Financial Engineering & Risk Management

MFIM 7111

Tamirat T.(PhD)
May 5, 2025
Addis Ababa University
School of Comerce

1
Table of Contents
Introduction to Fixed Income Derivatives
Basic of Fixed Income Securities
Bonds
Term structure of interest rates
Floating interest rates
Forward contract
Swaps
Basics of Futures Contracts
Futures Prices

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Introduction to Fixed Income
Derivatives
 Introduction to Fixed Income Derivatives
Interest

Interest

Definition 1
An amount A invested for n period at a simple interest rate of r
per period is worth A(1 + nr) at maturity
Definition 2
An amount A invested for n periods at a compound interest rate of
r per period is worth A(1 + r)n at maturity.

Interest rates are typically quoted on annual basis, even if the

compounding period is less than 1 year.

• n compounding periods in each year

• rate of interest r
• A invested for y years yields A(1 + nr )yn
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Introduction to Fixed Income Derivatives
Interest

Definition 3
Continuous compounding corresponds to the situation where the
length of the compounding period goes to zero. Therefore, an
amount A invested for y years is worth lim A(1 + nr )yn = Aery at
n→∞
maturity.

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 Introduction to Fixed Income Derivatives
Interest

Future value of a stream

Given a cash flow stream (c0 , c1 , . . . , cn ) and interest rate r each

period, the future value of the stream is

F V = c0 (1 + r)n + c1 (1 + r)n−1 + · · · + cn
n
X
= ck (1 + r)n−k .
k=0

Example 4
Consider a cash flow stream (−2, 1, 1, 1, 1) when the periods are
years and the interest rate is 10%. The future value is

F V = −2 × (1.1)4 + 1 × (1.1)3 + 1 × (1.1)2 + 1 × 1.1 + 1 = 1.713

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 Introduction to Fixed Income Derivatives
Interest

Present value of a stream

Price p of a contract that pays c = (c0 , c1 , c2 , . . . , cN )

• ck > 0 ≡ cash inflow, and ck < 0 ≡ cash outflow

Present Value (PV) assuming interest rate r per period

N
X ck
P V (c; r) = .
k=0
(1 + r)k

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Introduction to Fixed Income Derivatives
Interest

Frequent and Continuous Compounding

• Suppose that r is the nominal annual interest rate and

interest is compounded at m equally spaced periods per year.
Consider a stream (c0 , c1 , . . . , cn ).
n
X ck
PV = .
k=0
[1 + (r/m)]k

• If r is compounded continuously and cash flows occur at

times t0 , t1 , . . . , tn . We denote the cash flow at time tk by
c(tk ). In this case
n
c(tk )e−rtk .
X
PV =
k=0

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 Introduction to Fixed Income Derivatives
Interest

Effective Rate

• the simple interest rate that produces the same yield in one
year as compounded interest
• Thus if interest is compounded m times a year, then the
effective rate must satisfy the equation
r m
re = (1 + ) − 1.
m

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 Introduction to Fixed Income Derivatives
Interest

Internal Rate of Return(IRR)

• Let (c0 , c1 , c2 , . . . , cn ) be a cash flow stream. Then the IRR of

this stream is a number r satisfying the equation
c1 c2 cn
0 = c0 + + + ··· + . (1)
1 + r (1 + r)2 (1 + r)n

• The IRR is defined without reference to prevailing interest

rate. It is determined entirely by the cash flows of the stream.

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 Introduction to Fixed Income Derivatives
Interest

Internal Rate of Return(IRR) ... Cont’d

• The IRR can be used to rank alternative cash flow streams.

The higher the IRR, the more desirable the investment.
• A potential investment, or project, is presumably not worth
considering unless its IRR is greater than the prevailing
interest rate.
• If the IRR is greater than the prevailing interest rate, the
investment is considered better than what is available
externally in the financial market.

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 Introduction to Fixed Income Derivatives
Interest

Inflation

• an increase over time of the general level of prices of goods

and services, resulting in a decrease of purchasing power.
• governed by a compound interest formula.
• If rf is the inflation at annual rate and the price of an item is
A0 at current time, then the price after one year is
A0 (r + rf ), after two years A0 (1 + rf )2 , and so on.

