Risk free rate is 2,5%

• Commision on the stock trade – 0,02%
• Commision on the futures contract 10PLN per one contract
• The contract expiry date is: 30.12.20018

The theoretical value is:

………………………….

The theoretical modified value is:

If the futures contract price is lower than its theoretical value, one can
apply arbitrage that is to buy futures contracts and short sell stocks,
however the formula to count the break even point must be modified:

F<S(1-X*t/360)

Where:

F – price of a futures contract

X – the difference between the interest rate of a stock loan and the
interest rate of the deposit
Problems:
Illiquidity and how to overcome it?

Barrier
options

Barrier options are one of the most popular types of exotic options. One
of the reasons of their popularity is the fact that they allow to reduce
costs of hedging.

Barrier options are instruments where the payoff depends on whether

the underlying asset’s price reaches a certain level during a certain
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Prof. Izabela Pruchnicka-Grabias, Financial engineering

period of time.

Premiums of barrier options are always lower than prices of standard

options with the same parameters.

Types of barrier options

Barrier options are actually conditional options, dependent on whether
some barriers or triggers are reached within the lives of the options.

They belong to the group of path-dependent options. There are eight

types of barrier options: four call options and four put options:

• barrier knock-down-and-out call – the call option which

inactivates after the underlying instrument reaches the barrier
which is placed below the current price of the underlying asset,

• barrier knock-up-and out call - the call option whichinactivates

after the underlying instrument reaches the barrier which is placed
higher than the current price of the underlying asset,

• barrier knock-down-and-in call - the call option that activates

after the underlying instrument reaches the barrier which is placed
below the current price of the underlying asset,

• barrier knock-up-and-in call - the call option that activates after

the underlying instrument reaches the barrier which is placed
higher than the current price of the underlying asset,

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Prof. Izabela Pruchnicka-Grabias, Financial engineering

• barrier knock-down-and-out put - the put option which

inactivates after the underlying instrument reaches the barrier
which is placed below the current price of the underlying asset,

• barrier knock-up-and out put - the put option which inactivates

after the underlying instrument reaches the barrier which is placed
higher than the current price of the underlying asset,

• barrier knock-down-and-in put - the put option that activates

after the underlying instrument reaches the barrier which is placed
below the current price of the underlying asset,

• barrier knock-up-and-in put - the put option that activates

after the underlying instrument reaches the barrier which is placed
higher than the current price of the underlying asset.

It should be stressed that barriers can be monitored continuously or

discreetly, if discreetly it can be once or more times during option’s life.

To distinguish between this type of barrier feature when the barrier is

monitored once only, and the type where the barrier variable is
monitored more than once, market participants refer to the former as a
European barrier and to the latter as an American barrier.

Classic barrier options are activated or deactivated by an underlying

instrument. However, more complex barrier options activate or
deactivate if the barrier is crossed by another asset (this asset could be
an interest rate, a stock price, or an exchange rate).

The specific situation arises when the asset price is very close to the
barrier. This may increase market volatility around popular barrier
levels, particularly in the foreign exchange markets, due to
manipulation of the underlying asset price to activate knock-out.

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Prof. Izabela Pruchnicka-Grabias, Financial engineering

Generally, barrier options are liable to speculation in that sense that

investors may try to make it go up or down only to achieve the barrier
which activates (options buyers) or deactivates (options sellers) the
option.

The important parity relation for barrier option is:

“Knock-in” option + “Knock-out” option = Ordinary option

Applications for hedging

The four following cases compare costs of interest rates hedging
strategies conducted with barrier and standard options.

Case I
The investor purchases the up barrier or the standard put option on 12
March 2001.

Let’s analyse the up&in and up&out put option and compare their prices
with the standard option with the same market parameters as follows:
• underlying asset price = 10,9%,
• exercise price = 11,5,
• days to maturity = 180,
• standard deviation = 8%,
• risk-free interest rate = 11,8%,
• barrier level – depicted in table 2.

Tab.2. Simulation of barrier up-and-in and up-and-out put options

prices as a result of barrier level changes.
Underlying asset 10,9 10,9 10,9 10,9 10,9 10,9
price (WIBOR3M) % % % % % %
Exercise price 11,5 11,5 11,5 11,5 11,5 11,5
% % % % % %
Days to maturity 180 180 180 180 180 180
Standard deviation 8% 8% 8% 8% 8% 8%

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Risk-free interest 11,8 11,8 11,8 11,8 11,8 11,8

rate % % % % % %

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Prof. Izabela Pruchnicka-Grabias, Financial engineering

Barrier level 11,4 11,5 11,6 11,7 11,8 11,9

% % % % % %
Up-and-in-put 0,06 0,03 0,02 0,01 0,00 0,00
price [PLN] 123 846 233 204 603 280
Up-and-out-put 0,15 0,18 0,19 0,20 0,21 0,21
price [PLN] 823 101 713 742 344 666

Tab.3. Parameters of the standard call and put option.

Parameters Standard call Standard put
option option
Price [PLN] 0,269574 0,219468
Delta 0,543837 -0,456163
Theta -0,913865 0,366422
Gamma 0,647547 0,647547
Vega 3,035246 3,035246
Rho 2,790368 -2,560264

Case II
The investor purchases the barrier down or the standard put option on
1 June 2004.

The investor can choose between a standard option and a barrieroption

in order to hedge interest rate fluctuations in the given period. Tables 4
and 5 compare prices of a standard option and barrier options built in
the same market conditions that are specified in table 4.

Tab.4. Simulation of barrier down-and-in and down-and-out put options

prices as a result of barrier level changes.
Underlying asset 5,95 5,95 5,95 5,95 5,95 5,95
price (WIBOR3M) % % % % % %
Exercise price 6,1% 6,1% 6,1% 6,1% 6,1% 6,1%
Days to maturity 90 90 90 90 90 90
Standard deviation 8% 8% 8% 8% 8% 8%
Risk-free interest 6% 6% 6% 6% 6% 6%
rate
Barrier level 5,79 5,80 5,81 5,82 5,83 5,84
% % % % % %
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Prof. Izabela Pruchnicka-Grabias, Financial engineering

Down-and-in-put 0,09 0,102 0,10 0,10 0,11 0,11

price [PLN] 922 47 557 849 123 377
Down-and-out-put 0,02 0,025 0,02 0,01 0,01 0,01
price [PLN] 881 55 245 953 679 425

Tab.5. Parameters of the standard call and put option.

Parameters Standard call Standard put
option option
Price 0,067607 0,128025
Delta 0,407313 -0,592687
Theta -0,327381 0,033244
Gamma 1,642068 1,642068
Vega 1,146740 1,146740
Rho 0,580909 -0,901112

Case III
The investor purchases the barrier up or the standard call option on 20
August 1996. Options parameters are presented in the table beneath.