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Introduction to Fixed Income Derivatives
Interest

Example 5
If rf = 25% per year. A 100 Birr price now will be
100(1 + 0.25)2 = 156.25 Birr after two years.

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 Introduction to Fixed Income Derivatives
Interest

Inflation-adjusted rate of return

• The combined effect of inflation and interest. Let r be a yearly

compounded rate of return on an investment. The actual
annual rate of return ra with inflation taken into account is
1+r r − rf
ra = −1=
1 + rf r + rf

For small rf , ra ≈ r − rf

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Introduction to Fixed Income Derivatives
Interest

• Let r be the annual interest rate for an investment paying Q

dollars in one months. Considering the inflation rate rf , the
current value of this payment is
1
A0 = Q
1 + i − if
r rf
where i = 12 , if = 12 .
• If a payment of Q two months form now would have time-1
value
(1 + i − if )−1 Q

and hence time-0 value of

A0 = (1 + i − if )−2 Q

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Introduction to Fixed Income Derivatives
Interest

In general if you are to receive a payment of Q in n months, then

the present value of this payment, taking monthly inflation into
account, is
A0 = (1 + i − if )−n Q

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 Introduction to Fixed Income Derivatives
Fixed income securities

Fixed income securities

• The market items are not real goods, instead are traded only
as pieces of paper or as entries in a computer database
• This items, in general are referred to as finical instruments.
• If there is a well-developed market for an instrument, so that
it can be traded freely and easily, then that instrument is
termed as a security.
• Fixed- income securities are financial instruments that are
traded in well-developed market and promise a fixed income
to the holder over a span of time.

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Introduction to Fixed Income Derivatives
Fixed income securities

Importance for investors:

• they define the market for money1 , and most investors

participate in this market
• important as additional comparison point when conducting
analyses on investment opportunities that are not traded in
markets
✓ firm’s, research projects, oil leases, and royalty rights.

1
it means that these securities play a crucial role in the broader financial
market by providing a benchmark or reference point for interest rates and yields.
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Introduction to Fixed Income Derivatives
Fixed income securities

Fixed invome securities “guarantee" a fixed cash flow. Are these

risk-free?

• Default risk
• Inflation risk
• Market risk

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 Introduction to Fixed Income Derivatives
Fixed income securities

Annuities

• An annuity is a contract that pays the holder(the annuitant)

money periodically, according to predetermined schedule of
formula, over period of time.
• Perpetuity: ck = A for all k ≥ 1
∞
X A A
p= k
=
k=1
(1 + r) r

• Annuity: ck = A for all k = 1, . . . , n

✓ Annuity = Perpetuity - Perpetuity
 starting 
in year n + 1
A 1 A A 1
✓ Price p = r − (1+r)n · r = r 1 − (1+r)n

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Introduction to Fixed Income Derivatives
Fixed income securities

• Examples: the payment sequences of:

✓ Social Security funds
✓ pensions
✓ car loans,
✓ credit card dept, and
✓ mortgages

• Assume interest at an annual rate r compounded m times per

year and that a deposit (withdrawal) is made at the end of
each compounding interval.
• The value An (the value immediately after the nth deposit(
withdrawal)) of the account at time n will be computed

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 Introduction to Fixed Income Derivatives
Fixed income securities

Deposits (sinking fund)

At the end of n periods, the future value of the simple ordinary

annuity (payments occur at the end of each period) with payment
P and m− periodic compounding at r per annum is:

(1 + i)n − 1 r
An = P , i := . (2)
i m
More generally, if a deposit of A0 is made at time 0, then the
time-n value of the account is
(1 + i)n − 1
An = A0 (1 + i)n + P ,
i

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 Introduction to Fixed Income Derivatives
Fixed income securities

Withdrawals

• Let A0 be the initial value of the account and let An denote

the value of the account immediately after the nth withdrawal.
• The value just before withdrawal is An−1 plus the interest
over that period.
• Show that
1 − (1 + i)n
An = (1 + i)n A0 + P (3)
i

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Introduction to Fixed Income Derivatives
Fixed income securities

• The initial deposit required to support exactly N withdrawals

of size P form say, a retirement account or trust fund is given
by
1 − (1 + i)−N
A0 = P (4)
i
• or solving for P ,
i
P = A0 (5)
1 − (1 + i)−N

which may be used, for example to calculate the mortgage

payment for a mortgage of size A0 .

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Introduction to Fixed Income Derivatives
Fixed income securities

• Substitute (5) into (3) we get

1 − (1 + i)n−N
An = A0 (6)
1 − (1 + i)−N

the time-n value of an annuity supporting exactly N

withdrawals.

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 Introduction to Fixed Income Derivatives
Fixed income securities

Application: Retirement

Retirement account:

• make monthly deposits of size P

• an annual rate r, compounded monthly
• After t years transfer the account to one that pays annual rate
of r′ compounded monthly.
• monthly withdrawals of size Q for s years, drawing down the
account to zero

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Introduction to Fixed Income Derivatives
Fixed income securities

• Final value of the first account is the initial of the second

(1 + i)12t − 1 1 − (1 + i′ )−12s r ′ r′
P =Q , i= , i :=
i i′ 12 12
(7)
• Solving for P we obtain the formula

i 1 − (1 + i′ )−12s
P = Q (8)
i′ (1 + i)12t − 1

• Taking into account that yearly inflation rf × 100%, one can

get
! !
P i(1 + if )12t 1 − (1 + if )12s (1 + i′ )−12s
= .
Q (1 + i)12t − 1 i′ − i − f

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 Introduction to Fixed Income Derivatives
Fixed income securities

Application: Amortization

• Suppose a home buyer takes out a mortgage in the amount

A0 for t years at annual rate r, compounded monthly.
• From the point of view of the mortgage company, the
monthly mortgage payments P constitute a withdrawal
annuity with “initial deposit" A0 and is given by
i r
P = A0 , i= , N = 12t
1 − (1 + i)−N 12
• The amount An still owed by the homeowner at the end of
month n is given by
1 − (1 + i)n−N
An = A0
1 − (1 + i)−N
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Introduction to Fixed Income Derivatives
Fixed income securities

• Let In (Interest) and Pn (Principal) be portions of nth

payment
In = iAn−1 and Pn = P − In

which implies,

1 − (1 + i)n−1−N (1 + i)n−1−N
In = iA0 and Pn = iA0
1 − (1 + i)−N 1 − (1 + i)−N

• The sequences (An ), (Pn ), and (In ) for what is called an

amortization schedule

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Introduction to Fixed Income Derivatives
Fixed income securities

• Note that
In 1 − (1 + i)n−1−N (1 + i)N +1
= n−1−N
= −1
Pn (1 + i) (1 + i)n

• The ratio decreases as n increases

• The maximum and minimum ration are given by
I1 IN
= (1 + i)N and =i
P1 PN
respectively.
• Demonstrate an example using software.

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Introduction to Fixed Income Derivatives
Bonds

Bonds

Features of bonds

• Face value F : usually 100 or 1000

• Coupon rate α: pays c = αF/2 every six months
• Maturity T : Date of the payment of the face value and the
last coupon
• Price P
• Quality rating : to characterize the nature of the risk, bonds
are rated by rating organizations.

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 Introduction to Fixed Income Derivatives
Bonds

Yield to maturity

• A bond’s yield is the interest rate implied by the payment

structure.
• Specifically, it is the interest rate at which the present value of
the stream of payment is exactly equal the current price.
• It is just the internal rate of return of the bond at the current
price.

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Introduction to Fixed Income Derivatives
Bonds

• Suppose that a bond with face value F makes m coupon

payments of C/m each year and there are n periods
remaining.
• The coupon payments sum to C within a year.