Tab.6. Simulation of barrier up-and-in and up-and-out call options

prices as a result of barrier level changes.
Underlying asset 19,4 19,4 19,4 19,4 19,4 19,4
price (WIBOR3M) 4% 4% 4% 4% 4% 4%
Exercise price 20% 20% 20% 20% 20% 20%
Days to maturity 180 180 180 180 180 180
Standard deviation 8% 8% 8% 8% 8% 8%
Risk-free interest 20% 20% 20% 20% 20% 20%
rate
Barrier level 21,5 20,5 22% 22,5 19,5 21%
% % % %
Up-and-in-call 1,17 1,36 0,94 0,67 1,37 1,31
price [PLN] 535 627 679 782 176 5668
Up-and-out-call 0,19 0,00 0,42 0,69 0,00 0,05
price [PLN] 641 549 497 394 0000 609

Tab.7. Parameters of the standard call and put option.

Parameters Standard call Standard put
option option
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Prof. Izabela Pruchnicka-Grabias, Financial engineering

Price 1,371760 0,053315

Delta 0,899410 -0,100590
Theta -3,417720 0,206591
Gamma 0,161385 0,161385
Vega 2,406158
2,406158
Rho 7,946022 -0,990635

If the barrier level is set very close to the underlying asset price, the
barrier option value is similar to the standard option premium.

Case IV
The investor purchases the barrier down or the standard call option on
18.05.2004.
Tab.8. Simulation of barrier down-and-in and down-and-out call
options prices as a result of barrier level changes.
Underlying 5,98 5,98 5,98 5,98 5,98 5,98
asset price % % % % % %
(WIBOR3M)
Exercise price 6% 6% 6% 6% 6% 6%
Days to 180 180 180 180 180 180
maturity
Standard 8% 8% 8% 8% 8% 8%
deviation
Risk-free 6,5% 6,5% 6,5% 6,5% 6,5% 6,5%
interest rate
Barrier level 5,81 5,90 5,75 5,70 5,85 5,95
% % % % % %
Down-and-in- 0,03 0,10 0,01 0,00 0,05 0,17
call price 558 452 540 707 888 544
[PLN]
Down-and- 0,19 0,12 0,21 0,22 0,17 0,05
out-call price 806 912 823 657 476 819
[PLN]

Tab.9. Parameters of the standard call and put option.

Parameters Standard call Standard put
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option option
Price 0,233638 0,064359
Delta 0,705137 -0,294863
Theta -0,376401 0,001296
Gamma 1,026807 1,026807
Vega 1,448641
1,448641
Rho 1,964259 -0,901302

Other kinds of barrier options

It should be stressed that some barrier options can include a rebate. For
an “out” barrier option, the rebate is paid immediately when the barrier
is hit and the option passes out of existence.

For an “in” barrier option, the rebate is paid if the option expires without
ever hitting the barrier price. The higher rebate, the more expensive
barrier option is.

Besides, it should be noted that it is also possible to make an option with

a double barrier. Within the family of vanilla double barriers we can
distinguish between three groups:
• one-hit vanilla double barrier: a knock-in or knock-out is
triggered if either one of the two barriers is hit,
• arbitrary-order two-hit vanilla double barrier: a knock-in or
knock-out is triggered only after both barriers have been hit, but
there is no requirement as to which barrier must be hit first,
• fixed-order two-hit vanilla double barrier: a knock-in or knock-
out is only triggered when both barriers are hit in a fixed order.

Barrier options on the Polish financial market

In Poland mainly currency exotic options (for main foreign currency
rates) are traded. Interest-rate non-standard option contracts are still
unavailable. Of course, banks are able to quote every tailor-made
instrument that a customer wishes to pay for. The point is that if a
derivative is not commonly used and there is no liquid market for it,it
is very expensive when banks’ margins are added up to its price.

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 Financial engineering course, prof. Izabela Pruchnicka-Grabias

Case study – the choice of the hedging instrument

Imagine the situation of the copper producer that sells its product in
annual contracts, according to average monthly official copper prices
from LME. Thus its income is endangered with risk of prices decrease.
The producer should hedge against this risk. The best possibility is to
use derivatives. Let’s compare three variants of hedging:

• Taking a long position in an Asian put option

• Commodity swap (floating to fixed)
• Zero-cost option structure

Taking a long position in an Asian put option

The owner will realize it when the average monthly copper price will
be lower than the option exercise price.

Let’s assume that the producer wants to hedge at the level of 2080
USD/t, which is equal to the level of costs of extracting of one tone of
copper from the earth. Let’s also assume that the annual production of
copper is 500 thousand tones. The producer must buy a put option to
sell copper with the break-even point not lower than 2080 USD/t
(break-even point = exercise price minus premium).

This condition is realized for the option with the exercise price equal to
2200 USD/t, because its premium is 120 USD/t (all valuations in the
case study were done at the three month copper price of 2500 USD/t).

If the producer wants to hedge its income on selling products, it must

spend the following amount of money: (please fill in the dotted space)

…………………………………………

It is worth noticing that the cost of hedging would be higher for

further periods of time.

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Commodity swap (floating to fixed)

For example, in 2006 the average forward price for monthly commodity
swaps was 2200 USD/t.

Irrespective of market fluctuations, the company will sell the copper at

2200 USD/t.

What is the initial cost of the swap transaction? Please compare it with
the Asian option.

Zero-cost collar
A short position in a zero cost collar is combined of a long position
in a put option with a low exercise price and a short position in a call
option with a high exercise price. It is also called a short-range forward.

A long position in a zero cost collar is combined of the short position

in a put option with the low exercise price and a long position in a call
option with a high exercise price. It is also called a long- range forward.

Please draw payoff functions of zero cost collars.

Premium paid = Premium received

The company could hedge against the decrease of copper prices in 2006
at 2080 USD/t and at the same time participate in the increase of copper
prices up to 2320 USD/t.
Combining options gives a high level of flexibility, however if prices
go down, it is the level of 2080 USD/t that is hedged, which is lower by
120 USD/t than the delivery price of the commodity swap.

Table 1. Producer’s income in 2006 at different copper prices and hedging

variants – summary (USD)
Average Put option Collar Commodity No hedging
copper price [USD/t] – the [2080 – 2320 swap
in 2006 cost of 60 USD/t] 2200 USD/t]
[USD/t] mln USD

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Financial engineering course, Prof. Izabela Pruchnicka-Grabias, PhD.

3000 1,44 mld 1,16 mld 1,1 mld 1,5 mld

2500 1,19 mld 1,16 mld 1,1 mld 1,25 mld
2000 1,04 mld 1,04 mld 1,1 mld 1 mld
1500 1,04 mld 1,04 mld 1,1 mld 0,75 mld

Zero-cos collars and kinds of correlation options and

their valuation

Types of zero collars:

• Long zcc with one exercise price

• Short zcc with one exercise price

• Long zcc with two exercise prices

• Short zcc with two strikes

• Symmetric zcc
• Assymetric zcc (when call notional value is higher than the put notional vale or vice versa;
long zcc and short zcc, with one strike, with two strikes)

• Barrier zcc (barrier for the call option, barier for a put option or both)

Exchange options

Exchange options valuation

Exchange options are the simplest kind of correlation options. Their

valuation can be done with the modification of the Black Scholes
formula. Their value can be calculated with the following formulas:

EX = Pe −g1 (T −t ) N (d ) − P e−g2 (T −t ) N (d )
1 e1 2 e2

where:
P1 1 2
d =
e2 [ln( ) + (g 2 − g1 −  a )(T − t)] /( a T − t )
P2 2

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Financial engineering course, Prof. Izabela Pruchnicka-Grabias, PhD.

de1 = de2 +  T − t

 =  − 2  + 

P1 – the price of the first asset

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Financial engineering course, Prof. Izabela Pruchnicka-Grabias, PhD.

P2 – the price of the second asset

Example 1.
Please value the exchange option for exchanging one stock for another
after a one year period assuming that prices of these stocks are equal
to: P 1 =10PLN oraz P 2 =10PLN, volatilities:  =30% and   =10%, rates of
the dividend increase are: g 1 =2% oraz g 2 =3%, and the correlation
coefficient between rates of return on these assets is  =65%.
Example 2.
Please value the exchange option for exchanging one stock for another
after a one year period assuming that prices of these stocks are equal
to: P 1 =10PLN oraz P 2 =10PLN, volatilities:  =25% and   =15%, rates of
the dividend increase are: g 1 =2% oraz g 2 =3%, and the correlation
coefficient between rates of return on these assets is  =65%.
de1 = de2 +  T − t = − 0,083 + 0,2471 =0,164

EX = Pe −g1 (T −t ) N (d ) − P e−g2 (T −t ) N (d )
1 e1 10e−0,021N(0,164) −10e−0,031N(−0,083) =10
2 e2
=
 0,9802 0,5651−10 0,9705 0,4669=5,5391 – 4,5313 = 1,0078 PLN

Out-performance options
Quotient options
• call
f → max{(𝑃1 – X), 0}
𝑃2

• put
f → max{(X – 𝑃1), 0}
𝑃2

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Basket options

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Payoff functions:
• call
f → max{(P – X), 0}

• put
f → max{(X – P), 0}

where:
P – basket meaning the weighted average of all asset prices in the basket
P1, P2, P3,P4,P5
P = 20%*P1 + 25%*P2+30%*P3+ 15%*P4 +10%*P5

Flexo options
Payoff functions:
f → max (0, S f –X f ) dla opcji typu call
f → max (0, X f – S f ) dla opcji typu put

where:
S f – the price of the foreign underlying asset at the moment of exercise
X f – strike price expressed in foreign currency

Payoff functions expressed in the domestic currency:

f → ExRmax (0, S f – X f ) for call
f → ExRmax (0, X f – S f ) for put

where:
ExR – the price of one unit of the foreign currency expressed in the
domestic currency

Example 3.
Please assess the payoff for the Polish investor from European call and
put flexo options which are written COCA-COLA stocks, knowing that

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Financial enginering, Prof. Izabela Pruchnicka-Grabias

the close price of stocks is 44,09$, USD/PLN currency rate is 3,3747,

and the strike price of each option is 50$.

Example 4.
Please value from the point of view of the Polish investor a flexo option
call and put, written on COCA-COLA stocks assuming that it expires
in 1 year and its strike is 50$. The price of stocks is 44,09$, risk-free
interest rate in Poland 5%, in USA 3,25%, dividend yield 3%, volatility
of the underlying asset 10%, average current price for USD/PLN is
3,3747, its volatility 12%. Please assume the correlation coefficient
between COCA-COLA rates of return and rates of return on currency
rate USD/PLN equal to 0,2.

Example 5
Please calculate prices of the same options form Example 4 but assume
the correlation coefficient of minus 0,2.

Beach options – flexo options with no currency rate risk

Exotic options and hybrid products

valuationConvertible bonds

Example 1
Value a convertible bond that has time to maturity equal to 6 years,
nominal value of 100PLN, coupon 5% paid every year, with an
embedded European call option on issuer’s stocks which does not
entitle to dividends, having the exercise price of 15PLN and time to
maturity equal to 6 years. Let’s assume that the underlying asset’s
volatility is 21%, the present market value of stocks is 23PLN, and the
risk-free rate is 2%.
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 Financial enginering, Prof. Izabela Pruchnicka-Grabias

Example 2
Value a convertible bond that has time to maturity equal to 3 years,
nominal value of 100PLN, coupon 4% paid every half a year, with an
embedded European call option on issuer’s stocks which does not
entitle to dividends, having the exercise price of 25PLN and time to
maturity equal to 6 years. Let’s assume that the underlying asset’s
volatility is 18%, the present market value of stocks is 30PLN, and the
risk-free rate is 3%.

Binary options
Payoff function:

…………………………………..

…………………………………..

Cash-or-nothing options are valued in the following way:

• Call option:
CashC = Ze −r (T −t ) N(d2 )

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Financial enginering, Prof. Izabela Pruchnicka-Grabias

• Put option:
CashP = Ze −r (T −t ) N(−d 2)

where:
d 2 - defined in the same way as for standard options for stocks of
companies which do not pay dividends,
Z – cash amount agreed in advance which will be received by the buyer
if an option expires in-the-money.

Asset or Nothing
Call:
• dla opcji kupna wypłacającej jednostkę aktywów bazowych:
AssetC = Se-δ(T-t) N(d1)
Put:
• dla opcji sprzedaży wypłacającej jednostkę aktywów bazowych:
AssetP = Se-δ(T-t) N(-d1)

Example 3
Please value a binary AON call and put option assuming that itsexercise
price is 70 PLN, present underlying price is 80 PLN, time to maturity is
1 year, risk-free interest rate is equal to 5%, volatility of theunderlying
asset is 20%, the dividend yield is 4% and the cash amount which will
be received by the buyer if the option expires in-the-moneyis 10PLN.