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Introduction to Fixed Income Derivatives
Bonds

• Suppose also that the current price of the bond is P . Then

the yield to maturity is the value of λ such that
n
X C/m F
P = λ k
+ λ n
k=1 (1 + m ) (1 + m )
or
F C 1
 
P = λ n
+ 1− , (9)
(1 + m ) λ [1 + (λ/m)]n
• This value of λ, the yield to maturity, is the interest rate
implied by the bond when interest is compounded m times
per year.

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Introduction to Fixed Income Derivatives
Bonds

Why do we rely on yields?

• they serve as a concise summary of essential bond attributes,

including face value, coupon rate, maturity date, and credit
quality.
• yields offer insights into bond quality; lower-quality bonds
typically command lower prices, resulting in higher yield to
maturity.
• yields are intimately connected to interest rate movements,
reflecting how bond prices respond to shifts in the broader
financial landscape.
• However, it’s important to note that while yields provide
valuable information, they are not exhaustive measures and
may not capture every aspect of a bond’s complexity.
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 Introduction to Fixed Income Derivatives
Term structure of interest rates

The Yield Curve

• Yield curve is a plot of yield versus maturity for bonds of

similar quality.
• The slop of the yield curve can predict future interest rate
changes and economic activity.
• There are three main yield curve shapes:
1. normal upward-sloping curve,
2. inverted downward-sloping curve, and
3. flat.

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Introduction to Fixed Income Derivatives
Term structure of interest rates

• The “normally shaped" yield curve increases monotonically

with maturity. It reflects the that long-term bonds are usually
less desirable than short-term bonds.
• For the inverted case, the yield curve decreases as maturity
increases. This tend to occur when short-term rates remain
near their previous levels.
• A flat yield curve reflects similar yields across all maturities,
implying an uncertain economic situation

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 Introduction to Fixed Income Derivatives
Term structure of interest rates

The Term structure

Interest rates depend on the term or duration of the loan. Why?

• Investors prefer their funds to be liquid rather than tied up.

• Investors have to be offered a higher rate to lock in funds for
a longer period.
• Other explanations: expectation of future rates, market
segmentation.

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 Introduction to Fixed Income Derivatives
Term structure of interest rates

Spot Rates

Spot rates are the basic interest rates defining the term structure.
Spot rates st = interest rate for a loan maturing in t years.
A
A in year t =⇒ P V =
(1 + st )t

(a) Yearly Under the yearly compounding convention, the spot

rate st is defined such that

(1 + st )t

is the factor by which a deposit held t years will grow.

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 Introduction to Fixed Income Derivatives
Term structure of interest rates

Spot Rates ... Cont’d

(b) m periods per year Under a convention of compounding m

periods per year, the spot rate st is defined so that
(1 + st /m)mt
is the corresponding factor.
(c) Continuous Under a continuous compounding convention,
the spot rate st is defined so that
e st t
is the corresponding growth factor.
Spot rates can, in theory, be measured by recording the yields of
zero-coupon bonds.
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 Introduction to Fixed Income Derivatives
Term structure of interest rates

Discount Factors and Present Value

Discount factors dt are factors by which future cash flows must be

multiplied to obtain an equivalent present value.

(a) Yearly For yearly compounding,

1
dk = .
(1 + sk )k
(b) m periods per year For compounding m periods per year,
1
dk = .
(1 + sk /m)mk
(c) Continuous For continuous compounding,

dt = e−st t .
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 Introduction to Fixed Income Derivatives
Term structure of interest rates

Discount Factors and Present Value ... Cont’d

• The discount factors transform future cash flows directly into

an equivalent present value.
• Hence given any cash flow stream (c0 , c1 , . . . , cn ), the present
value, relative to the prevailing spot rates, is

P V = c0 + d1 c1 + d2 c2 + · · · + dn cn .

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 Introduction to Fixed Income Derivatives
Term structure of interest rates

Forward rates

The forward rate between times u and v with u < v is denoted by

fuv . It is the interest rate quoted today for lending form year u to
v.