Gap options

Payoff

functions:

• call
f = S – X + g for S > X
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f = 0 for other cases

• dla put
f → X – S + g for S < X
f → 0 for other cases

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Financial enginering, Prof. Izabela Pruchnicka-Grabias

where:
g – gap

Gap options valuation:

• call
− (−t)N(d ) − (X + g)e−r(T−t) N(d 2 )
GAPC = Se 1

• put
GAPP = (X + g)e−r(T−t) N(−d 2 ) − e− (T−t)SN(−d 1)

Example 4
Please value a call and put option with the gap equal to 2PLN for a call
option and g = – 2PLN for a put option. Option exercise price is 70PLN,
underlying asset current price is 80PLN, time to maturity is 1 year, risk-
free interest rate is 5%, volatility of an underlying asset is 20%,dividend
yield is 0%.

Exchange options
They give the right to exchange one asset for another. The payoff
function:
f = max (0; P 1 – P 2 )

where:
P 1 - the price of an asset which will be received by the option buyer in
return for the possessed one on the day of option exercise
P 2 - the price of an asset possessed by the option buyer on the option
exercise day

Valuation of exchange options

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Financial enginering, Prof. Izabela Pruchnicka-Grabias

The price of an option to exchange the firs asset into the second asset
is:
EX = Pe − g1 (T −t ) N(d ) − P e− g 2 (T −t ) N(d )
1 e1 2 e2

where:

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Financial enginering, Prof. Izabela Pruchnicka-Grabias

P1 1
d =
2

e2 [ln( ) + (g2 − g1 −  a )(T − t)]/( a T − t )

P 2
de1 = de2 + 2  T − t
 =  − 2  + 

P1 – price of the first asset

P2 – price of the second asset
g – rate of the dividend increase

Example 5
Please value the exchange option for the exchange of the first stock into
the second one after one year assuming that stock prices are the
following: P 1 =10PLN and P 2 =10PLN, volatilities:  =30% and  

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Financial engineering course, prof. Izabela Pruchnicka-Grabias

=10%, rates of the dividend increase: g 1 =2% and g 2 =3%, and

correlation coefficient of rates of return on these assets is  =65%.

Futures and forwards valuation

The forward price of the stock futures or forward contract is equal:

F = (S-I)e rT

The price of the stock contract with the fixed dividend yield:
F = Se (r −q)T

The forward price of index futures is:

F = Se (r −q)T

The forward price of commodity futures:

F = (S+U)erT

The forward price of currency futures is:

F = Se (r −rf )T

Example 1
Let’s value a 10-month forward on stocks worth 50zł. Please assume
that the annual risk free interest rate is (capitalised continuously) 8% ,
whereas the interest yield curve is flat. Please also assume that the
current value of dividends paid is 2,162 zł.

………………………………………………….
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Financial engineering course, prof. Izabela Pruchnicka-Grabias

Example 2
Please value a 3-month futures on the S&P index. Assume that the
annual dividend yield for all stocks building the index is 3%, the

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

current index value is 400, and the annual risk free interest rate (with continuous
capitalisation) is 8%.

……………………………………………….

Example 3
We have a 6M contract for stocks. The expected annual dividend yield paid
continuously is 4%. Annual risk free interest rate (capitalized continuously) is 10%.
The current stock price is 25 USD. Please calculate the forward price.

…………………………………………………

Example 4
Please value a one year futures for gold. Assume that annual cost of carry is 2 dollars
paid at the end of the year. Please also assume that the cash price is 450 and the
annual risk free interest rat is 7% and the yield curve is flat.

…………………………………………………
…………………………………………………

Example 5
Please value 3M futures on WIG20. Please assume the dividend yield of all stocks
at 5%, current index value is 1639, and the risk-free interest rate is 19%.

Example 6
Please value the 3M currency futures. The underlying asset price is 3,60 per
USD, risk-free interest rate is 24%, foreign risk-free rate is rf
= 17%.

Source:
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 Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

W. Tarczyński, Inżynieria finansowa, Placet.

Hedging of short positions in

optionson the Polish
currency market

Two methods:
1. Hedging by a contrary position in another option
2. Delta hedging

Example 1
Assume that a bank sold a call European option on EUR/USD for
20.000 EUR whose exercise price is 1,1836 and the exercise date is 13
October. The premium received by bank is 2300 PLN.

To hedge it, the bank buys a call European option on EUR/PLN with
the exercise date 13 October and the exercise price 1,1836. The
premium paid for the option is 2150 PLN.

Please draw a profit and loss function.

Fill in the table 1.
Table 1. Profits/losses of both parties of the option contract when
hedging is applied.
Currency rate Exercise price Profit/loss of Profit/loss of
EUR/USD on the bank selling the customer
the option the option buying the
maturity date option
1,1641 1,1836
1,1836 1,1836
1,2036 1,1836
1,3025 1,1836

Example 2
Assume that the bank sold the same option as in example 1, but it did
not hedge it.
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Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

Draw a profit and loss function and fill in the table 2.

Table 2. Profts/losses of both parties of the option contract when

hedging is not applied.

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

Currency rate Exercise price Profit/loss of Profit/loss of

EUR/USD on the bank selling the customer
the option the option buying the
maturity date option
1,1641 1,1836
1,1836 1,1836
1,2036 1,1836
1,3025 1,1836
The same analysis could be done for a put option.

Delta hedging
To apply the delta hedging it is necessary to buy or sell the suitable
amount of an underlying asset to compensate for losses generated on
the sold option. The amount of the underlying asset for the given option
can by calculated as:

∆= o
c

where:
∆ - delta
∆o – the change in the option price
∆c – the change in the underlying asset price

In beneath examples please fill in dotted spaces.

Example 3
Assume that a bank on 12 April sold a call EUR/USD option with the
nominal value of 50 000 000 EUR and the exercise price of 1,1798.
Delta is 0,63.

In order to hedge its position the bank buys the following amount of
euros:
…………………………………………………………
If the currency rate increases by 0,01 the bank must calculate the delta
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Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

again. Assume that the new delta is 0,7. It means that the bank must
have:

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

………………………………………………………….

Which means that the bank must buy:

………………………………………….

Example 4
Assume that the bank sold the call option with the nominal value of
30 000 000 EUR. The rest of parameters are depicted in table 3.

Let’s examine if the change in the currency rate EUR/USD requires

changes in the hedging strategy.