(a) Yearly For yearly compounding, the forward rates satisfy,

1
(1 + sv )v
 
v−u
v u (v−u)
(1+sv ) = (1+su ) (1 + fuv ) =⇒ fuv = −1
(1 + su )u

Hence,
1
(1 + sv )v
 
v−u
fuv = −1
(1 + su )u

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 Introduction to Fixed Income Derivatives
Term structure of interest rates

Forward rates ... Cont’d

(b) m periods per year For m period-per-year compounding, the

forward rates satisfy, for u < v,
(1 + sv /m)v = (1 + su /m)u (1 + fuv /m)(v−u) .
Hence,
(1 + sv /m)v 1/(v−v)
 
fuv = m −m
(1 + su /m)u
(c) Continuous For continuous compounding, the forward rates
fuv are derived for all u and v, with v > u, and
esv v = esu u efuv (v−u) .
Hence,
sv v − su u
fuv = .
v−u 43
 Introduction to Fixed Income Derivatives
Term structure of interest rates

Discount Factors

• The symbol dj,k or d(j, k) denotes the discount factor used to

discount cash received at time k back to an equivalent
amount of cash at time j.
• The normal, time zero, discount factors are
d1 = d0,1 , d2 = d0,2 , . . . , dn = d0,n = (1+s1n )n .
• The discount factors can be expressed in terms of the forward
rates as " #v−u
1
du,v =
1 + fu,v
• These factors satisfy the compounding rule
du,w = du,v dv,w
for u < v < w. 44
 Introduction to Fixed Income Derivatives
Term structure of interest rates

Short Rates

• Short rates are the forward rates spanning a single time

period. The short rate at time k is accordingly

rk = fk,k+1 .

• Relation between spot and forward rates

t−1
Y t−1
Y
(1 + st )t = (1 + fk,k+1 ) = (1 + rk ).
k=0 k=0

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 Introduction to Fixed Income Derivatives
Floating interest rates

Floating interest rates

• Interest rates are random quantities . . . they fluctuate with

time.
• Let rk denotes the per period interest rate over period
[k, k + 1)
✓ The exact value of rk becomes known only at time k
✓ 1-period loans issued in period k to be repaid in period k + 1
are charged rk

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 Introduction to Fixed Income Derivatives
Floating interest rates

Floating Rate Bond

• Cash flow of floating rate bond

✓ coupon payment at time k : rk−1 F
✓ face value at time n : F

• Goal: Compute the arbitrage-free price Pf of th floating rate

bond
• Split up the cash flows of floating rate bond into simpler cash
flow
✓ pk = Price of contract paying rk−1 F at time k
F
✓ P = price of Principal F at time n = (1+r)n
Pn
• Price of floating rate bond Pf = P + k=1 pk

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 Introduction to Fixed Income Derivatives
Floating interest rates

Price of contract that pays rk−1 F at time k

Goal: Construct a portfolio that has a deterministic cash flow.

• The price of a deterministic cash flow at time t = 0 is given

by the NPV
t=0 t=k−1 t=k
Buy contract −pk rk−1 F
k−1
Borrow α over [0, k − 1] α −α(1 + r0 )
Borrow α(1 + r0 )k−1 over [k − 1, k] α(1 + r0 )k−1 −α(1 + r0 )k−1 (1 + rk−1 )
Lend α from [0, k] −α α(1 + r0 )k

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Introduction to Fixed Income Derivatives
Floating interest rates

• Cash flow at time k

ck = rk−1 F − α(1 + r0 )k−1 (1 + rk−1 ) + α(1 + r0 )k

= (F − α(1 + r0 )k−1 )rk−1 + αr0 (1 + r0 )k−1

• In the last line the first part is random and the second part is
deterministic. Thus the random term becomes 0 if we set
F
α=
(1 + r0 )(k−1)

• Net cash flow is now deterministic

. . . ck = αr0 (1 + r0 )(k−1) = F r0

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 Introduction to Fixed Income Derivatives
Floating interest rates