Table 3. The simulation of currency rate EUR/USD fluctuations and the

delta value for a call option.
Risk-free
interest
rate
4% 4% 4% 4% 4% 4%
Date of
selling the
option 12.04. 12.04. 12.04. 12.04. 12.04. 12.04.
2004 2004 2004 2004 2004 2004
Exercise
date 13.10. 13.10. 13.10. 13.10. 13.10. 13.10.
2004 2004 2004 2004 2004 2004
Exercise
price 1,1836 1,1836 1,1836 1,1836 1,1836 1,1836
Currency
rate
EUR/USD
1,1757 1,1834 1,1836 1,1837 1,1845 1,1899
Number of
options
sold 1 1 1 1 1 1
Position Short Call Short Call Short call Short Call Short Call Short Call
Option
price 841.191 885.314 886.211 887.057 891.715 923.495

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

Volatility 23 23 23 23 23 23
Delta 56.5182 58.0861 58.0988 58.1467 58.3082 59.3919
Gamma 0.0205002 0.0202153 0.0202098 0.0202051 0.0201747 0.0199543
Time to
maturity 184 184 184 184 184 184
Theta -2.6924 -2.71102 -2.71134 -2.71168 -2.71341 -2.72405
Vega 32.8599 32.8346 32.8336 32.8327 32.8274 32.7776
Case A
The currency rate EUR/USD is 1,1836. The option seller applies the
delta hedging strategy and buys the following amount of euros:
……………………………………………..
Case B
The currency rate EUR/USD increased up to 1,1837. The option seller
should have:
…………………………………………..

It means that when the currency rate raises by just 0,0001 the bank
should buy ………..EUR. Otherwise its hedging strategy will not be
effective.

Case C
If the currency rate increases up to f.ex. 1,1845 one must have a long
position in the following amount of euros:
……………………………………………

It means that the hedger must buy again ................. EUR.

Case D
If the currency rate EUR/USD is lower than 1,1836 the option will not
be exercised by the customer, so the bank does not need any hedging.

To hedge a short position In a put option it is necessary to use the so

called short selling.

Example 5
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 Prof. Izabela Pruchnicka-Grabias, Financial engineering, exercises for students

Assume that the bank sold the put option with the nominal value of
30 000 000 EUR. The rest of parameters are depicted in table 3.

Let’s examine if the change in the currency rate EUR/USD requires

changes in the hedging strategy.

Tabela 4. The simulation of currency rate EUR/USD fluctuations and

the delta value for a put option.
Risk-free
interest rate 4% 4% 4% 4% 4% 4%
Date of selling 2004.04. 2004.04. 2004.04. 2004.04 2004.04. 2004.04.
the option 12 12 12 .12 12 12
Exercise date 2004.10. 2004.10. 2004.10. 2004.10 2004.10. 2004.10.
13 13 13 .13 13 13
Exercise price 1,1836 1,1836 1,1836 1,1836 1,1836 1,1836
Currency
rate
EUR/USD 1,1840 1,1836 1,1830 1,1825 1,1810 1,1800
Number of
options sold 1 1 1 1 1 1
Position Short Short Short Short Short Short
Put Put Put Put Put Put
Option price 697.618 699.328 701.901 704.05 710.527 714.871
Volatility 23 23 23 23 23 23
Delta - - -
41.7927 41.8735 -41.9948 42.0961 -42.4003 -42.6036
Gamma 0.02019 0.02020 0.02022 0.02025 0.02030 0.02034
6 64 86 3 54 65
Time to
maturity 184 184 184 184 184 184
Theta - - -
1.65439 1.65362 -1.65245 1.65143 -1.64835 -1.64624
Vega 32.8308 32.8334 32.8369 32.8397 32.8467 32.8504

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Dr hab. Izabela Pruchnicka-Grabias, Financial engineering

Case A
The currency rate EUR/USD is 1836. The option seller
creates thehedging strategy and short sells the following amount
of euros:

…………………………………………….

Case B
The currency rate EUR/USD fell to 1,1830. The option
seller shouldnow have sold:
……………………………………………

It means that the bank should short sell additionally

..................................................................................................EU
R.

Case C
In case of another fall of EUR/USD, f.ex. to 1,1810 the bank
must havethe short position in the following amount of
euros:

…………………………………………

It means that the bank must additionally short sell ............... EUR.

Case D
If the currency rate is higher than 1,1836 the option will not be
exercisedby the customer, so the bank does not need to hedge
it.

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Dr hab. Izabela Pruchnicka-Grabias, Financial engineering

Speculation with futures contracts on WIBOR

Yield curve
The yield curve is a graphical illustration of interest rates in
different periods of time. In practice it can be either positive or negative.
In theory it can also have other shapes.

Fig. 1. Positive yield curve

Interest rate

Maturity

Fig. 2. Negative yield curve

Interest rate

Maturity

Chart 1. Spread between WIBOR 6M and 3M in 2001-2004.

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Dr hab. Izabela Pruchnicka-Grabias, Financial engineering

Spread 6M-3M

0,5

2/ 6/ 4/ 0/ 4/ 0/ 7/ 7/ 0/ 0/ 2/ 7/ 8/ 8/ 4/ 1/ 6/ 9/ 3/ 1/ 5/ 1/ 7/ 1/ 5/ 1/
/0 /2 /2 /2 /1 /1 /0 /0 /1 /1 /0 /2 /2 /2 /2 /2 /1 /0 /0 /3 /2 /2 /1 /1 /0 /0
01 02 04 06 08 10 12 02 04 06 08 09 11 01 03 05 07 09 11 12 02 04 06 08 10 12
-0,5

-1

-1,5

Example 1
On 19 May 2003 the market expects that at the end of the year there will
be an increase in interest rates with the change of the shape of the yield
curve from a negative to a positive. On that day interest rates were the
following:
1M WIBOR = 5,7%
3M WIBOR = 5,51%
6M WIBOR = 5,28%
1Y WIBOR = 5,04%

On the basis of the above given interest rates, one can calculate the
theoretical value of futures contracts on interest rates:
1M WIBOR = 94,3 points
The value of the futures contract on 3M WIBOR =
The value of the futures contract on 6M WIBOR =
1Y WIBOR = 94,96 points

The above presented situation can be used by applying futures contracts

on WIBOR 3M and 6M. If analysts’ forecasts are true and interest rates
will really increase and the yield curve will change its shape, it means
that WIBOR 6M will grow more than WIBOR 3M. It
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Dr hab. Izabela Pruchnicka-Grabias, Financial engineering

is necessary to sell one futures contract on WIBOR 3M and to buy one

futures contract on WIBOR 6M.