Price of floating rate bond ... Cont’d

ck F r0
Price of the portfolio = pk − α + α = pk = (1+r)k
= (1+r)k
Recall that
n
F X
Pf = + pk
(1 + r0 )n t=1
n
F X F r0
= n
+
(1 + r0 ) t=1
(1 + r0 )k
n
F F r0 X 1
= +
(1 + r0 )n (1 + r0 ) t=1 (1 + r0 )k−1
F F r0 1 − (1+r1 0 )n
= + · 1
(1 + r0 )n (1 + r0 ) 1 − 1+r
0

=F
50
The price Pf of a floating rate bond is equal to its face value F
 Introduction to Fixed Income Derivatives
Forward contract

Forward contract

Definition 6
A forward contract gives the buyer the right, and also the
obligation, to purchase

• a specified amount of an asset

• at a specified time T
• at a specified price F0 (called the forward price set at time
t = 0)

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Introduction to Fixed Income Derivatives
Forward contract

Example 7
• Forward contract for delivery of a stock with maturity 6
months
• Forward contract for sale of gold with maturity 1 year
• Forward contract to buy $10m worth of Euros with maturity 3
months.
• Forward contract for delivery of 9− month T −Bill with
maturity 3 months.

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 Introduction to Fixed Income Derivatives
Forward contract

Setting the forward price F0

Goal: Set the forward price F0 for a forward contract at time t = 0

for 1 unit of an asset with
• asset price St at time t
• and maturity T
ft = value/price at time t of a long position in the forward contract
Value at time T : fT = (ST − F0 )
• long position in forward: must purchase the asset at price F0
• spot price of asset: ST
Forward price F0 is set so that time t = 0 value/price f0 is 0
Use no-arbitrage principle to set F0
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 Introduction to Fixed Income Derivatives
Forward contract

Forward price formula

Suppose:

• an asset can be stored at zero cost and also sold short.

• the current spot price (at t = 0) of the asset is S0 .
• The theoretical forward price F (for delivery at t = T ) is

S0
F0 =
d(0, T )

where d(0, T ) is the discount factor between 0 and T .

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 Introduction to Fixed Income Derivatives
Forward contract

No-arbitrage argument to set F0

At t = 0 Initial cost Final receipt

Short 1 unit −S0 0
S0
Lend $S0 S0 d(0,T )
Go long 1 forward 0 −F0
S0
Total 0 − F0
d(0,T )

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Introduction to Fixed Income Derivatives
Forward contract

The portfolio has a deterministic cash flow at time T and the

cost= 0. Therefore,
S0 S0
 
0= − F0 d(0, T ) =⇒ F0 =
d(0, T ) d(0, T )

If there is a constant interest rate r compounded continuously, the

forward rate formula becomes

F0 = S0 erT .

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 Introduction to Fixed Income Derivatives
Forward contract

Costs of Carry

• Holding a physical asset such as gold entails storage costs,

such as vault rental and insurance fees.
• Holding a security may, alternatively, entail negative costs,
representing dividend or coupon payments.
• These costs (or incomes) affect the theoretical forward price.
• Suppose an asset has a holding cost of c(k) per unit in period
k, and the asset can be sold short. Suppose the initial spot
price is S0 .
• Then the theoretical forward price is
M −1
S0 X c(k)
F0 = + , (10)
d(0, M ) k=0
d(k, M )

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Introduction to Fixed Income Derivatives
Forward contract

Example 8 (Sugar with storage cost)

The current price of sugar is 100 Birr per Kg. We wish to find the
forward price of sugar to be delivered in 5 months. The carrying
cost of sugar is 1 Birr per Kg per month, to be paid at the
beginning of the month, and the interest rate is constant at 9%
per annum.

The interest rate is 0.09/12 = 0.0075 per month. The reciprocal of

the 1-month discount rate (for any month) is 1.0075. Therefore

F0 = (1.0075)5 (100) + [(1.0075)5 + (1.0075)4

+ (1.0075)3 + (1.0075)2 + 1.0075](1) = 108.92 Birr

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 Introduction to Fixed Income Derivatives
Forward contract

The value of a forward

• Suppose a forward contract for delivery at time T in the

future has delivery price F0 and a current forward price Ft .
The value of the contract is

ft = (Ft − F0 )d(t, T ),

where d(t, T ) is the risk-free discount factor over the period

from t to T .