The market behaved as it was expected and on 30 December 2003

interest rates were equal:
1M WIBOR = 5,39%
3M WIBOR = 5,6%
6M WIBOR = 5,68%
1Y WIBOR = 5,79%

Values of futures contracts were equal:

Value of futures contract on 1M WIBOR =
Value of futures contract on 3M WIBOR =
Value of futures contract on 6M WIBOR =
Value of futures contract on 1Y WIBOR =

The total result on the speculator’s activity:

Example 2
On 30 June 2004 the market expects that during the next 6-7 months
there will be an increase in interest rates with the change of the shape of
the yield curve from a positive to a negative. On that day interest rates
were the following:
1M WIBOR = 5,75%
3M WIBOR = 6,05%
6M WIBOR = 6,41%
1Y WIBOR = 6,91%

On the basis of the above given interest rates, one can calculate the
theoretical value of futures contracts on interest rates:
Value of futures contract on 1M WIBOR =
Value of futures contract on 3M WIBOR =
Value of futures contract on 6M WIBOR =
Value of futures contract on 1Y WIBOR =

The above presented situation can be used by applying futures contracts

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Dr hab. Izabela Pruchnicka-Grabias, Financial engineering

on WIBOR 3M and 6M. If analysts’ forecasts are true and

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

interest rates will really increase and the yield curve will change its shape,
it means that WIBOR 3M will grow more than WIBOR 6M. It is necessary
to buy one futures contract on WIBOR 3M and to sell onefutures contract
on WIBOR 6M.

The market behaved as it was expected and on 30 December 2004 interest

rates were equal:
1M WIBOR = 6,66%
3M WIBOR = 6,65%
6M WIBOR = 6,64%
1Y WIBOR = 6,56%

Values of futures contracts were equal: Value

of futures contract on 1M WIBOR =
Value of futures contract on 3M WIBOR =
Value of futures contract on 6M WIBOR =
Value of futures contract on 1Y WIBOR =

The total result on the speculator’s activity:

Option
s

Option is the right to buy or sell the specified amount of an underlying

asset at the specified time at the specified price.

Options are derivatives which can be used both in risk mitigation and
for making profits.

There are two types of options: a call and a put option.

A call option is a financial instrument that gives its owner the right to
purchase an underlying good at a specified price for a specified time
whereas a put option is a financial instrument that gives its owner the
right to sell the underlying good at a specified price for a specified time.

European and American options.

Options can also be applied in hedging. Then they are treated as

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Prof. Izabela Pruchnicka-Grabias, Financial engineering course

insurance policies.

Risk strictly connected with financial options is called market risk. It

is the uncertainty of future quotations on the cash market which
influence option prices.

Investments in derivatives are liable to the so called financial leverage.

It means that big changes in options rate of returns are made while the
underlying asset market does not fluctuate as much as that. It gives the
possibility of generating high profits in comparison with the capital
invested which is only the option premium. However, the financial
leverage can also result in loses of 100% of the capitalinvested, i.e.
premiums paid for purchased options.

There is also another type of risk linked to options, i.e. liquidity risk.
It is one of the most important types of risk on the Polish derivatives
market. It is defined as how quickly one can sell a derivative one
possesses. In other words, it is the situation when an investor can not

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

find a partner to conduct a transaction at a suitable price. The higher is

volume for an instrument the lower liquidity risk is.

Furthermore, general macroeconomic risk is the possibility of sudden

moves in prices on the spot market as a result of important changes in
the economic situation in a country, which results in big fluctuations on
the derivatives market.

Speculative risk can also influence underlying asset market quotations

and thus derivatives prices. It is important especially when options
markets are not very liquid.

Generally, options risk can be divided to systematic and

unsystematic.

Systematic risk regards market as a whole and it can not be

eliminated by a single investor.

Unsystematic risk can be reduced thanks to the portfolio

diversification, i.e. by purchasing instruments having negative
correlation. These can be two options: a call one and a put one.

Options can be traded both on regular exchanges, such as for instance

Chicago Board Options Exchange (CBOE) or American Stock
Exchange (AMEX), and over-the-counter markets.

The investor’s income derived from an option can be written as:

I = Max(P- S, 0) for a long position in a call option

and
I = Max(S- P, 0) for a long position in a put option

Where:
I – investor’s income
P – underlying asset price
S – strike price

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Prof. Izabela Pruchnicka-Grabias, Financial engineering course

Basic types of options on the grounds of the underlying asset price

are:
• Stock options,
• Index options,
• Interest rate options,
• Currency options.

In practice, options can be issued on any financial or non-financial

instrument. It can even be the weather temperature.

Relation between the Call option Put option

underlying asset price
and the exercise price
X>S Out-of-the-money In-the-money
X=S At-the-money At-the-money
X<S In-the-money Out-of-the-money

No matter what the option’s type is, option’s price is determined by

the following factors:
• Market price of the underlying instrument,
• Exercise price,
• Time to maturity,
• Volatility of the underlying asset price,
• Interest rate,
• Dividend expected in the time of option’s life; however it is
important for stock options only.

The above mentioned factors influence the option’s price and its
value. However, relations are different for a call and a put option.

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

Factors influencing the value of an option

Parameters Type of a contract
Call Put
Underlying asset ↑ ↓
value
Exercise price ↓ ↑
Risk-free foreign ↓ ↑
interest rate (for
currency options)
Risk-free domestic ↑ ↓
interest rate
Volatility of the ↑ ↑
underlying asset
Time to maturity (for ↑ ↑
American options)
Dividend yield (for ↓ ↑
stock options)

Example 1
We assume that the investor buys either a call option or a put option.
Other details concerning these instruments are specified beneath:
Days until expiration = 30
Standard deviation per year = 0,17
Annualized Risk Free Rate = 0,07
Annualized Dividend Rate = 0
Exercise price = 20
Position in shares = 10
Table 1 depicts total portfolio value.

Table 1. Total portfolio value for a call and a put option with the same
strike prices.
Output data Call option Put option
Share price 5 10 20 30 35 5 10 20 30 35
Current 0 0 0,4 10,1 15,1 14,8 9,89 0,3 0 0
option 5 1 1 9 3

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

price
Price at 0 0 0 10,0 15,0 15,0 10,0 0 0 0
expiration 0 0 0 0
Current 0 0 4,4 101, 151, 148, 98,8 3,3 0 0
total 8 15 15 85 5 3
portfolio
value
Total
portfolio 0 0 0 100, 150, 150, 100, 0 0 0
value at 00 00 00 00
expiration

When share prices go down below the strike price, a call option is worth
nothing, if share prices move up above the strike price, a put option’s
value is zero. Therefore, if the investor buys one option only, in some
cases total portfolio value is zero (for a call option – when the cash
market falls below the strike price and for a put option – if it grows over
the strike price).

Greek measures definitions

It should be emphasized that the Greek parameters show only the
result of changing just one input data. In fact, if a few factors change,
a different measure must be calculated for each of them. The Greeks are
defined in the beneath explained way.

Delta measures the sensitivity of the option’s price to changing stock

prices. For example, if delta=0,798, it means that if the share price
increases or decreases by 1 currency unit, the option price change will
be equal to 0,798.

P
Delta =
S

Gamma of an option is a measure of how much the delta value

changes with changes in the underlying price. For instance, if

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Prof. Izabela Pruchnicka-Grabias, Financial engineering course

gamma=0,07543, it means that if the share price increases or

decreases by 1 currency unit, delta will change by 0,07543.

delta
Gamma =
S

Theta measures the change in the option price when there is a decrease
in the time to maturity of 1 day. If theta= -5,137, it means that after one
day, which is about 0,27% of a year, the option theoretical value will
change by 0,014 [(0,27%-5,137) : 100].

P
Theta =
T

Rho shows the option price change when the risk free interest rate
increases or decreases. If the risk free interest rate changes by 100 basic
points and rho=8,255, the option price will change by 0,082 currency
rates (0,01 8,255).

P
Rho =
r

Vega measures how fast an option price changes with the volatility of
an underlying asset. Mathematically, an option’s vega is the first-order
partial derivative of the option price with respect to the volatility of its
underlying asset. If vega=5,804 and the volatility changes by 1%, the
option price will change by 0,0584 (0,01 5,804).

P
Vega =
V

where:
∆ – rate of increase
P – price of the option
T – time to maturity
r – risk-free interest rate
V – volatility of the underlying instrument

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

Options theoretical price

Theoretical value for a European call or put option can be computed
using the Black-Scholes model (for companies that do not pay
dividends):
C = SN(d1) – X e- rT N(d2)
P = Xe- rT N(-d2) – SN(-d1)

where:
S  2 )T
ln( ) + (r +
d1 = X 2
 T
S
) + (r −  )T
2
ln(

 T
d2 = = d1 −  T

where:

c – value of a call option

p – value of a put option S
– underlying asset price
 - volatility of the underlying instrument
X - exercise price
r - risk free interest rate
T - time to expiration given in years
ln – natural logarithm function
e - the base of the natural log function = 2, 71
N (d) – the probability that a random draw from a standard normal
distribution will be lower than d

Example 1
Value the European call and put option on stocks of the company which
does not pay any dividend, assuming that the volatility ofstocks is 20%,
current underlying asset value is 40 zł, short-term risk- free interest rate
is 6%. The option strike price is 35zł, and time to maturity is 6 months.

……………………………………..

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Prof. Izabela Pruchnicka-Grabias, Financial engineering course

Example 2
Let’s assume the dividend yield of 5%.

………………………………………..

………………………………………..

For a company which pays dividends: (Merton)

C = Se − (T −t) N(d 1 ) − Xe−r(T −t) N(d 2)
P = – Se − (T −t) N(−d1 ) + Xe−r(T −t) N(−d 2)

where:

S
) + (r −  +  )(T − t)
2
ln(

d1 = X 2 = d2 +   − t
 (T − t)
S 2

ln( ) + (r −  − )(T − t)
d2 = X 2
 (T − t)

δ – dividend yield

Garman-Kohlhagen formula for currency options

C = Se − (T −t) N(d 1 ) − Xe−r(T −t) N(d 2)
P = – Se − (T −t) N(−d1 ) + Xe−r(T −t) N(−d 2)

where:

S
) + (r −  +  )(T − t)
2
ln(

d1 = X 2 = d2 +   − t
 (T − t)
S 2
ln( ) + (r −  − )(T − t)
d2 = X 2
 (T − t)
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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

δ – foreign risk-free interest rate

Some of the important assumptions underlying the formula are the

following:
• the stock will pay no dividends until after the option expiration
date,
• the arbitrage is not possible,
• the distribution of stock prices return is lognormal
• the trade on the market is continuous and the stock price is
described by the continuous diffusion process
• both the interest rate and variance (volatility) rate of the stock are
constant (or in slightly more general versions of the formula, both
are known functions of time – any changes are perfectly
predictable),
• short term interest rates are constant during option life. Besides
market participants can make investments at the same interest
rate,
• stocks can be divided endlessly,
• transaction costs and taxes are not taken into consideration,
• short sale is possible,
• stock prices are continuous, meaning that sudden extreme jumps
such as those in the aftermath of an announcement of a takeover
attempt are ruled out.

Those who have short positions in options must hedge them. In order to
do so, they are obliged to monitor Greek letters values in order to
modify the portfolios that hedge options. However, Greek letters are not
fixed during the time of option’s life. Their value changes each time
when for instance the underlying asset price fluctuates.

Options strategies

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

Long straddle = call plus put (one exercise price)

Income

Underlying asset price

0

Short straddle
Income

Underlying asset price

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 Prof. Izabela Pruchnicka-Grabias, Financial engineering course

Long strangle = call plus put (two exercise prices)

Income

0 X1 X2 Underlying asset price

Short strangle
Dochód

Cena instrumentu bazowego

0
X1 X2

Long strip = one call plus two put

Income

Underlying asset price

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 Financial engineering course, prof. Izabela Pruchnicka-Grabias

Long strap = two call plus one put

Income

Underlying asset price

SWAPS

They are used to manage and hedge interest rate risk and exposure,
while market makers will also take positions in swaps that reflect their
view on the direction of interest rates.

1) Interest rate Swap (IRS)

2) Currency Interest Rate Swap (CIRS)

An interest rate swap is an agreement between two counterparties to

make periodic interest payments to one another during the life of the
swap, on a pre-determined set of dates, based on a notional principal
amount.

A. Hedging a portfolio by Bank ABC against interest rates

fluctuations

Figure 1. Interest rate swap between two parties

10 mld zł

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Financial engineering course, prof. Izabela Pruchnicka-Grabias

1Y WIBOR+1%
BANK BANK

ABC DEF
6%

• Interest rate Swap

Two parties, A and B, want to take credits. There is a possibility of

taking a credit on a fixed or variable interest rate. They were offered the
following credit interest rates:

A – 11,2% or LIBOR+1%
B – 10,2% or LIBOR+0,5%.

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Financial engineering course, prof. Izabela Pruchnicka-Grabias

Let’s assume that the A party prefers a fixed interest rate, whereas the
B party a variable interest rate.

In order to take advantage of pluses offered by the swap transaction,

they behave reversely, that is the A party takes a credit at a variable
interest rate and the B party takes a credit at a fixed interest rate. The
amount of the credit is the same for each party. Next, both parties come
into the interest-rate swap with a swap dealer F.

The parties will swap their interest rates into the ones that they preferred
(fixed into variable and reversely) and at the same time they will
decrease the cost of their credits.

Please fill in the data on the beneath chart.

A F B

Please calculate the profit of each party.