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 Introduction to Fixed Income Derivatives
Forward contract

Forward value ft for t > 0

Recall the value of a long forward position

• at time 0: f0 = 0
• at time T : fT = ST − F0

Pricing via the no-arbitrage arguments

At t Initial cost Final receipt

Long 1, Ft contract 0 ST − Ft
Short F0 contract ft F0 − ST
Total ft F0 − Ft

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Introduction to Fixed Income Derivatives
Forward contract

The present value of this portfolio is ft + (F0 − Ft )d(t, T ), and

this must be zero. Therefore

ft = (Ft − F0 )d(t, T )

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Introduction to Fixed Income Derivatives
Swaps

Swaps

Definition 9
Swaps are contracts that transform one kind of cash flow into
another.
Example 10
• Plain vanilla swap: one party swaps a series of variable
payments for a series of fixed-level payments.
• Commodity swaps : exchange floating price for a fixed price.
e.g. gold swaps, oil swaps- is an agreement to exchange one
cash flow stream for another.
• Currency swaps

Why swaps? : Change the nature of cash flows

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Introduction to Fixed Income Derivatives
Swaps

Example: swap might be motivated by the fact that party B has

loaned money to a third part C under floating rate terms; but party
B would rather have fixed payments. The swap with A effectively
transforms the floating rate stream to one with fixed payments.

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Introduction to Fixed Income Derivatives
Swaps

Example of a commodity swap: Consider an electric power

company that must purchase oil every month for its power
generation facility.

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Introduction to Fixed Income Derivatives
Swaps

Fixed payments
Power company Swap counterparty
Spot payment
equivalents
Real
Oil
spot payments

Spot oil market

Figure 1: The power company buys oil on the spot market every month.
The company arranges a swap with a counter-party(or swap dealer) to
exchange fixed payments for spot price payments. The net effect is that
the power company has eliminated the variability of its payments
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Introduction to Fixed Income Derivatives
Swaps

Value of a Commodity Swap

• party A receives spot price for N units of commodity each

period
• party A pays a fixed amount X per unit for N units
• the agreement is made for M periods,
• The net cash flow stream received by A is

N × (S1 − X, S2 − X, . . . , SM − X)

where Si denotes the spot price of the commodity at time t

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Introduction to Fixed Income Derivatives
Swaps

Value of a Commodity Swap ... Cont’d

Use the concept of forward market.

• At t = 0, the forward price of one unit of the commodity to
be received at time i is Fi =⇒ by discounting back to time 0
the current value of receiving Si at time i = d(0, i)Fi
• Applying this argument each period, we find that the total
value of the stream is
M
X
V = d(0, i)(Fi − X)N. (11)
i=1
• The value of the swap can be determined form the series of
forward price.
• Usually X is choosen to make the V = 0, so that the swap
represents an equal exchange. 67
 Introduction to Fixed Income Derivatives
Swaps

Pricing interest rate swaps

Consider a plain vanilla interest rate swap in which party A agrees

to make payments of a fixed r of interest on a notional principal N
while receiving floating-rate payments on the same notional
principal for M periods
• rt = floating (unknown) interest rate at time t
• Cash flows at time t = 1, . . . , M
✓ Company A (long) : receives N rt−1 and pays N r
✓ Company B (short) : receives N r and pays N rt−1
• The cash flow stream received by A
N × (r1 − r, r2 − r, . . . , rM − r)
(N r1 − N r, N r2 − N r, . . . , N rM − N r)
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Introduction to Fixed Income Derivatives
Swaps

Recall how we prove the valuation for floating rate bond. We apply
the concept here,

• The floating rate cash flow stream is exactly the same as that
generated by a floating-rate bond of principal N and maturity
M , except that no final principal payment is made. Hence
M
X
VA = N − d(0, M )N − N r d(0, i)
i=1
M
" #
X
= 1 − d(0, M ) − r d(0, i) N
i=1

• Set r so that VA = 0, i.e.