• Currency Swap

Two parties, A and B, want to take credits denominated in different

currencies. There is a possibility of taking a credit on a fixed orvariable
interest rate. They were offered the following interest rates:

A – EURO 9% lub USD (LIBOR+0,5%)

B – EURO 10% lub USD (LIBOR+0,5%)

Let’s assume that the A party prefers a dollar credit at a variable

interest rate, whereas the B party a euro credit at a fixed interest rate.

In order to take advantage of pluses offered by the swap transaction,

they behave reversely, that is the A party takes a credit denominated in
euro at a fixed interest rate and the B party takes a credit

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Financial engineering course, prof. Izabela Pruchnicka-Grabias

denominated in dollars at a variable interest rate. The amount of the

credit is the same for each party. Next, both parties come into the
interest-rate swap with a swap dealer F.

Please fill in the data on the second chart.

B
EURO EURO

EURO
A F USD

USD USD

A F B

EURO EURO EURO

A
F B
USD USD USD

What is the profit of each party?

Please fill in the beneath table with words profit or loss in each space.

Profit/loss profile of a swap position

Fall in rates Rise in rates
Fixed-rate payer
Floating-rate payer

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Financial engineering course, prof. Izabela Pruchnicka-Grabias

Swaps valuation

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Financial engineering course, prof. Izabela Pruchnicka-Grabias

Interest rate swap valuation

To value a swap one assumes that there is no risk of not fulfilling the
terms of the contract by its parties. Such assumption lets value a swap
as a long position in one bond and a short position in another bond at
the same time or as a portfolio of two forward contracts.

Taking into consideration the rules of valuating swaps on the basis of

bonds, the swap is worth:

V = W1 – W2
n

W1 =  Ke
−ri ti
+ Xe −rntn
i=1

W2 = Xe-r1×t1+K1e-r1×t1
Where:
V – the swap contract value
W1 – the fixed interest rate bond value (the bond is similar to the swap
contract being estimated)
W2 – the floating interest rate bond value (the bond is similar to the
swap contract being estimated)
K – the amount of the fixed payment to be paid at periods ti
K1 – the amount resulting from the earlier known interest rate to be
paid at the time t1
ri – discount interest rate which is equal to the time that is left until t i (in
practice it is a variable interest rate received on the basis of
quotation table)
rn – discount interest rate at the time n
ti – periods of fixed payments (1  i  n )
tn – the last period of a fixed payment
X – nominal value of a swap contract
t1 – the time until the next coupon payment

The above presented formulas are true on the assumption that,

according to the swap contract conditions, the financial institution
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 Financial engineering course, prof. Izabela Pruchnicka-Grabias

receives fixed payments equal to K zł at periods ti (1  i  n ) and at the

same time pays amounts calculated on the basis of a variable interest
rate.

Example 1
Let’s consider a swap contract where one party obliges to pay a six-
month interest rate LIBOR in return for the interest rate equal to 10%
annually (continuous capitalization of interest rate). The nominal value
of the contract is equal to 50 mln PLN, time until the end of its life is
1,25 year, fixed interest rates for a steady capitalization for 3, 9 and 15
months are 12%, 12,5% and 13%. A six-month LIBOR for the last
payment was equal to 12,2%.

The fixed paymentPLN

50mlnx0.1x0.5=2.5mln is:
………………………………

The floating paymentPLN

50mlnx0.122x0.5=3.1mln is:
………………………….

W1 = ……………………………….
W2 = ……………………………….
V = …………………………………

On the basis of forward contracts prices, the value of a swap contract

for the party that receives fixed and pays variable interest rate is:

V = (K – K1)e-r1×t1 +  (K − 0,5  ST
i=2
i  X )e −ri ti

ri  ti − ri−1  ti−1
STi = ti − ti−1 i = 2,...,n

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 Financial engineering course, prof. Izabela Pruchnicka-Grabias

Where:
STi – forward interest rate for an i period

STi is given for an annual continuous capitalization. If a swap has

capitalization m times during the year, it is necessary to re-estimate STi
according to the formula:
ST * = m×(eST /m – 1)
i i

Example 1a for students

Let’s consider a swap contract where one party obliges to pay a six-
month interest rate LIBOR in return for the interest rate equal to 3%
annually (continuous capitalization of interest rate). The nominal value
of the contract is equal to 35 mln PLN, time until the end of its life is
1,25 year, fixed interest rates for a steady capitalization for 3, 9 and 15
months are 6%, 6,5% and 7%. A six-month LIBOR for the last payment
was equal to 6,8%.

Example 3
Using data from the example 1, calculate the value of the swap contract
applying the method based on prices of forward contracts.

ST2 = ……………………………

ST3 = ……………………………
ST * = …………………………….
ST2* = …………………………..
3
V = ………………………………

Currency swap valuation

While valuating currency swaps, the same assumptions are taken as
for interest rate swaps. Provided that there is no risk of not fulfilling the
terms of the contract, the swap is valued as a position taken in two
bonds. The value of a currency swap is counted on the basis of the
following formula:

V = S×W1– W2*

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 Financial engineering course, prof. Izabela Pruchnicka-Grabias

Where:
S – cash exchange rate counted as the amount of domestic currency
units per one unit of foreign currency
W2 – the value of bonds denominated in dollars, the formula is
*

identical as in the case of W1

W1 – defined as earlier; the value of a bond (expressed in a foreign
currency) which is a base of a swap and is denominated in
currency different from dollars

The above quoted formula is correct for the investor who takes a long
position in bonds denominated in a foreign currency and a short position
in dollar bonds. Thus V is true for the party which pays the interest rate
in dollars. For another party of the contract the value is the same but
with the opposite sign.

Example 3
Let’s assume that we are to value the following currency swap contract.
The annual interest rate in Germany is 6% and in the USA 11%
(continuous capitalization for both interest rates is assumed).

One company takes a position in a swap contract. It will receive 7%

on the nominal value given in a contract and it will pay 10% on the
nominal value expressed in dollars.

The nominal value fixed in a contract is equal to 1 million dollars and

0,9 million euro. The parties agreed that the swap contract lasts for three
years. The present currency rate is 2 euro per dollar.

W2* = ………………………………..
W1 = …………………………………..
V = …………………………………..

To sum up the example 3, it is enough to count the discounted cash

inflows received in a currency of another country. Next, the two
numbers should be expressed in one currency (for example in dollars as
in the example) and one should count the difference between the two
amounts.
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Financial engineering course, prof. Izabela Pruchnicka-Grabias

Sources:
K. Jajuga, Inwestycje, PWN, Warsaw 2001.
W. Tarczyński, Inżynieria finansowa, Placet.

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