1 − d(0, M )
r = PM
i=1 d(0, i)

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 Introduction to Fixed Income Derivatives
Basics of Futures Contracts

Futures Contract

A futures contract is similar with forward contract with two

differences.
1. Future contracts are traded at an exchange rather than
over-the-counter(directly by the parties).
✓ An exchange helps define universal prices
✓ provides convenience and security because individuals do not
themselves need to find an appropriate coounterparty and need
not face the risk of counter-party default.
✓ Individual contracts are made with the exchange, the exchange
itself being the counter-party for both long and short traders.
2. Daily futures prices, denoted below by a sequence
F0 , F1 , . . . , FT , are determined daily in a process called “daily
settlement" or “marking to market."
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 Introduction to Fixed Income Derivatives
Basics of Futures Contracts

Margin account

- initial amount of cash (10% ot 20%) of the price required form

both buyer and the seller.
• If the nth daily difference Fn − Fn−1 is positive, this amount
is transferred from the seller’s to the buyer’s margin account.
If negative, then the amount Fn−1 − Fn is transferred form
the buyer’s to the seller’s account.
• Thus, throughout the life of the contract, the buyer receives
T
X
(Fn − Fn−1 ) = FT − F0 .
n=1
• If an account dips below a certain pre-established level, called
the maintenance level, then a margin call is made and the
owner must restore the value of the account. 71
Introduction to Fixed Income Derivatives
Basics of Futures Contracts

Table 1: Example: The maintenance level is assumed to be $700. A

margin call is made on day 2, resulting in a $400 increase in the long
account.

Day Futures Long Margin Short Margin

Prices Account Account
0 5500 1000 100
1 5300 800 1200
2 5100 600+400 1400
3 5200 1100 1300
4 5400 1300 1100
5 5500 1400 1000

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 Introduction to Fixed Income Derivatives
Futures Prices

Futures Prices

• In the futures contracts, there’s always one price linked to a

contract—the delivery price. This price is usually not the
same as the spot price of the actual asset, but there’s a
connection between them.
• As the contract nears its maturity date, these prices get closer
and closer, finally ending up at the same value.

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 Introduction to Fixed Income Derivatives
Futures Prices

Futures-forward equivalence

• Suppose that interest rates are known to follow expectations

dynamics. Then the theoretical futures and forward prices of
corresponding contracts are identical.
• Relation to Expected Spot Price: One may ask whether
the current futures price for delivery at time T is a good
estimate of the future spot price, i.e., whether F0 = E(ST )?
• If either of the following conditions were true:
1. F0 < E(ST )
2. F0 < E(ST )

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Introduction to Fixed Income Derivatives
Futures Prices

• From a speculator’s perspective, if the first condition is true,

they might take a long position in futures and then, at time T ,
purchase the commodity at F according to the contract and
sell the commodity at ST for an expected profit of E(ST ) − F .
• If the second condition were true, the investor could carry out
the reverse plan by taking a short position in futures.
• Therefore, speculators are likely to respond to any such
inequality.

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Introduction to Fixed Income Derivatives
Futures Prices

• From a hedger’s perspective, hedgers participate in futures

primarily to reduce the risks associated with commercial
operations, not to speculate on commodity prices.
• Hence, hedgers are unlikely to be significantly influenced by
minor discrepancies between F and E(ST ).

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Introduction to Fixed Income Derivatives
Futures Prices

Normal backwardation is the term used to describe a situation

where there are many more hedgers who are short in futures than
those who are long. In this scenario, to achieve market balance,
speculators must enter the market and take long positions. They
will do so only if they believe that F < E(ST ).
Contango is the term used when there are more hedgers who are
long in futures than those who are short. In this case, speculators
will take the corresponding short position only if they believe that
F > E(ST ).

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References
Hull, J. C. (2021). Options futures and other derivatives. Pearson
Education India.

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